Wednesday, June 1, 2016

The SEC allows companies to go dark

There is a rule, Rule 12g, from the SEC which allows companies to deregister if they have less than 300 shareholders "of record".  A good background explanation can be found here.  If you invest in the microcap space this issue should concern you.  If you stay here long enough one of your companies will go dark and the stock price will tank and the company will tell you to go pound sand when you ask for a report...

Here is the SEC rule.  Rule 12g-4 allows a company to deregister if it has less than a certain number of shareholders.  That number is 1200 for a bank or 300 for other companies.
I think the 1200 is way too high but that's another discussion.  The rule's intention is if a company was public and now is nearly private then they should be able to deregister from the SEC, stop filing reports, and save themselves some money.  As a datapoint, KCLI approximated savings of $850k per year to stop filing with the SEC just last year.  That's a big draw and benefit to small companies who don't need to tap the public markets for additional funds.

Imagine a tiny company with only a million shares that is majority owned by someone.  The majority owner does not care about selling shares in their lifetime.  If they can save 3/4 of a million dollars annually that is a big deal.  Great deal for the insider who will know how operations progress but horrible for the general shareholder left in the dark.

The problem is with SEC Rule 12g-1 which defines shareholders "of record" to not include those shares held "in street name".  I hold shares in street name.  You likely hold shares in street name.  In late 2002, it was estimated that over 84% of securities were held in street name.  Street name means that while you own the shares, the official shareholders on the record books is your broker, such as Fidelity or Etrade or Merrill Lynch.  Myself and a thousand of my closest friends may hold shares through Fidelity but the company would only be required to count us as 1.  So when you see the number of shareholders listed on a companies 10K you are not seeing the real number of beneficial shareholders.  The company may only have 200 shareholders "of record" listed in the filings but really have 20,000 beneficial shareholders.  

Where am I going with this?  Well the SEC defines these rules and allows companies to go dark.  I will repeat that, the SEC allows this.  The SEC wrote the rule in 1965 when only 23.7% of shares were held in street name.  Now we have over 84% of shares held in street name and the SEC has not modified the rule.  

I have written to the SEC in the hopes they may change.  I don't think they will but who knows.  People have been urging them to change this rule for years but they have not.  I'm not sure why.  Even their own Advisory Committee on Smaller Public Companies advised them yet they did not act.  Below is my letter.  You should tell them how you feel

Recently the SEC asked for comments on a proposal.  They are considering what to require of companies when disclosing how many shareholders they have.  I took the opportunity to recommend they require proper disclosure of all shareholders.  

The SEC asked for comments be submitted by July 21, 2016 in this way:

ADDRESSES: Comments may be submitted by any of the following methods:
Electronic comments:
Use the Commission’s Internet comment form (http://www.sec.gov/rules/concept.shtml); Send an email to rule-comments@sec.gov. Please include File Number S7-06-16 on the
subject line; or
Use the Federal eRulemaking Portal (http://www.regulations.gov). Follow the
instructions for submitting comments. 
Even if you are late I encourage you to communicate with them.  It will only change if we push the issue.  

Dan









my email to the SEC:
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Hello,

I would like to comment on Item 201(b) listed on page 173 of the Business and Financial Disclosure Required by Regulation S-K concept.  

I am a private investor focused mainly on the microcap sector.  Large companies are followed by many high profile institutional investors and therefore competition is high for their securities.  There is little room to form an edge as an individual when thousands of others are all competing in the same space.  It is for this reason I, and many other individual investors, look at microcaps.  A tiny company is just too small to invite the large, well funded, and highly trained institutional investors of Wall Street.  The SEC must protect investors such as myself just as much as the large institutional investors.  

As it stands now the SEC is working with tiny companies to punish investors.  Let me say that again, the SEC is actively colluding with corrupt management to rip off shareholders.  It's time to stop.  The issue doesn't get air time because the companies in question are small so it's the individual investor such as myself who stands to lose.  Item 201(b) and Exchange Act Rule 12(g) do not require companies to recognize all shareholders.  Item 201(b) and 12(g) do not count shares held in street name as real owners of stock.  Rule 12g allows companies to deregister if they have less than 300 "shareholders" without so much as a vote and the SEC allows companies to conveniently forget about all shareholders held in street name.  What this means is there could be 10,000 people holding stock through one broker and the SEC would only consider this to be 1 shareholder.  When the Commission first adopted Rule 12g5-1 in 1965, approximately 23.7% of securities were held in nominee or street name.  In late 2002, it was estimated that over 84% of securities were held in nominee or street name. (credit to the SEC Advisory Committee on Smaller Public Companies).  The means right now most shares are held in street name yet the SEC does not recognize them; put another way the SEC is only protecting 16% of shareholders.  Think about that for a minute while considering why the SEC was formed in the first place. 

So let's say a tiny company wants to stop filing reports.  Management may have a number of reasons for doing this.  Some reasons are valid and noble such as wanting to save money.  Other reasons may be less so such as wanting to manipulate price to buy stock at depressed levels.  If the company is very small then chances are they have less than 300 shareholders "of record" as defined by Item 201b and Rule 12g.  All the company has to do is file a couple of forms and they can disappear forever with no thought given to the thousands of real shareholders holding shares in street name. 

Do you know what happens to the stock price of a company that deregisters from the SEC?  It drops to the floor.  Shareholders are left behind as the company discloses nothing.  No one knows revenue, earnings, or book value.  The only think people know is management doesn't care for shareholders so they sell and pretty soon the stock has lost most of its value.  

When a company goes public they sell shares to raise money with all buyers becoming shareholders.  The company owes it to these new shareholders to release information and the SEC owes it to the public to protect these new shareholders.  The new shareholders have helped out the company and the company must repay the favor by giving information, at a minimum.  But Item 201b and rule 12g allow companies to shirk this responsibility.  Imagine you buy stock in a small company.  You are excited about the opportunity this new company has to make it big.  Then the company abruptly stops filing any sort of report.  You ask the company for information only to be told they are not required to divulge anything because they have filed a form 12.  They don't answer the phone or respond to your emails.  The stock price tanks as shareholders are left in the dark.  Your retirement is a mess.  The company's management is now free to buy shares for pennies on the dollar as they are the only ones with any idea what is going on.  You have no one to turn to.  The government agency supposedly there to help, the SEC, does not recognize you as a shareholder so you are out of luck.  Eventually you have to sell at a huge loss.

Item 201(b) and rule 12(g) should be modified to require companies to recognize all beneficial shareholders, including those who whole share in street name.  This was surely the intent when rule 12g was adopted 50 years ago.  This is important for common stock shareholders of all companies.  This is mostly important for common stock shareholders of very small companies who have near 300 shareholders "of record".  

There is a long list of people who agree with my position.  The SEC Advisory Committee on Smaller Public companies recommended the SEC modify it's definition of shareholders "of record" to include those shares held in street name in 2006 (see Recommendation IV.S.1 here https://www.federalregister.gov/articles/2006/03/03/06-1992/exposure-draft-of-final-report-of-advisory-committee-on-smaller-public-companies).  Stephen J. Nelson, on behalf of eight institutional investors, authored a petition dated July 3, 2003 to amend Rule 12g5-1 in a manner similar to that which the Committee has proposed.  The NY State Bar also expressed general support for a reconsideration of the “held of record” definition.  Attorneys, who represent smaller public companies and are active members of the Committee on Federal Regulation of Securities and the Small Business Committee of the American Bar Association’s Section of Business Law have sent in a comment to File No. 265-23 in support of this position (see https://www.sec.gov/rules/other/265-23/aywalker041106.pdf).  

Yet the SEC has not acted.  It is time for the SEC to stand up for the little guy.  Stand up for the individual investor searching the microcap space.  Stand up for the couple managing their 401k as retirement quickly approaches.  I urge you to modify Item 201b and Rule 12g to redefine shareholders of record to include all those shares held in street name.  

I look forward to your response.  
Thank you for your time,

Dan Schum
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11 comments:

  1. Somehow Jason Zweig found this post and wrote a related article on the Wall Street Journal. Some really good info on there about how few shareholders "of record" many large companies have

    http://blogs.wsj.com/moneybeat/2016/06/10/shareholders-are-disappearing-before-our-eyes/

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  2. That's pretty impressive to be quoted by Jason Zweig and the WSJ, great job lol! I read that article in the WSJ (Zweig always seems to write fascinating articles and I enjoyed his updated version of The Intelligent Investor) today and decided to give your blog a look. The whole going dark thing is pretty scary, I'm glad I was made aware of that. Anyways, you remind me a lot of a net net Benjamin Graham type investor and if you stick with this style I think that you are going to reap great rewards in the end. A couple of questions: Peter Lynch probably has had the most influence on my investment style so I have a concentrated portfolio of both micro, small and large cap companies that are mostly at sane valuations. I own a couple of sub 100 million mkt cap companies currently (Peter Lynch got me really interested in small companies that have little to no analyst coverage and I have found some good deals so far) but I have never ventured into tiny, deep value names like you currently are. How do you make sure these companies are real and/or suspicious activity isn't taking place? And what author/blogger/person(s) etc has had the most impact on your investing style? Keep up the good stock investigative work.

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  3. Thank you. When I saw an email from Jason Zweig in my inbox I was floored. I've own his version of the Intelligent Investor. So amazing

    First thing to remember is there are a ton of crap companies on any exchange. Don't fool yourself into thinking a company is safe just because it's on the NYSE. Same goes for market cap or having an audit. Enron had audits. Huge well known and loved companies go down too

    Second thing is if you play in this area you will lose big on some stocks. It'll happen. Eventually some tiny company I own will go bankrupt or stop filing and fall to nothing. That's the risk

    oddball stocks did a post recently that you'd find interesting. http://www.oddballstocks.com/2016/06/how-to-eliminate-bad-microcap-companies.html

    I would put myself somewhere between an optimist and realist with these companies. I just look at the facts and generally take what I'm told to be true. I look at the financials and if it's cheap then buy. Anymore I make decisions within an hour, usually less. Find companies that are tiny, heavy inside ownership, no debt, illiquid, low number of shares outstanding, cheap and ignored. Of course you can check their website, check to see where the products are sold. There are definitely companies I've stayed away from. I'm weary of anything from China due to how many frauds have been found. There are companies out there with no revenue which I would not touch. If there are a ton of insider transactions I'd be cautious. And of course you never know what they aren't reporting but that's true with any company.

    I have moved more towards diversification and now own about 23 stocks. I used to concentrate but was wrong on the one I had most confidence in (GLGI) and it just showed me how much I don't know. I don't have confidence I'll ever know for sure enough about a company so I spread it out more now. That being said my current largest position is probably 1/3rd of my portfolio, so...

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    1. 2/2

      I follow a ton of blogs but don't read as intently on them as I used to. I spent a couple years reading like crazy to learn and now most of my reading is reports. I have a long flight and drive coming up so I got a few charting books to read, that's a new area for me. You can find my favorite blogs on my blog roll. Most educational blogger for me would be oldschoolvalue.com; I've learned a ton from Jae there. I loved reading about Walter Schloss on basehitinvesting.com. That was an eye opener and just clicked with me. He was so chill, just find cheap small companies. No crazy analysis or tons of time spent. I have a friend who's been investing for years and he really pushed this style. I like Phil Fisher and Buffet but just don't feel I can evaluate a business like they can. Haven't read Lynch yet. I used to own larger stocks because as a newcomer that's what I was comfortable with. I had AAPL, MSFT, etc but soon I realized there was no way for me to ever know more than other investors so why compete. I've seen some studies that mention the smaller companies have better returns, less liquid companies have better returns, etc. One thing for sure is most people will not even consider the stocks I buy so there is the opportunity, plain as day. Just read the comments on the WSJ article. I have a family and full time job. I have no formal business or investment training. There are a ton of really smart and highly trained people looking through the bigger companies constantly and I don't think I can compete with them. So my edge is to go places others will not and be more patient than the masses.

      Also the returns can be way better. Just think about how much money would have to flow in to double AAPL's market cap. It's mind boggling. But for a $2M market cap company all they need is one big contract and boom. Just look at what one agreement has done for ZMTP.

      Big companies make me uneasy now. These small companies are so simple. A 10k from these little companies can be read in 15 minutes. The investment decision on COMX and ADDC took 5 minutes. Maybe less. As fast as I could translate their numbers into per share values in my head I was deciding to buy.

      That got long. I enjoy this stuff. thanks for the comment
      -Dan

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  4. Thanks for the in depth answers, I appreciate it. I'm in the same boat as you (not much actual formal financial training) but fortunately I don't feel like it's a big crutch after I've read Graham, Lynch, Buffet, Fisher and a lot of financial blogs. I 100% agree with you that the microcap universe is where individual investors like us have an advantage (or least equal footing) with professionals since so few people actually follow these companies. A lot of potential hidden gems in this space. Also, thanks for the links and suggestions, I'm going to look into those. About your blog post: have you thought about leveraging your letter and now the attention from the WSJ into creating a formal petition of the going dark rule? I know that the SEC can be really stodgy and slow to get anything done, but maybe your letter, support from a major newspaper and a large social media following could possibly help the SEC see this is a big problem and affect change. Just a thought.

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  5. What do you mean by a 'formal petition'? Like a change.org thing where I gather signatures?

    I did submit a formal response to their request for comment. You can see it here: https://www.sec.gov/comments/s7-06-16/s70616.htm

    One blog reader has followed my lead and I'm hoping other will do the same.

    I know the SEC is slow. They took comments on this exact subject from 2006-2009. They formed a small business advisory committee which recommended changing the rule but ultimately didn't change. But we have to keep trying

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    1. Ah ok, I see now. Change.org isn't a bad idea. Enough signatures could enhance your request even more in my opinion. Not sure if it will speed up things at the SEC one iota but hey it could be worth a shot

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  6. Thanks Dan. I just read the WSJ article and followed the link here and joined you in sending a letter to the SEC.

    Oops, letter is too long for one post, so I will split it.





    Dear SEC,



    On pages 174-175 you commented and asked the following:



    "When Congress enacted Section 12(g) in 1964, most security holders in the United States owned their securities as record holders.



    Should we retain or eliminate Item 201(b)(1)? Why? If retained, should we modify the item and if so, how?



    As the vast majority of investors now hold their shares in street name, does disclosure about the number of record holders continue to be important to investors?



    Should we require registrants to disclose the amount of each class of

    equity securities held in street name?



    Should we require registrants to disclose the number of beneficial owners? If so, how should we define “beneficial owner” for purposes of Item 201(b)(1)?



    How would investors benefit from this additional information?



    What types of investors or audiences are most likely to value the information required by Item 201(b)(1)?"






    I think the most important question about a 'security holder' is not being asked. That is, "How should a 'record holder' now be defined?” The vast majority of shares are now held in 'street name' and in some cases these shareholders are not being treated the same as 'registered shareholders' in the same company.



    Here are a couple of recent examples which show this disparity in treatment. First, some companies I own only send out notice of their annual meeting to their registered shareholders and not to shareholders who hold their shares in street name at their brokers. Second, in some recent 'going dark' transactions only registered shares were purchased to get below the required 300 shareholder limit and not street-held shares.



    Since SarbOx was passed, hundreds of small companies have followed the letter of the law, deregistered and 'gone dark'. On average, these small companies save several hundred thousand dollars annually in expenses by no longer being required to file with the SEC. Some of the mid-size companies 'going dark' can save a million dollars annually.



    So there are good reasons to shrink the shareholder base to less than 300 "shareholders of record", but 'beneficial owners' should now be included in the 'record holder' class. In this day and age, it doesn't make sense to exclude beneficial owners from being record holders. It's an antiquated rule that should be changed.



    If street-held shares do continue to be treated unequally and unfairly after a company deregisters, then there should be restrictions on those now dark companies from going completely 'radio silent' and providing no ongoing financial information to their remaining shareholders.



    I invest in deep value small cap companies. I've owned some for years only to be told when they 'go dark' that the rules regarding transparency would be changed on a going forward basis. Some companies continue to post their financials quarterly or annually, only to stop doing so after a period of time. Others never even bother posting any financials from the day after they deregister.




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  7. What is a small investor to do in that situation? As shareholders, we can beg our company management to provide some transparency, but in many situations the company is unresponsive. We can send a letter insisting we have rights as shareholders, but the company can still make things very difficult for their outside shareholders. They can require an onerous and overly restrictive non-disclosure agreement to be signed. The can also insist that nothing will be mailed and a small window of time will be provided at a venue of their choice to pick up the financial statements of the company. So, in addition to the inconvenience and expense of travelling in order to get any information, sometimes a lawyer must be retained if the company doesn't wish to comply with even these limited chances to obtain information.



    If a company chooses to no longer provide any financial information to their shareholders, they should 'go private' and not 'go dark’. A fair price can be paid to all shareholders and, if unfair, shareholders have recourse in perfecting their appraisal rights. A newly dark company which provides no financial information creates a purgatory for remaining shareholders and as time rolls on, the total lack of communication results in a much lower stock price and a hellish experience. As shareholders, this is OUR company too and the choices shouldn't be to hang on and lose money or sell and move on.



    Shareholders in such companies still have the right to know what's going on in their company. Many companies are incorporated in Delaware which has a distinct set of rules for shareholders to get information, but companies incorporated in other states have different and often more restrictive or vague rules.



    I do understand why small companies want to save on expenses and no longer file with the SEC, but all companies have audited annual financial statements and it would not be difficult for these companies to do one or more of the following: (i) send those statements to OTC Markets to be publicly posted, (ii) email them to shareholders, (iii) provide a portal for shareholders to access or (iv) post them publicly on their website.



    It's totally unfair that some shareholders have an information advantage. The insiders know what is going on, while outside shareholders are left in the dark.



    Currently my brokers (e.g. Fidelity and CapitalOne) will no longer even let me invest in companies that provide no information. It doesn't matter that I owned these stocks for years at these firms, I can no longer even add to my position. So with an information vacuum and fewer buyers, it's no wonder the trend in price is down year after year after they 'go dark'.




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  8. The WSJ had an interesting article recently that may result in the SEC redefining 'shareholders of record' if larger companies start pulling the same stunt as smaller companies and restricting or curtailing information flow as discussed above.



    "According to S&P Dow Jones Indices, more than one-fifth of the 1,500 largest companies in the U.S. have fewer than 300 official shareholders. Eight companies with market values of at least $1 billion each report having no more than 10 shareholders of record."



    http://blogs.wsj.com/moneybeat/2016/06/10/shareholders-are-disappearing-before-our-eyes/



    So, technically, a large and controversial or beleaguered company could deregister and go dark. Some may even choose to do what their smaller brethren have done and make it very difficult to get information because after all they no longer file with the SEC.



    It was noted that, "Lumber Liquidators Holdings, the hardwood-floor retailer, has 27 million shares outstanding (total market value: $388 million), but only eight so-called shareholders of record."



    If insiders owned enough shares and grew tired of bad press or activist activities, they could simply just try to deregister. It's time to change the rules and count all shareholders the same and as equals. And for those who have already deregistered, to either provide financial information to their shareholders or go private.



    Thank You,

    Jim Rivest

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  9. Thank you Jim. Great letter. I hope we see some action

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