Source: TKTK
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.
Source: TKTK
limited role prior to an actual transaction, given that management usually already owns a signifi cant equity stake in the shell.
Shells do not need public relations fi rms, and they do not need to rent offi ce space. Often the third parties receiving payments for rent or public- ity have some business or even family relationship with the controller of the shell.
Strange Money-Raising Activity
It is not uncommon for a shell to raise money for the legitimate costs it incurs (such as to pay lawyers and auditors in order to maintain its public status). But if it raises money to pay management salaries and the like, this should defi nitely be questioned. In addition, if a shell’s stock is trading at a certain price, and money is raised at a much lower price, be suspicious. It is possible, however, to justify the lower price as the only price at which in- vestors are willing to put money into the shell, despite the trading price.
Insider Trading
Another concern is insider trading. Just prior to announcing a reverse merger, trading activity in the shell may increase. A company merging with a shell could inherit potential liability for the actions of a shell principal trading in his individual name. It is not simply the problem of the indi- vidual insider trader, and the liability is real (and criminal).
PRACTICE TIP
Monitor trading activity leading up to the announcement of the transaction.
Press Releases and Hype
Sometimes shell operators seek to promote possible mergers at a very early stage. Press releases are issued even when negotiations reach a late stage or when vague and nonbinding letters of intent are signed. The stock price rises, insiders sell on the increase in share price, the transaction falls apart, and the stock heads back down. Again, watch the trading patterns.
PRACTICE TIP
Be skeptical of predeal hype.
Recently, a private company client had reached terms with a shell, and our client submitted their signatures to the shell for the closing, which was to include an exchange of shares and payment of cash to my client.
We assumed within a day the shell would send their signatures back along with the cash and other closing documents.
Source: TKTK
Instead, upon receiving my client’s signatures, the shell “inadvertently”
issued a press release announcing that the transaction had been closed! Of course, neither our client nor we had seen or approved this release. It took three business days and, of course, no closing or cash delivery to my client, to get the shell to “amend” the press release to indicate that indeed we had not yet closed. Luckily, only a minimal amount of trading took place, but the stock did rise on the announcement. The deal fi nally closed about a month later.
Time Pressure
Another common practice involves insisting a deal must be consummated quickly. In too many cases, the shell operator pressures a private company’s principal to ignore his attorney’s entreaties to ensure that full due diligence is completed. “We have another candidate for the shell,” or “You know our shell is clean, what’s all this need for due diligence?” are common themes in deals. Be suspicious of these tactics.
A letter of intent binding the parties not to discuss a possible transac- tion with others is the best way to go, giving both sides the appropriate amount of time to complete due diligence and negotiate a formal agree- ment. Sometimes, if a real concern exists about locking in the shell, a good faith deposit in escrow, which is returned if the transaction ends, helps convince a shell of one’s serious intent. Everyone wants deals to be completed quickly, but legitimate players understand the need for focused, effi cient due diligence review.
Incomplete Disclosure
Another problem I continuously encounter involves out-and-out fraud.
Public fi lings by the shell sometimes simply fail to disclose all required information. When we insist on due diligence and undisclosed informa- tion is discovered, often the response is, “Gee, thanks for pointing that out, you’re right.” Counsel will suggest they were unaware of the oversight.
“My client never told me,” they say. To which we then reply, “Why wasn’t this question ever asked before?” The principal will typically offer vague claims of being inept at preparing these fi lings. Be suspicious when this happens.
Incomplete Insider Filings
Sometimes the true ownership of the shell is not disclosed. Anyone who owns more than 5 percent of any public reporting company must fi le with the SEC disclosing their ownership, and the shell is obligated to disclose the names of anyone that it knows owns more than 5 percent in its annual Form 10-KSB fi ling. In some cases, shell promoters simply do not make
Source: TKTK
these fi lings to avoid attention or dicey trading restrictions on large share- holders. This is obviously a bad sign.
Refusal to Back Up Representations and Warranties
A private company receives representations and warranties from the shell about such things as its operations, past fi lings, and compliance with laws.
Without a guarantee or holdback, these become essentially meaningless after the transaction has closed since the merged company can only sue itself. The more strongly a shell promoter refuses to even consider such ar- rangements, the more suspicious one should be. We’ll discuss this further in Chapter 9, Due Diligence.
Messy Isn’t Dirty and “Not Nice” Doesn’t Mean “Bad”
In some cases, a shell is just plain messy, as discussed in Chapter 9, Due Diligence. It is hard to fi nd documents, confi rm status of offi cers and directors, and so on. Do not mistake a messy shell for a “dirty shell” con- trolled by a shady operator, but be wary of a shell so messy that getting a deal done becomes diffi cult if not impossible.
Sometimes I hear the following about reverse merger players: “He’s a jerk,” or “He’s a tough negotiator,” or “He’s not interested in helping our business grow.” These may be good reasons not to do business with people, but they do not necessarily indicate evil, illegal, or even shady tactics.