INVESTORS FLOCK BACK TO DUAL CLASS

‘A campaign to rehabilitate them’

Dual class shares are a bit like that mystery sauce you get at Swiss Chalet. Some might profess not to like it, yet they keep dunking their chicken in it.

Swiss Chalet’s parent company, Cara Operations Ltd., last month went public in one of the most successful initial public offerings in recent memory. Investors gobbled up stock, with shares jumping 40 per cent on the first day of trading.

The dual share structure of the deal clearly wasn’t a concern. Investors bought about 10 million subordinate voting shares, in which one share gets one vote. Members of the Phelan family, which founded the restaurant chain, and Cara backer Fairfax Financial Holdings Ltd. acquired 37.4 million multiple voting shares, which grant 25 votes per share.

Cara is just the latest example. Ottawa-tech darling Shopify Inc. has filed papers for a $100-million IPO in Toronto and New York in which the public will be offered Class A shares that come with one vote per share, while company founders and insiders will receive Class B shares, which come with 10 votes a share.

These names add to a growing list. Google Inc., Facebook Inc., Groupon Inc. — all came to market with dual class shares, and they’ve succeeded in the face of long-standing opposition on the part of corporate democracy advocates for whom dual-class shares are a no-no. Governance gurus be damned, investors like them.

“Part of the reason dualclass shares survive is that people are prepared to invest in them,” says Carol Hansell, founder and senior partner of Hansell LLP, a legal boutique that specializes in corporate governance.

“If investors don’t like dualclass shares, don’t buy them.”

Some former opponents have changed their minds on dual-class shares. David Beatty, the Conway chair at the Clarkson Centre for Business Ethics and Board Effectiveness at the University of Toronto’s Rotman School of Management, was once a vocal critic. He now believes they might be an effective response to another menace — the short-term thinking that leads public companies to react an plan quarter-toquarter, rather than for the long term.

“I’ve rehabilitated them in my own mind, and I’m on a campaign to rehabilitate them in the minds of investors and the public at large,” Beatty says. “You don’t invest in your kid for the next quarter, right? You invest in your children for the mid to long term.”

Controlled-corporations — those in which founders or insiders have a minority of the equity but use dualclass shares to keep a majority of the votes — perform well. Beatty says a recent Clarkson Centre study found that Canada’s 23 largest publicly traded but family-controlled firms outperformed their peers on the TSX Index over the past 20 years.

California’s surging tech industry is behind much of this new-found love for dual-class shares. Tech entrepreneurs who take their companies public want to focus on building up their business, not dust-ups with activists seeking short-term gains on stock prices.

“Tech companies adopt them so as to preserve control over long-term strategy and founder vision,” says Emmanuel Pressman, co-chair of the corporate department at Osler, Hoskin & Harcourt LLP in Toronto.

“There’s a historical understanding in the United States which says that the financial system rewards innovation and founders,” adds Scott Fisher, a U.S. lawyer and a partner in the New York office of Davies Wa rd Phillips & Vineberg LLP. “The reason you’re seeing more of these dual-class companies, and this is the critical point, is that companies are paying more attention to activist investors that are out there.”

And sometimes, investors just want a piece of the action. If a difference in voting rights is arguably abusive, some investors see that as part of the deal.

“Little people like us want to eat at the big kid’s table,” Hansell says. “I guess people can decide for themselves how much abuse they’re prepared to put up with if they’re making a lot of money.”

Last September, China’s Alibaba Group Holding Ltd. raised $25 billion on the New York Stock Exchange in the biggest IPO in world history. This wasn’t a dual-class share offering because the founders of the Chinese e-commerce giant didn’t acquire mul- tiple voting rights for all corporate matters. Yet Alibaba’s governance structure gives the company’s founders the power to name a majority of Alibaba’s board. The company had wanted to list on the Hong Kong Stock Exchange but couldn’t because the founders’ control over director appointments runs afoul of that exchange’s “one share, one vote” rule.

The Canada Pension Plan Investment Board, the country’s largest pension plan, has a “one share, one vote” policy that leads it to “oppose new dual-class structures and support the collapse of existing dual-class share structures.” The CPPIB was an early investor in Alibaba and continued to invest even after the e-commerce

g i a n t ’s governance structure caused it to list in New York instead of Hong Kong. Of course, this is a “policy” and not a rule. The CPPIB continues to own Alibaba shares worth far more than the US$314.5 million investment.

“Our approach is not to simply divest, because each case must be assessed on merit,” said Michel Leduc, global head of public affairs and communications for the CPPIB. He added that the investment manager’s guidelines aren’t “static” and are reviewed regularly.

Dual-class shares have been a common feature of Canadian markets for a long time. Family or founder control isn’t the only reason for them. For example, Postmedia, owner of the National Post, has a dual-class share structure to ensure it has Canadian controlling shareholders so it can secure the tax advantages available to Canadian-owned publications.

The Canadian Coalition for Good Governance has established a policy with recommended best practices on how companies should set up dualclass shares. Stephen Erlichman, executive director of the group, said he is disappointed the policy, published in 2013, does not appear to have been followed in recent IPOs.

Remember the insiders’ 25:1 vote ratio in Cara and the 10:1 ratio in Shopify? The CCGG recommends a ratio of 4:1.

“By issuing this policy, we were trying to slow down or stop IPOs of dual class share companies in Canada in the future because we saw what was happening in the U.S.,” he said, adding that the document, a year in the making, was also intended to lay out best practices in the event a dual-class share company was brought to market. Over time, Canada has adopted ways to structure dual-class shares in ways that might protect investors from fu

ture abus- es. For example, multiple voting rights can convert to one-to-one votes after a certain time period, explains Jon Levin, a partner at Fasken Martineau DuMoulin LLP.

“For example, suppose that a respected founder has absolute control but only a minority equity position. Suppose that he or she becomes permanently incapacitated or dies. Unless the next generation has similar strengths, should the disproportionate voting rights necessarily remain since that individual will no longer be at the table?”

In the late 1980s, Canadian companies began adopting “coattail” provisions, in which holders of subordinate voting shares get equal treatment with multiple voting shareholders when asked to vote on a takeover.

Yet some companies have had dual-class shares for so long their structure pre-dates coattails and is “grandfathered.” Levin says this shouldn’t cause concern, since investors should know about those situations before buying in. “I am not sure how controversial that is in the sense that people knew what they were buying and the risks they were assuming and priced that into the trading price of the shares.”

Beatty, the one-time dual-class shareholder opponent, understands this. Dual-class shares come with so many different rights that it’s wrong to generalize them as all equally flawed.

“I was the first managing director of the CCGG. I built up the parameters for what we deemed to be good governance, and they certainly didn’t include dualclass shares,” Beatty says. “I’m now more holistic. I regard it as an eco-system with a number of different species. Each of them have their risk attendant upon them. There’s no golden chalice.”