www.issgovernance.com
February 13, 2012
The Tragedy of the Dual Class Commons
In anticipation of its upcoming public markets
debut, Facebook appears to have taken the same
outdated dance lessons as many other recent
tech sector debutantes.
Dual-class common shares—in keeping with the
recent trend in the IPOs of LinkedIn, GroupOn,
Zynga, and others, and in striking contrast to the
long-standing desires of the institutional shareholders whose cash Facebook hopes to take—are
a cornerstone of the corporate governance regime trumpeted in the company’s S-1 filing.
Other provisions range from the utterly superfluous (in a controlled company, how necessary an
anti-takeover defense is a classified board?) to
the antediluvian (an evergreen provision in the
equity plan conveniently precludes unaffiliated
shareholders from ever objecting that the dilution they endure is disproportionate to the performance they receive).
directorships, and the ability to amend certain
articles or bylaws by simple majority vote, if the
outstanding Class B shares ever represent less
than a majority of the voting power of total common shares.
If the welter of press reports on the forthcoming
IPO are any indication, even a strong distaste
among institutional investors for the company’s
retrograde governance practices is unlikely to
diminish the economic success of the IPO. Investing is ultimately about return. While good
corporate governance practices, by increasing
board and management accountability, can provide a robust framework to drive shareholder
value, this IPO event itself presents a Hobson’s
choice: accept governance structures which diminish shareholder rights and board accountability, or miss out on what appears to be one of the
hottest business models of the internet age.
CHART FOCUS:
US Issuers with Dual Class Common Share Structures
Total Russell 3000
7.3%
Total S&P 500
5.0%
Russell 3000 by Sector:
Utilities
Energy
0.0%
1.0%
Healthcare
Info. Technology
Financials
Industrial
Telecommunications
Consumer Staples
4.1%
5.6%
6.3%
7.8%
11.6%
13.8%
Consumer Discretionary
This is a governance profile with a defense
against everything except hubris.
Through the voting rights attached to the Class B
shares, the S-1 helpfully points out, the company’s founder/Chairman/CEO will retain “the
ability to control the outcome of matters requiring stockholder approval, even if he owns significantly less than a majority of the shares.” Perhaps to discourage any future challenge to that
executive fiat, the governing documents also
provide that shareholders will lose the right to
act by written consent, the right to fill vacant
© 2011, Institutional Shareholder Services
How Bad Can the Hangover Be?
The problems for both boards of directors and
institutional investors, instead, will begin the
morning after the IPO, when divergent interests
within the shareholder base have been institutionalized into different classes of common
stock. The adverse implications of Balkanized
ownership interests can linger for years, producing unintended consequences—despite widespread investor opposition to dual class structures— even when boards do finally attempt to
eliminate a dual class structure.
17.4%
Source: ISS GRId Data
CONTACTS
Juan I. Bonifacino, CFA
Phone: +1 301.556.0412
[email protected]
Chris Cernich
Phone: +1 301.556.0625
[email protected]
Nelson Seraci
Phone: +32 2 566.1128
[email protected]
PAGE 1 OF 4
Benihana: Half a Decade of Internecine Strife
Like Facebook, teppanyaki restaurant chain Benihana
Inc. had a dual class capital structure when its went
public. Both Class A Common (BNHN.A), with 1/10
vote per share, and Common (BNHN), with 1 vote per
share and control of the company, traded publicly,
but—long after the founder’s departure—powerful
players with divergent interests held concentrated
positions in each class, leading to a half decade of
proxy contests, boardroom, and family struggles.
significant premium to Class A common stock for sustained
periods over the three years prior to the reclassification
proposal, but the 1-for-1 exchange ratio effectively eradicated this market premium, to the detriment of Common
shareholders.
The board argued the action would bring multiple benefits
to all shareholders, including greater liquidity, an alignment
of common shareholder voting rights with economic considerations, and increased flexibility to use equity as an acquisition currency or to raise additional capital. BOT, however,
promptly launched a proxy contest to defeat the measure,
pointing out that that the Common share class—which had
voting control of the company—would not only lose the
market premium it had enjoyed, but would receive no compensation for the voting dilution and loss of control, and
that the net result of the reclassification would be to increase BFC’s influence. At the September meeting, Common shareholders rejected the proposal.
premium in exchange for the loss of voting control.
The alternative, however, was to force unaffiliated
Common shareholders, who had just demonstrated on
their September proxy cards they believed they were
entitled to economic compensation for what they
would give up in the transaction, to drink the same
Kool-Aid.
In the end the board opted for the cram-down and
called a second special meeting to adopt the same
proposal in November 2011. Ahead of the record date
for that meeting, BFC converted all of its remaining
preferred to Common shares, in order to ensure the
proposal would pass that share class. It did, with
56.7% of Common votes cast.
The founder's family trust, Benihana of Tokyo Trust
(BOT, which also owns and operates the brand in all
markets outside the United States), held most of its
shares in the Common stock class. Many of the company's directors and executives, as well as certain
TDS: Economic Value or Economic Rights?
other large minority shareholders, held Class A ComIn a less-extreme example, Telephone & Data Sysmon shares. The company's preferred shares, howtems—seeking to collapse two of its three classes of
ever, could also
common shares— also
be converted to
BNHN
vs.
BNHN.A
Price
Spread
TDS
vs.
TDS.S
Price
Spread
ran afoul of structurallyCommon shares
Nov-06
Nov-07
Nov-08
Nov-09
Nov-10
Nov-11
May-05
May-06
May-07
May-08 May-09 May-10 May-11
reinforced class antagoat the owner’s 15 %
15 %
nism in 2011.
discretion, and
in certain situaClass A Common shares,
tions voted on
5%
5%
with 10 votes per share,
an as-converted
also have the right to
basis. BFC Fielect 8 of the 12 TDS dinancial
Corp. (5)%
(5)%
rectors. Through its ownheld most of
ership of these supervotthe convertible
ing shares, the company
(15)%
preferreds, and (15)%
is controlled by the TDS
was also repreVoting Trust. A second
sented by two
class of Common shares
(25)%
directors on the (25)%
(TDS) have one vote per
board.
There turned out to be no moral high ground for the board. share and elect the remaining four directors. In 2005
The board argued that directors (particularly those from the company created a third class, Special Common
In September 2011, after years of antagonism beBFC, which could convert its preferred shares to Common) (TDS.S), which had identical voting rights to the Comtween BOT and BFC (among others), the board procould be accused of self-dealing if the exchange ratio were mon shares in election of directors, but no voting
posed a restructuring in which the two classes of comadjusted either to reflect the characteristic trading premium power on other matters.
mon stock would be collapsed into a single class at a 1of Common shares, or to provide Common shareholders a
for-1 exchange ratio. Common shares had traded at a
© 2011, Institutional Shareholder Services
PAGE 2 OF 4
www.issgovernance.com
The Special Common shares were intended to facilitate acquisitions without diluting the voting rights of
the controlling shareholder, and were granted the
same economic rights as the Common shares. Despite identical economic rights and near-identical
voting rights, however, the Special Common shares
soon traded at a significant discount to the Common,
impairing the company's ability to use the Special
Common as an acquisition currency. From the creation of the Special Common share class through the
announcement of the capital restructuring proposal,
this discount averaged about 8%—although, as the
company allocated fewer funds for share repurchases
after the onset of the recession, the discount eventually widened to double digits.
In August 2011, recognizing both that the Special
Common would not be an efficient currency for acquisitions and that the trading discount appeared to be
persistent, the company proposed collapsing the two
classes—despite the trading discount—at a 1-for-1
exchange ratio. Since the proposed restructuring
would have no effect on the company’s operations
and operating results, however, the company’s total
equity value was unchanged by the transaction. As a
result, the proposal effectively transferred value from
the Common share class to the Special Common share
class. The market response to the proposed restructuring underscored this point: the trading spread between the two share classes immediately narrowed—
Common shares decreased, and Special Common increased—as the market arbitraged the difference between market price and the proposed exchange ratio.
While the company repeatedly emphasized that the
exchange ratio was consistent with the identical economic rights of the two classes, shareholders—or at
least, Common shareholders, who stood to lose im© 2011, Institutional Shareholder Services
February 13, 2012
mediate economic value at a 1-for-1 exchange ratio—
focused more directly on the disparity between the proposed ratio and the de facto trading ratio established by the
market.
Unable to get majority support from all the affected share
classes, the company revised the proposed ratio in November to 1.087 Common shares to 1.0 Special Common—
effectively, the long-term average trading premium of Common to Special Common. On Jan. 13, 2012 shareholders of
all classes overwhelmingly approved the restructuring.
Magna: The Steep Price of Proportionate Representation
The scale of the disparity between economic ownership and
voting power at Facebook, however, trumps either Benihana or TDS, suggesting that the end game for public shareholders—even if decades in the future—may more likely
resemble the experience of shareholders at Canadian autoparts supplier Magna International.
In one of the most publicly-vilified proposals to eliminate a
dual class share structure, in May 2010 the board announced it had negotiated an arrangement in which all
shareholders other than founder and controlling shareholder Frank Stronach would pay Stronach an 1,800% premium to eliminate his controlling share class.
Ironically, the Magna proposal faced less resistance at the
shareholder vote than either the Benihana or the TDS proposals: Magna shareholders voted overwhelmingly to approve the restructuring as initially proposed. The vote was
clearly not an affirmation that the price was appropriate—
numerous shareholders filed legal challenges—but it did
appear to confirm that regaining control commensurate
with economic interest was still somehow worth it. The
market response to the announcement foreshadowed the
vote result: shares rose 15%.
Have we Seen this Movie Before?
By establishing a dual-class structure at the onset of
public trading, companies divide ownership interests
into potentially opposing groups. These early fractures
can widen into fault lines, eventually resulting in a
costly, distracting, and potentially unpopular restructuring. In this way, dual class structures create a vulnerability not unlike the tragedy of the commons, where
individual actors working to maximize their own self
interest collectively diminish or destroy the resources
they share.
Giving the founder of Facebook voting control may
seem tactically wise at the moment the firm goes public. His uncompromising vision for the company, after
all, is largely credited as the key driver of its success
thus far. Undoubtedly, it seemed just as wise when
Magna, or even Benihana, implemented capital structures that gave their founders voting control that was
wildly disproportionate to their economic interests.
Like those companies, the real dilemma of Facebook’s
dual class structure will only become evident when (or
in a best case scenario, if) an autocratic model of governance makes it less viable than a competitor whose
governance gives owners a voice proportionate to the
economics they have at risk.
*
*
*
We will continue to monitor this situation and market
trends, speak with interested parties and, where relevant, issue additional M&A Edge notes to provide further information and guidance for clients.
PAGE 3 OF 4
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Services, Inc. ("ICS"), a wholly-owned subsidiary of Institutional Shareholder Services Inc.
("ISS"), or ICS may have provided advisory or analytical services to the issuer in connection
with the proxies described in this report. No employee of ICS played a role in the preparation
of this report. If you are an ISS institutional client, you may inquire about any issuer's use of
products and services from ICS by emailing [email protected].
Chris Cernich
Phone: +1 301.556.0625
[email protected]
Nelson Seraci
Phone: +32 2 566.1128
[email protected]
Juan I. Bonifacino, CFA
Phone: +1 301.556.0412
[email protected]
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