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small. The fact that the pendulum had to swing farther in the direction of regulation than I feel was probably necessary is sometimes the cost of reacting to a real problem. Between the SEC Advisory Committee and at- tention it receives in Congress, it is hoped that some of the more extreme provisions in the Act can be altered or revisited to reduce the impact on smaller companies.
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Genesis of the June 2005 Rule Changes
In February 2004, I was invited to visit with about a dozen SEC staffers in their Washington offi ces to discuss the reverse merger business. I summa- rized the information I generally provide in my seminars so they could see how the private sector and the corporate bar were dealing with the various issues of the day.
We discussed, among other things, three major areas in the business that were subject to abuse by unscrupulous players. One was the seventy- one-day vacuum of information following most deals that is described above. The other was the popular use by public shells of Form S-8, nor- mally used for registering securities involved in a company stock option plan, to dole out tradable stock like candy to consultants, intermediaries, investor relations fi rms, and others doing work for shells. Last, I talked a bit about “Footnote 32 shells.” (For details, see the previous chapter.)
Shady dealers used the seventy-one-day window as an opportunity to manipulate the stock price by issuing press releases about the company after the merger but before the seventy-one days had passed. Often those press releases, even if factually correct, were misleading because they lacked the context of other information that was not yet public. For example, what if a company in dire fi nancial straits needs a fi nancing very soon, but nobody knows it? Then the company releases an announcement that it had hired a CFO, or obtained a new customer, or launched an exciting new product. Again, good news, but what value is it if neither of these was suffi cient to keep the company afl oat?
Form S-8 is not technically illegal (neither is the rosy press release in the prior example), but the form was not really designed to register securi- ties for use as compensation for consulting work. In some cases, “consul- tants” are actually affi liates of market-making fi rms trying to build support for a shell’s stock. Using stock to pay market makers is illegal. On the other hand, stock is an appropriate (and entirely aboveboard) way to compen- sate actual shell managers, such as offi cers and directors, who can benefi t from getting stock as a reward for their efforts, especially where a shell has not generated any cash to pay them for their admittedly limited services.
In our meeting, we also discussed the fact that more and more legiti- mate players were entering this fi eld for reasons mentioned throughout this book. The hope was to encourage the regulators to adopt a carrot-and- stick approach—to come down hard on abusers but encourage those who wish to do things the right way.
In April 2004, the SEC proposed changing its rules to take care of these problems. It proposed defi ning a shell company as a company with no or nominal assets (other than cash) and no or nominal operations. It proposed requiring an SEC fi ling within four business days after a merger
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with a shell company that makes it no longer a shell company or where there is a change in control of the shell company. This fi ling would include essentially all the information that a company completing an IPO would disclose, including audited fi nancial statements. The fi ling was to be made on a Current Report on Form 8-K, and would include all the “Form 10 information”—information that would be in a Form 10 or Form 10-SB for the merged company. Second, the SEC proposed eliminating the use of Form S-8 in a shell company.
Interestingly, in one public SEC hearing to announce the proposals, which I attended, the commissioners, normally well briefed and prepared with statements and comments, seemed a little surprised by the proposal coming from their staff in the Division of Corporation Finance and the Offi ce of Small Business Policy. SEC Chairman Donaldson asked, “Well, are there any legitimate reverse mergers?” Another commissioner com- mented that it seemed as if enforcement hearings were consistently in- volving reverse mergers gone bad and didn’t quite understand why these transactions were to be encouraged.
The staff calmly and patiently retorted that the technique itself is valid and legitimate, but some have abused it, and that there are a growing number of honorable fi nance professionals seeking to use this method as an alternative to an expensive, risky, dilutive, and time-consuming IPO.
The comment period followed. (The public must be allowed to com- ment on any proposed rule from an administrative agency before it be- comes fi nal.) This short six-week period was quite frenzied, and around forty people weighed in on the proposed rule. My main comments sug- gested a longer period before this major SEC fi ling, or perhaps dividing the fi ling into portions. I also suggested delaying the fi ling if the post- merger company’s stock is not trading and that the use of Form S-8 should be allowed solely for issuance of stock to offi cers, directors, and employees.
The full text of my comments may be found on the Web at http://www .sec.gov/rules/proposed/s71904/dnfeldman1898.htm.
The Rule Is Adopted
In the last public hearing before Chairman Donaldson’s departure, held on June 29, 2005, the SEC adopted new rules, almost exactly as proposed, without incorporating changes made during the comment period. New requirements included: a major fi ling four days from closing, the defi nition of a shell company given above, the prohibition on the use of Form S-8 to provide compensation to consultants, and the famous Footnote 32.
Most encouragingly, this time each commissioner had a prepared state- ment proclaiming the merits of the legitimate use of the reverse merger technique in corporate structuring. They all felt that the new rules would
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further discourage questionable characters from entering into these trans- actions. The fi nal rule as adopted and accompanying release can be found on the Web at http://www.sec.gov/rules/fi nal/33-8587.pdf.
Specifics of the Rule
The following sections discuss the overall requirements of the new rule along with a little commentary.
Shell Company Definition
A shell company is a public reporting company that has no or nominal assets (other than cash), and no or nominal operations. A merger with a shell company after which it is no longer a shell company or another transaction pursuant to which there is a change in control triggers various new disclosure requirements. Alas, as you recall, Rule 419 defi nes a blank check to be a development stage company with no business plan or whose business plan is to merge with or acquire another company. Clearly, shells and blank checks are similar. But there are distinctions that make a dif- ference.
For example, a legitimate start-up company with an idea to develop new software, if public and a reporting company, would qualify as a shell company (because it has nominal assets and operations) but not a blank check (since it has a real business plan). On the other hand, a dormant company that used to have operations but maintains signifi cant assets (perhaps valuable patents, third-party claims, or maybe even a signifi cant net operating loss carryforward) could qualify as a blank check (plan is to merge) but not a shell company (it has more than nominal assets). So, is the SEC confusing things here? I don’t think so.
As things stand, the legitimate software start-up can bypass Rule 419 to effect a public offering without the investor protections offered by that rule but would still be subject to the disclosure requirements upon any reverse merger (if it still maintains nominal assets and operations). The dormant company with assets could not effect an IPO without the Rule 419 restrictions, but could complete a reverse merger without complying with the new disclosure rules, since it did not have “nominal” assets.
One can only surmise that the SEC set out to broaden the scope of activities it seeks to regulate either with the Rule 419 restrictions or the new disclosure rule, if not both. But why the start-up software company is deemed a shell company is still confusing to me. I believe the SEC’s view is that the only negative consequence for being a shell company is the requirement to fi le a Form 8-K with Form 10 information (if it changes control or effects a transaction where it ceases to be a shell), and that this is not a major burden. And maybe, indirectly, this was a way to seek to
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deal with the Footnote 32 problem. By forcing “start-ups” into complete disclosure, people with unethical intentions would be less interested in completing an IPO of a fake start-up just to get past Rule 419, since they will be subject to the new disclosure rules.
Another challenge to contend with when considering the SEC’s shell company defi nition is the use of the word nominal, as in no or nominal assets (other than cash) and no or nominal operations. What does nominal mean? The SEC was aware of this concern, since in the rule proposal it included a request for comment on whether the word nominal is too un- certain and whether there should be more specifi c numerical defi nitions of a shell. In the end, however, it left the language and seems to have adopted the approach the U.S. Supreme Court used in trying to defi ne pornogra- phy: “I can’t defi ne it, but I know it when I see it.”
Apparently, the SEC wanted to allow individual practitioners the fl ex- ibility to determine the defi nition rather than having a specifi c quantita- tive cutoff. As indicated at the hearing when adopting the rule, if the SEC were to suggest, for example, a minimum of $100,000 in assets, a glut of shells would be created with $101,000. But how does one determine what constitutes a shell? Are the assets of a barbershop nominal? What about a consulting fi rm with three employees and $200,000 in billings?
Unfortunately, the answers here are unclear. One thing is certain:
Those who like to live at the edge of the law will surely test what nominal means, and one can imagine a number of SEC “no-action letters” being requested to clarify some of this. (A no-action letter is a response from the SEC staff to a letter from a specifi c company seeking the staff ’s confi rma- tion that it will seek no action against the parties if certain actions are taken.) I have been unoffi cially advised, for example, that maintaining a website probably constitutes nominal operations. In the meantime, much as in the time leading up to the development of Regulation D in private securities offerings, legal opinions on whether borderline situations are shell companies will be hard to come by.
Form 10 Information Required
The new rule requires a Form 8-K, known as a “current report,” be fi led within four business days of closing a transaction with a shell compa- ny if the transaction either effects a change in control or changes the shell company into a nonshell company. Usually, Form-8-Ks are not reviewed;
all one has to do is fi le them. However, the SEC always reserves the right to review any fi ling, and it may indeed do so.
The Form 8-K is to include all information that the merged company would have put into a Form 10 or Form 10-SB to voluntarily subject itself to the SEC reporting requirements, much like the Form 10-SB shells or, as
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we will see later, the fi lings sometimes undertaken in “self-fi ling” alterna- tives to reverse mergers.
This includes all the information that would be in a prospectus for a traditional IPO: two years of audited fi nancial information (or three years for a company not able to benefi t from the Regulation S-B disclo- sure scheme), full business description, risk factors, affi liate (related party) transactions, executive compensation, comparative period-to-period anal- ysis of fi nancial results, description of capital stock, discussion of prior securities offerings, and the like.
All material contracts and other key documents, such as the company’s charter and bylaws, must be included and fi led as exhibits. Full fi ve-year biographical information needs to be provided on all offi cers and directors and their ownership information as well as all 5 percent shareholders. All this needs to be put together and ready to fi le within four days of closing a reverse merger.
The 8-K also needs to be fi led if there is a change in control of a shell company, even if it still remains a shell. Interestingly, this provision applies if a shell simply issues a controlling interest to a new third party. If control changes to another shell promoter or banker, the new rule requires a Form 8-K fi ling. Presumably, however, that fi ling will be rather straightforward, saying something like, “We are still a shell, our mission has not changed, only our ownership.”
Prohibition on Form S-8
A shell company may no longer use Form S-8 to register shares for those who are employees of or consultants to a shell company. In fact, a former shell company must wait sixty days after its change in status before it can use Form S-8. This means, among other things, that our start-up software guy with nominal operations who goes public may not use Form S-8 until his operations and assets (other than cash) are not nominal. Our example of a blank check with signifi cant assets but no plan other than to merge into another company can use Form S-8 because, technically, it is not a shell company.
This is a step forward because underhanded actors who once used Form S-8 as a quick and easy way to reward their friends can no longer do so.
The New Check-Off
One change in the rule affects every single public reporting company, from General Motors and Microsoft on down. The front cover of every quarterly and annual report to be fi led by every public reporting company with the SEC now includes a check-off box to indicate whether or not the fi ler is a shell company under the defi nition.
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Look forward to a turf battle among those who are likely candidates for making this determination, including securities legal counselors and valuation experts. It is not clear whether the company’s attorneys or ac- countants should decide whether a company’s operations or assets are
“nominal.” Time will tell.
PRACTICE TIP
Don’t try to defi ne nominal at home. Get good professional advice.
One Nice By-Product: Information
Here’s one major benefi t of all these changes, including the Form 8-K to be fi led after a merger with a shell company (the industry has begun calling it the “super Form 8-K” or just “super 8-K” fi ling) and the declara- tion of shell company status through a check-off on SEC fi lings. For the fi rst time ever, shells and reverse mergers will be accurately tracked and information about these transactions gathered and disseminated. Before this, it has been impossible to get accurate answers to the questions I am frequently asked: How many reverse mergers are there? How many shells are there? How many have cash? How many do foreign deals?
DealFlow Media, Inc. publishes The PIPEs Report, which provides detailed rankings and other information regarding the PIPE (private investments in public equity) market. After all, fi lings relating to PIPEs are relatively easy to fi nd given many common words and phrases in their fi lings. Unfortunately, prior to the implementation of the June 2005 SEC rules on reverse mergers, the same information was not available for reverse mergers. Even though DealFlow Media, Inc. now publishes The Reverse Merger Report every quarter and attempts to catalog as many deals as possible, it still can’t be sure it has captured every transaction.
Now that the information will be available thanks to the check-offs and 8-K fi lings, it will be interesting to see just how many deals and shells are out there. Most of us speculate that hundreds of reverse mergers are done each year, but none of us really knows. We suggest that hundreds of shells exist, but again we do not know. The new check-off requirement will go a long way to adding transparency to the business via the use of quantifi able metrics.
Of course, this information will not be perfect. Nonreporting shells trading on the Pink Sheets still will not need to disclose their status. They are not subject to the new SEC 8-K reporting rule and their deals also would not be disclosed. In addition, some shell companies will try to claim they are not shells because their operations are more than nominal.
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Who Is Exempt?
The new 8-K requirement only applies to SEC reporting companies.
Those who do not trade or trade on the Pink Sheets and are nonreporting need not comply with the new rule, though it may be advisable in any event to do so, at least upon the commencement of trading in the merged company’s stock if the shell is nontrading. In a strange way, this may actu- ally improve the value and desirability of Pink Sheet shells (at least among those less interested in providing full disclosure or desiring to delay it).
Another transaction that is made exempt by the rule is a merger with a so-called business combination related shell company. If a real operating business sets up a shell solely to reincorporate or complete an acquisition, that entity will not be deemed a shell company for purposes of the new rule. Obviously, some commentators raised a concern that the proposed rule would inadvertently thwart major, legitimate merger transactions, and the SEC took care of that with this change. Certain asset-backed issu- ers also are exempt from the rule.
Any reverse merger involving a nonshell company also is exempt, even if there is a change in control. So the New York Stock Exchange’s takeover of public company Archipelago Holdings, completed in March 2006 with much fanfare, was technically a reverse merger, since the NYSE acquired 70 percent of Archipelago and took over its board. Since Archipelago had more than nominal assets and operations, however, it was not a shell com- pany, and the super 8-K requirement did not apply.
Blank check companies with substantial assets are also exempt because they are not shell companies under the defi nition. They are subject to Rule 419 whenever they try to register new shares but do not have to fi le the super 8-K upon a merger or change in control.
A Little More on Footnote 32
In the last chapter, we discussed Footnote 32. All I will add here is a men- tion of the importance of the fact that the SEC acknowledged, addressed, and sought to deal with these troublesome shells and the fact that maybe it did not go far enough. All the footnote says is (I am paraphrasing here),
“If you are a Footnote 32 shell trying to get around Rule 419 by putting in a business to be taken out, we consider you to be a shell company right from the start.”
Under the June 2005 SEC rulemaking, when that shell merges with an operating business or changes control, it must fi le a super Form 8-K just like everyone else; however, it does not otherwise penalize what I consider to be fraud on behalf of these promoters. In fact, it arguably emboldens them to do IPOs of these types of shells, start trading (unfair to legitimate shell creators not allowed to trade), do a merger, and then simply do a