Directorial fiduciary duties in a tracking stock equity structure: the need for a duty of fairness.

• Author: Hass, Jeffrey J.

INTRODUCTION

If some of Wall Street's financial engineers have their way, an exotic corporate financing tool known as [track]ing stock will be coming to a company near you.

When it does, some experts advise, run for the hills.(1)

Trouble is brewing in the seemingly sedate realm of corporate directorial fiduciary duties. A number of prominent U.S. companies -- including, among others, U S West, Inc., General Motors Corp., USX Corp., and Tele-Communications, Inc.(2) -- have been operating their, businesses using an evolutionary corporate equity structure that employs "tracking" stocks.(3) Like conventional common stocks, these hybrid forms of common stock legally represent an equity stake in a diversified parent corporation. Unlike their conventional counterparts, however, tracking stocks possess carefully tailored attributes that are designed to provide investors with the economic equivalent of an equity stake in a particular business segment or "group"(4) operated by a diversified parent corporation, rather than in the whole corporation.(5)

The advent of such a novel equity structure, in turn, presents unique and formidable challenges to directors that are not faced by directors of corporations with conventional equity structures. These challenges primarily stem from the extensive intergroup conflicts and directorial loyalty concerns inherent in tracking stock equity structures. These conflicts and concerns arise when a parent corporation implementing a tracking stock equity structure artificially divides itself into two or more distinct business groups. Although that corporation strives to present its business groups to the financial community as separate and distinct stand-alone corporations,(6) it remains intact and governed by a single board of directors and executive management team. Not surprisingly, the traditional corporate fiduciary duties of care and loyalty,(7) which were designed to promote due care in directorial decisionmaking and prevent improper self-dealing by directors,(8) fail to address the unique fairness issues raised by these intergroup conflicts and loyalty concerns. The ambiguities caused by this failure are a disservice to both the millions of stockholders holding shares of tracking stock(9) and the directors serving on tracking stock corporate boards.

On the one hand, directors of tracking stock corporations deserve the legal guidance necessary to make corporate decisions and formulate corporate policies giving rise to intergroup conflicts free from unwarranted stockholder litigation. On the other hand, stockholders of tracking stock corporations need legal assurance that these directors, when making business decisions and formulating corporate policies, are considering fully and fairly the needs of the business group to which their shares are linked economically. In addition, these stockholders deserve legal assurance that the individuals serving as directors are "disinterested"(10) from a financial point of view. The need for legal guidance in this area is all the more acute today because several additional corporations have adopted recently, or have proposed adopting, tracking stock equity structures.(11)

Corporate fiduciary law, therefore, needs to evolve to accommodate this novel capital structure development. This author argues that directors of tracking stock corporations should comply with a newly created "duty of fairness" when making decisions and formulating policies that could have disparate impacts on the business groups operated by those corporations. This new duty addresses head-on the intergroup conflicts and directorial loyalty concerns that arise in a tracking stock equity structure. The creation of this new duty is more appropriate than simply creating a judicial gloss on the traditional fiduciary duties of care and loyalty because those duties as currently interpreted can play the same vital role in the corporate governance of tracking stock corporations as they do in the corporate governance of conventional corporations.

Part I of this article briefly describes the key distinctions between a tracking stock corporation and a conventional corporation. It then touches on the reasons why corporations have adopted tracking stock equity structures. Part II articulates the unique legal challenges presented by a tracking stock equity structure. Part III discusses the disclosure that tracking stock corporations have made with respect to these challenges. Part IV briefly summarizes the fiduciary duties of care and loyalty and explores why these duties are ill-equipped to address these challenges. Part V presents the duty of fairness and discusses the duty's elements in detail. In addition, Part V sets forth practical advice as to what tracking stock boards can do today to help minimize their exposure to litigation that may be commenced by disgruntled tracking stock stockholders in the future.

1. TRACKING STOCK EQUITY STRUCTURE -- A PRIMER

   1. Key Distinctions Between a Conventional Corporation and a Tracking Stock Corporation

      A tracking stock corporation and a conventional corporation differ in several material respects. These differences all arise from a tracking stock corporation's attempt to link the performance of each class of its common stock(12) to a particular business group operated by that corporation. The distinctions between a conventional corporation and a tracking stock corporation are revealed by comparing the different classes of common stock issued by a conventional corporation and a tracking stock corporation, the respective voting, dividend and liquidation rights of those classes of common stock, and the corporate governance structure of those corporations.(13)

      1. Classes of Common Stock

         An examination of the classes of common stock issued by a conventional corporation and a tracking stock corporation reveals the most pronounced difference between them. The equity structure of a conventional corporation -- even one with diversified operations(14) -- typically consists of a single class of common stock.(15) The holders of the outstanding shares of that class collectively own the entire equity or ownership interest in the corporation.(16) To the extent the corporation as a whole performs well, shares of that class should likewise perform well regardless of how any particular division or subsidiary of that corporation performs.

         By contrast, a corporation with a tracking stock equity structure must have shares of at least two separate and distinct classes of common stock outstanding.(17) Holders of the outstanding shares of those classes own, in the aggregate, the entire equity interest in the tracking stock corporation. Yet, unlike a class of common stock of a conventional corporation, each class of common stock of a tracking stock corporation "tracks" or "targets" the financial performance of a distinct business segment or "group"(18) operated by that corporation. Such tracking is achieved by inserting specific provisions into a corporation's certificate or articles of incorporation that define the particular rights of each class of tracking stock. In addition, the board of directors adopts certain managerial and accounting policies that foster tracking.(19)

         As discussed below,(20) the goal in implementing a tracking stock equity structure is, in essence, to create a fiction in the investment community. This fiction maintains that a particular class of tracking stock is really common stock of a stand-alone corporation that operates the same type of business as the tracked business group. Tracking stock corporations bolster this fiction by publishing and distributing to the financial community separate audited financial statements of their various business groups.(21) Tracking stock corporations hope that shares of each class will trade in the financial marketplace based directly on how the tracked business group performs and only indirectly (if at all) on the performance of the corporation as a whole. Tracking stocks, however, do not provide stockholders with an outright equity interest in the tracked business group.(22)

      2. Dividend, Voting, and Liquidation Rights

         Holders of common stock of a conventional corporation ordinarily receive one vote for each share on all matters upon which common stockholders are entitled to vote. This right usually is set forth explicitly in the certificate or articles of incorporation of the corporation or, in the absence of such a provision, is granted by the corporate law of the state in which the corporation was organized.(23) Dividends on shares of common stock are payable at the discretion of the corporation's board of directors and then solely out of the funds of the corporation legally available for the payment of dividends, as determined by state corporate law.(24) Upon the liquidation or winding-up of the corporation, holders of common stock share ratably, based on the number of shares held, in any assets of the corporation remaining once creditors and preferred stockholders have received all amounts owed to them.(25)

         The voting and liquidation rights of holders of tracking stock differ significantly from those of holders of conventional common stock. With respect to voting rights, the holders of shares of different classes of tracking stock of the same corporation often have an unequal number of votes per share.(26) Typically, the number of votes per share for one class is fixed at one while the number of votes per share of the other class or classes is adjusted periodically based on either the relative per share values or relative market capitalizations of the various classes of tracking stock and fixed until the next periodic adjustment.(27) Similarly, the liquidation rights of the various classes of tracking stock typically are based on the relative market capitalizations of the various classes of tracking stock at the time of liquidation.(28) Most importantly, holders of a particular class of...