We are delighted to contribute to this symposium. Adriana Roberton’s article, Passive in Name Only, sheds important light on an overlooked but important part of the investment ecosystem, index providers. Our article, Corporate Governance by Index Exclusion, recently published in the Boston University Law Review, expands on the core message of Robertson’s article, that indexes are not passive. In particular, we look at one way in which indexes may not be passive, in the setting of their inclusion and exclusion rules. We focus on the potential of their non-passivity to influence corporate governance.

Robertson’s article focuses on the breadth and diversity of indexes by a wide range of index providers, and its use as both a benchmark and for index investment. We focus on the second of these purposes, and narrow our focus to the providers of the headline indexes, S&P Global, FTSE Russell, and MSCI, because funds that invest based on these indexes are the biggest holders of U.S. equity. In this, our focus is closer to that of Robertson’s related work on the S&P 500, The (Mis)Uses of the S&P 500.

Far from being “passive,” Robertson’s findings indicate that index investing is better understood as a form of delegated management. In our piece, we show that delegated along with management is the power of index providers to affect governance rules. We examine the nature and limits of this power.

Investors have long been unhappy with certain governance arrangements adopted by companies undertaking IPOs, such as dual-class voting structures. Traditional sources of corporate governance rules—the Securities and Exchange Commission, state law, and exchange listing rules—do not constrain these arrangements. Competitive pressures lead those institutions to choose rules that cater to the preferences of corporate insiders rather than outside investors. Left without other options to influence corporate governance rules, investors turned to a source with which they do have leverage: index providers.

Our article provides a comprehensive analysis of the exclusion rules of index providers, their likely effects on insider decision-making, and their ability to serve as investors’ new gatekeepers. We show that efforts to portray index providers as the new sheriffs of the U.S. capital markets are overstated. Index providers face complex and conflicting interests, which make them reluctant regulators, at best. This reluctance to regulate is clearly reflected in the dual-class exclusion rules they adopted. We also analyze, theoretically and empirically, the efficacy of index exclusions in preventing disfavored arrangements and show that their efficacy is likely to be limited, but not zero (as some scholars argue). We conclude by examining the lessons from this important experiment and the way forward for corporate governance.

In March 2017, Snap Inc. went public in a highly anticipated IPO, valuing the company at $24 billion, and making it one of the largest “unicorn” companies to go public.  But to many investors, Snap’s IPO was controversial for another reason: Snap proposed a multi-class capital structure, where insiders and some pre-IPO investors had the right to vote but other shareholders did not. Investors expressed complaints about being forced to invest in shares without any voting rights.  Snap, as some investors argue, had crossed “a line in the sand.”

The rise of index investing adds another dimension to this problem. Over the past two decades there has been a substantial shift from active management to index management. As Robertson describes, the investment decisions of index investors are determined by the inclusion and weightings of securities in the index. Once a company with a disfavored governance structure is included in an index, index investors are essentially required to invest in the company. This limits the investment decisions of index investors contemplating investing in companies like Snap and other future companies like it, but it also vests a potential source of power in index providers.

At the end of July 2017, S&P Dow Jones announced that the S&P Composite 1500 and its component indexes would no longer add companies with multi-class structures. Around the same time, another leading index provider, FTSE Russell decided to exclude companies with extremely low, or non-voting, rights from its indexes.

Market participants view these new exclusion rules as an important shift in the governance landscape. The Council of Institutional Investors has claimed that “[i]ndex providers’ action responds to a void left by years of inaction from stock exchanges, regulators and global regulatory coordinators.”  One commentator remarked that the key governance debate of the modern market regarding the use of dual-class shares “was fought and decided, not at the Securities and Exchange Commission or in Congress . . . but by a couple of for-profit index providers.”

In our article, we show that index providers face a complex set of conflicted interests and incentives. On one hand, where particular arrangements are strongly disfavored by their clients, index providers have an incentive to respond to those preferences by adopting an exclusion rule. On the other hand, there are numerous factors that make index providers reluctant regulators, at best. What constrains index providers?

First, index providers have reason to be concerned about federal regulation if they intervene too strongly in the corporate governance choices of their constituents. Second, the exclusion tool does not fit well with the business model of index providers and their preference not to limit their clients’ access to the investable universe of public companies. Third, index providers face a divergence in the views of their clients regarding exclusion rules, making them reluctant to adopt strong exclusion rules. Fourth, index providers also prefer to avoid sudden extreme changes in the composition of their indexes that would require substantial and costly portfolio rebalancing by their clients. Finally, index providers face some (albeit mild) competitive pressures that may reduce their inclination to adopt very restrictive exclusions.

Index providers’ reluctance to regulate is clearly reflected in the dual-class exclusion rules they adopted, which contained important loopholes and limitations. The S&P dual-class exclusion applies only to new IPO companies, and may not be relevant to many dual-class companies for years following an IPO.  The Russell exclusion can be circumvented by ensuring that public investors hold slightly more than five percent of voting rights and thus still enables the inclusion of companies with extreme separation between controllers’ equity and voting rights.

We also consider the likely effects of index exclusions on insiders’ decision-making. Even if index providers were able to serve as investors’ new gatekeepers, their exclusions are unlikely to fully prevent disfavored governance arrangements from emerging for several reasons. First, the financial effect of index exclusions on the firm stock price may be more limited than initially assumed, and empirical evidence on the existence of such an effect is mixed. Second, inclusion in indexes would happen at some point in the future, so the impact of index exclusions must be discounted to reflect the time value of money. Third, because S&P Global exercises discretion regarding which companies it includes in the S&P Composite Indexes, including the S&P 500, index inclusion is not assured. Thus, the effect of the index exclusion must be discounted by the probability that the company would not be included in the index even if it were eligible. Fourth, that index inclusion is generally delayed for some time provides insiders with a “free option” to have their company go public with the disfavored arrangement and maintain it until the company would otherwise become eligible for index inclusion, at which point they can remove the arrangement.

Given the foregoing, the likelihood that index exclusion rules would deter insiders from adopting certain governance arrangements they find valuable is limited. This is especially the case for post-IPO companies because the costs of index exclusions are shared among all shareholders in the company, whereas the private benefits of control from disfavored arrangements accrue exclusively to insiders.

Does this mean that the index exclusions were meaningless and should be eliminated as some scholars have argued?  We cannot agree.

At the very least, the index exclusions can represent a symbolic win for investors against the use of non-voting shares. The Snap IPO represented the high-water mark in a long trend towards more frequent and more unequal dual-class structures. Investors were concerned that if the Snap IPO went unchallenged, it would set a new and dangerous precedent for future companies going public. The ability of these investors to influence index providers to exclude dual-class companies, even in a limited fashion, reaffirms the power of those investors.

In addition, even limited index exclusions may have some effects on the choice of governance arrangements by IPO companies. Data that we collected on the incidence of dual-class IPOs before and after the adoption of the dual-class exclusions confirms our theory that index exclusions are likely to have limited but non-zero effects. While index exclusions were not effective enough to substantially eliminate the use of dual-class shares, they on the margin seem to cause insiders to reduce their use of dual-class structures at the IPO stage. Moreover, the details of the dual-class arrangements that have been adopted since the Snap IPO suggest a weakening of the dual-class arrangements that IPO companies choose. Recent IPOs have seen a limited increase in the use of time-based sunset provisions, and the no further cases of non-voting shares being issued in IPOs. Therefore, recent calls to eliminate index exclusions are premature, and investors, index providers, and policy-makers would be better served by pausing to observe the impact of the index exclusions.

Passive in Name Only makes valuable and innovative contributions to our understanding of indexes and index funds, and we expect that it will be an important building block for future research in this important and rapidly developing field. Among other things, Robertson’s explanation of indexes as delegated management has important implications, many of which are explored in her article. We hope that our article adds to this understanding by showing how this delegated management also gives index providers the power to affect governance rules. More importantly, however, we also highlight the limits of this power, showing that index providers face significant constrains in their ability to influence corporate governance.

Scott Hirst is an Associate Professor of Law at the Boston University School of Law, and Director of Institutional Investor Research at the Harvard Law School Program on Corporate Governance.  Kobi Kastiel is an Assistant Professor of Law at Tel Aviv University, and a Research Fellow at the Harvard Law School Program on Corporate Governance. 

This post is part of a symposium on delegated investment management. The rest of the posts in this symposium can be viewed here.