Breakingviews: Second-class citizens

Tronchetti Provera: no incentive to convert savings shares to voting shares

Source: www.breakingviews.com is Europe's leading financial commentary service
Date: June 2003
By Rob Cox

For all the talk about equality, European capital markets are still crowded with aggrieved second-class citizens. These are the shareholders of such securities as German preference and Italian savings shares that appear to have little or no say in the governance of the companies they invest in and few protections against mistreatment.

Many family-controlled companies issued these shares years ago to enable their owners to raise capital without relinquishing power. As a general rule, the securities offered a slightly higher dividend payout to compensate for the absence of voting rights, though there are variations among the classes. Some Italian preference shares, for example, carry a right to vote at extraordinary general meetings, but not at annual meetings.

Traditionally, the capital markets accorded differing valuations to savings and preference shares even though they had the same economic claim to the companies' future earnings streams as common shares. Italian savings shares usually traded at big discounts to ordinaries. Many German preference shares actually garnered a premium to common shares. This was largely a reflection of other distortions in the marketplace, such as the lower liquidity of common shares and their absence from indices.

While family shareholders remained firmly in control of these companies, the distinction between voting and non-voting shares was largely uncontroversial. But recent changes of control at some companies have highlighted the lack of protection that non-voting shareholders actually have. Takeover codes in most European countries make it obligatory to buy out non-voting shares in takeovers, and often provide a formula for determining the minimum price that must be paid. But regulators generally do not take into account the historical relationships between the share classes.

Take the case of Wella, the German hair-care products maker being acquired by Procter & Gamble. In March the US consumer giant bid e61.50 a share for Wella's preference shares - a one-third discount to the price it offered common shareholders. P&G's offer complied perfectly with the law. It surpassed the legal minimum, which required it to pay the three-month trading average. But many investors claimed it was insufficient because Wella preference shares had traditionally commanded a premium to the common.

Last month P&G raised its offer for the preference stock to e65 a share. But it did not do so out of concern for these clamouring shareholders, insists P&G vice-chairman Bruce Byrnes. Rather, the increase was made to win a recommendation for its bid from Wella's managers, whose compensation is linked to preference share performance. In a sense, that suggests the increase was really the result of an alignment between the interests of management and non-voting shareholders.

Though uncommon, something similar has happened before. The founders of German enterprise software maker SAP in 2001 voluntarily converted preference shares on a one-for-one basis with common shares. Even though that diluted their control, the move was intended to increase the value of their ordinary shares because the preference shares commanded a premium.

As in the Wella case, non-voting shareholders received a modicum of fair treatment only because their interests were aligned with those of either the controlling shareholder or management.

Given the absence of any legal precedents providing for better protection of non-voting shareholders, these kinds of alignments should be a top consideration for investors. Indeed, where they have not existed, non-voting shareholders have tended to receive poorer treatment. Telecom Italia illustrates the point.

Under Olivetti's takeover of Telecom Italia, in which it already has a controlling position, the Italian telephone company's savings shareholders will not see their shares converted to common stock. Instead, they will hand over TI savers for new ones issued by Olivetti. This is not a propitious outcome for them as the newly merged Olivetti/TI will be a more indebted company, with fewer incentives to squeeze out dividends than TI had.

Given the trend in non-voting share conversions, however, that should not have come as a big surprise. After all, Olivetti/TI boss Marco Tronchetti Provera had a disincentive to convert savings shares because it would dilute the already tenuous sliver of control his companies have over the group. If there is one rule of thumb for investing in non-voting stock, it is to look for the harmony of interests or steer clear entirely.