Shell brokers continue to tout the virtues of reverse merger transactions, 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, these promoters hark back to the glory days of the reverse merger transaction, pointing to well known companies that used them to go public, such as Blockbuster Entertainment, Tandy Corp. and Turner Broadcasting. The reality is that those days are long over, and the reverse merger game has dramatically changed.
Since 2005, 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 explained below, Depository Trust Company and national securities exchanges have joined in their efforts.
In recent years, the SEC as well as the Justice Department have brought actions against numerous shell purveyors and/or securities attorneys for their role in securities fraud schemes where reverse merger companies were involved in pump and dumps, ponzi schemes, insider trading, corporate hijackings, public shell companies, drafting bogus legal opinions and even forging legal opinions.
The SEC‘s recent case against reverse merger securities attorney, Virginia Sourlis demonstrates the SEC’s trend to charge corrupt securities attorneys who attempt to avoid the securities laws in order to complete reverse merger transactions. The SEC case against Sourlis resulted in her five year bar from practicing securities law after the SEC found her liable for securities fraud for her gate keeper and legal opinion writer role in Greenstone Holdings, Inc. According to the SEC, Sourlis’ legal opinions caused the public distribution of millions of unregistered and illegally free trading shares.
The SEC originally proposed to ban Sourlis after she allegedly made false statements concerning Greenstone’s issuance of non-existent promissory notes. The SEC also determined Sourlis made false statements concerning Greenstone’s note holders, and conversations with investors that did not exist. Sourlis was denied a hearing to appeal the SEC’s decision, and in July of 2013, settled for a five-year ban which prohibits her from practicing before the SEC. In the complaint filed in February of last year, the SEC accused Sourlis in her capacity as Greenstone’s securities attorney, of writing a legal opinion letter that falsely stated 12.3 million shares of Greenstone’s common stock could be issued as free trading after conversion from promissory notes.
The SEC claimed that the note was a sham created to create a false impression that the requirements of SEC Rule 144 had been complied with. According to the SEC, a portion of the notes, were created to pay off non-existent corporate debts and expenses.
The New Reverse Merger Task Force
On July 2, 2013, the SEC announced “Enforcement Initiatives to Combat Financial Reporting and Microcap Fraud and Enhance Risk Analysis.”
Keeping with the SEC’s trend of eliminating public shell companies demonstrated by Operation Shell Expell, the SEC has identified gatekeeper securities lawyers and shell purveyors as ripe targets for SEC enforcement actions.
The reality is that Reverse Mergers are more often vehicles for fraud and simply not worth the risks involved.
The Realities of Reverse Merger Transactions
For most private companies, a reverse merger provides NO benefit whatsoever, and it increases the risks and costs of a going public transaction as much as tenfold. A reverse merger is no longer faster, less expensive, easier or less dilutive than an offering registered with the SEC.
Form 8-K Amendments l Game Changer l Reverse Mergers
Shell companies are required to file extensive information with the SEC on a Current Report on Form 8-K within four days after the completion of a reverse merger. This information is comparable to that found in a Form 10 registration statement. It must include two years of audited financial statements of the post merger entity and unaudited interim periods, as well as comprehensive disclosure of the company’s business plan, risk factors, financial condition, management and properties. The preparation of the information required is comparable to that involved in filing a registration statement with the SEC. Reverse mergers are no longer simple and they do not require less disclosure than a registered offering, nor are they faster than a registered offering. Consider that the required Form 10 information must be filed within four days after the reverse merger. Any purchase of a public shell company for the contemplated merger must be delayed to allow for time to prepare this information. That could take 90 days or longer because of the audited financial statement requirement.
Rule 144 Shell Rule l Game Changer l Reverse Merger
Shell brokers continue to cling to the misplaced belief that a reverse merger is a capital raising transaction and come up with all kinds of creative and illegal ways to create free trading shares such as for the settlement of outstanding debt. The reality is that a Reverse Merger is not a capital raising transaction. Rule 144 can never be used by a company that is a shell company. A common misuse of Rule 144 in reverse mergers involves the issuance of free trading shares to (purported) non-affiliate stockholders in exchange for debt or services. Since Rule 144 is not available and there is no convertible debt exemption, the issuance of free trading shares under these circumstances is illegal.
This is absolutely prohibited under the securities laws. There is NO exemption from registration that allows a company to issue free trading shares in connection with a reverse merger, even to non-affiliates of the issuer. The only way to issue lawfully free trading shares in a reverse merger is to file a registration statement with the SEC that discloses all required information.
Rule 144 was amended in February of 2008, and it applies to issuers who are present or former shell companies, including companies that were shells prior to the adoption of the amendment.
The SEC addressed the use of Rule 144 by shell companies in its recently released Compliance and Disclosure Interpretations:
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 specifies that shareholders of present or former shell companies cannot 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. This destroys the argument that a reverse merger is faster than filing a registration statement in a direct public offering or IPO. Reverse mergers do not create liquidity, and may permanently destroy any chance of obtaining liquidity because the issuer must jump through numerous hoops to issue free trading shares.
Form S-8 l Game Changer l Reverse Mergers
Form S-8 is a short-form registration statement that is effective upon filing. It can be used to issue the shares registered without a restrictive legend. On July 15, 2005, the SEC amended Form S-8 to prohibit its use by shell companies.
FINRA Rule 6490 l Game Changer l Reverse Mergers
Issuers engaging in reverse mergers often undergo name changes, stock splits or other corporate change transactions. FINRA Rule 6490 requires issuers to obtain the regulator’s approval for corporate actions and reverse mergers. FINRA approval can literally take months and involve extensive document production and review when a reverse merger is involved. Upon this review, many reverse merger issuers find FINRA will not approve their transactions because they have sketchy corporate records. Additionally, after FINRA completes its review, reverse merger issuers are subject to a review by DTC. During this review, the issuer may lose DTC eligibility and its securities may become subject to DTC chills and global locks. Without DTC eligibility, it is almost impossible for a legitimate company to establish liquidity in its securities.
Stock Exchange Listings l Game Changer l Reverse Mergers
In November 2011, the SEC approved new NASDAQ, NYSE, and NYSE MKT (formerly AMEX) rules that impose more stringent listing requirements on companies that go 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 has 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 preceding its listing application.
The New Game l Direct Public Offering
For small companies 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 a quarter 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, shares held by its existing shareholders, or both.
Any private company seeking to go public 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 way, by filing a registration statement with the SEC and conducting an underwritten or direct public offering, thus avoiding 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 101 Plaza Real S, Suite 201 S, Boca Raton Florida, (561) 416-8956, by email at firstname.lastname@example.org or visit www.securitieslawyer101.com. This memorandum 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. For more information concerning the rules and regulations affecting the use of Rule 144, Form 8K, FINRA Rule 6490, Rule 506 private placement offerings, Regulation A, Rule 504 offerings, SEC reporting requirements, SEC registration on Form S-1 and Form 10, Pink Sheet listing, OTCBB and OTC Markets disclosure requirements, DTC Chills, Global Locks, reverse mergers, public shells, go public direct transactions and direct public offerings please contact Hamilton and Associates at (561) 416-8956 or by email at email@example.com. Please note that the prior results discussed herein do not guarantee similar outcomes.
Hamilton & Associates l Securities Lawyers
Brenda Hamilton, Securities Attorney
101 Plaza Real South, Suite 202 North
Boca Raton, Florida 33432
Telephone: (561) 416-8956
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