Riding on the coattails of Sergey Brin and Larry Page...or not

How much is a corporate vote worth? To answer this question, look no further than behemoth Google. One of Google's voting share costs $779, around 1.7% more than a non-voting share at $764.

Why has a "voting premium" emerged in Google shares? How might the shape of this premium evolve?

A bit of background first. The public can invest in one of two Google share classes: Class A shares, listed as GOOGL, or Class C shares, listed as GOOG. Class A shareholders benefit from one vote per share whereas Class C shareholders get no vote. Because a vote is the only difference between the two classes, we can infer that the Class A premium represents the value that investors attach to voting power. The total market cap ascribed to the 288 million or so Class A votes is $4.3 billion. (Note that Google has been recently renamed Alphabet).

I've mapped out the history the Class A voting premium below:

Since non-voting shares were first issued in 2014, voting shares have been worth as much as 5% more than non-voting shares with a minimum premium of 0.5%.

It just so happens that Canada, my home and native land, provides plenty of fodder for understanding Google's odd capital structure. For decades wealthy Canadian families have been using dual share class structures to simultaneously get access to capital markets while retaining control of the family firm. Sell the public non-voting shares (or single voting shares) and retain the voting class (or multiple voting). Think of the Bombardier family, the Desmarais clan (Power Corp), or the Billes bunch (Canadian Tire).

Large gaps, or voting premia, have often developed between the price of Canadian-listed voting and non-voting stock. Case in point is the differential between Rogers Communications' non-voting and multiple voting shares, controlled by the Rogers family, which has averaged around 5% going back to 2000:

With Google's dual share structure still  relatively new, should Google's investors expect a differential that reaches the size of Rogers' differential, which has hit as high as 15%?

Let's work through the logic. In Canada, the existence of a gap is usually traced to the unequal way that the two classes are sometimes treated in takeovers. A buyer desperate to consummate a deal with a Canadian-listed company characterized by a dual share structure will often offer voting shareholders a large premium to buy their vote while dangling a much smaller reward in front of non-voting shareholders.

For instance, in 2006 Bell Globe Media paid the owners of CHUM’s voting shares 12% more than it paid owners of non-voting shares when it took the company over. When BCE acquired Astral Media in 2012, it offered non-voting shareholders $50 per share (a 39% premium to the market price), single voting shareholders $54.83 (a 9.7% premium on top of the 39% premium accorded to non-voting shares) and multiple voting shareholders $769, an astonishing 1438% premium!

This sort of favoritism is detrimental to small shareholders. If an acquirer has earmarked a fixed amount of dollars to make a deal, non-voting investors may very well have to give up a large chunk of that pie to the voting elite. That may explain why Google's voting shares trade at such a large premium to the non-voting shares. When you buy non-voting Google shares, you do so at your peril. Buy the voting shares and at least you have a degree of protection against a low-ball takeover offer.

Note that this sort of unequal treatment may apply in share collapses too. When Toronto-listed ShawCor eliminated its dual class share structure in 2013 in order to adopt a standard single share structure, Class B multiple voting shareholders received 10% more of the newly-created shares than Class A subordinate voting shareholders did. By analogy, should Google ever choose to revert to a regular structure, Google Class C non-voting shareholders may not get as much of the new entity as its voting shareholders get—which might help explain the current 1.7% premium.

Non-voting shareholders are not without protection here in Canada. The degree of protection afforded depends on the coattail provisions that may (or may not have) been accorded to non-voting shareholders in a company's charter. Coattail provisions dictate that should a takeover occur, all classes of shareholders are to receive equal terms. In essence, the weaker group gets to "ride on the coattails" of the stronger. Since 1987, the Toronto Stock Exchange requires that all new share listings that suffer from voting restrictions include coattail provisions in their corporate charter. However, shares with restricted voting rights issued prior to 1987 were grandfathered their existing structure and not obligated to provide coattail provisions.

The protection offered by coattail provisions tends to reduce dual share pricing disparities. For instance, the difference between the subordinated and superior voting shares of Dorel, issued in 1991 and therefore not enjoying grandfathered status, have averaged around 1.05% since listing, much narrower than the 5% gap between Rogers share classes (which was grandfathered its unequal structure).

As these Canadian examples illustrate, the size of Google’s Class A premium over Class C non-voting shares should be very sensitive to the protections afforded to Google Class C shareholders in the event of a corporate change of control. So what about Google's coattails? Does it have any?

Unlike the Toronto Stock Exchange, the NASDAQ, the exchange on which Google is listed, does not require issuers to include coattail provisions. However, according Google’s articles of incorporation Class A and C shares enjoy some degree of protection. I've screenshotted one of the relevant passages, the so-called "Equal Status" clause:

From Google's Articles of Incorporation

In a nutshell, in the event of a merger, consolidation or other business combination requiring the approval of shareholders, holders of the Class A and C common stock have the right to receive the “same form of consideration” as the holders of the privately-held Class B common stock, the latter being the shares owned by founders Sergey Brin and Larry Page. So if Brin and Page are offered $800 for their shares, and they accept, then all other shareholders get the same right.

So given a cursory read through of Google's articles, a takeover premium on Class A shares should not exist and Google's share gap should not be wide like Rogers' share differential. Google coattail provisions as set out in the 'equal status' clause prevent it. Go out right now and short the living daylights of voting shares while going long the non-voting. It's an easy arbitrage.

Or not. The Canadian business community has a long history of successfully evading the triggering of coattail provisions. In 1997, for instance, Emily Griffiths offloaded the Griffith family's business, Western International Communications, or WIC, by selling its voting and non-voting shares to Shaw Communications, the voting shares being pawned off at a $22 premium to non-voting shares. WIC's articles contained coattail provisions that, in principle at least, should have allowed the non-voting shareholders to enjoy the same takeout price as the voting shareholders. Griffiths were able to structure the deal to avoid setting off the coattail provision (specifically, she sold her stake to multiple parties along with Shaw) and thus extracted the entire takeover premium for herself.

What does this have to say about the value of a Google vote? Beware the fine-print. As in WIC's case, an able team of lawyers might be able to hack Google's Class C coattail provision in order to steal money from the pockets of non-voting shareholders to put in the pockets of voting shareholders. If so, that would explain why a voting premium exists; it represents the price that investors are willing to pay to insure themselves against such chicanery.

A market for corporate votes

Berkshire Hathaway annual general meeting

When you purchase a share you're not only getting the opportunity to make some extra cash. You're also buying a vote. Put differently, a share offers two different features: a) a claim on earnings and b) the right to exercise partial control over the corporation.*

Why not separate the two features and put each of them up for sale? Let's have one market for corporate votes, and a separate one for corporate returns.

Here's how it would work. Imagine you want to buy some Microsoft shares but don't care to participate in the governance of Microsoft. The quoted price on the market, $44.93, is for a whole share of Microsoft, both its attached voting rights and its capitalized return. So you buy 500 whole shares for $27,465.

Next you turn to the parallel public voting market. Microsoft votes are trading for around 25 cents each, say. You 'detach' each of the 500 votes from the shares you've just bought and sell those votes for 25 cents each in the voting market for a combined $125. Not a bad day's work. In selling the votes that you never wanted anyways you've defrayed your initial purchase cost.

A few years later you decide to get out of Microsoft. One way is to find a set of buyers who, like yourself, don't care to vote, and sell the voteless shares directly to them. Alternatively you can repurchase the 500 votes in the voting market, reattach them to the shares, and sell them in the whole share market.

Here's another hypothetical: imagine that you have 500 shares of Microsoft but feel that it's your destiny to have a much more active role in Microsoft governance than your 500 votes would otherwise provide. Say you'd like ten times the votes, or 5,000 votes. To amass that quantity of votes it would normally cost you the price of 4,500 additional shares at $44.93 each, or about $207,000, but that's far out of your league. That's where the market for Microsoft votes comes in. For a mere $1125 you can pick up 4,500 detached votes, assuming they trade at 25 cents each. Without having stumped up too much capital, you've become a much more formidable shareholder activist.

So why have a market for corporate votes?

According to Broadridge, some 70% of retail shares go unvoted. Participation rates are better on the institutional front where some 90% of institutionally-owned shares are voted, but this is due to a legally-mandated fiduciary responsibility to vote. The responsibility for voting these shares is usually outsourced to a proxy advisory company like ISS which, according to one account, advised on over 50% of corporate votes cast in the world. ISS's success is due in part to the fact that institutional shareholders have scarce resources, most of which are ready allocated to searching for new investments and monitoring existing ones. They can't spare the cost of setting up expertise in corporate governance.

So to a large proportion of retail and institutional investors, votes represent little more than a nuisance. In order to play the stock market game, these investors hold their noses and pony up enough cash to buy a share and its combined vote; but they'd really be quite happy if they didn't have to buy the latter, especially if it meant reducing their overall costs.

If those who view votes as a nuisance comprise the sell side of the corporate vote market, then the buy side would be comprised of a cadre of institutional investors who specialize in corporate governance and shareholder activism. Activist investors, say someone like Bill Ackman, have developed expertise and a set of practices that allow them to efficiently put votes to work, instituting change in a company's structure or management in order to make it more profitable. They place a much higher marginal value on the votes attached to shares than the majority of their not-so-active colleagues.

A market in corporate shares would allow both the apathetic and the active to meet, with the final result being a more efficient allocation of returns and voting rights.

What I'm proposing may sound a bit sci fi, but what if I told you that such a thing already exists?

The fact is that we already have an informal market of sorts in corporate votes. In Canada, for instance, firms often issue both non-voting, voting shares, and multiple voting shares. In the U.S. the practice is less common, one example being Google which has issued 'A' shares with one vote apiece; 'B' shares with ten votes each; and 'C' shares with no votes. Or consider Warren Buffet's Berkshire Hathaway. An owner of $10,000 worth of Berkshire Class B shares has 0.15% of the votes that an owner of $10,000 worth of Class A shares has.

When companies have dual share structures, to buy votes, an investor need only short the non-voting shares in order to fund a long position in the voting class. And to sell votes, do the opposite. The cost one would incur on this transaction indicates the dollar value the market places on the right to vote.** Canadian readers may well remember that Mason Capital engaged in this strategy with Telus shares back in 2012 when it purchased Telus voting shares and shorted its non-voting shares.

But there's a more interesting way to get one's hands on extra votes. Start by borrowing whole shares just prior to a vote, much like a short seller borrows shares prior to selling them short. Rather than selling the borrowed shares, however, an activist holds them in order to exercise their voting rights, then returns the shares soon after the vote to the lender. The cost they'll pay on this round trip represents the price of a vote. From the perspective of the the owner who has lent the shares out, they require a high enough fee in order to compensate them for having foregone their franchise over the interim.

For instance, in 2002, Laxey Partners, a hedge fund, held about 1% of the shares of British Land, a major U.K. property company. However, on the day of British Land's shareholder meeting Laxey controlled 9% of the votes, note Hu and Black, all the better to support a proposal to dismember British Land. Just before the record date, Laxey had borrowed 8% of British Land's shares.

The term used for having more votes than shares is empty voting. Someone with 5,000 votes and only 500 shares is in possession of 4,500 empty votes, since those 4,500 votes have been 'emptied' of their economic interest. Empty voting is welfare-improving when an activist investor with a good plan acquires votes beyond his or her economic interest in order to ensure that their plan is adopted. However, at the extreme, empty voting can get downright spooky.  Consider a fund that has amassed short position in a stock (ie. it expects the shares to fall in value) while building a long position in votes. Perversely, this 'rogue' fund could very well use their franchise to implement changes that hurt the firm, not help it, and thereby bolster their short position.

Hu and Black, who refer to the decoupling of votes and economic interest as "the new vote buying", note that vote transactions are often hidden from the public and regulators. All the more reason to have a formal market for votes as described at the start of this post rather than the terribly confusing one that already exists. A transparent price for voting would help reveal rogue attempts to corral large empty voting positions. Those activists who truly want to create shareholder friendly changes would be able to accurately price out the cost of resisting the rogues.

And all those investors who are too unsophisticated to understand the murky world of stock lending, ie. retail investors, would be able to use widely-disseminated prices to better gauge the value of their vote and access an open market for the transferral of those votes.

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* A share also offers a third feature, a liquidity return. I've pointed this out many times before. For the sake of this post, we'll ignore the liquidity portion.
** Strictly speaking, if the non-voting shares you short also happen to be less liquid than the voting shares you are long, then you are not only buying votes, you're also buying liquidity. But as I pointed out in the above bullet point, I'm ignoring liquidity returns for the sake of simplicity.
*** I have an ulterior motive for a market for corporate votes. I think the phenomenon of naked shorting doesn't deserve the vilification it receives in the press and on blogs. In fact, naked shorting is a necessary part of ensuring that liquidity premia on equities are kept at market clearing prices. The proper functioning of what I've referred to as the 'moneyness market' depends on naked shorting. The problem with a naked short is that the resulting synthetic security that the short seller creates doesn't have a vote. It is a non-standard instrument. With the existence of a corporate vote market, a naked short seller might re-standardize the instrument by purchasing a vote and attaching it to the IOU that they've created via their naked short. I do plan on writing about this next month, so if you didn't understand my point, just wait. 

Links:
Hu & Black, 2006. The New Vote Buying: Empty Voting and Hidden (Morphable) Ownership
Aggarwal, Saffi, & Sturgess, 2010. Does Proxy Voting Affect the Supply and/or Demand for Securities Lending
Financial Post, November 2012. Empty Voting Clouds Shareholder Rights Law
Black, 2012. Equity Decoupling and Empty Voting: The Telus Zero-Premium Share Swap
Brav & Mathews, 2011. Empty voting and the efficiency of corporate governance

Shades of a liquidity premium peaking through in stock market prices

In my other life, I analyze the stock market. I always find it interesting when the stock market reveals its often hidden monetary nature. The common assumption is that monetary analysis should be confined to a narrow range of coins, dollar bills, central bank reserves, and bank deposits. But this ignores the fact that all valuable things in an economy have a degree of liquidity, including stocks.

A stock's price can be decomposed into a "fundamental" component and a liquidity component. Fundamental value arises from a stockholder's right to receive any distribution of the assets of a corporation. The liquidity component is the premium on top of fundamental value that arises from the owner's ability to easily sell that stock. Knowing that a stock can be easily sold provides the owner with a degree of comfort that would otherwise be lacking if the stock was less saleable, or not saleable at all. This "comforting service" is built into the stock's price as a liquidity premium.

While in theory we can determine a stock's monetary nature by subtracting its fundamental value from its price, in practice this is almost impossible to do. Computing fundamental value is more art than science. Nevertheless, we can get indirect evidence of the existence of a liquidity premium by comparing different share classes issued by the same company. In Canada, it's common for large family-owned corporations to issue non-voting and voting shares. The family controls the company by holding 51% of the voting shares while the public holds the balance of the voting and all the non-voting shares. Both voting and non-voting shares rank pari passu, meaning they receive the same claim on the company's assets.

Given these properties, we'd expect the market price of voting shares to be equal-to or greater-than the price of non-voting shares. After all, since everything else about the two classes is equal, having a vote can only add to the value of a share.

The chart below shows the voting and non-voting share price of a major publicly-traded Canadian retailer. Below the price is the premium/discount on the non-voting shares. At the bottom are relative volumes traded.

Now it's evident from the chart that our hypothesis doesn't hold. For long periods of time, the non-voting shares of our retailer have traded above the voting shares. What might explain this? One reason is that non-voting shares are far more liquid than the voting shares. Just look at the much higher trading volumes in the non-voting shares. From 2008 to 2010, shareholders valued the liquidity bonus of non-voting shares more highly than the element of corporate control provided by voting shares. In other words, the perceived benefits provided by the liquidity of the non-voting shares caused their liquidity premium to balloon to the extent that non-voting share prices rose above voting share prices.

Why doesn't the non-voting share premium get arbitraged away? Well, the comfort that liquidity provides is a very real service, not a mistaken bit of irrationality that can be ironed away. A highly-liquid share is like a fire extinguisher - even if it's not being used, just having it there makes you feel better. So while buying cheap voting shares and short-selling expensive non-voting shares may seem like a risk-free arbitrage, it isn't. After all, if the market decides to put an even higher value on the liquidity services provided by the non-voting shares, then non-voting's liquidity premium will grow even more and the trade will lose money.

While risk-free arbitrage can't shrink a stock's liquidity premium, there are indirect forces that ensure the premium stays thin. The larger a firm's liquidity premium, the lower its cost of capital. After all, if you need to raise money, having a larger liquidity premium means that you needn't issue as many shares. Because a low cost of capital is a boon, firms will try to replicate the success of competitors who have attracted a large liquidity premium. They may do so by pursuing similar lines of business or marketing their shares to the same group of shareholders. This will have the effect of drawing trading activity away from shares with large liquidity premiums to those without, thereby destroying the underpinnings of that large premium.

All of this plays into the ongoing bitcoin discussion between Mike Sproul and I. While Bitcoin might have some negligible fundamental, or non-monetary, value due to its value as a curio, its liquidity premium is surely huge. There is no way to arbitrage this premium away directly, but over time competitors will peck away at it, causing bitcoin's price to deteriorate back to its fundamental value, which I'd guess is <$1.