Nonvoting Shares and Efficient Corporate Governance.

• Author: Lund, Dorothy S.

Abstract. A growing number of technology companies, including Google, Zillow, and Snap, have issued stock that does not allow investors to vote on corporate decisions. But there is fundamental disagreement among scholars and investors about whether nonvoting stock is beneficial or harmful. Critics argue that nonvoting shares perpetually insulate corporate insiders from influence and oversight, and therefore increase agency costs. By contrast, proponents contend that nonvoting shares may provide benefits that exceed these agency costs, such as enabling corporate insiders to pursue their long-term vision for the company without interference from outside shareholders.

This Article offers a novel perspective on this debate. It demonstrates an important and previously unrecognized benefit of nonvoting stock: that it can be used to make corporate governance more efficient. This is because nonvoting stock allows companies to divide voting power between informed shareholders who value their voting rights and uninformed, "weakly motivated" shareholders who do not. When this efficient sorting happens, a company will lower its cost of capital by reducing agency and transaction costs. Specifically, informed investors will pay more for voting stock that is not diluted by the votes of uninformed, weakly motivated investors; indeed, a company may even entice informed investors to invest by offering two classes of shares. Likewise, weakly motivated investors will gravitate toward shares that do not require them to incur the costs associated with voting, especially because nonvoting stock tends to trade at a discount relative to voting stock. In other words, the company that issues nonvoting shares for its uninformed shareholders will make itself more valuable.

This insight has several implications for the law. Most importantly, this Article contends that recent proposals to restrict or deter companies from issuing nonvoting shares should be rejected Under certain circumstances, nonvoting stock has beneficial functions, and therefore, restricting its use may impede efficient corporate structuring.

Introduction I. Dual-Class Shares: Cycles of Innovation and Regulation A. A Brief History of the Regulation of Dual-Class Companies B. Recent Calls for Regulation C. Changes to the Investment Landscape II. Nonvoting Shares and Efficient Corporate Governance A. Weakly Motivated Voters and Nonvoting Stock 1. Agency costs 2. Transaction costs 3. Suboptimal voting outcomes B. Nonvoting Shares: Demand-Side Issues C. Nonvoting Shares: Supply-Side Issues III. Implications for the Law A. Misguided Policies B. Possible Restrictions Conclusion Introduction

In March 2017, Snap Inc. became the first company to go public on a U.S. stock exchange offering only nonvoting shares to the public. (1) This structure enabled the company's founders, two billionaire internet entrepreneurs in their twenties, to have perpetual control over the company. (2) Moreover, issuing only nonvoting stock allowed Snap to take advantage of exemptions from certain disclosure obligations under federal securities law. (3) Specifically, the company would not be required to release annual proxy statements to the public that would disclose background information about the directors, including their compensation and any conflicts of interest that could affect their decisionmaking. (4) Why bother when the company's shareholders would never have a say in director elections or other matters typically resolved by a shareholder vote?

The public reaction was swift and hostile. (5) Some, including the company itself, believed that Snap could pay for such a move. (6) And yet, the company encountered little resistance from the market. It priced its initial public offering (IPO) above the marketing range, and closed its first day of trading at a 4496 premium to the IPO price. (7)

The success of Snap's offering, however, rallied opponents of companies that issue different classes of stock with unequal voting rights ("dual-class" companies). The traditional dual-class company offers low-voting stock for public investors to buy, keeping the high-voting shares (which typically have ten times as many votes as the low-voting shares) in the possession of the company's insiders. (8) Opponents of dual-class structures contend that depriving investors of voting rights serves to entrench management and insulate them from the consequences of their inefficient or disloyal decisions. (9) These opponents view the increase in dual-class offerings in the United States as a serious problem for investors. (10)

Accordingly, following Snap's IPO, the Council of Institutional Investors (CII)--an investor advocacy group that believes "no-vote shares have no place in public companies" (11)--ramped up lobbying efforts, contending that U.S. stock indices and exchanges should bar companies that offer nonvoting shares to the public. (12) CII has also targeted companies contemplating public offerings with multiple classes of stock. (13) Large institutional investors likewise have lobbied the SEC to ban nonvoting shares. (14) These efforts have caught the attention of the SEC's Investor Advisory Committee, which held a meeting on dual-class stock shortly after Snap's offering. (15)

This public opposition has also begun to influence stock index policy. In June 2017, FTSE Russell announced that it would not add Snap or other companies with nonvoting shares to its major U.S. stock benchmarks. (16) Soon after, S&P Dow Jones Indices stated that it would exclude companies that issue multiple classes of shares from a number of its indices. (17) These decisions dealt a major blow to Snap and will provide a powerful deterrent to other companies planning to issue nonvoting stock in their public offerings. This is because index funds, which make up a significant percentage of the demand for equity shares, (18) will generally not buy stock that is not included on an index. (19) As such, these policy changes impose a high financial penalty on dual-class companies (20) that will likely deter companies from utilizing such a structure in the future.

Hostility to dual-class companies is not new. Indeed, academics and regulators have debated whether to restrict or otherwise regulate the use of dual-class structures for at least a century. (21) Yet even after so many years, the arguments on both sides remain the same. Critics of dual-class structures argue that issuing nonvoting or low-voting shares increases agency costs and results in suboptimal decisionmaking. (22) This is because corporate insiders can retain voting control even if their equity stake falls below fifty percent. (23) Because of the wedge between financial interest and control, the insiders' incentives to slack or otherwise misbehave are heightened, while outside investors, who bear the brunt of the risk, have limited options for exercising influence. (24) A newer version of this critique emphasizes that dual-class structures allow the insiders to maintain control in perpetuity, even after it becomes clear that the structure is no longer efficient. (25)

By contrast, proponents of dual-class structures have consistently claimed that nonvoting and low-voting stock have valuable uses. (26) Most importantly, they contend that dual-class structures allow those who control the company--whether it be the family in a family-owned business or the visionary founders of a successful technology company--to retain control without having to bear excessive risk. (27) Although dual-class structures may lead to increased agency costs--investors have to monitor management more closely and have limited recourse when problems emerge--the benefits of encouraging controlled companies to access capital markets, and of protecting them from the influence of shareholders with short-term interests, exceed the costs. (28) Moreover, these proponents claim that pressure from capital markets will discourage founders from using dual-class structures when the costs of doing so exceed the benefits. (29)

This Article posits that these arguments for and against dual-class structures ignore the fact that the world has changed dramatically in the past fifty years. Beginning in the 1970s, the shareholder base of U.S. public companies has consolidated in the hands of large institutional investors. (30) And in this new world of concentrated institutional investor ownership, nonvoting stock has a previously unrecognized but valuable function. Specifically, corporate issuance of nonvoting shares need not increase agency costs in all cases, but can actually reduce agency and transaction costs by transferring power between outside investors. Although Snap's IPO was not structured in this way, other companies--including Google (now Alphabet (31))--offer both nonvoting and voting classes of stock to the public. (32) And under certain conditions, a company that offers both nonvoting and voting stock to the public can lower its cost of capital--not because the structure protects the founding group from interference, but because it reduces inefficiencies associated with voting.

Not all shareholders value their votes equally. Some, including retail shareholders, value their votes so little that they rarely exercise them. (33) Others, such as hedge fund activists, accumulate shares with the purpose of using their voting power to agitate for changes that would increase the value of their investments. (34) When all shareholders hold voting stock, rationally apathetic investors must either incur the costs associated with voting or let their rights go unused, diluting the influence of other investors' votes. (35) In a better world, shareholders who do not value their votes could sell them to shareholders who do. So long as wealthy shareholders are not able to dominate elections to pursue idiosyncratic interests, the implementation of voting markets should lead to better electoral outcomes for the company...