Reverse Mergers Update

Reverse Mergers Update (February 26, 2019)

On February 20, 2019, the Securities and Exchange Commission (the “SEC”) announced the filing of a complaint (the “Complaint”) against a number of persons, including a broker-dealer, a transfer agent, certain of their principals and others (the “Defendants”) for their roles in creating a number of purported “shell companies” between 2009 and 2014.  The specific allegations against the Defendants, though not yet proven, reflect substantial and material issues and “Red Flags” anyone desiring to be party to a “Reverse Merger” should look for in conducting “due diligence” on any potential publicly-held company that is intended to be utilized in a “Reverse Merger” transaction.  Many of these issues were pointed out in our Reverse Mergers post of November 25, 2018, and our Reverse Mergers Update of January 15, 2019.

There is substantial evidence today that many unscrupulous individuals are involved in creating “shell companies” with nominee management and shareholders, without disclosing their controlling interest in these companies and the securities that they have been issued.  These cases are not unlike the “box job” frauds perpetuated in the past where promoters of these types of companies held all of the securities for delivery on the sale of these types of companies for use in Reverse Merger transactions.  In recent cases,  these persons are utilizing the SEC registration process to obtain the requisite Financial Investor Regulatory Authority (“FINRA”) and Depository Trust Company (the “DTC”) approvals that make these types of companies attractive for a Reverse Merger in an attempt to legitimize their fraudulent activities. 

The following should be on the list of the minimum due diligence to be conducted by any lawyer in reviewing any such Reverse Merger candidate: (i) a critical review of any registration statement, including all related SEC and issuer correspondence; (ii) a review of all subscription agreements and check copies of all shareholders who acquire shares under these registration statements and adequate evidence of the delivery of the stock certificates representing the shares purchased in any of these companies whose shares were registered; and (iii) a review all FINRA and DTC filings and related correspondence. Telephone calls to shareholders also go a long way in determining whether they have actual possession of their stock certificates.  Practioners should also obtain information on who solicited the purchases, how that person or persons is related to the purchasers and who introduced the soliciting person to them, among other relevant information.

The SEC Complaint in this announced action alleges that the Defendants engaged in a fraudulent scheme in which they made false and misleading statements and omissions about the legitimacy of approximately 19 small publicly-held companies and their management teams and the beneficial shareholders of these companies.  The Complaint alleges that management and shareholders were nothing more than nominees for the controlling persons who had always planned to package the securities of these companies and sell them in bulk as “free trading” securities when in fact they should have been deemed to be “restricted securities.”  The companies are alleged to have been nothing more than “shell companies,” which are defined in SEC Rule 405 promulgated under the Securities Act of 1933, as amended (the “Securities Act”), and SEC Rule 12b-2 promulgated under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), or “blank check” companies defined in Rule 419 of the Securities Act.

The factual basis for the violations contained in the Complaint include, among other allegations, that certain Defendants: (i) solicited nominee directors or officers; (ii) caused the filing of S-1 Registration Statements with the SEC to register securities of these companies for public sale; and (iii) orchestrated the sale of these companies’ securities to friends and family members, with the intention of never delivering the stock certificates representing these shares to the alleged purchasers, but having the nominee purchasers sign blank stock powers and deliver them to the controlling Defendants.  The Complaint also alleges that the controlling Defendants made various filings with FINRA and the DTC to give the appearance of a “public float” in the securities of these companies; and  that once these activities were completed, certain of the Defendants then sold and delivered all of the stock certificates of the respective companies with blank stock powers signed by the straw shareholders to a single group of buyers for a substantial cash price, and divided the cash price among themselves, following the payment of a nominal amount to the nominee directors or officers and the straw shareholders.  A copy of this Complaint can be accessed at Complaint.

Disclaimer:  The information about the Complaint and the Defendants provided herein is taken from public sources.  The allegations contained in the Complaint have not yet been proven in any court or administrative agency and are subject to such final determination.  These references are used herein solely for examples of actions perceived by the SEC to be in violation of applicable securities laws, rules and regulations.