Unequal Voting and the Business Judgment Rule

Charles M. Elson is the Director of the John L. Weinberg Center for Corporate Governance, and the Edgar S. Woolard, Jr., Professor, at the University of Delaware; Craig K. Ferrere is a term clerk for the Honorable Thomas L. Ambro of the United States Court of Appeals for the Third Circuit. Related research from the Program on Corporate Governance includes The Untenable Case for Perpetual Dual-Class Stock (discussed on the Forum hereand The Perils of Small-Minority Controllers (discussed on the Forum here), both by Lucian Bebchuk and Kobi Kastiel.

Increasingly, company founders have been opting to shore up control by creating voting structures that undercut shareholder voting power, where only a decade ago almost all chose the standard and accepted one-share, one-vote structure. Now the Snap Inc. initial public offering has gone even further with the first-ever non-voting stock model. By offering stock in the company with no shareholder vote at all, Snap—the company behind the popular mobile-messaging app Snapchat (that is all about giving a voice to the many)—has acknowledged that public voting power at controlled companies is only a fiction. This stock ownership structure undercuts shareholder influence, undermines corporate governance, and will shift the burden of investment grievances to the courts.

Snap’s March 2017 initial, non-voting-stock public offering is, in modern times, unprecedented. [1] Its multi-class, non-voting capitalization gives Evan Spiegel and Robert Murphy, the company’s founders, and holders of ten-vote shares, a lifetime lock on control, without the need to retain an expensive ownership position. [2] They exercise a decisive 89 percent of the voting power, despite holding only about 44 percent of the company’s total equity.

A New Deal For Shareholders

Dual- and multi-class capitalizations—in which founders and other insiders retain a class of high-vote shares while selling low-vote shares to the public—are nothing new for controlled companies. This mechanism has long allowed founding individuals and families to leverage minority economic ownership positions—say 10 or 20 percent—into total voting control of large companies such as Snap, Facebook, and Google. But the Snap plan stretches this logic to its limit—with no-vote shares, founders can sell off all but one voting share, and, nonetheless, control every aspect of company policy.

With zero-vote IPO stock, the logic of leveraging control from a minority interest through the dual-class structure has now reached its illogical conclusion. With non-voting shares, a founder can advise investors plainly, without any pretense or suggestion otherwise, that she will take their money but not their advice. We’ve reached the zenith, and in its wake is the normalization of the disenfranchisement of public shareholders through dual- and other multi-class structures.

The one-share controller hypothetical is, indeed, extreme. It is not, however, farfetched. There is a strong tendency for controllers to reduce their equity interest over time. [3] The high cost to founders of monitoring management and holding large, illiquid, and undiversified positions in a single company explains this push away from concentrated ownership.

Though a controller is unlikely to reduce her position to a penny, the controller-divestment phenomenon leads to extreme agency costs even at far less extreme points of divestment. As Lucian Bebchuk and Kobi Kastiel have explained, significant agency costs arise well before total controller divestment. As the fraction of the company’s cash flow rights held by the controller decreases, he or she can foist more of the cost of personal benefits taken from the company onto the other shareholders. This creates an incentive for the controller to make more inefficient choices over a range of outcomes that are increasingly bad for the minority shareholders. The result of this two-pronged dynamic is that expected agency costs increase sharply as a controller’s proportional cash flow rights decrease. As a result, a reduction of ownership from just 20% to 15% more than doubles the expected agency costs. [4]

How We Got Here

Not long ago, even simple dual-class capital structures were the anachronistic refuge of either media conglomerates or old-style industrial titans. Companies used the structure when the requirements for journalistic integrity and independence from the market demanded a safe-harbor fortified by an impregnable curtain of voting control—the New York Times Company, News Corp., and the Washington Post are the representative adopters. It was also used at companies built by a founder through such singular achievement that the market could be strong-armed into accepting little-to-no protection in exchange for the capital it was giving, in trust, to a “genius.” The Ford Motor Company, Berkshire Hathaway, and Estée Lauder Companies are some well-known examples.

A twenty-first-century trend, begun by Google in its 2004 IPO, is driving the dual-class capital structure out of the uncommon and into the mainstream. Increasingly, founders are opting to bolster control through highly leveraged voting structures, compared to the standard and accepted one-share, one-vote structure that was a constant for fear of an investor revolt and a public relations maelstrom.

Today 9% of the S&P 100—representing $2.26 trillion in market capitalization—is dual-class. In the Russell 3000, such companies represent 8% of the index. Now, the phenomenon extends well beyond the technology and media industries. Significant dual-class companies include AMC, Box, Nike, Ralph Lauren, Tyson Foods and Under Armor. (The Council of Institutional Investors maintains a complete list list.) As dual-class controlled companies are steadily increasing in prominence hard thinking about the importance of the shareholder vote is due. More than one-in-nine of the new companies added to the Russell 3000 index through IPOs is dual-class. In 2015, 13.5% of the 133 IPOs listed dual-class shares, compared to just 1% in 2005.

Many companies took Google’s example and pushed the envelope even further. Among them, Zynga, which went public in 2011, raising over $1 billion, had a founder-only class of stock with a staggering seventy votes per share. Zynga’s founder, Mark Pincus, has effective control with 37 percent of the vote, despite having only a 12 percent economic interest in the company. Prior to 2016, Groupon, Inc., had a 150:1 voting ratio and Universal Health Services has a 1,000:1 ratio.

That said, Snap’s issuance of shares with no vote was unprecedented: instead of having no effective voting power, its new shares have no actual voting power. The structure will allow its co-founders, twenty-six and twenty-eight years old, to control the company until the day both are dead. The growing number of dual-class companies in the American economy together with the advent of no-vote stock raises serious questions about how the courts will view transactions involving these companies, in light of the accountability that a meaningful shareholder vote provides.

No-Vote Shares in the Courts

Contemporary criticism of dual-class capitalizations has focused on the reduction in accountability. However, the lessened accountability’s effect on the approach that courts must take in reviewing the actions of these companies and their boards has not yet been considered. This issue presents the most significant problem with permitting the use of dual-class structures. We must reconsider the long-settled policy of judicial restraint wherein courts have concluded that with regards to business judgment management action will not be reviewed at all. American courts may decide that more active judicial intervention is necessary—because without a vote shareholders can’t provide oversight of boards and thus management—and take on greater responsibility for shareholder protection at these companies.

In most circumstances, when an disinterested and independent board of directors has acted in “good faith” and “with reasonable care” its decision will be considered a business judgment and not be interfered with by a reviewing court. This rule expresses the judicial reticence to second-guess the complex, real-time decisions of management. Where applied, the view that judicial regulation of management’s business judgment will not serve as a measure of additional shareholder protection justifies the rule.

Ordinarily, markets and corporate democracy get the job done, so courts need not. Thus, judges typically will not step up to protect shareholders from bad managerial decisions. Doing so would be duplicative and unproductive. [5] All things equal, bad management leads to poor company performance, which leads to depressed stock prices. Falling equity values hit executives hard, as today most of their pay and much of their assets are made up of stock and options. Glum results also beacon corporate raiders who, once inside, will fire the existing management and install more effective managers. Unemployed, formerly bad managers will find their prospects limited as companies want to hire high performers and today managers are evaluated by how high stock prices rise. This dynamic alone should spur effective action from any manager at all interested in her reputation, career longevity, and finances.

There is little use in the courts piling on after all is said and done. [6] Shareholders, by voting, can decide what to do with the ineffective managers. [7] For mistaken business judgment, a court’s post-hoc imposition of liability is only likely to chill corporate risk-taking. [8] There is no reason to believe, in any case, that judges will more ably decide the matter than managers and directors, who possess superior substantive business acumen. [9] Add the considerable expense and delay from litigation and it is no wonder courts leave shareholder protection largely to the markets and the vote. [10]

Markets can constrain the discretion of the controllers of one-share-class companies too. Even without the ability for minority shareholders to monitor them, large equity positions create powerful incentives for a controlling owner to run a tight ship. After all, she will bear a large part of the cost of every company expense and failed venture. In many respects, concentrated ownership is an antidote to the problem of monitoring management when shareholders are multiple, small, and dispersed. But the market does not punish controller self-dealing, as the direct fruits outweigh the proportional share of lost firm value borne by the controller. So, this is the point at which courts take a stand. [11]

The flip side of the idea that courts should not provide extra corporate control where markets do it better is that when markets fail the courts should be ready to jump in. Thus, they deploy greater scrutiny of interested transactions, culminating in the severe entire fairness standard. But these more exacting standards of review are reserved for transactions that expose conflicted controller interests that exclude the minority interests. Thus, as in Sinclair Oil Corp. v. Levien, a subsidiary’s proportional dividends are not subject to fairness review, for example, while its contracts with the parent corporation might be. 280 A.2d at 721–22, 723.

And even in these problematic circumstances, the courts are willing to walk back scrutiny so long as steps are taken to mimic market controls. By doing so, the transactions more resemble those within courts’ markets-backed comfort zone. For instance, in controller transactions the informed approval of a majority of the minority shareholders shifts the burden of proof on the issue of fairness to the plaintiff. The same effect follows the use of an independent committee of directors. The combination of these two methods can win the transaction business judgment review. [12] Altogether, there is an effort by the courts to substitute a form of market review for judicial review.

An Evolution in the Law? We Think Not

The Sinclair Oil rule makes less sense when applied to dual-class controlled companies. Unlike a single-class controlled company, for a dual-class controlled company there may be neither market nor board constraints. [13] A dual-class controller may bear very little of the cost of inefficient management and bad strategy. Through leveraged, multi-class ownership structures, she may, in the end, own only a small percentage of the company. Market incentives are significantly eroded, as only a fraction of the consequence of poor management is borne by the controller. In the case of the one-share controller hypothetical, those incentives would be non-existent. Thus, significant deviations from the efficient operation of the business can be sustained at the expense of the public shareholders who hold the majority of the firm’s economic interest. (In a recent paper, Lucian Bebchuk and Kobi Kastiel discuss in depth the incidence of and problems with these “small-minority” controllers.)

The $2.6 billion pay package awarded by Tesla to Elon Musk, its founder and controller, suggests a dollar figure for the scale of the eroded incentives. He will earn $50 billion if he meets a set of ambitious performance objectives. Tesla did not fear that Musk, a driven entrepreneur, would slack generally. Rather, the company sought to buy his attention with “a sum so large it might just ensure that Musk’s array of other passions and esoteric side projects won’t steal too much time from his work at Tesla.” Consider also Facebook’s recently proposed but then scrapped plan to issue nonvoting stock so that Mark Zuckerberg, its founder could offload $74 billion to charity, reducing his economic interest to 3 percent, without losing control.

Courts will need to confront this challenge to traditional business law doctrine. Without board and market forces protecting shareholder interests, the burden of monitoring investments and dealing with problems will end up in the courts. The judiciary must determine whether to add heightened review of operational decisions at dual-class controlled companies to the already heightened review of interested transactions. The alternative is allowing a new breed of unaccountable and unmotivated controlled corporations.

Of course, if courts decide to scrutinize a dual-class company’s transactions more forcefully, the minority shareholders of such companies are free-riding by shifting the costs of monitoring bad management to the judicial system. The public expense and difficulty of the resulting judicial review is another reason for restricting or eliminating dual-class ownership.

But there are costs imposed on America’s corporate courts even if they choose not to provide a meaningful heightened review. Those courts treat the protection of shareholder interests as their primary task and objective. If the courts choose not to engage in heightened scrutiny, allowing dual-class company founders a relatively free hand, the judiciary’s credibility and reputation will be harmed. That position also contradicts the doctrinal framework governing judicial review of corporate conduct. No doubt this is a problematic posture for the judiciary: the recognition, on the one hand, of a critical need for oversight, coupled with the decision to stay out of it. Judges are unaccustomed to throwing up their hands in the face of present harm.

What will the courts choose to do? Our belief is that they will continue to abstain from engaging in heightened review of day-to-day, non-conflicted transactions at dual-class controlled companies. Courts are ill-suited for policing poor managerial performance and low effort. Looking at a single unfavorable outcome, it is near impossible for a court to observe whether the cause was bad luck or bad management. [14] Across that expanse of time and knowledge, judges are unable to substitute their business judgment for that of experienced corporate management. Thus, while heightened review might be doctrinally prudent, it is practically unfeasible. The result will be a growing number of dual-class companies that are unaccountable to shareholders, the markets, and the courts. In consequence, we may need to discard the entire dual-class structure.

If not, we may end up with a governance snap-judgment day.

Endnotes

1Nonvoting shares are not historically unprecedented. However, except for a brief period in the early twentieth century, they have been used to avoid rather than facilitate concentrations of control. See David L. Ratner, The Government of Business Corporations: Critical Reflections on the Rule of ‘One Share, One Vote,’ 56 Cornell L. Rev. 1 (1970); Joel Seligman, Equal Protection in Shareholder Voting Rights: The One Common Share, One Vote Controversy, 54 Geo. Wash. L. Rev. 687 (1986).(go back)

2Lucian Bebchuk and Kobi Kastiel argue that, assuming dual-class ownership is permitted, the arrangement should at least include a “sunset” provision limiting the time before ordinary shareholders are allowed to vote on whether the company should continue on in dual-class form. Lucian Bebchuk & Kobi Kastiel, The Untenable Case for Dual-Class Stock, 103 Va. L. Rev. 585 (2017). Snap has a sunset provision (of sorts), which is triggered when both founders die. Evidence suggests controllers’ abilities decline over time and generations while the controllers nonetheless have incentives to retain the more and more inefficient structure. Id. (citing anecdotal evidence and numerous empirical studies). Indeed, a recent SEC study found that dual-class companies with sunset provisions outperformed those without. Commissioner Robert J. Jackson, Jr., Perpetual Dual-Class Stock: The Case Against Corporate Royalty (Feb. 15, 2018), https://www.sec.gov/news/speech/perpetual-dual-class-stock-case-against-corporate-royalty#_ftn21.(go back)

3Bebchuk & Kastiel, supra note 2, at 609 (finding that for the ten largest dual-class companies listed in the United States in 2015 the controller’s equity ownership had fallen since the time of the IPO, on average, from 30 to 12 percent).(go back)

4Id.(go back)

5Ronald J. Gilson, A Structural Approach to Corporations: The Case Against Defensive Tactics in Tender Offers, 33 Stan. L. Rev. 819, 823 (1982).(go back)

6Courts have repeatedly stated that “mere allegations of that directors made a poor decision . . . do not state a cause of action.” Ash v. McCall, 2000 WL 1370341, at *10 (Del. Ch. Sept. 15, 2000). This covers “degrees of wrong extending through ‘stupid’ to ‘egregious’ or ‘irrational.’” In re Caremark Int’l, 698 A.2d 959, 967 (Del. Ch. 1996). (go back)

7Brehm v. Eisner, 746 A.2d 244, 256 (Del. 2000) (“The inquiry here is not whether we would disdain the composition, behavior and decisions of” a board “if we were stockholders, . . . That decision is for the stockholders to make in voting for directors, urging other stockholders to reform or oust the board, or in making individual buy-sell decisions.”).(go back)

8Trenwick Am. Litig. Tr. v. Ernst & Young, L.L.P., 906 A.2d 168, 193 (Del. Ch. 2006), aff’d, 931 A.2d 438 (Del. 2007) (“[B]usiness failure is an ever-present risk. The business judgment rule exists precisely to ensure that directors and managers acting in good faith may pursue risky strategies that seem to promise great profit.”); Gagliardi v. Trifoods Int’l, 683 A.2d 1049, 1052 (Del. Ch. 1996) (“[O]nly a very small probability of director liability based on ‘negligence’, ‘inattention’, ‘waste’, etc., could induce a board to avoid authorizing risky investment projects to any extent.”).(go back)

9Paramount Commc’ns Inc. v. Time Inc., 1989 WL 79880, at *29 (Del. Ch. July 14, 1989), aff’d, 571 A.2d 1140 (Del. 1990).(go back)

10See Corwin v. KKR Fin. Holdings LLC, 125 A.3d 304, 313 (Del. 2015) (“When the real parties in interest—the disinterested equity owners—can easily protect themselves at the ballot box by simply voting no, the utility of a litigation-intrusive standard of review promises more costs to stockholders in the form of litigation rents and inhibitions on risk-taking than it promises in terms of benefits to them.”).(go back)

11Sinclair Oil Corp. v. Levien, 280 A.2d 717, 720 (Del. 1971) (holding that a decision by a controlling parent corporation is protected by the business judgment rule unless “the parent, by virtue of its domination of the subsidiary, causes the subsidiary to act in such a way that the parent receives something from the subsidiary to the exclusion of, and detriment to, the minority stockholders of the subsidiary.”); see also In re Martha Stewart Living Omnimedia, Inc. Stockholder Litig., 2017 WL 3568089, at *11 (Del. Ch. Aug. 18, 2017).(go back)

12In re MFW Shareholders Litigation, 67 A.3d 496, 535–36 (Del. Ch. 2013); Kahn v. Tremont Corp., 694 A.2d 422, 428 (Del. 1997); Weinberger v. UOP, Inc., 457 A.2d 701, 711 (Del. 1983).(go back)

13See generally Zohar Goshen & Assaf Hamdani, Corporate Control and Idiosyncratic Value, 125 Yale L. J. 560, 591–92 (2016) (“while the exposure to the control-agency problem is high in a dual-class structure (high incentive due to small equity), it is only moderate in the concentrated ownership structure (low incentive due to large equity). . . . Under a “one share, one vote” regime, the entrepreneur can retain control only if she holds cash-flow rights sufficient to give her control.”).(go back)

14Joy v. North, 692 F.2d 880, 886 (2d Cir. 1982) (“The circumstances surrounding a corporate decision are not easily reconstructed in a courtroom years later, since business imperatives often call for quick decisions, inevitably based on less than perfect information. The entrepreneur’s function is to encounter risks and to confront uncertainty, and a reasoned decision at the time made may seem a wild hunch viewed years later against a background of perfect knowledge.”); see also Paramount Commc’ns Inc. v. Time Inc., 1989 WL 79880, at *30 (Del. Ch. July 14, 1989) (“The value of a shareholder’s investment, over time, rises or falls chiefly because of the skill, judgment and perhaps luck-for it is present in all human affairs-of the management and directors of the enterprise.”).(go back)

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