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Tip of the Week - Reincorporating a Shell? Be Careful
Happy April to all! The season of renewal is upon us. And for shells (ok not great segue), that can sometimes mean reincorporation. Many shells are incorporated in nontraditional states due to the prior business that was in the shell. Some are in California, Texas, Florida and other places. Some manufactured shells are in Colorado, Utah, Nevada and so on.
In some of these states (such as California) there are somewhat stringent shareholder protection laws that require formal shareholder approval (and an annoying proxy process with the SEC) for things that might not otherwise require approval in most other states, including in some cases the classic reverse triangular merger that I describe in my book. In other cases, merger candidates feel being in Utah or Nevada evokes reverse mergers' shady past. In others, it is simply the desire to be in Delaware, the most business friendly state where virtually every corporate lawyer in America knows how to do business.
Thus, in more and more deals that our firm is involved with, the parties desire to reincorporate the shell, typically into Delaware. Seems simple no? Well as with many legal issues in the reverse merger world, there are tricks and traps that are too easy to fall into.
First let's talk about the mechanics of reincorporating. It's not a simple wave of a magic wand. The process actually involves a merger. Let's say your public shell was incorporated in Nevada. You incorporate a new company, let's say in Delaware. The most common approach is to initially issue 100% of the stock of the Delaware company to the Nevada company, making the public Nevada company the parent of the Delaware company.
The next step is a merger between the two. The merger generally requires approval of the shareholders of the public parent (ie a proxy process requiring a document to be approved by the SEC). Upon completion of the merger, the public Nevada company merges into the Delaware company, with the Delaware company surviving the merger. Under SEC rules it becomes the "successor issuer" and is permitted, if done right, to simply take over the public SEC reporting status of the Nevada company. In the merger, every shareholder of the Nevada company swaps their shares for new shares of the Delaware surviving company.
Under SEC Rule 145, the issuance of the Delaware shares in the merger is exempt from SEC registration, and the shares are as freely tradeable as the shares they were exchanged for. And under that same rule, the issuance of the Delaware shares to the Nevada shareholders is not deemed a "sale," which means state securities or blue sky law generally should not be applicable. Voila, you are now a Delaware public company.
When to do this? Some merger candidates want the reincorporation completed prior to a merger. This can delay things but can be particularly helpful if you are moving out of a state where the merger itself may require shareholder approval but in Delaware would not. Others wait and reincorporate after the merger.
So here are some tips if you are reincorporating:
1. Make sure it's a "pure" Rule 145 transaction. All the beauty of the SEC's approach to permitting reincorporation might go away if other things are happening at the same time. For the exemption to be available, it has to be done solely for the purpose of changing the company's "domicile," and no other purpose. If, for example, the reincorporation were a condition to a merger transaction, you might lose the exemption. Thus, either complete it before signing any binding merger agreement or after consummating the deal. It is also tempting, while seeking shareholder approval for one thing, to get approval for other things, like maybe a new option plan, for example. It's generally not a good idea as the two might be seen as being together.
2. Can you split shares as part of reincorporating? Most states seem to permit, and the SEC rules permit, a change in capitalization that is pro rata to all shareholders as part of reincorporating. Thus if you want to issue every Nevada shareholder one share of the Delaware company for every 10 shares of Nevada, that appears to be permitted (I am not an expert on Nevada and this is illustrative only), though each state you are working with should be checked. However, some states, like California, could decide to be more restrictive in this situation. If possible, try to avoid using the reincorporation as a method to effect a split.
3. Can you increase the authorized shares in a reincorporation? Since your Delaware company can have as many authorized shares as you want, there appears to be no restriction on reincorporating through a Delaware company that has many more authorized shares than your Nevada company, even if the Nevada shares are just being swapped one for one. This can be a neat way to solve a common shell problem, where not enough authorized but unissued shares are available to complete a transaction. In lieu of a split (potentially problematic as above), by increasing the authorized number of shares in the successor Delaware company, there would be enough shares to complete a merger, and a reverse split, if desired to reduce the number of outstanding shares and increase share price, can be completed after the merger. Again, it depends on your state and you need to check.
4. Is the proxy process difficult? In general, if you provide the proper disclosure and avoid some of the concerns above (don't do a split, don't do anything else at the same time, do it before signing a binding merger document), the SEC is not likely to give much attention to a proxy statement relating to a "run of the mill" reincorporation. There is much disclosure required, however, including a detailed comparison of the applicable laws of the two states in question. But there are good models out there of proxies that have met SEC approval comparing virtually every state. You can use those plus do your own research to ensure the disclosure is complete.
5. Can other SEC filings for the merger take place at the same time? What if you are changing the Board as part of a proposed transaction and, even though the merger agreement is unsigned, you want to file a Schedule 14F and mail it to shareholders (this is a required document if the majority of the board will change upon a transaction) to start the 10-day clock before you can close? One can do this and it would seem not to implicate the reincorporation, but you are probably better off being cautious and waiting until the reincorporation is totally clear before making other filings.
As always, please do not consider anything in this blog entry as legal advice. Check with your lawyer on all these things! [Note: this entry was updated on April 11 to clarify certain things.]
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