Tracking Shares, a valuable tool to enhance companies’ attractiveness in terms of investment – Option Droit & Affaires November 18th, 2020
Column by partner Lionel Lesur and associate Laura Isabelle Danet, from our Corporate-M&A department, published in Option Droit & Affaires n° 515 November 18th, 2020. (Unofficial translation)
Underused under French law, tracking shares nonetheless represent, due to the virtual spin-off it operates within the implementing entity, both a beneficial tool for the valuation of the issuing company and an incentive instrument for the managers. In this respect, the indisputable qualities of the tracking shares, including their flexibility and agility, deserve more attention in the hope of renewing the interest in these shares.
In the context of a sanitary and economic crisis, it becomes even more essential for companies to get the best valuation of their assets in order to increase their attractiveness to potential investors. While companies may implement various classic solutions to this end, these solutions are, for most of them, characterized by a distinct lack of flexibility, an incontestable cumbersomeness and are, for some, irreversible.
However, it exists an alternative, which is sophisticated only in appearance: the so-called “tracking shares”, whose dividend mirrors the financial performance of either a specific business, an operational unit or a simple asset held by the issuing entity that, overlooked in a vast entity, is not adequately put in evidence.
Over the last few years, these shares have been left out of the toolbox companies classically resort to, due to a supposedly complex implementation. Notwithstanding the questions the introduction of tracking shares may raise, companies would, however, be mistaken in depriving themselves of the essential qualities of these instruments, which are unique in our legal environment.
Created by American securities practitioners
The concept of tracking shares emerged in 1984 when General Motors took over Electronic Data Services. The implementation of these tracking shares, as true purchasing currency, granted the purchaser a payment indexed on future financial performances of the purchased company. The originality of these tracking shares lied in the determination of the assessment base of the dividend.
Financial rights attached to the tracking shares only tracked, indeed, financial performances of a specific unit of the purchased entity instead of tracking the overall financial performances of the target. While General Motors appeared as a pioneer, various American companies, such as Parkin Palmer or AT&T, then followed and also implemented tracking shares.
Announced as booming for years, tracking shares never found their place in French law .
A report published by the French Stock Exchange Authority (Commission des Opérations de Bourse (COB)), now the Autorité des Marchés Financiers (AMF) in 2000  and, as soon as the report was published, the issuance by Alcatel, on the first market of ParisBourse and on the NASDAQ National Market, of tracking shares which tracked the financial performances of its “Optronics” branch whose assets were split between a French law governed company and an American law governed company may barely be mentioned.
With the exception of these two events, tracking shares appear to have been set aside by practitioners, despite their well-known liking for flexible and agile solutions. The concept of tracking shares hence appears to be hindered by preconceptions and perceptions that should, at least, be quickly cleared out.
Unjustified reluctance, to say the least
A review of tracking shares’ specific features leads, quite naturally, to their classification in the category of preferred shares, which are very well known by practitioners. When considering them as such, tracking shares entirely comply with the general principles of French company law, provided that a few basic common law rules are followed by the issuer. The latter should therefore ensure that the financial right attached to the tracking shares might not be considered neither as one-sided nor as a fixed interest clause.
Furthermore, tracking shares do not challenge the legal personality of the issuing company provided that their implementation does not have any impact on the legal ownership of the tracked assets but only on the issuing entity’s shareholders.
Lastly, it would not be correct either to consider that tracking shares would damage the affectio societatis. While the rights attached are indeed correlated with identified underlying assets, the contemplated spin-off is only virtual as tracking shares carry equal right to participate in the company’s assets and holding these tracking shares results in the same obligation than holding ordinary shares.
As it stands, there is, therefore, no obstacle in principle which may explain the reason why tracking shares are not currently as successful in France as they deserve, being almost non-existent.
As a consequence, such a failure could only be explained by the perceived practical difficulties as regards their implementation. The major concern with this instrument lies in the definition of the scope which will be used as reference in order to determine as objectively as possible the basis of the remuneration of the tracking shares’ owners. This is, however, precisely the area where tracking shares are able to demonstrate their great flexibility.
The defined scope may cover a business line or an asset held by a sole company or broken down amongst several (French law governed or not) subsidiaries of a same group. The determination and the follow-up of the defined scope may result in the production of appropriate accounting data. As for Alcatel, specific accounts of the tracked branch were produced. This accounting requirement is perfectly in line with the virtual spin-off operated and should not keep the practitioners from seizing this concept given that this requirement does not constitute a difficulty that cannot be overcome.
Just as at the time of the implementation of preferred shares, it will only be necessary to pay special attention to certain potential events such as the transfer of the tracked scope or, as the case may be, the change of control of the entity(ies) holding the tracked assets, the conversion of tracking shares into ordinary shares or the dispute resolutions between the different classes of shareholders.
This means that none of the criticisms levelled against tracking shares appears to be substantial and that their specific features could certainly be beneficial to a widespread audience.
A suitable instrument in times of crisis
Some European countries did not hesitate in implementing the tracking shares mechanism and are now fully benefiting from their potential. The Grand Duchy of Luxembourg was, in this respect, one of the first European countries to successfully develop the concept of tracking shares. As a matter of fact, tracking shares allow for a streamlining of asset management structures through the setup of multiple investments platforms.
Tracking shares, as they virtually carve out and shed a light on an asset which value has not yet been fully perceived by the market, facilitate the asset valuation without any loss of control over it. It would inevitably be the case should an actual spin-off or carve out be contemplated, resulting in growth of the global value of the structure.
By doing so, implementing these tracking shares reduces the formalities to be carried out, prevents any waste of time, allows for decisions to be made quicker and is more cost effective than an actual legal reorganization. The unity of the legal entity remains while the tracked unit keeps benefiting from the operational, financial and tax benefits of the structure it belongs to.
Guided by financial opportunism, tracking shares are an ideal legal instrument due to their flexibility and the possibility of differentiating the corresponding political rights to accommodate the investors’ specific expectations or to enhance the managers’ performance in operations as diverse as share or asset purchases, LBOs or the implementation of incentive schemes. The many leverages (legal, financial, social, as well as in terms of information) triggered by tracking shares should thus prompt practitioners to reconsider their assessment of this instrument.