SEC has Modified Policies on Offerings by Shell Companies

Recently, albeit not officially, the Securities and Exchange Commission (“SEC”) has materially altered its position on offerings by shell companies that are not blank-check companies.  In particular, over the past year, numerous shell companies that are not also blank-check companies have completed offerings using an S-1 registration statement and successfully obtained market maker support and a ticker symbol from FINRA and are trading.  As recently as 18 months ago, this was not possible.

Rule 419 and Blank-Check Companies

The provisions of Rule 419 apply to every registration statement filed under the Securities Act of 1933, as amended, by a blank-check company.  Rule 419 requires that the blank-check company filing such registration statement deposit the securities being offered and proceeds of the offering into an escrow or trust account pending the execution of an agreement for an acquisition or merger.

In addition, the registrant is required to file a post-effective amendment to the registration statement containing the same information as found in a Form 10 registration statement, upon the execution of an agreement for such acquisition or merger.  The rule provides procedures for the release of the offering funds in conjunction with the post-effective acquisition or merger.  The obligations to file post-effective amendments are in addition to the obligations to file Forms 8-K to report both the entry into a material non-ordinary course agreement and the completion of the transaction.  Rule 419 applies to both primary and resale or secondary offerings.

Within five (5) days of filing a post-effective amendment setting forth the proposed terms of an acquisition, the Company must notify each investor whose shares are in escrow.  Each investor then has no fewer than 20 and no greater than 45 business days to notify the Company in writing if they elect to remain an investor.  A failure to reply indicates that the person has elected to not remain an investor.  As all investors are allotted this second opportunity to determine to remain an investor, acquisition agreements should be conditioned upon enough funds remaining in escrow to close the transaction.

The definition of “blank-check company” as set forth in Rule 419 of the Securities Act is a company that:

  • Is a development-stage company that has no specific business plan or purpose or has indicated that its business plan is to engage in a merger or acquisition with an unidentified company or companies, or other entity or person; and
  • Is issuing “penny stock,” as defined in Rule 3a51-1 under the Securities Exchange Act of 1934.

Shell Companies

The definition of “shell company” as set forth in Rule 405 of the Securities Act (and Rule 12b-2 of the Securities Exchange Act of 1934) means a Company that has:

  1. No or nominal operations; and
  2. Either:
    1. No or nominal assets;
    2. Assets consisting solely of cash and cash equivalents; or
    3. Assets consisting of any amount of cash and cash equivalents and nominal other assets.

Clearly the definitions are different.  Although a shell company could also be a blank-check company, it could be a development stage company or start-up organization or an entity with a specific business plan but nominal operations.  Until recently, however, the SEC has firmly held the position that Rule 419 applies equally to shell and development-stage companies.

In fact, the SEC Staff Observations in the Review of Smaller Reporting Company IPO’s published by the SEC Division of Corporate Finance contains the following comments:

“Rule 419 applies to any registered offering of securities of a blank-check company where the securities fall within the definition of a penny stock under the Securities Exchange Act of 1934. We frequently reviewed registration statements of recently established development stage companies with a history of losses and an expectation of continuing losses and limited operations. These companies often stated that they may expand current operations through acquisitions of other businesses without specifying what kind of business or what kind of company. In other cases, the stage of a company’s development, when considered in relation to the surrounding facts and circumstances, may raise questions regarding the company’s disclosed business plan. We generally asked companies like these to review Rule 419 of Regulation C. We asked these companies either to revise their disclosure throughout the registration statement to comply with the disclosure and procedural requirements of Rule 419 or to provide us with an explanation of why Rule 419 did not apply.”

Change in SEC Policy

The SEC will now allow a shell company that is not also a blank-check company to embark on an offering using an S-1 registration statement without the necessity to comply with Rule 419.  As noted above, an entity can be a shell company, but not a blank-check company, as long as it has a specific business purpose and plan and is taking steps to move that plan forward, such as a start-up or development stage entity.  In the last 18 months, several companies have filed S-1 registration statements with little more than a specific business plan, and such S-1’s have been declared effective, the shares have been successfully placed, and the company’s common stock is trading on the over-the-counter market.  A review of the comment letters associated with these shell company S-1 filings has not shown a single comment requesting that the issuing company comply with or explain why they did not have to comply with Rule 419.

Such entity will clearly need to disclose that it is a shell company as defined by Rule 405 of the Securities Act and accordingly, investors in the registered offering would not be able to rely on Rule 144 for resale unless all of the conditions of Rule 144(i) were met.  That is, in order for the investors buying in the S-1 to use Rule 144, the 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.

The question arises as to when a development-stage or start-up company ceases to be a shell.  Generally shell companies complete a clear transaction removing them from shell company status, such as a merger or acquisition, and file Form 10 information on the newly acquired business.  My review of the filings made by shell companies following the effectiveness of the S-1 registration statement indicate that each is still a shell.  However, I would suggest that at some point, such as when the company generates its first revenues or launches its product, or upon some other identifiable marker that would reasonably be interpreted as a change in shell company status, the company file Form 10 information disclosing its own business and operations and thereafter begin the one-year holding period for use of Rule 144.

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys

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, the OTC Market’s top source for industry news, and the producer and host of, 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.

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