How Nonvoting Shares Can Help Promote Efficient Corporate Governance

Companies that go public with multiple classes of shares will be excluded from the major U.S. stock indexes of S&P Dow Jones Indices, the organization announced in July. A few days earlier, FTSE Russell said it would bar dual-class companies from its indexes unless public shareholders hold at least 5 percent of the voting rights. These policy changes were made in response to a recent surge in dual-class initial public offerings, which generated hostile reactions from investors, regulators, and the public. Such structures were historically favored by family-owned companies seeking to preserve control but have gained popularity among successful technology companies, including Google, Facebook and, more recently, Snap Inc.

This hostility to dual class companies is not new. Indeed, academics and regulators have debated whether to restrict or otherwise regulate the use of dual class structures for at least a century. Yet even after so many years, the arguments on both sides remain the same. Critics of dual class structures argue that issuing low-voting or nonvoting shares increases agency costs and results in less than optimal decision-making. By contrast, proponents of dual class structures claim as they always have that nonvoting or low-voting stock should not be restricted because it has valuable uses, such as allowing the controlling group to avoid interference from shareholders with short-term interests. Moreover, these proponents argue that pressure from capital markets will discourage founders from using dual class structures when it is inefficient to do so.

I argue that in the new world of concentrated institutional investor ownership, nonvoting stock has an unrecognized useful function. Specifically, nonvoting shares, rather than increasing management agency costs in all cases, can be used to lessen agency costs. Therefore, offering nonvoting shares to the public can lower the company’s cost of capital, not because the structure protects the founding group from interference, but because it reduces inefficiencies associated with voting.

Not all shareholders value their voting rights equally. Some, including retail shareholders, rarely vote at all. Others, such as hedge fund activists, accumulate shares to use their voting power to agitate for changes that would increase the value of their investment. And yet, the law compels corporations to bundle the right to receive corporate cash flows with the right to vote.

I argue that nonvoting shares can allow companies and investors to unlock the same efficiency gains that would result if votes could be traded on the market. Specifically, nonvoting shares can be used to allocate voting power to informed and motivated investors who value their voting rights and are motivated to use them to maximize the firm’s value. Moreover, companies that issue nonvoting shares and channel them to uninformed and weakly motivated shareholders—which include some passively managed mutual funds, as well as retail shareholders—will make all shareholders better off.

When a company has a single class of shares, it cannot allocate voting power to informed and engaged investors. This creates three types of problems. First and most important, agency costs increase when weakly motivated voters dilute the voice of the informed voters because it is more costly and difficult for informed voters to discipline management. Second, the company experiences higher transaction costs when it must manage voting for a larger group, especially for closely contested issues. And third, when the weakly motivated voters have a large enough segment of the voting power and choose to exercise it, the risk that they will move the company in the wrong direction increases.

In some cases, therefore, a company can use nonvoting stock to reduce agency costs by making management more accountable to its informed investors, as well as minimize transaction costs associated with voting. The strategy is simply to channel uninformed investors to nonvoting stock.  And happily, market forces will accomplish much of this channeling because nonvoting stock generally trades at a discount to voting stock, despite having the same rights to dividends and cash flows. Therefore, weakly motivated voters, who by definition do not value their vote, should choose the discounted stock. Likewise, informed investors will essentially pay a premium to buy the voting stock, because without weakly motivated voters diluting the votes, those informed investors will be able to acquire influence more cheaply. In sum, from an agency cost perspective, management can be understood as attracting capital at low cost with this capital structure, which will entice informed outside investors to purchase voting shares.

Of course, such channeling might not always occur, and my paper, Nonvoting Shares and Efficient Corporate Governance, discusses complications that undermine my theoretical framework. But the main point is that stock index policies that deter companies from issuing nonvoting stock and the popular backlash against all dual class structures are misguided; nonvoting stock can be used to improve corporate efficiency and lower capital costs. And although the effect of issuing nonvoting stock has been to keep voting control with company insiders, the growing concentration of wealth in passively managed mutual funds should increase the attractiveness of company structures that allocate voting power to informed investors.

This post comes to us from Dorothy Shapiro Lund, Bigelow fellow and lecturer in law at the University of Chicago Law School. It is based on her recent article, “Nonvoting Shares and Efficient Corporate Governance,” available here.

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