U.S. proxy advisory firms are now caught in the middle of a heated debate over how-and even whether-they should be regulated.

These are the firms hired by mutual funds and other fund managers to help decide which way to vote on corporate issues.

While they may not have been that important a decade ago, they are now, thanks to new regulations requiring buy-side firms-namely mutual fund complexes-to publicly disclose how they vote their shares. That means that institutional investors are voting more often so they need all the advice they can get.

Now the Securities and Exchange Commission wants to know just how it should oversee proxy advisory firms as part of its overarching reform of the proxy distribution and voting industry.

Institutional investors and corporate governance firms that follow their advice like the status quo. But public companies and their advisors are pushing the SEC to more closely oversee proxy advisory firms because they wield great influence on voting decisions made by fiduciaries and others but face no regulatory oversight.

One firm so cited: RiskMetrics Group, a large proxy advisor now owned by MSCI, a provider of investment decision tools.

Among the recommendations for change: requiring registration as investment advisors or supervision similar to that for proxy solicitation firms or credit rating agencies. The common denominator: greater disclosure of potential conflicts of interest and an explanation of just how proxy advisory firms come up with their voting recommendations.

The dichotomy of the opinions is clearly expressed in the dozens of comment letters sent to the SEC over the past year. Here is how the viewpoints stacked up: "Contrary to the possible implications in the SEC's concept release, fund advisors do not blindly follow possibly inaccurate advisory firm recommendations," wrote the Investment Company Institute, the influential trade group for mutual funds. "We question the need for additional regulation of proxy advisory firms."

The opposing view: "The fact that proxy advisory firms owe no fiduciary duty to the issuer's shareholders or its constituencies is a dangerous gap in securities laws which should be corrected," wrote the law firm of Wachtell, Lipton, Rosen & Katz. "Proxy advisory firms have become de facto corporate governance regulators-issuers are pressured into falling in line to avoid facing disruptive vote no or withhold campaigns. However, under current law, these advisory firms are not accountable to either issuers or investors short of actionable fraud."

Institutional investors such as mutual funds and pension plans typically do not have enough staff or time to analyze and consider all of the proposals put forth by companies and shareholder groups. On average, a large mutual fund can hold stock in more than 5,000 companies with more than 50,000 different votes to cast. So they are happy to pay a fee to proxy advisory firms to formulate their own governance principles on how the institutional investors should vote. At issue is just how valid those governance principles are.

Case in point: RiskMetrics not only provides voting recommendations but also advises corporations on how to structure their corporate governance procedures. In 2007, RiskMetrics acquired Institutional Shareholder Services (ISS), a corporate governance and proxy voting adviser to institutional investors. That means that companies could easily have an incentive to hire ISS in an effort to sway votes from large institutional investors, say RiskMetrics' critics.

In 2009, RiskMetrics issued proxy and vote recommendations for more than 37,000 shareholder meetings in 108 countries and voted 7.6 million ballots representing over 1.3 million shares.

In addition to RiskMetrics, other major advisory firms include Glass Lewis & Co., Egan Jones Proxy Services, Marco Consulting Group, Proxy Governance, Governance Metrics International and CtW Investment Group. RiskMetrics, Marco Consulting and Proxy Governance are already registered as investment advisors.

RiskMetrics declined to comment.

Institutional investors say any analogy between proxy advisory firms and nationally recognized statistical rating organizations is fallacious. "Comparing proxy advisory firms to [credit rating agencies] accords greater significance to the marketplace than proxy advisory firms actually represent," wrote Abe Friedman, managing director of BlackRock in San Francisco in a letter to the SEC advocating the status quo. "Unlike [ratings agencies], whose evaluations of an issuer are required for certain securities offerings and whose ratings are closely tied to changes in security valuations, we believe that proxy advisory firms are less influential," he wrote.

But Tamara Belinfanti, associate professor of corporate law at New York Law School, believes mutual funds have no real economic incentive to police ISS or any other proxy advisory firm. Calling ISS a "lethal combination" of too much influence with no accountability, she recommended the SEC consider regulating the proxy advisory and corporate governance industry similar to the regulation it is considering for registered credit rating agencies.

Among the potential policies the SEC could set, according to Belinfanti: require that the firms disclose underlying information furnished by the corporations; and the procedures and methodologies used to determine the voting decisions.

The Shareholder Communications Coalition, a Washington, D.C., lobbying group comprised of corporate issuer trade associations and the shareholder recordkeeping group Securities Transfer Association, prefer that proxy advisory firms register as an investment advisors.

The SCC wants proxy advisory firms to disclose their procedures, guidelines and assumptions for making voting recommendations. The organization also said proxy advisory firms should be required to maintain a public record of all their voting recommendations, disclose conflicts of interest and have a complete and total separation of the proxy advisory business from all other business including consulting and research services.

Wachtel, Lipton, Rosen & Katz agreed that proxy advisory firms should register as investment advisors but goes one step further in recommending that they should be treated as "soliciting material" subject to federal proxy rules. Such a requirement would allow the corporation to include its own recommendation in the final report issued by the proxy advisory firm.

To the ICI, however, such a scenario would spell additional costs for proxy advisory firms, which it worries could be passed onto the funds and their shareholders.

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