2015 • Volume 40 • Number 1

Great Expectations: The Peril of an Expectations Gap In Proxy Advisory Firm Regulation

Asaf Eckstein

Large, institutional investors have come to wield great power over shareholder votes in publicly held companies. These investors, with their enormous ownership shares, can dramatically influence issues that are put to a shareholder vote. And when deciding how to cast their ballots, institutional investors look to proxy advisory firms. These are entities that advise investors on which actions to take in shareholder votes. Because institutional investors prefer to focus on building portfolios, rather than on researching shareholder votes, they often outsource these duties to proxy advisory firms. As a result, financial industry and government leaders have voiced concern that proxy advisory firms exert too much power over corporate governance to operate unregulated. The Securities and Exchange Commission as well as the U.S. Congress have investigated and debated the merits of proxy advisory regulation. The U.S. House of Representatives held a hearing on the matter in June of 2013, and the SEC followed this hearing with a round table discussion in December of 2013. On June 30, 2014, the Investment Management and Corporate FinanceDivisions of the SEC issued a bulletin outlining the responsibilities of proxy advisors and institutional investors when casting proxy votes. As of yet, no binding regulation has been promulgated, despite repeated calls for it. Rather than commenting on that debate, this Article urges policymakers to consider the potential for an “Expectations Gap” if proxy advisory regulation is adopted. An Expectations Gap arises when the parties interested in regulation, in this case particularly the mass media, academics, politicians and the general public, inaccurately estimate the efficacy of a regulatory regime. They typically overestimate a regulation’s effectiveness, which in the proxy advisory context could actually lead to a responsibility deficit. Both proxy advisory firms and institutional investors could shift blame away from themselves in the event of a corporate governance failure stemming from poorly-cast shareholder votes or a lack of oversight. This deficit would severely hamper the effect of any future regulation,and steps must be taken to reduce the possibility of that occurrence. This Article is the first to examine this potentially serious negative consequence of proxy advisory regulation. It is also the first comprehensive scholarly writing to propose solutions for minimizing an Expectations Gap arising from new regulation. This Article applies the Expectations Gap theory to the current proxy advisor debate taking place and uses the theory to develop mechanisms for making potential regulation more effective. Additionally, these suggestions are applicable to any new regulation that is susceptible to an Expectations Gap. Taken together or individually, these suggestions could improve information symmetry in the financial market and help prevent serious corporate governance failures.