Reverse Mergers 101
Traditionally, private companies become publicly traded by registering an offering under the Securities Act of 1933, as amended. Another established method for private companies to obtain public company status is through a Reverse Merger (“Reverse Merger”) with a public shell company. In a Reverse Merger, a private operating company or its business operations are acquired by or merges into a publicly traded Shell Company (“Public Shell”), often inactive with negligible operations and assets. Reverse Mergers can be structured a variety of ways but the end goal is the same – to take a private company or its operations public.
Despite success stories touted by shell brokers, reverse mergers involve a significant amount of legal and compliance risk. Additionally, failure to conduct proper due diligence and/or if the reverse merger transaction is not properly structured, the post reverse merger company can end up to be a private company with public company reporting requirements and expenses. In addition to the traditional reverse merger risks including SEC investigations or violations, undisclosed liabilities, litigation and potential litigation, companies now face increased compliance costs and regulations.
Private companies are learning the hard way that it is easier and more cost effective to simply file a Registration Statement with the SEC and complete a direct public offering (“DPO”) than to encounter the uncertainty and risks inherent in Reverse Merger transactions.
There are many misconceptions about reverse mergers that shell brokers use to entice private companies into purchasing a public shell company including but not limited to those set forth below.
Reverse Mergers are Inexpensive and Fast.
Stock promoters often compare the price of an initial public offering (“IPO”) with that of a Reverse Merger. This is misleading because with an IPO, a company pays an underwriter to sell securities to the public and develop an active market after the company becomes public. A Reverse Merger is not a capital raising transaction. A private company can go public and file their own Registration Statement for a cost of between $35,000 and $100,000. A public shell for a Reverse Merger can cost as much as $450,000 and 5% of the Shell Company’s outstanding securities. In addition to the time it takes to perform due diligence, negotiate the Reverse Merger agreement, and close the Reverse Merger, recent SEC and FINRA requirements eliminate the timeliness benefit of the Reverse Merger.
In 2005, new rules were adopted that require former Shell Companies to file “Form 10 Information” with the SEC within four business days after the completion of a Reverse Merger. This information is substantially equivalent to that found in a Form 10 or SEC registration statement and requires comprehensive disclosure of the company’s business plan, risk factors, financial condition, management, properties, and audited financial statements.
Prior to the rule change, Shells avoided disclosure of much of this information for up to seventy-five days after the Reverse Merger was completed. Now Form 10 Information must be filed within four days after the Reverse Merger, and closing must be delayed to allow for preparation time of typically thirty to sixty days.
Recently passed Rule 6490 requires that corporate acts frequently associated with Reverse Mergers obtain FINRA approval before effectiveness. This approval takes approximately a month to obtain.
Reverse Mergers require minimal disclosure.
Because Form 10 disclosure including audited financial statements is required for Reverse Merger companies, they must provide the same disclosures found in a Registration Statement. As such, substantial disclosures are required.
Reverse Mergers allow easy access to capital and create liquidity.
A Reverse Merger is not a capital raising transaction and a company engaging in a Reverse Merger cannot issue or receive “free trading” shares unless the shares are registered with the SEC. Reverse Mergers do not create liquidity, and in fact may permanently destroy any chance of obtaining liquidity. Issuers engaging in Reverse Mergers often undergo name changes, stock splits or similar transactions which are reviewed by both FINRA and DTC. Upon this review, many Reverse Merger issuers find they lose DTC eligibility and their securities have DTC chills and global locks. Without DTC eligibility, it is impossible for a company to establish liquidity in its securities.
Reverse Mergers allow for easy migration onto NASDAQ, or NYSE or AMEX.
In November of 2011, the SEC approved new NASDAQ, NYSE, and AMEX rules that impose more stringent listing requirements for companies that become public through a Reverse Merger. These rules prohibit a Reverse Merger company from applying to list until it has completed a one-year “seasoning period” by trading in the U.S. over-the-counter market or on another regulated U.S. or foreign exchange following the Reverse Merger, and filed all required reports with the Commission, including audited financial statements. The company must also maintain a minimum share price of $2.00 to $4.00 for at least 30 of the 60 trading days, immediately prior to its listing application.
Rule 144 Can Be Used For Debt Conversions By Shell Companies
Shell brokers continue to hold on to the misplaced belief that Shell Companies or former Shell Companies can issue free trading shares upon conversion of debt or convertible notes. Rule 144 was amended in February of 2008, and it applies to issuers who were shells prior to such time. This issue has already been addressed by the SEC in its Compliance and Disclosure Interpretations set forth below:
Question: If an issuer had previously been a shell company but is an operating company at the time that it issues securities, is the Rule 144 safe harbor available for the resale of such securities if all of the conditions of Rule 144(i)(2) are satisfied at the time for the proposed sale?
Answer: No. Rule 144(i)(1) states that the Rule 144 safe harbor is not available for the resale of securities “initially issued” by a shell company (other than a business combination related shell company) or an issuer that has “at any time previously” been a shell company (other than a business combination related shell company). Consequently, the Rule 144 safe harbor is not available for the resale of such securities unless and until all of the conditions in Rule 144(i)(2) are satisfied at the time of the proposed sale. [Jan. 26, 2009]
Question: Does Rule 144(i) apply to securities issued before February 15, 2008, which was the effective date of the amendments to Rule 144 in which the Commission adopted Rule 144(i)?
Answer: Yes. [Jan. 26, 2009]
Rule 144 requires that shareholders of present or former Shell Companies are unable to rely upon Rule 144 to sell their shares until the issuer of the securities has ceased to be a shell and at least one year has elapsed from the time the issuer filed current Form 10 Information with the SEC reflecting its non-shell status.
Form S-8 Can Be Used In Connection With Reverse Mergers
Registration of securities on Form S-8 is a short-form registration statement that is effective upon filing and which can be used to issue shares registered without a restrictive legend. On July 15, 2005, the SEC amended Form S-8 to prohibit its use by companies that are Shell companies.
The Direct Public Offering Solution
For small companies who will be unable to locate underwriters for an IPO, the direct public offering (“DPO”) is an appealing option which can result in an issuer having a ticker in as little as 90 days for less than 1/4 of the cost of a typical reverse merger. In a DPO, the issuer files a registration statement with the SEC, typically on Form S-1 that registers shares from the issuer’s treasury or shares held by its existing shareholders.
After the issuer files the registration statement it is then subject to review by the SEC. After review of the registration statement the SEC may render comments, which the issuer will address by filing amendments to its registration statement. When all of the SEC comments have been answered to the satisfaction of the SEC, it will declare the registration statement effective. The issuer is then able to apply for its ticker symbol and trade if it meets FINRA’s requirements.
FINRA requires that the issuer have at least 25 shareholders who hold either registered shares or with respect to Pink Sheet listed issuers, shares that have been held by non-affiliate investors for twelve months. These shares in the aggregate should represent at least 10% of the issuer’s outstanding securities and are often referred to as the “Float.” A market maker must sponsor and file the issuer’s Form 211 (“211”) with FINRA. After which, FINRA conducts a review and may provide comments for the sponsor to address. Upon receipt of confirmation that all comments have been answered satisfactorily, a ticker symbol is assigned and the issuers’ securities are publicly traded.
Any private company seeking to have its securities publicly traded should proceed with caution when considering whether to engage in a Reverse Merger. Similarly, investors should proceed with caution when considering whether to invest in reverse merger companies. Many Reverse Merger issuers either fail or struggle to remain viable. In light of these considerations, private companies should consult a qualified and independent securities attorney to perform thorough research and due diligence before engaging in a Reverse Merger.
To the extent that a private company is willing to expend the time and resources to become public, it should do so the proper by way by filing a registration statement with the SEC and conducting an underwritten or direct public offering and avoid the growing risks and new requirements involving reverse merger transactions and public shell companies.
For further information about this article, please contact Brenda Hamilton, Securities Attorney at (561) 416-8956 or by email at BHamilton@securitieslawyer101.