Do Not Get Complacent
Although you may represent the same clients with respect to many different “shell company” transactions, look at every transaction as a new and different one; go through the same procedures that you would go through the very first time. It is easy to get complacent where services are repetitive and the clients are the same. Nothing stays the same, and too often people get to creative in ways that are not aligned with applicable law and regulatory interpretations.
Do Not Be Too Creative
Do not be too creative, especially in trying to find ways to make shares in these types of transactions “free trading” shares. Often, the stock promoters of the shell company transaction have a different agenda than you or your clients may have. Accordingly, it is important that, to the extent possible, written guidelines are in place to protect against the unlawful “distribution” of securities following the closing of any such reorganization or merger; and that there is some type of a review process regarding press releases that are disseminated, at least for a 90 day period. Also, see the heading “Quiet Periods” below.
Where Did the Funds Come From?
It is important to determine where the funds that are utilized to pay debts, finders, to purchase any of the securities involved or otherwise, and to determine, to the best of your information, that they came from lawfully raised funds. There have been recent actions by the SEC in receivership actions where the receiver has attempted to recover funds paid in connection with these types of transactions where the funds were raised in a “Ponzi” scheme or were otherwise raised through questionable methods. Adequate “due diligence” is extremely important as a defense to any such claim. Additionally, make sure that the funds that are paid came from sources that are not insolvent or otherwise potentially subject to creditor or other claims.
Disclosure
No press release regarding these types of transaction should be disseminated (i) unless it complies with Rule 135 et. seq. of the SEC; and (ii) until the 8-K Current Report describing the transaction, and which includes the requisite information about the acquired company that would have been required to have been included in a Form 10 Registration Statement has been filed. Then, press releases should be considered in light of the information presented in the 8-K; and new, accurate, material information that was not known and was not included in the 8-K Current Report should be the subject of future press releases. Disclose any private transactions in securities of the shell company that closely preceded or followed the closing of any such reorganization or merger in the 8-K, along with any resale conditions affecting any of these securities. Further, use written share purchase agreements that contain confidentiality clauses to protect against the use of inside information by the parties to these transactions. Secretive or covert transactions are often considered suspect and are viewed as having an untoward intent by regulatory agencies. Full disclosure is required to protect all parties and to serve the public interest.
Quiet Periods
Consider a self imposed “quiet period” following a shell company transaction. There can be private placements of securities of the privately-held company or the shell company as part of the closing. Usually, the offering prices of these securities are at prices anticipated to be less than the expected trading price of the reorganized shell company, and sometimes, these offerings include “registration rights” of the securities acquired. These offerings may also create a demand for the reorganized shell company shares, whether intended or not. A self imposed quiet period may be appropriate to avoid excessive trading of shares at inflated prices that may subject the reorganized company and the transaction to regulatory scrutiny. In addition, press releases and other public relations activities may be found to have violated a required “quiet period,” if registration rights provide for the prompt filing of a registration statement or for demand registration rights.
Public Relations Firms
Stay away from transactions that involve the delivery of free trading securities to broker-dealers or public relations persons for any service, including “gypsy swaps” involving “restricted securities” issued to such persons that are then exchanged for free trading securities of others. These types of arrangements are subject to a great deal of scrutiny by the SEC, and companies are often swept up in proceedings that involve these types of arrangements because the persons involved in these types of transactions are continually engaged in these activities with others.
Resale Limitations
Convince your clients that they must execute and deliver Lock-Up/Leak-Out Agreements covering the resale of all of their securities in the reorganized shell company, and if anyone is negotiating to acquire any of their securities, that such purchases and sales be subject to the continued application of the Lock-Up/Leak-Out Agreements. By including “broker’s transactions” and “manner of sale” requirements in the Lock-Up/Leak-Out Agreements, you will be substantially limiting the possibility of delivering securities to broker/dealers and public relations persons for potentially unlawful distribution or other untoward uses. There should be adequate monitoring provisions to ensure compliance with these resale conditions of the Lock-Up/Leak-Out Agreements. Lock-Up/Leak-Out Agreements are evidence that your clients did not take their securities with a “view of distribution,” and resale limitations like required broker’s transactions and manner of sale requirements or other restrictions, along with limited numbers of shares sold over a reasonable period of time, will lean in favor of the availability of Section 4(a)(1) of the Securities Act for such resales. These agreements may also draw a line between what happened before the shell company transaction and what happens after; and that may be very important to you and your clients if there is subsequent regulatory scrutiny.
Change of Mind
Finally, do not be afraid to change your mind after having given advice to your clients. Stock promoters are masters at asking questions about the law and coming up with additional questions to find ways to skirt the law; and it is easy to go along, little by little, with their suggestions, until you find that you have agreed to something that was totally different than your initial advice. In this respect, do not be a sounding board for these types of discussions; rather, ask your clients what they are trying to achieve, and then follow these types of questions with an analysis of what you believe needs to be done to lawfully accomplish those results. Do not listen to or rely on statements like “Everybody does it this way.”
If you cannot get the parties to agree to Lock-Up/Leak-Out Agreements when you believe they are necessary, walk away from the transaction. That does not mean that you are always right; however, if someone refuses to go along with these types of suggestions and counters with statements like “I would never do that” or “We don’t operate like that” when you tell him or her that you are merely trying to protect from them from the scrutiny and other ramifications of a “pump and dump” scheme, recommend that the transaction not be completed. Reasonable resale limitations are usually acceptable to anyone that you do not to need worry about.
Use of Rule 504, S-8, Rule 701, Section 3(a)(10) and spin-offs for purposes of creating free trading securities should be strictly limited in these types of transactions, and for that matter, in any reorganization transaction.
Directors
On more than one occasion in the past while conducting “due diligence,” I have scheduled meetings with directors and officers of a shell company only to find out that none of them had ever met or conversed with the others, despite the fact that they had engaged in a public offering of the securities of the subject company and were represented by legal counsel.
Question the directors and executive officers. Point out their responsibilities for serving in these positions. Ensure that directors and executive officers are advised and consulted in all stages of the transaction; and that they are delivered copies of all drafts of “due diligence” you have and other material documentation for review, discussion and final approval.
If you have ever represented a “nominee” director or officer who is serving at the behest of another person and acting at the direction of that other person in an adverse regulatory proceeding, you will understand the importance of this step, having listened to responses like, “No, I do not recall seeing those documents” or “Yes, that is my signature.” That is a situation that you do not want to be involved in.
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, and which has been updated to current practices. Look for future posts by us on the subject of reverse mergers and current practices.