Reverse Mergers and Shells Under SEC Microscope

It has become increasingly obvious that the Securities and Exchange Commission (SEC) has reverse mergers and shells in its sights. Is this a temporary phenomenon? Will it pass? This column talks about what is happening in the small-cap industry that will affect companies that want to go public through a reverse-merger process.

In a previous column, [Theodore F. di Stefano, “Finding Dollars for Small-Cap Companies,” E-Commerce Times, June 28, 2004], I briefly mentioned that the SEC’s new approach “…might prove to be the death knell of reverse mergers.” This column explores what appears to be the SEC’s present intention toward reverse mergers and public shells.

A reverse merger occurs when an operating company merges into a corporate shell. After the merger, the shareholders of the operating company are in control of the new, merged entity.

Let’s say that you own a majority interest in a closely held corporation. Suppose you want to take your company public, but you realize that there are few opportunities for small companies like yours to successfully complete a fully underwritten Initial Public Offering (IPO).

The reason for the difficulty is that most underwriters in today’s market will not bother with the risk of trying to take a small company public. The IPO market is rather dormant today, and the small company has little chance of completing a successful IPO.

Dormant Company

You are told that one alternative for you is the reverse merger with a public shell. Your company can merge with a company that is already public, but inactive. It’s a merger in every sense, except that the company into which you are merging your business is sort of “brain dead.”

By that I mean that it usually has no operations, no sales and no management to speak of. The only thing that it has in its favor is that its stock is publicly held.

The dormant company, the “shell,” originally went through a fully underwritten IPO process, and its stock was actively traded. For some reason, however, (bankruptcy, lack of sales or obsolescence of its product or products) the company ceased existing as an operating company. It then became a shell, but its shares continued to be traded.

You realize that this may be a good opportunity for you to “instantly” go public with your company and garner all of the benefits of a publicly held corporation — thus, the merger of your company with the shell.

Current SEC Focus

Presently, the SEC has less tolerance of reverse mergers and shells. In fact, it has recently suspended trading on 26 stocks of shell companies. It plans to take steps to assure that these stocks are never traded again by revoking the registrations of these companies.

Note that a registration statement has to be filed by a company wanting to go public. After what is sometimes a lengthy process, the SEC calls the registration statement “effective,” and the company is then able to commence trading.

By revoking the registrations of these publicly held companies, the SEC is essentially eviscerating the company by removing the source of its rights to offer shares on public markets — the registration statement.

A New Direction?

Fortunately or unfortunately, depending on where your interests are, it appears as though this is a new direction for the SEC. The reason behind this new philosophy is that shells are considered very susceptible to unscrupulous operators, who have become quite common in the trading of shell corporations.

One SEC spokesperson recently said that the shares of shell companies are “…ripe for manipulation.” This statement, alone, means to me that the SEC is not going to “go away” soon when it comes to scrutinizing shells and the trading of shares of shells.

This is why I said in a previous column that the SEC’s new approach “…might prove to be the death knell of reverse mergers.” Therefore, I don’t see them retreating from their focus on shells.

SEC Faces Hurdles

It seems quite obvious to me that reverse mergers are in trouble. I can’t predict the final outcome of this battle. My guess, though, is that the government will win.

There are, however, some strategic restrictions on the SEC. There are more than 1,000 shell companies that are currently trading on the pink sheets. I think that it will be a gargantuan challenge for the federal government to shut down or stop the trading in so many companies. Therefore, I think that the government has its work cut out for it.

Think about it for a moment. A reverse merger is a corporate merger between an active operating company and an inactive (“brain-dead” or “comatose”) shell corporation whose shares are publicly traded. If you take away the shell corporation, you take away the reverse merger.

Reverse Merger ‘Abuse’

An article that I recently read talked about the fact that the SEC wants to eliminate the “abuse” of reverse mergers. Note how the word “abuse” is attached to reverse mergers. This doesn’t sound good for the future of reverse mergers.

My advice would be twofold:

First, if you are already in the process of a reverse merger with a public shell, you should consult your attorney and ask whether you should abort your effort and whether he or she still thinks that a reverse merger will get by the SEC’s scrutiny.

Second, if you have not started the process of a reverse merger, talk to your attorney about a nonunderwritten IPO for your company. I discussed this process in a previous column, but will be going into it in much greater detail in a future piece.

Benefits Remain

Keep in mind that there are still many benefits inherent in bringing your company public. In one of my early columns on going public [Theodore F. di Stefano, “Is Going Public the Right Move for Your Company?,” E-Commerce Times, July 14, 2004], I talk about the questions that you should be asking yourself when considering such a move. If, after answering these questions, you still think that the public route is the right one for you, you should realize that there are many positives to such a move.

The SEC attributes a variety of benefits to going public. I’ll list three of them; the rest can be found here.

1. Your access to capital will increase, since you can contact more potential investors.

2. Your company may become more widely know.

3. You may obtain financing more easily in the future if investor interest in your company grows enough to sustain a secondary trading market in your securities.

Stay the Course

If, after having done your research, you think that an IPO is right for your company, then by all means proceed along that path. At some point, you might have to abandon the process of a reverse merger with a corporate shell. This does not mean that you would have to abandon the idea of going public and having your shares actively traded on the market.

Remember that there are other SEC-friendly ways for you to go public. Talk to your securities attorney and look at all of the alternatives available to you. Also, read the previous articles that I wrote on the IPO process. Give this subject a great deal of thought, and, as always, Good Luck!

Theodore F. di Stefano is a managing partner at Capital Source Partners and can be contacted at [email protected].

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