Should Dual-Class Share Structures Be Eliminated?

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Dual-class shares make companies unaccountable to shareholders, markets and courts.

Over the last decade, company founders have been opting to shore up control by creating multi-class voting structures that undercut shareholder voting power. This stock ownership structure reduces shareholder influence, undermines corporate governance and shifts the burden of investment grievances to the courts.

A New Deal for Shareholders

Multi-class capitalizations — in which founders and other insiders retain a class of high-vote shares while selling low-vote shares to the public — are nothing new for controlled companies. This mechanism has long allowed founding individuals and families to leverage minority economic ownership — say 10% or 20% — into total voting control of large companies, such as Facebook and Google.

In the situation with Snap, where the company went public with zero-vote stock, the logic of leveraging control from a minority interest through the dual-class structure reached its illogical conclusion. With nonvoting shares, a founder can advise investors plainly, without any pretense, that she will take their money but not their advice. We’ve reached the zenith of the disenfranchisement of the investing public.

The one-share controller hypothetical is, indeed, extreme. It is not, however, far-fetched, given the strong tendency for controllers to reduce their equity interest over time. 

How We Got Here

Traditionally, such dual-class capital structures were the anachronistic refuge of either media conglomerates or old-style industrial titans. Companies used the structure when the requirements for journalistic integrity and independence from the market demanded a safe harbor — The New York Times Company, News Corp. and The Washington Post Company were the representative adopters. It was also used at companies built by a founder through such singular achievement that the market could be strong-armed into accepting little to no protection in exchange for the capital it was giving, in trust, to a “genius.” The Ford Motor Company, Berkshire Hathaway and Estée Lauder Companies are well-known examples.

A 21st-century trend, begun by Google in its 2004 IPO, is driving the dual-class capital structure out of the uncommon and into the mainstream. Increasingly, founders are opting to bolster control through highly leveraged voting structures, compared with the standard and accepted one-share, one-vote structure that was a constant for fear of an investor revolt and a public relations maelstrom.

The growing number of dual-class companies in the American economy raises serious questions about how the courts will view transactions involving these companies, in light of the accountability that a meaningful shareholder vote provides.

No-Vote Shares in the Courts

Contemporary criticism of dual-class capitalizations has focused on the reduction in accountability. However, the lessened accountability’s effect on the approach that courts must take in reviewing the actions of these companies and their boards has not yet been considered. This issue presents the most significant problem with permitting the use of dual-class structures. We must reconsider the long-settled policy of judicial restraint wherein courts have concluded that with regard to business judgment, management action will not be reviewed at all. American courts may decide that more active judicial intervention is necessary — because, without a vote, shareholders can’t provide oversight of boards and thus management — and choose to take on greater responsibility for shareholder protection at these companies.

In most circumstances, when a disinterested and independent board of directors has acted in “good faith” and “with reasonable care,” its decision will be considered a business judgment and not be interfered with by a reviewing court. This rule expresses the judicial reticence to second-guess the complex, real-time decisions of management. Where applied, the view that judicial regulation of management’s business judgment will not serve as a measure of additional shareholder protection justifies the rule.

Ordinarily, markets and corporate democracy get the job done, so courts need not. Thus, judges typically will not step up to protect shareholders from bad managerial decisions. Doing so would be duplicative and unproductive. All things equal, bad management leads to poor company performance, which leads to depressed stock prices. Falling equity values hit executives hard, as today most of their pay and much of their assets are made up of stock and options. Glum results also attract corporate raiders, who, once inside, will fire the existing management and install more effective managers. This dynamic alone should spur effective action from any manager at all interested in her reputation, career longevity and finances.

There is little use in the courts for piling on after all is said and done. Shareholders, by voting, can decide what to do with ineffective managers. For mistaken business judgment, a court’s post hoc imposition of liability is only likely to chill corporate risk-taking. There is no reason to believe, in any case, that judges will more ably decide the matter than managers and directors, who possess superior substantive business acumen. Add the considerable expense and delay of litigation and it is no wonder courts leave shareholder protection largely to the markets and the vote. 

Markets can constrain the discretion of the controllers of one-share-class companies too. Even without the ability for minority shareholders to monitor them, large equity positions create powerful incentives for a controlling owner to run a tight ship. After all, she will bear a large part of the cost of every company expense and failed venture. But the market does not punish controller self-dealing, as the direct fruits outweigh the proportional share of lost firm value borne by the controller. So, this is the point at which courts take a stand.
The flip side of the idea that courts should not provide extra corporate control where markets do it better is that, when markets fail, the courts should be ready to jump in. Thus, they deploy greater scrutiny of interested transactions, culminating in the entire fairness standard, which requires “fairness” in every aspect of the bargain and bargaining process. But these more exacting standards of review are reserved for transactions that expose conflicted controller interests that exclude the minority interests. Thus, as in Sinclair Oil Corp. v. Levien, the Delaware Supreme Court determined that a subsidiary’s proportional dividends are not subject to fairness review, for example, while its contracts with the parent corporation might be.
Even in these problematic circumstances, the courts are willing to walk back scrutiny so long as steps are taken to mimic market controls. By doing so, the transactions more resemble those within courts’ markets-backed comfort zone. For instance, in controller transactions, the informed approval of a majority of the minority shareholders shifts the burden of proof on the issue of fairness to the plaintiff. The same effect follows the use of an independent committee of directors. The combination of these two methods can win the transaction business judgment review. Altogether, there is an effort by the courts to substitute a form of market review for judicial review.

An Evolution in the Law? We Think Not

The Sinclair Oil rule makes less sense when applied to dual-class controlled companies. Unlike a single-class controlled company, for a dual-class controlled company there may be neither market nor board constraints. A ­dual-class controller may bear very little of the cost of inefficient management and bad strategy. Through leveraged, multi-class ownership structures, she may, in the end, own only a small percentage of the company. Market incentives are significantly eroded, as only a fraction of the consequence of poor management is borne by the controller. 

The $2.6 billion pay package awarded by Tesla to Elon Musk, its founder and controller, suggested a dollar figure for the scale of the eroded incentives. He would earn $50 billion if he met a set of ambitious performance objectives. Tesla did not fear that Musk, a driven entrepreneur, would slack generally. Rather, the company sought to buy his attention with what was, according to Bloomberg, “a sum so large it might just ensure that Musk’s array of other passions and esoteric side projects won’t steal too much time from his work at Tesla.” 

Without board and market forces protecting shareholder interests, the burden of monitoring investments and dealing with problems will end up in the courts. The judiciary must determine whether to add heightened review of operational decisions at dual-class controlled companies to the already heightened review of interested transactions. The alternative is allowing a new breed of unaccountable and unmotivated controlled corporations.

Of course, if courts decide to scrutinize a dual-class company’s transactions more forcefully, the minority shareholders of such companies are free-riding by shifting the costs of monitoring bad management to the judicial system. The public expense and difficulty of the resulting judicial review is another reason for restricting or eliminating dual-class ownership.

But there are costs imposed on America’s corporate courts even if they choose not to provide a meaningful heightened review. Those courts treat the protection of shareholder interests as their primary task and objective. If the courts choose not to engage in heightened scrutiny, allowing dual-class company founders a relatively free hand, the judiciary’s credibility and reputation will be harmed. No doubt the judiciary is put in a problematic posture: recognizing, on the one hand, a critical need for oversight, while deciding to stay out of it. Judges are unaccustomed to throwing up their hands in the face of present harm.

What will the courts choose to do? Our belief is that they will continue to abstain from engaging in heightened review of day-to-day, non-conflicted transactions at dual-class controlled companies. Courts are ill-suited for policing poor managerial performance and low effort. Looking at a single unfavorable outcome, it is near impossible for a court to observe whether the cause was bad luck or bad management. Across that expanse of time and knowledge, judges cannot substitute their business judgment for that of experienced corporate management. Thus, while heightened review might be doctrinally prudent, it is practically unfeasible. The result will be a growing number of dual-class companies that are unaccountable to shareholders, the markets and the courts. In consequence, we need to discard the dual-class structure altogether. Without such intervention, the integrity of our capital markets is at risk.  

Charles Elson is a member of the board of directors of Enhabit Home Health and Hospice Corporation and Blue Bell Creameries Inc., and executive editor-at-large of Directors & Boards. Craig Ferrere is an associate at Richards Layton & Finger P.A.

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