Falling Stock Prices and Rising Compliance Costs May Make Going Private an Attractive Option

Historically, many smaller companies entered the public market in order to increase their access to capital and create a liquid market for their shares. In the late ’90s, even some micro-cap stocks were swept up in a rising market fueled by the explosive growth of the technology industry. But these same companies were hit hardest when the bubble burst — some previously high-flying stocks now trade for pennies a share, when they trade at all. This is particularly true for smaller companies that are unable to attract analyst coverage that could create a higher profile for their shares.

In the wake of the ENRON debacle and other high profile corporate scandals, President Bush signed into law the far-reaching Sarbanes-Oxley Act in July 2002. This new law makes significant changes in corporate governance and disclosure requirements for public companies. Combine today’s sluggish market with the ever mounting cost of regulatory compliance, and many corporations are now considering a return to the private sector.

A company can “go public” in several ways, including an IPO, reverse merger or voluntary filing. Some companies become subject to SEC regulation simply because they have a large number of shareholders. Regardless of how they got there, all public companies are subject to an extensive body of rules and regulations, primarily under the Securities Exchange Act of 1934. For example, the Exchange Act requires companies to file annual and quarterly reports with the SEC. Sarbanes-Oxley added significant new requirements to the Exchange Act in an effort to protect the public against the fraudulent acts and accounting irregularities recently brought to light.

Rising Costs

Despite Congressman Michael G. Oxley’s protestations to the contrary, most experts agree that Sarbanes-Oxley and the new regulations it continues to spawn significantly increase the cost of being a public company, as well as the liability burden borne by the directors and officers of these companies. Furthermore, the new requirements generally don’t differentiate between the largest and smallest corporations, and have a disparate impact on smaller companies that are not easily able to absorb growing compliance costs. It is anticipated that costs for legal and accounting fees, D&O insurance, and investor relations services will all increase as a result of the new regulations. A recent study by Foley & Lardner and KRC Research estimates that the new law will almost double the regulatory cost of being a public company. The cost of attracting and retaining qualified independent directors to serve on public boards and newly-created committees is less easily calculated, but not insignificant.

Public corporations can avoid these burdensome new rules by “going private.” And returning to private status may also provide relief from the short-term pressures and growth expectations of the public market, allowing management to focus on the company’s long-term health instead of quarterly earnings. Perversely, being publicly-traded in today’s bear market may actually hinder liquidity for a small company that trades for less than its true worth, because management will be unlikely to convince a potential investor or acquirer to pay a significant premium over the stock’s market price. Of course, there are advantages to being public, but on balance, many companies have decided the benefits of going private outweigh the potential advantages of remaining public.

Exiting the System

Just as a company may become subject to SEC rules in several ways, there are various methods of exiting the system. All “going private” transactions take advantage of an SEC rule that allows a company to unilaterally deregister its shares if it has fewer than 300 shareholders of record (or 500, if its assets total less than $10 million). In fact, because the number of record holders is usually far lower than the actual number of shareholders since the shares of many investors are held in “street name” by their brokers, many small companies already have fewer than 300 record holders. For these companies, a brief filing with the SEC is all it takes to “go dark” and suspend all further Exchange Act filing requirements. For others, it is possible to drop below the 300 shareholder threshold in one of several ways. The most common going private transaction structures are a management buyout, third party tender offer followed by a “clean-up” merger, or a reverse stock split in which shareholders with fewer than a predetermined number of shares are cashed out.

Keep in mind that the cost of going private can be significant depending on the structure of the transaction, the number of shareholders and the price of the stock. However, without the last decade’s “irrational exuberance” artificially inflating stock prices, small shareholders can often be cashed out very economically. For example, I recently completed a reverse stock split where the company expended less than $120,000 to buy back enough shares to go private. Another pending going private transaction would require the payout of a mere $310.

Regardless of its structure, the going private transaction must also meet fairness standards to comply with fiduciary duties the officers and directors have to their shareholders. These standards will be significantly higher in a management buy-out. Depending upon the method selected for returning to the private sector, it may also be necessary for a company to obtain shareholder approval before proceeding, although in some instances this can occur without a meeting. Unless the company already has fewer than 300 shareholders, any action that would bring them below that threshold, like a reverse stock split, requires a fairly extensive filing that is subject to SEC review. And although not required, many boards will find it advisable to obtain a fairness opinion to protect them from the risk of a disgruntled shareholder’s lawsuit.

A Continuing Trend

In spite of these potential challenges, for many small companies the cost and regulatory burdens of being public simply outweigh its benefits. For these companies, the confluence of depressed stock prices and increased regulatory costs make going private an option that is too attractive to ignore. Although it’s difficult to ascertain how many companies are going private because of the new regulatory burdens, it is clear that a growing number are exiting the system. With additional SEC proposals on the horizon and no real relief in the capital markets, we can expect this trend to continue.

Christopher J. Hubbert is a partner of the Cleveland law firm Kohrman Jackson & Krantz. His securities practice focuses on capital formation via both public and private placements, SEC reporting for public companies, tender offers and proxy contests, and recently, going private transactions. Adarsh V. Mantravadi is a second-year law student at Indiana University School of Law and clerked at Kohrman Jackson & Krantz in the Summer of 2003.

This article originally appeared in the October 2003 issue of Law and Fact Magazine, a publication of the Cuyahoga County Bar Association.