A DUAL DIS­CUS­SION

Hong Kong is re-join­ing a global de­bate about dual-class share­hold­ing struc­tures. But the pres­sure to al­low these struc­tures at the be­hest of tech com­pa­nies where own­ers wish to re­tain con­trol of their com­pa­nies masks struc­tural prob­lems, par­tic­u­larly as

The Peak (Hong Kong) - - Contents - STORY NI­COLA CHUR­CHOUSE

The pres­sure for Hong Kong to al­low for dual struc­ture at the be­hest of tech com­pany own­ers who wish to re­tain con­trol of their com­pa­nies is set­ting off de­bate

In the mod­ern era of fi­nance, the no­tion of “one share, one vote” lies at the heart of cor­po­rate gov­er­nance. The idea that share­hold­ers should have vot­ing rights of the com­pa­nies they are in­vested in, at a level pro­por­tional to their own­er­ship is, in many ways, a ba­sic tenet of cap­i­tal­ism.

Share­holder meet­ings, an­nual events where share­hold­ers come to­gether (on­line or in per­son) to vote on cor­po­rate strat­egy or boards of di­rec­tors, have be­come cap­i­tal­ist car­ni­vals in some cases. The most leg­endary are the an­nual share­holder meet­ings of Wal­mart and Berk­shire Hath­away (Class A share­hold­ers only). These events can fea­ture day-long par­ties, mu­sic and dance per­for­mances, Q&A pe­ri­ods, speeches, and of course, vot­ing.

In 2015, Hewlett-packard (HP) be­gan hold­ing on­line-only share­holder meet­ings, in a bid to en­cour­age par­tic­i­pa­tion and cut costs. The pre­vi­ous year, the HP share­hold­ers meet­ing saw Rev­erend Jesse Jack­son push HP Chief Ex­ec­u­tive Meg Whit­man to en­cour­age more di­ver­sity in Sil­i­con Val­ley at the high­est lev­els. More re­cently, share­holder ac­tivists in Switzer­land’s pri­vate bank­ing and as­set man­age­ment in­dus­try have voiced con­cern over high pay pack­ages for un­der­per­form­ing top ex­ec­u­tives. Such are the ben­e­fits of one share, one vote sys­tems of share­hold­ing and cor­po­rate gov­er­nance. They al­low share­hold­ers to weigh in on the fate of their in­vest­ments.

But in re­cent years, in­vestors have come un­der in­creas­ing pres­sure, by tech­nol­ogy com­pa­nies in par­tic­u­lar, to ac­cept dual-class shares; that is, shares with re­duced vot­ing rights, or even no votes at all. Such share struc­tures give com­pany own­ers or founders ac­cess to cap­i­tal mar­ket fi­nanc­ing, but with­out ced­ing much, or any, con­trol of their com­pany.

De­spite their re­cent promi­nence, these forms of du­al­class share­hold­ing struc­tures, specif­i­cally where one class of share holds more vot­ing rights than oth­ers, have ac­tu­ally been around for nearly a cen­tury. As far back as 1925, the Michi­gan­based car marker Dodge Broth­ers, which ul­ti­mately sold to Chrysler, was listed on the New York Stock Ex­change (NYSE) with a du­al­class share­hold­ing struc­ture that al­lowed for the own­ers of just 1.7 per cent of the eq­uity to con­trol 100 per cent of the vot­ing power.

It wasn’t un­til 1940 that the NYSE pro­hib­ited listed com­pa­nies from is­su­ing any non-vot­ing eq­uity, and fur­ther­more lim­ited the ag­gre­gate vot­ing power of any su­pe­rior-vot­ing stock to ex­ceed 18.5 per cent of all out­stand­ing votes. While this wasn’t an out­right ban on dual-class (or multi-class) shares, it lim­ited multi-class list­ings to the ex­tent that in 1985 there were just ten such list­ings on the NYSE.

For decades, the “one share, one vote” rule guided US se­cu­ri­ties mar­kets.

But in the late 80s and early 90s, in­creas­ing com­pe­ti­tion among US ex­changes for list­ings busi­ness saw a change in pol­icy. The ma­jor US ex­changes be­gan to al­low multi-class struc­tures with no re­stric­tions on vot­ing rights what­so­ever for ini­tial pub­lic of­fer­ings (IPO). The U.S. Se­cu­ri­ties and Ex­change Com­mis­sion (SEC) at­tempted to ban the prac­tice in 1988 in an ap­par­ent ef­fort to level the play­ing field be­tween ex­changes, but a court sub­se­quently ruled against the eq­uity mar­ket reg­u­la­tor.

But it was Google’s (now Al­pha­bet Inc.) IPO in 2004 that trig­gered what was to be­come a wave of tech­nol­ogy IPO’S with multi-class shares. In Google’s IPO, new in­vestors would re­ceive Class A com­mon stock car­ry­ing one vote per share, while the founders would re­tain Class B com­mon stock with ten times the num­ber of votes per share. In 2012, Face­book sim­i­larly is­sued Class A and B stock with one and ten votes per share. Be­tween 2012 and 2016, some 15 per cent of tech­nol­ogy com­pa­nies that went pub­lic in the US used dual or multi-class shares; up from eight per cent be­tween 2007 and 2011, ac­cord­ing to Uni­ver­sity of Florida Fi­nance Pro­fes­sor Jay Rit­ter.

While the likes of Face­book and Al­pha­bet of­fered shares at IPO with at least some vot­ing power, Snap Inc., the com­pany be­hind so­cial me­dia plat­form Snapchat, took things a lot fur­ther when they went pub­lic ear­lier this year, of­fer­ing shares that car­ried no vot­ing rights what­so­ever. It was the first in­ci­dence of an IPO of non-vot­ing stock on a US ex­change. The Class C stock, held ex­clu­sively by co-founders Evan Spiegel and Bobby Mur­phy, en­sure that the 27 and 28-year old CEO and CTO, con­trols nearly 90 per cent of the com­pany’s vot­ing power.

Pro­po­nents of such dual or multi-class struc­tures that of­fer lim­ited vot­ing rights to share­hold­ers ar­gue that they give the founders, typ­i­cally those with the orig­i­nal vi­sion be­hind the com­pany it­self, the abil­ity to fo­cus on the long-term growth of the com­pany rather than short-term de­ci­sions that might help bump quar­terly re­port­ing met­rics at the cost of longer-term value creation. In the so-called “fast growth pe­riod” of a firm’s life cy­cle, com­pany lead­ers may also need to fo­cus their full at­ten­tion on ad­vanc­ing the firm’s growth, and there­fore pro­vid­ing some pro­tec­tion from out­side takeover threats would be a good idea.

In the Google ini­tial of­fer­ing prospec­tus, Co-founder Larry Page summed up the ra­tio­nale: “The main ef­fect of this struc­ture is likely to leave our team, es­pe­cially Sergey [Brin] and me, with sig­nif­i­cant

con­trol over the com­pany’s de­ci­sions and fate, as Google shares change hands. New in­vestors will fully share in Google’s long-term growth but will have less in­flu­ence over its strate­gic de­ci­sions than they would at most pub­lic com­pa­nies. Me­dia ob­servers have pointed out that du­al­class own­er­ship has al­lowed these com­pa­nies to con­cen­trate on their core, long term in­ter­est in se­ri­ous news cov­er­age, de­spite fluc­tu­a­tions in quar­terly re­sults.”

SO WHAT IS THE EF­FECT ON PER­FOR­MANCE?

Those in favour of dual-class list­ings con­sis­tently ar­gue that con­cen­trated vot­ing power al­lows man­age­ment to gov­ern with lit­tle to no out­side in­ter­fer­ence and even­tu­ally de­liver higher re­turns to share­hold­ers in re­turn for their lim­ited con­trol pow­ers. Joseph Tsai, vice chair­man of Alibaba (par­ent com­pany of South China Morn­ing Post Group, which pub­lishes The Peak), prior to the com­pany’s IPO ar­gued that in­sider con­trol would al­low man­age­ment to “set the com­pany’s strate­gic course with­out be­ing in­flu­enced by the fluc­tu­at­ing at­ti­tudes of the cap­i­tal mar­kets.”

Pro­fes­sor Zhang Tianyu, a cor­po­rate gov­er­nance spe­cial­ist at the CUHK Busi­ness School states: “The ben­e­fit of al­low­ing founders to have ab­so­lute con­trol of their com­pany is that they can fo­cus on the long-term strate­gic de­vel­op­ment of their com­pany with­out wor­ry­ing about the pres­sure on short-term earn­ings from in­vestors, es­pe­cially as in­vestors have be­come ever more fo­cused on short-term gains.”

De­trac­tors point out that du­al­class struc­tures de­prive in­vestors of their pro­por­tional vot­ing rights, and they in­cen­tivise man­agers to act in their own per­sonal in­ter­ests rather than those of the com­pany’s larger share­hold­ers (this is known as the “agency prob­lem”). Those most op­posed to dual-class struc­tures in­clude cor­po­rate gov­er­nance ad­vo­cacy groups such as the Coun­cil of In­sti­tu­tional In­vestors (CII), the In­vestor Ste­ward­ship Group, and the Asian Cor­po­rate Gov­er­nance As­so­ci­a­tion, among oth­ers.

Past scan­dals of­fer some in­sight as to why such in­vestors are leery of los­ing their say in cor­po­rate gov­er­nance. Per­haps the most fa­mous and egre­gious ex­am­ple of abuse of en­hanced man­age­ment vot­ing rights comes from Lord Con­rad Black and his pub­lish­ing com­pany Hollinger In­ter­na­tional. Lord Black owned less than 20 per cent of the com­pany yet he con­trolled 68 per cent of the vote. Be­tween 1997 and 2003, a spe­cial com­mit­tee re­port in­ves­ti­ga­tion into the com­pany found that Black and his cronies took over US$400 mil­lion (HK$3.2 bil­lion) from Hollinger for them­selves.

The re­port noted that Lord Black ap­pointed all of his com­pany’s di­rec­tors, and that “the board Black se­lected func­tioned more like a so­cial club or pub­lic pol­icy as­so­ci­a­tion than as the board of a ma­jor cor­po­ra­tion, en­joy­ing ex­tremely short meet­ings fol­low­ing by a good lunch and dis­cus­sion of world af­fairs… Ac­tual op­er­at­ing re­sults or cor­po­rate per­for­mance were rarely dis­cussed.”

Apart from pos­si­ble scan­dals, the other key ques­tion is the ex­tent to which du­al­class share­hold­ing struc­tures af­fect long-term share price per­for­mance. Aca­demic stud­ies have pro­vided mixed re­sults, although the con­clu­sions tend to­wards un­der­per­for­mance by dual-class com­pa­nies over time.

A study in Oc­to­ber 2012 by the In­vestor Re­spon­si­bil­ity Re­search Cen­tre In­sti­tute in­ves­ti­gated the rel­a­tive per­for­mance of “con­trolled com­pa­nies” listed on US ex­changes. These are com­pa­nies with con­cen­trated vot­ing con­trol by one party, ei­ther through a sub­stan­tial own­er­ship stake or through a multi-class cap­i­tal struc­ture cre­ated specif­i­cally to fa­cil­i­tate dis­pro­por­tion­ate vot­ing power in re­la­tion to eq­uity own­er­ship. The study found that the av­er­age tenyear to­tal share­holder re­turn for con­trolled com­pa­nies with mul­ti­class struc­tures was 7.52 per cent, com­pared to 9.76 per cent for non­con­trolled com­pa­nies. Con­trolled com­pa­nies with a sin­gle-share class how­ever re­turned 14.26 per cent by com­par­i­son.

A more re­cent ex­am­i­na­tion, “Does Multi-class Stock En­hance Firm Per­for­mance?” by the CII from May of this year in­ves­ti­gated the po­ten­tial im­pacts of dif­fer­ent vot­ing struc­tures on re­turn on in­vested cap­i­tal (ROIC) us­ing data on 1762 Us-listed com­pa­nies on the Rus­sell 3000 in­dex over nine years. Over­all, their mod­els found that multi-class struc­tures did not re­sult in a mean­ing­ful sta­tis­ti­cal in­crease in long-term value creation as mea­sured by ROIC.

MEAN­WHILE, IN HONG KONG

A fact of­ten over­looked by in­di­vid­ual in­vestors is that stock ex­changes are busi­nesses them­selves, op­er­at­ing in their own best in­ter­ests. They com­pete with one an­other for com­pany list­ings. More list­ings mean more trad­ing vol­ume and hence ex­change rev­enue.

It was com­pe­ti­tion among the ma­jor US ex­changes NAS­DAQ, AMEX and the NYSE, back in the 1980s that ul­ti­mately drove what many have la­belled a “race to the bot­tom” in terms of the eas­ing of cor­po­rate gov­er­nance re­stric­tions (i.e. al­low­ing dual-class share­hold­ings) to win list­ings. It was this com­pe­ti­tion that the SEC sought to elim­i­nate in 1988.

The IPO of main­land China in­ter­net gi­ant Alibaba in late 2014 pro­vided a stern test of Hong Kong’s list­ing rules, which ex­plic­itly pro­hibit dual-class share struc­tures. Alibaba sought a part­ner­ship

struc­ture al­low­ing a group of 27 man­agers to ap­point the ma­jor­ity of Alibaba’s di­rec­tors, thereby giv­ing them con­trol of the board. While not an ex­plicit A and B class share struc­ture like other re­cent tech­nol­ogy list­ings (although re­port­edly Alibaba did at first pro­pose this), the struc­ture falls into a gen­eral dual-class cat­e­gory, hence the Hong Kong ex­change’s re­fusal to list the com­pany.

The Alibaba IPO would go on to raise US$21.8 bil­lion for the com­pany on the NYSE, be­com­ing the largest US IPO in his­tory.

Cor­po­rate gov­er­nance ac­tivists ap­plauded the fact that the Hong Kong ex­change had stuck to its guns. But nearly three years af­ter Alibaba dropped their pur­suit of a Hong Kong list­ing in favour of the US, the ques­tion of dual-class list­ings is now firmly back on the agenda in Hong Kong.

Ear­lier this year, the Hong Kong Se­cu­ri­ties and Fu­tures Com­mis­sion (SFC) backed plans for a pub­lic con­sul­ta­tion pro­posed by the stock ex­change re­gard­ing the creation of a third board (af­ter the HKSE and GEM boards), aimed at tech­nol­ogy com­pa­nies, that would al­low for dual-class list­ings. This fol­lows a sim­i­lar con­sul­ta­tion an­nounce­ment made to­wards the end of last year re­gard­ing dual-class list­ings by the Sin­ga­pore stock ex­change, a re­gional com­peti­tor to Hong Kong’s stock ex­change.

“I am con­cerned about du­al­class share­hold­ings be­cause all the rea­sons given by the SFC to not pro­ceed in 2015 still ex­ist to­day,” says Robert Knight, for­mer part­ner and CEO of law firm Hei­drick & Strug­gles Fi­nan­cial Ser­vices Prac­tice in Hong Kong and for­mer Asia CEO of Stan­dard Life. “The fact that just two years on, and only af­ter Sin­ga­pore’s SGX is­sued their con­sul­ta­tive pa­per on dual list­ings in Fe­bru­ary, they are now re­con­sid­er­ing, al­lows one to as­sume that Hong Kong is more in­ter­ested in com­pet­ing with Sin­ga­pore for fu­ture list­ings, rather than pro­tect­ing the Hong Kong Stock Ex­change, or the best in­ter­ests of its share­hold­ers, par­tic­u­larly the smaller share­hold­ers.”

Jamie Allen, secretary gen­eral of the Asian Cor­po­rate Gov­er­nance As­so­ci­a­tion (ACGA) and a vo­cal ad­vo­cate of “one share, one vote” for all list­ings, says, “Our view on du­al­class shares has not changed. We think all com­pa­nies, whether new econ­omy or old econ­omy, should follow the same high stan­dards of in­vestor pro­tec­tion and cor­po­rate gov­er­nance. This is what is best for the long-term de­vel­op­ment of the Hong Kong mar­ket.”

On whether this makes Hong Kong less com­pet­i­tive, Allen goes on to say that, “there are many rea­sons why Hong Kong does not at­tract high-tech firms to list here. To re­duce the de­bate to the dual-class share is­sue is overly sim­plis­tic.”

Per­haps the largest and most pow­er­ful op­po­nent of such du­al­class list­ings comes from the Coun­cil of In­sti­tu­tional In­vestors (CII), a Us-based non­par­ti­san, non-profit as­so­ci­a­tion of em­ployee ben­e­fit plans, foun­da­tions and en­dow­ments with com­bined as­sets un­der man­age­ment

ex­ceed­ing US$3 tril­lion. Their mem­ber funds in­clude ma­jor long-term share­own­ers with as­so­ciate mem­bers be­ing a range of as­set man­agers with more than US$20 tril­lion in as­sets un­der man­age­ment. The “one share, one vote” prin­ci­ple was among their first mem­ber-ap­proved poli­cies when the CII was founded in 1985.

In a let­ter sent ear­lier this year to the CEO and Chief Reg­u­la­tory Of­fi­cers of Sin­ga­pore Ex­change Lim­ited, Kenneth Bertsch of the CII wrote that a move by the SGX to per­mit dual-class shares would “take a sig­nif­i­cant step in the wrong di­rec­tion,” say­ing that such a move “con­flated the in­ter­ests of in­ter­me­di­aries with the in­ter­est of the two core mar­ket par­tic­i­pants: in­vestors and pub­lic com­pa­nies.” He added that ac­cept­ing dual-class shares in Sin­ga­pore would “lead to re­gional com­pe­ti­tion to lower list­ing stan­dards, and re­flect ac­cord­ingly on Sin­ga­pore.”

In re­marks to the US SEC In­vestor Ad­vi­sory Com­mit­tee in March, Bertsch said: “It is clear that Sin­ga­pore and Hong Kong are re­spond­ing to com­pet­i­tive pres­sure from low stan­dards at the NAS­DAQ and the NYSE, just as NYSE was pres­sured to re­lax its rules in 1986 by the lack of re­stric­tions on dual-class list­ings at NAS­DAQ.”

Jamie Allen from the ACGA points to Hong Kong hav­ing one of the most suc­cess­ful IPO mar­kets in the world. “One of the rea­sons we have high liq­uid­ity and in­vestor con­fi­dence is be­cause we have higher stan­dards than most other mar­kets in this re­gion. Dual-class shares would only erode the long-term value of our mar­ket.”

THE PAS­SIVE PROB­LEM

There is of course a ba­sic point that sup­port­ers of dual-class struc­tures would make: if you are op­posed to in­vest­ing cap­i­tal in com­pa­nies that of­fer re­duced or no vot­ing, don’t in­vest. How­ever, those who in­vest in pas­sive funds may have lit­tle choice. Pas­sive as­sets un­der man­age­ment, which track an un­der­ly­ing bench­mark eq­uity in­dex, have con­tin­ued to grow as in­vestors have been with­draw­ing from ac­tive funds that typ­i­cally charge higher fees.

Ac­cord­ing to Van­guard Group, the largest provider of mu­tual funds and sec­ond largest ETF provider glob­ally, and Morn­ingstar, the Chicago-based in­vest­ment re­search and man­age­ment firm, US$264.5 bil­lion flowed out of ac­tively man­aged US eq­uity funds in 2016, with pas­sive in­dex funds and ETFS tak­ing US$236.1 bil­lion. In the last decade, more than a tril­lion dol­lars has shifted from ac­tive to pas­sive US eq­uity funds, and 2016 rep­re­sented the largest cal­en­dar-year change in ac­tive to pas­sive as­sets.

For this grow­ing body of pas­sive in­vestors, who now range from retail in­vestors to the largest pen­sion funds and in­sti­tu­tions, the in­dices the work to may bring them into con­flict with dual-class struc­tures, de­pend­ing on the

con­stituent stocks in the in­dex.

For ex­am­ple, of the largest ten con­stituents of the US bench­mark S&P500 in­dex, four carry re­duced vot­ing rights. These in­clude Face­book A shares, Berk­shire Hath­away B shares, and both Al­pha­bet’s Class A and Class C shares (which carry no vot­ing rights what­so­ever). The in­clu­sion of dual-class shares into key bench­mark eq­uity in­dices will there­fore drive in­vestors into the stock, re­gard­less of their opin­ions about dual-class shares and the im­pli­ca­tions for cor­po­rate gov­er­nance. A cur­rent bone of con­tention for in­dex providers sur­rounds the ques­tion of whether Snap Inc., with its non-vot­ing shares is­sued ear­lier this year, should be in­cluded in their in­dices.

If the com­pany is in­cluded, then pas­sive in­vestors be­come forced buy­ers of a com­pany whose cor­po­rate gov­er­nance struc­ture they vo­cif­er­ously ob­ject to, and hence in­dus­try groups are heav­ily lob­by­ing in­dex providers to ex­clude Snap Inc.

“The growth and pop­u­lar­ity of pas­sive in­vest­ment ve­hi­cles like in­dex funds and ex­change traded funds places a higher em­pha­sis on how in­dex method­olo­gies han­dle share­holder rights and cor­po­rate gov­er­nance is­sues,” says Bren­dan Ah­ern, chief in­vest­ment of­fi­cer for Krane­shares ETFS in China, who has been in­volved in the sec­tor since 2001 when he joined Bar­clays Global In­vestors dur­ing the roll­out of the ishares fam­ily of ETFS. “In­sti­tu­tional in­vestors have raised their voice to protest hav­ing to buy Snap if it is in­cluded in in­dices de­spite pro­vid­ing share­hold­ers ab­so­lutely no re­course on man­age­ment de­ci­sions and ac­count­abil­ity.”

The In­vest­ment As­so­ci­a­tion, a trade body rep­re­sent­ing over 200 UK in­vest­ment man­agers who col­lec­tively man­age over £5.7 tril­lion, has lob­bied ma­jor in­dex providers FTSE Rus­sell, S&P Dow Jones and MSCI Global to lodge strong ob­jec­tions to Snap Inc.’s in­clu­sion in eq­uity in­dices. Like­wise, the CII has con­tin­ued to lobby in­dex providers to ex­clude com­pany struc­tures like Snap Inc. in par­tic­u­lar.

In­dex providers ap­pear to be vac­il­lat­ing. In March, MSCI said that Snap Inc. would qual­ify for its in­dexes, but a day later said that Snap Inc's in­clu­sion would be re-as­sessed af­ter feedback from in­vestors. FTSE Rus­sell an­nounced it would de­fer its con­sid­er­a­tion of Snap Inc in­clu­sion at up­com­ing quar­terly in­dex re­views and re­con­sti­tu­tions like­wise pend­ing a con­sul­ta­tion with in­dex users. And S&P Dow Jones In­dices have stated they would re­quire six to 12 months post- Snap Inc IPO to study the com­pany struc­ture ac­cord­ingly. The con­tin­ued de­cline of Snap Inc’s share price may help sharpen that dis­cus­sion.

Ad­vo­cates for “one share, one vote” point out that tra­di­tional eq­uity struc­tures have not hin­dered the abil­ity of other ma­jor tech­nol­ogy com­pa­nies to de­liver value to share­hold­ers or raise cap­i­tal. As Allen from the ACGA points out that suc­cess­ful tech firms such as Ap­ple, Ama­zon and Mi­crosoft do not have dual-class shares. Closer to home, Hong Kong-listed Chi­nese tech­nol­ogy gi­ant Ten­cent Hold­ings Ltd. has suc­cess­fully built a HK$2.54 tril­lion-dol­lar com­pany ( by mar­ket cap­i­tal­i­sa­tion) with­out the need for dual-class shares with dif­fer­ent vot­ing rights.

What’s clear, es­pe­cially in the af­ter­math of Alibaba’s de­ci­sion to list in the US rather than in Hong Kong, is that large tech­nol­ogy com­pa­nies will con­tinue to shop around for ex­changes that al­low them to bal­ance the need for rais­ing cap­i­tal with their pref­er­ence for re­duced cor­po­rate gov­er­nance con­straints in the form of dual-class vot­ing struc­tures.

As a re­sult, both Hong Kong and Sin­ga­pore are likely to find them­selves un­der in­creas­ing pres­sure from their ex­changes to loosen re­stric­tions, es­pe­cially if more large and po­ten­tially lu­cra­tive tech­nol­ogy com­pa­nies come out of China look­ing to raise cap­i­tal. Of course, even if Hong Kong and Sin­ga­pore were to agree on keep­ing a sin­gle class struc­ture only, com­pe­ti­tion from New York is al­ways just over the hori­zon.

ABOVE Google's list­ing in 2004 on Nas­daq started the wave of dual share list­ings fa­vored by tech com­pa­nies.

ABOVE Alibaba Group opted to IPO through the New York Stock Ex­change be­cause of the pre-ipo struc­ture that al­lows for the board to main­tain greater con­trol and vot­ing power.

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