Saturday, August 25, 2018

A Tesla Riddle: When is 2/3 x 1156 < 300?

If you’re like me, you’ve been riveted by the Tesla drama and Elon Musk’s off-the-cuff, possibly Ambien-high, tweet announcing that he planned to take the company private at $420 per share, only to finally admit yesterday that, no, Tesla would stay public after all.

In any event, back when the idea was first floated, and investors (and, I assume, Musk’s counsel) demanded more information about this take-private scheme, Musk vaguely announced that he expected most shareholders – perhaps as many as two-thirds – would stay with the company, and roll over their shares into a special purpose vehicle.  He even invited shareholders to remain invested, writing, “I would like to structure this so that all shareholders have a choice. Either they can stay investors in a private Tesla or they can be bought out at $420 per share.”

Much has been written about this proposal, including all the reasons why it didn’t make financial sense, and the evidence that no, he never had funding or a plan, and now the SEC is investigating, and so forth, but there’s really one aspect I want to focus on, which is, the proposal never could have worked, because you can’t go private that way.

Companies incur the responsibility to periodically, and publicly, report on their financial status if they have a class of securities outstanding and traded by the public (with various definitions and trigger points for what that means).  In this case, we’re talking about public reporting obligations Tesla incurred by making its stock available to the public.  (A whole ’nother question might be whether the company would have maintained reporting obligations for its bonds, but let’s stick to stock for now.)

When that stock is no longer publicly held – which, under the Securities Exchange Act, means owned by fewer than 300 shareholders – the company has the option to “go dark” and cease reporting publicly.  So for Tesla to do this, it would have had to somehow get itself down to under 300 shareholders – while, according to Musk, still keeping most of the shareholder base.

His thinking, apparently, was that if one giant fund was created, and that fund held Tesla stock, and then two-thirds of Tesla’s current shareholders bought shares of the fund, then Tesla would have one shareholder – the fund – and would no longer have reporting obligations.

One potential problem with this idea is that then the fund would be considered public and might have its own reporting obligations, but leaving that point aside, the idea still wouldn’t fly.  Ordinarily, he’s right: if a fund or a vehicle or a trust holds shares in a company, it is considered a single holder for the purposes of a shareholder count.  This, in fact, is exactly what’s happened with Uber, as I previously posted: a couple of funds sprung up that bought Uber stock and sold fund shares to investors, thus allowing investors to gain exposure to a “private” company whose stock wouldn’t ordinarily be available to them.  But the SEC will only allow that if the funds are formed independently of the subject company.  As the SEC explained, they’ll look through to the fund’s real investors if the fund is simply a sham to evade reporting requirements, which is exactly what Musk announced that he planned to do.

That said, it’s not impossible that Musk would have been able to get Tesla down to fewer than 300 shareholders while maintaining two-thirds of the old shareholder base, in a manner of speaking (if he had the funding, and a plan, etc), but almost certainly some shareholders would have to be forced out, i.e., there would be no choice available to them.

The SEC has an odd way of counting shareholders.  If the shareholder keeps the shares titled in the name of his or her brokerage company, which most shareholders do, the brokerage company counts as the shareholder.  Because lots of beneficial owners of Tesla stock use the same set of brokerage companies, that means that the official count of Tesla shareholders is much lower than the real number.  In fact, Tesla’s latest 10-K says that Tesla has 168,919,941 shares of common stock outstanding, but only 1,156 shareholders of record.  Obviously, the true number of shareholders is much higher, but the official number is 1,156, because of the practice of holding shares through brokerage companies. 

So getting down to fewer than 300 shareholders is not so far-fetched.  To use an extreme example, if Musk offered a buyout and one-third of the shareholders accepted, but the remaining two-thirds all happened to hold their shares through, say, JP Morgan, Tesla could get itself down to a single shareholder of record. 

But here’s the rub:  I’m assuming that large institutional investors use a lot of the same large brokerage companies.  Which means, even though there are something like 886 institutional holders, the number for SEC purposes may in fact be much lower.  At the same time, though, retail shareholders hold 23% of Tesla stock.  I’m guessing that they also hold in a more far-flung set of brokerage companies, maybe even some hold in their own names, and of course, they each hold much smaller amounts of Tesla stock than do institutions.  So it’s very likely that, to get down to fewer than 300 shareholders, these are the ones Tesla would have to buy out.  And these are the shareholders who are unlikely to want to sell, because Tesla retail shareholders are a particularly devoted set of true believers.  Given a choice, many would likely to want to stay with the company.

They could, however, be forced out. For example, a company can do a reverse stock split at a very high ratio – like, 1 to 1,000 – and thereby cash out anyone who holds less than 1,000 shares.  After such a split, voila!  The company has fewer than 300 shareholders.  (Matt Levine discusses a recent example; and here’s a funny story from when Bacardi tried, and failed, the same trick).  If Tesla wanted to go that route, it could sort of keep two-thirds of its shareholders – in the sense that, the original holders of two-thirds of those 168,919,941 shares might still be in place – while bringing the official shareholder count down below 300.  But once again, the involuntary nature of that plan does not at all sound like what Musk was describing, and there’s no need to use a special purpose vehicle to accomplish it.

http://lawprofessors.typepad.com/business_law/2018/08/a-tesla-riddle-when-is-23-x-1156-300.html

Ann Lipton | Permalink

Comments

This is terrific analysis—clear and informative! Thanks!

Posted by: Frank Snyder | Aug 25, 2018 9:53:13 AM

Thank you! I'm glad you found it helpful.

Posted by: Ann Lipton | Aug 25, 2018 10:02:49 AM

Interesting analysis but a bit off. To do the deal, Musk would form a new entity (going private entity) which would be capitalized by the institutional investors. This entity would then acquire Tesla, likely through a reverse triangular merger. All Tesla stockholders would be cashed out in the deal resulting in Tesla having a single stockholder (the going private entity). Tesla would then deregister from the Exchange Act. No need to do a reverse split. As for letting current Tesla stockholders in the deal, perhaps one of the institutional investors could set up a fund to invest in the going private entity that would allow investment by former Tesla stockholders (maybe even simultaneously with closing on the going private transaction). The fund could simply cap the number of stockholders it is willing to take and decide which ones get in by lottery if the opportunity is oversubscribed.

Posted by: Constantine | Aug 27, 2018 9:04:10 AM

Hi Constantine. You misunderstand. My point is there is no way to go private as Musk seemed to envision it. Sure there are ways to go private; just not on his proposed terms. We can invent other complex structures (a limited fund with a lottery) but none are what Musk described (which he apparently recognized when he said he would drop the idea in part because of the lack of retail participation)

Posted by: Ann Lipton | Aug 27, 2018 9:12:41 AM

There's no way of knowing what Musk envisioned. My point is that it could be done in substance. You are the one who invented a complex structure for a going private transaction, not me. I was just pointing out how going private transactions are done.

Posted by: Constantine | Aug 27, 2018 9:23:15 AM

Well, we will have to agree to disagree on this one. I think Musk gave us an idea of what he had in mind, and his public explanation for abandoning the deal squares with my interpretation.

Posted by: Ann Lipton | Aug 27, 2018 9:30:28 AM

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