Reverse Mergers - trading OTCBB shells and Rule 419 shells - timing of PCAOB compliant audits

Promoters of trading OTCBB shells spend a great deal of time talking about the speed of a reverse transaction with their company. The theory seems to be that a reverse merger with a trading shell takes far less time than reverse merger with a Rule 419 shell because the trading shell transaction is reported on Form 8-K after the merger closes while the Rule 419 shell transaction is described in a post-effective amendment before the merger closes. Since there is no significant difference between the disclosure that needs to be included in a reverse merger Form 8-K for a trading shell and the disclosure that needs to be included in a post-effective amendment for a Rule 419 shell, a private company that is considering a reverse merger needs to carefully consider whether the claims of significant time savings are likely to materialize.

It is true that a trading OTCBB shell can close a reverse merger first and report the merger to the SEC three days after the closing. It is also true that the ability to close first and report later does theoretically shorten the time to the commencement of trading by the time it would normally take the SEC staff to review and comment on a post-effective amendment. But there is a major fly in the ointment that the trading OTCBB shell promoters usually fail to either recognize or mention.

A reverse merger with a trading shell is treated as an acquisition of the public shell by the private company for accounting purposes. That means the financial statements that the combined companies must file with the SEC within three days after closing must be audited by a PCAOB registered public accounting firm. If a private company that is considering a merger with a trading shell is fortunate enough to have financial statements that are audited by a PCAOB registered firm, then the promised time savings may materialize. If the private company's financial stateents are not already audited by a PCAOB registered firm, then the pre-closing timeline will have to be extended for several weeks while the private company goes out to hire a new PCAOB registered auditor and have its historical financial statements reaudited by the new firm.

In comparison, a post-effective amendment for a Rule 419 transaction does not require the private company to have a PCAOB compliant audit, either before the post-effective amendment can be filed or before the reverse merger closes. Once a reverse merger is closed, of course, the combined companies will need to have PCAOB compliant audits on a go-forward basis.

In our experience, the time required to prepare, file and obtain an order of effectivness for a post-effective amendment is far shorter than the time required to obtain new PCAOB compliant audits. So for a private company that does not already have a PCAOB compliant audit, we believe the timeline for a Rule 419 transaction will likely be shorter than the timeline for a reverse merger into a trading OTCBB shell.

It is commonly said that "it's easier to ask for forgiveness than permission." In our experience, that time-worn logic does not hold true in dealings with the SEC, FINRA (formerly the NASD) and institutional investors. There are immense differences in the regulatory and market perceptions of transactions that are reported before the fact and transactions that are reported after the fact. While shell transactions are gaining acceptance since the IPO market is all but closed to smaller companies, there is still a good deal skepticism among regulatory authorities and market participants about companies that choose the shell alternative. On balance, we believe Rule 419 transactions are far more transparent than other types of shell transactions and in many cases easier to complete and document.