Dual-Class Shares: A Role for the SEC?
While most public companies do not have duel class, shares there is a growing minority that have adopted the format. In many instances adopting the practice permits a person who may, for example, be the company founder and viewed as a leading visionary to retain control and manage for the long term. This structure, which is largely a function of state law and exchange listing standards, can disenfranchise most shareholders for at least a period of time if not permanently. While some argue that this is a simple matter of shareholder choice, others oppose the practice.
Recently, Rick Fleming, Investor Advocate at the SEC, addressed the practice at the ICGN Conference in Miami. His remarks were titled “Dual-Class Shares: A Recipe for Disaster” (Oct. 16, 2019) (here).
As the title of Mr. Fleming’s remarks suggest, he is not an advocate of dual-class shares. He began his remarks by suggesting that while this was a hot topic a few years ago, “recent events should have us revisiting the issue with greater urgency.” The basic theory of having duel-class shares, according to Mr. Fleming, is to permit the pubic to acquire shares in a firm by going public while retaining the benefit of the enterprise being guided by the founders who created it. Shareholders are effectively compensated for the lack of voting rights by the fact that the structure “allows the founders to guard against activists who demand short-term profits at the expense of long-term growth,” Mr. Fleming noted.
This approach has been effective in some instances, the Investor Advocate allowed. In many other instances it is questionable at best. There is a “growing body of research” which suggests that over the long-term firms with dual class structures tend to underperform. There are also inherent dangers in the structure for shareholders over the long term. Those include: The potential for self-dealing; outsized optimism; insular “group-think” among the entrenched management; poor accounting controls; a tendency to take the “eye-off-the-ball” and burn cash in ancillary projects; the declining mental health of the entrenched founder; and abusive working conditions.
While these issues may not arise for some time or be present in each company, over the long term the practice tends to create what Mr. Fleming called “a festering wound that, if left untreated, could metastasize unchecked and affect the entire system of our public markets. The question, then, is what can be done to avoid the inevitable reckoning.”
There is no quick fix for this important issue. The SEC, for example, was thwarted by the courts in a suit brought by the Business Roundtable when it sought to block super-majorities. Nevertheless, shareholders have options, Mr. Fleming insisted. Those include addressing the issue with stock exchanges which can deal with the question through their listing standards. Shareholders can also address the question with organizations such as the CFA Institute and the Council of Institutional Investors. These organizations, and others, can effectively deal with the question Mr. Fleming insisted.
Mr. Fleming has presented a significant issue that should be carefully considered. There is no doubt that in certain instances dual-class shares can benefit investors. Those benefits may include encouraging firms that otherwise might be reluctant to sell shares to the public to undertake an IPO and permitting a visionary founder to continue managing the firm with a long term view, avoiding the short term results oriented approach that may infect a public firm that is required to report quarterly.
The “parade of horrible” prospects Mr. Fleming presents should also be considered. While the list clearly does not apply to every firm, absolute power can have undesirable side-effects. Perhaps more importantly, as a firm grows and matures it may benefit from the recruitment of professional management. New management may augment, and perhaps at some point replace, the “visionary founder” whose time may be better spent envisioning the next great iteration of the company, which is how the enterprise was created, rather than pondering operations spreadsheets. While in the first instance duel class shares is a question of state law and exchange listing standards, history more than substantiates the fact that the Commission has a significant and important role to play here.