Our company right or wrong

Mar 15th 2007    , Economist.com

Foundersand their families often exert extraordinary power over publiccompanies, even when they own only a minority of the shares

Brett Ryder

INMID-2005 few investors in Porsche would have guessed that only 18months later their firm would be the dominant shareholder inVolkswagen. Then again, it is none of their business, because they havelittle say over the sports-car maker's managers or strategy. ThePorsche and Piech families have total voting control over the Germanfirm, despite owning only half of its equity. The publicly tradedshares, providing the other half of Porsche's capital, have no right tovote.

After a recent European ruling, the “VWlaw”, which prevents any shareholder from exercising more than 20% ofthe carmaker's votes, is likely to be repealed. If so, the Porsche andPiech clans will have control of VW,because Porsche holds 27.4% of the voting shares. In shareholderdemocracies, as in political ones, poor turnouts mean that aboutone-third of the votes can grant control of a company.

That is not the full extent of the families' influence. VWhas a 20% stake in Scania, a Swedish truck and engineering group, whichhas two classes of voting shares, one with ten times as many votes asthe other. Thanks to these super-voting shares, VWhas 35.3% of the votes in Scania. In other words, the Porsche and Piechfamilies will also control Scania, thanks to an economic stake in thefirm of a mere 2%.

Almostsince the first company listed on the first public market, capitalistshave sought to raise money without sacrificing control. Porschedemonstrates two techniques that families and founder-entrepreneurscommonly use. First is a cascade of companies?a ploy particularlyfavoured by Italians?to gain control of a larger group. Each stage ofthe cascade amplifies the capital governed by the tiny company at thetop. The second, on flotation, is to issue shares to the public withvastly inferior?or no?voting rights. Both are legal.

Porscheis an extreme example of how a family can wield great power byharnessing large amounts of other people's money. But it is notunusual. An American study concluded that 6% by number and 8% bycapitalisation of quoted companies in America had dual-class shares in2002. Only two-thirds of large European companies rigorously apply theprinciple that one share should command one vote, according to aBelgian study in 2005.

TheEuropean Commission, eager to create an open market for corporatecontrol, is studying whether it should act against them. Israel standsout for having made the even allocation of votes a requirement oflisting on the stock exchange. It is a tricky balance to strike.Liberalism argues that investors and owners should be free to enterinto contracts as they wish. On the other hand, sheltering familiesthat govern a company badly impedes restructuring. Isn't that badeconomics?

Sweden isthe European country with the most dual-class shares: some two-thirdsof its listed companies have them. The Wallenbergs, one of Sweden'smost famous business families, which controlled Scania before sellingmost of their stake to VW, could give amaster-class in their use. Their foundations own super-voting shares inInvestor, a quoted investment company that they control. Then there isanother layer of special shares. Investor has helped develop Swedishcompanies such as Electrolux, a white-goods maker, and Ericsson, atelecoms-equipment company. Most of these firms have shares withdisproportionate voting rights, a slug of which Investor owns.

Someof the best-known North American companies use dual-class shares. TheFord family may no longer own the company?it has a slender 3.75% of theshares?but nobody can doubt who is in control. When the firm wentpublic in 1956 the family's shares were converted into a special classthat is guaranteed 40% of the voting power, no matter how many ordinaryshares are in issue. The late Alex Trotman, who held the top job atFord in 1993-98, used to say that to be successful, the boss of Fordneeds to manage the family as well as the company.

Dual-classshares are no hangover from the past. When Google went public in 2004,its founders, Larry Page and Sergey Brin, insisted on a dual-classshare structure. Google sold the public new A shares with one vote per share; its existing shares, mostly held by Mr Brin and Mr Page, became Bshares with ten times as many votes per share. With around one-fifth ofGoogle's total equity, the founders still command about three-fifths ofvotes, and thus retain control.

Dualshares are designed to assure investors that a known group of managerswill control the company indefinitely. They shield the long-term visionand strategy of founders from stockmarket forces. At Google, they arein effect founded on the idea that Mr Brin's and Mr Page's judgment isbetter than that of investors?and will remain so until the firm'sfounding geniuses (or their heirs) decide differently. The duo clearlyspelt out why they wanted such a structure, in their “Owner's Manual”for prospective shareholders:

Such sharestructures are often set up just before a company's flotation, so youcan hardly accuse owners of foisting them on unsuspecting investors.Investors pay less for shares in a company with dual-class shares thanfor shares in an otherwise identical company that endows each sharewith one vote. Their rights are weaker in a firm with super-votingshares, because they can not kick out the family. Whatever theirdrawbacks, therefore, dual-class shares are “fair”.

That,at least, is the theory. Sometimes, though, it seems hard to believe.Italian entrepreneurs use convoluted cascades of companies (also knownas scatole cinesi, or Chinese boxes) to achieve the same endas dual-class shares. The company at the top of the cascade, the onethat calls the shots, is usually private. This firm's controllingshareholder has enough votes to secure an absolute (or de facto)majority at shareholders' meetings at each level in the cascade. Ineffect, Chinese boxes remove control of the quoted company from itspublic shareholders, because the majority is fragmented into a seriesof minorities spread over the cascade.

Thisis the mechanism that the Agnelli family uses to control Fiat Group, aquoted company and Italy's largest industrial group (see chart 1). Thefamily's cassaforte (literally, its strongbox), GiovanniAgnelli & C, a limited partnership, controls a 30% stake in Fiatthrough a cascade of two quoted companies, IFI and IFIL.This is enough to give it control of Fiat's annual shareholder'smeeting. (For instance, at the meeting in 2006 less than half of thoseentitled to vote did so, thereby in effect doubling IFIL's votes.)

Avivid illustration of the power of Chinese boxes came in 2003 when Fiathad needed a capital increase to prop up its ailing balance sheet. Itwas a lesson in how to turn €250m?which the Agnellis' limitedpartnership injected into IFI to pump-primethe cascade of capital increases?into €1.84 billion, which was theamount Fiat raised. In other words, the minorities in the three quotedcompanies in the cascade provided the majority of the money.

Thereis a further twist. John Elkann, a grandson and main heir of GianniAgnelli who ruled the Agnelli's empire until his death in 2003, pullsthe strings at Giovanni Agnelli & C. This is because he controls acompany called Dicembre, which has 31% of the votes in the limitedpartnership. Tens of other descendants of Fiat's founder, none of whomspeaks for more than 5%, own nearly all the rest of shares. This makesMr Elkann's position unassailable without an unlikely alliance againsthim in the rest of the family. The extended Agnelli family, Mr Elkannapart, provides the capital but has no real say in what happens to it.Meanwhile, the man who controls Fiat owns a mere 3.5% of its equity.

Highly preferred stock

Theeconomic costs of such schemes are complex. One attraction offamily-run companies lies in their managers' relationship withshareholders. In most companies, managers have an interest in creamingoff profits through, for instance, lavish expenses and vanity projects,rather than paying them out to the owners. By contrast family managersare the owners. The more of a family's wealth that is tied up in thebusiness the closer the alignment of managers' and shareholders'interests. Deterring family-run companies from listing in the publicmarkets or encouraging them to take on debt rather than raising equitymight therefore be inefficient.

Super-votingshares, however, undermine this argument. Dual-class shares andcascades tempt the powerful to benefit themselves, rather than to paymoney out to everyone equally. An extreme example, American prosecutorsallege, is Hollinger International (now called Sun-Times Media Group),once one of the world's largest newspaper groups, with titles includingthe Daily Telegraph, a British daily, and the Jerusalem Post.Lord Black, its former chief executive, is standing trial this week oncharges, which he denies, of siphoning tens of millions of dollars outof the firm.

Thegroup's capital structure was a factor in the alleged frauds. Through achain of companies, Lord Black indirectly controlled around 20% ofHollinger's shares. But he had around 70% of the votes; each of his B shares had ten times the voting rights of Ashares held by other investors. Nobody could stop Mr Black from packingHollinger's board with prominent and well-paid contacts, who seemed notto have asked too many questions. Mr Black had no counterweight,because nobody could fire him.

Despitethis increased risk, calls for the reform of super-voting shares insidecompanies are sporadic. Perhaps this is because a company's investorsknow they have no chance of success without some negotiating leverage.

Butwhen their position is strong, investors do force change. Part of thedefence of Arcelor, then the world's number two steel group, against ahostile bid in 2006 from Mittal Steel, the world's largest steel group,was to criticise the bidder's governance. Arcelor's main target was thedisproportionate voting rights of Mittal Steel's Bshares, owned by Lakshmi Mittal , the controlling shareholder. To helphis bid, Mr Mittal agreed that all shares in the new firm, ArcelorMittal, would have equal economic and voting rights.

Anothergovernance risk is in companies that look to the second generation formanagement. The worry is that Junior has got to the top thanks to Pops.This leaves no room for talented people with the wrong surname.American research suggests that second-generation companies tend tofare worse than others do.

TheLagardere family in France has found the ultimate way to pass on thequoted family firm, a magazines-to-missiles group, of which it controlsjust 7%. This is a French limited partnership (societe en commandite par actions).It has two types of partners: general partners and limited partners?theshareholders. The general partners have exclusive power to appoint themanaging partners (gerants), who are responsible for running the business. (The gerants are appointed for a six-year term, which may be renewed.)

Lagardere'sgeneral partners are Arnaud Lagardere, son of the late Jean-LucLagardere, who set up this structure, and Arjil Commanditee-ARCO (ARCO), a company that the Lagarderes control. Unsurprisingly, the general partners have appointed themselves as Lagardere's gerants.The firm's supervisory board, which the shareholders appoint, cannotdismiss Mr Lagardere as general partner unless he first decides to sackhimself as gerant. And ARCO's position as general partner is untouchable so long as the Lagardere family controls it.

Doinglip service to the demands of corporate governance, the company'sarticles provide that shareholders approve the appointment (orreappointment) of a gerant. Ultimately, however, shareholderscan refuse a candidate only by a majority of at least two thirds. Ifthey do, Mr Lagardere and ARCO assumeresponsibility for running the business in their capacity as generalpartners. In other words, the Lagardere family can run the business foras long as it likes. It would lose control only if someone acquiredmore than two-thirds of the firm's shares and then applied successfullyto the courts to change the statutes which give it control. Another ofFrance's main companies, Michelin, the world's largest tyre-maker, isalso a limited partnership of this sort.

Other French entrepreneurs or families have a less extreme way of entrenching their grip. PSAPeugeot Citroen, a quoted car company, grants double-voting rights toshares held in the same name for at least four years. The mainbeneficiaries of this rule are the Peugeot family: their 30% stakecommands 45% of the votes.

Thissystem was supposed to encourage loyalty in shareholders and to punishspeculation. But it has mainly benefited large family-shareholders,such as the Arnaults, owners of just under half of LVMH, a luxury-goods group; their rivals, the Pinaults, who control PPR; and the Bouygues, at Bouygues SA,a construction-to-telecoms conglomerate. Martin Bouygues, one of thesons of Bouygues's founder, runs this company, just as Francois-HenriPinault, one of Mr Pinault's sons, runs PPR.

Theshare-price discount of dual-class stock reflects the risk that thelack of control may lead to abuses. The evidence on how often thathappens is mixed. For instance, a study of firms that switched fromgiving each share one vote to a dual-class structure concluded that onaverage the change was good for shareholders. Another of a sample ofdual-class companies going public found that the share price of thesecompanies outperformed comparable firms with single-class shares.

Butthe most comprehensive piece of work on the subject, a recent study byWharton School, Stanford University and Harvard Business School of alldual-class firms from 1995 to 2002, concludes that shares with votingrights in excess of economic rights are bad for other shareholders, andthat the bigger the gap the worse the damage. “What you would reallylike to do is give managers a lot of economic ownership in a company,but no votes, which is the opposite of what you see in most dual-classcompanies,” says Andrew Metrick, one of the study's three authors.Using data from the study, The Economist has compiled a listof large dual-class companies, ranked by market capitalisation (seechart 2). Big media companies dominate the list and, as at the New YorkTimes Company, occasionally attract hostility. (Full disclosure: The Economist, albeit a private company, has four classes of shares.)

Dutch disease

Dominantfamilies are one thing. Managers who wield control even though theyhave no particular long-term interest in the company are more alarmingstill. The depository-receipt system in the Netherlands splits economicrights from voting rights and thereby, in effect, enables managers tohave voting control without owning any share capital. When a companywith this system issues shares, it does so to a voting trust, whichretains the voting rights. The trust then issues depository receipts,which have economic rights mirroring those of the underlying shares.

Thedepository-receipt holder can tell the trust how to vote. But fewholders give instructions, so the trust dominates the voting. “Thevoting trusts are a vehicle to get a ‘yes’ vote on every item on theagenda,” says Peter Paul de Vries, head of the Dutch Investors'Association (VEB). In 30 years of observing shareholders' meetings, Mr de Vries has not seen a trust vote against managers.

Fewer Dutch firms use the system these days. But the 10% that still do include ABN Amro (under siege from hedge funds) and ING, two banks, and Unilever, a consumer-goods giant. ING claims, as do others, that depository receipts prevent a minority from taking control. But the VEBis fiercely critical of the system, mainly because it deprivesshareholders of influence. “A dictator will rarely do away with his owndictatorship,” says Mr de Vries.

TheDutch system is perverse, but other systems of control are more finelybalanced. Families understandably want to keep control. On the otherhand, there is a whiff of inconsistency about a family seekingpublic-market funds, but having such little faith in investors that itrequires protection. Moreover, what looked like a good idea at the timeof the company's listing might not seem so clever five decades on. AtFord, Henry's memory has been eclipsed by his descendants' endlessstruggle with decline.