Slowly you start to become somewhat resentful of your faceless investors. They are cashing their dividend checks derived from your hard work, but they aren't involved in the business at all. They don't even seem to care what's happening with the business. You adapt to their disinterest and start to release news less often. Eventually you don't file financial statements as often because you don't think the investors care all that much. They continue to receive dividends in exchange for no effort, so why should you give them any extra?
This relationship disintegrates to a point where eventually you actively hide information from your investors and pay yourself richly. You're doing all the work, the investors aren't doing anything, plus they get dividends and don't make a fuss.
Does this story seem right? Or when you read it does it seem wrong? Does it make you made or angry? It should and unfortunately it's not just a story, it's something that is happening throughout the market with companies both large and small, but primarily small.
Shareholders are the rightful and legal owners of companies they are invested in. As shareholders they're entitled to returns from the company, either dividends or the assets in a liquidation. But there is a strange twist to shareholding, outside shareholders contribute nothing towards the success of the company yet reap the rewards. After a company's initial capital has been contributed outside shareholders are simply trading ownership interests between each other. It's easy to see how a company's management, or employees could see this as a negative. The company's management and employees work hard every day to put money in someone else's pocket. It's also not hard to see how some employees might think "I should take just a little extra for myself and department, we work hard and shareholders will hardly notice."
In financial textbooks shareholders should have power over their ownership interest by virtue of their voting rights for the Board of Director. Shareholders elect the Board, and the Board makes sure the company is managed in the interest of the shareholders. The problem is this scenario is only true in textbooks. Boards consist of people who interact monthly/weekly/daily with management teams, and with that level of interaction it's hard to not become colleagues or friends with management. It's much harder for the Board to stand up for faceless and nameless shareholders who own 100 shares with the certificates stuffed in savings deposit boxes in Dubuque, Iowa.
The idea that the Board is on friendly terms with management and neutral at best or usually on adversarial terms with shareholders isn't new. This relationship has been well known by investors for at least 100 years. In theory the Securities Exchange Commission (SEC) was created to combat this problem as well as further promote transparency and fairness in the markets.
Unfortunately the SEC is swamped with leads, both real and imagined and they don't have the staff or inclination to pursue most of them. A second confounding problem is that the SEC is staffed by people for whom the SEC is a career. These SEC employees have families, friends and hobbies and earning a paycheck and a promotion is only a portion of how they spend their day. SEC employees (rightfully so from their perspective) are focused on bagging the biggest cases because high profile or political cases can result in promotions, which means a nicer car, or a better boss, or a window office, or a bigger house in the DC-burbs, or really anything else career related. But none of those things are "upholding the fairness of the markets". And who could blame SEC employees? How many employees at any company show up to work each day and while passing the mission statement in the hallway think "I'm going to make the customer #1 and provide value in all aspects of my job today!!" Most people are thinking about where they want to go to lunch, or about some difficult project, or socializing with work friends. That work gets done is incidental to the experience.
The area of the market where the lack of a visible regulator or Boards that care about shareholders is most apparent is in small stocks that have "gone dark." These companies were at one point SEC filing companies that used a loophole in the SEC regulations as a way to cease filing financial reports. To cease updating shareholders with details about THEIR company. And to hide in the dark.
The SEC claims that any company with less than 300 registered shareholders (more for a bank) can cease filing financial statements and escape regulatory burdens. This is called "going dark." The theory is that a company this small should be considered privately held. I don't disagree with the SEC's logic, except for one area, the type of shares the SEC counts as 'shareholders'. The SEC believes that only registered shares count as true ownership interests. A registered share are shares held in certificate form. These are the fancy certificates that are held in safe deposit boxes and need to be mailed to to sold. The three day settlement period is an artifact of when everyone owned paper certificates. Three days gave investors enough time to mail their certificate to their broker after instructing a sale.
Since the markets have modernized most shareholders keep shares in street name at their broker. The brokerage has a giant digital lookup with each holder's name and the number of shares they own, which is called a beneficial interest. There is a substantial amount of case law confirming that beneficial holders, investors with street name holdings have the exact same legal standing as a registered shareholding. And it's because of this that beneficial shares receive dividends just like registered shares.
The problem is these dark companies get to have their cake and eat it too. They can pay dividends to beneficial shareholders but then hide behind their dark non-filing designation and claim they don't need to provide legally required information to shareholders.
Companies go dark for a variety of reasons. For some it's to save costs. The cost of being public can be onerous to a small company. Companies that go public for cost reasons often continue to update shareholders with news and their financial condition through the mail and on their website. The cost savers are the exception. The majority of dark companies are literally hiding in the dark. Either management is hiding nefarious dealings with themselves and at times outright theft from shareholders, to other management hiding just how good the company is doing from shareholders. In both cases management is lurking in the dark and escaping through an SEC loophole.
I own shares in a number of dark companies, they range from the cost savers mentioned above who are good stewards of shareholder capital to a number of cockroaches hoping shareholders never realize they exist. One company I own, Kopp Glass, decided this year that as a beneficial shareholder I have ceased to exist. It's almost a comical dance, the company claims I'm not a shareholder and have never been. Which is ironic because I've been to two annual meetings, and at one the CEO told me he'd looked to see how many shares I owned. It's worth noting that I have continued to receive my dividends quarterly just like I should. But if I ask for an annual report I'm "not a shareholder according to our records." The CEO acknowledged in the past I was an owner, but suddenly I'm not. At a dark company hiding in the shadows away from the SEC they can bend rules to fit whatever they want.
Kopp Glass isn't an exception either, they're just one of many companies that play this game. The problem is the game is illegal. In Pennsylvania (where Kopp is incorporated, but this rule also stands in Delaware and other states) it's illegal to grant different rights to shareholders of the same share class. This means you can't pay dividends to only some of the company's shareholders and not others if they all own the same class of shares. This also applies to information, a company can't distribute material financial information to a few shareholders and not everyone. While doing so is illegal it could also be construed as to giving certain shareholders an inside advantage. In the dark market these sort of occurrences seem normal, but they shouldn't be. The public would be outraged to find out that GM executives were mailing out pre-released financial figures to a select group of their friends, those executives would probably end up in jail. Yet with dark companies the SEC has implicitly approved the distribution of material information to whomever a company wants, not everyone by failing to act and take action against this blatantly wrong behavior.
Going dark doesn't mean a company can do anything they want. It just means they aren't burdened with quarterly SEC filings. To make an analogy a company that goes dark is acting like a person who moves from a city with zoning and a full time police force to a rural area without zoning and a local sheriff. Moving out of a city doesn't mean the person can start to distribute drugs, sell weapons, open a brothel and do anything they want because there isn't a full time police force anymore. They just moved from one form of structure to a different form, but the person would need to abide by the law of the land in both places. Unfortunately dark companies have decided that they are above the law and since the SEC has failed to enforce the law these companies are getting away with it.
We now have an area of the marke that's lawless and a complete mess. This is the breeding ground for pump and dump operations, unethical managers and anyone else who wants to hide in the dark. Is it any surprise that pink sheet and non-SEC filing companies are universally derided as scams and dangerous to investors?
As investors there isn't much we can do to change this. I have made it a point to write about companies that flaunt their dark status as a ticket to steal from shareholders, but writing can only do so much. At some point the SEC needs to step in and enforce their own rules.
Investors have a very unique opportunity in that right now the SEC has an open comments period on financial information requests. I know some investors who have let the SEC know their thoughts on dark companies, and I plan to as well. I hope you will also write a letter, no matter how long or short telling the SEC that companies need to treat beneficial shareholders the same as registered shareholders in doing dark transactions. The SEC should also ensure that going dark isn't a license to steal from shareholder pockets either directly or by giving out inside information to select parties.