Changes in Australian proxy-advice regulation will not improve investor outcomes
Proxy advisers can be akin to the pebble in the shoe of a company, painful and difficult to ignore. Changes in regulation may prevent the pebble from lodging in the first place.
OPINION / Recent proxy-advice regulation changes rushed into law prior to the end of the Australian parliamentary year are raising eyebrows in the investor community. The concern is across three fronts: the way the laws were enacted; the policy motivations behind them; and the changes themselves. Treasurer Josh Frydenberg argues these reforms encourage transparency and greater accountability of proxy advisers.
In Morningstar’s view, these changes are flawed as they place undue pressure on a sector that has been effectively highlighting corporate issues, helping institutional clients identify weaknesses and mitigate risks, and ultimately improving investor outcomes.
Why Should Shareholders Care About These Reforms?
Proxy advisers serve an important role in the otherwise fragmented market of Australian corporate governance. They help to bring companies and shareholders together to resolve issues that companies might otherwise dismiss or ignore. Proxy advisers are typically engaged by large institutional shareholders to provide corporate governance advice about the companies they are invested in or considering investing in. In essence, proxy advisers provide professional advice that institutions consider when casting their votes on important issues at shareholder meetings. The institutional shareholders, not the proxy advisers, hold the voting power in this setting.
Because of Australia's compulsory superannuation contribution requirements, the largest institutional shareholders in Australia are superannuation funds. Most superannuation members are invested in diversified default options, which typically have an allocation to Australian equities. The treasurer's own media release notes that approximately 20% of the Australian equities market, or $510 billion, is owned by superannuation funds on behalf of their members. Proxy advisers are making recommendations on a large pool of money that is mandated to continue to grow every year.
MORE ON THIS TOPIC:Â Investing basics: proxy voting and why you should care
Superannuation members are ordinary Australian people, and their superannuation investments will one day fund their retirements. As the fiduciaries of these life savings, institutional shareholders have heavy responsibility for the long-term performance of these investment pools and therefore engage a range of professional services to provide expert advice to them. This can include but is not limited to accountants, auditors, asset consultants, lawyers, and proxy advisers. All advice feeds into their decisions and, in turn, benefits their members directly and indirectly. In relation to proxy advice specifically, retail shareholders simultaneously stand to benefit from improved corporate governance and improved company performance based on the active ownership efforts of large investment institutions.
What Are the Regulatory Changes?
The new regulation entails four main changes:
- Proxy advisers must have an Australian Financial Services Licence, or AFSL, to provide advice to Australian institutional shareholders from 7 February 2022.
- Proxy advisers must simultaneously (on the same day) share their corporate governance advice to institutional shareholder clients with the specific companies they are providing advice on.
- Proxy advisers must be independent of their institutional clients by 1 July 2022.
- From 1 July 2022, institutional shareholders must publish detailed data about their voting records at annual general meetings, including whether they received proxy advice and their voting position on each resolution.
Sound simple enough? Some context helps to paint a more fulsome picture. Take the AFSL requirement. The main proxy advisers operating in Australia already have AFSLs. However, that AFSL has, without notice, been revoked by operation of law. Proxy advisers have until 7 February 2022 to obtain a new one. The conditions on which the new AFSL will be granted are more onerous and far-reaching than those for the previous AFSL. If proxy advisers do not agree to those conditions, then they have no new licence and no business after 7 February.
In relation to the second change, in many cases, proxy advisors already provide advice to both the institutional clients and the companies they invest in - just not necessarily on the same day. So, the issue that the reforms are addressing is timing. However, note the sanctions attached to noncompliance: Civil penalties of $11.3 million and $1.3 million could be sought by Australian Securities & Investments Commission to proxy firms and individual advisors, respectively, who deliver their advice late.
What about independence of proxy advisers? The regulation's explanatory statement clarifies that the third change is designed to reduce the possibility of one client influencing how a proxy adviser’s other clients may vote. During the government’s public consultation process, none of the submissions called for independence obligations for proxy advisers.
This requirement may have several unintended consequences. Proxy advisers whose business models do not currently meet the independence requirements will need to either restructure the way they operate or disband. Those that exit the industry will likely move in-house. This is feasible, as many super funds already have in-house portions of their investments. Simultaneously undermining the proxyadviser business model and creating in-house demand for advice will have a multiplier effect, like wet Mogwai from the movie Gremlins. Instead of gremlins, picture swaths of internal advisers knocking on company doors, demanding answers; this would be far less efficient for the company and more costly for the superannuation funds. The additional costs will ultimately be borne by the superannuation members via higher fees. The loss of economies of scale will occur on both sides.
Finally, superannuation funds must publish more detailed information about their voting decisions. Of all the reforms, this is the least controversial: Most already do this, and Morningstar considers voting transparency to be an important aspect of investment institutions' accountability to beneficial investors.
What Has Been Achieved by These Changes?
The treasurer promised more transparency and accountability for proxy advisers. Do the reforms achieve this? In our view, these reforms appear to change little on the corporate governance front but have ramifications to the operation of the industry itself. There are four major proxy advisers operating in Australia: ISS; Glass Lewis; Australian Council of Superannuation Investors, or ACSI; and Ownership Matters. Due to ACSIs unique operating structure —their board is made up of a subsect of its members who are also their clients—ACSI will falter under these reforms unless it can find a new operating model that is legally compliant with its extended AFSL requirements. None to date have been put forward.
It is not only ACSI that is affected, though. The new regulation is broad and dictates who can and cannot be employed by any proxy adviser. If you have worked for a superannuation fund or fund manager, it could be difficult to satisfy independence requirements to enable you to work for a proxy-adviser firm. No justifications are given for these restrictions, saving ensuring independence. Ironically, no such restrictions apply to the employees of our public regulators and regulated entities, where shifting between public and private-sector employment occurs with some regularity.
The manner of the reforms' enactment adds to the sense of unease. They were not passed through parliament but rather as regulations to existing statutes. Proposals were not offered for public comment. No parliamentary oversight was possible, as the normal processes were sidestepped in favour of quick reform. The justifications provided—namely improved governance and accountability—stand in stark contrast to the reform process' own lack of transparency and accountability.
The requirement for improved governance seems to be inconsistently applied through regulatory reform. The changes to proxy advice swiftly followed the Government’s 11 November 2021 release of its Corporation Amendment (Portfolio Holdings Disclosure) Regulations 2021. The final version introduced superannuation fund disclosure regulations that were meaningfully watered down compared to draft versions released to the market, did little to improve the superannuation fund disclosures available to Australian investors and are materially below global best practice for portfolio holdings disclosures.
What Is This Reform Really About?
A comparison with proxy-advisor reforms in the United States is instructive in understanding the full extent of this reform. Whilst there are similarities in regulation changes in the U.S. and Australia such as the timeliness of sharing proxy advice between clients and the companies themselves and the management of conflicts of interest, Australia's changes go much further. Notably, the harsh civil penalties for delays in sharing information and the requirement for proxy advice independence are key differences. Does this provide a precedent for other countries to take a similar harder line to proxy voting?
These changes whether intentional or not, act as barriers, making it more difficult to operate a proxy advice business. This has implications for active ownership, which primarily entails proxy voting and engagement, growing in significance as an investment tool. It allows shareholders to lend their voices to issues that they believe must be addressed in order to secure long-term investment performance. It has therefore become a core component of sustainable investing, and it challenges the status quo.
To appreciate the power of active ownership, one only must look at activist and impact investor Engine No. 1 and its outsize impact on Exxon Mobil. Frustrated by Exxon’s climate policies and glacial speed of transition to a carbon neutral economy, Engine No. 1 recommended four independent board candidates to join Exxon’s board and lobbied large institutional shareholders to back its plan. Its campaign was incredibly successful, as three of its four candidates were elected. Although Engine No. 1 was a small shareholder, it cleverly leveraged shareholder activism to pack a large punch.
Even with this stunning success story that shows what might be possible, this type of action is out of the reach of most shareholders. The cost alone is prohibitive, with estimates of tens of millions spent on the campaign. One also needs to have the research expertise, the connections, and knowledge of the process to have a fighting chance of implementing change.
Activism can be time consuming: It requires undertaking research, engaging with companies, and providing insights and advice on various issues such as voting on director reappointments, executive remuneration, and topical issues such as climate change. It appears Engine No. 1 had these capabilities, vastly improving its odds of success. For those who don’t, proxy advisors can help.
What Impact Have Proxy Advisors Had in Australia?
Criticism of proxy advisors in Australia typically comes from the company director and corporate executive community, who believe that proxy advisors have too much power over proxy-voting outcomes at Australia’s largest companies. Proxy advisors hold companies to account, shining a light on issues they believe need improving. That can be an understandable point of friction for companies, but they have a role to play as part of an efficient financial system.
Improvements in board diversity for Australian-listed companies is one success story. Years of activism undertaken by proxy advisors and their clients resulted in all ASX200 companies having a least one female board member.
Other examples, such as engagement with Rio Tinto and AMP, demonstrate improved accountability and governance caused by proxy-adviser influence. Rio’s chair has stated that shareholder concerns led to the resignations of key executives after the demolition of the culturally significant Juukan Gorge caves heritage site. It is reasonable to conclude that, had shareholders remained silent on this issue, the minimal action Rio proposed (initially a reduction of corporate bonuses) would have been all that occurred.
AMP Capital’s appointment of Boe Pahari to CEO is another high-profile example of shareholder activism. Pahrai was appointed to the position of CEO even though he had been previously involved in a sexual harassment claim. Shareholder activism led to the resignation of AMP Group’s chair, AMP Capital’s chair, and Pahari himself, who stepped back into his previous position as global head of infrastructure equity. Months later, he resigned from the company altogether.
Proxy advisers can be akin to the pebble in the shoe of a company, painful and difficult to ignore. Changes in regulation may prevent the pebble from lodging in the first place. Skewing the balance of power in favour of companies, as these regulations seem to do, is not necessarily a positive outcome for shareholders. Changes have been brought in the name of improving governance, but it is hard to see how watering down proxy advisers' ability to operate will improve investor outcomes.
We would like to acknowledge and thank Helen Bird, senior lecturer, law, at Swinburne University for her contribution to this piece.
