Anti-Fraud Provisions Apply To Public Float Schemes
When companies go public through reverse merger transactions, insiders often employ various mechanisms to obtain not only control of the public shell but also of its free trading shares. Public float schemes involving penny stocks have been around for years and have become routine features of reverse merger transactions, particularly where the services of third party escrow agents are used. A recent court decision may change the laws applied to schemes where the participants obtain control of an issuer’s public float.
The Escrow Agents
Public float schemes can be structured in a number of ways, and a variety of steps can be taken to conceal the fraudsters’ control. One common method is to use an escrow agent, who is typically a complicit attorney. Regardless of how the transactions are structured, the escrow agent holds and transfers all or substantially all of an issuer’s unrestricted shares to the participants without making public disclosures about the control of the public float or the persons involved.
The Reverse Splits And Illegally Free Trading Shares
Often a large reverse split is done in conjunction with reverse merger transactions. Once the initial transaction is complete, illegally free trading stock is issued and delivered to a third party such as an escrow agent or other participant working in collusion with the shell purveyors. Fraudsters and incompetent and/or complicit attorneys find ways to remove legends without compliance with the SEC’s registration requirements. The fraudsters and these attorneys cause the issuance of free trading shares upon conversion of aged debt or convertible notes, using baseless legal opinions improperly applying the Rule 504 exemption and /or Rule 144′s safe harbor.
The Bogus Form S-1 Public Float Schemes
Fraudulent S-1 filings are commonly used in public float schemes. Fraudsters file bogus S-1 registration statements registering nominal amounts of shares held by selling shareholders to create free trading shares. These registration statements contain bogus business plans and nominee selling shareholders. Once the S-1 is deemed effective, the participants declare large forward stock splits or stock dividends and deliver the shares issued to themselves or to escrow accounts and/or complicit attorneys for delivery at a later date. In some of the most brazen frauds, the S-1 shell becomes the subject of an aggressive promotional campaign centered around a fabricated business plan.
After the public float scam is complete, the fraudsters can even resell the S-1 shell to a private company seeking to go public. In some circumstances, the private company may have no idea who really controls its public float.
The Role of the Investor Relations Firms
It is common for stock promoters and/or investor relations firms to create shells using bogus S-1 registration statements and nominee shareholders, or to collaborate with the shell peddlers from the outset of the scam. Once they have their ticker symbol and bogus S-1, they pump and dump their shares.
Why They Want To Control the Public Float
Fraudsters need control of the public float because it is easier for them to manipulate the price and volume when it is under their control. They also make more money because investors are unaware of their public float scheme. Their object is to dump their shares while the investor is buying them. In the foregoing scenarios, fraudsters can obtain control of a company’s public float without making any misrepresentations to the public.
The End Goal
Regardless of which variation of the scheme is used, the end goal is the same: for the participants to gain control of the float so they can dump their shares into the public markets. Investors may have limited or no information about who controls the float and whether it it is being manipulated.
Advanced Multilevel Concepts
A recent decision could change the climate for these activities. In Advanced Multilevel Concepts, Inc. et al. v. Edward Bukstel et al., Civil Action No. 11-3718 (E.D. Pa. Jan. 25, 2013), the Court found that the anti-fraud provisions of the federal securities laws can be applied to schemes to control the public float even if no misrepresentations are made. The Court determined that the Securities Exchange Act of 1934 (the “Exchange Act”) applies to a fraudulent scheme designed to obtain such control.
In the Advanced Multilevel case, the Federal District Court was presented with the issue of whether a violation of the anti-fraud provisions of Section 10(b) and Rule 10b(5) can occur when officers of a public company engage in a scheme to gain control over the company’s public float and enrich themselves to the detriment of the corporation.
The Court found that the Supreme Court’s broad holdings enforcing Section 10(b) and Rule 10b(5) extended to a corporate officer’s scheme to manipulate the stock’s float, artificially inflate its share price through fraud on the market and reap substantial gains by selling his shares, causing the public company and its other stockholders to suffer loss. As such, the Court denied defendants’ motion to dismiss the counterclaims.
With judges finding the anti-fraud provisions applicable to these schemes, it is likely that the Justice Department will pursue criminal charges against public float manipulators in the near future.
For further information about this securities law blog post, please contact Brenda Hamilton, Securities Attorney at 101 Plaza Real S, Suite 202 N, Boca Raton, Florida, (561) 416-8956, by email at [email protected] or visit www.securitieslawyer101.com. This securities law blog post is provided as a general informational service to clients and friends of Hamilton & Associates Law Group and should not be construed as, and does not constitute, legal and compliance advice on any specific matter, nor does this message create an attorney-client relationship. Please note that the prior results discussed herein do not guarantee similar outcomes.
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Brenda Hamilton, Securities Attorney
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