Dual-class shares have long been controversial. Proponents of this type of share structure contend that it is a voluntary arrangement between outside shareholders and a controlling shareholder who seeks a control position without fear of takeover. Opponents argue that controlling shareholders take advantage of their disproportionate voting versus cash flow rights to the detriment of outside shareholders. In light of this controversy, many Canadian companies have eliminated their dual-class structure. We examine the effect of dual-class unification on share value and liquidity of 32 Canadian firms from 1989 to 2010.
We study Magna’s recent dual-class unification as a clinical case to show the impact of the unification announcement on the firm’s value and the implications of the exit compensation package approved for the controlling shareholder.
Why unify dual-class shares?
Exhibit 1 tabulates the reasons given by dual-class companies for unifying their shares. The unification of dual-class shares and Exhibit 1 tabulates the reasons given by dual-class companies for unifying their shares. The unification of dual-class shares and the resulting symmetry in voting and cash flow interests should reduce agency problems. Agency problems associated with dual-class shares include excess compensation for executives who are controlling shareholders, lower dividend payout and higher management entrenchment.1 the improved corporate governance attracts investors, especially institutional investors who otherwise avoid dual-class shares (Li et al. 2008). Greater investor interest means a higher market value for the company and it eliminates the so- called dual-class discount. Amoako-Adu et al. (2009) find that between 1998 and 2002, TSX-listed dual- class firms sold at a discount of 14% compared to single-class firms with concentrated ownership.
Click image to enlarge.
Increased investor interest following unification of dual-class shares also improves trading liquidity. Higher trading liquidity lowers the cost of equity capital.
Empirical analysis of Canadian dual-class unifications (1989-2010)
As shown in Exhibit 2, the proportion of TSX-listed companies which had dual-class shares declined from 14% to 6% between 1989 and 2010. This may be a reflection of the concerns raised with the corporate governance problems associated with dual-class shares. a similar trend is observed in Europe where Pajuste (2005) found that from 1995 to 2001, the proportion of listed dual-class companies declined by 42%.
Click image to enlarge.
For the sample of TSX-listed dual- class companies which unified their shares over the 1989 to 2010 period, after controlling for the general market movement (cumulative abnormal returns (car)), share prices increased by about 8% during the -1 to +5 event window (see Exhibit 3). This implies that dual-class unification is on average value-enhancing. Liquidity of the company’s stock improved following unification. We observed a statistically significant improvement in two measures of liquidity – the relative bid-ask spread divided by the mid-quote, and the Amihud measure which is a ratio of the absolute percentage price change per dollar of daily trading volume.
Click image to enlarge.
As shown in Exhibit 4, cross-sectional analysis of the announcement gains indicate that firms with higher management voting leverage (bigger voting right versus equity right) had a bigger gain, and firms with lower financial leverage also had a higher return. This is consistent with the argument that outside shareholders of firms with the greatest divergence between voting and equity rights and hence the biggest potential for agency problems should have the most to gain from unification. Agency theory argues that firms with higher financial leverage will have lower agency problems because of creditor monitoring and discipline. Hence, the unification should have a smaller impact on companies with higher financial leverage. The inverse relationship between car and the illiquidity measure implies that firms which were more illiquid responded less.
Click image to enlarge.
Management voting leverage is the ratio of percentage of votes controlled by management to percentage of equity owned. *** and ** denote the results are significantly different from zero at the 1% and 5% levels, respectively.
Controlling vs. outside shareholders
How well did the controlling shareholders fare in these transactions relative to outside shareholders? As shown in Exhibit 5, in 20 cases, the exchange ratio of superior voting to new common shares was 1, the same as that for restricted voting shares. Thus, the controlling shareholders unequivocally did not have a higher percentage gain than their restricted-share counterparts.
In seven cases, the exchange ratio of superior voting shares to new common shares was greater than 1. The exchange ratio ranged from 1.05 to 1.26. Company proxy circulars justified the ratios on the basis that they reflected the relative prices of superior voting over restricted voting shares in the open market prior to the unification announcement. That is, if a company’s superior voting shares previously traded in the open market at $10.50 per share and the restricted shares traded at $10 per share, the company would offer a 1.05 exchange ratio to superior voting shareholders. By being paid 5% more for each of their shares, the superior voting shareholders were compensated for the 5% higher value of the shares in the market.
There were only two cases in which the controlling shareholder clearly earned a percentage return greater than the outside shareholders’. The cases were Sherritt in 2003 and Magna in 2010.
Click image to enlarge.
Magna’s case
On May 6, 2010, Magna announced that it was going to eliminate its dual-class structure by buying back and cancelling all 726,829 class B shares held by the Stronach trust. Each share carried 300 votes, thereby allowing Frank Stronach to control 66.1% of the votes of the company with only 0.64% of the equity. Upon unification, the class a subordinate voting shares were reclassified as common shares and the Stronach trust ceded control of the company to outside shareholders.
In exchange for the class B shares, the company paid Stronach US$300 million cash plus 9 million common shares of Magna issued from treasury. This gave Stronach 7.44% of the common shares. Stronach was also awarded a consulting fee worth about $120 million. In addition, Magna agreed to be the largest investor in an electric car venture controlled by Frank Stronach.
Was the compensation to Stronach excessive?
Excluding the E-vehicle joint venture, the combined value of the payout to the Stronachs was
$983 million:
Cash. . . . . $300 million
9 million common shares @ US$62.53. . . .$563 million
Consulting contract . . . . $120 million
Total. . . . . . . .$983 million
Using May 5, 2010 closing stock price of class A shares of US$62.53, the value of Stronach’s holdings of 726,829 shares was $45.45 million. Arguably, the base value of the class B shares should be raised to reflect the normal premium of these shares over subordinate voting class A shares. The average premium of class B over class a shares equals 6.42% over the 10 years prior to the class B shares being delisted in 2007. With an adjusted class B price based on this average premium, the value of Stronach’s holdings would be $48.36 million. The gain to Stronach is 1,933% ($983/$48.36-1).
In comparison, outside shareholders of Magna earned a return of 20% over the -1 to +5 days surrounding the May 6, 2010 announcement. Thus, outside shareholders experienced about one-hundredth of the percentage gain of Stronach. The relative performance of the outside shareholders should be considered worse if we attribute part of the 20% gain to Magna’s concurrent positive news announcements. On May 6, 2010, Magna announced that its earnings for the first quarter beat analysts’ expectations by 132%, though it simultaneously reinstated a dividend and also its revenue guidance for 2010 was higher by $2 billion.
We can also compare Stronach’s percentage return to what the 31 other companies with unifications paid their controlling shareholders who held superior voting shares. There was only one other company that had a special payout to the controlling shareholder. In 2003, Ian Delaney, the founder of Sherritt, proposed a succession plan in which shares of the company would be unified on a one-to-one basis. Delaney held 100 multiple voting shares, which gave him majority control of the company with over 130 million subordinate voting shares outstanding. He proposed a retirement compensation package which we estimate was worth $9.2 million or 1.2% of the value of the company.
In contrast, the Stronach package was worth about $983 million or 12.4% of the company. The Stronach payout is exceptionally large.
Despite the abnormally generous payout package for Stronach, a majority of the outside shareholders of Magna voted in favour of the proposal. Some institutional investors contested the proposal through the courts. The court decided that the payout was ‘fair and reasonable’. Institutional investors appealed the court decision to the divisional court, where the original decision was upheld.
In summary, the compensation to Stronach was excessive relative to all previous unifications in the Canadian market. In addition, because of the confounding effects of unification and positive earnings news on the stock returns of Magna, we cannot state unequivocally that the cost of the payout was smaller than the increase in outside shareholders’ wealth unlocked by the unification.
Supporters of dual-class shares can use Magna as an example of a company whose founder used dual-class structure as a method of financing to implement his aggressive growth plans without the fear of losing control. Opponents of dual-class firms can point to the excessive pay of its founder, including the payout under the unification proposal, as well as some value destroying non-automotive acquisitions when Stronach controlled the company with less than 1% of the equity. With strong arguments on each side, it is not surprising that the case continues to stir controversy over dual-class shares.
Policy implications
We propose policy measures that serve to preserve the dual-class share structure as a legitimate tool for financing corporate growth but lessen the possibility of egregious treatment of outside shareholders:
Regulators should make sure that full information is provided to protect investors against extraction of private benefits. Who is drawing money from the corporation and for what reason should be fully disclosed to investors.
All dual-class listed companies should have coattail protection for restricted shareholders. There should be no exemption for the handful of companies (like Magna) that were listed before 1987 when coattail was introduced as a TSX listing requirement.
The coattail protection should be expanded to include equal treatment of superior voting and restricted shares upon unification.
The ratio of votes held by each superior voting share to each restricted share should be restricted to a maximum of 10:1. This would eliminate the excessive wedge between voting and equity rights. By implication, non-voting shares should be converted to subordinate voting shares.
The Ontario Securities Commission should require sunset clauses with automatic trigger and reclassification upon the exit of the controlling shareholder. Any special compensation to be provided should be specified in the sunset clause, which should have been approved by two-thirds of all shareholders. A shareholder vote should be required every five years to renew the terms of the sunset clause.
Download a pdf of this paper.
About the authors:
Dr. Ben Amoako-Adu is Professor of Finance, Wilfrid Laurier University, Waterloo, Dr. Brian f. Smith, Professor of Finance, Wilfrid Laurier University, Waterloo, Dr. Vishaal Baulkaran, Assistant Professor of finance, University of Lethbridge, Alberta.
Note: This article is an abridged version of a paper commissioned by the Capital Markets Institute, Rotman School of Management, University of Toronto and presented at the Capital Markets Institute Conference on Dual-class Shares on February 15, 2011. The full paper is available by request from the authors.