Saturday, June 24, 2017

Non-voting shares response

Todd Henderson and Dorothy Shapiro wrote me a thoughtful response to my post on non-voting shares. Todd and Dorothy:

Response to Cochrane

We are grateful for Cochrane’s thoughtful response to our op-ed in the Wall Street Journal. Space limitations prevent us from giving the necessary treatment to our ideas, but he is right to push us to be careful in our analysis, no matter the limits. We look forward to addressing his concerns and others in a forthcoming article.

In the meantime, here is a quick response to the thrust of Cochrane’s critique.

There is a logical inconsistency in Cochrane’s post—his “modest proposal” would require more legal change to accomplish than ours. (And we are the ones with a vested interest in more law!) For one, it’s not clear that companies would willingly issue non-voting stock in addition to voting stock (and in the right amounts)—this occurs very rarely in practice, if ever.

Second, even if the shares existed, Cochrane assumes that index funds would willingly buy them, although there’s no evidence to suggest that this would occur.

The hostile reaction from large passive institutional investors, including BlackRock and Vanguard, to the Snapchat IPO and other recent dual class stock offerings make it clear that passive funds wouldn’t buy non-voting stock willingly—institutional investors participated in those offerings under protest and have since been advocating for reforms that would prevent future non-voting offerings, even going so far as to lobby Russel FTSE to delist companies that have dual class shares.

It’s also unlikely that non-voting stock would be much cheaper than voting stock—empirical evidence has demonstrated that often, non-voting stock doesn’t trade at any discount to voting stock (such as when there's a controlling shareholder or the company is well run).

Even if passive funds could purchase non-voting shares at a small discount, it’s not obvious that they would have any incentive to do so. Index funds have the sole goal of replicating the performance of an index. Why would they want to get a different product for a lower price? This is especially true when doing so would cause them to give up power and influence over some of the companies that they invest in (for a small benefit that investors are unlikely to recognize).

So, under Cochrane’s proposal, the law would have to not only require companies to issue non-voting shares, it would also need to require index funds to buy them. Talk about a lot of law! (Read: coercion.) Not only would this be a more dramatic change than the one that we propose, it would surely lead to a worse world. As an example, there could be liquidity concerns—if passive funds wanted to sell en masse (as can happen when funds are tracking the same index), there would be no buyers. And, if passive funds instead wanted to buy, there would be no sellers (and in this situation, it's unlikely that the non-voting shares would really trade at a discount).

By contrast, our solution--encouraging (but not requiring) passive funds to abstain from voting—is much less intrusive. Rather than mandating the creation of a new market of non-voting shares, we advocate a voluntary legal change that would permit natural correctives to any corner solution. The concern seems to be that if index funds abstain, too much power will be vested in the hands of activists, not all of whom will be interested in long-term shareholder value. But if index funds are merely encouraged to abstain unless they have no strong interest in the outcome, then there is a natural, market-based corrective to this problem. If activists go overboard, then index funds will have a strong interest, and reenter the voting market at that time. In a sense, Cochrane’s critique is ironic: we are calling for less law. We want law to get out of the way, by letting index funds act naturally—to not vote when they have no interest in doing so, and where they have no comparative advantage in the process. (Our other alternative, a legal duty to vote in an informed matter, and not just blindly follow ISS and other proxy advisors, is a clear second best.)


A little response-response clarification:

I do not envision any coercion!  So I  deny "under Cochrane’s proposal, the law would have to not only require companies to issue non-voting shares, it would also need to require index funds to buy them."

Index funds need to wake up and ask for non-voting shares, and then companies will issue them. The funds get a discount and absolution from legal trouble. Or companies need to wake up and offer non-voting shares to index funds. The companies get a new source of financing.

The non-voting shares I have in mind need do need a lot of smart lawyering and contract writing by people like Todd and Dorothy.  I accept the point that current non-voting shares are not as protected as they should be, that the promise ``you get exactly as much money as the voting shares, and you can sue as bondholders do if you don't'' needs teeth.

Indeed, the market is hostile to non-voting shares because current non-voting shares are designed to concentrate control with insiders, not to create a vibrant outside market for corporate control. That's the last thing insiders want, and a reason that companies will be slow to offer such shares unless funds start demanding them.

Sometimes the world hasn't arrived by itself at the optimum, just because nobody thought of it, not because there is a market failure, and not because law has not compelled it. We live in a time of legal and financial innovation, not just gadget innovation.

And index funds not voting aggressively is not a screaming problem that can't take some time to sort out.

(How to start a fight in a libertarian bar -- "You're advocating government intervention! No, you're advocating government intervention! I probably should have left that out of the original, and there is not much need to spend time on it in further discussion. Laws and contracts and courts are all on the menu at the libertarian bar.)



This is a good point. Perhaps we just need some good intermediation/financial engineering for index funds to routinely lend out their shares around votes.

Update 2 here


  1. The Henderson and Shapiro response was really good. After reading the response-response clarification, I sense that one of their important observations is being missed: that index trackers don't have a use for non-voting shares, because those are not the shares that are included in the index. Thus they will not buy them, and will not benefit from a discount.

    A mutual fund that is not necessarily committed to tracking an index might be interested in non-voting shares. But we haven't really heard them asking for such shares.

  2. You could presumably make an index of non-voting shares. And then track that. But the critique of who else would buy those shares (i.e. liquidity) is a good one.

    I get the impression that Henderson and Shapiro are suggesting that in the current regulatory framework index tracking funds are _obliged_ to vote, whether they want to or not. If that is true, then removing that obligation would make a lot of sense - why force uninformed shareholders to vote?

  3. I too prefer a market for corporate voting. See my post on this subject:

    You'll see some links there to papers that discuss how voting power can be achieved via stock lending. It's a murky market.

    "The non-voting shares I have in mind need do need a lot of smart lawyering and contract writing by people like Todd and Dorothy."

    I think this is easy to achieve. Canada has a much more active history of issuing non-voting shares than the U.S. To protect investors who own non-voting stock, Canadian companies have been required to include "coattail provisions" in their corporate charters. See here:

    In essence, when corporate control is changed the non-voting shareholders get to ride on the coattails of the voting shareholders, enjoying all the same rewards and privileges.

  4. Interesting topic. Shareholder democracy and good corporate governance are interesting issues. The use of staggered boards to entrench management is worth looking at.

    Like John Cochrane, I do not favor legal solutions, but it would be nice if large shareholders lobbied exchanges and indexers etc. to delist companies that do not meet certain corporate governance minimums.

    I hope we get to the day where government starts taking cues from corporate governance on transparency and accountability!

    Side note: Is there any reason why most city governments are not completely online and transparent? That is, the city financial books are online, every payment made, all contracts and all meetings done in front of a webcam etc.?


  5. An even simpler solution - all shares are voting shares, but if you want to exercise the vote you pay a small but meaningful fee to the company - say 0.25-1% of VWAP - or forego a similar portion of the dividend. This effectively dilutes you with respect to shareholders who decide not to vote. In exchange for the dilution you get to vote for a year. Maybe big shareholders with more than a 5% holding need to declare their voting intentions and give other parties time to respond, like current takeover rules, to prevent some obvious shenanigans.

    Most of the time you'd expect just the board and a few shareholders to vote a very small portion of their shares to maintain status quo. But an activist with a large shareholding might announce their intention to vote and suffer dilution for all their shareholding - but enjoy the excess return for being an activist. It's then incumbent on other shareholders who like the current structure to vote too and suffer dilution. But the more people who vote - and gets diluted - effectively reduces the penalty for voting; so the more need there is to vote, the lower the penalty for voting.


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