Going Dark – An Alternative to Sarbanes-Oxley Compliance
by Brad Jacobsen and Chris Scharman
A client of ours recently learned first hand the significant costs that implementation of the Sarbanes-Oxley Act of 2002 (“SOX”) can have on a small business issuer. In connection with the review of the company’s quarterly report, its chief financial officer unfortunately made an off-hand remark regarding the company’s internal controls and procedures. As a result of such comment, the company’s auditors demanded that the audit committee hire independent counsel and conduct a full review of the company’s financial statements – with a materiality threshold (items requiring documented back-up to be provided to the auditors) of only $2,000. Over the next six weeks, the company incurred in excess of $300,000 in legal and auditing fees (not to mention lost opportunity costs and lost management time), filed its 10-QSB late and was threatened with potential delisting by Nasdaq. The resulting review by the auditors and the audit committee’s independent counsel found no improper or illegal acts by the company and only required that the company make adjustments to its accruals of a net aggregate amount of less than $1,000. The significant cost incurred by the company for this review nullified its entire third quarter profit.
Like other small business issuers, our client must now seriously consider whether being a public company is in the best interest of its shareholders. As the deadline for compliance with the costly and time-consuming internal controls and procedures requirements for small business issuers nears,1 many public companies (small and large) are also evaluating the merits of remaining public.
The primary means for a public company to avoid its obligation to comply with the reporting requirements of the Securities and Exchange Act of 1934, as amended (the “Exchange Act”), is to “go private.” While going private can be costly and time consuming, many companies are eligible to go private by simply filing a one-page form with the Securities and Exchange Commission (the “SEC”), a Form 15.2 The filing of the Form 15 without a preceding going private transaction is often referred to as “going dark” and is available to any company, with a few exceptions, that has fewer than 300 shareholders of record.3 While most public companies have more than 300 individual, or “beneficial,” shareholders, the ability to go dark measures only the shareholders “of record” (not the actual individual shareholders). It is estimated that over 84% of securities of most public companies are held in nominee or street name (not held of record by individual shareholders),4 therefore making the option to go dark available to many public companies. It should be noted, however, that there have been recent discussions to amend the Exchange Act rules to require that beneficial (actual individual shareholders) and not simply record shareholders be included in such count.5
“Going dark” and “going private” are sometimes mischaracterized and confused with one another. In fact, following a going private transaction (discussed later), an issuer will file a Form 15 in order to go dark. Going dark and going private both eliminate the obligation of an issuer to file periodic financial and other reports with the SEC, terminate the issuer’s obligations to comply with the most onerous provisions of SOX and relieve the issuer of the rules and regulations of its applicable stock exchange on which its shares were listed. However, there are important distinctions between the two, the most notable being that going dark companies usually continue to trade after the date of deregistration on a public market, such as the Pink Sheets.6 This article briefly discusses going private transactions, but focuses primarily on a company’s decision to go dark.
The following sets forth certain issues and matters related to the process of becoming a private company (i.e., no longer being required to file reports with the SEC under Sections 12(b), 12(g) or Section 15(d) of the Exchange Act).
Going Private vs. Going Dark
There are two distinct approaches to becoming a private company. The first is referred to as “going private,” and the second is referred to as “going dark.”
(a) Going private generally involves a transaction in which cash is exchanged for stock of a company’s existing public shareholders and is designed to reduce the number of shareholders to below the minimum threshold required to deregister a company’s stock. In fact, the transaction often results in the company’s stock being held by a single party or group of related parties. Such transactions typically include mergers, third party tender offers, reverse stock splits and self-tenders by the company. Those types of transactions are typically costly and require substantial disclosures and filings with the SEC. Going private transactions tend to be scrutinized closely by the SEC (the Schedule 13E-3 filed in connection with a going private transaction will almost certainly be reviewed and commented on by the SEC), as such transactions often include a risk of insider self-dealing. When a controlling stockholder or group of controlling shareholders is involved in the transaction (which is usually the case), the transaction will be reviewed under the “entire fairness” standard, rather than the lesser standard of the business judgment rule.7 If litigation ensues, which it frequently does in these cases, the board will have to meet this higher standard in defending both its decision to go private and the manner in which the company went private. Such transactions, however, are often favored by shareholders and institutional investors because they require shareholder approval in certain circumstances (mergers, reverse splits) or affirmative actions by the shareholder to tender their shares (which they have the option to do or not do depending on their perceived fairness of the transaction). Upon a merger (or reverse stock split in certain jurisdictions), shareholders will also have appraisal rights.
(b) Going dark, on the other hand, is significantly simpler but is available only to companies whose number of record shareholders already falls below the minimum requirement for continued public disclosure under the federal securities acts (300 shareholders in the case of most small business issuers).8 Going dark essentially requires only filing a simple form, the Form 15 (also a Form 259 for companies listed on a national securities exchange such as NYSE, AMEX and Nasdaq), which suspends a company’s public status and reporting obligations (described in more detail below). Although the required form and process are relatively simple and inexpensive (see below for further discussion), a company must properly analyze all aspects of going dark to determine if it is appropriate for the company and to ensure compliance with all SEC regulations.
Reasons to Go Dark
In 2003 and 2004, approximately 300 U.S. companies deregistered their common stock (for reasons other than in connection with a going private transaction) by simply filing a Form 15 and going dark.10 There are many reasons companies choose to go dark, including the following:
• reduction in the costs of being a public company, including those costs imposed by Section 404 (Internal Controls and Procedures) of SOX;11
• greater corporate governance flexibility;
• allowing management to spend less time on compliance and reporting activities and more time on the company’s business;
• the ability to focus more on long-term financial results and goals rather than short-term market concerns;
• termination of the requirement to disclose competitive business and other sensitive information;
• going dark may provide additional cash for distribution to shareholders or other corporate purposes;
• reduction of potential liability of directors;
• limitation to the risk of litigation (other than in connection with actually going dark) due to the lower number of shareholders; and
• termination of the compliance obligations with the proxy rules, insider reporting obligations, periodic reporting requirements and regulation FD, along with their associated legal liability and costs.
Potential Disadvantages of Going Dark
Going dark also has potential disadvantages that should be carefully considered, including the following:
• reduced liquidity of a company’s stock;
• reduced ability to use a company’s stock as currency in acquisitions;
• perceived loss of prestige;
• potential to make stock-based incentive plans less attractive to employees;
• loss of access to the capital markets to raise money;
• the risk that a company’s shareholder base will grow above 500 record shareholders requiring the company to again become a public reporting company;
• not having audited financial statements and complying with certain of the requirements of SOX may make a company less attractive as a potential acquisition target or for future financings;
• as a result of no longer filing periodic reports, holders desiring to sell pursuant to Rule 144 will usually be required to hold their securities for two years rather than one year;
• the substantial risk of shareholder litigation regarding the decision to go dark;
• potential loss of stock value12 and, even if the company maintains trading status on the Pink Sheets,13 lower trading volumes; and
• no payments are made to shareholders in connection with the loss of liquidity that going dark will bring.
To go dark, a company must have fewer than 300 record shareholders or, where the total assets of the company have not exceeded $10 million on the last day of each of the company’s three most recent fiscal years, 500 record shareholders.14 Upon filing the Form 15, the company’s obligation to file periodic reports is suspended for a 90-day review period (see below for further discussion). If the company’s shareholder base increases above the minimum shareholder number requirement during such period, then the company would again be obligated to begin filing periodic reports. This can happen for reasons outside of a company’s control, such as when a broker that holds company stock in street or nominee name distributes that stock to the beneficial owners, thereby effectively increasing the number of record owners. Following the 90-day period, the company would not again become obligated to file periodic reports unless its shareholder base exceeded the minimum requirement of 500 shareholders that applies to any other private corporation, irrespective of the deregistration.15
Filing the Form 15 (and Form 25 if Applicable)
To effectuate the termination of a company’s obligation to comply with the Exchange Act reporting requirement, a company must file a Form 15 with the SEC. A company that engages in a going private transaction must also file a Form 15 in order to terminate its reporting obligations. The Form 15 requires a company to certify that it meets the above-referenced record shareholder number requirements.
If the company is listed on a national securities exchange (Nasdaq, NYSE, AMEX), it will also need to file a Form 25. Pursuant to Rule 12d2-2 under the Exchange Act, ten days prior to filing the Form 25, the company must first notify the appropriate exchange, issue a press release regarding the imminent filing (filed as a Form 8-K, Item 3.01 “Notice of Delisting...,”) and post a notice on its website. The Form 25 delists the issuer’s shares from the relevant stock exchange. The delisting is effective ten days after the filing (unless the SEC postpones the effectiveness) and withdrawal from Section 12(b) reporting (reporting required by virtue of having a class of securities registered under Section 12(b) of the Exchange Act) by the issuer will take effect 90 days later.16 As with the Form 15, the requirement to file periodic reports is suspended on filing, although the tender offer and proxy rules will continue to apply to the issuer until the deregistration is effective. Although delisting under the Form 25 will terminate registration under Section 12(b) of the Exchange Act, the company’s SEC reporting obligations are not terminated because the shares will still be registered under Section 12(g). The company will then additionally need to file a Form 15 as described above.
The going dark/private transaction becomes effective 90 days after the filing of the Form 15 with the SEC, unless the SEC denies the application. Even though a company’s duty to file periodic reports (i.e., Forms 10-K, 10-Q and 8-K, but not necessarily proxy statements or Forms 3, 4 and 5) is suspended immediately upon filing the Form 15 with the SEC, if the SEC denies the Form 15, or it is otherwise withdrawn, then the company is required within 60 days to file all reports that would have been required had the Form 15 not been filed.
Recently Effective Registration Statements
A company registered under Section 15(d) of the Securities Act will not be able to suspend reporting during the fiscal year in which a registration statement covering a class of securities is declared effective. Additionally, no issuer may suspend reporting obligations under Section 15(d) unless the company has filed all of its annual and quarterly reports for the shorter of: (a) its most recent three fiscal years and the portion of the current year preceding the filing of the Form 15; or (b) the period since the company became subject to reporting obligations.17
Approval Procedure and Legal Risks
(a) Shareholder approval is not required to go dark, but a company’s board of directors must approve and authorize the going dark procedures and the filing of the Form 15. Board approval must be given at a duly-called meeting of the board or, alternatively, by unanimous written consent of the company’s board. In approving a decision to go dark, a board of directors must fulfill its fiduciary duties. The precise duties that apply in the context of going dark are not entirely clear, although it is clear that the board of directors must believe in good faith that going dark is in the best interests of the company and its shareholders and be able to provide reasonable justifications for reaching that conclusion. As previously described, a board’s decision will usually be reviewed under the business judgment rule standard.
(b) Although there is no affirmative duty to ensure a market in a company’s stock, a shareholder may argue that going dark is a breach of fiduciary duty because shareholders assumed or expected the company’s stock would have greater liquidity and that the company encouraged this perception. To reduce this possibility, companies not already listed on the Pink Sheets should consider taking steps to ensure that their stock will continue to be traded on an active secondary market such as the Pink Sheets. For stocks to be traded on the Pink Sheets, a market maker is required. See Note 13 of this Article for additional information regarding the Pink Sheets.
Contractual Obligations to Report
Certain contractual obligations may require a company to keep its stock public and comply with SEC reporting regulations. Those contractual obligations may be found in registration rights agreements, shareholder agreements, credit agreements, loan agreements, indentures or other similar agreements. The company should review all material agreements and charter document provisions to identify any ongoing reporting obligations contained therein, if any.
A company should, at a minimum, take the following steps if considering going dark:
• establish a special committee of its board of directors, comprised solely of independent directors, with separate legal, accounting and financial advisors, to consider all options of the company, including other transactions, such as a merger, a preceding “going private” transaction, sale of assets, sale of stock, etc., and to thoroughly analyze the effects going dark would have on the company and its shareholders;
• make any such determinations sooner rather than later in the event that the Exchange Act rules are changed as recommended to count beneficial, rather than record, shareholders in order to qualify to go dark;
• consider the impact going dark will have on the company’s ability to raise funds, make acquisitions, obtain financing, attract qualified employees, etc.;
• carefully review all material agreements and charter document provisions for obligations to remain a public company;
• keep proper records of all such proceedings;
• comply with all filing and disclosure requirements with the SEC;
• analyze the possibility of the shareholder base exceeding the minimum shareholder number requirements in the future;
• consider announcing its intention to go dark two to eight weeks prior to filing the Form 15 and/or Form 25 in order to give shareholders time to sell their shares prior to going dark; and
• consider continuing to publish the company’s audited financial statements on its website.
An issuer’s decision to “go dark” or “go private” is complex and complicated. Companies must weigh the costs and benefits of being public with the costs and benefits of being private. Although there may be important benefits to going dark, a board should carefully and thoroughly consider the decision with the advice of its legal, accounting and financial advisors.
1. While the deadline for compliance by small business issuers has been extended at least three times, Section 404 of SOX, relating to internal controls and procedures, currently is scheduled to be applicable to all small business issuers for their annual reports filed after December 16, 2007. Small business issuers preparing for such reporting requirements, therefore, will need to start implementing appropriate controls and procedures beginning on January 1, 2007.
2. The Form 15 is available on the SEC’s website at http://www.sec.gov/about/formsform15.pdf
3. Exchange Act Rules 12g-4 and 12h-3 regulate when an issuer can exit the reporting system under Section 12(g) or Section 15(d). These rules allow an issuer to terminate its Exchange Act reporting obligations with respect to a registered class of securities held of record by fewer than 300 persons, or fewer than 500 persons where the total assets of the issuer have not exceeded $10 million on the last day of the three most recent fiscal years.
4. Christian Leuz, Alexander J. Triantis & Tracy Yue Wang, Why Do Firms Go Dark? Causes and Economic Consequences of Voluntary SEC Deregistrations, 1 (Mar. 2006) (unpublished working paper, available at http://ssrn.com/abstract=592421).
5. The Final Report of the Advisory Committee on Smaller Public Companies to the U.S. Securities and Exchange Commission, dated April 23, 2006, recommended that the SEC amend Rule 12g5-1 to interpret “held of record” in Exchange Act Sections 12(g) and 15(d) to mean held by actual beneficial holders.
6. See Luez, supra note 4, at 5.
7. Jannat Thompson, Turning Off the Lights: “Going Dark” or “Going Private,” Wall Street Lawyer, Vol. 9 No. 7 (2005).
8. See Luez, supra note 4, at 1.
9. The Form 25 is available on the SEC’s website at http://www.sec.gov/about/forms/form25.pdf
10. See Luez, supra note 4, at 1.
11. A survey of 217 public companies with average revenues of $5 billion found that complying with the rules under Section 404 cost on average more than $4 million and that those companies devoted an average of 27,000 hours to their compliance efforts. See Financial Executives International, FEI Special Survey on SOX 404 Implementation (March 2005).
12. One study indicates that an issuer will lose 10% of its value on average as a result of its decision to go dark. See Martin C. Daks, Companies ‘Go Dark’ to Avoid SOX Compliance, New Jersey Law Journal, Aug. 3, 2006 (online article, available at http://www.law.com/jsp/ihc/PubArticleIHC.jsp?id=1154509535896).
13. After delisting, if a market maker is willing to provide quotations on a company’s stock, the stock may be listed in the “Pink Sheets,” an Internet-based real-time quotation service for over-the-counter securities. Securities that trade only on the Pink Sheets generally have much lower trading volumes (and therefore less liquidity) than securities on typical markets such as Nasdaq, NYSE and AMEX. For additional information, visit http://www.pinksheets.com.
14. See Exchange Act Rules 12g-4 and 12h-3.
16. See Thompson, supra note 7.
17. See Thompson, supra note 7.