The Pros & Cons of the Dual-Class Stock Structure: Two corporate governance experts battle it out
This summer, Snap Inc., the parent company of mobile-messaging app SnapChat, held a three-minute annual shareholder meeting via a webcast.
Atul Porwal, Snap’s associate general counsel adjourned the meeting saying, “we did not receive any questions from our stockholders so this concludes today’s meeting.
Holding a virtual shareholder meeting isn’t new, but the brief nature of the gathering that was also short on any strategic plans, despite the SnapChat’s decline in users in the most recent quarter, may have something to do with Snap’s dual-class stock structure.
When Snap went public it did so using the first-ever solely non-voting stock model. The founders hold the voting power with each share worth ten votes, as opposed to zero votes for those shares bought by outside investors.
It’s a stock ownership structure that either undercuts shareholder influence and corporate governance or bolsters growth among innovative companies that don’t want to be burdened by the short-term demands of investors.
To flesh it all out, two governance experts share their views on the pros and cons of the dual-class stock structure.
Taking on the “con” side is Charles Elson, the Edgar S. Woolard, Jr., Chair in Corporate Governance and the director of the John L. Weinberg Center for Corporate Governance at the University of Delaware, and a consultant to the law firm of Holland & Knight.
And addressing the “pro” side is David J. Berger, a litigation partner with Wilson Sonsini Goodrich & Rosati and a leader in the firm's corporate governance and shareholder activism practices.
Dual-class stock has existed for a long time. It basically consists of two share classes with unequal voting rights. Typically, dual-class stock was set up so that a selling founder of a family company or whatnot could retain control of a company despite taking the company public and selling their stock to others. Retaining stock with super voting is a way to preserve control, even though your economic interest has declined.
Traditionally, stock was one share, one vote. However, in dual-class, one has one vote, while the other class, usually held by the founder, has many, many votes and it's disproportionate to their economic interest.
Early in the last century, this structure existed in this country, but was considered such a real problem that it was outlawed by the Stock Exchange in the 1920s. The exchange called for every stock traded there to be one share, one vote. But in the 1950s, when the Ford Motor Company went public, the Stock Exchange, fearful that they would lose the listing of one of the great American icons, allowed an exception. The Ford family had this structure where the Ford family maintained controlling interest despite the fact their economic interest was too small to justify control.
We then began to see the structure make its way into media companies. The reasoning was the desire to insulate the editorial page of a newspaper from the marketplace; the paper could remain independent of someone trying to take control and change its editorial direction. A number of media companies adopted these structures, such as the Washington Post, New York Times, etc. A few family businesses retained this structure as well, where the founding family wanted to retain control after they went public. Estee Lauder is a good example.
But starting about 10 years ago, when some tech companies went public, they decided to adapt the same structure. The most famous example is Google. It was considered by some in the investment community to be highly troubling that they adopted such a structure.
There were calls for Google not to do it, but they did anyway and were followed by a number of other large, high-profile companies. After Google, Facebook came out with it — but the difference in the modern companies adopting this structure is the virtual complete control exercised by the managers, despite the fact their economic interest is significantly less than their voting interest.
Then Snap took it even further. Snap believed the voting in these companies was really a fiction, so they created a structure where the public common shareholders were given no vote at all.
The investment community sounded the alarm. One way of ensuring accountability on the part of management for the investor is by voting for the board that will oversee management. If the vote is eliminated, any kind of managerial accountability for the investor is eliminated.
The counter-argument asserts investors are only interested in the short-term, whereas the dual-class structure gives management, or the genius founder of the company, if you will, the ability to carry out long-term plans without having to worry about the short-term distractions of the marketplace or activist investors who they argue seek short-term profits.
The legal angle, which hadn’t been looked at, was how does this no voting structure impact judicial review of director decision-making and, more specifically, the business judgment rule. The business judgment rule, which basically says courts do not second-guess the business judgment of honestly functioning boards, was created for a very good reason. Judges frankly had neither the time, nor the temperament nor the expertise to second-guess a well-functioning board, the idea was to encourage people to serve and take reasonable risks. As a result, courts will not second-guess business judgment, but they of course will always review dishonesty.
The courts have always been active in reviewing self-dealing but are less active, in fact basically not active at all, in reviewing ordinary business judgments. Again, the theory is that, ultimately, the controlling shareholders are harming themselves by making bad judgments; but in a dual-class structure, does that really exist? In other words, instances where the economic interest is significantly less than the voting interest, are you really creating serious economic harm to a significant part of wealth through bad judgment?
In a dual class company, if the management makes a bad decision, the economic impact on the manager is limited because of their small economic stake. Thus the incentive to make good decisions (and conversely punished if they do not) is limited.
Ultimately, this disparity is going to force the courts to step in in a way they traditionally have not. But if a court is reluctant to examine bad judgment for traditional reasons, is there no one left to review it?
The answer is yes — the elected directors. And for investors, if you don't like what your directors have done, replace them. However, even though the vote in many public companies was almost a fiction for many years, there was always the possibility of the shareholders voting directors out who made the bad decisions. Therefore, there was a market check on problematic managerial behavior.
With nonvoting stock, the check ceases to exist. If shareholders dislike what management has done in respect to their judgment, what are they going to do about it? Selling is not an option for today’s large indexed institutional investors.
The concern nonvoting stock creates is an accountability structure that's not only problematic for the investor, but for the courts as well. What will the courts do if they stay out of this completely? The state and the courts will have abrogated their function as investor protector.
Investor protection is why you incorporate in Delaware. That's why investors rely on Delaware courts to prevent self-dealing, by enforcing the duty of loyalty as well as ensuring careful behavior by directors through the duty of care. But, as we have discussed, without voting there is no longer a safety valve in circumstances regarding poor business judgment where the courts can’t act.
The question remains: How will the courts handle this?
The board was elected to protect the investors. That's why corporations have a board. But if the controlling shareholder elects the board, their loyalty is to the controlling shareholder as opposed to the investors to whom they are legally responsible. But without a vote, how is loyalty enforced? The courts. But how are the courts going to answer this question if they are reticent to involve themselves in business decisions? Are they better judges of business acumen than a well-functioning board? How will they do it?
If they fail to act, in the end, the investors have no protection, whatsoever, particularly the indexed investors who cannot sell.
The whole structure creates a serious legal accountability issue.
The traditional argument is buyer beware; the person who bought the stock knew about its structure so too bad. That's simply the market at work.
The difficulty with that style of approach surfaces if/when the company goes off the rails. It's the public who ends up suffering because the board no longer acts as an accountability mechanism and shareholders have no vote. Ultimately, who has to regulate these institutions? The government. Who’s the government? All of us.
This cost is no longer simply absorbed by the investors, but also by society. And that would be the argument for the cost this structure creates and why it should ultimately be discarded.
Dual-class stock exists today because of market dysfunction that is part of the disease of short-termism in the market. Chief Justice Strine wrote eloquently about the consequences arising from the current situation where directors are elected by stockholders who are focused almost exclusively on short-term increases in stockholder value. That has hurt us in a number of ways as a country and as an economy and it has hurt our corporations.
One recent example comes from a recent report by Goldman Sachs, on a large drug company Gilead Sciences, “Is Curing Patients a Sustainable Business Model?”
According to the report, Gilead came out with a drug that literally cured Hepatitis C, which was a big problem, and at its peak Gilead was obtaining $12 billion a year from this drug. Now because Gilead’s drug has cured so many patients, Gilead’s revenue on this drug has declined to $4 billion annually. This reality led Goldman Sachs to question whether a company should develop a drug that cured a terrible illness because curing patients is not a sustainable business model. Is this the type of incentive we want to create for our corporations? Should companies really try to avoid curing a disease because saving patients reduces the number of “customers” for a drug? This is a problem with a model that is entirely focused on stockholder value.
A second problem with our total focus on stockholder value is that it encourages companies to outsource employees and/or take other actions to reduce employee compensation. This can be seen by a recent article in the New York Times, comparing a janitor at Apple to janitors who used to work at Eastman Kodak. The article noted that the average janitor at Apple isn't employed by Apple, and doesn't get any of the benefits of being an Apple employee, because the job is outsourced to subcontracting companies. In contrast, janitors at Eastman Kodak used to be full employees of the company, getting the benefits of being a full-time employee. As a society, we want a corporation to pay its employees a decent living wage so that they can actually participate in society and be good consumers. But if the sole goal of the corporation is to maximize stockholder value then cutting employee costs to increase stockholder value is a duty of the corporation and the board. That is where we are heading today.
A third problem with an exclusive focus on stockholder value is that it contributes to income and wealth inequality because stocks are disproportionality owned by a small group of people in this country. Recent studies estimate that about 50% of the people in the United States have nothing invested in the market; no retirement, no 401k, no pension plans, nothing. So if you're focusing all of your profits or all of your business on stockholders and investors, you're automatically excluding the interests of 50% of the people in this country. Of the remaining 50%, about 40% have only a tiny fraction of their income or wealth in the stock market. The result is that about 90% of the working people in this country have the overwhelming share of their wealth and income coming from their work, with little or nothing coming from the stock market.
The sole focus on stockholder value began in the late 1970s/early 1980s, and what companies and others are concluding is that this focus is not beneficial for companies, investors or society at large. One response to the world of stockholder dominance is dual-class stock. In particular, technology companies have led a movement to focus on issues other than short-term stockholder value, and this effort has led them to consider dual-class stock as an alternative to the one-share/one-vote model.
Google (now Alphabet) was the first example of this effort to focus on issues beyond short-term stockholder value. When Google went public it made explicit, in its letter to stockholders, that it wanted to have the flexibility to focus on long-term plans and not be influenced by short-term stockholder value, and for that reason it was adopting a dual-class structure. Since Google, a number of other tech companies wanted to focus on building great products, on expanding businesses, on trying to figure out some way to grow and not have to worry so much about what stockholders are concerned but think about the other constituencies.
That doesn't mean these companies were ignoring stockholders, far from it. Stock is critical to the success of Silicon Valley, as typically all (or at least most) of the employees in these companies get stock in their companies. And stock ownership for employees has been critical to wealth creation in Silicon Valley. But as a company and as a board you also want to be able to consider other constituencies and how best to grow the company for the long-term. You want to be able to focus on how the business is doing more broadly and not just be measured by short-term stockholder return. And it's the effort to balance stockholder value while also building a company for the long-term that has led a number of highly successful tech companies to adopt dual-class stock structures.
Now, dual-class stock is not a perfect response. It's got problems. Charles identified some of them.
However, the current system controlled by stockholder capitalism has led to a casino capitalism that has caused enormous problems in our country. And until we create some countervailing forces against the power of short-term stockholder value companies will continue to search for — and find — alternative structures that allow them to build for the long-term.
Now there are other alternatives to dual-class stock that can allow companies to focus on the long-term. For example, in the 1980s a number of companies started adopting so-called “tenure voting” or “time based voting.” Under this system, if you own a stock for a year, you get one vote per share. If you own it for two years, you get two votes per share. Three years, three votes per share. The idea being to encourage long-term investors, to give more votes to people who are actually going to be in the stock for a longer period of time and not going to trade it very, very quickly.
The Securities and Exchange Commission convinced the exchanges to ban time-based voting in the late 1980s, but recently a number of countries in Europe have adopted rules favoring time-based voting. In the U.S., the Long-Term Stock Exchange, a new exchange going through the approval process at the SEC, is considering time-based voting as a listing requirement. Again, this may not be a perfect solution, but it would help encourage companies to invest for the long-term by giving stockholders who invest for the long-term greater voting power in the corporation.
One might expect institutional investors to more strongly support time-based voting, as institutions claim to be long-term holders and argue in favor of companies taking a long-term perspective. Yet thus far most institutional investors have either opposed time-based voting or been silent on the issue.
I want to respond to Charles on the business judgment rule issue. I think his argument makes little sense for a variety of reasons. First, most companies with dual-class stock in this country are private, not public. In fact, while the total number of companies has remained about the same over the last 20 years, the total number of public companies today has declined by half from what it was in 1995, from about 8,000 to 4,000.
The investors in private companies are by and large people who actually invest in these companies, in contrast to most people who own stock in public companies who buy on the public markets where the money does not go to the company. Yet investors in private companies typically own preferred stock, and these companies have multiple classes of stock. If we are going to develop a new standard for companies with multiple classes of stock we need to focus on how this standard will apply to private companies.
Finding independent directors for private companies is quite difficult. As an initial matter, private companies, especially venture-backed companies, typically do not pay their directors. Another problem is that most venture-backed companies do not succeed. Further, most private companies have little money to buy D&O insurance, and if the company fails then its ability to indemnify its directors is, as a practical matter, not possible.
The end result is that most directors of private companies are people who invested money in the company, and are working hard to have it succeed. While they may occasionally have financial interests that differ from common stockholders — because they own a different class of stock — their interest in seeing the company succeed is not diminished. To the contrary, because they are investors in the company they have a very strong financial interest in having the company succeed.
Yet because these directors typically own preferred stock rather than common stock they actually are held to a higher standard than most public company directors. If Charles’ proposal is adopted, this standard would become even stricter, as all of their actions would be governed by entire fairness. It’s hard to imagine how creating an even more exacting standard for private company directors is beneficial.
Even with public dual-class companies, Charles’ proposal is ultimately not satisfying. Charles claims that boards are elected to protect stockholders. In fact, boards are elected to protect the corporation, not just stockholders. Even Charles’ complaints about Facebook have not resulted in harm to Facebook’s stockholders; to the contrary, Facebook’s stock is trading at record high prices. The real issue is, as I began, should the sole focus of the corporation be to increase the value of the company’s stock? The history of the last 50 years shows that this standard has not been successful for our economy or our country.