By Bonnie Liu
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. 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. 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. 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.” 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. 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. 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, and around 10 percent of publicly listed companies have multi-class structures, with renowned companies like Facebook, Comcast, Lyft, and New York Times among the ranks. 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.” 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.”
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.” Although this rule was invalidated by D.C. Court of Appeals on grounds that the SEC lacked authority for its adoption, 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).
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”). 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.” 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.
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.
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
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,” 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).
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, 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” 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.”
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.
At the heart of the problem, small minority shareholders generate significant governance risks. 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. 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. 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%.
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.” 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. 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 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.” 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.”
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.” Bebchuk, Kraakman, and Triantis further discover that agency costs escalate at an increasing rate as the controller’s stake declines. 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.
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, while the cost of debt financing, the likelihood of stock price crashes, and investment in projects with negative present value all increase. 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.” 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.” 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…” 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.
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.