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E-MailRimona Palas is an Associate Professor and head of the Accounting Department at the College of Law and Business; and Dov Solomon is an Associate Professor and head of the Commercial Law Department at the College of Law and Business, Ramat Gan Law School. This post is based on their recent paper. Related research from the Program on Corporate Governance includes The Untenable Case for Perpetual Dual-Class Stock (discussed on the Forum here); The Perils of Small-Minority Controllers (discussed on the Forum here); and Keynote Presentation on The Lifecycle Theory of Dual-Class Structures (discussed on the Forum here), all by Lucian Bebchuk, and Kobi Kastiel.
When Google went public with a dual-class capital structure in which shares owned by the founders confer greater voting rights than shares issued to public investors, its cofounders, Larry Page and Sergey Brin, sent shareholders a letter promising to provide them with high-quality information about the company. Using the words of Warren Buffett, the chairman and CEO of Berkshire Hathaway, another dual-class firm, they promised shareholders, “We won’t ‘smooth’ quarterly or annual results: If earnings figures are lumpy when they reach headquarters, they will be lumpy when they reach you.” Page, Brin, and Buffett definitely understood the importance of quality information to their investors. But do dual-class firms really provide investors with credible financial information?
The results of previous research regarding the quality of information provided by dual-class firms have been mixed, representing two competing explanations. On one hand, agency theory suggests that the controlling shareholders of dual-class firms would be interested in providing lower-quality information to investors, while on the other hand management’s insulation from market pressures reduces the need to manipulate earnings in order to achieve short-term goals and thus increases the informativeness of the financial reports of dual-class firms.
In The Quality of Earnings Information in Dual-Class Firms: Persistence and Predictability, forthcoming in the Journal of Law, Finance, and Accounting, we examine the quality of the financial reports of dual- versus single-class firms publicly traded in the U.S. over the 2012–2017 period, as measured by persistence and predictive ability of earnings and cash flows. The results are based on comprehensive information from financial statements analyzed using across-sample and within-sample tests. An additional external indicator of financial restatement filings is also used to support the results.
We find that dual-class firm earnings are significantly more persistent one quarter ahead than single-class firm earnings, with this persistence increasing over time. These results remain consistent when we add control variables to the regression and the forecast horizon is increased to one and two years (although not all results are significant).
Dual-class firms’ earnings are also better able to predict future cash flows, for one quarter-ahead, one-year ahead, and two-years ahead, than those of single-class firms, although the results are only significant for one-quarter ahead. Moreover, dual-class firms’ earnings are better able to predict future earnings, based on past earnings and on a comprehensive list of financial ratios, and are more reliable than single-class firms.
Using an external indicator, restatements, we find that fewer dual-class firms file restatements, and also the number of restatements filed by dual-class firms is smaller than that filed by single-class firms. These results support our previous results regarding the higher quality of earnings reported by dual-class firms.
Our findings suggest that for dual-class firms, freedom from market pressures is more influential than agency costs. Dual-class capital structures allow managers to focus on long-term value maximization without being distracted by temporary fluctuations in a firm’s share price caused by its missing analysts’ earnings forecasts. Without undue capital market pressures, managers of dual-class firms have a reduced incentive to manipulate reported earnings to meet short-term earnings goals.
The relationships between founders and investors of dual-class firms may provide some explanatory power for our results. Investors weigh the benefits of enabling founders to pursue their idiosyncratic visions against the agency costs. If investors believe the founders have unique skills and visions for the company, they may buy shares in dual-class firms despite the agency costs. To be viewed as trustworthy, founders must provide investors with high-quality information.
Once dual-class firms have raised capital from the public, it may seem as though they no longer have incentives to provide credible information to investors. However, dual-class firms need to maintain good reputations even after their IPOs. When dual-class firms need to raise more capital following their IPO, they may make a secondary share offering of their common stock. Indeed, the ability of dual-class firms to raise money in the capital markets may be severely impaired if investors doubt the credibility of their reports.
The results contribute to the heated debate about the transparency of dual-class firms by uncovering important and counterintuitive evidence about the existence of a tradeoff between the dilution of voting rights and enhancement of the credibility of information provided to investors. Our findings suggest that as far as financial information is concerned, dual-class firms do provide high-quality information to their investors.
The complete paper is available for download here.
