In my last post[1], I focused on the Council of Institutional Investors’ (“CII”) recent proposal to the New York Stock Exchange and Nasdaq to impose a listing condition that any super-voting rights on dual class stock must expire within at least seven years of listing. Although I sympathized with the CII’s goal and believe dual class capitalizations to be undesirable in the case of a public corporation, I also recognized that we cannot expect the holder of a control block to stand by passively and watch his voting power dissipate. Thus, as I noted, the control holder might sell the control block at a premium to a corporate acquirer in connection with a tender offer or merger proposal by that acquirer for all the company’s shares. To be sure, such a transaction might face attack under Delaware law (both in court and in appraisal proceedings), but predictably the parties would eventually come to some settlement (as this would be the only way the plaintiff’s attorneys could obtain a high fee award[2]).
Still, this is only one aspect of the broader issue. At bottom, a deeper question is: Should the public shareholders of a company with a dual class capitalization be entitled to confiscate the controlling founder’s control premium? Or rather, should they have to compensate the founder for the loss of his voting power? Look at it this way: When the controlling founder took the company public, but retained voting control based on a super-voting class, the founder (or his company) almost certainly received a lesser price for the low-voting shares that were sold to the public. This is definitional, because a rational shareholder will pay less for shares that lack meaningful voting rights and leave the founder in absolute control (as Mark Zuckerberg has done at Facebook). But if you receive less because you retained voting control, is it fair later for the other shareholders without compensation to take away that control (for which the founder indirectly paid in the form of its receipt of a lower IPO price)?
If this perspective has any logic, the next question becomes: What is the best compromise? The problems with allowing the founder to retain absolute control have been well illustrated by Sumner Redstone and Mark Zuckerberg; potentially, the board becomes irrelevant. Still, even if the stock exchanges did adopt a sunset provision on dual class stock (which is hardly imminent), it would still remain possible for the controlling founder to secure compensation by some variant on the following tactic: Create a convertible preferred class at or prior to the time of the IPO, which class would be held exclusively by the founders and which would have a conversion right entitling its holders to convert at any time into a higher percentage of the underlying common stock. Thus, hypothetically, if the founder held all the shares of a convertible preferred class with 20 percent of the cash flow rights and 60 percent of the company’s voting power, the certificate of incorporation would provide that this class could be converted at the founder’s option into 30 percent of the company’s cash flow rights, with all shares now having one vote per share. Thus, the founder would be compensated for its loss of control by a 50 percent increase in the founder’s cash flow rights (from 20 percent to 30percent), but the founder would suffer a 50 percent loss (from 60 percent to 30 percent) in voting power.
Is this fair? Some may respond that the founder could rig the conversion right to produce a very unfair conversion. For example, if the convertible preferred stock converted into 70 percent of the outstanding common (after the conversion), this would be extraordinarily dilutive and seemingly unfair. But here, I have two responses:
First, if the founder proposed such an unfair conversion formula, the founder would pay dearly for doing so, because, in the IPO, the issuer would receive only a greatly reduced price for the common stock issued. A dilutive formula would be obvious and would chill the IPO.
Second, one could also give the existing common shareholders the right to reject the conversion by a majority vote if they deemed it unfair (and such a rejection would delay the sunset of the super voting stock for a defined period—say, five years). The controlling shareholder could then propose another conversion after a defined period (say, three years) that would also be subject to a veto by the existing common shareholders. Admittedly, the problem with this procedure might be that the founder would deliberately propose an unfair conversion formula in the expectation that it would be rejected, knowing that it could thereby delay the sunset provision indefinitely. Still, other refinements could be added so that a sunset would eventually come, and the founder would now have a strong incentive to propose a conversion price that the common shareholders would not reject.
Alternatively—and this may be the fairest approach—the conversion formula could be determined in arbitration, with the founder appointing one arbitrator, a committee of representative institutional investors appointing a second, and those two selecting the third, neutral arbitrator. This arbitration could be conducted before the IPO (to maximize disclosure) or even afterwards (to assure the arbitration panel had a better sense of current market conditions).
The basic idea here is that there should be a fair exchange: The founder should be paid to surrender control. Many institutional investors will not like that because they believe a one-share-one-vote rule is the natural state of a public securities market. Yet, not only is that position historically inaccurate, but it is apt to keep many private companies remaining as “unicorns” and not entering the public markets. That may be as undesirable as dual class capitalization.
Of course, this proposal will hardly end the debate; nor is it intended to do so. This issue will be around for some time, and thus we would like to hear other proposals. Precisely because fairness often lies in the eye of the beholder, we ask readers to suggest their own preferred alternatives (with an explanation and hopefully in 300 words or less). Readers can email their responses to rh2804@columbia.edu. We hope to run these proposals (or edited portions of them) in a symposium on this blog. Tell us what is fair!
ENDNOTES
[1] See John C. Coffee, “Dual Class Stock: The Shades of Sunset,” CLS Blue Sky Blog, November 19, 2018.
[2] I will not here summarize the recent Delaware case law on “squeeze out” and similar mergers, which is complicated. But the key point is that plaintiff’s attorneys want to maximize the fee award. If all they secure is an injunction, the fee award (in a derivative action) will likely be modest, and in the case of a class action, there would be no fund at all from which to pay a fee. However, if a replacement deal can be negotiated, the fee can be based on a reasonable percentage of the recovery (in either a class action or a derivative action). Trust plaintiff’s counsel to find a way to a higher fee award.
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.