A. S-1 Proceedings
On February 3, 2014, the SEC initiated administrative proceedings against 19 companies that had filed S-1 registration statements. The 19 registration statements were all filed with an approximate 2-month period around January 2013. Each of the companies claimed to be an exploration-stage entity in the mining business without known reserves, and each claimed they had not yet begun actual mining. The 19 entities used the same attorney, who is the subject of a separate SEC action filed in August 2013 alleging involvement in a pump-and-dump scheme. Each of the entities was incorporated at around the same time using the same registered agent service. The 19 S-1’s read substantially the same.
Importantly, each of the 19 S-1’s lists a separate officer, director and sole shareholder, and each claims that this person is the sole control person. The SEC complains that contrary to the representations in the S-1, a separate single individual is the actual control person behind each of these 19 entities and that person is acting through straw individuals, as he is subject to a penny stock bar and other SEC injunctive orders which would prevent him from legally participating in these S-1 filings. In addition, the SEC alleges that the claims of a mining business are false. Presumably, the SEC believes that the S-1’s were filed to create public companies to be used for illegal purposes.
The SEC is playing hardball with this group as well. Please change it to “An S-1 generally contains language that allows it to be amended or modified (or even withdrawn) until it is declared effective by the SEC. This pre-effective S-1 is not deemed filed by the SEC or a final prospectus for Section 5 and broker-dealer prospectus delivery requirements. Upon initiation of the SEC investigation, all 19 S-1 filers attempted to withdraw their S-1 registration statements. The SEC suggested that they withdraw their requests to terminate the S-1 and cooperate fully with the investigation. The entities did not comply. Accordingly, in addition to claims related to the filing of false statements in the S-1, the SEC has also alleged that “Respondent’s seeking to withdraw its Registration Statement constitutes a failure to cooperate with, refusal to permit, and obstruction of the staff’s examination under Section 8(e) of the Securities Act.”
It is likely that the filing of the 19 S-1 registration statements were efforts to create salable shell companies and not efforts for the pursuit of a mining business. Unfortunately, each time there is a change in the business surrounding small-cap entities, there will be a few unscrupulous players that will seek to illegally capitalize on policies that in general can benefit small business enterprises.
Recently, albeit not officially, the 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. 18 months ago, this was not possible. The SEC’s change in policy coincides with the enactment of the JOBS Act and the general policy to encourage start-ups to embark on capital-raising transactions that were historically limited to more mature entities. The filing of an S-1 is or is associated with a capital raising transaction (either directly, or prior to the S-1 through a private placement offering).
Prior Shell Company Policy – 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 not to 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:
- No or nominal operations; and
- Either:
- No or nominal assets;
- Assets consisting solely of cash and cash equivalents; or
- 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 contain 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.[1]
The action against these 19 entities sends a clear message by the SEC: at the same time it opens the door to help legitimate small business capital formation, it will pursue those illegitimate individuals and entities that negatively impact the markets and reputation of the small-cap industry as a whole. In general, I continue to believe that the increased scrutiny by regulators may be just what the industry needed to weed out the unscrupulous players and invigorate the small-cap industry.
B. Shell Company Proceedings
On February 3, 2014, the Securities and Exchange Commission (SEC) suspended the trading in 255 dormant shell companies. The trading suspensions are part of an SEC initiative tabbed Operation Shell-Expel by the SEC’s Microcap Fraud Working Group. In May 2012, the SEC suspended the trading on 379 shell companies and in June 2013, it suspended 61 shell companies as part of the initiative. Each of the companies was a dormant shell that was not current in its public disclosures. Each of the companies failed to have adequate current public information available either through the news service on OTC Markets or filed with the SEC via EDGAR.
The federal securities laws allow the SEC to suspend trading in any stock for up to 10 business days. Once a company is suspended from trading, it cannot be quoted again until it provides updated information including complete disclosure of its business and accurate financial statements. Generally, this is accomplished through a Form 10 registration statement. The SEC comments on the Form 10 could be very difficult in light of the shell’s dormant history and trading suspension. Moreover, if there are new control people, the SEC is likely to question their intentions and review their background carefully to ensure that they are not either recidivists themselves or working on behalf of unknown third parties.
In addition to providing the necessary information, to begin to trade again, a company must enlist a market maker to file a new 15c2-11 application with FINRA. For a Company with a trading suspension, this is a difficult process. Many market makers are unwilling to take on the assignment and when they do, the comment process with FINRA can be lengthy. Moreover, even if a 211 application is approved by FINRA, the DTC may still refuse to qualify the security for electronic trading.
Bottom line: Short of a new registration statement and going public process, these companies have effectively been removed from the public company trading system.
The SEC continues to send the message that companies without current information will not be allowed to trade.
The Author
Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
LAnthony@LegalAndCompliance.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.
Follow me on Facebook, LinkedIn, YouTube, Google+, Pinterest and Twitter.
Download our mobile app at iTunes.
Legal & Compliance, LLC makes this general information available for educational purposes only. The information is general in nature and does not constitute legal advice. Furthermore, the use of this information, and the sending or receipt of this information, does not create or constitute an attorney-client relationship between us. Therefore, your communication with us via this information in any form will not be considered as privileged or confidential.
This information is not intended to be advertising, and Legal & Compliance, LLC does not desire to represent anyone desiring representation based upon viewing this information in a jurisdiction where this information fails to comply with all laws and ethical rules of that jurisdiction. This information may only be reproduced in its entirety (without modification) for the individual reader’s personal and/or educational use and must include this notice.
© Legal & Compliance, LLC 2016
