Crown image Columbia Law School

SEC Investor Advocate Calls Dual-Class Shares a Recipe for Disaster

Thank you, Kerrie Waring, for your kind introduction. I appreciate the opportunity to speak at a conference where you will spend the next two days discussing the stewardship responsibilities of shareholders.[1] I know you take those responsibilities seriously, and I do my best to encourage a regulatory environment that makes companies accountable to their shareholders.

Of course, before I begin, I must give the standard disclaimer given by all SEC speakers, that the views I express are my own and do not necessarily represent the views of the Securities and Exchange Commission, the Commissioners, or my colleagues on the Commission staff.

Let me start by thanking this group for your engagement with the SEC over the years. Feedback from groups like ICGN is especially valuable because you provide real-world insight into the types of information that investors utilize to make investment and voting decisions. The Commission and its staff need to know the value you place on things like quarterly reporting, auditor attestation of internal controls over financial reporting, ESG disclosure, the proxy voting process, and numerous other matters.

Today I would like to discuss a troubling trend—the increased use of dual-class shares by companies that seek to go public. Now, I know what you are thinking—that I should have been here a few years ago when this was a hot topic. But, in my view, recent events should have us revisiting the issue with greater urgency.

First, let me remind you of the justifications that have been used to give company founders and insiders more votes per share than public shareholders.[2] As the theory goes, some companies (especially technology companies) have founders who are so visionary and charismatic that the companies could not be as successful without them. By going public with multiple classes of shares, a company allows the public an opportunity to participate in the company’s growth, and the lack of voting rights for the public shareholders is advantageous because it allows the founders to guard against activists who demand short-term profits at the expense of long-term growth.

It is true that a few well-known companies have thrived with long-term founders. But less noticeable are the hundreds of public companies that now have entrenched management.[3] A growing body of research suggests that, over the long term, entrenchment of founders produces lower returns for investors. Specifically, companies with dual-class structures tend to underperform companies with dispersed voting power.[4]

And there is an even larger danger, from my perspective. Namely, without an appropriate level of accountability to shareholders, it is easy to predict that this trend will not end well.[5] Investors will be hurt, and badly, if we continue down this path.

While it would not be appropriate for me to comment on specific companies, you do not have to look far to see where unchecked corporate control can lead. Things like…

  • Self-dealing and treating the company like a personal piggy bank.
  • Outsized optimism and over-estimation of the skills needed for long-term success.
  • Insular group-think, in which the founder surrounds himself with unqualified yes-men (and yes, all too often it is just men).
  • Poor accounting controls.
  • A tendency to take the eye off the ball and burn cash by investing in ancillary businesses to satisfy personal whims.
  • Declining health or mental capacity of the entrenched founder.
  • Abusive working conditions, including discriminatory practices and harassment.

Granted, things can go well for a few years before these symptoms begin to appear. Indeed, it is quite possible that underlying issues may not be apparent until or even after a company launches its IPO. But founders are subject to human nature, just like the rest of us, and there is little doubt in my mind that we will see some really bad outcomes in the future. This seems almost a certainty given that, as SEC Commissioner Robert Jackson has observed, perpetual dual-class share structures require long-term public shareholders to place their faith not only in a founder, but also the founder’s children and grandchildren.[6] Long after the original visionary is gone, there will still be no disciplining governance mechanism.

In my view, what we now have in our public markets is a festering wound that, if left untreated, could metastasize unchecked and affect the entire system of our public markets. The question, then, is what can be done to avoid the inevitable reckoning.

We on the investor side need to start by being honest with ourselves. As much as we may want to talk about the stock exchanges and their race to the bottom with their listing standards—and trust me, I have talked about it[7]—we need to acknowledge that investors themselves have engaged in their own race to the bottom when it comes to corporate accountability to shareholders. Investors, and particularly late-stage venture capital investors with deep pockets, have been willing to pay astronomical sums while ceding astonishing amounts of control to founders. This means that other investors, in order to deploy their own capital, must agree to terms that were once unthinkable, including low-vote or no-vote shares. The end result is a wave of companies with weak corporate governance.

Again, we can anticipate where this will lead us. And our fear of that result should motivate us more than the “fear of missing out” on the next hot tech start-up. Investors who accept weak corporate governance with the expectation that they can bail out before disaster befalls them are simply passing along harm to other investors and ultimately damaging the marketplace. So it is my hope that investors will do more to push back against the trend toward weak corporate governance. Hopefully, recent events involving founder-controlled companies will serve as a wake-up call to investors, and we will begin to see a return to an appropriate level of shareholder stewardship.

However, I believe this is an area where policymakers should not be content to let the market fix itself. The stakes are far too high, and the issue presents a classic collective action problem. In other words, investors, acting in their own self-interest (or according to their investment mandates), may be inclined to invest in companies with weak corporate governance even though they know that these companies will ultimately harm the broader capital formation ecosystem. We cannot really expect this problem to be solved by investors acting for the common good when it goes against their individual interests, so regulators need to help us achieve the common good.

As many of you are aware, the SEC has tried before to step in and essentially ban the creation of super-voting share classes. Unfortunately, that effort was met with defeat in the courts,[8] but there is still a lot that the SEC can do. For example, the SEC’s Investor Advisory Committee, on which I serve, has recommended that the Commission enhance the disclosure of the many heightened risks that are associated with dual-class shares.[9]

In addition, there is nothing that prevents the stock exchanges from addressing this issue. Well, there is one thing—the for-profit model of the exchanges and their desire to profit from IPO listings—but the exchanges need to step up and reassert their role as self-regulatory organizations. They have an important role to play as guardians of market integrity, and the weakening of corporate governance in publicly-traded companies is not a hidden hazard, but one that stares us right in the face.[10]

The investor community including the Council of Institutional Investors,[11] the CFA Institute,[12] and your own ICGN,[13] among others, have offered up reasonable compromises for the exchanges to consider. These include, among other things, the sun-setting of super-voting rights, which would protect a visionary founder from activist investors for a reasonable length of time while preventing the harms that may occur over the long term due to poor corporate governance. I encourage the exchanges to quickly adopt these types of reforms in order to promote fair and efficient markets. It is in their interest to do so, for a market failure caused by weak corporate governance would implicate them as well.

Thank you, again, for the opportunity to present my views on this important topic. I would be happy to answer a few questions as time permits.

ENDNOTES

[1] The Securities and Exchange Commission disclaims responsibility for any private publication or statement of any SEC employee or Commissioner. This speech expresses the author’s views and does not necessarily reflect those of the Commission, the Commissioners or other members of the staff.

[2] See CFA Institute, “Dual-Class Shares: The Good, The Bad, and The Ugly (Aug. 2018) [hereinafter CFAI Report], at 8-9, https://www.cfainstitute.org/-/media/documents/survey/apac-dual-class-shares-survey-report.ashx.

[3] See “Dual Class Companies List,” available at Council of Institutional Investors, Issues & Advocacy, “Dual-Class Stock” (last accessed Oct. 8, 2019), https://www.cii.org/dualclass_stock. Some IPO statistics: In calendar year 2017, a total of 195 companies went public on U.S. exchanges. Of these, 23 had dual-class structures with unequal voting rights (excluding foreign private issuers, special purpose acquisition companies and master limited partnerships). Six of the dual-class IPOs will phase out their unequal voting structures with time-based sunsets. Last year, a total of 246 companies went public on U.S. exchanges. Of these, 15 had dual-class structures with unequal voting rights. Five of the dual-class IPOs will phase out their unequal voting structures with time-based sunsets. Through June of this year, a total of 101 companies have gone public on U.S. exchanges. Of these, 15 had dual-class structures with unequal voting rights. Three of the dual-class IPOs will phase out their unequal voting structures with time-based sunsets. Id. See the CFAI Report, supra note 2, at 35-36 for statistics from 1980-2017.

[4] See CFAI Report, supra note 2, at 16-20 (citing empirical research from SEC Commissioner Robert J. Jackson, Jr., among others).

[5] Law professor Renee Jones has chronicled shortcomings of this governance structure for investors, employees, consumers and society. See Written Testimony of Renee M. Jones, Associate Dean for Academic Affairs and Professor of Law, Boston College Law School, Before the U.S. House of Representatives, Committee on Financial Services, Subcommittee on Capital Markets, Securities, and Investment (Sept. 9, 2019), https://financialservices.house.gov/uploadedfiles/hhrg-116-ba16-wstate-jonesr-20190911.pdf. See also Renee M. Jones, The Unicorn Governance Trap, 166 U. Pa. Law Rev. Online 165, 179-183 (2017) (same).

[6] See Robert J. Jackson, Jr., Commissioner, SEC, Perpetual Dual-Class Stock: The Case Against Corporate Royalty (Feb. 15, 2018), https://www.sec.gov/news/speech/perpetual-dual-class-stock-case-against-corporate-royalty.

[7] See Rick A. Fleming, Investor Advocate, SEC, The Falling Leaves of the Buttonwood Tree (Feb. 19, 2016), https://www.sec.gov/news/speech/falling-leaves-buttonwood-tree.html.

[8] See The Business Roundtable v. SEC, 905 F.2d 406 (D.C. Cir. 1990).

[9] See SEC Investor Advisory Committee, Recommendation re: Dual Class and Other Entrenching Governance Structures in Public Companies (Dec. 17, 2017), available at https://www.sec.gov/spotlight/investor-advisory-committee-2012/recommendation-on-dual-class-shares.pdf.

[10] See Connie Loizos, In the Dual-Class Shares Debate, the Big Exchanges Should Get Off the Sidelines (Sept. 30, 2019), https://techcrunch.com/2019/09/30/in-the-dual-class-shares-debate-the-big-exchanges-should-get-off-the-sidelines.

[11] See, e.g., “CII letter to Nasdaq on sunset provisions” (Oct. 24, 2018), available at https://www.cii.org/correspondence.

[12] See CFAI Report, supra note 2, at 93-94.

[13] See, e.g., “Letter to NYSE Re Dual Class Share Structures – November 2018” (Nov. 7, 2018), available at https://www.icgn.org/policy/committees/shareholder-rights/shareholder-rights-letters.

These remarks were delivered by Rick A. Fleming, the investor advocate at the U.S. Securities and Exchange Commission, on October 15, 2019, at the ICGN Miami Conference in Miami, Florida.

Leave a Reply

Your email address will not be published. Required fields are marked *