Dual Class Stock: The Shades of Sunset

The most important issue in corporate governance today is dual class capitalization, and the most important recent development is the petition submitted on October 24, 2018 by the Council of Institutional Investors (“CII”) to both the New York Stock Exchange and Nasdaq, asking them to place a “sunset” on differentials in voting rights. Under the CII’s proposal, both exchanges would agree not to list an initial public offering (“IPO”) that had dual classes of stock with different voting rights, unless the disparity in per share voting power ended no later than seven years after the IPO. The CII sees this as a compromise (with some of its members viewing it as an overly lenient proposal). In fairness to the CII, it has offered a constructive compromise, but there are problems with the incentive effects of its proposal.

Regardless of the CII’s willingness to compromise, almost no one else is. Academics and practitioners have predictably become polarized, with the academics seeing dual class stock structures as indefensibly entitling corporate founders (and their progeny) to perpetual control,[1] and practitioners seeing dual class capitalization as the only feasible defense against hedge fund activists, who in their view are increasingly imposing a mandatory short-term mentality on Corporate America. Both sides in these debates tend to herd together and close ranks, demanding the unthinking loyalty of their colleagues. Only this columnist remains annoyingly objective and independent on these issues.

Meanwhile, the exchanges appear to be guided by their somewhat different assessments of their own self-interests. The NYSE has shown a willingness to enter discussions with the CII and others about placing time limits on dual class voting structures, but Nasdaq seems adamantly opposed to the proposal.[2] This may reflect Nasdaq’s belief that it is the competitor most likely to gain lucrative future IPO listings from Silicon Valley with such structures.

What is the likely outcome here? Is a compromise possible? Can the SEC do anything? These are three different questions, but it is best to begin by acknowledging that there is a long history to these issues. Back in 1990 (when I was already writing this column for the New York Law Journal), the SEC adopted Rule 19c-4, which was intended to be a “one share, one vote” rule, restricting the exchanges from listing issuers with certain types of dual class securities. The Business Roundtable promptly sued and won in the D.C. Circuit, which essentially held that, as a matter of federalism, corporate governance was controlled by the states and not the SEC.[3]

But while the Business Roundtable decision held that the SEC was without authority, the SEC was not without influence. SEC Chairman Arthur Levitt quickly went to work, twisted arms at the exchanges, and brokered a compromise. It was one of his greatest triumphs, as the exchanges adopted common rules on voting rights. However, these rules did not preclude an issuer from selling non-voting or lesser voting shares, but only from taking actions that impaired existing voting rights.

With the rise of activist hedge funds willing and able to threaten proxy fights to win board representation, Silicon Valley startups have been reluctant to conduct IPOs, at least without a dual class capital structure. Many such companies with a valuation of $1 billion or more (known popularly as “unicorns”) have remained on the sidelines and refused to enter the public equity markets. Others have accepted the discount in share value that a dual class voting structure entails and gone ahead. Both sides in this debate have cases that they deem symbolically representative. For the academics, it is Viacom, Inc., where Sumner Redstone, at age 95 and unable to communicate with anyone, remains in absolute voting control. In contrast, practitioners point to recent examples of dual class IPOs, which in 2018 included Dropbox, Inc., GreenSky, Inc., Pivotal Software, Inc., Pluralsight, Inc., and SmartSheet, Inc., to argue that these issuers would have remained outside the public markets if they could not have used a dual class capitalization. The exchanges in turn are mindful of the 2014 IPO offering by Alibaba Group Holding Ltd., which came to the NYSE to list because the Hong Kong Stock Exchange’s rules precluded such a dual class listing. In their view, more such listings might be attracted to the U.S. if dual class offerings remain possible (although Hong Kong reversed its position earlier this year to permit dual class listings). As a result, everyone sees history as on their side.

But could the SEC, if it were so motivated, again broker a compromise? Here, there are three critical differences:

First, since 1990, the stock exchanges have privatized and are less interested in playing a regulatory role (but are very interested in maximizing profits and their own share prices).

Second, there are no longer just three stock exchanges, but many more, and those that defect from any compromise stand to reap high profits from an increased share of IPO listings.

Third, there is no Arthur Levitt available for the task of brokering a compromise. Competent and moderate as SEC Chairman Jay Clayton is, this is not a priority issue for him. Absent SEC pressure, progress is likely to be slow ­— unless the CII could convince institutional investors to boycott IPOs, involving dual class shares. As of now, that still seems unlikely. Institutional investors would prefer regulators to mandate their desired outcome, rather than take costly actions themselves.

Still, at some point, there could be concerted action by institutions to disinvest from dual class stocks. That raises the question of whether the CII has offered the best compromise with its seven year sunset rule. What would happen under the proposed rule? Presumably, in CII’s view, the issuer’s founders would just accept the decay of their voting power and be thankful that they received seven years insulation from hedge fund activists because of the CII’s slow sunset. But that may overlook alternative scenarios. Suppose I am the Mark Zuckerberg of 2025, and I take my new social media firm public in a dual class capitalization IPO in which I retain 51 percent of the voting power (with only 10 percent of the equity). My controlling status will expire in seven years under the CII’s proposed listing conditions. Will I just accept the loss of control in seven years passively? Or, will I seek to do something? If so, what?

The short answer is that at or near the end of this seven year period, I could sell control in a merger to a large acquirer at a sizable premium. For example, I could cause my controlled board to approve a merger with AT&T, Microsoft, Apple or Amazon in which I will receive a control premium that reflects my controlling status. Delaware and other jurisdictions recognize the legitimacy of control premiums, and the acquiring firm should be ready to pay it. Of course, there will be litigation, and the public shareholders may have a strong claim if some of them file appraisal actions. But eventually, the litigation will settle (so long as high attorneys’ fees are paid to plaintiff’s counsel).

The problem with the CII seven year cutoff is that it creates a sharp cliff: on one day, I hold a control premium; on the next day, I do not. This sudden loss in value will motivate many in such a position to sell before that point. Perhaps, a subtler formula could require an annual percentage decay: Each year, I lose 14.2 percent of my voting power with the result that it gradually dissipates by the end of seven years. The incentive to sell control at the end would be somewhat less strong, but still present in the early years.

On the macro level, the impact of the CII formula might increase the (already high) level of concentration in American business. Young Apples, Microsofts and Googles would go public in IPOs and then be sold off to older, dominant firms within seven years. The end result would slow the process by which younger firms gradually replace older firms in the hierarchy of American corporations and instead encourage a permanent gerontocracy.

Of course, this problem could be solved by adding still an additional term to the CII’s proposed listing condition: No transaction (merger or sale) could be approved that provided for any control premium. Thus, the founder could sell his shares at a premium, but their enhanced voting rights would expire at the end of the same seven years. Any merger or sale would have to pay every equity shareholder the same price per share. This could work, but it would be another reason to encourage controlling founders not to go public in the first place.

Still another possibility should be considered: the use of a charitable foundation, run by independent directors, to hold the controlling shares, with such a body being exempt from the seven year rule on loss of special voting power. Historically, the Ford family gave control over Ford Motors to the Ford Foundation. Such a strategy would immunize perpetually the issuer from the perceived threat of an activist hedge fund attack, but it would not create any danger of a senile founder being in control of a troubled company (i.e., the Viacom scenario on which my academic colleagues focus). The founders could either give (or sell) their control stock to such a foundation before the IPO or just before the expiration of the seventh year.

On balance, the CII has made a constructive proposal to phase out dual class shares. The Council is correct that perpetual control locked into minority shares is dangerous, but much more attention must be given to how their sunset provision works. A sunset that goes sharply from day to night may have perverse effects. There is time to consider alternatives because Nasdaq appears to be in no hurry to accept this proposal. Its eventual adoption is possible, but likely will require an activist Democrat chairing the SEC. Still, for those who like to fantasize, the optimal sunset provision requires us to consider at least fifty shades of gray.

ENDNOTES

[1] For the standard academic review, co-authored by the leading proponent of shareholder power, see Lucian Bebchuk and Kobi Kastiel, The Untenable Case for Perpetual Dual Class Stock, 103 Va. L. Rev. 585 (2017).

[2] See Ron Orol, “NYSE, Nasdaq at Odds Over Dual Class Shares Talks,” The Deal Pipeline, November 1, 2018.

[3] Business Roundtable v. S.E.C., 905 F.2d 406 (D.C. Cir. 1990). (finding that Section 19(c) of the Securities Exchange Act of 1934 did not authorize the SEC to adopt a “one share, one vote” rule).

This post comes to us from John C. Coffee, Jr., the Adolf A. Berle Professor of Law at Columbia University Law School and Director of its Center on Corporate Governance.

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