The Inequality of Dual Class Shares

Sheba Gumis explains the concepts underlying dual class shares.

Dual class shares have been the talk of investors in recent years with at least two major stock exchanges amending their rules to allow for dual class shares to be listed on their markets and to be more attractive to companies seeking listing.
Yet, dual class shares are relatively unknown to the Malaysian layperson, given that such shares are not allowed to be listed on Bursa Malaysia. Notwithstanding this, the concept of dual class shares has existed since the early 1920s in America.
Dual class shares refer to the issuing of various types of shares by a single company. A dual class share structure can consist of Class A and Class B shares, for example. These classes of shares would possess different traits, which would usually be based on differing voting rights and possibly, economic benefits.
Dual class shares are issued primarily to ensure that a select group of shareholders control the management of the company in excess of their capital contribution to the company while still being able to access the capital market. For example, Class A shares would hold 10 votes each, whereas Class B shares hold 1 vote each. Class A shares would only be issued to certain people, e.g. the founders of the company, whereas Class B shares would be issued to members of the public. By doing so, the Class A shareholders’ votes would outweigh those of the Class B shareholders. The company would still be able to seek funds from the public without the Class A shareholders giving up control of their company.
This structure was previously implemented in family-owned companies, such as the previous Dodge Brothers’ Company, which is credited to be the first listed company in the United States to adopt a dual class share structure, and media companies, such as The New York Times Company. Media companies implemented this structure to protect editorial independence, whereas family-owned companies wanted to ensure that only members of the family controlled the company.
However, the current trend is for technology companies to adopt the dual class share structure, with companies such as Google and Facebook implementing the same. The reason technology companies require such a structure is to ensure that the management has control of the company in order to implement long-term goals of the company. This is more beneficial to the company in the long run as compared to control being placed in the hands of the public shareholders who may have shorter term goals and be interested only in short term profits.
Since its introduction in the 1920s, the number of listed companies in the United States which have adopted the dual class share structure has increased to 701, with 214 being listed in the 10-year period ending in 2015 (Report on Dual Class and Other Entrenching Governance Structures in Public Companies dated 27 February 2018 by the Investor as Owner Subcommittee of the Securities Exchange Commission). These companies range from family-owned companies, conglomerates to technology companies.
Family-owned companies, such as Ford Motor Company, implemented the dual class share structure to retain control of the company within the family. The Fords collectively own less than 2% of the shares in the company, but control 40% of the total voting power.
In the case of The New York Times Company, holders of Class A shares are entitled to elect 30% of the board members whilst the family trust and members of the Sulzberger family, the sole holders of Class B shares, are entitled to elect 70% of the board members.  
Berkshire Hathaway Inc, the renowned conglomerate helmed by investment guru, Warren Buffett, has two classes of shares. Its Class B shares have 1/200th of the votes of its Class A shares.
Social media giant, Facebook, has two classes of shares - Class A shares issued to members of the public, and Class B shares held by Mark Zuckerberg and other insiders of Facebook. The Class B shares carry 10 votes each, whilst the Class A shares carry 1 vote each.
Innovation did not stop at dual class shares. In fact, certain stock exchanges allow companies to issue more than two classes of shares.
Alphabet Inc (Google’s parent company), which is listed on the National Association of Securities Dealers Automated Quotations Exchange (NASDAQ), has issued triple class shares, namely Class A shares (bearing 1 vote each and issued to members of the public), Class B shares (bearing 10 votes each and issued to the company’s management and early investors) and Class C shares (bearing no votes and issued to employees of the company).
Snap Inc’s listing on the New York Stock Exchange (NYSE) was particularly noteworthy. Apart from the fact that it issued triple class shares, the company pushed the envelope further by issuing Class A non-voting shares to the public. Class B shares, which carry 1 vote each, were issued to the management and early investors, whereas Class C shares, which carry 10 votes each, were issued to the company’s co-founders, Evan Spiegel and Bobby Murphy. Control therefore lies only in the hands of Snap Inc’s co-founders, the management and early investors.
The jury is still out on whether the dual class share structure is beneficial. There are compelling arguments on both sides.
The advocates of the dual class share structure argue that the structure ensures that executives are able to focus on long term plans and that the retention of control within a select group of people allows for strong leadership.
It also encourages technology companies and family-owned companies to take the companies public and enjoy funding from the capital markets. It is a win-win situation for small investors who do not have any interest in managing a company, but wish to enjoy the profits of such company.
On a more jurisprudential aspect, proponents of the dual class share structure argue that based on the doctrine of freedom of contract, parties should be free to decide on the terms of their investment, even if it means that the investors do not have equal voting rights in respect of their shares.
There are also valid arguments against the dual class share structure. On a base level, it can be argued that the dual class share structure is undemocratic. It is only fair that if you invest in 50% of the shares of the company, you should control 50% of the management as well. The public investors are given unequal treatment in that they bear the brunt of the economic risk without enjoying management control of the company.
Additionally, the dual class share structure perpetuates control of the company in a small group of investors and may result in complacency and reduce accountability by an entrenched management. If the investors who control the company are capable, the company and the public investors would benefit. However, if they are incompetent, the public investors would not be able to step in to change the direction of the company as they lack the voting power to do so.
This could also lead to a problem in family-controlled companies, which is known as the “idiot heir problem”. Should the shares with control be bequeathed to incompetent heirs, the company will then be managed by incompetent leaders and the public shareholders would not be in a position to oust such heirs. These “idiot heirs” may also be prone to abuse their power in the company.
An interesting development in recent years is the attempt by activist investors in the United States to compel companies having dual class shares, such as Ford Motor Company, to convert their dual class shares into a single class of shares. Although these attempts have been unsuccessful, this development reflects the growing trend of investor activism in the United States.
The NYSE, NASDAQ, the Hong Kong Stock Exchange (HKEX) and the Singapore Stock Exchange (SGX) are among the stock exchanges that allow for the listing of dual or multiple class shares. However, these exchanges acknowledge that such structures need to be regulated for the benefit and protection of investors.
The NYSE and NASDAQ (the latter being the leading listing destination for technology companies) both have uniform rules prohibiting the reduction of voting rights of existing shares and the issuance of a new class of superior voting shares. They also allow listed companies to have more than two classes of shares.
Companies with dual class shares are allowed to list on the HKEX only if they are “innovative companies”. The rationale for dual class shares must be justified. Examples of innovative companies provided in the HKEX’s guidance are as follows: (i) the company’s success is attributable to the application of new technologies, innovations, and/or a new business model, to its core business; (ii) research and development is a significant contributor to the company’s expected value and constitutes a major activity and expense; (iii) the company’s success is attributable to its unique features and/or intellectual property; and/or (iv) the company has an outsized market capitalisation / intangible asset value relative to its tangible asset value.
The HKEX also requires a minimum market capitalisation of HK$40 billion or alternatively, HK$10 billion if the company has achieved a revenue of at least HK$1 billion in its most recent audited financial year. It does not permit the shares with enhanced voting rights to be listed and limits the ratio of such rights to a maximum of 10 times the voting rights attached to ordinary shares. Further, future equity capital raisings must not increase the proportion of shares with enhanced voting rights to ordinary shares.
The HKEX seeks to protect the interests of investors by stipulating that each share (irrespective of class) shall have 1 vote for reserved matters, namely amendments to the constitution, variation of class rights, appointment or removal of independent directors and auditors, and winding-up of the company.
Although the HKEX listing rules do not expressly permit companies to have more than two classes of shares, it appears that multi-class share structures may be permitted on a case-by-case basis.
SGX allows dual class share listing for companies with a minimum market capitalisation of SGD300 million. The enhanced voting rights are capped at 10 votes per share. Similar to the HKEX, SGX also safeguards the interests of investors by ensuring that each share (regardless of class) has 1 vote for specified matters, such as appointment and removal of directors and auditors, variation of rights, reverse takeovers and winding-up or delisting of the company. Additionally, there is a requirement for the multi-vote shares to have sunset clauses, i.e. that they will automatically convert into ordinary shares in circumstances which the company must stipulate at the time of its initial public offering.
Bursa Malaysia has confirmed that there are no current plans to facilitate the listing of dual class shares (The Star, 12 August 2017).
If Bursa Malaysia intends to follow suit in allowing for the listing of dual class shares, numerous amendments would need to be made to its listing requirements. It is likely that the Companies Act 2016 would need to be amended as Section 71(1)(c) stipulates that each share shall have one vote on a poll.
Further, Bursa Malaysia would have to consider whether to introduce measures to protect the interests of the public investors while ensuring that its regulatory regime remains attractive and competitive as compared to those of other stock exchanges.
Dual class share structures seem to be the way forward to attract more listings, notwithstanding the numerous arguments against it. It will be up to the stock exchanges to provide a balanced regulatory regime which is enticing enough for companies to list their dual class share structure on, and at the same time safeguard the interests of the public who intend to invest in the same.