Reverse Mergers hit Wharton

Wharton Teaches Reverse Mergers. I was visiting my alma mater, the Wharton School, this week, to give several seminars to the undergraduates on business networking and other topics. I greeted a professor friend who teaches finance, and lo and behold, he let me know that when he covers the going public process, reverse mergers, SPACs and other alternatives are indeed included!

As more newly minted MBAs come out with knowledge of these valuable techniques, our growing industry will enjoy more and more legitimacy and popularity.

News from SEC Staffers at ABA Conference

Yesterday I was honored to be included in a panel at the American Bar Association Section of Business Law's spring meeting in Washington (let's not discuss the fun I had fighting my way home to New York in this "spring" weather).

The topic of the panel was "Hot Securities Law Issues for Small Business." Among others, the speakers included David Lynn, Chief Counsel of SEC Corporation Finance, and Gerald Laporte, Director of Small Business Policy for the SEC. Here are some insights garnered principally from the comments of these two gentlemen:

1. David Lynn reported (with a bad cold) on PIPEs and Rule 415. He essentially reiterated their stated position, with nothing really new. During the Q&A section of the panel, I asked him whether they had re-thought their position that any second registration after a limited first one had to wait for the later of 6 months after effectiveness of the first or the sale of substantially all the shares registered in the first registration. He did not suggest that any further thought has gone into the issue, suggesting it had only been two months since the new regime was put in place, and again focused on the issue of whether the second registration can be deemed part of the first or indeed a new transaction.

2. Jerry Laporte reported some rather exciting developments concerning rule-writing that is going on now at the SEC. These include the following:

• Finders. The SEC's Division of Market Regulation at long last appears willing to look at the issue of unregistered finders and private placement broker-dealers, with the possibility of seeking a multi-agency effort to permit NASD registration of these intermediaries in some manner short of full broker-dealer registration.
• Rule 144 Reform. Rule 144 looks ready for a shortening of the period before which investors with unregistered shares can sell publicly, possibly to six months from one year. One also hopes that this Rule 144 reform might just provide some relief to the beleaguered sufferers under the so-called Worm/Wulff letters which do not allow Rule 144 to be available as an exemption to registration for most shareholders of blank checks and shells.
• Regulation S-B to be Eliminated. Regulation S-B, which allows smaller issuers to use different forms in reporting to the SEC (Form 10-KSB instead of Form 10-K for annual reporting for example) will probably be scrapped. Instead, its benefits (such as fewer years of reporting) will be incorporated into the larger disclosure scheme known as Regulation S-K. Also, currently once you hit $25 million in revenues you are out of the S-B system and its benefits. It is expected that number will rise, probably to about $75 million.
• Rule 504 Enforcement Up. He mentioned enforcement activity against questionable use of Rule 504 of Regulation D (in particular in Texas and Minnesota) is being stepped up dramatically. This rule allows raising up to $1 million in a public offering without SEC registration in certain circumstances, but is prohibited by most states.
• Edgar and Form D Updates. Edgar appears ready for an update and upgrade. Also Form D is getting an overhaul for those filing with the SEC after private placements. The Form also is now going to be able to be filed electronically.
• Federal Preemption for all Nasdaq. State "blue sky" regulation is ready to be preempted for all Nasdaq issuers but not for OTCBB issuers, who will still have to review state securities regulation when issuances are taking place.
• Form S-3 to be available for OTCBB. The availability of short-form registration on Form S-3 looks likely for smaller OTCBB issuers, possibly once a year, but only for a primary registration limited to 15-20% of the public float. This won't help PIPE investors in smaller companies.
• More General Solicitation. The hope is to loosen the ban on "general solicitation" (emails, advertising) in private placements limited to larger "super-accredited" investors.
• "Integration" Time to be Reduced. Currently two separate private placements run the risk of being joined as one if they take place within 6 months of each other. It appears the SEC will shorten this period, but it is not clear to what.

The political environment is very favorable for these initiatives which are clearly more friendly towards those involved in capital formation. There's even a rumor that SEC Chairman Cox may throw his hat in the ring for President, and these types of business friendly initiatives would certainly make sense were that true. I also understand that the Chairman's office is very directly involved in the proposals described above, which is somewhat unusual, and good. John White, head of Corporation Finance, has promised to try to have these proposals ready for our "summer reading."

Tip of the Week- Don't Fall into the Shell Tax Trap!

Greetings blogees! I was on the Left Coast last week on business, so I apologize for not appearing for a few days. Just one joke from the Carrot Top show in Vegas: "Don't you hate airlines? We all know Delta stands for 'don't expect luggage to arrive.'" Might just use that in future appearances.

Anyway, I've noticed over and over again a trap that clients fall into and wanted to blog on it this Saturday morning.

As most of you know, many of my clients have created "virgin" shells through filing Form 10-SB, in fact we've been hired to create over 100 of these. Other clients acquire shells that are trading by purchasing a large percentage of the outstanding stock. Either way, in many proposed reverse mergers, investment banks or other intermediaries are seeking compensation for putting the deal together, raising money or general consulting.

Many of these intermediaries think: let me acquire an interest in the shell just before the deal closes because I can buy stock for a very low price and then have the value of my shares increase dramatically just moments or days or a week or two later when the deal closes. This way, the intermediary thinks, I have no tax currently (I made an investment before the deal closed), and when I sell my interest, if it's at least a year later, I have long term capital gains tax treatment on the sale, with a much lower tax than ordinary income. The shell guy is happy because he doesn't have to pay me in cash. If I had just taken cash or stock as compensation when the deal closed I would have had to pay ordinary income tax immediately, so this pre-deal purchase of stock seems better. Or is it?

In general, if it is reasonably close to the closing of the merger, almost certainly not. Here is the problem. Even though the deal hasn't closed when the intermediary acquires the stock for a very low price, the IRS could come back and say that the parties basically knew the deal was going to close. In fact, in many cases the principals are already out seeking new capital for the post-merged company, of course at a much higher price per share than the intermediary is paying pre-deal. This, the IRS would say, is evidence you knew the shares were worth more than you paid, and the difference between what you paid and the "real" value is taxable currently as compensation to you- ordinary income. In addition, that amount is a deduction, or charge to earnings, to the merged company, which in most cases is something a newly public company does not wish to have.

Here's a real life example from a client situation, with some numbers changed so as to mask the real players. My client, the private company, signed a merger agreement with a shell after which 90% of the stock of the combined company would be owned by former owners of my client. The combined company would be worth about $70 million upon closing.

Shortly after signing the merger agreement, an intermediary putting the deal together acquired 20% of the stock of the shell for $10,000 (remember the merger hasn't closed yet). My client said, why do I care, as long as I end up with the same 90% of the deal after all is said and done, how the shell promoter and banker choose to whack up their 10% (even if 20% of that 10%, or 2% after the deal, was going to the intermediary) is up to them.

The intermediary was happy because upon closing several weeks later, his $10,000 investment instantly became worth $1.4 million! That's his 2% of the $70 million post-merger value. When he sells in a year, he is taxed at the much lower long-term capital gains tax rate. If instead he received $1.4 million in cash upon closing, or got stock at closing worth $1.4 million, he'd pay tax immediately at the much higher ordinary income rate.

My client, the private company, was so worried about this issue they felt they had to disclose to investors the risk that the IRS might re-characterize the stock as compensation with a net value of $1,390,000 after his $10,000 investment, which could result in a big income hit to the intermediary and a charge to earnings for the combined company of that amount. This disclosure was included in their disclosure documents for investors even though some felt we were basically writing a road map for the IRS to come after these players.

Hopefully you get it now. Here's a way to do this the right way, ready? Several of my clients who own shells and work pretty regularly with intermediaries and consultants who assist them have begun allowing those intermediaries to buy into one or two of their shells currently, long before there is any deal in place. The shell founder also gets the right to buy back the stock sold to the intermediary if no deal develops within a certain amount of time. Then, maybe 3-4 months later, a deal develops and is closed. In that situation, you have a much stronger argument that the stock purchase was not compensatory or connected to the deal completed much later.

My simple advice to intermediaries and shell founders: plan ahead!!

So how to do a primary offering and avoid 415?

As we have researched the matter further and consulted with experts, and while none of this constitutes legal advice (consult your lawyer, hopefully me!), here are some additional thoughts on turning secondary offerings into primary offerings so as to lawfully avoid the limitations on the number of shares to be registered under the SEC's new Rule 415 interpretation:

1. S-4 Probably Doesn't Work: It appears that S-4, while registering shares to be issued in a reverse merger and thus making their initial issuance valid, does not make the shares publicly tradeable in a resale. Thus a follow-on resale registration is required, and this is subject to all the 415 problems.

2. S-1 May Work: Two reverse merger scenarios are possible.

(a) In the first, a merger agreement is signed, the private company then completes a PIPE investment into it, then an S-1 is filed to register the shares to be issued in the merger pursuant to the merger agreement, including shares to be issued to the PIPE investor when he converts his shares of the private company in the merger. S-1 is permitted to be used in this way, and any company, even smaller public companies, may utilize this form. Then all shares, including shares held by affiliates and investors, become freely tradeable upon effectiveness of the S-1 and the completion of the merger. Since it's a primary offering document 415 analysis and limitations do not apply. The challenge here is whether the PIPE investor is willing to invest in the private company, even knowing that the S-1 will be filed immediately after the investment (more and more of our clients are willing to make this investment). If not...

(b) In the second approach, money will not be invested until the merger is completed. In this situation, the S-1 is used with a dual purpose. First, you register the shares to be issued in the merger to the holders of private company shares (excluding the investor for this purpose). Second, you register shares to be issued in a public offering of "pubco" securities which will close on the same day as the merger. It appears, subject to the investors possibly having to declare themselves subject to underwriter liability, these shares could then be issued in essentially a "public PIPE" and become immediately tradeable at the market. And the investor takes no risk of the registration not going through as he does not invest until it is effective. Of course here the company must wait until the registration is complete before raising money. A bridge financing prior to filing the S-1 might help tide the company over while it awaits approval of the S-1.

3. Neither of the scenarios has been tried to my knowledge in a reverse merger context, so it is now a question of time before someone files a registration using one of these approaches to see how the SEC reacts. In the end, however, the SEC hopefully can and should offer ways for practitioners to do exactly as they have asked - use a primary registration to allow a registrant to bypass the problems associated with a secondary registration and limits pursuant to Rule 415.

4. Does the suggested S-1 approach work any better than a self-filing? The big extra advantage appears to be the ability to register, without limitation, potentially all shares of the company at once. A self-filing, which is typically a resale or secondary offering, will be subject to 415 limitations. If the self-filing is pursuant to a Form 10-SB, any shareholder without an exemption from registration (such as Rule 144) will have to wait until an exemption is available. And almost certainly the new investor will not have such an exemption available.

Did I mention this does not constitute legal advice? Someone try this and let's see!