Do Proxy Service Firms Have Too Much Power?

Bathtub BoardroomFor nearly a decade, proxy service firms have held powerful sway over many C-Suites and their boards, pushing recommendations and ratings to institutional shareholders and others.

Born of the last round of corporate scandals such as Enron, proxy service firms are now under fire in a new round of business failures, such as Bear Stearns and Lehman Brothers.
The small band of firms, numbering about a half a dozen, is being confronted with demands to create a code of ethics, avoid conflicts of interest, establish high level and independent advisory councils and help create a panel by the U.S. Securities & Exchange Commission to investigate how much power they have and whether they are properly monitored.

Such are the recommendations put forth in recently months by the Millstein Center for Corporate Governance at the Yale School of Management.

A separate study by the law and graduate business schools at Stanford University has raised serious questions about whether the ratings offered by some proxy service firms have much merit. "People have been selling these rankings but we found very weak numbers," report co-author Robert Daines told me in an interview. "In some cases, we found that they were worse than random numbers. In some cases, the numbers registered a bad decision but they may have had nothing to do with bad governance, added Daines, who is Pritzker Professor of Law at Stanford.
Indeed, at times, the proxy service firms have been dead wrong. Standard & Poor's Governance Service, for instance, gave Fannie Mae nearly top scores in 2003 in its ratings. Three years later, Fannie Mae executives were restating $6.3 billion in earnings and by then, S&P had dropped its ratings service. This summer, Fannie Mae was so battered that it was seeking federal protection.

Still, proxy service firms wield impressive power. Created out of the flotsam of the spectacular sinking of WorldCom and Enron nearly a decade ago, they influence thousands of companies with their ratings on corporate performance, recommendations on new board directors and executives, and support for shareholder resolutions backing everything from dumping 1980s-style poison pills to better reporting on global warming.

Instead of pushing back or even questioning the firms' recommendations, some boards simply throw in the towel and go along with whatever the service firms want just to placate shareholders, some critics believe.

Consequently, "corporate governance then becomes an end in itself," says Michael J. Ryan, Jr., a former U.S. Chamber of Commerce governance specialist who became president and chief operating officer of ProxyGovernance, a McLean, Va.-based proxy service firm in June. "You just check all of these boxes and it becomes an oversimplication of what's going on at your company," he says.

Another practice under attack is ranking companies and then selling them consulting services. Critics say that doing so is similar to what got accounting firms in great trouble during the Enron days forcing some consulting firms, such as KPMG to sell off their consulting arms. Firms that do offer rankings and consulting, such as RiskMetrics/Institutional Shareholder Services insist that they handle both businesses in an ethical and arms-length way.

Over the next three days, "The Corner Office" will be looking at the questions surrounding proxy service firms. Next: is selling ratings and consulting a conflict of interest?