Dual-Class Shares: From Google to Alibaba, Is It a Troubling Trend for Investors?
In March, mainland Chinese company Alibaba finally announced that it would be listing its much-anticipated IPO in New York rather than in Hong Kong. This has left regulators in Hong Kong revisiting their stance on a one-share, one-vote standard and many corporate governance practitioners around the world concerned that this may hasten a growing trend — for companies to go public with a dual-class share structure that can disenfranchise shareowners. (See our views on the topic from October 2013).
The reasoning behind dual-class share structures is that company founders want to have their cake and to eat it, too. Hong Kong wouldn’t allow that, but the New York Stock Exchange (NYSE) does. If you are wondering, CFA Institute endorses a one-share, one-vote standard.
Dual-class shares often give some shareowners more voting rights than others. In this case, Alibaba’s founders likely would be able to control the vote at the company (with more than 50% of the voting power) without having to risk their own equal capital.
A quick example demonstrates how this separation of economic ownership from control can work. If a company has a dual-class share structure in which the founder gets four votes for every one of other shareowners, and there are one million shares with four votes controlled by the founder and four million shares with one vote controlled by other shareowners, the founder can still control all decisions at the company (he has 50% of the vote) while only taking 20% of the economic risk. If that founder wishes to control 50% of the shares, why doesn’t he simply take 50% of the economic risk?
Recently, dual-class shares have been making a comeback, with companies such as Google, Groupon, Facebook, and other tech companies preferring such a structure. Before dual-class shares became all the rage with technology companies, they were quite prominent at media companies such as the New York Times, Washington Post, and News Corp. The argument was that the dual-class structure helped these media companies keep their journalistic integrity.
What Kind of Message Are These Companies Sending?
Defenders of dual-class shares claim that the structure allows them to focus more on long-term performance than on short-term returns. This is a specious argument, as there is an easy way to retain control and show shareowners that you have as much at risk as they do — just own 50% of the shares. By adopting a dual-class structure, however, companies are sending the message that they want to control a majority of the votes but not take a majority of the risk. Another way to say it is that they want the public’s capital, just not their opinions. If they don’t want to give up control of the company they can finance through debt, raise venture or equity capital, sell fewer shares so they retain control, or they can simply choose to remain a private company.
Research has shown that an ownership situation in which a founder, family, or other entity controls a company’s voting power, but does so under a one-share, one-vote standard, performs better for minority shareowners and controlling shareowners, alike. In the United States, at least, a study by the Investor Responsibility Research Center (IRRC) has shown that on average, and over time, companies with dual-class shares underperform those with a one-share, one-vote standard in which the owner’s economic risk is commensurate with his voting power. This IRRC study also found that over the long term, controlled companies with a one-share, one-vote structure tend to outperform all others. In essence, the nature of control matters. A structure in which controlling shareowners share the same link between economic risk and control as other shareowners seems to work best for all parties.
Detractors of dual-class structures state that such structures insulate bad management from the discipline of the markets. They also cite the “next generation” problem with a dual-class share structure: inevitably, the management team or individual who founded a company — no matter how brilliant — will retire, cash out, or move on to other endeavors. This often leaves the dual-class voting power in the hands of the next generation who inherits the shares, a next generation who is rarely as interested in the business or as talented as the passionate creators who came before them. For this reason, some in the governance community have called for a sunset provision (perhaps five or 10 years) in a company’s dual-class share structure.
There is also a perception problem for stock exchanges. Perhaps the New York Stock Exchange is so big that by allowing a proportionately few companies to have different listing rules does not compromise the perceived integrity of the NYSE. However, if the trickle of dual-class issuers grows to a sizable proportion of listed companies, these exchanges will have to defend against investor concerns that they are allowing lax corporate governance standards.
The answer many companies give to those who voice concerns about the corporate governance shortcomings of dual-class shares is “buyer beware.” After all, no one is forcing investors to buy these companies. Issuers often argue that as long as the dual-class structures are clearly disclosed to shareowners, they can choose to invest or look elsewhere. There are plenty of choices to invest in companies with or without dual-class shares. However, index investors and many institutions that own the market do not have such a choice, and are locked into owning companies in which their rights — and their returns — are compromised by dual-class structures.
It will be interesting to see whether this trend continues, whether the Hong Kong exchange sticks to its principles, whether dual-class structures will continue to proliferate, and whether investor concerns are met. Stay tuned.
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