Will the competition among global exchanges offset growing pressure in the US to limit disparate voting arrangements?

Introduction

A number of high profile initial public offerings and proposed corporate restructurings have involved issuers adopting or enhancing equity capital structures featuring disproportionate voting rights. These voting structures, which are permitted by state law and the US exchanges, often consist of one class of stock with ten votes per share and a second class having one vote per share. The higher voting shares typically are issued prior to the IPO to founders and other insiders while the public has the opportunity to buy only the lower vote shares. Offerings by companies with dual class structures and proposed restructurings which seek to implement similar arrangements following an IPO have served to reinvigorate a corporate governance debate that has been ongoing since the 1980s. Most recently the debate has been joined by an SEC advisory panel, a recently appointed SEC commissioner, the investment management industry and Congress, among others. While proponents continue to emphasize the benefits of private ordering and opponents decry the agency costs that such structures may bring, evolving market dynamics and global competition may ultimately determine the continuing viability of disproportionate governance structures for listed companies.

The last ten years has seen a dramatic increase in the level of capital allocated to passively managed investment media. Over the corresponding period and as a consequence of enhanced scrutiny following the Great Recession, a number of significant institutional investors and asset managers in the US have adopted stewardship codes and are becoming more active and engaged in the oversight function associated with their investment activities. Several large institutional investors and asset managers, as an element of their stewardship codes, have advocated for modifications to the current permissive environment that allows companies to adopt dual class voting structures. The concerns related to disparate voting rights are particularly acute for index funds which cannot sell a security that forms a part of an index even if the company is being badly managed. For such funds, meaningful voting rights are a critical enabler of their stewardship function. While there may be support for a change in the current environment permitting dual class structures, any such change would potentially result in a competitive disadvantage for the US exchanges. Disparate voting structures are permitted under the laws of many countries and two significant exchanges (Singapore and Hong Kong) have adopted changes to their listing rules which permit some level of flexibility with respect to disparate voting arrangements. So while the growth of passively managed investment media and the adoption of stewardship codes may result in increased pressure on legislators, regulators and the exchanges to address disparate voting structures, it is unclear whether any such change would be able to reconcile the goal of “one share one vote” with the competitive challenges faced by the US exchanges in securing the listings of the most attractive issuers.

The Growth and Expanding Influence of Index Funds

In response to the growing influence of index funds and other passively managed investment media the related focus on the manner in which fund managers exercise their fiduciary duties, institutional investors, including CalSTRS and Washington State Investment Board, and asset managers, including BlackRock, Vanguard and State Street, have adopted voluntary stewardship codes that commit the investors and asset managers to engagement with the management teams of their portfolio companies and transparency with respect to their voting and stewardship activities. Additionally, the stewardship codes include a corporate governance policy for companies in which the institutions invest that reflects a principle of “one share-one vote”. As a consequence, a number of significant asset management firms have indicated that they will vote against incumbent directors of entities with a dual class voting structure. Others have signaled some flexibility in addressing the issue of dual class voting structures endorsing sunset provisions or the potential for the non-affiliate shareholders to vote periodically to eliminate the dual class structure. In any event, with passive investment vehicles projected to exceed 50% of assets under management in the US by 2024 asset managers will play an increasingly important role in all aspects of shareholder rights including voting rights.

With the growth of assets in passively managed funds, the developers of popular indexes, including S&P, MSCI and FTSE Russell, have solicited the views of the asset management industry regarding the potential adoption of selection criteria for companies under consideration for inclusion in an index based on a company’s voting structure. The asset management industry has offered varying views regarding such a request from MSCI. The Council of Institutional Investors provided a response that is representative in many respects of those provided by several other organizations confirming its commitment to proportional voting rights and proposing that dual class companies to be included in the index provided they adopt a sunset provision. The CII proposal would allow a company to maintain its dual class structure for a period of years and then the higher voting stock would have voting rights identical to the other class of common stock provided the unaffiliated shareholders could vote to extend the dual class arrangement for an additional period of years without jeopardizing inclusion in the index.

Not all fund managers believe that restrictions imposed by the creators of stock indices are an appropriate means of addressing corporate governance issues and have signaled some flexibility around the “one share-one vote” baseline. BlackRock, for example, sent a letter to MSCI endorsing the notion of equal voting rights as the “preferable” structure for public companies but stating that governance standards were better addressed by policymakers than index providers. BlackRock also acknowledged that dual class structures provide benefits to newly public companies, but should have a limited duration either via a sunset provision or via a periodic vote of shareholders.

Other Views Relating to Dual Class Structures

In February 2018, the SEC’s Investor Advisory Committee issued a paper regarding dual class and other “entrenching governance structures” and made a series of recommendations to the staff of the Division of Corporation Finance. The proposals included additional disclosures relating to risks that may accompany dual class structures as well as data regarding the difference between the economic ownership of the control group versus the voting rights that accompany the super voting shares owned by that group. The recommendations reflect the traditional approach of the SEC to focus on disclosure as a means of addressing issues rather than mandating governance modifications. While the recommendations were limited principally related to disclosure items, the subcommittee’s report was animated by serious reservations regarding the growing use of dual class structures by companies going public in the US.

In response to the recommendations of the Investor Advisory Committee, a bill has been introduced in Congress (the Enhancing Multi-Class Share Disclosures Act) that would enhance the disclosure obligations of issuers with respect to disparate voting structures. The enhanced disclosure would require companies to clearly show the difference between the voting power and economic rights of a shareholder or group of shareholders owning “super voting” shares. The draft legislation is most notable for what it does not address. In its current form it does not authorize the SEC to adopt new rules relating to voting structures nor does it seek to amend the federal securities laws to otherwise mandate a “one share one vote” standard of corporate governance which, in any event, would likely be subject to constitutional challenge.

While the SEC’s rule making authority in the context of voting rights is constrained by a 1990 DC Circuit Court decision which struck down a prior SEC rule making intended to eliminate disparate voting arrangements, Commissioner Robert Jackson has urged US exchanges to adopt rules designed to preclude companies with perpetual dual class voting structures from listing on the exchanges. Instead, Commissioner Jackson proposed that the exchanges should require companies with dual voting classes to adopt sunset provisions as a condition to listing. In his comments regarding current practice, Commissioner Jackson noted that perpetual super voting shares that put “eternal trust” in the hands of insiders is “antithetical to our values as Americans”.

The Evolving Positions of Key Foreign Exchanges

While a consensus may be developing in the US for the imposition of limitations on disparate voting structures, the same is not the case outside of the US. Many foreign countries permit disproportionate voting arrangements and the stewardship codes adopted in countries outside the US do not include a “one share-one vote” principal. Moreover, the relaxation of the listing standards the Hong Kong and Singapore exchanges to permit the listing of companies with disproportionate voting rights, subject to certain conditions, presents a competitive challenge for the US exchanges seeking listings of the emerging Chinese tech giants.

As widely reported, Alibaba chose to list its 2016 IPO on the NYSE in part because the Hong Kong Exchange would not grant an exception to its rule prohibiting disproportionate voting arrangements. The Hong Kong Exchange’s new rules reference the ability of companies with “weighted voting rights structures” to list subject to certain limitations. In addition to a minimum market cap, the exchange has indicated that it will consider factors including the nature of the business of the applying company (it must be an “innovative company” with significant value and substantial expected R&D activities). Importantly, the holder of the weighted voting shares must be a person who has been responsible for the growth of the business and has an active role as an executive and director of the enterprise. The exchange has also imposed other limitations intended to protect minority shareholders such as requiring the holders of the weighted shares to hold at least 10% of the economic interests of the company, providing that the weighted voting arrangement will cease upon the transfer of the beneficial ownership of the shares and permitting the non-controlling shareholders to cast at least 10% of the votes on matters presented to a general meeting. As is the case with the US exchanges, the higher voting shares may not have voting power that is greater than 10 times that of the ordinary shares. Additionally, resolutions relating to modifications to the constituent documents of the entity, changes to voting rights of any class of shares, the appointment of auditors and the dissolution of the entity require a vote of all shareholders on a one vote per share basis.

The Hong Kong exchange has indicated that it will review applications on a case by case basis and apply the new rules on a subjective basis with a view towards providing additional guidance in the future. The Singapore Exchange has taken a similar position and modified its rules to permit dual class structures with certain limitations including a requirement that the issuer provide for a “sunset” of the enhanced voting rights under circumstances referenced in the offering documentation. The new rules adopted by both exchanges attempt to reach a middle ground permitting flexibility for high-growth companies while seeking to mitigate the governance risks associated with dual class structures.

As the exchanges continue to vie for lucrative listings, there will be pressure for each exchange to adopt (or maintain) flexible listing standards with respect to voting structures. The number of cross-border IPOs over the last decade suggests that issuers have an increased receptivity to listings outside their home market. Typically, the reasons for a cross-border listing are driven by liquidity or other market conditions, but governance considerations can be an important factor that the exchanges must balance when contemplating changes to their listing requirements. While commentators may view modifications of voting restrictions by the Hong Kong and Singapore Exchanges as a “race to the bottom”, there is increasing competition among exchanges for key listings of large internationally oriented companies that originate from jurisdictions which permit disproportionate voting structures and, absent regulatory changes or strong push-back from the investment community, those forces will likely continue to have implications for the evolution of listing standards.

In its letter to MSCI, BlackRock acknowledged the challenges presented by competition among exchanges for listings and suggested that a global agreement relating to minimum corporate governance standards establishing a minimum level of investor protection should be pursued. It offered that a global body such as IOSCO would be an appropriate organization to establish global listing standards as a means of formalizing best practices for the protection of investors. To date, neither IOSCO nor OECD has adopted a “one share one vote” principle in connection with their governance related studies and position papers. While OECD endorses the notion that all holders within a given class should have the same voting rights, it has also recognized that many countries permit multiple class capital structures with disparate voting rights and “does not take a position on the desirability of “one share, one vote””.

Implications for Dual Class Structures

A 2007 report issued by the OECD states the issue well: “…discrepancies between ownership and control can exacerbate the misalignment of incentives of controlling and non-controlling shareholders and… a separation of voting and cash flow rights may compromise the efficiency of markets for corporate ownership and control. The questions facing authorities is whether these potential drawbacks actually manifest themselves and, if so, whether their economic costs are sufficiently large to justify regulation.” Currently, there is no global consensus with respect to this issue and it remains to be seen whether competition among the major exchanges can be reconciled with evolving views of corporate governance in the asset management and institutional investor community. No matter the outcome, the growing engagement and influence of institutional investors and asset managers with respect to the exercise of their stewardship undertakings has the potential of increasing pressure on legislators, regulators and the exchanges in the US to eliminate or restrict disparate voting structures. The question is whether any resulting modifications to the existing permissive private ordering approach in the US will allow for some flexibility such as a sunset provision or a modified listing structure like that adopted by Hong Kong as a means of protecting the competitive position of the exchanges while responding to the demands of large institutional investors and fund managers.

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