Winter Contrasts- and a New Idea?

This winter is a study in contrast more than many. During the last week I have been in balmy Los Angeles, chilly Las Vegas, barely freezing New York and then Vermont where the thermometer barely stayed above zero (finally back to New York). The US Presidential race, with no clear front-runner in either party, seems more and more like each candidate declaring themselves to be the opposite of the others. XM and Sirius Satellite Radio both compete with each other and are trying to merge. My 17-year old daughter, now accepted to college (Brandeis), has one foot out the door just as my 5-year old son gets used to a new school and life in kindergarten. These days my music tastes run just as much to John Mayer as John Mellencamp (still John Cougar to me).

In our RM world (you were wondering when I would get there), similarly, we have this dramatic moment when the 8-year old shell-restrictive Worm/Wulff letters are effectively lifted. At the same time the SEC pulled back on allowing shell owners and others the right to sell without registration in six months and now require up to a year. Yes better than before the change, but not as good a deal as some got in the Rule 144 changes. So is the SEC for or against shells and reverse mergers?

Apparently, the answer is yes. There is a strong and growing "glass mostly full" group who believe there is great promise in allowing the growing number of legitimate players to be protected and encouraged in helping companies achieve their goals with a public trading stock.


However, there are some, particularly those who have been around the Commission since the troubled 1980s, who look at the handful of shady players remaining and the enforcement actions against them and do not believe there can ever be a time where APOs and other IPO alternatives can become as legitimate as, say, the IPO itself. Of course they disregard the billions of dollars in fines paid for problems relating to IPOs of the 1990s.

Unfortunately, as indicated in a previous post, a little foonote in the new Rule 144 ruling likely will have the effect of further encouraging the creation of fraudulent shells. My hope is that the SEC pursues a "carrot and stick" approach in this $9 billion a year business. More enforcement dollars should be focused on those creating shells without real businesses or with real intentions masked. Insider trading in shells should be pursued more vigorously. Shell owners who "forget" to disclose their ownership should face consequences.

BUT, at the same time there should be more effort focused on rewarding those who do things the right way. I hope the SEC soon will take another look at the new one-year hold for shell owners and those who invest at the time of a reverse merger. There really is and has been no reasonable explanation for the distinction between these and other PIPE investors who can now sell in six months.

And here's a new suggestion. Maybe, as a counter to the footnote that encourages fraud, we can begin to discuss a "new" Rule 419 to encourage shell creation legitimately. Currently, Rule 419, passed in 1992, requires shares and money from an IPO of a shell to be in escrow pending a merger, and for shareholders to have the right to approve the deal or "opt out" and get their money back. But once approved and closed, the shares originally issued in the shell's IPO can immediately trade. The main problem, of course, is the delay in getting the SEC to approve a proxy statement needed to seek shareholder approval of the transaction.


As a next step, now with 16 years more experience and many more protections in the marketplace, maybe we can consider eliminating the shareholder approval requirement in Rule 419. Instead, one could posit a shareholder "notification" through a super 8-K type document which is filed and mailed to the shell's IPO investors, but not reviewed by the SEC. The holders then could have 10 days after mailing of the notification to opt out if they choose and receive virtually all their original investment back. A shell could still have to find and close a deal in 18 months as currently required. The money and shares can be in escrow, and the deal size could still be required to be at least 80% of the funds in escrow.


This simple, relatively minor change (though a formal SEC rulemaking would seem to be required), which would still protect shareholders, could help bring the end of footnote 32, 172 and their ilk. Rule 419 and the problems it created sent many to Form 10 or "virgin" shells, which were created by the hundreds. The shareholders in those shells have no ability to opt out, no right to vote on a deal, etc. Of course we defend them as protecting the public trading market as no public trading exists until a "super" 8-K is filed and either a subsequent registration is approved, or one year has passed under the new Rule 144 requirements. But again, the Rule 419 protections are not there. It is therefore possible now to get to trading with a virgin shell without ever filing a registration statement- but in all events with a full disclosure super 8-K. In the meantime, since no one is creating Rule 419 shells, their significant protections help no one.


By ensuring the right to "vote with their feet" and opt out of a deal, every investor in a "new 419" shell could have the right to choose not to participate in a merger. But by avoiding the need for a time-consuming, SEC reviewed proxy statement as currently required (and not required in a merger with a virgin shell), the technique will be much more attractive and draw more legitimate players to the possibility of a stock that can trade immediately upon a merger. To repeat: the main advantage is that stock can begin trade following the merger and full disclosure, instead of waiting for a subsequent registration or Rule 144 holding period in a virgin shell merger. I posit there is no real substantive investor protection difference in the two, yet a huge difference to shell founders who do not have to explain the delay in trading as they do in a virgin shell merger.


Do I think the SEC would consider such a thing? Well, after the 2005 rulemaking requiring much more disclosure and the super Form 8-K, I felt it was time to reconsider the Worm/Wulff letters. As reported in my book, I submitted a "no action letter" which I ultimately withdrew with a promise from the staff to address the issue in another way. While most assumed there was no shot, and it did take another two years, that change finally has now been incorporated into the Rule 144 changes. Thus, if the case is made and investors can remain protected in a manner that reduces impediments to capital formation, the SEC will indeed often listen.






Virtually no one pursues Rule 419 shells anymore. The SEC provided too many roadblocks both to taking the shell public in the first place and approving the proxy for the deal once found. Thus, in effect Rule 419 has been a failure unless its goal was to stamp out shell creation (I do not believe that was their goal, and in any event Form 10 shells have proliferated anyway). Removing the shareholder approval requirement in Rule 419, but protecting investors with an opt out feature following full disclosure, would be a reasonable counter-step to foonote 172 of the Rule 144 ruling which will further encourage bad players.

Let's all start a conversation about this.