Reverse Mergers - revised resale rules

The SEC has just revised Rule 144, the regulation that provides a safe harbor exemption for the public resale of stock that was purchased in a private placement transaction. The rule change became effective on the 15th of this month. Today's entry will provide an overview of the rule change. This discussion is general in nature, does not constitute legal advice to any person, and does not apply to directors, officers and other corporate insiders who can be classified as "affiliates."  If you own restricted stock that you want to sell, you should consult your own attorney before taking any action.

The SEC's goal in adopting the rule change was to make it easier for investors to sell restricted stock, while maintaining the bulk of the current restrictions for affiliates. While the changes are beneficial for most investors, they have complicated the analytical matrix and made it far more difficult for an average investor to understand what the changes mean to him.

The Old Rule 144

Most investors understood what the old Rule 144 required. If the issuer was registered under the Exchange Act and current in its reporting, and you were not an affiliate:

• During the first year of ownership you were not allowed to sell any stock;
  
• During the second year of ownership you were allowed to sell up to 1% of the company's outstanding stock in any rolling 90-day period; and
  
• After two years of ownership, the restrictive legends could be removed and your stock could be deposited in a brokerage account.
  

The old Rule 144 also included manner of sale restrictions and required the seller to report sale transactions on Form 144.

New Rule 144 - Reporting Issuers That Have Never Been Shells

The new Rule 144 is most beneficial for investors that hold stock issued by companies that have never been shell companies, are registered under the Exchange Act and are current in their SEC reports. If those three requirements are satisfied and you are not an affiliate of the issuer:

• During the first six months of ownership you can't sell any stock;
  
• After six months you can engage in unlimited public resales; and
  
• After one year restrictive legends can be removed and your stock can be deposited in a brokerage account.
  

New Rule 144 - Nonreporting Issuers That Have Never Been Shells

The new Rule 144 also provides rules for the resale of stock issued by companies that have never been shell companies and are not registered under the Exchange Act. If you are not an affiliate of a non-reporting issuer:

• During the first year of ownership you can't sell any stock; and
  
• After one year you can engage in unlimited public resales.
  

New Rule 144 - Current and Former Shell Companies

While the new Rule 144 is beneficial for the stockholders of issuers that have never been shell companies, it imposes harsh restrictions on the shareholders of current and former shell companies. The basic rule is that stockholders of issuers that are now or have ever been shell companies cannot rely on the safe harbor unless:

• The issuer is no longer a shell company;
  
• The issuer has registered under the Exchange Act;
  
• The issuer is current in its Exchange Act reporting; and
  
• At least one year has elapsed since the issuer filed Form 10 type information with the SEC reflecting its status as an operating entity.
  

We view the shell company limitations of the new Rule 144 as a potential minefield for investors and their lawyers, and will be curious to see how the SEC's staff interprets those limitations in the future. 

Until the staff's interpretive position is clarified, we will advise our clients to regard non-reporting shells and companies that have merged with non-reporting shells as toxic waste. We will also advise that the risks of a reverse merger with a reporting shell are far greater than they were before the rule change.

Reverse Mergers - ownership percentages

The percentage of public stock ownership is probably the most poorly understood aspect of reverse mergers. Shareholders of private companies that are negotiating reverse mergers always want to maximize the value of their interest in the combined companies. Unfortunately, they frequently attempt to do so by minimizing the ownership interest of the existing shareholders. While many shell promoters are all too happy to accommodate, experience shows that squeezing those last few points out of a reverse merger usually does far more harm than good.

Reverse mergers that give the owners of the private company 90%, 95% or even 98% of the combined companies are not uncommon in today's market. But to modestly increase the percentage ownership of the private company's shareholders, the number of outstanding shares has to increase dramatically. As a simple example, if a shell has 1,000,000 shares outstanding before a reverse merger:

• It takes 4,000,000 shares to give the private company shareholders an 80% interest;
  
• It takes 9,000,000 shares to give them a 90% interest; 
  
• It takes 19,000,000 shares to give them a 95% interest; and
  
• It takes 49,000,000 shares to give them a 98% interest.
  

Many small public companies can and do support a reasonable trading price with 5 million or even 10 million outstanding shares. But as the number of shares passes the 10 million mark, the number of companies that can support a reasonable trading price drops off precipitously. So the stockholders of a private company that is negotiating a reverse merger will ultimately have to choose between getting a small number of reasonably priced shares or a large number of very cheap shares.

We have never seen a good result when the shareholders of a private company demand too large a stake in connection with a reverse merger. Stock market investors are not always rational, but they can all multiply and divide. If a small public company has a sustainable market value of $25 million, it will be priced in the $5 range if there are 5 million shares outstanding and it will be priced in the $0.25 range if there are 100 million shares outstanding.

Low stock prices make it very difficult for small public companies to obtain additional financing on reasonable terms because investor confidence in the sustainability of market prices bears an inverse relationship to market prices. While a relatively high market price does not guarantee a high level of investor confidence, a relatively low market price will almost never give rise to a high level of investor confidence. Moreover, as the relative market price per share declines, the profit margin or "spread" that market makers charge buyers and sellers can and usually does increase rapidly as a percentage of the share price.

We believe the principal value of a public company lies in its inherent ability to issue additional shares in connection with future financing, property acquisition and compensation transactions. Initial ownership is important from a control perspective, but placing undue importance on initial ownership percentages can seriously impair a small public company's future.

While it is not a perfect analogy, we frequently compare public shells to printing presses. When the press is delivered to the buyer there are a limited number of stock certificates that were printed while the press was being built. Those shares are the initial public float. In connection with the sale of the press to the buyer, an additional pile of stock certificates is printed for the reverse merger transaction. The number of stock certificates that need to be printed in connection with the reverse merger is wholly dependent on the percentage ownership that the shareholders of the private company demand. Once the press is turned over to the buyer, he owns it and can print as many or as few additional stock certificates as he chooses.

If the press is used judiciously, substantial value is received in the reverse merger and substantial value is received every time a new stock certificate is printed, the market value of all outstanding shares will increase over time. If too many stock certificates are printed for the reverse merger or the press is used indiscriminately to print new stock certificates for dubious value, the market value of all outstanding shares will decline over time.

In the final analysis, there is no way to repeal the laws of supply and demand.

We once heard a Vancouver promoter quip "As long as a tree stands in British Columbia we will never run out of stock." This is a great truth and a real and present danger. A public company that indiscriminately issues stock in a reverse merger will permanently impair its ability to obtain new value in the future by issuing additional shares. If management lacks the discipline to maximize value per share from the outset, then their venture into the public markets is in grave peril before it starts.

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.

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.

Reverse Mergers - trading OTCBB Shells - the Dark side

It doesn't take much surfing around the Internet to find lots of material from promoters hawking trading OTCBB shells. The promotional descriptions invariably talk about how clean, or even pristine the shell company is. But I remain a devout skeptic.

It is virtually impossible to list a new shell, other than a SPAC, on the OTC Bulletin Board. So virtually every company that is being touted as a clean OTCBB shell is a public company that has already failed in at least one business. On balance, I think it would generally be fair to say that all the talk about clean OTCBB shells is about as reliable as a used car dealer's pitch about a shiny low-mileage beauty sitting on his lot.

In 28 years of representing entrepreneurs, the one immutable constant has been that when a company is experiencing operating or financial difficulties, its management team starts talking louder to support a sagging stock price and working harder to bring in badly needed capital. For a public company, these are very high risk behaviors because:

• Section 12 of the Securities Act makes it illegal for a company to sell stock by means of any written or oral communication that includes an untrue statement of material fact or fails to state a material fact that is necessary to make the other statements made by the company not misleading;
  
• Rule 10b-5 under the Exchange Act makes it illegal for anybody, in connection with the purchase or sale of a security, to (a) employ a device, scheme or artifice to defraud; (b) make any untrue statement of a material fact or to fail to state a material fact  that is necessary to make the other statements that were made not misleading; or (c) engage in any act, practice, or course of business that operates or would operate as a fraud or deceit upon any person; and
  
• The securities or "Blue Sky" laws of most states have similar provisions for investor protection
  

If a company violates Section 12, Rule 10b-5 or a wide variety of state securities laws, the measure of damages is usually the amount of money the investor lost as a result of the false or misleading statement.

Human nature being what it is, few entrepreneurs can stand idly by and watch their businesses fail without engaging in some conduct that will give rise to substantial carry-over liabilities under the securities laws. If you enter into a reverse merger with a public company that has undisclosed securities act liabilities, all of your assets and your business itself will be fully exposed to those claims.

For a company that is contemplating a merger with an OTCBB shell, the process of obtaining a reasonable level of comfort that there are no contingent Section 12, Rule 10b-5 or state securities law liabilities can be overwhelming. When we are asked to advise a private company that wants to combine with an OTCBB shell, our response is always the same:

"We cannot give you any comfort or assurance that there are no contingent securities law liabilities."

Since our clients are never happy with that answer, we fastidiously avoid reverse mergers with any shell that has sold any securities or been actively traded at any time within the last three years. In practice, we prefer shells that (a) have been through a full Chapter 11 reorganization, and (b) have not been actively traded for several years.

It is relatively easy to clean up the balance sheet of a failed public company; and if you're only interested in a balance sheet review, I suppose there are lots of clean OTCBB shells out there. 

As a practicing lawyer, the only way I can tell a client that an OTCBB shell is clean is by reviewing the docket in its Chapter 11 case and making sure that no trades have occurred for several years.

Undisclosed securities liabilities are not the only potential problem one typically encounters with trading OTCBB shells, but they're the ones that can cost you your company.

Reverse mergers - Good, bad and ugly - Introduction

Over the last 20 years, there have been phenomenal changes in the IPO market. My first transaction as lead issuer's counsel was in 1987 and involved an underwritten $3 million IPO for a small technology company that immediately listed on Nasdaq. In 2007, the average IPO size was over $200 million and the only place you'll see a $3 million number in today's IPO market is in Item 13 of Form S-1 which relates to the estimated costs of registration, issuance and distribution.

What was once the goal of an IPO has now become the minimum price for admission to the game.

There are a number of reasons for the changes in IPO market dynamics. But the hard cold reality is that many small companies that would have been reasonable IPO candidates 20 or even 10 years ago are completely frozen out of today's IPO market. The net result is that entrepreneurs who can't qualify for a $200 million IPO, but need $20 to $50 million in financing and want to be publicly held, are forced to seriously consider alternative ways to access the public capital markets.

That search for an IPO alternative almost always leads to a consideration of a reverse merger with a public shell.

One of the most important differences between the IPO market and the shell market is frequently overlooked, or at best not fully understood. The IPO market is populated by broker/dealers that want to earn fees by raising money. 

The shell market, on the other hand, is populated by promoters that expect to profit from a variety of sources including (a) the fees they charge for raising money, (b) the fees they charge for arranging a shell merger, (c) the profit they earn from the eventual sale of their shell shares, and (d) the fees they charge for post-closing services. While the costs in the IPO market are usually transparent and predictable, the costs in the shell market are usually far more opaque and unpredictable; meaning that a company considering an IPO alternative needs to be more vigilant in its dealings with shell promoters and more diligent in its efforts to understand the true nature and extent of all current and future transaction costs.

SEC regulations generally define the term "shell company" to include any company that has registered its stock under the Exchange Act and:

• Has no substantial operations; and 
  
• Has no substantial assets; or
  
• Has substantial assets that are principally held in cash and cash equivalents.
  

Implicit in the definition is the existence of shares that can be lawfully resold by current stockholders without further registration under the Securities Act. In general, the SEC's definition of "shell company" is broad enough to include:

• SPACs that conduct IPOs for the purpose of raising capital that can be used to purchase assets or companies; 
  
• Unsuccessful public companies have no substantial remaining assets; 
  
• Companies that voluntarily register under the Exchange Act for the purpose of serving as shells; 
  
• Blank check companies that conduct registered stock offerings under Rule 419; and
  
• Reporting companies that have specific business plans but otherwise fall within the definition.
  

In addition, other acquisition-oriented companies that are not registered with the SEC are often referred to as shell companies. Over the next few weeks, I will try to explain the principal differences between the various types of shells that promoters are offering to companies that are seeking IPO alternatives.