United States: Going Private and Going Dark

In a breakout session, "Going Private and Going Dark," at Foley & Lardner LLP's fourth annual National Directors Institute (NDI) held on March 10, 2005 in Chicago, Foley Transactional & Securities Practice Group partners Peter C. Underwood, Thomas E. Hartman, and Paul D. Broude moderated a discussion on:

• The general nature of going private and going dark

• Reasons to go private or go dark

• Distinctions between going private and going dark

• Important considerations and actions relating to going private or going dark

• Practical tips for successfully going private

• Traps for the unwary in going private

• Reasons against going private or going dark

In general terms, a "going private transaction" is the exchange of cash for the shares of a company's existing public shareholders so that, at the end of the transaction, the company's shareholder base has been sufficiently reduced to permit the company to elect to terminate its public company status.

The forms of going private transactions vary, including (i) mergers of the company with a newly formed company owned by the control group; (ii) tender offers by such a newly formed company; or (iii) a self-tender by the company for its own shares with a follow-up reverse stock split. The form chosen for a going private transaction in a particular case depends on:

• The structure of the company and its shareholder base

• Those participating in the transaction

• The source of financing for the transaction — almost all going private transactions require some degree of outside financing

In addition, each form has different implications, including costs, timing, disclosures, and legal standards of judicial review that should be considered with counsel in each case. For instance, the U.S. Securities and Exchange Commission (SEC) requires detailed filings in connection with a going private transaction, and the nature of these filings depends in part upon the structure of the transaction.

A going private transaction typically is initiated by a controlling shareholder or by a group of shareholders that either constitutes a majority or at least a control position in a company. Senior management of the company often comprises such a buyout group, often making going private transactions appear to be management buyouts.

In contrast, the process of "going dark" is not a transaction at all. It is a filing with the SEC pursuant to which a public company with fewer than a specified number of shareholders of record — either 300 or 500 depending on certain circumstances — and meeting certain other eligibility requirements under the Securities Exchange Act of 1934 (1934 Act) may suspend its obligation to make public filings. The company does not cash out existing shareholders. The shareholder base of the company does not change as a result of going dark. The company does not file any disclosure document with the SEC or distribute any disclosure document to its shareholders. Going dark means simply "flipping the switch" — a public company, without changing its shareholder base or entering into any transaction, simply becomes private by filing a form with the SEC.

The reasons for a company to go private and/or go dark include the following:

• Eliminating the significant costs of being a public company

• Realizing the full value of a company in a situation where the public market fails to adequately value the company (i.e., due to inadequate coverage of the company by analysts and other investors)

• Reducing or eliminating the obligation to disclose competitive business and other sensitive information

• Allowing for additional corporate governance flexibility

• Allowing management to focus more on long-term goals and objectives rather than short-term management of market expectations

• Allowing for a greater knowledge of and control over the company's shareholder base

• Reducing the potential liability for acts of directors and officers, especially in light of SOX reforms

• Providing liquidity to minority shareholders without brokerage fees and at capital gains tax rates

As previously mentioned, a going private transaction involves the payment of cash to existing public shareholders and the preparation of lengthy SEC filings. In contrast, going dark requires the filing of a brief form with the SEC and does not involve the payment of cash to existing shareholders. Nevertheless, most companies choose to enter into a going private transaction instead of going dark for two reasons. First, a going private transaction provides a better environment to defend against any lawsuit that might be brought by minority shareholders alleging a breach of the directors' fiduciary duty, since these shareholders receive cash for their shares in a going private transaction. In contrast, when a company goes dark, its shareholders receive no cash in exchange for the loss of the public market for their shares — although the company and its shareholders benefit from a reduction in the compliance costs associated with being public.

Second, a going private transaction reduces the risk of a scenario in which the company is required to "turn the lights back on'" This scenario occurs subsequent to going private or going dark if the number of record holders of the company's stock once again exceed the applicable 300/500 threshold used to deregister as a public company. A common situation in which this scenario occurs is in the event of a so-called "broker kick-out." In determining the number of shareholders a company has, the applicable SEC rules look to "record" holders, as opposed to "beneficial" holders. Beneficial shareholders do not appear on the official shareholder records of the company because they hold their shares through a broker, bank, or other financial institution (often called a "street" or "nominee" holder), rather than in their own name. A broker kick-out occurs when a street or nominee holder determines it no longer wants to serve in that position and kicks the shares out to its customers. This, in turn, causes those customers to change from beneficial holders to record holders, thus increasing the number of record holders, sometimes dramatically.

Going private and going dark result in a suspension, and not a termination, of a company's filing obligations under the 1934 Act. This suspension remains in effect so long as the company has fewer than the appropriate threshold number of shareholders. The broker "kick out" can require a company to once again become public by increasing the company's number of record shareholders. However, if a company eliminates enough beneficial shareholders through a going private transaction, it can completely eliminate or at least substantially reduce the risk of this occurrence.

To understand the considerations and actions necessary to accomplish a going private transaction, it is important to understand the concept of judicial review. As a general rule, actions taken by a company's board of directors are protected by the "business judgment rule" — the presumption that in making business decisions not involving direct self-interest or selfdealing, corporate directors act on an informed basis, in good faith, and in the honest belief that their actions are in the company's best interest. This rule shields corporate directors from liability for unprofitable or harmful corporate transactions if the decisions approving such transactions were made in good faith, with due care, and within the directors' authority. In cases where plaintiffs challenge a decision of the board of directors, assuming there is no allegation of self-interest or self-dealing, the plaintiff has the burden of proof to overcome the protection of the business judgment rule.

However, where a transaction involves self-interest or self-dealing — such as a going private transaction in which directors represent the shareholders as members of the board of directors and are members of the buyout group — the business judgment rule no longer applies. Instead, in such a case, the burden of proof shifts to the directors to prove the "entire fairness" of the transaction, both in terms of substance and procedure, to the minority shareholders. In other words, the going private transaction is subject to heightened judicial scrutiny that it must overcome to be upheld over judicial challenges by minority shareholders.

Consequently, a company undertaking a going private transaction must carefully consider taking several actions bearing upon substantive and procedural fairness, including:

• Obtaining proper and independent legal guidance and background information for directors to consider in approving the transaction

• Having all negotiations and evaluations conducted by truly independent directors, a special committee of truly independent directors, or a special independent representative of the minority shareholders

• Thoroughly documenting all meetings, negotiations, discussions, and actions of the board, the special committee, and other involved parties — such documentation will be disclosed to the SEC and shareholders and, to the extent they are not subject to attorney-client privilege, board books, minutes, resolutions, memos, and other background materials will be key evidence in judicial challenges to the transaction

• Releasing information to the public in a timely manner to address disclosure obligations while also "window shopping" the proposal

• Subjecting the transaction to one of the various "majority of the minority" voting standards in addition to the vote required by law

• Obtaining an independent valuation, fairness opinion, or both to establish a fair minority share price

Of all of the above actions, the primary step to take to satisfy the entire fairness test is the creation of an independent special committee of the board of directors that is empowered to negotiate and evaluate the transaction to determine whether or not it is fair. In fact, according to judicial precedents, a properly constituted and functioning special committee can shift the burden of proof back to the minority shareholders challenging the going private transaction to show evidence of any unfairness. Importantly, it is not enough that a special committee exist; it must (i) be comprised of truly independent directors (e.g., not involved in the transaction, having no interest therein, and as far removed as possible from any of the directors who are interested in the transaction); (ii) be empowered to negotiate and evaluate the transaction, consider alternatives, and reject the proposed transaction if it deems it to be unfair; and (iii) function properly (e.g., meet more than twice, preferably in person, take accurate records, and obtain advice from advisors, including independent legal counsel and independent financial representatives to render a fairness opinion).

In addition, to obtain a form of validation of the fairness of the proposal, many companies seek "majority of the minority" approval of going private transactions. This means obtaining the approval of the transaction by the majority of the unaffiliated, minority shareholders, which may be done in various forms (e.g., approval by a (i) majority of all outstanding unaffiliated, minority shares; (ii) majority of the unaffiliated, minority shares that actually vote on the proposal; or (iii) majority of the unaffiliated, minority shares that do not vote "no" on the proposal).

In addition, the following other important considerations and actions must be considered in a going private transaction or going dark context:

If the company takes advantage of its public company status by using its stock as an acquisition currency or to access capital markets, or otherwise relies on the prestige of being public, then going private may not make good business sense. On the other hand, if a company is not regularly raising funds in the capital markets or making acquisitions with its stock as currency, then the benefits to the company of going private and/or dark may outweigh the costs of being public.

Going private and/or dark may substantially reduce the attractiveness of stock-based incentive plans, which are often used for executives and other key employees.

The company must consider the effect of the transaction upon the company's balance sheet. If the company becomes too leveraged, it may become difficult to operate from a cash flow perspective on an ongoing basis following the transaction.

The nature of the shareholder base of the company impacts (i) the likelihood of judicial challenges to the going private transaction; (ii) the likelihood of "majority of the minority" approval of the transaction; (iii) who the buyout group chooses to retain as shareholders after the transaction; and (iv) how the company will be managed following the transaction. All of these factors should be considered.

The SEC extensively scrutinizes going private transactions, viewing them as inherently one-sided. As a result, the SEC makes extensive comments upon filings in connection with going private transactions. Certain "hot button" disclosure issues in this context include:

• Valuation, including metrics, multiples, ranges, and comparables used in determining price and fairness of price, the foundation of and assumptions underlying all such metrics, and, if applicable, why certain metrics are not used

• Transaction background, including negotiation history, alternatives considered, and relationships between the parties

• Independence of directors and special committee

• Reasons why the price is fair — parties should plan to spend four to six weeks or more clearing SEC comments on disclosures

• Disclosure, including all written proposals, budgets, projections, opinions (other than legal), and other information used to determine price! Adequate director and officer liability insurance coverage and, possibly, special indemnification arrangements with directors on the special committee

• Minority discounts and how they are applied under the law in a particular state in determining the fairness of the transaction price

• Continued trading of shares and the likelihood that its stock will continue to be quoted on the "Pink Sheets" — the trading medium through which the company's stock will likely be traded after going dark because of the inability to trade any longer on the over-the-counter (OTC) bulletin board or The NASDAQ Stock Market (NASDAQ)

Unfortunately, cases regarding fiduciary obligations of directors in a going dark context are not entirely clear. On the one hand, some cases indicate that there is no affirmative fiduciary duty to provide or maintain a market in a company's stock. On the other hand, there continues to be a risk of a shareholder challenging a company's going dark as a breach of fiduciary duty because the shareholder assumed it would have a liquid market in the stock, and the directors never disclosed any information to the contrary. In any event, if the company's stock will likely continue to be traded on the Pink Sheets, the risk of such a breach of fiduciary duty argument would be reduced.

Given the foregoing considerations, the following are tips for successfully consummating a going private transaction:

• Run a good process — the right process leads to the right price and offers better protection from liability

• Ensure the independence of and fully empower the special committee, although finding independent directors presents special challenges in a small company context

• Retain experienced legal, financial, and accounting advisors

• Ensure truly arms' length negotiations between the special committee and the buyout group

• Keep detailed and accurate records of all proceedings

• Prepare and file thorough and accurate disclosure documents — anticipate plaintiffs' and SEC hot buttons and proactively address them

In addition, to successfully consummate a going private transaction, parties should be aware of the following potential traps:

Disclosure of Valuation Materials
If a financial advisor is used or fairness opinion rendered, nearly all handouts, drafts, discussions, and other materials regarding valuation will be subject to disclosure — companies should be careful about what is discussed or given by the advisor to the special committee.

Inadvertent "First Step"
Companies must file disclosure materials as soon as a going private transaction commences, and the going private rules apply not only to a single transaction but also to a "series" of transactions. Thus, it is important to be aware of any transactions in the company's stock within the previous two years (e.g., a stock repurchase plan) to avoid any possibility that such earlier transactions could be deemed the "first step" in going private by the SEC.

In this context, it should be noted that the SEC takes a broad view when the obligation to begin filings relating to a going private transaction is triggered. For instance, if a group of senior executives has agreed in principle among themselves (even if not in writing) to make a proposal to acquire a public company, the group probably has, in fact, technically triggered the requirement to make an SEC filing if collectively the group owns at least five percent of the company. If the SEC suspects that a prior transaction(s) constituted the first step in a going private transaction, it may become necessary for the company to prove otherwise. While there are no hard and fast rules for such an inquiry, the SEC would likely examine the intent of the parties at the time of the prior transaction(s), public statements made, issues considered by the board of directors in entering into the prior transaction(s), and the impact upon the company's shareholder base from the prior transaction(s) and proposed transaction.

Putting Company "In Play"
The public announcement of the transaction proposal may put the company "in play" — if the buyout group does not control the company, it may not be able to control the process or outcome, especially if a third party makes a bid at a higher price than that offered by the buyout group.

Implications of Form of Transaction
The appropriate form of transaction can have fairness and other implications (e.g., more dollars spent on transaction costs and delays mean fewer dollars to minority shareholders in price. Mergers and/or reverse stock splits may have appraisal rights).

"Filing Person" Trap
The SEC takes an expansive view of who is required to make filings with the SEC in connection with a going private transaction, which may include not just the primary buyer, but also equity sponsors, members of senior management involved in the buyout group, subsidiaries, or other proximate parties.

Notwithstanding the reasons in favor of going private or going dark previously discussed, and given the various considerations and issues related to going private or going dark, the following potential reasons against going private or going dark should be noted:

• Potential liability to officers and directors associated with "interested" nature of transaction

• Significant increase in debt on balance sheet if "self-funded"

• Increased difficulty in raising equity capital in future, potentially limiting a company's ability to grow via acquisition

• Reduced liquidity and overall financial flexibility

• Potentially reduced attractiveness of equity-based incentives available to offer to executives and key employees or to use in acquisitions

• Potential loss of prestige from no longer being a public company

• High transactions costs (for smaller transactions, $100,000 to $250,000 for fairness opinion; $200,000 to $300,000 for legal costs, accounting fees, printing costs, etc., in addition to price actually paid to minority shareholders to cash them out) and consumption of time typically involved in going private transactions

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.