Pension funds and other institutional investors rail against dual-class shares and other tiered voting structures while companies fight vigorously to defend them. The debate over the “one share one vote” doctrine is not, however, solely jurisprudential – economists have conducted voluminous studies on this subject, and legal scholars have gathered compelling evidence for their own arguments. Yet, sophisticated empirical research has failed to determine conclusively whether the doctrine is optimal.[1] This reminds us of Ronald Coase, the receiver of the 1991 Nobel Prize, who once quipped, “if you torture the data enough, nature will always confess.”[2] Fundamental economic insights may shed helpful light on the issue.

It would be preposterous to discuss voting structures without considering the institutional context, since this affects the incentives of participants.[3] Individuals currently have almost limitless alternatives in every category of securities. No investment is completely unique, with substitutes providing identical combinations of risk and reward. Given this variety, an investor is not required to put “eternal trust”[4] in any financial instrument or any corporation. By transacting – buying or selling – certain types of securities, investors reveal their preferences. By purchasing shares with lesser voting rights, they manifest a willingness to give up some marginal power in the governance of a company. In other words, the owner of a lower-voting share has accepted the terms for participating in financing the corporation by buying an investment security of that particular category. The security holders within other categories (inter alia, bonds and shares with multiple votes) demonstrate similar acceptance with their own actions. Unforced actions reveal preferences, as Paul Samuelson (the 1970 Nobel Prize recipient) taught us.[5] Accordingly, we should not assume shareholders have the same interests. Although some investors certainly prefer to have more control rights, control may not serve the interests of others. Representatives of the latter group may even be convinced that the fewer voting rights investors have in total, the more stability and long-term prosperity for the company.[6]

Opposing or supporting voting differences is one thing, but actions taken with real money count in the market for consumer goods as well as for investment vehicles. Financial instruments, however, differ fundamentally from hard goods, such as cars that have their most important features hidden beneath the hood, away from the customer’s eyes. The late George Akerlof is known for his study of the “lemon risk.” A prospective purchaser cannot ascertain the condition of a used car before the transaction and is, therefore, unwilling to pay more than a price corresponding to a lemon – a car in poor condition. As a result, the seller of a car in good condition cannot receive real value unless he is able to convince – e.g., by offering a guarantee – the potential buyer of the car’s good condition.[7]

Akerlof’s insight also applies to securities markets. The features of a financial instrument are transparent, as the rights are stated in the bylaws or on the term sheet of a bond issue. The difference between an ordinary and a lower-voting share is evident for market participants as the terms of each share class and the number of issued shares are easily accessible public information. There remains nothing under the hood. Thus, institutional investors are more than likely to purchase lower-voting shares only at a discount to receive fair consideration for their money.[8] Consequently, the difference in votes is (almost) fully reflected in the market price of the share with lesser voting rights vis-á-vis the superior voting share. Due to this effect, even the most ignorant buyer who is not aware of the voting differences is protected by the price established on the stock market. In other words, the buyer of a lesser-voting share pays just what she has bargained for.[9]

Liquidity, the number of shares floated, is a salient factor in the value assessment. In earlier days, stockholders had to bear the risk that a crooked company would issue unauthorized shares in addition to the amount publicly disclosed.[10] These “stock-watering” scandals are history, but an investor must still account for the possibility of mid-term changes, such as a targeted share issue in which she is not allowed to participate pre-emptively. In some jurisdictions, when the bylaws contain nothing to the contrary, companies can even issue a new class of superior voting shares without the support of investors of the existing share class with lesser voting rights.[11] This is likely a major reason for institutional investors´ aversion to voting structures. The dilemma, however, also boils down to the teachings of Akerlof. If a corporation does not offer an investor protection against mid-term changes, it is bound to have a negative effect on the price that investors are willing to offer in the first place. Thus, a decision has to be made whether or not protections are worth the potential savings in its funding costs.

Every corporation sells promises – in various debt and equity terms – of future cashflows to those who are able to provide capital for the corporation’s operations.[12] Even though a ban on lower-voting shares would deprive companies of only one of many funding options, it would run counter to the evolution of financial markets over the last century: They have grown more and more complete through the introduction of novel instruments.[13] Society has benefited from the availability of investments with a wide range of potential returns in a variety of risk scenarios, as illustrated by the late Professor Kenneth Arrow.[14] In other words, complete markets – ones offering a vast array of investments – provide individuals with the greatest flexibility in planning for an uncertain future. Certainly, with the help of financial engineering, one can replicate the payoff structure of lower-voting shares, inter alia, but that does not establish a legitimate reason to ban them. On the contrary, without lower-voting shares, some investors might even be willing to bear the cost of replicating them with innovative financial instruments to achieve similar standing. But such costs would establish an unnecessary burden on the welfare of a society.

ENDNOTES

[1] For a timely summary, see Jill E. Fisch – Steven Davidoff Solomon, Dual Class Stock. Uinversity of Pennsylvania, Institute for Law & Economics Research Paper No. 23-21 p. 10-12 (https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4436331, visited 19 Dec. 2023).

[2] Ronald Coase, Essays on Economics and Economists. Chicago 1994 p. 27.

[3] Ronald Coase, Nobel Lecture 1991, The Institutional Structure of Production, paragraph 12 (https://www.nobelprize.org/prizes/economic-sciences/1991/coase/lecture/, visited 19 Dec. 2023).

[4] Cf. Speech by SEC Commissioner Robert Jackson Jr., Perpetual Dual-Class Stock: The Case Against Corporate Royalty, 15 Feb. 2018 (https://www.sec.gov/news/speech/perpetual-dual-class-stock-case-against-corporate-royalty, visited 19 Dec. 2023).

[5] Paul A. Samuelson, Consumption Theory in Terms of Revealed Preference. 15 Economica 1948 pp. 243-253, 243.

[6] Armen Alchian – Harold Demsetz, Production, Information Costs, and Economic Organization. 62 American Economic Review 1972 pp. 777-795, 789, note 14.

[7] George A. Akerlof, The Market for “Lemons”: Quality Uncertainty and the Market Mechanism. 84 The Quarterly Journal of Economics 1970 pp. 488-500.

[8] See generally, Jinhee Kim – Pedro Matos – Ting Xu, Multi-Class Shares Around the World: The Role of Institutional Investors, Nov. 2018 (https://web.nbs.ntu.edu.sg/general/NTUFinanceConference2019/downloadpapers/paperfolder/FC2019D1_MultiClassShares.pdf, visited 20 Dec. 2023).

[9] Eugene Fama, Nobel laureate of 2013, does not claim that the exchange quotations are always “right” in an absolute sense but that the current price represents the best available estimate of value as it emerges as consensus of the ultra-competitive transactions among market professionals. Eugene F. Fama, Random Walks in Stock Market Prices. 21 Financial Analysts Journal 1965 pp. 55-59, 56.

[10] See, e.g., Henry Winthrop Ballantine, Ballantine on Corporations –  Founded on Clark and Marshall Corporations. Chicago 1927 p, 151.

[11] E.g., Re Schweppes Ltd [1914] Ch 322.

[12] Armen Alchian – Harold Demsetz, op.cit. p. 787.

[13] See, e.g., Robert C. Merton, The Financial System and Economic Performance. Journal of Financial Services Research 1990 pp. 263-300.

[14] Kennetn J. Arrow, The Role of Securities in the Optimal Allocation of Risk-bearing. 31 Review of Economic Studies 1964 p. 91-96. As a particularly lucid treatment, see Peter H. Huang, Securities Price Risks and Financial Derivative Markets. 21 Northwestern Journal of International Law & Business pp. 589-606, 594-598.

This post comes to us from Timo Kaisanlahti, a professor of practice in the Faculty of Law at the University of Helsinki.