Viewpoint: Keeping Conglomerates On-Track –

The issuance of tracking stock as a device to unlock the unrecognized value of distinct businesses contained within a consolidated enterprise is gaining popularity in the New Economy. Recent transactions include those by The Walt Disney Co.’s, AT&T, Cendant Corp.’s, Sprint Fon-PCS, Snyder Corp.’s, Andrx-Cybear, Apollo Group’s Phoenix On-Line and Staples Inc.

First implemented by General Motors approximately 16 years ago when GM issued its Class E and Class H common stock tied to the financial performance of its EDS and Hughes Aircraft subsidiaries, the issuance of tracking stock can enable industry and street analysts to more directly follow the fiscal achievement and ascribe a more accurate value to consolidated businesses with disparate accounting models, capital requirements and performance indicia.

In the case of a publicly traded conglomerate with a single class of voting equity or even in the case of a dual Class A/Class B voting structure the combined prospects and value of the consolidated businesses are inherently subsumed in the market price of the conventional common stock. This is so because each outstanding share will necessarily participate ratably in the dividends and liquidating distributions of the issuer, which, in turn, are strictly dependent on the net earnings and values of a single pool of assets.

From the issuer’s perspective, although there may be some administrative convenience and resulting cost benefits to reporting results and managing the day-to-day affairs of its diverse businesses on a consolidated basis for the benefit of a unitary stockholder base, the market price of the issuer’s stock may be undervalued because it is difficult for analysts and financial experts to focus on the prospects and historical performance of each business segment in a vacuum. In this context, Securities & Exchange Commission segment reporting requirements and accounting on a consolidating (as well as consolidated) basis only goes so far to enhance the market’s understanding and accurate valuation of distinct, yet commonly owned businesses.

This is particularly true in our new economy where issuers have acquired or developed technology-driven businesses that, even if housed within separate consolidated subsidiaries, are co-mingled with conventional businesses and assets. Many of the traditional valuation methodologies employed by street analysts to assess and project the financial performance and fiscal integrity of “bricks”, simply do not translate over to the world of “clicks, hits and bytes”. For example, even in today’s more subdued stock market environment (compared to the preceding 12 months), a viable e-commerce or new media business is still likely to be valued using multiples of historical and projected earnings (and even losses) that would not be accepted by the investing public in the case of a widget business.

Although there may be a variety of reasons for this distinction, if the issuer-owner of the New Economy and widget businesses has outstanding one class of conventional common stock which is tied to the financial performance of both businesses, the stock may never be properly and efficiently valued.

Put another way, each business segment may obscure or disproportionately impact the other – resulting in an under-priced security.

Uncoupling the businesses with separate classes of stock can redress this problem because it enables more focused analyst research and each tracked business is viewed, to a large extent, as a de facto stand-alone entity.

Although this is not a sure-fire recipe for every issuer operating distinct business segments, where there is a high likelihood that the combined, disaggregated value of the parts is greater than the whole, the use of tracking stock can be a very useful mechanism to unlock hidden or unrealized values. Issuer’s with businesses having little or no functional overlap or economic interdependence seemingly would make better tracking stock candidates.

In addition to the objectives outlined above, the creation of tracking stock can also broaden the issuer’s stockholder profile. For example, the risk averse or more conservative investor may favor stock tied to a more traditional, old economy business with a proven history of earnings, dividends and stability. By contrast, the more speculative and proactive investor likely would be attracted to a less predictable and perhaps more volatile business with seemingly unlimited prospects.

Tracking stock also is utilized as acquisition currency. Often, the sellers of a business that is closely held or owned by a super-majority control group, may desire non-cash consideration payable directly upon consummation of the sale or on a deferred basis in the form of an equity earn out. The acquirer also may prefer an equity earn-out or stock component at closing to incentivize the sellers (if they are retained to manage the business) to maximize the performance of the purchased business after ownership has changed hands.

If the purchase price is paid with conventional parent common stock, the value of stock will reflect not only the performance of the sold business and perhaps the entrepreneurial efforts of the sellers, but also the performance of the issuer’s other business units or subsidiaries. The issuance of tracking stock tied to the very business being sold provides the sellers with upside potential that more closely parallels or approximates their original equity investment and can be an attractive inducement for the buyer and sellers to effect the transaction.

The issuance of tracking stock is sometimes referred to as a synthetic or de facto spin-off because it generally achieves many of the same divisive objectives of a true spin-off, with one primary organizational distinction. Unlike an actual spin-off – – which involves the corporate parent’s distribution to stockholders (typically by means of special dividend) of subsidiary capital stock – tracking stock tied to the subsidiary’s performance is stock of the parent and not the subsidiary. Accordingly, the subsidiary remains wholly owned by the parent, tax and accounting consolidation remains undisturbed, and control of the subsidiary has not been diluted or transferred. In the case of a spin-off, the parent’s stockholders wind up owning two classes of conventional common stock with a direct ownership interest in both the parent and the “spun off” entity.

The advantages of a tracking stock structure compared with the economic incidents of a spin-off typically include a lower cost of borrowing because of the larger asset pool available for loan collateral, the allocation of SG&A over a larger corporate enterprise, and the non-taxable nature of the transaction. As to this latter aspect, generally no IRS letter ruling is required to implement the tracking stock structure. So long as the tracking stock is respected as parent company stock, the creation and issuance of tracking stock and the conversion of tracking stock into conventional parent common stock are non-taxable transactions, and the “tracked assets” remain within the consolidated tax group. By contrast, to achieve tax-free treatment of a spin-off, there are a variety of technical requirements (relating to ownership continuity periods, valuations, business purposes of the transaction, etc.) that are not so easily satisfied.

Although there are certain common threads, the characteristics of tracking stock are designed through negotiation subject to the requirements of applicable tax, accounting and legal principles. For example, voting rights can be fixed or variable based upon the market value ascribed to the parent’s tracking and conventional stock. Subject to state corporate law requirements, the tracking and conventional classes of stock can vote together on a blended basis class and/or separately with respect to specific matters, including with respect to extraordinary corporate transactions involving the tracked business segment and in situations where the interests of tracking and conventional stockholders are not aligned. Liquidation rights can be established at a fixed amount per share or vary based upon market valuations.

As with all stocks, tracking stock dividends can be paid only to the extent of legally available surplus. A variety of tracking stocks have a fixed dividend per share equal to the maximum amount legally payable if the tracked business were a stand-alone corporate entity. Many tracking stocks have exchange rights and redemption features triggered, optionally or mandatorily, upon the occurrence of specific corporate events or financial achievements. Exchange ratios can be set a premium above the tracking stock’s market or appraised values. The organizational instruments of some tracking stocks provide for the exchange of the tracking stock into shares of the parent’s conventional common stock or, in some cases, the shares of the tracked subsidiary.

In the latter case, the exchange for subsidiary stock would constitute a true spin-off of the subsidiary. There are a variety of redemption features, including no-call periods, “puts”, premiums, etc. that can be employed. As should be evident from the foregoing illustrations, a great many permutations are possible.

It is important to note that the creation and maintenance of tracking stock structures involves complex fiduciary and corporate governance considerations. As noted above, tracking stock represents stock of the corporate parent and not the tracked subsidiary. Thus, the holders of tracking stock do not have a direct claim against the tracked assets to which their stock is linked and the parent’s conventional stockholders have a residual interest in the tracked business assets that may not necessarily be aligned with the economic interests of the tracking stockholders. Therefore it, is incumbent upon the issuer’s board of directors to adopt well-defined procedures to address issues relating to dividend policies, allocations of resources and expenses among tracked and non-tracked assets, distributions of proceeds upon business divestitures, exchange and redemption policies, and the like. The establishment of a special committee of the board typically is highly recommended to ensure arms’ length dealings on these matters.

In sum, notwithstanding the specter of federal tax initiatives that would tax issuers and stockholders on gains generated by tracking stock issuances and financings and would impose tax consequences on stockholders who acquire tracking stock in certain corporate reorganizations, the implementation of tracking stock capital structures remains a viable alternative to the traditional corporate spin-off and is likely to be used with increased frequency in our new economy.

Clifford E. Neimeth is a partner in the international law firm of Greenberg Traurig, LLP, where he represents public corporations, financial services institutions and closely-held and emerging companies in a variety of contested and negotiated acquisitions and business combination transactions, corporate restructurings, public offerings, venture capital investments and corporate governance and board fiduciary matters.