If I'm a hardliner, so be it...and another idea the SEC can implement now...
Some of the "other blogs" in this space have been preaching that it is ok to form so-called "footnote 32" or now "footnote 172" shells, because the SEC does not catch you in the act of deceiving the public. These at best questionable and at worst fraudulent shells are created by putting an apparently real business into a corporate entity, taking it public by avoiding all the restrictions on shell companies by claiming to be a real start-up or early stage company, then almost immediately marketing the entity as a shell, planning to strip out or shut down the "business" when a reverse merger is completed. In some cases real assets are put in, in other cases an actual tiny business, in others still an apparent start-up that is not real at all.
The problem, as I have preached many times, is that the shell promoter does not disclose his or her true intention at the time of going public, and often for a decent period thereafter. The shell then goes public and is allowed to have its stock trade, whereas shells formed legitimately either must raise over $5 million (such as SPACs) to trade, or must have no trading until after a merger and subsequent registration (such as "virgin" or Form 10 shells).
The arguments made by those who find this deception acceptable: (1) the SEC allows the entity's registration to go public, so who are they to figure out the true intentions of someone taking a company public- and if a company passes the SEC's disclosure review they should be allowed to be public. (2) Those of us who are opposed to this are really just protecting areas of our business that rely on Form 10 shells or other approaches and have only ulterior motives. (3) FINRA approves these stocks for trading, thus "who are we" they say to question what they allow to trade or not? (4) These shells are more valuable because they have had no or virtually no operations and therefore are "cleaner" and easier to complete due diligence review.
An article in the most recent Reverse Merger Report focuses on this and quotes another blogger who believes these shells should be permitted to proliferate. Put aside that all the other people quoted, including several industry leaders, strongly disagreed with this blogger. A prominent attorney (not yours truly) called this trend an "in-your-face affront to the SEC."
Here are the two key reasons we need to do all we can to put a halt to this misleading practice. First, it is simply unfair that these fraudsters can evade SEC rules, allow the stock of what is really a shell to trade, and get a significant premium upon sale of the shell while legitimate players do not get this benefit. I'm sorry, but suggesting that fraud should be permitted simply because the regulators do not catch the bad guys does not work in my book.
To suggest that this is all about protecting our "turf" is ridiculous, because if we felt that there was another legitimate technique that surpasses those we currently use, we would encourage our partners and clients to move to that technique. Indeed, for a number of years I suggested people stay away from Form 10 shells because I perceived that the SEC and FINRA (then NASD) were against them. I encouraged Rule 419 shells, which are much more difficult to create, take public and complete a merger. Once I learned that the SEC has no problem with Form 10 shells, I encouraged clients to move in that direction, and our firm has indeed been hired to create nearly 200 of these shells in the last 2-1/2 years. Thus, I would happily move my clients to the next technique, if there is one that is more valuable and legitimate.
Second, and really more important, is the hard hard work that so many of us have put in during the last 5-7 years to erase the negative image of reverse mergers and shells on Wall Street and Main Street. It is indeed frustrating that the SEC's resources and priorities do not allow a greater emphasis on going after these players (though there was one case a few years ago where a promoter who failed to disclose his intention to become a shell was fined). The problems of the 1980s stemmed from a similar attitude - it's not bad until they catch us. That led to a significant overreaction in 1992 in the form of Rule 419, which frankly has not been successful in its stated goals.
In addition to my prior post suggesting the SEC pass a rule to remove the shareholder approval requirement in Rule 419 as a way to move bad guys away from creating fraudulent shells, I have another suggestion that would not even require a rulemaking. SEC Division of Corporation Finance chief John White could send a memo to all 120 lawyers who examine registration statements, recommending that in the case of a company going public (other than pursuant to a traditional firmly underwritten IPO) that has less than $1 million in funding or operations, some additional disclosure be required. Namely, they should disclose that they have no intention of being or marketing itself as a shell, that all principals, board members, control persons and management have no blank check experience (or disclose if they have), and that they were not advised, assisted, funded or consulted by anyone who is in the reverse merger or shell business. Maybe even have management certify to the above "under penalty of perjury" (not sure if that would require a rule change though).
Will this change provide the ultimate long-term solution? No. Will it make everyone doing this think at least twice before undertaking these misleading tactics? I believe so. In fact, very few footnote 32/172 shells include disclosed individuals who are in the reverse merger business. Often they put up friends, relatives or others as "shills" to set up the public entity with the pretend or small real business to be stripped out. But they are typically advised by these shell players, and at some point the shell player has to emerge or he/she loses the opportunity to participate in the upside of having created the shell in the first place.
Therefore, if the "innocent" players who sign up as management of these companies have to certify they are not planning on being a shell, and that is not the case, many may indeed withdraw.
A number of other players, including my clients and friends in the RM world, have made other suggestions about how to address this issue. All the ideas are good. Which one(s) make the most sense to the SEC will be the question.
All I know is, if we allow fraudulent shells to continue unabated, we run the real risk of sending our entire industry back to the dark ages where no major investment bank would touch a company going public this way and the SEC had a strong default setting against them. For the many companies that could benefit from being public with no other way to get there, that would indeed be a real shame. While we wait for the SEC to decide to focus more on this, self-regulation is the only way we can quell this very disturbing trend.
The problem, as I have preached many times, is that the shell promoter does not disclose his or her true intention at the time of going public, and often for a decent period thereafter. The shell then goes public and is allowed to have its stock trade, whereas shells formed legitimately either must raise over $5 million (such as SPACs) to trade, or must have no trading until after a merger and subsequent registration (such as "virgin" or Form 10 shells).
The arguments made by those who find this deception acceptable: (1) the SEC allows the entity's registration to go public, so who are they to figure out the true intentions of someone taking a company public- and if a company passes the SEC's disclosure review they should be allowed to be public. (2) Those of us who are opposed to this are really just protecting areas of our business that rely on Form 10 shells or other approaches and have only ulterior motives. (3) FINRA approves these stocks for trading, thus "who are we" they say to question what they allow to trade or not? (4) These shells are more valuable because they have had no or virtually no operations and therefore are "cleaner" and easier to complete due diligence review.
An article in the most recent Reverse Merger Report focuses on this and quotes another blogger who believes these shells should be permitted to proliferate. Put aside that all the other people quoted, including several industry leaders, strongly disagreed with this blogger. A prominent attorney (not yours truly) called this trend an "in-your-face affront to the SEC."
Here are the two key reasons we need to do all we can to put a halt to this misleading practice. First, it is simply unfair that these fraudsters can evade SEC rules, allow the stock of what is really a shell to trade, and get a significant premium upon sale of the shell while legitimate players do not get this benefit. I'm sorry, but suggesting that fraud should be permitted simply because the regulators do not catch the bad guys does not work in my book.
To suggest that this is all about protecting our "turf" is ridiculous, because if we felt that there was another legitimate technique that surpasses those we currently use, we would encourage our partners and clients to move to that technique. Indeed, for a number of years I suggested people stay away from Form 10 shells because I perceived that the SEC and FINRA (then NASD) were against them. I encouraged Rule 419 shells, which are much more difficult to create, take public and complete a merger. Once I learned that the SEC has no problem with Form 10 shells, I encouraged clients to move in that direction, and our firm has indeed been hired to create nearly 200 of these shells in the last 2-1/2 years. Thus, I would happily move my clients to the next technique, if there is one that is more valuable and legitimate.
Second, and really more important, is the hard hard work that so many of us have put in during the last 5-7 years to erase the negative image of reverse mergers and shells on Wall Street and Main Street. It is indeed frustrating that the SEC's resources and priorities do not allow a greater emphasis on going after these players (though there was one case a few years ago where a promoter who failed to disclose his intention to become a shell was fined). The problems of the 1980s stemmed from a similar attitude - it's not bad until they catch us. That led to a significant overreaction in 1992 in the form of Rule 419, which frankly has not been successful in its stated goals.
In addition to my prior post suggesting the SEC pass a rule to remove the shareholder approval requirement in Rule 419 as a way to move bad guys away from creating fraudulent shells, I have another suggestion that would not even require a rulemaking. SEC Division of Corporation Finance chief John White could send a memo to all 120 lawyers who examine registration statements, recommending that in the case of a company going public (other than pursuant to a traditional firmly underwritten IPO) that has less than $1 million in funding or operations, some additional disclosure be required. Namely, they should disclose that they have no intention of being or marketing itself as a shell, that all principals, board members, control persons and management have no blank check experience (or disclose if they have), and that they were not advised, assisted, funded or consulted by anyone who is in the reverse merger or shell business. Maybe even have management certify to the above "under penalty of perjury" (not sure if that would require a rule change though).
Will this change provide the ultimate long-term solution? No. Will it make everyone doing this think at least twice before undertaking these misleading tactics? I believe so. In fact, very few footnote 32/172 shells include disclosed individuals who are in the reverse merger business. Often they put up friends, relatives or others as "shills" to set up the public entity with the pretend or small real business to be stripped out. But they are typically advised by these shell players, and at some point the shell player has to emerge or he/she loses the opportunity to participate in the upside of having created the shell in the first place.
Therefore, if the "innocent" players who sign up as management of these companies have to certify they are not planning on being a shell, and that is not the case, many may indeed withdraw.
A number of other players, including my clients and friends in the RM world, have made other suggestions about how to address this issue. All the ideas are good. Which one(s) make the most sense to the SEC will be the question.
All I know is, if we allow fraudulent shells to continue unabated, we run the real risk of sending our entire industry back to the dark ages where no major investment bank would touch a company going public this way and the SEC had a strong default setting against them. For the many companies that could benefit from being public with no other way to get there, that would indeed be a real shame. While we wait for the SEC to decide to focus more on this, self-regulation is the only way we can quell this very disturbing trend.
Labels: Footnote 32
posted by David N. Feldman at
2/19/2008 08:12:00 AM
3 Comments:
Very interesting reading, but how can you so boldly reference your early negative opinion of form 10's as evidence to support your argument against the footnote shells? I don't really know anything about them, but if you were wrong on the form 10 issue, is't it possible that you are wrong on this issue, too?
Simple answer: no. In the case of Form 10s, I had the SEC initially telling me that the Form 10 shell was not permitted because of Rule 419. I knew they were wrong and ultimately they were not only proved wrong, they were "brought around" and convinced that Form 10 shells are clean and preferable because no trading takes place in the shell.
There is no circumstance I can imagine where the SEC would suddenly change their mind and say, oh, if you go public with a company but your real intention is to market yourself as a shell almost immediately and you do not disclose that intention, it's fine with us.
In fact, they have officially published their objection to this in the famous foonote 32 back in 2005, which says if this is your intention, the SEC's view is the company is a shell and should be treated as such from day one.
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