The Proxy Advisory Racket: Life’s easier when the feds encourage people to buy your product.

August 20, 2013, 7:12 p.m. ET

Review & Outlook: The Proxy Advisory Racket

Life’s easier when the feds encourage people to buy your product.

Federal regulators helped create the financial crisis by requiring banks to follow the advice of private credit-rating agencies. When these private firms like Standard & Poor’s and Moody’s guessed wrong about the mortgage market, the error was repeated across the financial system. Now one Washington regulator is warning that the government is making a similar mistake about another category of private firms.In a speech last month that received far too little attention, Commissioner Daniel Gallagher of the Securities and Exchange Commission (SEC) discussed “the rise of proxy advisory firms.” These are companies that advise institutional investors how to vote in shareholder elections at public companies. There are only two significant players in this market: Institutional Shareholder Services (ISS) and Glass Lewis. And they have not exactly earned their powerful duopoly the old-fashioned way. They’ve received big assists from a 2003 SEC rule and subsequent letters from SEC staff.

The rule was intended to address potential conflicts of interest among the investment advisers who, for example, run mutual funds and often vote on behalf of the investors in these funds. As the votes might perhaps be influenced by other business relationships or investments maintained by the advisers, the SEC decided to encourage advisers to outsource these decisions.

In adopting its 2003 rule, the SEC said “an adviser could demonstrate that the vote was not a product of a conflict of interest if it voted client securities, in accordance with a pre-determined policy, based upon the recommendations of an independent third party.”

Mr. Gallagher says “this was akin to what the Commission had earlier done with credit rating agencies—essentially, mandating the use of third party opinions.” (See editorialnearby.) After the rule was written, so-called “no action” letters from SEC staff went even further to bless the use of proxy advisers, creating what some view as a legal safe harbor for fund managers who hire them.

While the original intent was to eliminate potential conflicts of interest among investment advisers, the SEC staff wasn’t much concerned about such conflicts among the proxy advisers. In one letter to a lawyer representing ISS, SEC staff opined that even if a proxy adviser was also providing consulting services to the same companies on whose shareholder elections they were opining, they could still serve as suitable proxy advisers.

And that’s exactly what ISS does. It sells consulting on corporate governance to public companies on one side of the house and on the other side opines on questions related to the governance of public companies.

ISS says it maintains a strict separation between the two parts of the business and that consulting clients do not get preferential treatment regarding ISS proxy recommendations. But this practice at ISS does have its critics, including former ISS President Nell Minow. Last year at the Journal’s CFO Network conference she called it “idiotic” to have proxy advisers providing governance consulting to the companies whose governance they rate.

Glass Lewis, for its part, does not offer consulting services and presents itself on its website as an “independent” firm. But a little lower on the same Web page the company acknowledges that it is an “indirect wholly-owned subsidiary of Ontario Teachers’ Pension Plan Board.”

It doesn’t take much imagination to conceive of situations in which the interests of a government-employees union pension fund might conflict with the goal of enhancing shareholder value at public corporations. But Glass Lewis says its owner has no role in setting its policies or determining voting recommendations and that the pension fund is not involved in “day-to-day management.”

The fact the proxy advisory firms have benefited greatly from SEC regulation while somehow also remaining free of SEC regulation has certainly raised eyebrows. And there’s an appetite at the SEC to conduct oversight of these firms that the commission has done so much to empower.

Conflicts of interest exist in many aspects of life and business, and the key is how they’re managed. But newspapers—which report on their advertisers—don’t benefit from a government purchase mandate, to pick one example. Proxy advisers get business steered their way by government.

Rather than regulate these firms, the better policy is to repeal the SEC rules and guidance that favor these firms. Let investors decide which fund managers they can trust to look out for their interests. And let fund managers decide which consultants deserve their business.