AMEX Proposal Could Create a Shareholder Caste System

In the next few months, the Securities and Exchange Commission is expected to rule on a technical change in shareholder rights that could have a dramatic impact on U.S. companies and the people who invest in them.

In a nutshell, the rule would allow companies listed on the American Stock Exchange to create separate classes of common stock. Shareholders in one class would be allowed more votes than those owning the second-class stock.

The AMEX says such two-tiered voting structures are a needed alternative for companies wanting to raise capital without giving too much control to investors. And, many companies like the proposed rule because dual-class voting provides an effective deterrent to hostile takeovers.

However, detractors liken the concept to allowing a handful of corporate insiders to stuff the ballot box at every election. And, they maintain that it creates a corporate caste system in which company managers are the powerful elite and individual shareholders the “untouchables.”

In any case, if adopted, this rule could hit individual shareholders right where it counts--the pocketbook.

Here’s how. The AMEX rule would allow already-listed companies to restructure and create a two-tiered system. However, to complete the restructuring, they would have to win approval from two-thirds of shareholders--including shareholders who would lose a substantial portion of their voting rights under the new deal.

Why would these shareholders give up some of their power? They’d probably get paid to do so. Typically, the way these plans work is that companies pay “special dividends” to all shareholders after the restructuring plan is approved. The amount of the special dividend varies in each deal.

In the long run, though, shareholders are likely to lose, according to a recent study by John Pound, associate professor at Harvard University’s John F. Kennedy School of Government.

The study, which looked at 1,100 of the nation’s biggest firms, found that companies that restrict shareholder rights are less likely to be “great” performers than companies that don’t.

The Harvard study looked at several measures of performance, including return on assets, operating margins and market value. It then divided companies into excellent, mediocre and poor performers. Overall, companies with few shareholder restrictions were between 30% and 50% more likely to be excellent performers than companies that had few, if any, such restrictions, the study said.

Pound said in the study that he didn’t know why the restrictions seemed to have such a negative effect on corporate performance.

He speculated that it could be one of three things: Companies with poor performance sought the restrictions to protect themselves, there was less opportunity for outsiders to force management at protected firms to correct their mistakes or “it may be that the adoption of governance protections, by providing management with long-term insurance against a hostile change in control, led in many cases to a direct diminution in effort and long-term planning.”

While the bulk of the companies studied by Harvard had some sort of takeover restriction, few had dual-class voting structures, Pound noted. That’s because the Securities and Exchange Commission and several of the nation’s biggest stock exchanges moved to limit disparate voting rights in the late 1980s.

In general terms, the limitations allowed companies to create dual-class structures when they first went public, but they barred companies that were already public from converting to the structure.

The general theory is that individuals who buy into initial public offerings are likely to get a prospectus that delineates the risks. Conversions leave open the possibility that at least a minority of the shareholders could be hurt through no fault of their own.

If the SEC approves the changes proposed by AMEX, some believe that the restrictions on dual-class voting will evaporate everywhere. Companies are placing a tremendous amount of pressure on exchanges to accept dual-class voting, and stock exchanges--which are desperately competing for business--may feel compelled to capitulate, said Robert Pozen, general counsel and a managing director of Fidelity Investments, one of the nation’s biggest mutual fund companies.

That’s dangerous, Pozen maintains.

Often, the high-vote shares land in the hands of company managers and other insiders, and the low-vote shares go to everyone else. That makes it nearly impossible for unhappy shareholders to oust managers or directors run amok. Admittedly, such happenings are rare, but it is important that shareholders have the power to act when necessary, he added.

“This takes away the safety valve,” Pozen said. “If this gets through the SEC, there will be a substantial number of companies where shareholders will not be able to hold management accountable. If shareholders lose the ability to police the outer limits of corporate conduct, they lose a very important thing.”