When Mark Zuckerberg took Facebook, Inc. public in 2012, investors were offered shares of Facebook Class A stock, which had one vote per share. Facebook reserved its Class B stock, which had 10 votes per share, for its founders and other favored insiders. After completing the public stock offering, Zuckerberg owned less than a quarter of the company’s equity, but was entitled to 58.5 percent of its voting control through his ownership of Class B shares.
Public investors in Facebook understood that Zuckerberg controlled the company and willingly invested in Zuckerberg’s vision. They also understood, however, that if Zuckerberg sold approximately 13.5 percent of his shares, he would no longer have absolute voting control over the company.
Public investors also knew, when they invested in Facebook, that Zuckerberg was a signatory to the “Giving Pledge,” a philanthropic movement started by Warren Buffett and Bill Gates that encourages wealthy individuals to commit to donate to charity 50 percent or more of their wealth during their lifetime or upon their death. Zuckerberg not only signed on to the Giving Pledge, he was also widely quoted as intending to start giving away his wealth sooner rather than later.
Zuckerberg’s philanthropic promises led public investors to believe that although Facebook was a controlled company, it may not be controlled forever. Facebook’s IPO raised $16 billion from private investors, among the largest IPOs ever.
In 2015, as he awaited the birth of his first child, Zuckerberg began focusing more specifically on his philanthropy. With his wife Priscilla Chan, he created the Chan-Zuckerberg Initiative (CZI) and started developing plans for how to fund his charitable endeavors. Zuckerberg told his advisers he wanted to donate approximately $2 to $3 billion per year.
Zuckerberg’s wealth consisted almost entirely of Facebook stock, which in 2015 had a market value of $35 billion. More than 99 percent of this stock, however, was Class B shares, sales of which would rapidly reduce his voting control. His advisers explained that Zuckerberg could only sell or donate approximately $6 billion worth of Facebook stock before his voting control fell below 50.1 percent.
Unwilling to let his philanthropic plans force him to surrender voting control over Facebook, Zuckerberg worked with Facebook’s legal department to develop a new plan that would allow Zuckerberg to donate the vast majority of his fortune to charity while continuing to control the company.
Specifically, on April 27, 2016, Facebook announced its plan (the reclassification) to issue a new class of stock, Class C shares, which would have no voting rights. Facebook would distribute these shares to all Class A and Class B stockholders. Each share of Class A or B stock would receive a dividend of two nonvoting Class C shares.
The reclassification would leave public stockholders owning two new nonvoting Class C shares in addition to each of their Class A voting shares. It would similarly grant Zuckerberg an additional 846 million nonvoting Class C shares, which he would be free to sell or donate, with no effect on his voting control.
Several Facebook stockholders filed class action lawsuits in the Delaware Court of Chancery challenging the reclassification and naming Zuckerberg, Facebook and its board of directors as defendants. The lawsuits alleged that the reclassification unlawfully granted Zuckerberg a personal benefit (the ability to sell billions of dollars of Facebook stock without diluting his voting control), at the expense of public stockholders.
The court appointed two institutional investors as co-lead plaintiffs, and their counsel (including this author) as co-lead counsel for the class. The lead plaintiffs were Amalgamated Bank and a Swedish national pension fund, Sjunde AP-Fonden (AP-7), which collectively own more than three million shares of Facebook stock.
Lead counsel pressed for an injunction preventing the reclassification from closing. Rather than let the court decide whether the reclassification posed a threat of “irreparable harm” to stockholders, defendants agreed that the reclassification would not close until the litigation was fully adjudicated through trial and appeals. As required by Delaware law, the reclassification was put to a stockholder vote, which only passed because Zuckerberg voted in favor of it. Of the 1.4 billion minority Class A shares that cast ballots, one billion (71 percent) were voted against the reclassification.
With the reclassification on ice pending trial, the parties commenced discovery. Much of the fact discovery focused on the process by which Facebook’s board evaluated the reclassification and “negotiated” with Zuckerberg. After Zuckerberg proposed that Facebook create the Class C shares to facilitate his charitable giving, Facebook’s board created a “special committee” of supposedly “disinterested and independent” directors to consider the proposal. These directors were Erskine Bowles (Bill Clinton’s White House chief of staff), Susan Desmond-Hellman (the CEO of the Gates Foundation), and Marc Andreessen (founder of Silicon Valley venture capital fund Andreessen Horowitz).
Plaintiffs alleged that neither Desmond-Hellman nor Andreessen were suitable candidates to negotiate against Zuckerberg. Andreessen is a longtime personal friend of Zuckerberg’s, after serving as one of his first Silicon Valley mentors. Andreessen was one of the few people to advise Zuckerberg against selling Facebook to Yahoo! for $1 billion in 2006, a decision that thereafter made Zuckerberg one of the world’s richest people. And Desmond-Hellman knew that rejecting the reclassification and impairing Zuckerberg’s philanthropy would run counter to the mission of the Gates Foundation, which seeks to cultivate and coordinate the efforts of the world’s richest philanthropists.
Discovery revealed that Zuckerberg in fact used his relationship with Andreessen to undermine the special committee process. Andreessen leaked Zuckerberg confidential information about the committee members’ thoughts and concerns, and coached Zuckerberg through his negotiations with the committee. In one instance, Andreessen and Zuckerberg texted back and forth during a group call with the committee, with Andreessen telling Zuckerberg things like, “This line of argument is not helping. J” and “THIS is the key topic.”
Another litigation battleground concerned the parties’ divergent views concerning damages. Defendants argued that like a typical stock split, the enterprise value of Facebook would not change by issuing two nonvoting Class C shares to holders of each Class A share, so the reclassification would cause Class A stockholders no economic harm. Plaintiffs only sought injunctive relief to block the reclassification from closing, so they never sought to quantify with precision the financial damages that would befall minority stockholders, but nonetheless alleged that the reclassification would result in a multibillion dollar harm to Facebook’s Class A stockholders. Even the special committee’s financial advisers had warned the committee that the reclassification posed a risk of “value leakage,” i.e., that Facebook’s Class A shares would be worth less, overall, after the reclassification.
Where would this “leaked” value go? Plaintiffs alleged that the reclassification shifted billions of dollars of economic value from the Class A shares to Zuckerberg. Before the reclassification, Zuckerberg owned 15 percent of Facebook’s economic value, while controlling the company’s voting. After the reclassification, Zuckerberg would be able to sell down to just 4 percent of Facebook’s economics while still controlling 50.1 percent of the voting power.
The plaintiffs’ expert cited financial literature explaining that the greater the “wedge” between a controlling stockholder’s voting control and his or her economic ownership, the less the minority shares are worth. This is because controllers with a large divergence between their economic ownership and voting control are less aligned with the minority stockholders’ economic interests, and historically are more apt to obtain “private benefits of control” for themselves at the expense of the company and its other stockholders. It is not difficult to imagine that Zuckerberg’s attention would be more likely to stray from managing Facebook after he donated billions of dollars to CZI and his economic interest in Facebook fell into the single digits. Under the reclassification, however, Zuckerberg would still control all of Facebook’s affairs.
Plaintiffs were set to prove at trial that the reclassification was unfair to Facebook’s minority stockholders. They would have proved that the process of approving the reclassification was uninformed and tainted by disloyal conduct. And plaintiffs would have proved that the result of the reclassification would be a permanent loss of value to the Class A stockholders.
Trial was set for Tuesday, Sept. 26, 2017, with Zuckerberg slated to testify as the plaintiffs’ first witness. On Thursday evening, Sept. 21, however, Zuckerberg asked Facebook’s board to withdraw the reclassification, which it did. This withdrawal mooted the plaintiffs’ litigation and averted the billions of dollars of harm to Class A stockholders that plaintiffs sought to prevent.
Facebook’s decision to surrender on the eve of trial had far-reaching consequences for corporate governance of controlled companies. Commentators noted that the withdrawal of Facebook’s reclassification likely ended a growing trend of other controlled companies’ founders attempting to adopt similar nonvoting reclassifications aimed at preserving their voting control. When Facebook announced that it was withdrawing the reclassification, Bloomberg News quoted Ken Bertsch, the executive director at the Council of Institutional Investors, who said, “This really is the death knell for existing companies trying to adopt a nonvoting share class.”
Lee D. Rudy represents investors and specializes in corporate governance litigation at Pennsylvania-based Kessler Topaz Meltzer & Check.