New Study Says Multiclass Voting Companies Underperform, Riskier

IRRCi, IRRCi Research

Tuesday, October 2, 2012

Webinar Scheduled for Monday, October 8, 2012 at 2 PM ET

NEW YORK, NY, October 2, 2012 – A new study finds that controlled companies – particularly those with multiple classes of shares – generally underperform over the long term. As compared to companies with dispersed ownership, controlled companies experience more stock price volatility, increased material weakness in accounting controls, more related party transactions, and offer fewer rights to unaffiliated shareholders. The study results challenge the notion that multiclass voting structures benefit a company and its shareowners over the long term.

The study, Controlled Companies in the Standard and Poor’s 1500: A Ten Year Performance and Risk Review, was commissioned and funded by the Investor Responsibility Research Center Institute (IRRCI) and conducted by Institutional Shareholder Services Inc. (ISS). The full study is available here.

Most U.S. companies feature “one share, one vote” governance provisions to allow voting power to elect directors that is directly proportional to an investor’s capital at risk. For a growing number of companies, however, voting power is concentrated through the use of different share classes to allow insiders or founders to control board of director elections.

The study discusses a recent quartet of high-profile technology companies that went public with such multiclass governance structures. Of these four, only Linked In has rewarded investors as of August 31, 2012, with a 138% stock price increase since its initial public offering (IPO). The stock prices of Zynga, Groupon, and Facebook, however, are far below their initial public offering (IPO) prices by 72.0, 79.3 and 52.5 percent, respectively. The study makes clear that this issue of multiclass ownership structures extends far beyond these recent technology sector companies.

Key findings of the study include:

  • The number of controlled companies has increased over the last decade. In 2002, there were 87 controlled firms in the S&P 1500 Composite; today, there are 114. Of these, 79 feature multiclass capital structures with unequal voting rights and 35 are controlled firms with a single class of voting stock.
  • Contrary to the theory, non-controlled firms outperformed controlled firms over the 3-year, 5-year and 10-year periods ended August 31, 2012. Control companies featuring multishare classes only outperformed over the shortest time period measured – one year – and materially underperformed over longer periods of time. By contrast, control companies with a single share class outperformed all others over longer time periods. The nature of the control mechanism appears to matter.
  • Controlled companies with multiclass structures consistently exhibit materially more share price volatility than non-controlled companies. By contract, controlled companies with a single class of shareholders consistently exhibit more share price stability.
  • Controlled companies have more material weaknesses in control environments than non-controlled companies.
  • Controlled companies have more related party transactions than non-controlled companies.
  • Institutional investors cite concerns with investing in controlled companies, but generally do not have formal policies concerning such firms. Most investors report that controlled firms are less responsive to their inquiries and engage in less outreach than non-controlled firms.
  • The governance provisions of controlled firms with a single class of stock often differ from those with multiclass capital structures, and in some respects more closely resemble those of non-controlled firms. Controlled firms with a single class of stock have more conventional governance features with respect to board accountability and shareholder rights compared to controlled firms with multiclass capital structures.

“Investors have long taken a limited view toward controlled firms with multiclass capital structures because of such structures’ inherent negative impact on the rights of unaffiliated shareholders,” said Sean Quinn, report author and vice president with ISS. “This study finds that in addition to offering unaffiliated shareholders comparatively fewer rights, these firms underperform and show higher levels of risk than their single-class peers,” he said.

“Recent IPOs have thrust the issue of multiclass companies into the spotlight,” said Jon Lukomnik, IRRCi executive director. “Supporters of these structures claim that control of a company’s voting power enables management to govern with minimal outside interference and focus on long-term business growth, and ultimately deliver higher returns to shareholders in exchange for control rights.”

“However, the study finds the opposite to be true. When control is exercised through multiclass structures, those companies perform worse and are more risky. In contrast, when company control is aligned with unaffiliated investors in a single class of stock, the result is companies perform better over the long haul and are less risky. Alignment matters. The method of control matters.”

In this study, the definition of control included any person or group owning 30 percent or more of a company’s voting power. The study examines firms in the S&P 1500 Composite Index as of Jan. 1, 2012, and discussions with representatives of six institutional investors and two investment banks to provide context to observable findings.

The Investor Responsibility Research Center Institute is a not-for-profit organization headquartered in New York, NY, that provides thought leadership at the intersection of corporate responsibility and the informational needs of investors. More information is available a the IRRCi Website

Institutional Shareholder Services Inc. is the leading provider of corporate governance solutions to the global financial community. More than 1,700 clients rely on ISS’ expertise to help them make more informed investment decisions on behalf of the owners of companies. More information is available at www.issgovernance.com.

Media Contact
Kelly Kenneally
+1.202.256.1445

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New Executive Compensation Research: Peer Group Benchmarking Inherently Flawed And Inflationary

IRRCi, IRRCi Research

Saturday, September 22, 2012

NEW YORK, NY, September 22, 2012 – An over-reliance on peer group compensation benchmarking is central to the persistent issue of rising executive pay in the United States, new research finds. While other research examines flawed peer group methodology, this new study makes it clear that peer grouping with minimal board discretion is a seriously flawed methodology even when the peer groups are fairly constructed.

The study also is the first to document that peer group benchmarking – now so widely utilized that it is enshrined in federal regulations – has accidentally become the de facto standard even though it never was designed to determine CEO compensation.

“Executive Superstars, Peer Groups and Over-Compensation – Cause, Effect and Solution,” finds that moving to a compensation system that instead focuses on internal, company-specific metrics and benchmarks will result in a more reasoned executive compensation approach, improved board oversight, and a healthier corporation.

The study is authored by Charles M. Elson and Craig K. Ferrere of the John L. Weinberg Center for Corporate Governance at the University of Delaware and funded by the Investor Responsibility Research Center Institute (IRRCi). The full study is available at http://www.irrcinstitute.org/projects.php and http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2125979.

“We find that peer group comparisons are central to the CEO ‘mega pay machine’ problem,” said study co-author Charles Elson, chair in Corporate Governance and director the John L. Weinberg Center for Corporate Governance, University of Delaware. “Even the best corporate boards will fail to address executive compensation concerns unless they tackle the structural bias created by external peer group benchmarking metrics. We find that boards should measure performance and determine compensation by focusing on internal metrics. For example, if customer satisfaction is deemed important to the company, then results of customer surveys should play into the compensation equation. Other internal performance metrics can include revenue growth, cash flow, and other measures of return,” Elson explained.

“This report is unique in that it takes a pragmatic approach to executive compensation theory, and begins with an examination the peer group process,” said study co-author Craig Ferrere, the Edgar S. Woolard Fellow in Corporate Governance at the Weinberg Center. He added, “It’s also important to note that the use of peer group analysis was never intended to be central to senior management compensation. Historically, it was designed after World War II to compare jobs such as accountants and civil engineers across companies. In hindsight, it was an easy but misguided approach that eventually led to the application of peer grouping to CEOs and senior executives.”

“These findings have profound implications for CEOs, directors, and investors,” said Jon Lukomnik, IRRCi executive director. “It indicates that corporate boards need to de-emphasize peer grouping, and increase the emphasis on their company and executive accomplishments. Companies are better served when directors use discretion – both up and down – in setting compensation structures and levels. For investors, the study reveals a need to move away from formulaic peer group analyses in judging compensation packages, and hold directors accountable for their judgements. Shifting from the peer benchmarking process certainly isn’t the total fix, but moving towards an internal metric approach has the potential to contribute to solving the compensation problems that plague many public corporations,” Lukomnik added. The research paper argues that:

  • Theories of optimal market-based contracting are misguided because they are based on the notion of vigorous, competitive markets for transferable executive talent;
  • Even boards comprised of the fiduciaries faithful to shareholder interests will fail to reach an agreeable resolution to compensation when they rely on the flawed and unnecessary process of peer benchmarking;
  • Systemically, a formulaic reliance on peer grouping will lead to spiraling executive compensation, even if peer groups are well constructed and comparable; and
  • The solution is to avoid arbitrary application of peer group data to set executive compensation levels. Instead, compensation committees must develop internal pay standards based on the specific company, its competitive environment and its dynamics. Relevant considerations include an executive’s current and historic performance and internal pay equity. Some reference to peer groups may be warranted, but the compensation process must maintain the flexibility necessary to arrive at a reasonable approximation to what is absolutely necessary to retain and encourage talent.

This research adds to the body of executive compensation research funded by IRRCi. A previous IRRCi funded study finds companies with high executive pay skew of compensation peer group benchmarking available at http://www.irrcinstitute.org/projects.php?project=46.

The Investor Responsibility Research Center Institute is a not‐for‐profit organization established in 2006 to provide thought leadership at the intersection of corporate responsibility and the informational needs of investors. The IRRC Institute ensures its research is available at no charge to investors, corporate officials, academics, policymakers, the media, and all interested stakeholders.

The John L. Weinberg Center for Corporate Governance proposes progressive changes in corporate structure and management through education and interaction. Established in 2000 in the University of Delaware’s Alfred Lerner College of Business and Economics, the Center provides a forum for those interested in corporate governance issues to meet, interact, learn and teach. Using the fully endowed Edgar S. Woolard, Jr. Chair of Corporate Governance as the base, the Center develops programs that generate local, national and even international interest.

Media Contact Kelly Kenneally +1.202.256.1445

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