Can Dual-class Stock Hurt Independent Investors?

If you believe buying stock in a public company guarantees you an input into how the business operates and that is elected to the board, then you might be mistaken. As a result of a change in stock market rules made over 30 years back that’s increasingly being used by companies going public, shareholders with common stock — even big institutional ones — have very little influence over the way the business is governed.

History

From 1940 until 1986 that the New York Stock Exchange didn’t record companies with dual-class voting. The rule was changed in response to a request from General Motors. Shareholder rights in the U.S. are mainly regulated by countries, and it’s the stock exchanges, not the Securities and Exchange Commission, which were making the rules.

If you believe buying stock in a public company guarantees you an input… you might be mistaken.

For the next 20 years, few firms that issued IPOs implemented the dual-class system. In the early 2000s, tech firms issuing IPOs latched onto dual-class stocks as a means to maintain all the advantages of being private businesses while getting a huge influx of people money.

Presently Nasdaq, NYSE, and NYSE American (previously American Stock Exchange) each license dual-class inventory listings by corporations provided that the dual-class arrangement is in place at the time of their IPO.

Most foreign stock exchanges don’t allow dual-class stock arrangements. When Chinese ecommerce behemoth Alibaba chose to go public in 2014, it bypassed the Asian stock exchanges and listed on the NYSE. It was the biggest IPO in history in a $21.8 billion evaluation.

A post in Columbia Law School’s”Blue Sky Blog” in July 2018 said,”From 2005 to 2015, the percentage of initial public offerings which generated dual-class share structures rose from a mere 1 percent to 24 percent. Over half of all U.S. technology, engineering, and telecommunications firms that issued an IPO in 2015 chose a dual class structure.”

Double class IPOs rose from 12 percent of the total in 2010 to 18 percent for 2017, through September. Source: Dealogic.

Companies with dual-class stocks include:

  • Alphabet (the parent company of Google),
  • Berkshire Hathaway,
  • Box,
  • Comcast,
  • Fitbit,
  • Ford Motor Company (which was allowed to float dual-class stocks in 1956 despite it being against American Stock Exchange rules),
  • Groupon,
  • LinkedIn,
  • Netflix,
  • UPS,
  • Wayfair,
  • Zynga.

Double Class: Pros, Cons

An argument for dual-class inventory is that founders understand best how to run their businesses and letting them have majority control offers stability and more revenue and profit.

But if there are no sunset provisions for the dual-class shares, they may be given to creators’ heirs who might know little about the company and yet find unfettered decision-making power.

Furthermore, there’s scant evidence that companies which have a dual-class arrangement do better than other public companies.

Moreover, dual-class stocks are undemocratic. Critics say one share, one vote is the ideal approach because public investors take some of the risk when they buy stock and they need to be able to vote for change in case direction falters. When insiders are left to manage themselves, poor performance can go undetected.

The boards of directors of dual-class businesses are usually full of company founders and employees and unique venture capital investors. Some dual-class boards don’t have any independent members. Sometimes this is deliberate. Nonetheless, a dual-class structure can limit a provider’s ability to attract independent board members.

SEC Weighs In

SEC Commissioner Robert Jackson Jr., appointed early in 2018, has taken on the dual-class conundrum. He says he knows the advantage of a dual-class inventory in the first years of a public company, but he is a foe of perpetual inequity.

In a speech earlier this year that he asked,”Should our public investors need to put eternal trust in corporate insiders? That is, should so-called perpetual dual-class inventory ownership arrangements, which grant corporate executives management of our public companies literally forever, be okay?”

“If our public investors need to put eternal confidence in corporate insiders?”

He believes shares that include exorbitant voting rights should die and become regular stock, to prevent what he calls”corporate royalty.”

Another SEC Commissioner, Kara Stein, chimed in, expressing her concerns in a 2018 demonstration where she said that dual-class stocks”provide a way to evade board and management accountability.”

Opposition Grows

The Council of Institutional Investors, a nonprofit institution whose members include public pension funds, recently called for dual-class listings to be removed from equity indicators. It said that”every share of a public company’s common stock should have equal voting rights and no-vote stocks don’t have any place in public companies.”

As of September 2017, indicator compiler FTSE Russell excludes all businesses whose public stocks constitute less than 5% of total voting power while S&P Dow Jones will now exclude all dual-class companies.

In July of this year, following the Facebook annual shareholders meeting, the biggest pension fund in the nation, the California Public Employees’ Retirement System, said the dual-class structure allowed the information hacking debacle and consequent privacy scandal in Facebook to happen because Mark Zuckerberg, who owns 1 percent of stocks but has 60 percent of the votes, chose to ignore or deny the hacking for several months. CALPERS requested that the structure be removed. The second biggest pension fund, California State Teachers’ Retirement System, issued a statement stating that Facebook’s government”is now akin to a dictatorship.”

New York City Comptroller Scott Stringer, who oversees $895 million of Facebook stocks from the City’s pension fund, said,”We have concerns about the construction of the board that the company does not look prepared to address, which may cause dangers — reputational, regulatory, and otherwise.”

Other investment funds indicated that the chairman function and the C.E.O. function — both held by Zuckerberg — be split and that Zuckerberg step down as chairman. Facebook’s answer was that such a move would cause”doubt, uncertainty, and inefficiency in management and board function,” in spite of the fact that more than 50 percent of public companies separate the chairman and C.E.O. positions.

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Another firm that inflamed the situation before this month is photo-sharing firm Snap Inc., owner of Snapchat. Both founders of the business, which went public in 2017, hold 96 percent of the voting rights and provide people stockholders no voting rights in any respect. That made the business ineligible for the S&P 500 Index. The IPO stock price was $17. As of August 14, 2018, it was trading at $12.34.

Snap lost over $700 million in its first year as a public firm yet Snap’s C.E.O. Evan Spiegel obtained a $638 million incentive. In the end of July 2018, Snap held a three-minute yearly shareholders meeting online with neither of the founders or any personnel attending. A lawyer read a statement and ended the meeting.

Snap held a three-minute yearly shareholders meeting online with neither of the founders or any personnel attending.

Solving the Problem

Many pension funds and the Council of Institutional Investors recommend sunset clauses for dual-class stocks a couple of years following an IPO. Evidence indicates that firms with sunset clauses over time do better financially than those without one. Others who see the practice as fundamentally undemocratic need a ban on the double class system.

In any event, the consensus is that some regulation is essential, as more companies are applying this system which shuts out the general investor.

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