The recent decisions by the S&P Dow Jones Indices to exclude all new dual class share offerings from the S&P Composite 1500 (comprised of the S&P 500, S&P MidCap 400 and S&P SmallCap 600) and the FTSE Russell to bar companies from inclusion in its benchmark indexes unless more than 5% of the voting rights are in the hands of public shareholders, was a major success for the shareholder empowerment movement (‘the movement’).
In the United States, the movement is made up primarily of U.S. public pension funds that hold more than $3 trillion in assets. Its trade organization, the Council of Institutional Investors (CII), has always been an unwavering and inflexible promoter of a ‘one share, one vote’ policy. Dual class share structures (multiple classes of common stock with unequal voting rights) clearly violate this policy and are an obvious threat to the power of the movement. That is, a public company that provides control to insiders through a dual class share structure can more easily resist the movement’s demands.
The CII saw the recent Snap Inc. initial public offering (IPO) of non-voting shares as a great opportunity to renew their attack on dual class shares. Once the successful offering was completed, the CII requested all the major index providers to enter into public consultations on non-voting shares and dual class shares in general.
For the majority of those who responded to these consultations, it appears that the removal or the exclusion of certain dual class share structures was appropriate. FTSE Russell reported that ‘68% of the respondents agreed that some minimum hurdle for the percentage of voting rights in public hands should be imposed.’ Obviously, the index providers were under a lot of pressure from their clients, both in the United States and abroad, to exclude or limit the use of utilize dual class shares in their indices.
Yet, it is becoming increasingly clear that the S&P Dow Jones Indices and the FTSE Russell made a major mistake in excluding or restricting the use of dual class shares in their indices. For example, Blackrock just released the following statement as part of a short policy memo:
'BlackRock is a strong advocate for equal voting rights for all shareholders. However, we disagree with index providers’ recent decisions to exclude certain companies from broad market indices due to governance concerns. Those decisions could limit our index-based clients’ access to the investable universe of public companies and deprive them of opportunities for returns.'
Both Vanguard and State Street Advisors have made similar statements in the recent past. What they are essentially saying is that if index funds are required to exclude the stock of certain public companies, then the funds will become much less representative of the investment universe they are trying to represent, the wealth creating power of the United States economy, and thereby reduce their value to mutual fund and ETF investors. This, of course, is stating the obvious. What should be equally worrisome to mutual fund advisors that sponsor equity index funds is the reduced opportunity of their funds to eventually purchase the stock of successful private companies who have equity market values that exceed one billion dollars (unicorns). Those unicorns who would consider going public with a dual class share structure now have less incentive to do so. Their absence will lead to increasingly less representative equity indexes over the long-term.
The public admission by mutual fund advisors that the index providers have made a big mistake in excluding dual class shares is actually quite startling as it goes against the interests of the movement. As I have recently argued, mutual fund advisors support the movement’s advocacy on dual class shares because of the opportunity to attract or retain the portfolio management business of the movement’s members, a business that is shifting away from high cost, actively managed mutual funds and hedge funds to low cost indexed funds. Moreover, while this business strategy may be good for the bottom line of the mutual fund advisor in the short-term, it is not necessarily good for the mutual fund investor who indirectly gets to support the movement’s non-wealth maximizing approach to investing.
By supporting the movement in its advocacy against dual class shares, mutual fund advisors have inadvertently found themselves participating in the destruction of their current golden goose, the equity index as means to provide tens if not hundreds of millions of unsophisticated and uninformed stock market investors with easy access to low cost portfolio diversification. Fortunately, it now appears that mutual fund advisors have figured out that the business costs of losing representative indexes will turn out to be much greater than what can be gained from the increase in public pension fund business. Most importantly, it is not too late to stop the destruction of the equity index as a useful tool for the investor population, assuming the S&P Dow Jones Indices and the FTSE Russell also see the light and roll back their decisions to exclude or limit the inclusion of dual class shares in their indices.
Mr. Sharfman’s recent article on dual class shares can be found here.
Bernard S. Sharfman is an associate fellow at the R Street Institute, a member of the Journal of Corporation Law’s editorial advisory board, and a visiting professor at the University of Maryland School of Law (Spring 2018).