The SEC, Corporate Governance and Dow Jones

We will begin a series of posts on the role of the Securities and Exchange Commission in the corporate governance process.  For those who think there is none, look again.  As my paper points out, the Commission has long been involved in the governance process, with the role only increasing.  SOX added to this authority and the role is likely to increase.  The debate, therefore, is not about whether there should be Commission involvement but the form that involvement should take.

The recent offer by News Corp, the Ruport Murdoch controlled company, for Dow Jones & Co represents a good place to begin the discussion.  Dow Jones has a dual class capitalization structure, something it created in 1984, part of a waive of these transactions that took place during the hostile takeover era.  The recapitalization resulted in a class of Common Stock with one vote per share and Class B Common Stock with ten votes per share.  The Class B shares effectively elected a majority of the board (the articles require a board of between 16-18 directors, with the Common Stockholders having the right to elect seven).  The articles are here.  The Class B shares retained voting control although they represented only about 25% of the outstanding shares.   As the 2007 proxy statement noted:   

• "At the close of business on the record date, February 23, 2007, there were outstanding and entitled to vote 63,685,401 shares of Common Stock and 20,077,479 shares of Class B Common Stock of the Company. Each share of Common Stock is entitled to one vote. Each share of Class B Common Stock is entitled to ten votes. The Common Stock, voting separately as a class, is entitled to elect seven directors at the Annual Meeting to each serve a one-year term expiring in 2008. The Common Stock and the Class B Common Stock vote together with respect to the election of nine directors at the Annual Meeting to each serve a one-year term expiring in 2008 and all other matters submitted to the stockholders."

The dual class system is the ultimate anti-takeover device.  The Bancroft family owns 82.4% of the Class B shares and 6.4% of the Class A.  They currently have about 64% of the total voting power but only somewhere around 25% of the total equity. 

The dual class structure raises two obvious questions.  The first concerns the independence of the board of directors.  The other concerns the fairness of a system that allows for the effective disenfranchisement of most equity shareholders. 

With respect to the first issue, the 2007 proxy statement lists as "independent" directors all "of the non-management directors of the Company" including at least four representatives of the Bancroft family, Christopher Bancroft, Elizabeth Steele, Leslie Hill and Michael B. Elefante.  This was the case despite the voting control exercised by these directors.  As noted in the Proxy Statement:  

• "As of January 19, 2007, Mr. Bancroft, Ms. Steele, Ms. Hill, certain of their relatives, and certain trusts and charitable organizations established by them, including trusts for which Mr. Elefante serves as trustee, owned beneficially a total of 4,065,088 shares (6.4%) of the outstanding Common Stock and 16,540,874 shares (82.4%) of the outstanding Class B Common Stock. Such shares account for approximately 64.2% of the votes represented by the outstanding Common Stock and Class B Common Stock and account for 24.7% of the total number of outstanding shares of Common Stock and Class B Stock."

In other words, these directors fulfilled the definition of independent contained in the rules of the NYSE.  This is because the NYSE merely asks whether directors have a "material relationship" with the company and does not take into account stock ownership.  Indeed, as the commentary to NYSE Manual 303A.02 provides, "as the concern is independence from management, the Exchange does not view ownership of even a significant amount of stock, by itself, as a bar to an independence finding."  The question of whether stock ownership by directors can impair independence is controversial enough (it can, for example, encourage support for questionable strategies designed to prop up share prices)  but where there is a growing divide between voting control and equity ownership, the case against independence is stronger. 

With respect to the second issue, the creation of the Class B shares raises questions about the vitality of fiduciary obligations and their ability to protect shareholders.  In creating the dual class structure, Dow Jones did so in a manner that brought little benefit to existing shareholders.  The Company distributed Class B shares to all shareholders but subjected the shares to transfer restrictions.  As thecharter  provided, they could be converted into Common Stock at any time.  Those shareholders favoring liquidity over control converted while the family retained the supervoting stock.  The recapitalization was challenged in state court (in the New York courts) but was settled.   

While the Bancroft family controls around 25% of the equity, this number could fall considerably without impacting voting control.  The family could retain around 8 million Class B shares, which would represent about 11% of the total number of shares (Common Stock and Class B), still have voting control, and prevent any unwanted acquisition, no matter how favorable to shareholders.

The concern about AB recapitalizations resulted in the most overt intrusion so far by the SEC into the corporate governance process.  In 1988, the Commission adopted Rule 19c-4, which mandated a one share, one vote listing standard.  See Exchange Act Release No. 25891 (July 7, 1988).  The rule was ultimately struck down by the DC Circuit in Business Roundtable v. SEC, 905 F.2d 406 (DC Cir. 1990).  In what will no doubt be viewed as a Pyrrhic victory, Business Roundtable limited the use of listing standards as the principal means employed by the Commission to improve governance. 

In fact, listing standards represented the most business friendly source of new governance requirements.  The exchanges weren't particularly aggressive about enforcing them and shareholders lacked a private right of action for violations.  With the Commission largely foreclosed by Business Roundtable from using listing standards to regulate governance, however, it would turn to other mechanisms, including a more aggressive use of disclosure.  Ultimately, it would need increased authority, something provided in SOX.  But for Business Roundtable, at least some of the provisions of SOX would have been unnecessary.

Comments

[David Harper]

Thanks, great information. Looking forward to series. Regarding the directors' independence test, of course their ownership in a single class situation is often viewed as good (e.g., director ownership guidelines. Although in my experience director ownership rarely really matters, it's a drop in the bucket for the typical publicCo director. Their monetary ownership is overwhelmed by fiduciary obligations) but in the dual-class structure, that is troubling they own Class B and still meet independence (??!!).

But on the other hand, the SEC has done it's job, right? The disclosures are there. It's up to investors and their "proxies" to decide. I think CalPers and others are starting to prove that governance can be an alpha source. Surely, many funds prohibit dual-class on a policy basis. So, the stock will trade deservedly with a permanent governance discount.