The market value of voting power and dividends

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The market value of voting power and dividends
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vi, 114 leaves : ill. ; 29 cm.
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Cox, Steven R., 1959-
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Stockholders' voting   ( lcsh )
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Dividends   ( lcsh )
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Thesis (Ph. D.)--University of Florida, 1993.
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Includes bibliographical references (leaves 110-113).
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by Steven R. Cox.
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Full Text







THE MARKET VALUE OF VOTING POWER AND DIVIDENDS


By


STEVEN R. COX












A DISSERTATION PRESENTED TO THE GRADUATE SCHOOL
OF THE UNIVERSITY OF FLORIDA IN
PARTIAL FULFILMENT OF THE REQUIREMENTS
FOR THE DEGREE OF DOCTOR OF PHILOSOPHY


UNIVERSITY OF FLORIDA


1993








ACKNOWLEDGEMENTS


I am grateful to the members of my committee, Professors Christopher

James, Michael Ryngaert, David Brown, and Sanford Berg, for their guidance

and patience. I would also like to thank the following people for their support:

Professor Joel Houston, Vinay Datar, Ivy Locke, Harold Nobles, Hugh Pratt,

Robin Radtke, and Jack Walters. Most importantly, I thank my wife Karla, who

made this project possible.






TABLE OF CONTENTS


ACKNOWLEDGEMENTS...... ii

ABSTRACT ..... v

CHAPTERS

1 INTRODUCTION AND BACKGROUND 1
Introduction . 1
Background 2
Research Objectives and Results. ... 4
Issue 1: The Impact of Preferential Dividend Offers. 5
Issue 2: Preferential Bids During Hostile Takeovers 9
Issue 3: Voting Premiums and the Value of the Firm 11
Organization of the Dissertation ..... 14

2 DUAL-CLASS RECAPITALIZATIONS AND RELATED STUDIES 15
Introduction 15
Regulatory and Legal History . 15
Mechanics of the Recapitalization 19
Dividend method 19
Exchange Method 20
Length-of-Time-Method. 21
Preferential Dividend Promises 21
The Case Against Dual-Class Recapitalizations. 22
The Case For Dual-Class Recapitalizations. 25
Previous Empirical Results 28
The Value of the Vote . 28
Wealth Effects of Recapitalization Announcements. 31
Subsequent Performance Studies. 34
The Contribution of this Dissertation 34

3 ANALYSIS OF AVERAGE PRICE RATIOS 37
Background and Methodology. ..... .37
Sample Selection and Classification .... 38
Results For Firms Grouped By Their Dividend Promises 45
Results For Individual Firms 54






4 THE IMPACT OF FIRM SPECIFIC VARIABLES. .59
Introduction . .. 59
The Impact of Firm Specific Variables on Price Ratios 60
Description of the Study 60
Dividend Policy (CAT2, CAT3, INT2, INT3) 63
Control Threats (CON). . 64
Liquidity (LNHW LNLW ). . 66
Regression Results. 67
The Promise and Pricing of Preferential Dividend Promises. 71
The Behavior of Price Ratios Over Time .... .81

5 VOTING PREMIUMS, EQUITY ISSUES, AND WEALTH EFFECTS. 87
Background 87
An Event Study of the Issue . 91

6 SUMMARY OF CONCLUSIONS 102

APPENDIX 107

REFERENCES 110

BIOGRAPHICAL SKETCH. 114








Abstract of Dissertation Presented to the Graduate School
of the University of Florida in Partial Fulfillment of the
Requirements for the Degree of Doctor of Philosophy

THE MARKET VALUE OF VOTING POWER AND DIVIDENDS

By

Steven R. Cox

August 1993


Chairman: Christopher M. James
Major Department: Finance, Insurance and Real Estate



This dissertation examines the relative pricing of the low and high-vote
shares of 64 firms with two classes of common stock trading in the United States

within the period 1984-1988. The firms feature common stock classes with

differential voting rights and, in some cases, differential rights to dividends.

I calculate ratios of the market prices of high and low-vote stock to

measure the value of the vote and promises of possible preferential dividends to

low-vote shareholders. To investigate the source of the value, I examine the

relationship between the observed premiums on high-vote shares and firm

specific variables.

The standard event study methodology is used to measure abnormal

returns around 44 dual-class recapitalization announcements. I test whether

post-recapitalization voting premiums and subsequent equity issues are related

to cross-sectional differences in abnormal returns.

The voting premiums from my sample are significantly higher than those

reported in previous studies of U.S. firms. This result corresponds with the







popularity of hostile takeovers during my sample period. I find the presence of a

control threat significantly increases the voting premium. I conclude that the

possibility of a takeover premium may induce outside shareholders to pay a

premium for high-vote shares even when they have no interest in exercising

actual control of the firm.

I also find that preferential dividend promises to low-vote shareholders

reduce price differences between classes of common stock. I provide evidence

that subsequent issues of low-vote equity may help explain why preferential

dividends are promised by insiders and priced by outside shareholders.

Finally, I final that firms which suffer a loss in market value at the

recapitalization announcement subsequently exhibit higher voting premiums and

are more likely to issue additional low-vote equity. Thus, negative

announcement reactions are associated with situations where the value of the

vote is high and where the market reacts negatively to equity issues.











CHAPTER 1
INTRODUCTION AND BACKGROUND

Introduction


Common stock ownership generally provides a claim to residual earnings

and the right to vote on certain issues. Most shareholders own a relatively small

number of shares and have limited incentive to participate in control issues.

Thus, the control of many large corporations rests effectively in the hands of

officers and directors. Recognition of the problems associated with the

separation of ownership and control dates back to Berle and Mean's (1932)

observation that opportunities arise for managers to redirect resources from

stockholders to themselves when ownership is separated from control of a firm's

activities.

In recent years, many publicly traded firms have further separated

ownership and control by adopting dual-class common stock. As of 1990, over

150 companies with dual-classes of stock were listed on the national

exchanges.1 In a dual-class recapitalization, a second class of common stock is

created with limited voting rights and, in some cases, preferred claim to

dividends. One or more low-vote shares are issued for each share held prior to

the recapitalization. The pre-existing shares are reclassified as high-vote. The

high-vote stock receives multiple votes per share and/or the ability to elect the

majority of the board of directors. The newly created, low-vote stock typically

1 According to Schultz (1990). Many of these firms have only one class of
publicly traded stock.




2


receives one vote per share and/or the ability to elect a minority of the board of

directors. In some cases the low-vote stock is nonvoting.

After most dual-class recapitalizations, shareholders have the right to

exchange high-vote stock for low-vote stock. To encourage this exchange, the

low-vote stock is often awarded preferred dividend status. In many firms, the

low-vote shares are promised 110% of the dividend paid to the high-vote shares.

In other cases, the low-vote shares are promised "at least" the dividend paid to

the high-vote shares.

As a result of the recapitalization, insiders ultimately increase their voting

control and decrease their equity investment. Thus, dual-class recapitalizations

may harm outside shareholders by insulating management. Alternatively, dual-

class recapitalizations may transfer voting rights from outside shareholders to

corporate insiders in a mutually beneficial exchange. Outside shareholders

receive the promise of preferential dividends while the transactions allow

insiders to issue new low-vote equity to finance investment opportunities without

jeopardizing their voting control.


Background


Most research on dual-class recapitalizations focuses on one of two

issues. First, the difference between the values of high and low-vote shares is

used to measure the value of control over a firm's activities. For example,

Lease, McConnell, and Mikkelson (1983) study 30 firms with two classes of

common stock trading within the period 1940-1978 and find that the stock class

with superior voting rights trades at a premium over the low-vote stock in 26

cases. The average voting premium for all 30 firms was 4.06%. Levy (1982)

finds that high-vote shares trade at a 45% average premium in a study of 25







Israeli firms with dual-class common stock. Megginson (1990) studies 152 dual-

class British firms over the period 1955-1982 and finds that high-vote shares
trade at a 13.3% premium over low-vote shares.
The above studies limit their samples to firms that promise equal cash

dividends and capital distributions to both stock classes. However, in order for
high-vote shares to trade at a higher price than low-vote shares, finance theory
indicates that high-vote shares must carry the expectation of benefits that low-

vote shares do not. Thus, evidence that common stock with superior voting
rights trades at a higher price than otherwise identical stock implies at least the
possibility of differential cash or non-cash payoffs to the two classes. The

source of these potential differential payoffs remains an unsettled issue.

The second focus of research on dual-class recapitalizations is on the

announcement effects of the intent to recapitalize. Although no immediate

change in cash flow results from a recapitalization, the size and distribution of

firm value may change as managerial incentives change, and the ability to
discipline management is reduced. The most frequent criticism of dual-class

stock is that it reduces the likelihood of unsolicited takeovers. Takeovers are an

important source of management discipline. With majority control of voting
rights, management can block any takeover attempt and deny shareholders the

premiums that typically accrue to the target company. If dual-class

recapitalizations are perceived as a takeover defense, then share price declines
should accompany the announcements of dual-class recapitalizations.2

Alternatively, firm value may change if the transaction is perceived to be a
mutually beneficial exchange of voting rights, or if the market perceives the


2 Jensen and Ruback (1983) report a 1% to 3% average loss from other
takeover defenses such as greenmail.








action as a signal of impending changes in the firm's capital structure and

dividend policy. A number of studies examine the stock price response to the

announcement of plans to create a second class of voting stock. Jog and Riding

(1986) find no significant response at the announcement date from 130 firms

listed on the Toronto Stock Exchange.3 Partch (1987) examines the stock price

reaction of 44 firms traded in the United States during the period 1962-1984.

She finds significant positive stock price responses at the announcement date

and over intermediate negotiation dates. However, the median stock price

response is negative. She concludes that shareholder wealth is not affected by

the creation of limited voting stock. Gordon (1986) and Cornett and Vetsuypens

(1989) also fail to find a significant stock price effect from a change to two

classes of common stock. In the most comprehensive study, Jarrell and Poulsen

(1988) investigate 94 firms from the period 1976-1987. They find small, but

statistically significant, negative stock price reactions to announcements of the

intent to recapitalize into two classes of common stock.


Research Obiectives and Results


Since 1978, the ending date in the sample used by Lease et al., there has

been a dramatic increase in the number of dual-class recapitalizations in the

United States. Previous studies of firms with dual-class common stock establish

that voting power has value and that dual-class recapitalizations have varying

impacts on firm value. In this dissertation I examine 64 firms with two classes of

common stock simultaneously traded on public exchanges in the United States

within the period 1984-1988. The sample firms feature common stock classes


3 At the end of 1983, 10% of the aggregate value of the Toronto Stock Exchange
was accounted for by shares with restricted voting rights.




5


with differential voting rights and, in some cases, differential rights to dividends.

Specifically, I focus my study on three issues.


Issue 1: The Impact of Preferential Dividend Offers


Most recent dual-class recapitalizations feature differential dividend

promises to the low-vote shareholders. Preferential dividends are offered to

encourage outside shareholder approval of the transactions and to entice

outside shareholders to convert their high-vote shares to low-vote shares. I

document two types of preferential dividend promises. One group of firms

promise explicit preferential dividends to the low-vote shareholders. In most

cases, low-vote shares are promised 110% of the dividend paid to high-vote

shareholders. In a limited number of cases, the low-vote shareholders are

promised a fixed amount before the two classes share equally in subsequent

distributions. A second group of firms promise the low-vote shares at least the

same dividend per share as paid to the high-vote shares. This structure allows

for the possibility of preferential dividends without guaranteeing them.

The form of these dividend promises is interesting because insiders offer

the preferential dividends to low-vote shareholders but tend to concentrate their

holdings in the high-vote stock. The preferential offers are structured so that

management can refuse to pay cash dividends and effectively nullify the

preferential benefits. This dividend policy allows insiders to share equally in the

rewards from firm ownership through price appreciation rather than participate

disproportionately through dividends.

Given the apparent incentive for managers to avoid paying preferential

dividends by eliminating dividends altogether, I examine whether the offers are

viewed as credible by the low-vote shareholders. To test whether low-vote







shareholders believe, and therefore price these promises, I classify firms by the

form of dividend promise and calculate ratios between the market prices of the

high and low-vote stock to measure the value of the vote and any preferential

dividends promised and possibly paid to the low-vote shareholders.

If preferential dividend promises are viewed as credible compensation

offers, then the average price ratio of firms that offer preferential dividends

should be lower than the average price ratio of firms that offer equal dividends.

Similarly, if the offer of "at least" equal dividends is perceived as a possible offer

of preferential dividends, then the average price ratio of these firms should fall

between the average price ratios of firms using the other two offers.

Alternatively, if preferential dividend promises are not viewed as credible offers,

or if the form of dividend compensation is related to the value of the vote, then

the price ratios may not differ significantly across dividend promises.

I find that preferential dividend promises to low-vote shareholders reduce

the price ratios between classes of common stock. Firms that offer equal

dividends exhibit the highest ratios while firms that offer preferred dividends

trade at the lowest ratios. Firms that offered "optional" preferential dividends by

promising at least an equal dividend trade at price ratios between the other two

forms of dividend promises. Statistically significant differences exist between

the average price ratios of firms grouped by the form of dividend promise.

Outside shareholders price the dividend promises and therefore must find the

promises credible. In fact, almost all the firms that promise preferential

dividends to low-vote shareholders pay dividends. Many firms that promise

"optional" preferential dividends actually pay preferential dividends.

Insiders who make preferential dividend promises to low-vote

shareholders tend to concentrate their holdings in high-vote stock and do not

share equally in dividend payoffs. I contend that personal portfolio concerns of







insiders, along with agency problems and the expectation of future equity issues,

may explain why preferential dividends are paid.

Personal wealth constraints and/or diversification concerns often prevent

managers from increasing their ownership investment. Dual-class

recapitalizations allow managers to decrease their ownership stake while

maintaining or increasing their voting power. Proposing such a recapitalization

signals that insiders may intend to reduce their investment in the firm. The

payment of cash dividends is an effective technique to reduce capital investment

without reducing voting power. As a result, when outside shareholders believe

that managers also desire dividends, the promise of preferential dividends to

low-vote shares becomes more credible.

Agency problems and the possibility of future equity issues may also

explain why preferential dividends are paid. Dual-class recapitalizations reduce

disciplinary forces from inside and outside the company. To alleviate outsiders'

concerns about the transaction, recapitalizing firms may find it advantageous to

promise alternative devices that will give immunized managers incentives to act

as better agents. Easterbrook (1984) suggests such substitutability among

disciplining devices. In particular, Easterbrook claims that increased dividends

will reduce the supply of internal funds, requiring firms to more frequently utilize

the capital market. When firms issue new securities they are subject to

extensive external monitoring from investment bankers and auditors. Thus,

management entrenchment is a less serious concern if the firm is constantly in







the market for new capital.4 In fact, firms that recapitalize are significantly more

likely to issue equity.5

Although higher dividends may reduce agency problems, outside

shareholders must believe that management will pay dividends. I argue that

management's intention to issue additional low-vote shares provides additional

motivation for outsiders to believe and price the dividend promises. Asquith and

Mullins (1986) argue that dividend policy and equity decisions are interrelated.

Dividends are credible vehicles to carry managements' assessments of firm

value to the investor because they require cash flow that the firm must generate

internally or persuade the capital markets to supply. Firms without good future

performance find dividend signaling especially costly. If managers intend to

issue additional low-vote equity, then they have the incentive to follow through

and support the market value of that class of stock.

I investigate whether the promise of preferential dividends to low-vote

shareholders is related to firm characteristics. I use LOGIT models to find that

subsequent issues of equity are significantly related to the form of dividend

promise.








4 Rozeff (1982) presents a model for optimal dividend payout ratios where
increased dividends reduce agency costs but raise the transactions cost of
external financing.

5 Partch (1987) finds that 38.6% of recapitalizing firms issued limited voting
stock within two years after issuance. By comparison, Mikkelson and Partch
(1986) find only 17% of randomly selected firms issued new common stock over
an eleven year period.







Issue 2: Preferential Bids During Hostile Takeovers


Although previous studies establish that voting rights have value, the

source of the benefits that support the value remains an elusive issue. The

typical explanation is that owners of high-vote stock, who are often also

managers, receive benefit from voting control by ensuring a long-run relationship

with their firm. The benefits of securing employment range from the non

pecuniary, such as power, recognition, and a nice office, to the cash value of a

"guaranteed" salary. With either cash or non cash benefits, there seems to be

clear incentive for managers to prefer high-vote stock over low-vote stock.

Although this is a persuasive explanation of the source of the premiums, it does

not directly explain why I find that control premiums are persistent and exist in

equilibrium for firms where control is already tightly held.

The market price of common stock reflects the supply and demand of

marginal shareholders who are actively trading in the stock. Once a firm has an

established group of dominant shareholders, then purchasing high-vote stock

will not qualify outsiders for management positions that might allow for the

extraction of the benefits. In addition, inside shareholders who have already

secured their management position are unlikely to remain active in the market

and should not significantly affect the price. As long as a dominant shareholder

group exists, outsiders should be unwilling to pay a premium for high-vote stock

and insiders should find the high-vote stock overpriced. Thus, the observed

premiums may not always directly reflect the value of control related to securing

an employment position.

When a dominate shareholder group does not exist and control of the firm

is contested, then it is likely that the marginal shareholders will be insiders or

potential insiders who may offer a premium price for high-vote stock. When








voting control is held by shares representing a small portion of a company's

invested capital, then a bidder can obtain control by offering to purchase only

the high-vote shares.6 Although most dual-class firms promise both classes

equal distributions during liquidation, shareholders may be offered differential

compensation in an acquisition.7 DeAngelo and DeAngelo (1985) document

that 4 out of 30 acquisitions of dual-class firms from 1960-1980 included

negotiated premiums to the high-vote shares. The premiums ranged from 83.3%

to 200%. Megginson reports that 43 out of 152 British dual-class firms were

acquired between 1955-1982. Out of the 43 successful acquisitions, 37 included

preferential offers to high-vote shareholders. The premiums ranged from 1.6%

to 260%.

The existence of differential takeover premiums suggests an explanation

for long-lived control premiums. Outsiders may be willing to pay a premium for

high-vote stock, even during periods when control is consolidated, as an option

to participate in the profits from possible future control contests. There are

cases where tightly held family firms seem immune to takeover threats but

subsequently become a target when an important family member dies. Thus,

outside shareholders who never intend to directly receive the benefits of control

may receive takeover premiums if the firm becomes involved in a control contest.

Of course, the premiums that outsiders pay for an option to participate in

future control contests are dependent on their assessment of the value that

6 Bergstrom and Rydqvist (1989) develop a model of the optimal bid prices for
voting and non-voting shares in corporate acquisitions.

7 While some European countries prohibit or restrict two tier and differential
bids, U.S. laws do not require that a bid for controlling shares be extended to all
shareholders. However, many firms have written fair price provisions into their
corporate charters requiring investors who acquire a certain fraction of the votes
to extend an offer to all shareholders. See Ryngaert (1988).







insiders, and potential insiders, will place on control, as well as their assessment

of the probability and timing of the event. Ultimately, the source of voting value

returns to the pecuniary and non pecuniary benefits of employment.

I test whether the possibility of a takeover premium explains why outside

shareholders are willing to pay a premium for high-vote stock. Although

Megginson (1990) and DeAngelo and DeAngelo (1985) document the existence

of takeover premiums paid to high-vote shares, they did not test for the impact of

an expected takeover on pre-takeover stock prices across voting classes. I

directly test whether the possibility of a takeover affects the voting premium.

The voting premiums from my sample are significantly higher than those

reported by Lease, McConnell, and Mikkelson. This result corresponds with the

popularity of hostile takeovers during the sample period. I also find the

presence of a control threat significantly increases the voting premium. I

conclude that the possibility of a larger takeover premium may induce outside

shareholders to pay a premium for high-vote shares even when they have no

interest in actual control of the firm.


Issue 3: Voting Premiums and the Value of the Firm


Previous studies have independently considered the impact of dual-class

stock on firm value and the subsequent relative price differences between

classes. Simply put, these studies measure (1) the change in the total value of

the firm and (2) how the total value of the firm is split between classes. I

investigate whether there is a relationship between the way ownership the firm is

divided between classes of stock and changes in the total market value of the

firm. Specifically, I test for a relationship between voting premiums measured

after the recapitalization and wealth effects measured on the announcement of







the recapitalization. My premise is that the motivation for dual-class

recapitalizations may vary greatly from firm to firm. The ambiguous average

wealth effects discovered in previous studies support this assertion. At some

firms, insiders with voting control may be unwilling to raise new equity capital

because of the possibility of losing voting control. If these firms have growth

opportunities, then not accessing the growth hurts inside and outside

shareholders equally. A dual-class recapitalization may allow these firms to

access the growth and should be considered a positive event by the market.

When the primary motivation for the recapitalization is to access growth

opportunities, as opposed to abusing voting power, I expect to find positive

announcement reactions and smaller voting premiums. The most obvious

evidence that firms intend to access growth opportunities is an equity issue soon

after recapitalization. I expect to find firms that subsequently issue equity

exhibiting more favorable announcement reactions.

Other firms may use dual-class recapitalizations simply as insulating

devices that may cause a loss in firm value that is borne by low-vote

shareholders. Jensen and Meckling (1976) suggest this possibility. They

assume that a corporation exists with two groups of shareholders, management

that controls the firm, and passive outsiders. Both groups are entitled to equal

dividends. According to their model, management will not act in the best interest

of outside shareholders and may choose a set of activities for the firm such that

the total value of the firm declines. As the manager's fraction of equity falls, his

fractional claim on outcomes falls and this encourages him to divert larger

portions of the firm's resources toward perquisites. Outsiders anticipate this

action by insiders and drive down the stock price and firm value. The insiders

maintain or increase their welfare by consuming non pecuniary benefits not







received by outside shareholders. In this case the two classes of shareholders
receive equal pecuniary benefits but unequal overall benefits.

Dual-class recapitalizations result in a situation similar to the scenario
suggested by Jensen and Meckling. Insiders typically increase their voting
control while decreasing their investment.8 As a result, dual-class
recapitalizations may reduce firm value as the agency costs associated with the
separation of ownership and control are magnified.9 The reduction in firm value
may ultimately be reflected in the low-vote shares that are primarily held by

outsiders. Although the firm may have a lower total value, insiders may not be
harmed because they use their high-vote shares to improve and secure their
employment positions and related salaries. The ratio of the high-vote share
price to the low-vote share price measures the value of the vote. I expect to find
that firms with negative announcement effects will exhibit larger price ratios.

The standard event study methodology is used to examine stockholder
abnormal returns around 44 dual-class recapitalization announcements. I test
whether post-recapitalization voting premiums and subsequent equity issues are
useful in explaining the size and sign of abnormal returns. As expected, I find
that voting premiums are negatively related to recapitalization announcement
effects. Firms that suffer larger losses in firm value as a result of the
recapitalization announcement, subsequently exhibit larger price differentials

between classes. Thus, the greater the value of the vote that is lost by low-vote

8 DeAngelo and DeAngelo (1985) find that officers of firms with two classes of
common stock averaged 54.8% of the voting power but only 27.6% of the claims
to cash flows. Partch (1987) finds that insider ownership and voting power was
48.6% before a dual-class recapitalization. Twenty one months after the event,
inside ownership fell to 43.7% while insider voting power rose to 58.6%.

9 Jarrell and Poulsen (1988), find a small negative share price reaction to the
announcement of the intent to recapitalize.







shareholders, the worse the announcement reaction. Contrary to my

expectations, I find that firms that offered equity within one year after the

recapitalization suffered significant negative reactions to the recapitalization

announcements. This result suggests that recapitalization announcements may

contain additional informational relating to pending capital structure changes.


Organization of the Dissertation


The remainder of this dissertation is organized in the following manner.

Chapter 2 presents a detailed discussion of dual-class recapitalizations

including a review of previous empirical studies. Chapter 3 utilizes average

cross-sectional stock price ratios to estimate control premiums and to determine

whether preferred dividend promises to low-vote shareholders are priced.

Results for individual firms are also presented. Chapter 4 studies the

relationship between dividend promises, dividend payments, and future equity

issues and suggests an explanation for the pricing of dividend promises given

inconsistent management incentives. In addition, I search for the source of

voting premiums in equilibrium by measuring the impact of takeover threats on

the observed control premiums. Chapter 5 investigates the relationship between

wealth effects measured at recapitalization and subsequently observed voting

premiums and equity offers. In Chapter 6, I summarize the principal results from

the prior chapters.










CHAPTER 2
DUAL-CLASS RECAPITALIZATIONS AND RELATED STUDIES


Introduction


Traditionally, the voting rights and cash flow claims of corporations have

been bundled together in the one-share, one-vote tradition. Recently, many

publicly traded firms have distanced themselves from this tradition by

recapitalizing and creating dual-classes of common stock with differential voting

rights. The possible agency problems associated with the resulting separation

of ownership and control make the transactions a controversial issue. In this

chapter, I first detail the regulatory and legal history of dual-class

recapitalizations along with some of the institutional details relating to the

transactions. I then summarize and discuss the theoretical cases for and

against dual-class recapitalizations including possible changes in the size and

distribution of firm value. Finally, I review the previous empirical results relating

to this topic.


Regulatory and Legal History


The competing views of the impact of dual-class recapitalizations are a

source of disagreement among regulators, managers, and shareholders.

Proponents of corporate democracy argue that unbundling voting rights from

ownership reduces the ability of shareholders to discipline managers.

Defenders of dual-class recapitalizations argue that corporations should be free

to select their capital structure as long as changes are approved by the

shareholders.







Prior to 1984 the New York Stock Exchange (NYSE) required that firms

listed on its exchange maintain a one-share, one-vote rule. As a result,
corporations with dual-class common stock were forced to list their stock on

other exchanges. The American Stock Exchange (ASE) required only that the

ratio of voting rights between the high-vote and low-vote stock not exceed 10 to

1 and the low-vote stock must have certain rights in selecting the board of

directors. The National Association of Securities Dealers (NASD) had no

restrictions regarding voting rights. In June of 1984, the NYSE imposed a
moratorium on its rule prohibiting disparate voting classes. The NYSE issued

the moratorium largely because of competitive pressures from the other

exchanges.10 The NYSE moratorium opened the door to a flood of

recapitalizations. Firms already listed on the NYSE were free to recapitalize

while firms listed on the other major exchanges may have felt that the stigma of

the recapitalizations was reduced by the moratorium. Between 1983 and 1987

over 90 firms recapitalized.11 In September 1986, the NYSE formally proposed

modification of its standards to allow dual-class trading. Although the NYSE is a

self-regulatory agency under Section 19 of the Securities Exchange Act of 1934,

the proposed change in its rules required Securities and Exchange Commission

(SEC) approval.

Rather than immediately approving the proposal, the SEC attempted to

persuade the major exchanges to negotiate a self-imposed regulation against


10 Although the NYSE cited general competitive pressures, the motivation for
the change in policy came when General Motors Corporation announced it
would issue a second class of common stock with inferior voting rights to finance
an acquisition. The NYSE decided to suspend its rule before it lost its biggest
listing customer.

11 From Lehn, Netter, and Poulsen (1990).







dual-class common stock. When the negotiations between the board members

of the three major exchanges failed, the SEC responded to growing public

criticism of dual-class recapitalizations and proposed a one-share, one-vote rule
on the nation's stock markets.12 In July 1988, SEC rule 19e-4 banned the

trading of all dual-class stock created from recapitalizations on all public

exchanges and on the National Association of Security Dealers Stock Quotation

System (NASDAQ). Dual-class stock was allowed to continue public trading if it

existed prior to rule 19e-4. In addition, new issues of low or no-vote common

stock were allowed to trade. The SEC's position was that transactions that

reduced the voting rights of existing shareholders were harmful and prohibited.

Otherwise, corporations were free to select their capital structure including initial

public offerings of a second class of common stock with inferior voting rights.13

In June 1990, a Federal Appeals Court ruled that the SEC overstepped its

authority with its July 1988 rule prohibiting dual-class restructuring. The court

decision in The Business Roundtable vs. Securities and Exchange Commission

was that the SEC had entered corporate governance, an area traditionally

determined by state law.14 The court told the SEC that the rule would allow the

establishment of federal corporate law by using access to the capital market as

an enforcement mechanism. Corporate law has traditionally been the domain of

12 Despite the fact that all three of the major exchanges allowed the trading of
dual-class stock at the time, the chairmen all argued for the one vote, one share
rule. Obviously, they considered the rule favorable, but only when all of the
exchanges enacted the rule together. The negotiations broke down when the
chairmen of the exchanges were unable to agree on the allowable exceptions to
the prohibition.

13 As Gilson (1993) states on page 43, "Dual-class capital structures remained
viable, but dual-class recapitalizations were prohibited."

14 The Business Roundtable is a group of 200 major corporations.







the states. If the SEC was allowed to ban corporations from accessing the

national exchanges as punishment for violating its rules, then it would effectively

be practicing federal corporate law.

The Federal Appeals Court ruling did not prevent the exchanges from

voluntarily adopting the principles in rule 19e-4. The NYSE and the NASDAQ

both maintained rules similar to 19e-4. The AMEX did not adopt similar rules. In

June 1991, the AMEX formally proposed a rule allowing the trading of dual-class

shares provided that the transactions are approved by two-thirds of the

outstanding shares. Following the AMEX action, the NYSE changed its policy

and again allowed dual-class recapitalizations, although under more restrictive

conditions. In order for firms to remain listed on the NYSE, dual-class

recapitalizations must be approved by a majority of a committee of independent

directors, a majority of the full board of directors, and a majority of shareholders

who are not directly interested in the transaction. The NASDAQ continues to

support its own 19e-4 type rule.

The frequency of dual-class recapitalizations has slowed dramatically

since the late 1980s. This change parallels the drop in popularity of hostile

takeovers. Without takeover pressure, the insulating value of dual-class stock

may be less valuable. In addition, the publicity over possible regulatory actions

may cause some firms to avoid the transaction. The comment of Frederick

Zuckerman, treasurer of Chrysler Corporation is typical, "I would be reluctant to

advise more than one class of common stock. It conveys a message of

manipulation even if it is unintended.".15




15 From Schultz, The Institutional Investor, Fall 1990, "Dual classes, multiple
possibilities", page 113.







Mechanics of the Recapitalization


Insiders initiate dual-class recapitalizations by describing the transaction

and its potential impact in a proxy statement. The shareholders then vote on the

transaction at the annual shareholders' meeting or at a special meeting. The

potential transaction is often described as an event that will allow the firm

greater flexibility in financing and provide protection from hostile takeovers.

Typically, the transaction must be approved by a majority of the shareholders. In

some cases, insiders already control the majority of the votes and the vote is a

formality. In other cases, approval of the transaction is dependent on insiders

persuading outsiders that the change is beneficial.

Firms that recapitalize into two classes of common stock use the dividend

method, the exchange method, or the length-of-time method. These methods

are discussed in detail below. The dividend method is the most popular and

accounts for roughly 50% of all recapitalizations. The exchange method

increased in popularity during the 1980s and accounts for about 40% of the

transactions. The remaining recapitalizations are length-of-time plans.16 After

recapitalizing using the exchange and the length-of-time method only the low-

vote class of stock typically trades publicly. In this study, I require that both

classes of common stock trade publicly. As a result, all the firms in my study

used the dividend method to recapitalize.


Dividend Method


The dividend method of recapitalization requires a stock split or stock

dividend to distribute one or more shares of newly created low-vote stock for


16 From an analysis of firms in my sample and previous empirical studies.








each share of common stock already held. The previously existing stock is
redesignated as high-vote stock. Typically, the low-vote stock is entitled to one

vote per share and/or the right to elect a minority of the board of directors. The

high-vote stock typically receives 10 votes per share and/or the right to elect the

majority of the board.17 The low-vote stock is often referred to as class A while

the high-vote stock is called class B.18

Immediately following a recapitalization using the dividend method,

insiders hold the same ownership and voting percentages as before the

recapitalization. Prior to the 1980s, the separation of ownership and control

occurred gradually as new low-vote stock was issued to outsiders and as

insiders purchased high-vote stock in the open market. In the 1980s, the

separation of ownership and control accelerated as most recapitalizing

corporations allowed the exchange of high-vote stock for low-vote stock on a

share-for-share basis. To encourage outsiders to exchange, the low-vote shares

are usually promised a preferential dividend. Insiders do not exchange their

low-vote stock but instead increase their relative voting power as outsiders trade

voting power for preferential dividend promises.


Exchange Method


The exchange method involves the exchange of newly created high-vote

stock for the previously existing stock that is redesigned as low-vote. The low-

vote stock is usually promised preferred dividends. The high-vote stock is

usually restricted to transfer only to family members and/or insiders. As a result,

17 In some cases the "low-vote" stock has no voting power.

18 Although this is the general rule, some firms call the high-vote shares class A
and the low-vote shares class B.







it does not trade publicly following the recapitalization. The exchange is usually

affected by a self-tender offer open for a limited time.


Length-of-Time Method


A small number of firms change the voting rights of existing stock based

on the time that the shares are held. At the recapitalization date all the existing

stock becomes long-term and is entitled to superior voting rights. Any share

traded after the recapitalization becomes short-term and low-vote with the

provision that it becomes long-term if it is held for a previously determined time,

typically four years.


Preferential Dividend Promises


Most recent recapitalizations feature preferential dividend promises to the

low-vote shareholders. The increase in preferential dividend promises during

the 1980s is probably the result of increased criticism of dual-class

recapitalizations and the need to accelerate the separation of ownership and

control. To encourage shareholder approval and to discourage regulatory

scrutiny, insiders offer dividend compensation to low-vote shareholders for their

pending loss in voting power. Management may also promise preferential

dividends as a way to signal their intent to reduce potential agency costs by

paying higher dividends that reduce the firm's free cash flow and force scrutiny

by the capital markets. This issue is further discussed in Chapter 4. Preferential

dividends play a key role in consolidating voting power for managers after the

recapitalization is approved. Most dual-class firms allow their shareholders to

exchange high-vote stock for low-vote stock at any time. By offering preferential







dividends to low-vote shares, insiders encourage outside shareholders to

convert their high-vote stock.

Two forms of preferential dividend promises are made to low-vote

shareholders. In one form, low-vote shares are promised 110% of the dividend

paid to high-vote shareholders. In a limited number of cases, the low-vote

shareholders are promised a fixed amount before the two classes share equally

in subsequent distributions. In the second form, firms promise the low-vote

shares at least the same dividend per share as paid to the high-vote shares.

The promises imply the possibility of preferential dividends without guaranteeing

them. A complete discussion of preferential dividend promises, including sample

promises from proxy statements, is presented in Chapter 3.


The Case Against Dual-Class Recapitalizations


Although the impact on firm value and potential agency problems can be

debated, empirical evidence reveals that dual-class recapitalizations separate

ownership and control. DeAngelo and DeAngelo (1985) find that officers of firms

with two classes of common stock averaged 54.8% of the voting power but only

27.6% of the claims to cash flows. Partch (1987) reports that insider ownership

and voting power was 48.6% before a dual-class recapitalization. Twenty-one

months after the event, inside ownership fell to 43.7% while insider voting power

rose to 58.6%.

Opponents of dual-class recapitalizations argue that managers with

decreased ownership and increased control are less likely to act in the best

interests of outside shareholders. There are two distinct components to this

complaint. First, managers with lower ownership shares can consume

perquisites at the primary expense of outside owners. For example, when a







manager is also the sole owner, then the cost of buying an expensive painting

for his office is borne only by the manager and perhaps the Internal Revenue

Service. As the manager's ownership percentage falls, then a greater portion of

the cost of the art is "paid for" by outside shareholders. Jensen and Meckling
(1976) show that managers with decreased ownership shares have greater

incentive to divert corporate resources for their own use at the expense of firm
value.

The second component of the complaint is that managers who

subsequently misbehave are now better insulated from discipline by outside

shareholders. Critics argue that corporate democracy requires that voting rights

be proportionate to ownership stake in the firm. Shareholders are often

absentee owners of the firm and must rely on management's ability to guide the

firm so that owners receive the best possible overall return on their investment.

Shareholders use voting power as a check on inefficient managers. Competition

for control of a corporation provides a mechanism to replace bad managers and
reallocate resources for the benefit of shareholders.

Takeovers are an important source of management discipline. The threat

of job loss from a takeover is a powerful incentive to manage a firm in the best

interests of all shareholders. The most frequent criticism of dual-class stock is

that it reduces the likelihood of unsolicited takeovers. Stulz (1988) argues that

increasing managers' voting power decreases the probability of undergoing a
change in control. With majority control of voting rights, management can block

any takeover attempt and deny shareholders the premiums that typically accrue

to the target company. If dual-class recapitalizations are perceived as a

takeover defense, then share price declines should accompany the







announcements of dual-class recapitalizations.19 20 Interestingly, proxy

statements proposing recapitalization often suggest that takeover protection will

allow management to protect outside shareholders by deflecting inadequate

offers.21

Defenders of dual-class recapitalizations argue that the transactions

should not harm outside stockholders because they require shareholder

approval and because the decision to exchange high-vote stock for low-vote

stock is voluntary. The first form of protection, shareholder approval, may not be

effective. Empirical evidence suggests that insiders control a significant

ownership percentage before recapitalization. In three studies, the average

percentage of stock held by insiders was 48.4, 30.0, and 44.5.22 Furthermore,

Austen-Smith and O'Brien (1986) show that, even without majority control,

management's agenda setting power can force shareholders to choose between

several wealth reducing alternatives. For instance, insiders who want to retain

control but are unwilling or unable to increase their personal investment in the

firm, may refuse to issue new equity to fund attractive new projects.

The value of the second form of protection, voluntary conversion of high-

vote stock, is addressed by Ruback (1988). He shows that outside shareholders

19 Jensen and Ruback (1983) find a 1% to 3% average loss from other takeover
defenses such as greenmail.

20 In contrast, Blair, Golbe, and Gerard (1989) show that the probability of value
enhancing hostile takeovers actually increases when voting rights are free to
trade separately from cash flow rights. In the presence of a capital gains tax,
some welfare enhancing takeovers will fail and outside shareholders will suffer.

21 DeAngelo and Rice (1983) claim that negotiated offers reduce the free-rider
problem and larger gains may be extracted during a takeover.

22 From, respectively, Partch (1987), Gordon (1987), Jarrell and Poulsen
(1988).







acting individually are caught in a Prisoner's Dilemma. If a shareholder believes

that insiders will not ultimately obtain majority power through the conversion

process, then he should exchange his high-vote stock for low-vote stock and

receive the "free" dividend bonus. If the shareholder believes that management

will ultimately obtain majority power, then he should similarly exchange and at

least be compensated for his loss of voting power. Thus, the only condition

where the exchange will not take place is when the shareholder considers his

vote pivotal. Because outside stockholders perceive a small probability that

their vote will be pivotal, they may individually act inconsistently with the

collective good.


The Case For Dual-Class Recapitalizations


Proponents of allowing companies to issue dual-classes of common stock

cite economic reasons for the transactions and argue that it is important to allow

corporations flexibility in their capital structure. Lease, McConnell, and

Mikkelson (1983) report that the vote has value. Thus, it might be beneficial for

shareholders who place little value on the vote to "sell" their votes to

shareholders who place high value on voting. Many shareholders never vote in

the corporate elections and have little interest in the operation of the firm. In

contrast, insiders and large shareholders are often keenly aware of voting issues

and power structures. As a result, dual-class recapitalizations with preferred

dividends promised to low-vote shareholders can be viewed as mechanisms to

transfer value in a mutually beneficial manner.

Dual-class recapitalizations may also increase the value of both classes

of stock as management's incentive to under-invest is reduced. With only one

class of common stock, new equity dilutes voting power unless management




26


proportionately increases its investment. Eventually, personal wealth constraints

and diversification concerns may force managers to bypass positive net present

value projects because they are unwilling to issue new equity and jeopardize

their control. Debt may not be attractive to management because interest

obligations reduce free cash flow and owners may fear creditor involvement and

the partial loss of control. In addition, the relative small size of many dual-class

firms, along with the high concentration of manager ownership may make debt

issues unattractive to the capital market. The solution for these firms is to offer a

second class of low-voting common stock that allows management to maintain

control and access all positive net present value projects. Firms that recapitalize

are significantly more likely to issue equity. Partch (1987) finds that 38.6% of

recapitalizing firms issued limited voting stock within two years after issuance.

By comparison, Mikkelson and Partch (1986) find only 17% of randomly selected

firms issued new common stock over an eleven year period.

A related argument favoring dual-class shares is based on the

assumption that managers are more likely to invest in firm specific human capital

when their positions are secure. Moreover, uninsulated managers with private

information have incentives to make decisions that favor short-run results at the

expense of the outside stockholders' best interests (Narayanan 1985). For

example, Stein (1988) shows that takeover pressure may lead managers to

focus on short-term profits rather than long-term objectives. Managers who are

immunized by dual-class recapitalizations have more freedom to pursue long-run

firm value optimization rather than sub-optimal myopic behavior.23 Alchin and


23 Meulbroek, Mitchell, Mulherin, Netter, and Poulsen (1990) find that firms
actually decrease research and development after takeover defenses are
enacted. This suggests that dual-class recapitalizations may reduce the
incentive to engage in long-term investment.







Demsetz (1972) argue that insiders-managers hold voting rights to deter
relatively uninformed outside shareholders from mistakenly replacing the

incumbent management team. Freedom from short-run pressures is often
mentioned as a motivation for the transaction in the proxy statements proposing
dual-class recapitalizations.

Although separating ownership and control appears to provide
opportunities for managers to consume firm value, insiders' opportunities to

consume perquisites may be dependent on the amount of free cash flow in the

firm.24 Managers of firms with very low free cash flow will be hesitant to

consume significant firm value if doing so will endanger the going concern of the

firm. Gilson (1987) argues that the amount of a firm's free cash flow may drive

the decision to enact dual-class recapitalizations rather than leveraged buyouts

(LBOs). Gilson speculates that firms that use LBOs are typically mature "cash

cows" without a preexisting dominant shareholder group. Mature firms with large

amounts of free cash flow benefit from an LBO because agency problems are

reduced as managers hold a larger ownership share and as free cash flow is
reduced by interest obligations. Empirical studies find the average impact on

shareholder wealth at the announcement of a LBO is significantly positive.
Gilson further argues that firms with dual-class stock are typically young

with strong growth options and pre-existing dominant shareholders. Young firms

generally have lower free cash flow and frequently need to access the capital
market for funds. Competitive pressures and monitoring by the capital market
may reduce conflicts of interests between management and shareholders. Thus,


24jensen (1986) defines free cash flow as cash in excess of that required to
fund all positive NPV projects. Incentive conflicts exist between managers who
want to increase the amount of resources under their control, and outside
shareholders who prefer payouts when excess resources exist.







dual-class firms have little to lose by creating apparent agency problems while

LBO firms have much to gain from reducing agency problems. Lehn, Netter, and

Poulsen (1989) find support for Gilson's argument with evidence of systematic

differences in growth rates, agency costs, and capital structure between firms

that perform LBOs and dual-class firms.

Dual-class recapitalizations may also have an informational impact on

firm value. The creation of dual-class voting stock may reveal information about

a firm's prospects. Expectations of higher dividends for the low-vote stock, and

the probable issue of new equity, may signal a firm with strong growth and cash

flow prospects. Ryngaert (1988) points out that firm value may increase as the

adoption of a takeover defense reveals that the firm may be undervalued and a

takeover candidate. Alternatively, the expectation of future equity offers may

lower stock prices because outsiders believe that management is revealing that

its stock is overvalued.25


Previous Empirical Results


The Value of the Vote


Managers may hold stock in their firm for several reasons. One familiar

motivation is that holding residual cash flow rights gives managers the proper

incentive to maximize firm value. Another motivation is that managers may hold

stock for its underlying voting rights. Most corporations have only one class of

common stock and it is therefore difficult to assess the relative importance of

each motivation. Dual-class stock with disparate voting rights and equal


25 Masulis and Korwar (1986) document a 3% drop in stock prices on the
announcement of an equity offer. Also see Myers and Majluf (1984)







dividend rights provides a unique opportunity to measure the value of the vote.

Stock price differences between shares that are identical except for voting rights

should reflect the value of the vote.

Lease, McConnell, and Mikkelson (1983) studied 30 firms with two

classes of common stock trading within the period 1940-1978. Both classes of

their sample firms were simultaneously publicly traded at some point within the

sample time. All the sample firms promised equal dividends to both classes.

Lease et al. calculate the voting premium by calculating a time series of the ratio

of month-end prices of the two classes of common stock for each firm. The

numerator is the month-end closing price of the high-vote stock and the

denominator is the month-end closing price of the low-vote stock. They find that

the stock with superior voting rights trades at an average premium over the low-

vote stock in 26 out of 30 firms. A time series of equal-weighted, average cross-

sectional month-end ratios is then calculated so that each month of the sample

period has an associated average voting premium. The authors report an

average monthly voting premium across all months using all 30 firms of 4.06%.

Lease et al. use statistical tests to determine if the mean of the time-series of

average cross-sectional ratios is different from 1.0.26 They find that the stock

prices trade at statistically significantly different prices and conclude that voting

has value.

Lease et al. also find that 4 out of the 30 sample firms exhibit the high-

vote stock trading at a statistically significant discount to the low-vote stock.

Interestingly, these four firms were the only firms in their sample with

outstanding voting preferred stock. The voting preferred stock did not control

26 Lease et al. actually use the natural logarithm of monthly ratios for statistical
tests because the transformed data more closely resembles a normal
distribution. As a result, the statistical test was for a mean of 0.0.







the firm in any of the four cases. While the presence of voting preferred stock

might reduce the relative benefit of holding high-vote stock, the authors were

unable to discover a plausible explanation for the high-vote stock trading at a

lower price than otherwise identical low-vote stock.

Levy (1982) studies 25 firms with two classes of common stock traded on

the Israeli stock market in early 1981. The stock classes are identical except

that one class has superior voting rights. Levy also measures relative price

ratios. He finds that high-vote shares trade at a 45% average premium above

low-vote shares. The results of his study are interesting because the premiums

are much higher than those found by Lease et al. and because the sample

constituted nearly 25% of all the firms listed on the Israeli exchange.

Megginson (1990) performed a study of 152 dual-class British firms over

the period 1955-1982 and finds that high-vote shares trade at a 13.3% average

premium over low-vote shares. Unlike the two previous studies, Megginson

uses his larger sample size to investigate whether firm specific characteristics

influence the voting premium. In addition, Megginson searched for evidence of

takeover bids as possible evidence of the source of the premiums. Of the 152

firms in the sample, 43 were targets of takeover bids. In 37 of the 43 cases, the

high-vote stock received preferential bids. The average preferential bid was

27.6%. This suggests long-lived voting premiums may reflect the possibility of a

larger premium in the event of a takeover.

Megginson also attempted to control for differences in liquidity and the

percentage of insider ownership in explaining the voting premium. He uses the

average-age-of-quote methodology to find that the high-vote stock trades

significantly less frequently than the low-vote stock. He concludes that liquidity

differences between classes will, if anything, reduce the observed high-vote

premium. Megginson also finds that the voting premium is positively related to







insider holdings of high-vote shares and negatively related to insider holdings of
low-vote shares.


Wealth Effects of Recapitalization Announcements


Given the variety of arguments for and against dual-class

recapitalizations, the question of whether shareholders are harmed by the

creation of dual-class voting stock is ultimately an empirical issue. A number of

studies examine the stock price response to the announcement of plans to

create a second class of common stock. Jog and Riding (1986) find no

significant response at the announcement date from 130 firms listed on the

Toronto Stock Exchange.27 Their sample includes firms that recapitalized into

two publicly traded shares during the period 1976-1984. They calculate market

adjusted abnormal returns over various prediction intervals centered on the

announcement of the intent to recapitalize. Although they find generally

negative reactions to the announcements, the results were not statistically
significant. Jog and Riding also examine the price changes of both classes after

both classes began public trading. They find that a significant portion of firms

exhibit declining share prices in conjunction with the actual issuance of low-vote

shares. They trace the decline to a decrease in low-vote share prices that

precedes an increase in high-vote prices by about one day. They find that high-
vote stock ultimately enjoys an average 7% premium over low-vote stock. This

part of their study is unique among the wealth studies I document below. If the

shareholders of a firm are divided in belief about the benefit of a dual-class

recapitalization, then it is not surprising that insignificant average reactions are


27 At the end of 1983, 10% of the aggregate value of the Toronto Stock
Exchange was accounted for by shares with restricted voting rights.








measured at the announcement. The relative impact on insiders and outsiders

may only be measurable after the stock classed are separated.

Partch (1987) examines the stock price reaction of 44 firms traded in the

United States during the period 1962-1984. She calculates abnormal returns

over various event windows including the date the board of directors approved

the proposal, the date the proxy statements were sent to the shareholders, the

date shareholders voted on the proposal, and the dates the Wall Street Journal

reported on these events. Partch finds the average stock price response to the

announcement of plans to recapitalize is positive and statistically significant.

However, she also finds that the median stock price reaction is negative so she

concludes that shareholder wealth is not affected by the creation of limited

voting stock classes. Partch also measures managers' ownership of votes and

shares before and after the recapitalization. She finds that officers, directors

and their associates controlled 48.6% of the shares before the event. On an

average of 21 months later, insiders owned only 43.7% of the shares but

controlled 58.6% of the votes.

Two other studies also fail to find an announcement reaction. Gordon

(1986) and Cornett and Vetsuypens (1989) do not find a significant abnormal

return in response to the announcement of the intent to recapitalize. In the most

comprehensive study, Jarrell and Poulsen (1988) investigate 94 firms from the

period 1976-1987. Sixty-seven of the 94 firms recapitalized after 1983. Jarrell

and Poulsen's sample period captures the increased popularity of the

transactions, the increase in hostile takeover activity, the political debate over

whether the transaction should be regulated, and the opportunity to compare

announcement reactions before and after the NYSE moratorium on the

automatic delisting of companies with dual-classes of equity. In contrast to the

previous studies, they find significant negative average abnormal price returns at







the announcement of the dual-class recapitalization.28 Jarrell and Poulsen also
separately consider the firms that recapitalized before and after the June 1984
NYSE moratorium. They find significant negative average abnormal returns for
firms that recapitalized after the moratorium and insignificant average returns in

the period before the moratorium. Firms that recapitalized in 1986 and 1987
exhibited the most significant negative average abnormal returns.
Jarrell and Poulsen also investigate whether firm specific variables play a

role in determining the wealth effects at announcement. In particular, they
investigate the pre-recapitalization percentage of insider holdings, the method of

recapitalization, and the exchange where the shares traded. They use average

data and regression analysis to measure the possible impact of each variable.

Jarrell and Poulsen find that the exchange where the shares are traded was only

significant for the NYSE firms that announced intent to recapitalize before the

NYSE lifted its ban on dual-class stock. Jarrell and Poulsen measure abnormal
returns across each of the three methods of recapitalization, dividend,

exchange, and length-of-time. Although the authors hypothesize that the

exchange method seems most coercive, they find that the dividend method is the
only method to show significant negative average abnormal returns.

Jarrell and Poulsen did not find a linear relationship between insider

ownership and abnormal announcement returns. They did find that the middle
two quartiles of firms based on the percentage of insider ownership exhibited

significant negative average abnormal returns while the top and bottom quartiles


28 Jarrell and Poulsen measure two-day cumulative abnormal returns (CARs)
around the event day. The two days are the event day and the preceding day.
They find average two-day negative abnormal return of 0.82%. In addition, 62%
and 63% of the firms experienced negative abnormal returns on the two days
respectively.








show insignificant average reactions. They conclude that the middle two

quartiles contain firms where managers are most likely to consolidate control as

a result of the recapitalization. In the upper quartile, management may already

be insulated, and in the lowest quartile, management may not be able to gain

control even after the recapitalization. Their results are consistent with the

findings of Morck, Schleifer, and Vishny (1988) regarding the nonlinear

relationship between management ownership and market valuation.


Subsequent Performance Studies


Researchers are beginning to investigate post-recapitalization firm

performance. Critics of dual-class stock and the resulting separation of

ownership and control claim that insulated managers will act inefficiently and not

in the best interest of outside shareholders. Defenders of the transactions argue

that insulated managers will have the freedom to pursue long-run firm value

maximization. Lehn, Netter, and Poulsen (1990) measure operating income

divided by sales as a measure of efficiency and report that the percentage

increases for dual-class firms exceed those of comparison firms over the first

three years following the change. In contrast, Mikkelson and Partch (1992)

report a decrease in operating cash flow following dual-class recapitalizations.


The Contribution of This Dissertation


The previous studies of firms with dual-class common stock find that

voting rights have value and the wealth effects stemming from the

announcements to recapitalize are ambiguous. Several studies find positive but

insignificant reactions while Jarrell and Poulsen (1988), find significant negative

wealth declines in the most comprehensive study of the issue.








Lease, McConnell, and Mikkelson (1983) is widely cited as the first study

to document the value of the vote in firms traded in the United States. Since

their sample period, a significant number of firms have recapitalized. Most of the

recent recapitalizations include preferential dividend promises. In this

dissertation, I study the value of the vote and the value of preferential and

possibly preferential dividend promises. I use a sample of 64 firms from the

period 1984-1988 to capture the growth in popularity of dual-class stock,

preferential dividend promises, and hostile takeovers. I group firms by the form

of their dividend promise and then calculate ratios of the market prices of high

and low-vote stock to measure the value of the vote and the impact of

preferential dividend promises to low-vote shareholders.

I examine firm specific variables cross-sectionally to better understand

why insiders promise, and often pay, preferential dividends to outside

shareholders when the insiders concentrate their holdings in the high-vote

shares. I also present an explanation for why these dividend promises are

priced by outsiders when insiders have the apparent motive and opportunity to

avoid paying dividends. I further investigate whether the threat of a takeover

increases the high-vote premium as the market anticipates a possible

preferential offer to the high-vote shares. The existence and anticipation of

preferential takeover offers may explain why voting premiums are observed for

firms that are tightly held.

Finally, the price ratios are used to evaluate whether dual-class

recapitalizations cause a loss in firm value that is borne by low-vote

shareholders. I investigate whether there is a relationship between the way the

firm is divided and the total value of the firm. Specifically, I test whether post-

recapitalization voting premiums and subsequent equity issues explain cross-

sectional differences in abnormal returns measured at the announcement date.




36


My premise is that the motivation for dual-class recapitalizations may vary

greatly from firm to firm. The ambiguous average wealth effects discovered in

previous studies support this assertion. In particular, some firms may

recapitalize to provide greater financing flexibility while other firms may

recapitalize to insulate management from market disciplinary forces.











CHAPTER 3
ANALYSIS OF AVERAGE PRICE RATIOS


Background and Methodology


This chapter measures the value that the capital market places on control

over a firm's activities and the promise of possible preferential dividends. The

value of control and preferential dividends is obtained by examining the market

prices of both classes of common stock from sample firms. Both classes of stock

have identical rights at liquidation and differ only in voting power and possible

dividend claims.29

Monthly price ratios are computed for each firm. The numerator is the

closing price of the high-vote stock and the denominator is the same day closing

price of the low-vote stock. If the two classes of stock are equally valued by the

capital market then the average ratio should not be significantly different from

1.0. Market prices were collected from the Center for Research in Security

Prices (CRSP) tapes. For each year in the sample period, prices for both stock

classes were selected from January 15, and then every 21st trading date

through December. This procedure yields twelve mid-month price ratios per

year for each firm in the sample. If both stock classes of a firm traded

throughout the sample period 1984-1988 then 60 price ratios were generated.




29 Although the two classes must be treated equally by the corporation, they do
not have to be treated equally by third parties during a takeover.







Sample Selection and Classification


The sample firms must have two classes of common stock simultaneously

traded on a public exchange sometime during the period January 1984 to

December 1988. This sample period captures the growth in popularity of dual-

class recapitalizations, dividend sweeteners, and hostile takeovers. The two

classes must feature unequal voting rights and equal cash flow rights at

liquidation.30 Unlike previous studies, firms with equal and unequal dividend

compensation between classes are included in the sample.

The 64 firms in my sample were obtained by searching the NYSE/AMEX

and NASDAQ CRSP tapes for companies with dual listings. Proxy statements

and Standard and Poor's stock guides were used to remove non-qualifying firms.

The sample includes 8 firms from Lease et al.'s study and 56 new firms.

Table 3-1 provides a summary of the sample firms' characteristics.

Columns 2 and 3 identify the firm name, the common stock class designation,

and the CUSIP number. Column 4 lists the stock exchange where each firm's

stock is traded. Three firms are traded on the NYSE, 34 firms are traded on the

ASE, and 27 firms are traded on the NASDAQ system. The beginning and

ending dual trading dates are provided in Column 5. The voting rights of each

class are described in Column 6. Despite the apparent variety of voting

arrangements, the recapitalizations systematically create one class of common

stock that is likely to control the board of directors. Column 7 of Table 3-1

indicates each firm's dividend arrangement between classes.


30 A few firms offer equal voting rights between the two classes of stock, but
feature differential cash flow rights at liquidation. These firms are essentially
offering one class of subordinate common stock. They are excluded from the
sample.








To investigate the market value of possible dividend compensation for

inferior voting rights, the sample firms are initially grouped into three categories

based on the form of dividend promise to the low-vote shareholders. The

dividend promises were discovered by reading proxy statements and the notes

to audited financial statements.

The first category includes 22 firms that promise equal dividends per

share to each class of common stock. The following promise by the Brown-

Forman Corporation is typical:

Every share of the common stock of both classes, whenever and for
whatever consideration issued, shall be entitled to the same rights as every
other share of common stock in all distributions of earnings or assets of the
corporation distributed to the holders of the common stock.


If preferential dividend promises are viewed as credible compensation offers,

then the average price ratio of firms that promise equal dividends should be

higher than the average price ratio of firms that promise preferential dividends.

Alternatively, if preferential dividend promises are not viewed as credible offers

or if the form of dividend compensation is related to the value of the vote, then

the price ratios may not differ significantly across dividend promises.

The second category contains 17 firms that promise to pay their low-vote

shareholders at least the same dividends per share as paid to the high-vote

class. This provision implies the possibility of preferential dividends without

guaranteeing them. The following promise by the Alberto Culver Company is

typical:

Class A & B are entitled to cash dividends, except that no dividends may
be paid in Class B unless an equal or greater dividend is paid on Class A,
and dividends may be paid on Class A in excess of dividends paid, or
without paying dividends on Class B.









TABLE 3-1
FIRMS WITH BOTH CLASSES OF COMMON STOCK PUBLICLY TRADED
(Both classes simultaneously trading within the period 1984-1988)


# Company(Class)
1. Alberto Culver(B)
Alberto Culver(A)

2. American Fructose(A)
American Fructose(B)

3. American Maize(A)
American Maize(B)

4. Associated Comm(A)
Associated Comm(B)

5. Autodynamics(B)
Autodynamics(A)

6. Baldwin & Lyons(A)
Baldwin & Lyons(B)

7. Base Ten Systems(B)
Base Ten Systems(A)

8. Beneficial Standard(A)
Beneficial Standard(B)

9. Bio Rad Labs(B)
Bio Rad Labs(A)

10. Blount Inc.(B)
Blount Inc.(A)

11. Brown-Forman(A)
Brown-Forman(B)

12. Canandaigua Wine(B)
Canandaigua Wine(A)

13. Care Corporation(B)
Care Corporation(A)

14. Care Enterprises(B)
Care Enterprises(A)

15. Charter Med.(B)
Charter Med.(A)

16. Crown Central Pet(A)
Crown Central Pet(B)


CUSIP
01306810
01306820

02629620
02629630

02733920
02733930

04554110
04554120

05277110
05277120

05775510
05775520

06977910
06977920

08176110
08176120

09057210
09057220

09517320
09517330

11563710
11563720

13721910
13721920

14164510
14164520

14164910
14164920

16124110
16124140

22821910
22821930


Exch.
NSE
NSE

ASE
ASE

ASE
ASE

OTC
OTC

OTC
OTC

OTC
OTC

OTC
OTC

ASE
ASE

ASE
ASE

ASE
ASE

ASE
ASE

ASE
ASE

ASE
ASE

ASE
ASE

ASE
ASE

ASE
ASE


Dates Listed
650611-881230
860624-881230

841116-881230
841116-881230

700218-881230
700218-881230

810707-881230
830718-881230

780427-840618
810603-840618

721214-881230
860509-881230

760914-881230
801209-881230

770425-850508
770426-850508

800225-881230
800227-881230

720717-881230
830718-881230

620702-881230
620702-881230

830602-881230
860714-881230

830721-861002
830804-861002

841130-880329
850926-880322

710614-880831
811211-880831

620702-881230
800107-881230


Voting
1 per share
1/10 per share

25% of board
75% of board

25% of board
75% of board

1 per share
1/25 per share

75% of board
25% of board

1 per share
none

75% of board
25% of board

33% of board
67% of board

75% of board
25% of board

75% of board
25% of board

1 per share
none

75% of board
25% of board

75% of board
25% of board

75% of board
25% of board

75% of board
25% of board

86% of board
14% of board


Dividend
A at least B


Equal


Equal


Equal


A at least B


Equal


A at least B


Equal


A at least B


A preferred


Equal


A preferred


A preferred


A preferred


A at least B


Equal




41


TABLE 3-1 (continued)


Companv(Class)
Dairy Mart(B)
Dairy Mart(A)


CUSIP
23386010
23386020


Exch.
OTC
OTC


18. Diagnostic Retrieval(A) 25245610 ASE
Diagnostic Retrieval(B) 25245620 ASE


19. Dickenson Mines(A)
Dickenson Mines(B)

20. Equitable of lowa(B)
Equitable of lowa(A)


25307520 ASE
25307530 ASE

29451010 OTC
29451020 OTC


21. Everest & Jennings(B) 29976710 ASE
Everest & Jennings(A) 29976720 ASE

22. Figgie International(A) 31682850 OTC
Figgie International(B) 31682860 OTC


23. First AM B&T PB(A)
First AM B&T PB(B)

24. First Citizens Bank(A)
First Citizens Bank(B)


25. Food Lion(B)
Food Lion(A)


26. Forest City Ent.(A)
Forest City Ent.(B)

27. Hechinger(B)
Hechinger(A)

28. Homestead Finan(A)
Homestead Finan(B)


29. Hubbell Inc.(A)
Hubbell Inc.(B)


30. Inter Dairy Queen(A)
Inter Dairy Queen(B)

31. Kelly Services(A)
Kelly Services(B)

32. Key Company(B)
Key Company(A)

33. Liberty Homes(A)
Liberty Homes(B)


31847210 OTC
31847220 OTC

31946M10 OTC
31946M20 OTC

34477510 OTC
34477520 OTC

34555010 ASE
34555030 ASE


Dates Listed
830722-881230
851105-881230

830811-881230
830811-881230

860708-881230
860708-881230

721214-881230
800428-881230

801105-881230
801202-881230

860124-881230
830719-881230

800923-881230
800923-881230

861022-881230
861022-881230

721214-881230
830922-881230

620702-881230
831110-881230


42266010 OTC 721214-881230
42266020 OTC 831101-881230

43771420 NYE 840125-881230
43771430 NYE 870115-881230

44351010 ASE 620702-881230
44351020 ASE 620702-881230

45937320 OTC 721214-881230
45937330 OTC 860212-881230

48815220 OTC 721214-881230
48815230 OTC 840802-881230

49308010 ASE 690715-881230
49308020 ASE 850924-881230

53058220 OTC 850426-881230
53058230 OTC 850426-881230


Voting
75% of board
25% of board

75% of board
25% of board

25% of board
75% of board


No vote
Vote


75% of board
25% of board

1/20 per share
1 per share


No vote
Vote


1 per share
10 per share


Vote
No vote


25% of board
75% of board

10 per share
1 per share

25% of board
75% of board

20 per share
1 per share

25% of board
75% of board


No vote
Vote


75% of board
25% of board

No vote
1 per share


Dividend
A at least B


B at least A


Equal


Equal


A preferred


A preferred


Equal


Equal


A preferred


A preferred


A preferred


A preferred


Equal


A preferred


A preferred


A at least B


A preferred








TABLE 3-1 (continued)


# Companv(Class) CUSIP Exch.
34. Malrite Comm 56133810 OTC
Malrite Comm(A) 56133820 OTC

35. McRae Industries(A) 58275720 ASE
McRae Industries(B) 58275730 ASE

36. Merchants Capital(A) 58853010 OTC
Merchants Capital(B) 58853020 OTC

37. Methode Electric(B) 59152010 OTC
Methode Electric(A) 59152020 OTC

38. Mobile Comm(B) 60724310 OTC
Mobile Comm(A) 60724320 OTC

39. Moog Inc.(A) 61539420 ASE
Moog Inc.(B) 61539430 ASE

40. Multnomah Kennel(A) 62574410 OTC
Multnomah Kennel(B) 62574420 OTC

41. Nielsen A.C.(A) 65409810 OTC
Nielsen A.C.(B) 65409820 OTC

42. Odetics Inc.(B) 67606510 ASE
Odetics Inc.(A) 67606520 ASE

43. Oriole Homes(A) 68626410 ASE
Oriole Homes(B) 68626420 ASE

44. Pasquale Food(B) 70266510 OTC
Pasquale Food(A) 70266520 OTC

45. Plymouth Rubber(A) 73002610 ASE
Plymouth Rubber(B) 73002620 ASE

46. Presidential Realty(A) 74100410 ASE
Presidential Realty(B) 74100420 ASE

47. Presidio Oil(B) 74101610 ASE
Presidio Oil(A) 74101630 ASE

48. Republic Pictures(A) 76072610 OTC
Republic Pictures(B) 76072620 OTC

49. Resorts Intemational(A) 76118510 ASE
Resorts Intemational(B) 76118520 ASE

50. Restaurant Assoc.(B) 76125210 ASE
Restaurant Assoc.(A) 76125220 ASE


Dates Listed
840120-881230
850625-881230

831003-881230
821210-881230

831018-881230
860825-881230

721214-881230
820927-881230

780517-881230
830331-881230

800612-881230
651103-881230

801224-881230
801224-870921

721214-840829
721214-840829

840809-881230
841107-881230

720705-881230
830404-881230

721214-870105
830823-870105

660816-881230
660816-881230

620702-881230
620702-881230

811105-881230
870325-881230

850830-881230
850830-881230

630522-881114
630522-880111

620702-871120
850903-871120


Voting
10 per share
1 per share

25% of board
75% of board

1/10 per share
1 per share

75% of board
25% of board

75% of board
25% of board

25% of board
75% of board

None
1 per share

No vote
Vote

75% of board
25% of board

75% of board
25% of board

75% of board
25% of board

Vote
No vote

67% of board
33% of board

1 per share
1/20 per share


Dividend
Equal


A at least B


A preferred


A at least B


A preferred


A at least B


Equal


Equal


Equal


B preferred


A at least B


Equal


Equal


A preferred


1 per share Equal
20 per share

1/100 per share Equal
1 per share

75% of board A preferred
25% of board







TABLE 3-1


# Company(Class)
51. Saunders System(B)
Saunders System(A)

52. Schwartz Brothers(A)
Schwartz Brothers(B)

53. Sequa Corp.(A)
Sequa Corp.(B)

54. Smith A&0(A)
Smith A&0(B)

55. Tele Comm(A)
Tele Comm(B)

56. Thomaston Mills(B)
Thomaston Mills(A)

57. Three D Depart(B)
Three D Depart(A)

58. Turner Broadcasting(A)
Turner Broadcasting(B)

59. United Foods(B)
United Foods(A)

60. Visual Graphics(B)
Visual Graphics(A)

61. Wang Labs(C)
Wang Labs(B)

62. Watsco Inc.(B)
Watsco Inc.(A)

63. Westmarc Comm.(A)
Westmarc Comm.(B)

64. Wiley John & Sons(A)
Wiley John & Sons(B)


CUSIP
80449810
80449820

80852720
80852730

81732010
81732020

83186510
83186520

87924010
87924020

88456910
88456920

88553910
88553920

90026240
90026250

91036510
91036530

92843810
92843820

93369610
93369620

94262210
94262220

96057510
96057520


Exch.
ASE
ASE

OTC
OTC

NSE
NSE

ASE
ASE

OTC
OTC

OTC
OTC

ASE
ASE

ASE
ASE

ASE
ASE

ASE
ASE

ASE
ASE

ASE
ASE

OTC
OTC


96822320 OTC


(continued)

Dates Listed
721220-860811
820201-860811

721214-881230
880701-881230

870112-881230
870112-881230

620702-881230
830930-881230

721214-881230
790807-881230

880616-881230
880616-881230

690620-881230
831223-881230

870901-881230
870901-881230

620702-881230
831202-881230

760802-881230
870224-881230

680910-881230
760412-881230

680410-881230
840618-881230

840622-881230
840625-881230

820914-881230


96822330 OTC 820914-881230


Voting
75% of board
25% of board

20% of board
80% of board

1 per share
10 per share

75% of board
25% of board

1 per share
10 per share

1 per share
None

75% of board
25% of board

1 per share
1/5 per share

75% of board
25% of board

75% of board
25% of board

75% of board
25% of board

75% of board
25% of board

1 per share
10 per share

30% of board
70% of board


Dividend
A at least B


A preferred


A preferred


B at least A


Equal


A at least B


A preferred


B preferred


A preferred


A preferred


B preferred


A at least B


Equal


A at least B








If low-vote shareholders price this promise from insiders, this category should

exhibit a smaller average high-vote premium than category 1.

The third category is composed of 25 firms that promise the low-vote

class preferential dividends. The low-vote shareholders are promised 110% of

the dividends per share paid to the high-vote shareholders or they are promised

a fixed amount before the two classes share equally in subsequent distributions.

The following promise by the Care Corporation is representative:

The Class A common stock and Class B common stock will have identical
dividend rights with the exceptions that no quarterly cash dividend may be
paid on Class B common stock unless a dividend of at least 2.5 cents per
share is paid on Class A common stock for the same quarter and that a
quarterly cash dividend of up to 2.5 cents per share may be paid on Class
A common stock without payment of any quarterly dividend on Class B
stock. Quarterly dividends in excess of 2.5 cents per share on Class A
common stock must be paid equally on both classes of common stock.


Firms promising preferential dividends are expected to exhibit the smallest

voting premium because low-vote shareholders receive compensation for their

inferior voting power if dividends are paid. Table 3-2 shows the number of

companies included in each category in January of each year.


NUMBER OF FIRMS


TABLE 3-2
IN EACH CATEGORY


IN JANUARY 1984-1 988


Category 1 Category 2 Category 3
Firms that promise Firms that promise low- Firms that promise low- Total
equal dividends to vote shares at least the vote shares preferential #
both classes of dividend paid to high- dividends if dividends of
Year shares vote shares are paid Firms

1984 14 12 11 37

1985 16 12 12 40

1986 17 14 15 46

1987 19 13 20 52

1988 18 13 22 53







Results for Firms Grouped by Their Dividend Promises

Figures 3-1 and 3-2 plot the time series of the equally weighted, cross-

sectional averages of mid-month price ratios for the period 1984-1988. Figure 3-

1 shows that firms offering equal dividends generally trade at the highest price

ratios. In all 60 months, the cross-sectional average price ratios were above 1.0.

The surge in late 1987 is the result of a takeover struggle for Resorts

International. As a result of the control contest, Resort's price ratio increased

from an average of 1.1 to a high of 7.68.31

As expected, firms that promised at least an equal dividend, appear to

trade at average price ratios between the average ratios of category 1 and 3

firms. Figure 3-1 also reveals that the average ratios for firms promising

preferred dividends were generally closest to 1.0 and occasionally dropped

below 1.0. Figure 3-2 displays the price ratios without Resorts International.

The price ratios remain generally stratified by the form of their divided

promises.

Table 3-3 displays the statistical results of average mid-month price ratios

grouped by categories based on dividend promises. Firms that offer equal

dividends to both classes average an 11.3% voting premium, which is much

larger than the 4.06% premium reported by Lease, McConnell, and Mikkelson for

similar firms from the period 1940-1978.

The average voting premium for firms that offer preferential dividends is

3.2%. Firms that promise "at least" an equal dividend display an average

premium of 6.1 %. The average premium for all 64 firms in my sample is 6.9%.


31 This transaction is discussed in detail in the Appendix.
























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TABLE 3-3
STATISTICAL RESULTS OF AVERAGE MID-MONTH PRICE RATIOS


GROUPED BY CATEGORIES BASED ON
(1984-1988)
Cat1
Firms


DIVIDEND COMPENSATION


Cat1
Firms*


Cat2
Firms


Cat3
Firms


All
Firms


Number of firms 22 21 17 25 64
Time series mean of average mid-month 1.113 1.084 1.061 1.032 1.069
price ratios
Sample standard deviation of average mid- .077 .046 4 .027 034
month price ratios
Time series mean of logged, average mid- .105 .080 .059 032 .066
month price ratios
Sample standard deviation of logged, .063 .042 .032 .025 .032
average mid-month price ratios ________
Number of monthly observations 60 60 60 60 60
Number of average monthly ratios greater 60 60 60 57 60
than 1.0
Number of average monthly ratios less than 0 0 0 3 0
1.0
t-value of null hypothesis test that logged 12.79 15.05 14.43 9.68 16.67
mean equals zero a
P-value of t-test b
P-value of t .001 .001 .001 .001 .001
P-value of sign test hypothesis that mean .001 .001 001 .001 001
equals 1.0
* Category 1 firms with the exception of Resorts International which traded at an
extremely high ratio during a takeover in 1987-1988.
a All t-tests are conducted using the natural logarithms of the mean monthly
ratios.
b P-value is the probability of observing the computed value of the t-statistic if
the natural log of the true price ratio is zero.
Cat1: Firms that promise equal dividends to both classes.
Cat2: Firms that promise low-vote shareholders at least the dividend paid
to high-vote shareholders.
Cat3: Firms that promise low-vote shareholders preferential dividends.



Two hypotheses relating to this data are formally tested in this study. The

first null hypothesis is that the two classes of stock for the average company in


each category are priced identically.









Ho: =0,


where: PH = Market price of high-vote stock observed at mid-month
PL = Market price of low-vote stock observed at mid-month

The distribution of price ratios is not normally distributed.32 A logarithmic

transformation is used to yield data that more closely resembles a normal

distribution. A t-test is used to examine whether the mean of the natural

logarithms of the average mid-month price ratios is equal to zero.

Y-0
[=



The t-values and related P-values from this test are shown in rows 9 and 10 of

Table 3-3. For each of the three categories, the null hypothesis is rejected as

the mean of the natural logarithm of the average ratios is significantly greater

than zero at the .001 level.

Non-parametric analysis supports the t-test results without distribution

assumptions. For each category, each observation of average mid-month ratios

is classified as greater than 1.0, less than 1.0, or equal to 1.0. The sign test is

conducted, assuming that observations above and below 1.0 are equally likely to

occur. In categories 1 and 2, all 60 observations are greater than 1.0. In

category 3, 57 out of 60 average ratios are greater than 1.0. All three categories

are significantly different from 1.0 at the .001 level using the sign test.


32 For a test of a mean of 1.0 the data are skewed to the right. When
constructing ratios from price pairs the ratio is bound by zero on the left but
unbounded on the right. For example, the highest monthly cross-sectional mean
price ratio in my study is 7.6850 while the lowest monthly cross-sectional mean
price ratio is .4545.







The second null hypothesis tested in this study is that the means of the

natural logarithms of the average cross-sectional ratios are not significantly

different between classes.


Ho: InH- =In' PH2- =lnI


where:


PLI

PH2 The average price ratio for firms promising "at least" equal dividends
PL2
P
H3 The average price ratio for firms promising preferential dividends
PL3


Using the t-test for the difference between two means,

t = T -xa


nb na


the null hypothesis is rejected for each combination of classes with a P-value of

.001. On average, category 1 stock classes trade at a higher ratio than category

2 stock classes. Similarly, category 2 stock classes trade at a higher ratio than

category 3 stock classes. These results, including t-statistics, are displayed in

Table 3-4.








TABLE 3-4
TESTS FOR STATISTICAL DIFFERENCES BETWEEN MEAN LOGGED
PRICE RATIOS GROUPED BY CATEGORIES BASED ON PROMISED
DIVIDEND COMPENSATION (1984-1988)


Category 1 (mean = .105, std. = .063) 5.03 .001
Category 2 (mean = .059, std. = .032) n=60
Category 2 (mean = .059, std. = .032) 5.22 .001
Category 3 (mean = .032, std. = .025) n=60
Category 1 (mean = .105, std. = .063) 8.31 .001
Category 3 (mean = .032, std. = .025) n=60
a All t-tests are conducted using natural logarithms of the mean monthly ratios.
b P-value is the probability of observing the computed value of the t-statistic if
the difference between logged price ratios is zero.
Category 1: Firms that promise equal dividends to both classes.
Category 2: Firms that promise low-vote shareholders at least the dividend paid
to high-vote shareholders.
Category 3: Firms that promise low-vote shareholders preferential dividends if
dividends are paid.


An F test is used to test for the simultaneous difference of all three

category mean ratios. The results, shown in Table 3-5, confirm that the price

ratios are significantly different.


TABLE 3-5
F TEST FOR THE COMPARISON OF MORE THAN TWO MEANS
F Value
where: F = n(sum of squared deviations of means)/(k-1) 43.66*
(sum of squared deviations about the means)/k(n-1) (3,177)
* P-Value less than .001


Equations 3-1 and 3-2 use individual firm data as opposed to cross-

sectional averages to test whether dividend promises significantly affect the


level of stock price ratios between classes.


it-valuea


P-valueb








RATIO = ao+acCAT2,+aCAT3,+ei (3-1)


In(RATIO,)= ao + aCAT2, + aCAT3 + e (3-2)



where:

RATIOi = Firm i's average monthly price ratio

ln(RATIOi) = Firm i's average monthly logged price ratio

ccO = Intercept

a0i = Parameter estimate for explanatory variable j

CAT2 -= 1 if firm i promises "at least" equal dividends to low-vote shares
0 otherwise

CAT3, = 1 if firm i promises preferential dividends to low-vote shares
0 otherwise

Si = Error term,



The coefficients on the dummy variables, CAT2 and CAT3, representing

the presence of preferential dividend compensation plans, are expected to be

negative and significant, confirming the results of the previous section.

The results from Equations 3-1 and 3-2 are presented in Table 3-6.

Equation 3-1, with its non-logged dependent variable, is used to provide an

intuitive measure of the value of the dividend promise. The regression confirms

that firms that offer preferential dividends to low-vote shareholders exhibit

classes of stock that trade at significantly lower price ratios. The parameter

estimate for the dummy variable representing the promise of preferential

dividends implies a 12.1% drop in the price ratio. This compares to the average

firm's offer of 10% preferential dividends. This indicates that the dividend

sweetener is being valued by the market although some recapitalizing firms have







yet to pay cash dividends. The results from Equation 3-2, with the dependent
variable logged to better resemble a normal distribution, are similar except for

lower significance levels.


TABLE 3-6
CROSS SECTIONAL ORDINARY LEAST-SQUARES REGRESSIONS
USING MEAN TIME SERIES DATA TO EXPLAIN PRICE RATIOS
(High-Vote/Low-Vote)
Equation 3-1 Equation 3-2
Intercept 1.156 0.093
(32.95)* (4.27)
CAT2a -0.094 -0.037
(-1.77)* (-1.11)
CAT3b -0.121 -0.068
(-2.53)* (-2.26)*
R2 .100 .077

Adj. R2 .071 .047

F Value 3.389 2.549

P-Value .0402 .0865

Number of Firms 64 64

a CAT2 equals one if firm promises at least an equal dividend to low-vote
shareholders; otherwise equals zero.
b CAT3 equals one if firm promises preferential dividend to low-vote
shareholders; otherwise equals zero.
* Significant at the 95% level
* Significant at the 90% level


Lease, McConnell, and Mikkelson (1983) find that 4 out of 30 firms in their

sample of equal dividend firms exhibit the low-vote stock trading at a premium to

the high-vote stock. The same four firms are also the only firms in the sample to

have outstanding voting preferred stock. The presence of this unexplained

result is tested in my sample of 64 firms by including a dummy variable








indicating the presence of preferred stock. Seven out of the 64 firms' balance

sheets reveal outstanding preferred stock. Although the sign of the parameter

estimate is negative as in Lease et al.'s study, this unreported variable is

insignificant under every model specification.


Results for Individual Firms


Statistical tests of the price data for individual companies are conducted

to supplement the cross-sectional study. The results for firms in categories 1, 2,

and 3 are presented in Tables 3-7. 3-8, and 3-9 respectively. Column 2 of each

table shows the mean of the time series of mid-month price ratios for each firm.

The related sample standard deviation is shown in column 3. The tested null

hypothesis is that the mean of the natural logarithm of monthly price ratios

equals zero.

,Wn PH

n
Ho: = 0,



where:

PH = Market price of high-vote stock observed at mid-month

PL = Market price of low-vote stock observed at mid-month
n = Number of monthly observations


t-statistics are calculated and displayed in column 7. The related P-values are

shown in column 8 and are calculated using the number of monthly observations

shown in column 6. The results of non-parametric sign tests are given in

columns 9, 10, and 11.







Category 1 firms, which promise equal dividends per share to both

classes, exhibit the greatest amount of price variability. As shown in Table 3-7,

category 1 firms also have the highest sample standard deviation of cross-

sectional ratios. Table 3-7 shows that 4 firms out of 22 show an average logged

price ratio significantly below zero using both the t-test and the sign test. The

existence of firms with the low voting stock selling at a premium when equal

dividends are offered to both classes suggests that factors other than voting

power and dividends affect the price of common stock.

In Table 3-8, all but four firms that offer potentially preferential dividends

have logged price ratios significantly greater than zero. None of the ratios are

significantly negative.

The results for category 3 firms, which offer preferential dividends to the

low-vote shareholders are displayed in Table 3-9. Eight firms out of 25 show

average ratios below zero. Five of the means are significantly below zero using

both the t-test and the sign test.









TABLE 3-7
TIME SERIES MEAN PRICE RATIOS FOR CATEGORY 1 FIRMS
(Firms That Promise Equal Dividends) (1984-1988)
Mean Std # of SignTest
Company Mean Std (In) (n) obs. t-stata Pvalueb # > 1 #< 1 P-valueb

American Fructose 0.928 0.055 -0.076 0.060 49 -8.85 0 001 0 45 0.001

American Maize 0.954 0.032 -0.048 0.033 60 -11.13 0.001 3 56 0.001

Associated Comm. 1.022 0.039 0.021 0.037 60 4.33 0.001 41 12 0.001

Baldwin & Lyons 1.109 0,064 0.102 0.059 19 7.45 0.001 18 1 0.001

Beneficial Std. 0.999 0005 -0.001 0.005 16 -1 25 3 6

Brown-Forman 0.926 0 036 -0.078 0.038 60 -15.74 0.001 1 59 0.001

Crown Cent Pete 1.186 0.086 0.168 0.072 60 17.99 0.001 60 0 0.001

Dickenson Mines 1.175 0189 0.149 0.157 30 5.19 0.001 22 3 0.008

Equitable Iowa 1.021 0.032 0.020 0.031 60 5.01 0.001 46 12 0001

First AM B&T 1.316 0324 0.248 0.227 60 8.47 0.001 52 6 0.001

First Cit. Bank 1.570 0.164 0.446 0.099 25 22.46 0.001 25 0 0.001

Hubbell Inc 0.992 0.029 -0.009 0.029 60 -2.25 0.025 20 37 0.016

Malrite Comm. 1.048 0053 0.046 0.050 42 5.88 0.001 32 7 0.001

Multnomah Kennel 1.217 0147 0.189 0.122 45 1042 0.001 40 0 0.001

Nielsen A.C. 1 003 0.008 0.003 0.008 8 1 01 _3 1

Odetics 1.211 0.137 0.186 0.106 50 12.38 0.001 50 0 0.001

Plymouth Rubber 1.112 0.280 0.081 0.214 60 2.94 0.005 29 20

Presidential Realty 1.138 0154 0.121 0.127 60 739 0.001 53 5 0.001

Republic Pictures 1081 0.137 0.071 0.119 40 374 0.001 29 9 0.001

Resorts Intl 1.745 1 171 0.426 0.469 47 623 0.001 46 1 0001

Tele Comm. 0.995 0.033 -0.005 0.033 60 -1 21 24 34 0.100

Westmarc Comm. 0.994 0.049 -0.007 0.049 53 -1 05 28 23
a All t-tests are conducted using the natural logarithms of the mean monthly
ratios.
b P-value is the probability of observing the computed value of the t-statistic
if the log of the true price ratio is zero.
P-Value greater than 0.10








TABLE 3-8
TIME SERIES MEAN PRICE RATIOS FOR CATEGORY 2 FIRMS
Firms That Promise "at least an equal dividend") (1984-1988)
Mean Std # of Sign Test
Company Mean Std (In) (In) obs. t-stata Pvalueb > 1 # < 1 P-valueb

Alberto Culver 1.221 0.118 0.195 0.099 30 10.74 0.001 28 2 0.001

Autodynamics 1.025 0.039 0.024 0.038 6 1.57 0.100 2 0 *

Base Ten Sys. 1.096 0.074 0.089 0.065 60 10.69 0.001 59 1 0.001

Bio Rad Labs 1.000 0,014 -0.000 0.014 60 -0.05 22 29 _

Charter Med. Corp 1 006 0.032 0.005 0.031 56 1.21 19 28 _

Dairy Mart Stores 1.021 0.053 0.020 0.051 38 2.36 0.025 23 11 0.020

Diagnostic Retr. 1.127 0089 0.116 0.077 60 11.64 0.001 57 2 0.001

Key Co. 1 079 0096 0073 0086 32 479 0.001 21 3 0.001

McRae Inds. Inc. 1.003 0.089 -0.001 0.083 60 -0.07 20 29 0 100

Methode Electric. 1.037 0066 0.034 0.062 60 430 0.001 40 12 0.001

Moog Inc. 1 069 0.165 0.056 0.137 60 3.19 0.005 34 20 0.030

Pasquale Food 1 038 0.076 0.035 0.070 36 2.99 0.005 21 13 0.090

Saunders System 1.005 0.049 0.004 0.047 31 0.45 10 12

Smith A & O Corp 1.076 0.048 0.073 0.044 60 12.70 0.001 58 1 0.001

Thomaston Mills. 1.079 0.039 0.075 0.036 6 5.18 0.005 6 0 0016

Watsco 1 096 0.090 0.088 0.081 54 8.06 0.001 44 5 0.001

Wiley John & Sons 1.080 0.107 0.073 0094 60 6.01 0.001 48 9 0.001
a All t-tests are conducted using the natural logarithms of the mean monthly


ratios.
b P-value is the probability of observing the
if the log of the true price ratio is zero.
* P-Value greater than 0.10


computed value of the t-statistic








TABLE 3-9
TIME SERIES MEAN PRICE RATIOS FOR CATEGORY 3 FIRMS
(Firms That Promise Preferred Dividends) (1984-1988)
Mean Std #of Sign Test
Company Mean Std (In) (In) obs t-stata Pvalueb > 1 < 1 P-valueb

Blount Inc. 0.994 0016 -0.006 0.016 60 -3.10 0.005 16 35 0.003

Canandaigua Wine 1.033 0.046 0 031 0.044 30 3.89 0.001 19 6 0.007

Care Corp. 1 037 0.057 0 034 0.054 33 3.68 0.001 23 4 0.001

Care Enterprises 1.345 0.514 0.246 0.300 30 4.49 0.001 28 1 0.001

Everest & Jennings 1.095 0124 0.085 0.106 60 6.26 0.001 43 8 0.001

Figgie Intl. Hold. 1.145 0.098 0.132 0.083 35 944 0.001 35 0 0.001

Food Lion 1.086 0.066 0081 0.059 60 10.61 0.001 55 0 0.001

Forest City Enter. 0.997 0.013 -0003 0.013 59 -1 62 0.100 21 29

Hechinger Co. 1019 0.038 0018 0.036 60 3.91 0.001 27 11 0.008

Homestead Fin 0.977 0.024 -0.024 0.024 24 -491 0.001 3 18 0.001

Int. Dairy Queen 0.997 0.027 -0,003 0.027 35 -0.06 14 16

Kelly Svcs. Inc. 1 006 0.030 0.005 0.030 53 1 30 25 17_

Liberty Homes 1.005 0.035 0004 0035 44 0.84 20 15 *

Merchants Capital 0.800 0.216 -0.261 0.290 28 -477 0.001 5 21 0.001

Mobile Comm. 1.023 0.033 0022 0.032 60 5.31 0.001 39 11 0.001

Oriole Homes 1.014 0.035 0013 0.035 60 2.95 0.005 33 17 0.016

Presidio Oil 0.969 0.073 -0.035 0 078 21 -2.03 0.050 7 10_

Restaurant Assoc. 1.137 0.085 0 125 0.076 27 8,56 0.001 24 1 0.001

Schwartz Brothers 0.966 0.061 -0036 0.066 6 -1.35 0 2

Sequa Corp. 1.037 0.062 0.037 0.020 24 9.16 0.001 24 0 0.001

Three D Depts. 1.034 0.050 0033 0.047 60 5.39 0.001 35 10 0.001

Turner Broadcast. 1.071 0.108 0.064 0.097 16 2.63 0.010 10 5_

United Foods 1.046 0.113 0040 0.102 60 3.01 0.005 25 12 0.021

Visual Graphics 1.045 0.049 0.043 0.046 22 438 0.001 20 1 0.001

Wang Labs 0.996 0.032 -0,004 0.033 60 -0.99 20 30 0.100
a All t-tests are conducted using the natural logarithms of the mean monthly
ratios.
b P-value is the probability of observing the computed value of the t-statistic
if the log of the true price ratio is zero.
P-value greater than 0.10













CHAPTER 4
THE IMPACT OF FIRM SPECIFIC VARIABLES


Introduction


In Chapter 3, I find that the form of the dividend promise to the low-vote

shareholders is significantly related to the price ratio between the high-vote and

low-vote stock. This evidence suggests that outside shareholders value the

promise of preferential dividends from insiders. Also in Chapter 3, I find that

voting premiums measured from 1984-1988 increased significantly over those

reported by Lease, McConnell, and Mikkelson (1983) relating to their pre-1979

sample. This finding is consistent with the increase in hostile takeover activity

during my sample period. It also supports the theory that voting premiums stem

from outsiders buying an option to participate in possible future control contests

when preferential offers may be made to high-vote shareholders.

In this chapter, I examine the impact of firm specific variables on the

behavior of dual-class firms. In the first section, I supplement the findings in

Chapter 3 by measuring the impact of firm specific variables on price ratios. In

the next section, I investigate the factors that may motivate the promise of

preferential dividends by insiders and explain why outsiders price the promises.

Finally, I examine the behavior of price ratios as a function of time from the

recapitalization.








The Impact of Firm Specific Variables on Price Ratios


In this section, I use pooled, cross-sectional, time series data to

investigate the impact of firm specific variables on the observed price ratios. I

am interested in the pricing impact of; (1) actual dividend policy given the form

of the dividend promise, (2) the presence of a control threat, (3) differences in

liquidity between stock classes, (4) the percentage of insider ownership, and (5)

the voting power of the low-vote stock.


Description of the Study


The use of averages of time-series data in the previous chapter is useful

in determining group characteristics. It is less useful when evaluating firm

specific variables that are likely to vary from year to year. In this chapter, I use

information gathered for each firm from August of each year in the sample

period. August was randomly selected as a representative month. Much of the

firm specific information is provided annually (i.e., dividends and insiders'

percentage ownership) so gathering information from each month would provide

redundant data. I present cross-sectional results for each year of the sample

period and for the pooled results that contain up to 5 observations from each

firm. This pooling process results in 240 cross-sectional observations from the

period 1984-1988.

The average price ratios of the 64 firms (240 observations) grouped by

the form of their dividend promise are displayed in Table 4-1.







TABLE 4-1
AVERAGE PRICE RATIOS FROM THE POOLED CROSS-SECTIONAL DATA


OF 64 FIRMS OBSERVED DURING AUGUST OF EACH YEAR (1984-1988)
Standard Deviation t-value on
Dividend Number of Mean Price Of Mean Price difference
Promise Observations Ratio Ratio from 0.0
Equal 88 1.1254 0.2501 4.70"
"At Least" 66 1.0625 0.1082 4.69*
Preferred 86 1.0383 0.1086 3.27*


** Significant at the 95% level

Consistent with the results in the previous chapter, the price ratios remained

stratified by the form of dividend promise. Firms that promise equal dividends to
both classes exhibit the largest voting premium while firms that promise some

form of dividend compensation exhibit lower ratios.

The actual dividend policy of the 64 firms (240 observations) grouped by
the form of their dividend promise are displayed in Table 4-2.


TABLE 4-2
DIVIDEND POLICY FROM THE POOLED CROSS-SECTIONAL DATA OF 64
FIRMS OBSERVED DURING AUGUST OF EACH YEAR (1984-1988)


Dividend Number of No Equal Preferential
Promise Observations Dividends Dividends Dividends
Equal 88 40 48 N.A.
"At Least" 66 18 25 23
Preferred 86 14 N.A. 72


N.A. Not Applicable


Of the 86 observations from 25 firms that promise preferred dividends, 72 paid

dividends in the sampled quarter (all were preferential). Of the 66 observations

from 17 firms that promised low-vote shareholders at least an equal dividend,
there were 23 observations of preferential dividends, 25 observations of equal

dividends, and 18 cases where no dividends were paid. Of the 88 observations
from firms promising equal dividends, 48 paid dividends while 40 did not. The








possible motivation for these dividend payments is discussed in the next section

of this chapter.

To examine the explanatory power of dividend promises, dividend

payments, control events and liquidity on price ratios, I use the regression model

displayed in Equation 4-1. The specification and expected impact of the

independent variables are discussed below.33 The results from Equation 4-1

are displayed in Table 4-3.
(4-1)
In(RATIO,) =eo +aCAT2, +a2CAT3, +a3/NT2, +a, 4NT3,
4r0CON, +aLNHVV, +acLNLVV, +e;

where,


In(RATIO) = The natural logarithm of firm i's average price ratio for the month

(XQ = Intercept

CAT2i = 1 if firm i promises "at least" equal dividends to low-vote shares
= 0 otherwise

CAT3i = 1 if firm i promises preferential dividends to low-vote shares
= 0 otherwise

INT2i = {CAT2i (low-vote dividend high-vote dividend)}/{(high-vote price + low-vote price)/2}

INT3i = (CAT3i (low-vote dividend high-vote dividend)}/{(high-vote price + low-vote price)/2}

CONi = 1 if there is evidence of a control issue within the 6 months before the observation date
= 0 otherwise

LNHVVi = The natural logarithm of firm i's average high-vote trading volume

LNLVVi = The natural logarithm of firm i's average low-vote trading volume

Ei = Error term,



33 I also test for the impact of the percentage of insider ownership and the form
of the voting arrangement but I find both variables insignificant under every
specification. I discuss my attempts to measure these variables later in this
section.







Dividend Policy (CAT2. CAT3, INT2, INT3)

The dividend variables represent the impact of actual dividends as well as

dividend promises. I examine actual dividend payments because both forms of

preferential dividend promises allow managers to avoid paying higher dividends

to the low-vote shareholders by simply not paying dividends, or in the case of

the promise to pay "at least" equal dividends, paying both classes the same

dividend. It is interesting to note that, as shown in Table 4-2, actual dividend

policies for firms that offer at least an equal dividend are nearly evenly

distributed between no dividends, equal dividends, and preferred dividends. In

addition, Table 4-2 shows that most firms that promise preferential dividends pay

preferential dividends. Thus, while preferential dividend promises imply possible

preferential dividends, dividend payments resolve uncertainty and reflect the

actual dividend intentions of management.

I do not use actual preferential dividends as an explanatory variable since
this would also capture the form of the dividend promise because only firms that

promise preferential dividends can pay them. Instead, I construct interactive

variables that reflect the relative size of the preferential dividend and the related

dividend promise. For example, INT2 is calculated by taking the low-vote

dividend minus the high-vote dividend and then dividing by the average market

price of the two stock classes. This preferential dividend yield is then multiplied

by the dummy variable indicating whether the firm promised at least equal

dividends to the low-vote shareholders. This technique allows me to measure

whether the payment of preferential dividends offers additional explanatory

power beyond the promise of optional preferential dividends. The variable INT3

is calculated in the same way except that the preferential dividend yield is

multiplied by the dummy variable indicating that the firm promised preferential

dividends. I expect that the interactive parameter estimates will be negative and








significant as actual dividend policy reveals management's true dividend

intentions.


Control Threats (CON)


Although previous studies establish that voting rights have value, the

source of the benefits that support the value remains elusive. The typical

explanation is that managers prefer high-vote stock because it allows them to

secure voting control, thus ensuring a long relationship with their firm. This

explanation of the source of the premiums does not explain why control

premiums exist even when control of the firm is tightly held.

The market price of common stock reflects the supply and demand of

marginal shareholders who are actively trading in the stock. Once a firm has an

established group of dominant shareholders, then purchasing high-vote stock

will not qualify outsiders for management positions that might allow for the

extraction of the benefits. In addition, inside shareholders who have already

secured their management positions are unlikely to remain active in the market

and should not significantly affect the price. As long as a dominant shareholder

group exists, outsiders should be unwilling to pay a premium for high-vote stock

and insiders should not be sufficiently active in the market to influence the price.

Thus, the observed premiums may not always directly reflect the value of control

related to securing an employment position.

When a dominate shareholder group does not exist, and control of the

firm is contested, then it is likely that the marginal shareholders will be insiders

or potential insiders who will offer a premium price for high-vote stock. Although

most dual-class firms promise both classes equal distributions during liquidation,

shareholders may be offered differential premiums in an acquisition. DeAngelo







and DeAngelo (1985) document that 4 out of 30 acquisitions of dual-class firms

from the period 1960-1980 included negotiated premiums to high-vote shares.

The premiums ranged from 83.3% to 200%. Megginson reports that 43 out of

152 British dual-class firms were acquired between 1955-1982. Out of the 43

successful acquisitions, 37 included preferential offers to high-vote

shareholders. The premiums ranged from 1.6% to 260%.

The existence of differential takeover offers suggests an explanation for

long-lived control premiums. Outsiders may be willing to pay a premium for

high-vote stock, even during periods when control is consolidated, as an option

to participate in the profits from possible future control contests. There is

evidence of tightly held family firms that seem immune to takeover threats but

subsequently become a target when an important family member dies. Thus,

outside shareholders who never intend to directly receive the benefits of control,

may receive takeover premiums if the firm becomes involved in a control contest.

I test the impact of increased expectations of a takeover on pre-takeover

stock prices across voting classes. The variable CON is a dummy variable

indicating the presence of a control threat. It was constructed by searching the

Wall Street Journal, Barrons, and the Dow Jones News Service for news of

control contests within the six months before each August observation.

Specifically, I searched for the key words; control, takeover, votes, buyout, and

tender. I defined control contests liberally and many "events" did not result in a

change of control. Any news of action taken toward securing a larger ownership

block was considered the presence of a control contest. In some cases, the

"pressure" came from outside the firm with either a formal takeover offer or the

news that an outsider had acquired a significant block of stock and was

considering a takeover offer. In other cases, the pressure came from within the

firm as management groups announced their intent to obtain greater control and







perhaps take the firm private. I expect this variable to be positive and

significant.


Liquidity (LNHVV, LNLVV)


The price ratio of dual-class stock is generally assumed to be a function

of voting power and expected cash flows. However, the price ratio may also

reflect differences in the liquidity of the two classes of stock. For companies in

my study, high-vote shares are often thinly traded compared to low-vote shares.

On average, low-vote shares in my sample traded at 6.36 times the volume of

high-vote shares.34 Since liquidity is expected to be positively related to price,

this result suggests that the observed high-vote premium is not inflated by

liquidity differences. If anything, liquidity differences should reduce the voting

premium and may provide some explanation for the existence of four equal

dividend firms exhibiting negative voting premiums.

Since cross-sectional differences in liquidity may affect the price ratio, I

control for liquidity by in the following way. I construct variables defined as

LNHVV and LNLVV. The LNHVV variable is the natural logarithm of the average

August trading volume for high-vote shares and will exhibit a positive

relationship if liquidity is reflected in price. If low trading volume reduces the

liquidity of high-vote shares, then the price of the high-vote stock price will fall

and the price ratio will also fall. Alternatively, low trading volume may indicate

that the high-vote shares are considered very valuable by insiders and so a

negative relationship might be observed. LNLVV is the corresponding average

August trading volume for low-vote shares and is expected to have a neutral or


34 Megginson (1990) also finds that low-vote shares are more actively traded
than high-vote shares in his study of British dual-class firms.







negative impact on average price ratios. If low trading volume reduces the
liquidity of low-vote shares, then the low-vote stock price will fall and the price

ratio will increase. Because the low-vote shares are generally actively traded

there may be no measurable liquidity impact on this class.35


Regression Results


The results from Equation 4-1 are presented in Table 4-3. The parameter
estimates for variables CAT2, CAT3, and INT3 are negative and significant for

the pooled, 1984-1988 sample. These variables are generally not significant in

individual years. INT2 is negative as expected but not significant at the 90%

level. In Chapter 3, I find that preferential dividend promises are valued and

effectively reduce the observed voting premiums. The results from this test

35 1 also attempt to control for liquidity differences between stock classes by
computing the ratio of LNHVV and LNLVV. The parameter estimate for this
independent variable is expected to be positive if the thin trading of high-vote
stock is significantly related to the price ratio. I find this variable insignificant.

I also use Roll's (1984) measure of the bid-ask spread to estimate liquidity
differences. The relationship is expressed in Equation 4-2.

%Spread= 2 -Cov(R,R,,) (4-2)

If a firm's high-vote stock is thinly traded then its bid-ask spread should exceed
the bid-ask spread of the more frequently traded low-vote stock. The use of
returns versus prices yields a percentage spread as opposed to a dollar spread.
The calculation of the liquidity variable is reflected by Equation 4-3.

% Spread (High-vote stock) % Spread (Low-vote stock) (4-3)

Daily returns for the covariance calculations are gathered from the 40 trading
days preceding the month of August. If liquidity concerns relating to the high-
vote stock are important then the spread variable will negatively affect the price
ratio of high-vote stock divided by low-vote stock. I find this variable insignificant
under all model specifications.








support the results in Chapter 3 and provide evidence that preferential dividend

payments by firms that promise preferential dividends are also effective in
reducing observed price ratios.


TABLE 4-3
ORDINARY LEAST SQUARES REGRESSION RESULTS FROM
EQUATION 4-1 USING CROSS-SECTIONAL AND POOLED CROSS-
SECTIONAL DATA TO EXPLAIN LOGGED PRICE RATIOS


Intercept 0.183 0.262 0.275 -0.028 0.164 0.265
(4.19) (3.08) (2.69)** (0.27) (1.67)* (2.48)*
CAT2 -0.037 -0.084 -0.030 -0.019 -0.056 -0.014
(-1.65)* (-1.69) (-0.58) (-0.36) (-1.18) (-0.24)
CAT3 -0.040 -0.075 -0.023 -0.071 -0.067 -0.028
(-1.68)* (-1.36) (-0.27) (-1.02) (-1.45) (-0.50)
INT2 -0.219 -0.378 -0.916 0.469 -0.137 -0.286
(-1.20) (-0.45) (-1.58) (0.55) (-0.490) (-0.84)
INT3 -0.359 -0.141 -0.408 0.701 -0.109 -1.127
(-2.16) (-0.61) (-0.41) (0.81) (-0.34) (-2.85)**
CON 0.136 0.077 -0.023 0.096 0.215 0.174
(5.51) (0.63) (-0.26) (1.88)* (3.63) (3.60)**
LNHW -0.006 -0.015 -0.005 0.018 0.003 -0.020
(-0.95) (-1.24) (-0.35) (1.22) (0.27) (-1.29)
LNLW -0.010 -0.011 -0.023 -0.001 -0.013 -0.013
(-1.72)* (-0.95) (-1.80)* (-0.11) (-1.05) (-0.85)
R2 .184 .261 .201 .120 .264 .414

Adj. R2 .159 .094 .032 -0- .155 .323

F Value 7.47 1.57 1.19 0.85 2.41 4.54

P-Value 0.0001 0.1830 0.3374 0.5501 0.0341 .0007

Observations 240 39 41 52 55 53

* Significant at the 90% level.
* Significant at the 95% level.
CAT2 = 1 if firm promises at least an equal dividend to low-vote shareholders;
otherwise = 0
CAT3 = 1 if firm promises preferential dividend to low-vote shareholders;
otherwise = 0
CON = 1 if the firm was subject to control pressure within 6 months of August
otherwise = 0


1984-88


1984


1985


1986


1987


1988







INT2 = [(low-vote dividend minus high-vote dividend)/average price] x CAT2 dummy variable
INT3 = [(low-vote dividend minus high-vote dividend)/average prices x CAT3 dummy variable
LNHW = the natural logarithm of the high-vote trading volume for the month of August
LNLW = the natural logarithm of the low-vote trading volume for the month of August


The CON variable is positive and significant in the pooled sample and in

the years 1986-1988. The significance in the last three years of the five year

study corresponds to the increase in takeover activity during the period. I

conclude that the possibility of a takeover premium may induce outside

shareholders to pay a premium for high-vote shares even when they have no

interest in exercising actual control of the firm. This motivation for ownership of

high-vote stock by outsiders may explain why control premiums exist during

periods when firms are tightly held.

To provide further information about the impact of control threats, I

examine the circumstances surrounding the trading disappearance of 11 firms

from my sample of 64 firms during the period 1984-1988. The results of the

survey, shown in the Appendix, provide further evidence that takeovers influence

stock price ratios. Of the eleven firms in my sample that ceased trading during

the period 1984-1988, eight were the targets of successful control contests.

Although six firms ultimately received equal takeover bids to both classes, Care

Enterprises and Resorts International provide excellent examples of preferential

takeover treatment of high-vote shares. The price ratios of firms involved in

control contests often rise as high-vote shareholders anticipate the greater

possibility of a premium offer to the high-vote shares. When the nature of the

takeover offer is revealed the price ratios quickly reflect the new information.

For example, in 1987 Southmark Corporation pursued Care Enterprises, a dual-

class firm. Southmark intended to selectively offer premiums to only the high-

vote shares. Before news of the acquisition, the price ratio of Care Enterprises

traded near 1.10. During the negotiations with Southmark the ratio climbed as








high as 3.0. Ultimately the acquisition was abandoned and the price ratio

returned to near 1.0. In 1988, the firm declared Chapter 11 bankruptcy.

The LNHVV variable is not significant in any year or in the pooled data.

This may imply that liquidity problems are not significant for high-vote stock or it

may imply that LNHVV is not a good proxy for liquidity. Alternatively, low trading

volume might be a symptom of high-vote shares with great value. If the value of

the vote is very high then insiders will have even greater incentive to hold their

shares. The LNLVV variable is negative and significant at the 90% level using

the pooled data. Firms with thinly traded low-vote stock exhibit higher price

ratios.

Megginson (1990) finds that the high-vote premium is positively and

linearly related to insider holdings of high-vote shares. I am unable to find a

similar relationship in my sample.36 I am similarly unable to find a significant

relationship between price ratios and the form of the voting arrangement.37

36 I measure the percentage of insider holdings in both the high-vote and low-
vote shares by gathering information from annual corporate proxy statements. I
define insiders as board members, managers, and other related stockholders
with significant holdings. On average I find that insiders own 50.97% of the
high-vote stock and 32.07% of the low-vote stock.

It may not be surprising that I do not find a linear relationship between insider
ownership and dual-class price ratios. McConnell and Servaes (1990) find a
significant curvilinear relationship between firm value and the percentage of
insider ownership. Specifically they find a "u-shaped" relationship where firm
value first increases as insider ownership climbs and then falls when insider
ownership reaches higher values. In a similar study, Morck, Schleifer, and
Vishny (1988) find that firm value increases, declines, and then increases again
as ownership by the board of directors rises.

I attempt to capture the nonlinear nature of insider ownership by creating dummy
variables designed to reflect cases where the percentage of insider ownership of
high-vote shares lies in a range that makes control contests most likely. To
estimate that range, a dummy variable is constructed which equals 1 if insider
ownership is between 40% and 60%. The same test is also conducted with
insider ownership defined between 40% and 50%. Regression analysis reveals








The Promise and Pricing of Preferential Dividends


Chapter 3 and the previous section of this chapter document that
preferential dividend promises and payments reduce the price ratios between

dual-classes of common stock. This result raises three interesting questions.

First, why do insiders offer preferential dividends to low-vote shareholders?

Second, why are the preferential dividend promises priced by outside

shareholders? Third, why do insiders pay preferential dividends?

These questions arise because insiders appear to have the ability and the

incentive to withhold dividends or at least not pay preferential dividends.

Insiders tend to hold the high-vote, low-dividend class of shares. In my sample,

insiders hold an average of 50.97% of high-vote stock and 32.07% of low-vote

stock. When preferential dividends are offered and paid to the low-vote shares,

insiders receive a disproportionately small amount of the proceeds. In contrast,

stock price appreciation allows insiders to share at least equally in cash

distributions. Instead of paying preferential dividends, insiders can retain the

firm's cash and invest in positive net present value projects. Ultimately, insiders

can sell their shares at equal or preferential terms. In a non control event, the

insider will probably sell high-vote shares at a small premium above the low-vote

price. The existence of this average premium is documented in Chapter 3. In a


that insider ownership is also not significant when measured linearly or as a
dummy variable described above.

37 In all 64 firms, the high-vote stock effectively has the power to control the
board of directors. In most cases the low-vote stock is assured the election of a
minority portion of the board of directors. In 11 out of 64 firms, the high-vote
stock has exclusive voting rights. I create a dummy variable indicating a firm
with low-vote stock that is actually no-vote stock. I find this dummy variable to
be insignificant.








control contest, the insider may sell high-vote shares at a significant premium

over low-vote prices. The existence of premium offers to high-vote shares

during hostile takeovers is documented earlier in this chapter.

In this section, I first discuss possible explanations for the offer, pricing,

and payment of preferential dividends to low-vote shareholders. I then use

statistical tests to support my explanations.

Insiders promise preferential dividends to low-vote shares because they

must expect to benefit from the promise. Outsiders may consider preferential

dividend promises compensation for the pending loss of voting power. As a

result, the promises may encourage outsiders to approve the dual-class

recapitalization when it is proposed. In addition, most recent recapitalizations

allow and depend on outsiders converting their high-vote shares to low-vote

shares. Without preferential dividends, only liquidity concerns might cause

outside shareholders to convert. Finally, insiders may promise preferential

dividends because they anticipate the need to issue low-vote equity in the future

and they expect to utilize the signaling benefit of dividends.

Although there are potential benefits to insiders from promising

preferential dividends, it is not immediately clear why outsiders should believe

the promises. After the recapitalization, insiders often have majority control of

the firm and can effectively negate the preferential promises by completely

withholding dividends in cases where preferential dividends are promised or by

paying only equal dividends if "optional" preferential dividends are promised.

The pricing of preferential dividend promises depends on outsiders believing

that it is in the best interests of insiders to follow through with their promise. In

order for this to be the case, there must be benefits to insiders from paying

preferential dividends and/or costs of not following through with the promise.







I contend that the personal wealth constraints and portfolio concerns of
insiders, along with the need to issue additional low-vote equity, provide

significant motivation for insiders to pay preferential dividends. If outsiders
believe that insiders are motivated to pay preferential dividends then they will

believe and price the preferential dividend promises.

Firms recapitalize to two classes of common stock, at least in part,
because the personal wealth constraints and/or diversification concerns of

insiders often prevent them from increasing their ownership share. Insiders
often have their investment portfolio and human capital dependent on their firm's
performance. Finance theory indicates that, absent concerns about voting

power, insiders should prefer a more diversified portfolio. Dual-class
recapitalizations result in managers with reduced ownership and increased

voting power. Thus, a dual-class recapitalization may signal that managers

intend to reduce their investment in the firm. The payment of cash dividends is

an effective strategy for withdrawing value from the firm without reducing voting
power. When outside shareholders perceive that managers also want to receive

dividends, then the promise of preferential dividends to low-vote shares is more

credible.
Firms also recapitalize because they intend to issue low-vote equity.

Some proxy statements explicitly state the possibility of a low-vote stock issue
after the recapitalization. Other proxy statements allude to the possibility by

referring to added capital structure flexibility. Many recapitalizing firms are in

growth industries with pre-existing dominant shareholders.38 When internal
financing is not sufficient to finance all positive net present value (NPV) projects,

38 In Chapter 5, I present evidence that dual-class firms enjoy strong growth
opportunities. Lehn, Netter and Poulsen (1989) also find evidence that dual-
class firms have relatively high growth rates.








management is faced with the dilemma of issuing debt, issuing equity, or

bypassing the projects. Finance theory states that, absent agency problems, all

positive NPV projects should be undertaken regardless of the method used to

finance the investment. However, management may not issue new equity if

ownership control is lost. As stated above, personal wealth constraints and

diversification concerns often prevent managers from joining equitably in new

issues. Debt may not be attractive to management because interest obligations

reduce free cash flow and owners may fear creditor involvement and the partial

loss of control. In addition, the relative small size of many dual-class firms,

along with the high concentration of manager ownership, may make debt issues

unattractive to the capital market. The solution for these firms is to offer a

second class of low-voting common stock that allows management to maintain

control and access all positive NPV projects.

Generally, when insiders intend to issue equity, they have the incentive to

support the market price of the stock. To support the low-vote stock price

management may take steps like promising and paying preferential dividends.

Preferential dividend payments enhance the market value of low-vote shares in

several ways. First, higher dividends have cash value to shareholders. Second,

higher dividends reduce the free cash flow of the firm. This provides insiders

with fewer opportunities to consume firm value and signals low-vote

shareholders that they can be less concerned about possible agency problems.

Third, promising preferential dividends, and then following through with the

payments enhances the firm's reputation and signals that insiders do not intend

to harm the outside shareholders.

Asquith and Mullins (1986) argue that dividend payments are credible

vehicles to carry managements' assessments of firm value to the investor. In

equity offers, significant uncertainty often exists regarding the value of the







assets in place. In the absence of effective signals of firm value, good firms are

pooled with bad firms and effectively subsidize the bad firms' offers. Higher
dividends must mean that the firm has positive NPV projects or the insiders in

the firm will ultimately suffer from providing an incorrect signal. Dividends are

costly signals because the payments require cash flow that the firm must

generate internally or persuade the capital markets to supply. Preferential

dividends are especially costly to insiders because they tend to hold the high-

vote, low dividend shares.

In summary, insiders may promise preferential dividends because they

need to signal strong firm value when they issue low-vote equity. Outsiders

consider preferential dividend signals persuasive because they cannot be

mimicked without costs and because the cost is higher to insiders that are most

likely to know the firm's true value. Thus, outsiders are more likely to price

preferential dividend promises when they perceive a high probability of future

equity offers.

I use means tests and LOGIT analyses to investigate whether the above

explanations of the offering, pricing and paying of preferential dividends are

reflected by the data from my sample firms. Table 4-4 shows the descriptive

statistics that are generated when dual-class firms are grouped based on

whether they issued equity within one year of the recapitalization. Equation 4-4

is used to test for statistical differences in means between two binomial

distributions. The results are shown in Column 4 of Table 4-4.

S P -Po
IP.-Q, ,Q.
N. (4-4)

Firms that issue equity are statistically more likely to offer preferred or "at least"

equal dividends to their low-vote shareholders. This evidence supports the








theory that preferential dividends are promised because insiders intend to issue

low-vote equity soon after the recapitalization. The payment of preferential

dividends, the ability to convert high-vote stock to low-vote stock, and the

percentage of insider ownership before recapitalization are not significantly

different between groups of firms.


TABLE 4-4
DESCRIPTIVE STATISTICS BASED ON WHETHER FIRMS ISSUED
EQUITY WITHIN ONE YEAR OF THE RECAPITALIZATION
Firms that issued Firms that did not P. -Pb
equity within one issue equity within one |PQ, +PQ
year of the year of the \ N, N
Firm Characteristics recapitalization recapitalization
Promise of preferential or 14/17 28/47
at least equal dividends (82.4%) (59.6%) 1.96
Payment of preferential 7/17 18/47
dividends (41.2%) (38.3%) 0.21
Existence of conversion 11/17 27/47
privilege (64.7%) (57.4%) 0.53
Pre-Recapitalization
insider holdings 45.6% 47.7% 0.16
Significant at the 95% level.


To further investigate the relationship between preferred dividend

promises and the subsequent decision to issue equity, I perform the LOGIT

analysis represented in Equation 4-5. The results from Equation 4-5 are shown

in Table 4-5.

EQUITY, =f(PREF,) (4-5)

where,

EQUITYi = 1 if firm i issued equity within one year after the recapitalization
= 0 otherwise
PREFi = 1 if firm i promises possible preferential dividends to low-vote shares
= 0 otherwise








TABLE 4-5
LOGIT ANALYSIS OF THE DECISION TO ISSUE EQUITY
WITHIN ONE YEAR AFTER RECAPITALIZATION
Parameter Estimate
(Chi-Sauare)


Intercept 1.846
(8.83)**
PREF 1.153
(2.70)*
Number of Observations 64


** Significant at the 95% level
* Significant at the 90% level



The LOGIT analysis confirms that subsequent offers of low-vote equity

are significantly related to firms that offer low-vote shareholders preferred

dividends.

Table 4-6 shows the descriptive statistics that are generated when

sample firms are grouped based on whether they promise preferred or

potentially preferred dividends versus equal dividends. Firms that offer

preferred or potentially preferred dividends are more likely to issue equity within

one year of recapitalization. Conversion privileges are significantly related to

the promise of preferred dividends. The percentage of insider ownership before

recapitalization is not significantly different between groups of firms.

To further investigate the relationship between equity issues and

conversion privileges on the decision to promise preferential dividends, I perform

the LOGIT analysis represented in Equation 4-6. The results from Equation 4-6

are displayed in Table 4-7.


II







TABLE 4-6
DESCRIPTIVE STATISTICS BASED ON THE FORM OF
DIVIDEND PROMISE TO THE LOW-VOTE SHAREHOLDERS
Firms that offered Firms that did not
preferred or at least offer preferred or at z P. -Pb
equal dividends to least equal P.OQ, +PQ
low-vote dividends to low- \ N, Nb
Firm Characteristics shareholders vote shareholders
Equity issue within one year 14/42 3/22
after recapitalization (33.3%) (13.6%) 1.91
Payment of preferential 25/42 0/22 Not
dividends (59.5%) (0%) Applicable
Existence of conversion 33/42 5/22
privilege (78.6%) (22.7%) 5.11
Pre-recapitalization insider
holdings 46.2% 49.2% 0.31
* Significant at the 90% level
** Significant at the 95% level


PREF, =f(EQUITY, CONV)


(4-6)


where,

PREFi = 1 if firm i promises possible preferential dividends to low-vote shares
= 0 otherwise
EQUITYi = 1 if firm i issued equity within one year after the recapitalization
= 0 otherwise
CONVi = 1 if firm i allows conversion of high-vote shares to low-vote shares
= 0 otherwise


TABLE 4-7
LOGIT ANALYSIS OF THE DECISION TO PROMISE
PREFERENTIAL DIVIDENDS
Parameter Estimate
(Chi-Square)
Intercept -0.980
(4.14)**
EQUITY 1.344
(2.73)*
CONV 2.560
(15.55)**
Number of Observations 64

Significant at the 95% level
* Significant at the 90% level








The LOGIT analysis shows that the decision to promise preferential dividends is

a function of the intent to issue low-vote equity and to encourage conversion of

high-vote shares to low-vote shares.

To summarize, I have provided evidence of a link between dividend

promises and subsequent equity issues. In Equation 4-7, I test whether the

decision to actually pay preferential dividends is related to equity issues

subsequent to the recapitalization. I limit my sample for this calculation to firms

that promised a preferential dividend or "at least" an equal dividend. I expect to

find that, among firms that promise preferential dividends, those that issue equity

have greater incentive to fulfill the promise.


PREFDIV, =f(EQUITY) (4-7)

where,

PREFDIVi = 1 if firm i pays a preferential dividend
= 0 otherwise
EQUITYi = 1 if firm i issues equity within one year of recapitalization
= 0 otherwise

The results from Equation 4-7 are shown in Table 4-8.

TABLE 4-8
LOGIT ANALYSIS OF THE DECISION TO PAY
PREFERENTIAL DIVIDENDS
Parameter Estimate
(Chi-Square)
Intercept 0.406
(0.99)
EQUITY -0.693
(1.05)
Number of Observations 42







I expect to find a positive relationship between the decision to follow

through and pay preferential dividends and the decision to issue equity. In fact,
the relationship is negative although not significant. While equity issues are

related to the promise of preferential dividends, the same relationship does not

exist with actual dividends. On closer examination, the insignificant impact of

this variable may not be surprising. Firms that promise preferential dividends

must then decide whether to pay preferential dividends. The decision is

influenced by plans to issue equity and the relative cost of dividend signaling.

Some firms decide to signal good quality with preferential dividends. Although

the signal is costly, the benefit is that the firm is separated from the pool of

uncertain quality firms. Other firms that also need to issue equity may find that

dividend signaling is too costly so they choose not to pay preferential dividends.

The promise of preferential dividends at the recapitalization gives firms the

option to evaluate the costs and benefits of dividend signaling when the time

comes to issue equity. Firms with very low cash flow and/or poor future

prospects will find dividend signaling prohibitively costly and they may actually

benefit from the pooling process.

Equity offers that are preceded by costly signals should exhibit less of a

price decline at the announcement than equity offers that are not preceded by

costly preferential dividends. As a future area of research, I intend to measure

the abnormal returns of dual-class firms relating the announcement of the intent

to issue additional low-vote equity. I intend to measure the reaction of both the

high-vote and low-vote shares.

The data from this section appears to support a strong relationship

between preferential dividend promises and equity issues. In Chapter 5, I

investigate whether the expectation of future equity issues explains why the







stock prices of some firms react negatively to the announcement of a dual-class

recapitalization.


The Behavior of Price Ratios Over Time


Agency costs between classes of common stockholders may change as

the firm's capital structure changes and/or as insiders consolidate control as

they reduce their investment. As a result, I construct a time-series of average

cross-sectional price ratios measured from the date of recapitalization to

investigate whether trends exist. I calculate price ratios for 55 firms from my

sample from which I had access to prices during the first five years after the

recapitalization transactions. I then calculate the cross-sectional average price

ratios for each month following the issue of a second class of stock. Figure 4-1

shows that price ratios increase up to about 30 months from recapitalization and

then decline to previous levels.

To better understand this time-series behavior, I present three additional

time-series graphs based on differential firm characteristics. Figure 4-2 shows

the time-series relationship between firms that issued equity within one year

after the recapitalization and firms that did not issue equity in that time span.

Consistent with the discussion in the previous section, firms that issue equity

trade at lower price ratios than other firms. Firms that intend to issue new low-

vote stock have the incentive to maintain the price of that class of stock. In

Figure 4-3, I compare the time-series ratios of firms that were subject to takeover

pressure during the first five years versus the time-series' ratios of other firms.

The graph shows that takeover pressure seems to occur one to three years after

the recapitalization. Closer examination of the data reveals that the spike

exhibited during month 28 is explained by a price ratio of 3.0 exhibited by Care





82


Corporation during a control contest. The impact of Care Corporation is also

noticeable in Figures 4-1 and 4-2 (firms that issued equity). In Figure 4-4, I

present the time-series of firms that issued equity within one year and were not

subject to takeover pressure. The graph shows that average price ratios started

below 1.0 and gradually increase over time. This figure provides further

evidence that the expectation of future equity offers provides motivation for

paying dividends and maintaining the low-vote share price.

























































































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CHAPTER 5
VOTING PREMIUMS, EQUITY ISSUES, AND WEALTH EFFECTS


Background


In this chapter, I investigate the relationship between wealth effects

measured on the announcement of the intent to recapitalize and four firm

specific variables: (1) voting premiums measured after the recapitalization, (2)

subsequent equity issues, (3) a measure of investment opportunities, and (4)

preferential dividend promises to low-vote shareholders.

Previous studies have independently considered the impact of dual-class

stock on firm value and the subsequent relative price differences between

classes.39 40 I test for a relationship between voting premiums measured

during the first six months after recapitalization and wealth effects measured on

the announcement of the recapitalization. Specifically, I investigate whether


39 Jog and Riding (1986) find no significant response at the announcement date
from 130 firms listed on the Toronto Stock Exchange. Partch (1987) examines
the stock price reaction of 44 firms traded in the United States during the period
1962-1984. She finds statistically significant positive stock price responses at
the announcement date and over intermediate negotiation dates. However, the
median stock price response is negative and she concludes that shareholder
wealth is not affected by limited voting stock. Jarrell and Poulsen (1988) look at
94 firms from the period 1976-1987. They find statistically significant negative
returns.

40 Lease, McConnell, and Mikkelson (1983) find an average voting premium for
of 4.06% for 30 firms traded in the United States. Levy (1982) finds that high-
vote shares trade at a 45% average premium in a study of 25 Israeli firms.
Megginson (1990) studies 152 dual-class British firms and finds that high-vote
shares trade at a 13.3% premium over low-vote shares.








there is a relationship between the division of firm ownership between classes of

stock and changes in the total market value of the firm.

Firms may recapitalize for a variety of reasons. For example, firms may

use dual-class recapitalizations primarily as insulating devices that may cause a

loss in firm value that is borne by low-vote shareholders. Jensen and Meckling

(1976) suggest this possibility. They assume that a corporation exists with two

groups of shareholders, management that controls the firm, and passive

outsiders. Both groups are entitled to equal dividends. According to their

model, management may not act in the best interest of outside shareholders. In

fact, Jensen and Meckling show that managers may choose a set of activities for

the firm such that the total value of the firm declines. As the manager's fraction

of equity falls, his fractional claim on outcomes falls and this encourages him to

divert larger portions of the firm's resources toward perquisites. Outsiders

anticipate this action by insiders and drive down the stock price and firm value.

The insiders maintain or increase their welfare by consuming non pecuniary

benefits not received by outside shareholders.

Dual-class recapitalizations result in a situation similar to the scenario

suggested by Jensen and Meckling. Insiders typically increase their voting

control while decreasing their investment. DeAngelo and DeAngelo (1985) find

that officers of firms with two classes of common stock averaged 54.8% of the

voting power but only 27.6% of the claims to cash flows. Partch (1987) finds that

insider ownership and voting power was 48.6% before a dual-class

recapitalization. Twenty-one months after the event, inside ownership fell to

43.7% while insider voting power rose to 58.6%. As a result, dual-class

recapitalizations may reduce total firm value as the agency costs associated with

the separation of ownership and control are magnified. The reduction in firm

value may ultimately be reflected in the low-vote shares that are primarily held







by outsiders. Although the firm may have a lower total value, insiders should not

be harmed because, (1) they proposed the transaction, and (2) they can use
their high-vote shares to improve and secure their employment positions and

related salaries. If the transaction is viewed as an opportunity for insiders to

consume significant firm value then outsiders will drive down the price before the

recapitalization and the low-vote shares will reflect the drop in price when the

stock classes trade separately.

Another group of firms may recapitalize because insiders with voting

control are unwilling to raise new equity capital because of the possibility of

losing voting control. Failing to access positive net present value projects hurts

inside and outside shareholders equally. A dual-class recapitalization allows

insiders to issue low-vote equity and access the growth. In these cases, there is

an apparent lack of intent by insiders to consume firm value at the expense of

outside shareholders so I expect to find firms with positive announcement effects

exhibiting smaller subsequent price differences between stock classes.

In this chapter, I also investigate the relationship between subsequent

equity issues and announcement effects. I identify two possible, but conflicting,

relationships. First, a substantial proportion of firms issue equity subsequent to

recapitalization. Thus, for firms with pre-existing dominate shareholders, the

announcement of a recapitalization plan may primarily signal future equity

issues.41 Similarly, the announcement of a recapitalization may signal that

dominant shareholders want to reduce their dollar investment in the firm and that

they intend to sell off blocks of their stock while maintaining control of the firm. If


41 Myers and Majluf (1984) show that stock prices will fall when management
with superior information, acting in the interests of passive shareholders,
decides to issue equity. Dann and Mikkelson (1984) find a significant negative
average price impact when equity issues are announced.







recapitalizations signal future equity offers then I expect to find firms that

subsequently issued equity exhibit worse announcement reactions.

The second possible relationship was indirectly discussed earlier in this

chapter. The primary motivation for some recapitalizing firms may be to raise

capital to access positive net present value projects while protecting the voting

control of insiders. For these firms, the recapitalization may prove to be equally

beneficial to both classes of stock. One way to identify firms with this motivation

is to investigate firms that subsequently issue low-vote equity. If accessing

positive net present value projects is the primary motivation for recapitalizing,

then I expect to find that firms that issued equity within the first year after the

recapitalization enjoyed favorable announcement reactions. Alternatively, if the

recapitalization is viewed as an announcement of an equity issue then the

market may infer that the stock price is overvalued and negative reactions may

be observed.

A second way to identify firms that recapitalize to access growth

opportunities is to measure growth opportunities before the recapitalization. I

use a calculation used by Smith and Watts (1992) shown in Equation 5-1.


GROWTH = (Total Assets + Market Value of Equity Book Equity) / Total Assets

(5-1)


I measure the components of this calculation at the last annual financial

statement date before the recapitalization. My data comes from the Standard

and Poor's COMPUSTAT tape and from the CRSP tape. This equation

measures the market's perception of the relative strength of the firm's investment

opportunities versus the value of the assets in place. Because I am using

accounting book values to measure the value of assets in place this variable is








measured with error. The growth variable should be greater than 1.0 if a firm's

investment opportunities exceed the value of assets in place. For my sample of

dual-class firms the average measure of growth opportunities is 1.50.42 This is

consistent with the general perception of dual-class firms as smaller, growth

oriented organizations. The value of GROWTH for each firm is displayed in

Table 5-2. If the primary motivation for recapitalizing is to access growth

opportunities then I should observe a positive relationship between GROWTH

and the abnormal announcement reactions.

Finally, I investigate whether preferential dividend promises to low-vote

shareholders lead to better market responses to the announcements of the

recapitalizations. Jarrell and Poulsen (1988) test whether dividend

compensation to low-vote shareholders leads to better market perception of the

transaction. They are unable to find with statistical significance that firms that

offer differential dividends outperform equal dividend firms at the announcement

date.


An Event Study of the Issue


My null hypothesis is that price ratios, equity issues, growth opportunities,

and dividend promises do not explain the difference in abnormal returns around

announcement dates. I first test the null hypothesis by comparing the average

abnormal returns of firms grouped by the form of dividend promise and by the

decision to subsequently issue equity. I then use weighted least squares

regressions to measure for significant explanatory power. My sample includes


42 Smith and Watts find an average ratio of 1.34 from their large sample of firms
from all industry classifications.







44 recapitalization during the period 1980-1988. I limit my sample to relatively

recent recapitalizations because of limited data from earlier recapitalizations and

to capture the recent surge of transactions that feature preferential dividend

offers and to coincide with the increased takeover pressure that seems related to

the popularity of the issues. My sample includes firms from the samples of

Partch (1987) and Jarrell and Poulsen (1988). I use the announcement dates

identified in those studies when they are available. My sample also includes

firms not measured by previous studies. I collected event dates for these firms

by searching the Wall Street Journal, Barrons, and the Dow Jones News

Service. I record the first report of the dual-class recapitalization proposal. My

sample size is smaller than Jarrell and Poulsen's because I require that both

classes of common stock trade publicly after the recapitalization. This permits

me to study the relationship between announcement effects and voting

premiums.

I estimate the two day abnormal returns around 44 announcements of the

intent to recapitalize using the methodology in James (1987). This requires

estimating by ordinary least squares the model in (5-2) using 80 daily returns

prior to t=-10, where t=0 is the date of the announcement.


R,, =a, +IRmt, (5-2)



Ri is the daily return for firmi, and Rmt is the daily return on a value-

weighted market index comprised of the securities on the Center for Research in

Securities Prices (CRSP) tape.

The event window is 10 days centered on t=0 for each prediction error

(PEit) and standardized prediction error (SPEt). I define these errors in
Equations 5-3 and 5-4.











PE,, =R, -(a, +,Rm,), (5-3)


SPE, = PE-
S 1 (R,,, -Rm)2
TT
T(Rmj -Rm )2
; .. (5-4)


T is the number of observations in the estimation period t= -80 to t= -10.


From SPEit, I find a two day standardized prediction error, STERRDAY,

shown in equation 5-5.


STERRDAY, = (SPE, +SPE,, ) / 2 (5-5)



I use STERRDAYi to test hypotheses. I define a mean STERRDAY in equation

5-6.

obs
STERRDAYn
Mean STERRDAY = STERRD
obs (5-6)



In Table 5-1, I report the average abnormal return and standardized

prediction error (STERRDAY). Consistent with previous studies, my study of 44

firms that recapitalized during the period 1980-1988 exhibits similar, ambiguous

announcement effects. Eighteen firms showed positive abnormal returns to the

announcement to recapitalize while 26 firms responded negatively. The average

two day response was -.73%. Although the mean and median returns are








negative, the responses are not statistically significant. The average voting

premium measured over the six months after the recapitalization is 3.67%.

Although this premium is lower than the average premium found in Chapter 3, it

is consistent with the lower premiums found near the recapitalization date in

Figures 4-1 through 4-4 in the previous chapter.

TABLE 5-1
AVERAGE ABNORMAL RETURNS BASED
ON RECAPITALIZATION ANNOUNCEMENTS
All Firms
Total number of firms 44

Number of positive responses 18

Number of negative responses 26

Mean Abnormal Return -0.0073
T= -1 to 0 (t-Value) (-0.96)
Standardized prediction error -.1726
T= -1 to 0 (t-value) (-0.86)
Mean Voting Premium 1.0367
(t-value on difference from 1.0) (3.36)
* Significant at the 95% level


In Table 5-2, I report the mean prediction errors and STERRDAY for each

recapitalization announcement. I also report the average price ratios measured

during the period six months after recapitalization, a measure of the firms' growth

opportunities, equity issues within one year after recapitalization, and the form of

dividend promise. Five firms exhibited positive responses to the announcements

at the 90% significance level or better. Five firms also reacted negatively at the

90% significance level or better. The average measure of GROWTH is 1.50.

Sixteen firms issued equity in the first year after the recapitalization.