Legal Corner Archive

I’ve received numerous inquiries and had many discussions regarding which way is the best way to become a public company. As the title to this latest article plainly suggests, there are indeed many considerations – more than can be covered in one article. This first article is a step though and will be followed by additional articles building on the information here.

When I first expanded my securities practice years ago to include reverse mergers and shell company transactions, I occasionally encountered skepticism from entrepreneurs and their lawyers from time to time regarding various alternative methods that allowed a company to become public without the traditional Initial Public Offering filing with the SEC (I’ll refer to these various methods and other going public strategies that don’t rely on an IPO as “IPO Alternatives”).

Even straightforward self-filings using an experienced securities attorney were considered out of the mainstream. This occasional skepticism and overly cautious view of IPO Alternatives was a result of several factors.

1. Going Public Raises Money for Operations. First, conventional wisdom had it that “going public” was to accomplish various goals – a primary one being the raising of money for operations and growth. Not only is the company registered with the SEC but shares of the company are also registered so that they may be legally sold to investors by one or more underwriters. IPO alternatives, like reverse mergers and self-filings, include the first element (the company is registered with the SEC) but financing is a separate element which, if needed, must be arranged. This may be a PIPE financing at the time of the transaction or shortly after, a Regulation D private offering beforehand (refer to my articles in the archive on Reg D) or market makers lined up and in place to handle the sale of shares following a self-filing.

2. Shareholder Base. In addition, a successful IPO creates a broad shareholder base as a result of the distribution of the shares by the syndicate of underwriters. This type of broad share distribution generally creates a diverse “float” of public shareholders and a healthy trading market. A self-filing or a reverse merger (which may also take the form of a share exchange or asset acquisition) doesn’t create new shareholders. The company needs to have enough shareholders to have a float and trading market following completion of documentation and filing with the SEC. While the shareholder base can be grown over time, regulator preferences and market realities require a sufficient shareholder base to make your efforts worthwhile.

3. IPO Legitimacy. Finally, an IPO has always had legitimacy because that was the clear roadmap laid out and supported by the SEC and custom-made for the SEC’s integrated disclosure and reporting framework. Further, it way it was done by the big players – the large brokerage houses and investment bankers – and they earned huge fees along the way for underwriting a conventional IPO. Creative entrepreneurs who didn’t have access to Wall Street, or whose businesses were not mature enough to justify even a “best efforts” commitment by underwriters, or didn’t have adequate revenue or capital for the going-public process, had to find other ways to provide their investors with free trading stock.

Unlike an IPO, the SEC had some real and often justified concerns with the way some IPO Alternatives were being implemented. Beginning in the 1970’s and 1980’s, entrepreneurs, investment bankers and their attorneys began using Rule 504 of Regulation D and/or various state and federal securities laws to sell stock that would be able to trade without restrictions. Even if there was no public market for the stock, the trading could eventually develop if a good company continued to have positive developments and it found support among market makers. Another strategy was to simply form a company with a basic business plan and attempt to raise money with a public offering (sometimes with every intention of continuing the business and sometimes with the intention to acquire a company with more substance to be identified in the future).

From the SEC’s point of view, many of the transactions employing these under-regulated alternatives were used simply to avoid the SEC’s securities registration requirements and they resulted in complaints from investors claiming securities fraud. A typical example might involve a promoter who raised money for a company, but since it was not underwritten it was not nearly enough for the company to truly carry out its business plan or to have a healthy public market. Over time, the money raised is depleted paying fees or salary to the promoter while he is seeking other sources of financing or has moved on to other deals.

Much to the chagrin of those companies who were trying to do things right, the SEC decided it needed to step in and regulate IPO Alternatives more directly. Among other things, the SEC’s Rule 419 in 1992 required promoters of “blank check companies” to keep all money raised in escrow until a merger or acquisition was generally approved by the shareholders and appropriate filings were made with the SEC. (A “blank check company” was defined by the SEC as “a development stage company that has no specific business plan or purpose or has indicated its business plan is to engage in a merger or acquisition with an unidentified company…”) If no acquisition was found or approved within 18 months, the funds had to be returned to investors with interest. Some readers may note the resemblance to a modern day specific purpose acquisition company, or “SPAC”, however SPACs, while structured generally in the same manner, raise well over $5 million dollars and are therefore outside the purview of Rule 419.

As reverse mergers increased in popularity, further problem areas inherent in the use of IPO Alternatives were addressed by the SEC. On January 21, 2000, Richard Wulff of the SEC wrote a letter in response to an earlier letter from Ken Worm of the NASD (now known as the “Worm-Wulff letters”) advising that Rule 144 was not available for the resale of securities initially issued by companies that are, or previously were, “blank check” companies. Since 2000, therefore, no resales of shares issued in connection with a reverse merger have been permitted without registration of the shares (as opposed to registration of the company) with the SEC. This became applicable to all holders of restricted and non-restricted shares of trading shells and non-trading shells, regardless of whether they were reporting or non-reporting (although see my recent article on Rule 144 - with recent changes to Rule 144 in 2008, holders of shares issued in shell transactions have a very narrow way out of the Worm-Wulff restrictions if the company is no longer a shell and files its required reports for 12 months).

Following the Worm-Wulff letters of 2000, the SEC adopted much more detailed filing requirements for reverse mergers in 2005 and prohibited shells from using Form S-8 (which had become commonly used in shell transactions as another form of compensation for insiders instead of its intended purpose related to employee-director stock grants).(See http://www.sec.gov/rules/final/33-8587.pdf.)

Even given the various limitations on IPO Alternatives which have been imposed along the way by the SEC, it is important to note that the SEC never prohibited shell company transactions – for the most part they have made promoters more forthcoming regarding transaction details. In its 2005 rulemaking, the SEC actually acknowledged there were legitimate purposes for the use of shells:

“The rules and rule amendments we are adopting today do not address the relative merits of shell companies. We recognize that companies and their professional advisors often use shell companies for many legitimate corporate structuring purposes. Similarly, our definition and use of the term “shell company” is not intended to imply that shell companies are inherently fraudulent. Rather, these rules target regulatory problems that we have identified where shell companies have been used as vehicles to commit fraud and abuse our regulatory processes.”

SEC respectability has accompanied acknowledgement from the big players on Wall Street that IPO Alternatives should be considered along with the traditional IPO approach. The term “reverse merger” gained new respect when the venerable 215 year-old New York Stock Exchange concluded a reverse merger with the registered upstart Archipelago Holdings rather than select a traditional IPO. While not perfect, Google’s “Dutch Auction” strategy worked impressively despite an initial push towards going the traditional IPO route. There have been a multitude of successful self-filings and transactions using IPO Alternatives that have firmly established that a conventional IPO is not the only way to go.

If you can get an underwriter’s commitment to take you public going the IPO route, you should seriously consider it and its costs. If you don’t have the luxury of a major brokerage house waiting to underwrite your deal, how do you choose the best IPO Alternative? These transactions are all complex and not for the faint of heart. You need experienced legal and financial professionals to discuss the multiple pros and cons of the different IPO Alternatives before you even start to consider those alternative ways for your company to become public. Regardless of what anyone says, this is not a situation where there are a couple of quick documents you can sign and then you are on your way.

Your company might be ideal for a straightforward self-filing. This is clearly the SEC’s most favored IPO Alternative because you are taking your company public “through the front door.” Your company might also be offered opportunities to merge with an existing public company. (Just be conscious of the numerous restrictions applicable if the merger partner is, or was ever, a shell.) There are a various IPO Alternatives that can be used to accomplish your objectives and with the cost ranging from under $100,000 for self-filings to up to $1 Million or more for other options, there is ample reason to consider the pros and cons of each alternative suitable to your company. (As an example, the fact that a company already has a trading symbol is only one aspect to consider – but clearly not enough upon which to base a decision on how you will achieve your objectives for your company.)

In follow-up articles, I hope to explore some of those various considerations with you. Be sure to send me an e-mail and let me know if this article was helpful to you or if you have other questions before continuing further in your own ventures.

This article provides general information only. It should not be construed as legal advice. We provide legal advice only to clients of the firm. Due to the complexities of securities law, the specific facts and circumstances must always be carefully considered and similar situations may lead to different conclusions.

If the objective of your company is to be public and you are not large enough to attract a big-time Wall Street underwriter for a traditional IPO, you need to consider the significant benefits of a direct filing with the SEC as an IPO alternative. Often referred to as a “self-filing” or a “direct public offering”, when completed this filing (either on Form 10 or Form S-1) establishes your company as a fully-reporting public company. An additional benefit of a Form S-1 filing is that shares of the company and shareholders can be registered for resale. In contrast, a Form 10 filing subjects the company to the SEC’s public information reporting requirements only, without any registration of shares. A Form S-1 would have to be filed afterwards to register shares for investors and others to enable a trading market beyond any non-restricted shares held by shareholders at the time.

This article will focus primarily on reverse mergers (accomplished with OTCBB reporting shells) vs. self-filing companies that file a Form S-1 directly with the SEC, referred to by some as “going public through the front door.”

Over the years, transactions using trading shell companies, which I will generally refer to in this article as “reverse mergers” (including reverse triangular mergers, “asset” acquisitions or otherwise), have gained some validity through their use by investment bankers and some major companies. Even the SEC has given credence to shell transactions by conforming rules and regulations to address shells. At the same time, however, the SEC has created several new issues with regard to shells that have complicated things substantially.

With apologies to my friends in the shell community, I have to say that while there are certain situations where a reverse merger with a shell may make sense, there are plenty of reasons not to go the shell route. Some important ones include:

By the way, we have successfully guided clients through both self-filings and shell transactions so I don’t necessarily have a horse in this race – we can certainly accomplish whatever a client needs. We will, however, make sure any client thoroughly understands all of the options (and the long-term ramifications) in order to make a fully-informed choice regarding these or other IPO alternatives.

Reverse Mergers. When current OTC Bulletin Board shells are being offered at prices in the $400,000-$600,000 range and up, the cost to complete a business combination with a shell is a significant issue, especially because that is the base cost of the shell only. You still have to add in audited statements, significant due diligence costs, legal fees and a variety of other costs just to hit the ground running.

Perhaps you can lower your out of pocket cost by using shares of your company to cover part of your acquisition costs. Now your transaction just got really expensive. You have just given away a big piece of your company, for no cash, at a price you might not ever consider accepting on a straight investor proposal. Since you have had to negotiate a purchase using stock instead of the cash price requested, the likelihood that you have to agree to other items increases (e.g. paying off liabilities or granting registration rights). Given the relatively low valuation you have just established in the transaction for your company and the significant dilution resulting from the arrangement, you might find the transaction is much more expensive in the long run.

Self-Filings. Conversely, legal fees for a self-filing will be less. I can’t speak for other law firms but we can file an S-1 and register shares for a client for well under $100,000. We can also provide introductions to experienced SEC-approved accounting firms that are accustomed to working with smaller companies and can provide some extremely competitive pricing. Being able to tell investors that they can invest in your company today and you will use their funds wisely, including promptly registering their shares with the SEC, makes for a compelling presentation. If you structure the investment properly to include both shares and warrants, you have just taken care of your second round of financing if your company performs. (And, since you didn’t go the shell route, you have an extra half million dollars in the bank that you can use to pay salaries and generally make sure your company performs.) Many things will affect the price of your shares – cash in the bank or lack thereof will affect pricing both with respect to your balance sheet and the ability to keep your professionals paid and your reporting current. A self-filing allows you to hold on to your cash to the extent possible and should help you avoid the ongoing search for financing that is the fate and the downfall of many smaller public companies.

Reverse Mergers. While the term “going public” has traditionally referred to an initial public offering of shares to raise money, IPO alternatives like self-filings and shell combinations make your company public but are not funding techniques. If your company does not already have sufficient revenues to carry it through the process and comfortably cover the extra costs of being public, a separate financing transaction should occur before, or contemporaneous with, the commencement of the IPO alternative.

One of the chief arguments for the cost of a shell (dollars and dilution) is that there is a ready-made float of public non-affiliated shareholders, sometimes numbering in the hundreds, and that this is necessary for a healthy trading market. It is argued that institutional investors may pass on an investment with your company prior to going public if, afterwards, the shareholder float is neither large nor developed. Further, it is argued that a reverse merger results in an active and meaningful trading market commencing immediately following completion of the transaction and regulatory approvals.

This argument requires some careful analysis. While there are always exceptions, the actual percentage of shares owned by public shareholders with no affiliation to the company, or its principals and promoters, is typically very small – maybe two or three percent, so perhaps one to two percent is actually being traded by public. Everything else is controlled by the principals and the typical terms might be delivery of up to 95% of the shares, give or take a percent or two. In some cases, virtually all the float is controlled, directly or indirectly, by insiders. In fact, a colleague recently advised me that someone was selling a shell and was able to deliver 100% of the shares if requested. Hundreds of thousands of dollars for a shell with a symbol only and no real trading market?

So does the argument mentioned earlier - that a shell combination results in an active and meaningful trading market – really end up being valid? It may certainly be “active” since you have long-time shareholders who invested in a different company and who have been hoping for a way to cash out, especially when they see a bit of movement in the price of the stock resulting from optimistic merger press releases. True, some may stay in to see how the new company works out but many of these hopefuls will also be tempted to dump their shares the moment the new company’s plans fail to materialize as fast as these shareholders expect (often unreasonably).

The question regarding whether the trading market is “meaningful” depends on who you ask. The fact that there is a trading market is a positive in general terms however there is often a good bit of insider trading going on initially. If you ask an institutional investor whether two percent is meaningful and demonstrates a trading market with depth, I am fairly certain the answer is no, unless the investor is not a long-term institutional investor and, instead, is an investor whose goal is to flip blocks of shares up to the limits allowed once they are registered – actions highly likely to depress the per share price with a thinly-traded stock.

Self-Filings. As an executive of your company, the question you may wish to ask yourself is whether such a thinly-traded and essentially illusory market is worth a half million dollars to you, give or take some. Everyone around you will be looking to make money on the stock market with the company’s shares when everything is underway. Due diligence with a shell is a major undertaking and it is often extremely difficult to tell who all of your shareholders are because of ownership in street name, untraceable ownership entities and so forth. It is not uncommon for shell combination companies to watch their stock rise and fall drastically from unknown parties taking short positions and generally affecting the price of a company’s stock much more than the company’s activities or when there has been no change at all.

What is truly in the interest of your company is the growing of your business. A self-filing means that you know who your shareholders are because your company grows organically. In fact, 40-50 shareholders are all you really need to begin trading and you build from there. Sometimes we’ll do a Regulation D offering or similar private placement immediately before the self-filing to secure some funds and increase the number of shareholders if needed. You may find that it is not that difficult to reach the requisite number of shareholders needed for a public float. You may also find that “meaningful” trading is more likely to come from a base of shareholders who have invested because of the business plan and management of the company rather than a base of shareholders who invested in the past in business of a different company or who have invested recently solely as speculators (nothing wrong with any of that of course but the focus here is on the stability of your public shareholder base).

Once again, I can’t speak for other law firms, but we can introduce our self-filing clients to a team of market makers, investor relations and PR companies, and transfer agents that can assist our clients in their efforts to build their shareholder base in an organized and professional manner. (You would of course discuss your company directly with these firms so that you can mutually decide whether you have a good fit.) If you don’t have one already, you can also bring in a Wall Street-savvy officer or investment banker to help establish your presence in the market and introduce your company to new investors.

Reverse Mergers. One of the benefits conventionally attributed to reverse mergers is speed when compared to IPO’s. Indeed, IPO’s take much longer to complete than reverse mergers, or self-filings for that matter (an often-used rule of thumb for IPO transactions is 9-12 months, although that varies of course). Not only are you dealing with a more complex filing but you are dealing with other parties, like syndicates of underwriters and their counsel, which involve wholly separate negotiations, due diligence and various agreements and expenses, even before you can commence the filing process for the IPO with the SEC. These factors are generally not present in a self-filing.

A proper comparison of the timing differences between a self-filing and a reverse merger can only be accomplished by looking at each transaction in its entirety. A reverse merger can easily take you, as an executive of your company, several months or more. From the point you make the decision, you have to go about the task of finding candidates for a merger. You will likely talk to several sources including investment bankers and brokers. Many of them are professionals with a track record of successful reverse merger transactions and they can provide good advice and experience with their services. Assume that at some point in the process you have located two shell companies and you begin to analyze whether one of these is the right company, with the right principals, to merge with your company. The principals with both shells have represented that their shell is “clean” and the transaction is very straightforward. You will begin to negotiate the price to be paid in cash, the equity of your company to be transferred to shell insiders, the proposed capitalization, including any required stock splits, and similar issues.

At this point, your attorneys will have to commence serious and detailed due diligence with respect to the shells. Did they have a bona fide, fully-operating business when they first went public or would the SEC view them as “Footnote 32” companies? How did the shell become reporting? What were the past circumstances with all past share issuances and does a complete shareholder transfer register exist? What about non-disclosed liabilities? These and other important due diligence items may not seem crucial with respect to the actual closing of a reverse merger and becoming public. The real problems might arise if you have promised investors that you will register their shares promptly following the merger because the registration of shares for sale to the public prompts the SEC to take a closer look at items such as the validity of registrations or exemptions relied on by the company with respect to shares already issued by the company as reflected in the registration statement under review.

Performing thorough due diligence on shells is not an easy task, and is the subject for an entire article on its own. Your attorneys will spend significant time performing a proper due diligence review and, if you are lucky, one of the shells will pass muster. Sadly, the likelihood is that you will have to look at other shells and go through the entire process again before finding one that you and your attorneys are comfortable with. There is often a search for funding at the same time (after all, the reverse merger is going to have a big price tag) and you may find that an investor prefers a different structure or has its own shell so you have to stay uncommitted to a certain extent. I have seen this dynamic play out for months at a time with the company relying on third parties, never being fully in charge of the process and more often than not unable to work out terms it prefers. Often, by that point, a company imposes on itself an urgency to complete a deal. It is so far down the road with so much invested in the process, in time and expenses, that it has difficulty backing out and is saddled with terms it would ordinarily reject.

At the same time, you will have to work with your attorneys so that they can draft the company’s “Super 8-K” filing (so-called because of the substantial amount of information now required in a filing for a reverse merger), draft merger documents, make filings with the state, and so forth. You will also be working with your accountants so your company will have audited financial statements. In fact, getting final audited statements can often take longer than virtually everything else.

Self-Filings. So - the reverse merger process from beginning to end can easily take several months, if not more. On the other hand, it may only take only one to two months longer, if that, to complete a self-filing. (Our firm will generally quote four to five months but we have been successful in obtaining SEC approval for many of our self-filing clients in less time.) During this period, you would have more direct control over the process and the timeline and will not be relying on third parties to the extent generally necessary for a successful shell merger. Instead of qualifying merger candidates and negotiating different terms with different parties, a self-filer can spend that time concentrating on funding and running the business. As an aside, our firm works with several different SEC accountants who are accustomed to dealing with small public companies on a fast-track basis and at a very competitive cost. If they wish, our self-filing clients can speak directly to these firms to discuss their needs.

Reverse Mergers. One of the most significant problems faced by any reverse merger company, or any company that has ever been a shell, has resulted from the SEC’s recent rulemaking with respect to Rule 144.

Since 2000, no resales of shares issued in connection with a reverse merger were permitted without registration of the shares (as opposed to registration of the company) with the SEC. This was applicable to all holders of restricted and non-restricted shares of trading shells and non-trading shells, regardless of whether they were reporting or non-reporting (I’ll refer to all of these categories of holders, including those of operating companies that have ever been shells, as “Shell Stockholders”). With a release issued by the SEC in December 2007, the SEC reversed its “registration or hold” policy with respect to shell transactions and opened a window slightly for Shell Stockholders. Upon the February 15, 2008 effective date of the release, a Shell Stockholder became able to resell securities in reliance on Rule 144 if 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 type information with the SEC reflecting its non-shell status. The issuer must also have filed all reports and material required to be filed under Section 13 or 15(d) of the Securities Exchange Act, as applicable, during the preceding 12 months.

While the SEC has offered some limited liquidity to Shell Stockholders – and that was good news in view of the prior no-sale rule – the SEC mandated at the same time that the company must remain current in its reporting requirements, essentially forever, if its shareholders ever desire to sell their shares after the initial 12 months of reporting. If for any reason the issuer falls behind in its reporting filings, its shareholders would be unable to avail themselves of Rule 144 regardless of how long they have held their shares. It is far from clear what is required for a non-current reverse merged company before reliance on Rule 144 is once again possible but a strict reading of the release could require another 12 months of uninterrupted current filings before unregistered shares might once again be sold in reliance on the rule.

Further, while there are efforts among private practitioners to get the SEC to relent from this treatment (e.g. perhaps if it has been a number of years since the termination of the company’s status as a shell or some other arbitrary factor) there is still no further revision or interpretation to rely on and no way to tell when or if such a change will be forthcoming. Despite the consternation in the reverse merger industry in 2000 with the SEC’s prohibition of all sales without registration, it took eight years for the SEC to loosen the grip slightly.

Self-Filings. This is not an issue with a company that has self-filed with the SEC because it was never a shell company and does not have the associated limitations placed on it. Not only can holders of unregistered shares sell their shares without concerns regarding any potential lags in reporting filings, their holding period is only six months after completion of the filing with the SEC.

Reverse Mergers. While Shell Stockholders may now have the right to have restrictive legends removed after their company has become an operating company and has been reporting for at least 12 months, actually accomplishing the legend removal has become more problematic (and, in some cases, impossible). Since the reporting filings of a company must be perpetually current, attorneys (who must render opinions of counsel that a restrictive legend may be removed) and transfer agents (who must cancel the share certificates on behalf of the company and reissue non-legend free trading shares) are simply unable to do what is normally done for companies that have never been shell companies.

Traditionally, a shareholder may request that a legend be removed after the expiration of the applicable waiting period and a process involving the company, its counsel and the shareholder’s broker begins and finally culminates with the request made to the transfer agent. Once the restrictive legend on the share certificate is removed, the shares become freely tradable from that point forward. In the case of shares of a Shell Stockholder’s shares, an opinion of counsel cannot be issued to remove the legend indefinitely because, while the company may be current in its reporting on the date of the opinion, there can be no assurance that the former shell company will be current in its reporting at the time the shareholder desires to sell the shares, as is required by the SEC.

There are ways to draft Rule 144 opinions artfully to deal these new hurdles but if not done correctly, you may face problems at the transfer agent stage. Many transfer agents hesitate to lift the restrictive legend in close cases because, even if the company is current in its reporting on the date the legend removal is requested, if the transfer agent removes the legend it is possible that the former shell company will not be current in its reporting at the time the shareholder actually decides to sell the shares in the future. In such case, the transfer agent does not want the liability of having removed a legend from a certificate which would enable the shareholder to sell the stock without compliance with Rule 144.

Self-Filings. Once again, a company that files directly with the SEC has none of the foregoing issues with respect to removal of restrictive legend because it became public through the front door with a direct filing. When a shareholder desires to sell his unregistered shares after the six month holding period, he or she uses the traditional legend removal process and the transfer agent cancels the old certificate and issues a new, free-trading certificate to the shareholder for deposit with a brokerage firm.

Reverse Mergers. Obtaining new financing for a company that has ever been a shell has also been substantially complicated. Financing obtained through a PIPE (private investment in public equity) and similar private funding will include “registration rights.” The company is typically required to complete and file a registration statement registering the investor’s shares so that they become free-trading as soon as possible after the investment. The company is also typically required by the investment documents to keep the registration of the investor’s shares effective until the earlier of (i) the sale of all shares that were registered by the company for the investor, or (ii) such time as the holder of the shares can sell in reliance on Rule 144. In the case of a former shell company, the holder will face the new, more encumbered regime of restrictive legend removal and will likely rely strongly on the Company’s pledge to keep the registration effective (possibly for years). The former shell company in need of financing may find itself in an untenable position. It must either agree to maintain the effectiveness of the registration indefinitely (at significant financial, administrative and operational costs and at the risk of facing stiff penalties under the registration rights provisions) or negotiate terms from a weaker position and give up more to escape the onerous requirements of maintaining an effective registration for years.

Self-Filings. These difficult issues do not exist if your company self-files. While you will agree to register the investor’s common stock to the extent permitted by SEC guidelines, six months is the limit of your liability to maintain the effectiveness of the registration statement. After six months, investor shares will not require registration because the investor can secure an appropriate opinion of counsel and have the restrictive legends on their shares removed through cancellation of the legend certificates and reissuance of clean certificates by the transfer agent.

There are indeed compelling reasons to consider self-filing as an IPO alternative but remember that this article only addresses this complicated area in very general terms. If your company is currently considering your options or long-term strategies in this regard, we’d be pleased to discuss them with you. Be sure to send me an e-mail and let me know if this article was helpful to you or if you would like to learn more about how we can assist you in your ventures.

Following proposed changes in July 2007 and a flurry of subsequent formal comments, the Securities and Exchange Commission issued a release on December 6, 2007 detailing amendments to Rule 144 and Rule 145 (although the release also addresses important related issues). One of the SEC’s primary objectives in adopting these amendments was to facilitate capital formation. In large part, the SEC accomplished this and several of its other objectives.

Thinking through my experiences in past shell transactions, reverse mergers and other going public alternatives, I have to say there are certainly some revisions that could be expanded further. Don’t get me wrong though – there are plenty of reasons to be pleased with this release as is. In addition to shortened holding periods for Rule 144 stock, there are advances for shareholders of companies that are or used to be shell companies as well as companies that may fit the technical definition of “shell company” but are, in fact, bona fide small operating companies.

Some of the most significant changes are summarized below but bear in mind that the release is well over 100 pages long (and references hundreds of pages of related releases and commentary). Many of the changes are subtle and a full understanding requires a broader knowledge of securities law beyond what is written in the release. (Translated: Keep your securities attorney on speed dial when venturing into these areas, especially where anyone else’s cash might be on the line.)

Restricted Securities. Generally, if you acquire securities that are not registered with the SEC, they are deemed restricted securities and you must find an exemption from the SEC's registration requirements to sell them in the marketplace. Restricted securities are securities acquired in unregistered, private sales from the issuer or from an affiliate of the issuer. Investors typically receive restricted securities through private placement offerings, Regulation D offerings, as compensation for professional services or in exchange for providing "seed money" or start-up capital to a company.

Control Securities. If you acquire control securities, you must also find an exemption from the SEC's registration requirements to sell them in the marketplace, even if those securities are registered, since they are deemed restricted for other reasons (e.g. stock held by those presumed to have insider knowledge has restrictions). Control securities are those held by an affiliate of the issuing company. An affiliate is a person, such as a director or large shareholder, in a relationship of control with the issuer. Control means the power to direct the management and policies of the company in question, whether through the ownership of voting securities, by contract, or otherwise. If you buy securities from a controlling person or affiliate, you take restricted securities.

Section 4(1) and the Underwriter Presumption. Section 4(1) of the Securities Act of 1933 (the “Securities Act”) provides that the registration requirements of the Securities Act “shall not apply to transactions by any person other than an issuer, underwriter, or dealer.” Section 4(1) was intended to exempt only routine trading transactions between individual investors with respect to securities already issued and not to exempt distributions by issuers or acts of other individuals who engage in steps necessary to such distributions. If you receive newly-issued securities directly from the issuer (or an affiliate), or receive securities as a result of a business combination or similar transaction, you would likely fall under the SEC’s broad definition of an underwriter if you attempted to sell shares into the market without registration. (Even individual investors may be deemed to be “underwriters” within the meaning of the statute if they act as links in a chain of transactions through which securities move from an issuer to the public.)

Rule 144 Safe Harbor. Given the difficulty of proving that you are not a statutory underwriter, the SEC created Rule 144.  Rule 144 provides a “safe harbor” 
or the resale of restricted and control securities because if you hold the securities for the period of time required by Rule 144, and satisfy a number of other
conditions of the rule, the SEC will presume that you do not fall within the definition of an underwriter under the statute. If so, you are permitted to sell the
securities publicly without registration. The SEC amendments recently made it much easier to comply with those conditions.

 
For both affiliates and non-affiliates, the Rule 144 amendments significantly shorten the holding periods applicable to resales of securities and lessen or 
reduce other requirements144 as well.

Affiliates. If you are an affiliate of a reporting company, you may resell restricted securities after a six-month holding period (previously one year), subject to the public information, volume, manner of sale and Form 144 filing requirements. These requirements apply as long as you remain an affiliate. The time period increases by six months if the company is non-reporting.

Non-Affiliates. If you are a non-affiliate of a reporting company, you may resell restricted securities after a six-month holding period, subject only to the public information requirement. If the company is non-reporting, no sales are permitted for 12 months. After holding restricted securities of both reporting and non-reporting companies for 12 months, non-affiliates may resell their securities without restriction.

The SEC’s revised holding periods and resale restrictions are summarized in the following chart:

In addition, the amendments changed additional parts of Rule 144 and raised the thresholds that trigger the requirement to file Form 144 to trades of 5,000 shares or $50,000 within a three-month period for affiliates. Of course, restrictive legends on stock certificates will still have to be removed to enable trading and issuer placement agents will likely continue to demand opinions of counsel acceptable to the company that all Rule 144 requirements have been met before they remove the legends.

Rule 145 of the Securities Act provides that exchanges of securities in connection with business combination transactions subject to shareholder approval constitute sales of those securities, which must be registered under the Securities Act. Prior to the current amendments, shares received by certain shareholders of an acquired company in a stock-for-stock transaction were subject to resale restrictions because they were presumed to be statutory underwriters. The Rule 145 amendments eliminate the "presumptive underwriter" doctrine with regard to these business combination transactions except with regard to transactions involving blank-check or shell companies.

Shell Companies / Reverse Mergers. The past seven years have required some extra work and creativity for entrepreneurs and attorneys structuring transactions with newly-formed and trading shells. On January 21, 2000, Richard Wulff of the SEC wrote a letter in response to an earlier letter from Ken Worm of the NASD (now known as the “Worm-Wulff letters”) advising that Rule 144 was not available for the resale of securities initially issued by companies that are, or previously were, “blank check” companies (defined by the SEC as “a development stage company that has no specific business plan or purpose or has indicated its business plan is to engage in a merger or acquisition with an unidentified company…” The SEC didn’t actually define the term “shell company” until later).

Remember the “presumed underwriter” issue discussed earlier in this article? It was the SEC’s view that “transactions in blank check company securities by their promoter or affiliates….are not the kind of ordinary trading transactions between individual investors of securities already issued that Section 4(1) [of the Securities Act] was designed to exempt.” Given that analysis, the SEC stated that “both before and after the [reverse merger], the promoters or affiliates of blank check companies, as well as their transferees, are “underwriters” of the securities issued. Accordingly, we are also of the view that the securities involved can only be resold through registration under the Securities Act.”

Therefore, the safe harbor exemption of Rule 144 was not available, even if there was technical compliance with the rule, because the resale transactions appeared to be “designed to distribute or redistribute securities to the public without compliance with the registration requirements of the Securities Act.” This has generally been the prevailing law since 2000 – no resales of shares issued in connection with a reverse merger have been permitted without registration of the shares (as opposed to registration of the company) with the SEC. This became applicable to all holders of restricted and non-restricted shares of trading shells and non-trading shells, regardless of whether they were reporting or non-reporting.

With its December 2007 release, the SEC has reversed its “registration or hold” policy with respect to shell transactions and has opened a window for purchasers of shell securities. Upon the February 15, 2008 effective date of the release, a security holder may resell securities subject to the Rule 144 if the following conditions are met:

a) The issuer of securities that was formerly a reporting or non-reporting shell company has ceased to be a shell;

b) The issuer of the securities is subject to the reporting requirements of Section 13 or 15(d) of the Exchange Act;

c) The issuer of the securities has filed all reports and material required to be filed under Section 13 or 15(d) of the Exchange Act, as applicable, during the preceding 12 months (or for such shorter period that the issuer was required to filed such reports and materials), other than Form 8-K reports; and

d) At least one year has elapsed from the time the issuer filed current Form 10 type information with the SEC reflecting its status as an entity that is not a shell company.

While many of us in the industry had hoped that we would also see a six-month holding period applied to these transactions as well, there is still reason to be pleased. Rule 144 is now available for the resale of restricted and non-restricted securities that were initially issued by (i) a reporting or non-reporting shell company or affiliate; or (ii) an issuer that has been at any time previously a reporting or non-reporting shell company or affiliate. Be aware, however, that numerous subtleties exist and your factual situation is often not as clear cut as you would like. Issues regarding shares of companies that had been legitimate public companies but later became shells, late filings during the one-year period, when the clock starts ticking, and other twists are subjects for another article. In fact, one of the most important “twists” facing shareholders of a company that has ever been a shell company involves the cancellation of share certificates bearing restrictive legends and the issuance by the transfer agent of new share certificates from share certificates. The process has become significantly more complicated for transfer agents, and attorneys who must give Rule 144 opinions, due to a variety of issues raised by the new rule and holders of shares of former shells may find that, while their shares may finally qualify under Rule 144, the holders might not be able to obtain non-legend share certificates.

PIPE Financing. Investment through a PIPE transaction (private investment in public equity) in a company that originated as a merger with a public shell faced the same prohibitions resulting from the Worm-Wulff letters. The securities had to be registered before they could be traded so detailed “registration rights” agreements were required as part of the transaction.

Registration agreements are typically accompanied by harsh penalties such as liquidated damages to make sure the company performed on its promises to register the PIPE investor’s securities for resale. In addition, because of the initial restrictions on share registration and concerns regarding what percentage of shares would be permitted by the SEC given certain other SEC rules and factors, shells often needed to accept the investment at a significant discount to value in the case of a trading shell.

While PIPE investors will continue to insist on registration rights agreements and other protections, the current amendments will generally provide earlier liquidity for PIPE investments in companies that have not been shells. With respect to investment in companies that were shells, there is at least the chance of some liquidity assuming the company has met the SEC requirements over the past year and it continues to remain current so long as the PIPE investor owns shares.

Self-Registrations. The BIG winners with regard to these recent amendments are companies planning a self-filing (when a company registers directly with the SEC). In a self-filing, not only does the company become a publicly reporting, but the company also registers shares of its recent investors, management or its other private shareholders, unlike a the filing involved with a reverse shell merger.

Since the self-filing company was never a shell company, it benefits greatly from the new Rule 144 holding period. Holders of shares that were not registered by the company in the initial round will be able to request that the restrictive legends on their share certificates be removed after only six months. Assuming the company is current in its SEC information reporting filings and that there is not another restriction on trading (e.g. insiders are subject to certain restrictions), the holders generally will be able to sell their shares on the open market after their six month holding period. Be sure to engage an experienced securities attorney to strategize with you regarding the best structure and timetable to accomplish your self-filing.

Start-Up Companies. For a number of years, companies in the start-up or development stages that want to be publicly-registered for valid purposes (e.g. to be in a position to attract financing needed to accomplish their business plan) have faced a significant SEC problem. There is a risk of being categorized as a “Footnote 32 shell” (so dubbed because of a footnote in SEC rulemaking related to reverse mergers in 2005). In Footnote 32, the SEC refers to transactions where the company filing with the SEC is actually not a legitimate business, or where it is a legitimate business with only nominal assets. In either case, the intent of the promoters or affiliates is to find a private company with which to merge with a new business resulting. In Footnote 32 scenarios, however, none of this is disclosed to the SEC, thereby avoiding the characterization of the company as a shell and the numerous restrictions on shells.

Start-up companies have faced the risk of being characterized as a shell because of their limited operations or nominal assets. With the recent December 2007 release, however, the SEC indicated (interestingly in another footnote) that “Rule 144(i)(1)(i) is not intended to capture a “startup company,” or, in other words, a company with a limited operating history, in the definition of a reporting or non-reporting shell company, as we believe that such a company does not meet the condition of having “no or nominal operations.” Therefore, in the event a company is a legitimate business and that business continues into the future, the new six-month holding period should apply. (Warning however: Footnote 32 is very much alive at the SEC with regard to shell companies that are masquerading as start-ups but never hire employees or even open bank accounts - in actuality, they often use the company’s cash to pay salaries and search for public shell companies with which to merge. Even a company that has ceased being a shell and has been trading for some time has significant risk if at some point in the past it was a Footnote 32 shell.)

For the most part, the SEC has taken significant steps to facilitate a company’s capital formation needs. Companies that work experienced securities counsel to self-file with the SEC are the big winners this time. Because of the recent amendments, they can now offer potential investors faster liquidity and improved information in most circumstances. Generally the amendments to Rule 144 should make capital raising and stock-for-stock acquisitions easier and less costly. Further, the revised holding periods and other amendments that have been adopted are “retroactive,” meaning that they are applicable to securities acquired before or after the effective date of February 15, 2008.

Regardless of the new amendments, however, continue to bear in mind that SEC rules are not available with respect to any transaction or series of transactions that, although in technical compliance, is part of a plan or scheme to evade the registration provisions of the Securities Act. In such cases, registration under the Act is required. The final release is available at http://www.sec.gov/rules/final/2007/33-8869.pdf. Many other issues are addressed in the release. Perhaps I will deal with some of them in a future article. Be sure to send me an e-mail and let me know if this article was helpful to you or if you have other questions before continuing further in your own ventures.

dshaheen@burkreedy.com

Whether it’s selling stock in exchange for equity of your company, selling notes to bring in money as a loan from private investors or whether other types of securities like preferred or convertible instruments are being offered, the process of raising money for your venture is made easier and safer for you if you comply with the requirements of Regulation D of the Securities Act of 1933 (“Reg D”).

These Reg D requirements extend far beyond document format. In fact, you can have a document formatted as a Reg D private placement memorandum (“PPM”), yet your offering may still fail to comply with Reg D for a variety of reasons, either because of the way disclosures are made in the PPM or the way the offering is conducted by the company or otherwise. If your offering does not comply with Reg D, (i) you will not benefit from the protections provided by the Reg D “safe harbor” and (ii) your potential exposure to liability in the future from an unhappy investor increases greatly. (One of the prime reasons to raise funds through a proper Reg D offering is to reduce your exposure to liability while at the same time increasing your control over the investment process.)

Attempting to comply with a complicated, interwoven set of securities regulations and statutes without using a securities attorney does your company no good and sometimes may cause a good deal of harm. You have put time and money into your venture but here is absolutely the wrong place to cut costs. This logic applies equally to an accounting firm. You should have your securities attorney and your accountant involved at the earliest stage. You are seeking money from other people – do it right! Even though I am a securities attorney and can tell you about the multitude of sections throughout the PPM that need to be drafted with the correct “twist of the phrase” (and the numerous other sections that must be qualified, limited or expanded), there are many practical reasons why you should not proceed without securities counsel. As mentioned previously, you limit your exposure greatly by raising funds in compliance with Reg D. In addition, investors are likely to think twice about investing in a company or venture that has not retained counsel. From a business standpoint, your attorney can assist tremendously in the structuring of the deal, perhaps finding more value than you thought was there, planning the roll-out of the offering to match capital requirements or making sure that your desired exit strategy is factored properly into the transaction. From an organizational standpoint, your attorney serves as your quarterback in lining up all the required pieces and information, reporting the progress to you as needed and freeing up your time to concentrate on your core business.

A securities attorney will often be amenable to working out a flat fee arrangement with you so that you can budget out your expenses. (Since we do so many Reg D’s, we have a good idea of what they will entail and have no problem offering the client a flat fee as an option to hourly billing but I can’t speak for all attorneys of course.) I will close this section by simply remarking that the law always changes – just recently new changes were made affecting Reg D offerings. You need to make sure the attorney is a securities attorney – not someone whose practice is, for example, litigation or wills and estates. If you want to sue someone or need a will, that’s the time to go to those specialists.

You may have a first-rate business plan but if you are seeking funding from a number of investors, it does not replace a PPM. While it may serve as an excellent internal document for determining attainment of sales or financial objectives, or to describe the business to a bank or another third party, it is not designed to satisfy the requirements of Reg D. In fact, a PPM is the ultimate business plan. It incorporates descriptions of management, the product or service, the competition and industry, the plan for marketing, sales and growth, and so forth and includes the many additional disclosures required by securities law as well (in a format experienced investors are used to seeing). It is not just the inclusion of additional information and disclosures that differentiates the PPM from the business plan. It is also the way the documents are written, which is actually a reflection of their intended use. The typical business plan is somewhat sales-oriented (appropriate for its intended reader) while a PPM is disclosure-focused and meant for review by investors. Because of this, some portions of a business plan may be used in a PPM as good supporting data but the actual text often requires a good bit of revision for a variety of reasons. This does not mean that a PPM can not be positive with respect to the market and potential growth of the company. Rather, favorable disclosure items are described consistent with securities law requirements and matters that may negatively impact the company are clearly disclosed as well – an investor reviewing a PPM for a Reg D offering knows he or she is getting the full story but a business plan will always leave questions.

You must view the PPM’s full disclosure of positive and negative aspects as your ally! When a client asks: “Do I really have to disclose that?” my response is always “Will it make a difference to the investor when considering whether or not to invest?” If it might make a difference, then it should definitely be disclosed. The PPM will also indicate there is no guarantee of success. Remember the end game – you are seeking investments from people who have money to invest (and have money for lawyers as well). You want to make sure that you decrease your exposure to liability during this process. If an unsatisfied investor comes to you in the future says “You never told me about ____,” you can refer him to the PPM where he was informed, probably several times, in writing. While there is, understandably, some discomfort with the extent of disclosures made in a PPM, my personal experience leads me to believe that investors are rarely surprised that there are risks – it generally comes down to the merits of the deal and they would be surprised if there were no flaws in the company or the transaction.

The general rule is that an entity may not make a public offering of its securities (stock, bonds, LLC interests, etc.) unless (i) the securities are registered with the SEC or (ii) the company is exempted from registering the securities being offered because the offering is deemed to be a private offering. Many factors determine whether this is the case and, if ever necessary, a company may have to prove those factors existed and it was therefore exempt from registration requirement. Recognizing the need for small companies to raise capital more easily, the SEC enacted Regulation D as a “safe harbor.” Reg D is not the only way to conduct a proper limited offering but if a company complies with Reg D, it will not have to prove it was exempt from full registration, if ever necessary in the future. This was a huge boon to the small to mid-size company capital market and Reg D continues to be revised in response to the market. While the format and content of the PPM are extremely important, the actions taken afterwards during the process of seeking investment are equally important in order to comply with Reg D. Advertising for investors, improper use of electronic media or the use of improperly drafted marketing pieces or executive summaries can be fatal to your attempts to comply with Reg D. In addition, the failure to make appropriate filings with the SEC and the states where your prospective investors reside can also preclude you from the benefits of Reg D. Following all the hard work by the company and its securities counsel during the preparation of the PPM, many mistakes can still be made – company and counsel must continue to dot the i’s and cross the t’s throughout the offering process to insure the Reg D exemption remains intact.

Many companies, complying with Reg D in other respects, go astray with their use of finders. The use of finders, even if you call them consultants, advisers, wholesalers or some other name, is a tricky matter and needs review on a case-by-case basis. It is not a question of integrity of the finder or amount of fee. (Value delivered deserves proper compensation). Rather, this is an issue related to the manner of your offering which, by its nature, must be non-public and limited in order to comply with Reg D. Remember that your company (through its key officers and directors) is one of the principals in the transaction, selling securities, and the other principal is the investor as buyer of the securities. Third party intermediaries presenting the offering, providing information, answering questions and otherwise facilitating the transaction are brokering the transaction between the two principals. When you buy stock in an exchange-listed company, you buy it through your broker representative who is licensed by the National Association of Securities Dealers (“NASD”). Brokerage firm representatives are regulated, are presumed to know the investment intentions and risk tolerance of their client investors and are traditionally paid a fee based on the amount of the purchase transaction (typically referred to as “transaction-based compensation”).

In the typical finder scenario, however, the finder often acts in a manner similar to a licensed broker, presenting the investment transaction, answering questions and then arranging a conference call or an initial meeting. If an investment follows, the finder expects transaction-based compensation (cash and/or stock), which is typically negotiated by a finder to be a percentage of the investment. The problem here, however, is that the typical finder is not licensed with the NASD. Nevertheless, if a finder is acting like a securities broker, the law generally requires the finder to qualify and register as a broker. This is clearly the case if a finder is providing this kind of service on a regular basis. If the finder is actually “in the business” of providing the services of a broker then he or she must be licensed. Both state law and federal law require it. The Reg D filing with the SEC requires a listing of the brokers in your offering and the states, in particular, have a strong interest in protecting their residents by regulating the parties who seek investments from them.

It is far preferable to utilize a licensed NASD broker to sell all or a majority of your securities. Simply said – just agree to pay the brokerage firm its standard fee for monies raised and let it present your deal to the firm’s investor pool in an organized, professional manner. If you cannot interest a broker in your deal, there are situations where isolated transactions, special provisions in state law or specific situations may allow a company to use the services of a finder. You may feel the pressure to accept funds through a finder but seek the advice of counsel and move forward cautiously. One complaint to one state securities administrator can lead to a real problem.

Despite your best efforts, a number of mistakes can be made when undertaking a Reg D offering. The positive side, however, is that Reg D offerings are conducted successfully every day throughout the country. They are flexible enough to suit most any company’s needs and can be structured as the financing component of a larger business objective such as a merger or PIPE transaction. In short, Reg D continues to be the best show in town for private financings.

Be sure to send me an e-mail and let me know if this article on Reg D was helpful to you or if you have other questions before embarking on your own funding efforts.

This article should not be construed as legal advice. Due to the complexities of Regulation D, the specific facts and circumstances and the current status of the law must be carefully considered when seeking to benefit from the Regulation D safe harbor exemption.

If you are seeking private investors to help fund your venture, you need to consider following the guidelines provided by Regulation D of the Securities Act of 1933. Why? Some of the many reasons are:

(i) Potential investors will receive the kind of professional investment package from you that they are accustomed to receiving from others seeking their investment dollars.

(ii) If you comply with certain rules of Regulation D you will not be subject to a ceiling on the amount of investment you can seek.

(iii) Because your investment is structured as a Regulation D transaction, you are better able to retain your desired equity or other deal terms in the face of investors who will be seeking better terms or concessions.

(iv) You will get the kind of protection from lawsuits and liability that you would never get using only a business plan (even a well-crafted one) or a similar generic investment document.

I have often begun seminars on venture financing with a simple maxim: If an investment is involved, it almost always involves an “issuance of securities” – in exchange for dollars, the company issues securities to the investor representing an interest in the company (in ownership, rights to payments or otherwise). It doesn’t much matter whether you call the interests issued to the investor shares of stock, LLC units, options, participating interests or otherwise – if someone invests money with the hope of receiving a profit mainly from the activities of the company or venture, you are dealing with a securities offering (you offered the securities, the investor gave something of value, you issued the securities.)

There are a lot of factors involved but its best to just assume you are involved in a securities offering (this is true even if it is a minimal dollar amount). As I learned as a young intern at the Securities and Exchange Commission, before you offer and issue any securities, they must be registered with the SEC (i.e. public registration subject to SEC review of prospectus and comments) or there must be an exemption from this type of registration.

The key is making sure you have an exemption from registration that you can “hang your hat” on. Companies taking in investor funds without regard to complying with an applicable exemption are taking on a significant risk because any company involved in a securities offering might be required in the future to affirmatively prove that there was an exemption that applied to them at the time securities were sold. For example, let’s say one of your investors has a problem with you or your company two years after investing and decides to sue (the thing about investors is that also have the money to hire lawyers…) You should assume one of the claims will be that the company offered and sold “unregistered” securities in exchange for his investment. The inability to refute this claim could spell disaster for your company and its other investors (your situation just became more precarious). While there are a few exemptions other than Regulation D that may apply, there is no “slam dunk” because you still have to prove you complied which can be tricky.

Like many other practitioners, I will often rely on the exemption from registration provided by Regulation D because, when complied with, it provides the client with a “safe harbor” from the general registration requirements enforced by the SEC. This is key so I will repeat it - when the various rules and provisions of Regulation D are complied with, you can rely on this “safe harbor” exemption from registration while seeking your funding. Many issues (relating to numbers of investors, specific information disclosed, limitations on soliciting interest and so forth) are involved in complying with Regulation D but, if you do comply, you can breathe a bit easier.

Yes, it takes some additional legal and accounting fees in the initial stages to complete a Regulation D offering document and to conduct the offering in the required manner (changes to specific provisions of Regulation D occur occasionally with a number of revisions under way right now at the SEC). At the end of the day, rely on your professional advisors and their input to help guide you in your decision regarding funding strategy and future risk assessment.

A great number of issues touched on briefly here are beyond the scope of this article but I will get into these in more detail in future articles. If you have questions or comments, send an email – perhaps I can address something of particular interest to you in the future.