AN ANALYSIS OF ECONOMIC AND LEGAL RAMIFICATIONS OF GOING DARK©
C. Matthew Colongeli, Esq.
(for and in conjunction with Law Offices of Randall J. Perry, Esq.)
March 12, 2007
I.Executive Summary
There has been a recent trend in which smaller companies are “going dark,” where the issuer deregisters their shares with the SEC and delists from an exchange. The most cited reason offered by going dark companies has been the costs of complying with the Sarbanes-Oxley Act, specifically Section 404. Under the current regulatory scheme smaller companies face inequitable treatment as a result of the uniform application of the Sarbanes-Oxley Act. When management decides that the net benefit of reporting is outweighed by the costs, the proper decision, under the theory of maximizing shareholder value, is to go dark. However, the market reaction to going dark has generally been negative. Upon the announcement of going dark, companies can expect on average a 10% to 12% potential decline in share price. This has led shareholders in various cases to initiate legal action against the issuer and its management, alleging liability based upon breach of loyalty and good faith. We attempt herein to not reach a conclusion on advisability of going dark but rather to provide a basis for such evaluation.
The current regulatory state may be shifting over the next several years. The SEC recently chartered an Advisory Committee on Smaller Public Companies to analyze the impacts of the current securities system as related to small and micro-cap companies. The Committee’s Final Report of April 23, 2006, recommended several changes which would lead to a proportional system of regulation. Although the proposed changes have yet to be adopted by the SEC, it illustrates the willingness to minimize costs and maximize benefits for smaller reporting companies.
II. Mechanics of Delisting
Under the Securities Exchange Act of 1934 (the “Act”), public companies may deregister their securities if there are fewer than 300 shareholders of record, or fewer than 500 holders of record and less than $10 million of assets for each of the prior three years. The Act distinguishes between shareholders of record and beneficial shareholders for the purposes of satisfying said requirement. A shareholder of record is an individual named on the corporate stock ledger as owning the issuer’s shares, while the beneficial owner receives the benefits of share ownership without actually being named on the corporate ledger. Typically, brokerage houses, in order to facilitate future transactions, will hold the shares in a “street name” rather than in the shareholder of record. Therefore, presently public companies with wide numbers of shareholders may still meet the requirements to deregister their securities. On July 3, 2003, a group of institutional investors petitioned the SEC to amend Rule 12g5-1 (see attached Exhibit 1) of the Act.(1) The petitioners sought to redefine the holder of record requirement, concerning beneficial owners as would represent the number necessary to effectuate a valid deregistration of securities; in particular a look through requirement for such determination (similar to that concept in regulatory registration requirements applicable to Investment Advisors).(2) On March 23, 2005 the SEC chartered the Advisory Committee on Smaller Public Companies to assess the current regulatory system as impacting smaller companies.(3) One of the secondary recommendations made by the Committee was a proposed revision of the language of Rule 12g5-1, to be more in line with the proposals made by the petitioners,(4) although, currently the recommendation has not been adopted by the SEC.
Issuers unable to meet the required record holder requirementare not without recourse. There are two approaches issuers can pursue in order to reduce the holder base to the required number, a reverse stock split or an issuer self-tender offer.(5) Under the reverse stock split the company would perform a significant split ratio and then purchase the fractional interests.(6) Although, a significant reverse stock split requires shareholder approval. The issuer will file a proxy statement combined with a Schedule 13E-3 filing which must be reviewed by the SEC prior to soliciting consent from shareholders.(7) A self-tender offer occurs when the issuer offers a broad solicitation to shareholders to repurchase shares at a fixed price. Although this approach also requires the filing of a Schedule 13E-3 there are two distinct advantages to an issuer self-tender offer. First, the process tends to be faster than reverse stock splits. Second, because outside shareholders decide whether to tender the shares, unlike with a reverse stock split, the negative backlash from delisting tends to be lessened.(8) However, the drawback to a self-tender offer is that there is no guarantee that enough shareholders will tender their shares, enabling the issuer to meet the record holder requirement.(9)
In addition to the shareholder requirement, there are additional ancillary requirements that must be satisfied in order to deregister securities. The issuer must not have any contractual obligations or restrictions in the certificate of incorporation, or by-laws, which require the company to continue to file reports with the SEC.(10) Contractual obligations include the registration rights granted to investors or vendors.(11) A final requirement is that within the fiscal year in which a registration statement related to a class of equity securities is declared effective, an issuer may not suspend its reporting obligation for said securities.(12)
If the issuer meets the requirements to deregister the securities, a Form 15 must be filed, which will result in the issuer no longer being subject to SEC rules and the Sarbanes-Oxley Act. The SEC has up to 90 days to approve or deny the termination of securities request; within the approval process time frame an issuer may withdraw its filing.(13) If the issuer is an exchange listed company, it must first terminate their listing prior to deregistering the securities. NASDAQ-listed companies may voluntarily delist upon compliance with Rule 12d2-2(c) (see Attached Exhibit 2) under the Act.(14) Subsequent to the filing of the Form 15, the securities will no longer be quoted on a major exchange, on NASDAQ, or on the OTC Bulletin Board. However, the issuer will be eligible for quotation on the Pink Sheets.
The Pink Sheets are an electronic quotation system, not a stock exchange, which does not qualify brokers or impose regulatory requirements on the stock they quote. Pink Sheets is a privately owned limited liability company which expresses its aims to improve the transparency of the over-the-counter (“OTC”) markets.
To be quoted on the Pink Sheets an issuer must take several steps. First, the issuer must find a market maker who is willing to quote the company’s stock. Only SEC-registered broker-dealers whom are members of the National Association of Securities Dealers (“NASD”) are allowed to quote securities to be listed on the Pink Sheets. The market maker, abiding by SEC Rule 15c2-11, must file a Form 211 with the NASD OTC Compliance Unit.
The Pink Sheets service is in process of launching a premium quotation service, the OTCQX.(15) The OTCQX is designed to encourage increased disclosure of Pink Sheet companies in an effort to establish intermediary levels of oversight between the unregulated Pink Sheet companies and the regulated exchanges.(16) There will consist of two levels, PremierQX(17) and PrimeQX.(18) The new system commenced trading on March 5, 2007.(19)
III. Benefits of Delisting
The primary incentive for going public has been increased liquidity, a “cheaper” source of capital, and the establishment of a non-cash currency (stock) which could be utilized for future growth.(20) Arguably, none of these benefits are enhanced as a result of compliance with Sarbanes-Oxley’s corporate governance and disclosure standards but rather additional burdens apply.(21) Therefore, as a result of Sarbanes-Oxley there is a greater incentive for an issuer to deregister shares and delist from an exchange.
A paper entitled, “Why Do Firms Go Dark? Causes and Economic Consequences of Voluntary SEC Deregistrations,” (the “Leuz Study”) articulated two rationales most often stated by management in press releases explaining the decision to go dark, “cost saving” hypothesis and “private benefits” or agency hypothesis.(22) The “cost saving” hypothesis emphasizes that many firms have decided to go dark as a response to the ever-increasing costs associated with remaining a reporting company.(23) Management’s decision to go dark seemingly maximizes shareholder value when the net benefit of reporting is outweighed by the costs of reporting.
It is estimated that micro-cap companies, which trade below $5.00 per share and with market capitalization(24) below $300 million, could expend upwards of $100,000 or more annually on Sarbanes-Oxley compliance costs.(25) The root of the problem lies in the uniform application of Sarbanes-Oxley to large and small companies, alike. The Final Report by the SEC Advisory Committee on Smaller Public Companies noted the inequitable result of uniform treatment. A 2004 Financial Executives International study determined that while companies with market capitalizations between $1 - $4.9B expended merely 0.16% of yearly revenues on compliance with Section 404 of Sarbanes-Oxley, companies with market capitalizations under $100 million expended 2.55%.(26) This disproportionate cost of compliance with Sarbanes-Oxley is leading to an increased willingness by company managers to consider “going-private” (merger, sale, going dark) transactions. In a 2006 Foley Lardner LLP study entitled, “The Cost of Being Public in the Era of Sarbanes-Oxley,” 21% of respondents indicated that they were considering “going-private” transactions as a result of corporate governance and public disclosure reforms, compared to 13% in 2003.(27) The mere enactment of Sarbanes-Oxley appears to be a tipping point toward a movement of firms to go dark. According to the Leuz Study, there was a significant increase in going dark deregistrations in 2003 and 2004.(28) Sarbanes-Oxley became effective in large part in 2002. The Sarbanes-Oxley Act is observed as the most likely catalyst for the increased deregistration movement.(29) Another contributing factor may have been the relatively weak stock performance during the preceding time period.(30)
The alternative hypothesis, “private benefits” or agency hypothesis, articulates the notion that controlling insiders will go dark to avoid outside scrutiny, which is associated with SEC reporting.(31) Upon deregistering the securities, insiders would be able to increase the private benefits associated with control of the company (perk compensation, loans on favorable terms, generous compensation packages, etc.). This hypothesis lends strength to the negative perception associated with un-reporting issuers, such as those listed on the Pink Sheets, discussed infra.
IV. Economic Cost/Restrictions
Although company insiders view the decision of going dark as maximizing shareholder value, by the reduction in reporting costs, shareholders tend to view deregistration as an assessment by insiders that the company expects a decline in future prospects; or, even worse, as a move motivated by insider’s private benefits.(32) This view would appear even further emphasized by the issuer also delisting from NASDAQ or other national exchanges, which would follow from general SEC reporting deregistration. As a result ofeither shareholder viewpoint, issuer’s shares decline on average 10%(33) to 12%(34) following the announcement of de-listing. This decline has led shareholders, in several instances, to initiate suit against management, alleging breach of loyalty and good faith, discussed infra. The probable decline resulting from the announcement of going dark is minimized when outside investors are better protected, as where specific transactions are initiated by the issuer to reduce the shareholder threshold level to enable the company to go dark.(35)
The apprehension apparent by shareholder reaction, both financially and legally, may result from the individuals and companies that use the benefits of non-reporting to commit fraud or perceived to do so. Exploiting the non-disclosure requirements that quotation services offers, such as Pink Sheets, allows potential fraud to be perpetrated.(36) To curb the prevalence of fraud committed on the Pink Sheets the SEC is seeking out and de-listing dormant stocks.(37) Another potential explanation for the decline is that on average, firms that go dark are small with relatively poor performance and low growth.(38) Due to this typical poor performance, investors are advised to purchase shares from un-reporting issuers only where the company publishes an annual report, announces important events, and holds annual meetings (including the election of outside directors). It is perceived that failure to provide the aforementioned communications with investors is indicative of the company’s deteriorating financial condition, bad accounting, or other infirmity.(39)
In addition to the costs, going dark may trigger potential barriers to the selling of restricted and controlled securities, as authorized by SEC Rule 144. For a delisting issuer the most pertinent condition of filing a Form 144 with the SEC is the “current public information” requirement.(40) Issuers who are fully reporting automatically meet the requirement. Many Pink Sheet companies meet the reporting public information standard through the Pink Sheet service or via website information and financial postings. However, Pink Sheet companies do not automatically adhere to the condition; rather a factual question as to sufficiency of the information occurs.(41)
V. Potential Legal Ramifications
The 10-12% average drop in share price following the initial announcement of a subsequent filing of deregistration may lead to potential shareholder derivative actions. One such company that has experienced the legal backlash was Niagara Corp. A dissatisfied investor filed suit, alleging breach of loyalty and good faith. The New York court denied Niagara’s motion to dismiss the complaint, finding that the plaintiff had provided sufficient evidence that the decision to de-list was motivated by personal board self-interest, rather than a disinterested decision.(42) Michael Scharf, Niagara’s CEO, stated that corporate decisions are motivated by an attempt to maximize shareholder value, and due to rising costs under Sarbanes-Oxley the appropriate action decided upon was to delist.(43) The court decision was later reaffirmed in Berger v. Scharf.(44) Although deregistering or delisting are permitted corporate actions; such will be prohibited when utilized to perpetrate an inequitable purpose.
In Hamilton, minority shareholders brought an amended suit(45) alleging that the directors breached their fiduciary duties upon the deregistering and delisting of United Coast’s common stock and by failing to provide adequate public information concerning United Coast.(46) It was alleged that these breaches resulted in the elimination of the market for United Coast’s stock.(47) While the court believed that the amended suit was merely an afterthought, it was unwilling to dismiss the lawsuit as the court believed that the justiciable issues were factual in nature, rather than legal, and thus the proper determination as to sufficiency of fact would need be determined by a jury.(48) If an issuer does not have a history of shareholder actions but rather a good shareholder relationship, the cost factor alone must be considered significant in handling potential shareholder actions upon the issuer deregistering, a cost factor possibly not necessary of contemplation prior thereto.
The preceding cases demonstrate the possibility of incurring significant legal expenses as a result of deregistering securities, even when defending an action based on sound business judgment by management. Corporate actions can be taken by the board which will reduce the risk of litigation; however, it is impossible to eliminate the risk entirely.(49)
VI. Changing Regulatory Environment
As noted above there are discussions ongoing about potential changes to the current regulatory structure as related to Sarbanes-Oxley and smaller public companies. The Advisory Committee on Smaller Public Companies was chartered on March 23, 2005 with the purpose of assessing the current regulatory system for smaller companies. In their Final Report, published on April 23, 2006, the Committee recommended a series of changes, which would result in a new system of proportional regulation for smaller public companies. One of the major proposals is that until an adequate framework for assessing internal controls over financial reporting which takes into account corporate characteristics and needs, small cap and micro-cap companies should be exempt from the external auditor involvement of Sarbanes-Oxley Section 404 and certain other applications of SOX.(50) Thus far there have been only extensions of such application given, currently to expire with many small issuers’ deadlines for filing their next annual report. If some of the Committee recommendations are adopted by the SEC there could be a reduction in the number of firms going dark. The force driving many of the companies that went dark was the cost-savings resulting from no longer being under Sarbanes-Oxley, specifically Section 404. If the regulatory system is modified to adequately account for the size of the reporting company, then the cost impact of Sarbanes-Oxley may be minimized.
VII. Securities Exchange Act of 1934
EXHIBIT 1
Securities Exchange Act of 1934
Rule 12g5-1 – Definition of Securities "Held of Record"
a. For the purpose of determining whether an issuer is subject to the provisions of Sections 12(g) and 15(d) of the Act, securities shall be deemed to be “held of record” by each person who is identified as the owner of such securities on records of security holders maintained by or on behalf of the issuer, subject to the following:
- In any case where the records of security holders have not been maintained in accordance with accepted practice, any additional person who would be identified as such an owner on such records if they had been maintained in accordance with accepted practice shall be included as a holder of record.
- Securities identified as held of record by a corporation, a partnership, a trust whether or not the trustees are named, or other organization shall be included as so held by one person.
- Securities identified as held or record by one or more persons as trustees, executors, guardians, custodians or in other fiduciary capacities with respect to a single trust, estate or account shall be included as held of record by one person.
- Securities held by two or more persons as co-owners shall be included as held by one person.
- Each outstanding unregistered or bearer certificate shall be included as held of record by a separate person, except to the extent that the issuer can establish that, if such securities were registered, they would be held of record, under the provisions of this rule, by a lesser number of persons.
- Securities registered in substantially similar names where the issuer has reason to believe because of the address or other indications that such names represent the same person, may be included as held of record by one person.
b. Notwithstanding paragraph (a) of this section:
- Securities held, to the knowledge of the issuer, subject to a voting trust, deposit agreement or similar arrangement shall be included as held of record by the record holders of the voting trust certificates, certificates of deposit, receipts or similar evidences of interest in such securities: provided, however, that the issuer may rely in good faith on such information as is received in response to its request from a non-affiliated issuer of the certificates or evidences of interest.
- Whole or fractional securities issued by a savings and loan association, building and loan association, cooperative bank, homestead association, or similar institution for the sole purpose of qualifying a borrower for membership in the issuer, and which are to be redeemed or repurchased by the issuer when the borrower’s loan is terminated, shall not be included as held of record by any person.
- If the issuer knows or has reason to know that the form of holding securities of record is used primarily to circumvent the provisions of Section 12(g) or 15(d) of the Act, the beneficial owners of such securities shall be deemed to be the record owners thereof.
VIII. Securities Exchange Act of 1934
EXHIBIT 2
Securities Exchange Act of 1934
Rule 12d2-2(c) – Removal from Listing and Registration
c.
- The issuer of a class of securities listed on a national securities exchange and/or registered under section 12(b) of the Act may file an application on Form 25 to notify the Commission of its withdrawal of such securities from listing on such national securities exchange and its intention to withdraw the securities from registration under section 12(b) of the Act.
- An issuer filing Form 25 under this paragraph must satisfy the requirements in paragraph (c)(2) of this section and represent on the Form 25 that such requirements have been met:
i. (i) The issuer must comply with all applicable laws in effect in the state in which it is incorporated and with the national securities exchange’s rules governing an issuer’s voluntary withdrawal of a class of securities from listing and/or registration.
ii. (ii) No fewer than 10 days before the issuer files an application on Form 25 with the Commission, the issuer must provide written notice to the national securities exchange of its determination to withdraw the class of securities from listing and/or registration on such exchange. Such written notice must set forth a description of the security involved, together with a statement of all material facts relating to the reasons for withdrawal from listing and/or registration.
iii. Contemporaneous with providing written notice to the exchange of its intent to withdraw a class of securities from listing and/or registration, the issuer must publish notice of such intention, along with its reasons for such withdrawal, via a press release and, if it has a publicly accessible Web site, posting such notice on that Web site. Any notice provided on an issuer’s Web site under this paragraph shall remain available until the delisting on Form 25 has become effective pursuant to paragraph (d)(1) of this section. If the issuer has not arranged for listing and/or registration on another national securities exchange or for quotation of its security in a quotation medium (as defined in Rule 240.15c2-11), then the press release and posting on the Web site must contain this information. - A national securities exchange, that receives, pursuant to paragraph (c)(2)(ii) of this section, written notice from an issuer that such issuer has determined to withdraw a class of securities from listing and/or registration on such exchange, must provide notice on its Web site of the issuer’s intent to delist and/or withdraw from registration its securities by the next business day. Such notice must remain posted on the exchange’s Web site until the delisting on Form 25 is effective pursuant to paragraph (d)(1) of this section.
1 Rulemaking Petition of Nelson Law Firm to SEC, (July 3, 2003), available at http://www.sec.gov/rules/petitions/petn4-483.htm
2 Id.
3 SEC, Final Report of the Advisory Committee on Smaller Public Companies, (April 23, 2006), 1.
4 Id. at 86.
5 Leuz, Christian, Triantis J. Alexander, and Wang Y, Tracy. Why do Firm go Dark? Causes and Economic Consequences of Voluntary SEC Deregistrations. Working Paper No. RHS-06-045. (March 2006).
6 Id.
7 Id.
8 Id.
9 Id.
10 Id.
11 Id.
12 Id.
13 Id.
14 Securities Exchange Act of 1934 Rule 12d2-2.
15 LaRocco, Joseph B, (April 15, 2006), Pink Sheets Launching Premium Quotation Service, Ant & Sons., available at: http://www.antandsons.com/takesalook/pinksheetsquotationservice_041506
16 Id.
17 Admission Criteria for OTCQX, available at http://www.otcqx.com/admission.html: PremierQX will require: (1) a minimum bid price of $1, (2) an annual shareholder's meeting, (3) financial qualifications of a national stock exchange, and (4) meet the requirement for PrimeQX
18 Admission Criteria for OTCQX, available at http://www.otcqx.com/admission.html: PrimeQX companies must have: (1) management disclosure and annual management affirmation letter, (2) posting of quarterly and annual financial reports on OTCQX.com, (3) interim material event disclosures of any information which will impact the stock price, (4) an annual GAAP Audit, (5) 100 round lot beneficial shareholders, (6) ongoing operation, (7) inclusion in the S&P or Mergent Maunal, which will satisfy Blue Sky requirements for secondary transactions coupled with a list of any other states which the security is Blue Sky compliance and eligible to be sold by brokers in those states, (8) opinion letter for Designated Advisor for Disclosure ("DAD") upon application and annually thereafter indicating that the issuer has made adequate current information publicly available and meets the tier requirements.
19 (January 11, 2007), Pink Sheets Raises Eligibility Standards for OTCQX Designated Advisors for Disclosure (DADs), OTCQX.com, available at http://www.otcqx.com/pr-dad_standards_release.html
20 Moregenstern, M and Nealis, P., (2004), The Impact of Sarbanes-Oxley on Mid-Cap Issuers, Kahn Kleinman, LPA, 4.
21 Id. at 5
22 Leuz, Christian, Triantis J. Alexander, and Wang Y, Tracy. Why do Firm go Dark? Causes and Economic Consequences of Voluntary SEC Deregistrations. Working Paper No. RHS-06-045. (March 2006), 39.
23 Id.
24 Market capitalization is determined by multiplying stock price by outstanding shares.
25 LaRocco, Joseph B, (April 15, 2006), Pink Sheets Launching Premium Quotation Service, Ant & Sons., available at: http://www.antandsons.com/takesalook/pinksheetsquotationservice_041506
26 SEC, Final Report of the Advisory Committee on Smaller Public Companies, (April 23, 2006), 1: NOTE: companies with market capitalization under $75 million did not have to generally comply with Section 404 in 2004. Individuals believe that if said companies were required the comply the resulting percentage would be even greater.
27 Hartman E, Thomas, (June 15, 2006), The Cost of Being Public in the Era of Sarbanes-Oxley, Foley & Lardner LLP.
28 Leuz, Christian, Triantis J. Alexander, and Wang Y, Tracy. Why do Firm go Dark? Causes and Economic Consequences of Voluntary SEC Deregistrations. Working Paper No. RHS-06-045. (March 2006), 15.
29 Id.
30 Id.
31 Id. at 8.
32 Id. at 32
33 Id.
34 Marosi, A. and Massoud, N., (2004), Why Do Firms Go Dark?, University of Alberta Working Paper.
35 Leuz, Christian, Triantis J. Alexander, and Wang Y, Tracy. Why do Firm go Dark? Causes and Economic Consequences of Voluntary SEC Deregistrations. Working Paper No. RHS-06-045. (March 2006), 3..
36 Krantz, M, (November 2005), Don't Get Carried Away by Pink Sheet Stock Scams, USA Today.
37 Id.
38 Leuz, Christian, Triantis J. Alexander, and Wang Y, Tracy. Why do Firm go Dark? Causes and Economic Consequences of Voluntary SEC Deregistrations. Working Paper No. RHS-06-045. (March 2006), 2.
39 Deyshe, John, (October 9, 2006), Going Dark: The Harsh Reality of Voluntary Deregistration.
40 SEC Rule 144, available at http://www.sec.gov/investor/pubs/rule144.htm
41 Spadaccini, Michael, (July 2003), Untangling Rule 144: Restricted Stock Sales and Affiliate Volume Limitations, The Securities Law Report, Vol. 7.
42 Berger v. Spring Partners, LLC, 816 N.Y.S 2d 693, (2006).
43 When Companies "Go Dark," Investors Can Lose, BusinessWeek Online. May 24, 2004.
44 Bessette, Paul R., Biles, Michael J., Ahart, Christopher W., and Heard, Helen V., (2006, November) Considering Going Dark, Financial Executive, 1-4.
45 See Hamilton v. Nozko, 1994 Del. Ch. LEXIS 139 (Del. Ch. 1994). Originally the plaintiffs filed suit alleging that a pending exchange offer between ACMAT and United Coast (ACMAT owned approximately 83.6% of United Coast common shares prior to the exchange offer) was coercive and unfair to minority shareholders. When the exchange offer was withdrawn the plaintiffs amended the complaint to allege the breach of their fiduciary duty resulting from deregistering the securities and delisting United Coast, which was trading on NASDAQ.
46 Id.
47 Id.
48 Id.
49 Bessette, Paul R., Biles, Michael J., Ahart, Christopher W., and Heard, Helen V., (2006, November) Considering Going Dark, Financial Executive, 1-4: (1) review corporate charter and by-laws to ensure delisting is possible; (2) Form a Special Committee of independent directors who will review and approve the plan; (3) the directors should fully document the meetings and establish that the directors were informed regarding the cost/benefit analysis of the decision; (4) establish a clear business purpose supporting the plan (i.e. costs associated with Sarbanes-Oxley compliance); (5) obtain independent research supporting the plan; (6) ensure that the plan benefits all shareholders, if not then have the plan address the rights of adversely affected shareholders; (7) ensure that no director received a direct or indirect benefit from the delisting plan; (8) ensure that the company's communications and public disclosures are thorough and accurate about the process.
50 SEC, Final Report of the Advisory Committee on Smaller Public Companies, (April 23, 2006), 7. Small Cap with less than $250 million in annual revenues but more than $10 million in annual products revenues, and Micro-cap companies with between $125 and $250 million in annual revenues.