Rule 144(i) address the Staff’s longstanding concerns with the (mis)use of the Rule 144 by shell company promoters and investors to free up shares for distribution without registration, finally attempting to “codify” (in part) the approach that started out with the January 21, 2000 letter from former SEC Staffer Richard Wulff to the NASD’s Ken Worm. (See our May-June 2000 issue at pg 3.) That letter dealt with, among other things, the (un)availability of the Rule 144 safe harbor to securities of blank check/shell companies before and after a reverse merger, or other business combination, with an operating company. (At the time, only blank check companies were defined by the SEC; the term “shell company” wasn’t defined until the SEC’s 2005 amendments to Forms
S-8, 8-K, etc.-see Rel. No. 33-8587).

In the Wulff/Worm letter, the staff took the view that promoters of affiliates of the shell (and their transferees) are always “underwriters,” thereby preventing distributive schemes using Rule 144 and leaving 1933 Act registration as the only alternative for resales of restricted securities and sales by affiliates even after the shell company’s combination with the operating company, no matter how much time has elapsed since the promoter/affiliate obtained their securities. The Staff drew a stark line in the sand, potentially even for those former shell companies where there is no likelihood of abuse (e.g., legitimate operating companies such as Berkshire Hathaway, Occidental Petroleum, Muriel Siebert and Texas Instruments that went public by (reverse) merger into a shell company.

The 144(i) Safe Harbor for Securities of a Former Shell Company
Now, 144(i), added with the 2007 Rule 144 amendments (see our November-December 2007 issue), prohibits reliance on the general  Rule 144 safe harbor for any securities “initially” issued (see below) by a company that is a (reporting or non-reporting) shell company. But, Rule 144(i)(2) provides a new “way out, ” as long as a post-combination issuer (i.e., former shell) is current in filing its 1934 Act reports for 12 months (the standard 144 (c)(1) current public information requirement), and one year has elapsed since the issuer filed its “Form 10 information,” which filing usually is triggered by either or both Item 2.01 (Completion of Acquisition or Disposition of Assets) and item 5.01 (Changes in Control of Registrant) of Form 8-K; the SEC noted in the adopting release that this one year clock starts on the filing date of the Form 10 information (on 8-K), not when the Staff has completed its review of the Form 10 information

Rule 144(i) immediately generated a number of interpretive questions, some of which are not yet resolved. The Staff has begun providing some guidance, however, and we hope more will be forthcoming (perhaps in the form of some line-drawing), in order to head-off any resurgence in the “shell game” (see our July-August 1999 issue at pg 3) if and when the market for this kind of thing heats up.

Retroactivity. Now that Rule 144 can become available for the public sale of shell securities by affiliates and holders of restricted securities beginning one year after the issuer ceases to be a shell, it is more important than ever that a former shell company maintains currency in its 1934 Act reporting. One question that has come up is whether Rule 144(i) applies only to the sale of securities of companies that cease to be a shell (i.e., acquire an operating entity) on or after the February 15, 2008 effective date of 144(i).

In Securities Act Rules CDI 137.02 (January 26, 2009), the Staff has clarified that Rule 144(i) does apply to securities issued before February 15, 2008. The Staff has separately indicated that the 12-month currency requirement of Rule 144(i) applies retroactively, so that a company that has ever been a shell (not just a shell that ceased to be a shell after February 15, 2008) is eligible for 144 (i)(2).

Main Difference from General Rule 144 Safe Harbor- 12- Month- Currency Requirement Perpetual for Restricted Securities (As Well As Control Stock). Rule 144(i)’s 12-month currency requirement applies forever. This is in contrast to Rule 144 generally, where, after the initial six-month holding period, non-affiliate sellers of restricted securities of a reporting issuer need determine, only for the next six months, that the issuer satisfies the 12-month currency requirement of Rule 144(c), and beginning one year after issuance may resell without compliance with any Rule 144 requirements; and, for non-reporting issuers, resales of restricted securities are permitted freely after a one-year holding period. (There is no 144(i) safe harbor for non-reporting issuers, but shells usually are reporting issuers.)

As a result, it has become difficult (or perhaps impossible) for non-affiliate investors in a shell to get the Rule 144 legend removed prior to an actual sale (e.g., by a PIPE investor who had baked into the PIPE agreement a requirement to remove legends once Rule 144 restrictions terminate), because it can’t be known until the time of sale whether the issuer is current for 12 months, i.e., there is never a complete cut-off for shares “initially issued” (see below) by a shell. Without the cut-off, former shells that become delinquent in their reports, or on that choose to stop reporting in the future, may find themselves in the uncomfortable position of not being able to remove legends and permit sales of restricted securities under Rule 144, no matter how long the shell has been a former shell or how long the investor has held the Securities

This problem is pushing some counsel representing former shells to consider providing a Section 4(1) opinion (rather than a 144 compliance instruction/verification) in cases where not all of the requirements of the new safe harbor are met, withstanding the warnings from the Wulff/Worm letter that 4(1) may never be available for shell company securities. Some counsel are taking the view that the current reporting prong of Rule 144(i) is not relevant to whether the seller is an underwriter, and thus 4(1) might nonetheless be available to exempt the resale. (We detected some sympathy for this 4(1) approach at the Northwestern Law School Securities Regulation Institute in San Diego in January.)

Reverse Merger specialist David Feldman and other interested counsel have been pressing the Staff (and the Commission, through a rulemaking petition) to eliminate the 12-month currency requirement for restricted securities for companies that have been publicly reporting for at least one year after ceasing to be a shell company. The Staff expressed some understanding and concern for the situation that the rule has created, and indicated late last year that the Staff had started to move on resolving the issue. On the other hand, removing this 12-month currency requirement would take any sort of “teeth” out of Rule 144(i) for ensuring a post-combination flow of information for the benefit of investors purchasing shares in non-affiliate resale transactions.

The “Initially Issued” Conundrum
Rule 144(i)’s safe harbor can apply to the resale of any securities “initially issued” by a shell company (other than a “business combination related shell company,” discussed below) or by an issuer that has been at any time previously (to the proposed resale) a shell company (e.g., Berkshire Hathaway), but only if the issuer has ceased to be a shell company and meets the conditions of Rule 144(i)(2), i.e., has filed the Form 10 information at least one year before, is subject to 1934 Act reporting and has filed all required reports for the past 12 months.

Initial Issuance By Former Shell? That sounds reasonable enough, but when exactly is “initially issued” to be measured, particularly with an issuer that has previously been a shell at some point, but was not a shell at the time the subject shares were first/initially issued? It seems that the SEC attempted to clarify “initially issued” in note 172 of the adopting release (Rel. No. 33-8869): “Rule 144(i) does not prohibit the resale of securities under Rule 144 [i.e. 144(i) allows 144 resales of securities- our change to eliminate the double negative] that were not initially issued by a reporting or non-reporting shell company or an issuer that has been at any time previously such a company, even when the issuer is a reporting or non reporting shell company at the time of sale.” In Securities Act Rules CD1 137.01 (January 26, 2009), the Staff clarified further that, if an issuer had previously been a shell company (but is an operating company at the time that it issues securities), Rule 144 is available for the resale of those securities but only if the conditions in 144(i)(2) are satisfied at the time of the proposed sale. By way of explanation, the Staff notes 144(i)(1) provides that the general Rule 144 safe harbor is not available for the resale of securities “initially issued” by a shell (other than a business combination related shell) or by an issuer that has “at any time previously” been a shell (other than a business combination related shell).  

Piecing this “guidance” together, the SEC and the Staff seem to be saying that, where an operating company that was never previously a shell issued securities but subsequent to issuance became a shell for whatever reason, the provisions of Rule 144(i) would not be available for sales of that company’s securities but rather the seller could look to the general Rule 144 safe harbor. By contrast, resales of securities issued by a company when it was a shell or at any later time (no matter what its present shell status), would always be subject to Rule 144(i).

Thus, even for, e.g., former shells that have taken an operating company public through a full blown Form S-4/merger proxy solicitation (rather than the more typical private exchange followed by a first public filing of Form 10 information under cover of a Form 8-K), where presumably any investor protection concerns have been satisfied though a registered transaction akin to an IPO, any securities “initially issued” by that entity will still be subject to Rule 144(i) when a holder seeks to resell.

New Wrinkle For the Shell Game- The “Start-Up” Exception
Note 172 also potentially opens up a Pandora’s box on what exactly constitutes a “shell company” (for the purposes of the SEC’s rules, including Rule 144(i). In response to commenters’ concerns that Rule 144(i)(1)(i) (the “shell” definition) might pick up some garden variety start-up companies technically meeting the definition (e.g., companies just beginning their operations) but actually attempting to implement a real business plan, the note says that companies would not be considered a shell if they have something more than “no or nominal operations’. This interpretive statement injects a significant element of subjectivity into the determination of what is in fact a shell company, opening the door for the proliferation of so-called “manufactured’ shells that seek to skirt the tougher safe harbor of Rule 144(i)  with some claim of a “real” business plan and “start-up company” status on the still present (but hopefully not shrinking) shady side of the shell game. [We understand that FINRA has been playing close attention to Form 211 applications (to comply with Rule 15c2-11) submitted by companies purporting to be operating companies but with shell ambitions. Much like the SEC Staff, FINRA Staff often, through a comment/review process, digs deep into a company’s business and intentions prior to approving the securities for trading on the OTCBB.]

More Focus on What is a Shell?
Rule 144(i) has focused attention (e.g., through the broker verification process for Rule 144 transactions) on whether securities are, in fact, completely ineligible for Rule 144.

SPACs. One class of issuer that certainly seems to fit the shell company definition is SPACs, i.e., special purpose acquisition companies (see our May-June 2008 issue at pg 8), which typically are initially capitalized through an underwritten S-1 registered offering. Given that the typical SPAC’s business plan is to start with nothing and raise capital for the purpose of later acquiring an operating company or companies, we expect that the Staff would say that any resales of securities initially issued by a SPAC would be subject to the added limitations of Rule 144(i) even after the SPAC has acquired an operating company. We don’t think SPACs would be eligible for the business combination  related shell carve-out, in that they are not “necessarily” formed by an entity  that is not a shell company “solely for the purpose of completing a business combination transaction,” i.e., the SPAC is formed to raise capital in anticipation of possibly doing a business combination down the road.

Business Combination Related Shell Companies. Another thorny area is determining whether shell entities in a merger are, in fact, “business combination related shell companies,” which as mentioned above are specifically carved out of Rule 144(i)’s limitations. This has proven particularly bothersome for those issuers using a “double-dummy” merger structure (i.e., where two dummy subsidiaries are set up below a holding company for the purpose of effecting the merger on a tax-advantaged basis), because the holding company formed in the double-dummy merger might not qualify as a “business combination related shell company,” in that the transaction is “among one or more entities other than” the holding company, and two of those entities (the two transitory merger subsidiaries necessary for the double-dummy structure) are shell companies. Such an outcome is definitely at odds with the purposes of the business combination related shell company carve-out from Rule 144(i); just because an issuer is using the relatively uncommon double-dummy structure as opposed to a reverse triangular merger, should not mean that the transaction suddenly involves the kind shell companies the SEC is concerned about. This is an area where further Staff Guidance would be helpful.