Firms Gone Dark: Another Reason to Abolish Street Name

Thanks to Jesse M. Fried for signing on to our draft petition to the SEC to abolish street name registration. (see also, Co-Filers Wanted on Petition to Eliminate Street Name Registration, 1/13/10 and Street Name Registration: An Antiquated Idea, HLS Forum on Corporate Governance and Financial Regulation, 1/30/2010) More important, Fried reminded us that moving to a system of direct registration would also represent a significant step in ending the abuses that often occur at Firms Gone Dark, which he explored in a paper by that name.

Securities laws generally permit firms to exit from mandatory disclosures even though their shares are held by hundreds (or even thousands) of investors and continue to be publicly traded if two
conditions are satisfied:

1. trading in the firm’s securities is moved exclusively to the “Pink Sheets” over-the-counter (OTC) market; and
2. the firm does not have any class of securities outstanding with three hundred or more “holders of record.” (section 12(g)(4) of the Exchange Act)

Since “holder of record” (see 17 CFR Section 240.12g5-1(a)) is the party “identified as the owner” of the security on the firm’s records, a firm with thousands of real (“beneficial”) owners can go dark. Fried describes the phenomenon, considers the desirability of mandatory disclosure and suggests that firms only be allowed to go dark if a majority of public shares (other than those held by insiders) are voted in the affirmative and it meets the two existing conditions.

Fried cites two previous efforts at reform.

1. A Petition for Commission Action to Require Exchange Act Registration of Over-the-Counter Equity Securities was filed on July 3, 2003 by several institutional investors to include beneficial owner holding securities in “street name” as holders of record.
2. In 2006, the SEC’s own Advisory Committee on Smaller Public Companies a recommended the SEC change the definition of “holder of record” to “beneficial owner.” (see Final Report of the Advisory Committee on Smaller Public Companies (April 23, 2006).

Either strategy (as well as that of our petition to require direct registration) would significantly reduce the number of firms going dark. However, the proposals “would not eliminate insiders’ incentives to undertake value-decreasing exits in order to expropriate value from public investors.” “Reverse stock splits and repurchase tender offers conduced in the shadow of an anticipated exit from mandatory disclosure can be used to cash out public investors at less that the actual value of their shares.”

While we favor Fried’s requirement that going dark be put to a vote of publicly held shareowners, we do believe acceptance of our petition would dramatically reduce abuses, since it is much easier to get below 300 “registered” owners when most are held in the name of Cede & Co. than it is to get below 300 actual owners under direct registration.

Take a look at some of the cases that have “gone dark.” From the petition by institutional investors:

“When the public’s investment interest was at its peak, SmartDisk was only too happy to access the public markets to finance its ideas. In these times, when capital-raising is difficult for technology companies with little or nothing in the way of earnings, SmartDisk’s management would callously plunge over 6,000 public investors into the dark, depriving them of the ability to monitor the management of the $17 million in total assets remaining from their original investment.”

United Road Services had assets of $100 million and 6,000 beneficial owners when it went dark in 203 with 294 holders of record. From Fried’s paper, “Over a twelve-month period beginning with the announcement, firms going dark experience abnormal negative returns of 16 percent, with these returns becoming more negative as the period lengthens.” The vast majority of firms not required to report provide little or no information to public investors. That makes it virtually impossible to monitor for self-dealing or for even normal business activities.

I encourage readers to sign on to our petition by e-mailing Jim McRitchie or Glyn Holton. Of course, we are also still looking for additional support in the way of papers like Jessie Fried’s Firms Gone Dark. Please let us know of additional examples where “street name” registration is problematic.