Over the past several years, corporate law scholarship has carefully analyzed the effects of dual-class capital structures, which allocate superior voting rights to insiders and inferior voting rights to public shareholders. My article, The Importance of Inferior Voting Rights in Dual-Class Firms, which will be published by the Brigham Young University Law Review, adds to the literature by focusing on a unique and novel type of dual-class structure—one in which the public shares have no voting rights at all. This structure is fundamentally different because in the absence of even highly diluted voting rights in public hands, the firm does not have to meet certain types of disclosure rules and corporate governance standards. Nonvoting shareholders are deprived of these significant components of investor protection.
After carefully identifying the serious consequences of nonvoting common stock for investor protection, I suggest two ways to address them. First, the Securities and Exchange Commission should act to protect nonvoting shareholders by requiring the same level of disclosure when nonvoting stock is issued, as is required when voting stock is issued. Towards implementing this proposal, I distinguish between the situation of no voting rights and the long-standing federal court decision asserting that the regulation of voting rights is beyond the delegated authority of the Commission. Second, stock exchange rules should impose requirements for listed firms aimed at protecting holders of nonvoting stock. These rules would grant nonvoting shareholders certain disclosure and governance rights they do not otherwise have under federal or state law.
The above proposals directly address the implications of nonvoting stock for disclosure and corporate governance, and therefore are preferable to the current incidental reaction of major index providers to dual-class capital structures.
Below I provide a more detailed account of my analysis:
Snap Inc., Silicon Valley’s social-media star, is a groundbreaking company that is reinventing the camera. In March 2017, it proved its ability to innovate in the financial field as well when it went public with a unique dual-class capital structure. In contrast to other companies that have also issued dual-class shares, such as Google or Facebook, the public float in Snap’s initial public offering (“IPO”) had no voting rights at all. The issuance of nonvoting common stock has serious implications for corporate governance and investor protection that go far beyond those of the traditional dual-class structures.
A dual-class capital structure creates a gap between voting rights and cash-flow rights. A company founder who wants to raise capital without relinquishing effective control of the company can issue different classes of shares with unequal voting rights. The shares issued to the public investors confer a right to residual cash-flows, but also grant either inferior voting rights or no voting rights at all, while the founder’s shares enjoy superior voting rights. By issuing two or more classes of shares with unequal voting rights, the founder can avoid the dilution that an IPO normally entails and hold on to most of the voting rights in shareholder meetings, despite her relatively low equity investment. In this way, she can entrench her control of the company even after it goes public.
There are two main incentives for going public with a dual-class capital structure: first, it allows the company’s founder to pursue her idiosyncratic vision for producing above-market returns; second, it insulates management from short-term market pressures and thus promotes long-termism. However, controllers of a dual-class firm, particularly small-minority controllers (see Lucian Bebchuk & Kobi Kastiel, The Perils of Small-Minority Controllers), have two fundamental characteristics that result in agency problems: weak ownership incentives and entrenchment. The combination of these characteristics produces situations where a controller might have interests that substantially diverge from those of public shareholders, and no threat of replacement exists to prevent her from pursuing these interests. This may lead to a distortion of various business choices, such as the extraction of private benefits of control at the expense of other shareholders. Moreover, since the controller can extract private benefits from capital that is inside the firm, while she bears only a fraction of the costs of deploying the capital in the firm rather than using it more efficiently elsewhere in the economy, her incentives may become distorted when considering whether the firm should expand, contract, or remain the same size.
Furthermore, agency problems in dual-class firms are substantially exacerbated when public shareholders are not entitled to voting rights. In the absence of even highly diluted voting rights in public hands, the firm does not have to meet certain types of disclosure rules and corporate governance standards. For example, if a company has registered only nonvoting shares, it is not required to distribute a proxy or information statement under federal securities law. Moreover, holders of nonvoting stock are unable to express their voice on a company’s key issues and raise shareholder proposals under Rule 14a-8 of the Securities Exchange Act of 1934. On the other hand, so long as shareholders have voting rights, even inferior ones, they are protected by certain disclosure and governance requirements for listed firms. From the perspective of investor protection, therefore, there are significant differences between issuing nonvoting and low-voting common stock.
It should be noted that passive investors, such as index funds, are forced to invest in nonvoting common shares despite their effects on investor protection. Therefore, S&P Dow Jones and FTSE Russell have recently revised their policies regarding multiclass shares and moved to exclude the stock of dual-class firms from stock indexes. The exclusion of the stock of certain most innovative companies, however, would prevent the indices from being as expansive and diverse as the underlying industries and economies whose performance they seek to capture. The indices then may no longer reflect the investable universe of public companies or represent the wealth-creating power of the U.S. economy. As a result, the access to the investment marketplace of Main Street investors, who often own stock in U.S. public companies through an index, would become limited.
Therefore, I suggest two different ways to address the consequences of nonvoting common stock for disclosure and corporate governance, which are not limited to the indices’ inclusion policy, but reflect a broader perspective of the issue. Instead of addressing these consequences incidentally by means of the index providers, and thus creating a gap between the indices and the economy, they should be directly addressed through SEC regulation and stock exchange rules.
First, the case of nonvoting stock should be distinguished from the case of low-voting stock, which was the subject of the Business Roundtable decision in 1990. This long-standing federal court decision asserted that regulating voting rights, which traditionally have been the exclusive province of state corporate law, is beyond the authority of the Securities and Exchange Commission (“SEC”). When public shareholders have no voting rights at all, however, there are direct negative implications for investor protection, which is indisputably subject to the SEC’s delegated authority under the Securities Exchange Act of 1934. Therefore, the SEC can and should act to protect nonvoting shareholders by requiring the same level of disclosure when nonvoting stock is issued as is required when voting stock is issued.
Second, stock exchanges should impose requirements for listed firms aimed at protecting holders of nonvoting stock. Since the exchanges have strong incentives to maintain good reputations, the concern that the competition to attract new listings may put “race to the bottom” pressure on listing standards is not reasonable. Indeed, stock exchange rules grant nonvoting shareholders certain disclosure and governance rights they do not otherwise have under federal or state law. Section 313.00(B)(2) of the New York Stock Exchange (“NYSE”) rules, for instance, requires that any materials sent to voting shareholders, including proxy material, also be sent to nonvoting shareholders.
The debate over the pros and cons of dual-class capital structures divides continents and legal systems. The analysis in this article shows, however, that regardless of one’s position on dual-class structures in general, having at least some voting rights in public hands is important for investor protection. So long as shareholders have even inferior voting rights, they are protected by important disclosure and governance requirements for listed firms. On the other hand, nonvoting shareholders are deprived of these significant components of investor protection. Therefore, it should be plainly apparent, even to advocates of multiple classes of common stock with unequal voting rights, that it is necessary to expand the disclosure and governance rights of nonvoting shareholders.