Extending Dual Class Stock: A Proposal

David J. Berger is a partner at Wilson Sonsini Goodrich & Rosati, Jill E. Fisch is the Saul A. Fox Distinguished Professor of Business Law at the University of Pennsylvania Carey Law School and Steven Davidoff Solomon is Alexander F. and May T. Morrison Professor of Law, U.C. Berkeley School of Law. This post is based on their recent paper, forthcoming in Theoretical Inquiries in Law, and is part of the Delaware law series; links to other posts in the series are available here. Related research from the Program on Corporate Governance includes The Untenable Case for Perpetual Dual-Class Stock (discussed on the Forum here), The Perils of Small-Minority Controllers (discussed on the Forum here), Keynote Presentation on The Lifecycle Theory of Dual-Class Structures (discussed on the Forum here) all by Lucian Bebchuk and Kobi Kastiel.

Dual class stock has become common and ubiquitous in U.S. capital markets. Dual class structures, which have evolved over the last decade, now often include a variety of sunset mechanisms. These come in various flavors, including term-based sunsets, dilution thresholds, and life cycle events. As companies that adopted dual-class stock structures with sunsets at the time of their IPOs age, some sunset mechanisms, particularly term-based sunsets, are beginning to take effect. As early-adopters consider whether to follow their initial sunset mechanisms, boards, investors, their advisors and courts need to assess when and how dual class stock should be extended.

In some cases, companies have allowed sunsets to take effect, resulting in the collapse of the company’s dual class structure. In other cases, companies have attempted to extend or revise the length of existing dual class structures. Alphabet, for example, succeeded in such an extension by issuing nonvoting Class C shares, but Facebook withdrew a similar proposal in order to settle litigation challenging its proposed adoption. Despite Facebook’s failure, courts have upheld such extensions even when they are litigated to a judgment. In the recent case of City Pension Fund for Firefighters and Police Officers in Miami v. The Trade Desk, Inc., No. CV 2021-0560-PAF, 2022 WL 3009959 (Del. Ch. July 29, 2022), the Delaware Chancery Court, applying the MFW standard, Kahn v. M & F Worldwide Corp., 88 A.3d 635 (Del. 2014), found that an arrangement to extend the life of dual class stock was appropriate.

While MFW has been put forth as the appropriate procedure to reduce judicial scrutiny of dual class extensions, we believe that it leaves a practical void for two reasons. First, MFW requires approval of the disinterested shareholders. However, given the structure of our capital markets, in most cases it is unlikely that institutional shareholders will approve an extension of a term-based sunset or other sunsets which they perceive as disenfranchising them. As we discuss, we believe this institutional bias is so strong that even when there is a strong case for such an extension, approval is likely to be difficult if not impossible to obtain from institutional investors. This is particularly true when the issue involves the extension of a term-based sunset, since sunsets are a feature that institutional shareholders and SEC officials have consistently supported.

Second, if a company fails to meet the MFW standard in connection with its decision to extend its dual class structure, judicial review is likely to involve an entire fairness analysis. However, dual class extensions present a novel issue for the application of the entire fairness standard. Unlike the cases for which entire fairness was created and is typically employed—i.e., those involving the valuation of a company in a squeeze-out merger, a transaction, or a business opportunity—here, entire fairness would involve an assessment of the terms of any extension and weighing of the extension terms against the potential effect on the company of continuing the dual class structure. Whether or not such an exchange is “fair” under Delaware law, it is a non-quantifiable event. In other words, the value of such a trade is not quantitatively measurable. It is also bespoke; the value of a dual class structure is firm-specific, and each negotiated extension will contain different terms and procedures. Thus a comparative analysis on a qualitative basis by a court will be difficult, if not impossible.

The legal and practical uncertainty of how Delaware law will treat sunset extensions has two adverse effects at the initial public offering (IPO) stage. The first is a classic lemons problem. Because shareholders do not know ex ante whether there will be an attempt at an extension or how the extension will be treated under Delaware law, they are likely to address this uncertainty by discounting all dual class companies. Second, because insiders cannot predict the difficulty of extending a sunset, they are likely ex ante to implement longer term sunsets than they otherwise would, leading dual class structures to persist in companies for which the structure is no longer appropriate or necessary.

We propose a solution to address these issues as well as the controversy inherent in dual class stock. We argue that companies should identify in their charter the terms and conditions of any potential dual class extension at the time of their IPO. Such terms could designate permissible procedures by which a corporation may extend its dual class structure, including the timing of such an extension, the extent to which the extension requires approval by directors and/or shareholders, and the threshold required for such approval. They could also set forth the substantive grounds on which an extension is permitted. These grounds could, for example, include the company meeting designated metrics such as stock price returns or earnings. An extension could also be conditioned on various non-economic terms such as the continuing commitment of the founder to the company, the development of certain technology, or the company’s adherence to specified environmental, social and governance criteria.

Our solution is designed to ensure that dual class stock creates the value for which its use is intended. More specifically, the rationale underlying dual class stock is that a company should be allowed to focus on issues other than stock price; this can include, for example, a visionary founder who steers and perpetuates that vision so long as the founder continues to provide extraordinary value to the enterprise or an AI company that wants to develop a novel technology without putting the power of that technology for sale to the highest bidder. By setting the terms of any extension at the time of the IPO, shareholders will have more concrete expectations of whether, when, and how sunset extensions will occur. Shareholders will be better informed about the likelihood that such extensions will be beneficial to the company, theoretically leading to more accurate IPO pricing. Setting these terms will also limit the impact of institutional shareholder forces which are inherently biased against these extensions for policy reasons.

Download the full paper here.

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