09 August 2017 by Jimmy Nicholls
Lack of voting rights creates concern over governance and investor input.
The exclusion of messaging firm Snap from the S&P 500 index has re-opened debate on whether indexes should include firms with multiple share classes, and even whether such companies should exist.
On 31 July, S&P opted to block firms with multiple share classes, including non-voting shares, from joining its three main indexes, aligning itself with a decision from its peer FTSE Russell.
The question is now what the future holds for companies with multi-class shares, especially since companies already included on the S&P 500, including Google parent Alphabet, Facebook and Alibaba, will remain on the index.
S&P’s decision effectively bars Snap from the S&P Composite 1500, which comprises the flagship benchmark S&P 500, S&P MidCap 400 and S&P SmallCap 600. The S&P Global BMI Indices and S&P Total Market Index will continue to accept firms with multiple share classes.
‘I think S&P is trying to balance being progressive and pragmatic, and I think the problem in the US market is it is so dominated by those companies [with multi-class shares],’ George Dallas, policy director at the International Corporate Governance Network, told Governance and Compliance.
‘S&P was put in a difficult position and I think it made a compromise call.’
Debate on multi-class shares is divided into two questions. First, whether companies should be allowed to issue non-voting or low-voting shares, and second, whether firms with multiple shares should be included in indexes.
The practice of issuing shares with different voting rights in the US dates back to the 1920s. This prompted a backlash from investors, with the New York Stock Exchange going so far as to ban them in 1940.
In the 1980s, US-listed corporations took up dual-class shares again as they sought to protect themselves from hostile takeovers. More recently dual-class shares have become popular among Silicon Valley technology firms whose founders want to raise money without ceding control.
Larry Page and Sergey Brin, the founders of Google, cited such benefits in a letter filed with the US’s Securities and Exchange Commission ahead of the search engine’s initial public offering in 2004.
‘Media observers frequently point out that dual class ownership has allowed these companies to concentrate on their core, long-term interest in serious news coverage, despite fluctuations in quarterly results,’ they wrote.
‘The Berkshire Hathaway company [a conglomerate owned by Warren Buffett] has applied the same structure, with similar beneficial effects. From the point of view of long-term success in advancing a company’s core values, the structure has clearly been an advantage.’
“If you are looking for an investment in Snap and you are prepared to accept the risk that you cannot influence management, what is the harm?”
For investors there are some benefits to buying shares with reduced or no voting rights, compared to standard stock.
‘Zero-voting shares are likely to be cheaper,’ said Peter Swabey, policy and research director at ICSA. ‘They give you an investment in the company; they do not give you ownership rights.
‘If you are looking for an investment in Snap because you think it is a well-managed company and the shares are likely to increase in value, and you are prepared to accept the risk that you cannot influence management, what is the harm?’
Others argue the harm comes because investors are unable to scrutinise management decisions properly.
‘There are really few if any investor protections in terms of traditional ownership rights, because there are no voting rights,’ Dallas said. ‘A lot of people in our sector are thinking we should be careful about that form of structure existing at all.
‘Our fear is that the highly-competitive nature of the global market for new listings and IPOs [initial public offerings] runs the risk of compromising quality standards in the leading stock exchanges – and puts at a disadvantage the interests of minority shareholders and their beneficiaries, which include retail savers and pensioners.’
Countering this, the Google founders’ letter cites academic research claiming that dual-class structures do not harm share price. But there is some scepticism as to whether the success of the search engine should be seen as an example.
‘It is true that several prominent companies in the US high tech sector employ dual class,’ said Dallas.
‘But I would observe that investors in US technology companies are wary of the long term governance risks of this ownership model, and we would suggest that it is inappropriate to causally associate the success of the US tech sector with the use of differential ownership structures.’
Despite backlash in the US, exchanges in other countries are thinking about allowing dual-class companies to list. Hong Kong Exchanges and Clearing’s chief executive Charles Li justified the potential changes as part of its bid to attract ‘new economy’ firms, such as those in technology.
Bourses in Singapore and Malaysia are considering similar plans.
Even those who tolerate dual-class share structures can still be sceptical about their inclusion in benchmark indexes, which are used by passive investors such as pension funds to track the share movement of the largest companies.
‘If you are an active investor you can choose whether or not to invest in a company and sell the shares if you are unhappy with performance or management,’ said Swabey. ‘If you are in a tracker fund, then no matter how badly a company behaves or performs you are stuck with the shares.
‘Normally, you can use your voting power to force management to change, but if you have zero-voting shares, or a majority owner in an indexed security, a tracker fund has neither voting power nor the ability to sell the holding.’
Some passive tracker funds are said to focus many resources on voting, according to Dallas. ‘These larger passive houses divert a lot of resources into voting. Their premise is they are stuck with these companies whether they like it or not, so they try to influence the companies.’
Although S&P and FTSE Russell have restricted dual-class shares on their indexes, MSCI, another provider of indexes, is still consulting on what it should do. Henry Fernandez, chief executive of MSCI, confirmed to Bloomberg that the group was working with its customers on the issue.
“If you have zero-voting shares, or a majority owner in an indexed security, a tracker fund has neither voting power nor the ability to sell the holding”
‘Until now, governance-based criteria has not been part of our global index methodology,’ the company said in a statement. ‘Through feedback we sought from the investment community at the time of the Snap offering, we made the subsequent decision to more formally engage around this topic.’
Whether attempts to block dual-class firms from indexes will encourage companies to abandon the share structure is another matter though.
‘We will see what influence the indexation has in terms of a company’s financing plans and objectives,’ Dallas said. ‘If a company does change its terms it is an acknowledgement that the company sees a benefit in indexation.
‘Being on an index tends to come with a certain amount of liquidity in holding the stock. There is an informal rule it might be associated with 10% capitalisation.’