Featured Expert Contributor, Corporate Governance/Securities Law
Stephen M. Bainbridge, William D. Warren Distinguished Professor of Law, UCLA School of Law.
Newly confirmed SEC Commissioner Robert J. Jackson, Jr., gave his inaugural speech at Berkeley on February 15, 2018. In it, he criticized—in an admittedly nuanced way—the growing phenomenon of dual class stock. As he explained, most U.S. public corporations have a single class of common stock in which all shares have one vote per share. In recent years, however, some companies—especially in the tech sector—have gone public with a so-called dual class capital structure, which typically has two classes of common stock.
One class will have the traditional one vote per share, but the other will have multiple votes—usually 10—per share. The former shares are the ones sold to the public in the IPO, while insiders hold the super-voting shares. Facebook is a paradigmatic example: Mark Zuckerberg’s super-voting shares represent only 16% of the company’s equity but give him 60% of the total voting power.
Commissioner Jackson acknowledged that there has been a longstanding debate over dual class stock and, moreover, that such capital structures can sometimes be justified:
On one hand, you have visionary founders who want to retain control while gaining access to our public markets. On the other, you have a structure that undermines accountability: management can outvote ordinary investors on virtually anything.
There is reason to think that, at least for a defined period of time early in a company’s life, dual-class can be beneficial. The structure can allow entrepreneurs to build for the long term—and even transform entire industries—without being subject to short-term pressure. When many managers are at the mercy of daily stock-market pressure, dual-class can help America’s most innovative companies create the sustainable long-term value we need to grow our economy.
But Commissioner Jackson argues that permanent dual class capital structures, in which the insiders’ super-voting stock can be inherited by their children is problematic. It contributes to wealth inequality and creates a virtual hereditary corporate aristocracy:
So perpetual dual-class ownership—forever shares—don’t just ask investors to trust a visionary founder. It asks them to trust that founder’s kids. And their kids’ kids. And their grandkid’s kids. (Some of whom may, or may not, be visionaries.) It raises the prospect that control over our public companies, and ultimately of Main Street’s retirement savings, will be forever held by a small, elite group of corporate insiders—who will pass that power down to their heirs.
Commissioner Jackson raises a legitimate concern, but it’s also a concern over which his agency has no legitimate authority.
Back in the 1990s, the SEC tried to regulate dual class stock via the back door. Using its power under Securities Exchange Act of 1934 § 19(c), which authorizes the Commission to adopt, repeal, or modify stock exchange listing standards,1 the Commission adopted Rule 19c-4, which created new listing standards essentially banning dual class stock. In Business Roundtable v. SEC,2 however, the D.C. Circuit struck down Rule 19c-4 as being beyond the scope of the SEC’s authority.
The court held that the Commission has no authority to regulate general corporate governance and that the Commission’s authority to regulate proxies did not create an exception to that rule with respect to shareholder voting rights. Instead, the SEC’s authority over shareholder voting is limited to disclosure and process; the SEC has no authority over the substance of shareholder voting, including the number of votes shares can possess. The substance of shareholder voting thus is solely and exclusively a matter for state corporate law.3
After Rule 19c-4 was struck down, the stock exchanges—purportedly voluntarily—adopted new listing standards governing the use of dual class stock. Those standards permitted listing of stock of a company that had a dual class capital structure in place when they conducted their IPO, but did not allow existing public companies to recapitalize to create a dual class structure.4
The stock exchange listing standards make sense. Although insiders are fiduciaries charged with protecting the shareholders’ interests, dual class stock gives them voting control and thus eliminates both proxy contests and hostile takeovers as potential accountability constraints on them. The insiders’ temptation to therefore act in their own self-interest is obvious.
While the insiders’ conflict of interest may justify some restrictions on some disparate voting rights plans, it hardly justifies a sweeping prohibition of dual class stock. First, not all such plans involve a conflict of interest. Dual class IPOs are the clearest case. Public investors who don’t want lesser voting rights stock simply won’t buy it. Those who are willing to purchase it presumably will be compensated by a lower per share price than full voting rights stock would command and/or by a higher dividend rate.
In any event, assuming full disclosure, they become shareholders knowing that they will have lower voting rights than the insiders and having accepted as adequate whatever trade-off is offered by the firm in recompense. In effect, management’s conflict of interest is thus constrained by a form of market review.
It is for this reason that Commissioner Jackson’s argument is unpersuasive. Yes, perpetual dual class capital structures ask investors to trust both the insiders and their kids. By buying the lesser voting rights shares in a dual class IPO, however, investors are effectively stating that they do trust the insiders and their kids. Or, at least, that they accept the tradeoff between the price they’re paying for the shares and the reduction in accountability.
Even if that were not the case, however, how would Commissioner Jackson propose to regulate perpetual dual class stock? He quite properly expresses concern about the recent actions by FTSE Russell, S&P Dow, and MSCI to exclude dual class stock companies from their market indices:
[M]iddle class investors often own stock in American public companies through an index. … If we ban all dual-class companies from our major indices, Main Street investors may lose out on the chance to be a part of the growth of our most innovative companies. The next Google or the next Facebook will deliver spectacular returns, but average Americans will, quite literally, not be invested in their growth.
Conversely, Commissioner Jackson nowhere proposes formal SEC action, presumably recognizing the Commission’s lack of authority in this area.
Instead, the Commissioner wants the stock exchanges to “consider proposed listing standards addressing the use of perpetual dual-class stock.” As we have seen, the stock exchanges previously intervened in this area when Rule 19c-4 was struck down. In doing so, however, they were not really acting voluntarily. Instead, the exchanges knuckled under to what the late securities law professor Donald Schwartz colorfully referred to as the SEC’s “raised eyebrow” power.5
The stock exchanges routinely need SEC approval and cooperation as a basic part of their business operations. They need to keep the cop on their beat happy. If that cop informally tells them to jump, they jump. Accordingly, as the D.C. Circuit noted in Business Roundtable, “[t]he Commission has on occasion … given hints that eventuated in the exchanges’ proposing a change, a practice viewed by one observer as ‘regulation by raised eyebrow.’”6
The SEC’s use of its raised eyebrow power following its loss in Business Roundtable was a troubling abuse of regulatory power:
Rather than obeying the law applicable to it, the Commission chose to end-run Business Roundtable by pressuring the exchanges to adopt ‘voluntary’ listing standards modeled on Rule 19c-4. In doing so, the SEC also did an end-run around both Congress and the Supreme Court to create uniform, national corporate governance standards. As Business Roundtable confirmed, the SEC lacked authority to directly regulate dual class stock. Suspecting that the front door was locked, the Commission tried using Rule 19c-4 to sneak federal regulation through the back door. In Business Roundtable, however, the court squarely barred the Commission from doing indirectly what it could not do directly. Finding the back door to be locked as well, the SEC therefore sneaked through the cellar window. In doing so, it ran rough-shod over the clear Congressional intent that the SEC was not to regulate corporate governance generally or the substance of shareholder voting rights in particular.7
The SEC was wrong to use its raised eyebrow power back in 1994. It would be equally wrong to do so now.
- The term “stock exchange” is used here broadly to include NASDAQ.
- Business Roundtable v. SEC, 905 F.2d 406 (D.C. 1990).
- See Stephen M. Bainbridge, Comments to the Securities and Exchange Commission on No. 4-537: The Scope of the SEC’s Authority Over Shareholder Voting Rights (May 7, 2007).
- Stephen M. Bainbridge, “Revisiting the One-Share/One-Vote Controversy: The Exchanges’ Uniform Voting Rights Policy,” 22 Sec. Reg. L.J. 175 (1994).
- See Donald E. Schwartz, “Federalism and Corporate Governance,” 45 Ohio St. L.J. 545, 571 (1984).
- Business Roundtable, 905 F.2d at 410 n.5 (citing Professor Schwartz’s article). As Professor Scott explains: The marketplaces have complex and multilayered relationships with the SEC. Even in areas where the SEC has no direct authority, like the promulgation of corporate governance rules, it is risky for a marketplace to resist strong SEC suggestions. The marketplaces usually have several issues pending for the SEC at any one time, including a variety of listing proposals, trading rule changes, and disciplinary matters. While there is no overt ‘linking’ of issues by the SEC, a marketplace is not likely to take a strong position in opposition to the SEC’s ‘raised eyebrow,’ particularly when the SEC is exerting similar pressure on all the marketplaces. Helen S. Scott, “The SEC, the Audit Committee Rules, and the Marketplaces: Corporate Governance and the Future,” 79 Wash. U. L.Q. 549, 555 (2001).
- Bainbridge, supra note 3, at 9 n.28.