Over the last eight years, the Securities and Exchange Commission (“SEC”) and the Financial Industry Regulatory Authority (“FINRA”) have overhauled the rules and regulations applicable to reverse merger transactions. Not only have the SEC and FINRA jumped on the bandwagon to eliminate them, but as will be explained, Depository Trust Company and national securities exchanges have joined in their efforts. Among the SEC’s efforts to stem microcap fraud is a campaign to eliminate dormant shell companies to prevent them from being used in reverse merger transactions.
Its efficacy is demonstrated by what the agency calls operation Shell Expel, which so far has resulted in trading suspensions for more than 1,000 dormant public companies. In addition, the SEC has recently identified gatekeepers – securities lawyers, transfer agents, accountants- and shell purveyors as ripe targets for enforcement actions.
Last year the SEC announced its new task force “Enforcement Initiatives to Combat Financial Reporting and Microcap Fraud and Enhance Risk Analysis” whose targets, among others, would be reverse merger purveyors and securities attorneys involved in reverse merger transactions.
The rules and regulations impacting reverse mergers have changed dramatically in recent years and reverse mergers are often misunderstood and misapplied. This is illustrated by the string of SEC cases involving reverse merger participants and their legal counsel.
Shell company purveyors praise the virtues of reverse merger transactions claiming they are easier and faster than filing a registration statement with the SEC, despite recent rule changes that eliminate many if not all of the benefits once conferred by them. Seeking to persuade clients to use their services, shell peddlers hark back to the glory days of unregulated reverse merger transactions. The reality is that those glory days are over. Anyone familiar with the rules and regulations impacting reverse merger transactions knows they can be toxic for private companies seeking to go public if not done properly.
We are frequently asked about the legal ways that reverse mergers can be completed and under what circumstances, if any, unrestricted shares can be issued. This bootcamp blog series will address changes to the rules and regulations impacting reverse mergers, the payment of finders fees and commissions in reverse merger transactions, the use of forward stock splits in reverse merger transactions, and the issuance of unrestricted securities in reverse merger transactions. Lastly, it will address rampant abuses of the process, including custodianship and/or receivership change of control transactions, fraudulent use of attorney escrow accounts in reverse mergers and the improper and illegal use of convertible debt and the securities exemptions provided by Rule 504, 3(a)(9) and 3(a)(10) of the Securities Act of 1933.
Creating Inventory for Reverse Mergers l Illegal Custodianship and Receivership Actions
Custodianship and receivership fraud has become an epidemic in the OTC markets particularly with non-reporting issuers. It is by far the most abusive and blatant crime committed by reverse merger scammers.
In these custodianship and receivership actions, fraudsters locate dormant tickers and/or public companies that are inactive in their state of domicile. They then file pleadings with a state court under penalties of perjury, falsely stating, among other things, that the issuer’s board of directors was deadlocked in a vote, and so shareholders, unable to break the deadlock, are appealing to a state court judge to appoint a receiver selected by the shareholders, who are in fact the fraudsters. In reality, there was no deadlock, vote or even a meeting of the board of directors or shareholders. Upon appointment, the receiver presents the fraudulent order to the issuer’s transfer agent and causes it to issue millions, sometimes billions and sometimes even billions, of illegally free trading shares. To issue the illegally free trading shares, the fraudsters solicit the assistance of incompetent or corrupt securities attorneys to render flawed opinions in reliance upon Rule 3(a) (10) or Rule 144 of the Securities Act. To conceal their illegal actions from the legitimate shareholders and board of directors, the fraudsters often change the name and domicile of the issuer and conceal material aspects of their transactions from public filings as well as from FINRA.
Once the coast is clear, the fraudsters sell the hijacked entity to unsuspecting small companies in going public transactions. Fortunately, these fraudsters’ days are numbered. In the last year, the Justice Department has charged numerous defendants for using similar schemes to exploit state court actions.
The Risk to Private Companies in Going Public Transactions
Any private company that purchases a custodianship or receivership shell is at risk of an SEC enforcement action even if they were an unknowing participant in certain securities violations that occurred. Section 5 of the Securities Act does not require scienter. In other words, even if someone is an unknowing participant relying upon a legal opinion to improperly issue free trading shares to himself or others, he can be charged with violating Section 5. In addition to SEC enforcement actions, issuers purchasing custodianship shells risk SEC trading suspensions. In the less than two years, the SEC has suspended approximately 700 dormant public companies to prevent corporate hijackings using fraudulent custodianship and receivership actions. Additionally, issuers may be subject to civil actions by legitimate management and shareholders of the entities hijacked in the custodianship proceedings. As stated above, most reverse mergers fail to properly disclose information material to investors. Additionally, where public vehicles are hijacked and/or taken over in custodianship proceedings, egregious accounting failures are present because the auditors employed fail to contact former management of the entity subject to the proceeding. To do so would reveal the scheme.
Any company considering going public through a reverse merger transaction should consider the decision carefully, and consult a qualified securities attorney before signing the dotted line for a reverse merger.
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 firstname.lastname@example.org 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.
Hamilton & Associates | Securities Lawyers
Brenda Hamilton, Securities Attorney
101 Plaza Real South, Suite 202 North
Boca Raton, Florida 33432
Telephone: (561) 416-8956
Facsimile: (561) 416-2855