The criticism is nothing new for ISS, which has been involved in both these areas for some time. But as the firm becomes larger and expands into new areas, many in the governance industry - including some ISS clients - say it needs to be more open about its business and more attentive to concerns about conflicts.

The issue has gained new attention since ISS's recent merger with Investor Responsibility Research Center Inc., consolidating the two largest players to form an entity that dwarfs relatively new competitors Glass Lewis & Co. and Proxy Governance Inc. ISS has also been expanding its non-advisory services, adding an M&A Insight report and a Corporate Governance Quotient, or CGQ, index.

ISS, which says its consulting makes it a good-governance intermediary between management and shareholders, said its vote advisers aren't aware of who the company's corporate clients are. Its Web site notes, "to avoid accidental discovery of a corporate client, Corporate Services division uses segregated office equipment and information databases."

Millstein noted that the "Chinese Wall" explanation was also used by investment banks and auditors before regulators pried open a nest of conflicts.

While ISS says its vote advisers can't find out whom the corporate clients are, the firm's institutional clients can. ISS has a system by which institutional clients can ask for a list of corporate clients if they give ISS their portfolio list, said ISS spokeswoman Cheryl Gustitus.

The vote recommendations provided to those institutional clients are one of several issues raised by critics, who suggest that ISS doesn't reveal enough about the criteria for the recommendations, creating a "black box" that could allow it to vary its judgment from company to company.

"Who is the Wizard of Oz creating these standards behind the iron curtain?" said Millstein, who pounded his fist on the table and repeated, "Show me the Web site" to all of Connolly's responses. Connolly said that ISS is becoming more transparent and already has open "policy jams" that let institutional clients weigh in on detailed issues, like whether a company's burn rate and the use of cash versus stock should be considered when ISS evaluates the suitability of an executive compensation plan.

    M&A Insight Criticized

Investment banker Gary Lutin said that the new M&A Insight product - which provides analysis of mergers and proxy contests - enables ISS to provide its "insights" and "interactive" communications about its thinking in relation to contested situations before making a recommendation. "What they are doing with the M&A Insight product," he said, "is the equivalent of an influential newspaper selling its advertisers an opportunity to guide the editorial process." Lutin runs Lutin & Co. as well as Shareholder Forum - a shareholder issues monitor that does not compete with ISS.

Gustitus said the product doesn't offer any unfair advantage. She said M&A Insight consists of two parts - notes, which go out sporadically to subscribers as the merger situation evolves and use only publicly available information, and a final analysis, which goes out to all clients.

The company's CGQ product, also flagged by Millstein, has been improved recently in a way that answers concerns about the variability of the measures it uses to assign companies a governance score, said Gustitus. In the most recent version, 3.0, ISS has added a chart explaining how it weights variables such as director independence. She also said the CGQ tool is a "self-help" device and that there's no interaction with ISS whereby the adviser tells the company what to do. Gustitus adds that ISS's clients get fuller information about its weightings than the public does. "There are some things that are in a model, a proprietary model that can't be given away," she says.

Connolly has said that he would get out of the non-proxy advisory business immediately if he believed ISS's model was flawed. "Our clients today say they are happy, and they renew. Why would I put this business in danger?" Connolly said, noting that ISS is a registered investment adviser and subject to oversight by the Securities and Exchange Commission.

Indeed, two customers of ISS's proxy advisory services, speaking on condition of anonymity at the conference, said they don't have a problem with ISS's dual roles, and noted that they go over voting policies themselves anyway. While they consider ISS recommendations, the ultimate decision is with them, they say.

But at least one institutional client has voted with its feet against ISS's corporate services.

"It's an issue that's not going to go away," said Cynthia Richson, corporate governance officer of the Ohio Public Employees Retirement System, or OPERS. "It's short-sighted to act like this conflict of interest issue is not important to its clients."

OPERS has chosen competitor Glass Lewis to take over as its proxy advisor in 2006, according to Richson, specifically dismissing ISS as a result of the "actual or perceived conflicts." The pension fund had previously used a combination of services from IRRC and Glass Lewis.

Greg Taxin, CEO of Glass Lewis, said that "a number of former ISS clients have decided to use our services instead because of their concern about the conflict of interest question." Taxin refers to the IRRC merger, as well as a 2004 interpretive letter from the SEC that suggested the onus is on investment managers and pension funds to make sure that their proxy advisory doesn't have any conflicts, as possible reasons.

ISS sent a letter to institutional clients in September saying that it has had more detailed correspondence with the SEC on the issue. According to the letter, the SEC has reiterated its position that "the mere fact that a proxy firm provides corporate services and receives compensation from the issuer for these services would not affect the first's independence from the advisor for purposes of making voting recommendations."

Millstein suggested that ISS's problem was related to a broader trend at the organization to answer to a profit motive rather than a social one. He suggested ISS would be more credible if it was a not-for-profit, as IRRC was before the two merged.

"I believe we have different points of view on the issue of ISS as a business," Connolly responded. "Over the last 20 years this has gone from a lifestyle-oriented approach to an industry."

(Corporate Governance, published by Dow Jones Newsletters, covers company management, shareholder relations and the regulatory environment in which businesses operate.)

-By Tiffany Kary, Dow Jones Newsletters; 201-938-4292; Tiffany.Kary@dowjones.com