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WORKING PAPER
ALFRED P. SLOAN SCHOOL OF MANAGEMENT



(T COERCIVE DUAL CLASS EXCHANGE OFFERS



Richard S. Ruback
Sloan School of Management
Massachusetts Institute of Technology



WP#1856-87



February 1987



MASSACHUSETTS

INSTITUTE OF TECHNOLOGY

50 MEMORIAL DRIVE

CAMBRIDGE, MASSACHUSETTS 02139



(^COERCIVE DUAL CLASS EXCHANGE OFFERS



Richard S. Ruback
Sloan School of Management
Massachusetts Institute of Technology



WP//1856-87 February 1987



MIT. "" '3

MAR i^ ^ ,^37

RECEIVED



COERCIVE DUAL CLASS EXCHANGE OFFERS*



by



Richard S. Ruback

Sloan School of Management

Massachusetts Institute of Technology



1 . Introduction

Dual class exchange offers give shareholders the opportunity to
exchange shares of common stock with superior voting rights for shares with
inferior voting rights. To induce shareholders to participate in the
exchange offer, the shares with inferior voting rights dominate the stock
with superior voting rights in some other dimension, such as marketability
or dividends. Since the managers and inside stockholders do not participate
in the exchange, it results in the concentration of voting power by the
insiders.

The concentration of voting power effectively blocks all hostile
takeover attempts. To complete a hostile takeover attempt, the bidder
either has to replace the target's board of directors or has to merge with
the target. Both of these avenues are foreclosed by dual class plans; a
hostile bidding firm that purchased all the outside shares cannot gain
control over the target. Therefore, dual class plans may be the most
effective universal anti-takeover device ever invented: they give the
insiders that do not own a majority of the stock complete veto power over
hostile bids.



*This study is adapted from a report that was prepared for Institutional
Shareholder Services, Inc. and was submitted to the Securities and Exchange
Commission in the hearings on the One Share, One Vote issue. I would like
to thank: D. Austin-Smith, R. Gilson, J. Gordon, N. Minow, R. Monks, J.
Parsons, J. Pound, and J. Rotemberg for comments on previous drafts.



Opponents of dual class exchange offers argue that the plans reduce
stockholder wealth by eliminating the possibility of receiving a takeover
premium. Proponents argue that outside stockholders have two important
safeguards to protect them. First, shareholders must approve the
recapitalization plan. Second, the decision to exchange their ordinary
shares for limited voting shares is voluntary.

Other studies suggest that the first safeguard - the stockholder vote
on the proposal - may not protect them. Austen-Smith and O'Brien (1986)
focus on the agenda setting powers of managers. In their model, managers
can force shareholders to choose among different value-reducing
alternatives. Shareholders approve antitakeover provisions because such
approval is the least costly alternative presented by managers. Gordon
(1986) discusses these collective action problems in context of dual class
recapitalizations. Also, Pound (9166) presents empirical evidence that
institutional shareholders are more likely to vote with management than
other shareholders in proxy contests.

This paper focuses on the second safeguard. It indicates that
voluntary exchange does not, in fact, protect shareholders. Outside
stockholders can be harmed. The terms of a dual class exchange offer can be
structured to compel individual outside shareholders to exchange their
shares for limited voting shares even though the same outside shareholders,
in the same circumstances, but acting collectively , would choose not to
exchange.

I develop a model to trace the impact of a dual class exchange offer
on share prices. In the analysis, shareholders are given the opportunity to



trade their shares for limited voting stock with higher dividends. This
choice presents outside shareholders with a classic prisoner's dilerrana. It
exploits the inability of individual shareholders to act together - each
shareholder's rational choice leads to an outcome that is worse than if all
shareholders retain their original shares. This occurs because individual
outside shareholders generally ignore the impact of their exchange decision
on the probability of receiving a takeover bid.

The exchange offers I examine entice outside shareholders with higher
dividends for limited voting class shares. Examples of this type of plan
include Wang Laboratories, Hershey, among others. If all stockholders
received the higher dividends, no change in value would result. The
dividends would simply be financed by reducing investments that just break
even. But the plan provides the opportunity for wealth transfers between
shareholders: shareholders that get the higher dividends receive a subsidy
from shareholders that retain their original shares. This provides an
inducement to exchange.

The perceived costs to the individual outside shareholders from
exchanging depends on the rules for dividing the gains from a takeover offer
across the classes of common stock. These rules are, of course, uncertain.
I examine two different rules: (i) shareholders of both classes receive the
same price in a takeover; and (ii) shareholders of stock with superior
voting rights receive all of the benefits of a takeover.

The model indicates that as more of the potential takeover benefits are
assigned to the limited voting class shares, the more effective is the
coercion in the recapitalization plan. For example, suppose the rule



required that in the event of a takeover, the limited voting stock would
receive twice the per share takeover premium than ordinary common stock
received. To a small outside stockholder, such a rule would mean that
there was a double benefit to taking the limited voting shares: higher
dividends and higher takeover benefits. But both of these benefits are
illusions. The higher dividends come from reduced investment. And the
higher takeover benefits never occur, because insiders use the veto power to
reject all hostile bids.

Section 2 presents a simple model of the firm that is used to trace the
impact of the dual class exchange offer. Section 3 uses this model to
explore the payoffs that outside shareholders confront when they decide
which class of stock to retain. Section 4 proposes a non-coercive method to
obtain a dual class equity capitalization. Finally, section 5 contains a
summary and conclusion.
2. The Model
2. 1 The Firm Prior To The Recapitalization

Suppose a firm earns $X in the first period. These earnings can be
paid as dividends to stockholders or re-invested. The investments earn the
cost of capital, r, so that each investment has a zero net present value.
Define D as the proportion of earnings that are paid out as dividends in
each period. The remaining earnings, X(l-D), are re-invested in the firm.
These re-investments earn the cost of capital, so that earnings grow over
time when D is less than one. The earnings in time 2, X2 , equals the
earnings in time 1, X, plus the earnings on the funds re-invested in period



1, X(l-D)r:



In general,



X, = X + X(l-D)r = X(l + (l-D)r).



^t " ^t-1 ^^ ^ (l-D)r) = X (1 + (l-D)r)'^"^ (1)



The value of the dividends accruing to stockholders is;



4. „ 1 w^ DX,

Present Value



. , ,.. xt



of Dividends i . (2)

t=l (1+r)

Substituting (1) into (2) yields:

oo « t-1

\ t = \ DX(1 + r(l-D))

t=l d^"-)' t=l (1^^)'

= X/r (3)

In addition to the value of the dividends, the equity value also

includes the expected value of a takeover. This expected value reflects the

probability that a takeover will occur and the expected takeover price if

such an offer occurs. The equity value of the firm, V, is the sum of the

value of the dividends plus the value of the takeover potential. Defining ir

as the probability of a takeover and T as the expected per share takeover

price, the value of the firm is:



V = -^ + ■^[m - - ]

r L r -'



-^ (1-TT) + TTNT, ^4)



where N is the number of the shares outstanding. The stock price is found
by dividing the equity value by the number of outstanding shares:

P = ;^ (1-.) . .T ^3^

2.2 The Dual Class Recapitalization

A hostile bidder either has to replace a target firm's board of
directors or has to merge with the target to obtain control. Dual class
recapitalizations serve as an antitakeover device by giving the incumbent
management team veto power over mergers and changes in the composition of
the board of directors. By creating stock with superior voting rights, dual
class plans allow the incumbent management to obtain the veto power without
owning a majority of the common stock.

Veto power occurs when a group of stockholders can block a merger or a
change in the board. The level of ownership required to obtain veto power
depends on the ratio of votes for classes A and B and the voting rules of
the corporation. Throughout this analysis I assume that class A shares have
10 votes per share and class B shares have one vote per share.

The voting rules of corporations with dual class equity seem to fall
into two categories: (i) plans in which both classes vote together to elect
directors, and (ii) plans in which the classes vote separately to elect
different directors, with the superior class of stock electing a majority of
directors. If the two classes vote together, and if a majority is required
to approve a merger or replace directors, the insiders will have veto power
if they obtain a majority of the votes. If the two classes vote separately
to elect directors, with class A electing most of the directors, veto power
is obtained with fewer shares since only a majority of the class A shares is



required to veto control changes. Anti-takeover corporate charter
provisions, such as a super-majority clause, can further reduce the number
of shares required for veto power.

Assume that the firm recapitalizes by redefining the existing common
stock as class A shares with 10 votes per share. The stockholders are given
the opportunity to exchange their class A shares for class B shares. The
class B shares have 1 vote per share, but the per share class B dividends
are A% higher than the class A dividends:

6^ = dgd+A) (6)

where d and d^ are the proportion of earnings paid out as dividends to a
single share of class A and B stock, respectively.

The proportion of earnings paid as dividends to each class of stock

depends on the total number of shares outstanding, N, and the fraction of

shares that are exchanged. The proportion of earnings paid as dividends to

class A shares, D , equals the number of class A shares, N multiplied by

the per share dividend payout ratio, d :

D = N d (7)

a a a ^ '

Similarly, the proportion of dividends paid to the class B shares, D. , is:

where Nj^ is the number of class B shares. The proportion of earnings paid
out as dividends to both classes of stock, D, is:
D = D^ + Dj^

= Na da + N^ (1 + A) d^

= dg (N + A Nj^) (9)



8



The present value of the class A dividends after the recapitalization is !

Present Value of _ D X
of Class A -^ —



^. ., , rD (10)

Dividends

Substituting (7) and (9) into (10) and simplifying provides:

Present Value N X
of Class A =



„. . , , r(N + A N. ) • (11)

Dividends ' b' ^ '



Similarly, the present value of the Class B dividends is;



Present Value R (1 + A)X
of Class B =



Dividends



r(N + A Njj) • (12)



3. Decision Analysis for an Individual Shareholder

An individual shareholder must analyze the valuation consequences of
exchanging shares conditional on the actions of other stockholders because
the stock price after the recapitalization depends on the fraction of
shareholders that exchange their shares for class B stock. Since the
purpose of the recapitalization is to increase the control of the inside
stockholders, I assume that inside shareholders retain their class A shares.
If insiders obtain veto power, I assume that they will use it to reject all
takeover proposals. This assumption simplifies the analysis, but it is not
required. Instead, I could assume that the expected takeover benefits are
lower when insiders have veto power. One explanation for this is that the
probability of a takeover is lower when insiders have veto power because
they will reject some offers that would be accepted by outside shareholders.

The decision of an individual outside shareholder is examined under
three different assumptions about the behavior of other outside



shareholders :



(i) inside shareholders do not obtain veto power regardless of the
remaining outside shareholder's decision because few other outside
shareholders exchange.

(ii) the remaining outside shareholder is pivotal: exchanging
gives the insiders veto power; not exchanging denies the insiders
veto power.

(iii) enough other outside shareholders exchange for class B so
that insiders obtain veto power regardless of the remaining
outside shareholder's decision.



In each of these cases the remaining outside stockholder decides to exchange
or not by simply comparing the prices under each alternative. If the price
of the class A stock, P , exceeds the price of class B, P. , the remaining
outside stockholder will not exchange. Conversely, if P. exceeds P the
shareholder will exchange.

The value of class A and B shares includes the present value of their
dividends, plus the expected premium in the event of a takeover. The
expected takeover premium is calculated assuming that the price an acquiring
firm is willing to pay for the target is not affected by the
recapitalization. If a takeover occurs, the bidder pays NT to acquire the
firm.

DeAngelo and DeAngelo (1985) document that takeover premiums can be
split a number of different ways across different classes of shareholders.
I focus on two possible splits. The first possible split is that both
classes of shares receive the same price in any takeover, $T per share. In
the second split, class B shareholders receive the present value of their
future dividends and the class A holders receive the difference between the
takeover price and the payment to class B. In other words, under the second



10



split, class B shareholders receive no takeover premium and class A
shareholders get all of the takeover benefits. Since division of the
potential takeover benefit affects the values of class A and B shares, it
also affects the exchange decision. Therefore, the exchange decision is
first analyzed assuming equal takeover prices for both classes and then
analyzed assuming class A captures all of the takeover premium.
3.1. Decision analysis assuming equal takeover prices

(i) Insiders do not obtain veto power regardless of remaining shareholders
decision: The minimum number of class B shares required for insiders to
obtain veto power, N^, depends on the voting rules of the firm. When the
number of class B shares is less than N^, , the exchange offer will not result
in veto power for the insiders regardless of the remaining shareholder's
decisions. The probability of a takeover remains positive with a value of
IT. The value of a class B share is:

^ X(l+A) , _ r-. X(l+A) .

b r(N+A N. ) ^ r(N+AN, ) ^ .,,,

D b (13)

The first term on the right-hand side of (13) is the present value of the

dividend flow to a class B stockholder. The second right-hand side term is

the expected takeover premium, that is, the probability of receiving an

offer, IT, multiplied by the difference between the takeover price, $T, and

the present value of the dividends. Re-arranging (13) provides:

^ X (1-t-A) (l-TT)
b r(N+A N. ) (14)

D

Similarly, the price of a class A share is:

% ~ r(N+A H^ ) "^ "^ (15)



11



These prices are presented in the first row of Table 1.

The shareholder makes the exchange decision by comparing the payoffs,
or equivalently, the stock prices. From the perspective of a single
stockholder, the exchange decision does not change the probability of a
takeover or the takeover price. And both class A and B have identical
expected takeover price components. The exchange decision, therefore,
hinges on the higher dividend for class B shares. The decision of the
remaining outside stockholder is simple: The class B stock receives a
higher dividend and thus has a higher stock price. Therefore, it is
rational for the remaining outside stockholder to exchange the class A stock
for class B stock.

(ii) Remaining Shareholder is Pivotal: In this scenario the remaining
shareholder's exchange decision determines whether insiders obtain veto
power. Exchanging reduces the number of class A shares held by outsiders,
which gives the insiders veto power. The probability of a takeover becomes
zero because the insiders obtain blocking power.

Exchanging gives the shareholder the higher class B dividends.

However, the exchange also eliminates the takeover potential. The payoff

from exchanging is the present value of the class B dividends:

^ X(l+A)
b r(N+AN ) . (16)

In contrast, if the remaining shareholder does not exchange, the payoff is
the price of the class A stock, which is given by (15).

As the second row of table 1 indicates, the decision of the remaining
outside shareholder involves comparing the expected takeover premium to the
present value of the dividend differential between class A and B shares.



12



TABLE 1



Stock Prices for an individual outside shareholder that either
exchanges or does not exchange a share of class A stock for a share of
class B stock. In the event of an acquisition, both classes would



receive equal takeover prices _



a/



INDIVIDUAL ACTION



ACTION OF
OTHER OUTSIDERS



EXCHANGE



DO NOT EXCHANGE



N -1
c



X (1 + A)(1-it)
r(N + A Nj^)



+ ttT



X (1-tt)
r(N+A Nj^)



+ ttT



2.



\ =



N -1
c



X(l + A)



r(N



. AN^)



X(l-TT)

r(N + A



\>



+ TiT



3.



\>



N



Xd+A)



r(N +



^v



r(N



. AN^)



a/ Class B dividends are A% higher than class A dividends, X is the initial
earnings of the firm, r is the interest rate, N is the number of shares
outstanding, Ni^ is the number of outside stockholders that exchange for
class B shares, N is the minimum number of class B shares for insiders to
obtain veto power, it is the probability of a takeover when insiders do not
have veto power, and T is the per share takeover price.



13



Increasing the probability of a takeover, tt, or the takeover price, T,
increases the payoff to retaining the class A shares. Increasing the
dividend differential. A, increases the payoff to exchanging for class B
shares. Thus, the decision of the pivotal shareholder depends on the
specifics of the dual class exchange offer.

(ill) Insiders Obtain Veto Power Regardless of Remaining Stockholder's
Decisions: In this scenario, enough other outside shareholders elect to
exchange their class A shares for class B shares for insiders to obtain veto
power regardless of the decision of the remaining shareholder. The
probability of a takeover becomes zero. The value of both class A and B
shares reflects the present value of their dividends. These payoffs are
presented in the third row of Table 1. Since the dividends are higher for
class B shares, the remaining outside stockholder will choose to exchange
class A shares for class B.

Analysis: When class A and class B equity holders receive the same takeover
price, outside shareholders always benefit by exchanging class A shares for
class B shares if their shares are not pivotal. Shares that are not pivotal
have no impact, individually , on the availability of takeover benefits. If
few shareholders exchange, as in the first scenario, then an individual
receives the expected takeover benefits regardless of the exchange decision.
Similarly, if many shareholders exchange, as in the third scenario, the
individual will not receive the expected takeover benefit regardless of the
exchange decision. Since the class B shares have higher dividends and equal
takeover benefits, class B shares have higher prices. Therefore, individual
outside shareholders that are not pivotal will rationally exchange their



14



class A shares for class B shares.

The decision is more complex for a pivotal shareholder. The exchange
decision determines the availability of the takeover benefit. The pivotal
shareholder faces a tradeoff between a class A share with its expected
takeover benefit and a class B share with higher dividends. The rational
decision depends on the relative magnitudes. In some cases, exchanging will
be rational; in others, not exchanging will be rational.

When the dividend differential and takeover benefits are such that the
pivotal shareholder exchanges for class B shares, exchanging is a dominant
strategy'. That is, every outside stockholder will choose to exchange. In
this case, the value of the class B shares after the exchange will be:

Xd+A)

b = r(N + AR )
b

Comparing the post-exchange stock price of class B shares to the initial
stock price in (5) shows that the potential takeover benefits are lost in
the exchange offer. The higher dividends to class B shares offset some of
this loss. But the present value of the higher class B dividends is less
than the dividend differential. The fraction of class B ownership
determines how much of the higher dividends paid to class B shareholders
will be paid by (i) lower re-investments and (ii) wealth transfer from the
class A shareholders. As the fraction of inside ownership declines, the
portion of the dividend differential financed by reduced investment
increases and transfers from class A shareholders decrease.

When the dividend differential and takeover benefits are such that the
exchanging is not a dominant strategy, the public choice problem inherent in



15



the exchange offer still distorts the exchange decision of outside
stockholders. The optimal exchange strategy for an individual outside
shareholder will depend on the probability that the shareholder is pivotal
because exchanging is still the best decision for shares that are not
pivotal. Since no shareholder can be certain of being pivotal, the decision
will not be based on a simple comparison of the payoffs for the pivotal
shareholder. An undistorted decision - which is the decision that outside
shareholders would make if they could act collectively - would be based on
such a simple comparison of the payoffs to the pivotal shareholder.
Therefore, the dual class exchange offer still distorts even when exchanging
is not a dominant strategy for all outside shareholders.
3.2. A Numerical Example Assuming Equal Takeover Prices .

Figure 1 plots the prices of class A and B shares as the fraction of
insider class A ownership increases. The example assumes an all equity firm
with 1000 shares of common stock outstanding; 200 shares owned by insiders
and 800 shares owned by outsiders. The annual earnings of the firm are
$10,000 and the interest rate is 10 percent. There is an assumed 10 percent
chance of receiving a takeover bid at $150 per share.

A dual class recapitalization plan is introduced that declares existing
common stock to be class A shares with 10 votes per share. Shareholders are
given the opportunity to exchange their class A shares for an equal amount
of class B shares which have one vote per share. In the event of a
takeover, both classes receive $150 per share in accordance with the equal
takeover price assumption. The class B shares receive a 10 percent higher
dividend than class A shares.



16



The prices on figure 1 are the payoffs from the exchange decision: P
is the payoff if the shareholder elects to retain class A shares; P. is the
payoff if the shareholder decides to exchange. As the discussion in section
2 shows, these payoffs depend on the actions of other shareholders.
Therefore, the example is based on various behavioral assumptions about the
exchange decisions of other outside shareholders. In all cases, the 200
inside shareholders are assumed to retain their class A shares.

The highest price of class B shares, P|^, of $109.99 occurs when there
is only one class B share. This corresponds to the assumption that the
other 799 outside shareholders retain class A shares and that the remaining
outside shareholder exchanges for a class B share. The percentage of inside
class A ownership is 20.02 percent (200 class A shares owned by insiders
divided by 999 total class A shares). The price is calculated using
equation (14), which also appears in the first column of the first row of
table 1:

^ X (1 + A) (l-TT)

b r(N+A N^ )


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Online LibraryRichard S. RubackCoercive dual class exchange offers → online text (page 1 of 3)