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
James J. Angel, a finance professor at Georgetown, is an
investor in the preferred stock of what used to be Equity
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
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
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
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
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
If the company — whose formal name is now
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.”
A version of this article appeared in print on June 14, 2013, on page B1
of the New York edition with the headline: Going Dark, And Putting
Blindfolds On Investors.
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