Earlier this week, the S&P Dow Jones Indices announced that the S&P Composite 1500 and its component indices (the S&P 500, S&P MidCap 400 and S&P SmallCap 600) will no longer add companies with “multiple share class structures.” Existing index constituents will be grandfathered in. This decision follows a similar, but less sweeping proposal announced last week by FTSE Russell, with FTSE focused on multiple classes with limited or no voting rights. (The proposal is expected to be published, subject to any further feedback, as changes to the “ground rules” on August 25.) Another index, MSCI, has made a similar proposal. While these changes in methodology are imposed against the backdrop of an ongoing conversation about voting rights, the S&P confirmed to me informally that the change in methodology for the S&P Composite 1500 applies to multiple classes of listed or unlisted outstanding common equity, regardless of whether any class has limited or no voting rights. The S&P also confirmed that the phrase “multiple class share structures” is not intended to capture any class of preferred stock. Why do these changes in methodology matter? As described in this article from Reuters, “[i]nclusion in a stock index has been an important milestone for young companies, bringing their shares into many passive funds and others that closely follow indexes like the S&P 500, a guide for trillions of dollars of capital worldwide.”
The announcement indicates that the S&P Global BMI Indices and S&P Total Market Index will continue to include companies with multiple share classes or with limited or no shareholder voting. In those cases, because they are “broad market indices intended to represent the investment universe,” the S&P determined that the methodologies “should not consider governance arrangements when selecting the universe of constituents. Therefore, the methodologies for these indices are not being modified.” In addition, the S&P indicated that the methodologies of other S&P and Dow Jones branded indices are not affected by the change. In contrast, the S&P Composite 1500 is subject to the new methodology because it is “designed to reflect the U.S. equity market and, through the market, the U.S. economy,” and, to that end, provides index objectives and follows more restrictive eligibility rules, such as requiring a minimum float of 50% and positive GAAP earnings.
The proposal from the FTE Russell will, in the future, require market constituents of all standard FTSE Russell indices, including the Russell US indices, “to have greater than 5% of the company’s voting rights (aggregated across all of its equity securities, including, where identifiable, those that are not listed or trading) in the hands of unrestricted (free-float) shareholders as defined by FTSE Russell. “ Companies that do not satisfy the voting requirement “will have their securities rendered ineligible for index inclusion. For potential new constituents, including IPOs, the rule will apply with effect from the September semi-annual and quarterly reviews.“ Existing constituents will have a five-year grace period: the rule will be effective beginning in September 2022, thus allowing existing constituents time to change their capital structures if desired. The standard will be reviewed annually.
Both the S&P and FTSE conducted consultations with members of the investment community prior to taking action. (See this PubCo post for a discussion of corporate governance principles favored by a group of large institutional investors and asset managers, including a one-share-one vote standard.) According to FTSE, 68% of respondents to its consultation advocated the imposition of some minimum threshold for percentage voting rights, although there was a split of opinion on the minimum level: 23% advocated a 5% level and 55% advocated a 25% level. However, further analysis showed that those advocating a 25% level “were predominantly users of the FTSE UK Series where a minimum free float threshold of 25% already applies.” FTSE identified 37 companies that would currently be affected.
Note that at a recent meeting of the SEC’s Investor Advisory Committee, one panelist reported that, when a number of CFOs were asked why they would decide not to go public, at the top of the list was the need to maintain decision-making control. In the private market, another panelist suggested, companies and investors have a kind of unspoken “pact” about long-term strategy. But, said one panelist, the rise of hedge-fund activism in tech and other product-cycle-driven public companies—a relatively recent phenomenon—has fueled concerns among founders and other management that they will be hampered in pursuing long-term strategic goals by activists with short-term perspectives. These companies fear that activity that may have significant long-term payout, but a near-term adverse price impact (e.g., M&A activity, change in product strategy, substantial investment in R&D), will draw scrutiny and intervention from hedge-fund opportunists—hence the recent prevalence of dual-class capital structures, which a panelist characterized as merging some private company benefits into a public company structure. (See this PubCo post.) Here’s a question: if institutional investors would be somewhat more amenable to relatively mild protective measures such as classified boards and other similar protections, might public companies feel less need for recourse to no-vote and low-vote multi-class share structures, which some view as blunt instruments to protect against hedge fund activists? Just a thought…