For what it’s worth, I could be rich and retired from all the business I have turned down over the years. But because I represent only those who I be- lieve to be legitimate and fair players, I can sleep at night. I do not expect my clients to be pushovers, since business often requires toughness, but I do expect them to stay within the law, even if they go right up to the line, as long as they do not cross it. And I do expect clients to be forthright with me at all times. If I ever have a concern about either of these, I generally resign from the project.
There is a selfi sh reason why I have turned down work as well. I have tried very hard to improve the legitimacy, acceptance, and popularity of the reverse merger technique in the face of decades of abuse. As part of this effort, I have worked closely with the SEC and other regulators, and I believe these efforts have borne fruit, including the new SEC regulation passed in June 2005, in which the SEC expressly recognized the legitimate use of this technique. In April 2006, I was invited to Washington to ad- dress more than a dozen SEC Enforcement Division staffers on reverse mergers. If the SEC or other industry groups were to believe that I was knowingly working with questionable players, the very ones I have insisted we should seek to eliminate, my status as an industry advocate would obvi- ously be in question.
Source: TKTK
The following are a few examples of clients I have had to walk away from, and some helpful anecdotes involving shady, but fairly common, business tactics.
Telltale Signs: Not Disclosing Biographical Information or Trying to Avoid Full Disclosure
A new client showed up at my offi ce without a referral. He was interested in raising money in the oil and gas arena. He claimed to have worked with major law fi rms in the past but wished to work with me now (reason for suspicion in itself, what I call the “why me” test).
He sent me an offering memorandum from a deal he was involved with recently, which included his biography and no mention of anything im- proper. I took a large retainer, and we began work. Then we researched his background and discovered a number of lawsuits relating to past, alleged securities violations.
I resigned, mainly because he intentionally withheld that informa- tion—information that I would have needed to include in his biography.
Not only would he be liable for failing to disclose, I might be liable for not investigating him carefully enough.
Do past problems mean I will automatically refuse to represent some- one? No. But I do need to develop a sense that previous bad behavior will not be repeated. First, I look for forthrightness. Does the client give me all the facts without my prodding? Second, is the client willing to make all proper disclosure about past problems? And third, do I have a way to independently verify the credibility of the client? If a client passes these tests, I may still represent them.
A case in point: A manager of an operating business asked me to rep- resent his company to raise money privately. At our fi rst meeting, he told me he had been convicted of a crime a number of years earlier. He had been unhappy with the performance of a business associate, went to this associate’s place of business, and some alleged bad activities ensued. The associate called the police and my client struck a plea deal to avoid the risk of jail. Both before and after that incident, the client had no legal prob- lems whatsoever.
The client understood that all of this needed to be disclosed and, understandably, he was not happy about it; however, the placement agent seeking to raise the money he needed had a different point of view. The agent felt it showed dedication to protecting his business! Several years after going public, we dropped the reference to the prior conviction be- cause it was old and had been disclosed on numerous occasions.
Another example: One day a very excited gentleman appeared at my offi ce. He had been in the securities business for almost thirty years and
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wanted to involve me in three major projects after he saw me speak at a seminar.
The transactions he described would, among other things, keep his involvement below the level that would trigger mandatory disclosure. I asked whether there was anything problematic in his background. Sure enough, he had been incarcerated for securities-related problems in the past. “Don’t worry,” he said, “I learned my lesson, I’m clean now and I want to do things the right way.”
I turned down almost $300,000 of immediate business from him. The main reasons were his desire to hide himself in his transactions, and the fact that I had to ask about his background. He had the experience to know I would care about his past problems and he should have been up front with me. So, I felt, maybe he hadn’t fully learned his lesson. Even if he had, I wasn’t going to take the chance.
One Company’s Search for a Clean Shell: A Case Study
A recent experience I had with a client in a service business dramatizes why it is so important to know the backgrounds of all the players in a reverse merger transaction.
I’ve changed the names and some facts here (to protect my relationship with my client) but none of the important ones. “Shell Shocked,” a private business, came to me seeking to go public through a reverse merger. He had engaged an investment banker who was to provide the shell. On its face, the shell appeared fairly decent. It had originally gone public in 1997 through a traditional IPO and had intended to enter a business relating to the art world. The president of the shell had a background in entertain- ment, but little experience in art.
The stock of the shell had begun to trade on the OTC Bulletin Board after the IPO (which only raised about $100,000), fi lings were made dis- cussing in detail the nature of the business including the risks, and a small inventory was kept and a small amount of revenues earned. By 2002, how- ever, according to their SEC fi lings, the company was not able to achieve its business plan and was terminating operations. The result was a public shell, now seeking to acquire another business.
An individual with vast experience in reverse mergers—call him the
“Dealmeister”—had become a principal in the shell and acquired some stock with the hope of fi nding a company to merge with. Shell Shocked was told that no operations had existed since 2002, almost three years, and that little business was currently being conducted, so no liabilities from prior operations existed. This could be confi rmed through due diligence.
Shell Shocked had no experience in reverse mergers and believed the Dealmeister’s representations that the shell in question seemed to be of
Source: TKTK
very high quality, especially since the investment banker, whom he liked, told him so. The promoters wanted to retain approximately 15 percent of the company through the shell after the transaction and expected to raise between $8 million and $9 million as a condition to the merger, thereby providing an additional 33 percent of the company to the new investors.
Unfortunately, through very little additional research, it became clear that Shell Shocked had to move away from this shell because of a real risk of being in the middle of a serious potential problem with the SEC.
Because of the Dealmeister’s involvement in at least a dozen other trans- actions where small businesses went public and then several years later suspended operations in a very similar fashion, we determined that the SEC might declare some of these IPO transactions as frauds intended to avoid the restrictions of Rule 419.
As discussed in detail in Chapter 9, Due Diligence, under the heading
“Footnote 32 Shells,” the Dealmeister’s transactions were very similar. A small business goes public (suspicion #1: small businesses with virtually no revenues rarely go public). It raises a token amount of money, sometimes even less than $100,000 in its IPO (suspicion #2: the costs and hassle of an IPO make raising such small amounts inadvisable). Often the principal of the small business has little or no experience in the industry in question, and often has little experience running a business at all (suspicion #3: no operating experience).
Finally, the Dealmeister, whose business is in fact reverse mergers (not taking tiny companies public through IPOs), had a hand in every deal. It was not always easy to fi nd the Dealmeister in his deals. In some cases, he appeared as a “buyer” of the shell long after the IPO. Although he admit- ted to us that he played a consulting role in all these companies at the time of the IPO, his involvement was not disclosed. In a few cases, he appeared as a principal from the start.
He virtually admitted to us that he did not want a simple search of his name to bring up enough information about his activities to serve as a road map for regulators (suspicion #4: trying to evade regulators). At the same time, he claimed that nothing inappropriate had occurred in any of his shells. His story was that he had successfully completed a number of reverse mergers and that he would not be willing to suggest that the small businesses he took public were not real, and so on.
When my client decided not to become involved with this particu- lar shell, another was presented. This time, the problem was different.
The shell had gone public through a complex “gifting” transaction back in 1990. The promoter apparently had done this many times before and ultimately was indicted and convicted of fraud and served time in jail. In
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this particular instance, however, he was not charged in connection with this particular shell.
In this case, I had to advise Shell Shocked that legally he was probably safe and could complete a reverse merger with this shell. Why? Clearly, a criminal took it public through a dodgy transaction, so isn’t there a con- cern about liability? In this case, no, because the alleged crime had taken place long ago, so long ago in fact that the statute of limitations likely would bar virtually all claims relating to the bad public offering. The “go forward” suggestion was contingent, however, on an assumption that the original promoter was long gone from the company.
The shell’s public fi lings do not mention the dodgy promoter as an owner of 5 percent or more of the company’s stock or as an offi cer or di- rector of the company, and fi lings would be required if he fi t any of these categories. Indeed, there is nothing in this shell’s fi lings about the criminal conviction of the original promoter. That is not on its face alarming, be- cause this disclosure might not be required so many years later.
During our due diligence process, however, we requested the list of shareholders from the shell’s transfer agent. Sure enough, an entity con- nected to the original promoter still owned more than 6 percent of the company. (We learned about this connection from our examination of other fi lings.) So the concern was that the promoter still directly or indi- rectly controlled the company (which would require disclosure). Assur- ances were given that his ownership would drop below 5 percent after the merger so that it would not have to be disclosed; however, the concern remained that the original promoter was controlling the shell, which led Shell Shocked to look for another shell yet again.
There was another reason this shell was shelved. Shell Shocked had invited several high-profi le individuals to join his board upon the merger.
He knew that if these individuals saw that the shell he acquired had a checkered past, even if no current liability existed, they would not be pleased. Related to that was a concern that the company’s competitors could take advantage of the “crooked shell” acquired by Shell Shocked.
The third shell my client considered was the result of the bankruptcy of an actual revenue-generating business. However, a former principal of that business had sued the shell. The lawsuit was still pending. Assurances were given that the prior shell owner would indemnify Shell Shocked for any costs or liabilities from that lawsuit. But we advised Shell Shocked that we could not assure that he could collect from the prior owner if and when necessary.
As a result, it was determined that the lawsuit should be settled. At this point, we stopped hearing from the shell promoter, which strongly implies they did not actually settle the suit and were hoping to fi nd another sucker
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to take the shell. In this case, before we stopped hearing from them, we were being pressured for time, to hurry up and take the shell before some- one else did, which was an immediate red fl ag.
We considered a fourth shell. An actual business had gone public and owned some assets. We were told the company wanted to go private and sell the assets back to management, leaving behind the shell. We were told that this agreement was almost completed and that shareholder approval for the sale (requiring a complex proxy statement) was to happen quickly and approval was assured. We were also told that the management buyers would fully indemnify the remaining shell for any liabilities of their business.
Again, we raised caution fl ags. Why now? Wait, it’s a real business, seeking to shed its assets properly, and there’s no suggestion of impropri- ety. The problem here was the recent business activity in the entity. Any creditor of the business that is spun off might be able to sue the shell for liabilities the entity incurred. An indemnity is nice, but as with the case above involving the lawsuit, how can one be sure that the indemnitor will indeed be able to provide the promised reimbursement? Short of money in escrow or a mortgage on the individual’s home, nothing is truly assured.
As of this writing, we have reviewed—and our client Shell Shocked has rejected—an additional fi ve shells, and the transaction still has not been completed. This odyssey epitomizes one of the most frustrating aspects of the reverse merger business—fi nding a clean shell controlled by clean people.