Red Oak Partners, LLC and the Red Oak Fund L.P. (collectively "Red Oak") comment on Digirad Corporation's (NASDAQ: DRAD) Tax Loss Rights Plan adopted on May 24, 2013.
Stated David Sandberg, Red Oak's Founder and Managing Member, "Below we disclose why this plan can't reasonably meet its stated objective and why we believe the plan is instead an attempt by insiders to entrench themselves. We remain disappointed both in the lack of demonstrated capability and the lack of good governance maintained under this Board. Specifically, we note:
Digirad's aggressive share buyback plan can constantly create new 5%+ shareholders which Digirad cannot reasonably track – Digirad's stated purpose of the plan is to protect tax loss assets by limiting the creation of or purchases by 5%+ shareholders, noting that transactions among such holders can bring Digirad closer to a change of control limitation under Section 382 of the IRS Code. However, as an important refresher, after being challenged for its lack of meaningful return of capital for nearly a year Digirad increased its share buyback plan from $2 to $7 million on February 28, 2013 and again from $7 to 12 million on March 13, 2013. This $12 million buyback reflects over 25% of shares outstanding at today's share prices, and Digirad has publicly touted their buyback efforts as "aggressive" in both of its 2013 earnings releases (including just two weeks before Digirad announced the rights plan). If Digirad is sincere about its intent to be aggressive with its $12 million share buyback, then any 4%+ shareholder, despite not purchasing additional shares, will become a 5% shareholder and bring Digirad closer to an unintended change of control. There is no way Digirad can reasonably track sub 5% holders given such holders are not required to disclose their ownership levels, thus Digirad cannot track how many 5%+ holders it creates. Digirad's Board does not appear to have contemplated this, despite this being the very reason that most public companies do not combine tax loss rights plans with an aggressive share repurchase plans. The plan is at a minimum poorly constructed, and we believe (for reasons addressed below) not sincerely intended to protect tax loss assets.
Lack of disclosure about the rights plan during a very close proxy contest – Digirad's surprise and poorly constructed rights plan was adopted less than three weeks after the results of a closely contested election were confirmed by the Inspector of elections. During the proxy contest, Digirad never mentioned its intent to materially limit share ownership despite shareholders in a closely contested election being highly likely to care about the Company's intent to limit their ownership. This should have been disclosed during the contest, but wasn't.
Digirad's rights plan was adopted just one week after Digirad was challenged in Court for a new election and specifically prevents 5%+ holders - the majority of which voted against Digirad's nominees - from acquiring more shares in advance of a new election - The Tax Loss Rights plan was adopted just one week after a Motion was filed by Red Oak in Delaware Court to Seek to Compel a New Director Election after Digirad's attempts to mislead investors with inaccurate preliminary voting results resulted in a narrow (six percent) margin of victory. In the recent Director election, Red Oak believes that four of Digirad's five largest shareholders (and four of Digirad's five disclosed 5%+ shareholders) voted against the re-election of Digirad's Directors. By adopting this plan, Digirad has limited its opposition's ability to acquire more votes for a potential new election while insiders have granted themselves an (inexplicable) exemption to buy more votes. This reflects awful governance under Governance Chair Charles Gillman and Board Chair Jeff Eberwein, who are business partners.
Inexplicable Director and insider exemption from the plan – Digirad's new rights plan limits purchases by 4.99%+ shareholders yet inexplicably exempts insiders and Directors from the plan's ownership limits under the guise of "acting in their fiduciary capacity." However, it is an indisputable fact that purchases can bring Digirad closer to a change of control but can never bring Digirad further away from a change of control. Thus there is no conceivable fiduciary duty related to tax loss preservation which can justify this exemption. The unjustified insider exemption makes it clear that this is not an "ordinary" tax loss plan and should raise doubts in shareholder's minds as to what Digirad's insiders are really seeking to accomplish. It is worth noting that although Digirad has claimed Red Oak is seeking control of the Company (see Digirad's May 20, 2013 press release as well as comments during the proxy contest), we believe Digirad has been dishonest with shareholders (including statements made about Red Oak's intent to control Digirad) because both prior to and during the recent proxy contest, Digirad's Chairman Jeff Eberwein was informed by one of Digirad's largest shareholders that after conversations with Red Oak –and although Red Oak remained extremely concerned about conflicts and capabilities amongst Digirad's current Directors - Red Oak would agree to a split Board plus the appointment of a 7th fully independent Director (to moot deadlocks with neither side having control). This was known to Digirad's Chairman in advance of the contest who therefore knew all along that Red Oak was not seeking control. Instead, Digirad's Chairman never contacted Red Oak to discuss ways to avoid the contest because he sought control of the Board (noting that he, Gillman, and Climaco are three fifths of the Board). We note that Digirad voted ineligible Treasury shares in favor if its Directors (such shares were ultimately rejected by the Inspector of elections at the annual meeting), touted a landslide victory (including via this improper voting boost) to shareholders before final results were in, and now after being further challenged, has adopted a surprise tax loss rights plan which was never mentioned during the contest and which imposes a materially stiffer 4.99% ownership limit vs. the already existing 20% limit imposed under the existing poison pill. Given Digirad's Chairman rejected an offer that would have caused him to lose control of the Board, but where Red Oak would not have had control either, and instead chose to pursue a costly proxy contest as he continues his new career in micro caps after departing Soros and partnering with fellow Director Charles Gillman, we believe Digirad has been dishonest with shareholders about who is really seeking control here, and this unjustified exemption to insiders is one reason why and should be questioned. Undisclosed Group between Digirad's Board Chair Jeff Eberwein and its Governance Chair Charles Gillman continues, Digirad's Directors continue to look the other way – Since early 2012, Eberwein and Gillman have contested four other public companies together as a disclosed group. After attending business school together, they met with Heartland Advisors together in early 2012 (according to what Red Oak was told by Jeff Eberwein in early 2012) in their efforts to seek Heartland's support to serve as Directors on Digirad's Board, and for over one year they have purchased identical amounts of Digirad stock on identical days at identical prices, spanning a whopping 39 separately filed Form 4 filings each across nearly 100 trading days all containing the exact same split trades. We believe these were clearly jointly purchased shares where Eberwein and Gillman acted in concert to accumulate stock together as opposed to competing for stock in the market as other shareholders (who are not part of a group) do. A group is defined as "acting in concert," and for the above mentioned reasons it is apparent to Red Oak that Eberwein and Gillman are a group and should have filed as such. In fact, Red Oak addressed this very issue during the proxy contest and Eberwein and Gillman refused to comment whatsoever. Since the adoption of this recent and questionable tax loss rights plan, Eberwein and Gillman have each already filed five Form 4's covering fourteen trading days in which they have continued to jointly split trades and purchase more shares on identical dates, amounts, and prices, despite their combined ownership already exceeding the rights plan limit. By not disclosing their group status they are seeking t to justify continued share purchases while blocking opposing 5%+ holders from additional purchases. Further, Red Oak - with significant public company tax loss experience – believes that Eberwein's and Gillman's lack of disclosure about being a group does not exempt them from an IRS determination that they are one. Should their continued purchases impair the very tax assets they allege they wish to protect, how will such potential damage and accountability play out, or is this why they have exempted themselves from the plan despite it not making sense to allow such exemptions? Although Digirad's other Directors - John Climaco (who was brought to the Board by Eberwein and Gillman), James Hawkins, and John Sayward – could have required this to be addressed, they have instead continued to look the other way as this conflict, which would normally fall under the Board Chair and Governance Chair's purview, continues to exist through the Board and Governance Chair's combined actions." Continued Mr. Sandberg, "We are not opposed to efforts to protect the tax loss assets nor are we opposed to the return of capital. In fact, we think that more than the stated $12 million should be returned given no Directors, aside from Jim Hawkins, has meaningful M&A experience (thus, why allow inexperienced Directors more house money to play with). If Digirad's Board truly and in good faith wishes to accomplish tax loss protection and it's stated aggressive return of capital to shareholders, then it should do so without conflict and in a well-thought out manner. To this end, we recommend that if Digirad has purchased shares since it adopted the tax loss rights plan, that it immediately discontinue the share repurchase plan so as to not risk creating new 5%+ owners and to not further increase the ownership of existing 5%+ owners (as this can also lead to a limit in the usage of tax assets under Section 382), and instead immediately announce a tax-efficient return of capital distribution to shareholders (or a dividend if such return of capital cannot be effected) in an amount at least equal to what is left on the $12 million buyback plan, as we suggest it be more. This will stop Digirad from potentially creating new 5%+ owners and from limiting the usage of its tax assets, while returning the capital it has told shareholders it will under a plan that is "aggressive," which is also how Digirad characterized its return of capital intent.
Coincident with this effort and in order to ensure best practices, Digirad should also:
undo the rights plan; inform shareholders of the current shares outstanding so they may know whether they have become 5%+ owners under recent repurchases; remove the exemption to insiders; require Eberwein and Gillman to file as a group or require that they abstain from purchases until they (not Digirad) secure a Private Letter Ruling from the IRS regarding whether they would be deemed a group from an IRS perspective, as this is the safe and right course of action if seeking to protect shareholders rather than taking unknown risk; require that either Eberwein or Gillman cede one of their Chair positions given they are business partners and the Board and Governance Chairs should not both be held by business partners; re-confirm Digirad's Section 382 change of control calculation based on new information received by shareholders and confirm a change of control has not since occurred; re-adopt the NOL plan (if such is the Board's decision) "We'd like to see a thoughtful, effective, and conflict-free plan executed which doesn't cause shareholders to scratch their heads in confusion, and hope Digirad will consider the above."
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