Reverse Mergers l The Game Changers
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 often securities lawyers hark back to the glory days of the reverse merger.
We have all heard the stories about the well known companies that used reverse mergers 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 because of changes in regulations.
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.
The SEC as well as the Justice Department have increasingly pursued actions against numerous shell purveyors particularly 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, fraudulent shell schemes, 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 securities attorneys who violate the securities laws in reverse merger transactions. According to the SEC, Sourlis’ legal opinions caused the public distribution of millions of unregistered and illegally free trading shares.
In July of of last year, Sourlis settled for a five-year ban which prohibits her from practicing before the SEC. In the SEC’s complaint, 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 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 if done properly, a reverse merger provides few if any benefits to Issuersin going public transactions. A reverse merger is no longer faster, less expensive, easier or less dilutive than an offering registered with the SEC.
Regulations Impacting 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. This requirement includes disclosure of information material to investors such as payments to finders and promoters as well as all terms of the reverse merger including any transfers of purportedly free trading shares in connection with the transaction even where the shares are issued in the names of so called “non-affiliates”. The required disclosures 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.
Many shell purveyors design reverse mergers in numerous creative ways to avoid making these mandatory disclosures. The fact that the SEC fails to detect these transactions under some circumstances does not make them legal.
There is NO exemption from registration that allows a company to issue or transfer free trading shares in connection with a reverse merger, even to non-affiliates of the issuer. The only way to lawfully issue or transfer free trading shares in a reverse merger transaction is to file a registration statement with the SEC. The fact that it may be common practice does not make it legal. Consider that many reverse merger participants have been charged in connection with these activities. 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. 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.
The SEC addressed the use of Rule 144 in its 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] 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 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
Issuers engaging in reverse mergers often undergo name changes, stock splits or other corporate transactions including changes of control. 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 may find themselves 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.
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 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.
Hamilton & Associates | Securities Lawyers
Brenda Hamilton, Securities Attorney
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