Unique Legal Opinion Issues
In most fi nancings and corporate combinations, lawyers are asked to deliver written opinion letters covering various matters relating to their client and the transaction. A few issues in legal opinion writing are unique to reverse mergers and shells.
A private company may ask for the shell’s lawyer to opine that the shell is not an “investment company” as defi ned by the Investment Company Act of 1940. Most people think of mutual funds as investment companies, but some hedge funds also fi t the defi nition. Essentially, an investment company has to be in the business of investing in the securities of others.
There are certain exemptions, but the most common argument for a shell not to be an investment company is that it intends to become an operating company through a merger. This creates the argument that they are not “in the business” of investing in others. Also, an exemption exists if that intention will be acted upon within one year.
This appears to be consistent with the SEC’s point of view, since I have yet to see them even question or threaten a shell with inquiry on the basis of whether or not it is an investment company. Yet shell lawyers typically refuse to give the investment company opinion. This can be frustrating since the implications if it is an investment company are major, requiring much more complex fi lings with the SEC and many more limitations on its activities.
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Shell lawyers argue (usually successfully) that the private company lawyers are as capable as they are of determining whether or not the shell meets the defi nition of an investment company.
A group of shell operators have taken things a step further. They own a public shell and use it to acquire company after company. After each acquisition, the shell spins off the new business through an SEC registra- tion process. SEC staffers have begun to quietly ask if these companies are indeed investment companies. I have discouraged clients from operating their shells this way.
Another unique opinion often requested of shell counsel is to affi rm that, to counsel’s knowledge, the shell’s fi lings with the SEC are complete and comply with the SEC’s disclosure rules. Shell counsels generally resist this as well, arguing that they were not fully knowledgeable of the shell’s affairs.
Sometimes, the shell has not completed its annual state franchise tax fi lings in the state of its incorporation, causing it to lose its “good standing”
as an offi cial corporation. Obviously, this is a problem because one cannot close a merger with a company that technically does not exist.
In the opinion process, virtually all shell lawyers are willing to give the “good standing” opinion and typically they pull a report to confi rm that the shell is indeed in good standing. The problem is that this is often done a day or two before closing, and if it turns out the company is not in good standing, a mad scramble occurs to prepare the fi lings and pay any back taxes, sometimes delaying a closing with millions of dollars sitting in escrow waiting for this ministerial issue to be resolved. I typically request that shell counsel review the good standing of its client early in the process so this last-minute scramble does not occur.
Are Reps and Warranties from a Shell Meaningless?
In virtually every business combination or fi nancing transaction, each party provides “representations and warranties” to the other parties. A rep- resentation is simply a statement of fact. For example, “The Company has 10 million shares of Common Stock outstanding.” A warranty, similar to the warranty on a car or refrigerator, is a promise that something is in a certain state or condition. For example, “All of our inventory is in saleable condition,” or, “We have complied with all applicable laws concerning our pension plan.”
The “reps and warranties” are often carefully negotiated and an impor- tant part of the comfort-building process in completing a transaction. It is not uncommon to have thirty or more reps and warranties on such issues as intellectual property, litigation, employee matters, environmental mat- ters, capitalization, authorization of the transaction, and so on.
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Reverse mergers, similar to many acquisitions, cause a challenge in the area of reps and warranties, in some respects in both directions. Why is this so? Well, take the shell side fi rst. The private company will receive reps and warranties from the shell. But what if, after the transaction, it turns out that one of the reps was false? Let’s say it turns out the company had 20 million shares of stock outstanding instead of 10 million (not likely but just use this as an example). Since the shell is now owned 90 percent by the former owners of the private company, who would they sue for this breach of a representation? In essence, themselves. Would one sue a company in which one now owns 90 percent? Thus, as a practical matter, without more teeth, the reps and warranties are meaningless.
From the point of view of the shell, a similar but much less dramatic effect is true. If a rep from the private company turns out to be untrue, the shell still sues itself—in other words, the former shell. But the former owners of the shell now own only 10 percent of that shell, and the former shell now has all the assets from the former private company; therefore, one can sue something with some value. Thus, this issue is a much more pronounced risk for the private company.
What happens in most normal acquisitions not involving reverse mergers? If an acquirer is provided with reps and warranties from his target, and then he acquires it, he also really has no one to sue. Thus, it is very common in acquisitions for personal guaranties to be provided by principals, promising that the reps are true and backing them up if not, and usually involving a reasonable limitation on the guaranty. Al- ternatively, or in addition, part of the consideration for the acquisition is sometimes placed in escrow for a period of time (maybe six months or a year) to be used against any claims of breaches of reps or warranties.
How do practitioners in reverse mergers deal with this problem? Not very well, in fact. In the 1990s, a number of shell principals were willing to personally guarantee the reps and warranties. In the next chapter, in the “messy shell nightmare” described there involving an unimplemented reverse stock split, the nightmare was resolved in part by those personal guaranties. Personal guaranties are especially common if there are particu- lar concerns or “hair” on the shell. Why give personal guaranties? For the reason described above. Private companies simply feel that the reps were meaningless if given by a company that they were about to take over.
The new millennium has changed everything. Part of the reason is the great demand for shells, giving shell operators more leverage in negotia- tions. In some cases, legal opinions from shell counsel serve as insurance policies for breaches of some reps by the shell. But very few deals that I have been involved with in the last three to four years have involved per- sonal guaranties or holdbacks of cash or other consideration to back up
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reps and warranties. Private companies simply are “going bare” when it comes to protection against misrepresentation.
Shell operators say, “Do any due diligence you want and get comfort- able and don’t worry about the reps.” Or they say, “Our shell is owned by your investment banker. Don’t you trust him to have done careful due diligence?” Or they say, “We’re a shell, not an operating business. There’s nothing important to give a rep about that you can’t independently verify.”
Or they say, “If we commit fraud and intentionally mislead you in any way, you can sue us all individually regardless.” Or they say, “We just bought this shell and, unfortunately, have no ability to provide comfort for what the shell did before we purchased it.” Predictably, some of these explanations hold water. Some don’t.
I believe it is good practice to have reps that have meaning and can be enforced. My response as a private company’s counsel would be, “Well, don’t you know these reps to be true? If so, you should have no problem standing behind them.” Or, “If we take 15 percent of the cash you are get- ting and put it in escrow for six months, if your reps are true you should have nothing to worry about.” Or, “As between you and us, if you just bought the shell, who should take the risk regarding things that happened in your shell before you bought it? Us or you?” Sometimes a middle ground can include a pledge of the shell operator’s stock, so that he relinquishes his ownership if he has misrepresented anything. Or one can provide for an adjustment in the terms of the deal, such as an increase in one’s even- tual ownership, if a rep turns out to be untrue. Often money held back or personal guaranties are capped, so that the shell operator knows the extent of his potential exposure.
Why is this so important even if one is comfortable that the shell operator is legitimate? Even assuming the best of intentions, if there is no or little incentive to make sure everything is indeed as it is being represented, problems will almost certainly arise. This is also true for op- erating without legal opinions. One assumes the lawyers will be diligent, but there is no question they are that much more careful when they have to opine as to an issue.
PRACTICE TIP
Try your best to make sure the reps have meaning.
Issues Relating to Fairness Opinions
In some cases, one party to the reverse merger is concerned about ensuring that the value placed on the deal is fair. They may not have enough expe- rience to be sure about the price. Or they may have a confl ict of interest and seek independent verifi cation of the deal structure. Or a board may
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simply wish to purchase an insurance policy, so that if their shareholders complain later about the price and value, the board can point to the expert review of the transaction.
What is a fairness opinion? As mentioned earlier, an independent fi rm, having no involvement in the transaction whatsoever, issues an opinion that almost always says that the transaction is “fair to shareholders, from a fi nancial point of view.” This differs from a valuation. In a valuation, an independent fi rm comes in and tries to determine the actual value of a company or asset. A fairness opinion is not necessarily saying that this is the best price or the most accurate, but merely that it is fair.
Firms that issue these opinions include most investment banks and some independent fi rms that specialize in valuations and fairness opinions.
Opinion prices vary widely. Investment banks may charge several hundred thousand dollars, whereas valuation consultants may issue an opinion for less than $50,000.
What do they do to determine fairness? They research comparable companies in the public arena. They interview management, the in- vestment bankers, and so on. They examine the fi nancial statements of the company. They may even do a mini-audit of certain aspects of the fi nancials. After a few weeks of work they generally are in a position to issue an opinion.
As indicated above, the opinions may be worthless if an investment bank thinks it will get a nice fee for taking a risk certifying fairness without any independent research. Be careful of opinion givers whose relationship to the parties may not be offi cially affi liated, but where close business ties might strain their objectivity. Also be sure the opinion is really necessary. If one is extremely comfortable with the valuation in question, the extra cost and delay to obtain a fairness opinion may simply be unnecessary if there are no confl icts of interest and the like.
One way to spot a bad guy: He strongly resists getting a fairness opin- ion, even if he is not paying for it. Always wonder what he may be trying to hide. He will argue that it will take too long, they are too conservative, whatever. The more he resists, the more necessary the fairness opinion.
PRACTICE TIP
Use real fi rms that are experienced in these matters, and make sure they do real work and provide real help in making sure a transaction is structured properly. And there generally is no need to spend more than $50,000 for such an opinion in the typical reverse merger context, at least based on today’s market.
Source: TKTK