Reverse Mergers After Amended Form 15c-21
A “Reverse Merger” is a transaction whereby a privately held company becomes a Public Company (“Public Company” or “Public Company Candidate”) by acquiring or merging with a publicly traded company that is usually quoted on the OTC Markets OTC Pink or OTCQB. Reverse Mergers can be structured in a number of ways and involve a series of transactions that vary among issuers and specific situations. Public Companies may publish disclosure and financial statements as issuers reporting with the Securities and Exchange Commission (“SEC”) or may follow the Alternative Standard of the OTC Markets.
The goal of a Reverse Merger is to cause the private company to become a Public Company in a faster, more efficient and cost-effective way than a direct public offering (“DPO”) or initial public offering (“IPO”).
The following will typically occur in a Reverse Merger:
(i) The Public Company will issue, or a holder will transfer, a substantial majority of its shares to the private company or its control persons, and the new holder of such shares will become the control person of the Public Company;
(ii) the board of directors of the Public Company will resign and be replaced by the board of directors of the private company or its designees;
(iii) the business of the purchaser or private company becomes the business of the Public Company;
(iv) the public shell company seeks Financial Industry Regulatory Authority (“FINRA“) processing of a name change and reverse stock split; and
(v) begins making disclosure in compliance with the OTC Markets Alternative Standard or, if the Reverse Merger involved the acquisition or merger of an SEC reporting company, the post-Reverse Merger entity must file reports with the SEC shortly after closing.
As explained below, the price of a Public Company varies depending upon the transaction and could be paid in the form of cash, securities, and/or intellectual property. In a typical Reverse Merger, certain fillings, procedures, and approvals will be required depending on where the Public Company is listed or trading (NASDAQ, NYSE, NYSE American, or OTC Markets) and whether the Public Company is eligible for electronic trading (“DTC Eligible”).
This roadmap focuses on Reverse Mergers involving companies quoted on the OTC Markets OTCQB or OTC Pink.
When reviewing potential Public Company candidates for a Reverse Merger, we recommend eliminating the following types of vehicles:
- Expert Market – Zombie Tickers
In September 2021, the SEC amended its Rule 15c-211, which caused thousands of issuers delinquent in their SEC and OTC Markets reporting requirements to be demoted to the OTC Markets “Expert Market.” That resulted in their shares being quoted only on an unsolicited basis, which prevents the shares from being publicly traded. Many of these issuers had sketchy operating histories, bad actors, and a history of regulatory issues. Many more were abandoned by their management years or even decades ago, and so ownership may be difficult to trace.
To have shares publicly traded on a solicited basis, an issuer must provide adequate public information as required by Rule 15c-211 and locate a sponsoring market maker to submit a new Form 211 to FINRA for processing. The challenge for these vehicles is locating a sponsoring market maker and obtaining FINRA processing of a new Form 211. This process can take up to 12 months and may never come to fruition. Processing can be denied at the discretion of FINRA. These vehicles should not be considered viable candidates for a Reverse Merger, even for companies seeking quotation on the OTC Pink or OTCQB.
- Shell Companies and SEC Limitations
Private companies should be aware of the implications of a Reverse Merger with a “shell” company. According to Rule 144 of the Securities Act of 1933, as amended (the “Securities Act”), a shell company is a company that has: (a) no or nominal operations; and (b) either: (1) no or nominal assets; (2) assets consisting solely of cash and cash equivalents; or (3) assets consisting of any amount of cash and cash equivalents and nominal other assets. Additional rules apply to shell companies, including the unavailability of certain resale exemptions for investors in them. These and other requirements and limitations must be taken into account when considering a Reverse Merger with a shell company. If possible, shell companies should be avoided.
- Custodianship Shells
A custodianship shell is an issuer that still publicly trades but at one point was abandoned and became delinquent with its public disclosures, including annual reports and taxes in the state in which it is domiciled. Such issuers become vulnerable to shell hijackers, who can file a petition with a local court to gain custodianship of the shell. The court order gives the applicant governing power over the shell, allowing him to reinstate it and get it back into good standing with the local Secretary of State. It is common practice for the custodian to then shop the shell around as a reverse merger vehicle. Custodianship shells come with a slew of challenges. Most were abandoned because they had sketchy operating histories, bad actors and a history of regulatory issues, and because they were inactive for a number of years, gathering information and corporate records to support past business operations and changes in control can be next to impossible. Those deficiencies will be considered red flags when the new owner of the vehicle seeks FINRA processing of a name change and reverse stock split, likely prompting FINRA to deny the request.
Public Company Candidates
Public Company Candidates can vary dramatically and may display a wide range of characteristics. Some are quoted on the OTCQB Market, while others may be quoted on the OTC Pink Market. Although the price may be attractive and intermediaries convincing, troubled shells are not a good value, and should be avoided. Private companies should look for the following qualities in a public shell:
(i) The Public Company should be quoted on the OTC Markets OTCQB or OTC Pink and not the Expert Market;
(ii) the Public Company should not have been the subject of a custodianship or receivership action;
(iii) shell companies should be avoided when possible;
(iv) the Public Company Candidate should have a meaningful number of shareholders holding freely trading shares (a minimum of 35 for the OTC Pink and 50 for the OTCQB holding at least 10% of the issuer’s shares outstanding);
(v) the Public Company Candidate should be an SEC reporting company (meaning subject to the reporting requirements of the Securities Exchange Act of 1934) or making disclosure under the OTC Markets alternative standard, and should be current with its filing requirements;
(vi) the Public Company Candidate’s shares should be eligible for electronic trading (“DTC eligible”);
(vii) the Public Company should not have a history of bad actors, reverse mergers, changes of control, extended periods of inactivity, or liabilities;
(viii) the Public Company Candidate should deliver shareholder approval of the Reverse Merger;
(ix) there should be no history of non-compliance by the Public Company Candidate with SEC reporting that has not been remedied, including the filing of Form 15 at a time when the issuer was not current;
(x) the Public Company Candidate should have at least 3 market makers; and
(xi) the Public Company Candidate should not have engaged in investor relations activity in the prior 12 months.
Private Companies should be wary of intermediaries acting on behalf of the Public Company Candidate. They can often be considered unregistered broker-dealers and may mark up the price of shells as much as 100 percent without disclosing the details of their fees. Unregistered broker-dealer activity can also be detected by FINRA or the SEC, with unfortunate consequences for all involved.
The Reverse Merger Transaction
The Reverse Merger transaction will typically begin with a letter of intent or memorandum of understanding outlining the potential transaction. The transaction will entail due diligence of both the private and public companies, negotiation of the terms of the transaction, and the exchange of information by the parties. Finally, they will sign a merger, acquisition, stock purchase or share exchange agreement.
If the private company is being acquired by or is merging into a Public Company that reports to the SEC, within four business days following the transaction, the combined company will be required to file an audited financial statement of the private company prepared in accordance with US GAAP standards.
If the Public Company follows the alternative reporting standard of the OTC Markets, it must submit a current information report through the OTC Markets. Gaining access to the OTC Markets Disclosure and News Service to submit a current information report following the change of control requires paying the application fee and submitting a new application following the change of control. To complete this application, the post-Reverse Merger issuer will be asked to provide a recent shareholder list obtained from the company’s transfer agent as well as certain personal information (full name, birthdate, legal and disciplinary history) about all officers, directors and control persons.
Once a suitable Public Company is found, due diligence must be conducted, which takes time. The history of the shell company, its shareholders, and its officers/directors must be documented and reviewed to ensure a smooth transaction and help safeguard against problems post-acquisition.
All the transactions associated with the Reverse Merger must be completed, and the private company must have the signatures of the Sellers and the Public Company Candidate on the documents required for the closing. The private company should ensure it has all items required by FINRA for processing of corporate actions in the event it desires to change the name or enact a reverse stock split of the Public Company Candidate after closing, including:
(i) Executed and notarized copy of the Board of Directors Resolutions or notarized officer’s certificate authorizing the requested corporate action.
(ii) Executed and notarized shareholder approval authorizing the requested corporate action or notarized officer’s certificate indicating shareholder approval of requested corporate action.
(iii) File stamped Articles of Incorporation from the time the company began using its current name.
(iv) File stamped Articles of Amendment citing the split (if a reverse split is being enacted).
(v) CUSIP confirmation from the CUSIP Service Bureau (212-438-6565 or www.cusip.com) indicating the status of the CUSIP for the Issue(s).
(vi) A current shareholder list.
(vii) Transfer Agent Verification Form.
(viii) Letter providing a full corporate history beginning at the original date of incorporation, including but not limited to all corporate changes, changes of control, reverse mergers, name changes, share exchanges, purchase agreements, etc. that have occurred until present day. FINRA requires that the following types of transactions be disclosed in the corporate history:
- Name changes
- Reverse/forward stock splits
- Mergers, including reverse merger transactions
- Holding company reorganizations
- Dormant shell revivals
- Changes of corporate control via shareholder vote and/or with consent of prior officers, share exchange/purchase agreements, custodianships or receiverships, large block private purchases of company stock, convertible debt/preferred share conversions
- Reinstatements with the state of incorporation
(ix) Executed appointments of the current corporate officers and directors of the issuer. The appointments may be submitted as executed resolutions by the former officers appointing the new officers; filings made to the SEC; filings with the Secretary of State showing the appointment of the new officers and the resignations of the prior officers; or appointments reaffirming the officer’s position within the company executed and notarized.
(x) Executed resignation from the prior corporate officers and directors of the issuer. The resignations may be submitted as executed resignation letters; filings made to the SEC; certifications from the secretary of the company stating that the former officers of the company departed on their own accord and that their departure was not followed by a change of control/corporate shell transaction; legal opinion letter from outside counsel certifying that the former officers of the company departed on their own accord and that their departure was not followed by a change of control/corporate shell transaction. The letter should include the details surrounding the resignations and specify that control was obtained in accordance with the corporation’s by-laws and State and Federal securities law; or filings with the Secretary of State showing the appointment of the new officers and the resignations of the prior officers.
(xi) File stamped Articles of Amendment amending the company’s current name to the new name.
(xii) File-stamped articles of merger if name change is the result of a merger.
(xiii) Plan of merger if name change is the result of a merger.
(xiv) Any other documents or information that FINRA may request during their review.
Once the acquisition is completed, the Public Company’s obligations begin immediately. If the post-Reverse Merger entity is SEC reporting, within four business days after the closing of the acquisition, the newly merged company must file a Current Report on Form 8-K with the SEC, including audited financials of the private company. If the public vehicle is not legally a shell, the time within which the company must file is significantly longer. Thereafter, the company will need to continue to meet its reporting requirements with the SEC. The shareholders of the private company must ensure that the auditors for both the old Public Company and the private company are on board and paid up at the time of closing.
Becoming a Public Company can offer benefits, including access to capital and a higher profile, but rigorous diligence must be undertaken in structuring and implementing a Reverse Merger. The SEC and FINRA have traditionally taken a negative view of companies going public via reverse merger, and for good reason. Reverse Mergers can be rife with fraud, and should be approached with caution.
To speak with a Securities Attorney, please contact Brenda Hamilton at 200 E Palmetto Rd, Suite 103, Boca Raton, Florida, (561) 416-8956, or by email at [email protected]. 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 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 Attorneys
Brenda Hamilton, Securities Attorney
200 E Palmetto Rd, Suite 103
Boca Raton, Florida 33432
Telephone: (561) 416-8956
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