Should investors be worried by controlled companies?

Unhappy shareholders can voice their disapproval by pressing for change at badly-run companies. But what happens if chief executives don't care? Corporate governance concerns have long been an issue at Sports Direct, but controversial chief executive Mike Ashley pays little heed to shareholder rebellions, given the fact he owns 62 per cent of the company. Similar concerns were also an issue at WeWork, which was forced to pull its initial public offering (IPO) last month.

Concerned by valuation and unorthodox business practices, investors weren't reassured by the power afforded to chief executive Adam Neumann, who was due to receive 20 votes per share, for every one for public shareholders. Under pressure, WeWork reformed its voting structures and Neumann departed, although the practice of issuing shares with unequal voting rights remains widespread. It wasn't always thus. A few decades ago, controlled public companies with unequal voting rights were a rarity. Such structures were sometimes utilised by media companies stressing the need to maintain editorial independence, as well as by family-controlled firms such as Samsung and healthcare giant Roche.

‘Proliferating like rabbits’

By 2016, however, Edward Kamonjoh of Institutional Shareholder Services (ISS) was complaining that controlled companies had been "proliferating like rabbits", a trend often traced back to Google's decision to opt for a dual-class structure at the time of its 2004 IPO. Stressing their long-term vision and the need to remain immune from "short-term market forces", founders Larry Page and Sergey Brin made the case for shares with unequal voting rights, saying new investors "will fully share in Google's long-term economic future but will have little ability to influence its strategic decisions through their voting rights". Investors were happy to accept these terms as Google became one of the world's biggest companies, encouraging other tech firms to follow suit. Facebook did so in 2012; in 2014, it was the turn of Chinese giant Alibaba; Dropbox, Pinterest, Lyft and Spotify have all listed in New York over the last 18 months, in each case creating B shares that carry between 10 and 20 votes for every class-A vote.

Photosharing app Snap went even further when it went public in 2017, selling shares carrying no voting rights whatsoever. In three of the last four years, more than a third of technology companies going public have done so by issuing multiple classes of stock. In 2018, Hong Kong, stung by losing the Alibaba IPO in 2014, changed its rules to allow dual-class shares. Months later, Singapore followed suit.

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Concern

There is concern the trend has gone too far. Last year, 21 top finance executives, including BlackRock founder Larry Fink and JPMorgan's Jamie Dimon, signed the Commonsense Principles 2.0, corporate governance principles cautioning that "dual-class voting is not best practice". In 2017, index provider FTSE Russell said it would exclude Snap and other companies that denied investors certain voting rights from membership of its indices. Shortly after, S&P Dow Jones Indices said it would no longer add companies issuing multiple share classes to its indices. Existing S&P 500 companies were unaffected, so major companies like Facebook and Google parent Alphabet remain index components, but the restrictions showed there "is a limit to anti-democratic stewardship", Ritholtz Wealth Management chief executive Josh Brown said at the time. Around the same time, the perils associated with near-unchecked executive power were recognised by Uber, which had become embroiled in a number of scandals under controversial founder Travis Kalanick. Following Kalanick's resignation, Uber reformed its voting structure, stripping super-voting rights from Kalanick and other early investors and instead opting for one share, one vote.

Entrenched Critics say cases

such as pre-2017 Uber, WeWork and Sports Direct illustrate the risk of allowing little or no checks on entrenched chief executives. In July, shareholder advisory firm Pirc labelled Sports Direct “an embarrassment to UK corporate governance” following multiple delays to the release of the company’s annual results and the shock revelation of a €674 million tax bill.

Shareholders and analysts have frequently voiced their disquiet, but Ashley's majority ownership means they can be safely ignored. In 2016, 57 per cent of independent shareholders voted against the reappointment of then Sports Direct chairman Keith Hellawell, but he kept his job on account of Ashley's support. In 2018, Ashley didn't even bother attending the company's annual meeting, citing "overriding demands on his time".

Super-voting shares

Of course, Ashley can point out he owns more than half the company, unlike CEOs like Facebook's Mark Zuckerberg, who have minority shareholdings but maintain control via super-voting shares. Critics see that as anti-democratic. Dual-class shares are "horrible for long-term accountability", Kurt Schacht of the CFA Institute complained earlier this year, as it "relegates the providers of public capital to a squeaky little voice in the corner" and treats them as a "nuisance".

Critics contend shareholders’ concerns risk being ignored and that management can become entrenched, free to make bad decisions with few, if any, consequences. Some critics, like the Investor Stewardship Group (ISG), whose members manage $31 trillion in assets, want dual-class shares to be eliminated; others, like the Council of Institutional Investors (CII), whose members oversee $25 trillion in assets, want a “sunset clause” that would limit dual-class structures to a seven-year period. In contrast, those in favour say it allows founders to pursue long-term goals, minimising pressure from activists and speculators. Banning dual-class stock also runs the risk of more technology companies opting to stay private, say supporters.

Evidence

Both sides can cite supporting evidence. Since 2006, family firms have easily outperformed equity markets in all regions of the world, according to a 2018 Credit Suisse report, with some of the best performers being companies using special voting rights to retain control and pursue their long-termist goals. Similarly, a report by index provider MSCI found unequal voting stocks outperformed global markets between 2007 and 2017.

Such companies were better managed, MSCI said, whilst cautioning it was not obvious whether they were “better managed because of concentrated voting power or in spite of it”. However, companies with “poor shareholder protection” tend to be “penalised with lower valuations”, according to a 2002 study which noted risk was elevated in countries with weak legal investors’ protection. A 2010 report found dual-class firms don’t invest more in general or in research and development. Research has found Swedish companies with dual class shares are valued at a discount and that such firms have lower returns on assets.

Underperform

A 2016 report by Institutional Shareholder Services' (ISS) Edward Kamonjoh found "controlled" companies tend to underperform. Their directors, said Kamonjoh, "have less financial expertise, are often long-tenured, Caucasian, and male who, notably, tend to overpay their CEOs". Professional investors appear divided on the issue – a 2018 CFA survey found 53 per cent of respondents were opposed to dual-class structures and 47 per cent in support. Some research suggests there are potential benefits to dual-class structures, but these benefits diminish over time as management becomes entrenched. Accordingly, one compromise measure sometimes mooted is the aforementioned sunset clause, whereby companies phase out dual-class shares over a predetermined period. That would prohibit cases like Levi Strauss, the 166-year-old jeans maker whose recent IPO left 99 per cent of voting shares with the controlling family. In the absence of any sunset clause, then investors must, as former US regulator Robert Jackson said last year, trust not only a visionary founder, but their children and grandchildren.