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Editorial

Dual-class debate demands scrutiny

The recent initial public offering of Lyft Inc. with dual classes of shares has reignited a debate about whether companies should be allowed such corporate structures when they go public.

Institutional investors will play a major role in determining the outcome of the debate. Some activists have argued dual-class share offerings should be banned because they violate the basic concept of taking companies public — that those who provide capital should have a say in how the companies are run.

Others have suggested that dual-class share structures should be allowed but time limited. After a predetermined number of years, companies should be required to eliminate the more powerful share class.

Yet others have argued that the market should decide. If investors feel disadvantaged by dual-share structures, they will avoid stocks with such structures and that will be reflected in the share prices. At some point that would prompt an end to the dual-share structure.

Some have asked what the fuss is about. Dual-share structures have existed at least since 1925 when the auto manufacturer Dodge Brothers Inc., then owned by Dillon, Read & Co., issued non-voting stock, giving the owners total control. Investors bought the stock even without voting rights.

Many other companies, particularly family-owned firms, have used dual-class share structures since then without causing significant outrage. Even now, many investors do not appear to be deterred from investing in companies where they will have no say in management decisions as there is little difference in the prices of voting stock and non-voting stock at many firms.

For example, Alphabet Inc.'s Class C stock, which carries no voting rights, is priced little differently from Alphabet Class B stock that carries voting rights. Perhaps that's because many investors do not feel they have significant influence over board or management decisions even when they have voting shares.

As the authors of one study of dual-share structures wrote in the Harvard Business Review: "Investors' continued clamor for inferior-voting shares, even those with zero voting rights, suggests there must be some economic reason for their existence."

Some academic studies have found lower stock returns for dual-class firms compared with single-class firms, lower trading prices compared to fundamentals, higher management entrenchment and executive compensation, and value-destroying acquisitions. Other studies have found that dual-share structure appears to be optimal in certain cases. A recent analysis by MSCI Inc. found that unequal voting stocks outperformed the market over the November 2007 to August 2017 period.

The recent furor over dual-class stock seems to be related to their use by technology-related companies. Almost 50% of recent technology IPOs used dual-class stocks, according to the Harvard Business Review study.

The authors noted that the "growing popularity (of dual-class stock) is due to the increasing importance of intangible investments, the rise of activist investors, and the decline of other protection mechanisms available to existing management such as staggered boards and poison pills."

The Investor Stewardship Group, whose members oversee $22 trillion in assets, has demanded total elimination of dual-class stock. The Council of Institutional Investors, which represents funds with $25 trillion in assets, has proposed limiting how long a company can keep a dual-class structure to seven years.

The authors of the Harvard study concluded that a ban on dual-class shares would encourage technology companies to remain private or motivate listed tech companies to go private, "eliminating common investors' chance to buy even inferior voting stock."

The authors also had reservations about a sunset clause because of the difficulty of determining an ideal fixed termination period. They found the age at which growth companies become mature has been declining, depending on technology and business models.

They propose instead that companies with dual-class structures be required, after a period of years, to gain approval to maintain that structure from a majority of shareholders.

Activist investors seem to be driving the move to end dual-class structures, but other institutional investors should thoroughly investigate the implications of the various options before lending their support.

Is the perceived unfairness of dual-class stock significant enough to cause market disruption and risk unintended consequences by taking action to ban or limit them?