By Bonnie Liu
I. Introduction
On January 20th, UCloud Technology, a Chinese cloud computing services provider, became publicly listed on the Science and Technology Innovation Board of the Shanghai Stock Exchange, making it the first company with dual-class share structure to go public in mainland China.[1] Due to its dual-class share structure, upon a fully subscribed initial public offering (IPO), UCloud's three co-founders retain 23% of the company's total shares but command 60% of the voting rights.[2] UCloud’s dual-class stock structure deviates from traditional ownership schemes.
By virtue of equity contribution, shareholders of a company enjoy claims to both income stream and voting rights.[3] Rooted in democratic ideals of political philosophy, the aptly named “one share – one vote” principle dictates that all securities have the same proportional claim to votes and income. However, in a departure from precedence, dual-class stock structures have emerged in the market for corporate governance, where “one share of a particular class may have a claim to votes which is disproportionately larger or smaller than its claim to income.”[4] Dual-class stock structure features two types of stock: superior stock with multiple votes per share reserved for founders and corporate insiders, and inferior stock with one vote per share issued to public investors. As a convenient instrument for separating cash flow rights from voting rights, it enables founders of public companies to retain a lock on control while holding a minority of the company’s equity capital. Shareholders of common stock effectively grant the corporate controllers the discretion to implement their vision, with faith in their loyalty and expertise.
The legitimacy and desirability of a dual-class structure are subjects of heated controversy. Proponents of dual-class structure highlight the necessity to respond to corporate governance misalignment that favor short-term investor profit in stock markets over corporate long-term development.[5] Its advent offers alternative capital and governance structures when conventional single-class structure proves inadequate, as “no single capital structure is right for all companies.” On the other hand, market participants and policy makers alike have voiced opposition, contesting its fairness and efficacy, both theoretically and empirically. Prominently, the Council of Institutional Investors -- an organization of public, unions, and corporate pension funds -- petitioned the stock exchanges to adopt a one-share, one-vote policy.[6] Confusion reigns over the merits and drawbacks of dual-class structures; nevertheless, appetite for these structures persists.
According to the Council of Institutional Investors (CII), 182 American corporations have been publicly listed via dual-class structures as of September 2019,[7] and around 10 percent of publicly listed companies have multi-class structures,[8] with renowned companies like Facebook, Comcast, Lyft, and New York Times among the ranks.[9] Despite this nouvelle vague, other notable companies like Amazon, Microsoft and Yahoo! maintain the traditional single-class structure. Dual-class structures can be instituted either at the IPO or via midstream changes like reclassification or new issuance of nonvoting or low-voting stock. Alphabet (formerly Google), for instance, recently adopted such a nonvoting stock reclassification, permitting its cofounders to issue additional shares while retaining control. Such technologies can reduce ownership stake to negligible amounts.
II. Regulatory Landscape
a. United States
Since the Dodge Brothers’s dual-class IPO in 1925, the tortuous history of U.S. regulations encapsulates the perennial debate. Since 1926, the New York Stock Exchange (NYSE) has prohibited companies with nonvoting common stock or unequal voting rights from listing, citing its “commitment to encourage […] corporate democracy […] and accountability to shareholders.”[10] NYSE preserved its one share – one vote policy for sixty years, until competition with Nasdaq forced it to revert to leniency. Compared to NYSE’s antagonism turned into acquiescence, Nasdaq harbors an embracive and sanguine outlook: in an endorsement of dual-class stock, it promoted “multiple paths [for entrepreneurs to take] to public markets” and “flexibility [for publicly traded companies] to determine a class structure that is most appropriate and beneficial for them, so long as this structure is transparent and disclosed up front.”[11]
The Security and Exchange Commission (SEC) similarly transitioned from prohibition to permission. In 1988, it adopted Rule 19c-4 “to limit the ability of existing companies with one-share, one-vote structures to move to dual-class structures.”[12] Although this rule was invalidated by D.C. Court of Appeals on grounds that the SEC lacked authority for its adoption,[13] SEC persuaded major stock exchanges to prohibit dual-class recapitalizations. In a 2018 talk, SEC Commissioner Kara M. Stein contended that dual-class capital structure defeats the mutualistic symbiosis between companies and shareholders in the corporate ecosystem and systematically disenfranchises some shareholders by design (referring to non-voting stock).[14]
b. International
Internationally, attitudes towards dual-class structures reveal heterogeneity. While permitted and prevalent in jurisdictions like Canada, mainland China, and Denmark, dual-class structure is prohibited or rare in others, such as the United Kingdom (effective preclusion due to hostility of institutional investors) and Hong Kong (due to Hong Kong Stock Exchange’s explicit prohibition, with exemptions under hitherto nonexistent “exceptional circumstances”).[15] Such disparate regulatory standards and fierce competition can trigger a legislative race-to-the-bottom towards ever more charitable and minimalistic restrictions in order to attract foreign companies and stem the exodus of firms seeking overseas listings, and create a “market for corporate law.” This laissez-faire sentiment on the policy level may engender apathy or condonation of corporate misconduct. In 2014, the leading Chinese e-commerce platform Alibaba pursued a listing on NYSE after rejection from HKSE. While Alibaba insisted on its internal partnership of senior executives keeping control of the strategic direction and culture, HKSE “refused to allow the company to hand-pick most of its board members.”[16] This missed business opportunity prompted HKSE to conduct comprehensive appraisal and public consultation, and to reassess the one share – one vote principle. Similar circumstances deterred the NYSE-listed Manchester United from a U.K. IPO. Regulatory fluidities across time and discrepancies across jurisdictions catapult the cost-benefit analysis of dual-class structures to the forefront of discourse.
III. Mechanisms for Controllers to Solidify Power
Minority controllers preside over a panopoly of governance arrangements that enable them to retain control with meager equity capital, through the allocation, utilization, and transfer of voting rights, all of which sever the nexus between governance and ownership. First, controlling executives often hardwire provisions in company bylaws to secure preferential governance rights, for instance, allowing the controller to elect a majority/fixed number of board members, or mechanically allocating a fixed percentage of votes to the controller. For instance, Ford Motor Company’s charter grants the controlling Ford family with 40% of the company’s voting power, regardless of the size of its holdings.[17]
Second, they can increase widen the gap in voting power between superior and inferior stock. Bebchuk and Kastiel (2019) found that 97% of the companies in their dataset went public with a ratio greater than or equal to 10:1 (superior stock has 10 times the voting power of inferior stock). Gompers et al. find that “The most common structure is for superior shares to have ten votes per share, while inferior shares have one vote per share.” Alarmingly, Lyft and Pinterest used a 20:1 ratio. Large voting power disparity allows controlling shareholders to sell shares without forsaking control. Straightforward calculations show that a controller of a company with a 10:1 ratio can hold as little as 9.1% without losing majority control (having more than 50% of votes). Furthermore, nonvoting shares -- an extreme case of infinite ratio of high/low vote – safeguard the controller’s volition from external impediments. Snap, owner of Snapchat, debuted non-voting share in its March 2017 IPO.[18]
Lastly, executives can institute arrangements to cushion their control against dilution upon their sale of high-voting stock to third parties. Bebchuk and Kastiel (2019) identify two coping mechanisms employed by controllers: 1) voluntary conversion of high-voting stock into low-voting stock, and 2) authorization of a large number of low-vote shares at the IPO stage and their issuance at a later stage, with the intention that the controller can sell them instead of high-vote shares to circumvent transfer of control.
IV. Advantages of Dual Class Stock Structures
a. Fairness
Fairness and efficiency arguments underlie justifications for dual-class stock. On the grounds of fairness, dual-class structures embody a meritocracy, whereby the right to govern is awarded according to contribution and capacity. The corporation’s “founder- controller” parallels Plato’s “philosopher- king;” whereas in The Republic, the wisest and most virtuous governs the polis, in dual-class stock companies, the most senior and experienced uniquely can navigate the company’s strategic and managerial direction. Dual-class structures, which accord disparate voting rights to different kinds of stakeholders, also mirror Aristotelian conception of justice. In the Nicomachean Ethics, Aristotle delineates two forms of distributive, particular justice: geometric and arithmetic. Under geometric equality, “awards should be ‘according to merit’” and “in accordance with geometrical proportion,”[19] implying equal treatment of equals and unequal treatment of unequals, as epitomized by dual-class (which awards superior stock to founders and inferior stock to the public).
b. Efficiency
Insofar as operational and economic efficiency is concerned, dual-class stock structure addresses the corporate “double coincidence of wants” and matches excesses (supply) with deficiencies (demand) better than does single-class structure: public investors can offer financial capital but lack entrepreneurial expertise, while founders have a wealth of ideas and a paucity of capital. The stock market performs this matching, and dual-class stock structures amplify the founder’s abilities more so than single-class structures. Founders are uniquely equipped with leadership experience and technical skill; thus, empowering them with greater decision-making authority enables higher efficacy at the executive level. Subsequently, scholars argue that permitting public listings of dual-class voting companies incentivizes IPOs for companies that otherwise would have to seek private financing arrangements.
This financing choice insulates the company from short-term market pressures, reduces the likelihood of over-speculative hostile takeovers,[20] and prolongs the firm’s lifespan. Dual-class structure mitigates takeover risks, for the controller’s entitlement to multiple votes per share renders it at best difficult and at worst impossible for outside investors to accumulate enough voting power to sway the board or management via purchase of inferior stock. Cronqvist and Nilson (2003) observe that “firms with family [controlling minority shareholders] are about 50% less likely to be taken over compared to other firms”[21] Furthermore, dual-class firm exhibit greater persistence power – resistance to 1) sale of their shares, 2) privatization, 3) delisting from stock exchanges, and 4) unification of stocks into a single class -- due to controllers’ strong private incentives to avoid relinquishing power. Cremers, Lauterbach, Pajuste (2018) find that “dual class firms survive longer […] than their matched single class firms” and that “unifications become rare as firms age,” owing to the lower likelihood “to delist due to distress and to be taken over.”[22]
V. Downfalls of Dual Class Stock Structures: Perils of Minority Controlling Shareholders
The theoretical legitimacy of dual-class structures is disputable, as its inherent inequality threatens the corporate liberal democracy. Not only does it violate Aristotelian arithmetic equality (equal treatment of equals and unequals alike), it also causes a rift and disconnect between the interests of public shareholders and corporate insiders, violates principles of mutualism, harms the principal-agent relationship.
Aside from philosophical debates that portend little hope of resolution, empirical literatures, both historical and recent, suggest from various angles that dual-class may be less desirable than one share - one vote. In a comparative study, Kim and Michaely (2018) find that “relative to single-class firms, we find that dual-class firms experience a 10% larger decline in valuation as they mature,” and that dual-class firms that revert back to single-class structures exhibit Tobin’s Q (a measure of productivity computed as the ratio of company’s market value to its assets’ replacement cost) that is 0.55 higher than remaining dual-class firms since age five, controlling for relevant factors. When firms transition from single to dual-class structures, negative repercussions manifest at the recapitalization and endure afterwards. Examining shareholder wealth effects of 94 firms recapitalizing with dual-class common stock, Jarrell and Poulsen (1988) report significant, negative abnormal stock price returns at the announcement of the dual-stock recapitalization.[23]
At the heart of the problem, small minority shareholders generate significant governance risks.[24] Small minority controllers, also known as “controlling minority shareholders (CMS),” arise from “ownership structure in which a shareholder exercises control while retaining only a small fraction of the equity claims on a company’s cash flows.” This structure amalgamates a dispersed corporate ownership framework with a centralized corporate governance framework.
Separation of Governance and Ownership Rights
Dual-class structures enable controllers to substantially reduce their fraction of equity capital and to unload shares without relinquishing their deterministic control (via ownership of more than 50% of the voting power or a majority control of the board). Controlling shareholders often unload holdings to diversify their portfolios, finance other investments, and reduce idiosyncratic risk.[25] According to Gompers et al., corporate insiders have on average around 60% of the voting rights and 40% of the cash-flow rights in dual-class firms. For almost 40% of dual-class firms, insiders have more than half of the voting rights (guaranteeing control) but less than half of the cash-flow rights.[26] Focusing on the ownership stake dimension, Bebchuk and Kastiel (2018) discover that governance provisions of over 30% of dual-class structured companies would enable the controller to reduce their share of equity capital to below 5% and still retain control. Furthermore, in over 80% of cases, they can reduce stakes to below 10% while preserving control; lastly, over 90% of instances allow share reduction to below 15%.[27]
Incentive Misalignment in Absence of Constraints
Separation of voting rights and cash flow rights necessarily lead to inadequate and misaligned incentives. Entrenchment of control and detachment of profit are two factors that together erode accountability. The former results from too many votes, the latter from too few shares. In the furtherance of their objectives, minority controllers are both unencumbered in the process due to lack of quasi-political constraints (i.e. preponderant voting power minimize threat of removal) and unfettered by the outcomes due to lack of economic incentives (reduced holdings minimize impact of dividends and stock prices). Ideally, checks and balances exist within both the mechanism and the result. In widely held companies characterized by diverse ownership of shares without a single controlling shareholder, “the market for corporate control and the threat of replacement incentivize corporate insiders to serve the interests of public investors.”[28] In controlled companies characterized by majority owners, the controller’s high equity stakes compel her to absorb a considerable portion of the effects on total market capitalization and align her interests with those of public investors.[29] Each of these structures has a mechanism that protects public investors by aligning their interests with those of corporate decision makers. By contrast, a company with a small-minority controller lacks both the “discipline” of the control market and the incentives of the stock market.
Alternatively formulated, this phenomenon exemplifies an economic externality. Regarding negative externalities like related party transactions, private benefit entirely accrues to the controller at a public cost that is collectively shouldered by all shareholders. The converse is true for positive externalities, i.e. firm-optimal but individual-suboptimal behavior. Since the controller’s total profit is a convex linear combination of company-related dividends and remuneration as well as company-unrelated income (perhaps from affiliation with other companies), maximizing this objective function may entail foregoing projects that are collectively beneficial but privately costly, when such conflicts and tradeoffs are present. For instance, they may tolerate underperformance by the company if private benefits offset or exceed the fraction of firm value reduction borne by the controller.
Agency Problems
Agency problems arise from the separation of control and ownership and the ensuing divergence of interests of management and shareholders, both factors heightened/exacerbated by dual-class structures. Jensen and Smith (1983) define agency costs to include "all costs frequently referred to as contracting costs, transactions costs, moral-hazard costs, and information costs.”[30] Agency costs plague the principal-agent relationship, in which “skilled managers (the agents) run the firm for shareholders and receive compensation for their efforts. Shareholders (the principals) provide the necessary capital and receive the rights to residual cash flows.”[31]
As “wedges” widen between insider and outsider, as well as between governance and ownership, equity shares held by the controller decrease, and agency costs increase. As noted by Masulis, Wang, and Xie (2009), “Corporate cash holdings are worth less to outside shareholders, CEOs receive higher levels of compensation, managers make shareholder value-destroying acquisitions more often, capital expenditures contribute less to shareholder value.”[32] Bebchuk, Kraakman, and Triantis further discover that agency costs escalate at an increasing rate as the controller’s stake declines.[33] From the public investor’s perspective, Grossman and Hart (1988) conclude that when incumbent management is entrenched and isolated from the market for corporate control, one share-one vote is generally in security holders' interest.[34]
Other Efficiency Costs
Increasing agency costs is accompanied by untoward occurrences like declining performance and valuation of dual-class companies. Specifically, stock market valuation of free cash flow and the dividend payout ratio decrease,[35] while the cost of debt financing, the likelihood of stock price crashes, and investment in projects with negative present value all increase.[36] Analyzing the relationship between cash-flow rights, voting rights, and company valuation, Gompers, Ishii, and Metrick found “strong evidence that firm value is increasing in insiders’ cash-flow rights and decreasing in insider voting rights.”[37] They document further that “the strongest results come from the separation sample, where insiders have voting control but less than 50% of the cashflow rights. For these firms, all the evidence supports the positive effect of cash flow on valuation.”[38] The authors suggest a nonlinear relationship between the controller’s cash-flow rights and company value as measured by Tobin’s Q, namely a relationship in which costs rise faster as ownership declines.
Using an extensive sample of U.S. IPOs during 1980-2015, Cremers, Lauterbach and Pajuste (2018) find “initial valuation premium of dual-class firm declines in the years after the IPO, and on average it becomes insignificantly negative in the matched sample about six to nine years after the IPO…”[39] This value stagnation imputes to sluggish innovation. According to Baran, Forst and Via (2018), multi-class structures correlate with more innovation and value creation in the 5-year period after an IPO, but beyond this period, there is a strong deterioration in the innovation and value-enhancing properties.
VI. Remedies
Given the declining efficiency after IPO, some scholars suggest eliminating the option of perpetual dual-class structure in the corporate governance landscape by precluding IPOs of companies with such structures.
i. Emphasizing Fiduciary Duty
While universally required, executives in possession of superior voting-power stock must observe fiduciary duty especially in the context of dual-class structures. In addition to the aforementioned triad of duties (good faith, loyalty, and care), fiduciary duties should further require 1) transparency, as reflected in objective and timely full disclosure, 2) fair value considerations in related-party transactions, as prescribed by the arm’s-length principle (that is, in transactions involving related parties, terms and considerations must be fair as though the parties were unaffiliated), and 3) due process of decision-making featured by approval of disinterested board members/directors.
ii. Enhancing Incentive Structures
Greater power warrants greater responsibility: since controlling minority shareholders have greater leverage on corporate decisions, they should bear economic and legal consequences to a commensurate degree. To reduce moral hazards and foster judiciousness, accountability mechanisms must be instituted to compensate for misaligned and inadequate incentives and to urge internalization of externalities. To this end, the author proposes negative reinforcement through legal punishment as well as positive reinforcement through pecuniary award.
Enforcing Punitive Damages
Punitive damages can effectively deter misconduct when directors fail to uphold business judgement rule or breach fiduciary duty and inflict damage upon the company and shareholders. In shareholder derivative suits alleging a director’s harm to the company, her reasonable business decision is upheld by the court if it conforms with the business judgement rule; that is, if she acts (1) in good faith, (2) with the care exercised by an informed and reasonably prudent person, and (3) with the reasonable belief that the action furthers the corporation’s best.[40] Despite the exoneration from accusations offered by this presumption, if the director breaches any one of the triads (see Cede & Co. v. Technicolor, Inc.)[41] – in bad faith (violating duty of good faith), gross negligence (violating duty of care), or conflict of interest (violating duty of loyalty) – she will have to pay compensatory damages to the company.
To enhance standard practices, the author proposes punitive damages, which scales up the standard compensatory damages by the high/low vote ratio. Although punitive damages are mostly awarded under tort law (see BMW of North America, Inc. v. Gore),[42] application to the corporate setting is an appropriate extension. While compensatory damages suffice in cases of negligence or recklessness, deliberate intention to maximize self-interest in disregard of corporate interest necessitates punitive damages. In addition to punishing the tortfeasor and indemnifying the victim (objectives also accomplished via compensatory damages), punitive damages exert the additional effects of encouraging other victims to seek redress, deterring future misconduct, and educating and pacifying the public. Setting the multiplier equal to the vote/share ratio means that, if the superior stock grants the controller n votes per share, or if the superior stock has n times the voting power of inferior stock, the punitive damage is nD where D is the actuary damage. While this may appear excessive.
However, punitive damages should not be universally applied as it deters potentially beneficial risk-taking behavior. Due to risk aversion (preference for certainty over uncertainty) and ambiguity aversion (preference for known probability distribution of outcomes over unknown distributions), minority controllers/directors will be reluctant to inaugurate projects that portend variable returns, even if such undertakings are projected to confer benefits in the long run; i.e. returns have a positive expected value but a high variance.
iii. Limiting entitlement to superior stock
A second approach consists in limiting the entitlement to superior class stock, i.e. restricting its acquisition and expiration. As noted in Section IV, deleterious effects of dual-class stock are amplified by the progression of time and by the reduction of the controller’s ownership stake. Thus, governance provisions can stipulate the termination of dual-class structure (nullification of superior voting power, unification of two stock classes) based on time or ownership criteria.
a. Time-Based: Fixed Duration
While superior abilities and vision of founders are often cited to justify dual-class structures, in dynamic business environments characterized by disruptive innovation, skills of the leader erode or disappear. A permanent installment of founders to the throne is malapropos in view of evolving internal objectives and external stimuli. As leadership advantages recede, efficiency benefits decline and efficiency costs increase over time. Reservations about inferior leadership are aggravated by transfers of the founder’s control to an incompetent heir.
Restricting entitlements to superior stock can be time-based, accomplished via imposing “sunset” provisions, or quasi-term limits.[43] Sunset provisions specify the structure’s expiration and reversion to one share – one vote after a fixed period of time, such as ten or fifteen years, triggered at predetermined date. As Bebchuk and Kastiel (2017) suggest, structures that remain efficient can be retained, as the initially specified duration can be extended by an affirmative vote from the majority of shareholders unaffiliated with the controller. As an empirical caveat, they find that most time-based sunsets delay termination of dual-class structures to the time of founder death or retirement, and suggest that such event-triggered sunsets may be too late for underperforming controllers.[44] SEC Commissioner Robert Jackson Jr. remarked in support of sunsets, “by the third year and all subsequent years following the IPO, firms with perpetual dual-class stock have valuations that are approximately 0.66 to 0.67 lower than firms with sunset provisions.”
Objection 1: End-Period Moral Hazards
One of the key apprehensions surrounding sunset clauses is that controlling shareholder on the verge of losing dominance will aggressively take advantage of their vanishing power immediately before abolition of dual-class structure. End-period moral hazards precipitate opportunistic behavior whose consequence materializes only after their “term” concludes. In their defense of sunset provisions, Bebchuk and Kastiel (2017) highlight that enabling public shareholders to vote on extending the duration of a dual-class structure that is scheduled to sunset could discourage end-period opportunism, since the prospect of dual-class’s perpetuation creates incentives for commendable performance, much like how hope of re-election alleviate the lame duck syndrome in presidents. Far from a panacea however, this remedy is ineffectual if the controlling shareholder is not seeking or has minimal chance of obtaining an extension.
In lieu, the author proposes restrictive stock units (RSU) and incentive stock options (ISO), which give controllers/ executives the right to purchase or own shares contingent on meeting time and performance criteria. When the controlling executive receives restricted stock grants, her rights in the stock are restricted during the stock’s vesting period, which may be time-based or milestone-based. Once the vesting requirements are met, the executive is entitled to dividends and rights of complete ownership and disposal (e.g. transactions).
The direct monetary incentive offered by restrictive stock units and employee stock options fortify the causal channel between the controller’s performance and income. Time-based conditions can forestall end-period moral hazards, as the executives obtain full ownership only after a specified period from the grant date, presumably set to be long enough for repercussions of end-period decisions to eventuate (say, one or two years). At the end of the vesting period, projects that decrease company-value will be reflected in the stock market’s dynamic equilibrium prices; hence, any irresponsible action of the controller will redound upon her in the form of lower stock prices and returns in the future. Complementarily, performance-based conditions, often linked to achievement of corporate objectives, require controllers to properly steer the company in order to realize their own stock grant.
Objection 2: Efficient Market Hypothesis
A second objection is predicated upon the presumed supremacy of free markets in adjudicating between alternatives and producing the optimal outcome, reminiscent of an amalgamation of libertarian principles and the Efficient Market Hypothesis proposed by Nobel laureate Eugene Fama. Under this contention, perpetual dual-class structures should be presumed efficient if they emerge triumphant from market forces: since markets self-correct, private ordering by market participants ensures adoption and implementation of the value-maximizing governance arrangement.
However, this untenable objection assumes extreme market efficiency, possible only in presence of near perfect information symmetry. It demands not only (1) that the market accurately prices the difference between dual- and single-class structures, but also (2) that the market prices accurately reflect the difference between dual-class structures with and without a sunset clauses.
Since these underlying assumptions fail to hold, this objection’s empirical strength is compromised. Information asymmetry is inherent within dual-class structures, which are typically less transparent than their single-class counterparts. First, crucial private information may never reach the public market. As the “wedge” between control and ownership widens, the amount of industry and market information incorporated into stock prices decreases.[45] Such correlations instantiate hypotheses that controlling shareholders are incentivized to contain private information within the firm and outside public scrutiny, possibly because public knowledge of opportunistic behavior invites opprobrium.
Second, even if all information was theoretically available, public investors may not devote the necessary time and effort to access it, read proxy statements, and form independent views on whether or not to purchase shares. Grossman and Hart find empirically that “it is optimal for small shareholders to vote with management.”[46] As such, institutional investors are excessively deferential, not adversarial, to corporate insiders; consequently, the likelihood that public investors will object to dual-class structures by boycotting its shares or requesting its expiration is minute.
b. Ownership-Based: minimum threshold
Alternatively, sunset provisions could rely on company ownership criteria. If the controller’s equity stake falls below a specified minimum threshold, then high-vote shares will be automatically converted to single-vote shares, through either regulation or private ordering. A controller with a sizable equity holding is likely to better internalize and act in furtherance of the interests of the company’s public shareholders. However, ownership-triggered sunsets enforce/impose arbitrary thresholds which can be opportunistically evaded by retaining just enough shares to stay above the specified floor.
iv. Limiting the exercise of superior stock
To supplement limitations on access to superior stock, policy-makers can discipline dual-class structures by circumscribing the exercise of superior voting power, for the period after the superior stock’s acquisition and before its expiration; namely, in addition to reducing the longevity of dual-class stock, we can also reduce its potency. For this purpose, again adopting a two-pronged approach, we can limit both the magnitude of unequal voting power (by decreasing the high/low vote ratio), and the scope of its permissible exercise (by interdicting exercise of superior vote in certain areas).
a. Limiting the vote ratio between superior/inferior stock
A first approach involves limiting the ratio between high/low vote shares, as well as eliminating the issuance of non-voting shares (interpreted as an infinite vote ratio). Extreme disparities in cash-flow rights and voting rights, manifest in a flagrantly high vote ratio between superior and inferior stock, expose public investors to substantial governance risks. Currently, U.S. exchanges impose no limits on the ratio of high/low votes, permitting corporations to designate an inordinate amount of votes to superior stock. As a laudable precedent, the American Stock Exchange’s (AMEX) obsolete policy subjected dual-class listings to a maximum 10:1 high/low vote ratio.[47] Likewise, jurisdictions like Denmark, Netherlands, and Sweden outright prohibit non-voting shares. The quantity of issued non-voting shares must be periodically monitored beginning at the IPO and until the termination of dual-class structures, for it is possible for companies to reclassify low- and non-voting stock or to initially authorize non-voting shares but issue them after the IPO.
b. Limiting the purview of voting rights
A second approach involves limiting the purview of voting rights, so that superior voting power cannot take effect including momentous decisions, diversion of value from the shareholders, and perpetuation of control in the board. Momentous decisions like mergers, acquisitions, divisions, and establishing subsidiaries dictate the company’s future development and calls for democratic input and wider consensus. For instance, the percentage of board members that affiliated minority controlling shareholders can elect should be capped at a fixed ceiling.
We should also consider curtailing control over unilateral/arbitrary measures that adversely affect public investors’ interest without their expressed informed consent (preferably via voting). Bebchuk (2019) notes that disproportionate voting rights do not apply to considerations pertaining to instigation of a special audit or initiation of a liability action.[48] These include external loan guarantees. Companies acting as guarantors in external loan guarantees assume the debt obligation of a borrower in case the borrower defaults. Such disposals of company assets are purely concerned with interests of the external borrower; since company assets are derived from those of shareholders, risky disposals of company assets not in pursuance of the company’s long term interest require non-cosmetic shareholder input. Similarly, corporate laws in some European states (e.g. Hungary, Turkey) prohibit controlling shareholders from voting on resolutions that involve conflicted transactions or confer them with non-pro rata benefits.[49] A prominent example is related party transactions with entities affiliated with controller, which are intrinsically neutral but become harmful given agency distortions.[50]
Institutional Investors and other market agents
In resolutions via private ordering, institutional investors play decisive roles in pressuring companies to adopt charter provisions that protect public shareholders interests. Similarly, indices can exclude companies with multi-class stock structures from rankings; for instance, on July 31, S&P Dow Jones announced that, effective immediately, companies with multiple share classes will no longer be eligible for inclusion in the indices comprising the S&P Composite 1500.[51]
[1] “UCloud明日科创板上市：募集资金近20亿.” 创事记_新浪科技_新浪网. Accessed January 31, 2020. https://tech.sina.com.cn/csj/2020-01-19/doc-iihnzhha3517983.shtml.
[2] “China Approves First Dual-Class IPO in Bid to Lure Tech Firms.” Bloomberg, 2019. https://www.bloomberg.com/news/articles/2019-09-30/china-approves-first-dual-class-ipo-in-bid-to-lure-tech-firms.
Yu, Xiaoming. “Tech Firms to Benefit from Innovation.” Tech firms to benefit from innovation - Chinadaily.com.cn, January 8, 2020. https://www.chinadaily.com.cn/a/202001/08/WS5e153feea310cf3e355832b2.html.
[3] Grossman, Sanford J, and Oliver D Hart. “One Share-One Vote and the Market for Corporate Control.” Journal of Financial Economics, vol. 20, no. C, 1988, pp. 175–202.
[4] Ibid.
[5] Supra note 5 (Berger)
[6] Bebchuk, Lucian A., and Kobi Kastiel. “The Untenable Case for Perpetual Dual-Class Stock.” Virginia Law Review, vol. 103, no. 4, 2017, pp. 585–631.
[7] Council of Institutional Investors. “Dual Class Companies List (Sep 2019)”. https://www.cii.org/files/FINAL%20format%20Dual%20Class%20List%209-27-19.pdf
[8] Berger, David. “Dual-Class Stock and Private Ordering: A System that Works.” Harvard Law School Forum on Corporate Governance and Financial Regulation, May 24, 2017.
[9] Bebchuk, Lucian, and Kobi Kastiel. “The Perils of Lyft’s Dual-Class Structure.” Harvard Law School Forum on Corporate Governance and Financial Regulation, Apr 3, 2019.
[10] Seligman, Joel. Equal Protection in Shareholder Voting Rights: The One Common Share, One Vote Controversy, George Washington Law Review 687, 693–707 (1986).
[11] Nasdaq, The Promise of Market Reform, Reigniting American’s Economic Engine, May 2017. http://business.nasdaq.com/media/Nasdaq%20Blueprint%20to%20Revitalize%20Capital%20Markets_tcm5044-43175.pdf
[12] Voting Rights Listing Standards; Disenfranchisement Rule, Federal Regulation 26,376, July 12, 1988. invalidated by Bus. Roundtable v. SEC, 905 F.2d 406, 417, D.C. Court 1990.
[13] Ibid
[14] Stein, Kara M. “Mutualism: Reimagining the Role of Shareholders in Modern Corporate Governance.” Harvard Law School Forum on Corporate Governance and Financial Regulation, February 15, 2018. https://pcg.law.harvard.edu/wp-content/uploads/2018/03/June-2018-Roundtable-Background-Materials.pdf
[17] Supra note 21 (Bebchuk and Kastiel 2019)
[18] Hall
, Joseph A., and Michael Kaplan, Snap Decision: Leading Index Providers Nix Multi-Class Shares
Harvard Law School Forum on Corporate Governance and Financial Regulation, August 2, 2017 https://corpgov.law.harvard.edu/2017/08/02/snap-decision-leading-index-providers-nix- multi-class-shares/
[19] Aristotle, and H. Rackham. The Nicomachean Ethics. Book V, Chapter 3. Harvard University Press, 2003.
[20] Johnson, William C, et al. “The Bonding Hypothesis of Takeover Defenses: Evidence from IPO Firms.” Journal of Financial Economics, vol. 117, no. 2, 2015.
[21] Cronqvist, Henrik & Mattias Nilsson, Agency Costs of Controlling Minority Shareholders, 38 Journal of Financial and Quantitative Analysis 695, 709 (2003)
[22] Cremers, Martijn, Beni Lauterbach, and Anete Pajuste, The Life-Cycle of Dual Class Firm Valuation, European Corporate Governance Institute, Working Paper No. 550, 2018. https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3062895
[23] Jarrell, Gregg A., and Annette B. Poulsen. “Dual-Class Recapitalizations as Antitakeover Mechanisms.” Journal of Financial Economics 20 (1988): 129–52. https://doi.org/10.1016/0304-405x(88)90042-6.
[24] Bebchuk, Lucian A., and Kobi Kastiel. “The Perils of Small-Minority Controllers.” Georgetown Law Journal, vol. 107, no. 6, 2019, p. 1453.
[25] Bebchuk, Lucian, et al. “Stock Pyramids, Cross-Ownership, and Dual Class Equity: The Creation and Agency Costs of Separating Control from Cash Flow Rights.” Concentrated Corporate Ownership. University of Chicago Press, 2000.
[26] Paul A. Gompers, Joy Ishii & Andrew Metrick, Extreme Governance: An Analysis of Dual-Class Firms in the United States, 23 REV. FIN. STUD. 1051, 1052–55, 1067 (2010)
[27] Supra note 21 (Bebchuk and Kastiel 2019)
[28] Bebchuk, Lucian A. and Kobi Kastiel. The Lifecycle Theory of Dual-Class Structures. December 2018. http://dx.doi.org/10.2139/ssrn.3300841
[29] Ibid.
[30] Jensen, Michael C., and Richard S. Ruback. “The market for corporate control: The scientific evidence” Journal of Financial Economics, Volume 11, Issues 1–4, April 1983, Pages 5-50. https://doi.org/10.1016/0304-405X(83)90004-1
[31] Supra note 20 (Jarrell and Poulsen)
[32] Ronald W. Masulis, Cong Wang & Fei Xie, Agency Problems at Dual-Class Companies, 64 J. FIN. 1697, 1697 (2009).
[33] Supra note 22 (Bebchuk, Kraakman, and Triantis)
[34] Supra note 8 (Grossman and Hart)
[35] Mikko Zerni, Juha-Pekka Kallunki & Henrik Nilsson, The Entrenchment Problem, Corporate Governance Mechanisms, and Firm Value, 27. 1169, 1201 (2010)
[36] Supra note 21 (Bebchuk and Kastiel 2019)
[37] Supra note 23 (Gompers, Ishii, and Metrick)
[38] Ibid
[39] Footnote
[40] “Business Judgment Rule.” Cornell Legal Information Institute. Accessed January 21, 2020. https://www.law.cornell.edu/wex/business_judgment_rule.
[41] Cede & Co. v. Technicolor, Inc. Supreme Court of Delaware, November 1, 1993. https://law.justia.com/cases/delaware/supreme-court/1994/634-a-2d-345-1.html.
[42] BMW of North America, Inc. v. Gore, 517 U.S. 559 (1996). Supreme Court of Alabama, May 20, 1996. https://supreme.justia.com/cases/federal/us/517/559/.
[43] Supra note 21 (Bebchuk and Kastiel 2019)
[44] Ibid.
[45] Supra note 21 (Bebchuk and Kastiel 2019)
Sabri Boubaker, Hatem Mansali & Hatem Rjiba, Large Controlling Shareholders and Stock Price Synchronicity, Journal of Banking and Finance. 80, 81, 88–89 (2014)
[46] Supra note 8 (Grossman and Hart)
[47] Supra note 9 (Seligman)
[48] Supra note 21 (Bebchuk and Kastiel 2019)
[49] Supra note 21 (Bebchuk and Kastiel 2019)
[50] Bebchuk, Lucian, and Hamdani, Assaf. “The Elusive Quest for Global Governance Standards.” University of Pennsylvania Law Review, vol. 157, no. 5, 2009.
[51] Supra note 38 (Hall and Kaplan)
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