Issuance of Tracking Stocks by Privately-held Companies

Definition von Tracking Stocks:  Common stock issued by a parent company that tracks the performance of a particular division without having claim on the assets of the division or the parent company. Also known as „designer stock“. Eine Aktiengattung, wie es sie so in Deutschland nicht gibt. Einmal mehr waren die Gesellschaftsrechtler des angelsäxischen Rechtssystems sehr kreativ…

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By Andre Perey (Blake, Cassels & Graydon LLP). Canada

What are the primary drivers of the lack of use of Tracking Shares?

Given the short lifespan of Tracking Shares in the US and the few examples of use of Tracking Shares in Canada, it is useful to consider the primary difficulties with this type of structure.

First, and foremost is the potential conflicts of interests which will inevitably be faced by the directors of a Tracking Share issuer.  Since the Tracked Unit underlying the Tracking Shares remains part of the greater company, under the control of the same board, there may be instances in which different classes of shares will have divergent interests.  As a director’s fiduciary duty is to the company itself, it is not clear how directors would resolve such conflicting interests among equity holders.

Second, given that a Tracking Share remains part of the company, they are generally subject to the same risks as investments in the company as a whole.  Should the company face liquidation or bankruptcy, the assets of the Tracked Unit will be available alongside the assets of the company as a whole to satisfy the outstanding obligations to creditors.[1]

Third, it can be difficult to appropriately value the Tracked Unit.  This is a particularly pertinent issue with respect to private companies.  Any rights (see discussion below) which rely on the relative market value of the Tracked Unit in comparison to the company as a whole would require the company to rely on a market value estimation method or engage a professional business valuator (which would be costly and could lead to protracted disputes).

Finally, issuing Tracking Shares creates significant complexity in the corporate structure of the company.[2]

What are the common features of Tracking Shares when they are used?

1) Priority on liquidation, dissolution, or wind-up:

Tracking Shares do not typically impact the priority positions of creditors or preferred shareholders.  The rights of these shares to the distribution of surplus funds upon liquidation, dissolution, or wind-up are typically based on one of two types of ratios: 1) a pre-determined or fixed ratio; or 2) a variable ratio based on the size of some characteristic of the Tracking Shares relative to the corresponding characteristic of the entire company.  For example, USX employed a variable ratio in the liquidation rights of its Tracking Shares which was based on the market value of the Tracked Unit relative to the market value of the rest of the company.[3] Inco also used a variable ratio but based it on the total VBN shares outstanding relative to the aggregate number of VBN and common shares combined.

Nuinsco demonstrated that these are not the only options however, as its authorized Tracking Shares (Special Share Classes A, B, C, D, and E) rank senior to the company’s common shares with respect to the assets of each class’ Tracked Unit in the event of liquidation, dissolution, or wind-up.[4]

2) Conversion Rights:

Tracking Shares may carry conversion rights at the option of their holders.  For example Inco’s VBN shareholders were entitled to convert into common shares upon the sale of all or substantially all the assets of VBNCL, or upon Inco holding less than 76% of the outstanding shares of VBNCL.

More extensive conversion options may also be available.  For example, it is common for companies issuing Tracking Shares to retain the right for the board to exchange the Tracking Shares for ordinary common shares (normally at a premium) either at the board’s discretion, or after a certain period of time has passed.[5] Constating documents often also enable the company to exchange its Tracking Shares for shares of a subsidiary should it transfer the assets and liabilities of the Tracked Unit into that subsidiary.  In addition, a company’s charter will typically carry a mandatory exchange provision effective upon the sale of all or substantially all of the assets of the Tracked Unit, again, normally at a premium (Inco had such a conversion right).

3) Redemption and Retraction Rights:

In cases where there is no mandatory exchange provision upon a sale of the Tracking Unit, the company’s constating documents may include a provision requiring the company to pay out a dividend on the Tracking Shares in the amount of the proceeds of the sale.

4) Voting Rights:

The voting rights to which Tracking Shares are entitled range from none to full voting rights on par with those of common shareholders.  There are effectively two possible voting right formats.  First, there is a fixed vote per share.  This may be a single full and equal vote per share (as in the case of Inco’s VBN Shares), or it may be a fraction of a vote per share (as in the case of GM’s Class E shares).  Second, the Tracking Share’s voting right per share may be variable and dependent upon an underlying characteristic such as the market value of the Tracking Shares relative to the ordinary common shares.

5) Dividend Rights and the Inclusion or Exclusion of the Tracked Unit by common shareholders:

There are generally two types of Tracking Shares: 1) Close Tracking Shares, which include an entitlement to dividends derived from the profits of the Tracked Unit (as if it were a stand-alone entity), to the exclusion of common shareholders whose dividend entitlement is derived only from the profits of the other divisions of the company; and 2) Loose Tracking Shares in which the company (and thus the common shareholders) maintain an interest in the Tracked Unit, participating in the Tracked Unit’s success along with the Tracking Shares.  Inco’s VBN Shares, which were entitled to dividends reflecting a 25% interest in the adjusted net income of VBNCL, are representative of Loose Tracking Shares.

Under Inco’s structure, VBN shareholders would only receive dividend if one was so declared (at the discretion of the directors).  The VBN Shares carried no preference or priority in entitlement to receipt in comparison to Inco’s common shares.  One or both of VBN and common shares could have a dividend declared depending on the performance of the underlying business.  However, up until August 2006, if a dividend was declared on the common shares, the VBN Shares were entitled to a minimum dividend of at least 80% of the common share dividend.

VI. Conclusion and Recommendations

Given the difficulties inherent in the use of Tracking Shares there are certainly grounds for concern about the use of Tracking Shares as part of the structure for investment into a private company.  However, it may be possible to design sufficient safeguards to overcome the difficulties with Tracking Shares to allow such shares to work in this context, including the following:

1.      adoption of arm’s-length agreements between the issuer and the holders of the Tracking Shares to define how inter-company transactions will take place (addressing the determination of transfer prices, allocation of resources, division of proceeds upon the sale of assets, and the apportionment of various head-office and entity level expenses);

2.      creation of a special committee of the company’s board of directors to oversee the operations of the Tracked Unit;[6] and

3.      provision of a right for Tracking Shareholders to appoint directors to the company’s board (the difficulty with this being that the directors may not be satisfying their fiduciary duties if they are acting solely in the best interest of the Tracking Shareholders).[7]



[1] Note:  For example, Pittston Co. converted all three of its Tracking Shares into a single class of common shares as there was concern that the price of shares of one Tracked Unit were being greatly reduced by the large liabilities existing in the other Tracked Units. (Source: Governance Analytics, Pg. 4.)

[2] Note: When converting its VBN Shares back to common shares, Inco’s President cited many of these reasons stating that the company needed “maximum flexibility in how we choose to configure, finance and sequence major capital projects” and that retiring the VBN Shares will mitigate “potential conflicts, simplify [Inco’s] capital structure and maximize [its] strategic options”. (Source: Inco News Release dated September 6, 2000, Pg. 1.)

[3] Source: Governance Analytics, Pg. 4.

[4] Source: Nuinsco Resources Limited Management Information Circular dated May 11, 2006

[5] For example, Inco was permitted to convert its VBN shares at a premium of 120% premium after a 10-year period had expired.

[6] Source: Governance Analytics, Pg. 3.

[7] Note: Inco’s VBN Shares were entitled to vote as a class to elect to directors to the company’s board.

Andre Perey Partner | Blakes andre.perey@blakes.com

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