Dual class stock structures have become increasingly popular in the last couple of years. Initial public offerings that feature dual-class stock structures have risen from 4 percent in 2009 to 14 percent in 2018. ((Kosmas Papadopoulos, Dual-Class Shares: Governance Risks and Company Performance, Harv. L. Sch. F. on Corp. Governance & Fin. Reg. (Friday, June 28, 2019), https://corpgov.law.harvard.edu/2019/06/28/dual-class-shares-governance-risks-and-company-performance/.)) However, their increased usage has also brought on a new wave of skepticism and oversight. This post examines the arguments for and against this share structure before putting forth two solutions to this supposed paradox. By involving shareholders in the formation and management of dual-class stock structures, firms can capitalize on the advantages of such a structure without ignoring minority shareholder interests.
Dual class stock structures can take several different forms. For the purposes of this discussion, dual-class stock structures are most simply defined as companies that issue two or more classes of shares with different rights assigned to each class. ((James Chen, Dual Class Stock, Investopedia, https://www.investopedia.com/terms/d/dualclassstock.asp. (last updated Apr. 26, 2019).)) More specifically, dual class stock structures often assign different voting rights to each class of shares. ((Id.)) Although there are several justifiable reasons for adopting a dual class stock structure, the most commonly voiced justification is to consolidate voting power in one distinct group of individuals – often the founders or other higher executives. ((Vijay Govindarajan, Shivaram Rajgopal, Anup Srivastava, and Luminita Enache, Should Dual-Class Shares Be Banned?, H. Bus. Rev. (Dec. 3, 2018), https://hbr.org/2018/12/should-dual-class-shares-be-banned.)) Dual class structures have become increasingly popular in several different industries – ranging from the tech industry with companies like Alphabet to the automotive industry with companies like Ford Motor Company. ((Benjamin Robertson and Andrea Tan, Dual-Class Shares, Wa. Post. (Jan. 14, 2019 at 9:25 PM EST), https://www.washingtonpost.com/business/dual-class-shares/2019/01/14/a6158f3a-186d-11e9-b8e6-567190c2fd08_story.html.)) However, the most recent resurgence comes primarily from new technology companies such as Snap and Lyft. ((Zoe Condon, A Snapshot of Dual-Class Share Structures in the Twenty-First Century: A Solution to Reconcile Shareholder Protections with Founder Autonomy, 68 Emory L. J. 355 (2018).))
As an extreme case study, Alphabet employs a split class stock structure, broken into three groups – Class A Common Stock, Class B Common Stock, and Class C Capital Stock. ((Alphabet, Annual Report (Form 10-K) (Feb. 4, 2019). )) As is typical with most split-classes, the voting rights between each of the categories is vastly different. Class B Common Stock is afforded 10 votes per share; Class A Common Stock has only one vote per share; and Class C Capital Stock receives no voting power at all. ((Id.)) Unsurprisingly, a significant portion of the voting power is concentrated with a tightly-defined group of owners. In this case, Larry Page, Sergey Brin, and Eric Schmidt own over 90% of the Class B Common Stock. ((Id. at 19.)) This corresponds to over half of the voting power of the outstanding common stock in the company. ((Id. at 19.)) Thus, by employing a split-class stock structure, Alphabet has consolidated voting power in a small class of defined corporate executives while still soliciting funds from public investors via the market.
As mentioned above, the debate surrounding the use of these dual-class stock structures has intensified as well-known tech companies such as Snap and Facebook have increasingly used such structures. However, this structure has historically been used in several other industries such as newspaper and media sectors. ((Lucian A. Bebchuk & Kobi Kastiel, The Untenable Case for Perpetual Dual-Class Stock, 103 Va. L. Rev. 585, 595 (2017) (“The use of dual-class stock is not limited to the tech industry.”))) For example, dual class structures are found in several non-technology-related firms such as Berkshire Hathaway, New York Times, Comcast, and Viacom, to name a few. ((Id. at 595) (“Major companies with dual-class structure operating in other sectors include AMC, Berkshire Hathaway, Cablevision, CBS, Comcast, Estée Lauder, Ford, Hershey, News Corp., Nike, Ralph Lauren, Tyson Foods, and Viacom.”))) The diverse use of dual-class stock structures makes sense in other corporate contexts besides tech. For example, in traditional family-controlled enterprises such as The New York Times or The Wall Street Journal, dual-class stock structuring provides a means to ensure family voting control while still accessing the public market. ((MarketWatch, NYT: Dual-Class Stock Structure Not Unique to Company, (Apr. 24, 2007 8:18 AM), https://www.marketwatch.com/story/nyt-dual-class-stock-structure-not-unique-to-company. )) The potential reasons for seeking to retain voting control are vast and spread beyond the applicability to only technology-focused companies. Thus, while it is certainly true that tech-age companies drive the recent resurgence in the public discourse around dual-class structures, the use of these unique capital structures predated their more prevalent use in today’s market.
Criticism towards dual-class stock structures is not a new phenomenon. Just like dual-class structures existed prior to the advent of the tech-age, criticisms of the dual-class structure existed prior to their modern implementation in Snap and Facebook’s initial public offering. For most of the New York Stock Exchange’s history, the Exchange refused to list companies with dual-class voting. ((Daniel R. Fischel, Organized Exchanges and the Regulation of Dual Class Common Stock, 54 U. Chi. L. Rev. 119 (1987).)) It wasn’t until the takeover frenzy of the 1980s that corporate insiders began to lobby the Exchange to change course in allowing for more protections for executive control. ((Robert J. Jackson Jr., SEC Comm’r, Speech at University of California, Berkeley, Perpetual Dual-Class Stock: The Case Against Corporate Royalty (Feb. 15, 2018).)) This pressure eventually led the New York Stock Exchange to change its course and allow companies to use dual-class stock structures when issuing shares to the public market.
As more and more companies decide to issue their shares to the public market, the option to implement a creative dual-class structure presents itself much more often. ((Bob Pisani, IPOs Have Their Best Quarter in Years in Terms of Performance and Capital Raised, CNBC (Friday, June 28, 2019 at 9:10 AM EDT), https://www.cnbc.com/2019/06/28/ipos-have-their-best-quarter-in-years-in-terms-of-performance-and-capital-raised.html.)). Indeed, almost 50 percent of recent technology firms that have issued shares on the public market employed a dual-class stock structure. ((Vijay Govindarajan, Shivaram Rajgopal, Anup Srivastava, and Luminita Enache, Should Dual-Class Shares Be Banned?, H. Bus. Rev. (Dec. 3, 2018), https://hbr.org/2018/12/should-dual-class-shares-be-banned (“Almost 50% of recent technology listings have a dual-class status.”) )) However, with creativity comes critique. In the wake of highly-touted initial public offerings such as Snap and Lyft failing to live up to expectations, public criticism of dual-class stock structure returned to the limelight. (( See, e.g., Kurt Schacht, Lyft’s Dual-Class Share Structure Makes it Poisoned at Birth, Fin. Times (Apr. 29, 2019), https://www.ft.com/content/24fa8b6a-6a4f-11e9-a9a5-351eeaef6d84.)). In Lyft’s case, the controlling group of executives receives twenty votes per share, as opposed to the one vote per share that the common investor receives. ((Id.)) As these structures get more and more brash, critics have raised several defensible arguments against their implementation in the public markets.
For starters, many critics suggest that the practical consequences of dual-class stock structure undermine the fundamental tenets of the public market. ((Council of Inst. Inv’rs, Dual-Class Stock, https://www.cii.org/dualclass_stock (last visited Oct. 20, 2019).)) More specifically, dual-class stock structures run afoul of the commonly held democratic principle of one-share, one-vote. As the above discussion clarifies, dual-class stock structures give a pre-defined control group a massive multiplier in voting power over the average investor. Indeed, in Lyft’s case, a more apt catchphrase would be one-share, twenty-votes. ((Kurt Schacht, Lyft’s Dual-Class Share Structure Makes it Poisoned at Birth, Fin. Times (Apr. 29, 2019), https://www.ft.com/content/24fa8b6a-6a4f-11e9-a9a5-351eeaef6d84.)). More specifically, the practical upshot of this undemocratic result is that a small group of corporate executives exert perpetual authority over the dispersed group of individual minority shareholders. Even SEC Commissioners have advanced this argument – signaling a potential shift in SEC enforcement priority. ((Robert J. Jackson Jr., SEC Comm’r, Speech at University of California, Berkeley, Perpetual Dual-Class Stock: The Case Against Corporate Royalty (Feb. 15, 2018).))
Additionally, and closely related to critics’ last point, dual-class stock structures have the potential to misalign corporate priorities with what the majority equity shareholders would theoretically prefer. For example, in Lyft’s case, the share structure allows Lyft’s co-founders to have a practical guarantee of control via voting power while only holding less that 5 percent of the company’s equity. ((Lucian Bebchuk & Kobi Kastiel, The Perils of Lyft’s Dual-Class Structure, Harv. L. Sch. F. on Corp. Governance & Fin. Reg. (Wednesday, Apr. 3, 2019), https://corpgov.law.harvard.edu/2019/04/03/the-perils-of-lyfts-dual-class-structure/.)) Thus, the traditional incentive for executives to make decisions grounded in profitability (equity ownership as a prerequisite for voting power) is no longer required. This frees the control-group to make decisions based on considerations that may not be in the equity-majority’s best interest. As several critics, including the SEC, have mentioned, this structure leads to much higher governance costs as minority shareholders look to litigation of fiduciary duties as a means to reign in corporate governance decisions. ((Id.))
In the face of renewed criticism, proponents of dual-class stock structures assert several traditional justifications for such a structure. One of the most frequently cited justifications derives from the specific nature of technology companies and the current market conditions. Proponents of dual-class structure argue that the lack of traditional protection mechanism such as the poison pill require the availability of an alternative method to defend against rising shareholder activism. ((Vijay Govindarajan, Shivaram Rajgopal, Anup Srivastava, and Luminita Enache, Should Dual-Class Shares Be Banned?, H. Bus. Rev. (Dec. 3, 2018), https://hbr.org/2018/12/should-dual-class-shares-be-banned.)) Dual-class stock structures provide an effective defense mechanism because of they effectively split equity rights and voting rights. Thus, an activist shareholder can acquire a majority of a company’s widely traded equity stock without necessarily acquiring a large enough stake to make their desired changes to the board – thereby erasing their primary incentive for stock acquisition in the first place.
The desire for independence could be even stronger in the context of new technology companies. Arguments for the splitting of equity and voting rights are particularly persuasive if it can be demonstrated that the minority shareholder’s expectations are misplaced or erroneous. For example, take a healthcare technology firm. First, the subject matter that the firm is engaged in is highly-complex and difficult for the average investor to understand. Thus, it may make more sense to allow corporate executives (assuming that they are in their role due to their increased knowledge base on the subject matter) to make decisions on highly specialized corporate governance. Additionally, there may be an alternative motivation aside from pure profit. In this example, the medical advances that could result from more research and development perhaps justify taking a temporary profit loss. In both of these instances, it may make more practical sense to allow highly-trained executives to make important governance decisions that take into account a wide array of factors aside from pure profit.
Both of these sides raise credible arguments about the desirability of the dual-class stock structure. Proponents raise practical concerns about firm-independence in specialized industries while critics raise equally-justifiable concerns about minority shareholder efficacy. In my opinion, the practical solution lies somewhere in between. The costs of completely forbidding dual-class stock structures would likely be too high. Not only would highly specialized firms decide against going private and thus deprive the public marketplace of added value; would-be entrepreneurs may be chilled out of starting a new venture because they may have no practical way to retain control of their company should they choose to go public (a particularly desirable result for most early-stage companies). However, the costs of allowing iron-clad dual-class stock structures are already imposing real costs on the marketplace. In firms that are not highly specialized, dual-class structures may allow inefficient executives to entrench themselves to the detriment of the firm, and the market as a whole. ((Vijay Govindarajan, Shivaram Rajgopal, Anup Srivastava, and Luminita Enache, Should Dual-Class Shares Be Banned?, H. Bus. Rev. (Dec. 3, 2018), https://hbr.org/2018/12/should-dual-class-shares-be-banned.))
A proposal that allows for sufficient operational independence while still ensuring minority shareholder participation would bring this cost-benefit analysis into alignment. For example, a dual-class stock structure that requires a supermajority of shareholder approval every “x-amount of years” could help alleviate some of the concerns surrounding the longevity of the current dual-class structures.
Additionally, shareholders could be involved in the initial formation of the dual-class structure. In this instance, major stock exchanges (such as NYSE) could issue rules that prohibit executives’ unilateral decision to apply a dual-class structure in the firm’s prospectus. Instead, the NYSE could allow dual-class stock structures to be put in place, but only after a 30-day “hold” period starting when the firm is publicly listed. After this “hold” period expires, the firm could propose a dual-class structure to the current shareholders for approval whereby current common stock holders would negotiate for the exchange of their shares for those with lesser voting power relative to the owner’s new proposed class. Thus, this would give all shareholders a say in the details of such an important corporate governance proposal and allow both parties to efficiently bargain to obtain a mutually desirable result.
The current state of affairs concerning dual-class stock structures is complex and fluid. Much of the development that may occur over the next few years will largely depend on the intensity of public opinion. Additionally, SEC regulations could drastically alter the playing-field, similar to how SEC regulations effectively nixed initial-coin-offerings. ((SEC Chairman Jay Clayton, Statement on Cryptocurrencies and Initial Coin Offerings, SEC (Dec. 11, 2017), https://www.sec.gov/news/public-statement/statement-clayton-2017-12-11.)) It will primarily be up to individual markets such as the NYSE and regulators such as the SEC to make these important decisions. An efficient remedy would take into account the above-mentioned factors in formulating a flexible and equitable standard.