The debate over dual class common arises at the hinge of public law vs. private law conceptions of corporate governance. In the early 20th century, dual class common stock was used by financiers to retain control of the companies that they shepherded to public stock markets. You could certainly spin a private law story that the bankers used their control to minimize managerial agency costs and to provide reputational services at a time of inconsistent disclosure and weak corporate law. Nevertheless, a public law story prevailed – that disparate voting stock was a mechanism by which the Money Trust exercised excessive control over American business, and it had to be barred. And so it was, except for a handful of legacy cases, mostly media companies and Ford Motor Co., for nearly 80 years.
The recent revival of dual class common stock has been a private law story: that before launching into public markets, an entrepreneur has the right to obtain assurances that public shareholders will be unable to disrupt the entrepreneur’s business vision via the threat of a control challenge. Google’s successful 2004 IPO opened the way to a new wave of dual class issuances, now quite common in the tech area. The business case points to the rise of shareholder activism that works in tandem with a reconcentration of stock ownership in institutional investors; the entrepreneur needs protection from the short-termist hedge funds and the investors who might follow on. Contestable control is a distraction that needs to be minimized.
The efficiency implications have never been clear. Even if the market correctly prices the diminished governance rights for public shareholders so that the controllers fully internalize the governance costs, the controller may be trading utility for cash flow at a rate that is hard to assess and quantify.
Two questions strike me as most salient: First, should controllers be able to extend the economic power as set forth in the class structure of the IPO through unilateral adoption of a new diminished voting class: for example, Class C stock with no-votes or 0.1 votes? Second, should dual class stock structures be permanent or subject to mandatory sunsets or shareholder refreshment (which would be the same thing, since institutional shareholders have a normative governance view that favors single class common, much like single class boards)?
The public/private hinge becomes relevant in addressing these questions. Mismatches between control rights and cash flow rights give rise not only to private agency costs, the focus of much corporate governance theorizing, but what might be called “public” agency costs. These refer to our concerns about unaccountable power in the socio-political realm. A match between cash flow rights and control rights naturally constrains these public agency costs.
Some deviation may well be acceptable in the name of creating additional economic value; the organizational experiment is worth running. Boundary drawing will have some arbitrariness, but it seems to me that unilateral expansion, via unilateral adoption of Class C, is an easy move to prohibit.
Rather than a mandatory rule on permanence, I have two suggestions. The first is to facilitate negotiated surrender of control rights when the utility of control to the controller is less valuable than the increase in value from unification of the two classes of stock. At some point, entrepreneurial vision and energy will run out. To minimize the dissipation of economic value, the controller should be encouraged to sell back control to the firm, after negotiation with a special committee and ratification by public shareholders and under a business judgment standard of judicial review. Yes, this is a put option for the controller on predictably favorable terms, but the alternative is prolongation of inefficient control.
The second suggestion is adoption of a “breakthrough” rule similar to what is found in the Takeover Directive of the European Union. If a party obtains 75 percent of the cash flow rights of a firm with a dual class structure, the super voting stock votes alongside all other classes, one vote per share, in voting for directors. Porting this over to the U.S. will provide a limit to the wedge between cash flow rights and control rights and also place a boundary on the inefficient use of economic resources by the controller, since a significant inefficiency shortfall could well lead to a hostile bid. The case for such a breakthrough rule sounds both in a public law rationale as well as a private law one.
This post comes to us from Jeffrey N. Gordon, the Richard Paul Richman Professor of Law at Columbia Law School.