Glossary of Reverse Merger Terms

This list, adapted from my book, provides definitions of some of the most-commonly used terms on this blog.

backdoor registration. A method by which a company’s shares can become publicly tradable through a merger directly with a public shell, after which the private operating company survives the merger and succeeds to the public status of the shell.

blank check. As defined in SEC Rule 419, a development stage company with no business plan or whose business plan is to merge with or acquire an operating business. Also referred to as a blank check company.

blue sky laws. Securities laws and regulations in each of the fifty states, regulating the offering of securities in that state. According to www.investopedia.com, the term is said to have originated in the early 1900s when a Supreme Court justice declared his desire to protect investors from speculative ventures that had “as much value as a patch of blue sky.”

due diligence. The process of reviewing a company’s operating history, assets, liabilities, risks, uncertainties, and management in anticipation of entering into a transaction with that company.

Footnote 32. Note in the SEC’s June 2005 reverse merger rulemaking which acknowledges a questionable tactic whereby individuals take supposedly operating companies public with the intention of shutting down or spinning off the business upon a reverse merger. This allows the promoter to avoid Rule 419 restrictions. The SEC declares these entities shell companies.

Footnote 32 shell. Shells created when individuals take supposedly operating companies public with the intention of shutting down or spinning off the company upon a reverse merger. This allows the promoter to avoid Rule 419 restrictions. The SEC declared these entities as shell companies in its June 2005 rulemaking.

Form 10-SB shell. Shell company created by filing Form 10-SB on behalf of previously private shell. Creates a clean but nontrading shell.

Form 8-K. Current report required to be filed by reporting companies between periodic reports when certain material events occur, including a reverse merger. The timing of filing was made shorter and the scope of items covered was made more comprehensive following implementation of the Sarbanes-Oxley Act of 2002.

initial public offering (IPO). The process of going public through an offering of securities by a corporation to the public and filing and seeking effectiveness of a registration statement under the Securities Act of 1933.

investor relations (IR). The process by which a company seeks to garner positive attention from broker-dealers and others in a position to influence investment in the company’s public stock. Also includes day-to-day dealings with existing shareholders of a company.

IPO window. The period of time in which IPOs are popular with investors and available to private companies seeking to become public through an IPO. The IPO window is described as open during periods of popularity, and otherwise closed.

private investment in public equity (PIPE). A private placement of equity or equity-linked securities effected for a public company, typically with immediate required registration of the equity sold to the investor.

reverse merger. A method by which a private operating company arranges for its stock to be publicly traded following a merger or similar transaction with a publicly held shell company, pursuant to which the equity owners of the private company typically take control of the former shell company.

reverse takeover (RTO). Another term sometimes used for reverse merger.

reverse triangular merger. A reverse merger in which the public shell company creates a wholly owned subsidiary, and which subsidiary merges with and into the private company seeking to merge. As a result, the private company becomes a wholly owned subsidiary of the public shell company. Typically used to avoid shareholder approval at the level of the shell company and to allow the operating business to maintain its corporate existence.

Rule 144. This SEC rule, under the Securities Act of 1933, provides a popular exemption from registration, allowing otherwise restricted securities to be sold in the public market if they have been held for a sufficient period of time, typically at least six months and in some cases one year.

Rule 144A. This SEC rule permits qualified institutional buyers, or QIBs, to trade restricted securities between and among themselves and allows for broader exemptions from registration for those offering securities to QIBs.

Sarbanes-Oxley Act of 2002 (SOX). The largest and broadest change in U.S. securities laws since 1934, SOX shortened reporting times for most companies’ periodic reports and insider reports, mandated establishment and maintenance of internal financial controls, added corporate governance requirements, in particular with respect to oversight of a company’s audit, eliminated all extension of credit to executives, and required top executives to certify as to the material correctness of their financial statements.

self-filing. The process by which a private company may seek a public trading market for its securities without an IPO or a reverse merger, by completing its own filings with the SEC either to resell securities held by shareholders or to voluntarily become a reporting company.

shell company. A company with no or nominal assets (other than cash) and no or nominal operations. Also referred to as a public shell company.

specified purpose acquisition company (SPAC). A blank check that completes an IPO pursuant to an exemption from Rule 419 for companies raising more than $5 million. SPACs generally have an industry focus with a related management team, and adopt several of the Rule 419 restrictions to assist in attracting investors.

underwriter. Broker-dealer that serves to complete an IPO of a company by purchasing shares from the company at a discount and then reselling them to the broker-dealer’s customers.

Worm/Wulff Letters. Series of letters between the SEC and Nasdaq providing that affiliates or promoters of blank check companies can never sell their shares either publicly or privately under Rule 144 or Section 4(1) of the Securities Act without those shares being fully registered first. These restrictions were effectively reversed by SEC rulemaking effective February 15, 2008.


Adapted from Reverse Mergers: Taking a Company Public Without an IPO ©2006 by David N. Feldman. All rights reserved.

Worm/Wulff Change: A Major Improvement with Some Disappointment

It has taken a bit of analysis, discussion and interaction with SEC staff, but I am now able to offer some thoughts on the ultimately very positive change (albeit not as far-reaching as hoped) implemented by the SEC with respect to codifying certain positions of the staff under what have been known as the Worm/Wulff letters. Along with the improvement, however, are some disappointments that we hope to work to ameliorate over time. This entry is a little long and I apologize in advance, but I hope you will read through it as the changes are very important.

Worm/Wulff Background

In two letters in 1999 and 2000 between the SEC and the NASD, the SEC laid out its view that any affiliate or promoter of a blank check company (one without a business plan or whose business plan is to acquire another business) may sell his shares publicly only after being registered with the SEC, presumably after a reverse merger. The common exemption from registration, which allows sale after a certain holding period under Rule 144, was deemed not available to these holders. This also applied to transferees of affiliates and promoters. In time the SEC staff went further, and made clear that in their view the pronouncement in the letters applied to all holders of shares in a blank check, whether or not affiliates or promoters or transferees thereof.

Despite this restriction, practitioners generally assumed that any investor buying into a former shell (such as a PIPE investor in a typical "alternative public offering" or APO) had the availability of the Rule 144 exemption.

The restriction on shell holders was a major problem, as it required them to negotiate complex protections in reverse mergers in the event that the post-merger company did not register the shares of the former shell owners. The SEC has now finally reversed this position.

The New Rule - Shell Holders Get Back Rule 144 Exemption

The very good news in the new Rule 144 release is that the Worm/Wulff letters, at long last, have been all but obliterated. All holders of shares in the former shell will be able to sell publicly under Rule 144 starting one year after the completion of a reverse merger and release of so-called "Form 10 information" on Form 8-K as required by rules passed in 2005. While most of us were hoping the time period would gel with the new six-month hold for everyone else (and in fact the original proposal was to do just that), this is still a significant and positive change.

A few other items also were clarified. First, the one year period will start as of the first filing of the Form 10 information, even if the SEC comments on it and requests amendments.

Second, the SEC made clear that if you received shares in a real public operating business that later became a shell, you have the new six-month holding period for Rule 144 purposes even after the entity has become a shell. This was never clear and some practitioners believed any new investment decision (such as a desire to sell) while the entity was a shell may have been barred under Worm/Wulff if someone was trying to sell unregistered securities under Rule 144.

Footnote 172: Start-ups are not Shell Companies

In a soon-to-be-famous footnote in the release, the SEC declared that a legitimate start-up company does not fit the definition of shell company (the type of company subject to the one-year hold vs. new six-month period). In 2005 the SEC defined a shell company as having no or nominal assets (other than cash) and no or nominal operations. Most practitioners had difficulty determining what was nominal, though most believed that at least $1 million in non-cash assets or operations was not nominal, and anything below that was uncertain.

This is a victory for those who represent the tiniest public companies that are indeed real businesses. Prior to this rule change, the only negative impact of being deemed a shell was the need to file Form 10 information once the entity ceased to be a shell. Now the impact would include the unavailability of Rule 144 while it is a shell and the one year hold vs. six months. With this change, these tiny public companies would have the full six-month benefit of the new Rule 144 changes and not be subject to the codification of Worm/Wulff.

The concern is that this may encourage the formation of "footnote 32" shells (see prior blog entries), which may now be renamed footnote 172 shells. These are not real businesses, or real businesses that are intended to be shut down or stripped out upon a merger. The promoter takes them public to avoid various SEC restrictions on shells, but does not disclose their real intent to find a private company with which to merge. Now with the certainty that six-month Rule 144 hold is available, and that the "super" Form 8-K and release of Form 10 information is no longer necessary for non-shell companies, unfortunately this form of misleading activity would be further encouraged.

A number of leading RM players have expressed to me deep concern that fraudsters will now see more incentive than ever to creating these misleading vehicles and those setting up legitimate Form 10-SB or "virgin" shells will have a tougher time competing with these improper entities. There may actually be a legitimate way to work this footnote to one's advantage, but I'll save that one for my clients!

This clarification is significant, however, as it appears to allow real companies, even startups, regardless of size of assets or operations, to go public without inadvertently being characterized as shells.

The Catch - All Must Wait for One Year Anniversary

of Release of Form 10 Information

As with too many good things, there is a catch. In a change from the original proposal, the SEC has declared that anyone receiving shares in the shell while it is a shell or even thereafter (ie at or following a reverse merger) must wait to sell under Rule 144 until the later of the one year anniversary of the release of Form 10 information (the "Anniversary") and six months following acquisition of the shares.

This means that a PIPE investor putting money in at the time of an APO, who otherwise would have had the benefit of the new six-month holding period, now must wait until the Anniversary. Someone investing three months after the APO would have a nine-month hold and so on. This continues until six months after the APO, upon which everyone would have no more than a six-month hold. Remember, the requirement is not to hold for one year, it is to hold only until the Anniversary or six months, whichever is longer.

This will mean that PIPE investors will continue to look to registration of shares they might be interested in selling within one year following the reverse merger. This might bring us back to the Rule 415 problem which dogged us last year. Here the SEC sought to limit what percentage of a company's securities can be registered at one time. Happily, although the SEC set a guideline limiting registration to one-third of a company's public float, in the last year it has routinely allowed much more than this to be registered in registrations immediatley following reverse mergers.

This also may cause PIPE investors concerned about near-term liquidity (in general most investing in reverse mergers have longer-term outlooks) to phase their investment over time. If $10 million is needed for a company to get through a year, maybe $5 million can be invested at the time of the APO and another $5 million in six months. This means only the first $5 million is subject to the one year hold.

So What Happened?

Many clients have asked why I believe the SEC proposed a more attractive package than was finally adopted. The comment letters were overwhelmingly positive. So there should have been no reason not to adopt the proposals as written.

My belief is that there remain anti-RM forces in high staff level positions (and maybe even at the Commissioner level) at the SEC. I had thought we had finally gotten past the "shells are inherently bad" mentality of the 1980s and 1990s. When the SEC adopted enhanced disclosure to increase the transparency and legitimacy of these transactions in 2005, they declared that they recognize the legitimate use of these techniques in corporate structuring.

So why this? I think those who are not as positive on this field did not pay much attention to the proposal when written, but when it came time to deal with comments suddenly woke up and decided that the proposal was in their mind too generous. Why a PIPE investor putting in money at the time of or following a deal should somehow be lopped in with shell guys is a bit of a mystery to me frankly.

Just when I thought I might run out of advocacy issues to draw attention to the Staff, we have a new one. I will make it my business to do all I can to see if there is any possibility of ameliorating this change. Like all things, however, it may take time.

Self-Filings Still Attractive

These changes also bring more attention to the option of a self-filing as a method to go public. Rather than using a merger with a shell, a company can simply file with the SEC either to register some of its existing shares for resale, or a class of securities which makes the company subject to the reporting requirements of the SEC.

Self-filings would not be subject to the Worm/Wulff changes requiring a hold until the Anniversary. Holders would benefit from the new six-month holding period, so that a company considering a self-filing where most or all shareholders have held their shares for six months has more options to establish a public trading market for its stock.

As in prior posts, I always warn that self-filings do not always make sense, and certain conditions should be present before considering this option.

Net Result - Much Better than Before

Let's go back to that PIPE investor in the APO. Before these changes, if his shares were not registered he would have to wait one year before being able to sell any shares under Rule 144. During year two he would generally be severely limited in selling only 1% of the company's securities during each 90 day period. In addition the company had to be current in its SEC filings during year two for Rule 144 to be available. Only after the second anniversary would the investor be able to sell without any of these restrictions.

Under the new rule, the PIPE investor still waits up to a year, but has no volume restrictions whatsoever following the Anniversary. In addition, there is no requirement that the company be current in its filings after the Anniversary. This is much better than in the past, when most PIPE investors looked at the Rule 144 holding period as essentially two years because of the volume limits.

In addition, the reversal of the SEC's position in Worm/Wulff, to now allow shell owners the ability to sell under Rule 144 following a reverse merger, is very significant and something our industry has been fighting for almost since the letters were first released. While we would have preferred the six month hold originally proposed, that takes almost nothing away from the importance of this sea change.

In the end, these changes should further encourage those creating and acquiring shells (including legitimate virgin shells) and desiring to complete reverse mergers. That, combined with the further easing of barriers to capital formation once public, achieved by the new six-month holding period for Rule 144, results in a very large net positive for those interested in RM, APOs and the small and microcap markets.

Let me wish all of you, my thousands of faithful blogees, a very happy and healthy New Year.

Rule 144 Changes Effective February 15, 2008

On December 15, the SEC's release incorporating all the Rule 144 changes was published in the Federal Register. This means the changes will be effective on February 15, 2008. As a reminder, the new Rule 144 holding periods are retroactive, and relate to securities whether purchased before or after February 15.

In the next few days I will post a number of thoughts on the major change incorporated in the release concerning the so-called Worm/Wulff letters.

Greetings of the season to all!

Barron's Article Serves as Good Reminder

An article in this week's Barron's magazine raises a number of concerns about a Chinese company that went public through a reverse merger. The article points primarily to the company's Chinese auditors and a question about their true independence and the extent to which that potential problem was disclosed. As a result, it appears the company's financial statements may not be as reliable as hoped.

The article briefly (and negatively) mentions reverse mergers of Chinese companies, essentially warning investors to adopt a "buyer beware" approach to these transactions.

What is a shame, in talking to friends who are familiar with the Chinese company in question, is that most people who know anything about this company know it to be successful, profitable and growing. It does not appear that the new disclosures change that. But the article seems to imply that, as a result of the questions about the auditors, nothing can be relied upon with regard to this company.

Thankfully, the number of negative articles about reverse mergers has gone down dramatically in the last 3-5 years. The Wall Street Journal declared "reverse mergers move into fashion" back in 2005. US News had a positive article on SPACs this year, referring to "formerly shady reverse mergers." Even the New York Times has come around.

In truth, a number of the few recent negative articles (there was another one not too long ago in Forbes) have centered around problems with Chinese companies. This is sort of unfair given that out of the several hundred Chinese businesses that completed reverse mergers, only a few have faced these kind of difficulties and scrutiny. But unfortunately it's all perception, especially following recent scandals involving dangerous toys and other products being exported from the PRC.

All that said, the article does point out something real and important to pay attention to. That is, placing a high priority on choosing the right auditors in a reverse merger or self-filing, especially when dealing with a foreign enterprise. It is important to check the accountants' references carefully, talk with CEOs of other public companies they have audited, do online research to determine if they have ever faced regulatory scrutiny, and the like.

This goes both ways. If you are an auditing firm, look at yourself in the mirror and make sure you can handle that difficult client who is going to try to get you to help the company "make its numbers" even if that means fudging the information a bit. In the wake of the Sarbanes-Oxley Act and the added burden placed on auditors, one would think that all auditors have learned the importance of taking a relatively conservative approach in such matters. Sadly, as the article points out, this does not appear to be the case 100% of the time.

As with all things Wall Street, the RM world has yet to rid itself of every unsavory character. But there has been a dramatic positive change as the vast majority in our industry have joined the march to the high road to ensure that RM's "shady past" is indeed almost entirely in the past.

Thankfully, more and more articles, TV coverage and conferences highlight these positive developments leading to greater reliability, transparency and legitimacy of the IPO alternatives that help bring so many exciting entrepreneurial ventures to the next level. But as we go three steps forward, as the article indicates, we will occassionally go one step back. We must remain vigilant to ensure that we each do our best to minimize the backwards steps even as the growing popularity of these techniques does draw some players who we would humbly suggest take their marbles elsewhere.

P.S. I have a number of thoughts and comments about the fine print in the final Rule 144 release, including the codification of aspects of the Worm/Wulff letters, but I would like to do a bit more consultation before posting on them. Might be over the holidays or shortly thereafter.

P.P.S. To my faithful blogees (as one put it my "avid readers"), thanks for a wonderful year of sharing our thoughts on this most dynamic and exciting industry. I wish you all a happy and healthy New Year.

SEC Offering More Sarbanes 404 Relief for Smaller Companies

The SEC intends to propose delaying for another year the need for smaller public companies to have outside auditors assess internal financial controls under Section 404 of the Sarbanes-Oxley Act, and expect it to start in 2009. According to published reports, you would still have to have management assess the controls. This is not official yet, but SEC Chairman Cox told Congress yesterday that they plan to do that early next year. This is great news for many who were scrambling about thinking auditor review would start with years ending after December 15, 2008.

Alert: S-3 Availability Limited to Exchange-Traded Stocks

Today the SEC approved the expanded availability of "short form" registration on Form S-3 (and F-3 for foreign companies), as well as changes to Regulation D. Unfortunately I was not able to listen in, so will have to play the replay at some point in the next few days. I have heard, however, that they decided to limit the availability of S-3 to companies trading on exchanges, in other words, no OTC Bulletin Board companies will be able to use short-form registration. In a piece of good news, however, they increased the percent of float a company can register on short-form registration to one-third of the float.

In the meantime I am looking into several aspects of the Worm/Wulff changes in the Rule 144 release and will have more to report on that soon.

Some Rule 144 Tidbits

Dear blogees: I have read the new Rule 144 release initially. There are a few things that are not clear to me that I am discussing with colleagues and others to report about later. In the meantime, here are some interesting tidbits, which should be taken together with my brief summary from the other day below:

1. Paying purchase price. They are not changing the prior 144(d) requirement that the holding period does not commence until the full purchase price is paid when shares are acquired by purchase.

2. New issuers. The new six-month holding period will only apply to issuers that have been subject to SEC reporting requirements for at least 90 days before the Rule 144 sale. Those considering a self-filing as a method to go public should take note. This should not effect those completing reverse mergers with shells subject to the reporting requirements.

3. Removal of Restrictive Legends. They made clear that they do not object if issuers remove legends from securities held by non-affiliates after all of the applicable conditions in Rule 144 are satisfied. Presumably this will mean after holding for one year. This is because, despite the reduction in the holding period to six months, the issuer must remain current in its filings for the next six months until one year.

4. No more Rule 144(k). The entire 144(k), which allowed resale without any restrictions after two years previously, is taken out and replaced by the rule that says all non-affiliates can sell in six months without restriction so long as the company remains current in its filings for the next six months.

5. Worm/Wulff Changes - Important Insight into "Nominal." Footnote 172 of the final release indicates that a real startup company, or as they also put it, a "company with a limited operating history," would not be deemed a shell company because its operations are not nominal. This is very different from the informal guidance we had previously received as to the definition of "nominal." This would seem to help very tiny newly public companies to avoid the prohibition on using Rule 144 if you are a shell company, since the SEC is declaring these tiny companies not to be shells. But it might have the unintended consequence of further encouraging the creation of so-called "footnote 32 shells" which I have written about many times in the past. For sure this will be the subject of much more in depth analysis over the months to come.

6. Form 144: Form 144 filings will be eliminated for non-affiliates. Affiliates will still have to file. In a change from the proposal, affiliates have to file Form 144 if the trade involves over $50,000 or 5,000 shares. They had proposed 1,000 shares. In addition, while we had thought they would not act to help affiliates who have to file both Form 144 and Form 4, in a piece of good news they said "we expect to issue a separate release in the future to provide affiliates that are subject to both the Form 4 and Form 144 filing requirements with greater flexibility in satisfying their requirements."

7. More on Worm/Wulff codification: As mentioned, they went for a one-year post reverse merger and release of Form 10 information holding period for former holders of a shell. There are several things that are unclear in the release that I am hoping to gain some clarity on in the near future. In the meantime, one clarification was good - they confirmed that the Form 10 information will be deemed filed (and the clock starting to tick on the one year period) when the initial filing is made with the Commission, even if they subsequently comment on the "super" 8-K filing and request changes. Kudos to Sichenzia Ross for requesting this clarification. Stay tuned on all this.

8. Adjustment to Regulation S. In response to comments, the release reduces the Regulation S "distribution compliance period" from one year to six months. Since that period in offshore offerings was always meant to be tied to the 144 holding period, this change made sense.

December 11 SEC Open Hearing to Approve Form S-3 Availability

The SEC has announced that there will be an open hearing of the Commission on Tuesday, December 11 at 10 am with the following agenda items included:

1. The Commission will consider whether to adopt amendments to the eligibility requirements of Form S-3 and Form F-3 of the Securities Act of 1933 to allow companies that do not meet the current public float requirements of the forms to nevertheless register primary offerings of their securities, subject to certain restrictions, including the amount of securities those companies may sell pursuant to the expanded eligibility standard in any one-year period.

2. The Commission will consider whether to adopt amendments to mandate electronic filing of Form D and revise the information requirements of that form. Form D is a notice required to be filed by companies that have sold securities without registration under the Securities Act of 1933 based on a claim of exemption under Regulation D or Section 4(6) of the Act. Form D filings are also required by most states.

The first item is much more important than the second. It is the other major linchpin in the SEC's response to the work of its Advisory Committee on Smaller Public Companies (the other being the changes to Rule 144). Allowing smaller public companies to have "shelf" registrations to issue shares that are immediately tradeable is a major step forward in giving these issuers some of the benefits that have always been available to larger companies.

I'm looking forward to hearing how the final proposal will be shaped.

Alert: Rule 144 Final Release Out; Shell Holders Can Sell in One Year

Today the SEC published the final Rule 144 release. I have not yet read it fully. It takes effect 60 days after publication in the Federal Register, which presumably will be soon.

The big news: Worm/Wulff is officially lifted. They did change from their original proposal and now will allow former holders of shell shares the right to sell after one year following a merger and release of "Form 10 information." This is still huge, as holders now have an exit that was previously cut off.

The other big news: The new Rule 144 changes, including the new six month holding period, are retroactive and apply to securities acquired before or after the effective date of the changes.

More after I have read the whole thing in a few days.