The private ordering of corporate governance arrangements is a wonderful thing. It ‘allows the internal affairs of each corporation to be tailored to its own attributes and qualities, including its personnel, culture, maturity as a business, and governance practices.’ In effect, ‘observed governance choices are the result of value maximizing contracts between shareholders and management.’
Unfortunately, as we have learned from the recent Snap initial public offering (‘IPO’), which utilized a dual class share structure that included non-voting shares, the ability of a newly minted public company to take advantage of wealth maximizing corporate governance arrangements based on private ordering is slowly being eroded by the advocacy efforts of the shareholder empowerment movement (‘movement’) and its current allies, the mega-mutual fund advisors (Blackrock, Fidelity, Vanguard, State Street Global Advisors, T. Rowe Price, etc). As a result, we should expect the following effects on companies who utilize the US capital markets: 1) more and more successful private companies will be encouraged to remain private or delay going public, 2) the capital raising capabilities of these companies will be restricted by not having access to the US public markets, including the large and expanding pool of capital held by indexed funds, 3) the movement’s potential advocacy response to the corporate governance arrangements of a newly minted IPO is a new risk factor that a private company must now take into consideration when considering an IPO, and 4) index funds will become less representative of the investment universe they are trying to represent, reducing their value to mutual fund and exchange traded fund (‘ETF’) investors.
The movement, made up primarily of US public pension funds that hold more than $3 trillion in assets, advocates for the shifting of corporate decision-making authority to shareholders, without regard to the wealth impact on its pension fund beneficiaries. The Council of Institutional Investors (‘CII’), the trade organization that represents the movement, has always promoted a ‘one share, one vote’ policy. Dual class share structures clearly violate this policy and are an obvious threat to the power of the movement. That is, a public company that provides control to insiders through a dual class share structure can more easily resist the movement’s demands.
For purposes of raising capital, the Snap IPO was a huge success. Even though it offered no voting rights in the shares sold to the public, Snap priced its IPO at $17 per share, giving it a market valuation of roughly $24 billion. The book was more than 10 times oversubscribed and Snap could have priced the IPO at a price of up to $19 per share.
Such a success should not have been a surprise. In my recently posted paper ‘A Private Ordering Defense of a Company’s Right to Use Dual Class Share Structures in IPOs,’ I rely on Zohar Goshen and Richard Squire’s newly proposed 'principal-cost theory’ (see also here for a summary post) to argue that dual class shares in IPOs are a value-enhancing result of private ordering, even those that include non-voting shares. Fortunately, I am not a lone voice in the wilderness. Consistent with this understanding, NASDAQ Inc. recently declared:
Each publicly-traded company should have flexibility to determine a class structure that is most appropriate and beneficial for them, so long as this structure is transparent and disclosed up front so that investors have complete visibility into the company. Dual class structures allow investors to invest side-by-side with innovators and high growth companies, enjoying the financial benefits of these companies’ success.
Daniel Fischel beautifully summed up the private ordering argument in the following statement made some thirty years ago:
Some may argue that unequal voting rights are undesirable because they are inconsistent with the principle of ‘corporate democracy This argument, however, is fundamentally flawed. All firms, including corporations, consist of contractual relationships freely entered into by economic actors to maximize their joint welfare. Who has the right to vote and how and when the vote can be exercised are rights that are typically allocated by contract. In contrast to governmental democracies--which are usually designed to serve broader goals than wealth maximization—the optimal voting rules for any particular firm are those that maximize its value.
Well, let’s forget all about such shareholder wealth maximizing business and get down to reality. The CII saw Snap as a great opportunity to renew their attack on dual class share structures and their efforts have been rewarded. The S&P Dow Jones Indices has decided to exclude all new dual class share offerings, including Snap’s, from the S&P Composite 1500 (comprised of the S&P 500, S&P MidCap 400 and S&P SmallCap 600). So much for the ’position that an index provider should provide a comprehensive representation of the investable universe.’ Moreover, this is not a trivial exclusion as some $8.7 trillion in assets is benchmarked or indexed to the S&P 500. However, all firms with dual class shares that are already included in the S&P Composite 1500, such as Facebook, Berkshire Hathaway, and Alphabet, will be grandfathered in, helping to give the appearance that not much has changed, at least until it becomes obvious that the next wave of growth companies are missing from the targeted indexes.
The result of this decision should be quite significant. For private companies with a compelling need to have founders or insiders retain a firm lock on control even after going public, they now know that the value of a very desirable corporate governance arrangement to maintain that control has been dramatically reduced. If so, then perhaps the best alternative for these companies is to remain private and not proceed with an IPO.
Of more immediate concern, the S&P Dow Jones Indices has thrown the investors of Snap’s newly issued non-voting shares and dual class shares of other newly minted public firms under the bus in order to appease the movement and their allies, the mega-mutual fund advisors. Billions of dollars of investor value must have been lost because of this decision, impacting both mutual fund investors and the beneficiaries of public pension funds.
As I have argued in a previous blog post, mega-mutual fund advisors support the movement’s advocacy on dual class shares because of the opportunity to attract or retain the portfolio management business of the movement’s members, a business that is shifting away from high cost, actively managed mutual funds and hedge funds to low cost indexed funds, the kind of funds that the top 10 largest mutual fund advisors dominate in terms of market share. Yet, this advocacy has nothing to do with the interests of those who are investors in mutual funds, but of their agents. In contrast to what Bebchuk, Cohen and Hirst have recently argued, I find that mega-mutual fund advisors participate too much in corporate governance, not too little, as the primary benefits of their participation go to the advisors themselves and all the costs are absorbed by the mutual fund investors. In sum, the corporate governance activities of mega-mutual fund advisors is just another variation of what Ronald Gilson and Jeffrey Gordon would call the ‘agency costs of agency capitalism.’
When these two groups align in their advocacy, an alliance is formed that is very difficult for an index provider to overcome. Given their economic leverage in the domain of indexing, the members of the movement as investors and the advisors as the dominant index users, it is no wonder that the S&P Dow Jones Indices felt compelled to capitulate to their demands.
It was unfortunate but understandable that Snap did not realize that when valuing its primary corporate governance arrangement, the providing of control to its founders through the issuance of non-voting shares, it needed to take into consideration the possible post-IPO advocacy response of the movement and its allies. Perhaps Snap would have stayed private if it had known the true value of this arrangement. This advocacy response is a new risk factor that must now be taken into consideration when the next young and promising company considers an IPO.
Of course, index funds that are required to exclude the stock of certain public companies because they exhibit a certain attribute that is distasteful to the movement will become less representative of the investment universe they are trying to represent, reducing their value to mutual fund and ETF investors. But perhaps more fundamental to the objective of creating the most representative portfolio possible, these funds will not have the opportunity to include the stock of successful private companies that have shied away from going public.
It is not difficult to understand that if the value of private ordering is significantly reduced when a company goes public, then a lot more companies will not be going public. This may not be what the movement wants, but that is what it is going to get. So, if the movement has any sense, it will no longer enter into advocacy activities where the expected result is a reduction in the value of private ordering in public companies.
Finally, as a symbolic gesture, I have gone ahead and purchased a small number of Snap Inc. non-voting shares. It is the least that I could do.
Bernard S. Sharfman is an associate fellow at the R Street Institute, a member of the Journal of Corporation Law’s editorial advisory board, a visiting professor at the University of Maryland School of Law (Spring 2018), and a former visiting assistant professor at Case Western Reserve University School of Law (Spring 2013 and 2014).