Institutional EYE

Commentary on Corporate Governance Issues

Prepare to unfriend promoters

May 9, 2016

Last month, Facebook announced that its board of directors had "approved a proposal to amend and restate our existing certificate of incorporation to create a new class of non-voting capital stock, known as the Class C capital stock. If the proposal is approved, we intend to issue two shares of Class C capital stock as a one-time stock dividend in respect of each outstanding share of our Class A and Class B common stock. This proposal is designed to create a capital structure that will, among other things, allow us to remain focused on Mr. Zuckerberg's long-term vision for our company and encourage Mr. Zuckerberg to remain in an active leadership role at Facebook".

Facebook currently has two classes of shares - Rs 2,311,052,873 Class A common stock and Rs 548,638,840 Class B common stock. Class A shares entitle shareholders to one vote per share. Class B shares carry 10 votes each. The new class C shares will not carry any voting rights.

Zuckerberg, the company's chief executive, owns nearly four million Facebook Class A shares and 468 million of the super-voting Class B shares, giving him control of over 60 per cent of the votes.

But, over time, Zuckerberg will be diluted down - for two reasons. The first is in the "ordinary course of business". The company will issue shares to employees or use shares as a currency for acquisition. The second, which will dilute him quicker, is the commitment that 99 per cent of the shares held by him will be sold/gifted to charity.

Zuckerberg's big bets on Instagram and Whatsapp, questioned at the time of the acquisition, are starting to pay off, cementing his status as a visionary and as the best person to lead Facebook. The board believes that "a large part of Facebook's success has stemmed from the leadership, creative vision and management of Mark Zuckerberg, and that the company's future success will depend on Mark's continued leadership".

So, the issuance of these shares will help keep operational and ownership control with Zuckerberg.

Issuing Class C (or non-voting shares) as bonus implies that he can sell the shares in sequence - first Class C shares, then Class A, before finally touching the Class B shares retaining in control for a lot longer. A Bloomberg analysis shows while under the existing structure, selling shares aggregating just US$6.1 billion pushed him below 50.1 per cent voting: but, under the proposed structure, he will be able to sell shares aggregating US$32.7 billion without losing dominant control over voting rights.

Facebook has already been hit with lawsuit over a plan to issue new stock, citing that "Zuckerberg wishes to retain this power, while selling off large amounts of his stockholdings, and reaping billions of dollars in proceeds" and that the "company takes our money, but does not give us a say in management". That proceeds are to be used for charity does not seem to cut ice as this proposal strikes at the heart of corporate democracy: One share one vote.

The case in favour of dual or multiple class shares argues that the promoters/founders have a long-term vision - as opposed to investors, who often have a short-term outlook. The dual class protects this vision and the company during a lean patch.

Those opposed to dual or multiple class voting shares argue that this allows "owners" to own only a small portion of the total shares, but get a disproportionate control over the votes. Given their emotional connect, (generations of) families entrench themselves into the operations of the company and are difficult to dislodge regardless of their abilities or performance.

The regulatory opinion, too, is divided. The New York Stock exchange permits multiple classes of shares to list (though there was a 15-year period after 1940 when it did not allow non-voting shares to list). Marquee names like Berkshire Hathaway and Alphabet (earlier Google), have dual classes of shares. The Hong Kong Stock Exchange does not permit these, which explains why a large number of Chinese firms, including Alibaba, Baidu and JD.com, are all listed on the Big Board. In fact, just prior to the Alibaba listing last year, the Hong Kong Stock Exchange toyed with the idea of changing regulations and permitting listing dual class shares, but the Hong Kong Futures and Exchange Commission is believed to have shot down the proposal.

Are there lessons for India Inc.?

India has permitted dual class shares since 2000. Four companies have a dual class structure (Tata Motors Ltd, Future Retail Ltd, Jain Irrigation Systems Ltd and Gujarat NRE Coke Ltd) and these on an average trade at a 28 per cent discount to the market price. What explains this steep discount given that investors have traditionally not voted their shares?

My take is that this discount reflects that investors don't like differential voting rights, and perceive these to increase the risk of being abused by controlling shareholders. Unless investors start to trust managements, companies will find limited takers for non-voting shares.

There is one other important lesson for boards in India: the Facebook special committee of directors and its board played a critical role in designing the new capital structure that both keeps and protects the company from its founder. While proposing non-voting shares, the independent directors have negotiated a clause that permits them to revoke the super-voting rights of the Class B shares (i.e. they convert to Class A shares) held by Zuckerberg should he die, be fired or resign. Have we ever seen the board take such a stance in India? When did you hear about a board scenario prepare for the potential termination of a founder-CEO and then insert clauses in the company's bye-laws? Or planning for a promoter's exit, who still casts such a long shadow that his successor is not able to function freely? Or saying that the board will decide on what is willed to the legal heirs? Boards in India need to create a distinction between the interest of the company and that of the promoter. This is the shift they need to make in their thinking.

 

 

A modified version of this article written by Amit Tandon appeared in Business Standard. View article Prepare to unfriend promoters.

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