Should you invest in dual-class shares?

Should you invest in dual-class shares?

Have you ever found yourself in a position where you’ve had to turn away business – because accepting it would either bend (or break) your company rules, or strongly challenge the principles with which you traditionally carry out your work?

When it’s a small client, the decision is usually easy. But what about when it’s a potentially big new client that can catapult your business to the next level?

Maybe if you’re a private banker, it’s turning down a hugely wealthy client because it’s difficult to verify the source of his wealth. Or if you’re an advertising exec, it’s turning down a big tobacco account because you believe it’s fundamentally wrong to be in the business of convincing people to harm themselves.

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When the promise of profit clashes with principles, it can be a tough decision.

Hong Kong Exchanges & Clearing Ltd, or “HKEX”, (Hong Kong Stock Exchange; ticker: 388), the operator of Hong Kong’s stock and futures markets, along with the Securities and Futures Commission (SFC), the independent body set up to regulate those markets, faced such a decision back in 2013.


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Chinese internet giant Alibaba was looking to go public in what would ultimately be the largest initial public offering (IPO) of all time, at US$25 billion. The stakes couldn't have been higher for HKEX or the SFC.

Given Alibaba's size (US$225 billion at listing), a successful listing in Hong Kong would have brought in many tens of millions of dollars or more in annual listing and trading fees. It would also likely have paved the way for more large Chinese technology listings - as Hong Kong was, according to Alibaba Vice Chairman and co-founder Joe Tsai, the "natural" first choice of listing for Alibaba.

The problem was, Alibaba wanted to retain the power to nominate the majority of its board, even after listing - effectively giving Jack Ma and the other founding partners full control of the board.

This was a violation of Hong Kong's "one share, one vote" rules, which ban dual-class shareholding structures where not all shares are equal in terms of voting rights.

A war on shareholder rights

Over the years we've seen technology companies in particular (Google and Facebook, for example) issue dual-class shares (that is, shares with vastly reduced voting rights for investors) or even none at all in the case of Snap Inc.'s IPO earlier this year, and super-voting shares for the company founders who are raising capital.

Company founders argue that this allows them to preserve the long-term vision of the company, without the risk of shareholder activism, or pressure to manage earnings quarter-to-quarter in order to satisfy impatient shareholders.

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Critics scoff at this, pointing out that issuing shares without accountability to investors represents a "have your cake and eat it" attitude to corporate governance. Critics also highlight the fact that if managers are not beholden to their shareholders then they can be inclined to act in their own interests, not those of shareholders.

It's worth noting that large corporate governance advocacy groups the world over, like the Asian Corporate Governance Association and U.S.-based Council of Institutional Investors, strongly oppose dual-class listings. They say that these structures undermine corporate governance and shareholder rights.

And that is why Hong Kong's SFC said no to Alibaba.

The dollars will win

Profit usually wins. When Alibaba's founders decided to take their record IPO to New York instead of Hong Kong, they did so in pursuit of their own interests. The founders wanted to retain control. Hong Kong wouldn't let them do that, but New York has looser rules. So Alibaba listed in New York.

Unfortunately, standing firm on basic corporate governance principles by losing Alibaba cost HKEX money, and it cost Hong Kong a potentially huge feather in its cap as a big financial player alongside New York and London with the Alibaba listing.

The HKEX tried to push forward with a market consultation on introducing dual-class structures two years ago (a solicitation to the market, generally a precursor to a change in rules) but this was rejected by the SFC.

But now those principles are being threatened again. Earlier this year, the SFC supported HKEX's request for another market consultation regarding dual-class structures. And this consultation is the first step towards a change in SFC rules.

Why? Well, money is one motive. And the other is competition. The Singapore Exchange (SGX) recently wrapped up a public consultation on potentially introducing dual-class shareholdings.

This has all the signs of becoming a race to the bottom. Large companies, especially technology ones, looking to list will shop around for the most flexible (i.e. lax) listing jurisdiction. This is exactly what Alibaba did. So if Hong Kong can't compete with other major jurisdictions with its current rules, it will eventually succumb to pressure to relax them. Singapore is taking steps in the same direction.

Should you invest in dual-class shares?

Whether investors should touch companies with dual-class shares should be addressed on a case-by-case basis. When it comes to Snap Inc., for example, I think as an investor you'd be out of your mind to buy shares of this company. The founders, in their late 20s and who control nearly 90 percent of the vote, don't strike me as particularly remarkable or even mature individuals. To trust them with your investment, with no voting rights recourse, is foolhardy.

When it comes to Alphabet (Google), on the other hand, it's a different story. The company has a phenomenal track record and a strong competitive moat around its business. Management has proven itself. I think it's easier to - grudgingly - accept the lack of voting rights.

But either way, I predict we will see these kinds of listings start to permeate Asian exchanges in the not-too-distant future. So whilst Asian investors might get future Alibaba's listed in their backyard, the price of this convenience will be a chipping away of corporate governance standards.

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