Richard Truesdell, Davis Polk & Wardwell
Richard Truesdell at Davis Polk & Wardwell discusses the various corporate governance issues that arise when it comes to initial public offerings, and their effects on market practice.
Historically, large capitalisation companies, particularly those in the S&P 500, have been the focus of the overwhelming majority of attention on corporate governance issues. This year, however, the Snap initial public offering (IPO), which was the largest technology IPO since Alibaba, “pushed the envelope” by being the first US issuer to go public with non-voting common stock. As a result, Snap not only brought investor, media, academic and regulatory attention to its non-voting structure, but also engendered a broader conversation about shareholder rights in IPO companies more generally, including the predominance of staggered boards, plurality voting and other structural provisions considered to impair shareholder rights.
Snap went public with three authorised classes of common stock:
• Class A non-voting stock issued to the public in the IPO and listed on the New York Stock Exchange;
• Class B with one vote per share held by management and pre-IPO investors; and
• Class C with 10 votes per share held by the two co-founders.
While there are a few companies that have issued non-voting stock, including Alphabet and Under Armour (both by way of a dividend), and a few more that have authorised it but not yet issued it, including Facebook and IAC (although IAC recently announced it was abandoning plans to issue non-voting stock in response to a lawsuit by the California Public Employees’ Retirement System), Snap was the first to issue it to the public in its IPO.
There is a stark contrast between the “typical” corporate governance provisions for IPO companies versus public companies, in particular compared to medium-sized and large capitalisation public companies. It is quite common for IPO companies to include a litany of anti-takeover and other defensive provisions that, if proposed or adopted by a mid-cap or large-cap public company, would never receive shareholder approval and would likely engender shareholder proposals to eliminate such provisions. For example, in our 2016 corporate governance survey we found that 83 per cent of IPO companies surveyed had a classified board, as opposed to only 10 per cent of the companies in the S&P 500. Similarly, we found that 97 per cent of IPO companies surveyed had plurality voting as opposed to only 4 per cent of the companies in the S&P 500. Why the dichotomy? Traditional wisdom has been that the portfolio managers at large institutions that decide whether to buy IPOs are not very focused on corporate governance issues. In contrast, the proxy voting arms of institutional investors, which at most large investors are a discrete group separate from the portfolio managers, are keenly focused on corporate governance issues. As a result, prior to Snap, corporate governance issues have rarely created any marketing issues in the IPO context.
It is not that IPO corporate governance received no scrutiny before the Snap IPO. The influential proxy advisory firm Institutional Shareholder Services (ISS) has been troubled by the corporate governance standards for IPO companies for some time and instituted a policy in 2015 that it would hold directors of newly public companies accountable by issuing a negative recommendation if they approved pre-IPO corporate governance structures that impaired shareholder rights. Since then, ISS has continued to tighten this policy in 2016 stating that they would continue to issue negative recommendations until the provisions were addressed and in 2017 stating that public shareholder approval of the provisions post IPO would no longer be considered a mitigating factor. The other principal proxy advisory firm, Glass Lewis, has also increased its focus on newly public company corporate governance issues in recent years. Notwithstanding ISS and Glass Lewis’ focus, however, we have not seen a shift in practice prior to Snap.
Snap’s non-voting stock attracted investor attention and concerns not just because it was unprecedented and took the impairment of shareholder rights to a new level but also because of the ancillary consequences of issuing non-voting stock as opposed to voting stock. Non-voting stock is not an “equity” security for purposes of Section 13 or Section 16 of the Securities and Exchange Act of 1934. Accordingly, beneficial owners of 5 per cent or more of the outstanding shares are not required to disclose their ownership on a Schedule 13D or 13G and 10 per cent owners are not required to file a Form 4 in connection with transactions in the shares. As a result, there is less transparency to the market regarding changes in ownership of significant shareholders other than directors and officers that are still required to file Form 4s. In addition, because the stock is non-voting, Snap will not be required to file proxy statements under Section 14 of the Securities Exchange Act of 1934 unless a vote of the Class A stock is required by law and therefore will be able to avoid certain diclosures that are mandated only in proxy statements.
Snap has also drawn the attention of regulators. The SEC’s investor advisory committee discussed the topic at its quarterly meeting in March 2017. At the meeting, Ken Bertsch, the executive director of the council of institutional investors, argued that the SEC and the exchanges should revisit the listing rules that permit the listing of multi-class capital structures on the grounds that separating ownership from control poses substantial risks with respect to all three aspects of the commission’s tripartite mission: protecting investors; maintaining fair, orderly, and efficient markets; and facilitating capital formation. Although the comments were mostly critical of Snap’s non-voting structure, given the current deregulatory environment it is unclear what if any recommendation the investor advisory committee may make and what if any action the SEC may take. In addition, given the competitive pressure created by other exchanges, such as Hong Kong and Singapore, having proposed or are considering permitting multi-class voting structures, it is unlikely that the NYSE or NASDAQ will make their rules more restrictive. Even if the regulators do not act, investors, including the Council of Institutional Investors, have been lobbying the major index publishers to exclude non-voting and limited voting common stock from their indices. As a result, all of the major index publishers have publicly stated that they are reconsidering the eligibility of non-voting and limited voting stock for inclusion in their indices.
So where does that leave us? Probably back where we started. Since the Snap IPO we have not seen any other issuers attempting to go public with non-voting stock and only one company, Blue Apron, that included the ability to issue non-voting stock in its certificate of incorporation at the time of its IPO. It is unlikely that many issuers will want to risk the adverse reaction to non-voting stock for the marginal benefit it provides over low voting stock. Ten-to-one dual class structures are relatively uncontroversial. In our 2016 Corporate Governance Survey approximately 20 per cent of the IPO companies surveyed had dual class structures and they rarely create any marketing issues. While Snap temporarily brought a renewed focus on corporate governance in IPOs by academics and the proxy advisory firms, portfolio managers continue to be agnostic to shareholder-“unfriendly” corporate governance structures. Unless and until the portfolio managers become concerned about these issues it is unlikely we will see any change in market practice.