Securities Attorney Laura Anthony, Author at Reverse-Merger.com

FINRA Seeks to Eliminate the OTCBB and Impose Regulations on the OTC Markets

Posted by Securities Attorney Laura Anthony | March 11, 2015 Tags: Finra, OTC BB, OTC Markets, OTCBB, OTCQX, PinkSheets, Rule 6431

On October 7, 2014, the SEC published a release instituting proceedings to determine whether to approve FINRA’s request to delete the rules related to, and the operations of, the OTC Bulletin Board quotation service. On June 27, 2014, FINRA quietly filed a proposed rule change with the SEC seeking to adopt rules relating to the quotation requirements for OTC equity services and to delete the rules relating to the OTCBB and thus cease its operations. Although the rule filing was published in the Federal Register, it garnered no attention in the small cap marketplace. Only one comment letter, from OTC Market Group, Inc. (“OTC Markets”) (i.e., the entity that owns and operates the inter-dealer quotation system known by its OTC Pink, OTCQB and OTCQX quotation tiers) was submitted in response to the filing.

The OTCBB has become increasingly irrelevant in the OTC marketplace for years. In October 2010, I wrote a blog titled “Has the OTCBB been replaced by the OTCQX and OTCQB”; at the time and up until May 16, 2013, my opinion was “yes” with one caveat. Prior to May 16, 2013, the OTCBB was considered “an established market” but the OTCQB and OTCQX were not. On May 16, 2013, that caveat was removed (see the blog detailing the changes Here) In particular, on May 16, 2013, the SEC updated their Compliance and Disclosure Interpretations confirming that the OTCQB and OTCQX marketplaces are now considered public marketplaces for purposes of establishing a public market price when registering securities for resale in equity line financings.

Since that time, the OTCBB has been largely irrelevant, and worse, a cause of confusion in the OTC marketplace. The OTC market is comprised of publicly traded securities that are not listed on a national securities exchange. The trading platforms for OTC securities are referred to as “inter-dealer quotation systems.” Today there are two main inter-dealer quotation systems: (i) the OTC Markets comprised of OTCQX, OTCQB, and pinksheets (www.otcmarkets.com); and (ii) the FINRA owed OTCBB (www.otcbb.com). Many small cap participants believe that the OTC marketplace is comprised of a single marketplace, and are confused by the actual existence of two such marketplaces.

The regulatory framework related to inter-dealer quotation services and OTC securities in general is widely centered on ensuring compliance with Section 17B of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Section 17B of the Exchange Act is the Securities Enforcement Remedies and Penny Stock Reform Act of 1990 (the “Penny Stock Act”). Although a complete discussion of the Penny Stock Act is beyond the scope of this blog, the goal of the Act is to ensure the widespread dissemination of reliable and accurate quotation information on penny stocks. Over time, the OTC Markets has become much more efficient in meeting the goals of the Penny Stock Act while at the same time, the OTCBB has become much less efficient at meeting those same goals.

As set forth in the SEC Release, “FINRA proposed to adopt rules: (1) governing the treatment of quotations in OTC equity securities by member inter-dealer quotation systems and addressing fair and non-discriminatory access to such systems; (2) requiring member inter-dealer quotation systems to provide FINRA with a written description of quotation-related data products offered and related pricing information, including fees, rebates, discounts and cross-product pricing incentives; (3) expanding the reporting requirements related to quotation information in OTC equity securities; and (4) deleting the Rule 6500 Series and related rules and thereby ceasing operation of the OTCBB.”

The FINRA rule release seeks to eliminate the OTCBB and impose governing regulations on the remaining inter-dealer quotation system—to wit, the OTC Markets comprised of the OTCQX, OTCQB, and pinksheets (www.otcmarkets.com).

Proposed Deletion of the OTCBB Related Rules and OTCBB Marketplace

FINRA is proposing to delete the FINRA Rule 6500 Series, which governs the operation of the OTCBB, and cease operation of the OTCBB. In its request, FINRA states that the level of transparency in OTC equity securities facilitated by the OTCBB has been declining significantly for years such that the amount of information widely available to investors relying on the OTCBB bid and offer data has become negligible. FINRA further expressed its belief that “the remaining OTCBB information being disseminated to investors is so incomplete as to be potentially misleading with respect to the current pricing in these securities.”

There are approximately 10,000 OTC equity securities quoted on the OTC Markets, of which less than 10% are duly quoted on the OTC Markets and OTCBB and fewer than twelve (yes, 12) are solely quoted on the OTCBB. Moreover, it is widely known in the industry that the technology used to facilitate quotation on the OTCBB is antiquated and unreliable such that broker-dealers are derisive of using the system. Accordingly, FINRA notes that the discontinuance of the OTCBB will not have an impact on issuers, investors or member firms. FINRA has also committed to take steps to ensure a smooth transition for those few issuers still using the OTCBB system, including by directly contacting these issuers and assisting with a transition to OTC Markets.

Finally, FINRA believes that the requirements related to the Penny Stock Act, and in particular widely disseminated information regarding penny stocks, better lay with the issuers, broker-dealers, and FINRA members (such as OTC Markets) rather than with FINRA itself, which is an SRO (self-regulatory organization). In other words, FINRA does not believe it needs to own and operate an inter-dealer quotation system. However, presumably to address the SEC concerns in this regard, if the availability of quotation information to investors significantly declines, FINRA has committed to revisit and, if necessary, file a proposed rule change to establish an SRO-operated inter-dealer quotation system (or other measure) to ensure that compliance with the Penny Stock Act is met.

In response to FINRA’s request to eliminate the OTCBB, the SEC received a single comment letter and it was from OTC Markets. Needless to say, OTC Markets strongly supports the proposal as well as the proposed amendments to Rule 6431 discussed below. OTC Markets welcomes the enhanced responsibility and regulations imposed upon it and FINRA’s oversight as a regulator, and it agreed with all aspects of FINRA’s proposals. OTC Markets stated that the discontinuation of FINRA’s OTCBB, together with FINRA’s expanded oversight of OTC Markets, would help eliminate investor and issuer confusion while promoting compliance with the Penny Stock Act.

OTC Markets points out that “FINRA’s OTCBB no longer provides broker-dealers with an effective service for pricing securities, and market participants will be better served by FINRA regulating Qualifying IQSs [inter-dealer quotation services] instead of expending resources trying to operate the OTCBB.”

The Proposed Regulatory Rule Changes Related to Inter-Dealer Quotation Systems

Pursuant to Section 15A of the Exchange Act, FINRA is tasked with adopting and implementing regulations designed “to produce fair and informative quotations, to prevent fictitious or misleading quotations, and to promote orderly procedures for collecting, distributing, and publishing quotations.” In that regard, FINRA has developed a regulatory framework including FINRA’s Rule 6400 series (Quoting and Trading in OTC Equity Securities) and Rule 5200 Series (Quotation and Trading Obligations and Practices) and the Rule 6500 series, governing the OTCBB. FINRA also owns and operates the OTCBB.

The current regulatory framework governs the FINRA member firm’s quotation activity and not the inter-dealer quotation service itself. That is, the current regulatory framework governs the broker-dealers/FINRA member firms’ activities in entering quotes on the inter-dealer quotation system, but does not impose rules or regulations on the inter-dealer quotation system itself.

For example, there are rules that require FINRA members to either file a Form 211 with FINRA including due diligence and disclosure on the company whose securities are being quoted, or be able to rely on another firm’s 211 filing (piggyback qualified) prior to initiating a quote; rules related to minimum bid price increments ($0.0001 for OTC equity securities priced under $1.00 and $.01 for those priced over $1.00); rules prohibiting cross-quotation; rules requiring the display of customer limit orders; and a requirement that any quoted bid or asked price represent a bona fide bid for or offer of such security (i.e., the “fictitious quotation” prohibition).

FINRA is now proposing to adopt rules that regulate the inter-dealer quotation service itself, which after elimination of the OTCBB will be comprised of the OTC Markets, including the OTCQX, OTCQB, and pinksheets.

Proposed Rule 6431 Amendment

FINRA is proposing to implement new regulations by amending Rule 6431 to require OTC Markets (or any inter-dealer quotation service) to: “(1) adopt and provide to FINRA written policies and procedures relating to the collection and dissemination of quotation information in OTC equity securities, (2) establish and provide to FINRA fair and non-discriminatory written standards for granting access to quoting and trading on its system, and (3) provide to FINRA for regulatory purposes a written description of each quotation-related data product offered by such member inter-dealer quotation system and related pricing information, including fees, rebates, discounts and cross-product pricing incentives.”

Rule 6431 (Recording of Quotation Information) was originally implemented in 2003 to provide FINRA with access to quotation information on the OTC marketplace. When implemented, FINRA member broker-dealers had the duty to independently report to FINRA when quoting on the OTC Markets, because at the time OTC Markets was not, in and of itself, a FINRA member. Since that time, OTC Markets has become a licensed ATS (Alternative Trading System) and FINRA member. The proposed Rule 6431 amendment includes an adjustment such that now OTC Markets will be required to provide the quotation information and the broker-dealer will not. In practice, OTC Markets has been submitting the information on behalf of member firms already, and the rule change will codify this practice and officially relieve the broker-dealer member firm from the obligation.

As the vast majority of securities quoted on the OTC markets are also penny stocks, the new rules will also bolster the Exchange Act requirements related to ensuring the availability and dissemination of reliable and accurate information on penny stocks.

(1) Written policies and procedures relating to the collection and dissemination of quotation information

The amended Rule 6431 would require OTC Markets (or any inter-dealer quotation service) to establish, maintain and enforce fair and reasonable written policies and procedures relating to the collection and dissemination of quotation information in OTC equity securities. Such policies and procedures must ensure that quotations received are treated fairly and consistently and include methods for prioritizing and displaying such quotations. In simple terms, if an investor enters a buy or sell order with a broker, or a market maker enters such buy or sell order for their own account, there must be systems in place to ensure that that order is treated fairly vis-a-vis competing buy and sell orders on behalf of other investors through other brokerage firms and market makers.

In that regard, under amended Rule 6431, the OTC Markets will be required to address its method for ranking quotations, including factors such as price, size, time, capacity and type of quotation and any other factors used or considered in ranking and displaying quotations. OTC Markets will also be required to provide FINRA with a copy of its written policies and procedures relating to the collection and dissemination of quotation information, and any material updates, modifications and revisions thereto, upon enactment of the Rule change and thereafter within five business days following the establishment or material change in such written policy or procedure.

(2) Written standards for granting access to quoting and trading on its system

The amended Rule 6431 would require OTC Markets to establish “fair and non-discriminatory written standards for granting access to quoting and trading on the system that do not unreasonably prohibit or limit any person in respect to access to services offered by such inter-dealer quotation system.” In addition, OTC Markets will be required to keep records of all grants of access and denials or limitations of access, including the reasons for denying or limiting access. OTC Markets must provide FINRA with a copy of these written standards upon enactment of the Rule change and thereafter within five business days following the establishment or material change in such written standards.

(3) Written description of each quotation-related data product and related pricing information

The amended Rule 6431 would require OTC Markets to prepare a written description of each quotation-related product offered and related pricing information, including fees, rebates, discounts and cross-product pricing incentives—for example, the listing requirements for the OTCQB including application and annual fees (see Here); the OTC Disclosure and News Service; and the various other products and services offered by OTC Markets. OTC Markets must provide FINRA with a copy of the written product descriptions upon enactment of the Rule change and thereafter within five business days following the establishment or material change in such products or pricing.

SEC Proceedings Related to Approval of the Proposals

The SEC has instituted proceedings to determine whether the proposed rule changes, including elimination of the OTCBB, should be approved. The SEC is requesting comments from interested persons in support or opposition to the change. The SEC notes that in considering the proposal, it must (i) determine whether the changes are “designed to prevent fraudulent and manipulative acts and practices, to promote just and equitable principles of trade, and, in general, to protect investors and the public interest”; (ii) the rules include provisions governing the form and content of quotations on the OTC marketplace; and (iii) whether the rules support the Penny Stock Act.

The SEC has opened a 21-day total period to submit comments and a 35-day total comment period including time for rebuttals to submitted comments.

Brief Commentary

First, like OTC Markets, I am proponent of the rule changes all around. The discontinuation of the OTCBB is a natural and necessary progression of the reality of the marketplace.

However, neither the legal publications by FINRA or the SEC nor the comment letter from OTC Markets address some basic market realities. That is, with the elimination of the OTCBB and the implementation of listing standards and fees associated with quotation on the OTCQB, a new regime has been established for OTC market securities. Penny Stock issuers that are subject to the reporting requirements of the Exchange Act will no longer have the ability to achieve the turnkey credibility associated with not being a pinksheet.

Although pinksheets will now include a large class of entities that are subject to the Exchange Act reporting requirements, in order to achieve a level of credibility and prestige, such issuers will be required to meet the quotation standards and pay the fees associated with listing on the OTCQB or OTCQX. I wonder if issuers that do not meet the standards for the OTCQB will opt to cease being subject to the Exchange Act reporting requirements in a sort of acquiescence to the new regime – i.e., if we are going to be a pinksheet anyway, why report, resulting in an overall reduced level of disclosure in the OTC marketplace.

The Author

Attorney Laura Anthony

LAnthony@LegalAndCompliance.com

Founding Partner, Legal & Compliance, LLC

Securities, Reverse Merger and Corporate Attorneys

Securities attorney Laura Anthony and her experienced legal team provides ongoing corporate counsel to small and mid-size OTC issuers as well as private companies going public on the over-the-counter market, such as the OTCBB, OTCQB and OTCQX. For nearly two decades Ms. Anthony has structured her securities law practice as the “Big Firm Alternative.” Clients receive fast, personalized, cutting-edge legal service without the inherent delays and unnecessary expenses associated with “partner-heavy” securities law firms. Ms. Anthony’s focus includes, but is not limited to, registration statements, including Forms 10, S-1, S-8 and S-4, compliance with the reporting requirements of the Securities Exchange Act of 1934, including Forms 10-Q, 10-K and 8-K, 14C Information Statements and 14A Proxy Statements, going public transactions, mergers and acquisitions including both reverse mergers and forward mergers, private placements, PIPE transactions, Regulation A offerings, and crowdfunding. Moreover, Ms. Anthony represents both target and acquiring companies in reverse mergers and forward mergers, including the preparation of transaction documents such as Merger Agreements, Share Exchange Agreements, Stock Purchase Agreements, Asset Purchase Agreements and Reorganization Agreements. Ms. Anthony prepares the necessary documentation and assists in completing the requirements of federal and state securities laws and SROs such as FINRA and DTC for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile.

Contact Legal & Compliance LLC. Technical inquiries are always encouraged.

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« Penny Stock Rules And Broker Dealers Insider Trading- A Case Study »

Penny Stock Rules And Broker Dealers

Posted by Securities Attorney Laura Anthony | March 11, 2015 Tags: penny stock, penny stock act, penny stock issuer, Penny Stock Rules, Schedule 15G, Section 15(h), Section 17B

In last week’s blog regarding FINRA’s request to eliminate the OTC Bulletin Board quotation service (OTCBB) and to adopt rules relating to the quotation requirements for OTC equity services by inter-dealer quotation services, I touched upon the significance of penny stock rules related to the OTC marketplace. As further described herein, penny stocks are low-priced securities (under $5.00 per share) and are considered speculative and risky investments.

Penny stock rules focus on the activity of broker-dealers in effectuating trades in penny stocks. As a result of the risk associated with penny stock trading, Congress enacted the Securities Enforcement Remedies and Penny Stock Reform Act of 1990 (the “Penny Stock Act”) requiring the SEC to enact rules requiring brokers or dealers to provide disclosures to customers effecting trades in penny stocks. The rules prohibit broker-dealers from effecting transactions in penny stocks unless they comply with the requirements of Section 15(h) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”) and the rules promulgated thereunder and, in particular, Exchange Act rules 15g-1 through 15g-100 (the “penny stock rules”).

Section 17B of the Exchange Act, which was enacted as part of the Penny Stock Act, regulates automated quotation systems for penny stocks (such as OTC Markets) and provides, among other things, that the SEC shall facilitate the widespread dissemination of reliable and accurate last sale and quotation information with respect to penny stocks.

Definition of Penny Stock

A penny stock is defined in Exchange Act Rule 3a51-1. Like many SEC rules, the penny stock rule begins by including all equity securities and then carves out exemptions (for example, all offers and sales of securities must be registered unless an exemption applies). In particular, Rule 3a51-1 defines a penny stock as any equity security other than:

(a) A NMS (national market system) stock that is a reported security that is (i) registered on a national securities exchange that is grandfathered in because it has been in continuous operation since prior to April 20, 1992; or (ii) is quoted on either a national securities exchange or automated quotation system that that has certain quantitative initial listing standards and continued listing standards that are reasonably related to the initial listing standards. The initial listing standards must meet or exceed the following criteria: (a) the issuer must have $5 million of stockholders’ equity, market value of listed securities of $50 million for 90 consecutive days prior to applying, or net income of $750,000 (excluding extraordinary or non-recurring items) in the most recently completed fiscal year or in two or the last three most recently completed fiscal years; (b) the issuer must have an operating history of at least one year or a market value of listed securities of $50 million; (c) the issuer’s stock must have a minimum bid price of $4 per share; (d) there shall be at least 300 round lot holders of common stock; and (e) there must be at least 1,000,000 publicly held common shares with a market value of at least $5 million.

(b) Is issued by an investment company registered under the Investment Company Act of 1940, as amended

(d) Has an inside bid quotation price of $5.00 (the Rule requires that the price be net of broker or dealer commissions, mark-up or mark-downs)

(e) Is registered, or approved for registration upon notice of issuance, on a national securities exchange that makes price and volume transaction reports available, subject to restrictions provided in the rule

(f) Is a security futures product listed on a national securities exchange or an automated quotation system sponsored by a registered national securities association; or

(g) Whose issuer has: (i) net tangible assets (as calculated in accordance with the rule) in excess of $2 million, if the issuer has been in continuous operation for at least three years, or $5 million, if the issuer has been in continuous operation for less than three years; or (ii) average revenue (as calculated in accordance with the rule) of at least $6 million for the last three years.

Section 15(h) of the Exchange Act

Broker-dealers are required to comply with the penny stock rules, which rules center around disclosure of the risks and other market information associated with penny stock transactions and a determination of the suitability of the customer to engage in such high-risk transactions. Section 15(h) of the Exchange Act provides that no broker or dealer may effectuate the purchase or sale of any penny stock by a customer unless such broker or dealer (i) approves the customer for the specific penny stock transaction and receives from the customer a written agreement to the transaction; (ii) furnishes the customer a risk disclosure document describing the risks of investing in penny stocks; (iii) discloses to the customer the current market quotation, if any, for the penny stock, including the bid and ask price and the number of shares that apply to such bid and ask price; and (iv) discloses to the customer the amount of compensation the firm and its broker will receive for the trade. In addition, after executing the sale, a broker-dealer must send to its customer monthly account statements showing the market value of each penny stock held in the customer’s account.

Section 15(h) requires that the risk disclosure document include (i) a description of the nature and level of risk in the market for penny stocks in both public offerings and secondary trading; (ii) a description of the broker or dealer’s duties to the customer and of the rights and remedies available to the customer with respect to violations of such duties or other requirements under the federal securities laws; (iii) a brief, clear, narrative description of a dealer market, including “bid” and “ask” prices for penny stocks and the significance of the spread between the bid and ask prices; (iv) contains the toll-free telephone number for inquiries on disciplinary actions; (v) defines significant terms used in the disclosure document or in the conduct of trading in penny stocks; and (vi) contains such information, and is in such form as the SEC requires.

Section 15(h) also requires the SEC to adopt rules setting forth additional standards for the disclosure by brokers and dealers to customers concerning transactions in penny stocks. As indicated above, those rules can be found in Exchange Act Rules 15g-1 through 15g-100.

The Penny Stock Rules – Penny Stock Disclosure Requirements

Brokers and dealers that are subject to the penny stock rules (see exclusions below set forth in Rule 15g-1) are required to comply with the penny stock disclosure requirements set forth in Rules 15g-2 through 15g-9.

Exchange Act Rule 15g-2 requires the delivery of a Schedule 15G and, in particular, makes it “unlawful for a broker or dealer to effect a transaction in any penny stock for or with the account of a customer unless, prior to effecting such transaction, the broker or dealer has furnished to the customer a document containing the information set forth in Schedule 15G, Rule 15g-100, and has obtained from the customer a manually signed and dated written acknowledgement of receipt for the document.”

Rule 15g-3 requires the disclosure of quotations and other information relating to the penny stock market. Rule 15g-3 makes it unlawful for a broker or dealer to effect a transaction in any penny stock for or with the account of a customer unless such broker or dealer provides the customer with (i) the inside bid and offer quotation; (ii) where there is no inside bid and offer, the dealer’s bid or offer; and (iii) the number of shares to which the bid and offer apply.

Rule 15g-4 requires the disclosure of compensation to the broker or dealers. Rule 15g-4 makes it unlawful for a broker or dealer to effect a transaction in any penny stock for or with the account of a customer unless such broker or dealer provides the customer with the aggregate amount of any compensation received by such broker or dealer in connection with such transaction. Similarly, Rule 15g-5 requires the disclosure of the compensation to the natural person associated with the broker dealer, related to the penny stock transaction. Rule 15g-6 requires the broker-dealer to send to its customer monthly account statements showing the market value of each penny stock held in the customer’s account.

Rule 15g-9(a)(2) provides that, prior to effecting certain transactions in penny stocks, brokers and dealers must approve an investor’s account for transactions in penny stocks and receive a written agreement from the investor that provides the quantity of the particular stock to be purchased. In order to approve an investor’s account, the broker or dealer must obtain information regarding the investor’s financial situation, investment experience and investment objectives. Based on this information, the broker or dealer must determine whether transactions in penny stocks are suitable for the investor and whether the investor, or his or her adviser, has sufficient knowledge and experience to evaluate the associated risks. This determination must be delivered to the investor in writing and must be signed by the investor and returned to the broker or dealer prior to the broker or dealer effecting the trade.

In addition to the exemptions contained in Rule 15g-1 described below, no suitability determination need be made for established customers. Established customers are those that have held an account and effected transactions with that broker or dealer for more than one year prior to the subject penny stock transaction, or have made at least three purchases of penny stocks on different days and involving different issuers.

Schedule 15G

Schedule 15G is commonly referred to as the “penny stock disclosure document.” Rule 15g-100 contains the complete text of Schedule 15G. Schedule 15G may be delivered electronically, including by a link to the schedule on the SEC website. Schedule 15G sets forth information a customer must receive from the broker or dealer including the current market quotation, if any, for the penny stock, the bid and ask price and the number of shares that apply to such bid and ask price and discloses to the customer the amount of compensation the firm and its broker will receive for the trade. Schedule 15G can be read in its entirety Here.

If sent by e-mail, no other information can be included other than instructions on how to provide the broker-dealer with a signed acknowledgment of receipt and a standard privacy or confidentiality message.

Cooling-off Period

Rule 15g-2 also requires a two day “cooling-off” period after sending the Schedule 15G to the customer prior to effectuation of the penny stock transaction. Similarly, Rule 15g-9 to require a broker or dealer to wait two business days after sending its suitability determination and the transaction agreement to an investor before effecting a transaction.

Exclusions to Application of Penny Stock Rules to Broker-Dealers

Rule 15g-1 contains certain exclusions to the penny stock rule requirements and, in particular, exclusions for certain broker-dealers and certain transactions. Broker-dealers whose total commissions in penny stocks comprise less than 5% of its total generated commissions and who do not act as market makers for penny stocks are exempted from compliance with certain of the penny stock rules, including the requirement to furnish a Schedule 15G and to make a suitability determination. In addition, no Schedule 15G must be provided and no suitability determination must be made (i) for institutional accredited investors; (ii) for transactions involving private Regulation D offerings; (iii) where the customer is the issuer or an officer, director, or 5% or greater shareholder of the issuer; (iv) transactions that are not recommended by the broker or dealer; or (v) for transactions or persons for which the SEC grants an exemption.

Section 17B of the Exchange Act

Section 17B of the Exchange Act, which was enacted as part of the Penny Stock Act, establishes and regulates automated quotation systems for penny stocks (such as OTC Markets) and provides, among other things, that the SEC shall facilitate the widespread dissemination of reliable and accurate last sale and quotation information with respect to penny stocks. The preamble to Section 17B finds that (i) “the market for penny stocks suffers from a lack of reliable and accurate quotation and last sale information available to investors and regulators” and (ii) “it is in the public interest and appropriate for the protection of investors and the maintenance of fair and orderly markets to improve significantly the information available to brokers, dealers, investors, and regulators with respect to quotations for and transactions in penny stocks.”

In that regard, Section 17B requires the SEC to “facilitate the widespread dissemination of reliable and accurate last sale and quotation information with respect to penny stocks.” Ensuring compliance with Section 17B is a focus of the recent FINRA request to eliminate the OTC Bulletin Board quotation service (OTCBB) and to adopt rules relating to the quotation requirements for OTC equity services by inter-dealer quotation services, which was the subject of my blog last week.

Other Significances Related to Penny Stocks

Penny Stock issuers may not avail themselves of certain disclosure or offering rules and benefits afforded their non-penny stock counterparts. Rule 405, promulgated under the Securities Act of 1933 (the “Securities Act”), contains a definition of “ineligible issuer” which definition includes penny stock issuers. Certain disclosure and offering rules throughout the Securities Act exclude “ineligible issuers,” including penny stock issuers.

For example—and this is not meant to be an exhaustive summary—a penny stock issuer may not use a free writing prospectus in conjunction with the registered offering of securities. A well-known seasoned issuer (WKSI) cannot be a penny stock issuer. A penny stock issuer may not incorporate by reference into a Form S-1. Rule 419 applies to all registered offerings of securities by blank check companies when the securities are penny stocks.

To be eligible to trade on the OTC Markets OTCQX trading platform, an issuer must meet one of the following penny stock exemptions under Rule 3a51-1 of the Exchange Act: (i) have a bid price of U.S. $5 or more; or (ii) have net tangible assets of U.S. $2 million if the company has been in continuous operation for at least three years, or U.S. $5,000,000 if the company has been in continuous operation for less than three years; or (iii) have average revenue of at least U.S. $6,000,000 for the last three years.

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Securities, Reverse Merger and Corporate Attorneys
LAnthony@LegalAndCompliance.com

Contact Legal & Compliance LLC. Inquiries of a technical nature are always encouraged.

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« Risk Factor Disclosures For Reporting Public Companies FINRA Seeks to Eliminate the OTCBB and Impose Regulations on the OTC Markets »

Risk Factor Disclosures For Reporting Public Companies

Posted by Securities Attorney Laura Anthony | March 11, 2015 Tags: Item 503, Regulation C, Regulation S-K, Risk Factor Disclosures, Risk Factors, Safe Harbor, Section 21E

A risk factor disclosure involves a discussion of circumstances, trends, or issues that may affect a company’s business, prospects, operating results, or financial condition. Risk factors must be disclosed in registration statements under the Securities Act and registration statements and reports under the Exchange Act. In addition, risk factors must be included in private offering documents where the exemption relied upon requires the delivery of a disclosure document, and is highly recommended even when such disclosure is not statutorily required.

The Importance of Risk Factors

Risk factors are one of the most often commented on sections of a registration statement. The careful crafting of pertinent risk factors can provide leeway for more robust discussion on business plans and future operations, and can satisfy a wide arrange of SEC concerns regarding existing financial and non-financial matters (such as potential default provisions in debt, dilution matters, inadvertent rule violations, etc.).

Although smaller reporting companies are not required to include risk factors in their annual Form 10-K and quarterly Form 10-Q, they may do so voluntarily and we recommend that such risk factors be included in their annual Form 10-K. As a reminder, a “smaller reporting company” is an issuer that is not an investment company or asset-backed issuer or majority-owned subsidiary and that (i) had a public float of less than $75 million as of the last business day of its most recently completed second fiscal quarter; or (ii) in the case of an initial registration statement, had a public float of less than $75 million as of a date within days of the filing of the registration statement; or (iii) in the case of an issuer whose public float as calculated by (i) or (ii) is zero, had annual revenues of less than $75 million during the most recently completed fiscal year for which audited financial statements are available.

Risk factors, together with safe harbor language regarding forward-looking statements, can provide protection for forward-looking information contained in a document, such as plans and expectations, that do not pan out as expected or intended. Risk factors warn current and potential investors as to the risks of either purchasing or continuing to own the company’s stock. As the securities of smaller reporting companies are often high-risk penny stocks or thinly traded, and such companies tend to be in the business development and growth stage of their corporate life cycle, protections against failed or changed plans is fundamental.

By providing proper disclosure of the material risks associated with investing in a company’s securities, a company can mitigate the risk of liability to its shareholders should that risk come to pass. Risk factors act as an insurance policy and strong defense in the face of shareholder litigation.

The “bespeaks caution” doctrine refers to a line of judicial case law holding that statements of future forecasts, projections and expectations in an offering or other disclosure document are not misleading as long as they contain adequate cautionary language disclosing specific risks. Section 21E of the Exchange Act, enacted as part of the Private Securities Litigation Reform Act of 1995, codifies this doctrine for qualifying issuers. Section 21E provides a public company with a safe harbor defense in securities litigation challenging forward-looking statements. Among other exclusions, companies that issue penny stocks may not rely on Section 21E, but may rely on the “bespeaks caution” line of case law.

To avail itself of the safe harbor protection, the forward-looking statements must be identified and be accompanied by meaningful, cautionary language that identifies important factors that could cause actual results to differ materially from those projected—i.e., risk factors. To provide protection, the risk disclosure must be specific, not just boilerplate.

SEC Rules and Guidance on Risk Factors

Regulation S-K sets forth the non-financial statement disclosure requirements for both the Securities Act of 1933 (“Securities Act”) and the Securities Exchange Act of 1934 (“Exchange Act”) and is applicable to both registration statements and ongoing reporting requirements. In addition, Regulation S-K serves as a guide in the preparation of private placement disclosure documents. Items 501 and 503 of Regulation S-K include the requirements for the disclosure of risk factors.

Risk factors must be disclosed in registration statements under the Securities Act and registration statements and reports under the Exchange Act. Item 503 of Regulation S-K requires concise, logically organized statements of the particular risks involving either the company, industry or the offering being made by the company. The statements should be categorized and appear in order of importance under each category. Item 503 requires that the disclosure of risk factors in a registration statement be included in the beginning immediately following the summary section, or if there is no summary section, immediately following the cover page.

Item 501 requires that the risk factor section must be prominently cross-referenced by page number, on the cover page of a registration statement. Most companies comply with this rule by using bold, italics, larger font size or a combination thereof to comply with this rule.

Risk factor disclosures cannot contain countervailing or offsetting language. That is, a company cannot explain away the risk.

Like many areas of securities laws, the SEC gives broad guidance on disclosure, trying to avoid boilerplate language. The SEC requires the reporting company to make relevant risk factor disclosures that are germane, concise and written in plain English. The risk factors should be written as of the date of the report in which they are contained regardless of the period of the financial statements contained in such report. Each risk must have a heading that adequately describes the risk being disclosed and such heading should be bolded, italicized or both. Each risk must be concise and focused on a single material risk. The risks must be easy to read and written in such a way to highlight the most important information.

As mentioned above, the SEC requires that the risks be written in plain English. This requirement is codified in Rule 421(d) of Regulation C. Over the years, the SEC has published and updated plain English handbooks. The SEC plain English guidelines require that the risk factor section contain (i) short sentences; (ii) definitive, concrete, everyday words; (iii) active voice; (iv) tables or bullet point lists, whenever possible; (v) no legal jargon or highly technical business terms; and (vi) no multiple negatives.

Categories of Risk Factors

In general, risk factors pertain to the company, the industry, or the investment or offering. Company risks are those specific to the reporting company such as particular restrictive covenant documents, reliance or dependence on a concentrated source, or a history of losses. Industry risks are particular to the industry of the reporting company, such as technology, manufacturing, textile, or commonly in today’s market, cannabis. Investment or offering risks are those specifically tied to the security or trading market for the company’s securities, such as illiquidity. The risks included in each category should be organized in the order of materiality and importance.

The common broad areas of risk factor disclosure include:

Absence of an operating history;
Absence of revenues;
Absence of profits;
An accumulated deficit;
High degree of leverage (debt);
Dependence on a single or small number of products, suppliers, customers, manufacturers or markets;
Dependence on key personnel;
Dependence on particular financial resources or source of capital;
Early stage of product development;
Competition;
Adequacy of production and/or distribution;
Technological factors such as possible obsolescence;
Capital needs and the lack of adequate current or future funding;
A concentration of voting control in management or others;
The absence of a trading market or a thinly traded, low-priced market;
Litigation;
Governmental regulations;
Foreign operations and the effects of foreign regulations, export laws, and currency fluctuations;
Labor matters;
Intellectual property matters;
Restrictive covenants in contracts; and
Off-balance sheet arrangements

Risks that apply to any issuer or any offering should be avoided. For example, a general statement that an economic downturn would negatively impact a business should not be included; however, a concise statement that a particular economic change, such as a reduction or increase in the federal interest rate (or whatever change impacts the reporting business), and the particular risk associated with that change, could be included. Specific example are encouraged.

Typical SEC Comments on Risk Factors

Risk factors are one of the most often commented on sections of a registration statement or SEC report. These common SEC comments illustrate the SEC’s focus in reviewing risk factor disclosures.

We suggest that you revise your risk factor captions to make your disclosure more meaningful to your investors and shareholders. Some of your risk factors merely state a fact about your business. You should succinctly state in your captions the particular risk that results from the uncertainty.
Some of your risk factors are too vague and generic and do not adequately describe the risk that follows. Readers should be able to read the risk factor heading and come away with a strong understanding of what the risk is and the result of the risk as it specifically applies to you. Revise your subheadings accordingly.
In each risk factor, get to the risk as quickly as possible and provide only enough detail to place the risk in context. In some of your risk factors, the actual risk you are trying to convey does not stand out from the rest of the information.
Avoid presenting risks that could apply to any issuer in your industry, do not reflect your current operations, are not material, or are generic, boilerplate disclosures. Rather, tailor each risk factor to your specific facts and circumstances.
Revise each risk to remove mitigating information.
Consider including a risk factor that addresses XYZ.
Provide the information investors need to assess the magnitude of the risk.
Where possible, quantify the risk.
The introductory paragraph to your risk factors section is not complete, there may be risks that you do not consider material now but may become material, or there may be risks that you have not yet identified. You must disclose all risks that you believe are material at this time.
You include more than one risk under one subheading. Revise to include only one risk under each subheading.

As always, competent legal counsel should be utilized in crafting SEC reports and/or offering disclosure documents.

The Author
Attorney Laura Anthony
LAnthony@LegalAndCompliance.com
Founding Partner, Legal & Compliance, LLC
Corporate, Securities and Business Transaction Attorneys

Contact Legal & Compliance LLC. Technical inquiries are always encouraged.

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« SEC Suspends Trading On 128 OTC Markets Companies Penny Stock Rules And Broker Dealers »

SEC Suspends Trading On 128 OTC Markets Companies

Posted by Securities Attorney Laura Anthony | March 11, 2015

On March 2, 2015, the Securities and Exchange Commission (SEC) suspended the trading in 128 dormant shell companies trading on the OTC Link. The SEC suspended the trading in these shell companies because of questions regarding the accuracy and adequacy of publicly disseminated information concerning the companies’ operating status, if any.

The SEC notes in its release that OTC Markets had been unable to contact each of the issuers for more than one year. None of the subject issuers had filed any information or updated with either OTC Markets or the SEC in over a year. The SEC staff then independently attempted to contact the issuers and was able to contact 10 of the 128 companies and confirm from those ten that they had either ceased operations or gone private.

The trading suspensions are part of an SEC initiative tabbed Operation Shell-Expel by the SEC’s Microcap Fraud Working Group. As part of the initiative, the SEC Enforcement Division’s Office of Market Intelligence utilizes technology to search OTC traded securities and identify dormant companies. The SEC has a concern that unscrupulous individuals will take over the companies without the legal right to do so (corporate hijacking) and use the company to conduct a pump-and-dump scheme.

Since 2012, Operation Shell-Expel has suspended trading in more than 800 OTC companies. The federal securities laws allow the SEC to suspend trading in any stock for up to 10 business days. Once a company is suspended from trading, it cannot be quoted again until it provides updated information including complete disclosure of its business and accurate financial statements. In addition to providing the necessary information, to begin to trade again, a company must enlist a market maker to file a new 15c2-11 application with FINRA.

For a company with a trading suspension, this is a difficult process if not impossible. Many market makers are unwilling to take on the assignment and when they do, the comment process with FINRA can be lengthy and arduous. FINRA is charged with regulating the OTC Markets and taking measures to prevent potential fraud. In the case of a defunct or dormant entity, FINRA will exercise its full authority to conduct an in-depth review of the company history and associated people. Moreover, even if a 211 application is approved by FINRA, DTC may still refuse to qualify the security for electronic trading.

Bottom line, short of a new registration statement and going public process, these companies have effectively been removed from the public company trading system.

The SEC continues to send the message that companies without current information will not be allowed to trade. Moreover, the SEC has become much quicker at identifying and shutting down dormant shell companies.

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Securities, Reverse Merger and Corporate Attorneys
LAnthony@LegalAndCompliance.com

Contact Legal & Compliance LLC. Inquiries of a technical nature are always encouraged.

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Legal & Compliance, LLC makes this general information available for educational purposes only. The information is general in nature and does not constitute legal advice. Furthermore, the use of this information, and the sending or receipt of this information, does not create or constitute an attorney-client relationship between us. Therefore, your communication with us via this information in any form will not be considered as privileged or confidential.

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« Once Again, DTC Amends Proposed Procedures For Issuers Affected By Chills And Proposes Subsequent Rule Change Risk Factor Disclosures For Reporting Public Companies »

Once Again, DTC Amends Proposed Procedures For Issuers Affected By Chills And Proposes Subsequent Rule Change

Posted by Securities Attorney Laura Anthony | May 15, 2014 Tags: Deposit Chill, Deposit Chill Notice, DTC Depository, DTC Eligibility, Global Lock, Regulatory Filings, Rule 144 Eligibility, Rule 144A, Rule 22(a), SEC Rule 144(a)(3)

Background

On October 8, 2013, I published a blog and white paper providing background and information on the Depository Trust Company (“DTC”) eligibility, chills and locks and the DTC’s then plans to propose new rules to specify procedures available to issuers when the DTC imposes or intends to impose chills or locks. On December 5, 2013, the DTC filed these proposed rules with the SEC and on December 18, 2013, the proposed rules were published and public comment invited thereon. Following the receipt of comments on February 10, 2014, and again on March 10, 2014, the DTC amended its proposed rule changes. This blog discusses those rule changes and the current status of the proposed rules.

The new rules provide significantly more clarity as to the rights of the DTC and issuers and the timing of the process. For a complete discussion on background and DTC basics such as eligibility and the evolving procedures in dealing with chills and locks, including a complete discussion of the proposed rules published December 18, 2013, please see my white paper here 12/18/13.

As stated in the rule release, the current proposed rules “specify procedures available to issuers of securities deposited at DTC when DTC blocks or intends to block the deposit of additional securities of a particular issue (‘Deposit Chill’) or prevents or intends to prevent deposits and restrict book-entry and related depository services of a particular issue (‘Global Lock’).”

In the Matter of the Application of International Power Group, Ltd.

On March 15, 2012, the Securities and Exchange Commission (SEC) issued an administrative opinion stating that an issuer is entitled to due process proceedings by the DTC as a result of a DTC chill placed on an issuer’s securities (In the Matter of the Application of International Power Group, Ltd. Admin. Proc. File No. 3-13687).

In September 2009, the DTC put a chill on the trading of International Power Group, Ltd. (IPWG) securities following the initiation by the SEC of an action against certain defendants, not IPWG, for improper issuance and trading in certain OTC securities, including IPWG and 3 other issuers. In May 2010, the SEC settled with the defendants related to IPWG for the usual penalties and permanent injunctions, which settlement did not address the already issued securities. As a result of this process, the DTC imposed a chill on the securities of IPWG. IPWG was unsuccessful in getting the DTC to be responsive to its inquiries, let alone determine a process for removing the chill. So, although IPWG was clearly and undeniably greatly impacted by the DTC chill, at the time the DTC took the position that it didn’t have any particular obligation to IPWG for its actions.

IPWG filed an administrative appeal with the SEC looking for assistance. In its opinion, the SEC held that an issuer, in this case IPWG, was an Interested Person for purposes of DTC Rule 22 and was impacted by the DTC chill such that they are entitled to due process and fair proceedings. The SEC did not tell the DTC what the criteria were for determining whether the chill was appropriate or not should be, but only that the issuer is entitled to “fair procedures.”

Moreover, the SEC stated, “DTC should adopt procedures that accord with the fairness requirements of Section 17A(b)(3)(H), which may be applied uniformly in any future such issuer cases”; “Those procedures must also comply with Section 17A(b)(5)(B) of the Exchange Act, which requires clearing agencies when prohibiting or limiting a person’s access to services, to (1) notify such person of the specific grounds for the prohibition or limitation, (2) give the person an opportunity to be heard upon the specific grounds for the prohibition or limitation, and (3) keep a record.”

Finally, the SEC confirmed that the DTC can still put a chill on an issuer’s security, prior to giving notice and an opportunity to be heard to that issuer, in an emergency situation, stating, “[H]owever, in such circumstances, these processes should balance the identifiable need for emergency action with the issuer’s right to fair procedures under the Exchange Act. Under such procedures, DTC would be authorized to act to avert imminent harm, but it could not maintain such a suspension indefinitely without providing expedited fair process to the affected issuer.”

A DTC Chill or Global Lock – General

A DTC chill is the suspension of certain DTC services with respect to an issuer’s securities. Those services can be book entry clearing and settlement services, deposit services (“Deposit Chill”) or withdrawal services. A chill can pertain to one or all of these services. In the case of a chill on all services, including book entry transfers, deposits, and withdrawals, the term of art is a “Global Lock.”

From the DTC’s perspective, a chill does not change the eligibility status of an issuer’s securities, just what services the DTC will offer for those securities. For example, the DTC can refuse to allow further securities to be deposited into the DTC system or while an issuer’s securities may still be in street name (a CEDE account), the DTC can refuse to allow the book entry trading and settlement of those securities.

DTC Statement of the Purpose of the Proposed Rule Changes

Once a security is approved as eligible for DTC depository and book-entry services, banks and broker-dealers that are participants with the DTC (which is almost all such entities) may deposit securities into their DTC accounts on behalf of their respective clients. Securities deposited into the DTC may be transferred among brokerage accounts by book-entry (electronic) transfer, facilitating quick and easy transactions in the public marketplace. Eligible securities are registered on the books of a company in the DTC’s nominee name, Cede & Co.

A basic premise to use of the DTC is that securities be freely tradable. Therefore, in order to be DTC eligible, an issuer’s securities must (i) be issued in a transaction registered with the SEC under the Securities Act of 1933, as amended (“Securities Act”); (ii) be issued in a transaction exempt from registration under the Securities Act and that, at the time of seeking DTC eligibility, are no longer restricted; or (iii) be eligible for resale pursuant to Rule 144A or Regulation S under the Securities Act.

Since deposited securities are in fungible bulk, the deposit or existence of any illegally or improperly deposited securities (restricted securities) taints the bulk of all securities held by the DTC for that company. As such, the DTC monitors enforcement actions, regulatory actions and pronouncements and red flags in the securities of DTC-eligible securities. A red flag includes unusually large deposits of thinly traded, low-priced securities. DTC Rule 6 allows the DTC to limit certain services to particular deposited securities. In addition, Section 1.B.2 of the DTC’s Operational Arrangements give the DTC the power to require companies’ outside counsel to provide legal opinions in support of eligibility and free tradability of deposited securities.

In addition, the DTC looks for other red flags, including FINRA’s list of red flags such as the following:

A customer of the broker opens a new account and delivers physical certificates representing a large block of thinly traded or low-priced securities;
A customer of the broker deposits share certificates that are recently issued or represent a large percentage of the float of the security;
The company was a shell company when it issued the shares;
A customer of the broker with limited or no other assets under management at the firm receives an electronic transfer or journal transaction of large amounts of low-priced, unlisted securities;
The issuer has been through several recent name changes, business combinations or recapitalizations, or the company’s officers are also officers of numerous similar companies;
The issuer’s SEC filings are not current, or are incomplete or nonexistent.

Where the DTC’s monitoring raises concerns that securities held at the DTC have been distributed in violation of federal law, the DTC may impose a deposit chill or global lock. The two main scenarios when this occurs are as follows: (i) Where the DTC detects suspicious, unusually large deposits of a low-priced or thinly traded security, they may and often do impose a Deposit Chill until, in the words of the DTC, “the issuer convincingly demonstrates that the securities are freely transferable.” (ii) If the DTC determines that there is “definitive evidence” that restricted shares have been deposited, it will impose a Global Lock. According to the DTC, definitive evidence is established if the SEC or other regulatory agency has brought an enforcement action against any defendant that has deposited the issuer’s securities into the DTC. The DTC may also impose a Global Lock where the Issuer fails to respond to or adequately resolve a Deposit Chill.

DTC Proposed Process for Issuers

The newest amendments to the proposed rules clarify and narrow the DTC’s authority as a protector of the overall marketplace, to just a protector of the DTC system. Rather than give an explanation of each of the changes from the last version of the proposed rules, this blog explains the proposed rules as they exist today.

The DTC has proposed rules (new Rules 22(A) and 22(B)) such that issuers will be notified in writing of chills and locks, have a set time frame in which to respond, and will have clear guidelines to be met to either prevent a chill or lock or remove same. The DTC will agree to respond within a set time frame. Moreover, and importantly, the DTC will agree to keep communication open between the issuer and its counsel, and the DTC and its counsel, throughout the process.

A.Deposit Chills (Rule 22(A)) In general, proposed Rule 22(A) provides companies with an opportunity to establish that they meet the DTC’s eligibility requirements, including by submitting an opinion from independent legal counsel: “Proposed Rule 22(A) will not apply when DTC impose[s] operational restrictions on deposits or other services in connection with ordinary course of business processing of Eligible Securities. One example of ‘ordinary course of business processing’ is the processing of corporate actions, including name changes and stock splits.”

Notification of Deposit Chill. Pursuant to its Proposed Rule, the DTC will notify an issuer of a deposit chill no later than 20 business days prior to imposition of the Deposit Chill, or if the chill has already been imposed, no later than three business days after the chill has been imposed.

The DTC will send the notice via overnight courier to the issuer’s address in its regulatory filings or where it is incorporated. If the DTC cannot locate the issuer with reasonable diligence, it will send it the notice to the issuer’s registered agent for service of process.

The DTC has narrowed and clarified when a deposit chill may be imposed prior to notice. In particular, the DTC may impose the chill prior to notice “in order to prevent imminent harm, injury or other such consequences to DTC or its Participants” or “if DTC reasonably determines that such action is necessary to protect the prompt and accurate clearance and settlement of securities transactions through DTC.”

The notice will provide an explanation of the specific grounds upon which the restrictions are being or have been imposed including the legal authority upon which DTC relies. The notice will state the actions that the issuer must take in order to prevent or remove the restrictions, including generally requiring a legal opinion from independent counsel. It will also provide the date the Deposit Chill was imposed or the date it will be imposed, should the issuer fail to respond to the Deposit Chill notice.

The issuer has 20 days to respond to the notice. The DTC may extend this deadline for up to an additional twenty business days if the issuer establishes “good cause.” If the issuer demonstrates to DTC’s “reasonable satisfaction” that the issue complies with the DTC’s eligibility requirements and the applicable procedures, the Deposit Chill will be lifted or will not be imposed.

The Proposed Rules provide that the issuer must support its response with a legal opinion, prepared by independent counsel, confirming that the issuer’s securities deposited at the DTC satisfy the DTC’s eligibility requirements, including that they are freely tradable. In particular, the opinion letter must specify that the securities “(i) are not restricted securities under SEC Rule 144(a)(3), or (ii) are exempt from any restrictions on transferability under the Securities Act.” The DTC will provide a template for the legal opinion to the issuer. It is not anticipated that the legal opinion requirements will be different than as in effect today.

DTC Review of Issuer Response. The DTC may request further or additional information, in which case the issuer will have at least ten (10) days to provide such additional information. The DTC will respond in writing to the issuer’s submission and legal opinion within twenty business days for pre-chill notices and within ten business days if the chill has already been imposed.

Determination. An officer of the DTC who did not participate in the decision to impose the chill, together with outside counsel as appropriate, will decide whether the issuer’s response is satisfactory. If the response from the issuer is sufficient, the chill will either not be imposed or will be lifted. If a chill was imposed prior to the issuance of a Notice, the determination whether to lift such chill will be provided to the issuer within ten business days after receipt of the issuer’s response. In the event of a pre-chill notice, the determination will be provided to the issuer within twenty business days after receipt of the issuer’s response. This timing was not in the prior version of the proposed rules.

If the issuer does not respond in a timely manner (including after extensions) or such response is not sufficient, the chill will remain and a lock may be imposed. In an adverse decision, prior to imposing a Global Lock, the DTC will give the issuer ten days in which to submit a supplemental response. The supplemental response will be limited to establishing that either (1) the issuer did timely respond to DTC previously, or (2) that the DTC’s determination was the result of the DTC’s clerical mistake or a mistake arising from an oversight or omission in reviewing the issuer’s response. This added process will not include an added substantive review. The DTC will provide a determination within ten (10) days of receipt of the supplemental response.

The Record: The record of a proceeding, for purposes of use in an appeal to the SEC, shall include: (i) The Deposit Chill Notice, the Deposit Chill Response, the Deposit Chill Decision, the Supplemental Deposit Chill Response, the Supplemental Deposit Chill Response Decision, the Additional Information Request, and the Additional Information Response; (ii) all documents submitted in connection with (i) and (iii) any written communications created pursuant to the proposed rules as described herein.

DTC reserves authority to modify or lift a chill or to impose a chill after making a favorable determination, with a restart of the proposed procedures.

B.Global Locks. Global locks can be imposed either where (i) an issuer has failed to respond or failed to adequately respond to a deposit chill notice or (ii) the DTC becomes aware that the SEC or other state or federal agency has commenced a judicial or administrative proceeding alleging that DTC-eligible securities have been sold in violation of Section 5 of the Securities Act or other applicable law.

Notification of Global Lock. Pursuant to its proposed rule, the DTC will notify an issuer of a Global Lock no later than 20 business days prior to imposition of the Global Lock, or if the lock has already been imposed, no later than three business days after the lock has been imposed. The issuer shall have twenty (20) days to respond. The DTC may extend the deadline for up to an additional twenty (20) days if the issuer establishes “good cause.”

The notice will provide an explanation of the specific grounds upon which the restrictions are being or have been imposed including the legal authority upon which the DTC relies. The DTC will impose the lock prior to notice (i) to prevent imminent harm, injury or other such consequences to the DTC or its participants or (ii) if the DTC reasonably determines that such action is necessary to protect the prompt and accurate clearance and settlement of securities transactions through the DTC. It will also provide the date the Lock was imposed or the date it will be imposed, should the issuer fail to respond to the notice.

The proposed rules differentiate Global Locks based on enforcement proceedings and Global Locks based on an issuer’s failure to respond or adequately respond to a chill. Where the Lock is imposed as a result of an enforcement proceeding, the notice will provide that a “Global Lock will not be imposed, or, if already imposed, will be released if the issuer demonstrates either (1) that the Eligible Securities were not the intended subject of the Proceeding, or (2) that the Proceeding was withdrawn or dismissed on the merits with prejudice or otherwise resolved in a final, non-appealable judgment in favor of the Defendants.” The DTC will not provide a forum for litigating or re-litigating the allegations or findings in the enforcement proceeding. As noted above, the notice will give twenty days to respond, with the ability to receive a twenty-day extension.

To be very clear, a DTC Global Lock may be imposed if an action is brought against any shareholder that has deposited the issuer’s securities into the DTC and the DTC reasonably believes that the action relates to the issuer’s securities. The issuer itself does not have to be a party to the enforcement or legal proceeding.

DTC Review of Issuer Response. The DTC will respond in writing to the issuer’s submission within twenty business days for pre-lock notices and within ten business days if the lock has already been imposed. The DTC is cognizant of not providing an alternative forum for an issuer to litigate enforcement proceedings. Accordingly, where there is a pending enforcement action, it is unlikely that a Global Lock will be lifted and the DTC’s review will be limited.

Determination. If the response from the issuer is sufficient, the DTC decision will be to either (i) not impose or release the Lock; or (ii) impose or not release the Lock. Otherwise, the DTC will release the Global Lock upon the eligible securities becoming eligible for free trading status pursuant to Rule 144 – that is, within either one year or six months, depending on whether the issuer is subject to the reporting requirements of the Exchange Act and depending on the company’s Rule 144 eligibility.

In particular, the proposed rules include a provision whereby Global Locks can be lifted and removed after a holding period analogous to Rule 144. In particular, the DTC’s proposed rules include the lifting of a Global Lock after the following periods have elapsed:

For non-reporting issuers – one year after the latest date on which the outstanding litigation or administrative proceeding has been resolved with respect to any defendant that deposited securities at the DTC.
For reporting issuers – six months after the latest date on which the outstanding litigation or administrative proceeding has been resolved with respect to any such defendant.
Where the Global Lock was imposed for a failure to respond or properly respond to a Deposit Chill issue – for non-reporting issuers – one year after the date the Global Lock was imposed;
Where the Global Lock was imposed for a failure to respond or properly respond to a Deposit Chill issue – for reporting issuers – six months after the date the Global Lock was imposed.

The release of the Global Lock as set forth above would only be available to issuers that are not and have never been a “shell company” as defined by Securities Act Rule 144(i), unless the issuer had ceased to be a shell company and filed Form 10 type information.

The record for purposes of an appeal to the SEC will consist of the Global Lock Notice, the Global Lock Response and the Global Lock Decision. Moreover, the proposed rules give the DTC full discretion to lift or modify a Global Lock on the same grounds for which a Lock can be imposed or lifted as set forth above.

The Author

Attorney Laura Anthony

LAnthony@LegalAndCompliance.com

Founding Partner, Legal & Compliance, LLC

Securities, Reverse Merger and Corporate Attorneys

Corporate and Securities Attorney Laura Anthony’s legal expertise includes but is not limited to registration statements, including Forms S-1, S-4, S-8 and Form 10, PIPE transactions, debt and equity financing transactions, private placements, reverse mergers, forward mergers, asset acquisitions, joint ventures, crowdfunding, and compliance with the reporting requirements of the Securities Exchange Act of 1934 including Forms 10-Q, 10-K and 8-K, the proxy requirements of Section 14, Section 16 filings and Sarbanes-Oxley mandated policies. Moreover, Ms. Anthony represents both target and acquiring companies in reverse mergers and forward mergers, including preparation of deal documents such as Merger Agreements, Share Exchange Agreements, Stock Purchase Agreements, Asset Purchase Agreements and Reorganization Agreements. Ms. Anthony prepares the necessary documentation and assists in completing the requirements of federal and state securities laws and SROs such as FINRA and DTC for corporate changes such as name changes, reverse and forward splits and change of domicile.

Contact Legal & Compliance LLC. Technical inquiries are always encouraged.

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« Reverse Merger Attorney SEC Suspends Trading On 128 OTC Markets Companies »

Reverse Merger Attorney

Posted by Securities Attorney Laura Anthony | May 8, 2014 Tags: Going Public, Merger Agreement, Public Shell, Reverse Merger, Reverse Merger Attorney, Reverse Merger Process | Reverse Merger Attorneys, Rule 144

What is a reverse merger? What is the process?

A reverse merger is the most common alternative to an initial public offering (IPO) or direct public offering (DPO) for a company seeking to go public. A “reverse merger” allows a privately held company to go public by acquiring a controlling interest in, and merging with, a public operating or public shell company. The SEC defines a “shell company” as a publically traded company with (1) no or nominal operations and (2) either no or nominal assets or assets consisting solely of any amount of cash and cash equivalents.

In a reverse merger process, the private operating company shareholders exchange their shares of the private company for either new or existing shares of the public company so that at the end of the transaction, the shareholders of the private operating company own a majority of the public company and the private operating company has become a wholly owned subsidiary of the public company. The pre-closing controlling shareholder of the public company either returns their shares to the company for cancellation or transfers them to individuals or entities associated with the private operating business. The public company assumes the operations of the private operating company. At the closing, the private operating company has gone public by acquiring a controlling interest in a public company and having the public company assume operations of the operating entity.

A reverse merger is often structured as a reverse triangular merger. In that case, the public shell forms a new subsidiary which new subsidiary merges with the private operating business. At the closing the private company, shareholders exchange their ownership for shares in the public company and the private operating business becomes a wholly owned subsidiary of the public company. The primary benefit of the reverse triangular merger is the ease of shareholder consent. That is because the sole shareholder of the acquisition subsidiary is the public company; the directors of the public company can approve the transaction on behalf of the acquiring subsidiary, avoiding the necessity of meeting the proxy requirements of the Securities Exchange Act of 1934.

The SEC requires that a public company file Form 10 type information on the private entity within four days of completing the reverse merger transaction (a super 8-K). Upon completion of the reverse merger transaction and filing of the Form 10 information, the once private company is now public. Form 10 information refers to the type of information contained in a Form 10 Registration Statement. Accordingly, a Super 8-K is an 8-K with a Form 10 included therein.

Like any transaction involving the sale of securities, the issuance of securities to the private company shareholders must either be registered under Section 5 of the Securities Act or use an available exemption from registration. Generally, shell companies rely on Section 4(a)(2) or Rule 506 of Regulation D under the Securities Act for such exemption.

The Transaction

A reverse merger is a merger transaction with the difference being that the target ultimately ends up owning a majority of the acquirer. However, the documentation and process to complete the transaction is substantially the same as a forward merger.

Generally the first step in a reverse merger is executing a confidentiality agreement and letter of intent. These documents can be combined or separate. If the parties are exchanging information prior to reaching the letter of intent stage of a potential transaction, a confidentiality agreement should be executed first.

In addition to requiring that both parties keep information confidential, a confidentiality agreement sets forth important parameters on the use of information. For instance, a reporting entity may have disclosure obligations in association with the initial negotiations for a transaction, which would need to be exempted from the confidentiality provisions. Moreover, a confidentiality agreement may contain other provisions unrelated to confidentiality such as a prohibition against solicitation of customers or employees (non-competition) and other restrictive covenants. Standstill and exclusivity provisions may also be included, especially where the confidentiality agreement is separate from the letter of intent.

Next is the letter of intent (“LOI”). An LOI is generally non-binding and spells out the broad parameters of the transaction. The LOI helps identify and resolve key issues in the negotiation process and hopefully narrows down outstanding issues prior to spending the time and money associated with conducting due diligence and drafting the transaction contracts and supporting documents. Among other key points, the LOI may set the price or price range, the parameters of due diligence, necessary pre-deal recapitalizations, confidentiality, exclusivity, and time frames for completing each step in the process. Along with an LOI, the parties’ attorneys prepare a transaction checklist which includes a “to do” list along with a “who do” identification.

Following the LOI, the parties will prepare a definitive agreement which is generally titled either a “Share Exchange Agreement” or a “Merger Agreement.” In a nutshell, the Merger Agreement sets out the financial terms of the transaction and legal rights and obligations of the parties with respect to the transaction. The Merger Agreement sets forth closing procedures, preconditions to closing and post-closing obligations, and sets out representations and warranties by all parties and the rights and remedies if these representations and warranties are inaccurate.

The main components of the Merger Agreement and a brief description of each are as follows:

1. Representations and Warranties – Representations and warranties generally provide the buyer and seller with a snapshot of facts as of the closing date. From the seller the facts are generally related to the business itself, such as that the seller has title to the assets, there are no undisclosed liabilities, there is no pending litigation or adversarial situation likely to result in litigation, taxes are paid and there are no issues with employees. From the buyer the facts are generally related to legal capacity, authority and ability to enter into a binding contract. The seller also represents and warrants its legal ability to enter into the agreement.

2. Covenants – Covenants generally govern the parties’ actions for a period prior to and following closing. An example of a covenant is that the private company must continue to operate the business in the ordinary course and maintain assets pending closing and if there are post-closing payouts that the seller continues likewise. All covenants require good faith in completion.

3. Conditions – Conditions generally refer to pre-closing conditions such as shareholder and board of director approvals, that certain third-party consents are obtained and proper documents are signed. Closing conditions usually include the payment of the compensation by the buyer. Generally, if all conditions precedent are not met, the parties can cancel the transaction.

4. Indemnification/remedies – Indemnification and remedies provide the rights and remedies of the parties in the event of a breach of the agreement, including a material inaccuracy in the representations and warranties or in the event of an unforeseen third-party claim related to either the agreement or the business.

5. Schedules – Schedules generally provide the meat of what the seller is purchasing, such as a complete list of customers and contracts, all equity holders, individual creditors and terms of the obligations. The schedules provide the details.

6.In the event that the parties have not previously entered into a letter of intent or confidentiality agreement providing for due diligence review, the Merger Agreement may contain due diligence provisions. Likewise, the agreement may contain no-shop provisions, breakup fees, and/or non-compete and confidentiality provisions if not previously agreed to separately.

The next and final steps are the actual closing in which the shares of stock and reverse merger consideration change hands and a Super 8-K is filed with the SEC.

Reverse Merger Consideration/The Cost of the Shell

In a reverse merger transaction, the private operating business must pay for the public shell company. That payment may be in cash, equity or both. Although the cash price of shell entities can vary and changes over time as does the value of all assets, as of the day of this blog, the average cash value of a fully reporting public entity with no liabilities, no issues (such as a DTC chill) and which is otherwise “clean” is between $280,000 – $400,000. The price variance depends on many factors, such as pre- and post-closing conditions (such as a requirement that the public entity complete a name change and/or stock split prior to closing); the ultimate percent ownership that will be owned by the private operating company shareholders; how quickly the transaction can close; whether the private entity has its “ducks in a row” (see below); whether the entities have complete due diligence packages prepared; and whether any broker-dealers or investment bankers must be paid in association with the transaction.

Where the private operating business is paying for the public shell entity with equity, the current shareholders of the public shell company keep a larger portion of their pre-closing equity and therefore own a greater percent of the new combined companies post-closing. That is, the current public company shareholders have a lower level of dilution in the transaction.

For example, in a cash reverse merger transaction, generally the current control shareholders of the public company cancel or otherwise divest themselves of all of their share ownership and the post-closing share ownership is anywhere from 80%/20% to 99%/1% with the private operating company shareholders owning the majority. In an equity transaction, the current control shareholders keep some or all of their current share ownership. In addition, the final post-closing capitalization will generally be anywhere from 51%/49% to 80%/20% with the private operating company shareholders owning the majority.

The percentage of ownership maintained by the public company shareholders will depend on the perceived value of the private operating company and an expectation of what the value of their share ownership could be in the future. Clearly there is risk involved for the public company shareholders. That is, control shareholders may have to decide whether to accept $300,000 today or maintain a stock ownership level that they hope will be worth much more than that at some time in the future. From the private operating company’s perspective, they are diluting their current ownership and giving up a piece of the pie.

Accordingly, in an equity transaction, the parties to the reverse merger will negotiate the value of the private operating business. For business entities with operating history, revenue, profit margins and the like, valuation is determined by mathematical calculations and established mathematically based matrixes (usually 1x to 8x EBITDA). For a development stage or start-up venture, the necessary elements to complete a mathematical analysis simply do not exist. In this case, valuation is based on negotiation and a best guess.

Establishing valuation for a development stage or start-up entity ultimately comes down to an investor’s (i.e., in a reverse merger, public company shareholders who agree to forgo cash and keep equity instead) perception of risk versus reward. Risk is easy to determine: If I could get $300,000 cash for the public shell today, I may lose that $300,000 by accepting equity instead. Reward, on the other hand, is an elusive prospect based on the potential success of a business.

In determining value, an analysis (due diligence) should be conducted on a minimum of the following: market data; competition; pricing and distribution strategies; assets and liabilities; hidden liabilities; inflated assets; technology risks; product development plans; legal structure; legal documentation; corporate formation documents and records; and management, including backgrounds on paper, and face-to-face assessments.

Areas of Consideration in Determining Valuation

The following areas should be researched and considered in valuation. The below list is in no particular order.

1. Investment comps: Have investors, either private or public, recently funded similar companies, and if so, on what terms and conditions and at what valuation;

2. Market Data: What is the product market; what is the size of the market; how many new players enter the market on a yearly basis and what is their success rate;

3. Competition: Who are the major competitors; what is their valuation; how does this company differ from these competitors;

4. Uniqueness of product or technology: How is the product or technology unique; can it easily be duplicated; patent, trademark and other intellectual property protections;

5. Pricing and Distribution Strategies: What are the major impediments to successful entry into the marketplace; what is the plan for successful entry into the marketplace; has order fulfillment, including transportation costs, been considered; connections to end users for the product or service; what are profit margins and will the margins increase as the business grows and scales;

6. Capital investments to date: What capital investments have been made to the company to date, including both financial and services;

7. Assets and liabilities: What does the balance sheet look like; are there hidden liabilities; any off-balance sheet arrangements; how are assets valued; are any assets either over- or undervalued; is there clear title to all assets;

8. Technology Risks: What technologies are relied upon; what is the state of evolvement of those technologies; can they keep up;

9. Product Development Plans: Are there a model and samples; have they been tested; have manufacturing channels been established; exclusive contracts with manufacturers; what is the overall plan to bring the product to market and subsequently become a competitor in the industry;

10. Legal Structure: Legal structure of current outstanding equity – just common equity or common and preferred, and if preferred, what rights are associated therewith (redemption rights; liquidation preferences; dividends; voting rights);

11. Legal documentation: Not only whether corporate records are in order, but are all contracts and arrangements properly documented;

12. Future financing needs: Will significant future financing be necessary to achieve the business plan; what is the risk of a future down round (note that a down round is a future financing at a lower valuation resulting in dilution to the current investors);

13. Exit strategies: How will the current shareholder be able to sell; will the shares have piggyback or demand registration rights; reliance on Rule 144?; lockup or other additional holding periods?;

14. Management: This is perhaps the most important consideration – Does the management team have a proven history of success; prior business experience in this and other industries; work ethic; general management skills; organization skills; presentation skills; research skills; coachability; ability to attract others with strong credentials who believe in the business and are willing to work to make the business a success; does management present well in meetings and face-to-face discussions;

16. Developmental milestones: Has the company achieved its developmental milestones to date?

Advantages of a Reverse Merger

The primary advantage of a reverse merger is that it can be completed very quickly. As long as the private entity has its “ducks in a row,” a reverse merger can be completed as quickly as the attorneys can complete the paperwork. Having your “ducks in a row” includes having completed audited financial statements for the prior two fiscal years and quarters up to date (or from inception if the company is less than two years old), and having the information that will be necessary to file with the SEC readily available. The reverse merger transaction itself is not a capital-raising transaction, and accordingly, most private entities complete a capital-raising transaction (such as a PIPE) simultaneously with or immediately following the reverse merger, but it is certainly not required. In addition, many companies engage in capital restructuring (such as a reverse split) and a name change either prior to or immediately following a reverse merger, but again, it is not required.

Raising money is difficult and much more so in the pre-public stages. In a reverse merger, the public company shareholders become shareholders of the operating business and no capital raising transaction needs to be completed to complete the process. Accordingly, companies that may be less mature in their development and unable to attract sophisticated capital financing can use a reverse merger to complete a going public transaction and still benefit from being public while they grow and mature. Such benefits include the ability to use stock and stock option plans to attract and keep higher-level executives and consultants and to make growth acquisitions using stock as currency.

Disadvantages of a Reverse Merger

There are several disadvantages to a reverse merger. The primary disadvantage is the restriction on the use of Rule 144 where the public company is or ever has been a shell company. Rule 144 is unavailable for the use by shareholders of any company that is or was at any time previously a shell company unless certain conditions are met. In order to use Rule 144, a company must have ceased to be a shell company; be subject to the reporting requirements of section 13 or 15(d) of the Exchange Act; filed all reports and other materials required to be filed by section 13 or 15(d) of the Exchange Act, as applicable, during the preceding 12 months (or for such shorter period that the issuer was required to file such reports and materials), other than Form 8-K reports; and have filed current “Form 10 information” with the Commission reflecting its status as an entity that is no longer a shell company – then those securities may be sold subject to the requirements of Rule 144 after one year has elapsed from the date that the issuer filed “Form 10 information” with the SEC.

Rule 144 now affects any company that was ever in its history a shell company by subjecting them to additional restrictions when investors sell unregistered stock under Rule 144. The new language in Rule 144(i) has been dubbed the “evergreen requirement.” Under the so-called “evergreen requirement,” a company that ever reported as a shell must be current in its filings with the SEC and have been current for the preceding 12 months before investors can sell unregistered shares.

Another disadvantage concerns undisclosed liabilities, lawsuits or other issues with the public shell. Accordingly, due diligence is an important aspect of the reverse merger process, even when dealing with a fully reporting current public shell. The third primary disadvantage is that the reverse merger is not a capital-raising transaction (whereas an IPO or DPO is). An entity in need of capital will still be in need of capital following a reverse merger, although generally, capital-raising transactions are much easier to access once public. The fourth disadvantage is immediate cost. The private entity generally must pay for the public shell with cash, equity or a combination of both. However, it should be noted that an IPO or DPO is also costly.

In addition, the NYSE, NYSE MKT (formerly AMEX) and NASDAQ exchanges have enacted more stringent listing requirements for companies seeking to become listed following a reverse merger with a shell company. The rule change prohibits a reverse merger company from applying to list until the combined entity had traded in the U.S. over-the-counter market, on another national securities exchange, or on a regulated foreign exchange for at least one year following the filing of all required information about the reverse merger transaction, including audited financial statements. In addition, new rules require that the new reverse merger company has filed all of its required reports for the one-year period, including at least one annual report. The new rule requires that the reverse merger company “maintain a closing stock price equal to the stock price requirement applicable to the initial listing standard under which the reverse merger company is qualifying to list for a sustained period of time, but in no event for less than 30 of the most recent 60 trading days prior to the filing of the initial listing application.” The rule includes some exceptions for companies that complete a firm commitment offering resulting in net proceeds of at least $40 million.

Finally, whether an entity seeks to go public through a reverse merger or an IPO, they will be subject to several, and ongoing, time-sensitive filings with the SEC and will thereafter be subject to the disclosure and reporting requirements of the Securities Exchange Act of 1934, as amended.

The Author

Attorney Laura Anthony

LAnthony@LegalAndCompliance.com

Founding Partner, Legal & Compliance, LLC

Securities, Reverse Merger and Corporate Attorneys

Contact Legal & Compliance LLC. Technical inquiries are always encouraged.

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« How Does My Company Go Public? Once Again, DTC Amends Proposed Procedures For Issuers Affected By Chills And Proposes Subsequent Rule Change »

How Does My Company Go Public?

Posted by Securities Attorney Laura Anthony | May 8, 2014 Tags: DPO, DTC Eligibility, Form 10, Public Shell, Public Shells, Reverse Merger, Rule 144, Rule 15C2-11, Small Cap Market

Introduction

For at least the last twelve months, I have received calls daily from companies wanting to go public. This interest in going public transactions signifies a big change from the few years prior.

Beginning in 2009, the small-cap and reverse merger, initial public offering (IPO) and direct public offering (DPO) markets diminished greatly. I can identify at least seven main reasons for the downfall of the going public transactions. Briefly, those reasons are: (1) the general state of the economy, plainly stated, was not good; (2) backlash from a series of fraud allegations, SEC enforcement actions, and trading suspensions of Chinese companies following reverse mergers; (3) the 2008 Rule 144 amendments including the prohibition of use of the rule for shell company and former shell company shareholders; (4) problems clearing penny stock with broker dealers and FINRA’s enforcement of broker-dealer and clearing house due diligence requirements related to penny stocks; (5) DTC scrutiny and difficulty in obtaining clearance following a reverse merger or other corporate restructuring and significantly DTC chills and locks; (6) increasing costs of reporting requirements, including the relatively new XBRL requirements; and (7) the updated listing requirements imposed by NYSE, AMEX and NASDAQ and twelve-month waiting period prior to qualifying for listing following a reverse merger.

However, despite these issues, the fact is that going public is and remains the best way to access capital markets. Public companies will always be able to attract a PIPE investor, equity line or similar financing (the costs and quality of these financing opportunities is beyond the scope of this blog). For cash-poor companies, the use of a trading valuable stock is the only alternative for short-term growth and acquisitions. At least in the USA, the stock market, day traders, public market activity and the interest in capital markets will never go away; they will just evolve to meet ever-changing demand and regulations.

What is a reverse merger? What is the process?

A reverse merger is the most common alternative to an initial public offering (IPO) or direct public offering (DPO) for a company seeking to go public. A “reverse merger” allows a privately held company to go public by acquiring a controlling interest in, and merging with, a public operating or public shell company. The SEC defines a “shell company” as a publically traded company with (1) no or nominal operations and (2) either no or nominal assets or assets consisting solely of any amount of cash and cash equivalents.

In a reverse merger process, the private operating company shareholders exchange their shares of the private company for either new or existing shares of the public company so that at the end of the transaction, the shareholders of the private operating company own a majority of the public company and the private operating company has become a wholly owned subsidiary of the public company. The public company assumes the operations of the private operating company. At the closing, the private operating company has gone public by acquiring a controlling interest in a public company and having the public company assume operations of the operating entity.

A reverse merger is often structured as a reverse triangular merger. In that case, the public shell forms a new subsidiary which the new subsidiary merges with the private operating business. At the closing the private company shareholders exchange their ownership for shares in the public company, and the private operating business becomes a wholly owned subsidiary of the public company. The primary benefit of the reverse triangular merger is the ease of shareholder consent. That is because the sole shareholder of the acquisition subsidiary is the public company; the directors of the public company can approve the transaction on behalf of the acquiring subsidiary, avoiding the necessity of meeting the proxy requirements of the Securities Exchange Act of 1934.

The primary advantage of a reverse merger is that it can be completed very quickly. As long as the private entity has its “ducks in a row,” a reverse merger can be completed as quickly as the attorneys can complete the paperwork. Having your “ducks in a row” includes having completed audited financial statements for the prior two fiscal years and quarters up to date (or from inception if the company is less than two years old), and having the information that will be necessary to file with the SEC readily available. The SEC requires that a public company file Form 10 type information on the private entity within four days of completing the reverse merger transaction (a super 8-K). Upon completion of the reverse merger transaction and filing of the Form 10 information, the once private company is now public. The reverse merger transaction itself is not a capital-raising transaction, and accordingly, most private entities complete a capital-raising transaction (such as a PIPE) simultaneously with or immediately following the reverse merger, but it is certainly not required. In addition, many Companies engage in capital restructuring (such as a reverse split) and a name change either prior to or immediately following a reverse merger, but again, it is not required.

There are several disadvantages of a reverse merger. The primary disadvantage is the restriction on the use of Rule 144 where the public company is or ever has been a shell company. Rule 144 is unavailable for the use by shareholders of any company that is or was at any time previously a shell company unless certain conditions are met. In order to use Rule 144, a company must have ceased to be a shell company; be subject to the reporting requirements of section 13 or 15(d) of the Exchange Act; filed all reports and other materials required to be filed by section 13 or 15(d) of the Exchange Act, as applicable, during the preceding 12 months (or for such shorter period that the Issuer was required to file such reports and materials), other than Form 8-K reports; and have filed current “Form 10 information” with the Commission reflecting its status as an entity that is no longer a shell company, then those securities may be sold subject to the requirements of Rule 144 after one year has elapsed from the date that the Issuer filed “Form 10 information” with the SEC.

Rule 144 now affects any company who was ever in its history a shell company by subjecting them to additional restrictions when investors sell unregistered stock under Rule 144. The new language in Rule 144(i) has been dubbed the “evergreen requirement.” Under the so-called “evergreen requirement,” a company that ever reported as a shell must be current in its filings with the SEC and have been current for the preceding 12 months before investors can sell unregistered shares.

The second biggest disadvantage concerns undisclosed liabilities, lawsuits or other issues with the public shell. Accordingly, due diligence is an important aspect of the reverse merger process, even when dealing with a fully reporting current public shell. The third primary disadvantage is that the reverse merger is not a capital-raising transaction (whereas an IPO or DPO is). An entity in need of capital will still be in need of capital following a reverse merger, although generally, capital raising transactions are much easier to access once public. The fourth disadvantage is immediate cost. The private entity generally must pay for the public shell with cash, equity or a combination of both. However, it should be noted that an IPO or DPO is also costly.

What is a Direct Public Offering? What is the process?

One of the methods of going public is directly through a public offering. In today’s financial environment, many Issuers are choosing to self-underwrite their public offerings, commonly referred to as a Direct Public Offering (DPO). An IPO, on the other hand, is a public offering underwritten by a broker-dealer (underwriter). As a very first step, an Issuer and their counsel will need to complete a legal audit and any necessary corporate cleanup to prepare the company for a going public transaction. This step includes, but is not limited to, a review of all articles and amendments, the current capitalization and share structure and all outstanding securities; a review of all convertible instruments including options, warrants and debt; and the completion of any necessary amendments or changes to the current structure and instruments. All past issuances will need to be reviewed to ensure prior compliance with securities laws. Moreover, all existing contracts and obligations will need to be reviewed including employment agreements, internal structure agreements, and all third-party agreements.

Once the due diligence and corporate cleanup are complete, the Issuer is ready to move forward with an offering. Companies desiring to offer and sell securities to the public with the intention of creating a public market or going public must file with the SEC and provide prospective investors with a registration statement containing all material information concerning the company and the securities offered. Such registration statement is generally on Form S-1. For a detailed discussion of the S-1 contents, please see my white paper here. The average time to complete, file and clear comments on an S-1 registration statement is 90-120 days. Upon clearing comments, the S-1 will be declared effective by the SEC.

Following the effectiveness of the S-1, the Issuer is free to sell securities to the public. The method of completing a transaction is generally the same as in a private offering. (i) the Issuer delivers a copy of the effective S-1 to a potential investor, which delivery can be accomplished via a link to the effective registration statement on the SEC EDGAR website together with a subscription agreement; (ii) the investor completes the subscription agreement and returns it to the Issuer with the funds to purchase the securities; and (iii) the Issuer orders the shares from the transfer agent to be delivered directly to the investor. If the Issuer arranges in advances, shares can be delivered to the investors via electronic transfer or DWAC directly to the investors brokerage account.

Once the Issuer has completed the sale process under the S-1 – either because all registered shares have been sold, the time of effectiveness of the S-1 has elapsed, or the Issuer decides to close out the offering – a market maker files a 15c2-11 application on behalf of the Issuer to obtain a trading symbol and begin trading either on the over-the-counter market (such as OTCQB). The market maker will also assist the Issuer in applying for DTC eligibility.

A DPO can also be completed by completing a private offering prior to the filing of the S-1 registration statement and then filing the S-1 registration statement to register those shares for resale. In such case, the steps remain primarily the same except that the sales by the company are completing prior to the S-1 and a the 15c2-11 can be filed immediately following effectiveness of the S-1 registration statement.

Basic differences in DPO vs. Reverse Merger Process

Why DPO:

As opposed to a reverse merger, a company completing a DPO does not have to worry about potential carry-forward liability issues from the public shell.

A company completing a DPO does not have to wait 12 months to apply to the NASDAQ, NYSE MKT or other exchange and if qualified, may go public directly onto an exchange.

A DPO is a money-raising transaction (either pre S-1 in a private offering or as part of the S-1 process). A reverse merger does not raise money for the going public entity unless a separate money-raising transaction is concurrently completed.

As long as the company completing the DPO has more than nominal operations (i.e., it is not a very early-stage start-up with little more than a business plan), it will not be considered a shell company and will not be subject to the various rules affecting entities that are or ever have been a shell company. To the contrary, many public entities completing a reverse merger are or were shells.

A DPO is less expensive than a reverse merger. The total cost of a DPO is approximately and generally $100,000-$150,000 all in. The cost of a reverse merger includes the price of the public vehicle, which can range from $250,000-$500,000. Accordingly, the total cost of a reverse merger is approximately and generally $350,000-$650,000 all in. Deals can be made where the cost of the public shell is paid in equity in the post-reverse merger entity instead of or in addition to cash, but either way, the public vehicle is being paid for. NOTE: These are approximate costs. Many factors can change the cost of the transactions.

Why Reverse Merger

Raising money is difficult and much more so in the pre-public stages. In a reverse merger, the public company shareholders become shareholders of the operating business and no capital raising transaction needs to be completed to complete the process.

A reverse merger can be much quicker than a DPO.

Raising money in a public company is much easier than in a private company pre going public. A reverse merger can be completed quickly, and thereafter the now public company can raise money.

Reverse Mergers and DPO’s are both excellent methods for going public

As I see it, the evolution in the markets and regulations have created new opportunities, including the opportunity for a revived, better reverse merger market and a revived, better DPO market. A reverse merger remains the quickest way for a company to go public, and a DPO remains the cleanest way for a company to go public. Both have advantages and disadvantages, and either may be the right choice for a going public transaction depending on the facts, circumstances and business needs.

The increased difficulties in general and scrutiny by regulators may be just what the industry needed to weed out the unscrupulous players and invigorate this business model. Shell companies necessarily require greater due diligence up front, if for no other reasons than to ensure DTC eligibility and broker dealer tradability, prevent future regulatory issues, and ensure that no “bad boys” are part of the deal or were ever involved in the shell. Increased due diligence will result in fewer post-merger issues.

The over-the-counter market has regained credibility and supports higher stock prices, especially since exchanges are forcing companies to trade there for a longer period of time before becoming eligible to move up. Resale registration statements, and thus disclosure, may increase to combat the Rule 144 prohibitions. We have already seen greater disclosure by non-reporting entities trading on otcmarkets.com.

The bottom line is that issues and setbacks for going public transactions since 2008 have primed the pump and created the perfect conditions for a revitalized, better reverse merger and DPO market beginning in 2014.

The Author

Attorney Laura Anthony

Founding Partner, Legal & Compliance, LLC

Securities, Reverse Merger and Corporate Attorneys

Ms. Anthony’s focus includes, but is not limited to, registration statements, including Forms 10, S-1, S-8 and S-4, compliance with the reporting requirements of the Securities Exchange Act of 1934, including Forms 10-Q, 10-K and 8-K, 14C Information Statements and 14A Proxy Statements, going public transactions, mergers and acquisitions including both reverse mergers and forward mergers, private placements, PIPE transactions, Regulation A offerings, and crowdfunding. Moreover, Ms. Anthony represents both target and acquiring companies in reverse mergers and forward mergers, including the preparation of transaction documents such as Merger Agreements, Share Exchange Agreements, Stock Purchase Agreements, Asset Purchase Agreements and Reorganization Agreements. Ms. Anthony prepares the necessary documentation and assists in completing the requirements of federal and state securities laws and SROs such as FINRA and DTC for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile.

Contact Legal & Compliance LLC. Technical inquiries are always encouraged.

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« Mergers and Acquisitions; Merger Documents Outlined Reverse Merger Attorney »

Mergers and Acquisitions; Merger Documents Outlined

Posted by Securities Attorney Laura Anthony | May 8, 2014 Tags: LOI, Merger Agreement, Regulation S-K, Reverse Merger

An Outline Of the Transaction

The Confidentiality Agreement

Generally the first step in an M&A deal is executing a confidentiality agreement and letter of intent. These documents can be combined or separate. If the parties are exchanging information prior to reaching the letter of intent stage of a potential transaction, a confidentiality agreement should be executed first.

The Letter of Intent

Many clients ask me how to protect their interests while trying to negotiate a merger or acquisition. During the negotiation period, both sides will incur time and expense, and will provide the other with confidential information. The way to protect confidential information is through a confidentiality agreement, but that does not protect against wasted time and expense. Many other protections can be used to avoid wasted time and expense.

Many, if not all, letters of intent contain some sort of exclusivity provision. In deal terminology, these exclusivity provisions are referred to as “no shop” or “window shop” provisions. A “no shop” provision prevents one or both parties from entering into any discussions or negotiations with a third party that could negatively affect the potential transaction, for a specific period of time. That period of time may be set in calendar time, such as sixty days, or based on conditions, such as completion of an environmental study, or a combination of both.

A “window shop” provision allows for some level of third-party negotiation or inquiry. An example of a window shop provision may be that a party cannot solicit other similar transactions but is not prohibited from hearing out an unsolicited proposal. A window shop provision may also allow the board of directors of a party to shop for a better deal, while giving a right of first refusal if such better deal is indeed received. Window shop provisions generally provide for notice and disclosure of potential “better deals” and either matching or topping rights.

Generally, both no shop and window shop provisions provide for a termination fee or other detriment for early termination. The size of the termination fee varies; however, drafters of a letter of intent should be cognizant that if the fee is substantial, it likely triggers a reporting and disclosure requirement, which in and of itself could be detrimental to the deal.

Much different from a no shop or window shop provision is a “go shop” provision. To address a board of directors’ fiduciary duty and, in some instances, to maximize dollar value for its shareholders, a potential acquirer may request that the target “go shop” for a better deal up front to avoid wasted time and expense. A go shop provision is more controlled than an auction and allows both target and acquiring entities to test the market prior to expending resources.

Another common deal protection is a standstill agreement. A standstill agreement prevents a party from making business changes outside of the ordinary course, during the negotiation period. Examples include prohibitions against selling off major assets, incurring extraordinary debts or liabilities, spinning of subsidiaries, hiring or firing management teams and the like.

Finally, many companies protect their interests by requiring significant stockholders to agree to lock-ups pending a deal closure. Some lock-ups require that the stockholder agree that they will vote their shares in favor of the deal as well as not transfer or divest themselves of such shares.

The Merger Agreement

In a nutshell, the Merger Agreement sets out the financial terms of the transaction and legal rights and obligations of the parties with respect to the transaction. It provides the buyer with a detailed description of the business being purchased and provides for rights and remedies in the event that this description proves to be materially inaccurate. The Merger Agreement sets forth closing procedures, preconditions to closing and post-closing obligations, and sets out representations and warranties by all parties and the rights and remedies if these representations and warranties are inaccurate.

The main components of the Merger Agreement and a brief description of each are as follows:

Representations and Warranties – representations and warranties generally provide the buyer and seller with a snapshot of facts as of the closing date. From the seller the facts are generally related to the business itself, such as that the seller has title to the assets, there are no undisclosed liabilities, there is no pending litigation or adversarial situation likely to result in litigation, taxes are paid and there are no issues with employees. From the buyer the facts are generally related to legal capacity, authority and ability to enter into a binding contract. The Seller also represents and warrants its legal ability to enter into the agreement.

Covenants – covenants generally govern the parties’ actions for a period prior to and following closing. An example of a covenant is that a seller must continue to operate the business in the ordinary course and maintain assets pending closing and if there are post-closing payouts that the seller continues likewise. All covenants require good faith in completion.

Conditions – conditions generally refer to pre-closing conditions such as shareholder and board of director approvals, that certain third-party consents are obtained and proper documents are signed. Closing conditions usually include the payment of the compensation by the buyer. Generally, if all conditions precedent are not met, the parties can cancel the transaction.

Indemnification/remedies – indemnification and remedies provide the rights and remedies of the parties in the event of a breach of the agreement, including a material inaccuracy in the representations and warranties or in the event of an unforeseen third-party claim related to either the agreement or the business.

Schedules – Schedules generally provide the meat of what the seller is purchasing, such as a complete list of customers and contracts, all equity holders, individual creditors and terms of the obligations. The schedules provide the details.

In the event that the parties have not previously entered into a letter of intent or confidentiality agreement providing for due diligence review, the Merger Agreement may contain due diligence provisions. Likewise, the agreement may contain no shop provisions, breakup fees, non-compete and confidentiality provisions if not previously agreed to separately.

Disclosure Matters

In a merger or acquisition transaction, there are three basic steps that could invoke the disclosure requirements of the federal securities laws: (i) the negotiation period or pre-definitive agreement period; (ii) the definitive agreement; and (iii) closing.

(i) Negotiation Period (Pre-Definitive Agreement)

Generally speaking, the federal securities laws do not require the disclosure of a potential merger or acquisition until such time as the transaction has been reduced to a definitive agreement. Companies and individuals with information regarding non-public merger or acquisition transactions should be mindful of the rules and regulations preventing insider trading on such information. However, there are at least three cases where pre-definitive agreement disclosure may be necessary or mandated.

1. The first would be in the Management, Discussion and Analysis section of a Company’s quarterly or annual report on Form 10-Q or 10-K respectively.

Item 303 of Regulation S-K which governs the disclosure requirement for Management’s Discussion and Analysis of Financial Condition and Results of Operations requires, as part of this disclosure that the registrant identify any known trends or any known demands, commitments, events or uncertainties that will result in or that are reasonably likely to result in the registrant’s liquidity increasing or decreasing in any material way. Furthermore, descriptions of known material trends in the registrant’s capital resources and expected changes in the mix and cost of such resources are required. Disclosure of known trends or uncertainties that the registrant reasonably expects will have a material impact on net sales, revenues, or income from continuing operations is also required. Finally, the Instructions to Item 303 state that MD&A “shall focus specifically on material events and uncertainties known to management that would cause reported financial information not to be necessarily indicative of future operating results or of future financial condition.”

It seems pretty clear that a potential merger or acquisition would fit firmly within the required MD&A discussion. However, realizing that disclosure of such negotiations and inclusion of such information could, and often would, jeopardize completing the transaction at all, the SEC has provided guidance. In SEC Release No. 33-6835 (1989), the SEC eliminated uncertainty regarding disclosure of preliminary merger negotiations by confirming that it did not intend for Item 303 to apply, and has not applied, and does not apply to preliminary merger negotiations. In general, the SEC’s recognition that companies have an interest in preserving the confidentiality of such negotiations is clearest in the context of a company’s continuous reporting obligations under the Exchange Act, where disclosure on Form 8-K of acquisitions or dispositions of assets not in the ordinary course of business is triggered by completion of the transaction (more on this below). Clearly, this is a perfect example and illustration of the importance of having competent legal counsel assist in interpreting and unraveling the numerous and complicated securities laws disclosure requirements.

In contrast, where a company registers securities for sale under the Securities Act, the SEC requires disclosure of material probable acquisitions and dispositions of businesses, including the financial statements of the business to be acquired or sold. Where the proceeds from the sale of the securities being registered are to be used to finance an acquisition of a business, the registration statement must disclose the intended use of proceeds. Again, accommodating the need for confidentiality of negotiations, registrants are specifically permitted not to disclose in registration statements the identity of the parties and the nature of the business sought if the acquisition is not yet probable and the board of directors determines that the acquisition would be jeopardized. Although beyond the scope of this blog, many merger and/or acquisition transactions require registration under Form S-4.

Accordingly, where disclosure is not otherwise required and has not otherwise been made, the MD&A need not contain a discussion of the impact of such negotiations where, in the company’s view, inclusion of such information would jeopardize completion of the transaction. Where disclosure is otherwise required or has otherwise been made by or on behalf of the company, the interests in avoiding premature disclosure no longer exist. In such case, the negotiations would be subject to the same disclosure standards under Item 303 as any other known trend, demand, commitment, event or uncertainty.

2. The second would be in Form 8-K, Item 1.01 Entry into A Material Definitive Agreement.

Yes, this is in the correct category; the material definitive agreement referred to here is a letter of intent or confidentiality agreement. Item 1.01 of Form 8-K requires a company to disclose the entry into a material definitive agreement outside of the ordinary course of business. A “material definitive agreement” is defined as “an agreement that provides for obligations that are material to and enforceable against the registrant or rights that are material to the registrant and enforceable by the registrant against one or more other parties to the agreement, in each case whether or not subject to conditions.” Agreements relating to a merger or acquisition are outside the ordinary course of business. Moreover, although most letters of intent are non-binding by their terms, many include certain binding provisions such as confidentiality provisions, non-compete or non-circumvent provisions, no-shop and exclusivity provisions, due diligence provisions, breakup fees and the like. On its face, it appears that a letter of intent would fall within the disclosure requirements in Item 1.01.

Once again, the SEC has offered interpretative guidance. In its final rule release no. 33-8400, the SEC, recognizing that disclosure of letters of intent could result in destroying the underlying transaction as well as create unnecessary market speculation, specifically eliminated the requirement that non-binding letters of intent be disclosed. Moreover, the SEC has taken the position that the binding provisions of the letter, such as non-disclosure and confidentiality, are not necessarily “material” and thus do not require disclosure. However, it is important that legal counsel assist the company in drafting the letter, or in interpreting an existing letter to determine if the binding provisions reach the “materiality” standard and thus become reportable. For example, generally large breakup fees or extraordinary exclusivity provisions are reportable.

3. The third would be in response to a Regulation FD issue.

Regulation FD or fair disclosure prevents selective disclosure of non-public information. Originally Regulation FD was enacted to prevent companies from selectively providing information to fund managers, big brokerage firms and other “large players” in advance of providing the same information to the investment public at large. Regulation FD requires that in the event of an unintentional selective disclosure of insider information, the company take measures to immediately make the disclosure to the public at large through both a Form 8-K and press release.

(ii) The Definitive Agreement

The definitive agreement is disclosable in all aspects. In addition to inclusion in Form 10-Q and 10-K, a definitive agreement must be disclosed in Form 8-K within four (4) days of signing in accordance with Item 1.01 as described above. Moreover, following the entry of a definitive agreement, completion of conditions, such as a shareholder vote, will require in-depth disclosures regarding the potential target company, including their financial statements.

(iii) The Closing

The Closing is disclosable in all aspects, as is the definitive agreement. Moreover, in addition to item 1.01, the Closing may require disclosures under several or even most of the Items in Form 8-K, such as Item 2.01 – Completion of disposal or acquisition of Assets; Item 3.02 – Unregistered sale of securities; Item 4.01 – Changes in Certifying Accountant; Item 5.01 Change in Control, etc.

The Author

Attorney Laura Anthony

Founding Partner, Legal & Compliance, LLC

Securities, Reverse Merger and Corporate Attorneys

Contact Legal & Compliance LLC. Technical inquiries are always encouraged.

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« 14C Information Statement Requirements for a Pre-Merger Recapitalization How Does My Company Go Public? »

14C Information Statement Requirements for a Pre-Merger Recapitalization

Posted by Securities Attorney Laura Anthony | May 8, 2014 Tags: 14A Proxy Solicitation, 14c Information Statement, Form 10, Schedule 14c, Section 14, Super 8-K

Background on 14C Information Statements

All companies with securities registered under the Securities Exchange Act of 1934, as amended, (i.e., through the filing of a Form 10 or Form 8-A) are subject to the Exchange Act proxy requirements found in Section 14 and the rules promulgated thereunder. The proxy rules govern the disclosure in materials used to solicit shareholders’ votes in annual or special meetings held for the approval of any corporate action requiring shareholder approval. The information contained in proxy materials must be filed with the SEC in advance of any solicitation to ensure compliance with the disclosure rules.

Solicitations, whether by management or shareholder groups, must disclose all important facts concerning the issues on which shareholders are asked to vote. The disclosure information filed with the SEC and ultimately provided to the shareholders is enumerated in SEC Schedules 14A.

Where a shareholder vote is not being solicited, such as when a Company has obtained shareholder approval through written consent in lieu of a meeting, a Company may satisfy its Section 14 requirements by filing an information statement with the SEC and mailing such statement to its shareholders. In this case, the disclosure information filed with the SEC and mailed to shareholders is enumerated in SEC Schedule 14C. As with the proxy solicitation materials filed in Schedule 14A, a Schedule 14C Information Statement must be filed in advance of final mailing to the shareholder and is reviewed by the SEC to ensure that all important facts are disclosed. However, Schedule 14C does not solicit or request shareholder approval (or any other action, for that matter), but rather informs shareholders of an approval already obtained and corporate actions which are imminent.

In either case, a preliminary Schedule 14A or 14C is filed with the SEC, who then reviews and comments on the filing. Upon clearing comments, a definitive Schedule 14A or 14C is filed and mailed to the shareholders as of a certain record date.

Generally, the information requirements in Schedule 14C are less arduous those in a Schedule 14A in that they do not include lengthy material regarding what a shareholder must do to vote or approve a matter. Moreover, the Schedule 14C process is much less time-consuming, as the shareholder approval has already been obtained. Accordingly, when possible, Companies prefer to utilize the Schedule 14C Information Statement as opposed to the Schedule 14A Proxy Solicitation.

Pre-Merger Recapitalization

Generally, public company shareholders do not have the right to vote on a merger or acquisition transaction. Such mergers or acquisitions are usually structured such that the public company completes the merger or acquisition via the issuance of shares of common or preferred stock. In such cases, where the merger or acquisition is being accomplished via the issuance of authorized but previously unissued stock of a public company, the board of directors has the full power and authority to complete the transaction without shareholder approval.

However, in many instances the public company requires a pre-transaction recapitalization involving a reverse stock split and/or increase in authorized capital stock in order to have the available capital stock to issue at the closing of the merger or acquisition transaction and to provide the target entity and its shareholders with the agreed-upon share ownership and capital structure. Shareholders do have the right to vote on recapitalization transactions, including a reverse stock split and a change in authorized capital stock.

Here is the catch. Item 1 of Schedule 14C requires that the company provide information that would be required as if a vote were being solicited via a 14A Proxy Solicitation and specifically provides “[N]otes A, C, D, and E to Schedule 14A are also applicable to Schedule 14C.” Note A to Schedule 14A provides:

“Where any item calls for information with respect to any matter to be acted upon and such matter involves other matters with respect to which information is called for by other items of this schedule, the information called for by such other items also shall be given. For example, where a solicitation of security holders is for the purpose of approving the authorization of additional securities which are to be used to acquire another specified company, and the registrants’ security holders will not have a separate opportunity to vote upon the transaction, the solicitation to authorize the securities is also a solicitation with respect to the acquisition. Under those facts, information required by Items 11, 13 and 14 shall be furnished.”

In other words, if you are filing a Schedule 14C for a pre-merger or acquisition recapitalization, you must provide all the information related to that merger or acquisition as if the shareholders were voting on the merger or acquisition even though the shareholders are only voting on the recapitalization and even though the shareholders have no legal right to vote on the merger or acquisition itself.

Specific Disclosure Requirements in the Pre-Merger 14C

As enumerated in Note A to Schedule 14A, a pre-merger recapitalization 14C Information Statement must include the information required by Items 11, 13 and 14 of Schedule 14A. Items 11, 13 and 14 of Schedule 14A require in-depth disclosures on the merger or acquisition transaction itself and on both the target and acquiring companies, including audited financial statements and stub periods to date and pro forma financial statements on the combined entities. Management discussion and analysis must also be provided for both entities.

In addition to financial information, Item 14 also requires, for example, in-depth disclosure regarding the business operations and disclosures related to regulatory approvals, transaction negotiations and property descriptions. Many reading this will notice that the disclosures are analogous to a Super 8-K. The analogy is accurate, although the Super 8-K has additional requirements as well.

For entities engaging in a merger or acquisition transaction that would require the filing of a Super 8-K (i.e., where the public company is a shell company), the positive side is that the attorneys, accountants and auditors are putting together documents and information and engaging in efforts that would need to be completed for the Super 8-K in any event, just with an altered earlier timeline. The efforts can be seen as a head start on the Super 8-K preparation.

However, for entities that would not be required to file a Super 8-K, such as where the public company is not a shell company, the efforts and altered timeline are substantially different. When a public company that is not a shell company completes a merger or acquisition that requires the preparation and filing of financial statements on the acquired company (the determination of financial statement requirements is beyond the scope of this blog), it has 71 days following the closing to file such financial information via Form 8-K. In the case of a pre-merger recapitalization 14C filing, the financial information, including audited financial statements, must be completed and filed prior to the closing.

Conclusion

Companies with securities registered under the Securities Exchange Act of 1934 and the target companies that they are planning to acquire or merge with must be prepared to file audited financial statements, pro forma financial statements, management discussion and analysis and other in-depth disclosure in a pre-merger 14C Information Statement where such Information Statement is for the purpose of a pre-merger recapitalization.

The Author

Attorney Laura Anthony

Founding Partner, Legal & Compliance, LLC

Securities, Reverse Merger and Corporate Attorneys

Contact Legal & Compliance LLC. Technical inquiries are always encouraged.

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« Section 3(a)(10) Debt Conversions In a Shell Company Pre-Reverse Merger Mergers and Acquisitions; Merger Documents Outlined »

Section 3(a)(10) Debt Conversions In a Shell Company Pre-Reverse Merger

Posted by Securities Attorney Laura Anthony | May 8, 2014 Tags: Going Public, Reverse Merger, Reverse Merger Process | Reverse Merger Attorneys, Rule 144, rule 145, Section 3(a)(10)

Section 3(a) (10) of the Securities Act of 1933, as amended (“Securities Act”) is an exemption from the Securities Act registration requirements for the offers and sales of securities by Issuers. The exemption provides that “Except with respect to a security exchanged in a case under title 11 of the United States Code, any security which is issued in exchange for one or more bona fide outstanding securities, claims or property interests, or partly in such exchange and partly for cash, where the terms and conditions of such issuance and exchange are approved, after a hearing upon the fairness of such terms and conditions at which all persons to whom it is proposed to issue securities in such exchange shall have the right to appear, by any court, or by any official or agency of the United States, or by any State or Territorial banking or insurance commission or other governmental authority expressly authorized by law to grant such approval.”

The Securities and Exchange Commission (SEC) has given guidance on the operation of Section 3(a) (10) in its Division of Corporation Finance: Revised Staff Legal Bulleting No. 3. In particular, in order to rely on the exemption, the following conditions must be met:

The securities must be issued in exchange for securities, claims, or property interests, not cash;A court or authorized governmental entity must approve the fairness of the terms and conditions of the exchange;

The reviewing court or authorized governmental entity must (i) find that the terms and conditions of the exchange are fair to those that the securities will be issued to; and (ii) be properly advised that the Issuer will be relying on the court’s findings to issuer securities;

The reviewing court or authorized governmental entity must hold a hearing before approving the fairness of the terms and conditions of the transaction;

A governmental entity must be expressly authorized by law to hold the hearing;

The fairness hearing must be open to everyone to whom securities would be issued in the proposed exchange;

Adequate notice must be given to all those persons; and

There cannot be any improper impediments to the appearance by those persons at the hearing.

Section 3(a) (10) does not preempt state law and accordingly, the implementing state statutes must also be abided by. Many state securities law statutes that authorize a Section 3(a) (10) court process require that there be a majority shareholder vote approving the transaction prior to the hearing.

Re-sale of 3(a)(10) securities

Importantly, SEC Staff Bulletin 3 provides that the resale of securities issued in a Section 3(a) (10) transaction may be had without regard to Rule 144 if the seller is not an affiliate of the Issuer either before or after the Section 3(a) (10) transaction. That is, as long as the Seller is not an affiliate of the Issuer, securities issued in a 3(a) (10) transaction are freely tradable.

If the seller is or will be an affiliate either before or after the Section 3(a) (10) transaction, resale’s are subject to Rule 144, except for the holding period and notice filing requirements. That is, affiliates would still be subject to the drip rules, manner of sale and current public information requirements, but not the holding period requirements.

As a practical matter, many over-the-counter traded securities (over-the-counter bulletin board or OTCBB and pinksheets) have been utilizing the exemption found in Section 3(a) (10) to convert debt into common stock. The conversion of debt into common stock can assist an Issuer in two ways. First, and obviously, it eliminates the debt from the balance sheet and increases liquidity and solvency. Second, and less obviously, is that the Section 3(a) (10) exemption can be used to convince lenders to make investments into a company without the investor relying solely on the Company cash flows for repayment.

3(a)(10) and shell company reverse mergers

As described herein, shareholders that receive their securities in a 3(a)(10) transaction by a shell company that subsequently completes a merger, reverse merger, reclassification or asset transfer will be restricted until (i) 6 months after issuance; and (ii) ninety (90) days after the reverse merger, reclassification or asset purchase has been completed.

Rule 145 promulgated under the Securities Act of 1933 governs the resale restrictions on shares of stock issued or received in a reclassification, merger or asset transfer. Like Rule 144, Rule 145 contains prohibitions against the resale of securities in a shell company.

Shareholders of an entity that has completed a reverse merger, reclassification or asset transfer and that receive their securities pursuant to a 3(a)(10) transaction can resell their securities in accordance with revised resale provisions pursuant to Rule 145(d)(1) and (2) below, which provide that:

Rule 145….

(d) Resale provisions for persons and parties deemed underwriters. Notwithstanding the provisions of paragraph (c), a person or party specified in that paragraph shall not be deemed to be engaged in a distribution and therefore not to be an underwriter of securities acquired in a transaction specified in paragraph (a) that was registered under the Act if:

(1) The issuer has ceased to be a shell company, is reporting and has filed the requisite Exchange Act reports and filings reflecting that the issuer is no longer a shell company; and

(2) One of the following three conditions is met:

(i) The securities are sold in accordance with the Rule 144 restrictions and at least 90 days have elapsed since the date the securities were acquired from the issuer in the Rule 145 transaction;

(ii) The seller has not been, for at least three months, an affiliate of the issuer, and at least six months have elapsed since the date the securities were acquired from the issuer in the Rule 145 transaction, and current information regarding the issuer is publicly available; or

(iii) The seller has not been, for at least three months, an affiliate of the issuer, and at least one year has elapsed since the date the securities were acquired from the issuer in the Rule 145 transaction.

Although Rule 145(d) specifically refers to shares received in a reclassification, merger or asset transfer that was registered under the Act, the Rule specifically provides that transactions for which statutory exemptions under the Act, including those contained in sections 3(a)(9), (10), (11) and 4(2), are otherwise available are not affected by Rule 145.

The bottom line is that a shell company can complete a 3(a)(10) transaction prior to and in contemplation of a reverse merger transaction and such shares will become freely tradable 90 days after the closing of the reverse merger and after a total of a 6-month holding period from the date of issuance in the 3(a)(10) transaction. The SEC analysis in Staff Legal Bulletin No. 3. supports this conclusion, and this firm’s personal and direct experience (including via SEC comment letters and responses) also support this conclusion.

The Author

Attorney Laura Anthony

Founding Partner, Legal & Compliance, LLC

Securities, Reverse Merger and Corporate Attorneys

Contact Legal & Compliance LLC. Technical inquiries are always encouraged.

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