Preliminary Musings as to the New Rule 415 Regime - Now What?

Here are some initial thoughts and humble suggestions as we all adjust to the “new normal” under 415 (remember our first reactions when Sarbanes-Oxley was passed?). Bottom line: it ain’t the greatest but the sky is indeed not falling and I believe the SEC is not trying to stop these transactions but rather to rein in some excessive players, and we can all adjust.

I apologize in advance for the somewhat lengthy post, but we have been waiting for this for eight months, so I wish to cover a number of implications and a new idea worth considering that can eliminate the issue.

PIPEs Market in General

My partners and others, I am sure, will have much to say about the overall implications of the new 415 interpretations on the PIPE market as a whole, so I will not say much other than that deals for the smallest public companies are probably going to be more difficult to do and more expensive for the issuers. This does not seem likely to quell the strong growing market for PIPE investments in any meaningful way. In fact, through all this tumult over the last eight months the PIPE business in our law firm has only grown busier and stronger, and there is no sign of letting up.

My hope is that the SEC staff concentrates on punishing true bad guys in the market and removes as many restrictions as possible on the legitimate players. While we finally have a new standard, which is good, with deference to those I do respect at the SEC, I believe it went a bit too far and is unnecessarily restrictive as a guard against a few bad apples.

I am also disappointed in their approach to a second registration, and hopefully that will be revisited. To suggest that you can never register more shares until the LATER of six months and the time that substantially all the shares in the first registration are sold seems counter to what the SEC is trying to achieve here (ie effectively saying you can never register more until all the shares are sold from the first registration). It makes much more sense for it to be the EARLIER of these two things.

Reverse Mergers- Virgins Win?

As to reverse mergers, I suppose there is both good and bad news, leading to a conclusion that deals should and will go forward, but with different assumptions and expectations.

The bad news is I had hoped there might be a different clear standard for first registrations following reverse mergers than the standard applied to PIPE investments into already public companies. Since there is essentially no “float” in a post-reverse merged company, limiting registration to any percentage of float is almost meaningless. This will require the first few deals to go through a trial and error process to see what will work. Hopefully within a short time we will have a sense of their attitude and approach.

The good news is, the SEC has acknowledged and recognizes this problem, and on Friday SEC top lawyer David Lynn mentioned the “no float” issue and suggested that they would be more receptive to registering a reasonable number of shares after a reverse merger even where there is no float, following the six-factor test outlined in their old telephone interpretation. I was slightly disappointed that it took a question from the audience for him to address this rather than being part of his prepared remarks.

So what does this mean for shell mergers? Let’s remember the concern that the 415 issue addresses: that individuals with tradeable shares might get substantially diluted by a large resale registration with virtually no notice or disclosure. I have argued to the SEC staff, and they confirmed the logic of the argument, that in a merger with a virgin shell, there are literally no tradeable shares prior to the merger, so this concern simply does not apply at all. Every shareholder, before having tradeable shares, understands what percent of the company will become tradeable. In a trading shell there is more of a concern about diluting the public shareholders of the shell with the registration following the merger.

Thus, I believe that the staff will be more receptive to registering more shares in a registration following a merger with a virgin (ie fully reporting but non-trading) shell than with an already trading shell. Now, there are other perceived advantages to a merger with a trading shell, such as a larger shareholder base and the momentum that an immediate trading market after a merger can provide. But I will leave the rest of the trading vs. non-trading argument for another post.

Some say to me, well you support virgins because you get money from many clients doing it and you have a few yourself. It’s the other way around. I encourage my clients to do it, and also put my own interests into them, because I believe in the value of the vehicle. It is not for every deal but has tremendous benefit and simplicity in many situations. It is, frankly, almost an accident that this new Rule 415 analysis ends up helping the virgin shells, but here we are.

Self-Filings and SPACs Also Win

It appears that a PIPE placed into a private company just before it proceeds with a self-filing of an SB-2 or 10-SB will be more favorably received under 415 than a similar PIPE invested into a shell merger or already public company. This is because the staff is more comfortable that the PIPE has been “completed,” reducing the concern that the investor is an underwriter. This should increase the value of self-filings, so long as PIPE investors are willing to make that large investment in a private company initially (some are prohibited by their fund documents). It appears that the staff will be more willing to register a larger percentage of the stock for resale in this situation.

None of the 415 issue affects SPACs, since their money is raised through a primary offering not subject to Rule 415 analysis. SPACs, which have grown dramatically, face other challenges from the SEC, including long delays in getting proxies approved for deals awaiting shareholder approval. But it appears they will continue apace undaunted, and this is a good thing. Also, smaller SPACs, again with no 415 problem, may develop as an interesting alternative to virgins and trading shells, which will continue to face the problem at some level.

How about a Form S-4 in Reverse Mergers? Might just work..

Another approach worth considering that some have begun talking about is to register shares to be issued in a reverse merger under an S-4 registration statement. There would be no limit on the number of shares registered because S-4 involves a primary offering, not a secondary. The problems are (1) that the SEC has to review and approve your S-4, and a merger registration is notoriously annoying and (2) you have to wait to close your reverse merger while they do, which could be several months. However, an S-4 approach should be quicker than a self-filing, which still may undergo 415 review. With the S-4 route you do need a shell to merge into that would be the subject of the registration, whereas in a self-filing no third party is necessary. So weigh your own pros and cons.

Ideally, if a PIPE investor is willing to invest prior to the S-4, you will have raised your money just the same as in a merger with a virgin shell and subsequent resale registration. In both cases there is no trading until a registration is approved, so where that investment is available there may not be much difference, except that the S-4 has the benefit of allowing you to register without limitation.

This approach would be exactly what the SEC is hoping everyone will do – turn secondaries that seem large into primaries. Might be another nice application for the virgins, and would eliminate the 415 issue in a reverse merger with a trading shell.

Conclusion

In sum, I’m happy that the uncertainty is mostly over in this area. We all wish the standard would have been higher, but at least we now have one. It’s workable for most players, and reverse mergers will continue.

In truth, any investor in a PIPE into a reverse merger who was betting on the importance of having tradeable shares within a few months and then in fact trading those shares, made the wrong bet. Most of our clients who invest in reverse mergers understand that it is “public venture capital” and they need to have a longer-term outlook with respect to liquidity. Thus, in reverse mergers, this is simply less of a major concern in most cases. Since the average market capitalization in reverse mergers has hit about $60 million, it also won’t be long before most become eligible for short-form registration and are exempt from the 415 analysis.

So I guess I don’t have to recall all the copies of my book after all…

Summary of David Lynn's Comments Today on Rule 415

Below is a memo just distributed by my partner Joe Smith, who attended the PIPE conference this morning:

To: Clients and Friends of Feldman Weinstein & Smith LLP

January 26, 2007

I just got back from listening to David Lynn, Chief Counsel of the SEC’s Corporation Finance Department, discuss the Staff’s new interpretation of Rule 415 for non-shelf eligible issuers (below $75 million float).

What you need to know:

• The issuer can register up to one-third of its pre-deal public float at one time.
  
  
• There may be certain situations, however, where companies seeking to register more than 10% of the float on behalf of a particular investor may be restricted from doing so, or other limitations below the 1/3 threshold may be imposed if the staff has other reasons to think an investor is an affiliate (certain covenants in debt deals may create this impression, as will deals where the investor is only registering 1/3 of the float but has purchased substantially more than 1/3).
  
  
• The SEC will consider, on a case-by-case basis, allowing more than 1/3 of the float to be registered. This goes back to the six Telephone Interpretation D.29 factors. They will be MORE inclined to let a larger number of shares be registered if the deal is common stock or a non-resettable fixed price convertible, and if there are a larger number of smaller investors; and LESS inclined with a toxic or resettable deal or a deal with fewer, larger investors.
  
  
• Contrary to some press reports from an SEC conference in San Diego, once the first registration statement is effective, the company can file a follow-on for an additional 1/3 of the pre-deal float the LATER OF 6 months after the effective date of the first registration statement, or 60 days after “substantially all” of the registered securities have been sold. This means that investors may be forced to sell out their position sooner than they would wish to in order for the balance of the deal to get registered. Mr. Lynn acknowledged after questioning from the crowd that this was not their intent, and that they may have to “reconsider” this element.
  
  
• If the company does another deal for another purpose (acquisition rather than working capital) while the first registration is out there and yet not used up, they will not block the second registration. They will be looking for overlapping investors, and the issuer will need to show that the deals are unrelated. Mr. Lynn said that they had nothing against an investor who understands the company re-investing but they are looking for “structured” deals which attempt to hide that the investor is an affiliate. Query how this may impact rights of participation.
  
  
• Shell mergers: they don’t have a special rule, but acknowledged that there is no float, so they will let issuer make its case for a useful number of registrable shares on a case-by-case basis. [Feldman comment: this is a positive thing for reverse mergers.]
  
  
• Equity Lines: no new guidance, assume an equity line can be registered for no more than 1/3 of the float.
  
  
• New disclosure rules, which have been circulated in at least one comment letter, will require that each investor disclose, among other things, how many shares it shorted pre-effectiveness and when.

Rule 415 - You Heard it Here First..well after Dow Jones..

At the San Diego PLI conference, SEC Corporation Finance Deputy Director Shelley Parratt was the first to announce the new internal registration guidelines this evening. The standard will be one-third of the non-affiliate stock, below which you're probably OK, and above which they are very willing to entertain arguments that those seeking to register do not meet the test of being an underwriter. The next registration for the same investors, it appears, must wait for 6 months after the PIPE or, if earlier, 60 days after substantially all the shares are sold in the first registration. I'm sure we'll be hearing lots more in the next few days. Bloomberg News, I know, is covering this extensively. More to come when I have it...

Rule 415 Guidelines - Stick a fork in it...

It's done. As I understand it, the SEC staff has now completed their internal guidelines under Rule 415. I believe Marty Dunn will talk about it today in Chicago, and I understand there will be a meaningful media presence, so hopefully we'll hear something even by tomorrow. Also, David Lynn, as previously indicated, is appearing at the PIPE conference here in New York on Friday morning (my partner Joe Smith is speaking at that conference tomorrow). I am confident he will go into detail at that appearance.

My prediction: some percentage of float (ie nonaffiliate stock), similar to other predictions maybe 30-33%, in most PIPE transactions, but with a facts and circumstances test that can go higher, in particular in reverse merger situations. I do not believe there will be a separate reverse merger rule per se, but rather we will do trial and error on a few deals and get a sense. We already know of one company that finally got approved in recent weeks with almost 50% of the outstanding stock following a reverse merger. I also believe Marty and David will talk about how quickly a second registration can get completed. Stay tuned!

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.

Today's Rule 415 Update

As of midday today, the internal guidance at the SEC has not yet been issued, but it is still anticipated imminently. As mentioned below, the hope is that David Lynn's appearance on January 25 at a PIPE conference in NY will provide information. Also, Deputy Director of Corporation Finance Marty Dunn is speaking at Northwestern University Law School's conference on securities law, which runs Jan 24-26. I expect to get reports from that appearance as well. I'll hold off on further blogging on this topic untiil there's some news.

Very soon I hope this will cease to be the "415 blog" and move back to its original purpose!

Top SEC Lawyer to Speak on Rule 415; Other Stuff

David Lynn to Speak: At the PIPE conference in New York scheduled for January 25 and 26, the SEC's Chief Counsel of Corporation Finance, David Lynn, has been confirmed to speak on the issues surrounding Rule 415. My partner Joe Smith is one of the speakers at this conference. Here is a link if you are interested: http://www.frallc.com/conference.aspx?ccode=b407

Miami PIPE Conference: I spoke at the PIPE conference held in Miami this week, along with a very impressive cadre of other speakers. I gave a four-hour workshop on reverse mergers (fun but tiring!), then joined a panel on the topic, as well as a panel put together at the last minute on Rule 415. The views of the 415 panel essentially mirrored my summary on this blog below. All agree we are beginning to come out of the period of confusion and uncertainty that ruled the last few months, and that more clear guidance is expected in a few weeks.

The RM Blog is Growing! I just learned that our average daily page views on this blog are in the mid-hundreds, which is amazing! Thanks to all for your support and don't hesitate to post responses or other thoughts below my posts. I look forward to your input and reactions. I will work to continue to earn your interest and regular visits.

My Meeting with the SEC on January 3 - More Good News on 415

Happy New Year to all!

On Tuesday, January 3, 2007, I met with Martin Dunn, Deputy Director of the SEC’s Division of Corporation Finance (Corp Fin) and David Lynn, Chief Counsel of Corp Fin. Subject to signoff from their boss John White, the Director of Corp Fin, these two, with the assistance of other staffers, have been formulating the Staff’s response in the Rule 415 matter. They are aware that I am blogging on this meeting, and have asked only that I clarify that we had "discussions not pronouncements" and that nothing has been finalized yet.

I apologize for some of the technical language for the non-lawyers, but here are the headlines:

Rule 415 Status: In the internal guidance to be issued, the staff intends to focus on two areas, disclosure and the primary vs. secondary offering analysis. In the latter case, a percentage is going to be set as a threshold. If you seek to register an amount below that percentage, it will be a very good sign that you have a valid secondary offering and the registration can proceed. Otherwise you need to provide ameliorating factors, most important of which appears to be keeping the ownership of any one investor as low as possible. The percentage threshold has not yet been decided upon, nor has it been decided whether the percentage will be based on “float” or outstanding shares.

Second Registration: Assuming the percentage to be registered will be limited, a big question has been, how quickly can a second registration for additional shares be filed? The staff understands the need for the market to have clear guidance on this point, and intends to provide it. The hope is that a second registration can take place relatively quickly, such as within 60-90 days after the first.

PIPE Structure is Irrelevant: To correct certain statements circulating in the marketplace (and possibly representing an evolution of their thinking), they indicated that PIPE structure is not at all relevant, and they have no problem whether the deal is a common, debt or preferred instrument. What does matter is the ultimate percentage of the company the investors will receive on a fully diluted basis.

Rule 144 Period to Shorten? It appears the staff is ready to seek a rulemaking to reduce the Rule 144 holding period from one year to six months. This would be a major development and reduce the negative impact of limiting registration, but is expected to take up to a year to complete. They may, however, seek to bring back a tolling of the holding period in connection with shorting activities.

Form S-3 for OTCBB Companies? The staff is moving toward seeking a rulemaking to allow short form registration on Form S-3 for all reporting companies for up to 20% of their stock per year in a primary offering sold at the market. Mr. Dunn initially floated this idea in a speech this fall.

Post-Reverse Merger Registrations Different? The staff appeared receptive to treating registrations immediately following reverse mergers differently than other registrations currently in their sights. The hope is, if they must limit, they will focus on limiting registration to a percentage of the outstanding stock rather than the stock held by non-affiliates.

Worm/Wulff Relief for Non-Affiliates? The staff appeared receptive to considering some relief under the so-called Worm/Wulff letters for certain non-affiliate holders of shares. Stay tuned on this one. If so, this could further enhance the utility of so-called “virgin” shells.

Self-Filings More Attractive: It appears the staff will look more favorably on registrations done as self-filings following a PIPE completed into a previously private company. This is because the PIPE transaction, in their mind, has been "completed," and this might create the opportunity to register a larger percentage of the stock.

Timing: I know I have predicted relief deadlines before without success, but it really does appear that the internal guidance will be released this month. At that time the staff intends to appear at conferences and get the word out since, as we all know, Wall Street abhors uncertainty.

It appears, at long last, we are on the verge of much greater certainty in these transactions.

For more info, do not hesitate to get in touch with me.