You can't sell your firm and own it too: disallowing dual-class stock companies from listing on the securities exchanges.

• Author: Wen, Tian

INTRODUCTION I. WHY DUAL-CLASS STOCK IS DETRIMENTAL to Shareholders A. Dual-Class Stock Companies Have Inadequate Checks on Management B. Dual-Class Stock Structures Facilitate Managerial Entrenchment C. Dual-Class Stock Companies Do Not Benefit from Institutional Investor Monitoring D. Pricing of Dual--Class Stock E. Companies Are Turning to the United States for Its Soft Regulation F. Dual-Class Stock Structures Are Unnecessary G. Dual-Class Stock Companies Have Continued to Decouple Voting and Economic Power II. UNIFICATIONS AND ACQUISITIONS A. Unifications B. Mergers and Acquisitions III. CHANGE REQUIRES CONGRESSIONAL ACTION CONCLUSION INTRODUCTION

In 2004, Google's initial public offering (IPO) revealed that the company would go public with a dual-class capitalization structure. (1) A dual-class stock company has a capital structure whereby insiders hold common stock with multiple votes per share (typically ten), while the public holds common stock with just one vote per share. (2) This structure was popular in the 1980s as a defensive measure to ensure that a company was protected against hostile takeovers, management would adopt and keep high vote share classes. (3) The NASDAQ Stock Market (NASDAQ) and NYSE MKT LLC (4) have consistently allowed corporations with such structures to list on their exchanges, (5) while the New York Stock Exchange (NYSE) has had different rules over time. (6) In 1988, the Securities and Exchange Commission (SEC) came into the picture and attempted to regulate companies with dual-class stock (and other structures with shareholder voting restrictions) by prohibiting such companies from listing on the stock exchange. (7) However, the Court of Appeals for the District of Columbia subsequently vacated this SEC rule. (8) Today, corporations can list on the NYSE, NASDAQ, or AMEX as long as the dual-class structure was in place at the time of the initial public offering. (9)

Since Google's 2004 IPO, an increasing number of companies have begun to go public with similar capitalization structures. (10) In light of dual-class stock's resurgence, Congress and the stock exchanges should revisit the use of such capitalization structures in the United States. In this Comment, I argue that decoupling voting rights from economic ownership is detrimental to shareholders because it allows companies to avoid the threat of market mechanisms that have traditionally served to keep management in check. In the long term, this decoupling is incompatible with principles of corporate governance, and thus stock exchanges should reevaluate their policy of accepting companies with dual-class stock structures. Part I discusses how the dual-class structure allows management to entrench itself and effectively prevent shareholders from exercising any sort of control over a company they technically own. Part II explains how dual-class stock companies have led to both stock unifications that are detrimental to the general public and controllers extracting benefits for themselves in acquisitions. Finally, Part III discusses how such reforms can be achieved.

1. WHY DUAL-CLASS STOCK IS DETRIMENTAL TO SHAREHOLDERS

   While there are legitimate reasons why dual-class stock can be beneficial for a company and its shareholders, on balance, such structures are undesirable. Management should not be able to enjoy the benefits of controlling a public company while ignoring the voice of its shareholders.

   1. Dual-Class Stock Companies Have Inadequate Checks on Management

      One of the strongest arguments in support of the dual-class structure is that management can more easily set long-term goals and innovate. (11) The structure allows "founding entrepreneurs or family members access to the equity markets without diluting control." (12) For example, at the time Google went public, holders of Class A stock--public shareholders--were entitled to one vote per share; (13) holders of Class B stock--Executive Chairman Eric Schmidt and founders Larry Page and Sergey Brin--were entitled to ten votes per share. (14) This meant that, while the Class B stock comprised only 31.3% of total shares outstanding, Google executives--Schmidt, Page, and Brin--collectively held 66.2% of shareholders' total voting power. (15) While dual-class proponents may argue that such figures have little effect on governance as long as the company has "terrific management, an engaged board of directors, and a strong governance culture," (16) this imbalance in voting rights between management and public shareholders eliminates the market checks on managerial misconduct on which shareholders of single-class companies rely.

      One of the primary focuses of corporate governance is to monitor possible mismanagement or self-dealing by those in control of the corporation. (17) However, because publicly traded corporations are owned by a large number of widely dispersed shareholders, there is no single shareholder to monitor the corporation. In their oft-cited work, Berle and Means identified this phenomenon as the "[separation of ownership and control." (18) This collective action problem has led to the traditional conception of corporate governance, whereby the shareholders' role is to elect the board of directors, which in turn performs the monitoring function and selects the officers (e.g., CEOs and CFOs) who run the corporation. (19)

      In a company with dual-class stock, however, the mechanism for board oversight does not function as it should because the CEO--the largest shareholder--effectively selects the board. (20) If directors can be fired by a single person or family, they will be impeded from exercising the fiduciary duties that they owe to all shareholders. (21) For example, when Google recently approved the issuance of nonvoting stock that further concentrated control in the hands of its founders, the board of directors unanimously approved the measure. (22) Even though the directors met sixteen times to deliberate, "[t]he only likely alternative to voting 'yes' would have been to resign and explain why [they] voted 'no.' Or they most likely would not have found their names on the board nomination list next year." (23) When the top directors and the largest shareholders are one and the same, it is unrealistic to expect the board dutifully to make decisions that are beneficial to shareholders as a whole.

      Furthermore, when voting rights are not proportional to the economic interests of the shareholders, controllers can easily obtain private benefits while imposing disproportionate costs on the broader shareholder base. (24) However, shareholders are not the only ones disproportionately affected--when these structures lead to less board accountability, the monitoring function of boards will be transferred to third parties (e.g., the courts, the regulators, and the government), and the public will be forced to bear these costs. (25) For example, Reader's Digest Association (RDA) had a dual-class structure that was controlled by two not-for-profit philanthropic foundations created by its founders. (26) These not-for-profits, driven by a need to fund their own projects, pushed the company toward a policy that eventually led RDA to issue dividends in excess of cash flows. (27) Michael Geltzeiler, who served as the company's CFO at the time, noted that the interests of the controlling shareholders were not aligned with those of the other shareholders. (28) While investors generally want the board to determine what is in the best interest of all shareholders in order to create the most long-term value, "[t]hat can become more difficult in a dual-class structure if one party views the firm not as the public's company but as their business, one that they own." (29)

      To further exacerbate the problem of inadequate checks on management, dual-class companies that fall under the definition of a "controlled company" do not have to comply with NYSE governance rules 303A.01, 303A.04, and 303A.05. (30) Rule 303A.01 requires listed companies to have a majority of independent directors on the board, (31) Rule 303A.04 requires listed companies to have nominating and corporate governance committees composed entirely of independent directors, (32) and Rule 303A.05 requires listed companies to have a compensation committee composed entirely of independent directors. (33) Independent directors, a particular focus of corporate-governance reforms post-Enron, ensure that corporate officers do not abuse their authority or shirk their responsibilities. (34) At least in theory, directors' independence prevents managers from engaging in self-dealing and allows them to objectively oversee managerial decisionmaking. (35) While the exchanges were required to adopt such rules in accordance with the Sarbanes-Oxley Act, (36) companies are exempt from these requirements as long as they qualify as a controlled company--"[a] listed company of which more than 50% of the voting power for the election of directors is held by an individual, a group or another company." (37) Therefore, even if managers in dual-class stock companies do not have more than a fifty-percent economic interest in the company, by virtue of their voting power, they are entitled to do away with these shareholder safeguards.

   2. Dual-Class Stock Structures Facilitate Managerial Entrenchment

      In addition to weakening market mechanisms for management oversight, the dual-class stock structure can also be used to facilitate managerial entrenchment. (38) As Vice Chancellor Noble explains, even though the two structures may seem similar, a company with dual-class stock is different from a company with a large majority shareholder because at least the large shareholder in a single-class company holds a proportionate economic interest. (39) Having a proportionate economic interest is desirable because a market-oriented approach is the optimal way to lower agency costs. (40) For example, if the Efficient Capital Markets Hypothesis...