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While corporate finance theory holds that in the long run markets are reasonably efficient, it is not surprising that most directors of public companies with market capitalizations below $250 million do not agree. With these companies, there is increasingly a low correlation between stock price and the intrinsic value of the business. Over the past two years, despite solid operating performance, strong financial controls and consistent quarterly results, the equity capital markets have been punitive to the more than 5,000 companies in this category. As boards invested enormous attention and millions of dollars to comply with the Sarbanes-Oxley Act, the question was whispered, “Why are we public?” More and more, public companies have been leaving the public stage, and there are significant legal implications that directors and managers need to consider when starting the “going private” journey. The case for initially going public probably made sense when the decision was made, as companies tried to enhance the ability to access growth capital or provide shareholder liquidity, or because of a need for another form of acquisition currency. However, an unintended consequence of Sarbanes-Oxley is that it has actually made it more difficult for small-cap companies to access capital. Sarbanes-Oxley drove a wedge between research analysts and investment bankers. Whereas once cooperation between these two garnered the attention of institutional investors, today small-company growth stories are overlooked by analysts and consequently ignored or disregarded by institutional players. Compounding the lackluster analyst coverage is the fact that institutional investors increasingly care less for companies with market capitalization below $1 billion. Meanwhile, the cost of compliance has skyrocketed. According to a 2004 study published by Foley & Lardner, the average costs of compliance increased 130% last year since the inception of Sarbanes-Oxley, and approximately $4 million in direct and rapidly growing expense is essentially fixed, regardless of whether a company’s revenue is $1 billion or $100 million. See “The Cost of Being Public in the Era of Sarbanes-Oxley,” presented by Thomas E. Hartman, Foley & Lardner, May 19, 2004. See www.complianceweek.com/_articleFiles/foley-lardner-052504.pdf. A disproportionate number of small companies account for the total percentage of restatements, as these companies can least afford the expense of compliance and do not have the internal resources to keep up with the pace of change. As a result, these companies are the ones most targeted by “strike” suits for restating their financials. In addition to the high cost of compliance, the current regulatory environment subjects the company, directors and officers to a substantially higher and inherited risk of litigation. Finally, there are strategic motivations to exit the public markets, making the quarter-by-quarter challenges less pertinent to operating and executing the business plan. Even so, going private is not easy or cheap, and there are substantial legal and financial-related risks. A going-private transaction will almost always increase the leverage to the surviving enterprise, and that debt may limit near-term financial flexibility with more restrictive financial covenants. Perhaps more importantly, the process essentially puts a company “in play,” and attracts considerable attention from the Securities and Exchange Commission (SEC), previously passive shareholders and plaintiffs’ attorneys. The going-private transaction also triggers the board’s fiduciary obligation to obtain the best deal available for shareholders. This obligation, often referred to as the “ Revlon duties,” requires a board to undertake an inclusive process to ensure that all potential bidders for the company are involved and the best possible price for the company is obtained. Revlon Inc. v. MacAndrews & Forbes Holdings Inc., 506 A.2d 173, 182-184 (Del. Super. 1985). Obviously, this objective causes an immediate conflict of interest with directors and officers who are involved in the proposed transaction. As a result, the board will usually form a special committee composed of independent directors to evaluate and make recommendations regarding all proposals received with respect to the company. The special committee, in turn, should consider obtaining a fairness opinion from an investment bank. Fortunately, the private capital markets currently have a strong appetite for these transactions, especially if the prototypical candidate has low debt, strong cash flow and high insider ownership. Today, with more than $100 billion of private equity capital sitting on the sidelines, there is no liquidity crunch, and lending multiples are starting to expand. Three paths to going private A going-private transaction can be effectuated by a tender offer, a cash-out merger or a reverse stock split, the latter often referred to as “going dark.” The key hurdle to a going-private transaction is reducing the number of recorded company shareholders to fewer than 300. Upon reaching this threshold, the company is freed from the requirements to file regular reports with the SEC. These reports are both the hallmark and principal burden of a public company. As part of the going-private transaction, the company is required to make certain disclosures to its shareholders regarding the transaction and its effect. The most direct form of a going-private transaction is the tender offer. In a tender offer, the company purchases the outstanding public shares directly from its shareholders. The company sends each shareholder tender offer materials that contain disclosures required by the SEC. The board is responsible for the terms of the tender offer on behalf of the company’s shareholders. The tender offer materials include the recommendation of the board that the shareholders of the company accept the tender offer. In making this recommendation, the board or a special committee of the board must determine that the price to be paid in accordance with the tender offer is fair to the tendering shareholders. Generally, the company will tender for 90% of its shares. Although fewer shares may be required to effect practical control of the company, Delaware courts have required that tender offers that involve going-private or other transactions that cash out minority shareholders tender for at least 90% of a company’s shares. In addition, Delaware courts have required that the company agree to execute a cash-out merger immediately after the completion of the tender offer in which remaining shareholders are paid the same price as that paid to tendering shareholders. Finally, to avoid unfair coercion of minority shareholders, Delaware courts require that a majority of the minority shareholders of the company agree to tender their shares. In re Pure Resources Inc. Shareholder Litigation, 808 A.2d 421, 445 (Del. Ch. 2002). The advantage of the tender offer is its relative safety for directors, officers and majority shareholders. As described above, Delaware courts have outlined a distinct path to meet the requirement of fairness to the company’s shareholders. Unfortunately, the tender offer mechanism is potentially the most costly means to go private and may also require the longest period of time to complete. The second common form of a going-private transaction is a cash-out merger. In a cash-out merger, a new corporation formed by the company merges with and into the company. Although the company generally survives the merger, most of the outstanding shares of the company are redeemed for cash pursuant to the merger. A designated group, which usually includes insiders, retains ownership in the surviving company. Shareholders of the company must vote to approve the cash-out merger. The company will generally solicit proxies that are voted at a special meeting of the shareholders. As part of the proxy solicitation, the shareholders will receive a proxy statement that contains required disclosures regarding the cash-out merger transaction and the effect of going private. Delaware courts have offered considerable guidance regarding cash-out mergers to the effect that the board has satisfied its fiduciary duties to the shareholders if it diligently undertakes a process in connection with its consideration of the cash-out merger that offers a fair price and fair dealing to the shareholders, particularly minority shareholders. In addition to forming a special committee of the board, the board should, at a minimum, determine that the merger price to be paid approximates the fair-market value of the company and, if possible, solicit additional proposals regarding the sale of the company. See, e.g., In re Cysive Inc. Shareholders Litigation, 836 A.2d 531 (Del. Ch. 2003). So long as the board of directors faithfully carries out its fiduciary duties to the company’s minority shareholders, the cash-out merger is a relatively low-risk method to complete the going-private process. In addition, the process of soliciting proxies may be completed relatively quickly and for reasonable expense. Reverse stock split The final, and perhaps the most controversial, method of going private is a reverse stock split. The company amends its articles of incorporation such that each outstanding share is converted into a fraction of a new share, and holders receive certificates representing whole shares and cash in lieu of fractional shares. For example, a 1-for-1,000 reverse stock split would result in each shareholder who owned fewer than 1,000 shares receiving only cash. As with the cash-out merger, the company is required to obtain shareholder approval for the amendment to its articles of incorporation to effect the reverse split. The company solicits proxies and holds a special meeting of shareholders regarding approval of the reverse split. Unfortunately, companies seeking to go private without the capital resources to pursue a tender offer or cash-out merger have often used the reverse split as a measure of last resort. As a result, a reverse split may generate considerable negative attention. When considering a reverse split as a means to go private, the board should take every precaution to ensure that it meets its fiduciary obligations to its shareholders, especially in the case of minority shareholders, who will be either cashed out entirely or severely diluted as a result of the reverse split. Since the reverse split is procedurally similar to the cash-out merger, the board should follow the same procedural framework, including forming a special committee and taking reasonable steps to evaluate the market for the company and explore alternatives to the reverse split transaction. See Cysive, 836 A.2d at 553-54. Although on its face the reverse split is no more onerous that the tender offer or cash-out merger, the specter of potential abuses that surrounds this type of transaction should cause directors, management and majority shareholders to tread gingerly when considering it. Although the intent of Sarbanes-Oxley was noble, some practitioners believe that this overwhelming compliance effort has little to do with the fraud and greed at Enron, WorldCom and the other relatively few notorious cases since the irrational-exuberance bubble burst. Fraud has always been fraud, and, they argue, the vast majority of companies that submitted to the massive compliance requirements imposed by Sarbanes-Oxley did not need that exercise to demonstrate adequate financial controls. Ironically, the burden of wrongdoing has fallen more on the law-abiding than the lawbreakers. Instead, perhaps the underlying economy would have benefited more from the reinvestment of the billions of dollars that have been diverted to the cottage industry of lawyers, accountants and consultants that abound in the compliance environment created by Sarbanes-Oxley. Jeffrey R. Manning ([email protected]) is senior managing director of FTI Capital Advisors LLC, the wholly owned investment banking subsidiary of FTI Consulting, and works out of Washington. Fred S. Stovall is a partner in the Dallas office of Washington-based Patton Boggs. He has extensive experience assisting investors and growing companies to navigate complex legal issues.

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