Clean, Dirty, and Messy Shells (and Footnote 32 Shells)
Footnote 32 Shells
The now infamous Footnote 32 is part of the SEC rule passed in June 2005 to require a detailed disclosure fi ling four days after a reverse merger with a shell company (much more about this in the next chapter). First, it had to defi ne shell company, which it did by essentially saying that it is any company with no or nominal operations and no or nominal assets (other than cash). The footnote is short and worth repeating in full:
We have become aware of a practice in which a promoter of a company and/or affi liates of the promoter appear to place assets or operations within an entity with the intent of causing that entity to fall outside of the defi ni- tion of blank check company in Securities Act Rule 419. The promoter will then seek a business combination transaction for the company, with the assets or operations being returned to the promoter or affi liate upon the completion of that business combination transaction. It is likely that similar schemes will be undertaken with the intention of evading the defi nition of shell company that we are adopting today. In our view, when promoters (or their affi liates) of a company, that would otherwise be a shell company, place assets or operations in that company and those assets or operations are returned to the promoter or its affi liates (or an agreement is made to return those assets or operations to the promoter or its affi liates) before, upon completion of, or shortly after a business combination trans- action by that company, those assets or operations would be considered
“nominal” for purposes of the defi nition of shell company.
By my estimation, this one tiny footnote sweeps aside a large percent- age of the public shells in the marketplace and deems them worthless. For years, since the passage of Rule 419 in 1992, savvy promoters have been completing tiny initial public offerings of supposed operating businesses or start-ups. “We are going into the book business,” they would say. Or,
“We will be a beverage distributor.” A number own mining or mineral rights or have options on entertainment properties. I saw one in which a former entertainer said she was going into an art business.
They seek to raise a small amount in their IPO, maybe $50,000 or even only $10,000. In most cases, they don’t even raise anywhere near that.
They do this because Rule 419, which governs the IPOs of blank check companies, is very restrictive. But operating businesses or start- ups are exempt from Rule 419. Those who comply with Rule 419 are at
a disadvantage because, under this rule, the stock issued in an IPO of a Source: TKTK
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shell cannot trade, and promoters believe it is important for their shells’
stock to trade.
These fi lings are creative. Flowery language about a shell’s intended business, the risks involved, and so on is very impressive. The untrained eye will see nothing suspicious when presented with a shell that says it went public hoping to develop a business that has not materialized, or mineral rights that they will hand back to the promoter because they couldn’t raise money to do the exploration. Rather, the unaware will think, “A business never really happened here, so there is not much in the way of liability exposure. A pretty clean shell.” We know better.
Footnote 32 shells are problematic even though some promoters be- lieve all they are doing is making a victimless end run around Rule 419.
There are two sets of victims of these shells. First is every purchaser or seller of the stock in these shells who thinks they really are going to develop those mineral rights and hit it big. Suddenly, they fi nd themselves being reverse split one-for-twenty and merging with a biotechnology com- pany—not what they signed up for. Now, in truth, most of these shells trade, as they say, by appointment. In other words, they don’t trade with much liquidity. But there generally is some trading and those buying the stock presumably have no idea what the promoter’s real plans are.
The second set of victims is every legitimate player who seeks to form shells the right way, either by using Rule 419 or a Form 10-SB shell or a SPAC (specifi ed purpose acquisition company). Why are they victimized?
Because they are trying to do things as the SEC would prefer, and they still end up with a shell that cannot trade, or in the case of a SPAC a shell which still has a number of Rule 419 restrictions, whereas the Footnote 32 shells manage to trade, increasing their value in the marketplace (at least prior to the appearance of Footnote 32).
Footnote 32 shell promoters seek to parse the language and question the intent of the footnote. They argue it only applies if a promoter or an affi liate puts the assets in himself. So if they get their friend to put the assets in, that is okay. They argue the footnote only applies if the assets are to be removed upon a merger. What if we leave the assets in but de- clare ourselves out of the business we were intending? That should work, right? We had real revenues, they will say, so it was a real business that just didn’t work out.
They also argue that the footnote does not suggest these are frauds (although it uses the term scheme), but simply states that they should be categorized as shell companies for purposes of the new rule requiring dis- closure. That means a full disclosure document (the super Form 8-K, to be discussed in the next chapter) has to be fi led after the merger. They also argue that the SEC allowed the company to go public, which, they believe,
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indirectly blesses it. The SEC would certainly be embarrassed to come back and say, “Oh no, you were a fraud all along and we didn’t spot it.” There- fore, the SEC will leave the company alone, or so the promoters argue.
That being said, I still strongly advise my clients to stay away from transactions with all Footnote 32 shells. At the end of the day, they are frauds and hurt legitimate shell players. Also, SEC staffers have told me they are stepping up enforcement efforts against these operators. I advise each client considering a merger with a Footnote 32 shell that they may fi nd themselves in the middle of an SEC investigation that could bring down the company.
The best legitimate way to avoid Footnote 32 is to take a real, actual small business public, maybe even one that shouldn’t be public just on its own, with the intent of growing by acquiring other businesses in the same industry. Bring real management with knowledge of the industry on board.
The small business will continue to operate after those acquisitions as part of the continuing public company; it will not be spun off or shut down.
Trying to do a “roll-up” in an industry is not a fraud. It is a legitimate way to avoid Rule 419 and the new SEC disclosure rule on merging with a shell, as long as the operations of the original small business cannot be deemed “nominal.”
How does one spot a Footnote 32 shell, since on the surface it looks like a real company struggling to make it? First, look for the fi ve telltale signs of Footnote 32 shells, and then check for the fi nal confi rming clue.
The fi ve telltale signs are as follows (not every company with these charac- teristics is bad, but these are certain indications):
❑ A start-up or very early stage company is doing an IPO or other
“going public” fi ling and allowing shareholders to resell their stock in the public market.
❑ The IPO is seeking to raise very few dollars and may be structured under SEC Rule 504 (to be discussed in Chapter 13, Form 10-SB).
❑ Management of the “company” has little or no experience in the supposed business they are entering into or has experience in the securities or consulting business or other area of Wall Street.
❑ Sorry to say this, but the company claims to be based in Utah, Nevada, or Canada.
❑ Sorry to say this, too, but the company intends to be engaged in a business relating to oil, gas, mineral rights, or to own rights in entertainment projects that are not yet developed.
And now the fi nal clue: The offi cers, directors, large shareholders, or consultants of the company have done it multiple times before. This usually takes literally fi ve minutes to check online, though at times the
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promoters are fairly cagey about bringing in nominees to run each little shell (another indication that they think they might be doing something wrong). But in the end, they have to have their interest somewhere, so names do appear and do repeat (sometimes they are buried as “consul- tants” or selling shareholders in a resale registration, so look closely).
Sometimes they think they are being careful by doing one only every year or two. A simple search reveals them.
When I see Footnote 32 features, I immediately check the background of the individuals involved. Unfortunately, I almost always fi nd nearly iden- tical fi lings for other companies and, sure enough, each of them completed a reverse merger not long after going public with a supposed business.
One would hope that, now armed with Footnote 32, thanks to the sharp folks at the SEC Offi ce of Small Business Policy who recognized and sought to address the problem by including the footnote, we all will be on the lookout for these disguised shells.
I will continue to steer clients away from these shells. In my view, the only way the former shady image of reverse mergers can be erased is by removing as much gray from the black and white world as possible. If it looks like it may be sort of bad, stay away. As mentioned in Chapter 7, it might be easier for me to take whatever business comes in the door and not try to elevate this technique to the high road where it belongs. But I care about my reputation and integrity. I know that the only way reverse mergers will continue to blossom is if Wall Street and Main Street become completely convinced of the legitimacy of the players and their tactics.
Post-Deal High Jinks
Sometimes the dirty shell operator doesn’t show his colors until after the deal. How? He enlists unsavory investor relations people to illegally pump the stock so his shell owners can reap the rewards. It is almost always a problem when a $10 million company fi nds its stock trading at a $300 million market valuation, not to mention a likely SEC investigation.
PRACTICE TIP
Check out the aftermarket performance of previous reverse mergers completed by this promoter, and always work with reputable IR fi rms.
Hiding Control Status
Some underhanded promoters seek to hide their ownership of the shell. Why? Either they have had some prior problems with regulators, they want to be under the radar to avoid a problem, or they are hiding from a Footnote 32-type situation. They hide in various ways. If they own
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more than 5 percent of the company, they have to disclose their owner- ship, but in some cases they simply don’t do the fi ling. In other cases, they try to spread their ownership over various entities, relatives, and trusts so each shareholder individually stays under 5 percent, which may or may not work (“groups” are supposed to aggregate their ownership for purposes of determining whether they own 5 percent). They do this repeatedly.
Another reason they hide relates to owning more than 10 percent. Of- fi cers, directors, or 10 percent owners of public companies face restrictions on their trading under the SEC’s “short swing profi t rule.” This rule pro- hibits buying and then selling, or selling and then buying the stock within a six-month period at a profi t. Should this happen, with limited exceptions, that profi t is disgorged back to the company. It is permitted consistently to buy, or consistently to sell, but not one and then the other. This certainly restricts an active shell promoter seeking to trade in and out of his stock.
These individuals reason that by not fi ling, they can avoid the short swing profi t rule. Of course, that violates SEC rules and may even be a crime.
If a company merging in asks about all this, unscrupulous shell play- ers may reply, “It’s my problem not yours, so don’t worry about it.” And they don’t fi le, they argue, because after a merger they will own less than 5 percent or 10 percent, so who’s hurt? The fact is this can initiate an SEC investigation and any SEC investigation hurts the company. When a shell promoter turns up on a perp walk on Court TV, shareholders get mad at their advisers.
PRACTICE TIP
Always get a list of shareholders from the shell’s transfer agent and carefully scrutinize who owns what, asking questions about relationships and making sure all appropriate fi lings were made.
Hurry, Don’t Worry
In some cases, private companies and their investment bankers face tremendous pressure from a shell operator to complete a deal quickly. “We have someone else ready to take it,” he says, “Hurry up, don’t worry about due diligence, everything is fi ne, if you don’t take this by tomorrow you lose it.”
This hurry-up attitude is almost always a sign of dirty shell she- nanigans. Any legitimate shell operator should patiently encourage due diligence. Tim Keating of Keating Investments, a well-known reverse merger investment banker, sets the standard. If Tim is selling a shell, he sends beautifully organized binders containing everything necessary for a due diligence review, and other information as well.
Source: TKTK
PRACTICE TIP
Stick to your guns and insist on proper due diligence, which you promise to complete quickly.
Due Diligence Review of the Private Company
Due diligence is as important for shell owners as for private companies—
in fact, in some ways more important. Directors of a shell have a fi duciary responsibility to the shell’s public shareholders to carefully review the pri- vate company, especially when shareholder approval of the proposed trans- action will not be obtained (most of the time). If the shell’s controlling shareholder has another interest in the deal—if the shareholder is also the investment bank that will seek to raise money for the merged company, or if they have an ownership interest in the private company merging in—fulfi lling this responsibility is even more crucial.
I do not need to spend much time talking about the process of review- ing due diligence of an operating business, as it is not dissimilar to the process in any private offering or acquisition. One reviews all the legal documents, corporate structure, intellectual property, litigation, press re- leases, and so on, along with checking out management, fi nancials, and so on. Any capable corporate lawyer should be able to complete this process with the assistance of fi nancial professionals trained in the skills of deal- making. Of course, investment bankers also generally play an important role in this review process.
Due diligence of the private company includes assessing whether or not it is “ready” to be public. This includes determining which of the company’s contracts will have to be disclosed once public, whether the company’s fi nancial team has the background to work for a public com- pany, who the company’s board members are, and whether a full fi ve-year biography might include some negative disclosures, and the like.