The structure of dual-class stock, where one class of shares confers more votes per share than the other, creates a gap (“wedge”) between voting rights and cash flow rights that allows insiders to raise capital without relinquishing effective control of the company. In the past few years, the policy debate over this structure has intensified. Proponents argue that it encourages innovation by insulating management from short-term market pressures. But opponents argue that the combination of weak ownership incentives and entrenchment results in agency problems.
Meanwhile, the regulatory debate about dual-class stock is developing in opposite directions. While this capital structure has historically been permitted in the United States, institutional investors and index providers have recently expressed strong opposition to it. By contrast, jurisdictions that traditionally prohibited the use of dual-class stock have faced increasing market pressures to allow it. Stock exchanges in London, Hong Kong, and Singapore recently revised their listing rules to facilitate the use of dual-class shares.
However, the binary, restrict-or-allow regulation of dual-class firms does not account for the size of the wedge. In a recent article, we provide policymakers with analytical tools for evaluating the effectiveness of current financial regulation and assessing whether a nuanced regulation that considers the size of the wedge would be more effective.
We use a comprehensive sample of 248 dual-class firms publicly traded in the United States between 2012 and 2019 and measure the size of the wedge for each firm and each year. Our use of panel data enables us to track each firm over time and make comparisons with other firms.
We find correlations between the wedge size and specific firm characteristics. As the wedge increases, dual-class firms tend to become older (more time has passed since their IPO), smaller, more profitable, and less leveraged.
We then examine whether the quality of financial reports changes across the wedge-size spectrum by using well-established proxy measures for information quality: earnings persistence, cash flow persistence, and the use of discretionary accruals. Our measures indicate that firms with a larger wedge demonstrate a higher quality of financial reporting. Specifically, a larger wedge does not indicate a lower quality of reported earnings.
While agency theory would suggest that the larger a firm’s wedge size, the lower the quality of its financial reporting, our findings indicate that the freedom from the market for corporate control resulting from a large wedge is stronger than agency costs. Management’s insulation from market pressures seems to reduce motivation to manipulate earnings to achieve short-term goals in dual-class companies compared with their single-class counterparts, thus making the financial reports more accurate and complete. Our findings suggest that this effect extends beyond the dual- versus single-class distinction and is influenced by the size of the wedge as well. When the gap between voting rights and cash flow rights is small, the company may still be vulnerable to a takeover, which may give management an incentive to manipulate earnings. However, as the wedge size increases, the threat of being taken over and the motivation to manipulate earnings decrease, making the financial reports more informative.
A larger wedge may also imply more pressure from the capital market, leading to better quality reporting. High-quality financial reports may enable a firm to attract investors who agree to disproportionate control. Investors weigh the likely benefits of enabling founders of dual-class firms to pursue their idiosyncratic visions against agency costs. If investors believe the founders have unique skills and a compelling vision for the company, the investors may agree to the allocation of super-voting rights to the founders. To be trustworthy, founders must provide investors with high-quality information. Moreover, since dual-class companies are repeat players in the capital market, they have strong incentives to maintain good reputations and the credibility of their financial reports even after their IPO.
Our findings uncover important and counterintuitive evidence about the tradeoff between the dilution of voting rights and enhancement of the quality of information provided to investors. Given the debate over dual-class structures and their implications for investors, our results suggest that a regulatory framework distinguishing among dual-class firms based on the size of the wedge may not be more effective in terms of financial reporting quality. As for disclosure of financial information, since a larger wedge does not decrease the quality of reporting, permitting dual-class structures regardless of the size of the wedge seems to be effective.
This post comes to us from professors Rimona Palas and Dov Solomon at the College of Law and Business in Ramat Gan and Dalit Gafni and Ido Baum at the College of Management-Academic Studies (Colman) in Rishon LeZion. It is based on their recent article, “Does Wedge Size Matter? Financial Reporting Quality and Effective Regulation of Dual-Class Firms,” available here.