In this post, we’ll profile an interesting case study that illustrates the potential dangers of owning shares within a dual class share structure where insiders benefit from owning a majority of the class with supermajority voting control.
Recently, for instance, we profiled Urbana Corp (GM:URNAF), which has common shares and A shares. The public shareholders predominantly hold the more liquid but non-voting A shares whereas insiders own a majority of the voting common shares. In this dual share structure, insiders don’t own a majority of the company’s equity, but effectively control the company via owning a majority of the voting shares.
Sometimes, insider supermajority voting control can add value, if an insider can make decisions that may be unpopular to short-term-oriented public shareholders but beneficial for the long-term interests of the company. Other times, as in the case of MIM, supermajority voting shares by insiders can substantially destroy value for public shareholders.
In 2003, auto parts maker Magna Automotive spun off ownership of their real estate assets as MI Developments (NYSE:MIM). In short, MIM owned factories and office space and received steady rental income from Magna Automotive through long term triple net leases. The twist was that the founder and controlling shareholder, Frank Stronach, received 400,000 class B super voting shares in MIM, giving him effective voting control. Also, MIM owned a controlling stake in a money losing horse racing venture dubbed Magna Entertainment (MECA), which was a pet project of Stronach’s. Naturally, Stronach and the management of MIM made promises that MIM’s stable rental income would not be used to finance ongoing losses at the unpopular horse-racing venture.
The firm was spun off in November 2003 for about $23 a share, with firms including David Einhorn’s Greenlight capital taking a large stake in the common Class A Shares.
Below is a chart of MIM shares since the company’s spinoff (click to enlarge image):
Despite assurances to the contrary, MIM made an offer to buy out the remaining stake of the horse racing venture in July 2004. The plan was to use the rental income on the Magna factories to renovate and build out slot machine gaming rooms at race tracks in states that would permit it. Shareholders balked at the proposal. After the typical set of management resignations, Stronach quasi-backed downed and instead had MIM lend the money to MECA. Unsurprisingly, horseracing popularity continued to decline and the expensive renovations failed to pay off.
Over the ensuing years, MIM continued to extend ever-larger loans with ever-lighter covenants. Finally, in 2009, MECA filed for bankruptcy, leaving MIM high and dry for most of the loans.
To resolve the situation, MIM management proposed a reorganization that would pay a $15/share special cash dividend to shareholders by borrowing against MIM’s stable rental income. MIM could then use its position as a creditor to the horse racing franchise to foreclose on the race tracks, which would then be 51% owned by Stronach. Were it not for a concerted legal effort by the shareholders of MIM, the deal would have gone through.
To make matters worse, junior creditors of the bankrupt horse racing franchise sued MIM for the mismanagement. MIM settled for about $100 mil, which was the proceeds from the sale of several of the racetracks auctioned by the court. The remaining racetracks, now valued at only $350 mil, were transferred to MIM. But the story didn’t end there, because Frank Stronach still owned the super voting shares in MIM and he still wanted the racetracks.
Eventually, Stronach got what he wanted. In exchange for his 400k super-voting shares, he received 480k regular shares plus full ownership of the horse racing assets, a deal valued at over $900/Super Voting Share. And should anyone be surprised? Trade democracy for monarchy and well, the king will behave like a king and help himself to the fattest pickings of the fiefdom.
Superior voting control leads to a superior equity claim on the assets of a company, and must be contemplated when evaluating an equity investment in a dual class structure where different share classes have different voting rights. At the time of the spinoff, investors may have been correct in their valuation of MI Development’s assets. But investors should have also asked the following question: just how much did Stronach’s majority voting control detract from the company’s valuation? In some cases, majority voting control can add value. But in the case of MIM, we saw a situation where a control investor’s disregard for passive shareholders was a company’s Achilles heel.