Internet tracking stocks: The e-share

Practical Law UK Legal Update 5-101-1142 (Approx. 7 pages)

Internet tracking stocks: The e-share

by Anna McCrum, PLC

What is tracking stock?

Tracking stock (also known as "targeted stock", "letter stock"

or "alphabet stock") is a special class of shares with dividends

and/or rights to return of capital linked to a specific segment

of the issuer's business. Quite often the tracking stock gives

investors only a percentage of economic interest, retaining the

remainder for the issue. The procedure does not involve the

creation of a separately listed company as in a demerger and,

therefore, the issuer retains management control over the tracker

stock business.

General Motors is believed to have been the first company to

issue tracking stock when, in 1984, it issued a separate stock

representing its newly acquired Electronic Data Systems business.

So far, most issues of tracking stock have been by way of scrip

issue to existing shareholders or as consideration for an

acquisition rather than to outside investors as part of a

fund-raising exercise. However, this is changing as part of the

purpose of the internet tracking stock is to raise the cash

required to invest in these businesses.

Attractions

The issue of tracking stock offers attractions to companies

whose share price does not fully reflect the underlying value of

different parts of the group's businesses. Since such shares

confer no right to participate in any of the group's other

businesses, the market price of each class of share should more

closely reflect the value of the relevant underlying

businesses.

The advantages of tracking stock include:

The ability to offer shares which appeal more to investors as
a result of being more precisely targeted to their differing
requirements.
Increased investor focus on each business and greater
interest from analysts in the company as a whole leading to an
overall increase in the value of the group.
The ability to offer management incentives (particularly
equity participation) more closely linked to the performance of
specific businesses which should make retention of management
easier.
The creation of an acquisition currency which hopefully will
have an "internet" rating, making deals in that sector less
dilutive.
Lower borrowing costs than on a demerger, resulting from the
stronger credit rating attributable to the company as a whole
rather than each pool separately. The cost of borrowing for an
internet start-up company, if debt financing is available at all,
will be much higher than for an internet subsidiary of a stronger
parent which benefits from the creditworthiness of the group as a
whole.
Simpler, more flexible arrangements for sharing costs or
expertise than on a demerger.

Procedure for issue

Although no UK company has yet issued listed tracking stock

(other than in the context of investment trusts (see "C

shares and S shares: a different class of share", PLC, 1997, VIII(10), 27),

the procedure for issue would be similar to that of any new class

of shares.

The company issues a circular to existing shareholders

explaining the reasons for the issue and giving the financial and

other information about the company required by the rules of the

London Stock Exchange. Because the tracking stock will be a new

class of share, the Stock Exchange rules will require listing

particulars or a prospectus to be produced regardless of the size

of the issue.

This circular will include a notice convening an extraordinary

general meeting of shareholders of the company to pass a special

resolution to:

Increase the authorised share capital of the company by the
aggregate nominal amount of the new class of shares and to create
the new class of shares.
Authorise the directors of the company to allot the new class
of shares. If the tracking stock is to be issued for cash rather
than by rights, a disapplication resolution may also be required
(assuming the tracking stock is equity share capital).
Amend the articles of association to set out the rights of
the new class of shares.

Difficult issues

The US experience of tracking stocks has thrown up a number of

tricky issues that will need careful consideration in the UK

context.

Voting rights. Tracking stocks which have

been issued in the US have usually had floating voting rights,

which would be a novelty in the UK. These work by giving the

holders of the tracking stock a proportion of the total votes of

the company equal to the proportion of the total market

capitalisation represented by the tracking stock. This means that

a shareholder's percentage of the total votes will float up and

down.

In the UK this might, in theory, cause problems with

compliance with the Takeover Code. The Rules Governing

Substantial Acquisitions of Shares (SARs), which are issued by

the Takeover Panel, restrict the speed with which a person may

build up a stake in a company in excess of 15% of the voting

rights. Inadvertently these rules could be breached as a result

of the adjustment made to the voting power of the tracking

stock.

Under the Takeover Code a person may be required to make a

mandatory offer under Rule 9 if he acquires 30% or more of the

voting rights. This could also, in theory, be triggered

inadvertently as a result of the floating voting adjustment

provisions.

Directors' duties and conflicts of interest.

Directors are under a duty at common law to act in good faith in

what they consider to be the best interests of the company

(Percival v Wright [1920] 2 Ch 421). They will need to

be able to justify to all shareholders the benefits of the issue

of tracking stock and each class of shareholder will want to

receive assurance that they will be treated fairly. Where a

company has more than one class of share in issue and where a

decision would bear differently upon the classes, the directors

must act fairly having regard to the interests of both

classes.

In order to reduce the likelihood of any conflict, it will be

important that the rights of the shares set out in the articles

of association make it clear which assets "belong" to the

tracking stock part of the business or group and how business

opportunities are to be allocated as between the two so that both

directors and shareholders are clear on which part of the

business of the whole company falls into which sub-division.

Other steps that should be considered include establishing arms

length arrangements between the two businesses, establishing a

committee to consider issues of potential conflict and make

recommendations to the board, ensuring that the tracker stock

business is housed in a separate out-going with its separate

management and balancing the board's obligations as between the

two businesses.

Distributable profits. The availability of

realised profits for the purposes of making a distribution has to

be determined by reference to the financial position of the

company as a whole, rather than of the tracking stock business

(section 263(3), Companies Act 1985). If a company has

realised profits available for distribution created by the

tracking stock business but a realised loss in its tracking stock

business, the maximum amount which could be distributed would be

the net amount. But the ordinary shareholders might feel

aggrieved if the amount of their dividend was reduced because of

a problem in the tracking stock business or vice versa.

There is little that can be done to combat this other than to

make it clear in the prospectus that this is a risk.

Accounting issues. A company with ordinary

shares and tracking shares will have two separate pools of assets

which must be separately identifiable. Separate accounting

records will have to be maintained for this purpose and the

audited accounts would be expected to show the performance of the

two pools separately.

Rights of creditors. The creation of tracking

stock will not, itself, affect the rights of creditors of the

company. Creditors will have their rights against the assets of

the company as a whole. This is, however, subject to contrary

agreement with the creditor in question; and it would be possible

for a creditor to agree that his rights against the company are

limited to, say, the value from time to time of the assets in the

tracking stock pool. Non-recourse financing by ensuring that the

tracking stock business is within a limited liability entity with

no cross-guarantees would obviously be possible in theory.

Unwind rights. The terms of the tracking

stock could include a mechanism to allow the issue to be unwound

in case managing the two businesses separately becomes too

difficult. This could be done by making the tracking stock

convertible into ordinary shares at the option of the

company.

London Stock Exchange issues. In the absence

of precedent, the London Stock Exchange's formal views on the

implications of a tracking stock on, for example, Class 1

transactions and the contents of the prospectus remains an

unknown.

Pre-emption rights. If both classes of shares

are equity share capital - who could qualify for future cash

issues of shares? Would UK institutional shareholders accept

effective permanent disapplication of pre-emption rights as

between the two classes making them two entirely separate pools

for equity fund-raising purposes?

Anna McCrum, PLC.

End of Document

Also Found In

Resource ID 5-101-1142

Published on 27-Jan-2000

Resource Type Legal update: archive

Jurisdiction

United Kingdom