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SEC Proposes To Close The Window on Shell Company Mergers

By Brian Jaffe

Private companies that want to go public but lack the size and track record needed to support a traditional underwritten IPO have often resorted to a merger with a public shell company. The shell company has ceased operations but still exists as a publicly-traded entity and is registered under the Securities Exchange Act of 1934. By merging with the shell, the formerly private company can obtain a vehicle to raise money in the future by selling more shares to the public, as well as a potentially attractive and liquid stock "currency" to pay for acquisitions. These transactions can serve legitimate purposes and often have been successful, but they have a long history of being used by unscrupulous promoters to enrich themselves at the expense of the owners of the private company and the investing public. The Chief of the Office of Small Business Policy of the Securities and Exchange Commission warns that these shell company mergers "have been used in ways that cause investors to lose money and have been used in the past with fraudulent and abusive conduct." 1

The SEC has now proposed: (1) to block the sale of shell company shares to its employees and consultants without full registration under the Securities Act of 1933; and (2) to require immediate detailed disclosure about the newly merged company, including closing the "71-day window" which currently allows the company to delay the filing of audited financial statements for more than two months after the merger. 2 The first set of proposed rules substantially limits the use of Form S-8 in public shell merger transactions, and the second set imposes quicker Form 8-K deadlines and other informational requirements.

These proposed SEC rule changes are intended to protect investors from fraud and manipulation in the securities markets arising from shell company merger transactions. One such abuse has been the "pump and dump" scheme, in which the promoters of the public shell company issue large amounts of stock to themselves and their associates in conjunction with the merger, then "pump" up the price of the stock by issuing unduly positive press releases, exaggerated tout sheets and fraudulent internet messages, using high pressure tactics to lure investors, and creating artificial market demand. Once the price has been sufficiently pumped up but before adequate disclosure about the business is available, the promoters and their friends "dump" their stock and take large profits, halt their promotional activities, and allow the price to sink in value in the hands of the public investors who have been misled into purchasing it.

The Commission has targeted two related types of transactions. In a "reverse merger," the private business merges into the public shell company and the former shareholders of the private business control the surviving public company. In a "back-door registration," the shell company merges into the formerly private company, with the formerly private company surviving the merger and the shell company's shareholders becoming shareholders of the surviving entity.

The SEC's proposed rules seek to regulate abusive practices in these transactions by making it very difficult for the shell company to issue stock to its employees, consultants and advisors before the merger, and by requiring full disclosure about the surviving operating company within four business days after completion of the merger. Under these proposals, a "shell company" is defined as a public company registered and required to file periodic reports under the Exchange Act with no or nominal operations and with either (i) no or nominal assets or (ii) assets consisting solely of cash and cash equivalents.

The Securities Act Form S-8 Proposal

The SEC proposes to prohibit shell companies from using a registration statement on Form S-8 to register their shares under the Securities Act for sale to their employees and consultants. Form S-8 is designed to be used by public companies to easily register their shares for sale to employees and consultants in connection with employee benefit plans and arrangements. Form S-8 calls for minimal disclosure about the business, does not require a prospectus to be filed as part of the registration statement, and becomes effective without SEC review. The employees receiving shares registered under Form S-8 are, subject to certain restrictions, free to resell their shares into the market without further registration or disclosure to the public. However, the use of Form S-8 to raise capital is prohibited. Under the SEC's proposal, a company that ceases to be a shell company would not become eligible to use Form S-8 until 60 days after it has filed with the SEC the same type of detailed information about its business and financial condition required of a company filing a registration statement for an IPO or an annual report on Form 10-K.

The SEC believes that shell companies are routinely abusing Form S-8 to give stock compensation to purported employees, consultants and advisors in return for their services in capital-raising transactions and for promoting a market in the issuer's securities. Shell companies do not have substantial operations with employees to compensate. Any purported "employees" of shell companies are typically involved only in capital raising and similar activities. Shell companies have often used multiple Form S-8 filings to register a large percentage or even a majority of the company's outstanding securities.

The SEC believes that allowing these "employees" and consultants to resell their shares into the market without the usual registration and disclosure procedures circumvents the registration and prospectus delivery requirements of the Securities Act, thus denying the uninformed public investors who buy these shares the full disclosure protections of the securities laws. In the Commission's view, these purported employees are effectively acting as underwriters for the shell company's shares by acquiring the shares under the guise of an employee compensation arrangement, and then quickly distributing them to the public who do not have access to the usual information about the company's business, management and finances that publicly traded companies normally are required to make available, as on Form 10-K. Though the proposed rule does not by its terms bar shell companies from registering sales of shares to its employees and consultants by filing and clearing with the SEC a detailed registration statement on Form S-1 or Form SB-2, as a practical matter the SEC expects the new rule will stop these kinds of sales to shell company personnel.

The Exchange Act Form 8-K Proposal

Many companies completing shell company conversion transactions now make relatively little disclosure on Form 8-K under the Exchange Act concerning the operations, prospects, risks and financial condition of the surviving operating company. Therefore, the SEC has proposed to amend Form 8-K to require that when a shell company reports a merger or other combination with a formerly private operating company, it must promptly file with the SEC all relevant 10-K information -- that is, the same type of comprehensive information, including audited financial statements, that is required to be provided on a Form 10-K to investors in other reporting public companies.

Under the current rules, a shell company that ceases to be a shell company through a merger with or acquisition of an operating business is only required to file a short report on Form 8-K describing the acquisition or change in control transaction and a "brief description" of the assets. Under the revised Form 8-K filing deadlines, effective on August 23, 2004, the Form 8-K is due within four business days after the closing of the merger or acquisition transaction.

Moreover, the current rules permit a shell company acquiring a new business to wait up to 71 days after its initial filing on Form 8-K to file audited financial statements and pro forma financial information reflecting the new financial profile of the company. The SEC is concerned that promoters of shell company schemes can take advantage of the lack of financial and other information in the Form 8-K filing during this "71 day window" period to pump up the company and sell their shares at artificially high prices. During this window period, the market may have difficulty pricing the stock because of the lack of available information. When reliable financial information is later disclosed, the share price often drops and investors lose money. Sometimes, the financial statements never are filed.

The SEC is proposing to close the 71-day window for shell company transactions and require that detailed audited financial information, together with all other Form 10-K information, about the merged company be filed on Form 8-K within four business days after the merger. By requiring the prompt filing of this information, the SEC hopes to decrease significantly the opportunity to use shell company transactions to engage in fraudulent and manipulative activity.

We note that the proposed SEC rules described above relating to the use of Form S-8 and Form 8-K in shell company mergers are subject to change and must be formally adopted by the Commission before they become effective.

[1] An Often Risky Route for Going Public," The New York Times, April 29, 2004, p. C7.

[2] Proposed Rule: Use of Form S-8 and Form 8-K by Shell Companies, SEC Release Nos. 33-8407 and 34-49566 (April 15, 2004).

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