Does Wedge Size Matter? Financial Reporting Quality and Effective Regulation of Dual-Class Firms

The dual-class structure, where one class of shares confers more votes per share than the other, creates a gap (‘wedge’) between voting rights and cash flow rights that allows insiders to raise capital without relinquishing effective control of the company. In the past few years, the policy debate over the desirability of this capital structure has intensified. On one hand, proponents of the dual-class structure argue that it encourages innovation by insulating management from short-term market pressures. On the other hand, opponents argue that the combination of weak ownership incentives and entrenchment results in agency problems.

The regulatory debate over the use of dual-class stock is ongoing and, interestingly, developing in opposite directions. While this capital structure is historically permitted in the United States, institutional investors and index providers have recently expressed strong opposition to the use of dual-class structures. By contrast, jurisdictions that traditionally prohibited the use of dual-class stock have faced increasing market pressures to allow this capital structure. London’s, Hong Kong’s, and Singapore’s stock exchanges have recently revised their listing rules to facilitate the use of dual-class shares.

However, the current binary, restrict-or-allow regulation of dual-class firms does not consider the size of the wedge between voting and cash flow rights. Our recent paper ‘Does Wedge Size Matter? Financial Reporting Quality and Effective Regulation of Dual-Class Firms’ provides policymakers with analytical tools for evaluating the effectiveness of current financial regulation and assessing whether a nuanced regulation of dual-class firms, considering the size of the wedge, would be more effective.

We use a comprehensive sample of dual-class firms publicly traded in the US between 2012 and 2019 and measure the size of the wedge for each firm each year. We find that as the wedge enlarges, dual-class firms tend to be ‘older’, smaller, more profitable, and less leveraged.

We then examine whether the quality of financial reports changes across the wedge size spectrum by using well-known proxy measures for information quality: earnings persistence, cash flow persistence, and the use of discretionary accruals. Our measures indicate that the larger the wedge, the higher the quality of financial reporting. Specifically, a larger wedge does not indicate lower quality of reported earnings.

While agency theory suggests that as the wedge size increases, the quality of financial reporting decreases, our findings indicate that the freedom from the market for corporate control resulting from a large wedge is stronger than agency costs. Management’s insulation from market pressures seems to reduce motivation to manipulate earnings to achieve short-term goals in dual-class companies, compared to their single-class counterparts, thus increasing the informativeness of the financial reports. Our findings suggest that this effect of management’s insulation from the market for corporate control continues beyond the dual- versus single-class distinction and is influenced by the size of the wedge as well. When the gap between voting rights and cash flow rights is small, the company may still be vulnerable to a takeover, which may incentivize management to manipulate earnings. However, as the wedge size increases, the threat of the market for corporate control and the motivation to manipulate earnings decrease, improving the informativeness of the financial reports. 

While a larger wedge implies less pressure from the market for corporate control, it may also imply more pressure from the capital market, leading to better quality reporting. High-quality financial reports may allow for attracting second-class investors who agree to disproportionate control. Investors weigh the likely benefits of enabling founders of dual-class firms to pursue their idiosyncratic visions against agency costs. If investors believe the founders have unique skills and visions for the company, they may agree to the allocation of super-voting rights to the founders. To be trustworthy, founders must provide investors with high-quality information. Moreover, since dual-class companies are repeat players in the capital market, they have strong incentives to maintain good reputations and the credibility of their financial reports even after their IPO.

Our findings uncover important and counterintuitive evidence about the existence of a tradeoff between the dilution of voting rights and the enhancement of the quality of information provided to investors. Given the regulatory controversy over the use of dual-class structures and the heated debate about their implications for investor protection, our results suggest that a regulatory framework distinguishing among dual-class firms based on the size of the wedge may not be more effective in terms of financial reporting quality. As far as disclosure of financial information is concerned, since a larger wedge does not decrease the quality of reporting, the current regulation adopted by many jurisdictions that permits dual-class structures regardless of the size of the wedge seems to be effective.

Rimona Palas is an Associate Professor of Accounting (senior lecturer) and Head of the Accounting Department at the College of Law and Business in Ramat Gan.

Dov Solomon is an Associate Professor of Law (senior lecturer) and Academic Director of the LL.M. program at the College of Law and Business in Ramat Gan.

Dalit Gafni is an Associate Professor of Economics (senior lecturer) and Vice Dean of the School of Economics at the College of Management-Academic Studies (Colman) in Rishon LeZion.

Ido Baum is an Associate Professor of Law (senior lecturer) at the College of Management-Academic Studies (Colman) in Rishon LeZion and Director of the Brandeis institute for society, economy, and democracy.