The strongest argument against dual class stock rests on conflict of interest grounds. There is good reason to be suspicious of management's motives and conduct in certain mid-term dual class recapitalizations.[1] 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."[2] That the board has a conflict of interest thus does not necessarily mean that their conduct will be inconsistent with the best interests of any or all of the corporation's other constituents. To the contrary, the annals of corporate law are replete with instances in which managers faced with a conflict of interest did the right thing.[3] 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.
Accordingly, efforts to categorically prohibit dual class stock are essentially misguided.
[1] In the 1980s, before the adoption of the current stock exchange listing standard restrictions on dual class stock, a number of public corporations recapitalized to create a dual class stock structure:
The basic dual class recapitalization is a good example. Shareholders approve a charter amendment creating two classes--typically referred to as Class A and Class B--of common stock. The Class A shares are essentially the preexisting common stock under a new name, retaining all of its former attributes, including the usual one vote per share. The Class B shares possess all of the attributes of common stock, with three exceptions: (1) ownership of Class B stock may not be transferred except to certain specified persons, such as the holder's spouse and heirs; (2) Class B shares, however, may be converted into shares of Class A, which are freely transferable; and (3) the Class B stock has a larger number of votes, usually ten, per share. The Class B shares are then distributed to the shareholders as a stock dividend on their existing common shares.
Because the Class B shares are not transferable, if a shareholder wishes to sell her shares of Class B stock, she must first convert them into shares of Class A. (An improper transfer automatically results in conversion.) Over time, as public investors adjust their portfolios by selling out of the company, the number of outstanding Class B shares accordingly falls. In contrast, long-term investors--especially incumbent managers--retain their Class B shares, concentrating the superior voting shares in management's hands. Management thus may eventually obtain voting control without ever investing any additional equity in the firm. Moreover, the plan's antitakeover effect is immediate, as the restrictions on transferability preclude an offeror from acquiring the Class B stock.
A closely related alternative involves issuing the Class B shares, previously created by appropriate charter amendments, in an exchange offer. Shareholders are invited to exchange their existing Class A stock for the higher-voting rights Class B shares. In these cases, however, the Class B shares typically possess lesser dividend rights and a concomitant lower dividend rate. Accordingly, most public investors will not exchange their shares. If only management and its allies acquire the higher-voting right shares, an exchange offer dual class recapitalization may effectively give management immediate voting control.
Stephen M. Bainbridge, The Short Life and Resurrection of Sec Rule 19c-4, 69 Wash. U. L.Q. 565, 572–73 (1991).
[2] Committee on Corporate Laws, Changes in the Model Business Corporation Act —Amendments Pertaining to Directors' Conflicting Interest Transactions, 44 Bus. Law. 1307, 1309 (1989).
[3] Cf. id. (observing that "while the history of mankind is replete with acts of selfishness, we have all witnessed countless acts taken by persons contrary to their personal self-interest").
