Dell/EMC Merger Highlights the Return of Tracking Stock and the Associated Corporate Governance and Shareholders Rights Issues

Tracking Stocks Are Now Relics,” declared the Wall Street Journal in January 2008.  Tracking stocks had been the hot trend during the dot-com boom of the late 1990s, when companies sought to take advantage of wild valuations of internet business that they owned.  Recently, however, tracking stock has returned to the news due to its role in the Dell/EMC merger.  Dell, to help pay for the merger, plans to issue tracking stock to track EMC’s interest in VMWare.  Because that tracking stock will be a form of Dell common stock, Dell in essence is returning to the public markets, as noted by UC Berkeley professor Steven Davidoff Solomon in this NYTimes DealBook column.

A tracking stock is a form of common stock that “tracks” or depends on the financial performance of a specific business unit or operating division of a company – rather than the operations of the company as a whole.  Tracking stocks trade as separate securities. Thus, if the unit or division fares poorly, the value of the tracking stock would fall, even if the company at large was doing well.  And vice versa.

Interesting corporate governance and shareholders’ rights issues arise in connection with tracking stock as a result of the limitations inherent to tracking stock:

  • Tracking stock does not entail ownership of the tracked entity’s assets. Rather, for financial reporting purposes the company allocates consolidated assets, liabilities, revenue, expenses and cash flow between the entire company and the tracked entity.  That allocation, however, does not change the legal title to any assets, which remain with the company.
  • It does not confer voting rights on its shareholders, typically.
  • The tracked entity does not have its own board of directors. The board of directors operates the entire company, of which the tracked entity is but one division or business.  The board could make decisions which are good for the company overall, but not necessarily for the owners of the tracking stock.  As a result, conflicts may arise between the board of the company and the shareholders of the tracked entity
  • The tracking stock holders have no right to participate in a tender offer for the common shares of the company (unless the tender also was directed to the tracking shareholders).
  • As a result of the foregoing, owners of tracking stock may lose out on takeover bids and other activity by activist investors. In that sense, a tracking stock resembles the stock of a spinoff with a permanent anti-takeover provision.

A case arising out of the dot com era illustrates some of these issues.  In Sedighim v. Donaldson, Lufkin & Jenrette, Inc., 167 F. Supp. 2d 639, 644-45 (S.D.N.Y. 2001), DLJ had offered tracking stock in its online brokerage business, DLJdirect, in 1999.  The following year, Credit Suisse made a tender for all outstanding common shares of DLJ – but not for DLJdirect.  So while the DLJ shareholders obtained a nice premium, the DLJdirect shareholders missed out.

DLJdirect shareholders asserted claims under Sections 11 and 12 of the Securities Act of 1933, alleging the DLJdirect prospectus misrepresented the rights that DLJdirect shareholders would have in a merger.  They claimed, for instance, that statements such as that “DLJdirect shareholders would be subject to all the risks of an investment in DLJ” suggested DLJdirect shareholders would be entitled to participate in the tender for DLJ common shares.  The plaintiffs also asserted they were entitled to participate in Credit Suisse’s tender under the SEC’s “All Holders, Best Price” rule (Rule 14d-10), which requires that a bidder make its tender available to all holders of the same “class” of securities subject to the tender.  DLJdirect shareholders asserted that because the prospectus described the tracking stock as a part of the common stock of DLJ, they were entitled to participate along with DLJ’s common shareholders. The court rejected this argument, holding that the DLJdirect shares were “vastly different securities with different rights, and trade at significantly different prices in the market.” Id. at 651.  The rule could not be used to “erase distinctions of different types of securities.” Id.

The Sedigham decision highlights the different rights of tracking stock.  In essence, DLJ’s board could properly ignore the interest of the shareholders of DLJdirect in the context of the merger between DLJ and Credit Suisse.  These issues were spelled out in the IPO prospectus for the DLJdirect tracking stock, and despite claims to the contrary its shareholders had no reasons to believe otherwise.  The court granted defendants’ motion to dismiss.

It will be interesting to see whether tracking stocks return in any significant number, and any corporate governance issues that develop – in particular, the nature and scope of the duties owed by a company’s board of directors to owners of tracking stock.

The Comverge Case: Fiduciary Duties and Break-up Fees in M&A

Our partner Richard Renck in Wilmington recently posted an entry on our Delaware Business Law Blog regarding the Comverge case decided last month by the Delaware Court of Chancery.   Among other things, the Court’s opinion provides practitioners and clients with insight regarding break-up fees as well as a road map of  how the Court of Chancery reviews challenges to third-party sale transactions, approved by a disinterested board, under the enhanced scrutiny of Revlon.  Please see Richard’s post here.

Recent Federal Court Decisions Revitalize the Government’s Civil Enforcement Power Under FIRREA

Our partner Marvin G. Pickholz recently co-authored Recent Federal Court Decisions Revitalize the Government’s Civil Enforcement Power Under FIRREA, which appeared in the July/August issue of the Financial Fraud Law Report.

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SEC Ends Losing Streak; Conflict Minerals Rule Upheld

The SEC scored a victory in the U.S. Court of Appeals for the District of Columbia Circuit in a case filed in October 2012 by the U.S. Chamber of Commerce, the Business Roundtable, and the National Association of Manufacturers. The plaintiffs challenged the SEC’s rule on disclosure of the use of conflict minerals on grounds that aspects of the rule were arbitrary and capricious under the Administrative Procedure Act and claiming that the disclosures required by the SEC and by Congress run afoul of the First Amendment. In a 63-page decision in favor of the SEC, the Court found no problems with the SEC’s rulemaking and disagreed that the “conflict minerals” disclosure scheme transgressed the First Amendment.

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Fifth Circuit to Dodd-Frank Whistleblowers: Call the SEC First

The U.S. Court of Appeals for the Fifth Circuit’s decision last week in Asadi v. G.E. Energy (USA) has been hailed as a triumph for employers because it requires whistleblowers who bring retaliation claims under the Dodd–Frank Wall Street Reform and Consumer Protection Act to show that they suffered retaliation because they reported potential violations to the U.S. Securities and Exchange Commission. The Fifth Circuit rejected the position adopted by the SEC in its regulations implementing Dodd-Frank and by the few district courts that have addressed the issue. That rejected approach interprets Section 922 of Dodd-Frank to apply its enhanced protections to certain whistleblowers even if they had not reported their concerns to the SEC. Although this decision narrows the category of employees who can seek the enhanced protections of Dodd-Frank, it will likely increase the number of whistleblowers who report their concerns to the SEC.

Our firm’s client alert regarding the case can be found here.

July 1, 2013 – D-Day for Compensation Committee Approval of Independent Legal Counsel

In theory, a company could be delisted from a national stock exchange as a result of a chance meeting anywhere and a casual conversation, if a compensation committee member receives any legal advice from independent company counsel.  Beginning on July 1, 2013, the listing standards of national securities exchanges and national securities associations mandated by Section 952 of the Dodd-Frank Act become effective.  Under these standards, compensation committees of issuers listed on national securities exchanges will be required to consider specified independence factors prior to the committee’s retention of or obtaining advice from a compensation consultant, outside legal counsel or other advisor.  If the compensation committee, or a committee member, chooses (or just happens) to discuss legal matters with the issuer’s current outside legal counsel, the exchange’s listing standards require the committee to have gone through the process of considering that firm’s independence prior to obtaining advice from such counsel; and neither the federal securities laws nor the exchanges’ listing standards afford a curative provision.

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SEC Says Social Media Can Pass Muster for Regulation FD Disclosures

Yesterday, the Securities and Exchange Commission issued a release and report of investigation announcing that issuers can use social media outlets, such as Facebook and Twitter, to disclose material information in compliance with Regulation FD, so long as investors have been alerted in advance about which social media will be used by the issuer to disseminate such information.

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FTC Revises Hart-Scott-Rodino Thresholds

The Federal Trade Commission announced yesterday that it has made its annual adjustments to the thresholds for determining whether a transaction is reportable under the Hart-Scott-Rodino Antitrust Improvements Act of 1976 and the amount of the related filing fee. The new thresholds were published today in the Federal Register. Under HSR, certain transactions may not be completed until a waiting period (generally 30 days unless extended by a request for additional information or terminated early upon request) has expired after the required notifications are filed.

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New York Comptroller Seeks Qualcomm’s Records on Political Giving; SEC Contemplating Political Contribution Disclosure Rules

A “books and records” action brought by New York’s comptroller to determine how Qualcomm Incorporated “is spending corporate funds in the political arena” may create a precedent for shareholders seeking to force corporate disclosure of political contributions.

The suit was brought last week in Delaware Chancery Court by Comptroller Thomas DiNapoli as trustee of the New York State Common Retirement Fund, a shareholder of Qualcomm. The complaint cites to recent studies concluding that “corporate political spending is negatively correlated with enterprise value” and may indicate “more widespread control and governance deficiencies.”

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SEC Staff Issues Wells Notice to Netflix and Its CEO

The Wall Street Journal and other news outlets reported late yesterday that Netflix, Inc. filed a Form 8-K disclosing that each of Netflix and its CEO, Reed Hastings, had received a Wells notice from the staff of the Securities and Exchange Commission relating to an alleged violation of Regulation Fair Disclosure (FD) in connection with a Facebook post by Hastings on July 3, 2012. Hastings’ Facebook post stated that “Netflix monthly viewing exceeded 1 billion hours for the first time ever in June. When House of Cards and Arrested Development debut, we’ll blow these records away.”

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