Worm/Wulff Change: A Major Improvement with Some Disappointment
It has taken a bit of analysis, discussion and interaction with SEC staff, but I am now able to offer some thoughts on the ultimately very positive change (albeit not as far-reaching as hoped) implemented by the SEC with respect to codifying certain positions of the staff under what have been known as the Worm/Wulff letters. Along with the improvement, however, are some disappointments that we hope to work to ameliorate over time. This entry is a little long and I apologize in advance, but I hope you will read through it as the changes are very important.
In two letters in 1999 and 2000 between the SEC and the NASD, the SEC laid out its view that any affiliate or promoter of a blank check company (one without a business plan or whose business plan is to acquire another business) may sell his shares publicly only after being registered with the SEC, presumably after a reverse merger. The common exemption from registration, which allows sale after a certain holding period under Rule 144, was deemed not available to these holders. This also applied to transferees of affiliates and promoters. In time the SEC staff went further, and made clear that in their view the pronouncement in the letters applied to all holders of shares in a blank check, whether or not affiliates or promoters or transferees thereof.
Despite this restriction, practitioners generally assumed that any investor buying into a former shell (such as a PIPE investor in a typical "alternative public offering" or APO) had the availability of the Rule 144 exemption.
The restriction on shell holders was a major problem, as it required them to negotiate complex protections in reverse mergers in the event that the post-merger company did not register the shares of the former shell owners. The SEC has now finally reversed this position.
The very good news in the new Rule 144 release is that the Worm/Wulff letters, at long last, have been all but obliterated. All holders of shares in the former shell will be able to sell publicly under Rule 144 starting one year after the completion of a reverse merger and release of so-called "Form 10 information" on Form 8-K as required by rules passed in 2005. While most of us were hoping the time period would gel with the new six-month hold for everyone else (and in fact the original proposal was to do just that), this is still a significant and positive change.
A few other items also were clarified. First, the one year period will start as of the first filing of the Form 10 information, even if the SEC comments on it and requests amendments.
Second, the SEC made clear that if you received shares in a real public operating business that later became a shell, you have the new six-month holding period for Rule 144 purposes even after the entity has become a shell. This was never clear and some practitioners believed any new investment decision (such as a desire to sell) while the entity was a shell may have been barred under Worm/Wulff if someone was trying to sell unregistered securities under Rule 144.
In a soon-to-be-famous footnote in the release, the SEC declared that a legitimate start-up company does not fit the definition of shell company (the type of company subject to the one-year hold vs. new six-month period). In 2005 the SEC defined a shell company as having no or nominal assets (other than cash) and no or nominal operations. Most practitioners had difficulty determining what was nominal, though most believed that at least $1 million in non-cash assets or operations was not nominal, and anything below that was uncertain.
This is a victory for those who represent the tiniest public companies that are indeed real businesses. Prior to this rule change, the only negative impact of being deemed a shell was the need to file Form 10 information once the entity ceased to be a shell. Now the impact would include the unavailability of Rule 144 while it is a shell and the one year hold vs. six months. With this change, these tiny public companies would have the full six-month benefit of the new Rule 144 changes and not be subject to the codification of Worm/Wulff.
The concern is that this may encourage the formation of "footnote 32" shells (see prior blog entries), which may now be renamed footnote 172 shells. These are not real businesses, or real businesses that are intended to be shut down or stripped out upon a merger. The promoter takes them public to avoid various SEC restrictions on shells, but does not disclose their real intent to find a private company with which to merge. Now with the certainty that six-month Rule 144 hold is available, and that the "super" Form 8-K and release of Form 10 information is no longer necessary for non-shell companies, unfortunately this form of misleading activity would be further encouraged.
A number of leading RM players have expressed to me deep concern that fraudsters will now see more incentive than ever to creating these misleading vehicles and those setting up legitimate Form 10-SB or "virgin" shells will have a tougher time competing with these improper entities. There may actually be a legitimate way to work this footnote to one's advantage, but I'll save that one for my clients!
This clarification is significant, however, as it appears to allow real companies, even startups, regardless of size of assets or operations, to go public without inadvertently being characterized as shells.
As with too many good things, there is a catch. In a change from the original proposal, the SEC has declared that anyone receiving shares in the shell while it is a shell or even thereafter (ie at or following a reverse merger) must wait to sell under Rule 144 until the later of the one year anniversary of the release of Form 10 information (the "Anniversary") and six months following acquisition of the shares.
This means that a PIPE investor putting money in at the time of an APO, who otherwise would have had the benefit of the new six-month holding period, now must wait until the Anniversary. Someone investing three months after the APO would have a nine-month hold and so on. This continues until six months after the APO, upon which everyone would have no more than a six-month hold. Remember, the requirement is not to hold for one year, it is to hold only until the Anniversary or six months, whichever is longer.
This will mean that PIPE investors will continue to look to registration of shares they might be interested in selling within one year following the reverse merger. This might bring us back to the Rule 415 problem which dogged us last year. Here the SEC sought to limit what percentage of a company's securities can be registered at one time. Happily, although the SEC set a guideline limiting registration to one-third of a company's public float, in the last year it has routinely allowed much more than this to be registered in registrations immediatley following reverse mergers.
This also may cause PIPE investors concerned about near-term liquidity (in general most investing in reverse mergers have longer-term outlooks) to phase their investment over time. If $10 million is needed for a company to get through a year, maybe $5 million can be invested at the time of the APO and another $5 million in six months. This means only the first $5 million is subject to the one year hold.
These changes also bring more attention to the option of a self-filing as a method to go public. Rather than using a merger with a shell, a company can simply file with the SEC either to register some of its existing shares for resale, or a class of securities which makes the company subject to the reporting requirements of the SEC.
Self-filings would not be subject to the Worm/Wulff changes requiring a hold until the Anniversary. Holders would benefit from the new six-month holding period, so that a company considering a self-filing where most or all shareholders have held their shares for six months has more options to establish a public trading market for its stock.
As in prior posts, I always warn that self-filings do not always make sense, and certain conditions should be present before considering this option.
Let's go back to that PIPE investor in the APO. Before these changes, if his shares were not registered he would have to wait one year before being able to sell any shares under Rule 144. During year two he would generally be severely limited in selling only 1% of the company's securities during each 90 day period. In addition the company had to be current in its SEC filings during year two for Rule 144 to be available. Only after the second anniversary would the investor be able to sell without any of these restrictions.
Under the new rule, the PIPE investor still waits up to a year, but has no volume restrictions whatsoever following the Anniversary. In addition, there is no requirement that the company be current in its filings after the Anniversary. This is much better than in the past, when most PIPE investors looked at the Rule 144 holding period as essentially two years because of the volume limits.
In addition, the reversal of the SEC's position in Worm/Wulff, to now allow shell owners the ability to sell under Rule 144 following a reverse merger, is very significant and something our industry has been fighting for almost since the letters were first released. While we would have preferred the six month hold originally proposed, that takes almost nothing away from the importance of this sea change.
In the end, these changes should further encourage those creating and acquiring shells (including legitimate virgin shells) and desiring to complete reverse mergers. That, combined with the further easing of barriers to capital formation once public, achieved by the new six-month holding period for Rule 144, results in a very large net positive for those interested in RM, APOs and the small and microcap markets.
Let me wish all of you, my thousands of faithful blogees, a very happy and healthy New Year.
Worm/Wulff Background
In two letters in 1999 and 2000 between the SEC and the NASD, the SEC laid out its view that any affiliate or promoter of a blank check company (one without a business plan or whose business plan is to acquire another business) may sell his shares publicly only after being registered with the SEC, presumably after a reverse merger. The common exemption from registration, which allows sale after a certain holding period under Rule 144, was deemed not available to these holders. This also applied to transferees of affiliates and promoters. In time the SEC staff went further, and made clear that in their view the pronouncement in the letters applied to all holders of shares in a blank check, whether or not affiliates or promoters or transferees thereof.
Despite this restriction, practitioners generally assumed that any investor buying into a former shell (such as a PIPE investor in a typical "alternative public offering" or APO) had the availability of the Rule 144 exemption.
The restriction on shell holders was a major problem, as it required them to negotiate complex protections in reverse mergers in the event that the post-merger company did not register the shares of the former shell owners. The SEC has now finally reversed this position.
The New Rule - Shell Holders Get Back Rule 144 Exemption
The very good news in the new Rule 144 release is that the Worm/Wulff letters, at long last, have been all but obliterated. All holders of shares in the former shell will be able to sell publicly under Rule 144 starting one year after the completion of a reverse merger and release of so-called "Form 10 information" on Form 8-K as required by rules passed in 2005. While most of us were hoping the time period would gel with the new six-month hold for everyone else (and in fact the original proposal was to do just that), this is still a significant and positive change.
A few other items also were clarified. First, the one year period will start as of the first filing of the Form 10 information, even if the SEC comments on it and requests amendments.
Second, the SEC made clear that if you received shares in a real public operating business that later became a shell, you have the new six-month holding period for Rule 144 purposes even after the entity has become a shell. This was never clear and some practitioners believed any new investment decision (such as a desire to sell) while the entity was a shell may have been barred under Worm/Wulff if someone was trying to sell unregistered securities under Rule 144.
Footnote 172: Start-ups are not Shell Companies
In a soon-to-be-famous footnote in the release, the SEC declared that a legitimate start-up company does not fit the definition of shell company (the type of company subject to the one-year hold vs. new six-month period). In 2005 the SEC defined a shell company as having no or nominal assets (other than cash) and no or nominal operations. Most practitioners had difficulty determining what was nominal, though most believed that at least $1 million in non-cash assets or operations was not nominal, and anything below that was uncertain.
This is a victory for those who represent the tiniest public companies that are indeed real businesses. Prior to this rule change, the only negative impact of being deemed a shell was the need to file Form 10 information once the entity ceased to be a shell. Now the impact would include the unavailability of Rule 144 while it is a shell and the one year hold vs. six months. With this change, these tiny public companies would have the full six-month benefit of the new Rule 144 changes and not be subject to the codification of Worm/Wulff.
The concern is that this may encourage the formation of "footnote 32" shells (see prior blog entries), which may now be renamed footnote 172 shells. These are not real businesses, or real businesses that are intended to be shut down or stripped out upon a merger. The promoter takes them public to avoid various SEC restrictions on shells, but does not disclose their real intent to find a private company with which to merge. Now with the certainty that six-month Rule 144 hold is available, and that the "super" Form 8-K and release of Form 10 information is no longer necessary for non-shell companies, unfortunately this form of misleading activity would be further encouraged.
A number of leading RM players have expressed to me deep concern that fraudsters will now see more incentive than ever to creating these misleading vehicles and those setting up legitimate Form 10-SB or "virgin" shells will have a tougher time competing with these improper entities. There may actually be a legitimate way to work this footnote to one's advantage, but I'll save that one for my clients!
This clarification is significant, however, as it appears to allow real companies, even startups, regardless of size of assets or operations, to go public without inadvertently being characterized as shells.
The Catch - All Must Wait for One Year Anniversary
of Release of Form 10 Information
As with too many good things, there is a catch. In a change from the original proposal, the SEC has declared that anyone receiving shares in the shell while it is a shell or even thereafter (ie at or following a reverse merger) must wait to sell under Rule 144 until the later of the one year anniversary of the release of Form 10 information (the "Anniversary") and six months following acquisition of the shares.
This means that a PIPE investor putting money in at the time of an APO, who otherwise would have had the benefit of the new six-month holding period, now must wait until the Anniversary. Someone investing three months after the APO would have a nine-month hold and so on. This continues until six months after the APO, upon which everyone would have no more than a six-month hold. Remember, the requirement is not to hold for one year, it is to hold only until the Anniversary or six months, whichever is longer.
This will mean that PIPE investors will continue to look to registration of shares they might be interested in selling within one year following the reverse merger. This might bring us back to the Rule 415 problem which dogged us last year. Here the SEC sought to limit what percentage of a company's securities can be registered at one time. Happily, although the SEC set a guideline limiting registration to one-third of a company's public float, in the last year it has routinely allowed much more than this to be registered in registrations immediatley following reverse mergers.
This also may cause PIPE investors concerned about near-term liquidity (in general most investing in reverse mergers have longer-term outlooks) to phase their investment over time. If $10 million is needed for a company to get through a year, maybe $5 million can be invested at the time of the APO and another $5 million in six months. This means only the first $5 million is subject to the one year hold.
So What Happened?
Many clients have asked why I believe the SEC proposed a more attractive package than was finally adopted. The comment letters were overwhelmingly positive. So there should have been no reason not to adopt the proposals as written.
My belief is that there remain anti-RM forces in high staff level positions (and maybe even at the Commissioner level) at the SEC. I had thought we had finally gotten past the "shells are inherently bad" mentality of the 1980s and 1990s. When the SEC adopted enhanced disclosure to increase the transparency and legitimacy of these transactions in 2005, they declared that they recognize the legitimate use of these techniques in corporate structuring.
So why this? I think those who are not as positive on this field did not pay much attention to the proposal when written, but when it came time to deal with comments suddenly woke up and decided that the proposal was in their mind too generous. Why a PIPE investor putting in money at the time of or following a deal should somehow be lopped in with shell guys is a bit of a mystery to me frankly.
Just when I thought I might run out of advocacy issues to draw attention to the Staff, we have a new one. I will make it my business to do all I can to see if there is any possibility of ameliorating this change. Like all things, however, it may take time.
Self-Filings Still Attractive
These changes also bring more attention to the option of a self-filing as a method to go public. Rather than using a merger with a shell, a company can simply file with the SEC either to register some of its existing shares for resale, or a class of securities which makes the company subject to the reporting requirements of the SEC.
Self-filings would not be subject to the Worm/Wulff changes requiring a hold until the Anniversary. Holders would benefit from the new six-month holding period, so that a company considering a self-filing where most or all shareholders have held their shares for six months has more options to establish a public trading market for its stock.
As in prior posts, I always warn that self-filings do not always make sense, and certain conditions should be present before considering this option.
Net Result - Much Better than Before
Let's go back to that PIPE investor in the APO. Before these changes, if his shares were not registered he would have to wait one year before being able to sell any shares under Rule 144. During year two he would generally be severely limited in selling only 1% of the company's securities during each 90 day period. In addition the company had to be current in its SEC filings during year two for Rule 144 to be available. Only after the second anniversary would the investor be able to sell without any of these restrictions.
Under the new rule, the PIPE investor still waits up to a year, but has no volume restrictions whatsoever following the Anniversary. In addition, there is no requirement that the company be current in its filings after the Anniversary. This is much better than in the past, when most PIPE investors looked at the Rule 144 holding period as essentially two years because of the volume limits.
In addition, the reversal of the SEC's position in Worm/Wulff, to now allow shell owners the ability to sell under Rule 144 following a reverse merger, is very significant and something our industry has been fighting for almost since the letters were first released. While we would have preferred the six month hold originally proposed, that takes almost nothing away from the importance of this sea change.
In the end, these changes should further encourage those creating and acquiring shells (including legitimate virgin shells) and desiring to complete reverse mergers. That, combined with the further easing of barriers to capital formation once public, achieved by the new six-month holding period for Rule 144, results in a very large net positive for those interested in RM, APOs and the small and microcap markets.
Let me wish all of you, my thousands of faithful blogees, a very happy and healthy New Year.
Labels: Worm/Wulff
posted by David N. Feldman at
12/30/2007 07:15:00 PM
3 Comments
Links to this post
