USX Corporation and Associated Teaching Note Stuart C.

Gilson Harvard Business School Jeremy Cott affiliation not provided to SSRN

Case No.: 9-296-050 Teaching Note: 5-298-085 REQUESTS FOR COPIES: To receive a copy of this case, please contact Harvard Business School Publishing, 60 Harvard Way, Boston, MA 02163. Phone: (800) 545-7685 . E-Mail: MAILTO:custserv@hbsp.harvard.edu or you may contact Stuart Gilson by E-Mail: MAILTO:sgilson@hbs.edu USX Corporation, a large diversified steel and energy firm, is pressured by a corporate raider to spin off its steel business in order to increase its stock price. As an alternative to the spinoff, management proposes replacing the company's common stock with two new classes of "targeted" stock that would represent separate claims against each business segment's cash flows, allowing the stock market to value each business separately (and more accurately). A targeted stock structure differs from a spin-off, in that the firm remains a single legal entity, and there is no physical separation of its assets. This case gives students an opportunity to discuss how the terms of targeted stock should be set to maximize the market value created. The issues ar e complicated. For example, it may be desirable to limit management's discretion to allocate corporate overhead expenses, which will affect how the firm's earnings are distributed between different targeted stock classes. The relative voting power of different targeted stock classes will also have to be adjusted by some formula when the relative market values of the shares change. And shareholders may wish to give management the option to undo the targeted stock structure at some future date if circumstances warrant. The case challenges students to critically assess the merits of targeted stock, and discuss whether pure financial restructuring can create value when a firm has fundamental business problems. One can question how much targeted stock truly helps investors value a firm's business segments, since segment earnings and dividends will be affected by how management allocates corporate overhead and sets transfer prices for inter-segment transactions. In addition, targeted stock may not completely address the firm's agency problems, because managers' control over corporate assets is unchanged.

D. Logue, J. Seward and J.P Walsh, Rearranging Residual Claims: A Case for

Targeted Stock, (Financial Management, Spring 1996).

Corporate restructuring activity has grown substantially in recent years as top managers struggle to improve firm performance and enhance shareholder value. In part, these transactions reflect an overall trend toward greater corporate focus. Although a variety of techniques exist for repackaging corporate assets, liabilities, and equity ownership, the underlying motivation for this recent trend seems to be improved incentives for shareholder monitoring of management decisions. For example, share prices react positively to the announcem ent of transactions in which 1) excess cash is distributed to shareholders; 2) unrelated businesses are sold or liquidated; and 3) existing assets are reallocated into new organization forms with new equity ownership structures. Implementation of these tra nsactions has been accomplished through both debt -based and equity-based methods of restructuring.

Many of these restructuring decisions have been predicated on the findings of financial economics research that documents the important role of leverage -based transactions (i.e., leveraged recapitalizations, debt -financed share repurchases, and leveraged buyouts) in re-directing free cash flows to investors and away from negative-Net-Present-Value investments. There are, however, limitations on the extent to which leverage-based transactions can feasibly be used by corporations. For example, if leveraged -based transactions are designed primarily to reduce a manager's propensity to squander excess free cash flows, then only those companies generating excess ca sh from existing operations can benefit from this type of transaction. Moreover, as Myers (1977) argues, organizations holding significant intangible growth options are not good candidates for debt financing. Although some firms are unable to take on large amounts of incremental debt, they may still benefit from restructurings designed to improve operating performance, enhance corporate financing opportunities, and strengthen management incentives to pursue share-price-maximizing decisions. This type of company is more likely to be a candidate for an equity -based form of restructuring.

While the economic benefits of leveraged transactions have been studied extensively (see, for example, Jensen, 1989), there has been somewhat less investigation of equity-based restructurings, such as spin-offs, equity carve-outs, and dual-class recapitalizations. Given the increased use of equity -based restructurings recently, these latter types of transactions deserve more extensive theoretical and empirical examination. In this paper, we describe and analyze a relatively new method of equity -based restructuring known as "Targeted Stock." In contrast to equity reorganization

methods that result in the complete or partial separation of subsidiary assets from the parent organization (such as spin-offs or equity carve-outs), a Targeted Stock structure retains the consolidated organizational form. Consequently, on this dimension, Targeted Stock possesses some features similar to a dual class common stock structure. Targeted Stock differs from a dual class recapitalization, however, because voting rights are not reallocated to concentrate majority ownership among insiders. Rather, voting rights in a Targeted Stock structure remain largely under the control of public investors and float in proportion to the market value of the underlying businesses. Moreover, each Targeted Stock tracks the performance of a particular business unit; Targeted Stock does not result in differential per -share voting rights or cash flow distribution. Clea rly, all forms of equity reorganization are not alike. Targeted Stock is controversial. For instance, when U.S. West announced that it would issue shares in its telephone business and in its cable business, the reaction on Wall Street was quite mixed (see Pulliam and Lepin, 1995). Although U.S. West stock rose by roughly 1.5% on the day of the announcement, one portfolio manager declared that "if [U.S. West] announced a [spin -off instead of a Targeted Stock] the stock would have been up multiples of dollar s rather than fractions of a dollar" (p. C15). In this paper, we document that Targeted Stock, though perhaps not universally approved by investors, does nonetheless enhance shareholder value. Indeed, the criterion we use to assess the success or failure o f an innovation is whether shareholders benefit without any obvious losers. By this criterion, Targeted Stock represents for many companies a good decision relative to doing nothing. Our objective is to examine the methods of and motives behind the use of Targeted Stock. We also discuss the dimensions on which Targeted Stock, spin -offs, equity carve-outs, and dual class common stock differ, thus highlighting management considerations when choosing among the various forms of equity reorganization. In addition, we consider the question of whether or not Targeted Stock heightens the likelihood of internal conflict within the firm, possibly signaling the prospect of a further separation of the firm's targeted business units at some future date.

The remainder of the paper is organized as follows. Section I describes Targeted Stock. Section II offers a brief history of Targeted Stock, including a discussion of canceled or withdrawn Targeted Stock offerings. Section III compares Targeted Stock to three other forms of equity reorganization - equity carve-outs, spin-offs, and dual class common stock. Section IV contains an assessment of the effectiveness of Targeted Stock as a restructuring alternative by providing a detailed case study of its use by the USX Corporation. Section V examines the announcement period share price performance of firms proposing Targeted Stock reorganizations and demonstrates that the price reaction compares favorably with the reactions

documented for alternative forms of equity reorganizat ion. Section VI summarizes and concludes the paper.

I. What is Targeted Stock?

Targeted Stock is a special class of a corporation's common stock (or possibly preferred stock) designed to provide an equity return linked to the operating performance of a distinct business unit, sometimes referred to as the targeted business. Figure 1 illustrates the difference between the equity structure of a standard, multi-business corporation and a targeted common stock structure. A Targeted Stock transaction typicall y splits a company's business operations into two (or more) publicly-traded common equity claims but allows the businesses to remain as wholly-owned segments of a common parent organization.(1) Thus, rather than a single class of common stock, which reflects the aggregate value of all of the business units of the firm, the value of each targeted business is reflected in its own class of common stock, the Targeted Stock.

It is important to recognize that Targeted Stock is common stock of the consolidated company and not of the subsidiary itself. As a result, Targeted Stock does not represent a legal ownership interest in the assets of the targeted business and subsidiary. Targeted Stock owners receive dividend rights against the computed earnings of the targeted business division, thus reducing, though not eliminating, the prospects of one business cross-subsidizing another over a prolonged period. However, there is no legal separation or transfer of assets from the corporation to the targeted business. The total value of the common stock of the firm is equal to the aggregate value of all of the firm's Targeted Stock,(2) which is, presumably, equal to or greater than the value of the common equity if no Targeted Stock arrangement had been adopted. From a corp orate governance and control perspective, the Targeted Stock structure does not alter board of director composition or management control of the corporation.

A. Design and Implementation of Targeted Stock

The implementation of a Targeted Stock structure requires certain actions by management and shareholders. First, features of each Targeted Stock must be established. This step is necessary because Targeted Stock represents an ownership interest in the firm, not in the targeted business. Second, management

must determine the financial design of the Targeted Stock arrangement. Explicit decisions include the notional allocation of debt and other assets and liabilities and the computation of allowable dividends for each category of stock and retained interest in the targeted business units. There must be a clear understanding within the firm itself about how joint costs will be allocated across different types of the targeted business units. This accounting issu e takes on great significance given that each Targeted Stock within a corporation will have different reported earnings growth rates, hence different dividend growth streams. Third, a proxy statement describing the proposed amendments to the company's char ter must be prepared. Changes to the existing corporate charter will generally be required in order to authorize the issue of Targeted Stock. Finally, a shareholder vote is required to authorize the new class(es) of common stock and amend the corporate cha rter.

Shares of Targeted Stock can be distributed in one of three ways. First, a company can elect to distribute shares pro rata to existing shareholders via a special stock dividend declaration. Thus far, this method of distribution has been the most common. Second, the parent company can elect to sell Targeted Stock to new public investors in an underwritten equity offering. The portion of the Targeted Stock that is not sold to investors is retained by the parent company. An obvious distinction between these two techniques is that the dividend distribution method does not raise new capital, while the latter method does. In cases where Targeted Stock is sold to new investors, proceeds can be retained by the targeted business unit or allocated elsewhere in the parent organization's other business operations. It is noteworthy that a Targeted Stock transaction does not trigger a taxable event at the corporate or individual level, regardless of how the offering is structured, because there is no legal separation of businesses. The third method of distribution is through the acquisition of a target company. Target company shareholders receive Targeted Stock in the acquiring firm in exchange for their ownership stake in the target company. This approach permits a tax-free acquisition while simultaneously allowing target firm shareholders to participate directly in the future growth of the target firm, rather than the combined entity.

B. Cash Flow Rights and Voting Characteristics of Targeted Stock

The specific terms of the Targeted Stock that require delineation include voting rights, liquidation rights, dividend policy, redemption provisions, and exchange provisions.(3)

Dividend Rights. Dividend policy ultimately remains subject to the discretion of the board of directors of the parent, who must reconcile the interests of all the company's shareholders. In practice, the dividend rights of the Targeted Stock typically are based upon the earnings of the targeted business units over time. The "available dividend amount" is usually determined in either of two ways: 1) fixed at a specified dollar level and adjusted over time according to the net income, dividends, other cash distributions, or other adjustments to the shareholders' equity of the tracked business or 2) fixed as a percentage of the targeted business' net income that is attributable to Targeted Stockholders. Moreover, the dividend payments of any Targeted Stock are subject to the same limitations that exist on other classes of parent common stock and to clearing up dividends in arrears on outstanding preferred stock. Cash distributions to shareholders are also typically constrained by covenants in corporate bonds and loan agreements. Such covenants limit the total amount of funds that can be distributed to shareholders, thereby preventing management from undertaking activities that benefit shareholders at the expense of creditors. Since Targeted Stock does not involve a separate legal ownership of corporate assets, dividend distributions to shareholders o f each class of Targeted Stock must also comply with the company's consolidated credit agreements.

Voting Rights. Most issues of Targeted Stock have some form of floating voting rights. The voting rights float in proportion to the market value of the und erlying businesses. The issue of fixed versus floating voting rights is important because, in most cases requiring a shareholder vote, Targeted Stock investors vote as a single class. Hence, voting rights can potentially impact the ability of holders of on e class of Targeted Stock to control the outcome of a shareholder vote and thus affect the possibility of a change in corporate control.

There are at least two reasons why floating voting rights matter. First, floating voting rights preclude a potential acquirer from obtaining more voting power for less cost/fewer shares. With fixed voting rights, an outside acquirer could attempt to gain control by accumulating shares in the class of common stock with the greatest voting power relative to its market value. Floating voting rights eliminate the possibility of outside acquirers obtaining control of the consolidated entity at a "cheap" price. The second advantage of floating voting rights that are tied directly to a Targeted Group's relative market value is that the individual investor's influence increases and decreases with changes in the underlying market values of the targeted businesses. Thus, floating voting rights vest more decision -making in those business entities representing a greater portion of ove rall company value. This offers a disincentive for top management to divert productive resources to the less successful targeted business units.

Asset Disposition and Liquidation Rights. In order to illustrate the important role of asset disposition and liquidation rights in this type of equity reorganization, this section provides a comparative discussion of these ownership rights in Alphabet Stock and Targeted Stock. This comparative analysis is provided to illustrate how seemingly minor differences in these security characteristics can have potentially significant wealth consequences for shareholders. Alphabet Stock, sometimes termed "Letter Stock," and Targeted Stock are often viewed as fairly similar securities. There are, however, important differenc es between the two. Table 1 contains a summary of certain key terms of the General Motors Alphabet Stock and the USX Steel Targeted Stock. The comparison illustrates that while Alphabet Stock and Targeted Stock shareholders both retain the same exposure to the consolidated entity's financial and contingent liabilities, Targeted Stock shareholders enjoy superior rights in terms of asset disposition [TABULAR DATA FOR TABLE 1 OMITTED] and control. This could account for the use of Alphabet Stock by only one company.(4)

Targeted Stock and Alphabet Stock differ with respect to how the proceeds from the sale of assets in the business units are allocated. If General Motors sells its Hughes Electronics subsidiary, its H class shareholders are not entitled to recei ve the full proceeds. Rather, the H class shareholders receive General Motors common shares with a market value equaling 1.2 times the prior market value of their class H stock; their premium is limited to 20%. Furthermore, the actual exchange ratio is cal culated over a time period ending the day prior to the announcement of any asset sale agreement. Consequently, any price appreciation in the class H shares due to the transaction announcement is not included in determining the actual value allocated to the class H stockholders. By contrast, proceeds from the sale of U.S. Steel Group assets must be distributed to Targeted Stock holders through a special dividend distribution or through share repurchase. USX retains the right to distribute Marathon Stock (rather than the cash distribution) to the Steel Targeted Stock holders at a 10% premium. In this latter case, relative share prices of Marathon and Steel are calculated subsequent to the transaction announcement. Shares issued in this situation are considered to be a tax-free exchange.(5)

In the event of liquidation, proceeds are distributed according to the relative proportions of voting rights in the General Motors Alphabet Stock structures. If the market values of the separate businesses have changed dram atically since the distribution of shares, the fixed voting rights may cause the relative distribution of proceeds to differ sharply from the relative market values. This discrepancy may be especially acute when the low -value business (which may even be the cause of the

liquidation) retains a relatively large share of the voting rights. By contrast, liquidation proceeds in the Targeted Stock structure are distributed in proportion to average relative market value during a specific time period prior to liqui dation.

Targeted Stock provides a bit more separation between business units in a corporation. There is more of a "pure play" feature to Targeted Stock than Alphabet Stock. If the sum of the parts can be greater than the whole, it can only be because splitting up the firm changes the quality of real decisions. In this case, incentives of managers who hold Targeted Stock, options on Targeted Stock, or stock appreciation rights should be more closely aligned with the interests of Targeted Stock shareholders than would their Alphabet Stock counterparts.

C. Capital Acquisition and Income Tax Features of Targeted Stock

The Targeted Stock structure provides important capital acquisition and income tax features for a corporation. First, the company continues to borrow funds and service debt as a consolidated entity. As a result, the Targeted Stock structure preserves the company's existing lending arrangements and allows future borrowings to be based on consolidated assets. This, in principle, increases a firm 's total debt capacity because it retains the co -insurance effect of diversification. Spin -offs and carve-outs do not allow for this. Second, access to the equity markets can be achieved separately through each of the individual targeted business entities. This may enhance a corporation's flexibility in raising new equity capital in the future since each of the targeted business entities can be separately used to raise funds. Furthermore, Targeted Stock can provide the parent corporation with a choice of equity securities to use as an acquisition currency.(6) Finally, a company with a Targeted Stock structure continues to be treated as a consolidated entity for corporate income tax purposes. Consequently, companies do not increase their tax liabilities with the Targeted Stock structure because net operating losses from poorly performing business units can still be used to shield taxable income from other profitable business units in the parent organization.

D. Summary of Advantages of Targeted Stock

Overall, Targeted Stock is an equity -based method of restructuring that provides many of the benefits associated with the creation of separate public equity securities, while preserving certain advantages of remaining a single, consolidated entity.

Among the benefits of creating separate public equity securities, Targeted Stock 1) allows the financial markets the opportunity to value disparate businesses according to their relevant individual operating fundamentals, 2) provides investors with quasi pure play investment opportunities, 3) improves flexibility in raising equity capital, 4) provides for a choice of acquisition currency, 5) allows dividends to be set on the basis of performance in each targeted business unit, and 6) allows stock -based management incentive programs to be designed for each targeted business unit.

Targeted Stock also preserves the following features associated with remaining a consolidated entity: 1) no change in management or the board of directors, 2) preservation of tax consolidation, 3) retention of operating synergies that would be lost if integrated businesses became independent, and 4) retention of consolidated debt capacity and existing lending arrangements. The Targeted Stock structure also preserves subsequent equity restructuring options.

E. Potential Disadvantages and Implementation Impediments

As is the case with any method of reorganization, Targeted Stock has certain limitations. The main disadvantages of adopting this form of equity structure are 1) the targeted business retains continued exposure to the liabilities of the consolidated entity; 2) the board of directors may find itself challenged to meet the fiduciary responsibilities to the shareholders of all classes of common stock, hence not favor one or the other group in deciding certain cost allocations, particularly when there is conflict; 3) the "notional" allocation of assets and liabilities to operating entities limits access to the cash flows from other businesses; and 4) costly conflicts among managers of different target businesses may arise as a consequence of cost allocations or any other internal transfer transaction that could potentially reduce their target business notional earnings, the typical basis of actual dividends and management compensation. Since Targeted Stock does not involve complete or partial legal separation of the company, the structure preserves the benefits of remaining a single, consolidated entity. Thus, compared to alternative forms of equity reorganization discussed in Section III, Targeted Stock seems to be most useful for firms in which the benefits of integration and total control over some activities outweigh the benefits of a complete or partial separation of the targeted business unit, that is, when the transaction costs associated with internal organization are less than the transaction costs of market -based exchange. However, Targeted Stock may be used even when an alternative pure play may be economically more advantageous if top executives' incentives and compensation are linked to overall firm size.

Given the advantages of such a powerful financial innovation, one might wonder why only nine Targeted Stock transactions have been completed as of year -end 1995. Stated differently, when viewed from the perspective of the shareholder, what impediments exist that might limit the number of firms implementing Targeted Stock? Two questions come to mind regarding the use of Targeted Stock. First, why do these companies not effect a legal separation? Without some form of enforce able segregation of cash flows, the board of directors can always allow one business to invade the other for financial resources. To the extent this happens, what is the real meaning of a pure play in this context? And second, because dividends (thus, presumably share prices) are supposed to be linked to business earnings and because estimated earnings are a function of cost allocations by top managers among businesses, division managers may have incentives to spend time on unproductive rent-seeking activities - making transfers from one business to another via accounting allocations. Since voting power is proportional to market value, a high-value division may enjoy some immunity and perhaps may even be able to shift costs to a less prosperous division, lea ving it even less prosperous.

With these questions in mind, let us now consider a brief history of the evolution of Targeted Stock as well as the several alternatives to Targeted Stock that actually do juridically separate cash flows and/or voting rights . These alternatives include equity carve-outs, dual class recapitalizations, and spin -offs.

II. A Brief History of Targeted Stock

The investment banking firm of Lehman Brothers is widely regarded as the originator of Targeted Stock. The first Targeted Stock transaction occurred in May 1991 when USX distributed U.S. Steel stock to its existing shareholders and redesignated the existing USX common stock as USX Marathon stock. Shortly thereafter, in September 1992, USX created a third Targeted Stock when it sold shares of USX Delhi Group Stock in an initial public offering. A comprehensive list of all actual issuers of Targeted Stock appears in Table 2.

In addition to these successfully completed transactions, there have been several notable canceled Targeted Stock transactions. On January 5, 1994, Kmart Corporation announced its intention to create four new Targeted Stocks, known as Specialty Retail Stock. Each class was intended to reflect the performance of one of its specialty retail units.(7) The com pany's shareholders voted against the proposal,

however, and the planned equity issues were canceled.(8) Table 3 shows the current status of all non-consummated Targeted Stock announcements.

Table 4 (Panels A and B) shows the market -adjusted abnormal returns for each Targeted Stock announcement around the announcement date. (Fletcher Challenge is not included because it was not then traded in the U.S. markets).(9) Panel A in Table 4 shows announcement period abnormal returns for those transactions that were completed, and Panel B in Table 4 shows announcement period abnormal returns for those that were canceled or pending as of August 1995. For those deals that were actually completed, the cumulative average two -day abnormal return for the day prior to The Wall Street Journal announcement and the day of the announcement is 2.9%. Given that these few observations comprise the entire Targeted Stock population, tests of statistical significance are neither appropriate nor revealing. Of the eight companies that completed Targeted Stock issues, [TABULAR DATA FOR TABLE 2 OMITTED! four experienced very large positive abnormal returns of 4% or more on one day or the other in the two -day event window. For three of the four companies that had not yet completed their a nnounced Targeted Stock issues as of August 1995, the average abnormal return was positive on the day before the announcement and negative the day of the announcement.

It is tempting to try to tell an idiosyncratic story for each company - those that issued Targeted Stock, those that canceled deals, and those that were awaiting SEC or shareholder approval at the end of 1995. However, such stories are not particularly useful as we try to generalize about the motivations for and the beneficial consequences of issuing Targeted Stock. Perhaps the most eloquent appraisal of the attractiveness of Targeted Stock is not the abnormal return evidence but rather the fact that since 1991, only eight companies went forward with the innovation and only three are currently planning to issue Targeted Stock. Despite the positive abnormal returns experienced by issuers, the innovation has not generated very much activity.

This could be due to the fact that Targeted Stock is a bad idea, or it could merely, and most likely in our judgment, reflect the fact that the problems and inefficiencies Targeted Stock helps to overcome are confined to few companies at this time. A company must first decide that an equity-based reorganization would enhance its aggregate market value. The n, the company must choose among the alternative forms of equity reorganization. Targeted Stock represents only one of the available choices, but it is the only one that preserves the coinsurance effect of diverse businesses and keeps the size of the asset base controlled by top management intact. Thus, Targeted Stock should be viewed as the optimal form of equity

reorganization only for certain types of firms. The generally positive abnormal returns associated with this innovation would seem to support thi s view. Table 3. Canceled or Pending Issuers of Targeted Stock

This table identifies the parent companies that have announced a Targeted Stock transaction but either canceled or have not yet completed the transaction.

Announcement Company Date Status

Seagull Energy Inc. March 14, 1994

Pending

Kmart shareholder approval

January 5, 1994

Failed to win

U.S. West scheduled for

April 10, 1995

Shareholder vote

March 21, 1996

MCI

August 2, 1995

Shareholder vote

not yet scheduled

The following sections describe firm characteristics that lend themselves to this form of corporate restructuring. We end with a detailed look at one firm that seems to have benefited from the use of Targeted Stock.

III. A Comparison of Targeted Stock and Other Forms of Equity Reorganization

In this section, we compare Targeted Stock with alternative equity reorga nization forms that actually do juridically separate cash flows and/or voting rights. These alternative methods include equity carve -outs, dual class recapitalizations, and spin offs.

A. Equity Carve-outs

An equity carve-out is the sale of some portion of a wholly-owned subsidiary's common stock to public investors. The shares in the subsidiary can be sold through a secondary offering by the parent company or through a primary offering by the subsidiary itself. Generally, the parent company retains a co ntrolling interest in the subsidiary and oftentimes retains at least 80% of the voting rights in order to qualify for tax consolidation. As a consequence, tax and control considerations may limit the amount of equity capital raised in an equity carve -out.

Schipper and Smith (1986) study 76 equity carve -outs completed between 1963 and 1983.(10) They find that, on average, parent company shareholders earn a 1.8% abnormal return around the time of a carve -out announcement. This increase contrasts with the 3% average abnormal loss associated with announcements of seasoned equity offerings by publicly traded firms. The researchers attribute the differential share price reaction between equity carve -outs and seasoned equity offerings to the following four distin guishing characteristics. First, by separating subsidiary investment projects from those of the parent, the use of a carve -out for external equity financing may reduce the asymmetry of information between managers and investors regarding the value of paren t company assets. Relatedly and second, the initiation of public trading of subsidiary common stock can improve investor understanding of subsidiary growth opportunities due to increased financial reporting requirements. Third, the restructuring of manager ial responsibilities and revisions in incentive contracts could lead to improvements in the efficiency of asset management. Finally, the creation of a minority shareholder interest in the subsidiary stock may lead to conflicts of interest between parent co mpany shareholders and the minority shareholders. As Schipper and Smith (1986) document, however, the benefits of an equity carve -out may be obtainable with only a "temporary" public market for the subsidiary shares. Many minority stakes in subsidiaries ar e

subsequently re-acquired by the parent; other subsidiaries are spun -off entirely to shareholders; and sometimes, the subsidiary is sold.

B. Dual Class Common Stock

While most publicly held corporations issue common stock in which voting rights are proportional to residual cash flow rights, some firms have multiple classes of common stock with unequal voting rights.(11) Multiple classes of common stock with unequal voting rights are typically known as dual class common stock. The voting rights of the multiple classes of common stock are usually distinguished by the number of votes allocated to each share. Oftentimes, one of the dual classes obtains greater voting rights in exchange for inferior cash flow rights. The valuation of the common equity in a dual class common stock structure will reflect the relative voting and cash flow rights of the separate classes.

[TABULAR DATA FOR TABLE 4 OMITTED]

The source of cash flow for each class of common stock is that of the consolidated entity rather than a specific subsidiary or division. Thus, one feature that distinguishes dual class common stock from Targeted Stock is that cash flows to equity claimants in the latter structure are tied more directly to specific business units within the consolidated enti ty. A second distinguishing characteristic relates to the allocation of voting rights. With dual class common stock, the voting power of the different classes, although disparate, is fixed. Consequently, insiders can assure their continuity of control by a cquiring or maintaining sufficient voting power in the high-vote shares. Because voting power varies in a Targeted Stock structure according to the relative market value of the targeted businesses, insiders can assure continuity of control only by holding a sufficiently large ownership percentage of each Targeted Stock. To date, none of the companies issuing or distributing Targeted Stock have had majority inside ownership. Thus, consolidation of control does not seem to be a primary objective in the Target ed Stock structure.

Lehn, Netter, and Poulsen (1990) argue that corporate insiders create dual classes of common stock with disparate voting rights in order to concentrate the high -vote stock (and hence control over corporate resources) among themselves. This consolidation of corporate control may have important incentive effects. In particular, the asymmetry between voting control and residual cash flow rights may distort

managerial incentives away from the objective of maximizing shareholder value. Partch (1987) views the primary motive for the introduction of dual class common stock to be insulation of insiders from outside shareholders and the market for corporate control. This view is consistent with the argument that dual class recapitalizations entrench corporate insiders and diminish operating efficiency. But this is not a compelling story in view of event study announcement effects.

Despite the potential consequence of managerial entrenchment, dual class recapitalizations can only be accomplished through shareholder approval. Once approved, the new class of common stock is distributed either through an exchange of existing common shares for the new high -vote stock or as a stock dividend. In order to make the low-vote stock attractive, these shares generally have a higher cash dividend than the high -vote stock. In this way, insiders retain their high -vote stock and increase voting control without a proportional increase in their ownership of residual claims.

C. Corporate Spin-offs

A spin-off divides the existing asset base of a corporation into two (or more) separate parts. Current shareholders receive a pro rata distribution of separate equity claims on the assets of each new corporate entity. Thus, there is no exchange of cash or financial securities for assets in this transaction. Rather, the existing corporate asset base is legally allocated into at least two separate organizations with no change in the proportional equity ownership claims of the existing shareholders.

Several recent studies document significant positive share price reactions to the announcement of a spin-off, despite the fact that some spin -offs result in adverse tax consequences for taxable investors. Existing research supports the view that the creation of a new stand -alone, publicly-traded entity enhances shareholder value by legally, operationally, and financially separating a subsidiary from the parent organization. The sources of the increase in shareholder value appear to be directly related to three important changes that occur as a consequence of a spin -off: 1) enhanced access to the capital markets, 2) implementation of improved management incentives, and 3) increased exposure to the market for corporate control.

The separation of parent organization and subsidiary assets creates financial flexibility by allowing each of the stand -alone entities access to the capital markets directly. Rather than relying on subjective, internal resource allocation decisions as in a typical conglomerate structure, the exposure of the separate independent entities to the external capital markets allows investors the opportunity to evaluate each organization's investment opportunities. This process should lead to higher levels of capital expenditures and, ultimately, cash flow growth ra tes, if profitable investment opportunities had been foregone prior to the spin -off. An improvement in operating performance may also result from the design and implementation of new management incentives after the spin -off. For example, the creation of se parately traded equity claims for the parent organization and spun -off subsidiary allows the board of directors the opportunity to link performance and managerial rewards directly through market-based incentive compensation contacts. Typically, both the parent organization and the spun -off entity do elect to implement such incentive contracts after the completion of the spin -off (see Seward and Walsh, 1996).

While improved managerial incentives and enhanced access to the capital markets should improve operating performance through better management decisions, spin offs also create the opportunity for better resource allocation decisions by exposing both the parent organization and spun -off subsidiary to the corporate control market. This suggests that at least some of the shareholder value enhancement may be due to the transfer of assets to a higher -value acquirer, rather than due to operational improvements implemented by the incumbent management team (see Cusatis, Miles, and Woolridge, 1993, and Seward an d Walsh, 1995).

IV. An Assessment of the Effectiveness of Targeted Stock as a Restructuring Alternative: The Case of USX Corporation

The origins of the USX Targeted Stock transaction can be traced back to the early 1980s, when the company consisted primarily of steel-making operations. At that time, U.S. Steel was one of the largest integrated steel producers in the United States, engaging primarily in the production and sale of a wide range of steel mill products, coke, and taconite pellets. Other busin esses included operations in domestic coal, management of mineral resources, real estate, engineering and consulting services and technology licensing, fencing products, leasing and financial activities, and titanium metal products. In 1982, the company ac quired Marathon Oil for $6.2 billion in cash and notes. At the time, Marathon was the 17th largest oil producer in the country. Four years after the Marathon acquisition, the company acquired Texas Oil & Gas for $3 billion in stock. According to its annual reports, USX's motivation for the acquisitions was that owning businesses that had different

growth and earnings patterns would smooth out the overall cash flow of the company and strengthen USX's borrowing ability.

USX is now a diversified company enga ged in the steel business through its U.S. Steel Group, in the energy business through its Marathon Group, and in the natural gas gathering and processing business through its Delhi Group. The U.S. Steel Group includes the operations of U.S. Steel, which i s still one of the largest integrated steel producers in the United States. In addition to its integrated steel operations, the U.S. Steel Group also includes a number of other diverse businesses. Their businesses include the management of mineral resource s, domestic coal mining, engineering and consulting services, technology licensing, real estate development and management, fencing products, leasing and financing activities, and a majority interest in a titanium metal products company. U.S. Steel Group sales as a percentage of total consolidated USX sales were 28% in 1992, 26% in 1991, and 29% in 1990.

The Marathon Group includes the operations of Marathon Oil Company, a wholly owned subsidiary of USX, which is engaged in worldwide crude oil and natural gas exploration, production, and transportation as well as the domestic refining, marketing, and transportation of crude oil and petroleum products. The Marathon Group is now the eleventh largest U.S. -based integrated oil and natural gas concern in terms of total proved oil equivalent reserves and the seventh largest domestic refiner in terms of combined stated refinery capacity. Marathon Group sales as a percentage of total consolidated USX sales were 69% in 1992, 72% in 1991, and 69% in 1990.

The Delhi Group consists of Delhi Gas Pipeline Corporation and certain related companies engaged in the purchasing, gathering, processing, transporting, and marketing of natural gas. Sales from the businesses included in the Delhi Group as a percentage of total USX consolidated sales were 3% in 1992 and 2% in 1991 and 1990.

While the diversification program USX pursued in the 1980s may have successfully lowered corporate risk and reduced the company's cost of debt capital, the company's price performance throughout the decade was poor. This performance was manifest in the fact that the company's stock generally traded at lower market to-book ratios and lower earnings multiples than both its energy and steel company industry peers. As the company's share price performance lagged through 1985, Carl Icahn began to accumulate what became by 1991 a 13.3% ownership stake in

USX. In order to enhance corporate performance, Icahn forced a shareholder vote in 1990 that would have obligated the company to spin -off its steel division as a separate, stand-alone company. Incumbent management publicly opposed the proposal for three reasons: 1) A spin -off would create higher financing and administrative costs for the separate companies; 2) a spin -off could not be accomplished on a tax-free basis; and 3) a spin-off would create an adverse balance sheet impact on the stand-alone steel company because of the elimination of Marathon's "goodwill."

Shareholders voted on the spin -off proposal in May 1990. Although Icahn's proposa l lost by a narrow margin, he continued to hold his shares. Consequently, management began to explore alternative restructuring plans in an effort to enhance the company's market value and potentially alter its ownership structure. On January 31, 1991, the company announced its Targeted Stock plan. The plan was approved by shareholders at the May 6, 1991, shareholders meeting. The plan consisted of redesignating USX common stock as Marathon Group Targeted Stock and distributing 1 new share of Steel Group Ta rgeted Stock for every 5 shares of Marathon Stock. Subsequent to the share distribution, the company's common stock outstanding consisted of approximately 256 million shares of Marathon Group Targeted Stock and 51 million shares of U.S. Steel Group Targete d Stock.

The stock market's reaction to the announcement was positive. As Table 4 (Panel A) indicates, the two-day (day prior to and day of announcement) market -adjusted abnormal [TABULAR DATA FOR TABLE 5 OMITTED] return surrounding USX's Targeted Stock announcement was approximately 1.8%. This is equal to an increase in the market value of the shareholders' investment of roughly $130 million.

Based upon this successful equity distribution, USX announced the creation of a third Targeted Stock, the Delhi Group Targeted Stock. On September 24, 1992, USX issued 9 million shares of Delhi Stock, raising a total of $144 million through an initial public offering. This Targeted Stock transaction represented the first successful initial public offering of Target ed Stock. USX stock's two-day abnormal return on the company's shares at the announcement of this issue was approximately zero. Thus, USX avoided the typical fate of a company announcing an equity sale - a stock market decline of approximately 3%, on avera ge.

Table 5 indicates that USX raised a total of more than $1.5 billion in new equity and equity-linked security offerings between January 1992 and July 1993. To the extent that the business cycle (see, e.g., Choe, Masulis, and Nanda, 1993) and/or time -

dependent asymmetric information (see, e.g., Korajczyk, Lucas, and McDonald, 1992) affect the adverse selection costs associated with public equity offerings, the Targeted Stock structure may have created a valuable timing opportunity in selling new common stock. This benefit is likely to be greater when the underlying targeted business units are differentially affected by the business cycle and/or time dependent information asymmetries. Interestingly, in the ten years prior to the implementation of the Targ eted Stock structure, USX sold no new common equity as a consolidated entity with a single class of common stock.

One benefit of Targeted Stock is the creation of separate pure play equity investments, which allow shareholder clienteles to invest directl y in each of the targeted businesses. Targeted Stocks reduce the cost to investors of achieving certain types of economic exposure. Relatedly, the creation of pure play equity investments should make information collection and analysis less costly. In the case of USX, for example, separate financial statements report the assets, liabilities, and stockholders' equity for each of the targeted businesses. Thus, although stockholders of Marathon Stock, Steel Stock, and Delhi Stock are, in effect, stockholders of USX and hence collectively responsible for the company's aggregate liabilities, information regarding segment operations and performance is now disseminated in greater detail.

While Targeted Stock may facilitate an increase in the supply of information to the financial markets, we have not yet provided any evidence regarding demand by investors for such information. In Table 6, we list the firm affiliations of the 29 additional analysts who instituted new coverage of at least one business subsequent to the Targeted Stock transactions at USX. The table indicates that 15 additional analysts began new coverage of Marathon Group, 10 additional analysts began new coverage of U.S. Steel Group, and 4 additional analysts began new coverage of Delhi Group. Given the pre-transaction size and shareholder base of USX, it is perhaps surprising that the Targeted Stock transaction structure would generate such a large increase in analyst coverage. Most of these firms, and many others, covered USX prior to the Targeted S tock deal. The issuance of Targeted Stock, however, apparently provided these firms with the incentive to assign additional analysts to cover the particular business segments directly.

Table 7 documents the relative U.S. Steel Group and Marathon Group sh are holdings of the largest institutional [TABULAR DATA FOR TABLE 6 OMITTED] stockholders subsequent to the Targeted Stock transaction. The table shows ownership that is quite different from the initial distribution, which suggests substantial portfolio re balancing by these investors after the creation of the Targeted

Stock. The ability to hold different ownership percentages in the separate businesses of USX allows investors the opportunity to hold equity claims that are nearly pure play claims. Extreme examples of this can be seen in those instances where large institutional holders of one of the Targeted Stocks hold no shares in the other Targeted Stock. Although case study evidence regarding increased analyst coverage and different institutional sharehol der groups does not necessarily imply that these factors cause the positive market reaction to the Targeted Stock structure, it does indicate that coverage and ownership profiles can change substantially after this form of equity reorganization.

The increase in the amount and quality of information about the separate businesses in a diversified firm makes it easier for investors both to understand the firm's operations and to value the firm. Further, owners of Targeted Stock know that the managers of that business will find it in their interests to argue against spending plans in other businesses if they cannot be justified on efficiency grounds. The cost allocation systems that must be put in place in Targeted Stock arrangements could penalize one set of managers for poor decisions made by others. Managers themselves may have greater incentives to monitor and limit agency costs of other managers. As such, mutual monitoring may be more efficient and effective if it takes place within these firms.

Figures 2 and 3 show the price performance of the Targeted Stock relative to indices of companies in the same industry following the issuance of the U.S. Steel stock on May 7, 1991. The index companies were those in the Bloomberg financial data system identified as comparable companies. The index is an equally weighted portfolio of these companies.

U.S. Steel's share performance parallels that of the industry group until early 1993 when it experiences a sharp and unaccounted for improvement relative to its industry. After a brief period of exuberance for the stock, however, it fell back to roughly average industry performance.

The story for USX-Marathon is a less happy one. After a brief period of positive industry-adjusted performance, the stock price declined b y a significant amount. This can be partly attributed to some substantial disappointments in the company's foreign drilling and exploration programs.

One surprising aspect of the case is the degree to which the industry -adjusted performance of USX-Marathon and U.S. Steel diverged in late 1992 and 1993. One experienced a severe relative decline, the other kept pace with its industry. Despite the potential for top management to divert funds from steel stockholders to oil stockholders, the market seems to ha ve treated these entities almost as if they were legally separate. Investors seemingly did not drive up U.S. Steel stock out of fear that it would be damaged by management efforts to bolster USX Marathon; there is no evidence of fear of cross -subsidization.

[TABULAR DATA FOR TABLE 7 OMITTED]

V. Investor Implications of Alternative Equity Reorganization Methods

Table 8 summarizes the relevant empirical literature concerning these different forms of equity reorganization. Only one of these studies (Jarrell and Poulsen, 1988) documents a negative share price reaction. This study examines share price reactions to dual-class recapitalizations and obtains a result different from the study by Partch (1987), who documents a positive share price reaction. The empirical studies of equity carve-outs and spin-offs uniformly document positive share price reactions. Overall, equity reorganizations generally seem to enhance (or at least not significantly diminish) shareholder wealth.

The empirical results for spin -offs and equity carve-outs may indicate that these corporate separations reflect the fact that the original motiva tions for combining businesses may no longer be valid (or, perhaps, were never valid). A recent paper by Comment and Jarrell (1995) shows that tight corporate focus is closely linked to superior security return performance. By allowing top management to co ncentrate more narrowly on relatively simpler businesses, corporate performance may be improved. A study by Berger and Ofek (1995) shows that multi -segment firms sell at approximately a 15% discount when compared to relatively pure play firms. Targeted Stock may help to recapture at least some of this discount. See also Gaver and Gaver (1995). As long as the coordination of decision -making across business divisions is not necessary, then the partial or complete legal separation of the business entities should not adversely impact aggregate cash flows.

Yet, for some corporations, business units can be most effectively managed if decision-making is coordinated hierarchically rather than through markets. Scale

economies and scope economies may require that a multi-division entity remain intact. Benefits would be lost if the business entity were legally separated. Targeted Stock serves a useful role in such corporations. Coordination of internal decision making and corporate strategy is enhanced, yet investors are able to value the businesses separately and establish targeted ownership claims against divisional cash flows.

VI.Conclusion

This paper examines a comparatively recent financial innovation known as Targeted Stock. It is a much weaker form of separat ing divisional businesses than other forms of equity reorganization that have been used, yet the available empirical evidence suggests that investors view it favorably. The abnormal security return experience of those companies that have implemented Target ed Stock structures is generally favorable and is similar in magnitude to other forms of equity reorganization.

We identified and discussed a number of benefits of creating separate public equity securities: 1) allowing stock-based management incentive programs to be designed for each targeted business unit, 2) allowing the financial markets the opportunity to value disparate businesses according to their relevant individual operating fundamentals, 3) providing investors with quasi -pure play investment opportunities, 4) improving flexibility in raising equity capital, 5) providing for a choice of acquisition currency, and 6) allowing dividends to be set on the basis of performance in each targeted business unit. We attribute investors' positive view of Tar geted Stock to the fact that it provides many of the benefits associated with the creation of separate public equity securities, while preserving certain advantages of the company remaining a single consolidated entity.

The maintenance of a consolidated entity is not necessarily always beneficial, however. For some firms, partial or complete separation of its assets in conjunction with the creation of new classes of equity securities will be optimal. Thus, the choice of the most beneficial form of equity reorganization involves a complete analysis of the costs and benefits associated with the partial separation, complete separation, or full retention of the consolidated business form.(12) Currently, market trends seem to favor the partial or complete separ ation for many firms, based on the observed frequency of equity carve-outs and spin-offs. However, we believe that Targeted Stock [TABULAR DATA FOR TABLE 8 OMITTED] represents an improvement over the traditional, multi -division, single common stock class o rganizational form for some firms.

Although the number of completed Targeted Stock transactions remains relatively small at this point, the frequency of new issues is likely to increase in the future. While other equity reorganization alternatives exist, we have shown that Targeted Stock is different and that it may be a better option for generating pure plays for certain types of firms. In addition, many financial innovations can remain relatively dormant for periods of time while investors and managers try to understand their advantages and disadvantages. The diffusion of such innovations takes time. (See, e.g., Tufano, 1989.) Indeed, corporate spin -offs were not used for a long period with the frequency that we observe today. Those firms in which the be nefits of integration and control over corporate activities outweigh the benefits of a complete or partial separation of the targeted business unit(s) will enhance shareholder value by implementing Targeted Stock.

1 In principle, a targeted business can be defined quite broadly. A targeted business can be represented by a line of business, geographic segment, product line, or any other separable business activity.

2 Because there is no longer a single class of common equity for the consolidated entity, earnings and dividends are reported separately for each of the Targeted Stocks.

3 Definition of these terms must be structured carefully to ensure that the IRS considers the Targeted Stock to be common stock of the company rather than stock of a subsidiary. A determination of the latter by the IRS would potentially trigger tax liabilities at the time of the distribution or sale of Targeted Stock, as well as potentially affect any future benefits from filing a consolidated income tax return.

4 On March 1, 1993, RJR Nabisco Holdings announced a plan to create an Alphabet Stock for its Nabisco Food Group. However, on June 23, 1993, RJR postponed equity issue, citing the decline in the value of comparable food stocks and improvement in its own financial cond ition. Subsequently, on January 19, 1995, RJR sold 45 million shares of Nabisco in an equity carve -out at $24.50 per share.

5 On January 6, 1995, Ralston Purina announced the sale of its Continental Baking Co. subsidiary to Interstate Bakeries Corp. This transaction represents the first time that the underlying business in a Targeted Stock structure has ever been sold.

Ralston Purina had the same three alternatives - special dividend, share repurchase, or tax-free exchange offer - for allocating proceeds from the transaction. In April 1995, Ralston Purina announced that it would exchange 0.0886 shares of parent company stock for each share of Continental Baking stock held by public shareholders. Using a formula based upon the comparative prices of Continen tal's and Ralston's shares between March 31 and April 6, the exchange ratio represented a 15% premium for Continental shareholders.

6 Using Alphabet Stock (which we argued earlier bears some similarity to Targeted Stock), General Motors, for example, created its Class E letter stock for its acquisition of EDS and its Class H letter stock for its acquisition of Hughes Aircraft.

7 The four classes proposed by Kmart were as follows. The Borders -Walden stock would comprise principally the company's Borders, Inc. and Walden Book Company, Inc. subsidiaries. The Builders Square stock would comprise principally the company's Builders Square, Inc. subsidiary. The Office Max stock would comprise principally the company's interest in Office Max, Inc., a partially owned subsidiary of the company. The Sports Authority stock would reflect the performance of The Sports Authority, Inc. subsidiary.

8 Kmart subsequently announced its intention to restructure through the equity carve-outs of its various subsidiaries.

9 Abnormal returns were computed by subtracting the NYSE Composite Value Weighted Index return from the company's raw returns. None of t he companies had betas that were statistically different from one. 10 It is perhaps noteworthy that in the early stages of equity carve -out activity, there was also a paucity of completed transactions. 11 The New York Stock Exchange has historically proh ibited dual class common stock because of the risk of unwarranted wealth transfers between different groups of investors. 12 For instance, Michaely and Shaw (1995) compare spin -offs to carve-outs for limited partnerships. An even more rigorous analysis de serves to be done comparing all forms of equity reorganization.