Dual-class shares have significant benefits but none of them flow through to minority shareholders. And while an argument could be made that a dual-class share structure is not absolutely bad, data and evidence gathered by these authors point unequivocally to the existence of a negative drag on a company with dual-class shares.
Dual class share structures under the spotlight
The reputation of firms with a dual-class share capital structure has suffered recently, the result of high-profile scandals in which controlling shareholders were accused of diverting large sums of money for their personal benefit. Examples include Vic De Zen of Royal Group Technologies Limited and Conrad Black of Hollinger International Inc. Forensic accountants (special board committee). At the two companies, special board committees concluded that the controlling shareholders, Mr. De Zen and Mr. Black, conducted related-party transactions on a non-arms-length basis. Mr. De Zen agreed to repay part of the profits and bonus and to convert his multiple voting shares into single voting shares following the delivery of the report. Mr. Black is disputing the charges in court.
Firms having dual-class shares are also criticized on the basis of compensation, investment, and financing decisions that do not appear to be in the best interests of minority shareholders. For instance, Frank Stronach (Magna) and Jim Shaw (Shaw Communications) were severely criticized following the disclosure of their hefty 2002 compensation packages. Mr. Stronach managed to obtain $52 million in consulting fees, plus $6 million from stock options, even though Magna’s stock had fallen 30 percent in the previous year. Mr. J.R. Shaw received a $6.3-million bonus, while Shaw posted a $288-million loss in the same year. Mr. Stronach was also criticized for taking Magna away from the auto parts industry by acquiring the Santa Anita race track near Los Angeles, establishing an Austrian sports television channel, and planning a $1 billion amusement park in Vienna. In another case, the Bombardier family came under scrutiny after rejecting an Ontario Teachers’ Pension Plan $1 billion investment in return for giving up dual-class shares. Instead, the family decided to issue additional subordinate voting shares, which diluted the ownership of minority shareholders and resulted in a higher cost for the capital that has been raised.
These examples create significant concerns for participants in financial markets, who, in general, have a negative perception of the creation of dual-class share capital structure. In this article, we analyze the validity of these concerns by looking at the risks and rewards that investors face when investing in firms with dual-class shares.
Many Canadian firms have a dual-class share structure in which shares with single voting rights are coupled with shares having multiple voting rights or shares without voting rights1. While different in terms of voting power, both classes of shares will typically have the right to receive similar dividends. Such a capital structure is well-liked by entrepreneurs, as it allows them to raise capital without diluting their control over the firm that they founded2. For instance, the Bombardier family controls 59.7 percent of Bombardier’s voting rights but holds only 17.5 percent of its equity. The Stronach family controls 75 percent of the votes at Magna but only 3 percent of its equity. Similarly, a combination of single-voting and non-voting shares permits the Shaw family to control 78 percent of the votes while owning 4 percent of Shaw Communication’s equity.
Investors are free to buy non-voting or subordinate voting shares: But, caveat emptor. The lack of voting power is usually well-disclosed and is associated with a slightly lower stock price. Superior voting shares are traded at a premium that varies across countries, based on the legal protection provided to minority shareholders. The voting premium ranges from 3 percent to 10.5 percent in the U.S., 7 percent to 20 percent in Canada, and reaches as high as 82 percent in Italy, 19 percent in the UK, and 12 percent in Sweden.
However, shareholders face critical risks when a firm announces its intention to change its capital structure. For instance, in the U.S., results show that the creation of a dual-class share structure reduced shareholders’ wealth by 0.8% during the 1980s3. In Canada, findings show that the stock market reacts negatively to the creation of dual-class share structures, a reflection of the potential decline in firm performance following the recapitalization decision. Hence, the creation of a dual-class share structure is not perceived positively by stock market participants.
Investors holding subordinate voting shares may also find themselves at the mercy of temperamental controlling shareholders. Moreover, once an entrepreneur retires or dies and his/her controlling shares fall into the hands of heirs, it is doubtful that the latter will necessarily have the same business acumen as their parent. A case that comes to mind is the Jean Coutu Group Inc. Following the retirement of the 78-year-old founder, Jean Coutu, his heirs decided to pursue the largest acquisition in the group’s history, the purchase of Eckerd drugstores from J.C. Penney Company. Though the deal was applauded by various financial analysts, the outcome was a failure. The group witnessed a decline in share price and a downgrade in the company’s credit rating, as management faced significant challenges with the hefty debt resulting from the acquisition, and with the integration of the information technology systems of the two retailers’ chains. These challenges prompted Jean Coutu to regain control over the group by reappointing himself as the executive officer. At the same time, he demoted his son, François, from president and CEO to vice-chairman and president of the Canadian operations, and transferred key responsibilities from his son, Michel, head of the firm’s U.S. division, to Pierre Legault, head of Paris-based pharmaceutical giant Sanofi-Aventis.
Given these examples, how should non-controlling investors assess their risks? In fact, any minority stockholder in a firm where a shareholder has a majority of the voting power faces similar risks, irrespective of the share-class structure. The share structure is one among many aspects of a firm’s governance structure that can affect the value of an investor’s investment. Board independence, competent directors, a firm’s financial condition, transparency, executive compensation…all are governance practices that can be as relevant and that would minimize investors’ risks. External auditors are also expected to play a key role in alleviating agency costs arising from the separation of cash flow rights and control rights. In fact, auditors charge higher fees to firms with a dual-class share structure. Results also document higher audit fees in firms having a greater wedge between cash flow rights and control rights.
What returns can investors expect?
What type of a return can investors expect from an investment in non-voting or subordinated voting shares? Long term, such shares yield returns that are comparable to single voting shares. Moreover, some studies do find that family-controlled firms, many of which have dual-class share structures, exhibit better stock market performances than widely-held firms. Hence, two classes of shares do not necessarily translate into poor performance.
Profit opportunities may also arise for investors who can identify firms that intend to convert their dual -class share structure into a single class. The elimination of dual-class share structure is expected to result in an increase in share price for three main reasons. First, it alleviates the agency costs arising from the wedge between cash flow rights and control rights. Second, it enhances board monitoring and increases the likelihood of a takeover bid following suboptimal firm performance. Third, the unification of dual-class shares into a single voting class enhances the liquidity of the firms’ equity and reduces the cost of capital.
Anecdotal evidence supports these contentions. For instance, corporate disclosure shows that Canadian firms eliminate dual-class shares in order to improve corporate governance structure, to increase the appeal of the firms’ equity to investors, and to enhance the liquidity of the firms’ equity. Evidence also shows that the majority of firms eliminating dual class share structure witness an increase in the share price at the announcement elimination date or following that date (Table 1; Figure 1). For instance, Unihost’s share price a day after the elimination announcement date was higher than its share price one day prior to the elimination date by 18%. Similarly, Sceptre Investment’s share price increased by 29 percent, Assante’s share price gained almost 27%, while the share price for the remaining firms increased by 0.45 percent to 9.2 percent4. Furthermore, results seem to support the conclusion that the stock market reaction is more positive when firms have a higher wedge between cash flow rights and control rights. For instance, Assante Corporation and Sceptre Investment Counsel, which have a high wedge, realized hefty positive abnormal returns at and following the elimination announcement date. In such a context, it is tempting for a controlling stockholder to put forward his or her own interests to the detriment of non-controlling shareholders.
While dual-class structures do raise legitimate questions, it must be pointed out that they are one aspect of a firm’s governance, and not necessarily the most important. For example, a well-informed investor should check out the presence of coattail provisions which protect minority stockholders in a takeover situation. However, it is worth noting that a coattail provision does not represent an absolute guarantee. For example, WIC Western International Communications Ltd. had a coattail provision that allowed subordinate shareholders to share in the premium paid to superior voting shares. Despite this fact, Emily Griffiths, wife of founder Frank Griffiths, managed to avoid the coattail and keep the premium for herself ($22 a share over her subordinated shares) by selling her superior voting shares to different parties.
|Aeterna Laboratories||Assante Inc.||Gildan ActiveWear||Home Capital||MDC Partners||Sherritt International||Sceptre Investment||Sino Forest||Unihost Inc||YMG Capital||Laidlaw Inc|
|Panel A: Stock Price|
|Panel A: Stock Price|
t: Date of the news release announcing the elimination of dual class share structures (in italics).
1 The National Union of Public and General Employees reports that, as of April 2005, 6.57% of the 1,459 firms listed on the TSX had a dual class share structure.
2 Entrepreneurs also favor a dual class share structure since it allows them to raise capital without breaching the limit on foreign ownership in certain regulated industries.
3 In contrast, few findings show that abnormal returns are significantly positive for firms that changed from one share one vote into a dual class common share structure during the period 1979-1998.
4 The only exception was the share price for Laidlaw Inc. which declined by 1.4%.