Unexpectedly Intriguing!
11 October 2005

One of the unintended consequences of the regulations put into place upon publicly-traded companies by the Sarbanes-Oxley Act of 2002, aside from the dramatic increase in the cost of SEC compliance for the companies whose stock is traded on the nation's equity markets, is the corresponding desire by smaller companies to avoid these increased costs by taking their companies private.

These companies have a clear bottom-line incentive for delisting their stock from public exchanges - but what about individual investors? Is there a way that the Average Joe can profit from these companies' decisions?

Bill Mann of the Motley Fool explains how small-fry investors can gain from delisting, with the example of using ASA International, which ceased being publicly-traded in 2004:

Here's the trick: Find a company that is going private by cashing out its shareholders. Last year, for example, ASA International elected to delist its stock, which at the time traded on the Nasdaq. To delist, companies must file reams of paperwork with the SEC, but they can avoid doing so if they have less than 300 shareholders. So ASA determined that if it did a reverse split of its stock at 600:1 and then cashed out anyone with partial shares, it would get rid of enough shareholders to delist. It announced that it would cash people out at $5 per share. After ASA had cleared out the rabble, it would re-split its now-unlisted stock at 600:1.

Now, you might presume that the moment ASA announced that it was going private at $5, its share price would pin itself within a few pennies of that price. You'd be wrong. This is a tiny company, without much liquidity (which is why being public no longer made sense), so selling shareholders exited the company at prices as low as $4.25 after the company had announced that it would essentially cash small shareholders out at $5.

Note how government regulations influenced not just ASA International's decision to delist its stock, but also its delisting strategy. In this case, the SEC regulation that greatly increased the amount of paperwork that would be required to delist the stock (and thereby the cost of doing so) if there were 300 or more stockholders, determined the shape of the deal.

But between the government's arcane regulations, there is opportunity for profit. In the ASA International example, it would be possible to gain up to 75 cents per share in a short period of time. If you held 599 shares, just under the 600-share threshold qualifying your shares to be cashed out, you could pocket just over $449. In the short time between the delisting announcement and the execution date, an individual could get a double-digit rate of return on their investment with substantially little risk.

There are downsides involved with this strategy too. These potential downfalls include:

  • The deals typically involve small companies, so the amount of the money to be made is small, at best.
  • The number of companies delisting varies widely from year-to-year. This variability makes the ability to make money using this strategy on a regular basis unpredictable.
  • The company's delisting arrangements may be complicated. Thorough due diligence is required to avoid being potentially burned by conditions that may affect the company's delisting plans.
  • The amount of time required for a company to delist its stock may make the investment undesirable from an opportunity cost standpoint.
  • The company may fail in its bid to go private.
  • Transaction costs, such as commissions, may take up a substantial portion of your potential gain.

Still, if you're willing to do your homework, there are opportunities out there to be had in this investing niche.

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