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ANALYSIS: Will Investors Stick With Dual-Class Shares?

April 18, 2019, 7:17 PM

Lyft, Inc.’s much-ballyhooed IPO reignited the debate over the use of dual-class shares by public companies. Should a tiny minority of shareholders lock in control of a corporation’s votes indefinitely, simply because they are founders or family owners?

Dual-class stock commonly refers to any capital structure involving shares with unequal voting rights. The term can be a bit misleading, as it also includes companies that issue multiple share classes with differing rights. In the Lyft IPO, announced March 1, 2019, company insiders received shares with 20 votes each while shares issued to the public carried only one vote. This governance structure will give the company’s co-founders approximately five percent of Lyft’s outstanding shares, but they will control nearly 50 percent of the voting power.

Proponents argue that the structure encourages entrepreneurs and protects young companies from short-term focused activism, while critics express concern for investor rights and decry the disconnect between ownership and control. Given that regulators and the exchanges have either little interest or little authority to compel changes to companies’ capital structures, it appears that the markets will be the ultimate arbiters of the question.

When discussing dual-class shares, it is easy to think of the structure as a tech company phenomenon, with Facebook, Google, Snap and Lyft all offering shares with different voting power. Many long-established companies, such as Ford and the New York Times, also employ dual-class capital structures to protect the control by the Ford and Sulzberger families.

Dual Class Shares: What’s Not to Like?

According to the defenders of dual-class shares, a super-voting capital structure promotes strong leadership from the company’s founders and the continued support of early investors. By allowing dual-class share structures, companies may organize their businesses in a way that best serves their business model and the interests of their various stakeholders. Super-voting shares also protect the young company from takeover attempts and activist campaigns, which, according to defenders of dual-class structures, would allow founders to concentrate on the long-range strategic plans of the company.

Amit Singh, a shareholder in the San Diego office of Stradling Yocca Carlson & Rauth, told me that a dual-class structure allows public investors to participate in the growth opportunities afforded by young companies. In the absence of a provision allowing the founders to retain control of their companies, many ventures would choose to remain private and seek capital in the booming private markets. The dual-class structure, in his view, allows the company founders to continue to steer the business toward their long-term goals. He also thinks it is short-sighted for stock indices to exclude newly-public companies due to their capital structure. Such a move would do little to protect investor interests and could deny retail investors the opportunity to participate in the gains made by market newcomers.

SEC Commissioner Robert J. Jackson Jr. shares this view. He referred to the exclusion of these issuers from the major market indices as a “blunt tool” that concerns him. According to the commissioner, “Main Street investors may lose out on the chance to be a part of the growth of our most innovative companies ... the next Google or the next Facebook will deliver spectacular returns, but average Americans will, quite literally, not be invested in their growth.”

Proponents’ support for these structures is generally based on full disclosure and transparency of the risks of minority shareholder control, so that investors completely understand what they are purchasing. Former Delaware Supreme Court Chief Justice Myron T. Steele took a less nuanced approach to the idea of shares with different voting power when he spoke at a recent corporate governance symposium, when he stated “if you don’t like them, don’t buy them.”

Dual-Class Shares: A Terrible Idea!

Critics of dual-class shares, such as the Council of Institutional Investors (CII), argue that “when a company goes to the capital markets to raise money from the public, equity investors with the same residual claims should have equal protections and rights, including the right to vote in proportion to the size of their holdings.” Investor advocates see these structures as producing weak corporate governance, which in their view will lead to poor performance over time.

Public investors holding shares with limited voting power have few tools to deal with what they perceive as mismanagement. Holders of shares in companies with a one share, one vote structure may voice their displeasure by casting negative votes on “say on pay” proposals or by voting against director nominees. Institutional investors may also cast their lot with activist investors in an attempt to influence corporate changes.

Holders of limited-voting shares have few realistic options to express their displeasure with management, however. They can sell their shares and effectively vote with their feet. Investors can also file derivative actions for fiduciary duty breaches, but, under the business judgment rule in Delaware and other states, mere mismanagement is not actionable under state law. For investors, proving actionable misconduct is a difficult, expensive and often a losing proposition.

Sunset, Sunset

A possible compromise exists between the two sides. Some dual-class companies have included time-based sunset provisions into their organizational documents. At a defined time, the super-voting privileges expire and the dual-class structure converts to capitalization with one vote per share.

A sunsetting arrangement gives the company founders control or significant influence over the company’s operations for a set period of time, such as five or seven years. In 2018, CII submitted a proposal to Nasdaq and the New York Stock Exchange that asked the exchanges to require listed companies with dual-class shares to sunset these provisions in seven years, unless the shareholders voted with one vote per share to extend the structure.

Commissioner Jackson seems to be amenable to such an approach. He stated that “dual-class can be beneficial, as the structure can allow entrepreneurs to build for the long term—and even transform entire industries—without being subject to short-term pressure.” In his view though, perpetual dual-class ownership requires investors to trust not only the founders, but generations of their descendants to come.

Amit Singh recognized the potential value of sunsetting provisions but asked some interesting questions. If these provisions are made mandatory, such as through an exchange listing requirement, will the mandated sunset terms be “one size fits all” provisions? He wonders about companies that might require more than seven years of exclusive control by the framers, and if they would thrive under mandatory sunsetting. Should these companies be forced to deal with potential takeover attempts and activist campaigns that distract management from implementing the firm’s strategic objectives after the expiration of an arbitrary time period?

The Regulatory Framework Isn’t a Regulatory Framework

One key problem in this area is that there currently is either no interest or authority on the part of the major players in this space to act. There is no specific statutory authority for the SEC to act in this area under the Exchange Act. In a 1990 case brought by the Business Roundtable, the D.C. Circuit found that the agency’s general authority to oversee stock exchange rulemaking did not support the adoption of Exchange Act Rule 19c-4. This rule provided that issuers could not take actions having the effect of “nullifying, restricting or disparately reducing” the per share voting rights of existing holders.” Courts have subsequently interpreted Business Roundtable to preclude any SEC action in this area, including requiring any listing standards dealing with dual-class shares. For example, the D.C. Circuit stated in a 2005 case involving Investment Company Act rules that “[i]n Business Roundtable v. SEC, we held the Commission did not have authority under the 1934 Act to bar a stock exchange from listing common stock with restricted voting rights.”

Unlike the SEC, the exchanges do have the authority to act in this area, but show little inclination to do so. Nasdaq has committed fully to supporting multi-share class listings. The exchange said in a 2017 report that:

“One of America’s greatest strengths is that we are a magnet for entrepreneurship and innovation. Central to cultivating this strength is establishing multiple paths entrepreneurs can take to public markets. Each publicly-traded company should have flexibility to determine a class structure that is most appropriate and beneficial for them, so long as this structure is transparent and disclosed up-front so that investors have complete visibility into the company. Dual class structures allow investors to invest side-by-side with innovators and high growth companies, enjoying the financial benefits of these companies’ success.”

The New York Stock Exchange has not been as fulsome in its praise of dual-class structures as Nasdaq, but the exchange allows and solicits such listings. In a competitive environment, it is highly unlikely that the NYSE will take any steps to limit the listing of multi-class shares when its rival exchange is welcoming them with open arms. We are also not alone here in the U.S., given that as of last year, the exchanges in Hong Kong and Singapore accepted dual-class listings.

If You Don’t Like Them, Don’t Buy Them

In the absence of regulation, the markets will be the ultimate arbiter of multi-class shares. Issuers will have to decide whether the control provisions are worth the sacrifice of market activity that will result from their exclusion from several major index providers. So far investors seem open to the idea, and have voted with their dollars. Investors can be fickle, though, and a downturn in performance coupled with entrenched management may have investors heeding the words of Chief Justice Steele and not buy them.