Steven Davidoff Solomon discusses the split between firms with dual class stock and those without:
The haves are armed with dual-class structures that give voting control to their founding shareholders or the private equity firm that bought them. These are companies like CBS, Ford Motor, Facebook, Google, News Corporation and Viacom, where the shareholders often have one vote or none per share and the founders 10 votes (The New York Times Company also has dual-class voting). These companies are largely free from challenge by any of their other shareholders, and control is centered with the founders, who have largely unfettered authority to hire and fire the board and the executives.
The have-nots lack this dual class structure and instead have no controlling shareholder. Instead, these companies have one vote for each share. In these companies, institutional investors like mutual funds and pension funds wield great control and the ability to influence, if not outright direct, the company’s actions.
Is there any justification for dual class stock?
Many defend dual-class stock because it may insulate a company from pressure to take short-term actions at the behest of shareholders. It also allows the founders to take a long-term approach and invest in the company in a way that may not produce immediate results. And finally, defenders point out that institutional investors are often conflicted in their desires, and that dual-class stock allows more deliberate consideration of shareholder issues. ...
So how are shareholder activists reacting?
Calpers, the California pension fund, has taken the position that it will not invest in I.P.O.s with dual-class stock. And yet, this seems like a finger in the dike. Dual-class initial offerings keep coming as other shareholders keep buying. It’s an odd state of affairs. The same shareholders who repeatedly assert that they care about corporate governance and are for a shareholder voice do not seem to care about that voice at the initial offering stage.
Perhaps this says a lot about how much shareholders value their vote, and it may be very little. Certainly institutional investors talk a good game and are increasingly taking steps to influence companies. But when push comes to shove, they seem ready to drop the vote for a good I.P.O. deal.
So what to do?
Perhaps the time has come to decide whether dual-class stock makes continued sense and for either all companies or no companies to be able to adopt it. Or perhaps the conversation should include other possible mechanisms that are more accommodating to shareholders.
He goes on to explore some options.
I've been writing about dual class stock for a long time:
The Short Life and Resurrection of SEC Rule 19c-4. Washington University Law Quarterly, Vol. 69, Pp. 565-634, 1991. Available at SSRN: http://ssrn.com/abstract=315375: 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.
The Scope of the SEC's Authority Over Shareholder Voting Rights (May 2007). UCLA School of Law Research Paper No. 07-16. Available at SSRN: http://ssrn.com/abstract=985707: At a May 2007 Roundtable on The Federal Proxy Rules and State Corporation Law, the Securities and Exchange Commission posed the following question for discussion: What should be the relationship of federal and state law with respect to shareholders' voting rights and ability to govern the corporation? To answer that question, this essay reviews the legislative history of Section 14(a) and of the Securities Exchange Act generally, as well as the leading judicial precedents. It concludes that, as a general rule of thumb, federal law appropriately is concerned mainly with disclosure obligations, as well as procedural and antifraud rules designed to make disclosure more effective. In contrast, regulating the substance of corporate governance standards is a matter for state corporation law.
So here's my take:
Do principles of corporate democracy justify a mandatory one share-one vote standard?
One of the most common arguments against dual class stock is based on notions of corporate democracy. Some argue that shareholder participation in corporate decisionmaking on a one-vote per share basis is desirable in and of itself. This notion makes for powerful rhetoric, but its premise is refuted both by history and modern practice. As the preceding sections demonstrated, deviations from the one share-one vote standard were historically commonplace. Moreover, the analogy between modern public corporations, even those with a single class of voting shares, and democratic institutions is simply inapt. As Delaware’s Chancellor William Allen has observed, our “corporation law does not operate on the theory that directors, in exercising their powers to manage the firm, are obligated to follow the wishes of a majority of shares. In fact, directors, not shareholders, are charged with the duty to manage the firm.”[1] Allen further recognized that the fact that many, “presumably most, shareholders” would have preferred the board to make a different decision “done does not . . . afford a basis to interfere with the effectuation of the board’s business judgment.” In short, corporations are not New England town meetings.
Does the principle of director accountability justify a mandatory one share-one vote standard?
Some argue that equal voting rights help reduce agency costs by ensuring that management accountability to shareholders. This argument, however, proves unpersuasive on close examination. First, shareholder voting as such is a relatively inefficient accountability mechanism. The shareholders’ incentives to be rationally apathetic, coupled with their relative powerlessness, renders them the corporate constituency perhaps least able to hold management accountable for misbehavior.
To be sure, voting rights enable shareholders to indirectly hold management’s feet to the fire via a proxy contest or by selling their shares to a takeover bidder. From this perspective, dual class capital structures are problematic not because they deprive shareholders of voting rights, but because they shield management from exposure to the full force of these other accountability mechanisms. Having said that, however, the anti-takeover effects of dual class stock do not justify prohibiting such a capital structure. Proscribing dual class stock because of its takeover effects puts one on a very slippery slope indeed. Taken to its logical extreme, the argument against dual class stock based on its anti-takeover effect would justify a sweeping prohibition of all effective takeover defenses, a solution that no court or legislature has been willing to adopt.
Does the potential for shareholder injury justify a mandatory one share-one vote standard?
Opponents of dual class stock commonly argue that it somehow harms shareholders. But the empirical evidence as to the effect of dual class stock on shareholder wealth is, at best, mixed. Lesser-voting rights shares typically sell at a slight discount to full-voting rights shares.[2] At a minimum, this differential suggests that the market anticipates a lower future stream of income from the lesser-voting shares. Surprisingly, however, studies find that dual class recapitalizations have no statistically significant effect on shareholder wealth (as measured by changes in the firm’s stock price).[3] One study in fact found positive shareholder wealth effects in certain types of recapitalizations.[4]
The inconclusive nature of the empirical studies may be attributable to a variety of offsetting factors. The higher dividends often payable to the lesser-voting rights shares may offset any negative price effects. In addition, because an oft-stated rationale for adopting a disparate voting rights plan is the desire to raise new equity capital, while maintaining insider control, the recapitalization proposal is a signal that management believes profitable investment opportunities are available to the firm. This good news about the firm’s future performance may mask any negative effects resulting from the recapitalization itself. Finally, many firms adopting a dual class capital structure exhibit substantial ownership by insiders prior to recapitalizing. The market previously will have discounted the firm’s stock price to reflect its lower probability of a takeover in comparison to more diversely-held firms. Adoption of the plan thus will not significantly affect the market’s evaluation of future payouts nor the firm’s stock price.
Do managerial conflicts of interest justify a mandatory one share-one vote standard?
The strongest argument against dual class stock rests on conflict of interest grounds.[5] There is good reason to be suspicious of management’s motives and conduct in certain dual class recapitalizations. Dual class transactions motivated by their anti-takeover effects, like all takeover defenses, pose an obvious potential for conflicts of interest. If a hostile bidder succeeds, it is almost certain to remove many of the target’s incumbent directors and officers. On the other hand, if the bidder is defeated by incumbent management, target shareholders are deprived of a substantial premium for their shares. A dual class capital structure, of course, effectively assures the latter outcome.
In addition to this general concern, a distinct source of potential conflict between managers’ self-interest and the best interests of the shareholders arises in dual class recapitalizations. An analogy to management-led leveraged buyouts (“MBOs”) may be useful. In these transactions, management has a clear-cut conflict of interest. On the one hand, they are fiduciaries of the shareholders charged with getting the best price for the shareholders. On the other, as buyers, they have a strong self-interest in paying the lowest possible price.
In some dual class recapitalizations, management has essentially the same conflict of interest. Although they are fiduciaries charged with protecting the shareholders’ interests, the disparate voting rights plan typically will give them voting control. The managers’ temptation to act in their own self-interest is obvious. Yet, unlike MBOs, in a dual class recapitalization, management neither pays for voting control nor is its conduct subject to meaningful judicial review. As such, the conflict of interest posed by dual class recapitalizations is even more pronounced than that found in MBOs.
While management’s conflict of interest may justify some restrictions on some disparate voting rights plans, it hardly justifies a sweeping prohibition of dual class stock. First, not all such plans involve a conflict of interest. Dual class IPOs are the clearest case. Public investors who don’t want lesser voting rights stock simply won’t buy it. Those who are willing to purchase it presumably will be compensated by a lower per share price than full voting rights stock would command and/or by a higher dividend rate. In any event, assuming full disclosure, they become shareholders knowing that they will have lower voting rights than the insiders and having accepted as adequate whatever trade-off is offered by the firm in recompense. In effect, management’s conflict of interest is thus constrained by a form of market review.
Another good example of a dual class transaction that fails to raise conflict of interest concerns is subsequent issuance of lesser-voting rights shares. Such an issuance does not disenfranchise existing shareholders, as they retain their existing voting rights. Nor are the purchasers of such shares harmed; as in an IPO, they take the shares knowing that the rights will be less than those of the existing shareholders. For the same reason, issuance of lesser-voting rights shares as consideration in a merger or other corporate acquisition should not be objectionable.
Second, even with respect to those disparate voting rights plans that do raise conflict of interest concerns, it must be recognized that there is only a potential conflict of interest. Despite the need for skepticism about management’s motives, it is worth remembering that “having a ‘conflict of interest’ is not something one is ‘guilty of’; it is simply a state of affairs.”[6] That the board has a conflict of interest thus does not necessarily mean that the directors’ conduct will be inconsistent with the best interests of any or all of the corporation’s other constituents. The mere fact that a certain transaction poses a conflict of interest for management therefore does not justify a prohibition of that transaction. It simply means that the transaction needs to be policed to ensure that management pursues the shareholders’ best interests rather than their own.
Why not regulate dual class stock the same way we regulate other conflict of interest transactions, such as two-tier tender offers, freeze-out mergers, and interested director transactions?[7] At the outset, we need to identify those dual class stock recapitalizations that actually entail a conflict of interest. Hence, for example, no safeguards over and above those already provided by state law are necessary with respect to dual class stock issued in an IPO, a subsequent offering or dividend of lesser-voting stock, or dual class stock issued in a bona fide acquisition. Nor are any additional safeguards necessary with respect to super-voting rights shares issued without transfer restrictions or in a lock-up.
Transactions involving more subtle conflicts require some additional safeguards. Among these are exchange offers and recapitalizations creating super-voting rights stock bearing transfer restrictions. In order to dissipate the conflicts of interest they raise, they should be permitted only if they are approved by the corporation’s independent directors and disinterested shareholders.
Requiring approval by a committee of independent board members created to negotiate with management and/or the controlling shareholder is common in conflict of interest transactions. In the freeze-out merger context, the Delaware Supreme Court has made clear that this procedure is “strong evidence that the transaction meets the test of fairness.”[8] Statutes governing interested director transactions and two-tier tender offers effectively presume that the transaction is fair if approved by the independent directors.[9] There is always, of course, some risk that purportedly independent directors will be biased in favor of their compatriots, but courts give greatest deference to independent directors in contexts like this one in which a market test of the transaction is impractical.[10] This is so in large part, of course, because the absence of a market test gives courts little option but to rely upon independent directors as the chief accountability mechanism. Yet, it is also so because courts know that independent directors are capable of serving as an effective accountability mechanism. Despite the potential for structural or actual bias, independent directors have affirmative incentives to actively monitor management and to discipline managers who prefer their own interests to those of shareholders. If the company suffers or even fails on their watch, for example, the independent directors’ reputation and thus their future employability is likely to suffer. Guided by outside counsel and financial advisers and facing the risk of person liability for uninformed or biased decisions, disinterested directors therefore should be an effective check on unfairness in a dual class recapitalization.
If the board lacks independence or is otherwise disabled by conflicted interests, approval by a majority of the disinterested shares should also insulate the dual class recapitalization from judicial review.[11] Approval of a freeze-out merger or interested director transaction by a majority of the disinterested shareholders, for example, shifts the burden of proof with respect to fairness back to the complaining shareholder. Under so-called fair price statutes, the obligation to pay a statutorily defined fair price in the second-step of a two-tier offer will be waived if the transaction is approved by the disinterested shareholders. These rules give the shareholders a collective opportunity to reject unfair proposals, thereby helping to eliminate the pressure on individual shareholders to accept the offer. Shareholder approval of a dual class recapitalization should likewise vitiate conflict of interest and collective action concerns.[12]
Admittedly, neither approval by independent directors nor disinterested shareholders will perfectly eliminate the possibility of management self-dealing in connection with a dual class recapitalizations. But that is true of every conflict of interest transaction. As we have seen, the problems associated with dual class stock are no different than those associated with any other conflict of interest transaction. One therefore must again ask, why should dual class stock be singled out for special treatment? No good reason has been forthcoming. As has been the case with all other corporate conflicts of interest, the law should develop standards of review for dual class recapitalizations that are designed to prevent self-interested management behavior but not to proscribe all such transactions. But the law thus far has failed to do so.
[1] Paramount Communications Inc. v. Time Inc., 1989 WL 79880 at *30 (Del. Ch. 1989), aff’d, 571 A.2d 1140 (Del. 1990).
[2] Ronald C. Lease, et al., The Market Value of Control in Publicly-Traded Corporations, 11 J. Fin. Econ. 439, 466 (1983).
[3] See, e.g., SEC Office of the Chief Economist, The Effects of Dual-Class Recapitalizations on the Wealth of Shareholders 4 (June 1, 1987).
[4] Megan Partch, The Creation of a Class of Limited Voting Common Stock and Shareholder Wealth, 18 J. Fin. Econ. 313, 332 (1987) (statistically significant positive price effect found in subsample of firms in which insiders already owned sufficient shares to pass recapitalization plan over objection of all minority shareholders; Partch, however, questions the significance of this finding).
[5] The following argument differs from the accountability argument discussed and rejected above largely in terms of timing. The accountability argument focuses on the ex post effects of a dual class recapitalization. The conflict of interest argument focuses on management’s ex ante incentives. See generally Stephen M. Bainbridge, Revisiting the One-Share/One-Vote Controversy: The Exchanges’ Uniform Voting Rights Policy, 22 Sec. Reg. L.J. 175 (1994).
[6] Committee on Corporate Laws, Changes in the Model Business Corporation Act–Amendments Pertaining to Directors’ Conflicting Interest Transactions, 44 Bus. Law. 1307, 1309 (1989).
[7] Imposing a requirement that the disparate voting rights plan fully compensate shareholders for the loss of their voting rights is an alternative solution. Dual class stock would be unobjectionable if management provided such compensation. However, the difficulty of measuring the voting rights’ value makes this solution impractical. One simply could not be confident that the plan fully compensated the minority.
[8] Weinberger v. UOP, Inc., 457 A.2d 701, 709-10 n.7 (Del. 1983).
[9] See, e.g., Pogostin v. Rice, 480 A.2d 619 (Del. 1984) (disinterested director approval of interested director transaction shifts burden of proof to plaintiff to show transaction amounts to waste).
[10] Stephen M. Bainbridge, Exclusive Merger Agreements and Lock-Ups in Negotiated Acquisitions, 75 Minn. L. Rev. 239, 278-79 (1990).
[11] Of course, the vote must be an informed one. Compare Lacos Land Co. v. Arden Group, Inc., 517 A.2d 271, 279-81 (Del. Ch. 1986) (preliminary injunction granted where proxy statement failed to fully disclose consequences of dual class plan), with Weiss v. Rockwell Int’l Corp., 15 Del. J. Corp. L. 777 (Del. Ch. 1989), aff’d without op., 574 A.2d 264 (Del. 1990) (preliminary injunction denied where proxy statement made full disclosure of effect of dual class plan on voting control of firm).
[12] In Weiss v. Rockwell Int’l Corp., 15 Del. J. Corp. L. 777 (Del. Ch. 1989), aff’d without op., 574 A.2d 264 (Del. 1990), plaintiff claimed that a disparate voting rights plan violated management’s fiduciary duties. The Delaware Chancery Court held that informed shareholder approval of the plan constituted an effective ratification of the plan and thereby precluded judicial review of the fiduciary duty claim.
