August 02, 2005
In 1999, a series of communiqués between The Market Regulation Department of the NASD and the Office of Small Business of the Division of Corporation Finance of the Securities and Exchange Commission confirmed that some blank check company stockholders may forever lack an active public trading market for their shares of stock unless a registration statement covering those shares becomes effective. Since publication of those letters, practitioners counseling clients in the area of reverse acquisitions have been left scratching their heads in an attempt to advise these clients on how to dispose of their shares in a public market and, to date, the challenge still remains.
This article provides a brief overview of the problem, summarizes the correspondence between the NASD and the SEC, clarifies some of the guidance contained in these letters, and offers practical advice on handling issues that arise in the context of the transfer of unregistered shares of stock of blank check companies.
Overview of the Problem
In the case of a traditional merger between operating companies which results in a publicly held surviving company, under Rule 144(k), a shareholder of the surviving company can sell his stock in the surviving company without regard to volume limitations if he is not an "affiliate" at the time of sale, he has not been an affiliate for the preceding three months, and at least two years has elapsed since the acquisition of his shares from the issuer or another affiliate. In the context of a reverse merger involving a blank check company, however, the SEC staff has expressly prohibited use of Rule 144 as an exemption from registration for the sale by the original stockholders or promoters of a blank check company of unregistered securities. Consequently, these stockholder have no readily available exemption to registration and cannot sell their shares unless they are registered under the Securities Act of 1933 (the "Securities Act").
Affiliates of public shell companies (and their transferees) holding unregistered shares were faced with the absence of a market for their shares and began to assess alternative, ostensibly more creative methods of disposing of their shares. Staff members of the OTC Compliance Unit of NASD Regulation ("NASD Regulation") who were charged with reviewing Form 211 filings submitted by market makers pursuant to Rule 15c2-11 and NASD Rule 6740, encountered issues regarding the legality of the proposed distributions or redistributions of these unregistered shares and the "free trading" status of shares of blank check company stock.
The Worm Letter and the Wulff Letter
On November 1, 1999, Ken Worm, the Assistant Director of NASD Regulation wrote a letter to Richard Wulff, the Chief of the Office of Small Business of the Division of Corporation Finance of the Securities and Exchange Commission, in which Mr. Worm requested interpretive guidance on the legality of distributions or redistributions and the "free trading" status of shares of blank check company stock (the "Worm Letter"). The Worm Letter requested guidance from the SEC on the legality of transfers of shares of a blank check company issuer, based on the initial security distribution or redistribution of such shares, in the following seven different scenarios:
Scenario 1: Transfer of Nominal Amount by Gift-Less than 10% of the total float is gifted to between 20 and 50 individuals under Section 4(2) of the Securities Act. A Form 211 reflecting the shares as the only free trading securities is filed by a brokerdealer after the donees have held the shares for at least two years, without noting the sophistication of the holders.
Scenario 2: Significant Transfer Followed by Nominal Amount by Gift-A significant amount of the total float is transferred to a single individual who subsequently gifts such shares to between 20 and 50 individuals under Section 4(2) of the Securities Act. A Form 211 reflecting the shares as the only free trading securities is filed by a broker-dealer after the donees have held the shares for at least two years, without noting the sophistication of the holders.
Scenario 3: Nominal Gift Two Years After a Significant Transfer-A significant amount of the total float is transferred to a single individual under Section 4(2) of the Securities Act who holds the shares for two years and subsequently gifts a nominal amount of the shares to between 20 and 50 individuals. A Form 211 reflecting the shares as the only free trading securities is filed by a broker-dealer after the gift recipients have held their shares for a few months, without noting the sophistication of the recipients.
Scenario 4: 100% Closely Held-Fewer than 10 stockholders hold all of the free trading shares of an issuer. A broker-dealer files Form 211 indicating the concentration of shares with so few shareholders will not result in an ongoing distribution because the market will be slow to develop.
Scenario 5: Almost Closely Held-Fewer than 10 stockholders hold more than 90% of the free trading shares of an issuer. The remaining 10% of the shares are widely dispersed among 50 or more stockholders. A broker-dealer files Form 211 indicating the concentration of shares with so few shareholders will not result in an ongoing distribution because the market will be slow to develop.
Scenario 6: Two Companies Under Common Control-Two companies are under common control by an individual and the first company issues shares to the second company pursuant to Rule 701 of the Securities Act. The issuer files a Form 10 and the second company sells all shares through a brokerage firm. A second broker-dealer files a Form 211 indicating that the shares sold through the first brokerage firm are all free trading.
Scenario 7: Reverse Merger-After the merger of a reporting company and a private company, the controlling stockholder of the reporting company sells his shares to multiple individuals after three months, during which time the controlling stockholder was not an affiliate. A Form 211 reflecting the shares as the only free trading securities is filed by a broker-dealer.
The letter, dated January 21, 2000, from Wulff (the "Wulff Letter"), responding to the Worm Letter, did not address the merits of any of the scenarios on an individual basis, noting that the availability of exemptions under Rule 144 and Section 4(1) of the Securities Act, involves a fact-specific analysis. The Wulff Letter then articulated the view that the promoters or issuers in the posited scenarios appeared to be in the business of creating blank check companies and illegally gifting or selling the securities without registration. The SEC's view in the Wulff Letter was that Section 4(1) of the Securities Act was not intended to exempt "transactions in blank check company securities by their promoters or affiliates, especially where they control or controlled the 'float' of the 'freelytradeable' securities."
The following statements of the SEC staff in the Wulff Letter demonstrate that an analysis of the seven scenarios above (or similar scenarios) turns on the fact that the promoters and affiliates of the issuer in each of the scenarios were statutory underwriters:
It is our view that, both before and after the [reverse merger], the promoters or affiliates of blank check companies, as well as their transferees, are "underwriters" of the securities issued. Accordingly, we are also of the view that the securities involved can only be resold through registration under the Securities Act. Similarly, Rule 144 would not be available for resale transactions in this situation, regardless of technical compliance with that rule, because these resale transactions appear to be designed to distribute or redistribute securities to the public without compliance with the registration requirements of the Securities Act.
Based on this view, Rule 144 will never be available to promoters and affiliates to create a public float in blank check company securities without an effective registration statement, notwithstanding the fact that technical compliance with Rule 144 is possible. In its Notice to Members 00-49 (the "NASD Notice"), the NASD broadens the SEC's view as it stated in "most, if not all, cases, the resale of securities of blank check companies is restricted and such securities can only be resold through registration under the Securities Act."
One should anticipate that transactions in unregistered securities of blank check companies will continue to be carefully scrutinized as the SEC's view is that these types of transactions simply involve an effort to distribute or redistribute securities to the public without compliance with the registration requirements of the Securities Act.
Points of Clarification
Although helpful, the guidance provided by the Wulff Letter leaves open some practical questions that arise when counseling those involved with blank check companies. For example:
These questions are discussed below.
Status of the Holder
The Wulff Letter focuses on securities of a blank check company that are held by promoters and affiliates of blank check companies and their transferees. Wulff states that it "is our view that, both before and after the business combination or transaction with an operating entity or other person, the promoters or affiliates of blank check companies, as well as their transferees, are 'underwriters' of the securities issued." The SEC has left open the question of whether other purchasers of securities of blank check companies face the same transfer restrictions as those affecting promoters and affiliates.
Although the NASD likewise focused on securities held by promoters, affiliates, and their transferees, the NASD Notice took the SEC's position one step further to capture within the breadth of those subject to the registration requirements, presumably as a result of having statutory underwriter status, not just promoters and affiliates but all holders of securities issued by blank check companies. Indeed, the NASD Notice states that based "on the Division's response letter as well as subsequent conversations with Division staff, in most, if not all, cases, the resale of securities of blank check companies is restricted and such securities can only be resold through registration under the Securities Act."
From a securities law perspective, the logic underlying the SEC's interpretation is sound, but as the SEC itself states, the analysis and conclusion are fact-specific. The SEC staff is taking the position that Section 4(1) of the Securities Act and Rule 144 thereunder is not available because purchasers of securities of blank check companies are mere conduits for a wider distribution of those securities. If this assumption is correct, then such purchasers (including those that are not promoters, affiliates, or transferees thereof) are underwriters and their securities may only be sold through registration.
The SEC staff took the position that in all of the scenarios (including scenarios 1, 4, and 5, which arguably involve situations where the transferees or initial holders of the securities of the blank check company are not necessarily promoters, affiliates, or their transferees), resale of the securities would require registration. Additionally, SEC and NASD comment letters issued after the Wulff Letter and NASD Notice seem to interpret the Wulff Letter as applying to all persons who acquire stock from a blank check company and not just promoters, affiliates, and their transferees.
Changes in Operating Status of the Issuer
The Wulff Letter does not address whether registration is required for the resale of securities acquired from an operating company that later becomes a blank check company, or that are issued when a company is winding down its operations or selling off its assets. Nor does the Wulff Letter address the extent of "operations" that a company must have so that it is not deemed a blank check company.
The Wulff Letter viewed each of the scenarios as a scheme to evade the registration requirements of the Securities Act. It appears that Wulff may have taken this position in part because there was no real business purpose for the issuance of securities of the blank check company other than to increase the size of the float. The resale of such securities, therefore, involved a wider distribution of the securities and their holders were deemed underwriters.
An unaddressed issue is whether registration would still be required if, at some point, the blank check company issued securities at a time when it had vibrant business operations which were later wound down or sold to leave only a blank check company. In such cases, the securities of the operating company are usually issued to raise capital for the company's operations or for some other legitimate business purpose and not for the mere purpose of creating a larger float. Therefore, securities issued by such a company should be eligible for resale under the exemption provided by Section 4(1) of the Securities Act and Rule 144 thereunder without the need for registration.
Another tricky issue is determining the status of securities issued by an operating company as it is winding down or after it has committed to sell its assets. In such a situation, management of the company may have made a determination that the new business purpose of the company is to become a blank check company and search for acquisition targets instead of dissolution.
Whether securities issued by a company in this stage of transition must be registered before they can be resold is not clear. The analysis involves a determination of the purpose for the issuance of the shares. If the shares are being issued for reasons related to the business operations of the company, then it is likely that they can eventually be resold under the exemption provided by Section 4(1) of the Securities Act and Rule 144. If, on the other hand, the securities are being issued in order to increase the float and create a "shell" company, then it is more likely that the Wulff Letter will apply and that the exemption provided by Section 4(1) of the Securities Act will not be available.
Difficult issues also arise in situations where companies purport to have operations, but in fact are development stage companies with minimal or no revenues and very limited assets. It is easy to conclude that these small companies have subjected themselves to the cost and other burdens of the public reporting regime of the Securities Exchange Act and the corporate governance requirements of the Sarbanes-Oxley Act solely for the purpose of becoming a public "shell" company. This concern is often reflected in comment letters from the SEC staff.
Determining the status of the securities issued by these companies requires judgment and experience. A seasoned practitioner would be well advised to analyze multiple factors in reaching a judgment, such as the extent and duration of the company's operations, the revenue generated by the company, the existence of a well-developed business plan, means of achieving that plan, and the funds used in the execution of the business plan.
Another critical factor to analyze is the track record of the promoter. The Wulff Letter noted that "in a number of cases, promoters of these issuers appear to be in the business of creating blank check companies, then gifting or selling the securities of the companies without registration, either directly or through intermediaries." Evaluating a company with minimal operations is not easy and is never free from doubt.
Furthermore, the fact that the SEC staff has cleared a registration statement filed by a company with some, but only limited, operations and NASD has allowed a market maker to commence quotation in the securities of such a company on the over-the-counter market is not always dispositive. This is because the SEC staff and the NASD made their decisions based upon representations made by the company and its management. If these representations later turn out to be false, nothing will stop the SEC staff or the NASD from reversing their positions.
Reliance on Section 4(1) After a Business Combination
You might think that a purchaser of securities of a blank check company should be permitted to rely on Section 4(1) of the Securities Act following a business combination between the blank check company and a real operating company. Two years following such a business combination, you might think that the initial purchaser of the securities of the blank check company, if he is not, and never was, an affiliate, should be able to rely on Rule 144(k) and be entitled to resell his securities without restriction.
However, one theory behind the Wulff Letter is that purchasers of securities of blank check companies are mere conduits for a wider distribution of those securities and are therefore underwriters. So, if these persons are underwriters, then they can never rely on Section 4(1), which exempts from the registration requirements of the Securities Act transactions by any person other than an issuer, underwriter, or dealer.
The Wulff letter clearly states that "Both before and after the business combination or transaction with an operating entity or other person, the promoters or affiliates of blank check companies, as well as their transferees, are 'underwriters' of the securities issued." This position has since expanded (or been clarified) to apply to all purchasers of securities of blank check companies and not just promoters, affiliates and their transferees. And the position applies regardless of the amount of time that has passed since the business combination.
A purchaser of securities of blank check companies is exposed to serious investment risk if the purchaser cannot cause the issuer to register his or her securities. Under the Wulff Letter, unregistered securities of a blank check company can never be resold and given this risk of illiquidity; an entire investment could be lost.
Practical Advice on Handling Issues Relating to the Wulff Letter
Risks associated with reverse mergers can be mitigated only through careful due diligence. At a minimum, due diligence should involve reviewing copies of any comment letters received from the SEC staff and the target company's responses to those comments. If the SEC staff has commented that it believes the target company may be a blank check company, then careful consideration should be given to the target company's response and whether the proposed acquisition is consistent with the response given by the target company to the SEC staff.
As noted above, an analysis should be done regarding the duration of the target company's existence, the amount of revenue generated by the target company since inception, the amount spent by the target company to develop its business plan, and the extent of any progress made toward achieving the goals of that business plan. Also, consideration should be given to the reasons why the target company decided to wind down its business or sell off its assets. After considering these factors, then the attorney and his client must make a judgment call regarding the risk of the SEC staff or NASD taking the position that the target company was in fact a blank check company at the time it issued securities.
A conservative approach should be taken in this regard, because if it is later determined that the target company was a blank check company at the time it issued its securities, the shell loses all value and the company must go through the registration process from start to finish.
From the perspective of an investor making an investment in a shell company or a company that has only minimal operations, but is nevertheless in the process of becoming a public reporting company, registration rights are key. The ability to demand registration of your shares for resale would be the best case scenario, but piggyback registration rights would be sufficient. As discussed above, without these registration rights, the stock acquired from a blank check company or a company with only minimal operations could become worthless.
Louis A. Bevilacqua is a partner in Thelen's Business Department. In addition to working with NYSE and NASDAQ listed companies, he specializes in reverse acquisition transactions and representing micro cap public companies whose securities are quoted on the over-the-counter markets.
This article has been re-published as an information service for clients and friends. Please recognize that the information is general in nature and must not be relied upon as legal advice. The authors, listed above, or your Thelen attorney contact, would be happy to discuss the information in this article in greater detail and its application to your specific situation. We welcome your comments and suggestions.
About Thelen LLP
Thelen LLP is a national law firm with more than 440 lawyers located in New York, San Francisco, Washington, D.C., Los Angeles, Silicon Valley and northern New Jersey. The firm provides superior legal services with a focus on complex commercial litigation; corporate and capital markets transactions; project and asset finance; construction; labor and employment; intellectual property; domestic and international tax; employee benefits; government affairs; and real estate. Thelen's client service philosophy emphasizes teamwork, collaboration and communications-values that are critical to a successful attorney-client relationship. Thelen is committed to recruiting, retaining and promoting attorneys and staff who reflect the diversity of its clients and surrounding communities. The firm is the proud recipient of the Defense Research Institute's (DRI) 2004 Commitment to Diversity Award, as well as the California Minority Counsel Program's 2005 Drucilla Stender Ramey Majority-Owned Law Firm Award, which is given annually to the CMCP majority-owned law firm member that has demonstrated the strongest commitment to diversity.
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