Tip of the Week: Need a Reverse Split? Avoid a Merger Proxy

When a public shell is in the process of completing a reverse merger it often finds itself with too many issued and outstanding shares or not enough authorized shares. One solution is a reverse stock split. A reverse stock split is a pro rata reduction in the number of shares of capital stock of a company that are outstanding. It is often used to increase per-share price, or to make more authorized shares available in order to complete a reverse merger. At the time of the split, each shareholder still owns the same overall percentage interest in the company. Most states’ laws require a reverse stock split to be approved by shareholders, and this requires a proxy or information statement under SEC rules, if the shell is subject to the SEC’s reporting requirements. If the reverse split is a condition of the reverse merger, the SEC requires a much more complex merger proxy.

There are three lawful ways to avoid an involved merger proxy:

• If sufficient shares are available for issuance in order to consummate the transaction, the reverse merger is closed with the number of shares already existing. After the merger is completed, the combined company could then seek a reverse split that is not a condition to the merger and only a reverse split proxy is necessary.


• Even if insufficient shares are available, the shell might be able to issue pre-authorized shares of preferred stock that converts into common stock when a reverse split or increase in authorized shares is approved after the reverse merger. Other strategies are possible even if the shell does not have so-called "blank check" preferred stock.


• The SEC requires a full merger proxy when the reverse spilt is a condition to the merger. To address this provide in the merger agreement that the parties request a reverse split, contemplate it, but do not make it a condition to the transaction. Again, in this case only the much simpler reverse split proxy is necessary.

Quality Time

Just got back from a fabulous cruise with my daughter, who's heading to Brandeis University next year. Just the father-daughter thing which was great. Really missed my son (he's 6 in a week), fabulous wife and wonder pup Toby, but had a really great time just relaxing, hitting the islands, nice dinners and yes a few trips to the blackjack table (daughter played too!) to help pay for it all...

In my office I've always had the rule that you lose your vacation if you don't use it. The reason is not to be a Scrooge, but rather the opposite - namely I want my staff to take all the vacation they are entitled to each year. If not, it is too easy to burn out. I've known people who left a job with 3 months of unused vacation, which to me is crazy.

Life is way too short not to make the most of every single stage. So if you are reading this as a young single, recently married, new children, teenagers, grown kids or even ready to retire, take that extra time with all the people who matter to you. No one on their death bed ever said, "I wish I spent more time at the office." Of course, in a perfect world you enjoy your work (as I do) and also make time for family and friends.

The people in our lives also keep us grounded. If anyone ever feeds my ego just a bit, I just have to go home and take out the garbage to put things in perspective. Lean on them as you deal with all that life throws at you. As for my daughter and me, well, that bittersweet moment where she begins life on her own is just a few months away, and I savored every second of our seven days alone together.

OK, back to the RM world this week!

Season of Renewal

Ah Spring. The time for flowers, new relationships, new beginnings. When enjoying a warm, sunny day can elevate one's outlook and mood. For those of us who suffer cold and snowy winters (yes I know you folks in Canada have it rougher than us in New York), it is indeed a wonderful relief to hear the birds singing and my kids' cabin fever finally broken as T-ball, soccer and playgrounds all come back to life.

Not to stretch an analogy, but I feel the RM world has entered its Spring. Some have begun to call this the beginning of the "heyday" of alternative methods of taking companies public and providing financing. To me the door was slammed shut on RM's difficult past when Goldman Sachs recently announced that they are underwriting a SPAC. Citibank, Wachovia and others financing their operations with multi-billion dollar PIPEs. More and more calls to me from large firm lawyers taking venture and private-equity backed companies through reverse mergers with valuations well over $100 million. The IPO market completely shut down, leaving companies that could benefit from being publicly held with no other way to get there. Even the SEC getting into the game by easing the regulatory burden on smaller public companies to enhance the process of capital formation by reducing the Rule 144 holding period and other changes.

As many of us get ready to head to Los Angeles in June for the Reverse Merger Conference, the largest and most prestigious RM conference of the year (though there are a number of other excellent conferences as well), we can pause and possibly even allow ourselves a small victory lap around the Millennium Biltmore Hotel where it will be held.

Just a small one, though. Unlike some of my law clients and friends on Wall Street, while I am a supreme optimist, I worry when any trend heats up too much and too fast. How many of us said, "The Internet boom could last forever." "Real estate prices could continue to rise indefinitely." "Biotech stocks have no place to go but up." "We have defeated the business cycle." Those of us that have been around the block a few times (or the Millennium Biltmore) know that everything in business has cycles.

That said, I have enjoyed the fact that, for the most part, the RM and PIPE worlds are not market-sensitive or cyclical. Our business in both areas have steadily grown each year since the early 2000s. Indeed I was doing many reverse mergers during the Internet boom of the late 1990s, when companies could complete IPOs very easily. The problem then - some companies wanted to be public even faster than the six months or so it took to complete an IPO. So reverse mergers are an attractive alternative regardless of market conditions or the state of the IPO market.

As a entrepreneur, I am always shooting for the sky. Over time, however, watching myself and clients and friends, I have learned that the old adage "slow and steady wins the race" also can be a very successful, very lucrative way to approach one's business philosophy. I do believe that the RM world is not seeing a "bubble" which could burst disastrously as with the Internet boom, but much more of a slow and steady growth. Let's do our best to keep shooting for the sky while keeping our feet on the ground. But a nice little smile on a nice Spring day we have earned.

Private Placement Broker Registration - Finally?

I spoke on a panel last Friday at the American Bar Association's Section of Business Law's Spring meeting in Dallas (don't ask about my awesome travel experience on American Airlines). My fellow speakers and I updated the attendees on the new rules for smaller companies, including Rule 144 and Form S-3 changes.

For me a very interesting part of the discussion, though brief, was welcome. Namely, it appears that the vexing "finder" problem in the private placement arena may be improved sooner rather than later. For a number of years an SEC task force has been working with several different SEC divisions to encourage registration with the SEC of folks who act to find privately placed money for both public and private companies. Many, many "investment bankers" help companies raise money but are not registered as broker-dealers with the SEC. Technically, probably most if not all of them should be.

However, the SEC does not have significant resources to go after these violators in the absence of a complaint, which frankly rarely comes. This further encourages these players not to register. It is a little tougher for the finders in dealing with public companies, but in raising money for private companies, there is currently very little incentive to go through the rigorous process of registering, then maintaining a registration, as a broker-dealer.

Prior to 2001, there was a stronger argument for finders to claim an exemption from registration. The SEC no-action letters until then suggested that if an intermediary simply made an introduction of a money source to a company and then stepped away, no registration was necessary even if the intermediary pocketed a fee representing a percentage of the money raised. So long as he did not provide financial advice or help structure or negotiate the transaction, he was OK.

Starting in 2001, however, a group of no-action letters started to suggest that virtually no situation was OK if the intermediary took a percentage of the proceeds. Even if they introduce and step away. This led to some legitimate advisors turning to consulting arrangements paying flat fees regardless of the amount raised, which may or may not have reduced their exposure.

In any event, one of the fairly important challenges for smaller public companies raised by the SEC's Advisory Committee on Smaller Companies, whose recommendations were issued in April 2006, was that many smaller companies are afraid to work with unregistered intermediaries and the regulatory environment was, at best, unclear. The Committee suggested a modified and simplified form of registration for such players.

It now appears, at long last, that the various necessary SEC divisions which must collectively get comfortable with this seem to be ready to do so in the near term. It is not yet clear, but a much simpler registration process appears to be in the works. It is hoped that these "registered private placement brokers" would not need to maintain net capital like other broker-dealers, might not even have to maintain monthly "focus reports," etc. It is not yet clear how the state regulators will react, but of course it is hoped that they cooperate and see the benefit of more information being available about these intermediaries, and more certainty for issuers about who they are dealing with and whether they are operating within the law.

If this goes through, the next step would be to do the same for merger & acquisition brokers. Many of the same issues apply.

Keep those fingers crossed!

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.