Does Diversification of Share Classes Increase Firm Value?
In the absence of agency conflict and market frictions, it is beneficial to allow greater freedom to firms in their choice of corporate financial policy. Unconstrained optimization is always better than constrained optimization. However, if management is standing ready to pursue its own self-interest at the expense of shareholders, granting greater freedom can be suboptimal. Likewise, if information asymmetry between the firm and the market is severe, granting greater freedom may signal bad news or aggravate the adverse selection problem.
This study examines whether granting firms greater freedom to choose share classes—that is, allowing firms to adopt whichever type of share classes they wish—is desirable. The literature on share classes is limited. It is also heavily tilted toward studies on dual-class stocks and convertible preferred stocks. However, firms can issue stocks classified in many other ways, including in terms of voting rights, dividend rights, redemption rights, and conversion rights. Moreover, no study has investigated the effect of a policy experiment allowing greater freedom to firms in their choices of share classes.
This study uses the 2011 Commercial Act amendment, which significantly relaxed regulation over share classes in Korea. Prior to the 2011 amendment, Korea allowed only a limited number of share classes: common stocks, preferred stocks, convertible preferred stocks (with conversion rights bestowed only on shareholders), and redeemable preferred stocks (with redemption rights bestowed only on issuing companies). The amendment allows firms to adopt new types of share classes. Among these, two classes have become particularly popular. One is convertible preferred stocks, the conversion rights for which are bestowed on management. The other is redeemable preferred stocks, the redemption rights for which are bestowed on investors. They account for 45 percent and 49 percent, respectively, of the newly introduced share classes (384 in total) adopted from 2012 to 2015.
We call convertible preferred stocks, the conversion rights for which are bestowed on management, “entrenchment stocks,” and redeemable preferred stocks, the redemption rights for which are bestowed on investors, “financing stocks.” Entrenchment stocks are so named because they can be used as an entrenchment device. They are initially issued as non-voting or limited-voting stocks but can later be converted into voting stocks at the discretion of management. Financing stocks are so named because they are likely to be used as a financing means of last resort. The fact that redemption rights are in the hands of investors suggests that the adopting firms were in urgent need of external capital at the time of adoption.
We investigate the motivation behind and the effect of adopting these two share classes and find several noteworthy results. First, we find that entrenchment stocks are adopted by firms that have weak managerial control (low inside ownership) or that are more likely to have agency conflicts (high cash holdings or low outside director ratios). Second, our results show that financing stocks are adopted by firms that lack alternative means of financing. They are financially weak and have low foreign ownership.
Third, we find that the market reacts negatively to the adoption of entrenchment stocks. This finding is consistent with our hypothesis that managerial entrenchment from outside takeover threats and the private consumption of corporate resources should lower future cash flows to outside shareholders.
Fourth, we find that the market reacts negatively to the adoption of financing stocks. This result is consistent with our prediction that the adoption of financing stocks may reveal adverse changes that were not fully known to the public and may raise suspicions that share prices are overvalued. We also find that the negative market reaction is stronger for financially weaker firms.