An argument against delisting

A promoter has a solid business plan and wants to invest in a plant. The total investment required is 1 crore but he has only 60 lakh. He approaches the people known to him to seek additional capital. You and I, being interested in investing in sound businesses also hear from him. We have the money but there is a problem. Once our money is invested in the plant, we cannot ask for it whenever we need it. The business will pay dividends but there is no way to ask the principal amount back on demand. You can't sell one tenth of a plant!

The promoter understands our dilemma. He contacts other businessman, named Exchange, who facilitates trading of partial ownership in businesses. Together, they come out with an offer that the money we invest will get us units of partial ownership called stocks. We can trade these stocks with other investors through the Exchange. We invest 10 lakh each. The promoter ropes in another two investor X and Y, who also invest 10 lakh each and we form a company. The plant is set up, the stock is listed.

The company does good business and pays good dividends amounting to 15 lakh per year. Three years go by. In these 3 years, we get 4.5 lakh each, the promoter gets 27 lakh. We splurge our dividend income. X and Y splurge not only the dividends but keep selling portion of their stocks every year. The promoter uses part of his dividends to buy out stocks from X and Y through 'creeping acquisition'. His stake rises to 75%. Rest of the ownership lies with you (10%), me (10%) and X (5%). Meanwhile, the business has now completed the consolidation phase and is ready to move into a really high growth phase. The promoter knows it but we, being sleeping partners, are asleep.

One day, we get a call from the promoter telling us that he wants to buy back his business. We don't want to sell. The business has given us 4.5 lakh in dividends in 3 years and it is growing. We have no urgent need for money. We consult with each other and refuse to sell.

This is one scenario. Another, and more likely, scenario is that we don't know each other. The promoter makes each investor a call saying that he is willing to pay 40% premium over the current price. If the other two investors sell out to him and his stake will rise above 90%, he will delist the company from the Exchange. He will give an option to you to sell the stake back to him at the exit price but this option is available only for one year. After that he may not buy although you are free to keep your stake or arrange a buyer for your stake. Will you sell? Quote your price.

Now each one of us thinks the other is selling out, lured by the premium over the current price. We are afraid of losing our liquidity. Remember, the option to sell the stake at the exchange is the key point which tilted our decision in favour of buying when the initial offer was made. Each one of us tries to squeeze little more than the promoter is offering. Finally, the deal is settled at 50% over the market price on the day the deal was offered.

We are happy. We got an opportunity to sell at a price 50% higher than what was prevailing before the delisting offer was made. What a gain in 7 days! Or is it?A transaction involves a buyer and a seller. They agree at a price. Now this price will either be higher than the intrinsic value of the stock or lower than that. When the transaction is being done, both parties can only guess this value but as the future unfolds, one party will emerge a winner and the other a loser. There is no win-win situation here unlike the one that prevailed when the company was listed. We all pooled in capital and we all shared the returns.Delisting transforms a win-win partnership into a win-lose game.

Now if it's a win-lose game, let's analyze which side is more likely to be the loser. Here is the analysis of the position of the promoter:

1. He knows the ground realities of the business better than the other investors. His estimate of the intrinsic value of the business is likely to be better than the estimate of the other investors.
2. He can build a margin of safety into the price. He can proceed on the presumption that if the price worked out during the delisting process is at least 20% below my estimate of the intrinsic value, I'll buy else I will reject the price and wait for a more opportune moment.
3. He has surplus money right now and given that he expects the business to do better in future, his individual financial position is strong.
4. He can appeal to the fear in the minds of investors that if other investors sell out, the remaining investors will lose liquidity.
5. He can appeal to the greed in the minds of investors by offering a price that is higher than the historical price of the stock in the recent time.
6. He is one entity. He knows exactly what he is doing.
   

And here is where we stand:

1. We have limited information about the business that we can get from published results. We know that financial results can be 'cooked'. They can be spiced up, they can be watered down.
2. From the exit price, we have limited margin of safety. If we think the exit price is below our estimate of intrinsic value and we don't sell we have two risks (a) Even if we are right, there will be no takers of the delisted stock at the fair price. It's a seller's market now (b) If we are wrong, we have lost the last opportunity to sell out at a fair price. (c) We have the information to decide the intrinsic price today but if we remain invested in a delisted company there may not be enough information to decide what is the fair price of the stock at a later date. Even if our hope of a subsequent offer post delisting, is materialized, how will we know if the price offered is correct. (d) The listed companies are subject to many laws to ensure investor protection, corporate governance and adequate disclosure. The delisted company goes out of the ambit of many laws and for the laws that are still applicable, the enforcement mechanisms are weak. If a delisted company doesn't pay out dividend worth 5000 Rs, what can you do?
3. We don't have enough surplus funds to stay invested in the delisted company for a long time.
4. We are afraid that others are selling out and we'll be left holding an illiquid stock with no buyers.
5. We are enticed by the premium over the market price and fear losing the opportunity.
6. We are fragmented and can't communicate amongst ourselves.
   

Now, enough of this loser talk. We aren't that weak after all.

1. As per the Delisting rules^#1, delisting requires prior approval of the shareholders of the company by a special resolution passed through postal ballot. The rules also say that, "the special resolution shall be acted upon if and only if the votes cast by public shareholders in favour of the proposal amount to at least two times the number of votes cast by public shareholders against it".
2. We have the ultimate weapon. We are the ones who decide the price to sell at. We can ask for a price at some premium over our best estimate of the intrinsic value of the stock.
3. If we don't know enough, we can abstain from participating in the delisting process. Even if the company gets delisted, we can still sell our shares at the same exit price.
4. We have time on our side. Once the exit price is decided, we have one year to offer our shares at that price. This creates the real support price for us. In one year, if the business improves significantly and we are financially strong to hold on to the delisted stock, we can stick to it. If not, we can sell out.
5. Even if we aren't that smart, there are smarter people who will smell the opportunity and drive up the price between the time of the announcement of delisting and the commencement of the delisting process. We can use the market price as an indicator of value and quote a price at a premium over the prevailing price (as well as the offered floor price).

This is an account of the strengths and weaknesses of both sides. History however shows that the promoters have won the game more often than not. They have judiciously used their strengths and the investors have succumbed to the attraction of the premium over the historical price as well as to the fear of illiquidity. The net result has been bad for minority investors.

When the promoters need money, they come out with IPOs. We queue up to get a piece of the cake. The IPOs are timed to perfection. IPOs are at their peak when two conditions are met.1. The profitability of business is higher than usual2. The market price demanded for sharing each rupee of these profits is higher than usual.

The delistings happen when the prevailing conditions are at the opposite extreme.1. The businesses are recovering from the lows of their profitability and the future looks brighter in comparison.2. The current market prices are below the intrinsic value and historical prices lower still.

Delisting creates problems for long term investors. Suppose a good company goes through a bad patch for few years. The long term investor will typically ride out the rough weather taking a long term view. The price may fall in the short term, sometime significantly below intrinsic value. When business shows signs of recovery and the promoters will be the first to spot those signs. They may choose to delist the company by offering substantial premium over the rock bottom prices. For the long term investor, this is a loss because he was prepared to ride it out but now he is forced to sell when the prices are low.

There may be people who may argue that delisting helps in propping up depressed prices. Some people give this 'seemingly logical' argument – They believe that buybacks are good for the investors; delisting being buy-back of 100% of the remaining investors is even better. This is logicial fallacy. Buybacks, if done at a price below the intrinsic value, are good for the remaining shareholders#. Delisting, which is 100% buyback of non promoter shareholding, is good for the only remaining shareholder, the promoter. You can rest assured that he will delist only at a price below the intrinsic value.

[# It's the price relative to intrinsic value that decides who is the losing party. Mom gives box containing 5 chocolates to John, to share it equally with his 3 younger siblings. He tells the youngest one, "Don't you wanna take your chocolate and go out to play". Little one is happy and John hands him one chocolate and lets him go. Then he tells his two sisters "uff…melting. We got to keep them in the fridge for a day. Would you like cotton candy today instead of chocolate tomorrow?", the girls choose the cotton candy over chocolate. John grows up to become promoter of a large company]

Benjamin Graham had lashed out at the stupid arguments in favour of buyback in his article "Should Rich Corporations Return Stockholders' Cash?" ^#2 published in 1932. He said, "To withhold the owners' money from them by suspending dividends, and then to use this same money to buy back their stock at the abnormally low price thus created, comes perilously close to sharp practice." [Sharp practice is misrepresentation just short of the legal definition of fraud]. Delisting, too, is an opportunistic act on the part of promoters, who, by exploiting their advantageous position, to take advantage of minority shareholders who helped make the company what it is today.

The regulators must improve the laws to avoid this completely legal, unfair and covertly dishonest way of dealing with minority investors. In particular:

1. They must change the myopic calculation of the floor price for bidding in the delisting process which is currently a 26-week average of the traded price quoted on the stock exchange or the average price of the preceding 2 weeks, whichever is higher. Such a short time frame allows promoters to buy back investors cheaply when the prices remain depressed for 6 months. Such periods of low prices are not unusual in markets. The floor price must be the higher of (a) book value (b) 1 year average price (c) average price of preceding 2 weeks. This will not only set the correct long-term basis for price discovery but also deter 'hit and try' offers in depressed market conditions. This is so because the rules require promoters to deposit the "total estimated amount of consideration calculated on the basis of floor price and number of equity shares outstanding with public shareholders" to an escrow account.
2. Bring the delisted companies within the ambit of laws regarding investor protection, corporate governance and adequate disclosure. Even if it means that private companies as well as former public companies need to be treated differently. There IS a difference. The shareholder of the private company invested in the company knowing that the company is private. The remaining shareholders of a delisted company invested in a public company and now find themselves private investors because they did not agree to the exit price.
3. There will be many investors who didn't participate in the delisting process simply because they didn't understand delisting or were unaware that the company was being delisted. This is not inconceivable. A significant portion of investors are passive ones, (for example those who may have inherited the stocks). Some may have been outside the country at the time of delisting etc. They should have some way to sell.
4. There should be provisions for trading of delisted shares in OTC exchanges. OTC exchanges exist for trading of companies that are small or unable to meet the listing requirements by the regular stock exchanges. These securities are traded by broker-dealers who negotiate directly with one another over computer networks and by phone. India already has the OTC Exchange of India which can perform this role.

Till these problems are sorted out, what are the options available for me when my company is delisted? The same set of options as Hobson gave to his customers! To rotate the use of his horses, he offered customers the choice of either taking the horse in the stall nearest the door or taking none at all. My options are to sell at an unattractive price or to sell never.

References

1. SEBI (DELISTING OF EQUITY SHARES) REGULATIONS, 2009

http://www.sebi.gov.in/acts/delisting2009.pdf

2. Benjamin Graham, Should Rich Corporations Return Stockholders' Cash?

http://www.forbes.com/forbes/1999/1227/6415405a.html

Other 2 thought provking articles from Graham in this 3 part series

Inflated Treasuries And Deflated Stockholders

Should Rich But Losing Corporations Be Liquidated?