Enhancing Governance in Dual-Class Share Firms

By Anita Anand 

Originally posted on The CLS Blue Sky Blog.

In a typical public company, shareholders can elect the board, appoint the auditors, and approve fundamental changes.  In other words, they can participate in the governance of the firm. Firms with dual class shares (DCS) alter this balance by inviting the subordinate shareholders to carry the financial risk of investing in the firm without providing them with the corresponding power to elect the board and exercise other voting rights. I argue that this misalignment of rights and risks should be subject to three modest reforms in order to enhance governance in DCS firms.

The rationale underlying DCS is that they allow firm founders to protect themselves against a loss of control,[1] thereby ensuring that they can implement a long-term corporate strategy notwithstanding  short-term market pressures.[2] But the central question must be asked: to what extent (and for how long) should the law allow the founders to pursue their “idiosyncratic vision” for the DCS corporation?[3]

Empirical data specifically collected for my study suggest that the governance of DCS firms is not uniform. In particular, a large proportion of Canadian DCS firms have no majority-of-the-minority voting provisions and no independent board chair. Almost half of the DCS firms in the sample have a sunset clause and a majority of independent directors. Finally, just under one-third of DCS firms have change of control provisions over and above existing law.

Thus, in at least some respects, DCS firms do not adopt commonly-accepted good governance practices, such as having an independent board chair in place. This fact is unsurprising given the founders’ objective to maintain control.[4] The conspicuous question is: what, if anything, should be done about the potential governance failings inherent in DCS structures? One option would be to prohibit DCS altogether in order to ensure that all shareholders stand on an equal footing in DCS firms. Normatively, this reform proposal is well worth considering, although it would also mean that investors do not get to benefit from investments in companies with high growth potential. In the absence of a blanket prohibition, certain reforms would lead to better governance. I put forward three modest proposals.

First, securities regulators should require a fixed-term sunset with a mandatory vote at the end of the term for DCS firms. In other words, once a company goes public, the DCS structure can only be in place for a limited period of time, unless further majority-of-the-minority shareholder approval is obtained for the DCS structure. It is true that DCS legitimately allow founders to pursue long-term strategies, but the subordinate shareholders’ interests may be abused when the corporation makes consistent non value-maximizing decisions, an incumbent’s performance declines, or less talented individuals take control of the company.

A fixed-term sunset provision would mitigate this risk by barring perpetual DCS, unless the subordinate shareholders agree to maintain DCS by a majority-of-the-minority vote at an annual meeting.  A recent speech by SEC Commissioner Robert Jackson supports the benefits of fixed-term sunset clauses. He and his staff found that firms with perpetual DCS in place for seven or more years from their IPOs trade at a significant discount to those with sunset provisions. Among the small subset of firms that decided to dispense with DCS later in life, they also found that those decisions were associated with a significant increase in valuations.[5]

Second, securities regulators should mandate that shareholder voting records be made available for shareholder review. Without such disclosure, one cannot tell how shareholders unaffiliated with the controlling shareholder voted, potentially leading to a false sense of support for management. By mandating disclosure of superior and subordinate vote results separately, subordinate shareholders will be able to view how insiders are actually voting. They will be able to express their dissatisfaction with the status quo and exercise the potential disciplining effects that come with expressive voting noted above.

Third, to protect subordinate shareholder rights, an important next step would be to require independent valuations and majority-of-the-minority approval of buy-outs of the founder in a DCS firm. It is true that securities regulators seem to be moving towards greater scrutiny of DCS. In Canada, they have published guidance regarding minority shareholders in conflict of interest transactions. This guidance usefully isolates several key areas for their review of material conflict transactions, namely: timely formation of special committees; a broad special committee mandate; independence of special committee members; reluctance to over-rely on fairness opinions; and, considerations relating to the best interests of both the corporation and its minority shareholders.[6] Procedure becomes very important in the buy-out context as the somewhat infamous Magna transaction in Canada highlights.[7]

These three reforms would better align the interests and incentives of subordinate shareholders and founders in a DCS setting. They would help to ensure that the benefits of DCS are time-limited without further approval from the subordinate shareholders. In short, they would lead to better governance in DCS firms overall.

This post comes to us from Anita Anand, the J.R. Kimber Chair in Investor Protection and Corporate Governance, Faculty of Law and Rotman School of Management, University of Toronto. It is based on her article, “Governance in dual class share firms,” forthcoming in the Annals of Corporate Governance and available in draft here.  

 

[1] See, for example, Onur Arugaslan, Douglas O Cook & Robert Kieschnick, “On the Decision to go Public with Dual Class Stock” (2010) 16:2 J Corp Fin 170, online: <www.sciencedirect.com/science/article/pii/S0929119909000510> who find that deviations form a one-share one vote regime are done primarily so insiders can retain control.

[2] Bradford Jordan, Soohyung Kim & Mark H Liu, “Growth Opportunities, Short-Term Market Pressure, and Dual-Class Share Structure”, (2016) 41 J Corp Fin 304, online:

<https://www.sciencedirect.com/science/article/pii/S0929119916301444&gt;.

[3] The term “idiosyncratic vision” is used by Zohar Goshen & Assaf Hamdani, “Corporate Control and Idiosyncratic Vision” (2016) 125:3 Yale L J 560, online: <https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2228194&gt;.

[4] See Anita Anand, “Governance in Dual Class Share Firms” (2018) Ann Corp Gov (forthcoming).

[5] Speech by Robert Jackson, “Perpetual Dual Class Stock – the Case Against Corporate Royalty” (February 15, 2018), online: <https://www.sec.gov/news/speech/perpetual-dual-class-stock-case-against-corporate-royalty&gt;. Jackson cites Lucian A Bebchuk & Kobi Kastiel, “The Untenable Case for Perpetual Dual-Class Stock” (2017) 103:4 Va L Rev 585 at 598-599, online: <https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2954630&gt;.

[6] CSA Staff Notice 61-302 – Staff Review and Commentary on Multilateral Instrument 61-101 and CSA Staff Notice 61-302 – Staff Review and Commentary on Multilateral Instrument 61-101.

[7] Anita Anand, “Was Magna in the Public Interest?” (2012) 49:2 Osgoode Hall LJ 311, online: < http://digitalcommons.osgoode.yorku.ca/cgi/viewcontent.cgi?article=1058&context=ohlj&gt; and Anita Anand, “Offloading the Burden of Being Public: An Analysis of Multi-Voting Share Structures” (2016) 10:3 Va L & Bus Rev 395, online: <https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2728481&gt;.