The Untenable Case for Perpetual Dual-Class Stock

Lucian Bebchuk is the James Barr Ames Professor of Law, Economics, and Finance, and Director of the Program on Corporate Governance, at Harvard Law School. Kobi Kastiel is the Research Director of the Project on Controlling Shareholders of the Program. This post is based on their Article, The Untenable Case for Perpetual Dual-Class Stock, forthcoming in the Virginia Law Review. The Article is part of the research undertaken by the Project on Controlling Shareholders.

We recently placed on SSRN our study, The Untenable Case for Perpetual Dual-Class Stock. The study, which will be published by the Virginia Law Review in June 2017, analyzes the substantial costs and governance risks posed by companies that go public with a long-term dual-class structure.

The long-standing debate on dual-class structure has focused on whether dual-class stock is an efficient capital structure that should be permitted at the time of initial public offering (“IPO”). By contrast, we focus on how the passage of time since the IPO can be expected to affect the efficiency of such a structure.

Our analysis demonstrates that the potential advantages of dual-class structures (such as those resulting from founders’ superior leadership skills) tend to recede, and the potential costs tend to rise, as time passes from the IPO. Furthermore, we show that controllers have perverse incentives to retain dual-class structures even when those structures become inefficient over time. Accordingly, even those who believe that dual-class structures are in many cases efficient at the time of the IPO should recognize the substantial risk that their efficiency may decline and disappear over time. Going forward, the debate should focus on the permissibility of finite-term dual-class structures—that is, structures that sunset after a fixed period of time (such as ten or fifteen years) unless their extension is approved by shareholders unaffiliated with the controller.

We provide a framework for designing dual-class sunsets and address potential objections to their use. We also discuss the significant implications of our analysis for public officials, institutional investors, and researchers.

Below is a more detailed summary of our analysis:

1990, Viacom Inc., a prominent media company, adopted a dual-class capital structure, consisting of two classes of shares with differential voting rights. This structure enabled Viacom’s controlling shareholder, Sumner Redstone, to maintain full control over the company while holding only a small fraction of its equity capital. At the time, Redstone was already one of the most powerful and successful figures in Hollywood. Indeed, three years earlier, he had bought Viacom in a hostile takeover, exhibiting the kind of savvy and daring business maneuvers that subsequently helped him transform Viacom into a $40 billion entertainment empire that encompasses the Paramount movie studio and the CBS, MTV, and Showtime television networks. Investors during the 1990s could have reasonably been expected to be content with having Redstone safely at the helm.

Fast-forward twenty-six years to 2016: Ninety-three-year-old Redstone faced a lawsuit, brought by Viacom’s former CEO and a long-time company director, alleging that Redstone suffered from “profound physical and mental illness”; “has not been seen publicly for nearly a year[;] can no longer stand, walk, read, write or speak coherently; … cannot swallow[;] and requires a feeding tube to eat and drink.” Indeed, in a deposition, Redstone did not respond when asked his original family birth name. Some observers expressed concerns that “the company has been operating in limbo since the controversy erupted.” However, public investors, who own approximately ninety percent of Viacom’s equity capital, remained powerless and without influence over the company or the battle for its control.

Eventually, in August 2016, the parties reached a settlement agreement that ended their messy legal battles, providing Viacom’s former CEO with significant private benefits and leaving control in the hands of Redstone. Notably, despite the allegation and the evidence that surfaced, the settlement prevented a court ruling on whether Redstone was legally competent. Note that even a finding of legal competency would have hardly reassured public investors: Legal competence does not by itself qualify a person to make key decisions for a major company. Moreover, once Redstone passes away or is declared to be legally incompetent, legal arrangements in place would require the control stake to remain for decades in an irrevocable trust that would be managed by a group of trustees, most of whom have no proven business experience in leading large public companies. Thus, even assuming that Viacom’s governance structure was fully acceptable to public investors two decades ago, this structure has clearly become highly problematic for them.

Let us now turn from Viacom to Snap Inc. The company responsible for the popular disappearing-message application Snapchat has recently gone public with a multiple-class structure that would enable the company’s co-founders, Evan Spiegel and Robert Murphy, to have lifetime control over Snap. Given that they are now only twenty-six and twenty-eight years old, respectively, the co-founders can be expected to remain in control for a period that may last fifty or more years.

Public investors may be content with having Spiegel and Murphy securely at the helm in the years following Snap’s initial public offering. After all, Spiegel and Murphy might be viewed by investors as responsible for the creation and success of a company that went public at a valuation of nearly $24 billion. However, even if the Snap co-founders have unique talents and vision that make them by far the best individuals to lead the company in 2017 and the subsequent several years, it is hardly certain that they would continue to be fitting leaders down the road. The tech environment is highly dynamic, with disruptive innovations and a quick pace of change, and once-successful founders could well lose their golden touch after many years of leading their companies. Thus, an individual who is an excellent leader in 2017 might become an ill-fitting or even disastrous choice for making key decisions in 2037, 2047, or 2057. Accordingly, as the time since Snap’s IPO grows, so does the risk that Snap’s capital structure, and the co-founders’ resulting lock on control, will generate costly governance problems.

The examples of Viacom and Snap highlight an important dimension—the passage of time since a company’s IPO—that has thus far received insufficient attention. This Article seeks to provide a comprehensive, systematic analysis of how the potential costs and benefits of a dual-class structure—and thus the overall efficiency of such a structure—change over time. Our analysis demonstrates that, as time passes, the potential costs of a dual-class structure tend to increase and the potential benefits tend to erode. As a result, even if the structure were efficient at the time of the IPO, there would be a substantial risk that it would not remain so many years later, and this risk would keep increasing as time passes. Furthermore, we show that controllers have strong incentives to retain a dual-class structure even when that structure becomes inefficient over time. Thus, even those who believe that a dual-class structure is often efficient at the time of the IPO should recognize the perils of providing founders with perpetual or even lifetime control.

The debate going forward should focus on the assessment and permissibility of dual-class structures with a finite term—that is, structures that sunset after a fixed period of time (such as ten or fifteen years) unless their extension is approved by shareholders unaffiliated with the controller. We examine how sunsets could be designed, address potential objections to their use, and explain the implications of our analysis for public officials, institutional investors, and corporate governance researchers.

The analysis of our Article is organized as follows. Part I explains the substantial stakes in the policy debate that we seek to reframe. We begin by discussing the importance of dual-class companies in the United States and around the world. A significant number of U.S. public companies, including such well-known companies as CBS, Comcast, Facebook, Ford, Google, News Corp., and Nike, have dual-class structures. Furthermore, since Google decided to use a dual-class structure for its 2004 IPO, a significant number of “hot” tech companies have followed its lead.

Part I also discusses the long-standing debate over the desirability of dual-class structures. The New York Stock Exchange (“NYSE”) prohibited dual-class structures for approximately sixty years, until the mid-1980s, and they are still prohibited or rare in some jurisdictions, such as the United Kingdom and Hong Kong. However, the rules now prevailing in the United States, as well as in some other jurisdictions around the world, permit the use of dual-class stock. Moreover, the debate on the subject is still ongoing—both in jurisdictions that prohibit dual-class structures and those that permit them.

In this debate, which has thus far focused on whether and when it is desirable for companies to go public with a dual-class structure, we side with those who are skeptical of the value of dual-class IPOs. In this Article, however, we seek to reorient the debate by focusing on the mid-stream desirability of dual-class structures in long-standing public companies. Showing that dual-class structures are likely to become inefficient over time even if they happen to be efficient at the time of the IPO, we suggest taking one option—a perpetual dual-class structure—off the table. Going forward, the debate should focus on whether companies should be allowed to go public with finite-life dual-class structures—that is, structures with a sunset clause. Perpetual dual-class stock, without any time limitation, should not be part of the menu of options.

Part II analyzes how the potential costs of dual-class structures change over time. These costs tend to increase for two major reasons. To begin, in a dynamic business environment, even a founder who was the fittest leader at the time of the IPO might eventually become an inferior leader due to aging or changes in the business environment, and this risk increases the expected costs of providing the founder with a lifetime lock on control. Indeed, the expected costs of a lifetime lock on control are likely to be especially large when the founder is young or even middle-aged at the time of the IPO. Concerns about the emergence of inferior leadership over time are further aggravated when the dual-class structure enables a transfer of the founder’s lock on control to an heir who might be unfit to lead the company.

Furthermore, many dual-class structures enable controllers to substantially reduce their fraction of equity capital over time without relinquishing control, and controllers often do so to diversify their holdings or finance other investments or assets. When the wedge between the interests of the controller and those of the public investors grows over time, the agency costs of a dual-class structure can also be expected to increase.

Part III then analyzes how the potential benefits of a dual-class structure can be expected to change over time. Dual-class structures are often justified on the grounds that the founder of a company going public has skills, abilities, or vision that makes her uniquely fit to be at the helm. Many years later, however, the founder’s superiority as the company’s leader, and with it the expected value of having the founder retain a lock on control, could erode or disappear altogether. Another potential benefit often ascribed to dual-class structures is that they insulate management from short-term market pressures. However, the expected benefit from such insulation is likely to be larger when the controller is a fitting leader for the company and likely to decline when the passage of time makes the controller ill fitting for the leadership role. Finally, it might be suggested that insulation from market forces might be beneficial to companies that are new to the public market, but any such potential benefit is again expected to decline and eventually disappear as time passes from the IPO.

Part IV explains why public officials and investors cannot rely on private ordering to eliminate dual-class structures that become inefficient with time. We show that controlling shareholders, especially those who hold a small fraction of equity capital, have significant perverse incentives to retain a dual-class structure that has become inefficient, even when dismantling it—via a conversion to a one-share-one-vote structure or a sale of the company—would produce substantial efficiency gains. The reason is that the controller would capture only a fraction of the efficiency gains, which would be shared by all shareholders, but would fully bear the cost of forgoing the private benefits of control associated with the dual-class structure.

To address the distorted incentives of controllers to retain dual-class structures even when those structures become substantially inefficient, IPO dual-class structures can include sunset provisions stipulating the structures’ expiration after a fixed period of time, such as ten or fifteen years. Part V discusses the merits and design of such sunset provisions. To enable the retention of structures that remain efficient, we explain that the initially specified duration of the dual-class structure could be extended if such extension is approved by a majority of the shareholders unaffiliated with the controller. We also address potential objections to arrangements that preclude or discourage perpetual dual-class structures. In particular, we respond to objections that (1) perpetual dual-class structures should be presumed efficient if they are chosen by market participants and (2) allowing perpetual structures is necessary to induce founders to go public.

Finally, Part VI discusses the implications of our analysis for policymaking, investors, and corporate-governance research. Public officials and institutional investors should consider precluding or discouraging IPOs that set a perpetual dual-class structure. They should also be attentive to the aggravated agency problems that are posed by companies that went public with perpetual dual-class structures a long time ago. Researchers should take the time dimension into account in their analyses of dual-class structure and should test several empirical predictions that Part VI puts forward. We hope that future assessments of dual-class structures will be informed by the problems that we identify in this Article and the framework of analysis that we put forth.

The Article is available for download here.

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