The Google IPO highlighted the recurring issue of whether ordinary investors are harmed by dual-class stock capital structures in which one class of stock (typically held by insiders) has supervoting rights. A paper by economists Andrew Metrick, Paul Gompers, and Joy Ishii (available at Knowledge@Wharton, which is free but requires registration) finds that:
Company values improved as insider ownership rose, with the effect reaching a peak when insider ownership reached 33%, based on their share of “cash flow” such as dividends. As insider ownership grew from zero to 33%, Tobin’s Q grew by about 15%. “As the fraction of cash flow ownership increases, the incentives of management become more closely aligned with those of outside shareholders and thus lead to better decisions (from outside shareholders’ perspective) and higher valuations,” Metrick and his colleagues write. The effect levels off as ownership exceeds 33%, probably because of the wealth effect. Insiders become so rich they have dwindling interest in accumulating more and prefer corporate strategies that emphasize safety over performance.
Growth in insiders’ voting power had the opposite effect as growth in economic stakes. Tobin’s Q declined as insider’s voting power grew, with the loss bottoming out as their voting control reached 45% of the votes available to be cast. As voting power grew from zero to 45%, Tobin’s Q fell by 25%. “This is consistent with the entrenchment effect of voting ownership, i.e., the more control that the insiders have, the more they can pursue strategies that are at the expense of outside shareholders,” the authors write.
Does this mean that we should ban dual class stock? I have argued against doing so. As the abstract to my article The Short Life and Resurrection of SEC Rule 19c-4 explains:
In the 1980s, many corporations adopted disparate voting rights plans (also known as dual class stock plans) to concentrate voting control in the hands of incumbent managers and their allies. At most adopting firms, such plans were intended mainly to deter unsolicited takeover bids. Incumbent managers who cannot be outvoted, after all, cannot be ousted. In 1988, the Securities and Exchange Commission adopted rule 19c-4 pursuant to a claim of regulatory authority under Section 19(c) of the Securities Exchange Act of 1934. Rule 19c-4 purported to amend the listing standards of the self-regulatory organizations (i.e., the major stock exchanges and NASDAQ) so as to prohibit most forms of dual class stock. The United States Court of Appeals for the District of Columbia Circuit, however, subsequently invalidated rule 19c-4 as exceeding the scope of the SEC's delegated authority. This article reviews the history of dual class stock and stock exchange listing standards affecting it. The article then demonstrates that the D.C. Circuit was correct in concluding that the SEC lacked authority to adopt rule 19c-4. Finally, the article proposed an alternative exchange listing standard that responded to the conflict of interest inherent when management proposes a dual class stock recapitalization.
