Dual-Class Shares: The Good, The Bad, and The Ugly
ESG, Regulation, Market Integrity, Regulatory changes, Investor Education
Country or region:
Asia Pacific (Overall)
A Review of the Debate Surrounding Dual-Class Shares and Their Emergence in Asia Pacific
The existence of dual-class shares (DCS) has generated much debate for over a century. Sometimes known as shares with weighted voting rights or unequal voting rights, DCS structures provide owners of certain share classes with superior voting rights, giving them voting control over a company that is disproportionate to their equity shareholding. DCS structures are most common in founder-led companies where:
■ the founders are perceived to be instrumental in the success of the company;
■ to be able to fund rapid growth, the company has had to raise a significant amount of funding before an initial public offering (IPO); and
■ the founders are averse to a change in control and thus use such structures as a poison pill, or defense mechanism.
In these situations, granting the founders super voting rights allows them to maintain control while giving investors an opportunity to participate in the company’s growth.
Although DCS structures are not new—having first came into existence in the late 19th century—such structures have become increasingly commonplace in recent times on the back of a wave of high-profile IPOs of technology companies, such as Google LLC (now Alphabet Inc., 2004), LinkedIn Corporation (2011), Facebook, Inc. (2012), Alibaba Group Holding Limited (2014), and Snap Inc. (2017). According to Ritter (2017), in the five years between 2006 and 2010, there were a
total of 46 DCS IPOs in the United States. In the following five years (2011–2015), the number rose to 104. The popularity of DCS IPOs has renewed the debate on how these structures affect corporate governance and investor protection.
Proponents like DCS because they protect the founding shareholders and beneficiaries of super voting rights from the vagaries of the stock market. Their voting power ensures them absolute control, giving them the opportunity to carry out their vision and invest in the long term for the benefit of all shareholders.
Another argument for supporting DCS is that many entrepreneurs would simply choose not to take their companies public if they could not retain control; this would deprive investors of opportunities to invest in growth companies.
The very reasons that make many DCS companies widely admired are also the same reasons critics use to argue against DCS. Safe from the disciplinary forces of the market, founding shareholders never have to worry about losing their jobs––their voting control sees to that. If they are fitting leaders, all may be well and good. However, if they mismanage the company or make bad decisions, unaffiliated shareholders are powerless to do anything about it. Their only remedy is to sell their shares in a disillusioned market. In addition, given the low equity shareholding these founders typically have, bad decisions proportionally affect them much less. The gap between high voting power and low equity shareholding is often referred to as the “wedge”, and the larger the wedge, the more serious the distortions become.
DCS have a much longer history in Western countries; they are much less prevalent in the Asia-Pacific region (APAC), although this is rapidly changing. As recently as a few years ago, Singapore and Hong Kong, two of the leading financial centers in the region, rejected listings of companies with DCS structures and stood by the one-share, one-vote principle. However, such rejections did not put the DCS argument to bed, and the debate intensified in subsequent years. Both Singapore and Hong Kong are keen to attract IPOs from companies in high-technology, innovative sectors, and founders of such firms have strong preferences for DCS structures. The quest for these IPOs became more urgent as global stock markets reached new highs, propelled by soaring prices of technology stocks (in particular, those listed on the US stock markets).
For Singapore, losing out on Manchester United PLC’s IPO in 2012 prompted the government to undertake a comprehensive review of the country’s Companies Act. This review made a number of recommendations, including an amendment to the Companies Act to allow for DCS companies. Subsequent endorsement by Singapore’s parliament in 2014 paved the way for IPOs of companies with DCS structures.
In Hong Kong SAR, Charles Li, the Chief Executive of the Hong Kong Exchanges and Clearing Limited (HKEX), the owner of the Stock Exchange of Hong Kong (SEHK), admitted that the IPO of Alibaba on the New York Stock Exchange (NYSE) in 2014 made HKEX reconsider its stance to DCS IPOs. HKEX’s first attempt to introduce DCS IPOs in 2014 was unsuccessful. Its second attempt, which began in 2017, proved far more fruitful. The new administration of the Hong Kong Special Administrative Region, led by Chief Executive Carrie Lam and Financial Secretary Paul Chan, voiced their belief that landing DCS IPOs would strengthen Hong Kong’s position as a leading international financial center.
Not unexpectedly, given this background, both HKEX and Singapore Exchange (SGX) amended their listing rules in the first half of 2018 to allow DCS IPOs. A pipeline of DCS IPOs is already in the works, and Xiaomi Corporation, the world’s fourth-largest smartphone maker by shipment, became the first DCS IPO in Hong Kong with a value of US$54 billion. Reportedly, companies from various markets have asked for more information about the revised listing regime, indicating their interests in listing with DCS structures.
Despite these recent developments, CFA Institute remains firm in the belief that “one-share, one-vote” remains the fairest and most optimal market practice. We are concerned that allowing DCS structures will lead to an erosion of corporate governance standards and are worried that we are witnessing the start of a race to the bottom. Unfortunately, given the number of commercial, for-profit stock exchanges in APAC, this trend is unlikely to stop at the Hong Kong and Singapore exchanges. Under this scenario, we ask three questions:
■ What are the safeguards that investors can most rely on?
■ What are the lessons learned that are most applicable for investors, standard setters, and regulators in APAC?
■ Who should investors look to for investor protection?
To answer these questions, we have (1) assessed developments in other markets (notably the United States), (2) conducted a range of literature review on the subject, and (3) interviewed a number of practitioners from different parts of the industry. We also conducted a survey in March 2018 to gauge the views of our members on the introduction of DCS and the necessary safeguards in APAC (CFA APAC Survey). Details of the survey are in Appendix A; we will refer to the CFA APAC Survey throughout this report.
Many exchanges and regulators in the region are watching developments in the Hong Kong and Singapore markets closely and may be deliberating whether to follow suit. As DCS companies become more widespread in APAC, we believe that investors need to become more familiar with such structures, the common safeguards that are being offered, and the limitations of such safeguards. Our study will be a useful point of reference for their policy development.
In Chapter 2, we review the debate for and against DCS as well as look at the performance of DCS companies with the passage of time and examine the implications for policymakers. Chapter 3 focuses on the historic development of DCS in the United States––the rise and fall of the DCS structure in the United States holds interesting lessons for us all. A review of regional APAC developments is found in Chapter 4, followed by an assessment of common safeguards in Chapter 5. Some case studies that illustrate how DCS companies have hurt investors are covered in Chapter 6. In Chapter 7, we conclude by providing recommendations to improve investor protection in the face of the increasing prevalence of DCS companies.
Summary of Findings
From the history of DCS usage in the United States, we learned the following:
■ The current boom in DCS listings has very similar hallmarks as the previous high watermarks in DCS listings in the United States during the 1920s and 1980s, including increased liquidity and outsized optimism.
■ The booms in the 1920s and 1980s were each followed by a prolonged period of market turmoil.
■ The rise and fall (and rise again) of DCS listings in the United States shows that the present situation is neither inevitable nor unique, and that there are many more options than a wholesale adoption of DCS structures.
■ For stock exchanges contemplating joining the fray, it is perhaps appropriate to reflect on their own unique selling propositions. If and when there is a level playing field in rules, and issuers cannot arbitrage between exchanges, what are the factors that would make one stock exchange more attractive than another?
From the handful of case studies, we learned the following:
■ For family businesses with a DCS structure, it is much easier for major shareholders to abuse their position and take advantage of public shareholders, either through massive executive compensation packages or questionable consultancy arrangements.
■ Major shareholders are not incentivized to maximize the company’s potential—after all, given their low equity ownership, few benefits would accrue to them.
■ A company may have an excellent track record, but there is no assurance that such outperformance will continue indefinitely. When things go wrong, public shareholders of listed DCS companies have little influence—without a vote, they cannot provide oversight of boards or management. As the Financial Times said, “Shareholder democracy is a burden to companies that are well-run. But for shareholders, this is akin to the burden of carrying an umbrella. When it begins to rain … the cost can suddenly seem like one worth paying.”
■ Time is not on our side. Perpetual super voting rights that are transferrable store up trouble for the future.
We have considered a range of safeguards and examined their effectiveness in relation to investor protection. Our recommendations are as follows:
■ Mandatory time-based sunset: We have been urging exchanges that have DCS structures in place to consider mandating time-based sunset provisions, which means super voting rights will automatically convert to regular voting rights on a “one-share, one-vote” basis after a period agreed upon between management and investors.
In our view, the single most important safeguard is a mandatory time-based sunset of not more than five years. On the one hand, this safeguard provides enough time for founding shareholders to execute their strategy and create value without undue worries of market vagaries; on the other hand, it protects public shareholders from entrenchment.
▲ We note that five years is the absolute maximum time period, especially because issuers now come to the market at a much later point in their life cycle and are already large, established companies by the time they list on an exchange.
▲ We believe the time-based sunset provision should be a “hard stop” for clarity and certainty.
▲ Corporate and evergreen entities should not be allowed to benefit from super voting rights without a mandatory time-based sunset provision.
■ Event-based sunset: Super voting rights attached to beneficiaries’ shareholdings should lapse if such beneficiaries:
▲ are no longer directors of relevant companies; or
▲ die or are incapacitated; or
▲ transfer their shares to another person.
■ We believe the event-based sunset provision should be a “hard stop” for clarity and certainty.
We believe the following safeguards are also important when enacted as a “package” together:
■ Implement enhanced corporate governance measures.
■ Limit the maximum voting differential (to below 10 votes per share).
■ Revert to a one-share, one-vote system on related party transactions and large transactions.
Enhancing Investor Awareness
We cannot rely on market forces alone for investor protection. Rather, stakeholders must play an important role in protecting themselves:
■ Investors need to perform thorough due diligence.
■ Exchanges need to balance the tension between business development and upholding a high corporate governance standard.
■ Regulators need to ensure effective monitoring and enforcement.
■ The courts in the United States have taken on significant responsibilities in upholding investor rights. However, even in jurisdictions where courts have a history of stepping in and intervening, it can take years for cases to be resolved.
In APAC, legal action against rogue companies or management is not an avenue available to most investors. In markets where direct retail participation is significant, not only does the caveat emptor (i.e., buyer beware) argument offer scant comfort to investors, in times when many investors feel taken advantage of, they inevitably turn to governments and regulators for assistance, which is seldom forthcoming.
Our recommendations, therefore, are as follows:
■ Exchanges and regulators should coordinate their efforts and invest in investor education and awareness.
■ In jurisdictions where class and derivative actions are unavailable or uncommon, governments and regulators should establish a mechanism to enable small investors to
■ Regulators must intervene in a timely manner when investors are taken advantage of or harmed.
DCS structures are a relatively new development in APAC. CFA Institute will continue to remain watchful of market developments and work with stakeholders to raise investor awareness. We will continue to engage with regulators and stock exchanges going forward.
This publication qualifies for 2.0 CE credits under the guidelines of the CFA Institute Continuing Education Program.
We encourage CFA Institute members to login to the CE tracking tool to self-document these credits.
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