Composition of Canadian indexes leaves much to be desired

It seems like the biggest boosters of dual-class share structures in Canada could be the index makers, whose restrictions for which firms are eligible for Canadian indexes are looser than what is permitted in the U.S.

A run through the S&P/TSX 60 index reveals 12 companies with dual-class share structures.

While some have two classes of shares to help enforce foreign ownership restrictions, others have become controversial over the years because the separate classes are meant to secure voting control for groups that retain minority equity ownership.

In May, Bombardier Inc. faced a shareholder proposal at its annual general meeting to unwind its dual-class shares. The Bombardier extended family holds over 50% of the votes while owning roughly 12% of the equity. Several large institutional shareholders and proxy advisory firms backed the proposal to eliminate the current structure. Ultimately, the proposal failed without the votes of the Bombardier clan.

Eligibility for Canadian and U.S. indexes

Who decides what companies are included in the most quoted and followed Canadian equity indexes? S&P Global, through its majority-owned subsidiary S&P Dow Jones Indices, manages the Canadian S&P/TSX indexes. Specifically, the index committee, comprising four people from S&P and three from the Toronto Stock Exchange, makes the ultimate decision on how billions of dollars tied to index changes will flow, and what types of corporate structures are permitted.

The index committee allows Canadian indexes to include companies with dual-class share structures, limited partnerships, investment trusts and royalty trusts.

Since 2017, the index committee in the U.S. has not allowed companies with dual-class shares to be added to the S&P 500. Likewise, the committee also prohibits limited partnerships and trusts from inclusion.

Looking at recent changes to the S&P/TSX 60 in Canada, the inclusion of Brookfield Infrastructure Partners LP and Shopify Inc. would not have been permitted south of the border.

Implications for investors

What does this discrepancy mean for the overall governance level of the S&P/TSX 60, and its investability versus U.S. indexes? One could make the case that recently floated companies like Shopify could balance founder control and the execution of their vision to the benefit of minority shareholders (although governance pundits might like to see a hard-date sunset clause for the dual-class shares).

But it’s hard to believe that Brookfield’s public limited partnerships (subsidiaries of the parent Brookfield Asset Management) are acceptable to anyone who perceives democratic governance as important to investing. Brookfield goes out of its way to craft agreements between the parent and subsidiaries that circumvent normal governance protections. Furthermore, the self-styled independent directors of the subsidiary can side with the parent if they choose, and against the interests of the minority investors whom they are ostensibly tasked with protecting.

Governance issues aside, why double up on the Brookfield LP when the parent is already part of the index? It seems like repeating the mistake of having both Loblaw Companies and George Weston Limited in the S&P/TSX 60 when Weston owns over 50% of Loblaw.

Investors also shouldn’t lose sight of the fact that they are minority shareholders in several other companies in the S&P/TSX 60, whether those share structures are egalitarian or not. Husky Energy, Imperial Oil and Thomson Reuters all have majority owners with more than 50% of the shares outstanding. The index committee for the S&P/TSX indexes are not concerned with the governance angle (or size of the float) so much as they are focused on the liquidity aspect (turnover of the float).

What can be done?

The takeaway for advisors is that Canadian indexes are more arbitrary than they are efficient or reasonably reflective of the Canadian economy. It’s one of the major reasons that some advisors look to diversify clients beyond Canadian index ETFs and closet-indexed mutual funds.

If you want to limit governance concerns, steer clear of the S&P/TSX 60 in favour of more democratic options. The index can always be a starting point, but the value-add for your clients over an ETF or closeted fund could be screening out governance concerns and minority shareholder positions, especially when there is interest from them for ESG investment solutions.

Dr. Al Rosen, FCA, FCMA, FCPA, CFE, CIP and Mark Rosen, MBA, CFA, CFE run Accountability Research Corp., providing independent equity research to investment advisors across Canada. www.accountabilityresearch.com