Index Eligibility as Governance Battlefield: Why the System is Not Broken and We Can Live With Dual Class Issuers

As passive investing via funds that track market indices continues to grow, the terrain where investors are fighting battles over governance reform is now expanding beyond contested stockholder meetings and into debates over the criteria for eligibility of issuers for inclusion in these indices. Indeed, in this era of index fund investing, a company focused on the future trading price of its shares should be much more concerned about gaining entry into and maintaining eligibility for indices than whether there will be a withhold vote recommendation on the members of its governance committee. If this direction continues to gain traction, we could end up with a market dominated by passive strategy investing where the current importance of familiarity with the hot button governance concerns of proxy advisory firms and institutional investors becomes subsidiary to understanding how to navigate new, governance-related eligibility requirements of major equity indices.

The recently launched campaign by the Council of Institutional Investors, among others, to block Snap Inc.’s eligibility for S&P Dow Jones and other indices, as a result of Snap’s dual class share structure, may be looked back on as a turning point in this expansion of the governance battlefield. Significantly, CII’s public position is to exclude from the indices not only all new classes of “no vote” shares, but also all “low vote” shares in new dual class issuers absent a strict five-year sunset or ratification by the low vote holders. [1] We may well see future campaigns by CII and others to enshrine other corporate governance practices into eligibility criteria for indices. Recent developments in the realm of dual class issuers sheds light on whether this potential movement of governance matters into index eligibility criteria is sensible.

One argument against inclusion of dual class issuers with controlling stockholders in an index is that these issuers merit “controlled company” discounts due to the risk of non-alignment between their controlling stockholders and the public stockholders and therefore these issuers are fundamentally different than the other issuers in the index. But, of course, not all controlled companies are the same as there are many variables beyond capital structure and the presence of a controlling stockholder that feed into a company’s trading multiple [2] and therefore the major indices have not historically excluded issuers strictly on the basis of a dual class structure or the presence of a controlling stockholder.

Hence, the current debate over dual class structures tends to focus less on any automatic, empirically-based link between performance metrics and dual class structures and more on concepts, such as “the promotion of accountability” (by the opponents of dual class) vs. “insulation from the forces of short-termism” (by the proponents of dual class). Ironically, both the opponents and the proponents argue that our current “system is broken” and that is why we need bright line rules either to prohibit dual class structures—otherwise investors will be left naked and vulnerable to the costs of entrenched control groups—or to enshrine dual classes—otherwise boards will be at risk of being voted out for sacrificing near-term results to permit the pursuit of extraordinary, long-term achievements. Fortunately, the “system” is not broken and there is a well-worn path to a market solution to this debate and that is where the focus should be, rather than on creating barriers such as eligibility requirements for market indices.

Even if the growth of passive-strategy investing continues, there will always be a place for the active manager and, indeed, even for the activist. Thanks to the active manager class, there will, from time to time, be a trading discount attributable to the entrenchment of control by holders of high-vote shares that becomes sufficiently glaring such that it will become feasible to negotiate a collapse of the dual class structure through a reclassification transaction that is a win for both the public shareholders and for the control group. In the reclassification, all the high vote shares are converted into low vote shares at a premium to the exchange ratio that would otherwise apply, while the premium is low enough to preserve room for a multiple bump in the trading price attributable to the elimination of the control group and their entrenchment via the dual class structure. Should boards miss these scenarios where unwinding the dual class makes sense for both the control group and the public, observant activists should be able to pick out these scenarios on their screens and bring them to the attention of boards.

Arguably this is what happened over the last year at Forest City, a dual class company that had been founded and controlled by the same extended family since its IPO in the 1960s. The family, through its ownership of high-vote stock, controlled the election of 75% of the board seats (the other 25% were set aside by the charter to be elected by the low vote shares) while owning just 10% of the economics. The largest public shareholders, as is typical for a multi-billion dollar market cap issuer, included not only passive funds managed by Vanguard and Blackrock, but also active managers like Fidelity and Senator. In June 2016, Scopia, an activist fund, filed a Schedule 13D revealing a 7% interest and a desire to push for the collapse of the dual class structure. At the heart of Scopia’s thesis was that Forest City was trading at a steep discount to where its financial metrics indicated it should be trading, which left the entrenchment of control through the dual class structure as the culprit. The board, dominated by family members, accepted the recommendation of Scopia to explore reclassification and appointed directors, who were elected by the low-vote shares and unaffiliated with the family, to a special committee to negotiate with the family a collapse of the dual class structure. Within less than six months, a deal was cut that provided for the conversion of all the high vote shares into low votes at a 1:1.31 ratio (a 31% conversion premium over the 1:1 ratio otherwise available under the charter) and Scopia agreed to support the transaction, which was conditioned on approval by a majority of the low vote shares voting as a separate class. Decades of dual class-based control were set to be unwound based on arm’s-length negotiations focused on economic rationality. On June 12, 2017, just about one year from the date of Scopia’s initial Schedule 13D, both classes of shares formally adopted the reclassification to eliminate the dual class. The transaction was a win for both the controllers (who received a 31% premium for their high vote shares) and the public (the low vote shares traded up over 10% on the announcement).

Among the factors that will make an issuer more or less ripe for a reclassification transaction and that merit taking into account in any negotiation or consideration of such a transaction is the magnitude of the equity position (disregarding voting power) represented by the holdings of the control group. The smaller the equity position, the easier it may be to provide the control group with a generous exchange ratio that still leaves lots of room for all the low vote shares to benefit from a multiple expansion triggered by the reclassification’s elimination of the overhang of control. This conclusion is contrary to that reached in the leading “anti-dual class” paper, most recently revised in May 2017, by Harvard’s Lucian Bebchuk and Kobi Kastiel (discussed on the Forum here). [3] Their paper incorrectly assumes that a reclassification transaction would not occur, due to deterrents under applicable corporate law, if the exchange ratio were to result in the receipt by the control group of a portion of the overall increase in the company’s market capitalization attributable to the reclassification disproportionate to the control group’s pro rata ownership on a per share basis. But, while there are procedural hurdles for any related party transaction with a controlling holder such as a reclassification, these hurdles are far from insurmountable. In fact, the roadmap for transactions between a company and its control group, laid out in the Delaware Supreme Court’s MFW decision [4] and generally followed by Forest City (although Forest City is organized under Maryland law), actually greatly facilitates the ability to enter into a reclassification transaction. The requirement is not strict allocation of the benefits pro rata between the low vote and high vote, but terms negotiated by a committee of independent directors, conditioned on approval by a majority of the disinterested (i.e., non-control group) shareholders and reasonably characterized by the committee in good faith as being at least fair to and in the best interests of the non-control group stockholders.

Factors that may make a dual class company less ripe for a reclassification transaction include:

• Minority protections under the dual class structure, such as the reservation of board seats and other matters for class votes of the low vote holders
• Sunset provisions for the dual class structure (e.g., as a result of the death of the members of the control group or a near-term date)
• Failure of the dual class to entrench control of the company by any group—e.g., if the high vote shares are freely tradeable and are increasingly held by entities and individuals who do not act in concert

Dual class is necessarily neither a vice nor a virtue. The lesson of Forest City is that, when a dual class structure ceases to be economically rational, a relatively easy escape valve exists and, most importantly, incentives for the control group to head for that exit become palpable. [5] The system is not broken. Before market indices start serving as gatekeepers for corporate governance “best practices,” they should undertake a similar analysis of whether the system really needs fixing.

Endnotes:

1http://www.cii.org/files/issues_and_advocacy/correspondence/2017/20170426%20CII%20comment%20S&P%20no%20vote%20share.pdf(go back)

2In addition to the readily available anecdotal evidence of high performing controlled companies with dual class structures, the compilations of financial and market data, collected and cited by even the critics of dual class structures, shows that many controlled, dual class issuers out-perform the market under a spectrum of metrics. See, e.g., the latest IRRC/ISS study strongly opposing the entrenchment of control via dual class structures, but providing a series of charts that show numerous categories (three-year and five-year average shareholder return, five-year and ten-year average EBITDA growth, average return on equity, five-year and ten-year return on invested capital, five-year and ten-year return on assets, and current assets to current liabilities ratio) where the results for controlled multi-class issuers are superior to or statistically indistinguishable from those of non-controlled issuers, at https://irrcinstitute.org/wp-content/uploads/2016/03/Controlled-Companies-IRRCI-2015-FINAL-3-16-16.pdf(go back)

3https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2954630, (discussed on the Forum here).(go back)

4http://www.clearymawatch.com/2016/10/delaware-chancery-applies-mfw-dismiss-challenge-going-private-transaction-clarifies-obligations-controlling-stockholders/ (discussed on the Forum here).(go back)

5There are numerous other examples of recapitalization transactions that collapse dual class structures, see. e.g., those cited in the descriptions of the financial analyses by the financial advisors on the Forest City transaction at https://www.sec.gov/Archives/edgar/data/1647509/000119312517124689/d289676ds4a.htm(go back)