Dear Dagen: What Happens to Tracking Stocks in Bankruptcy?

Also: Do shareholders of the parent company get shares of a newly created tracking stock?
Author:
Publish date:

Tracking stocks have emerged as one of the trendy financial products of 1999 -- even though few investors seem to know exactly how they work.

Following my

recent column on them, a few readers admitted their confusion and raised some interesting questions.

Share your investing and mutual fund questions on the

Dear Dagen board

"It sounds like it's some mysterious entity that doesn't really own anything, but people pay money for," writes reader

Richard Buck

.

Adds reader

Atit Desai

: "I'm not clear on what you own. If you really have no rights and recourse, then basically you are just placing a bet on a number."

You're right. You don't really own anything. Tracking stocks, unlike traditional common stocks, do not provide equity ownership and only track the performance of a designated segment of a corporation. Plus, tracking shareholders usually have limited voting rights or none at all, while common shareholders get full voting rights.

That raises another question: "If the company goes into bankruptcy, what are the rights of the holders of the tracking stock?" asks Desai.

In a bankruptcy, creditors and bondholders get paid before the stockholders. Secured debt, like a building's mortgage, is paid first. Payment of senior debt comes next, followed by junior or subordinated debt.

Assuming a company goes bankrupt and there isn't enough money to go around to pay off all the creditors, the effect would be the same for both sets of stockholders (owners of the original stock and of the tracking stock).

Both groups get nothing.

If there is indeed something remaining after the creditors are paid, the picture gets murkier. Each tracking stock is structured somewhat differently, and the effects will vary slightly. However, there's the possibility that holders of the tracking stock will wind up at the bottom of the food chain.

"I presume the tracking stock cannot file for bankruptcy only the parent can?" Desai continues.

The division or group that the tracking stock follows cannot technically file for bankruptcy on its own. Although it has its own separate set of books, the tracking stock doesn't exist as a separate corporation and is still, after all, part of the original company.

The company's original stock and the tracking stock share a common board of directors, which has an obligation to protect both groups of shareholders. However, a catastrophe at one of the divisions certainly could hurt the other group of shareholders. Both divisions share a joint obligation on liabilities.

If the balance sheet of the tracked business is depleted, action would certainly be taken. "In order to protect the other shareholders of the company, at some point it's incumbent upon board of directors to act similarly to the way that a bankruptcy trustee would operate," says Ron Gallatin, senior advisor to

Lehman Brothers

.

That could mean a reorganization to keep the business viable or a total liquidation.

This is entirely a theoretical discussion. No tracking stock has ever gone under in this fashion.

Picking Up a Tracking Stock

Reader

Mike Pandoli

wants to know, "If a company creates a tracking stock, do the shareholders of the original stock receive shares of the tracking stock?"

Maybe. Maybe not.

"It just depends," says Diane Garnick, equity derivatives strategist at

Merrill Lynch

. "Part of the frustration is that each one is set up a little differently."

A company may issue shares of the tracking stock only to existing common stockholders, to the public at large or to a combination of the two.

AT&T

(T) - Get Report

, for example, plans to conduct an initial public offering of tracking shares in its wireless business in the spring, and will also distribute shares of the tracking stock to AT&T's common shareholders. The company says less than 20% of the wireless division's shares will be offered in the IPO. The rest will go to AT&T shareholders.

When

Ziff-Davis

(ZD)

unleashed a tracking stock for its Web properties earlier this year, it sold

ZDNet

(ZDZ)

to the public but did not distribute shares to Ziff-Davis shareholders. At the time of the IPO, Ziff-Davis retained 84% of the ZDNet shares and sold 16% of them to the public.

Ziff-Davis shareholders probably aren't lamenting their lack of ZDNet shares. The tracking stock is down 38% since the close of its first day of trading.

Send your questions and comments to

deardagen@thestreet.com, and please include your full name.

Dear Dagen aims to provide general fund information. Under no circumstances does the information in this column represent a recommendation to buy or sell funds or other securities.