Synthetic Governance

Abstract

Although securities regulation is distinct from corporate governance, the two fields have considerable substantive overlap. By increasing the transparency and efficiency of the capital markets, securities regulation can also enhance the capacity of those markets to discipline governance decisions. The importance of market discipline is heightened by the increasingly vocal debate over what constitutes “good” corporate governance.

Securities product innovation offers new tools to address this debate. The rise of index-based investing provides a market-based mechanism for selecting among governance options and evaluating their effects. Through the creation of bespoke governance index funds, asset managers can create indexes that correspond to investors’ governance preferences. We argue that this “synthetic governance” offers a way to gather evidence on the economic impact of corporate governance by providing a market-based tool for evaluating the relationship between corporate governance and stock returns.

We illustrate the potential of synthetic governance by creating a new governance-based index, the Dual Index, which selects portfolio companies on the basis of a dual class voting structure and comparing its performance to various benchmarks. We further modify the Dual Index by implementing synthetic sunsets to highlight the value creation of dual class companies in their early years and provide evidence on the appropriate length of a time-based sunset provision. Finally, we expand our analysis of synthetic governance with a second index—the Split Index—which tests the effect of separating the positions of CEO and Chairman of the Board. We conclude that synthetic governance demonstrates the ability of securities market innovation to discipline corporate governance.

Keywords: Law and economics, corporate governance, capital markets, securities regulation, mutual funds, dual-class stock, shareholder voting, investment choices, asset management, index funds, split board chair and CEO

JEL Classification: G11, G32, G38, K22