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The Business Times, June 4, 2014
Where Dual-Class Structure Might Work By Dr. Emir Hrnjic THE Singapore Exchange (SGX) has been in the news lately, but not for the right reasons: commentators have noted the relative dearth of major initial public offerings (IPOs) on the local bourse in recent months. To its credit, the SGX has tried to spice things up, most recently by proposing to make it easier for foreign companies already listed elsewhere to have a secondary listing in Singapore. But one other way it could help revive the moribund IPO market is to reconsider introducing dual-class listing structures. Such structures have generated controversy over the years, as they allow differentiation among a company’s shareholders, which is considered by some to be unfair. They give one class of shareholders higher voting rights than another class, even though both classes are entitled to the same dividends. Dual-class share structures have been allowed on all United States exchanges since 1985, and have been used by more than six hundred US firms, including Nike, Visa, Google and Facebook. But they are not as welcome in Asia. They have been expressly banned on the SGX, because there are concerns about the “entrenchment of control”. The only exception to this rule is Singapore Press Holding; its “management” shares have 200 votes each as compared to “ordinary” shares with one vote each. Hong Kong’s stock exchange (HKEx) technically allows such structures in “exceptional circumstances”, although this provision has never been exercised. As a result, regional bourses have sometimes lost out on plum listings. Earlier this year, in what is set to be one of the largest IPOs in history, China’s Alibaba Group shunned the HKEx and instead opted to list in New York – partly because of the HKEx’s reluctance to let Alibaba get around its ban (?) on dual-class shares. Costs and benefits Critics of dual-class share structures argue that they are not equally fair to all shareholders. Shareholders with higher voting power, usually top executives, may decide to consume extravagant perks and take excessive risks, with the consequences disproportionately borne by other shareholders who have almost no say in the matter. Companies that have insider voting rights, such as in a dual-class share structure, also tend to have lower market value according to studies by Gompers, Ishii and Metrick in Review of Financial Studies (2010) and Smart and Zutter in Journal of Financial Economics (2003). This suggests that a company’s founder may decide to accept a lower valuation of the company in order to maintain control. A recent study by Masulis, Wang and Xie in The Journal of Finance (2009) have also found that CEOs of companies with dual-class share structures receive higher compensation and make worse acquisitions. But such structures clearly have benefits too. Their proponents argue that they allow controlling shareholders to pursue their long-term vision, protecting them from public investors who prefer short-term outcomes. They also incentivise company founders to take their companies public without the fear of losing control. Moreover, compared to other ways of retaining founder control, such as pyramid ownership or cross-shareholdings – frequently used in some countries such as South Korea and Japan – the dual-class share structure is simpler and more transparent. Another stream of research shows that shareholder value is improved by dual-class share recapitalisations, which is when companies with a single-class share structure raise funds by adopting a dual-class share structure to issue more shares. Such firms grow 20 per cent more than other firms and earn 23.11 per cent higher stock returns over a four-year period, compared to single-class firms of similar sizes within the same industry. Whether firms and their shareholders benefit from having a dual-class share structure depends on two main factors: the transparency of the company, and the level of its managers’ talent. The recent empirical evidence by Anderson, Duru and Reeb in Journal of Financial Economics (2009) shows that transparent dual-class share structure firms perform better. A decrease in opacity of 10 per cent for a founder-controlled firm with a dual-class share structure leads to a 5.2 per cent increase in firm value, compared to non-dual-class, non-founder controlled firm of a similar size and in the same industry. Opacity index is constructed from trading volume, bid–ask spread, analyst following, and analyst forecast errors, while firm value is measured by Tobin’s Q which is calculated as the sum of the market value of equity, the book value of debt and the book value of preferred stock divided by total assets. This is consistent with the notion that insiders in transparent firms focus on shareholder value enhancement, while those in opaque firms are more likely to seek to entrench themselves. Theoretical model by Chemmanur and Jiao in Journal of Banking and Finance (2012) suggests that dual-class firms with talented managers also perform better, while untalented incumbents may use the structure to dissipate value. Anecdotal evidence The success of dual-class share structures can also be seen in some anecdotal cases. Warren Buffett’s Berkshire Hathaway, for instance, is one instance where founder control – albeit by a very talented founder – has resulted in handsome rewards for shareholders who don’t necessarily have the same voting rights. Berkshire Hathaway’s shareholders enjoyed a 19.7 per cent compounded annual return over the period 1965-2012, while the S&P 500 experienced a 9.4 per cent return in the period. In other words, a US$1,000 investment in Berkshire Hathaway in 1965 would have grown to a spectacular US$5.6 million in 2012, compared to a relatively modest US$74,600 for a similar investment in the S&P500. There are also situations where a company without a dual-class structure could have benefited from one. Apple's founding CEO Steve Jobs was forced out of the company he founded in 1985, leading to the decline of the company until his return in 1997. The series of initiatives he initiated in the following years helped make Apple the world's largest company. His original ousting could potentially have been prevented if, as the founder, he had owned “higher voting” shares – as other company founders like Facebook’s Mark Zuckerberg do. Implications for SGX If the US has managed to successfully implement dual-class share listings, should the SGX follow suit? One caveat is that circumstances in the US are different from those in Asia. The exchanges there are more mature and there are more influential and activist investors. In addition, the US has a strong litigious culture, where minority shareholders can sue a company if the controlling shareholders abuse their power or breach their fiduciary duty. Having said that, it may be time the SGX looks at whether dual-class share structures are now workable here, to attract successful companies whose founders are reluctant to cede control. In this region, with the plethora of family firms in South East Asia, it is conceivable that many need capital but are concerned with potentially losing control of their companies. Investors' concerns over potential corporate abuse could be alleviated through a simultaneous improvement of regulatory enforcement, transparency and corporate governance. Even though controlling shareholders have the power to elect directors to the board, the directors still have a duty to safeguard shareholders’ interest. Hence, a possible governance safeguard would be to mandate increased number of independent directors and give them control of the nominating committee, thereby ensuring strong oversight and monitoring of top management. Another suggestion would be to impose extra disclosure requirements on dual-class IPOs – such as higher disclosure standards for related party transactions and executive compensation – to minimise the chance of corrupt activity. As oversight and corporate governance are enhanced, investors' concerns over dual-class listings will be alleviated. After all, the objectives of improving regulatory enforcement, transparency and corporate governance are already a priority for our regulators.
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