A Rule Change Brings an Era to an End

SEC Rule 15c2-11 Effectively Shuts Down the Market for "Dark Stocks"

Author’s note: PharmChem, which I wrote about a few months back, has attracted activists. I strongly support the efforts of these activists. If you are a PharmChem holder of record for this year’s shareholder meeting, I hope you will consider supporting them as well.

A certain subset of investors, myself among them, has long enjoyed hunting for bargains amongst so-called “dark stocks.” These are the securities of companies that have withdrawn their SEC registration and ceased providing statutory financial information through the official channels. While some have continued to publish results on their own websites, through wire services, or on OTCMarkets.com, many are completely silent and only disclose financial information to existing shareholders upon request. The potential for mis-pricing is obvious. It is always an exciting moment when I open an e-mail or envelope from one of these companies and discover it is trading at some absurdly cheap valuation.

But the fun is ending. The era of enterprising and yes, slightly eccentric investors seeking out value in dark stocks will end in just a few weeks. The SEC has approved a change to Rule 15c2-11 that will effectively bar brokers and market makers from providing public quotes on companies that do not disclose their financials publicly. The rule change becomes effective on September 28. For a brief moment, the SEC had considered granting regulatory relief that would allow certain investors to continue accessing quotes in an “expert market,” but the SEC now states it does not intend to allow the creation of this market in the short term.

So, what happens now? Practically all significant retail-oriented stockbrokers have already indicated they will cease accepting buy orders for dark stocks in the next few weeks. Perhaps more ominously, I hear rumors of custodians planning to enact the same restrictions, disallowing the inbound transfer of any additional dark stock shares. Post September, all current dark stocks will fall to the “grey market,” the true Wild West of OTC trading. Without the benefit of market makers, execution and price discovery will become truly difficult for the average investor. Brokers permitting, these stocks will still trade, as unsolicited orders are permitted. But the every day retail investor with an Interactive Brokers/Schwab/Fidelity account will be locked out.

I have plenty of thoughts about the entire thing, and readers are welcome to contact me to discuss them. I think there is great potential for a specialized investment vehicle to continue offering exposure to companies like these, and I am exploring launching one myself, if I can find brokers and custodians who will allow it. I’m not giving up! But also, I’m sad. There are hundreds of fully legitimate companies and thousands of investors in those companies that will be hurt by this. Removing the ability of investors to trade these shares rewards bad and abusive management teams, who would like nothing more than for their shareholders to be restricted from transacting.

The SEC’s goal in this rule change is to crack down on market manipulation and illegal transactions by insiders. And these certainly do happen amongst non-reporting stocks. But the SEC is uninterested in or unable to properly address the problem, choosing instead to lay waste with a blunt instrument. Are retail shareholders being hurt by the public existence of Boston Sand & Gravel with its 100,000 shares outstanding and average daily volume of approximately zero? Are they being hurt by Hershey Creamery, or Reo Plastics? If dark stocks as a group were a city block, then sure, there were would be a few decrepit and dangerous properties in need of demolition. But the SEC’s chosen solution is to run a bulldozer from end to end.

If there is any silver lining here at all, it is that the upcoming rule change has spurred some of the more shareholder-friendly dark companies to go current, releasing their financials publicly through OTCMarkets.com. Many investors are seeing these companies’ results for the first time, which may lead to increased interest and higher valuations. Here are a few of the more interesting companies to open their books to the world recently.

Please note all of these companies’ shares are highly illiquid, and anyone attempting to transact following their own due diligence should exercise caution and patience.

J. G. Boswell, BWEL - Sprawling California agricultural company. Cotton, fruits, tomatoes, and other crops. Water rights, oil & gas, mineral rights. In all, nearly $1 billion in irreplaceable assets acquired over the course of the 20th century. It’s tough to imagine a more inflation-proof collection. On the negative side, the company’s results are unpredictable and cyclical, and it rarely earns an attractive cash return on its invested capital. Despite publishing its financials, the company remains rather inscrutable to investors and does not seem interested in changing.

National Stockyards, NSYC - They of a distinguished history and wonderful logo, National Stockyards operates what else, a stockyard.

In 2020, they sold over 430,000 head of cattle and earned a healthy profit doing so. The company also owns 84 acres of St. Louis real estate, which it is selling off gradually at prices well over carrying value.

Four Corners, FCNE - Supplies for the charity bingo market in Texas. Consistently profitable, though unlikely to be a fast grower. Then again, as long as bingo remains popular in Texas, there will be a market for its products. I kinda doubt the average bingo player is looking to switch over to online sports wagering. COVID-19 hurt results in calendar 2020, but the company has recovered well. Four Corners carries healthy net cash and likes to share its earnings with shareholders through dividends.

Merchants National Properties, MNPP - This is one of the “OG” dark stocks, appearing in various editions of Walker’s Manual through the years. Merchants is a collection of commercial properties mainly in the Northeast and Mid-Atlantic states, concentrated in New York. These properties are conservatively financed and Merchants generates excellent cash flow. On the other hand, the ownership structure of many of the properties is complicated (JVs, minority interests) making it difficult to pick apart their actual value. Because Merchants owns so many properties of different types and in different locations, it is tough to figure out what the company’s investment strategy is beyond “opportunistic.”

Happy researching!

Alluvial Capital Management, LLC holds shares of PharmChem, Inc. and Four Corners, Inc. for client accounts it manages. Alluvial Capital Management, LLC may hold any securities mentioned on this blog and may buy or sell these securities at any time. For a full accounting of Alluvial’s and Alluvial personnel’s holdings in any securities mentioned, contact Alluvial Capital Management, LLC at info@alluvialcapital.com.