Dual Class Shares: A Shareholder Right or Wrong
A Conversation Between Christopher Skroupa, Skytop Editor-in-Chief, and Andrew Shapiro, President, Lawndale Capital Management, Skytop Contributor / March 14th, 2022
Christopher Skroupa: Institutional investors and activists argue that dual class shares are a vice, allowing founders and management to maintain indefinite control of a company at the expense of other classes of shareholders. Do you agree? If so, why? And how would you frame the basis for contention between dual class and other shareholders.
Andrew Shapiro: In most instances, yes. Dual class share structures (basically shares issued with unequal rights, most often voting rights) are designed and issued to founders and management exactly for the purpose of preserving control while enabling access to equity capital from others. The shares’ special privileges provide a disproportionate share of control than the holder’s actual share of equity investment and serve to insulate their holders from accountability to outside shareholders and the independent board members responsible to represent shareholders.
As to whether dual share structures are a ‘vice’, varies both from what side of the boardroom you sit and also as to the terms and conditions the ‘super class’ benefit from and how that power is used or abused.
However, the removal of shareholder’s ability to ‘throw the bums out’ can lead to self-interested behavior, including excessive and misaligned compensation and other extraordinary perks as well as the potential of extracting an unfair and unequal control premium in a sale of the super-voting class at the expense value that would otherwise flow to all shareholders equally.
Additionally, the insulation from accountability to outside shareholders and the independent board members can lead to bad capital allocation and strategic decisions resulting from poor return on investment spending (e.g. research, marketing campaigns, etc.) and overpaid acquisitions and underpriced dispositions.
Christopher: Snapchat and Facebook as well as other notable companies have dual class shares. Can you explain a scenario or two that highlights the kinds of issues they are creating.
Andrew: In 2017 Snapchat was reported to be the first IPO where the newly issued shares sold to the public had NO voting rights at all, while the Co-Founders CEO Evan Spiegel and CTO Robert Murphy controlled 96% of the voting rights. At the time Spiegel, in his mid-20s, was being promoted as an “enigmatic genius”. In a little more than a year, Spiegel was no longer hero worshiped but instead was considered a liability responsible for the ill-fated redesign of the app (creating a need for another costly redesign to recover) and the money burning Spectacles failure. The non-voting SNAP shares sold to the public were down over 70% from the IPO price a little over a year-and-a-half earlier.
Yet the company’s first Annual Shareholders Meeting, where shareholders would normally get to engage with and elect or replace board members whose responsibility includes hiring, overseeing and, when necessary, replacing CEO and senior management was not only not in-person with such dialogue and engagement with shareholders. It was literally a 3-minute audio recording of the company’s lawyer reading a script that highlighted that management had 96% of the vote and stating a typical shareholder meeting was not necessary and that this management team had also basically unilaterally elected a new director to the board.
Another scenario of dual share structure dysfunctionality that is on-going is with Reading International (the successor to the old Reading Railroad of Monopoly game fame). In this instance, 100% voting control is via Reading’s Class B shares, which represent only less than 8% of Reading’s 21.7MM combined Class A non-voting and Class B shares. 67% of the voting Class B shares were held by a talented corporate raider named James Cotter, Sr. until his death in 2014. In a plot quite similar to HBO’s drama “Succession”, Cotter, Sr. left behind not only a dysfunctional family of three adult-aged children he employed in the company in competition with each other, but also a dysfunctional estate plan that, in addition to leaving substantial non-voting Class A shares to these children, left his entire 67% block of Class B voting shares to a long-dated trust for the sole benefit of his five very young grandchildren, the oldest of which at the time of his 2014 death was only 5 years old.
Within months of Cotter, Sr’s. death, his children broke into two factions that began litigating for control of the Grandchildren’s Trust with Cotter’s daughters seeking entrenched employment and their younger brother, Jim Cotter, Jr. (originally the successor CEO) who the sisters ousted in a boardroom coup, seeking the monetization of the Class B shares in a value-maximizing auction that he hoped would also lead to a value maximizing auction of the company (and the non-voting Class A shares). The on-going costly and distracting estate and trust litigation is already in its 8th year.
Christopher: It is argued, as part of the counterpoint in favor of dual class shares, that they allow a founder to focus on long term growth, as opposed to quarterly earnings. What is your position on this? Do you agree or disagree and why?
Andrew: I do agree that providing founders super voting rights in a separate class of shares ensures them of absolute control protecting them from losing their jobs. Some say such safety from the disciplinary forces of the market allow founders to carry out their vision and invest in the long term for the benefit of all shareholders rather than managing to avoid short term stock price plunges. If a founder is a leader worthy of such protection, all may be well and good. However, as I mentioned before, if they mismanage the company or make bad decisions, shareholders are powerless to enact needed change. Given the disproportionate equity investment super-voting stock enables founders to control a company with, bad decisions proportionally affect them much less.
Christopher: Research shows that having insiders with this sort of security may serve as a disincentive to accountability, thereby hindering performance. Are there examples out there that might validate this claim?
Andrew: I acknowledge that the benefits that might come from protecting a visionary with super-voting rights may initially match up with the risks of poor performance but I have heard of studies that have shown whatever net benefit that might occur degrades over time and, during the 5th to 7th year, the advantage degrades and thereafter the costs more clearly outweigh the benefits.
Christopher: Apparently, dual class shares were popular in the 1920s, taken away and then allowed back in during the 1980s to make the U.S. markets more competitive against others. Do you believe this assumption is correct?
Andrew: Not in terms of making the underlying companies more competitive. But if you mean making the NYSE or NASDAQ market more attractive to list an issuer’s stock on vs. Hong Kong, yes.
Stock exchanges in search of ever more listings have been in a ‘race to the bottom’ with weaker and weaker governance requirements. We should return to an implicit contract that exists to mandate a one share/one vote policy when a company seeks to take in capital from a broad swath of the general public, especially passive index funds and large pension funds that must own in perpetuity all equities as an asset class, versus when the company negotiates at arms-length for capital from a small group of qualified professional private investors.
Christopher: If companies cannot reverse the voting rights of the new class or superior class, then what is the solution if the market is to move against allowing them?
Andrew: Short of an outright ban on listing such securities from our most liquid markets, there are several ways to rein in the proliferation and most egregious abuses of dual class share structures. First, require the super-voting terms sunset and convert to single share single vote stock after a reasonable amount of years or at a minimum require the renewal of another set of years of the super-voting benefit via a shareholder vote with all shares classes having an equal single vote per share. Additionally, to prevent the extraction of economic rents from the minority voting class, broadly ban the transfer, exchange and inheritance of the super-voting shares and instead require their conversion into single share voting stock in order to transfer.
As for disincentivizing creation of such divergent rights in the first place and protecting the general passive public investor pools like index funds and pensions who don’t have the choice to avoid purchase of such shares, ban such shares from inclusion in broad market indices. Moreover, large pension and other institutional investors in the venture capital firms can demand or allocate capital to the venture funds who install good governance in these nascent companies prior to them taking in the public’s money.