Home Corporate Governance What are proxy advisory firms and their role in Indian corporate governance

Corporate Governance

What are proxy advisory firms and their role in Indian corporate governance

October 22, 2021

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This article is written by Pranjali Aggarwal, from the University Institute of Legal Studies, Panjab University, Chandigarh. This article elucidates the basic meaning of corporate governance and proxy advisors, how corporate firms depend on proxy advisors and talks about guidelines issued by SEBI on proxy advisors.

Table of Contents

What is corporate governance

The word ‘corporate’ basically means a body that can either be public or private and is a legal entity in the eyes of law. Once formed, it becomes a corporate citizen and enjoys independent existence from its owners. The word ‘governance’ is derived from the Latin word “gubanare” which means “to steer” and in the ordinary sense; it refers to the exhibition of powers to control, direct and guide the actions and affairs of any entity in order to achieve a particular goal. Thus corporate governance is the framework that acts as a guiding tool for the businesses that aids in the drafting of rules, policies, and guidelines that are not only just and fair for all the stakeholders but even aim at reaping profits for the corporate. Corporate governance can be described as an “amalgamation of rules, law, and voluntary private sector practices which helps the firms to utilize their economic and financial resources efficiently to generate profits for its shareholders while also paying heed to the interests of stakeholders and society as a whole”. The basic aim of corporate governance is to facilitate effective, entrepreneurial, and prudent management that can ensure long-term success by ameliorating a company’s image, efficiency, effectiveness, and social responsibility.

It basically encompasses aspects like accountability, transparency, independence, honesty, fairness, sustainability, ethics, stakeholder interfacing, good board practices, etc.

Proxy advisory firms

Proxy advisory firms are relatively new institutions in the corporate landscape but they play an imperative role and have gained popularity among the shareholders of the company. According to Regulation 2(1)(p) of the SEBI (Research Analysts) Regulations, 2014, ‘proxy advisor’ refers to any individual or any organization that prepares recommendations and gives advice for the institutional investors or shareholders so as to aid them in the casting of their vote in respect of any policy issues or a public offer.

These are independent research outfits that weigh all the pros and cons of any decision and thus provide research and voting recommendations for their clients. Generally, only the directors decide upon the everyday issues of the company but as shareholders are the real owners of the company, they also vote on the crucial matters of the company. Some shareholders are mainly concerned about the profits (dividends, interests, etc) and thus are not well-acquainted about the issues, policies, and notices of the company and thus need an independent analyst to evaluate the decision taken by the company and here the proxy advisory firms act as a helping hand and provide recommendations to shareholders according to which they can cast their vote on issues such as executive compensation, corporate governance, etc.

Evolution of proxy advisory firms

At first, when the companies were formed, the best possible way to have a unanimous decision was voting and for this purpose the physical presence of all the members was necessary. This is not a practical situation to have every member in the meeting every time because people buy shares through the share market and do not have any personal access to the firm. Moreover, because of the global market, even foreigners invest in the companies, and thus it is not feasible for everyone to cast their votes physically and it is a cumbersome and expensive process even for the firms to follow. These reasons lead to the evolution of the concept of ‘proxy’ in which one person was appointed to represent the other and the proxy has the power to vote on the behalf of the shareholder if the shareholder authorized the proxy for the same and this emerged as a more convenient way of voting.

This mechanism of voting evolved according to the needs of society and the proxy advisory firms came into the picture that acted as third-party consultants and provided expert advice and recommendations on whether to vote ‘for’ or against’ the motion decided in the company. Basically, these firms are products of shareholders’ activism that have boomed because of unscrupulous corporate governance in the organizations. Their main aim is to provide counseling to the shareholders but they can also be given the right to vote if they are expressly authorized by the stockholders.

This system was prevalent in the USA’s financial market from the 1980s but in India, the proxy advisory industry was even invisible during the 2000s. In 2009, when the Satyam scam took place, the entire financial market shivered. SEBI incorporated several steps to prevent these scandals and one such measure was the passing of the Securities and Exchange Board Of India (Mutual Funds) (Amendment) Regulations, 2010 in July 2010. This regulation demanded more transparency in the voting and disclosure of the norms followed to determine the voting right of the shareholders. This regulation by SEBI and as already there was a rise in shareholder’s activism and indulgence, investment climate was becoming more common day by day, leading to the beginning of the proxy advisory industries in India. The ‘InGovern Research Services’ was the first proxy advisory firm of India started by Mr. Shriram Subramanian in June 2010. Since then several firms like the Institutional Investors Advisory Services (IIAS), Stakeholders Empowerment Services (SES), etc have been incepted and enormous growth of these firms has been recorded.

Functions of advisory firms

The major task is proxy advisory i.e. advising on the intricate matters of the company.
They aid shareholders in exercising their voting rights in the company in significant decisions like the appointment of the directors, changes in the policies of the company, etc.
To provide a report that is basically a scorecard or rating on the corporate governance of the entity.
To provide the Environmental, Social, and Governance (ESG) analysis. ESG analysis is done to study all the factors (environmental, social, and governance) of the company to calculate all the prospective growth opportunities and threats. It helps the company and shareholders to prepare accordingly.
To monitor risks and protect the interests of the investors.

Indian corporate governance and advisory firms

The implementation of the Companies Act, 2013 and enhanced corporate governance standards under the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015, has made the role of proxy advisors very significant in the corporate landscape. The Economist even referred to advisors as to the ‘èminence grise’ of corporate governance which refers to a person who exercises power or influence in a certain sphere without holding an official position. In other words, the person or entity working behind the scenes.

Driving force for corporate governance

The proxy firms act as the shaping tool that helps in complying with the stringent corporate governance norms. Investors are drivers of corporate governance and they are assisted by these proxy firms to understand the agendas of the company, to provide them with analysis of different proposals and voting decisions of the company. Basically, they can guide them in every decision that is to be taken by the investors regarding the company. Corporate bodies also need to adhere to these recommendations otherwise it could negatively impact their reputation and adversely affect the confidence of the investors which may lead to a decline in share price, fewer funds, etc. There are several examples where the proxy advisors’ recommendations helped in the administration of better governance policies in the companies. For instance, the Global Funds advised against the appointment of Deepak Parekh as the non-executive chairman of HDFC as he was already on board of eight companies as they were of the view that he would not be able to handle all positions judiciously at the same time. Another situation where the InGovern advised against the appointment of B.C. Prabhakar as independent Director in Wipro, against Shardul Shroff in IDFC, and against S.H. Khan as ID of IDBI stating that they are in the same position for several years and remarked that their relationship is like, ‘if they are married to the company’. Another reason for such negative recommendations was the introduction of clause 49 in the Equity Listing Agreement between SEBI and listed companies. Thus, proxy advisors through their recommendations ensure the efficient functioning of the company.

Recommendations drive companies to follow good governance policies

Their reports help the companies to build their reputation and trust among the shareholders. If the report showcases a positive report of the company regarding their decisions and legal compliance, then this would attract investor’s confidence in the company. This helps in more investments in the company. Thus, companies tend to follow good governance policies so that the recommendations drafted by the proxy advisors favor them. Generally, it is seen that shareholders like to invest in the companies that fall under the jurisdiction of these advisory firms because they could access insider information and the status of the company which would otherwise not have been available for the investors.

Watchdogs for the companies

They act as the watchdog for the corporate bodies. They keep a check on companies whether they are adhering to the rules and regulations and working in the interest of shareholders. Earlier investors only acted as passive members in the firm and because of this they were not able to analyze the pros and cons of the changes made in the organization and this affected them adversely. But this whole situation has been transformed by these advisors as now any matter that is against the interests of the shareholders can be called out by them and the same has to be considered by the company. Like in the case of Lavasa, where Ajit Gulabchand was receiving the salary five times than what was allowed by the Central government without any express sanction of the shareholders, which is necessary in this case. This scenario was analyzed by the proxy advisory firms and finally, he was ordered to refund all the excessive amounts that had been received by him over the years. Thus, the corporate bodies need to work according to the recommendations of the advisory firms.

SEBI rules related to Proxy Advisory Firms

As discussed above, proxy firms play a significant role while voting in the company. Any biased recommendation can be disastrous for the firm, as the major decisions to be voted upon by the shareholders in the company are influenced by their advice. Thus, to avoid such conflict of interest and any faulty report, the SEBI Guidelines, 2014 have been issued. These guidelines were developed for regularizing the powers of proxy firms on August 3, 2020, which came into force on January 01, 2021 (September 01, 2020, was earlier decided as the date of enforcement but was extended because of the COVID-19 pandemic). These were the first guidelines that brought proxy advisors under the umbrella of law where they could be monitored. Although these regulations were nascent but following parameters were mandatory to be followed:-

First of all, all the proxy advisory firms have to get themselves registered with SEBI.
They have to disclose all the recommendations that are made by proxy advisors
A proper framework is to be established to look after the internal functioning and discipline of the firm
Proper records are to be maintained regarding the recommendations that are being given by the advisory firms.
It also gave a roadmap regarding the code of conduct that is to be followed which encompassed eight principles like honesty, good faith, confidentiality, etc

These guidelines were governing Indian proxy industries till 2018. In August 2018, there was a vote on the reappointment of three directors of a private sector bank in India. The domestic and international proxy advisors voted against this decision and as a result, two of them backed out and the third one was reappointed with a small margin as the director of the bank. This incident was criticized by several experts in the market. The main reason behind such criticism was that these pieces of advice are being framed by the international advisories and are not apt for the Indian scenario. As these international firms are formulating recommendations on the basis of practices as followed in their home country, the recommendations thus are not apt for the Indian scenario. So they feel that they are not competent enough to draft the advice for the Indian situation. Moreover, some baseless and hasty advice could lead to egregious results. The demand for stringent policy to regulate functions of the proxy advisory firms was made. Due to this incident, SEBI constituted a committee in November 2018 to look into this matter and to suggest any changes that can be made in the guidelines of 2014 that were guiding proxy advisories earlier. The committee issued its report in May 2019 to SEBI and newly formulated guidelines were enacted. These included procedural guidelines for proxy advisors, as well as the mechanism of grievance resolution between listed entities and proxy advisors.

New procedural guidelines for proxy advisors

They have to disclose policies on the recommendation of voting and these are to be reviewed every year.
The report should be shared simultaneously with the company and investors and if there are any clarifications or comments that the company wants to suggest, the same could be sent by the company to proxy advisors within the timeline decided beforehand and the needful changes can be made in the report
If the opinion of the company varies from that of the proxy advisor’s report and it could not be justified by minor amendments then the needful changes can be done by issuing additional reports or adding an addendum depending on the issue.
If there are any discrepancies, false information, or material revisions are required to be done, the same should be disclosed to clients within 24 hours of realizing such an error. (Regulation 20)
The methodologies, procedures, and sources that were being referred to or followed, to formulate the report should also be disclosed to the clients.
An explicit framework is to be set up to handle and resolve any conflict of interest that arises during the ancillary course of service like if they provide consultancy service in addition to the advisory which could lead to a biased point of view and the same should be disclosed to the clients also. (Regulation 15(1))
Clarify the situations in which the firm will not provide voting recommendations in its voting recommendation policy.
They also need to mention adequate reasons if they are suggesting any higher standard in their recommendations than generally stipulated by law.
The stated communication process between clients and the listed company should be developed so as to interact and inform the clients regarding recommendations and to get reviews on the same (Regulation 23)

Grievance Redressal Mechanism for listed companies

Apart from these disclosure measures for the proxy advisors, a mechanism has been set up by SEBI under these new guidelines which will redress the issues faced by listed companies and provide relief for the same. Under this, the aggrieved company that has a contrary opinion than that of the recommendations provided by proxy firms can report to SEBI about their grievance. The SEBI will act as an arbiter between the two and after examination of the issue, will discharge the case accordingly. This system is based on natural justice as this provides the company with the right of being heard in case they are being exploited by the policies and recommendations formed by the proxy advisors.

These guidelines will create additional safety for both the companies and the shareholders by regularizing the proxy industry. This will ensure transparency and even build the credibility of the advisors. Compliance with all these measures will however create additional liability on the advisory firms.

Challenges faced by the proxy advisory industry

No doubt, there is a huge potential in this industry to boom but there are still some hindrances that should be paid heed to and incorporate necessary measures so as to overcome them. The hurdles faced by the proxy industries are as follows:-

The passive attitude of shareholders

The shareholders, most of the time, are unaware and indifferent about the norms of corporate governance of the organization unlike in the foreign countries where investors work according to the recommendations by the proxy industry. This is because they have had a passive attitude for many years. Thus, the awareness is to be created so that shareholder’s activism can boost which will in turn help in the rise of the proxy advisory industry. Many bodies like the Institute of Chartered Accountants of India, the Institute of Company Secretaries of India, and even SEBI have come forward to create awareness about them.

Unacceptance by the corporate bodies

They started facing resistance from the corporate entities before they could even win the confidence of the investors. Many allegations of having personal interest, not following proper research practices, lack of concern towards companies, and misleading investors through unreliable recommendations became very common. These allegations hampered their growth at the embryonic stage. And now after the guidelines issued by SEBI, the proxy firms have made them more credible but still, they need to put in more effort to prove themselves.

Higher competition

The limited scope of the firms is another drawback and that is why there is no room for multiple firms in this uncertain environment. In the USA also, the advisory industry mostly remained as a monopoly or duopoly only for the practical working of the market. Thus, where the space is limited and there are three firms in the Indian market and even international advisors, there exists cut-throat competition in the market to establish themselves.

Insufficient human resource availability

There was no specialized degree or program that was curated for the employees so as to cater to the needs of this industry. The companies were hiring engineers based on their logical reasoning and then training them to induct them. Thus, it is a huge issue because there is a lack of desired human resources with expertise in this field.

Hefty cost

The whole process of preparing reports on the inside matters is cumbersome as well as expensive because it involves extensive research and analysis in itself but now as they have to build up the system for communication and even more detailed reports would require more funds to be incurred, thereby, putting a burden of additional cost to be borne by the proxy industry.

Conclusion

The stock market of India is growing day by day and investors have become more engrossed in the intricacies of the matter than before. This surely has created an apt situation for the growth of the proxy industry in India. The proxy advisory firms have revolutionized the concept of corporate governance as they play a vital role in the working of the company. Now the annual meetings are not dictated by a few people only, instead, the directors of the company have to tune themselves and work according to the suggestions by proxy advisors because they are the guiders of the institutional investors. The firms ensure the system of transparency, check, and balances for the investors in the companies as the minute happenings in the company are notified to them which in some cases could go unattended. This could help in the better understanding of the situation and in turn aids in the formulation of the decisions by the shareholders. No doubt still the role of the proxy industry in India is very less as compared to the USA because India is the hub of family-owned businesses and the shareholders are in minority because of which the authority cannot be challenged easily. But this role of proxy advisors will likely change over the next decade because of an increase in startups that would have diversified shareholding and the firms could benefit from that and they will play a pivotal role in giving vent to investor concerns by engaging positively with the companies.

References

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