FOR INSTITUTIONAL INVESTORS
One Share, No Vote
Dual-class capital structures are a recipe for executive entrenchment, fiduciary misconduct, and erosion of shareholder rights
Principally authored by Brandon Marsh
Increasingly, companies in the technology sector
and elsewhere are issuing two classes or even three classes of
stock with disparate voting rights in order to give certain executives and founders outsized
Recent developments in the securities markets are drawing institutional investors' attention back to core principles of corporate governance. As investors strive for yield in this postGreat Recession, low interest rate environment, large technology companies' valuations climb amid promises of rapid growth. At the same time, some of these successful companies are exploiting their market favor by asking investors to give up what most regard as a fundamental right of ownership: the right to vote.
Companies in the technology sector and elsewhere are increasingly issuing two or even three classes of stock with disparate voting rights in order to give certain executives and founders outsized voting power. By issuing stock with one tenth the voting power of the executives' or founders' stock, or with no voting power at all, these companies create a bulwark for managerial entrenchment. Amid ample evidence that such skewed voting structures lead to transfers of value and skewed managerial incentives, many public pension funds and other institutional investors are
standing up against this trend. But in the current environment of permissive exchange rules allowing for such dual-class or multi-class stock, there is still more that investors can do to protect their fundamental voting rights.
A rising tide of multi-class shares sparks a backlash
Historically, companies with dual-class stock structures have been a distinct minority of the market. Prominent among such outliers are large media companies that perpetuate the managerial oversight of a particular family or a dynastic editorial position, such as The New York Times, CBS, Viacom, and News Corp. Now, corporate distributions of non-voting shares are on the rise, particularly among emerging technology companies. In 2012, Google -- which already protected its founders through Class B shares that had ten times the voting power of Class A shares -- moved to dilute further the voting rights of Class A shareholders by issuing to them third-tier Class C shares with no voting rights as "dividends." Shareholders,
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To forego the ownership gymnastics of diluting existing shareholders'
voting rights by issuing non-voting shares as dividends, the more
recent trend is to set up multi-class structures from the IPO stage.
led by a Massachusetts pension fund, filed suit, alleging that executives had breached their fiduciary duty by sticking investors with less valuable non-voting shares. On the eve of trial, the parties agreed to settle the case by letting the market decide the value of lost voting rights. When the non-voting shares ended up trading at a material discount to the original Class A shares, Google was forced to pay over $560 million to the plaintiff investors for their lost voting rights.
Facebook followed suit in early 2016 with a similar post-IPO plan to distribute nonvoting shares and solidify founder and CEO Mark Zuckerberg's control. Amid renewed investor outcry, the pension fund Sjunde AP-Fonden and numerous index funds filed a suit alleging breach of fiduciary duty. Also in 2016, Barry Diller, the controller of IAC/InterActiveCorp, tried an even more egregious gambit, creating a new, non-voting class of stock in order to insulate his ability to pass control of the business to his heirs without regard to the dilution that would come from new stock compensation and stock acquisitions, and despite the fact that they owned less than 8 percent of the company's stock. The California Public Employees' Retirement System (CalPERS), which manages the largest public pension fund in the United States, filed suit in late 2016. (BLB&G represents CalPERS in this litigation.) Both suits are currently pending.
To forego the ownership gymnastics of diluting existing shareholders' voting rights by issuing non-voting shares as dividends, the more recent trend is to set up multi-class structures from the IPO stage. Tech companies Alibaba, LinkedIn, Square, and Zynga each implemented
dual-class structures before going public. Overall, the number of IPOs with multiclass structures is increasing. There were only 6 such IPOs in 2006, but that number more than quadrupled to 27 in 2015.
Snap pioneers the "No Voting Rights Whatsoever" tech IPO
Snap Inc., which earlier this year concluded the largest tech IPO since Alibaba's, took the unprecedented step of offering IPO purchasers no voting rights at all. This is a stark break from tradition, as prior dualclass firms had given new investors at least some -- albeit proportionally weak -- voting rights. As Anne Sheehan, Director of Corporate Governance for the California State Teachers' Retirement System (CalSTRS), has concluded, Snap's recent IPO "raise[s] the discussion to a new level."
CalSTRS was not alone in its criticism of Snap's IPO. The Council of Institutional Investors (CII) called for an end to dualclass IPOs in 2016. After Snap announced its intended issuance of non-voting stock earlier this year, CII sent a letter to Snap's executives, co-signed by 18 institutional investors, urging them to abandon their plan to "deny outside shareholders any voice in the company." The letter noted that a single-class voting structure "is associated with stronger long-term performance, and mechanisms for accountability to owners," and that when CII was formed over thirty years ago, "the very first policy adopted was the principle of one share, one vote." Anne Simpson, Investment Director at CalPERS, has also strongly criticized Snap's non-voting share model, stating: "Ceding power without accountability is very troubling. I think you have to relabel this junk equity. Buyer beware."
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Peter C. Vey/The New Yorker Collection/The Cartoon Bank
Investors have also called for stock index providers to bar Snap's shares from becoming part of major indices due to its non-voting shares. By keeping index fund investors' cash out of such companies' stock, these efforts could help provide concrete penalties for companies seeking to go to market with non-voting shares. It remains to be seen how index providers will respond.
Dual-class structures hamper accountability
There are many compelling reasons why institutional investors strongly oppose dual-class stock structures that separate voting rights from cash-flow rights. Such structures reduce oversight by, and accountability to, the actual majority owners of the company. They hamper the ability of boards of directors to execute their duties to shareholders because corporate managers with outsized voting power can dictate important company decisions. And they can incentivize managers to act in their own interests, instead of acting in the interest of the company's owners. Hollinger International, a large international newspaper publisher now known as Sun-Times Media Group, is a striking example. Although former CEO Conrad Black owned just 30 percent of the firm's equity, he controlled all of the company's Class B shares, giving him an overwhelming 73 percent of the voting power. He filled the board with friends, then used the company for personal ends, siphoning off company funds through a variety of fees and dividends. Restrained by the dual-class stock structure, Hollinger stockholders at large were essentially powerless to rein in such actions. Ulti-
mately, the public also paid the price for the mismanagement, footing the bill to incarcerate Black for over three years after he was convicted of fraud.
Academic studies also reveal that giving select shareholders control that is far out of line with their ownership stakes results in perverse incentives and weaker corporate governance structures. A 2012 study funded by the Investor Responsibility Research Center Institute (IRRC), and conducted by Institutional Shareholder Services Inc., found that controlled firms with multi-class capital structures have more material weaknesses in accounting controls and are riskier in terms of volatility. A follow-up 2016 study reaffirmed the findings, noting that multi-class companies have weaker corporate governance and higher CEO pay. As IRRC Institute Execu-
Continued on back cover
Academic studies also reveal that giving select shareholders control that is far out of line with their ownership stakes results in perverse incentives and leads to weaker corporate governance structures.
The Advocate for Institutional Investors
FOR INSTITUTIONAL INVESTORS
One Share, No Vote
Continued from page 4
tive Director Jon Lukomnik summarized, multi-class companies are "built for comfort, not performance." Earlier this year, Harvard Law School Professor Lucian Bebchuk also published an analysis of dual-class structures, finding that they result in "perverse incentives" and that "the potential advantages of dual-class structures (such as those resulting from founders' superior leadership skills) tend to recede, and the potential costs tend to rise, as time passes from the IPO." Based on his findings, Professor Bebchuk concludes that "the debate should focus on the permissibility of finite-term dual-class structures -- that is, structures that sunset after a fixed period of time (such as ten or fifteen years)."
The typical retort from proponents of dual-class structures is that depriving most investors of equal voting rights allows managers the leeway to make forwardthinking decisions that cause short-term pain for overall long-term gain. This assertion, however, ignores that many investors -- and in particular public pension funds and other long-term institutional investors -- are themselves focused on long-term gains. If managers have good ideas for long-term investments, such prominent investors will likely support them. Moreover, any argument that managers should be blindly trusted to make decisions for long-term gain must take into account the significant waves of managerial scandals and securities fraud in recent decades. Such conduct has resulted in record fines, countless violations of the securities laws, reduced shareholder returns, and the imposition of significant externalities on the court system and regulators.
Institutional investors can help curb dual-class shares
As the trend of issuing dual-class or multi-class stock continues, institutional investors should remain vigilant to protect shareholders' voting rights. Pre-IPO investors can oppose the issuance of non-voting shares during IPOs. Investors in publicly traded companies can speak out against proposed changes to share structures or resort to litigation when necessary, such as in the Google, Facebook, and IAC cases.
Institutional investors may also lobby Congress, regulators, and the national exchanges to ban non-voting shares or make it harder to issue no-vote shares. For instance, in the wake of the Snap IPO, CII Executive Director Ken Bertsch and other investors met with the SEC Investor Advisory Committee. They encouraged the SEC to work with US-based exchanges to (1) bar future no-vote share classes; (2) require sunset provisions for differential common stock voting rights; and (3) consider enhanced board requirements for dual-class companies in order to discourage rubber-stamp boards. Whether by working with regulators, securities exchanges, index providers, or corporate boards, institutional investors that continue to fight for shareholder voting rights will be working to promote open and responsive capital markets, and the longterm value creation that comes with them.
Brandon Marsh is Senior Counsel in the firm's California office. He can be reached at firstname.lastname@example.org.
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