by Cydney Posner
An interesting topic of discussion at a meeting last week of the SEC’s Investor Advisory Committee was “unequal voting rights of common stock” — the trend over the last decade (plus) for a small number of IPO companies, particularly tech companies, to offer low-vote or, more recently, no-vote common shares to the public. (Of course, the concept of dual class common with unequal voting rights is not novel at all. Many companies, particularly some that are family run, have in decades past had a class of common shares with 10:1 voting rights, not to mention the highly respected Berkshire Hathaway with a class holding voting rights of 10,000:1.) The debate centered around whether these measures are a legitimate effort to protect companies from the pressures of short-termism exerted by hedge fund activists or are a mechanism that causes shareholders to cede power without providing accountability. Of course, the answer depends on where you sit.
In her opening statement before the Committee, Commissioner Kara Stein indicated that the SEC needed to examine the impact of this new innovation on investors: “Voting rights have been a foundational component of sound corporate governance. Unequal voting rights present complex and new issues that need to be understood and addressed. We also must be mindful of the precedent being created. What is the effect on capital formation and emergent public companies when the bundle of rights offered to shareholders in a public offering excludes voting rights? In the long-run, we need to critically assess our regime for initial public offerings. The current structure is premised on taking an investor’s capital, while giving that investor the rights that help hold a company’s management accountable in the use of that capital.”
(The following is based solely on notes, so standard caveats apply.) The first panelist, a Silicon Valley attorney, stated flatly that Silicon Valley companies are genuinely concerned about corporate governance issues. Why is it then, he asked rhetorically, that the most dynamic companies are now subject to so much criticism about their corporate governance? The problem, he contended, is that there is a “corporate governance misalignment” — essentially a misplaced focus on public shareholders, with the power dynamics essentially controlled by holders with a short-term perspective, including hedge fund activists. By contrast, companies want to pursue long-term strategies and to benefit other constituencies, including employees. Under his analysis, the trend toward multi-class common is a reasonable — perhaps the only available — response to this misalignment.
The majority of people, he contended, either do not invest in the market at all or invest through mutual funds, and, as a result, exercise very little control over stocks. Instead, fund managers, who invest the capital of others, make the voting determinations. Notably, however, their financial incentives are premised on short-term stock price performance, which tends to drive their voting interests, he argued. Consequently, key issues affecting people, such as the development of new technology, wages, training, jobs and corporate citizenship, are “ignored by the professional investor class.” Moreover, as a result of legal principles (such as the shareholder preeminence theory) and other factors, the voices of these equity holders are often the loudest, drowning out the voices of other constituencies, such as the community and employees. Notably, the shareholder-preeminence theory has not always been widely accepted; in the 1930s, he said, attention was given to a broader group of stakeholders, and a sole focus on shareholders was considered improper. (For more on the shareholder preeminence theory, see these news briefs dated 10/11/11, 7/2/12, 10/5/12, 8/30/13 and 9/7/13 and this PubCo post.)
Compounding this short-termist risk, he maintained, is the perception that hedge fund activists tend to target companies with significant cash and relatively high R&D and SG&A expenses, all factors that tend to characterize technology companies. (See, e.g., this PubCo post.) These companies are especially vulnerable when a new product or technology has not met expectations and stock prices fluctuate. In addition, the power of these short-term holders has caused companies to remove many types of protective measures, such as board classification. A committee member observed that, at the end of the day, hedge fund activists are frequently successful in their efforts, even if they lose in the first instance, and can act with institutional holders in combinations that are difficult for companies to reject. (One example would be the DuPont proxy contest. See this PubCo post.) These risks (and others) have led many companies to stay private longer, leading to a historic low in IPOs.
To withstand these pressures, a number of companies undertaking IPOs — and concerned about potential impediments to execution of their long-term strategies as public companies — have implemented dual- or multi-class common structures. The panelist acknowledged that there were no guarantees that this approach would succeed — indeed, a recent study by the Council of Institutional Investors showed mixed results. But so far, he saw few alternatives. In his view, time-based or tenure voting (see this PubCo post) faces a number of regulatory impediments. Corporations are more than just shareholders, he contended, and, until the misalignment is repaired, companies may well continue employing multi-class common as a potential solution.
One committee member suggested, as an alternative, the “public benefit corporation” model, authorized in Delaware within the last few years, which expressly authorizes corporations to be governed not simply for the best interests of shareholders, but also for the best interests of the corporation’s employees, consumers, communities and society generally. In response, the panelist observed that public benefit corporations are relatively new, and it still unknown whether they will be accepted in the public markets.
SideBar: Delaware Chief Justice Strine has come out in favor of public benefit corporations. See this PubCo post. Note also that a Delaware public benefit corporation has recently gone public. See this PubCo post.
A representative of CII on the panel, while recognizing that other stakeholder interests should not be ignored, nevertheless questioned whether the decision-making authority regarding what is best for all of these interests should be vested solely in such a limited group. With no shareholder-elected directors, he was concerned about the absence of an appropriate accountability structure. To prevent a “race to the bottom” among the exchanges, he advocated that the SEC revisit the voting rights issue with the exchanges, suggesting, for example, that a realistic sunset provision be required, not one tied solely to the sale of all shares or the death of the founder. (Concern with respect to the absence of a “compelling transition plan” was also expressed by a law professor on the panel.) In addition, he noted, a recent study by CII showed that, comparing average ROIC over nine years, the companies with multi-class common showed no discernible benefit. What then is the purpose, he asked. He also questioned whether stock with no vote attached was properly considered to be equity. He advocated that these types of shares be excluded from index funds.
A law school professor on the panel took issue with the “misalignment” theory, arguing that voting rights (presumably held by institutional investors) have helped to improve corporate governance over time: companies now have more independent directors, as well as a better focus on executive comp and on ESG and a wide variety of other social goals that she attributed to pressure from the exercise of voting rights by institutional holders. This view was echoed by others. For example, one committee member argued that, until recently, shareholders could not even vote “no” on directors because of the prevalence of plurality voting.
A representative of asset manager State Street Global Advisors on the panel concurred that some institutional investors, including her own fund, seek to invest responsibly and promote social progress. She also argued that passive index funds could not always sell their shares and instead used engagement or proxy votes to hold management accountable. With as much as 12% of the S&P 500 composed of companies with multi-class common, index funds were often required to invest in companies with multi-class common. In the absence of accountability, she was concerned that these funds were “left vulnerable to the interests of the controlling shareholders,” whose interests may diverge from non-controlling holders. (See this PubCo post.) She advocated improved sunset provisions for non-voting or low-voting shares.