Heard Better Medleys Than This

A new US Court of Appeals case known as SEC vs. M&A West, Inc. et al provides important reminders about how not to structure reverse mergers and compensate intermediaries. Thanks to our friend Sam Krieger, who sent a note out to his blast list about the case. OK here we go, haven’t had to brief a case in quite awhile!

For you fellow members of the bar, the case can be found at Case No. 06-15165 (9th Cir. August 12, 2008). The main protaganist in the case is one Stanley R. Medley, and the case involves several reverse mergers dating back to the late 1990s and an SEC case originally brought in California in 2001.

Basically, Medley introduced three affiliated private companies to three different shells, and reverse mergers were completed in each case. Medley was compensated with cash and also with stock “sold” to him and his buddies by the controlling shareholders of what was the shell. He paid a few thousand dollars and resold the shares less than nine months later and earned several million dollars in profit on the three deals.

Apparently Medley didn’t stop to review securities law before he made his sales. The trial court, granting part of a request for summary judgment by the SEC, ruled that he violated Section 5 of the Securities Act for selling shares to the public that were not registered, because he had purchased them from affiliates of the company. That made him a presumed statutory underwriter with the ability to sell only with registration or waiting out the appropriate holding period under Rule 144, neither of which he did.

Medley tried to argue that the affiliates he bought the shares from stopped being affiliates on the closing date, when the private company took over the former shell. The district court didn’t buy it (and the appeals court agreed, saying he did violate Section 5) and said he had to disgorge over $2 million in profits and interest (the appeals court also affirmed this) as well as more severe “second tier” penalties for particularly egregious acts (the appeals court sent this determination back to the trial court for more fact finding).

Essentially the court ruled that, even if the closing of his purchase of the shares happened after the closing of the reverse merger, and pursuant to an agreement separate from the main merger agreement, and at a time when the sellers were not technically affiliates, it was all part of a “single actual transaction with multiple stages.” Since the agreements were contingent on each other, and the failure of Medley to get his shares would give him the right to undo the reverse merger, and the agreements were entered into when they were still affiliates, the appeals court, agreeing with the district court, said they effectively sold to him while still affiliates. They pointed out that prior court rulings make clear you can’t get a Section 4(1) exemption just by giving up affiliate status shortly before completing a transaction.

One judge dissented in the case. He felt that the plain language of Rule 144 must be honored even if it doesn’t clearly follow SEC policy goals, and even though the sellers entered into the contract while affiliates, it was performed when they were not. He felt the majority improperly took an old case interpreting Section 4(1) and applied it to Rule 144, which has different language. He said the SEC is free to change its rules to make this more clear, then pointed out that shortly after this case was argued, the SEC did indeed revise Rule 144 (as we know) exactly “to target the precise sort of reverse merger transactions at issue here.”

Bottom line? Probably some of you just skipped right down here, that’s ok. First, we have at least one Federal circuit saying you can’t buy from a guy who just stopped being an affiliate in facts that are similar to these. If it’s contingent on the reverse merger (even as a condition subsequent), and you enter into the agreement while still an affiliate, it won’t fly and you have to wait for the applicable Rule 144 holding period without “tacking” the holding period of the seller.

Second, unfortunately this probably gives those at the SEC who may wish to defend their decision to put in the new Rule 144(i) restrictions a place to hang their hat and say “see?” But remember this involves deals that happened almost 10 years ago. The RM landscape has changed so much since then, and I hope this case will not affect our advocacy efforts to get the SEC to take another look at all this.

What’s the right way to do this? Ironically, most legitimate players have long since abandoned structuring transactions this way. Some players purchase a shell long in advance of a deal to avoid receiving shares for any reason at the closing. Others receive newly issued shares of the company and understand they have at least a one year wait (or registration) following the reverse merger. Others acquire shares from affiliates but again understand they need to wait a year.

Another way: the Medleys of the world can arrange to acquire shares from a variety of non-affiliates, eliminating this issue completely. Of course this is harder, but in some deals the affiliates are familiar enough with other shareholders who are not affiliates to arrange this. Of course the non-affiliate sellers need to get something for their generosity of selling shares basically for nothing to the intermediary. One way: if the non-affiliate agrees to sell, say 100,000 unrestricted tradable shares for nothing to the intermediary, the company then issues the non-affiliate seller 200,000 new shares which are restricted and have to be held for the applicable Rule 144 period. I don’t see anything improper in doing this.

One warning I always give clients who are intermediaries and acquire shares for basically nothing at the time of a reverse merger. The IRS could conclude that the difference between the price the intermediary pays for the stock and its real value represents compensation to the intermediary and must be taxed. In some deals this risk can be a significant problem.

Oh and by the way, the court hadn’t even gotten to another big issue, whether Medley should have been registered as a broker-dealer with the SEC and FINRA to be able to do what he did. That’s another risk which has continued to dog the small and microcap worlds when deals are being put together.

Anyway, never a dull moment in the RM world! By the way, several have asked: I still have not received a response from the SEC to my request for interpretive guidance regarding the retroactivity of the “evergreen” aspect of new Rule 144(i).

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