Commentary: Tracking Stocks Are Accidents Waiting To HappenPeter Coy
Microsoft Corp., whose fast-rising shares have consistently outpaced the bull market, is considering a tracking stock? That should give us pause. The logic is straightforward enough: With growth rates in its core software businesses tapering off, the ascent of Microsoft shares could also slow. Why not, then, issue a stock that reflects the growth potential of its newer Internet businesses? After all, everybody's doing it.
Microsoft shares soared on reports of a tracking stock, despite the fact the company has indicated nothing will happen anytime soon. Never might be a better idea. A tracking stock would be a mistake. In fact, that's true for any company embracing the fad for tracking stocks. They are accidents waiting to happen.
Here's the problem: A company that issues a tracking stock creates a conflict for its board of directors and chronic management headaches. Why? Because the interests of the two sets of shareholders are bound to collide. In Microsoft's case, it's easy to imagine conflicts over whether to fund an operating system (the old shares) or an Internet portal (the new shares). "It's a duty-of-loyalty bear trap," says New York Law School professor Jeffrey Haas. "You have one servant, the board, serving two or more masters."
FRIEND OR FOE? A tracking stock is a class of shares of the parent company that are linked to the performance of a particular business--usually the fastest-growing one. General Motors issued the first such shares in 1984 and 1985--"lettered" stocks for its Electronic Data Systems and Hughes Electronics subsidiaries. But it's only in the past year or so that tracking stocks have gotten hot. Among the recent issuers: AT&T; Donaldson, Lufkin & Jenrette; and Ziff-Davis. DuPont Co. is readying a tracking stock for its life-sciences division. Others considering them are General Electric Co. and Walt Disney Co.
Tracking stocks unlock the market value of a new business, much as a spin-off would, while letting management retain control. But by keeping the tracked business in-house instead of spinning it off, the parent preserves the tax advantages and credit quality that come from having diversified businesses with ups and downs that aren't synchronized. Meanwhile, managers of the tracked business can be rewarded with tracking-stock options--a big issue for Disney, which has lost top executives to Internet startups. The tracking stock can also be used to make acquisitions.
But all those advantages pale beside the disadvantage posed by the board's conflicts of interest. Take this warning from DLJ's prospectus for DLJdirect: "The board of directors may make decisions that favor DLJ at the expense of DLJdirect. Due to the extensive relationships between DLJ and DLJdirect, there will be inherent conflicts of interest." For instance, the prospectus goes on to say, "there can be no assurance that DLJ will not expand its operations to compete with DLJdirect." Think about that: The directors supposedly looking out for DLJdirect's interests are reserving the right to compete with it.
EVERYBODY LOSES. There are more immediate conflicts as well: How much investment should go into the high-flying, cash-hungry business, vs. the cash-rich, old-line company? If you say each should stand on its own, then the fast-growing but perhaps money-losing business will starve. But if you provide nourishment from the coffers of the mature business, shareholders of the larger company could justifiably cry foul.
And what happens if one part of the company can't pay back its loans? The other part is on the hook. "They're like financial Siamese twins, attached at the hip through their ownership by the same parent," says New York Law School's Haas.
Sound like fodder for shareholder lawsuits? It is. Delaware Chancery Court recently ruled against holders of GM E and H shares who said that GM had treated them unfairly. The court said that since shareholders had voted for the transactions in question, the plaintiffs didn't have a case. Lawyers for holders of the former E shares are appealing, arguing that GM directors duped the shareholders.
The main reason there haven't been more lawsuits over tracking stocks is that until recently, few tracking stocks existed. That is changing, and without a doubt, train wrecks lie ahead.