Authors: Suhana
Second year student at Hidayatullah National Law University, Raipur
I. Introduction
In the recent times, the rise of Proxy Advisory Firms ("PAF") is evident from the May, 2024 headline which highlighted the rejection by institutional investors of Nestle to raise the royalty of “Societe des Produits Nestle” from 4.5% per annum to 5.25% on the basis of advice given by the proxy advisory firm: Institutional Investor Advisory Services ("IIAS"). This serves as a demonstration of the substantial impact that PAFs exert over corporate governance. This also showcases the control PAFs have in laying down the procedures, policies and internal controls of a company’s operation and reflects its relation with all the stakeholders which include employees, government, customers and other industry entities.
II. Role of Proxy Advisory Firms in The Corporate Realm
With the increase in modern day corporate bodies and their worldwide alliances formed due to globalization, the patterns of shareholding and investing have undergone drastic changes. One such change is the crucial role played by institutional investors who have a good say in the decisions made by the companies to ensure that other shareholders do not face the brunt of the domination by majority shareholders. Such active participation by investors also requires investment in terms of time and knowledge in order to analyze every corporate event in detail and take appropriate action after calculating the pros and cons of the same which is quite burdensome in real business world. This gap is filled by the PAFs which act as intermediaries between shareholders and corporate boards giving research, analysis and recommendations to the former. Section 2(1)(p) of the Securities and Exchange Board (Research Analysts) Regulations, 2014 define proxy advisor as any person who offers suggestions and advice via any method to the shareholders or institutional investors of a company on matters related to their rights, public offers or voting recommendations on agenda items. In the essence, the concept of PAFs can be rooted to the idea of proxy votes wherein a shareholder delegates the authority to vote on his/her behalf to another individual on resolutions proposed by the management. They operate in a two-fold manner wherein they give suggestions about i) regulatory compliance and ii) governance risks. The governance compliance is examined using non-legal thresholds which implies the lack of any binding force of law. Such advice is solely from the viewpoint of convenience and value as against necessity or mandate. Talking about India, proxy advisory firms can be directly related with corporate activism due to three-fold reasons. Firstly, foreign investors hold considerable shares in Indian companies making the management more cautious. Secondly, succession and other legacy challenges along with high debt in promoter-owned companies pose a risk of instability. Lastly, activities of company boards can now be closely examined by PAFs in the backdrop of judiciary trying to focus on the protection of shareholder rights.
III. Navigating The Potential Constraints in The Operation of PAFs
The most common challenge faced by PAFs is the lack of awareness which may result in less inclination on the part of institutional investors and listed companies to adhere to their advice. While impeding the growth of such advisory firms, it also makes their value proposition and benefits offered go in vain. Investors have been a little skeptical about the policies employed by PAFs in their research and recommendations. For instance, InGovern was engaged by three companies to provide guidance on voting decisions for the appointment of Independent Directors. It suggested voting against Wipro’s BC Prabhakar, Shardul Shroff of IDFC and SH Khan as Independent Directors stating that the candidates had longstanding associations with the companies akin to marriage. InGovern reasoned that their appointment would violate SEBI (LODR) Regulations, which in contrast stipulate the appointment of Independent Directors for no more than two terms of five years each, maximum tenure of ten years. Along with this, critics point the “one-size-fits-all” approach that PAFs use ignoring the varying corporate governance standards across different regions and industries. PAFs, hence, may use uniform benchmarks overlooking critical differences leading to suggestions that do not fit in every situation or organization. The problem does not end here. Due to heavy reliance of investors on their advice, shareholder’s individual judgements may be overshadowed, skewing voting outcomes in such a way that may not align with the long-term interests of the stakeholders.
There is also a high chance that proxy advisory firms are drawn into disputes concerning corporate fraud when companies provide misleading information or engage in fraudulent activities in their voting process. A mere association with companies involved in fraud can rupture the reputation, market value and future prospects of the PAF.
Another set of challenge pertains to the need of Indian PAFs to register with the SEBI in order to operate within the country and the exemption of foreign PAFs from this requirement. Consequently, foreign firms function without direct oversight from SEBI resulting in a competitive disadvantage for Indian PAFs. Thus, there is a need to establish a code of conduct under the SEBI Research Analysts Regulations that would apply on both domestic and foreign PAFs emphasizing fairness, disclosure and conflict of interest. Foreign firms not only enjoy this leverage but there exist many factors which hold back the Indian PAFs to function at their best optimization. Firstly, India has, since decades, witnessed the presence of family-owned businesses with concentrated shareholdings but with the emergence of PAFs, it saw a shift to inculcate globally validated techniques in the corporate parlance. This discrepancy between the PAF’s recommendations and the established method of operation by Indian businesses made PAFs be perceived as more or less “intellectual armchair critics.” Secondly, the Indian PAFs are marked by their traditional concentrated shareholding structure with approximate 34% shares of institutional investors in publicly listed companies. This differs from the practices in other countries, like the US, where the institutional investors hold a larger share rendering their advice more perceptible. Thirdly, India lacks an effective mechanism to hold the PAFs accountable for the shortcomings in their recommendations despite guidelines established for grievance redressal. There is no recognized interpretation of “recommendation” as “solicitation” as is common in the US which ensures that misleading suggestion by any PAF can trigger anti-fraud provisions. This further instills confidence in companies to trust their advice on one hand and encourage the firms to exercise greater caution in preparing their reports on the other. Lastly, investment advisors act as fiduciary in the US and in case they hire PAFs as a third party, relevant policies are designed to monitor them. As a result, they owe a duty of care to their clients making them act in the best interests of businesses. However, despite the coming of similar stewardship guidelines by SEBI for Alternate Investments Funds and Mutual Funds in India, there has been no significant increase in the objective participation of investors with investee companies.
IV. Strategic Recommendations in Enhancing The PAF Framework
To tackle the problem of corporate fraud, India can adopt a similar strategy to the Sarbanes-Oxley Compliance in the US. Under this, all the public companies doing businesses are required to implement internal controls, file reports with the “Securities and Exchange Commission” ("SEC") and pass an independent audit containing all the financial statements annually. It also lays down guidelines for firms that audit public companies and analysts who publish research on securities, imposing fines and criminal penalties in case of non-compliance. India should also issue strict guidelines making auditors and PAFs more independent from their clients and mandating corporate executives to be personally responsible for financial disclosures. This will reduce the risk of fraud incentivizing PAFs to act more effectively. A stronger legal framework and transparent corporate practices will support the growth of PAFs, enabling them to provide better advice to the stakeholders. As the stewardship guidelines did not get the expected result, regulators should now focus on fostering an ecosystem where asset owners will voluntarily adopt such practices rather than being forced to comply with the same. An increase in the minimum public shareholding requirement and re-examining the “free float” in companies would definitely work in favor of the growth of PAFs. However, it is not suggested to remove institutional investors from the free float to increase public participation in the corporate realm as they do not enjoy the domination in foreign companies like what the foreign institutional investors enjoy in our domestic arena. SEBI should also ensure that PAFs establish a dedicated window channel to specifically address the inquiries of retail investors. Lastly, greater awareness about PAFs would make the reports and recommendations more widely acceptable increasing their influence.
V. Conclusion
India’s rise as a leading economy will require the undertaking of international corporate governance for long term sustainability. With increasing foreign direct investments and institutional investors becoming more important, PAFs are essential in creating a new model of corporate governance in India. The effectiveness of the legislature, government, market regulator and the corporate sector in achieving this goal will be closely monitored, shaping the future landscape of corporate governance in India.
Note: This article has been reviewed by Mr. Vinod Kothari (Managing Partner, Vinod Kothari and Company) at the Tier II Stage.