Dan Irvine | Principal
3Summit Investment Management, LLC
When an investor buys stock in a company, they are not merely giving a company money, they are buying an ownership stake in the company. The board of directors and management of the company are then accountable to the owners(shareholders) for how they run the business…at least that is how it used to work.
Sky-high valuations and strong market demand for many companies shares, especially in the tech sector, have allowed some companies to weaken the traditional framework for management accountability that comes with taking outside investor money. Make no mistake about it, the only parties that benefit from bad corporate governance are the managers who run the company. Inflated compensation packages, lower company performance, increased risk, expensive and ill-advised acquisitions, inability to make management changes, these are just some of the results of bad corporate governance.
The slow erosion of shareholder accountability
Silicon Valley has led the way in systematically working to debase corporate governance practices and management accountability to shareholders. Google began using a dual share class structure in 2004 which really set the example companies began to follow. Google was such a hot company and so many investors wanted to buy shares that the founders and chairmen decided to use that power to ensure they could retain control and not be beholden to shareholders. Imagine the indignity of having to be accountable to investors who are funding your company’s growth and making you rich beyond imagination.
Multiple share class structures allow a company to issue two or more share classes, one with voting rights and the other with diluted voting rights or without voting rights at all. Guess who gets the voting shares, you are correct, management. Facebook is the next most prominent company that jumped on this multiple share class structure. Both Google and Facebook have continued to innovate in weakening shareholder rights in the last few years. Both companies have added a third share class that have super voting rights making it possible for the founders to put most of their shares into charitable structures without losing control of the company. So now the founders retain full control of the businesses and get the tax shelter of tax advantaged charitable organizations they also control. Mark Zuckerberg owns around 30% of Facebook but has about 60% of the voting power. He runs the company unchecked, and investors have no recourse should his leadership prove ineffective in the future.
Snapchat may be the turning point in the fight for stronger corporate governance
Since late last week, new hope has emerged that fewer companies will be incentivized to create corporate structures designed to take money from investors while providing no accountability for their management in return. FTSE Russell, which owns the commonly used Russell 1000, 2000 and 3000 stock indices in addition to thousands of others, decided to exclude Snapchat (SNAP) from its indices. They made this decision because of Snapchat’s share class structure which included selling non-voting shares to the public, which leaves the company totally controlled by its 20 something founders.
Index owners hold the keys to incentivizing good corporate governance
FTSE Russell deciding to exclude SNAP from its indices is a big deal for both the company and for investors that care about better corporate governance practices. MSCI, another huge owner of indices is said to be also considering the same policy for excluding companies from their indices. A large number of investors buy stocks through mutual funds and ETF’s that mimic or closely follow an index including Russell indices. Because most investors are not buying individual stocks but index funds, many companies shares are bought in large quantities simply because they are a constituent of an index. Not only is more capital available to companies that are index constituents, but their stock prices can often be bolstered by non-organic demand from managers simply needing to buy shares because the company is included in an index and they are managing a fund that replicates that index.
Currently, about 46% of all assets in the U.S. stock market are in index funds according to Morningstar. This amazing statistic demonstrates the enormous role index owners like FTSE Russell have in maintaining the integrity of the financial market. The responsibility index owners have to the markets begins by making sure companies are not rewarded for establishing corporate governance policies which disenfranchise shareholders therefore threatening the long-term stability of the financial markets. FTSE Russell has made a huge step by listening to the concerns of institutional investors who have been encouraging index owners to take the action of excluding stocks with inadequate corporate governance from their indices to combat the further erosion of shareholder rights.
The Lessons for Companies to Learn from SNAP
The impact the decision that FTSE Russell has rendered to exclude SNAP from their indices are broad reaching and should be a warning sign to other management teams with similar disdain for their shareholders. Since this decision by FTSE Russell was announced SNAP is down -2%. However, should you be holding SNAP or considering buying at these prices which are off -53% from their post IPO high and -19% from the IPO price, you may want to reconsider.
SNAP has many problems, but their arrogance in asking the public for investment with no recourse is where their problems began. The stock has not found traction for many reasons, but a big reason is that institutions mostly avoided participating in the IPO and subsequent market for shares specifically because of the corporate governance deficiencies. SNAP is now facing strong headwinds as a result of their unacceptable corporate governance practices including exclusion from major indices and unwillingness of institutions to buy shares. To make matters worse, the lock up periods are beginning to expire for insiders this week and within a few months almost a billion shares of SNAP may be registered. To put that number into prospective, SNAP sold only 200 million shares at IPO and the share price is not finding any price support yet. Who is going to buy the billion shares and at what price?
Corporate governance matters
Corporate governance is not just picking on the rich, nor does it seek to stymie innovation or risk-taking within growing companies. Corporate governance is so important because it protects the trust in financial markets which underpin their success. The U.S. has been so successful and maintained such a dominant economy because businesses are able to attract domestic and international investment, making capital not only abundant but cheap. The reason for the availability of capital the U.S. has enjoyed is simple…trust. In return for providing the financing a company needs to grow, investors can count on accountability from management, and if needed investors have recourse to protect their investment by voting to change management through their voting rights. Good corporate governance is not only in the interest of companies but society as a whole. A strong economy requires trust which comes through the best corporate governance possible.
Despite being in the best interest of both companies and society, good corporate governance often does not get the attention it deserves because it only matters when things go wrong. Policing and regulating corporate governance is like disaster planning, no one cares or wants to spend the time or money planning for emergency readiness until a huge hurricane strikes a major urban center that is caught unprepared. Disaster planning only matters when things go very wrong, but by the time it is needed it is too late. Corporate governance must be maintained and nurtured or there will be a huge economic price to pay when economic challenges present themselves.
The tech mega companies have hundreds of billions of dollars in market cap, the economic damage, and damage to the trust of investors when things do go wrong cannot be overstated. Economies and markets change and companies never dominate forever. When these poorly governed companies struggle, investors will have no way to get new managers in with a different skill set that is better suited to the environment because the founders have locked in their control.
In a very positive turn of events, S&P has decided to follow suit and no longer include companies with multiple share classes in their indexes.