By: David A. Stockton
The debate over the propriety of offering low or no-vote shares in IPOs has been at a slow boil for years. But since no-vote shares were first offered to the public in March 2017, things have heated up. What had been primarily an academic discussion has now seen potentially significant market and regulatory forces weighing in, including the major index fund sponsors and SEC commissioners. Since the NYSE allowed listings of issuers with dual class voting structures (one low vote and one regular voting) in the late 1980’s, they have occurred on a limited but significant basis. While investor groups have not been happy about it, there have been no real impediments to a dual class issuer completing the SEC review process and then being listed on an exchange. The only limitation has been the theoretical diminished value of a share that bears low or no voting rights. But this hasn’t been a very significant limit, as evidenced by the number of listed issuers with dual class structures having increased by 44% between 2005 and 2015, and by the fact that investors continue to thirst for those shares. Index Funds Limit Low/No Vote Shares
Lobbying pressure from the Council of Institutional Investors and others on the major stock index providers to bar non-voting or low-voting shares from their indices heightened in 2017. Unlike comparable efforts over the years to pressure major stock exchanges to limit dual class listings, these pressures met with great success, as three major index providers took substantial steps to limit participation by dual class capital structure companies in their stock indices. FTSE Russell announced plans to exclude all companies where less than 5% of voting rights were held by the public, which would exclude most dual class companies doing IPOs today. This would affect the broad market Russell 3000 Index and the Russell 2000 Index. S&P Dow Jones announced that many of its indices will completely exclude companies with dual classes, subject to certain grandfathering provisions. MSCI will reduce the weight that dual class issuers occupy in its indices. Being excluded from a major stock index causes a loss of potential additional demand for an issuer’s stock and a loss of the increased value that additional demand brings. But this theoretical loss is not, standing on its own, likely to change an issuer’s decision to implement a dual class structure. These moves by the index providers nevertheless are significant because they mark the first time a market participant has imposed a tangible financial disincentive (even if an immeasurable one) on use of a dual class structure. They could have an impact on future IPOs with a dual class structure, but likely only if combined with other market forces. SEC Expresses Concern With Dual Class Structures (Particularly Perpetual Ones)
The SEC has also become more active in the debate over the use of dual class voting structures. The SEC’s Investor Advisory Commission has been an early and active proponent of limiting the usage of dual-class voting structures, including by lobbying the index providers to limit inclusion of dual class issuers. In addition, Commissioner Robert Jackson recently stepped forward to advocate limiting perpetual dual-class structures. He is clearly broadly opposed to these structures, but has chosen his battle carefully by making the narrow point that disparate voting structures should after some time be subject to sunset provisions, rather than being perpetual. In his February 2018 speech, Commissioner Jackson expressed his hope that stock exchanges would require companies with dual class structures to include sunset provisions which would phase out those divisions over time. He acknowledged that, in the earlier years of a company, a dual class structure could be beneficial by allowing entrepreneurs to build for the long term without being subject to short term pressures. But he believes that these early advantages eventually are outweighed by the fact that these structures prevent stockholders from holding management’s feet to the fire. He finds it offensive that a perpetual dual class structure works to preserve voting control for the heirs of a founder. He also put forth empirical evidence developed by his staff demonstrating that, within three to six years after an IPO, perpetual dual class stock trades at a substantial discount to dual class stock with a sunset provision. This is potentially significant because to date there has been little clear evidence that low or no voting rights impair the value of a share. Most recently, the SEC’s Investor Advisory Committee on March 8, 2018 adopted recommendations that the Division of Corporation Finance require clearer and more detailed disclosure by dual class issuers in their SEC filings. This Committee was clearly of the view that dual class structures were detrimental to good corporate governance, but like Commissioner Jackson it chose to take a narrow focus, in this case on the adequacy of disclosure of the special risks arising from these structures. The Committee recommended that disclosures be improved so that investors could more readily identify the difference between the percent of total equity as opposed to percent of the vote held by an insider. They also recommended that dual class issuers disclose the risk that their shares could be ineligible for inclusion in certain stock indexes. These and the Committee’s other disclosure recommendations, many of which are already being implemented by the Division of Corporation Finance staff in its review process, are highly technical points that are not likely to impact an issuer’s decision to adopt or continue a dual class structure. SEC Chairman Indicates Limiting Low/No Vote Shares is Not a Priority
The most significant announcement coming out of the SEC with respect to these matters was from Chairman Jay Clayton at the March 8, 2018 meeting of the SEC Investor Advisory Committee. In his opening remarks, Chairman Clayton made clear that the dual class structure reforms were not on his list of near term priorities. While acknowledging that discussion of proper disclosures regarding the operation of dual class voting structures was worthwhile, he indicated that he had larger concerns with calls to limit dual class structures. He cited the excessive short-term focus of American companies, apparently endorsing the argument that dual class structures allow founder/managers to take a longer view and avoid short-termism. He also indicated concern for the continuing attractiveness of U.S. capital markets compared to foreign alternatives. He fears that limits on the ability of dual class issuers to offer and trade their shares in the U.S. might drive them to alternative foreign markets without such limitations. There is a new urgency among the market and regulatory participants aligning against dual class structures, and they have some reason for optimism from the actions of the index providers. But the lack of enthusiasm for any such limitations by SEC Chairman Clayton, and presumably the other Republican commissioners, makes clear that there will be little meaningful support from the SEC for any such limits. Of course, investor demand will dictate the future of low or no vote shares and the fact that IPOs of low vote stock continue to be snapped up by investors strongly suggests that they are not going anywhere. As long as that demand continues we should expect to see a significant subset of founder-led companies continue to employ dual class structures when they elect to go public.