Dual-Class Shares, Second-Class Investors

From the files of stuff you don't think about very often: Did you ever wonder why so many companies offer multiple classes of shares?

I'm not talking about preferred stock, which has some debt-like attributes to it, nor about the rapidly decreasing number of tracking stocks like Sprint PCS (NYSE: PCS  ) . I'm talking about those companies with "A" shares, and then "B" shares. In each of these situations, there is a component of privilege that one class has that the other lacks. In many cases, this has to do with voting rights, and it means that those with the secondary class status have even less of a say in the company than they would under a single class.

Feel free to guess which class of shares the company's management usually owns. Yep, that's right, the class with the higher level of voting power.

In effect, management is allowing outside shareholders to provide the majority of the capital while retaining majority control of these companies. This strikes me as a great deal for the management: They get many of the advantages of being a public company, yet their need to listen to shareholders is muted, even if those shareholders control a majority of the capital.

It would be like going to the polling booth on election day and discovering that for each one vote you get, the politicians who are running the country get 500. By so doing, they give you the ability to voice your opinion, but in a rigged election where you (or your entire class) have no real say in how the company is managed. Think this isn't a big deal? Ask the long-term owners of Digex, now a fully owned subsidiary of MCI (OTC BB: MCWEQ).

In Sept. 2000, before WorldCom fell apart in a blaze of scandal, it made a deal to acquire competitive local exchange carrier Intermedia Communications for about $6 billion in cash, stock, and assumption of debt. Now, Intermedia was a money-hemorrhaging business, and WorldCom didn't have much use for it. What WorldCom wanted was Intermedia's control of Digex, an enterprise hosting business. Intermedia owned 55% of Digex's stock, but because it owned a special A class, it controlled 94%, not 55%, of Digex voting power. Other Digex shareholders, including its management, were completely helpless to stop what was effectively a WorldCom takeover of Digex.

This shouldn't matter that much, right? After all, each individual shareholder barely has a say in corporate matters at any rate. That's a common view, and it's hopelessly fatalistic.

We've recently seen shareholder votes demanding change at companies like Hewlett-Packard (NYSE: HPQ  ) -- even the voice of the shareholders would have been muted in that case had management held a special class of stock that controlled, say, 50 votes per share. Shareholders are supposed to keep managements accountable, and their lack of participation itself allowed managements to run roughshod over shareholder interests in the 1990s. With dual-class stock structures, managements have even less reason to consider minority shareholders' interests. Burgundy Asset Management found in a survey a definitive cost for this disenfranchisement: Dual-class stocks tend to underperform over time.

Efforts to fight the dual-class share structure can be futile, once again, because the method of doing so usually involves a shareholder vote. In 1999, the big California pension fund CalPERS took on the dual-class structure at Tyson Foods (NYSE: TSN  ) , arguing that the company had underperformed for years while under the dictatorial control of the founding family, and thus a recapitalization under a single-class structure was warranted. This push was rejected by Tyson's board (the putative advocates of shareholders) and defeated by the Tyson family's supervote.

Just this past month, the dual-class structure at Quebecor, parent company of Quebecor World (NYSE: IQW  ) , received criticism as the company prepared to hold an initial public offering for subsidiary Quebecor Media. In this case, though they have sold more than half of the company's financial interests, the founding Peladeau family retains control of Quebecor's voting rights through its retention of a special class of shares.

How do you find out whether you're a second-class citizen in a company you hold? In the case of separate class shares that are also publicly traded, you'll see both listed when you search by company name. For example, Berkshire Hathaway (NYSE: BRK.A  ) offers a B share (NYSE: BRK.B  ) that has 1/30th the financial interest of its A class, but 1/200th the voting power. Still, there's no limitation against any shareholder buying an A share, with the possible problem that few have the spare 95 grand laying around to buy one.

Contrast this with LeapFrog (NYSE: LF  ) , which has a separate, untradable B class share (Note: There's no real naming convention for these things.) The traded A shares of LeapFrog comprise 22 million shares, or 39.4% of the economic interest of the company. Of the 33.9 million untraded B shares, Knowledge Universe, controlled by Michael Milken and Oracle (Nasdaq: ORCL  ) CEO Larry Ellison, control 93%. The B shares get 10 votes for every vote of the A shares, so the B shares as a class control 93% of the total voting.

This renders the traded shares of LeapFrog almost completely powerless to make any decisions for the company in terms of executive compensation, mergers, acquisitions, poison pills, board construction, anything. They put their money up, but they get no say.

My friends at West Coast Asset Management wrote about this subject recently (inspiring me to follow up with this column), asking: "Who will hold management accountable if shareholders cannot hold the board accountable?" They further noted that excellent management does not require the extra protection of a stacked voting deck. Too right.

When I considered LeapFrog as a potential investment recently, the dual-class share structure sealed the company's fate as a no-go. I am under no illusion that my shares would carry the day in a shareholder vote, but to have the collective opinion of all outside shareholders rendered unimportant told me what I needed to know about this company's management. We recently made some fun of Ctrip.com (Nasdaq: CTRP  ) and its disclosure that it had no plans to ask foreign shareholders for their opinions, but now that I think of it, situations like the ones at Quebecor, LeapFrog, and Digex are not much better.

Fool on!
Bill Mann, TMFOtter on the Fool Discussion Boards

Mathew Emmert searches high and low for good dividend-paying companies that offer the highest levels of corporate governance. Interested? Take afree trialof Motley Fool Income Investor today.

Bill Mann's looking forward to the next "family night" with the Atlanta Hawks. He owns shares of Berkshire Hathaway. Refer to his profile for a full list of his holdings. The Motley Fool is investors writing for investors.


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