A Shell or Not a Shell?

As discussed in my book, in its June 2005 rulemaking on reverse mergers, the SEC created a new defined term "shell company." Any company that is a shell company is subject to the enhanced disclosure requirements which were adopted in that rulemaking, including the "super 8-K" to be filed within four business days of closing a reverse merger with a shell including audited financial statements and prospectus-like disclosure about the merged company.

One big change adopted as part of all this was a "check the box" requirement on the cover of every periodic filing by every single public company, from General Motors to the smallest reporting company on the OTC Bulletin Board. Every company must indicate whether it is or is not a shell company.

Shell company was defined as any SEC reporting company that has no or nominal assets (other than cash) and no or nominal operations. At the time of proposing the rule, the SEC invited comment as to whether they should be more specific about what nominal means. One of the comments I provided was to request that indeed they provide more clarity on this. In the end, however, the staff did not change the language and felt that setting a threshold would encourage fraudsters to design things with $1 more, etc.

It was a little confusing to the market that another definition, "blank check company," was also in use by the SEC under Rule 419 adopted in 1992. A blank check is subject to numerous restrictions on its ability to register shares to become publicly tradable under the Securities Act of 1933, and is subject to the Worm/Wulff letters which do not allow shareholders to avail themselves of certain exemptions from registration such as Rule 144. Rule 419 defined blank check as a company with no business plan, or whose business plan is to acquire another business.

There are clearly companies that qualify as blank checks but not public shells, and vice versa. The shell definition, I believe, was intended to make life a little more difficult for questionable players putting small businesses into companies and taking them public claiming that they are not blank check companies. Under the new definition these tiny companies usually qualify as shell companies.

Indeed in the famous footnote 32 (see earlier posts) to the rulemaking, the SEC said they are targeting people that do an improper end around Rule 419's restrictions when they put a small business into a company to take it public but with an undisclosed intention to strip out the company upon a merger.

In my practice I have encountered a number of entities being marketed as shells but they do not "check the box." The control people of the shell generally claim they either have assets or operations that are not nominal. The question we constantly wrestle with is, what is nominal? If a public company obtains royalties from a license agreement, what is the agreement worth as an asset? If the company is engaged in research and development, how much spending is necessary for it not to be nominal? Does a company need revenues to avoid having nominal operations, or are expenses enough? What if the company is spending money on finding an acquisition? Does that constitute "operations"?

As we see, there are more questions than answers here. As indicated in my book, it seems that either assets (other than cash) or operations (whatever that means) in excess of $1 million is probably not nominal. Short of that, we have to apply a facts and circumstances analysis to the situation. If you are unsure, it never hurts to contact the SEC and see if they can provide general guidance based on your situation. Or hire me to help!

Have a great week all.