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Summary

  • GS bought the common but not preferred shares of Equity Inns, then made the preferred shares (now called W2007 Grace Acquisition I "Grace") "go dark" with no public financial information.
  • GS delisted Grace preferred from NYSE, then deregistered from SEC and even DTC, making it hard to trade. Grace stopped paying preferred dividends and price plummeted.
  • Potential sweetheart deal to tunnel assets out of Grace. GS affiliate secretly buys Grace preferred shares (WGCBP and WGCCP) before price doubles. Also apparent violations of SEC reporting rules.
  • Proceedings at SEC to examine issues surrounding Grace.
  • Potential for serious enforcement action against GS for with significant financial, regulatory, and reputation risk.

Goldman Sachs' (NYSE:GS) actions surrounding the preferred stock of W2007 Grace Acquisition I ("Grace") have created a significant regulatory and reputational risk to the firm. The case has already received media publicity and may receive more.

I'm not a Goldman Sachs basher. I have enormous respect for the firm. They hire the best and the brightest and are very good at what they do. I own some of their stock. Indeed, I own more of their shares than I own of W2007 Grace Acquisition I preferred Class B shares, which I also own. However, their actions surrounding the company make it appear that they are attempting to hide their activities in ways that could have serious repercussions for the firm.[1]

Here is the back story: At the height of the real estate boom in 2007, Goldman engineered a takeover of Equity Inns, an NYSE-listed hotel REIT that owned over 100 mid-level hotels. These hotels were operated under various brands including Courtyard and Hampton Inns. Goldman Sachs Mortgage Company (GSMC) lent money to one of Goldman's Whitehall partnerships to purchase all the common shares of Equity Inns. The resulting entity was named W2007 Grace Acquisition I. GSMC earned a fee for arranging the financing, and Grace hired Goldman-owned Archon Group to run the hotels for a hedge-fund-like fee. Archon then hired others to actually run the hotels.[2]

However, Whitehall/Goldman did not purchase the preferred shares of Equity Inns, and left over $100 million worth of the NYSE-listed preferred shares outstanding. These preferred shares, which were owned primarily by retail investors, did not get to vote on the takeover and lost significant value upon the announcement and consummation of the merger, as seen in the following chart:

(click to enlarge)

Source: Author's chart based on NYSE data.

Grace then "went dark." They delisted the preferred shares from the NYSE, even though there were and still are well over 1,000 beneficial shareholders. They filed the requisite paperwork to deregister the shares from the SEC.[3] This meant that the firm no longer filed public financial statements with the SEC. It no longer discloses public financial statements, and makes shareholders sign a non-disclosure agreement (NDA) every time they ask for a financial statement.

The firm didn't just go dark. It went super dark. The replacement preferred shares are not even eligible for electronic transfer at DTC, so shareholders have to resort to old fashioned paper certificates in order to transfer the shares. This makes it very cumbersome and expensive to trade the shares. Many brokerage firms will not touch transactions in securities that are not "DTC-eligible."[4] A firm with the reputation and expertise of Goldman Sachs would have had no problem in filling out the paperwork to make the shares of Grace eligible for electronic settlement at DTC.

The financial crisis intensified in 2008, and W2007 Grace Acquisition I ran into trouble. Goldman restructured the debt several times, paying itself a fee each time. [5] Note that each debt restructuring was the result of Goldman negotiating with Goldman. It looks like no one was looking out for the preferred shareholders. As part of one of the restructurings, W2007 Grace Acquisition I provided an option to GSMC to purchase the bulk of the hotels. Was this an appropriate restructuring of the debt? Or was it a sweetheart deal that tunneled assets away from the company by promising to sell the hotels at a rock-bottom price? Such a sweetheart deal could leave an almost empty shell behind to the detriment of the preferred shareholders. Because of the veil of secrecy over the company, it is hard to tell whether the deal was appropriate or just self dealing.

Grace stopped paying dividends on its preferred shares in 2008. Under the terms of the preferred shares, this created two seats on the board of directors to represent the preferred shareholders. Grace went through the motions of holding elections to elect directors three times, and each time claimed that there was no quorum. The corporate bylaws give the board of directors the ability to fill any vacancy on the board of directors. I've served on corporate boards and it is a routine item for a board to fill vacancies. The board of directors of W2007 Grace Acquisition I - all employees of Goldman Sachs -- has gone for over 4 years(!) without filling these vacant director positions belonging to the preferred shareholders. [6] Is this a wanton dereliction of duty by the board of directors? Was this an attempt to muzzle representation for the preferred shareholders and permit sweetheart deals to go through? Or did the board just get bad legal advice from counsel who didn't understand the duties of a board of directors and couldn't read the corporate bylaws?

The firm maintains a "code-of-silence" policy with regard to the release of information. The firm issues no public financial statements. In order to get any information from the firm, one had to already be a shareholder and sign a non-disclosure agreement (NDA). Indeed, the firm even charged 10 cents a page for what information it did give out, until it got slammed in the press for its tactics. The firm has lightened up a bit after this publicity, and will now email the information for free to potential investors who sign an NDA.

The stonewall-the-shareholder policy was exemplified during one of the preferred shareholder meetings held to elect directors. At the meeting, I personally witnessed management's refusal to answer questions from the shareholders regarding the financial condition of the firm. I have attended numerous shareholder meetings of many companies and I have never seen such a situation in which management appeared as if it was trying to hide something. Usually corporate executives answer questions about the state of the firm at shareholder meetings. This would have been especially appropriate in a case where the firm was in distress and not paying the preferred dividends.

Clearly with no public information, no dividends, hostile management, limited stock transferability, and no board representation, the preferred shares are unattractive to most investors. Indeed, many brokerage firms will not permit their customers to even buy the shares at all because of the lack of DTC eligibility. It is no surprise that the share price plunged to almost nothing.

Who would want to buy such shares? Goldman, that's who. After this series of actions that suppressed the public market in the shares, another Goldman entity, PFD Holdings, has quietly purchased a majority of the preferred shares. What is even more suspicious to me is that they began their first buying binge just before the share price doubled. Clearly, PFD has been purchasing the shares while in possession of material non-public information. Goldman and its affiliates clearly must have material information about what is going on inside the company, or otherwise they would not be spending millions buying the shares. And that material information has to be non-public because there is no public information. This sure looks like blatant insider trading. The following chart shows the share price trajectory of the Class B shares after the buyout:

(click to enlarge)

Source: OTCMarkets.com with author's annotation.

Furthermore, their buying more than a 10% stake without a formal tender offer appears to be a violation of Tennessee corporate law that requires formal tender offers in such situations.[7] In addition, the shares they have acquired are more than the shares that have been reported to the public tape, an apparent violation of the trade reporting rules.[8]

Speaking of 10% ownership, how can anyone purchase more than 10% of the company when the corporate charter contains language that appears to forbid anyone from acquiring more than 10% of the preferred shares? Apparently the company changed its REIT status (and thus removed the 10% limit) without bothering to disclose this material information to the market. Goldman/PFD was undoubtedly aware of this material information, or it would have been unable to purchase more than 10% of the shares.

And now the word has come out that another Goldman affiliate, WNT Holdings, LLC, has acquired the option to buy the hotels at what is potentially a bargain price, and has exercised the option.[9] It looks like the tunneling operation has been completed. It is possible that PFD may attempt to buy out the remnants of the preferred shareholders at some steeply discounted price to the real value of what they should receive.

There may be an innocent explanation for Goldman's shareholder-hostile policies. Maybe Goldman just got and followed some really bad legal advice. Some lawyers will tell companies that deregister from the SEC to do everything they can to avoid promoting trading activity in the stock. After all, if a company is friendly to its shareholders it may wind up with <GASP!> more shareholders. And if the number of shareholders of record creeps over the magic 300 number, then a company has to resume filing financial information with the SEC. Thus, counsel may advise a company to follow a scorched earth policy of giving out zero information and doing everything possible to make the shareholders just go away.

One can see why the preferred shareholders are peeved. One day they had a nice stable dividend paying preferred share in a public NYSE-listed company. Soon they had non-dividend paying shares in a dark Gray Sheet company at much lower value. One of the shareholders created 300 separate trusts, which show up as shareholders "of record". By pushing the company over the 300 shareholder of record limit, this would have forced the company to file public financial statements with the SEC. The company has petitioned the SEC to not count the trusts as separate shareholders of record in an attempt to avoid filing public financial statements. The public comments on the SEC web site are worth reading. This matter has been sitting at the SEC for over a year, and so far there is no sign of any action by the SEC. Even if the SEC rules that the 300 trusts are really only one shareholder, there still appear to be 400 other shareholders of record according to the shareholder list as of December 31, 2013. The company has apparently been in violation of its reporting requirements for several years, a thumbing of its nose at the SEC as well as the shareholders. This may also result in adverse regulatory actions against the company.

So, what are the implications for shareholders? There is a scandal brewing here, with the possibility of adverse legal and regulatory action which could result in large fines and further reputation damage. On page 99 of its latest 10-Q, Goldman lists a number of government investigations, including "insider trading, the potential misuse of material non-public information regarding private company and governmental developments and the effectiveness of the firm's insider trading controls and information barriers." Whether that means that the SEC is investigating this particular case or some other is not clear.

For those interested in W2007 Grace Acquisition I Preferred, there are two classes of shares that trade in the over-the-counter market on what are known as the Gray Sheets, Class B (OTC:WGCBP) and Class C (OTC:WGCCP).][10] The shares were originally issued to the public, and have a liquidation preference, of $25 per share. They are redeemable by the company at $25 per share plus accrued but unpaid dividends, which would bring the redemption value to about $37. The shares are now trading around $16. Although financial information is embargoed by the firm, potential shareholders can request the financial information if they are willing to sign an NDA. The form can be found at www.equityinns.com under "information request form."

Are there enough assets left in W2007 to redeem the preferred shareholders at the proper price? Given the fact that I am in fact under the NDA, I cannot release any of the financial information that I have seen. However, if one does a rough back-of-the-envelope calculation valuing the number of hotel rooms times the recent selling prices of similar hotel rooms, it would appear that the hotels (before the tunneling operation) are worth enough to cover the debt and redeem the preferred shares. No wonder Goldman/Whitehall/Grace/PFD/WNT is trying to keep things quiet.

[1] As a GS shareholder, I reported my concerns to GS through its official channel for reporting concerns in July 2013. The reply I received stated "this matter has previously been reported to Goldman Sachs and its directors."

[2] Some of the details of these transactions can be found in the takeover proxy statement available on the SEC web site for the corporate filings of Equity Inns. Additional information regarding the post-acquisition operation of W2007 Grace Acquisition I such as annual financial statements are available to shareholders and to potential investors who sign non-disclosure agreements. The form can be found at www.equityinns.com under "information request form".

[3] Firms with fewer than 300 shareholders "of record" can file a Form 15 to deregister from the SEC. Shareholders "of record" are those directly registered on the books of the company. "Beneficial" shareholders who hold their shares in "street name" at brokerage accounts usually don't count. It seems strange that the SEC, charged with protecting retail investors, doesn't count them when figuring out whether a company is big enough to require registration with the SEC.

[4] As Choicetrade.com explains: "In simple terms, if a stock is "DTC-eligible" it can be cleared electronically. Most major-exchange-traded stocks are DTC-eligible. Many penny stocks are non-DTC-eligible. There are a variety of reasons for this including missed regulatory filings, improper filings, SEC investigations, and more. Bottom line? If a stock becomes non-DTC eligible, it must be cleared manually. The cost of clearing a trade manually can be very high -- sometimes resulting in a trade surcharge amounting to hundreds of dollars per trade." DTCC also provides information on DTC eligibility. Tradingdirect.com has a list of non-DTC eligible stocks.

[5] Once again, some but not all of the details of the debt restructurings are provided in the financial statements available to shareholders and potential investors who sign the NDA.

[6] Details on the missed dividends and the attempts to hold elections are publicly available on the FAQ on the Equity Inns web site.

[7] W2007 Grace Acquisition I is chartered in Tennessee. Tennessee's Investor Protection Act requires that takeover offers be publicly registered and provides various protections for shareholders. The Investor Protection Act defines a takeover offer as an "offer to acquire or the acquisition of any equity security of an offeree company, pursuant to a tender offer or request or invitation for tenders, if after the acquisition thereof the offeror would be directly or indirectly a beneficial owner of more than ten percent (10%) of any class of the outstanding equity securities of the offeree company;" Disclaimer: I am not now nor have I ever been an attorney, so my pointing out what appears to me to be violations of various laws and regulations should not be interpreted as a legal opinion or conclusion.

[8] Stock transactions by brokers are required to be reported to the tape under FINRA Rule 6622. In particular, on April 4, 2013, Grace reported in its application to the SEC that an affiliate owned a total of 2,018,250 shares of the Class B (OTC: WGCBP) and Class C (OTC: WGCCP) preferred shares of the company. On August 13, 2013, the company announced that PFD Holdings, LLC ("PFD"), an affiliate of the Goldman-controlled Whitehall funds, had acquired 58.8% of the outstanding preferred shares of the company, or approximately 3,439,800 shares, an increase of 1,421,550 shares. However, only 232,170 shares were reported as having been traded to the tape over this period for both the Class B and Class C preferred shares based on data from otcmarkets.com. This implies that over the period from April 4, 2013 through August 13, 2013 that a Goldman Sachs-affiliated entity purchased at least 1,189,380 shares that were not reported to the tape. There are exceptions to the trade reporting rules, such as trades between two private parties who are not broker-dealers. However, I find it unlikely that a Goldman entity would not be subject to the trade reporting rules. The CEO of Grace is not only a GS employee, but also a FINRA-registered representative.

[9] The firm has not responded to my request for information about the exercise price of the option, even though I have signed the NDA, so it is impossible for me to know whether the exercise price of the option represents a sweetheart deal or not. However, the lack of a response to this request leads me to be suspicious.

[10] There are also 125 Class D preferred shares that were issued to Goldman employees for "REIT tax compliance purposes" according to the company's petition to the SEC. (REITs are required to have at least 100 shareholders.) The issuance of this special class of shares at the beginning of the deal, when the company already had many hundreds of preferred shareholders, could be construed as indicating that the company planned from the beginning to squeeze out the Class B and Class C preferred shareholders.

Disclosure: I am long GS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am also long the preferred shares of the Class B stock, WGCBP.

Source: Goldman Sachs And W2007 Grace Acquisition I: Reputation And Regulatory Risk