Analysis: Loyalty shares, dual-share classes and their role in investor stewardship

Is ‘one share, one vote’ really the only option for long-term investors?

For many in the responsible investment world, ‘one share, one vote’ is on a par with ‘one person, one vote’ – a fundamental tenet of shareholder democracy.
Just last week, for example, the US Council of Institutional Investors (CII) wrote to Martin Schulz, 
President of the European Parliament, to express its opposition to a proposed amendment to the Shareholder Rights Directive (amendment 42) that it said would “upend the bedrock principle of ‘one share, one vote’.”
The CII has also petitioned the New York Stock Exchange and Nasdaq to introduce standards that require newly-listed companies to have a single class of common stock with equal voting rights.
How can companies truly be overseen by investors, goes the thinking, if there are skewed ownership structures? Take News Corp., with its controlling shareholder, apparently short-changing investors. The ownership structure is one of a host of complaints investors have with Murdoch, of course. The lack of ‘one share, one vote’ is, in the words of one well known governance figure, “absolute anathema”.
But how true is it that ‘one share, one vote’ is the best solution for long-term investment? Shouldn’t long-term, patient capital rather look at each situation on a case-by-case basis and not simply reject what appears to be “unequal” treatment out of hand?
The issue came to the fore last week in Italy when a group of investors (in fact, asset managers such as Fidelity, Aviva, Threadneedle Investments, Schroders, UBS and board members at leading firms such as Eni and UniCredit) objected to the government’s plan to introduce loyalty shares. In the event, the government of Prime Minister Matteo Renzi backed down under the pressure.
Into this debate has stepped First State Investments, the Australian-owned fund manager. In a recent article (“Dual share class blundering”), the firm has explained how its position on this has changed over time. It is an interesting counter-argument to the ‘one share, one vote’ orthodoxy.

“Fifteen years ago we used to send letters to companies and stock exchanges extolling the virtues of single share classes, tag along-rights and ‘one share one vote’. Today, we actively seek out companies with dual share classes,” the firm says.This is because the “collapse of time horizons” has increased the damage that short-term markets can inflict on listed businesses, First State reckons.
The lack of a “long-term, protective” shareholder leads to short term pressures on firms, runs the argument, with short-termism being responsible for value destroying buybacks, bonuses and accounting practices.
“It can take decades,” First State argues, “rather than years or months, to manoeuvre listed companies towards more sustainable business models.” The firm acknowledges that dual share structures come with significant risks for minority shareholders but “find the right combination of structure and steward and those risks are worth the benefits”. First State advises that the “integrity of the steward must be beyond question” and that for its investments in companies such as Henkel in Germany and Banco Bradesco (Brazil) “the presence of a long-term steward” is vital.
“We suspect the best long-term solution may be the separation of capital markets, into a long-term, slow, long-only equity market and a high turnover casino for short-term speculators,” says First State. But it admits it has no idea how such a system could be designed in theory or introduced in practice. So the firm is hoping to launch a stock exchange competition “to invite smarter people than us to apply their brains to the problem”.

Some academic work on this topic was put together a few years ago by Columbia Business School Professor Patrick Bolton and Frédéric Samama of Amundi. They argued so-called L-shares (loyalty shares) could encourage longer-term investing by giving shareholders a reward after a contractually set period of time in the form of a warrant. L-shares are a “simple contractual innovation that helps restore the balance between long-term investors and short-term speculators,” the researchers concluded in their paper. This research prompted Al Gore, the former US Vice President, to advocate loyalty shares. In France, major players like L’Oreal and Air Liquide have loyalty share programmes, where shareholders on the register for two straight years receive a 10% dividend boost.
But there is academic research offering evidence that dual-class share structures hinder corporate performance.
A Wharton School and Harvard Business School study found that while large ownership stakes in executives’’ hands tend to improve corporate performance, heavy voting control by insiders weakens it. And dual-class companies tended to be burdened with more debt than single-class companies. The bottom line of the research is that dual-class stocks tend to under-perform the market as a whole.

Elsewhere, a study commissioned by the Investor Responsibility Research Center Institute (IRRCI) and conducted by Institutional Shareholder Services in 2012 found that so-called “controlled companies – particularly those with multiple classes of shares” – generally underperform over the long term.They experience more stock price volatility, increased material weakness in accounting controls, more related party transactions, and offer fewer rights to unaffiliated shareholders, the study found. It challenged “the notion that multiclass voting structures benefit a company and its shareowners over the long term”.

Loyalty, stewardship – these are unusual terms, perhaps, for an investment website. But they emphasise the idea of a “bond” between investors and companies, of a set of rights and responsibilities for both sides that should be mutually understood. The long term is not going anywhere, so maybe it’s time for a rethink about how to get there?