By Joseph R. Magnas, Morrison & Foerster LLP
A “shell merger” or “reverse merger” generally refers to the merger of a private operating company into a public shell company with few or no assets. For accounting purposes, the shell must only have nominal assets. A reverse merger with a shell is generally structured so that, upon closing, the private company shareholders receive, in exchange for their shares in the private company, shares of the public reporting company. Once the merger is complete, the private company shareholders, in the aggregate, will hold a substantial majority of the outstanding securities of the combined company, and the operations of the private company become the operations of the public company.
There are many risks to which a post-shell merger is subject, including, but not limited to, the following:
Listing Qualifications for Post-Shell Merger Companies
until there have been six months of trading of the combined entity on the OTC Bulletin Board or other exchange or foreign market;unless the company has maintained a bid price of at least $4.00 per share for 30 out of the 60 days prior to the filing of the applicable initial listing application; andif a domestic company, unless the company has filed with the SEC (or other regulatory authority) its most recent two required periodic financial reports or, if a foreign private issuer, the company has similar information as that for domestic companies but on a Form 6-K, 20-F or 40-F.
The NYSE and the NYSE Amex each filed their rule proposals with the SEC in July 2011. The proposed rules are similar to the Nasdaq proposed rules, but there are differences. Under the proposed NYSE rule, the combined entity must comply with one of certain enumerated listing standards and must have:
traded for at least one year in the U.S. over-the-counter market, on another national securities exchange, or on a regulated foreign exchange following the consummation of the merger and (A) in the case of a domestic issuer, have filed with the SEC a Form 8-K containing all of the information required by Item 2.01(f) of Form 8-K, including all required audited financial statements, or (B) in the case of a foreign private issuer, have filed all of the information described in (A) above on Form 20-F;maintained, on both an absolute and an average basis, for a sustained period a minimum stock price of at least $4.00; andtimely filed with the SEC all required reports since the consummation of the merger, including the filing of at least one annual report containing audited financial statements for a full fiscal year commencing on a date after the date of filing with the SEC either the Form 8-K or Form 20-F referred to above. In addition, a post-shell company will be required to maintain on both an absolute and an average basis a minimum stock price of at least $4.00 through listing.
Under the proposed NYSE Amex rule, a post-shell merger company will not be eligible for listing when the combined entity has, immediately preceding the filing of the initial listing application:
traded for at least one year in the U.S. over-the-counter market, on another national securities exchange or on a regulated foreign exchange following the consummation of the merger and (A) in the case of a domestic issuer, filed with the SEC a Form 8-K including all of the information required by Item 2.01(f) of Form 8-K, including all required audited financial statements, or (B) in the case of a foreign private issuer, filed the information described in (A) above on Form 20-F;maintained on both an absolute and an average basis for a sustained period a minimum closing stock price equal to the stock price requirement, including all requirements based on stock price, applicable to the initial listing standard under which the post-shell merger company was qualifying to list; andtimely filed with the SEC all required reports since the consummation of the shell merger, including the filing of at least one annual report containing audited financial statements for a full fiscal year commencing on a date after the date of filing with the SEC of the filing described in (i) above.
The proposed rules for each of the NYSE and the NYSE Amex provide that the applicable exchange, in its discretion, may impose more stringent requirements than those described in the proposed rule if the NYSE believes they are warranted in the case of a particular company. Additional requirements may be necessitated by, among other things, an inactive trading market in the company’s securities, the existence of a small number of publicly-held shares that are not subject to transfer restrictions, whether the company has not had a Securities Act registration statement or other filing subjected to a comprehensive review by the SEC, or whether the company has disclosed that it has material weaknesses in its internal controls which have been identified by management and/or the company’s independent auditor and has not yet implemented an appropriate corrective action plan. The rules for both exchanges also make clear that the proposed rules do not apply to exemptions for special purpose acquisition companies (SPACs); SPACs remain eligible to rely on the listing standards of the applicable exchange.
An exchange listing is the most likely way that a post-shell merger company may realize some of the anticipated benefits of the transaction. Assuming that an exchange listing is the goal, one would expect that the target shells would have large holder bases so the combined entity would be closer to achieving the applicable listing qualification. Yet we have noted of late that many companies have merged with shell companies with few shareholders, making them less than optimal participants in these transactions. In recent years, so-called “virgin shells” have been introduced to the market. Virgin shells are blank-check entities formed specifically to serve as the shell in shell mergers. Virgin shells have only one or up to a handful of shareholders. They are not quoted on the OTC Bulletin Board or the Pink Sheets and experience no trading prior to the merger. Accordingly, the combined entity realizes no benefits from merging with the shell insofar as moving toward an eventual listing. Virgin shells may, however, help the combined entity become eligible to use a registration statement on Form S-3 sooner because they are reporting companies and, therefore, have a history of reporting. However, other factors may make S-3 eligibility unlikely or irrelevant.
The SEC also has been very active with respect to shell mergers. In a letter dated April 27, 2011, SEC Chairman Mary L. Schapiro responded to a letter from Congressman Patrick T. McHenry regarding the SEC’s efforts to protect investors from shell companies based outside of the United States that violate U.S. securities laws. Chairman Schapiro noted some of the SEC’s efforts that are discussed below (although other SEC initiatives were undertaken after the letter was sent). She stated that the SEC had taken action against a U.S. audit firm relating to improper professional conduct in connection with audit work for a Chinese post-shell merger company. Chairman Schapiro also explained that the SEC experienced significant difficulty and delay in obtaining work papers from foreign auditors, a problem that is addressed in Section 929J of the Dodd-Frank Act which relates to the production of foreign audit documentation. Finally, Chairman Schapiro advised that the office of the Chief Accountant was working with the Division of Enforcement, the Division of Corporation Finance and PCAOB to identify problematic audit practices and auditor conduct in connection with post-shell merger companies, a significant portion of which are from China. The SEC also issued an investor bulletin in June 2011 warning the public of the potential risks relating to investments in post-shell merger companies.5
In recent months, the SEC has suspended trading in a number of post-shell merger companies and has revoked several registration statements. Common issues leading to these actions include the following:
In addition to the foregoing, the exchanges have begun to scrutinize reverse mergers, as seen with the recent efforts by the NYSE, NYSE Amex and Nasdaq to introduce heightened listing standards for post-shell merger companies.
It is also quite important that the private company identify its goals in entering into the transaction. A clear understanding of both the goals and risks will help ensure that the company not be disappointed by the results. For example, if the goal is a quick listing on an exchange, the company must identify a shell with a large shareholder base. It would not be prudent to rely on post-merger trading to increase the size of the shareholder base. If a resale registration is important, a shell with filing history may shorten the wait for S-3 eligibility, which would make the resale registration statement more efficient. The use of a registration statement on a Form S-1 will take longer to prepare and, because forward incorporation by reference of Exchange Act filings made by a company after the filing of the registration statement is unavailable, will require constant supplementing and amending. The continuous filing of supplements and amendments to a Form S-1 will not only increase those filing/printing/legal costs—it may also result in trading halts while amendments are waiting to be declared effective.
A foreign company that merges with a U.S. shell will not be eligible for foreign private issuer status. Foreign private companies must be sure they understand that they will lose the advantages available to foreign private issuers with respect to reliance on home country corporate governance practices and with respect to SEC filing requirements.
Last, the post-transaction company will be a public company like any other public company. Accordingly, it will be subject to Sarbanes-Oxley compliance, corporate governance issues and other public company issues. These obligations will be greater if the company is listed on a national securities exchange. Many companies find that these costs quickly make the savings realized by pursuing a shell merger over other transactions insignificant.
Although there are many reasons to pursue a shell merger, these transactions are fraught with risk. The risk of fraudulent transactions with Chinese companies is interesting, but the risks relate to all companies interested in these transactions. The decision to complete a shell merger should not be made lightly. A company should make sure that it has considered all alternatives and understands the implications of completing such transactions.
Joseph Magnas is Of Counsel in Morrison & Foerster's Capital Markets Group, based in the New York office. He also serves as Co-Head of Morrison & Foerster’s Israel desk. Mr. Magnas's practice focuses on securities transactions, mergers and acquisitions, private equity financings, and securities-related disclosure and compliance matters. Mr. Magnas represents issuers, underwriters, placement agents, and investors in a variety of financing matters. Mr. Magnas's work in the private equity field includes representation of emerging companies and venture capital investors. In his mergers and acquisitions work, Mr. Magnas represents issuers, strategic and financial market participants, and private equity funding sources.
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