Spinoff & Reorg Profiles
June 2005 Excerpt
Copyright 2005 William E. Mitchell
PROFITING FROM VOLUNTARY SEC DEREGISTRATION
A new family of opportunities has taken shape, thanks to the vilified Sarbanes-Oxley act (SOX). With accelerating frequency, smaller firms are going dark, or, as the SEC would term it, voluntarily deregistering their stock to avoid SOX compliance requirements.
Not all companies do this merely to avoid scrutiny. Cost is a big factor. As the CFO of a small public RLEC told us recently, SOX compliance is costing even the smallest firms about $1.5 million per year. Thus a company with under $100 million in sales can substantially increase its earnings by going dark, other things equal. A sad day for American capitalism, but as investors, we see at least three ways to take advantage of the situation.
First, smaller individual investors have a simple arbitrage opportunity, as follows. Most voluntary deregistrations are accomplished by reverse split. The company does, say, a 1-for-2,000 split. Everyone who previously held fewer than 2,000 shares now holds a fraction of one share. The company then cashes out all fractional shares at an announced price. This essentially forces all small shareholders to sell. The split ratio is scaled such that, after the cash-out of fractional shares, the company is left with fewer than 300 shareholders, which under SEC regulations frees them from the obligation to file financial statements, report to the SEC, or comply with SOX. Typically there is a spread of a few percent between the market price and cash-out price, so a small investor can buy a number of shares that will convert to a fractional share, and receive a cash return from the issuer of a few percent in a couple of months. Note there is no commission on the sell side, since the sale of stock is directly to the issuer, not through a broker. The limitation of this idea is scale: it’s hard to make more than a couple of thousand dollars per transaction.
Another gotcha is cancellation: as this tactic has become popular, some managements have seen unexpected numbers of smaller shareholders suddenly appear after a voluntary deregistration is announced.
Management decides the cash cost has become too high, and cancels the deal, leaving you stuck with the commissions on both the buy and sell side. A good resource for navigating these waters is the person who first described this arb to us: Richard Dixon at Standard Investment Chartered.
A more scalable way to play deregistrations is simply to…
…before deregistering the parent.
To find all voluntary deregistrations of U.S. firms as they become available, please visit our automated SEC filing analysis system, Qscreen, at www.qscreen.com. Running as a public free beta since March 2005, Qscreen will become a commercial service after certain improvements are incorporated. Please send your suggestions – we’ll try to include the most popular ones. [ Update: qscreen moved to http://situations.gemfinder.com in 2007, and is no longer free. ]
If you find we’re routinely leaving out information you would find relevant to your decision-making, please contact Spinoff & Reorg Profiles with your suggestions. When we receive a preponderance of sensible requests for a particular element, we’ll include it in future issues.
ABOUT THE AUTHOR
William Mitchell is a private investor in Orange County, California. In addition to Spinoff & Reorg Profiles, he contributes to IncomeProfiles, a conservative investing guide for individuals. He holds an MBA from Stanford University, a BS in engineering from Caltech, and a BA in physics from Reed College.