OTC Markets; Rule 144; The SPCC

Posted by Securities Attorney Laura Anthony | June 11, 2021 Tags: OTC Markets, Rule 144, The SPCC

Small public companies are in trouble and they need help now!  Once in a while there is a perfect storm forming that can only result in widespread damage and that time is now for small public companies, especially those that trade on the OTC Markets.  The trains on track to collide include a combination of (i) the impending amended Rule 15c2-11 compliance deadline (which alone would be and is a clear positive); (ii) the proposed Rule 144 rule changes to eliminate tacking upon the conversion of market adjustable securities; (iii) the SEC onslaught of litigation against micro-cap convertible note investors claiming unlicensed dealer activity; (iv) the OTC Markets new across the board unwillingness to allow companies to move from the Pink to the QB if they have outstanding convertible debt; and (v) the SEC’s unwillingness to recognize the OTC Pink as a trading market and its implications on re-sale registration statements.

Any one of these factors alone would not be catastrophic, and in the case of the 211 overhaul, is extremely beneficial.  However, putting together all of these elements will inevitably result in the complete failure of many small public companies and unfortunately, a disproportionate number of those companies will be operated by woman and minorities.

Of course, I am not the only one that realizes this.  In late 2020 a group of market participants including small public companies, investors, law firms, and advocates formed the Small Public Company Coalition (SPCC) as a first-in-kind, high-level properly organized advocate and lobbying group to bring the issues in front of those that can make a difference including the SEC and Congress.

The SPCC is a member-driven, federal advocacy coalition consisting of participants in the micro-cap space.  The SPCC is the real deal with active involvement from the brightest at Gibson Dunn & Crutcher, an international law firm with over 1,400 lawyers, and organized lobbying efforts led by Polaris Consulting, a top 10 lobbying firm in D.C.  The team at Gibson, Dunn wrote an excellent comment letter response to the SEC proposed changes to Rule 144 that was signed by over 60 market participants and includes a complete economic impact analysis prepared by James Overdahl, Ph.D, who is the former Chief Economist for both the SEC and the CFTC.  The SPCC has also been actively meeting with groups at the SEC and in Congress in support of the cause.  For more information on the SPCC see www.thespcc.com or reach out to info@thespcc.com.

15c2-11 Compliance

On September 26, 2020, the SEC adopted final rules amending Securities Exchange Act (“Exchange Act”) Rule 15c2-11.  From a high level, the amended rule will require that a company have current and publicly available information as a precondition for a broker-dealer to either initiate or continue to quote its securities; will narrow reliance on certain of the rules exceptions, including the piggyback exception; will add new exceptions for lower risk securities; and add the ability of OTC Markets itself to confirm that the requirements of Rule 15c2-11 or an exception have been met, and allow for broker-dealers to rely on that confirmation.  The new rule will not require OTC Markets to submit a Form 211 application or otherwise have FINRA review its determination that a broker-dealer can quote a security, prior to the quotation by a broker-dealer.  For a detailed summary of the new rules, see HERE.

Compliance with the majority of the rule’s requirements, including that all quoted companies have current information in order to remain 211 eligible, is slated for September 28, 2021.  For companies that are Alternatively Reporting or intend to be Alternatively Reporting to OTC Markets, the ability to upload information requires access to the OTC Markets OTCIQ system.  A company must apply to OTC Markets in order to gain access to the OTCIQ system (and thus publish current information on OTC Markets).  If a company has been inactive for a period of time, or if a company goes through a change of control, a new OTCIQ application must be submitted.

Access to the OTCIQ system is the first barrier to entry for companies that wish to publish current information in compliance with the 211 rules, using the Alternative Reporting Standard.  OTC Markets is inundated with such applications and has publicly announced that if an application is not submitted before June 30, 2021, it will not be processed in time to allow a company to access the system to upload current information prior to the September 28th deadline.  Upon submitting an application, the current processing time is approximately 12 weeks.

Unlike obtaining EDGAR filing codes from the SEC, access to the OTCIQ system involves a merit review.  The application itself requires the disclosure of all officers, directors and 5% or greater shareholders and the submittal of a background check authorization form for each.  If there is negative history, either actual or reputational, related to any of the people listed on the form, OTC Markets has the authority to, and will likely, deny the application.  In addition, if a company’s stock has been the subject of volatility in recent months (as so many have – see my blog on Gary Gensler’s recent speech on the subject including social media influencing stock prices – HERE), OTC Markets can, and has routinely been, denying the OTCIQ application.

I applaud the efforts to clean up the micro-cap markets but have issue with the discretionary and arbitrary nature of the review and decision-making process.  The SEC has clearly defined bad actor rules, which include a shareholder ownership threshold of 20% and does not include a person’s “reputation.” For a detail of the bad actor rules, see HERE.  Small and micro-cap companies often go through changes of control including both organic changes and reverse acquisitions.  In fact, the new 211 rules give shell companies an 18-month runway to complete an acquisition.  As I discuss below, I understand that OTC Markets is in a unique position to witness micro-cap fraud and the dealings of those that give penny stocks a bad name.  I also understand that they are trying to find a balance between allowing access and protection of investors and the reputation of the marketplace itself.  However, I would advocate for a more prescriptive test that mirrors the SEC bad actor rules with discretionary power only in extreme circumstances.

I am reminded of FINRA’s similar arbitrary use of Rule 6490 back in 2013-2015.  Rule 6490 allows FINRA to deny a corporate action (such as name change, reverse split, etc.) if, among other reasons, “FINRA has actual knowledge that the issuer, associated persons, officers, directors, transfer agent, legal adviser, promoters or other persons connected to the issuer or the SEA Rule 10b-17 Action or Other Company-Related Action are the subject of a pending, adjudicated or settled regulatory action or investigation by a federal, state or foreign regulatory agency, or a self-regulatory organization; or a civil or criminal action related to fraud or securities laws violations; (4) a state, federal or foreign authority or self-regulatory organization has provided information to FINRA, or FINRA otherwise has actual knowledge indicating that the issuer, associated persons, officers, directors, transfer agent, legal adviser, promoters or other persons connected with the issuer or the SEA Rule 10b-17 Action or Other Company-Related Action may be potentially involved in fraudulent activities related to the securities markets and/or pose a threat to public investors.”

For a period of time, FINRA was relying on “may be potentially involved in fraudulent activities related to the securities markets and/or pose a threat to public investors” to deny corporate actions to companies that had any relationship, no matter how far removed, with a person that FINRA deemed a threat, regardless of any actual legal proceedings.  See HERE for more information.  Several issuers litigated FINRA’s seemingly expansive and arbitrary use of the rule to deny corporate actions.  Although the SEC sided with FINRA and upheld their authority, FINRA adjusted their policy moving forward.

FINRA will still deny a corporate action if there is an actual bad actor involved in the company, and even if there is a significant shareholder or investor, whether debt or equity, that is the subject of a pending SEC or other regulatory proceeding but now the results of a review can be anticipated.  FINRA considers actual filed legal proceedings and will even provide a company with an opportunity to explain the circumstances and provide exculpatory information.  FINRA no longer considers unsubstantiated anonymous internet trolls in its review process.  I hope OTC Markets goes the same route.

I also hope that OTC Markets changes its policy of penalizing a company’s ability to provide current public information, because of recent stock volatility and/or internet chat activity.  In January 2021 the equity markets saw unprecedented volatility fueled in part by the use of trading apps such as Robinhood and TD Ameritrade and chat rooms such as on Reddit.  Many exchange traded middle market companies, such as GameStop and AMC Theaters, were affected as were multiple OTC Markets entities, many of which lacked current public information.  In February 2021 the SEC suspended the trading of several OTC Markets companies as result of social media triggered trading volatility without corresponding public information.  Of course, this was a valid response.

However, I do not understand OTC Markets denying the ability to provide current information as a result of third-party social media activity or trading volatility (especially when the whole market was experiencing trading volatility).  As OTC Markets pointed out in its comment letter response to the proposed 15c2-11 rules and in its application to the SEC for the formation of an expert market, there are companies that trade without current public information that are legitimate businesses.  There are also many companies that are now motivated to provide current information as a result of the impending 211 compliance date.  They should be allowed to do so, regardless of trading activity.

I note that if any of these companies have engaged in improper stock promotion, pump and dump activity, providing fraudulent or inaccurate public information or misinformation, there are numerous remedies available.  The OTC Markets can tag the company with a caveat emptor designation and the SEC can initiate a trading suspension and subsequent enforcement action.

Even once an application for filing code access is granted, all information must be reviewed by OTC Markets prior to receiving current information status or confirmation of 15c2-11 eligibility.  Absent actual identifiable bad actors, this seems the best gateway for OTC Markets to exercise its gatekeeper role.  Also, in that gatekeeper role, OTC Markets should follow its stated position in its comment letter to the SEC in response to the 211 rule changes and make the review process more objective and efficient.   OTC Markets should not review the merits of the information itself.  The goal should be to ensure the markets have the information mandated by Rule 15c2-11, that such information is publicly available for the investing community, and that an issuer has the responsibility for the accuracy of the information.

Proposed Rule 144 Rule Changes

On December 22, 2020, the SEC proposed amendments to Rule 144 which would eliminate tacking of a holding period upon the conversion or exchange of a market adjustable security that is not traded on a national securities exchange. Market adjustable securities usually take the form of convertible notes which have become a very popular and common form of financing for micro- and small-cap public companies over the past decade or so but have been under attack in recent years.  The reasoning for the attacks range from the dilutive effect of the financing (yes, it’s dilutive); to labeling all market adjustable security investors and lenders as predatory sharks swimming in a sea of innocent guppies; to the SEC’s claim that serial lenders are acting as unlicensed dealers; to no articulated reason at all.

When the rule was first proposed and I blogged about it (see HERE), I saw the rule as adding some clarity to an opaque attack by market participants against a category of investors.  In other words, I saw it as adding boundaries to what was otherwise just discrimination.  Now I think it is a reactive, under-educated, excessive regulatory response to a perceived issue, fraught with unintended consequences.  The hardest hit group from the fallout of this rule will be woman- and minority-majority-owned businesses.

In a standard convertible note structure, an investor lends money in the form of a convertible promissory note.  Generally, the note can either be repaid in cash, or if not repaid, can be converted into securities of the issuer.  Since Rule 144 allows for tacking of the holding period as long as the convertible note is outstanding for the requisite holding period, the investor would be able to sell the underlying securities into the public market immediately upon conversion.  The notes generally convert at a discount to market price so if the converted securities are sold quickly, it appears that a profit is built in.  The selling pressure from the converted shares has a tendency to push down the stock price of the issuer. On the flip side, because of the market adjustable feature, the lender can usually offer a lower interest rate and better terms.

The notes also generally have an equity blocker (usually 4.99%) such that the holder is prohibited from owning more than a certain percentage of the company at any given time to ensure they will never be deemed an affiliate and will not have to file ownership reports under either Sections 13 or 16 of the Exchange Act (for more on Sections 13 and 16, see HERE).  As a result, there is the potential for a note holder to require multiple conversions each at 4.99% of the outstanding company stock in order to satisfy the debt.  Each conversion would be at a discount to the market price with the market price being lower each time as a result of the selling pressure. This can result in a large increase in the number of outstanding shares and a decrease in the share price.  Over the years, this type of financing has often been referred to as “toxic.”

Extreme dilution is only possible in companies that do not trade on a national securities exchange.  Both the NYSE and Nasdaq have provisions that prohibit the issuance of more than 20% of total outstanding shares, at a discount to a minimum price, without prior shareholder approval.  For more on the 20% Rule, see HERE.  In addition to protecting the shareholders from dilution, the 20% Rule is a built-in blocker against distributions and as such, the SEC proposed Ruel 144 change only includes securities of an issuer that does not have a class of securities listed, or approved to be listed, on a national securities exchange.

Although on first look it sounds like these transactions are risk-free for the investor and that the proposed legislation makes perfect sense – they are not and it does not.  Putting aside the fact that not even the SEC could enunciate the problem they are trying to fix (the SEC does not even mention extreme dilution), and only provided a few sentences on the economic impact of the rule (i.e., the impact is “unclear”), a further review makes it obvious the rule doesn’t make sense.

It isn’t all profits and using dollars to light cigars for adjustable security investors.  First, Rule 144 itself creates some hurdles.  In particular, in order to rely on the shorter six-month holding period for reporting companies, the company must be current in its reporting obligations.  Also, if the company was formerly a shell company, it must always remain current in its reporting obligations to rely on Rule 144.  If a company becomes delinquent, the investor can no longer convert its debt and oftentimes the company does not have the cash to pay back the obligation.  Further, over the years it has become increasingly difficult to deposit the securities of penny stock issuers.  Regardless of whether Rule 144 requires current information, most brokerage firms will not accept the deposit of securities of a company without current information, and many law firms, including mine, will not render an opinion for the securities of those dark companies.

There are market risks as well.  If a company has very low volume and/or an extremely low price, market adjustment will not save the day for the investor.  Also, conversion is generally based on a formula over the days prior to the conversion.  There is no guarantee that the price will not drop in the time it takes to convert and deposit securities.  Of course, there is the time value of money.  No matter what, an investor is in for 6 months and would have foregone options on how to put the money to better use.

The problems with the proposed rule go deeper.  I urge everyone to read the Comments of the SPCC in response to the rule, the response letter by Michael A. Adelstein, Partner at Kelley, Drye & Warren, LLP and the numerous, almost across the board, comments in opposition to the proposed rule.  Whereas the SEC proposed rule contains almost no economic analysis whatsoever, the SPCC’s 187-page response contains an in-depth economic analysis by James Overdahl, Ph.D, who is the former Chief Economist for both the SEC and the .  The results are grim, especially for development stage companies with limited capital and revenue.

It is quite possible that the rule’s implementation will bankrupt hundreds of small public companies.  As the SEC notes, unlisted small public companies often have one source, and only one source, of quick affordable capital and that is market adjustable convertible securities.  Eliminating this source of financing will likely drive these companies out of business (eliminating jobs and investment funds at the same time).  As it is undeniably harder for woman and minorities to raise money, especially from traditional sources, they will be the hardest hit.  (See my summary of the Annual Report of Office of Advocate for Small Business Capital Formation – HERE.)

The SEC comment letter focuses on the grievous consequences to small businesses as well as the legal legislative issues with the proposed rule (arbitrary and capricious, etc.).  The letter also contains an excellent history of Rule 144 including citing the numerous reasons the SEC amended the rule in 1997 to codify the long-standing practice of allowing tacking to the original issue date of a convertible note upon conversion to securities.  Likewise, the comment letter contains a thoughtful dissertation that convertible notes are not overly dilutive but rather provide an affordable valuable form of financing and support the SEC’s mission of promoting access to capital for small companies.

Michael A. Adelstein’s comment response letter takes a more analytic approach with a broader market view discussing the different types of issues and investors and even propounding alternative language to the proposed rule.  The fact is that the issuers targeted by the proposed rule change are generally not S-3 eligible, cannot rely on the National Securities Market Improvements Act for registrations (i.e., they must comply with state blue sky laws which are arduous) and generally have smaller floats limiting the amount that could be sold in a re-sale registration statement (because it would be considered an indirect primary offering).  For these companies’ private placements of public equity or debt (i.e., a PIPE) is the only potential source of meaningful capital.  If the company properly uses the capital obtained in PIPE transactions, they will grow out of the need for market-adjustable securities and will move on to registered and underwritten offerings.

Moreover, the SEC does not even consider the impact on small exchange traded companies.  If an exchange traded company is struggling financially, under the new rules, it is unlikely that an investor will provide market adjustable convertible sources of capital for fear the company will be delisted and they will lose the ability to tack onto the holding period.  As Mr. Adelstein notes, “[A] market-adjustable security can save entire businesses and thousands of jobs, as well as some or all of the value of investments already made into such businesses.”

Likewise, the SEC focuses only on convertible notes, disregarding the multiple types of market adjustable convertible securities which will also be impacted such as floaters, amorts, resets, forced convertibles and default convertibles.  Mr. Adelstein’s comment letter contains an excellent discussion of these different types of instruments and provisions, but the most important point is it is not a one-size-fits-all investment.  The SEC must at least consider the use of these different instruments and what impact a broad swipe of the pen can have.

Similarly, not all investors are the same.  The SEC lumps together all market-adjustable security investors as pump-and-dump offenders out to take advantage of the marketplace.  This simply isn’t true.  There are some bad actors, but in my experience the majority are sophisticated investors looking to establish a long-term funding relationship with a client.  The dumpers earn a reputation as such very quickly and are not sought after for further investments.  I don’t mean to say the good ones are purely altruistic, but it just makes good business sense to establish long-term relationships and trade wisely to support growth.  Fundamentals count.  It is costly from an administrative perspective (accounting, deposit fees, opinion letters, brokerage fees, etc.) to manage multiple small investments.  Also, the profit ratio for small investments is significantly lower than for larger ones.  A company that utilizes capital properly and continues to grow will have a higher sustained stock price, more volume and more access to a diverse portfolio of capital only rounding out with market adjustable securities.  A sophisticated investor will not just dump but will wait for good news and market changes, trading strategically.  In this case, all investors make a larger return on investment dollars and are invited back to participate in future opportunities with even higher potential ROI’s and growth opportunities (every company is a small company in the beginning).

Considering the dramatic negative impact, the proposed rule will have on small and micro-cap companies, it seems obvious that there are many, less intrusive ways in which to approach the perceived problem.  The SEC could require shareholder approval for any market adjustable convertible security issuance that could result in 20% or greater dilution, mirroring the current Exchange rules for all public companies.  The SEC could also allow for tacking where, in fact, the securities were not issued at a discount to market regardless of market adjustable provisions in the security.

SEC Unlicensed Dealer Litigation

Prior to proposing the amendment to Rule 144, the SEC launched a different attack on investors/lenders of market adjustable securities.  In November 2017 the SEC shocked the industry when it filed an action against Microcap Equity Group, LLC and its principal alleging that its investing activity required licensing as a dealer under Section 15(a) of the Exchange Act.  Since that time, the SEC has filed approximately four more cases with the sole allegation being that the investor acted as an unregistered dealer.  I am aware of several other entities that are under investigation for the same activity, which will likely result in enforcement actions.

The SEC certainly knew of the proliferation of convertible note and other market adjustable securities financings over the years.  Rule 415 governs the registration requirements for the sale of securities to be offered on a delayed or continuous basis, such as in the case of the take down or conversion of convertible debt and warrants.  In 2006 the SEC issued guidance on Rule 415 that the rule would not be available for re-sale registration statements where in excess of 30% of the company’s float was being registered for re-sale.  The SEC indicated it would view such registrations as indirect primary offerings, that could not be priced at the market.  The SEC action was in direct response to the proliferation of market adjustable equity line of credit financings during that time.  Although there were a few large investors that did the majority of the financings, the SEC did not raise the dealer issue.

As mentioned before the Rule 144, 1997 amendment which specifically allowed tacking of the conversion holding period, spoke in depth as to this kind of financing.  Likewise, the 2008 amendments that reduced the holding periods to six months and one year also addressed convertible financing and added a provision to clarify that tacking is also allowed upon the exercise of options and warrants where there is a cashless exercise feature.  Again, the SEC did not raise an issue that the most prolific investors could be acting as an unlicensed dealer.  To the contrary, the SEC recognized the importance of this type of financing.

On September 26, 2016, and again on the 27th, the SEC brought enforcement actions against issuers for the failure to file 8-K’s associated with corporate finance transactions and in particular PIPE transactions involving the issuance of convertible debt, preferred equity, warrants and similar instruments. Prior to the announcement of these actions, I had been hearing rumors in the industry that the SEC has issued “hundreds” of subpoenas (likely an exaggeration) to issuers related to PIPE transactions and to determine 8-K filing deficiencies.  See HERE for my blog at the time.  The SEC did not mention any potential violations by the investors themselves.

Nothing in the prior SEC rule making, interpretive guidance, or enforcement actions foresaw the current dealer litigation issue.  The SEC litigation put a chill on convertible note investing and has left the entire world of hedge funds, family offices, day traders, and serial PIPE investors wondering if they can rely on previously issued SEC guidance and practice on the dealer question.  So far, the SEC has only filed actions for unlicensed dealer activity against investors that invest specifically using convertible notes in penny stock issuers.  Although there is a long-standing legal premise that a dealer in a thing must buy and sell the same thing (a car parts dealer is not an auto dealer, an icemaker is not a water dealer, etc.), there is nothing in the broker-dealer regulatory regime or guidance that limits broker-dealer registration requirements based on the form of the security being bought, sold or traded or the size of the issuer.

Specifically, there is no precedent for the theory that if you trade in convertible notes instead of open market securities, private placements instead of registered deals, bonds instead of stock, or warrants instead of preferred stock, etc., you either must be licensed as a dealer or are exempt.  Likewise, there is nothing in the broker dealer regime that suggests that if you invest in penny stock issuers vs. middle market or exchange traded entities you need to be licensed as a dealer. Again, the entire community that serially invests or trades in public companies is in a state of regulatory uncertainty and the capital flow to small- and micro-cap companies has diminished accordingly.  Although the SEC has had some wins in the litigations, the issue is far from settled.

Importantly, the dealer litigation, together with the proposed Rule 144 rule changes, makes it that much harder for small and developing public companies to obtain financing to execute on their business plans, support job growth and support the U.S. economy.

OTC Markets QB Standards

I mentioned above that most of the comment letter responses to the proposed Rule 144 amendments were in opposition to the rule change.  One that was not, is OTC Markets itself. In supporting the proposed rule change, OTC Markets merely suggested that it not discriminate against OTC Markets securities, but rather that the new rule should apply across the board to both OTC Markets and Exchange traded issuers.

OTC Markets is in a unique position to witness the red flags of micro-cap fraud and has valiantly been engaged in an uphill battle to combat that fraud, and earn the respect of the SEC, FINRA and other regulators.  To its credit, it has done an amazing job.  Nothing is more illustrative of that than the complete dichotomy between the December 16, 2016 SEC White Paper on penny stocks which disregarded OTC Markets as a viable marketplace and showed a complete disinterest in it or its efforts to create a venture market (see HERE) and the new 15c2-11 rule release which hands over the power to determine compliance with the rule to OTC Markets itself.

Moreover, in the years prior to the 2016 White Paper and certainly since, the OTC Markets has consistently implemented new rule and policy changes, all in an effort to deter micro-cap fraud and create a respected market.  They have and are succeeding.

But I don’t agree with everything.  In recent years, OTC Markets has taken a stance against convertible note lenders and the issuers that rely on their financing.  Effective October 1, 2020, OTC Markets formally updated its QB rules to add that it may “[R]efuse the application for any reason, including but not limited to stock promotion, dilution risk, and use of ‘toxic’ financiers if it determines, in its sole and absolute discretion, that the admission of the Company’s securities for trading on OTCQB, would be likely to impair the reputation or integrity of OTC Markets Group or be detrimental to the interests of investors.”

This would be fair enough if, like FINRA, it only denied an application if one of the investors or participants was a bad actor under the SEC rules, or had actual proceedings filed against it.  Rather, though, OTC Markets has taken it one step further and has been denying the majority of QB applications where the applicant has convertible securities on the books.

In the past few months, this has become a big topic of conversation among market participants.  In addition to clients and potential clients, other attorneys, broker-dealers and transfer agents have reached out to me to discuss insight or guidance.  Is one convertible instrument enough to deny a QB application?  Is three too many?  Why are applications being denied even when the convertible instruments are not market adjustable?  Will shareholder approval of the financings solve the problem?  What if the total amount of potential dilution is less than 20%? 10% or even 5%?

Yesterday, on June 7, 2021, OTC Markets published some guidance on dilution risk associated with an OTCQB or OTCQX application.   OTC Markets is focusing on:

• Whether an issuer has recent or currently outstanding convertible notes with conversion features that provide significant discounts to the current market price and whether such notes are held by company officers, directors and control persons;
• Whether an issuer has other classes of outstanding securities that are convertible into common stock at largely discounted rates and are not held by officers or directors;
• A capital table and/or “toxic financing” structure that will substantially reorganize the share ownership of the company;
• Whether an issuer has had a history of substantial increases in the amount of its outstanding shares;
• Whether an issuer has had a history of multiple or large reverse stock splits; and
• Whether an issuer has engaged lenders that have been the subjects of regulatory actions regarding “toxic financing” and related concerns.

The OTC Markets guidance indicates that an application can be renewed if a company takes corrective measures including enhancing corporate governance, providing additional disclosure, changing capital structure or adding protections for minority investors.

Although we appreciate all guidance, it is still opaque.  It comes down to effectively identifying and solving a problem.  The guidance indicates “substantial discount to market” but in my experience, even convertible notes at a fixed conversion price have been problematic.  I know OTC Markets wants to allow listings on the QB and QX and is also trying to be a good steward and fiduciary to the marketplace.  It is clear that we are in a period of transition.

In addition to the existence of convertible debt, like the OTCIQ application, OTC Markets has been doing a deep-dive merit review on all companies that apply to the QB and has been quick to deny an application, often without articulating the reasons or in perfunctory emails with a high-level reason that has been the source of some frustration for applicants.

Trading on the QB is not merely for optics.  It has a definitive regulatory and capital raising impact.

The OTC Pink is not a Recognized Marketplace

A company that trades on the OTC Pink market may not rely on Rule 415 to file a re-sale registration statement whereby the selling shareholders can sell securities into the market at market price.  That is, all registration statements, whether re-sale, primary or indirect primary, must be at a fixed price unless the issuer is trading on the OTCQB or higher.

Rule 415 sets forth the requirements for engaging in a delayed offering or offering on a continuous basis.  Under Rule 415 a re-sale offering may be made on a delayed or continuous basis other than at a fixed price (i.e., it may be priced at the market).  It is axiomatic that for a security to be sold at market price, there must be a market.  There was a time when the SEC refused to recognize any of the tiers of OTC Markets, as a “market” for purposes of at-the-market offerings.  On May 16, 2013, the SEC issued a C&DI recognizing the OTCQB and OTCQX as market for purposes of filing and pricing a re-sale registration statement.

However, OTC Pink is still not a recognized market.  As there is no actual rule that identifies what is a market for purposes of Rule 415, the SEC has looked to Item 501(b)(3) of Regulation S-K.  Item 501 provides the requirements for disclosing the offering price of securities on the forepart of a registration statement and outside front cover page of a prospectus.  Item 501 requires that either a fixed price be disclosed or a formula or other method to determine the offering price based on market price.  The SEC uses this rule to require a fixed price where a company trades on the OTC Pink since there is no identifiable “market” to tie a price too.

In light of the SEC dealer litigation and proposed Rule 144 amendments, many companies are engaging with investors for registered offerings.  Even though the SEC is a proponent of exempt offerings (thus the redo of the entire exempt offering structure in November 2020), it seems that encouraging companies to register offerings will reduce micro-cap fraud and should be supported by OTC Markets.  However, in order to properly utilize registration statements for capital market financing transactions, a company must trade on the OTCQB or better. A company’s added difficulty in being accepted to trade on the QB is just another notch on the tightening noose of OTC Markets companies.

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Recommendations Of SEC Government-Business Forum On Small Business Capital Formation

Posted by Securities Attorney Laura Anthony | May 23, 2017 Tags: ATS Registration, Blue Sky Pre-Emption, Finra, Form S-3, NASAA, Non-GAAP Accounting Standards, OTC Markets, Regulation A, Regulation CF, Regulation S-K, Rule 144, Rule 147, Rule 147A, Rule 15C2-11, Rule 504, Rule 506(b) Offerings, SEC, SEC Advisory Committee, SEC Office of Small Business Policy, SEC Rule 15c2-11, Section 4(a)(2), Small Business Capital Formation, Smaller Reporting Companies

In early April, the SEC Office of Small Business Policy published the 2016 Final Report on the SEC Government-Business Forum on Small Business Capital Formation, a forum I had the honor of attending and participating in. As required by the Small Business Investment Incentive Act of 1980, each year the SEC holds a forum focused on small business capital formation. The goal of the forum is to develop recommendations for government and private action to eliminate or reduce impediments to small business capital formation.

The forum is taken seriously by the SEC and its participants, including the NASAA, and leading small business and professional organizations. The forum began with short speeches by each of the SEC commissioners and a panel discussion, following which attendees, including myself, worked in breakout sessions to drill down on specific issues and suggest changes to rules and regulations to help support small business capital formation, as well as the related, secondary trading markets. In particular, the three breakout groups were on exempt securities offerings; smaller reporting companies; and the secondary market for securities of small businesses.

Each breakout group is given the opportunity to make recommendations. The recommendations were refined and voted upon by the forum participants in the few months following the forum and have now been released by the SEC in a report containing all 15 final recommendations. In the process, the participants ranked the recommendations by whether it is likely the SEC will give high, medium, low or no priority to each recommendation.

Recommendations often gain traction. For example, the forum first recommended reducing the Rule 144 holding period for Exchange Act reporting companies to six months, a rule which was passed in 2008. Last year the forum recommended increasing the financial thresholds for the smaller reporting company definition, and the SEC did indeed propose a change following that recommendation. See my blog HERE for more information on the proposed change. Also last year the forum recommended changes to Rule 147 and 504, which recommendations were considered in the SEC’s rule changes that followed. See my blog HERE for information on the new Rule 147A and Rule 147 and 504 changes.

Forum Recommendations

The following is a list of the recommendations listed in order or priority. The priority was determined by a poll of all participants and is intended to provide guidance to the SEC as to the importance and urgency assigned to each recommendation. I have included my comments and commentary with the recommendations.

1. As recommended by the SEC Advisory Committee on Small and Emerging Companies, the SEC should (a) maintain the monetary thresholds for accredited investors; and (b) expand the categories of qualification for accredited investor status based on various types of sophistication, such as education, experience or training, including, but not limited to, persons with FINRA licenses, CPA or CFA designations, or management positions with issuers. My blog on the Advisory Committee on Small and Emerging Companies’ recommendations can be read HERE. Also, to read on the SEC’s report on the accredited investor definition, see HERE.
2. The definition of smaller reporting company and non-accelerated filer should be revised to include an issuer with a public float of less than $250 million or with annual revenues of less than $100 million, excluding large accelerated filers; and to extend the period of exemption from Sarbanes 404(b) for an additional five years for pre- or low-revenue companies after they cease to be emerging-growth companies. See my blog HERE for more information on the current proposed change to the definition of smaller reporting company and HERE related to the distinctions between a smaller reporting company and an emerging-growth company.
3. Lead a joint effort with NASAA and FINRA to implement a private placement broker category including developing a workable timeline and plan to regulate and allow for “finders” and limited intermediary registration, regulation and exemptions. I think this topic is vitally important. The issue of finders has been at the forefront of small business capital formation during the 20+ years I have been practicing securities law. The topic is often explored by regulators; see, for example, the SEC Advisory Committee on Small and Emerging Companies recommendations HERE and a more comprehensive review of the topic HERE which includes a summary of the American Bar Association’s recommendations.

Despite all these efforts, it has been very hard to gain any traction in this area. Part of the reason is that it would take a joint effort by FINRA, the NASAA and both the Divisions of Corporation Finance and Trading and Markets within the SEC. This area needs attention. The fact is that thousands of people act as unlicensed finders—an activity that, although it remains illegal, is commonplace in the industry. In other words, by failing to address and regulate finders in a workable and meaningful fashion, the SEC and regulators perpetuate an unregulated fringe industry that attracts bad actors equally with the good and results in improper activity such as misrepresentations in the fundraising process equally with the honest efforts. However, practitioners, including myself, remain committed to affecting changes, including by providing regulators with reasoned recommendations.

4. The SEC should adopt rules that pre-empt state registration for all primary and secondary trading of securities qualified under Regulation A/Tier 2, and all other securities registered with the SEC. I have been a vocal proponent of state blue sky pre-emption, including related to the secondary trading of securities. Currently, such secondary trading is usually achieved through the Manual’s Exemption, which is not recognized by all states. There is a lack of uniformity in the secondary trading market that continues to negatively impact small business issuers. For more on this topic, see my two-part blog HERE and HERE.
5. Regulation A should be amended to: (i) pre-empt state blue sky regulation for all secondary sales of Tier 2 securities (included in the 4th recommendation above); (ii) allow companies registered under the Exchange Act, including at least business development companies, emerging-growth companies and smaller reporting companies, to utilize Regulation A (see my blog on this topic, including a discussion of a proposed rule change submitted by OTC Markets, HERE ); and (iii) provide a clearer definition of what constitutes “testing-the-waters materials” and permissible media activities.
6. Simplify disclosure requirements and costs for smaller reporting companies and emerging-growth companies with a principles-based approach to Regulation S-K, eliminating information that is not material, reducing or eliminating non-securities-related disclosures with a political or social purpose (such as pay ratio, conflict minerals, etc.), making XBRL compliance optional and harmonizing rules for emerging-growth companies with smaller reporting companies. For more on the ongoing efforts to revise Regulation S-K, including in manners addressed in this recommendation, see HERE and for more information on the differences between emerging-growth companies and smaller reporting companies, see HERE.
7. Mandate comparable disclosure by short sellers or market makers holding short positions that apply to long investors, such as through the use of a short selling report on Schedule 13D.
8. The SEC should provide scaled public disclosure requirements, including the use of non-GAAP accounting standards that would constitute adequate current information for entities whose securities will be traded on secondary markets. This recommendation came from the secondary market for securities of small businesses breakout group. I was part of the smaller reporting companies breakout group, so I did not hear the specific discussion on this recommendation.  However, I do note that Rule 144 does provide for a definition of adequate current public information for companies that are not subject to the Exchange Act reporting requirements.  In particular, Rule 144 provides that adequate current public information would include the information required by SEC Rule 15c2-11 and OTC Markets specifically models its alternative reporting disclosure requirements to satisfy the disclosures required by Rule 15c2-11.
9. The eligibility requirements for the use of Form S-3 should be revised to include all reporting companies. For more on the use of Form S-3, see my blog HERE. 
10. The SEC should clarify the relationship of exempt offerings in which general solicitation is not permitted, such as in Section 4(a)(2) and Rule 506(b) offerings, with Rule 506(c) offerings involving general solicitation in the following ways: (i) the facts and circumstances analysis regarding whether general solicitation is attributable to purchasers in an exempt offering should apply equally to offerings that allow general solicitation as to those that do not (such that even if an offering is labeled 506(c), if in fact no general solicitation is used, it can be treated as a 506(b); and (ii) to clarify that Rule 152 applies to Rule 506(c) so that an issuer using Rule 506(c) may subsequently engage in a registered public offering without adversely affecting the Rule 506(c) exemption. I note that within days of the forum, the SEC did indeed issue guidance on the use of Rule 152 as applies to Rule 506(c) offerings, at least as relates to an lternative trading systemintegration analysis between 506(b) and 506(c) offerings. See my blog HERE.
11. The SEC should amend Regulation ATS to allow for the resale of unregistered securities including those traded pursuant to Rule 144 and 144A and issued pursuant to Sections 4(a)(2), 4(a)(6) and 4(a)(7) and Rules 504 and 506.
12. The SEC should permit an ATS to file a 15c2-11 with FINRA and review the FINRA process to make sure that there is no undue burden on applicants and issuers. An ATS is an “alternative trading system.” The OTC Markets’ trading platform is an ATS. This recommendation would allow OTC Markets to directly file 15c2-11 applications on behalf of companies. A 15c2-11 application is the application submitted to FINRA to obtain a trading symbol and allow market makers to quote the securities of companies that trade on an ATS, such as the OTC Markets. Today, only market makers seeking to quote the trading in securities can submit the application. Also today, the application process can be difficult and lack clear guidance or timelines for the market makers and companies involved. This process definitely needs attention and this recommendation would be an excellent start.
13. Regulation CF should be amended to (i) permit the usage of special-purpose vehicles so that many small investors may be grouped together into one entity which then makes a single investment in a company raising capital under Regulation CF; and (ii) harmonize the Regulation CF advertising rules to avoid traps in situations where an issuer advertises or engages in general solicitations under Regulation A or Rule 506(c) and then converts to or from a Regulation CF offering.
14. The SEC should provide greater clarity on when trading activities require ATS registration, and when an entity or technology platform needs to a funding portal, broker-dealer, ATS and/or exchange in order to “be engaged in the business” of secondary trading transactions.
15. Reduce the Rule 144 holding period to 3 months for reporting companies. I fully support this recommendation.

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
330 Clematis Street, Suite 217
West Palm Beach, FL 33401
Phone: 800-341-2684 – 561-514-0936
Fax: 561-514-0832
LAnthony@LegalAndCompliance.com
www.LegalAndCompliance.com
www.LawCast.com

Securities attorney Laura Anthony and her experienced legal team provides ongoing corporate counsel to small and mid-size private companies, OTC and exchange traded issuers as well as private companies going public on the NASDAQ, NYSE MKT or over-the-counter market, such as the OTCQB and OTCQX. For nearly two decades Legal & Compliance, LLC has served clients providing fast, personalized, cutting-edge legal service. The firm’s reputation and relationships provide invaluable resources to clients including introductions to investment bankers, broker dealers, institutional investors and other strategic alliances. The firm’s focus includes, but is not limited to, compliance with the Securities Act of 1933 offer sale and registration requirements, including private placement transactions under Regulation D and Regulation S and PIPE Transactions as well as registration statements on Forms S-1, S-8 and S-4; compliance with the reporting requirements of the Securities Exchange Act of 1934, including registration on Form 10, reporting on Forms 10-Q, 10-K and 8-K, and 14C Information and 14A Proxy Statements; Regulation A/A+ offerings; all forms of going public transactions; mergers and acquisitions including both reverse mergers and forward mergers, ; applications to and compliance with the corporate governance requirements of securities exchanges including NASDAQ and NYSE MKT; crowdfunding; corporate; and general contract and business transactions. Moreover, Ms. Anthony and her firm 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’s legal team 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. Ms. Anthony is also the author of SecuritiesLawBlog.com, the OTC Market’s top source for industry news, and the producer and host of LawCast.com, the securities law network. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Las Vegas, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington, D.C., Denver, Tampa, Detroit and Dallas.

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

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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

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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« 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.

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 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.

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.

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

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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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

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.

Follow me on Facebook  and LinkedIn

 

 

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« Small-Cap Reverse Mergers Poised for a Comeback 14C Information Statement Requirements for a Pre-Merger Recapitalization »

Rule 144 Seller’s Representation Letter

Posted by Securities Attorney Laura Anthony | October 20, 2011 Tags: 144 Holding Period, 144 Opinion Letter, Removing a Restrictive Legend, Restricted Stock, Rule 144, SEC Law Firm, Securities Attorney, Shell Companies, Transfer Agent

Securities Act of 1933 (“Securities Act”) Rule 144 sets forth certain requirements for the use of Section 4(1) for the resale of securities. Section 4(1) of the Securities Act provides an exemption for a transaction “by a person other than an issuer, underwriter, or dealer.” “Issuer” and “dealer” have pretty straight forward meanings under the Securities Act but the term “underwriter” does not. Rule 144 provides a safe harbor from the definition of “underwriter”. If all the requirements for Rule 144 are met, the seller will not be deemed an underwriter and the purchaser will receive unrestricted securities.

Following the amendments to Rule 144 in 2008, a shareholder cannot simply have a legend removed from restricted shares following the holding period, but rather, must have a present intent to sell in order to have a legend removed. Moreover, following the revisions in 2008, Rule 144 is not available to shell companies, or former shell companies that are not current in their Exchange Act filing requirements. The requirements of Rule 144 must exist as of the date of sale.

Although not set out in the statute, all transfer agents and Issuers, and most clearing and brokerage firms, require an opinion of counsel as to the application of Rule 144 prior to removing the legend from securities and allowing their sale under Rule 144. An opinion letter is generally valid for ninety (90) days from the date of issuance. Accordingly, an attorney may issue an opinion and a transfer agent act to remove a restrictive legend, following which, the requirements of Rule 144 may no longer be valid (such as if a former shell company fails to file its quarterly report or ceases operations and becomes a shell, etc..)

In other words, attorneys, transfer agents and brokers must be certain that all of the conditions of Rule 144 are met prior to taking action to remove a restrictive legend, but only the Seller can ensure that all the conditions are present at the actual time of sale. In order to protect themselves in issuing opinion letters and removing legends, transfer agents and most attorneys now require a letter from the Seller making certain representations and affirmations regarding their eligibility to rely on Rule 144 in the sale of their securities. This letter is commonly referred to as a Seller’s Representation Letter.

The affirmations commonly required and contained in the Seller’s Representation Letter, are:

1. The Seller is the beneficial owner of the subject securities;

2. The Seller has been the beneficial owner of the subject securities for the required holding period (the holding period varies from six months to one year depending on whether the Issuing Company is subject to the reporting requirements of the Securities Exchange Act of 1934, as amended);

3. Confirmation that the Seller is not an affiliate of the Issuing Company and has not been an affiliate for at least 3 months, or that the Seller is an affiliate and is therefore subject to the Rule 144 volume restrictions on sales (drip rules);

4. Confirmation that the Seller is not an underwriter and is not selling the securities for the purpose of making a distribution for or on behalf of the Issuer;

5. Confirmation that the Seller is selling for his/her own account and not for the benefit of a third party, or the Issuer; and

6. Confirmation that the Seller is aware of the Rule 144 requirements and will sell only in accordance with such requirements, including the manner of sale requirements (through a broker).

Attorney Laura Anthony,
Founding Partner, Legal & Compliance, LLC
Securities, Reverse Mergers, Corporate Transactions

Securities attorney Laura Anthony provides ongoing corporate counsel to small and mid-size public Companies as well as private Companies intending to go public on the Over the Counter Bulletin Board (OTCBB), now known as the OTCQB. For more than a decade Ms. Anthony has dedicated her securities law practice towards being “the big firm alternative.” Clients receive fast and efficient cutting-edge legal service without the inherent delays and unnecessary expense of “partner-heavy” securities law firms.

Ms. Anthony’s focus includes but is not limited to compliance with the reporting requirements of the Securities Exchange Act of 1934, as amended, (“Exchange Act”) including Forms 10-Q, 10-K and 8-K and the proxy requirements of Section 14. In addition, Ms. Anthony prepares private placement memorandums, registration statements under both the Exchange Act and Securities Act of 1933, as amended (“Securities Act”). Moreover, Ms. Anthony represents both target and acquiring companies in reverse mergers and forward mergers, including preparation of deal documents such as Merger Agreements, Stock Purchase Agreements, Asset Purchase Agreements and Reorganization Agreements. Ms. Anthony prepares the necessary documentation and assists in completing the requirements of the Exchange Act, state law and FINRA for corporate changes such as name changes, reverse and forward splits and change of domicile.

Contact Legal & Compliance LLC for a free initial consultation or second opinion on an existing matter.

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