Tip of the Week - Beware Footnote 32

As mentioned in my book, a tiny footnote in the SEC's rulemaking on reverse mergers in July 2005 essentially invalidated, in my mind, a large number of publicly trading shells. Sometimes a "company" (sometimes an actual tiny business and other times an entity alleging it is a start-up) completes an IPO or other going public event with the plan to either shut down the business or transfer it back to the promoter upon a merger with a real operating business. If that intention is not disclosed, that company is deemed a shell company under SEC rules from day one. There are a number of implications of this, but in my view this is fraud, plain and simple and I urge clients to stay away from shells which might contain these characteristics.

Why do people do this? Because SEC Rule 419, passed in 1992, makes it extremely difficult to complete an IPO of a blank check or shell company, and never permits trading in the shell's stock prior to a merger. If you intend to be or are an operating business, even a start-up, Rule 419 does not apply to you and you can go public and start trading, which rather dramatically increases the market value of the shell. Thus savvy promoters sought an end-around this rule through this tactic.

Here are the telltale signs of a "footnote 32 shell:"

• A start-up or very early stage company is doing an IPO or other "going public" filing and allowing shareholders to resell their stock in the public market.
• The filing is completed less than one year after the company is started.
• The IPO is seeking to raise very few dollars (maybe $100,000), and may actually raise even less.
• Management of the "company" has little or no experience in the supposed business they are entering into or has experience in the securities or consulting business or other area of Wall Street.
• Sorry to say this, but the company claims to be based in Utah, Nevada or Canada.
• Sorry to say this, too, but the company intends to be engaged in a business relating to oil, gas, mineral rights, or to own rights in entertainment projects that are not yet developed.
• The officers, directors, large shareholders or consultants of the company have done it multiple times before.

Of course not every company with these characteristics is a sham. The SEC has told me they are stepping up enforcement efforts on these shells. The fact that the SEC let a footnote 32 shell go public should NOT be taken as an assumption that the shell is "bulletproof" after a reverse merger. In fact, we hear of comments being received after a merger in connection with a subsequent registration of shares, where the staff is questioning issuances and transfers of shares in the shell prior to the merger under so-called "Worm/Wulff" analysis. Here the staff, after the fact, is suggesting the entity was always a shell and did not declare itself as such.

Why do we care? There are two sets of victims of footnote 32 shells. First is anyone who trades the stock not knowing that the real intent is not to be in the oil and gas business but find a merger, reverse split everyone 1 for 100 and be part of a biotech company. Second are all the legitimate players in the industry who wish to create shells for their own use the proper way and are not permitted to have those shells trade prior to a merger. I applaud all efforts (1) for the SEC to go after these fraudsters and (2) for practitioners to stay away from these very risky vehicles.