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content and the U.S. Securities and Exchange Commission’s turnaround.
Some shell company management teams also are concerned, quite frankly, about ensuring their shareholders actually show up to vote or send in a proxy for a merger. Thus, avoiding shareholder approval is generally con- sidered advantageous.
There are several ways to avoid this encumbrance in connection with reverse mergers. One possibility is to use a nonreporting shell to do the reverse merger. Nonreporting shells have no obligation to fi le proxy state- ments, so obtaining shareholder approval for things is a much simpler pro- cess. Nor are their offi cers, directors, and 10 percent shareholders required to fi le information about their holdings. In addition, the new SEC require- ment of signifi cant disclosure immediately after the merger is avoided. It is prudent to remember, however, that if these shells trade, they do so on the Pink Sheets because reporting status is a prerequisite for trading on all other markets and exchanges, including the OTC Bulletin Board.
Companies that report voluntarily are not required to fi le full proxies either. These companies fi le quarterly and annual reports with the SEC even though they are not required to do so. This provides some comfort to merging companies in that information has been disclosed, without having other SEC obligations mentioned above such as the requirement to prepare and seek approval of proxy statements.
This advantage notwithstanding, most in the shell marketplace pre- fer to use reporting companies because they inspire more confi dence in investors. Reporting companies must make available high-quality infor- mation about their activities, performance, and insider holdings. In addi- tion, a nonreporting company has to become a reporting company after a reverse merger in order for its stock to trade on the OTC Bulletin Board or higher.
Reporting companies must be very careful to proceed in a manner that minimizes the likelihood that shareholder approval and, therefore, fi ling a full proxy statement will be required. Any number of actions that take place during a reverse merger have the potential to put a company after a reverse merger in the unhappy position of having to complete a full proxy.
These situations include the following (which will be discussed in more detail below):
❑ Structural approaches to shareholder approval—If the re- verse merger is structured so that the public shell itself is a direct party to the merger, shareholder approval is necessary under most states’ laws. A
“merger proxy,” if required, is extremely detailed and diffi cult, and rarely gets approved by the SEC after only one or two rounds of comments.
Fully audited information on the company to be acquired is required, and information such as a detailed review of every conversation between
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the parties, the price or valuation at which the discussion began, why it changed, etc., is also typically mandated.
❑ Forward and reverse stock splits—If there are insuffi cient au- thorized but unissued shares of stock, or in the rare circumstance that it is desired that more shares be outstanding, a stock split may be necessary, requiring shareholder approval in most states and a full proxy.
❑ Changing the charter to allow for issuance of more shares—
Sometimes this is done rather than engaging in a stock split. It requires shareholder approval.
❑ Name changes—In general, a shell needs to change its name after a reverse merger, and this requires shareholder approval, which might be avoided in Delaware.
❑ Board changes—If a stock transaction contemplates a change in a majority of the board, a mailing to shareholders is required, though share- holder approval is not.
❑ Public offerings and private placements—In general, these avoid the requirement for shareholder approval as long as the securities being is- sued have already been authorized under the company’s charter.
Structural Approaches to Avoiding Shareholder Approval Reverse Triangular Mergers
Many reverse mergers are structured as reverse triangular mergers. In large part, this is to avoid having to obtain shareholder approval for the merger. The companies involved in a merger are known as the constituent corporations. As mentioned earlier, in a merger, one constituent corpo- ration “survives” the merger and the other is swallowed up and simply disappears with its assets, liabilities, and business taken over by the sur- viving corporation. In a reverse triangular merger, a shell company cre- ates an empty, wholly owned subsidiary. The shell owns 100 percent of the subsidiary’s shares. Then, the subsidiary merges with and into a pri- vate company. The end result of this is to make the private company the
“surviving” corporation and a wholly owned subsidiary of the shell. The original subsidiary is the nonsurviving corporation and, therefore, it disap- pears. Shares of the private company are exchanged for shares of the parent company shell. By the way, the “reverse” part of the merger applies because the private company effectively takes over the shell company, yet the shell company survives as the ultimate parent.
In this situation, the two parties to the merger are the private company and the shell’s subsidiary. The private company’s shareholders must ap- prove the deal; so must the subsidiary’s shareholder.
State laws govern how a private company’s shareholders are notifi ed of and consent to ownership changes. Generally, those laws require either
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(1) written consent by all or a majority of the shareholders, with notice to the others; or (2) advance notice (typically a simple one-page notice) of a shareholders meeting, holding that meeting on at least ten days’ notice with at least a majority present and approval of the transaction at the meeting.
The shareholder of the shell’s subsidiary is the shell itself. The shell grants or withholds approval through the action of its board. There is no need to seek approval from the shell’s public shareholders.
Thus, a reverse triangular merger can typically be completed without the need of approval from the shell’s shareholders.
When Non-U.S. Companies Are Involved
Some transactions are not structured as mergers but also achieve avoid- ance of shareholder approval. For example, most reverse mergers involving foreign companies, which generally cannot engage in direct mergers with U.S. entities, involve a simple exchange of shares. The shell and the pri- vate company’s shareholders agree that the private company’s shareholders will give up their shares of that company in exchange for shares of the shell. The shell, if it has suffi cient shares available, approves that issuance through its board. Again, no shell shareholder approval is required.
Why doesn’t everyone use this simple technique even in domestic transactions? Because, in a share exchange situation, every shareholder of the private company must agree to swap his or her shares, and sometimes this gives one or two small shareholders enough power to hold up the deal. In a reverse triangular merger, a simple majority vote of the private company’s shareholders approves the transaction.
Asset Acquisitions
Another, less popular method of avoiding shareholder approval is an asset acquisition. In this structure, the private company sells its assets (and presumably its liabilities) to the shell in exchange for shares of stock.
The private company then liquidates and distributes those shares to its shareholders. Again, the shell’s shareholders do not have to approve the transaction as long as there are suffi cient shares available. The primary disadvantage of this approach is that the operating company ceases to exist and its contracts, licenses, and customer arrangements need to be assigned or amended in many cases.
Forward and Reverse Stock Splits
Often in a reverse merger, the shell does not have the appropriate number of shares outstanding for the transaction to work. For example, in one recent transaction we worked on, the shell had 10 million shares issued
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and outstanding, and was authorized through its corporate charter to is- sue 100 million shares of stock in total. Our client—the private operating company—wished to acquire 90 percent of the stock. This could happen if our client acquired the remaining 90 million authorized shares.
My client believed, however, that after the reverse merger it would be benefi cial to have a high per share price in the marketplace. Therefore, he believed that having 100 million shares of stock available to sell was too many. He felt that the right way to get the most desirable share price was to have 10 million shares available in the public fl oat. Ninety percent of 10 million is 9 million, the number of shares that would be given to the private company to complete the reverse merger. This would leave the current own- ers of the shell with 1 million shares and a 10 percent ownership stake.
To achieve this goal, my client needed the current owners of 10 mil- lion shares to complete a “reverse stock split.” A one-for-ten reverse split would turn their 10 million shares into 1 million shares. The purpose of the split was to increase the per share stock price by taking the number of shares owned by each person and dividing by ten in order to get the new number of shares. At the time of the split, each shareholder would still own the same total percentage of the company, just with fewer total shares outstanding.
In most states (but not all), shareholders must approve a reverse stock split. Thus, if a shell is fully reporting, a proxy statement must be pre- pared, then fi led with and approved by the SEC. The proxy is then mailed to shareholders at least ten days before a shareholder meeting to approve the split. Generally, proxy cards are included, giving a shareholder the right to appoint a member of the shell’s management to vote their shares for them and, therefore, vote without attending the meeting.
Typically, a proxy for a reverse split is short (four to fi ve pages), straight- forward, and often is not reviewed by the SEC (if they do not comment ten days after fi ling, the proxy is deemed approved). However, if the proxy relates to a matter which is a condition to a reverse merger, even one where the shell is not a direct party (such as a reverse triangular merger), the SEC takes the position that this is the same as asking the shareholders to approve the merger itself, and a full-blown merger proxy (the nightmare described above) is required.
There are two ways to avoid this complication. First, in some cases, if suffi cient shares are available for issuance in order to consummate the transaction, the reverse merger is closed with the number of shares already existing. In our example, that means the current owners of the shell would keep the 10 million shares they have, and the private company would be issued the 90 million remaining shares. After the merger is completed, the combined company could then seek a reverse split that is not a condition
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to the merger, and a merger proxy would not be necessary, just the more simple reverse split proxy. Since the private company’s shareholders would now control the shell, approval of the reverse split generally would be assured.
The second method for avoiding a full merger proxy is subtler, but we have used it successfully on many occasions. The SEC requires a full merger proxy when the reverse split is a condition to the merger. To address this problem, in the example above, we provided in our merger agreement that the parties requested a reverse split, contemplated it, but did not make it a condition to the transaction. We provide for Plan A if the reverse split is approved and Plan B if it is not. Using our example, Plan A was to reverse split the 10 million outstanding shares to 1 million, then issue 9 million to our client’s shareholders. Plan B, if the reverse split was not approved, was to leave the current shell shareholders with their 10 million existing shares and issue 90 million to our client’s shareholders.
As a practical matter the approval of the reverse split is assured, since as part of the merger agreement we obtained an agreement from a major- ity of the holders of shares of the shell to vote for the reverse split. Thus, whereas a proxy was necessary for the reverse split taking place before the merger, and the approval was assured, a full merger proxy was not necessary since the reverse split was not technically a condition to the merger. Pretty smooth, eh? Feel free to use it.
Other Problems in Capitalization and Share Availability
Another very common problem in reverse mergers is that the shell may not have suffi cient shares authorized under its corporate charter in order to complete the transaction.
Let’s change our example to assume that the shell has 50 million shares issued and outstanding, and only 100 million shares authorized. Our cli- ent seeks to acquire 90 percent, so without any change in the ownership of the existing shell holders, this would theoretically require our client to obtain 450 million shares. This is because the 450 million would represent 90 percent of that plus the 50 million already outstanding (or a total of 500 million shares). But the shell does not have the authority in its charter to issue more than 100 million shares.
There are several methods to deal with this. The most common ap- proach is simply to implement a reverse stock split in the shell, so that the 50 million issued shares are split into 1 or 2 or 3 million, whatever number is appropriate. The problem, of course, is again the proxy. If that split is a condition to the merger, a full merger proxy is necessary. If it is not a condition, the problem then becomes dealing with Plan B, since in the event the split is not approved, an available number of shares does
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not exist to issue 90 percent without some sort of split or change in the capital structure.
Even if voting agreements are obtained from shell shareholders to ap- prove the reverse split, the agreement for merger still has to contemplate Plan B if the split is not to be an express condition. And it is not possible to create that plan based solely on the number of shares outstanding. Or is it?
Recently, a public company with operations came to me, with their attorneys, to try to solve this problem. They were making an acquisition that was structured as a reverse merger. The private company merging with their public operating business would end up with 51 percent of their stock. The problem was the insuffi ciency of available shares. We offered two approaches, one of which was ultimately adopted and implemented.
The fi rst suggestion was to use preferred stock. In this case, the public entity had available but unissued preferred stock. Its corporate charter permitted the board to decide the rights and powers of the preferred stock and to issue it without shareholder approval. This type of security is gen- erally referred to as “blank check preferred.”
Thus, their Plan B was that, to the extent its regular common stock was used up, a number of shares of preferred would be issued. Those preferred shares would have the same number of votes as the “missing” common stock. Also, the preferred shares would be convertible into the missing number of common shares; however, those common shares could not be issued until the company’s charter was changed to increase the total num- ber of common shares available. A condition at the closing of the reverse merger would be that a majority of shareholders agree in advance to vote for this change to the charter. After the closing, a proxy would be prepared and the charter changed.
There is another approach. In certain cases, a shell does not have pre- ferred stock available in its charter. Thus, it has no means of handling the overage. In such an instance, it is possible to issue a shareholder “rights certifi cate.” The certifi cate entitles the holder to obtain the number of shares in the overage as soon as the company holds a shareholder meeting to amend its charter and make more shares available.
Again, in this situation, voting agreements are obtained in advance, which require the majority of shareholders to approve the charter change.
In addition, the merger agreement requires the proxy for the vote for this change to be fi led immediately following the merger. In fact, in some cases the actual form of proxy to be used after closing is approved by both parties prior to the closing of the merger.
In both cases one might ask, why not just wait for the charter to be amended, and then close the transaction? Well, as indicated above, if the amendment is a condition to the merger, a full merger proxy may be
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required. But even more important, parties want the transactions to be completed quickly. The above approaches allow a merger to be closed with needed fi nancing obtained. In both actual cases, this occurred with- out the delay of getting a proxy approved by the SEC, the wait while the proxy is then printed and mailed, and the second wait of ten days before the meeting may be held.
Name Change of the Shell
In almost all cases after a reverse merger, aside from its shareholdings, the shell’s corporate entity is unchanged. Its name also stays the same. If the name of your shell is ABC Acquisition Company, and its subsidiary merg- es with the Goodison Steel Company, it is common for the steel company to want to change the name of its new parent public holding company to more closely resemble its name when it was a private company.
Most assume that a name change, which is set forth in a company’s corporate charter, requires shareholder approval, a proxy, and the whole drawn out process required by the SEC for a shareholder meeting. In many cases, this is required, and most parties to a reverse merger wait until the next shareholder meeting to effect the change; however, some wish to make this change immediately.
Shells incorporated in Delaware (which many are because of corporate- friendly Delaware law) have another option.
A provision in Delaware law passed in 1998 permits a shell, say it is called ABC Acquisition Company, to establish a new wholly owned subsidiary, called perhaps Goodison Steel Holdings, Inc. Delaware then permits a so-called short form merger—no shareholder approval required when the parent owns more than 80 percent of the subsidiary. According to Delaware law, the shell, ABC Acquisition Company, can “survive” the merger and the subsidiary, Goodison Steel Holdings, goes away as the nonsurviving corporation. As part of the merger, however, the surviving entity can adopt the legal name of the subsidiary. In this example, ABC Acquisition Company would become Goodison Steel Holdings, Inc.
Thus, a name change is effected, without shareholder approval, at least in Delaware.
Schedule 14F: Board Changes
A little known and little used provision of the Exchange Act, Section 14(f ), essentially says that if there is an agreement involving the sale or exchange of at least 5 percent of a public company’s stock, and as part of that agree- ment there is an arrangement or understanding to change the majority of the members of the board of directors, then an SEC fi ling, mailing to shareholders, and waiting period are required. The intention of this law