The Journal of Financial Research Vol. XXVIII, No.

2 Pages 197213 Summer 2005

DO TRACKING STOCKS REDUCE INFORMATION ASYMMETRIES? AN ANALYSIS OF LIQUIDITY AND ADVERSE SELECTION

John Elder
North Dakota State University

Pankaj K. Jain
University of Memphis

Jang-Chul Kim
North Dakota State University

Abstract
A firms announcement that it intends to restructure based on tracking stock is usually associated with a positive stock price reaction, at least in the short run. Typically, this reaction is attributed to expected reductions in a diversification discount, through reduced agency costs or information asymmetries. We reinvestigate this latter hypothesis by focusing on the liquidity provided by market makers before and after a firm issues a tracking stock. Our results suggest that such restructurings are not effective at reducing information asymmetries. Rather, firms that issue tracking stocks exhibit less liquidity and greater adverse selection than comparable control firms. JEL Classifications: G14, G34

I. Introduction Tracking stock is a unique form of corporate restructuring in which a multisegment firm creates a new class of shares whose value is linked to a particular business segment. An important feature of a restructuring based on tracking stock is that additional financial disclosures are required, whereby the parent firm (i.e., general division) and the tracked segment (i.e., business group) file separate financial statements with Securities and Exchange Commission (SEC). Some researchers suggest that these additional disclosures may improve the information environment, thereby reducing information asymmetries among investors. The theoretical and empirical evidence on this effect, however, is ambiguous. We detail the issues involved and reexamine the effect of restructurings based on tracking stock on

We thank Matthew Billett (the reviewer), Ken Small, and participants at the 2004 Midwest Finance Association conference for useful comments. Any errors are our own.

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information uncertainties by using market-microstructure-based tools. In particular, we examine changes in the liquidity provided by market participants following the issuance of tracking stocks. Our results contribute to the existing literature on tracking stocks as well as the growing literature on the relation between equity restructurings and market liquidity. Although recent research shows that, ex post, tracking stocks underperform the usual benchmarks either significantly or insignificantly (e.g., Billett and Vijh 2004; Clayton and Qian 2002), initial announcements of an intention to issue a tracking stock tend to increase firm value in the short term. Billett and Mauer (2000), DSouza and Jacob (2000), and Elder and Westra (2000) document positive abnormal returns between 2% and 4% in the days surrounding such announcements. These gains are typically attributed to expected reductions in a diversification discount through reduced information asymmetries or reduced agency costs. For example, Zuta (2000) finds that multisegment firms with tracking stocks have lower diversification discounts than comparable firms, whereas Billett and Mauer (2000) find that such firms tend to have lower diversification discounts before the tracking stock is issued. Harper and Madura (2002) find evidence that the tracking stock structure reduces agency costs in multisegment firms. Several studies investigate the effect of tracking stocks on information asymmetries. The usual premise is that because the SEC requires the disclosure of additional financial statements detailing the performance of the general division as well as the tracked business group, analysts can better focus on the performance of each segment. This increases both the number of analysts following the firm and, because analysts tend to specialize in particular industries, the accuracy of their forecasts. Both of these factors may reduce information asymmetries. There are, however, theoretical and institutional factors that may counter this effect, making the net effect of the tracking stock structure on information asymmetries ambiguous. The institutional factors include accounting and corporate governance issues associated with the tracking stock structure. For example, a tracking stock does not represent a legal claim on the assets of the associated business group. Instead, a tracking stock represents a claim on a fraction of the assets of the consolidated firm, where, in the event of liquidation, the claim typically depends on the proportion of the total market value accounted for by each class of stock. It may therefore be difficult for analysts to value the general division and the tracked business groups based on their liquidation values. A tracked business group is also not governed by an independent board of directors. Rather, the tracked business group is governed by the directors of the parent firm, with the shareholders typically having voting rights that float with the market value of their tracking stock relative to that of the total market capitalization of all classes of common stock for the firm. Such voting rights imply that the directors will answer to at least two groups of shareholders with potentially

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different and competing interests, with the interests of the tracked group subordinate to the interests of the consolidated firm. This aspect of the tracking stock structure may introduce substantial uncertainties about how the tracked business group will be strategically managed relative to pure plays in the same industry and create difficulties in valuing the various business segments as going-concerns. In addition, formal theoretical foundations suggest that restructuring a firm into various business segments does not reduce information asymmetries. For example, multisegment firms may diversify away segment-specific information asymmetries, as formalized by Gorton and Pennacchi (1993). The empirical evidence on whether an equity structure based on tracking stock reduces information asymmetry is mixed. With regard to analyst coverage, DSouza and Jacob (2000) do not find any significant increase in coverage after a firm issues a tracking stock,1 whereas Zuta (2000) and Chemmanur and Paeglis (2000) find increased analyst coverage. Chemmanur and Paeglis interpret their results as indicating that decreased information asymmetries are likely to have a positive effect on firm valuation, at least in the short run. In contrast, Billett and Vijh (2004) measure analyst earnings forecast errors, the dispersion of earnings forecasts, and the market reaction to earnings announcements, each before the tracking stock announcement and after issuance. Their analysis suggests that there is little or no decline in information asymmetry for the general division and some increase for the tracked business groups. An alternative and more direct measure of information asymmetry, however, is based on the liquidity provided by market participants. The extant literature indicates that market makers provide less liquidity during periods of greater information asymmetry, that is, when they perceive a higher probability of trading with more informed traders. For example, Lee, Mucklow, and Ready (1993) find that such adverse-selection costs induce market makers to widen spreads around earnings announcements. Similarly, if a corporate restructuring based on tracking stock affects information asymmetries, it should be possible to discern the sign and magnitude of the effect by examining the liquidity provided by market makers during the relevant period. Similar empirical investigations are conducted, for example, by Huson and Mackinnon (2003) in the context of spin-offs. Given the contradictory theoretical literature, the ambiguous empirical results, and the availability of more direct measures of information asymmetry, further empirical investigation seems warranted. As such, we examine the behavior of liquidity providers before and after a firm issues a tracking stock. If the restructuring effectively reduces information asymmetries through the release of more detailed financial statements on the various business segments, we should expect to see

DSouza and Jacob (2000) argue that the main motivation for issuing tracking stocks is their tax-free nature compared with spin-offs, which create tax liabilities.

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increased liquidity, as measured by narrower spreads, after the tracking stock structure is implemented. If, however, the other aspects of tracking stocks detailed earlier substantially counter this effect, or if such restructurings tend not to reduce information uncertainties for the reasons cited previously, the effect on liquidity after the tracking stock structure is implemented may be negligible, or even negative. We conduct our analysis on the basis of 28 tracking stock issues between 1984 and 2002, using data for liquidity variables from the Institute for the Study of Security Markets (ISSM) at the University of Memphis and the Trade and Quote Database (TAQ) from the New York Stock Exchange. Anticipating the principal results, we find that after a tracking stock structure is issued, there is a relatively small and insignificant increase in liquidity for the general division, relative to a large and marginally significant increase in liquidity for our control sample, which is consistent with documented market trends. Moreover, the adverse-selection component of the total spread increases significantly after firms issue tracking stock. The effects on the tracked divisions are qualitatively similar, although less significant statistically. Tracked divisions have substantially less liquidity and greater adverse selection than a sample of matched control firms. Finally, cross-sectional regressions reveal that the observed effects on the general division are not driven by a subset of firms with particular characteristics. Rather, the effects are systemic throughout our sample. Our results, based on more direct measures of information asymmetry, reinforce the empirical findings of Billett and Vijh (2004). Markets may interpret announcements to issue tracking stocks as value increasing events in the short run, but the actual issue of tracking stocks is not likely to reduce the information asymmetries. More generally, our results are consistent with those of Huson and Mackinnon (2003), who find that spin-offs do not improve liquidity, although our sample is not large enough to discern statistically significant differences between restructurings that improve focus and those that do not. The failure of restructurings based on tracking stocks to mitigate information asymmetries is likely the result of either the additional uncertainties introduced by this unique form of restructuring or the more general failure of corporate divestitures to cause any improvements in liquidity. II. Tracking Stocks Tracking stock, also known as targeted or lettered stock, is a class of common stock whose value is linked to the performance of a specific business group within a diversified firm. Since its introduction in 1984, nearly 60 firms have issued or announced plans to issue tracking stock, with a disproportionate amount in the late 1990s. A common justification for issuing tracking stock is that it unlocks the hidden value of a business segment by separating it, to some degree, from the parent. Since 1998, the tracked business group has often been, or was intended to

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be, an Internet pure play, such as those proposed or issued by Donaldson, Lufkin & Jenrette (DLJ Direct), Staples (Staples.com), New York Times (Times Company Digital), Korn Ferry (Futurestep.com), and others. Despite its increasing prevalence, however, tracking stock is not particularly well understood. The creation of tracking stock for a business group within a diversified firm is nominally similar to spinning off or carving out the division, in that each of the restructurings creates a new security whose value is linked to the associated business group.2 The differences among the three forms of restructuring, however, are considerable. Under both spin-offs and carve-outs a new corporate entity is created with shareholders possessing the conventional rights: the right to elect a board of directors to oversee management, the right to vote on matters of great importance, and a claim against the new entitys net assets. A tracking stock, however, does not represent a new corporate entity. A tracking stock structure is formed by creating a new class of common stock whose value is linked to the performance of a specific business group through special provisions introduced into the firms articles of incorporation. This link is usually strongest through a limited claim on the earnings generated by the division. Typically, the dividends paid to the owners of tracking stock depend on the earnings generated by the tracked group, expressed as function of shareholders equity or net income, although many firms issuing tracking stock indicate that earnings for the tracked group are not likely to be positive in the near future. A substantial complication of the tracking stock structure is that the tracked group may disproportionately share with the parent firm the cost of fixed inputs, such as corporate offices and payroll services, that it otherwise would not share as a separate corporate entity. Another complication introduced by the tracking stock structure relates to the allocation of the firms physical assets to the various business groups. In particular, a tracking stock does not represent a legal claim on the assets of the associated business group. Instead, tracking shareholders typically have a claim on a fraction of the assets of the consolidated firm, where that fraction fluctuates with the proportion of the total market value accounted for by each class of stock. Probably one of the most controversial aspects of a tracking stock is that the tracked group is governed by the directors of the parent firm rather than by its own board. This suggests that the interests of the tracked group will be dominated by the interests of the consolidated firm, potentially introducing serious conflicts of interest (Haas 1996). It also creates the opportunity for considerable cross-subsidization across business groups, either through exposure to the liabilities of the consolidated

Shares in the tracking stock may be distributed either as a public offering, as dividends to existing shareholders, or as currency for an acquisition.

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firm or through purposeful redirection of resources. These features of tracking stock significantly curtail the extent to which a tracked business group can be considered a pure play. Some firms have even indicated the potential for such conflicts in regulatory filings, such as Sprint has with its two tracking stocks, FON Group and PCS Group. These unconventional features may account for the range of opinions expressed in the financial press. Headlines range from numerous claims, including many by practitioners, that tracking stocks unlock value3 to On the Wrong Track: Complex Financial Innovations Like Tracking Stocks . . . Bring Few Benefits to Shareholders.4 More recently, critical press seems to dominate, with headlines such as Sprint Shows Pitfalls of Investing in Tracking Stocks.5

III. Tracking Stocks and Liquidity: Testable Hypotheses Glosten and Milgrom (1985) depict that, in the presence of information asymmetry, market makers earn the bid-ask spread from uninformed noise traders, who trade for liquidity reasons, and lose the difference between the full-information value of the stock and trade price given to informed traders, who trade on the basis of private information. The magnitude of the spreads depends on the proportion of liquidity traders and informed traders, which affects the probability of trading with an informed trader, which is known as adverse selection. Several studies analyze bid-ask spreads to investigate empirically the adverse-selection environment in a market. Lee, Mucklow, and Ready (1993) and Krinsky and Lee (1996) examine earnings announcement effects for the existence of asymmetric information about expected earnings. They find significant and increasing adverse-selection costs around earnings announcements, with market makers widening spreads and decreasing quoted depth immediately before and after earnings announcements. Kim and Verrecchia (1994) argue that spreads widen because earnings announcements provide new information that allows certain traders to make judgments about a firms valuation that are superior to the judgments of other traders. The main hypothesis we test is that if the additional financial disclosures on the tracked business groups effectively mitigate the information asymmetry between informed and uninformed investors, and more generally, if the focusincreasing events reduce information asymmetries, we should expect that bid-ask

Genzyme Tracking Stocks Are Off Track on Returns, June 24, 1999; Firms Turn to Tracking Stocks to Unlock Value of Web Units, July 12, 1999, Dow Jones Newswire; Shares that Track Assets Add Value at a Cost, July 18, 1999, New York Times, p. 3.7. 4 Complex Financial Innovations Like Tracking Stocks Allow Managers to Retain Control, but Bring Few Benefits for Shareholders, May 18, 1999, Financial Times, p. 22. 5 Sprint Shows Pitfalls of Investing in Tracking Stocks, March 7, 2003, Wall Street Journal, p. C1.

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spreadsin particular, the adverse-selection component of spreadsto decrease after a firm issues tracking stock. In contrast, rejection of this hypothesis is evidence that the unique aspects of the tracking stock structure mitigate any effect of increased financial disclosure, or more generally, that corporate divestitures do not to reduce information asymmetries. As discussed previously, both the theoretical and empirical evidence on this hypothesis is ambiguous, although recent empirical evidence, such as that provided by Huson and Mackinnon (2003), suggests it may be rejected. Finally, the magnitude of change in spreads may depend on the motives for the restructuring and the parent firms characteristics. For example, Harper and Madura (2002) find that some firm-specific characteristics related to corporate governance help explain cumulative abnormal returns around a firms announcement of a tracking stock. Such variables may also be associated with changes in liquidity around the announcement and issue dates. We examine this possibility in a cross-sectional regression.

IV. Data Sources and Empirical Method Tracking Stock Issues Our initial sample consists of 28 tracking stock issues occurring between 1984 and 2002, for which ISSM and TAQ data are available. Table 1 catalogs these issues, with the ticker symbol for the general division, the tracked division, and the control firm. The control firms are selected based on a matching procedure, as described later. Because of the accounting irregularities surrounding WorldCom, we exclude it from our analysis, although its inclusion has no significant effect on our results. Liquidity Variables Data for liquidity variables are obtained from ISSM and TAQ. We extract bid-ask quotes, transaction prices, and volume for these firms for every transaction in our sample windows. Our sample windows consist of a benchmark window that is in the range of (100, 93) days relative to the announcement, an issue window that is (0, +1) days relative to the issue of the tracking stock, and two post-issue windows (+13, +14) days and (+30, +31) days relative to the issue of the tracking stock. The recorded announcement date is the date when news of the tracking stock appeared in a printed news source. Each observation in the data file includes the quote date, time stamp, ticker symbol, bid price, ask price, bid depth, ask depth, and exchange code where the quote originated. Our initial sample has more than 1 million quote observations. We

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TABLE 1. Tracking Stock Issuances. Date Issued 1984 1019 1992 0925 1993 0802 1994 1216 1995 0811 1995 0726 1995 0721 1995 1101 1996 0909 1998 0302 1997 0204 1997 0917 1998 1117 1997 1217 1998 1124 1999 0506 1999 0331 1999 0804 1999 0526 1999 1029 1999 1118 1999 0216 2000 0427 2000 0907 2001 0330 2000 0928 2000 1020 2001 0608 2002 0201 Parent Corporation General Motors USX Ralston Purina Genzyme Corp. Tele-Communications Inc. American Health Properties CMS Energy Corp. US West Inco Limited Delmarva Power and Light Circuit City Stores Inc. Tele-Communications Inc. Genzyme Corp. Georgia-Pacific Corp. Sprint Perkin-Elmer Ziff-Davis Quantum Corporation Donaldson, Lufkin & Jenrette Snyder Communications Walt Disney Co. Genzyme Corp. ATT Andrx Cablevision Systems Corp. Apollo Group Inc. Alcatel WorldCom Loews Corp. Notes Acquisition Focus Acquisition Simultaneous Focus Parent Ticker GM MRO RAL GENZ TCOMA AHE CMS USW N DEW CC TCOMA GENZ GP FON PKN ZD QNTM DLJ SNC DIS GENZ T ADRX CVC APOL ALA WCOM LTR Track Ticker GME DGP CBG GENZL LBTYA AHEPZ CPG UMG NVB CIV KMX TCIVA GZTR TGP PCS CRA ZDZ DSS DIR CIRC GO GZMO AWE CYBA RMG UOPX ALAO MCIT CG Control Ticker GE UCL ENE SMED ORCL ABF JR NYN UEP CLN IGL PCCW PAIR AMR AUD TOT GIM PSFT GD IM PEP CNTO SBC CITC USM ASBC PWJ LNC

Acquisition Acquisition

Acquisition Focus Acquisition/focus

Focus

Simultaneous Simultaneous

Note: This table summarizes the sample of tracking stock issuances. The first column gives the issue date and is followed by name of the parent firm; a note on the status of the restructuring; and ticker symbols for the parent, the tracked business group, and the associated control firm. A tracking stock is defined as focus improving if it has a different two-digit Standard Industrial Classification code from the parent.

apply the following data filters, which are standard in the microstructure literature (e.g., Huang and Stoll 1996), to clean the data of errors and outliers: 1. 2. 3. 4. Delete quotes if either the bid price or the ask price is negative. Delete quotes if either the bid size or the ask size is negative. Delete quotes if the bid-ask spread is greater than $4 or is negative. Delete trades and quotes if they are out of time sequence or involve an error. 5. Delete before-the-open and after-the-close trades and quotes. 6. Delete trades if the price or volume is negative. 7. Delete trades and quotes if they changed by more than 10% compared with last tick.

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8. Delete unlisted firms and other firms that are missing in TAQ on any event date. 9. Delete firms that are missing in the Center for Research in Security Prices (CRSP) or Compustat. This filtering process reduced the number of usable observations by about 2%. We compare spreads, volume, number of trades, and an adverse-selection component of spreads for the periods indicated earlier. Spreads are defined as follows: Quoted spread = (Ask price Bid price), (1) Effective spread = |Transaction price Quote midpoint| 2, (2) Percentage (or Relative) spread = Quoted spread/Quote midpoint, (3) Percentage (or Relative) effective spread = Effective spread/Quote midpoint. (4) Quoted spreads represent the ex ante expected costs of trading. Effective spreads reflect the price improvement received in a trade and represent the actual ex post cost of liquidity. Although we present results for both quoted and effective spreads, these two measures should be viewed as alternative expressions of the same concept. Spreads are inverse measures of liquidity, and higher spreads indicate poor liquidity. When an adverse-selection problem is severe, market makers widen their spreads to recover the increased costs of trading with informed traders. To better gauge changes in adverse selection, we use Glosten and Harriss (1988) model to decompose the spread. In their model, the adverse-selection, inventory-holding, and order-processing components are expressed as a linear function of transaction volume. The model can be described in the following equation: Pt = c0 Q t + c1 Q t Vt + z 0 Q t + z 1 Q t Vt + t , (5)

where Qt is a trade indicator that is +1 if the transaction is buyer initiated and 1 if it is seller initiated, Pt is the transaction price at time t, V t is the volume traded at time t, and t captures innovations in public information and specification error. In the model, the adverse-selection component is Z 0 = 2(z0 + z1 V t ), which, if estimated to be negative or greater than 1, is dropped from the sample. The inventory-holding and order-processing components are given by C 0 = 2(c0 + c1 V t ). Employing the usual procedure for trade classification,6 an estimate of the adverse-selection component is
Trades are defined as buys (sells) if the trade price is greater (less) than the bid-ask midpoint. We define the quotes as the most recent quotes that were time stamped at least five seconds before the trade. Changing this interval from five seconds to zero seconds in a robustness test did not affect our conclusions.
6

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Zi =

2(c0,i

2(z 0,i + z 1,i Vi ) , + c1,i Vi ) + 2(z 0,i + z 1,i Vi )

(6)

where Vi is the weekly average transaction volume for stock i. This measure yields the proportion of total spread that is due to adverse selection. To obtain the adverseselection component of the spread in dollar terms, we multiply these proportions by the dollar spreads. Changes in spreads are calculated as the difference between mean value of the liquidity variable over the window of interest relative to the mean value over the benchmark. For example, the abnormal spread (AS) for each firm over the issue window is computed as AS Issue = Issue spread Benchmark spread. (7)

We then perform t-tests to examine whether these differences are statistically different from zero. Robustness Tests To test for robustness, we first use an alternative benchmark window of (14, 13), in addition to the primary benchmark of (100,93), to ensure that our results are not driven by nonrepresentative benchmark windows. These alternative benchmarks yield qualitatively similar results. Second, we add a matched control sample to rule out the possibility that our results are driven by a trend in spreads over time. For each announcement we find a matching firm by employing Huang and Stolls (1996) method. The matching criteria include (1) share price, (2) market capitalization, and (3) volume to minimize the following expression:
3

X iG D
i=1

X iControl

X iG D + X iControl 2

(8)

where XiGD denotes matching variable i for the general division issuing the tracking stock, and XiControl denotes the value of matching variable i for the control stock. We find relatively good matches for each firm in the sample, with composite matching scores of 0.10 or less. Studies adopting this type of matching procedure typically impose a maximum value of 1.00. Table 2 reports the mean, standard deviation, and percentile statistics of share price, market capitalization, and trading volume for the 28 tracking stock issuers and the matched control sample of 28 firms. Table 2 reveals that firms issuing tracking stocks tend to be large in terms of market

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TABLE 2. Descriptive Statistics. Standard Deviation 21.80 23.95 Percentile Min 6.50 6.78 25th 22.23 23.17 50th 35.47 39.69 75th 58.05 50.42

207

Variable

Sample N

Mean 40.56 42.61

Max 91.34 110.53

Share price ($) Issued 28 Control 28 Market cap ($M) Volume (000)

Issued 28 11,640.92 21,166.55 433.97 1,970.35 4,554.35 9,273.43 100,497.25 Control 28 11,088.77 20,061.35 449.48 1,842.26 4,567.46 8,973.59 95,815.10 Issued 28 1,005.77 Control 28 1,000.45 1,310.69 1,323.20 27.20 27.00 227.43 233.60 499.20 432.20 926.60 985.72 5,185.30 4,204.65

Note: This table presents summary statistics on the share price, market capitalization, and trading volume for 28 firms that issued tracking stock, and for the firms serving as matched controls for each sample. To construct the matched control samples, we minimize an objective function over three observable firm characteristics: average share price, market capitalization, and average daily trading volume. The objective function is
2 3 i=1

X iG D X i Contr ol
G X i D + X i Contr ol 2

where X iG Dk denotes the value of matching variable i for each firm issuing a tracking stock, and X iContr ol denotes the same value for each control firm.

capitalization (approximately $4.5 billion) and relatively liquid, with high trading volumes. This is not surprising given that a tracking stock is a restructuring tool for multisegment firms. Cross-Sectional Regressions Finally, we examine whether the changes in liquidity are associated with cross-sectional differences in firm characteristics. In particular, we regress abnormal spreads during the issue window on a dummy variable for whether the tracking stock was issued to finance an acquisition, the dollar value of sales, dollar value of total debt, the ratio of price to earnings, the ratio of market to book value, the dollar value of assets, the size of the tracked group relative to the parent, and a dummy variable for whether the tracking stock was focus improving. We follow Huson and Mackinnon (2003) and define a restructuring as focus improving if the tracked division has a different two-digit Standard Industrial Classification (SIC) code from the general division. These data are obtained from CRSP, Compustat, and Lexis-Nexis. V. Empirical Results Our empirical results are reported in Tables 3 and 4 and Figure I. Table 3 presents the liquidity and volume statistics for the sample of 28 issuers of tracking stock and their controls. The first column indicates the statistic reported,

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TABLE 3. Liquidity and Volume Before, During, and After Tracking Stock Issues. Post-Issue (+30,+31) Minus Benchmark 1.16 0.53 3.95 2.88 0.07 0.09 0.03 0.01 1.70 1.25 3.70 3.03 0.08 0.10 0.05 0.00 14.67 14.79 14.89 0.14 194 220 75 23

Sample

Benchmark (100,93)

Issue (0,+1) 16.35 16.67 15.09 13.96 0.50 0.50 0.62 0.42 12.64 13.16 10.49 10.96 30% 31% 28% 22% 83.15 89.29 57.33 41.31 652 683 521 735

Post-Issue (+13,+14) 15.81 16.40 13.22 13.84 0.47 0.46 0.51 0.43 12.27 12.58 10.86 10.86 28% 29% 27% 21% 60.27 56.74 75.81 37.25 566 572 544 662

Post-Issue (+30,+31) 15.68 16.23 13.27 14.34 0.47 0.46 0.52 0.47 11.88 12.36 10.23 10.86 27% 28% 26% 22% 58.45 54.93 73.96 37.29 677 700 573 659

Quoted spreads (cents) Issued 28 16.84 Nonfocus 23 16.76 Focus 5 17.11 Control 28 17.22 Relative quoted spreads Issued 28 0.54 Nonfocus 23 0.55 Focus 5 0.49 Control 28 0.46 Effective spreads (cents) Issued 28 13.58 Nonfocus 23 13.61 Focus 5 13.93 Control 28 13.89 Adverse selection (% of total spread) Issued 28 19% Nonfocus 23 18% Focus 5 31% Control 28 22% Average daily volume ($ millions) Issued 28 43.78 Nonfocus 23 40.14 Focus 5 59.07 Control 28 37.15 Average number of trades Issued 28 483 Nonfocus 23 480 Focus 5 498 Control 28 682

Note: This table reports three measures of liquidity (spread, percentage spread, and effective spread), a measure of adverse selection, and two measures of volume (dollar volume and number of trades) for two samples: the sample of 28 firms implementing the tracking stock, and the 28 firms serving as a control sample. The measurement windows include the benchmark window (100,93) days before the announcement and three windows relative to the actual issue: (0,+1), (+13,+14), and (+30,+31). The final column reports the difference between the post-issue value (+30,+31) and the primary benchmark value (100,93).

Significant at the 1% level. Significant at the 5% level. Significant at the 10% level.

the second column indicates the sample, and the third column indicates the number of observations. The remaining columns indicate the respective windows over which the liquidity and volume statistics are calculated. For example, the fourth column reports the statistics over the benchmark period, the fifth column reports

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TABLE 4. Cross-Sectional Regression of Liquidity During Issue of Tracking Stocks. Variable Intercept Acquisition Sales Total debt PE ratio Market-to-book ratio Total asset Relative size (track/parent) Nonfocus dummy N R2

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Post-Issue Spread Minus Benchmark Spread 0.0163 (0.43) 0.0396 (1.10) 0.1567 (1.27) 0.0001 (0.08) 0.0582 (0.66) 0.0003 (0.15) 0.1278 (1.16) 0.0156 (0.31) 0.0291 (0.84) 28 0.21

Note: This table reports the results of a regression of the abnormal spread during the issue window on variables related to firm and event characteristics. The variables related to the firm and event characteristics are a dummy variable equal to 1 if the tracking stock was issued to finance an acquisition, and 0 otherwise; dollar value sales; dollar value of total debt; ratio of price to earnings; ratio of market value to book value; dollar value of assets; a variable for the size of the tracked group relative to the parent; and a dummy variable for whether the tracking stock was focus improving. A tracking stock is defined as focus improving if the tracking stock has a different two-digit Standard Industrial Classification code from the general division, and nonfocus improving otherwise.

Significant at the 1% level. Significant at the 5% level. Significant at the 10% level.

the statistics over the post-issue period, and the last column reports the change in liquidity resulting from the issue of tracking stock. For the sample of 28 firms issuing tracking stock, the mean quoted spread over the benchmark window is 16.84 cents, or 54 basis points; the mean effective spread is 13.58 cents. Mean daily volume is about $44 million in an average of 483 trades. We report spreads and volume at issue and at 14 days and 30 days after issue, but we focus on the spread and volume measures 30 days after issue. At these times, the parent company has submitted all the regulatory filings and made the necessary accounting disclosures, breaking out the results for the general division and the tracked business group. If the net effect of these additional disclosures, relative to the other aspects of the tracking stock structure discussed previously, is to reduce information asymmetries, we should observe significantly lower spreads.

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The data indicate, however, that quoted spreads for the sample of firms that issued tracking stock are not statistically different from those during the benchmark period. Although there is some decline in the quoted spread, the decline is not statistically significant. In contrast, the decline in quoted and effective spreads for the control group is about double in magnitude and statistically significant for both. For example, the quoted spreads for the control group decline from 17.22 during the benchmark period to 14.34 during the post-issue window, and this drop of 2.88 cents is statistically significant at the 10% level. The drop in spreads for the group of firms that issued the tracking stock is much smaller (about 1.16 cents) and is not significant. Similar quantitative results are obtained for effective spreads (3.03 cent drop for the control group vs. 1.70 cent drop for firms implementing tracking stocks). Note also that the lack of significance for changes in the relative spread is not surprising, given that before decimalization market makers tended to quote absolute spreads that, for example, clustered around 1/8 and 1/16 with small variations relative to the underlying share price. This tends to make the sample variance of the relative spread much greater. Thus, statistical tests applied to measures of the absolute spread are most appropriate for detecting changes in spreads over our sample. Such a decline in quoted and effective spreads for the control group is not surprising, given the documented effects (cf. Jones 2002) of alternative trading mechanisms and reductions in tick size that were implemented over our sample. Note that a direct comparison of the magnitude of the decline in our control sample with published sources such as Jones (2002) is not possible because our sample is in event time rather than calendar time. However, the magnitude of the decline in our control sample is not inconsistent with published sources, suggesting that our control sample is approximately representative of market trends. The sharp decline in spreads from the control sample relative to the tracking stock sample reinforces the conclusion that implementing tracking stock has not reduced, and may tend to increase, information asymmetry. There is a larger decline in spreads for tracking stocks that were focus improving, in contrast to the analysis of spinoffs by Huson and Mackinnon (2003), although our statistical tests on this item suffer from low power because of the few observations (only five focus-improving restructurings). The most striking result is that although the spread measures drift lower, in absolute terms, at issue, the proportion of the spread due to adverse selection actually increases. Moreover, the indicated increase in the adverse-selection component is large in magnitude and significant at the 1% level. During the benchmark window, the adverse-selection component of the spread is 19% for the sample of firms that subsequently issued the tracking stock. At issue, the adverse-selection component of the spread is 30%. Thirty days after issue, the adverse-selection component is still 27%, significantly different from the benchmark at the 5% level. For the control sample, the adverse-selection component is virtually unchanged at 22% from

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3.5 3 2.5 2 1.5

211

Spread: Sample Minus Control Adverse Selection: Sample Minus Control

Cents

1 0.5 0

-9

-8

-7

-6

-5

-4

-3

-2

-1

10

11

12

13

14

-15

-14

-13

-12

-11

-10

Announce

-0.5 -1 -1.5

Days Before Announcement/Days After Implementation

Figure I. Difference in Total Spread and Adverse-Selection Implementation Sample Minus Control Sample. This graph plots the difference in total spread and adverse selection for a sample of firms that issued a tracking stock and a sample of control firms matched by share price, market capitalization, and volume. The data are reported for the 15-day period before the announcement that a tracking stock would be issued and the 15-day period after the tracking was issued. The intervening period, which varies for each firm, is represented by the time-series average across the sample and is labeled Ann to Imp.

the benchmark to the issue windows. With regard to the focus-increasing versus non-focus-increasing sample, the unfavorable effect is most severe for non-focusincreasing restructurings, but it is difficult to make a conclusive determination on this issue because of the small sample sizes. Figure I reinforces these points. This figure plots the difference, for firm issuing tracking stocks versus the control sample, in both the total spread and the adverse-selection component of the spread (in cents). Before the announcement window, the two lines fluctuate around zero, whereas just before the announcement both the difference in spreads and the difference in adverse selection tend to increase. After issue, the difference remains positive, fluctuating between .5 cents and 2 cents. We also examine spreads and the adverse-selection component of spreads for the tracked divisions after issue and find similar qualitative results, although they are less significant statistically. That is, tracked divisions tend to have less liquidity and greater adverse selection than a sample of control firms matched by the procedure described in section IV. We conclude from this analysis that the information asymmetries introduced by tracking stock restructurings are likely to outweigh any benefits obtained from additional financial disclosures. Our results, based on more direct measures of information asymmetry, reinforce the empirical results of Billett and Vijh (2004).

Ann to Imp

Implement

15

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The Journal of Financial Research

Markets may have interpreted announcements to issue tracking stocks as valueincreasing events in the short run, but the actual issue of tracking stocks is not likely to improve liquidity or reduce the information asymmetries affecting multisegment firms, and it may increase the information asymmetries. Finally, in Table 4 we report the results of the cross-sectional regression, where the dependent variable is the change in spreads during issue window, and several firm- and event-specific characteristics are used as independent variables. The regression explains 21% of the variation in the dependent variable, although none of the individual firm-specific characteristics is statistically significant. This suggests that the observed variation in spreads is not driven by a subset of firms with particular characteristics. Rather, the effects are systemic throughout the sample of firms that have implemented the tracking stock structure.

VI. Conclusion Several studies investigate the effect of tracking stocks on information asymmetries. The usual premise is that because the SEC requires the disclosure of additional financial statements detailing the performance of the general division as well as the tracked business group, analysts can focus better on the performance of each segment. This would increase both the number of analysts following the firm and, because analysts tend to specialize in particular industries, the accuracy of their forecasts. Both of these effects should reduce information asymmetries. There are, however, theoretical and institutional factors that may counter this effect, making the net effect of the tracking stock structure on information asymmetries ambiguous. We explore these issues and reexamine the effect of tracking stocks on information uncertainties by using a relatively new data set and microstructure approach. Rather than examining the behavior of equity analysts, which produces some conflicting results, we examine the behavior of market makers, who provide liquidity to the market by posting bid and ask prices. If tracking stocks reduce information asymmetries, market makers should respond by providing additional liquidity to the market. Our results, however, indicate only a marginal increase in liquidity for the general division after a firm issues a tracking stock, relative to a large and significant increase in liquidity for our control samplea trend that is at least consistent with documented marketwide effects. In addition, the adverse-selection component of the total spread significantly increases as a firm implements the tracking stock structure while remaining essentially flat for our control sample. Similar qualitative effects are observed for the tracked divisions relative to a sample of matched control firms, although the difference is not statistically significant. We conclude that the actual issue of tracking stock is not likely to significantly reduce the information asymmetries affecting multisegment firms. Rather,

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the uncertainties induced by the tracking stock structure substantially mitigate any potential benefits associated with more detailed financial disclosure and may even increase information asymmetries.

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