The Wrinkle in New Rule 144(i) - A Former Shell Must Stay Current in SEC Filings Forever
Almost everything in the new Rule 144 makes things better than they were before for shell operators and folks involved in reverse mergers generally. Even though the final release did pull things back from the original proposal, and even though shareholders of former shells must wait longer to have the exemption from registration available from Rule 144 than those that were not shells, the overall wait period and restrictions have improved over that which was the case prior to the rule change.
So when some complain that people involved in reverse mergers have to wait a year before Rule 144 is available, I remind them that before the rule change shell shareholders never had Rule 144 available (they do now), and that previously after one year those that did have it available had volume restrictions during the second year of hold (those volume restrictions are gone).
Almost going unnoticed, however, is a change imported from the requirements to avail oneself of "shelf" or short-form registration on Form S-3. That is, the requirement to have been current for the past year for S-3 to be available. In fact, to use S-3 each filing must have been made on a timely basis, not late. In new Rule 144(i), if a company ever was a shell company, the company must have done all its periodic SEC filings for the last 12 months or 144 is not available. The slightly good news is, unlike with Form S-3, the filings do not have to have been made on time. So a company could have missed a few filings but caught up prior to the attempt to utilize 144.
Why is this a pretty big deal? Well for one thing notice the italicized word above. Any company that ever was a shell is subject to this. I have learned the SEC views this requirement as retroactive. Thus the requirement to stay current applies to any company, even if it was a shell many years ago. So someone needs to tell Berkshire Hathaway, Occidental Petroleum, Texas Instruments, Blockbuster Entertainment and Jamba Juice (and every former SPAC) that this new rule applies to them.
The next problem comes in connection with fashioning registration rights. In the past in PIPEs, companies generally were required to complete a registration making shares tradable, and to keep that registration effective until the earlier of (i) the sale of all shares that were registered and (ii) such time as the holder can sell without any restrictions under Rule 144. Prior to the rule change, in most cases for non-affiliates the period in (ii) was two years. After the rule change, most agree that period (other than in shell situations) for non-affiliates is now one year (since even though one can sell starting in six months, the company must remain current for the next six months, thus creating a potential restriction). In a situation involving a company that was ever a shell, this period is now never.
Why is this? Because even five or ten years or more down the road, if a company was ever a shell, under the new rule you cannot use Rule 144 if the company is not current in its filings at the time of the exercise. Thus what to do now about registration? Require registration to be effective forever? Add additional penalties? We have developed solutions for a number of clients, and happy to share that upon request. Still, it's a real problem.
The third problem this creates is the removal of legends. PIPE investors, as well as any holder who acquires shares from a company that are unregistered or "restricted," contain a legend on the back of the certificate stating that the shares cannot be sold unless registered or an exemption from registration applies. Freely tradable shares have no such legend, and handing it to a brokerage firm generally provides free tradability without more questions.
It is most common to have a legend removed at the time of a sale where a holder seeks to sell utilizing the exemption under Rule 144. That is a somewhat cumbersome and sometimes time-consuming process involving the company, the transfer agent, company counsel giving an opinion, etc. In the past a Form 144 also had to be filed, though that has now thankfully been eliminated for non-affiliates under the new rule. Thankfully, for what it's worth, a legend will still be able to be removed at time of sale in this cumbsersome manner as a company can show it is current in its filings at that time.
The problem is that convention has developed allowing the legend to be removed not in connection with a sale, but when the holder has held the shares long enough so that they can be sold without any restrictions under Rule 144. Again, pre-rule change for non-affiliates that was generally two years, and post-rule change in non-shell situations for non-affiliates that is one year. Removing the legend in advance is very helpful as it saves time at the time of sale to avoid the difficult process described above. Plus occassionally a company refuses to remove a legend or counsel has some issue delivering an opinion, and so on. Removing the legend in advance takes away this worry.
Unfortunately, now a holder of shares in a company that ever was a shell can never have their legend removed in advance of a sale. Why? Because if a year has passed and no volume restrictions apply, there remains forever another restriction: that at the time of sale the company must have been current for the past year. Since you cannot know this in advance, it is not possible to remove the legend. If one did, and a holder sought to sell later, and the company was not current, they would be in violation of Rule 144.
One last problem. This additional restriction will further encourage those who create "bogus" shells pursuant to footnote 172 of the Rule 144 rulemaking, claiming as an apparently true startup that they are not a shell and therefore can have their stock trading, and now, be free of the requirement that applies to former shells to remain current for Rule 144 to be available. Luckily, a number of those lately trying to do this and avoid checking the "shell box" this way have been required by FINRA (formerly the NASD) to go back and amend their filings to check the box before allowing their stock to trade. Plus the SEC has made clear that there still need to be some actual operations in a business before it can avoid checking the box. This was not entirely clear when the rule was released.
In any event, I hope some enterprising reporter gets in touch with the shareholder relations people at some of the more famous reverse mergers to let them know this is now the case and note their reaction.
I respectfully find no logical basis that protects investors with this rule applying to shells forever. A company that completes an IPO or self-filing is not subject to this permanent restriction (by the way, this is now one additional advantage that self-filing brings). What makes reverse mergers so differerent? Apparently there are some within the SEC that believe the reverse merger technique is still abused by enough folks that complete a transaction, raise money, and then don't bother with silly things like keeping current in their filings so that investors are fully informed about the company at the time of sale.
As a concept I can see the benefit of this restriction for a short period of time. As mentioned above, in order to reduce the Rule 144 holding period in non-shell situations to six months, the staff required the company to remain current in its filings for the next six months. So even in non-shell situations, no legends can be removed until one year has passed from holding.
What makes absolutely no sense is a company completing a reverse merger being stuck with this three, five, ten, twenty years after the transaction. It paints the company with a "scarlet letter" suggesting it is somehow tainted for life. I implore the regulators to make a priority of taking another look at this restriction, possibly added in the haste of completing the drafting of a rule and not fully thinking out all the implications and unintended consequences. Does it really make sense that Warren Buffett's shareholders are subject to this? No, it does not.
Let me close as I opened. The new rulemaking (I am talking about this rule as a speaker on a panel at the American Bar Association Section of Business Law conference later this week in Dallas) was a major, positive step forward. The hard work of the SEC staff took many of the key recommendations of the blue-ribbon Advisory Committee on Smaller Public Companies and implemented them.
Our deal flow has never been better, and it shows that regulators can and do listen to what is happening in the marketplace and adjust to changes as they occur over time. It is a shame that with everything being better than it was before, this one change actually takes us backward to a restriction that did not exist in the past. That, unfortunately, makes the champagne we just popped a little flatter than we had hoped.
So when some complain that people involved in reverse mergers have to wait a year before Rule 144 is available, I remind them that before the rule change shell shareholders never had Rule 144 available (they do now), and that previously after one year those that did have it available had volume restrictions during the second year of hold (those volume restrictions are gone).
Almost going unnoticed, however, is a change imported from the requirements to avail oneself of "shelf" or short-form registration on Form S-3. That is, the requirement to have been current for the past year for S-3 to be available. In fact, to use S-3 each filing must have been made on a timely basis, not late. In new Rule 144(i), if a company ever was a shell company, the company must have done all its periodic SEC filings for the last 12 months or 144 is not available. The slightly good news is, unlike with Form S-3, the filings do not have to have been made on time. So a company could have missed a few filings but caught up prior to the attempt to utilize 144.
Why is this a pretty big deal? Well for one thing notice the italicized word above. Any company that ever was a shell is subject to this. I have learned the SEC views this requirement as retroactive. Thus the requirement to stay current applies to any company, even if it was a shell many years ago. So someone needs to tell Berkshire Hathaway, Occidental Petroleum, Texas Instruments, Blockbuster Entertainment and Jamba Juice (and every former SPAC) that this new rule applies to them.
The next problem comes in connection with fashioning registration rights. In the past in PIPEs, companies generally were required to complete a registration making shares tradable, and to keep that registration effective until the earlier of (i) the sale of all shares that were registered and (ii) such time as the holder can sell without any restrictions under Rule 144. Prior to the rule change, in most cases for non-affiliates the period in (ii) was two years. After the rule change, most agree that period (other than in shell situations) for non-affiliates is now one year (since even though one can sell starting in six months, the company must remain current for the next six months, thus creating a potential restriction). In a situation involving a company that was ever a shell, this period is now never.
Why is this? Because even five or ten years or more down the road, if a company was ever a shell, under the new rule you cannot use Rule 144 if the company is not current in its filings at the time of the exercise. Thus what to do now about registration? Require registration to be effective forever? Add additional penalties? We have developed solutions for a number of clients, and happy to share that upon request. Still, it's a real problem.
The third problem this creates is the removal of legends. PIPE investors, as well as any holder who acquires shares from a company that are unregistered or "restricted," contain a legend on the back of the certificate stating that the shares cannot be sold unless registered or an exemption from registration applies. Freely tradable shares have no such legend, and handing it to a brokerage firm generally provides free tradability without more questions.
It is most common to have a legend removed at the time of a sale where a holder seeks to sell utilizing the exemption under Rule 144. That is a somewhat cumbersome and sometimes time-consuming process involving the company, the transfer agent, company counsel giving an opinion, etc. In the past a Form 144 also had to be filed, though that has now thankfully been eliminated for non-affiliates under the new rule. Thankfully, for what it's worth, a legend will still be able to be removed at time of sale in this cumbsersome manner as a company can show it is current in its filings at that time.
The problem is that convention has developed allowing the legend to be removed not in connection with a sale, but when the holder has held the shares long enough so that they can be sold without any restrictions under Rule 144. Again, pre-rule change for non-affiliates that was generally two years, and post-rule change in non-shell situations for non-affiliates that is one year. Removing the legend in advance is very helpful as it saves time at the time of sale to avoid the difficult process described above. Plus occassionally a company refuses to remove a legend or counsel has some issue delivering an opinion, and so on. Removing the legend in advance takes away this worry.
Unfortunately, now a holder of shares in a company that ever was a shell can never have their legend removed in advance of a sale. Why? Because if a year has passed and no volume restrictions apply, there remains forever another restriction: that at the time of sale the company must have been current for the past year. Since you cannot know this in advance, it is not possible to remove the legend. If one did, and a holder sought to sell later, and the company was not current, they would be in violation of Rule 144.
One last problem. This additional restriction will further encourage those who create "bogus" shells pursuant to footnote 172 of the Rule 144 rulemaking, claiming as an apparently true startup that they are not a shell and therefore can have their stock trading, and now, be free of the requirement that applies to former shells to remain current for Rule 144 to be available. Luckily, a number of those lately trying to do this and avoid checking the "shell box" this way have been required by FINRA (formerly the NASD) to go back and amend their filings to check the box before allowing their stock to trade. Plus the SEC has made clear that there still need to be some actual operations in a business before it can avoid checking the box. This was not entirely clear when the rule was released.
In any event, I hope some enterprising reporter gets in touch with the shareholder relations people at some of the more famous reverse mergers to let them know this is now the case and note their reaction.
I respectfully find no logical basis that protects investors with this rule applying to shells forever. A company that completes an IPO or self-filing is not subject to this permanent restriction (by the way, this is now one additional advantage that self-filing brings). What makes reverse mergers so differerent? Apparently there are some within the SEC that believe the reverse merger technique is still abused by enough folks that complete a transaction, raise money, and then don't bother with silly things like keeping current in their filings so that investors are fully informed about the company at the time of sale.
As a concept I can see the benefit of this restriction for a short period of time. As mentioned above, in order to reduce the Rule 144 holding period in non-shell situations to six months, the staff required the company to remain current in its filings for the next six months. So even in non-shell situations, no legends can be removed until one year has passed from holding.
What makes absolutely no sense is a company completing a reverse merger being stuck with this three, five, ten, twenty years after the transaction. It paints the company with a "scarlet letter" suggesting it is somehow tainted for life. I implore the regulators to make a priority of taking another look at this restriction, possibly added in the haste of completing the drafting of a rule and not fully thinking out all the implications and unintended consequences. Does it really make sense that Warren Buffett's shareholders are subject to this? No, it does not.
Let me close as I opened. The new rulemaking (I am talking about this rule as a speaker on a panel at the American Bar Association Section of Business Law conference later this week in Dallas) was a major, positive step forward. The hard work of the SEC staff took many of the key recommendations of the blue-ribbon Advisory Committee on Smaller Public Companies and implemented them.
Our deal flow has never been better, and it shows that regulators can and do listen to what is happening in the marketplace and adjust to changes as they occur over time. It is a shame that with everything being better than it was before, this one change actually takes us backward to a restriction that did not exist in the past. That, unfortunately, makes the champagne we just popped a little flatter than we had hoped.
Labels: Rule 144
posted by David N. Feldman at
4/08/2008 06:27:00 AM
7 Comments:
"Unfortunately, now a holder of shares in a company that ever was a shell can never have their legend removed in advance of a sale."
I have restricted shares in a company that was once a shell. I've held the stock for one year. Do most companies and/or their attorneys realize they can't remove the legend? If I ask to have the legend removed and they agree, could that cause problems for me later? (I'm not planning to sell yet. I just want to be ready.)
Thanks,
Jeff
Well speak to your counsel of course. The presence of the legend or not does not legally change whether the shares are actually restricted. Thus of course I do not advise selling under 144 if the rule does not permit it. We are aware, however, that there are more than a few lawyers and transfer agents who are yet aware of this and have issued opinions to remove legends of shares in former shells. It would be great if the SEC at least would declare in interpretive guidance that this was not meant to be retroactive.
I have spoken with Chief Counsel's office and the intrpretaion is that it is retroactive. So all those PIPE investors in non-reporting pinksheet entities have lost all liquidity.
Well, maybe we can have further discussions with them about that interpretation. When they start getting calls from outraged executives from Blockbuster, Radio Shack, Texas Instruments and Berkshire Hathaway, maybe they will rethink re retroactivity. That might have been a "kneejerk" reaction since the entire Rule 144 change itself was deemed retroactive, but overall that was meant to help people sell under 144more quickly. We shall see.
Nice article. One nit, however. You cannot "violate" Rule 144 since it is a safe haven rule. Your sale may, however, violate Section 5 if the Rule or another exemption is not available.
Dave T.
I, too, have spoken with the Chief Counsel's Office at the Division of Corporation Finance at the SEC and share your frustration over their position; some companies were shells so long ago that one wonders how you're even supposed to ascertain such fact, as older filings did not require a company to indicate whether it was a shell and not all former shells were reporting companies or underwent reverse mergers. Furthermore, I find it positively ludicrous that an investor who invests in an "operating" company with no revenues that within a short time later "becomes" a shell can sell, whereas an investor who invests in an operating company that was a shell several or more years ago cannot. Perhaps that is why so many brokers, attorneys and transfer agents are unaware of how the restriction in Rule 144(i) works.
KM said:
Just ran into a situation where comany counsel insisted that they could not provide an opinion for a former shell even though it had met all the requirements under 144*(i)(2) unless the holder had a "bona fide intention to sell"--the quoted phrase (the title of the sub-section) seems to be derived from the Form 144 requirements where you filed Form 144 if you had a bonafide intention to sell within a reasonable time--but if I'm recollecting correctly, the new rules only require F. 144 for a smaller subset of clients. This would negate any possibility of advance derestricting . . .
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