Identifying a Shell Company
The definition of a shell company is provided in Rule 4051 under the Securities Act of 1933, as amended (the Securities Act), and Rule 12b-22 under the Securities Exchange Act of 1934, as amended (the Exchange Act). Shell companies generally fall into one of three categories:
Blank check. Shell companies formed for the specific purpose of effecting a reverse merger are known as blank check shell companies. Despite the advantages of this entity type, only 5% of the Reviewed Transactions involved blank check shell companies.
Development stage. Shell companies that have previously filed a registration statement under the Securities Act and may have a business plan but only have nominal operations are known as development stage companies. Approximately 66% of the Reviewed Transactions involved development stage shell companies.
Natural. Shell companies that previously conducted operations that were either disposed of or otherwise terminated are known as natural shell companies. Approximately 29% of the Reviewed Transactions involved natural shell companies.
A central concern for privately held companies when identifying the shell company with which to execute a reverse merger is whether the shell company is free of liabilities. Upon consummation of the merger, the surviving reverse merger company will bear all liabilities of the shell company and, as discussed below, post-closing indemnification for these liabilities from shell company pre-closing shareholders is unlikely to be available. Therefore, comprehensive due diligence is essential, especially in the case of development stage and natural shell companies, with particular attention to be paid to securities law compliance, accounting controls, and legacy tax, employee, environmental, and tail liabilities that may arise from prior transactions by the shell company.
