A Proxy Adviser's Two Sides

By Dean Starkman
Washington Post Staff Writer
Monday, January 23, 2006

From a nondescript office park near the Shady Grove Metro stop, Institutional Shareholder Services Inc. runs a global operation with offices as far-flung as London and Manila.

ISS, the world's leading adviser to big shareholders on corporate elections, has a client roster of 1,600 institutions that together own $23 trillion worth of stocks -- about half the world's stock-market value. Nearly all pay for ISS's views on corporate elections, known as proxy votes.

Corporate chieftains routinely travel to Rockville to lobby for ISS support on controversial ballot proposals -- as did Hewlett-Packard Co. chief executive Carly Fiorina and dissident shareholder Walter B. Hewlett in 2002 when they faced off over the company's deal to buy Compaq Computer Corp. Last fall, News Corp. chairman and chief executive Rupert Murdoch took part in a lengthy conference call with ISS executives to explain why his company's new anti-takeover device was good for shareholders.

As an important shareholder watchdog of corporate behavior, ISS has long been criticized by corporate managers who take issue when ISS recommendations do not go their way. Many executives chafe at ISS's close scrutiny of their company's corporate governance.

But these days, ISS is taking criticism from all sides.

Academics, shareholder advocates and, lately, some clients are complaining that ISS compromised its role as chief arbiter of corporate behavior by tolerating its own conflict of interest.

The questions center on ISS's growing business of selling services to the same corporations it scrutinizes. For example, ISS ranks corporations according to how well they score on its corporate-governance test. But it also sells services that corporations use to improve those scores.

"If your governance is not getting a good grade, you go see them and they tell you how to get a good grade," said Ira M. Millstein, a securities lawyer and partner at New York's Weil, Gotshal & Manges LLP. "If that's not a conflict, I don't know what is."

In 2004, the head of Missouri's $8 billion public pension fund dropped ISS over concerns about corporate consulting fees, according to a series of letters exchanged in 2004 and obtained by The Washington Post. In the letters, Gary Findlay, executive director of the Missouri State Employees' Retirement System, said ISS couldn't provide enough assurance that its loyalty was solely with shareholders.

"I see no merit in further wasting your time or mine regarding this issue," Findlay wrote. "From this point forward, we will . . . engage an organization that at least has the appearance of undivided loyalty to . . . clients."

ISS spokeswoman Cheryl Gustitus said Findlay never spoke to ISS to learn about the company's safeguards against potential conflicts. Findlay declined to comment.

Other pension funds have come forward with concerns. Last year, the $69 billion Ohio Public Employees Retirement System chose a new rival, San Francisco-based Glass, Lewis & Co., over ISS and cited the Rockville company's corporate business as a key reason. "The thing that tipped us was [ISS's] actual or perceived conflicts due to the corporate consulting," said Cynthia Richson, the Ohio system's corporate governance officer.

In November, the board of the $34 billion Colorado Public Employees' Retirement Association terminated its contract with ISS after 16 years and hired Glass Lewis, noting in a statement that the San Francisco firm, among other things, "was free of any appearance of conflict."

ISS executives say the concerns are unwarranted. President and chief executive John M. Connolly said in an interview that the company has no conflicts and goes to great lengths to separate the sales of services to corporations from the researchers who issue recommendations. He said ISS does not consult but offers access to tools and research data to corporate clients.

"Everything we do is for the interests of institutional clients," Connolly said in an interview. "We are not here to grow at any cost." The services ISS sells help further the cause of shareholders by helping companies improve their governance, he said. The sales account for only 15 percent of ISS's revenue, he said.

Connolly said that despite 30 client defections, ISS had a 94 percent renewal rate by its customers last year and added 424 clients.

In some ways, the scrutiny of ISS is a result of its remarkable rise. Its roots date to the once-scruffy shareholder-rights movement of the late 1960s and early 1970s, when campus protesters pushed universities to justify investments in companies involved in nuclear power, weapons, and apartheid-ruled South Africa.

The corporate landscape at the time was dominated by imperial chief executives and rubber-stamp boards. Most institutional investors -- including pension funds, foundations and mutual funds -- either routinely sided with management in corporate votes or didn't vote at all. Shareholder activists were seen as gadflies or pie-in-the-sky economists.

ISS founder Robert A.G. Monks, a former money manager who once ran for the Republican nomination for U.S. Senate from Maine, said he was inspired to start the company in the late 1970s by a paper company polluting the Penobscot River. After a stint in the Reagan administration as head of the Labor Department's Pension and Welfare Benefits Administration, he founded ISS in 1985 to help shareholders exert more control over the companies they owned.

In 1988, Monks's former office at the Labor Department ruled that pension-fund managers who ignored proxy votes exposed themselves to legal risk. The edict -- the first in series of government mandates requiring money managers to pay closer attention to proxy votes -- boosted the fledgling proxy advisory business.

ISS took off in the mid-1990s after Canadian media giant Thomson Corp. bought the company and invested heavily in an electronic system to cast institutions' ballots. The ISS "agency voting" system collects ballots, marks them (with ISS recommendations, if the client chooses) and delivers them to vote-tabulation companies without money managers having to see them.

"That's where the explosion came from," said ISS's executive vice president, Patrick S. McGurn, who worked at an ISS rival before joining ISS in 1996.

ISS, meanwhile, rode the rise in the power of the institutional investor. In the 1980s and 1990s, tens of millions of Americans invested in stocks for the first time, mostly through pension plans and mutual funds. In 1985, institutional investors controlled 46 percent of a U.S. stock market worth $2.2 trillion; today institutions control 63 percent of a market worth $17 trillion, according to the Federal Reserve.

With institutions demanding a more systematic approach to proxy voting, ISS over the years drew up policies that defined good corporate governance. Its Corporate Governance Quotient, or CGQ, includes 63 features that all corporations should have, including some now considered commonplace: that boards include formal nominating and compensation committees, that boards be controlled by a majority of independent directors and that "independence" be strictly defined.

Corporations complained that ISS imposed a "politically correct" governance model that had little to do with whether the corporations made money for shareholders. "You have centralized decision-making about what governance should look like," said Gary Lutin, principal of New York investment bank Lutin & Co. and a longtime ISS critic. "Who anointed these guys?"

Activist shareholders applauded. ISS supporters say the company has played a major role in defending shareholder interests against the worst corporate abuses -- insider deals, anti-takeover devices, excessive pay and cronyism. "It does a serious job on behalf of its clients," said Damon A. Silvers, associate general counsel for the AFL-CIO, which supports shareholder initiatives. "It has been a target of a long history of unfair attacks by various people acting on behalf of the corporate community."

By the end of the 1990s, ISS was a Goliath. Its current clients include the $1.1 trillion Fidelity Investments and hundreds of smaller funds, including the $48 billion Virginia Retirement System.

ISS has 500 employees, including 290 researchers who prepare reports on 33,000 corporations worldwide, including 8,000 in the United States. A plaque listing clients covers a wall in the reception area of ISS's headquarters.

ISS recommendations have been credited for tipping some blockbuster corporate battles, including Hewlett-Packard's Compaq acquisition and a vote in 2004 that forced Michael D. Eisner to quit the chairman's post at Walt Disney Co. ISS also provides recommendations for votes at small and mid-size companies, and for social initiatives pushed by activist shareholders -- such as whether corporations should be forced to abide by the Kyoto Protocol on global warming (ISS says generally yes) or be asked to label genetically modified foods (ISS says no).

Shareholders and executives alike puzzle over the influence of ISS recommendations on shareholder votes. Susan E. Wolf, vice president at Schering-Plough Corp. and chairman of the Society of Corporate Secretaries and Governance Professionals, said some organization members think ISS controls a third or more of their shareholder votes. Millstein agreed, adding: "That's scary."

A 2002 study published in the academic journal Financial Management found that ISS recommendations unfavorable to management were associated with lower vote totals of 14 to 21 percent, depending on the question.

ISS executives play down the influence of their recommendations. "ISS doesn't control any percent of the vote," said Martha L. Carter, ISS's director of research. "It's our clients who do."

In an interview, Connolly acknowledged that 15 to 20 percent of ISS clients use a service that automatically votes according to ISS recommendations, although the clients can override it. He said such clients represent a small portion of any shareholder vote. He said most of ISS's biggest clients vote according to their own criteria, using ISS to research whether companies measure up.

In 2001, a group led by New York merchant bank Warburg Pincus LLP bought the company, made a series of acquisitions and revved up the corporate business.

The next year, ISS began a long-planned service that sells information to corporations on how to improve governance ratings. A corporation's CGQ is stamped on the front of ISS's reports to money managers. A low rating is considered embarrassing. ISS sells corporations access to a Web site that shows how changing certain governance policies -- for example, eliminating related-party deals -- would boost their CGQs. Companies can find out free what their CGQs are and what changes would boost their scores but must pay for the Web-based tool that calculates the value of each change. They can also buy comparative data on corporate peers.

Another corporate product allows companies to calculate whether stock-based executive compensation plans exceed ISS standards.

Some academics accused ISS of misusing its influence by creating a governance test and then selling the answers. "This starts to resemble the protection schemes of bullies," Jeffrey A. Sonnenfeld, a professor at the Yale School of Management, wrote in 2003.

And business groups said their members felt squeezed to buy ISS products out of fear of receiving unfavorable recommendations on crucial proxy votes. "The U.S. Chamber gets a number of calls from members who feel strong-armed," said David C. Chavern, vice president of the U.S. Chamber of Commerce.

Lately, some of ISS's clients have begun to object.

In one of his letters to ISS, Findlay, of the Missouri retirement system, compared ISS to the big accounting firms of a few years ago, which sold consulting services to corporations while at the same time auditing their books.

"I would have thought you might have reevaluated your business plan given the upheaval in the accounting community," Findlay wrote.

Last month, Millstein denounced ISS's business model at a conference celebrating ISS's 20th anniversary held at the Ronald Reagan Building and International Trade Center. "Anybody who can't see a conflict between consulting and standard-setting has trouble with their eyesight," Millstein said during a discussion with Connolly. "We who are on the other side are saying, 'How do they get away with this?' "

In the interview, Connolly said he had invited Millstein to the conference and was happy with the exchange of views. But he disagreed with the lawyer, a longtime advocate of better corporate governance who was legal adviser to the outside directors at General Motors Corp. in 1992 when they forced Chairman Robert C. Stempel to resign.

ISS executives noted that the company's corporate services sales division is physically separate from its shareholder research division, using separate office equipment and computer databases to prevent shareholder staffers from stumbling upon the names of corporate clients. Bonuses for those who provide research for institutional investors are calculated from a different pool than bonuses for those on the corporate sales side, Connolly said.

While Connolly acknowledged the failure of such "Chinese walls" in the accounting industry and on Wall Street, "we believe we've protected ourselves," he said.

He added that ISS, as a registered investment adviser, is regulated by the Securities and Exchange Commission, which he said has inspected its procedures and found no significant problems. In 2004, the SEC issued a legal ruling that said investment firms could rely on ISS and other proxy advisers if the firms properly checked out the advisers' conflict procedures. The agency, however, said it took "no position" on whether ISS's conflicts procedures were impartial.

ISS executives say that the heart of the company is good governance and that the cause is served both by its fee-based products and the amount of free governance resources for corporations that ISS provides. And some corporate executives, while not thrilled with the system, say they don't feel pressured to buy an ISS product to win its favor.

"I've never heard of a corporation that thought that paying for the consulting actually got them a better result," said Margaret M. Foran, senior vice president for corporate governance at Pfizer Inc. She said companies can improve their scores only by making changes, not by buying the ISS product.

The question keeps coming up.

Last month, at a meeting that included Connolly and McGurn, officials of a building-trades union accused ISS of retreating from full support of a union-backed shareholder measure that would make it easier to remove corporate directors, according to a source who spoke on the condition of anonymity because the meeting was supposed to be private. Union officials accused ISS representatives of compromising what had been a clear endorsement of the initiative, instead leaving open the possibility that ISS might approve corporate alternatives case by case.

"Are you going to charge for that?" asked Ed Durkin, director of corporate affairs for the United Brotherhood of Carpenters and Joiners of America, according to the source and later confirmed by Durkin.

McGurn, in an interview, said that the answer was an "unequivocal no" and that the company sells services for only matters, such as compensation plans and governance, that depend on written policies, not on the judgment of analysts. In any case, McGurn said, the union officials were mistaken. ISS had not changed its policy and would almost certainly back most of the unions' shareholder proposals, he said.

In an interview, Durkin said union officials "remain watchful" of ISS's stand on the question but are satisfied that "it isn't based on any consulting business that could raise conflicts."

"Is there a perception that there is a conflict?" Connolly said in an interview. "It sounds like there is. Can I assure you there is no conflict? Absolutely."