Risk & Compliance

For Some Companies, A+B=1

Why Raytheon is combining its two classes of stock.
Lisa YoonFebruary 13, 2001

Raytheon is the latest company to consolidate its two classes of stock.

The Lexington, Mass.-based defense contractor announced earlier this month that it had received a private letter ruling from the Internal Revenue Service allowing the company to combine its Class A and Class B shares into a single class of common stock.

Raytheon’s reasons for the action: Increased liquidity and greater clarity for investors. Good move, say experts.

“[Investment banks], in general, urge companies to get rid of dual classifications and simplify the class structure to keep them more transparent,” says Kenneth Froewiss, a finance professor at New York University’s Stern School of Business.

Indeed, Raytheon’s move is the latest in a trend that has been going on for the past 10 years.

Companies that have consolidated their multi-classes of stock in recent years include Symbollon Corp. (in 1997), Vion Pharmaceuticals Inc. (1998), PacifiCare Health Systems Inc. (1999), Dairy Mart Convenience Stores Inc. (2000), Waddell & Reed Financial Inc. (2000), and, most recently, Continental Airlines (January 2001).

Raytheon’s dual-class structure was established as part of its merger with the defense business of Hughes Electronics Corp., which is part of General Motors Corp. The 1997 merger was done through a Morris Trust transaction, in which a unit (in this case, Hughes’s defense business) is spun off by its owner (GM), and subsequently merged with another company (Raytheon).

Under the law at the time, GM needed to retain 80 percent of the voting rights of the merged stock in order to receive favorable tax treatment on the deal. Since GM owned less than 80 percent of the stock to begin with, two classes of stock were created, one of which enabled GM to retain 80.1 percent of the voting rights (now Raytheon Class A).

According to Dana Trier, a tax partner with law firm Davis Polk & Wardwell, most companies have followed a rule of thumb of waiting five years before consolidating share classes. They feared that converting to a single class too soon after a dual-class structure was created could send a message to the IRS that the company is simply trying to gain tax-free treatment, which might invoke stiff penalties.

But, in 1997 Congress passed a law that quietly did away with Morris Trusts. Among other things, the law requires taxation on any merger that results in more than a 50 percent change in ownership, making the five-year rule of thumb moot. Deals made since the passage of this legislation require only shareholder approval, rather than IRS approval.

Since Raytheon’s deal was made before the law was passed, the company needed IRS approval. Its move, if approved by shareholders at Raytheon’s annual meeting in April, should be applauded by Wall Street, say analysts.

“I think it’s a favorable move,” says Paul Nesbit of JSA Research. “It gives them more liquidity. It also makes them less confusing for investors trying to figure out the difference between the two.”

More stock consolidations could be on the way, he adds. “Any time you can simplify your equity structure, it makes it easier for your investors to understand your company, and therefore it’s a benefit.”

Froewiss agrees. “Investors seem to prefer a cleaner structure where everyone has the same class of shares,” he says. “So from the perspective of an investment banker or someone trying to convince investors to buy the shares, the less distractions there are and the easier and cleaner the story, the better.”

Of course, one reason companies like multiple classes of stock with uneven voting rights is that it helps to discourage hostile takeover bids. However, the same condition that keeps away the sharks also holds down the company’s stock price since investors can’t count on a possible windfall from an acquisition.

“If there are dual-class shares that are structured in a way that diminishes the chance of a takeover bid, presumably the shares will be even less attractive because the management will stay entrenched and they don’t have the discipline in the market to force them to perform,” says Froewiss. “I think in an era in which corporate governance practices have tended to encourage companies to be open to the discipline in the market, the dual-class shares that would preclude a takeover seem somewhat out of step.”

He adds: “Any company wishing to maintain a dual-class should think long and hard as to exactly why they are different, why it makes sense for them when it seems not to be the general rule.”