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Source: New York Times, June 13, 2013 column

High & Low Finance

Going Dark, and Putting Blindfolds on Investors

What happens to investors who buy securities issued under the protection of United States securities laws and continue to hold them after many of the protections are removed? Sometimes it is not pretty.

James J. Angel, a finance professor at Georgetown, is an investor in the preferred stock of what used to be Equity Inns.


That is happening more and more often as companies avail themselves of the right to “go dark” because they do not have very many public shareholders. They no longer have to file financial information with the Securities and Exchange Commission, but the securities are still publicly traded.

These days, such investors seem to have few friends. Congress is much more interested in making it easier for companies — or “job creators” in the current jargon — than it is in protecting unfortunate investors. The so-called JOBS Act, enacted last year with widespread bipartisan support, included a provision making it much easier for small banks to go dark, and hundreds have done so.

Going dark, it should be noted, is not the same thing as going private. When that happens, securities are purchased from the public investors. They may not like being forced out, but they are out.

Not so when a company goes dark. The investors are in, but they may or may not be told what is going on. Companies that go dark sometimes make audited financial statements public, and sometimes they do not.

There is no better example of the perils of going dark — as well as proof that “preferred” can be a misnomer when it comes to stock — than the former Equity Inns, an owner of hotels, whose common shares were acquired by Goldman Sachs in 2007.

Although the common shares went away, preferred shares remained — or actually, new issues of preferreds replaced old ones. What has happened since then “smells like insider trading,” says James J. Angel, a finance professor at Georgetown University and an investor in the preferred stock. Goldman says that is nonsense.

While Goldman acquired the common stock, for $23 a share, or $1.9 billion, it did not acquire the $146 million of preferred shares in public hands. Those shares were in par values of $25 and had been sold primarily to individual investors interested in collecting a reasonably safe income stream. One series paid 8.75 percent a year, and the other 9 percent.

Before the takeover, those shares had been trading above par, and Goldman could have called them at par value. Instead, it took the preferred shares into the dark. The company assured the S.E.C. that there were fewer than 300 shareholders of record for each series of preferred, giving the company the right to go dark. The securities continued to trade over the counter in what Wall Street calls the “gray market.”

Goldman soon halted the dividend payments, and the share prices fell to as little as a penny.

How was the company doing? The financial statements were confidential, but Goldman did agree to let preferred shareholders see them — for a fee — as long as they signed confidentiality agreements that would prevent them from sharing the statements with anyone else, including prospective buyers of the shares.

Someone has, however, violated that confidentiality agreement. After I began calling around for this column, a set of financial statements arrived in an envelope with no return address. Assuming they are accurate, they show that over the three years through 2012, the company had net losses of $315 million on revenue of $1.2 billion. But most of those losses came from $251 million in depreciation. Operating cash flow was a positive $174 million. Told of some of the numbers in the statement, a Goldman spokeswoman did not dispute them.

Those numbers, however, are for the entire company. The preferred shares seem to have an interest in only 1 percent of the assets. If Goldman could find a way to put the 1 percent owner in bankruptcy, while keeping the other 99 percent out, it might be able to largely eliminate the preferred.

Even that might not be necessary. Goldman was also the lender in the deal, and perhaps it could restructure the debt in ways that would essentially give the debt holders — Goldman, that is — the ability to get everything, leaving the preferred shareholders with nothing.

Evidently, few saw any value in the preferred shares. But then prices began to rise, and in September the company disclosed that “a sister company” — presumably another Goldman affiliate — had “recently” acquired “approximately 35 percent” of the outstanding preferred shares. This week Goldman told me that it bought all of the shares in one private transaction from a single seller. It would not identify the seller or the price, but said it had not made any further purchases or sales since then.

The September purchase amounted to about as many shares as had traded in public markets in the previous six months. It is not clear when the seller accumulated them, and Andrea Raphael, a Goldman spokeswoman, denies there was any advance agreement to purchase them. Mr. Angel sees evidence of a violation of insider trading laws, but Ms. Raphael says that is ridiculous.

“We complied with applicable law in all respects,” she said. “Any assertions otherwise are based purely on speculation.”

If the company — whose formal name is now W2007 Grace Acquisition I — were still registered with the S.E.C., and the preferred shares traded on an exchange, we would not have to wonder about this. Anyone who acquired more than 5 percent of the issue would have been required to disclose that fact — as well as the prices paid for recent purchases. But such protections for investors vanish when a company goes dark.

The fact of the purchase breathed new life into the shares. If Goldman, which controls what will happen, saw value in the preferred, surely there was value, or so some traders evidently concluded. The price, which had risen to $4 from about $2 in the months before the disclosure, has now climbed to about $9.

This has become news now because one preferred shareholder, Joseph M. Sullivan, a Sacramento accountant, took it upon himself to assure that the preferred shares had more than 300 owners of record. In December, he set up 301 separate trusts to hold his shares, each of which he said had different beneficial owners but the same trustee — himself. He demanded that the company file its financial statements with the S.E.C.

In April, a lawyer for Goldman, William G. Farrar of Sullivan & Cromwell, asked the S.E.C. to issue an order exempting the company from any need to file with the commission. The issuer of the preferred shares, he explained, was “simply a real estate investment firm with a small economic interest in 130 hotels and no employees” and Mr. Sullivan was engaging in subterfuge to force the company to resume its filings.

The S.E.C. chose to ask for public comment on the request, bringing letters of protest from a number of shareholders, including Mr. Sullivan, who told me he would disclose the identities of the beneficial holders to the S.E.C., but only if it promised not to make them public.

There is no question that the level of 300 owners of record is a magic number in determining whether the company must resume filing with the S.E.C. There is no doubt that there are more than 300 beneficial owners even without counting Mr. Sullivan’s trusts. But the rules allow companies to ignore many such owners if all their shares are held at the same brokerage firm. Mr. Sullivan would like the S.E.C. to make it harder for companies to go dark and stay dark.

Even if he prevails in that, it is far from clear what he will have accomplished. Public filings would make it easier to see what was going on, but Goldman would still have all the cards and might find ways to assure that the preferred holders received little or nothing from their investment.

There is one sidelight to this that emphasizes how convoluted it can be when a company has public investors but chooses to keep the public in the dark. The company’s charter, available on its Web site, seems to say no one can buy more than 9.9 percent of the preferred shares. But the Goldman affiliate did. The rules do not apply if the company gives up its tax status as a real estate investment trust, or REIT, but nothing I could find on the Web site indicates that happened. In his letter to the S.E.C., Mr. Farrar, the lawyer for Goldman, referred to the company’s “REIT sub,” short for subsidiary, which sounds as if it is still a REIT.

Not so, Goldman assured me. The company gave up its REIT status years ago and disclosed that in financial statements that are not public.

So why did Mr. Farrar use the language he did?

“Historically it was referred to internally as the ‘REIT sub’ and we simply continued that reference,” Ms. Raphael said. “The reference is not indicative of the company’s tax status.”

© 2013 The New York Times Company




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