Dual-class Stock

Discussion

One very effective way for a firm to thwart hostile takeovers is to concentrate its voting power in the hands of management or other insiders. The easiest way to do this is to issue to members of management common shares with voting rights superior to the common shares held by other shareholders, through either a dual-class exchange offer or dual-class recapitalization. Dual-class exchange offers involve a transfer of voting rights from one group of common shares (usually those held by regular shareholders or institutional investors) to another group of common shares (usually those held by management). Typically, a firm must offer a preferential dividend to its shareholders in a dual-class exchange offer in order to convince them to cede their voting power to management. A dual-class recapitalization also establishes two classes of common stock with unequal voting rights, but initially involves an equal distribution of preferential and inferior voting shares to current share-holders. For instance, a recapitalization may involve the exchange of a current common share for one-half of an inferior voting common share and one-half of a superior voting common share.

Regulatory Background

Although traditionally the exchanges held to a one share, one vote standard, this came to an end on Dec. 19, 1994, when the SEC formally adopted a "uniform voting rights listing standard" that had been proposed by the three major domestic securities markets after some reportedly heavy prodding from SEC Chairman Arthur Levitt.

The new rule is loosely based on the old Rule 19c-4, the SEC's so-called "no disenfranchisement" rule, which the commission promulgated in 1988 but was later invalidated by a federal appeals court in 1990 at the behest of the Business Roundtable. With a few exceptions, the standard prohibits companies from taking actions that disparately reduce or restrict the voting rights of existing shareholders. Among other things, the rules outlaw the issuance of time-phased or super-voting stock, the adoption of capped voting rights plans, or the issuance of stock with voting rights less than the per-share voting rights of the existing common stock through an exchange offer.

Loopholes

All of Rule 19c-4's "loopholes," including those opened by the exchanges' staffs via interpretive letters, remained intact. The disenfranchisement provisions apply only to existing shareholders, so shares with disparate voting rights issued in connection with IPOs are permitted. Companies also may issue shares with voting rights that are less than those of its existing stock, including shares with no voting rights. Issuance of tracking shares-where multiple classes of stock are linked to the performance of specific business lines, with voting rights based on the relative market values of the classes of stock-is permitted. Voting rights limits caused by state antitakeover laws or shareholder rights plans (poison pills) are exempt from coverage, as are shares of non-U.S. companies. Finally, where a company is in financial distress, the exchanges continue to evaluate the issuance of nonqualifying securities on a case-by-case basis.

Rule 19c-4 had grandfathered in a large number of dual-class voting schemes, but it provided that future issuances of high-vote stock could be made only if they were part of a transaction that did not further disenfranchise shareholders. Under the new uniform standard, the "no further disenfranchisement" protection disappeared. Firms with grandfathered dual-class capital structures are permitted to issue additional shares of the existing super-voting shares in a "capital raising transaction, via a stock dividend, through the issuance of stock options, or even in a stock split." In addition, companies that take advantage of the loophole that allows them to issue a second (or multiple) class of lower-vote stock may still issue more "regular" stock. Under Rule 19c-4, no more high vote shares were allowed after lower voting stock was issued.

While framed as a mere grandfathering of existing unequal voting rights schemes, in reality the adoption of a uniform standard amounted to an outright amnesty. Companies that risked delisting from the NYSE, for example, by adopting capital proposals that ran afoul of the market's listing requirements after the invalidation of Rule 19c-4 got a fresh start without fear of sanctions.

Debates On The Impact of Unequal Voting

There is considerable disagreement among economists as to the long-term effect of multiple classes of stock on shareholder wealth. Some studies suggest that shareholders in some recapitalizations have incurred abnormal losses of five percent to ten percent of the total market capitalization of the firm.[1] Other studies demonstrate that multiple classes of stock lower shareholder value over the long term.[2] In contrast, economists Kenneth Lehn, Jeffry Netter, and Annette Poulsen argue that in many instances the creation of dual-classes of stock does not hurt shareholders, but serves useful purposes and is valuable to closely held companies.[3] They suggest that the increased flexibility provided by the issue of a second class of stock in a high-growth firm will allow the firm to invest in positive net present value projects that it would not have pursued-for fear of losing control-had it not issued additional stock. Additionally, the company's request for more capital may provide a positive signal to the market not only about the firm's investment opportunities but also about its commitment to investing in firm-specific capital (that is, the supervoting shares of stock are similar to stock option grants). These studies suggest that dual-class recapitalization does not significantly affect shareholder returns but might actually have a positive effect on firm value. Other research also supports this view.[4]

Evaluating Dual-class Recapitalizations

Although there may be cases in which dual-class recapitalizations deserve support, it is extremely difficult to determine those situations. In order to support a dual-class exchange offer, shareholders must be confident that the present value of the special dividend received in the offer equals or exceeds the short-term and long-term losses associated with holding limited voting right stock in a dual-class company. Security analysts like to use rules of thumb to value the vote at any company (five percent of the market value of the stock is a commonly used rule of thumb). But the reality seems to be that the value of the vote at company depends on its specific circumstances, and thus requires a separate calculation for each offer.[5] This calculation is difficult, if not impossible, for many institutional investors. Given the fact that even thorough examinations yield inconclusive results, shareholders are probably better off opposing dual-class exchange offers on the grounds that they contribute to the entrenchment of management and allow for the possibility of management acquiring superior voting shares in the future.