Dual-Class Index Exclusion

Andrew Winden is a Fellow at the Rock Center for Corporate Governance at Stanford University and Andrew C. Baker is a Doctoral candidate in Accounting at the Stanford Graduate School of Business. This post is based on their recent paper. Related research from the Program on Corporate Governance includes The Untenable Case for Perpetual Dual-Class Stock (discussed on the Forum here), and The Perils of Small-Minority Controllers (discussed on the Forum here), both by Lucian Bebchuk and Kobi Kastiel.

One of the most contentious and long-standing debates in corporate governance is whether company founders and other insiders should be permitted to use multi-class stock structures with unequal votes to control their companies while seeking capital through a public listing. Institutional investors have lobbied Congress, state legislatures and the Securities Exchange Commission unsuccessfully for decades to prohibit such stock structures. Following competitive pressure from the American Stock Exchange and NASDAQ, the New York Stock Exchange changed its listing rules to permit such structures in 1984. In the increasingly competitive global environment for listings, other stock exchanges have also started permitting multi-class listings.

Stymied by the permissive attitudes of legislatures, regulators and stock exchanges, and alarmed by Snap Inc.’s decision to offer only non-voting shares to public investors in its initial public offering in 2017, institutional investors sought a new corporate governance regulator as a bulwark against multi-class stock in global capital markets: equity index providers. Index providers choose the stocks included in the benchmark equity indexes, such as the S&P 500, followed by passive index funds. Their choices are guided by rules they write—eligibility criteria—to determine which stocks should be included. As passive index investing becomes increasingly popular, billions of dollars follow index inclusion decisions, and index providers have increasing influence over global capital flows.

Institutional investors and their advocates petitioned the largest stock index providers, FTSE Russell, MSCI, and S&P Dow Jones Indices to exclude companies with unequal multi-class voting structures from their benchmark equity indexes, hoping to force corporate founders to accept a one share, one vote standard of corporate governance when going public. The index providers, who make their living constructing and licensing indexes to institutional investors and the managers of passive index funds, acceded to their requests and, to one extent or another, limited the access of multi-class companies to their benchmark equity indexes.

While there is a voluminous financial literature on the effects of index inclusion and exclusion on stock prices—see Pyemo N. Afego (2017) (Effects of changes in stock index compositions: A literature survey, International Review of Financial Analysis) for a good summary—the legal literature has yet to consider the power of the parties who write the rules for index investing: index providers. A number of legal scholars have explored the implications of the exponential expansion of passive index investing on corporate governance by considering the role and influence of passive index investors and fund managers. Some have expressed concern about the anti-competitive effects of concentration of ownership among a small number of asset managers, while others have assessed the incentives of passive managers to exercise control over corporate managers through engagement and voting. Neither the financial nor the legal literature have considered the corporate governance role or influence of index providers.

We start to fill this gap in the literature with our recent paper, Dual-Class Index Exclusion. The effort to influence corporate governance standards through an index exclusion penalty for multi-class stock structures presents an opportunity to test the regulatory influence of index providers. We assess their role and influence through this rubric. We begin by explaining the background to the institutional investors’ efforts to get indexers to exclude multi-class stock structures from their benchmark indexes, describing the increase in dual-class stock listings, the investors opposition to such structures, their attempts to obtain redress through regulators and stock exchanges and the regulators’ unwillingness to change the status quo.

Next, we summarize the business of indexing and index providers and the reasons institutional investors reached out to index providers to provide a solution to investors’ dissatisfaction with multi-class share structures, including, most importantly, the hope that index exclusion would penalize companies adopting such a structure by preventing them from benefiting from the index inclusion effect—the market perception that firms added to benchmark equity indexes enjoy a long-term increase in their stock price due to forced buying by index investors. We then cover the three largest indexer’s responses to the investors’ petitions—prohibition in the case of S&P Dow Jones Indices, a voting rights hurdle from FTSE Russell, and index weighting by voting power from MSCI, Inc.

With this background, we proceed to consider whether the effort to regulate corporate governance structures through index eligibility rules will succeed. We start with the premise that the index exclusion sanction will not work unless it is sufficiently costly to outweigh the perceived benefits of founder control through a multi-class stock structure. We expect the index exclusion sanction will not be sufficiently costly for several reasons. First, it is difficult, if not impossible to implement a sanction through the public capital markets. In their recent essay, How Investors Can (and Can’t) Create Social Value (2018) (discussed on the Forum here), Paul Brest, Ronald Gilson and Mark Wolfson explain the challenge of creating social value through impact investing in public capital markets. They note that it is virtually impossible to subsidize socially valuable activities or penalize socially adverse activities through public market investments and divestments. The challenges inherent in impact investing in public markets apply with equal force to the effort to apply governance sanctions through index exclusion. Second, several recent studies on the index inclusion effect in the financial literature have concluded that the effect has essentially disappeared in recent years and may never have been a real source of long-term lower capital costs. See Nimesh Patel and Ivo Welch (2017) (Extended Stock Returns in Response to S&P 500 Changes, The Review of Asset Pricing Studies); Kim et al. (2017) (Adaptation of the S&P 500 Index Effect, The Journal of Index Investing); Konstantina Kappou (2017), The Diminished Effect of Index Rebalances, available on SSRN; Jan Schitzler (2016) (S&P 500 Inclusions and Stock Supply). Third, despite the explosive growth of index investing in recent years, passive funds following stock indexes still hold a relatively modest percentage of the market capitalization of U.S. equities—around 12% of the S&P 500, for example. Finally, the proliferation of index investing opportunities has weakened the market-moving influence of any one benchmark index.

To test our hypothesis that the cost of the index exclusion sanction will be insufficient to change corporate governance choices, we conduct an event study of the S&P announcement that dual-class companies would henceforth be excluded from the S&P 1500 Composite Index and it’s components—the S&P 500, S&P 400 mid-cap and S&P 600 small-cap indices. Because S&P grandfathered dual-class companies currently in the index, we are able to compare movements in the stock prices of dual-class companies currently in the index with movements in the stock prices of dual-class companies not yet included in the index at the time of announcement. We do not observe any statistically significant abnormal returns in the stock prices of either included or excluded firms as a result of the S&P announcement, suggesting that exclusion is not expected to have a significant adverse cost of capital effect on firms that elect to list with a dual-class stock structure in the future and the sanction is ineffective.

We conclude by exploring the consequences of an ineffective index exclusion sanction. While an ineffective sanction will not affect corporate governance choices, it may have unintended adverse consequences. We note that indexers are violating indexing theory in their efforts to please their customers, index investors may be adversely affected if the indexers persist, and the index providers themselves are likely to lose influence over time unless they reverse course.

The complete paper is available for download here.

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