Resales of “Restricted Securities”
On February 15, 2008, the Securities and Exchange Commission’s (the “SEC”) amended Rule 144, which governs the resale of “restricted securities.” These amendments were an attempt to deal with the resale of “shell company” securities, shell company transactions and the persons who promote them. In many instances, these amendments have resulted in lawyers rendering the types of legal opinions that were customarily rendered prior to the adoption of Rule 144 in 1972. In our estimation, this is a step backwards.
The 2008 amendments preclude the use of Rule 144 for the resale of securities initially issued by a shell company until: (i) the issuer files “Form 10 Information” (defined as to be the equivalent of information that would be included in a Form 10 Registration Statement) with the SEC; (ii) the passage of one (1) year from such filing; and (iii) the issuer has “current public information” available as required by Rule 144(c)(1). These requirements have in many cases made Rule 144 unavailable and required lawyers to render legal opinions under Section 4(a)(1) of the Securities Act of 1933, as amended (the “Securities Act”). Section 4(a)(1) (formerly known as “Section 4(1)”) exempts “routine trading transactions” from registration under the Securities Act.
Our firm renders Rule 144 legal opinions and, in cases where an issuer may have shell company issues in its history and compliance with the provisions of subparagraph (i) of Rule 144 as cited above cannot be met, Section 4(a)(1) legal opinions. We also provide combined legal opinions under Rule 144 and Section 4(a)(1) when both exemptions from registration under the Securities Act are deemed to be available. With increased scrutiny of current and former shell companies and the resale of all “restricted securities” and “free trading” securities by the SEC and FINRA, broker-dealers frequently require legal opinions on all stock certificates, regardless of whether there is a restriction on the front or reverse side of the stock certificate. In many cases, broker-dealers also charge their customers a fee for having the brokers’ legal counsel review opinions obtained by their customers.
When we are engaged to render these types of legal opinions, we conduct extensive due diligence and review all documentation that may support the legal opinion. This information is summarized in the opinion letter and the letter is forwarded to the issuer, the transfer agent and the broker-dealer that will be relying on the opinion. Depending upon the client and the client’s current or prior relationship with the issuer, we may also prepare a proprietary Customer Resale Agreement that is formulated for the protection of the client, signed by the client and acknowledged by the client’s broker-dealer. These agreements contain provisions ensuring that all sales under the opinion are made in “routine trading transactions” and are therefore exempt from registration under the Securities Act. We conduct our due diligence free of charge, and clients owe us nothing if they decide not to proceed with an opinion letter following our fee quote.
We believe that our detailed analysis and due diligence, along with the terms of the Customer Resale Agreement, which are tailored to cover necessary circumstances that may arise or result from our due diligence and the factual basis for the legal opinion, provide additional legal protection to our clients; their brokers; the issuers; and the transfer agents who rely on them. We also believe that our thorough approach to rendering Rule 144 legal opinions or Section 4(a)(1) legal opinions stands up to regulatory scrutiny and encourages prompt issuer, transfer agent and broker acceptance of our legal opinions.
A Trap for the Unwary
In today’s securities market, many micro-cap issuers choose to raise funds through “self-underwritten” offerings, in which securities are sold directly by the company’s directors and officers rather than through an outside underwriter. Both federal and state securities laws acknowledge this method of fundraising, commonly exempting issuers from the statutory definition of “broker-dealers.” Section 61-1-13(1)(c)(ii)(B) of the Utah Uniform Securities Act is one example. However, self-underwritten offerings contain traps for the unwary. Section 15(a) of the Securities Exchange Act of 1934 is a statute that can cause serious problems for directors and officers who engage in such offerings.
Section 15(a) makes it unlawful for a broker or dealer “to effect any transaction in, or to induce or attempt to induce the purchase or sale of, any security . . . unless such broker or dealer is registered” with the Securities and Exchange Commission. The potential trap for micro-cap company management is that both Congress and the Commission define the term “broker or dealer” quite broadly. Section 3(a)(4) of the Exchange Act defines a “broker” as “any person engaged in the business of effecting transactions in securities for the account of others” and Section 3(a)(5) defines a “dealer” as “any person engaged in the business of selling securities . . . for such person’s own account through a broker or otherwise.”
Recent Commission enforcement actions illustrate both the Commission’s broad view of the types of activities that create broker-dealer status and the severe penalties that unregistered broker-dealers can face. Many of these activities are the very things that many micro-cap companies do on a regular basis to keep themselves afloat financially. These include:
- solicitation of potential investors, including persons with no pre-existing relationship with the issuer;
- expressing an opinion on the merits of an investment in the issuer’s securities with statements such as “it’s a great opportunity” and “investors could realize tremendous gains;”
- the receipt of commissions or other transaction-based compensation for security sales; and
- engaging in a high number of transactions such that the issuer or officer/director appears to be “engaged in the business of selling securities.” In one recent case, a corporate officer made an average of more than 200 securities sales per year over a four-year period, helping to support the Commission’s conclusion that he had violated Section 15(a).
Penalties for violations of Section 15(a) can also be severe. In addition to being suspended from association with any broker-dealer in the future, violators may be ordered to pay disgorgement of hundreds of thousands, even millions, of dollars. Such penalties can be financially crippling, both for individual violators and for violators at the corporate level. In the Commission’s recent Ironridge enforcement action, for example, the corporate violators were ordered to pay disgorgement of $4.4 million. There is a sad irony in the fact that a micro-cap issuer’s dedicated effort to raise much-needed capital may be the very thing that causes its financial devastation.
If your company is contemplating a self-underwritten securities offering, the Burningham Law Group can help.
The attorneys of the Burningham Law Group have a collective 90 years of experience in mergers and acquisitions, specializing in “reverse mergers.” We have been instrumental in the completion of well over 200 mergers or acquisitions involving publicly-held companies and have served as consulting attorneys to lawyers across the United States that have been involved in similar securities transactions. In addition, we have prepared and/or reviewed thousands of legal opinion letters relating to the resale of “restricted securities” under Securities and Exchange Commission (the “SEC”) Rule 144 and Section 4(a)(1) of the Securities Act of 1933, as amended (the “Securities Act”), among other available registration exemptions under the Securities Act, on behalf of clients, transfer agents and broker-dealers. Our participation in completing over 200 reverse mergers and our due diligence in preparing and reviewing these opinion letters has provided us with substantial insight and expertise in identifying issues that are paramount to successfully completing a reverse merger.
Reverse merger transactions are a fast and efficient method of “going public” that avoids the high cost and the time consuming process of registration. However, when used by unscrupulous promoters, they can be a method of avoiding the registration process as part of a scheme to unlawfully distribute unregistered securities for the benefit of promoters, founders and controlling persons. Therefore, a clear understanding of the Securities Act and the general rules and regulations promulgated thereunder by the SEC are the first and most important steps in engaging in a reverse merger.
A reverse merger is like any other merger or reorganization, with one very distinct characteristic - the transfer or sale of “free trading” shares is often involved. These shares may be already outstanding; or are to be issued, bought or sold as part of the transaction; or are shares currently held by the stockholders of the publicly-held company whose “successor” existence continues following the closing of the transaction. Each transaction is unique and the correct legal advice depends upon the facts and circumstances of each. Although there is no one way to complete a reverse merger, it is very important to keep in mind that the Securities Act was enacted “to provide full and fair disclosure of the character of securities sold in interstate and foreign commerce and through the mails, and to prevent frauds in the sales thereof, and for other purposes.” These purposes must be weighed in each and every transaction, and the following observations should be helpful.
Norman S. Johnson, Esq., who served as an SEC Commissioner from 1996 to 2000 and who had a long and distinguished legal career as a securities lawyer prior to his death in 2002, always advised that when representing someone in connection with a merger, it boils down to “What’s the deal and who are the players?” That advice is even more important in a reverse merger.
What Is the Deal?
It is important for you and your attorneys to know every facet of the proposed reverse merger transaction, especially any plans that may involve the issuance, sale or transfer of “free trading” securities. Your attorneys can provide guidance only if they are well informed. During the course of our due diligence process, we often discover matters that we were not advised of and are able to timely resolve these issues for the benefit of the issuer of these securities and the parties involved.
Who Are the Players?
It is also important to take the name and address of every person involved in the reverse merger transaction. This includes the principals and principal stockholders of any party, as well as principals, promoters, founders, advisors and lawyers. We customarily run the names of these persons through the SEC website and Pacer U.S. Case Index (or another similar website) to search for adverse legal proceedings or conduct background checks on them through a reputable firm. If we have further questions, we have requested written representations from the parties’ lawyers, accountants or business associates about any “bad boy” proceedings. We also have each such person fill out a questionnaire that sets forth at a minimum his or her principal occupation and whether he or she has been subject to any “bad boy” actions. If anything adverse comes up in our due diligence review the scope of our inquiry broadens and is more detailed.
Know the Law
You will need a working knowledge of applicable securities and corporate law and the specific legal issues attendant to reverse merger transactions. Keeping abreast of current legal and administrative actions is also very important. These types of proceedings clearly describe the unlawful activities of some practitioners and stock promoters and will help you to better understand the applicable law. Our lawyers stay well-informed of recent developments in this area of law and can help avoid potential issues before they become problems.
Every resale of securities needs to be registered or exempt from registration under the Securities Act and applicable state laws. Technical compliance with the letter of the law means little when the parties’ actions work as a “public distribution” of unregistered securities. Our lawyers have a thorough understanding of statutory and rule-based resale exemptions, including Section 4(a)(1) of the Securities Act and Rule 144 promulgated thereunder. We have prepared (and have reviewed for clients, broker-dealers and transfer agents) thousands of opinion letters expressing reliance on these exemptions. In addition, we routinely draft agreements that are designed to ensure that stockholders conduct resales of securities in accordance with these securities laws and regulations. Allowing someone to purchase shares in the publicly-held merger candidate without imposing resale restrictions risks violation of the securities laws and can put your own reputation at risk. Our extensive knowledge of the issues and our custom-drafted resale agreements substantially limit this type of exposure.
Every Reverse Merger Transaction is Different
What will work in one situation may not work in another. Our best advice is to keep in mind the questions outlined by the SEC in its Preliminary Note to Rule 144: (i) ensure there is adequate current information about the issuer; (ii) ensure that resales by persons involved do not result in an unlawful distribution of securities; (iii) ensure that all resales are effected in “routine trading transactions” and are covered by clear and concise written terms and conditions; (iv) require additional holding periods and resale conditions as appropriate, regardless of whether Rule 144 or other holding periods have been previously satisfied; and (v) consider the potential impact of the particular transactions on the trading market for the publicly-held company’s securities following the closing of the transaction. Our attorneys have seen all of these issues at one time or another and can provide reasonable solutions that will protect the parties long after the completion of the reverse merger.
Always Assume the Worst
We represent clients in a fair, open, competent and diligent manner but always assume the worst possible outcome, regardless of the good intentions of the parties. Although it seems counterintuitive, this is a very positive stance! Would you be worried if the SEC or some other regulatory agency asked to see your attorneys’ files on the reverse merger and asked to discuss the transaction with you? Are you concerned about any of the advice that you may have been given in connection with the transaction or the related legal opinions? The amount of due diligence that you and your attorneys conducted or did not conduct? We maintain all files and all communications to protect our clients because we want to ensure that anyone looking at them will see that the reverse merger and all related transactions were lawfully completed and provided for current and future compliance with applicable securities laws, rules and regulations. It is important to have this information available to prove that all aspects of the reverse merger were done strictly within the guidelines of applicable law and not in a manner that, although technically correct, may violate the spirit of the law.
This partial summary of issues related to reverse mergers was excerpted from a presentation at the 27th Annual Securities Law Workshop/Securities Law Section/Utah Bar Association on “Shell Reorganization/Merger Transactions” presented by Leonard W. Burningham, Esq. in 2005. Look for future posts by us on the subject of reverse mergers from that presentation, updated to current practices.