Reverse Mergers - trading OTCBB Shells - the unknown stockholders

Since there can be no active public market unless a company has outstanding shares that can trade freely without further registration under the Securities Act, a fundamental requirement for a public shell is that some portion of the outstanding shares can be resold by the current stockholders. In our experience, it is very unwise for a private company to negotiate a reverse merger into a public shell without extensive knowledge of who the stockholders are.

When public companies are relatively young, the bulk of their shares are held in registered form and the holders are identified on the company's stockholders list. As companies mature, an increasingly large percentage of their shares find their way into brokerage accounts where it becomes far more difficult to determine who the stockholders are and how many shares they own. 

Substantially all brokerage firms that hold shares for client accounts use the services of The Depository Trust & Clearing Corporation, or DTCC, which serves as an electronic clearinghouse for corporate securities. Since DTCC holds all "street name shares" in a single account for CEDE & CO, all shares held in brokerage accounts show up as a single line item on their stockholders lists. In an effort to foster a degree of transparency in the securities markets, DTCC will, upon request, provide a Securities Position Report ("SPR") that identifies (a) the brokerage firms that  hold shares in the DTCC system, and (b) the number of client accounts that hold shares in each brokerage firm. DTCC does not, however, provide any information about who the ultimate owners of brokerage account shares are.

Substantially all brokerage firms that hold shares for client accounts use the services of Automatic Data Processing, Inc. or ADP, for their shareholder communication function. Like DTCC, ADP will, upon request, provide a list of Non-Objecting Beneficial Owners ("NOBO list") that identifies all customers who own shares in brokerage accounts and have not instructed their broker to keep their identities confidential. Unfortunately, NOBO lists do not provide any information about the firm where a particular customer holds his shares. They merely tell you who the customer is and how many shares he holds.

The combination of a stockholders list, an SPR and a NOBO list can give a due diligence analyst a good idea of who the stockholders of a public shell are and how many shares each of them hold. But since the SPR and NOBO list are not cross referenced to each other, and stockholders who want to keep their identities secret do not show up on the NOBO list, there will always be gaps in the available information. Sometimes the gaps will be modest and sometimes they will be substantial.

If a public shell has a large number of holders who want to keep their identities secret, or a small number of large holders who want to keep their identities secret, it is virtually impossible to determine which brokerage firms hold the secret shares and who the ultimate owners of the secret shares are.

From the perspective of a shell promoter, every share that he does not own is a lost profit opportunity. So it is not uncommon to find that a shell promoter has quietly gone out and purchased certificated shares from people who show up as registered owners on the formal stockholders lists. It is also not uncommon to find that a shell promoter has quietly gone out and accumulated a substantial portion of the "worthless" shell shares that were previously held in brokerage accounts. Unless the promoter records and discloses all of his accumulation transactions, this type of activity is almost impossible to track.

A public shell that has large blocks of transferable stock in a small number of hands presents significant risks for a private company that merges into the shell. Large holders have a clear financial incentive to engage in behavior that might be construed as manipulative and may even engage in well orchestrated pump and dump schemes. Shell shares are also frequently used for money laundering and other criminal activities. In the final analysis, it is the go forward public company that suffers from the bad acts of the old shell shareholders.

It can be very difficult for a small public company to overcome the problems created by old shell shareholders who engage in manipulative conduct or other bad acts. In our view, engaging in a reverse merger with a public shell that cannot provide complete and reliable information about who owns the substantial bulk of the transferable stock is begging for trouble.