Changes to Rule 144 taking effect this month are seen by many market players as a sign that the Securities and Exchange Commission is giving more validation to the reverse merger process.

What’s more, the regulatory agency’s late 2007 ruling appeared designed to provide some much-needed clarity to the waiting periods for PIPE investors in traditional shell companies.

There’s a big issue the ruling is raising, though, in the form of a small footnote.

Buried within its 111-page, Dec. 6 release on changes to Rule 144, the SEC said in a footnote – No. 172, to be precise – that a startup business, or one with minimal operations, does not necessarily fit the definition of a shell company.

That’s a notable change from a couple years ago, when the SEC defined a shell company as one with no or nominal assets, and no real operations.  Most reverse merger practitioners understood “nominal” to mean having less than $1 million in operations or non-cash assets.

At first blush, the new definition is a winner for legitimate, smaller companies on the Bulletin Board that have real operations, who can avoid any stigma of being a shell.

But for reverse merger practitioners, that change has a larger meaning.  And it is likely to become a big talking point going forward – with some predicting a wave of new shell filings, or “Footnote 172 shells.”

“This gives a much wider berth of how (a small business) can view their company,” says Ralph Amato, chief executive officer for Ventana Capital Partners, a La Jolla, Calif.-based reverse merger advisory firm.

“A combination of 172 and (other Rule 144 changes) is going to allow people the luxury of deciding whether they’re an emerging growth company or a shell,” he says.

That’s the upside of the ruling.  Other critics charge that the footnote will just end up unnecessarily muddying the definition of what a shell company is, while leading to abuse and misleading filings with the SEC.

Taken to its extreme, it “will fling Pandora’s Box wide open by providing massive financial incentive to scammers through the creation of hundreds of phony public companies,”  says Tim Keating, founder and president of Denver-based Keating Investments.

In a recently published opinion piece in his firm’s newsletter, Keating says that the SEC has effectively reversed itself on Rule 419, also known as the Blank Check Rule.  What’s more, the commission has “unwittingly fostered an environment for small-cap stock fraud like never before.”

Under the new Rule 144 rules, a company that checks off the “shell company” box on their SEC filings now effectively has a one-year holding period for securities held by shareholders in the former shell, following the first filing of Form 10 information with the SEC.  Those companies are also bound by some additional restrictions resulting from the Worm/Wulff letters of 1999 and 2000.

But a Footnote 172 shell, masquerading as a startup, would avoid the “shell company” designation altogether, and would have a six-month hold instead of one-year hold.  That could be a big incentive to sell sponsors explicitly looking to flip those shells as quickly as possible.  These shells could also end up costing less to buy than other shells, perhaps by as much as $100,000 or so.

Whether that will pay for a factor in decision-making for reverse merger investors remain to be seen.  One big West Coast reverse merger and PIPE investor says that while his company was familiar with the ruling, it was too early to determine any changes to its investment strategy.

Punishing ‘Honest’ Shells

Under Keating’s scenario, an entrepreneur (or more likely, an unscrupulous stock promoter) can create a “startup” business that’s exempt from the SEC definition of a shell company, while at the same time filing a Form 10 registration statement to become reporting and going about getting a ticker symbol.

The “startup” business will simply be discontinued after the reverse merger is completed.

Since “this startup company never met the SEC technical definition of a shell, the promoters and affiliates of the bogus shell ( and later, PIPE investors) can not avail themselves of the six-month hold under the new Rule 144,” Keating says.

Honest shell sponsors who can’t obtain a ticker through the Form 10 shell methods now used by many in the industry will end up being hurt by the ruling, as will unwitting investors in a proliferation of counterfeit companies coming on the market, Keating says.

It’s a concern shared by others in the industry.  Some are worried that fraudsters will see more incentive than ever to create Footnote 172 shells, and those setting up legitimate Form 10 shells will have a tougher time competing, according to David Feldman, managing partner with law firm Feldman Weinstein & Smith, in a recent posting on his reverse merger blog.

Keating’s suggestions to the SEC for fixing the rule include providing a bright-line definition of a shell, halting trading in stocks that merge with Form 172 shells, and equalizing the Rule 144 holding period for any PIPE investor from one year to six months.

Sour Grapes?

Not everyone in the industry is as up in arms about the SEC’s ruling.

Footnote 172 shells “still have to go through audits.  They still have to answer the same questions from the SEC, “says Amato.

“My opinion is that the SEC is widening its viewpoint concerning certain (reverse merger) rules.  They’ve gone from being very standoffish to ‘this is actually a good thing’ for smaller companies,” he says.

There’s also a question of self-interest.  For firms like Keating’s and Feldman’s, which has made a franchise out of virgin shell creation in recent years, the new rule could create cheaper competing shells, impacting their bottom lines.

The Footnote 172 decision would be the second footnote in a recent SEC rulemaking that leads to big debate over what is or is not a true shell company.

Prior to 172, Footnote 32 – made in a 2005 SEC ruling – stirred up a similar debate, and led to a number of manufactured shells being created under what many believe were dubious methods.  The SEC is rumored to be stepping up enforcement on Footnote 32 shell deals, although many mergers using these types of shells have passed muster.

“The (effect of) 172 is not really new.  There have always been these types of issues out there,” says Harvey Kesner, partner with the New York office of law firm Haynes and Boone.

Amato has argued in favor of the Footnote 32 shells, too, noting that 80% of the company’s that go public end up failing.  As such, there’s little difference between a shell that’s used shortly after it is approved for trading and one that sells years later after the company fails, he says.  Ultimately though, the SEC isn’t likely to be the ones to stamp out the creation of Footnote 172 shells, Amato says.

“Attorneys are going to be the ones putting brakes on this,” he said.

Big law firms that deal in reverse mergers appear to agree.  Kesner said that his firm wouldn’t take the business of any company that manipulated the ruling to spin off businesses from these types of shells.

“That would be seen as an in-your-face affront to the SEC,” he said.

Kesner says he expects to see a “proliferation of deals” resulting from the Rule 144 changes, although not directly from the Footnote 172 decision. 

That said, Kesner is not seeing a rush of companies looking to file Form 10 information, which starts the one-year countdown on selling securities.