a) Increase of Number of Authorized Common Shares or Reverse Stock Split Pre-Closing
The easiest ways to enable Public Shells to issue enough common shares to the shareholders of the Private Company to accomplish the reverse shell merger are: (i) the increase in the number of its authorized common shares; or (ii) a reverse stock split before the merger is consummated. Pursuant to Section 242 of the Delaware General Corporation Law (“DGCL”),[3] each of these alternatives requires an amendment to the certificate of incorporation (CoI) of the Public Shell. Pursuant to the same provision, shareholder approval is necessary to amend the CoI. Whether such shareholder approval can be obtained by written consent of the majority shareholder(s) depends on the applicable corporate statute and the Public Shell’s by-laws. For instance, under DGCL 228, majority shareholder consent is possible unless the by-laws state otherwise; under Section 615 of the New York Business Corporation Law, generally unanimous shareholder consent is required, unless the CoI provides otherwise. Depending on the outcome of the analysis of the applicable corporate law, the CoI, and the by-laws, a shareholders’ meeting might be required prior to closing. However, both a shareholders’ meeting and a majority shareholder written consent will trigger time consuming procedures mandated by federal securities laws as set forth in Section III.1., which will delay a closing substantially.
b) Increase of Number of Authorized Common Shares Post-Closing
To avoid the timing problem set forth under (a), practitioners have developed a technique by which the transaction closes before the number of authorized common shares is increased or the reverse split is accomplished. This might appear puzzling because, after all, one closing condition is the payment of consideration in the form of the issuance of shares of common stock to the Private Company’s shareholders, which is in turn impossible without enough authorized common shares. The solution to the problem is referred to as the “Preferred Stock Solution”. A “good” Public Shell will generally have authorized but unissued preferred shares. In such a case, the Public Shell Board of Directors can file a Certificate of Designations with the Secretary of State (assuming that, as will generally be the case, the CoI vests corresponding powers in the board [4]) determining that each preferred share shall be convertible into a certain number of common shares so that after the conversion, the shareholders of the Private Company will hold the percentage of common shares in the Public Shell they are supposed to hold under the terms of the deal.
Example:
A Public Shell has 10,000,000 shares of common stock authorized, of which 5,000,000 are issued to its 200 shareholders. In the merger with a Private Company, the shareholders of the Private Company are supposed to receive 80% of the Public Shell’s stock, which is impossible without an increase in the authorized number of common shares or a reverse split of the outstanding common shares, both of which would require shareholder approval before closing. However, the Public Shell also has 1,000 preferred shares authorized. At the closing of the merger, it can issue 5,000,000 common shares and 1,000 preferred shares, with each preferred share convertible into 15,000 common shares upon authorization of a sufficient number of the underlying common shares and each preferred share having 15,000 voting and other rights incidental to common shares. After the closing, an increase in the number of authorized common shares by shareholder approval can take place and 15,000,000 additional common shares can be issued for the Private Company’s shareholders so that they end up with 20,000,000 common shares, which equals 80% of the then total outstanding number of common shares.
Advantage: The closing of the reverse shell merger can take place prior to a shareholders’ meeting or adoption of a shareholders’ consent (with all its time consuming security law implications described in Section III.1.), which is necessary for the authorization of additional shares of common stock. Naturally, the necessity for such a shareholders’ meeting or shareholder consent is only postponed, not avoided, through the Preferred Stock Solution.
Part III. Securities Law Aspects
1. Timeline and Scope of Proxy or Information Statement
As stated above in Section II.2, if the capital structure of a Public Shell is not adequate to accomplish the merger, the capital structure will have to be altered by effecting either an increase in the authorized number of shares or a reverse split of the outstanding shares, with both options generally requiring Public Shell shareholder approval. Depending on the applicable corporate statute and the bylaws, such shareholder approval can be obtained by either majority consent or by vote in a shareholders’ meeting. In the first case, a proxy statement complying with Schedule 14A under the 34 Act is required. In the second case, an information statement complying with Schedule 14C under the 34 Act is required. The filing, review and distribution procedure for a proxy or information statement can be delayed until after the closing by utilizing the Preferred Stock Solution, if possible. However, a proxy or information statement can only be avoided entirely if the Public Shell already has the necessary capital structure in place to accomplish the merger, which in our experience is rarely the case.
a) Timeline
A preliminary Schedule 14A proxy statement must be filed with the SEC at least ten calendar days before a final proxy statement is to be sent out to the Public Shell shareholders in preparation of the shareholders’ meeting.[5] The period between the mailing of the definitive proxy statement and the shareholders’ meeting is usually determined in the by-laws. It is usually at least 20 days. It would be erroneous, however, to assume that based on these two time periods, the necessary capital restructuring could be accomplished within 10 days plus the notice period specified in the by-laws. The SEC can, and for reasons stated below in (b) almost certainly will, give the preliminary proxy statement a full review, and this process can take weeks, if not months. Accordingly, if a capital restructuring is to be accomplished before the closing, the parties to the reverse shell merger are well advised to assume that the closing will not take place before at least three months after the merger agreement has been signed, if not later.
The timeline for a Schedule 14C information statement is similar. A preliminary information statement must be filed with the SEC at least 10 calendar days prior to the date the definitive information statement is to be distributed to the shareholders.[6] The definitive information statement, in turn, must be sent to the shareholders at least 20 days before the shareholder consent can be adopted. Again, because an SEC review of the preliminary information statement is likely, the parties should assume that shareholder action cannot be taken for at least three months after the filing of the preliminary information statement.
b) Scope
The subject of the required content of the Schedule 14A or 14C is a trap for the unwary. Since technically the restructuring of the Public Company’s capital only requires an amendment of the CoI, it would be tempting to include only the very limited information required under Item 19 of Schedule 14A (which is also applicable to Schedule 14C), which states:
If action is to be taken with respect to any amendment of the registrant’s charter, by-laws or other documents as to which information is not required above, state briefly the reasons for and general effect of such amendment.
First, the language “as to which information is not required above” necessitates providing any information required by any other applicable items. For example, item 11, which deals with the authorization or issuance of securities otherwise than for exchange, would certainly be applicable where the Public Shell needs to increase its number of authorized shares to accomplish the merger. Therefore, such a situation would require a detailed description of the Public Shell’s securities in question.
Second, and more importantly, Note A to Schedule 14A (also applicable to Schedule 14C) states:
Where any item calls for information with respect to any matter to be acted upon and such matter involves other matters with respect to which information is called for by other items of this schedule, the information called for by such other items shall also be given. For example, where a solicitation of security holders is for the purpose of approving the authorization of additional securities which are to be used to acquire another specified company, and the registrant’s security holders will not have a separate opportunity to vote upon the transaction, the solicitation to authorize the securities is also a solicitation with respect to the acquisition. Under those facts, information required by items 11, 13, and 14 shall be furnished.
This Note, although addressing directly only the situation in which an increase in the authorized number of shares is contemplated to accomplish a merger, is certainly also applicable to situations where the Public Shell intends to perform a reverse share split for the same purpose. The Note is applicable because, as stated above in Section II.1., no Public Shell shareholder approval is necessary for the merger. The implications - inclusion of the information required by items 11, 13, and 14 - are substantial. We have already explained the information required by Item 11. In addition, Item 13 requires financial information for both the Public Shell and the Private Company, as well as pro forma financial statements giving effect to the merger and related transactions, as required by Article 11 of Regulation S-X. Finally, in a reverse shell merger scenario, Item 14 requires all the information required under an S-4 registration statement, including, for instance, a description of the businesses of the Public Shell and the Private Company, risk factors and a Management’s Discussion and Analysis (“MD&A”).
Essentially, the proxy statement and information statement require the same effort as a registration statement on Form S-1, which is generally used for an initial public offering. Also, we believe this would apply even though the capital restructuring is supposed to occur pre- or post-closing. Therefore, one of the major advantages of a reverse shell merger, - to be a quick way to go public - disappears.
It should be mentioned here that in our experience the SEC staff does not favor the technique of reverse shell mergers because, as shall be explained in Section III.2.(c), this technique is often utilized to the detriment of the shareholders of the Public Shell. Accordingly, the SEC staff will seize any opportunity to scrutinize a reverse shell merger, and consequently shall in all likelihood give a full review to any preliminary proxy or information statement. Due to the described scope of the required proxy or information statement, the SEC review will generally be a time consuming and expensive process involving management, accountants, auditors and legal advisors.
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