Going Private Or Going Dark, Opportunities And Risks For U.S.-Listed China Stocks

by: Dutch Trader

Investors weren’t the only ones fleeing the stock market this year. US-listed China companies (Harbin Electric, China Security & Surveillance) are also heading for the exits by going private or going dark. Especially when a company decides to "go dark" or voluntarily deregister its shares investors can get boiled.

What does it all mean?

When a company “goes dark” it deregisters with the Securities and Exchange Commission (SEC) and delists its shares. Deregistered companies are no longer required to make SEC filings such as annual reports, proxies, 10-Ks, 10-Qs and other important documents. And they’re no longer required to have annual meetings or elect outside directors.

Especially in the reverse merger space this could have huge implications. Investors are left in the dark about the company's finances and prospects. Many Chinese reverse merger companies are listed on the OTC-markets and vulnerable to "going dark". One of the last examples of Chinese reverse merger stocks that went dark is Sancon Resource Recovery, a company listed on the OTC market.

Many US-listed China companies have to consider whether being a public company is in the best interest of its shareholders. The costs of compliance and time-consuming internal controls and procedures requirements can weigh hard on many small public companies but also big corporates.

“Going dark” and “going private” are sometimes mischaracterized and confused with one another. In fact, following a going private transaction (more later), an issuer will file a Form 15 in order to go dark. Going dark and going private both eliminate the obligation of an issuer to file periodic financial and other reports with the SEC, terminate the issuer’s obligations to comply with the most onerous provisions of SOX and relieve the issuer of the rules and regulations of its applicable stock exchange on which its shares were listed.

However, there are important distinctions between the two, the most notable being that going dark companies usually continue to trade after the date of deregistration on a public market, such as the OTC Markets.

Going Private vs. Going Dark

There are two distinct approaches to becoming a private company. The first is referred to as “going private,” and the second is referred to as “going dark.”

Going private generally involves a transaction in which cash is exchanged for stock of a company’s existing public shareholders and is designed to reduce the number of shareholders to below the minimum threshold required to deregister a company’s stock. In fact, the transaction often results in the company’s stock being held by a single party or group of related parties. Such transactions typically include mergers, third-party tender offers, reverse stock splits and self-tenders by the company. Those types of transactions are typically costly and require substantial disclosures and filings with the SEC. Going private transactions tend to be scrutinized closely by the SEC (the Schedule 13E-3 filed in connection with a going private transaction will almost certainly be reviewed and commented on by the SEC), as such transactions often include a risk of insider self-dealing. When a controlling stockholder or group of controlling shareholders is involved in the transaction (which is usually the case), the transaction will be reviewed under the “entire fairness” standard, rather than the lesser standard of the business judgment rule. If litigation ensues, which it frequently does in these cases, the board will have to meet this higher standard in defending both its decision to go private and the manner in which the company went private. Such transactions, however, are often favored by shareholders and institutional investors because they require shareholder approval in certain circumstances (mergers, reverse splits) or affirmative actions by the shareholder to tender their shares (which they have the option to do or not do depending on their perceived fairness of the transaction). Upon a merger (or reverse stock split in certain jurisdictions), shareholders will also have appraisal rights.

Going dark, on the other hand, is significantly simpler but is available only to companies whose number of record shareholders already falls below the minimum requirement for continued public disclosure under the federal securities acts (300 shareholders in the case of most small business issuers). Going dark essentially requires only filing a simple form, the Form 15 (also a Form 259 for companies listed on a national securities exchange such as NYSE, AMEX and Nasdaq), which suspends a company’s public status and reporting obligations (described in more detail below). Although the required form and process are relatively simple and inexpensive (see below for further discussion), a company must properly analyze all aspects of going dark to determine if it is appropriate for the company and to ensure compliance with all SEC regulations.

Reasons to Go Private or Go Dark

There are many reasons companies choose to go private or go dark, including the following:

  • reduction in the costs of being a public company, including those costs imposed by Section 404 (Internal Controls and Procedures) of SOX;
  • greater corporate governance flexibility;
  • allowing management to spend less time on compliance and reporting activities and more time on the company’s business;
  • the ability to focus more on long-term financial results and goals rather than short-term market concerns;
  • termination of the requirement to disclose competitive business and other sensitive information;
  • going dark may provide additional cash for distribution to shareholders or other corporate purposes;
  • reduction of potential liability of directors;
  • limitation to the risk of litigation (other than in connection with actually going dark) due to the lower number of shareholders; and
  • termination of the compliance obligations with the proxy rules, insider reporting obligations, periodic reporting requirements and regulation FD, along with their associated legal liability and costs.

The risk of going dark on OTC markets is much higher than when the companies are listed on AMEX, NASDAQ or NYSE. I think "Going Private" proposals are going to flush the US-listed China space. Especially in the reverse merger space candidates are plenty.

Ultimately, the decision to go private lies in the hands of insiders and managers seeking a more efficient corporate structure and better value for their company, a very important reason behind the decision to go private.

The inability of US-listed China Reverse Merger companies to attain a critical mass by sustaining sufficient financial interest and visibility (proxied by the growth in analyst coverage, change in institutional ownership, and stock turnover) gives them more reason to go private.

Without proper analyst coverage, however, access to capital markets becomes more difficult and costly. Lower equity prices can also adversely affect a company’s ability to issue public debt at a fair rate.

Because there has been a lack of investor appetite for China RM stocks and the incredible low stock prices this year I think the following companies could be potential candidates.

American Lorain (NYSEMKT:ALN)

American Lorain is an international processed snack foods, convenience foods, and frozen foods company based in China.

Metrics Per Share
Price 1.28
Book Value 4.31
Cash 0.35
EPS 2011 0.54
P/E 2.37

China Auto Logistics (NASDAQ:CALI)

China Auto Logistics Inc. operates one of the leading automobile portals for car dealers and consumers of vehicles and auto-related services in China. Additionally, it is one of China's top sellers of luxury imported cars and a leading developer of websites for buyers and sellers of imported and domestic automobiles.

Metrics Per Share
Price 0.95
Book Value 2.46
Cash 0.32
EPS 2011 0.56
P/E 1.70

China Shengda Packaging Group (NASDAQ:CPGI)

China Shengda Packaging Group Inc. is a leading paper packaging company in China . It is principally engaged in the design, manufacturing and sale of flexo-printed and color-printed corrugated paper cartons in a variety of sizes and strengths. It also manufactures corrugated paperboards, which are used for the production of its flexo-printed and color-printed cartons. The company provides paper packaging solutions to a wide variety of industries, including food, beverage, cigarette, household appliance, consumer electronics, pharmaceuticals, chemicals, machinery and other consumer and industrial sectors in China.

Metrics Per Share
Price 0.86
Book Value 2.44
Cash 0.57
EPS 2011 0.30
P/E 2.87

China XD Plastics (NASDAQ:CXDC)

China XD Plastics Company Limited, through its wholly owned subsidiary, Harbin Xinda Macromolecule Material ("Xinda"), develops, manufactures, and sells modified plastics, primarily for automotive applications. The products are used in the exterior and interior trim and in the functional components of more than 70 automobile brands manufactured in China, including AUDI, BMW, Toyota, Buick, Mazda, VW Golf, Jetta, and Hafei new energy vehicles. The company's wholly owned research center is dedicated to the research and development of modified plastics, and benefits from its cooperation with well-known scientists from prestigious universities in China. As of September 30, 2011, 202 of Xinda's products have been certified for use by one or more of the automobile manufacturers in China.

Metrics Per Share
Price 4.74
Book Value 5.26
Cash 3.34
EPS 2011 1.10
P/E 4.31

Winner Medical Group (NASDAQ:WWIN)

Winner Medical is a China -based exporter and retailer of high-quality medical dressings and consumer products made from 100% cotton. The company manufactures and sells tailored medical dressings and disposables, as well as non-woven fabric made from natural cotton. Its products include those with FDA, CE mark, TUV and other global standard certifications and the company holds 54 domestic and international patents.

Metrics Per Share
Price 3.19
Book Value 4.94
Cash 0.71
EPS 2011 0.50
P/E 6.38

Disclosure: I am long ALN.

Disclaimer: The article is provided for informational purposes only and does not constitute an offer to sell or a solicitation to buy any security or other financial instrument. While based on information believed to be reliable, no guarantee is given that it is accurate or complete. The opinions, forecasts, assumptions, estimates, derived valuations and target price(s) contained in this material are as of the date indicated and are subject to change at any time without prior notice. The investments referred to in this material may not be appropriate or suitable for the specific investment objectives, financial situation,knowledge, experience, or individual needs of recipients and should not be relied upon in substitution for the exercise of independent judgement.