Say ‘no’ to dual class shares

First published in Business Times on November 27, 2015

By Mak Yuen Teen

FROM the first quarter of 2016, public companies in Singapore can issue ordinary shares with different voting rights. The Singapore Exchange (SGX) and Monetary Authority of Singapore (MAS) are currently reviewing whether to allow dual class shares for listed companies.

Hong Kong recently shut the door on dual class shares after the Hong Kong Securities and Futures Commission (SFC) rejected it. The Australian Securities Exchange does not allow it (with minor exceptions for cooperatives and mutuals), and the Financial Conduct Authority (FCA) in the UK has also recently banned dual class shares for companies listing on the Main Market of the London Stock Exchange.

In the US, the recent popularity of dual class shares among technology companies going public has re-ignited the debate about its merits. Dual class shares were largely disallowed by the New York Stock Exchange (NYSE) from 1940 until the takeover era in the 1980s, when the NYSE suspended the restriction as some companies seeking to shield themselves from takeovers started to convert from one-share-one-vote to dual class shares and moved to other US exchanges. The Securities and Exchange Commission (SEC) eventually adopted a rule prohibiting companies that were already listed with a single class of shares from converting into dual class shares, which remains the position in the US today.

Source: Directors Daze by Mak Yuen Teen and Chris Bennett

Recently, a number of commentators here have expressed support for dual class shares for listed companies. The pros and cons of dual class shares have been extensively discussed, and I shall not repeat them. Perhaps Financial Times columnist Andrew Hill best summed up the conundrum as follows: “The advantage of a dual-class share structure is that it protects entrepreneurial management from the demands of ordinary shareholders. The disadvantage of a dual-class share structure is that it protects entrepreneurial management from the demands of shareholders.”

Founders and management who wish to protect themselves from the demands of outside shareholders have options such as retaining sufficient shares in a one-share-one-vote structure, issuing preference shares with no voting rights, or using debt financing. Using dual class shares is a case of wanting to have the cake and eating it too.

The empirical evidence supporting dual class shares is at best mixed. Arguably the most comprehensive academic study on dual class shares published in 2010 by three professors from Harvard, Stanford and Yale found evidence indicating that dual class shares reduce firm value in US companies.

However, we cannot reduce the question as to whether we should introduce dual class shares here to a matter of statistics – and even if dual class shares work in the US and other markets, we cannot assume that they will work here. As Geoff Colvin, senior editor-at-large of Fortune magazine said in Directors & Boards magazine: “The founders of the United States didn’t survey types of government around the world and then run a regression analysis to figure out which was going to be the most effective. They set up a governance system according to the principles that they thought made the most sense.”

It would be imprudent for us to allow dual class shares without considering our legal and institutional environment, and our approach to corporate governance. We should ask ourselves some fundamental questions, including:

Does our legal system provide sufficient safeguards against abuse and practical means for shareholders to seek redress?
Are dual class shares consistent with our legal and institutional environment, and with our philosophy about shareholders’ rights and corporate governance generally?

When HKEx consulted on the issue earlier this year, the respondents were highly divided, largely in accordance with their backgrounds. Accountancy firms, sponsor firms/banks, law firms and listed company staff overwhelmingly supported dual class shares under certain circumstances.

Large global investment managers such as Blackrock and Fidelity opposed it under all circumstances. The Asian Corporate Governance Association (ACGA) survey of 54 of its institutional investor members showed “overwhelming opposition” to it. Most broker-dealers, retail investors and HKEx staff responding in their individual capacity opposed it. Those respondents who support it do not believe that they should be allowed under all circumstances.

Some commentators have suggested limiting dual class shares to certain companies, such as technology companies. This appears to be based on the recent trend of technology companies using dual class shares, rather than the potential merits of dual class shares only applying to such companies as one can just as easily make a case for other types of companies. It may be technology companies today and space travel companies tomorrow that favour dual class shares.

Dual class shares are also used by US companies in industries such as media and communications, fashion and home goods. Some well-known companies that are not in the technology sector that have dual class shares include Berkshire Hathaway, News Corp and Nike.

Among technology companies in the US, Facebook, Google, Groupon and LinkedIn are examples that have dual class shares. However, many others do not have them, including Amazon, Apple, Microsoft, Netflix and Twitter. Some have argued that dual class shares encourage innovation. Are the latter companies really lacking in innovation? Others have argued that hostile takeovers encourage short-term thinking or threaten founder control and therefore founders and management need to be shielded from them through dual class shares. So, should we also relax our takeover rules to allow boards to take actions to frustrate takeover offers?

RESTRICTIONS AND SAFEGUARDS

Another suggestion is to restrict dual class shares to large listings that attract institutional investors and fund managers. However, as the responses to the HKEx consultation indicate, these investors tend to object to dual class shares. They may still invest in companies with dual class shares not because of fondness for them, but because their passive investment strategies lead them to index some portion of their funds’ portfolios.

It has also been proposed that the number of independent directors on the board or nominating committee can be increased to improve oversight and monitoring. As it currently stands, many independent directors are already beholden to controlling shareholders. Having more independent directors who are appointed by those with superior voting rights is unlikely to do much good.

To counter this, it has been suggested that superior voting rights should not extend to the voting for independent directors or that ordinary voting shares should be able to approve or veto certain major corporate actions, such as changes to the core business or constitution of the company. Since one of the main reasons that founders and management want dual class shares is to have more control over key corporate decisions and actions, excluding or limiting the superior voting rights in such situations would miss the main point of such shares. Companies are unlikely to accept dual class shares with major exclusions and may soon be asking the SGX for waivers.

Another suggestion is that superior voting rights should be suspended when certain trigger events occur, such as insolvency or qualified accounts. There may be practical difficulties in prescribing the situations under which such rights should be suspended, and when these trigger events occur, the horse may have already bolted.

Finally, other proposed safeguards include “sunset” clauses requiring shareholder vote every few years or automatic conversion of superior voting shares to ordinary voting shares when the former are sold to outside investors. In the US, some of these restrictions do exist. For example, in Facebook and Google, the superior voting shares convert to ordinary voting shares when the founders sell their superior voting shares to outside investors. However, these are voluntary restrictions adopted by individual companies, and blanket rules around these will further limit the popularity of dual class shares.

There are two key safeguards in the US that provide protection for minority shareholders against abusive conduct by those who control companies through dual class shares.

First, controlling shareholders, like directors, owe fiduciary duty of loyalty to the company and shareholders. This is different from the UK approach, followed by Singapore, which imposes fiduciary duty on directors but not on controlling shareholders. This is how two lawyers from a US law firm explain it in the context of dual class shares in The Corporate & Securities Law Advisor:

“Corporate law provides shareholders with protections against abuses by those in control of the corporation. Directors and controlling shareholders owe shareholders a fiduciary duty of loyalty. The duty of loyalty requires that directors and controlling shareholders act in the best interests of the company and its shareholders, and without regard to personal motivations not shared by shareholders generally. Directors or controlling shareholders may be found to have violated the duty of loyalty if they approve transactions in which they have a conflict of interest because they or someone with whom they are aligned will benefit from the transaction. Such conflict of interest transactions are subject to an entire fairness review unless procedural protections, including an independent committee and minority shareholder approval, are used. To survive the stringent entire fairness review, the transaction must be the result of fair dealing and must be at a fair price. Any breach of the duty of loyalty entitles shareholders to seek judicial relief and remedies. There have been several judicial actions where the control group in a dual class company has been successfully challenged by shareholders.”

It seems clear that the protection that minority shareholders have in the US against abusive actions by controlling shareholders is far more extensive than what is provided by section 216 of the Singapore Companies Act dealing with oppression of minority shareholders.

Second, the contingency fee-based class action system in the US gives minority shareholders a viable means for taking actions to seek redress, something that is clearly lacking in Singapore.

Investor rights and protection should not be sacrificed at the altar of attracting listings. The MAS must make the call on this in the same way that the SFC in Hong Kong and the FCA in UK made the decision.

I would urge MAS to bear in mind a comment from Charles Elson, director of the Weinberg Center for Corporate Governance at the University of Delaware, who is also a lawyer and an independent director, that when you have dual class shares, what you are doing is exporting the monitoring function to third parties – to the government, the courts, the regulators. This is because dual class shares will severely inhibit the role of directors, shareholders and markets in corporate governance. Are our regulators up to the task and prepared to shoulder this responsibility?