Spinoff & Reorg Profiles

July 2005 Excerpt

Copyright 2005 William E. Mitchell


If it’s advantageous to buy a company whose management owns a significant stake in the firm, then it’s even better to find management actively buying up more of the company. And still better if management appears to be trying, within the law, to limit public knowledge of its buying, or limit the opportunity for outsiders to enter. If you are one of the few people to notice such a situation, it can be much easier to identify a bargain.

Imagine a poker game in which you, and only you, know of one other player that can see all the cards before they’re dealt. Yes, that other player has an advantage over you. But you, by simply watching his betting strategy, automatically have an advantage over all other players in the game.

It’s a bit like this with insider buying. Managers see all the cards – or, at least, many more than you – and in the long run will allocate personal funds accordingly. If you are one of only a few watching their game, you have an
advantage over other investors. Thanks to SEC reporting requirements, the real world works better than the analogy, because as long as you analyze financial statements carefully and don’t overpay, you’re not gambling. You’re simply using the actions of management as a marker of potential value for further study, while avoiding competition with other investors.

Like the poker player above, a manager faces signaling problems when investing in his own firm. If he just buys on the open market, his insider status may cause speculation, cause the share price to rise, and limit his ability to buy cheaply. Some managers avoid this through a carefully designed rights offering.

In a rights offering, a company offers existing shareholders the right, but not the obligation, to buy newly issued shares in the firm. Since the offering is not public, there are no underwriting fees. Rights offerings are thus a way to raise additional capital for a growing business with less complexity and transaction cost than a public offering.

Since shareholders are not obligated to exercise their rights, many authorized shares typically go unpurchased — though a failure to exercise these free rights, which are nearly always struck slightly below the market price, should mainly be ascribed to the ignorance of the shareholder. What happens to these unexercised rights? That depends upon the terms of the rights offering, and the intentions of management.

Perhaps most meticulously fair to shareholders would be simply to let them expire. Second fairest, and most common, is to assign them to remaining exercising shareholders pro-rata (a so-called “oversubscription” privilege), so that they may buy up more shares at the advantageous price. This has the effect of diluting the ownership of non-exercising shareholders, but the benefits accrue proportionally to other existing shareholders.

There are still other ways, possibly less fair, but still legal, to handle those extra shares. For example, management may decide to dole out all unexercised rights to themselves and their friends. Management can argue this is not a violation of fiduciary responsibility, because (i) the shares were first offered pro rata to all shareholders at one price, and (ii) management is exercising only residual rights, and only at the original exercise price.

Why would management go to this trouble? Couldn’t they just do a private placement and accomplish the same effect? Actually, no: they would run afoul of their fiduciary role if they purchased shares below market price, without first offering them to all shareholders. By using the rights offering, they give existing shareholders a nominally fair chance to buy. But the fact is that, for these insider oversubscription situations, management depends upon shareholder ignorance to create a supply of unexercised rights for them to reallocate.

Whatever the ethical implications, this insider oversubscription is legal, to the best of our knowledge. And as long as the exercise price is reasonably close to the market price, it signals unmistakably to the investor that management sees great things ahead. Situations like this do occur, and often go unreported by the media. This month’s selection, American Bank Holdings, Inc., is a case in point.

We found American Bank Holdings using Qscreen, our structured screening system for corporate filings, currently in free beta at www.qscreen.com. [Update:  site now resides at situations.gemfinder.com. ]  The system continuously scans for certain situational investments, ranks the results, and displays only those items most
likely to bear further study. Qscreen is not intended as a substitute for research; it merely automates the first steps in qualifying certain types of situational opportunities, for further analysis by a real person. The system is currently configured to identify spinoffs, rights offerings, voluntary deregistrations and delistings; however, it can be customized to seek any type of situational opportunity.

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William Mitchell is a private investor in Orange County, California. In addition to Spinoff & Reorg Profiles, he publishes Gemfinder Special Situations Notifier, an online system for analyzing corporate filings, and IncomeProfiles.com, an investing guide for individuals. He holds an MBA from Stanford University, a BS in engineering and applied science from Caltech, and a BA in physics from Reed College.