Dual Class Share Structures: The Next Campaign

The arguments over the merits of dual class share structures have been heating up of late. The issue has resurfaced as institutional investors have complained about the increasing number of IPO companies (Facebook, Groupon, Zynga being the most notable) who have gone public as dual class stock companies limiting the rights and influence of shareholders and turning them into economic bystanders.

One of the stories we cited comes from IR Magazine “CalPERS Strategy Could Avoid IPOs with Dual Class Share Structures” discussing how the fund giant is planning to advocate against the use of dual class structures for companies exiting private equity and entering the public market. Earlier in August, at the ABA Business Section CLE conference, in Chicago, there was a panel discussion on the topic (“Dual Class Stock: Value Enhancer or Corporate Governance Killer?”) The panel comprised of institutional investors, a corporate director (and former investment manager), as well as a corporate attorney and Delaware jurist, all squared off on the issue.

Points of View

Institutional investors raise the point that dual class shares limit their ability to press boards and managements to make corrections or changes through the use of the shareholder vote. Those limits, investors allege, create an economic imbalance between management insiders, who usually hold the high voting rights shares and ordinary shareholders whose voting rights are essentially proscribed. Thus insulated, the board and management may engage in (or ignore) value destroying behavior — i.e: News Corp in the phone-hacking scandal or company insiders whose proposed transactions may appear, to some investors, to lack value for all shareholders and could be seen as questionable.

Companies with dual class structures argue that the insulation provides boards and management with an ability to plan and execute for the long-term, lessening the harsh power of quarterly earnings analysis and the short-term challenge of “making the numbers”. Dual class stock schemes also create a permanent level of protection against hostile takeovers by short-term holders. The advocates for the use of dual structures state that institutions with concerns about stock performance or shareholder rights can simply sell the stock and walk away.

Both sides cite studies defending their points of view. Governance advocates claim that companies with dual class structures trade at a discount to their non-dual class peers and create less value for ordinary shareholders in the long-term. Dual class companies point to their stock performance refuting the charge they underperform or are perceived by the market as discounted.

The Next Campaign

In reality institutional investors — the mutual fund complexes, the large public pension funds and the institutional asset managers – with their large pools of indexed capital — are limited in the nature of the responses they can undertake. Simply selling the stock, the “Wall Street Walk” is not a viable option. Divestment is a difficult process especially for the public pension funds that would need to manage the cost of financial and legal opinions, and lost opportunity cost to the fund’s equity portfolios.

So the question, from the governance advocate perspective, is what to do about this trend? Well the answer may be, as posited by some investor, to force changes in regulation via Congress, the SEC, the stock exchanges or at the index creators, the Russell Indexes.

What are the prospects for those potential changes? No matter the results of the upcoming November election, the House and Senate are likely to remain divided regardless of which party controls the White House so the legislation mandating such a change is doubtful. The SEC may experience more latitude if President Obama is re-elected, but with Mary Schapiro expected to depart at year’s end a new chairman will likely focus on pushing thru the Dodd-Frank regulatory backlog and not on a new investor crusade. A Romney SEC would not be fertile ground for “pro-investor” ideas such as this. Nor is it likely the stock exchanges would champion such a proposal. That leaves Russell Indexes. Were the Russell to restrict placement of companies with dual class shares in its indexes that might have the effect governance advocates are seeking. However, it is not clear that pressure from CalPERS, CalSTRS and other governance advocates would be sufficient to move Russell in that direction.

Along with push back against specific aspects of the JOBS Act, the new campaign against dual class structures is one we will be hearing more about in the months ahead.