Considerations for a reverse merger...
Below you'll find some considerations and basic rules/regs, followed by how this could relate to KATX/BVIG in the event of a merger
Special thanks goes to one of my trusted friends and advisors for the excellent work in providing this summary.
There's many types of r/m's and here's one that is very interesting...
Gypsy Swap -- Rule 144 Issue for Pink Sheet Reverse Merger Companies
One of the most important issues in a Pink Sheet company is to find paths to raise new money...
Free trading stock has more marketability than restricted stock and a Pink Sheet company cannot file a registration statement with the SEC because they lack the necessary PCAOB audited financials.
They bought a clean shell, but could not sell stock privately to investors and ask them to wait a year to sell under Rule 144 because Rule 144 is not available for a former shell company...
So perhaps they do what is called a "Gypsy Swap."
In a Gypsy Swap, the company has a shareholder with free trading stock to sell his stock to a new, cash investor. The money goes to the company and the company issues restricted stock to the shareholder who had the free trading stock originally. The old shareholder keeps his stock position, the new investor gets free trading stock, and the company gets the money.
The SEC does not look kindly on end runs around Section 5 of the Securities Act of 1933. This is the section that requires new sales of stock to be registered with the SEC. Consequently, the SEC has taken the position for a number of years that Gypsy Swaps are violations of Section 5 and the shares received by the new investor are restricted securities under Rule 144(a)(3).
In Zacharais v. SEC, the Circuit Court of D.C. agreed with the SEC, finding that the new investor and the original shareholder were "underwriters," or participants in the distribution.
So let's review security compliance for reverse mergers...
In most small reverse mergers, the parties overlook complying with the securities laws. Under the Securities Act of 1933, when you issue securities you must register, with some stated exceptions.
In a reverse merger, the public company is typically exchanging securities with the operating company. These securities must be registered or have an exemption.
If the operating company being acquired has a number of shareholders, both accredited and unaccredited, in a number of states, then registering or finding an exemption from registration can be difficult.
In this scenario there are two issues...
First, does the company issuing the stock, that is the public company, have an exemption entitling it to issue the stock.
Second, once the public company stock is issued, to the operating company's shareholders, the public company's stock is restricted or free trading in the hands of the recipients, the operating company's shareholders.
Private Exemption
If the operating company being acquired has only a few shareholders, and they are all accredited, the public company can issue the stock privately. The public company stock these shareholders received will be restricted in the hand of the operating company shareholders as it was issued privately.
Reg D, Rule 506 can be used if all the operating company's shareholders are accredited and the company will not have to qualify under state law.
Reg D, Rule 504 can be used if the offering can qualify with the states where the operating company's shareholders live.
Form S-4
Typically, larger companies that can register the securities in a merger usually use Form S-4. This form must contain full disclosure not only about the company issuing its securities (the public company), but also full disclosure about the company being acquired (the operating company), and information on the surviving, combined entity. Because this is an SEC registration, the entities must have two years of audited financial statements. The filing will take time for the SEC to review.
Regulation A
Regulation A has been used, but it may have to be filed in some states where the operating shareholders reside. As a practical matter, some states do not favor Reg A offerings. Audited financials are not required. The filing will take time for the SEC to review.
Form CB
Little known, Form CB can be used if the the operating company is a foreign entity with less than 10% of the shareholders. However, the securities are restricted in the hands of the operating company shareholders.
Regulation S
Reg S can be used if all of the operating companies shareholders are foreign. The public company stock issued to the operating company shareholders is restricted.
Section 3(a)(10) Exemption
Simply summarized, Section 3(a)(10) of the Securities Act of 1933, is an exemption for issuing securities where (1) the securities are issued in exchange for securities, claims, or property interests (not cash -- you cannot use this to raise new money), (2) an authorized court or authorized governmental entity must have a hearing to approve the fairness of the terms and conditions of the exchange, and, (3) due process of law is required, notice and hearing for those who would get the securities.
Note that the 3(a)(10) securities are free trading – immediately – in the hands of the operating companies shareholders if they are not affiliates of either the public company or the operating company before or after the transaction. Note also that the SEC has allowed foreign courts to have the fairness hearing.
The question of what is a shell company is most important (1) in determining if stock can be sold under Rule 144, (2) in determining if the company has to check the shell box on SEC filings, and (3) in getting a Form 211 approved by FINRA to get the stock trading.
First, we present the rules in their entirety:
The Rule 144 Shell Company
Under Rule 144(i):
“Unavailability to securities of issuers with no or nominal operations and no or nominal non-cash assets.
1. This section is not available for the resale of securities initially issued by an issuer defined below:
i. An issuer, other than a business combination related shell company, as defined in Rule 230.405, or an asset-backed issuer, as defined in Item 1101(b) of Regulation AB (Item 229.1101(b) of this chapter), that has:
A. No or nominal operations; and
B. Either:
A. No or nominal assets;
B. Assets consisting solely of cash and cash equivalents; or
C. Assets consisting of any amount of cash and cash equivalents and nominal other assets; or
ii. An issuer that has been at any time previously an issuer described in paragraph (i)(1)(i).
2. Notwithstanding paragraph (i)(1), if the issuer of the securities previously had been an issuer described in paragraph (i)(1)(i) but has ceased to be an issuer described in paragraph (i)(1)(i); is subject to the reporting requirements of section 13 or 15(d) of the Exchange Act; has filed all reports and other materials required to be filed by section 13 or 15(d) of the Exchange Act, as applicable, during the preceding 12 months (or for such shorter period that the issuer was required to file such reports and materials), other than Form 8-K reports (Rule 249.308 of this chapter); and has filed current "Form 10 information" with the Commission reflecting its status as an entity that is no longer an issuer described in paragraph (i)(1)(i), then those securities may be sold subject to the requirements of this section after one year has elapsed from the date that the issuer filed "Form 10 information" with the Commission.
3. The term "Form 10 information" means the information that is required by Form 10 or Form 20-F (Rule 249.210 or Rule 249.220f of this chapter), as applicable to the issuer of the securities, to register under the Exchange Act each class of securities being sold under this rule. The issuer may provide the Form 10 information in any filing of the issuer with the Commission. The Form 10 information is deemed filed when the initial filing is made with the Commission.”
So a shell is a company with no or nominal assets (other than cash). Assets in this case will be measured by GAAP standards. We do not purport to be accounting experts, but we do believe that the meaningful rules here are (1) for an asset to have value, it has to have economic value or some market value to the company, and (2) R&D is not capitalized, so it cannot show up as an asset.
There are several scenarios here...
Typically, a company that was an operating company becomes a shell when these operations fail and management stops. Managements have been known to sweep out the cash assets at the last minute. Managements also have been known to limp along hoping a miracle will happen. They may also recognize that the company will have value as a shell and keep it operating so that it will not fall into the Rule 144 shell definition...
Footnote 32 shell
"We have become aware of a practice in which the promoter of a company and/or affiliates of the promoter appear to place assets or operations within an entity with the intent of causing that entity to fall outside of the definition of blank check companies in Securities Act Rule 419. The promoter will then seek a business combination transaction for the company, with the assets or operations being returned to the promoter or affiliate upon the completion of that business combination transaction.
"It is likely that similar schemes will be undertaken with the intention of evading the definition of shell company that we are adopting today. In our view, when promoters (or their affiliates) of a company that would otherwise be a shell company place assets or operations in that company and those assets or operations are returned to the promoter or to its affiliates (or an agreement is made to return those assets or operations to the promoter or its affiliates) before, upon completion of, or shortly after a business combination transaction by that company, those assets or operations would be considered 'nominal' for purposes of the definition of shell company."
So... A shell is a company with no or nominal assets and no real operations, you will be happy to know that the SEC in another footnote, number 172 in a later release, has said that a startup business, or one with minimal operations, does not necessarily fit in the Rule 144(i) shell definition, even though it could have little or no assets or operations.
Contrary to commenters’ concerns, Rule 144(i)(1)(i) is not intended to capture a “startup company,” or in other words, a company with a limited operating history, in the definition of a reporting or non-reporting shell company, as we believe that such a company does not meet the condition of having “no or nominal operations.”
Up to Footnote 172, some reverse merger practitioners understood “nominal” to mean having less than $1 million in operations or non-cash assets. Now it seems that you can have less than that [$1 million] in operations or non-cash assets and still not be a shell if you have a bona fide intent to grow the company. This raises the next question.
How to identify “Footnote 32 Shell?”
If we compare the Footnote 32 shell, a company with a small sham business that was set up only to be a disguised shell, with a Footnote 172 shell, a company with a small business that was set up to truly be developed, how do we tell the difference?
As we cannot read the minds of the promoters who may be disguising their intentions anyway, it has been suggested to consider the following factors:
(1) how long has the company been in operation, (2) is it a start up or early state business, (3) most conclusive from a point of view, is the company in a business that is likely to grow into a real public company of some size, or is it a small business that has simply been recruited as an obvious scam, (4) is only a small amount of money being raised, (5) does the management have real credentials in their industry or are they simply financial promoters, (6) the company is incorporated in a state known for this type of foolery, e.g. Nevada, (8) the company purports to being the oil and gas, mineral or other business that is known for its promotional companies, (9) the principals, have promoted such thin companies for reverse mergers before, and (10) have they made agreements and hired employees in such a manner as to indicate that this is a real effort to make a real company.
The company files a Form 211, it may not pass and the promoters will lose their time and effort...
Rule 144 is an important exit strategy for investors. Rule 144 sales can not be made, and if made could lead to legal problems. Investors may not want to invest in a company that cannot make 144 sales. If they invest under false pretenses, that their stock is 144 salable when it is not, this can create a serious problem.
If the company is a legitimate operating company, and wants to sell the public listing to another operating company, problems can occur if the public company takes out its operations leaving a shell company that then merges with the private operating company in a reverse merger. This is because after the existing operations were removed, the company was for some moment in time a shell company. If the company was ever a shell company, it cannot use Rule 144.
Further, the company [can] restructure this reverse merger transaction to provide that the old operations of the public company stay in the public vehicle for a short period of time after the merger. Then the public company has not been a shell, right? However, is it not actually a Footnote 32 shell, which is to say a public company that is actually looking to act as a reverse merger shell company and uses its operations as a scam in a scheme to evade the rules on shells? No doubt the future rulings of the regulators will edify us as to this issue and we would expect those rulings to allow legitimate corporate restructurings and slam those deals that are founded in deception.
Form 10 Shells...
Public shells or OTC shells, sometimes referred to as clean public shells, are used to take companies public through what are called reverse mergers or reverse take overs. The reasons these reverse mergers are used is because the market for IPOs or initial public offerings is weak for small to medium sized enterprises and these companies need to raise money by selling stock. When a company is public after a reverse take over or RTO, the possibility of liquidity gives the investors who do a private placement the hope of liquidity when they do a PIPE deal, or private investment in public equity.
There are several types of such reverse merger public shells...
The best are now trading in the public market, be it OTCBB or Pink Sheets. The value of the trading shell is the fact that you do not need to file a Form 211 with FINRA through a market maker to get the stock trading. Filing a Form 211 can be expensive and time consuming. Many market makers who file a Form 211 for you will try to charge you $10,000 or so for “due diligence” or clearing services with their affiliated clearing firm, even though FINRA rules prohibit a market maker from charging to file a Form 211.
Then the Form 211 has to be processed by FINRA. This can be a difficult and lengthy process, as FINRA wants to be sure that all stock was issued properly and will ask for copies of cleared checks and properly executed subscription agreement, as one example, not to mention a thorough background check on the person. These issues are avoided with a trading shell, whereas they occur with a gray company Form 211 and with a Form 10 Shell and with an S-1 offering. However, with an offering that is filed with the SEC, Form 10 or S-1, the due diligence may be somewhat more relaxed.
What is a Form 10 shell?
A Form 10 shell is created when a shell company, a company with limited assets and business, files a Form 10 with the SEC.
A Form 10 registers a company with the SEC under the Securities and Exchange Act of 1934, but Form 10 does not allow the company to issue securities publicly. That is accomplished by a registration under the Securities Act of 1933, a different statute than the Securities and Exchange Act of 1934,
The game plan of the Form 10 shell is to get the company registered with the SEC so that subsequent filings to register the stock proceed more rapidly.
The procedure is that a Form 10 shell merchant, perhaps a securities lawyer, or other professional in the industry, creates a new company, gives it enough money to withstand the initial expenses of an audit and filing, gets an audit that qualifies under SEC rules (an audit from a PCAOB accountant), and files Form 10 with the SEC. The SEC may or may not comment on the filing. Once the filing has been commented on and corrected, the Form 10 shell merchant seeks a merger partner, an operating company for a reverse merger. Note here that up to this point, there are no securities in public hands and the stock of the company does not trade. There is no market maker and no trading volume. The stock is not listed anywhere.
When a reverse merger is agreed on, the combined companies are one and “Super 8-K” is filed with the SEC. This registers the stock to trade. The company will also find a market maker and a Form 211 will be filed with FINRA. The SEC may comment on the Super 8-K, but is not required to do so.
When the stock is cleared for trading, trading starts, usually with relatively low volume and the hopes on the part of the company that it will be able to develop volume one way or another.
Trading volume is important because many PIPE investors will not locate their checkbooks unless and until they see enough volume in the stock that they can be assured of market when they are ready and able to sell their stock.
You can imagine that having a large paper profit on your $1 million investment in a trading company, even if the stock is readily salable under the securities laws, is worth little or nothing if the stock trades only $5,000 of stock per day. Theoretically, you could sell in 200 trading days = ten months, but putting that amount of stock on the market would push the stock toward its ultimate support level at $0.00 per share. By selling into that market, you would only be watching your profit evaporate as your selling depressed the price and you cut your own throat.
The Pro's and Con's of a Form 10 Shell...
Promoters use Form 10 shell to sell their wares:
First, they can obtain PIPE [private investment in public equity] financing by telling the investors you are going to get the company trading and develop a market.
PIPE investors want liquidity as fast as possible which means the stock is already trading so this is a problem. It takes time and money to develop a market, even for an already trading shell reverse merger. Also, there is always the risk that FINRA will hold up approval of the Form 211.
In a Form 10, the control persons of a trading shell get whatever cash and/or cash/stock they can from selling control in the negotiations and keep it in a Form 10. The stock can be 5-10% of the combined company.
The cost of creating a Form 10 shell can be $35,000 to $40,000 to get it filed and the cost of maintaining it each year thereafter can be $20,000 each year.
S-1
When a company goes public using an S-1 registration, the holders of the stock, if they buy in the offering, have freely trading stock. FINRA will still want to see enough stock in public hands that a market can be developed.
If the holders of stock in a company registered under Form 10 have held their stock for the required six months, they may sell under Rule 144 and a market may be created or the company may register stock using the S-1.
A Form 10 is used...the company may continue to solicit private placement money after it files with the SEC. If an S-1 is filed, only if those buyers are already connected to the company can they buy while the S-1 is being processed.
From the company's viewpoint little time is actually saved. While the stock may have a market, until the stock has an actively trading market, private money will be hard to find and thus we have a bigger problem; no liquidity and no time to get it.
So... conclusions and further thoughts in relation to KATX/BVIG:
Pink Sheet shells do not require audited financial statements and they do not have to go through the time and expense of having a market maker file a Form 211 with FINRA. However, they need to develop a real trading market with a market maker and some shareholders to start.
If they use a Reg A offering, audited financials are not needed, but they must be GAAP and will have to file with the SEC. Form 211 will have to be filed and a trading market developed.
We have an OTC BB shell, barely trading, and filed the Super 8-K's (or something very similar IMO) with the SEC, no Form 211 is needed, but they did due to recent changes on the FINRA OTCBB and they will still need to develop the market as in the Pink Sheets....
If they do an S-1, they need audited financials, a Form 211, and to develop the market...
If they do the Form 10 shell, they will have some cost, but they've already done a version or filed the Super 8-K and the Form 211...
If they want to save money and wait a few months, they want the S-1.
If they cannot do audited financials, then they are stuck with the Pink Sheets unless they file a Regulation A offering.
The point in doing the Form 10 means they can solicit money after filing with the SEC.
No matter how they became public, they need liquidity, and Market maker(s) who make money mainly on volume.
FINRA processes the Form 211 and requires that there be enough non-affiliated shareholders with free trading stock to make trading in the stock possible. They do not want this stock to be concentrated in a few hands and someone holds a monopoly here (not to mention investors have no voting power whatsoever).
Granted, before making the share distribution offering they should have documented in detail how this stock was to be offered and/or sold and proved it was in full compliance with all the securities laws and rules of the the SEC and the states. There was a question regarding this distro and normally stock has to bought in a bona fide transaction for investment and not simply gifted to shareholder(s) in this type of process, but the assumption is this was done and dusted in December 2010...we'll have to wait and see.
They repeatedly state and 'prove' the company is not a shell (see previous BVIG filings stating the company's opinion that it is NOT a shell) as defined in Rule 144, show that it's a bona fide business with limited assets, and at least be a development stage company...
They had to produce a shareholder list from the T/A clearly showing free trading stock and an opinion letter from the securities lawyer that this stock is in fact free trading stock and not restricted...
The question is... did FINRA stop the Form 211?...If so, they have the right to appeal to the SEC, but any such appeal is likely to be unsuccessful.
Peace,
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