Experts support dual-class shares

JD's problems have not deterred analysts' backing for listing mechanism

The allegations made against the chairman of the Chinese e-commerce company JD, Liu Qiangdong, have reminded investors of the corporate governance risks behind dual-class share structures.

However, experts believe the structure's pros outweigh the cons and are in favor of China's recent efforts to introduce it to the A-share market.

Technology companies in the country will be allowed to adopt such structures under revised legislation and regulations, the State Council, China's Cabinet, said in a guideline released on Sept 26.

Investors' concerns over dual-class structures and JD's future arose after Liu, also known as Richard Liu, was accused of rape in the United States. Decisions in the company are primarily made under his direction.

After the allegation was made public, the company's share price dropped by as much as 16 percent in two trading days.

"JD faces the problem of whether its management model would remain sustainable if Richard Liu left the company," says Dong Dengxin, director of the Finance and Securities Institute at Wuhan University of Science and Technology.

Liu's control of the company is backed up by his considerable voting power under its dual-class share structure. This structure divides JD's ordinary shares into two classes. Holders of Class A shares are entitled to one vote per share, while holders of Class B shares are entitled to 20 votes per share.

According to the company's disclosure, by indirectly holding all of JD's Class B shares, Liu owns 15.5 percent of its total ordinary shares but controls 79.5 percent of the voting power, entitling him to pass every company resolution, both ordinary and special, at his discretion.

In companies such as JD that use these share structures to guarantee that decision-making is concentrated in the leadership, personal risks may easily transform into corporate ones, Dong says.

Besides the risk of losing the key decision-maker with no succession plan, dual-class share structures could also expose investors to managerial misconduct risks, experts say.

Under these structures, the management's massive power, together with its limited equity shares and thus lower interests in the company, could breed management misconduct in pursuing personal interests at the expense of investor interests, according to Hong Rong, an MBA tutor with the Shanghai Advanced Institute of Finance and founder of investor education platform Hongda Education.

For instance, in the 1970s and 1980s, dual-class share structures were popular on the Hong Kong stock exchange but were finally banned in 1989.

"Investors were dissatisfied, as these structures were taken advantage of to impair their interests," Hong says.

Despite risks and controversies, dual-class structures are now common among technology companies on many bourses around the world. Technology giants such as JD, Facebook, Google and Baidu have adopted the structure.

In June, the Singapore Exchange began to allow companies to list there with dual-class structures, following the Hong Kong stock exchange allowing the same in April, joining their counterparts in the United States, Canada and some European countries.

One major purpose of introducing the system is to guarantee founders' control of the company despite enormous equity financing scales, which is important for the long-term development of a technology company, Hong says.

Under single-class share structures, when a company does not make a profit - a common situation among tech startups - shareholders with substantial stakes often call for changes in the company's business scope to focus on short-term profits, undermining long-term potential, he says.

"Unlike a traditional enterprise relying more on capital to expand, tech companies instead rely heavily on their founders," Hong says.

The other major advantage of dual-class share structures is avoiding hostile takeovers, in which an entity takes control of a company despite its management's disagreement, Hong says. Under the dual-class share structure, the would-be acquirer would not control the target company even if it bought the majority of the company's Class A shares on the open market, which would only represent minor voting power.

Currently, public and private companies on the Chinese mainland are not allowed to adopt dual-class structures, but the government has accelerated reform efforts.

Before the State Council's statement on Sept 26, mainland and Hong Kong stock exchanges had said in July that they would work on detailed rules for incorporating Hong Kong-listed companies with dual-class structures into southbound trading under the stock connects.

As part of policy moves to welcome the dual-class structure, the introduction of Chinese Depositary Receipts in June has allowed several Chinese technology companies listed on overseas exchanges to issue certificates on mainland exchanges. Once issued, CDRs enable mainland investors to buy into companies with dual-class structures, such as internet giant Baidu and smartphone maker Xiaomi.

Experts say that although JD's situation is a reminder of the risks behind dual-class shares, A-share reforms to permit them should continue, along with the necessary improvements in investor protection and education.

"Overall, the pros of the structure outweigh the cons for tech companies.

As for potential managerial misconduct, laws and investor protection systems are in position to shield investors from risks," says Hong from the SAIF. China's investor protection system needs to improve to deal with risks related to such structures, says Li Shuguang, a law professor at China University of Political Science and Law. He cites specific areas such as the regimen of class-action lawsuits litigated by small and midsized investors, detection of insider trading, and transparency and information disclosure.

"China can learn from the US's mature system of investor protection and make adjustments in accordance with Chinese culture," Li says. "But it takes time to promote related improvements gradually."

Hong says that before the improvements are implemented, it is probable the authorities will give special permits allowing dual-class structures to companies falling into special categories and meeting particular standards, to avoid risk management issues prompted by the mass introduction of dual-class shares.

As for the risk of losing key decision-makers, Dong from WUST says the risk would be mitigated by companies giving voting power to a group of leaders, rather than concentrating power into one or two people.

"Though JD and Alibaba both adopted these structures, Alibaba's team decision-making mechanism may be more sustainable", Dong says, when Alibaba founder Jack Ma exits. Ma has said he will leave his position as the company's chairman next year.

Alibaba's governance is led by Alibaba Partnership, a group of partners selected from senior managers. The partnership retains its dominance over the company through its exclusive right to nominate or appoint the simple majority of members of the board of directors, according to company disclosures.

Dong says this model is akin to a dual-class structure because it functions in much the same way, giving decision-making power to the management instead of substantial shareholders. But this model features team decision-making and smoother leadership succession, he says.

However, not every tech company can benefit from Alibaba's team decision-making model, and in some circumstances, JD's power concentration model would be more efficient, he adds.

"Tech companies should learn from both Alibaba and JD to design a governance structure that suits themselves and achieves governance efficiency and sustainability."

From a broader perspective, Dong says, introducing dual-class share structures is an important reform in China's capital market to support new economy enterprises. He says another reform being considered is to allow new economy enterprises posting financial losses but strong growth to list on mainland exchanges.

So far, for a company to list on mainland bourses, it must meet certain profitability standards that are not necessary in the US. But the State Council pledged to change the rules on Sept 26.

Dong says that since retail investors account for the majority of investors on mainland exchanges, their approval is indispensable to accelerate reforms. Retail investors should be educated to be more open to new economy enterprises and understand the interests of incorporating new economy enterprises with dual-class structures or negative earnings into the A-share market, he adds.

Educating investors is key, since investor quality is a major influence on the speed of reform, Hong says.

zhoulanxv@chinadaily.com.cn

(China Daily Africa Weekly 10/05/2018 page28)