David Feldman's book, Reverse Mergers: Taking a Company
Public Without an IPO, now in its third printing, was published in 2006
by Bloomberg Press (available on http://www.amazon.com).
View David Feldman's reverse merger blog at www.reversemergerblog.com.
Joseph Smith and David Feldman are coauthors of PIPES:
Revised and Updated Edition - A Guide to Private Investments in Public Equity
(Bloomberg Press, 2005) available on http://www.amazon.com.
In the News
David
Feldman quoted in Reverse Merger Report
on June 14, 2007 about potential future
problems arising from Footnote 32.
Footnote
32 Shells Pose Threat
by
Reg Crowder
A little-noticed footnote
tucked away in a two-year-old Securities
and Exchange Commission rule may be
a "ticking time bomb" capable of destroying
some of the companies that have gone
public by reverse merging into trading
shell companies.
Boiled down to its essence, the problem
arises when the SEC discovers that
what was really a shell company went
public some time in the past by masquerading
as an operating business or a start-up.
Securities lawyers and reverse merger
players say they don't know exactly
when or how this time bomb will go
off. But they believe the SEC staff
has been giving them -- for some time
-- subtle indications that it is just
waiting for the perfect case that
will enable the SEC to drop the hammer
on "Footnote 32 shells."
"When that happens, even for a company
that innocently merged into a trading
shell that falls under Footnote 32,
it's "game over" for the company,"
said securities lawyer Jim Moloney,
a former SEC staff attorney who is
now a partner in the Orange County,
Calif. office of Gibson Dunn &
Crutcher. His six years with the SEC
included three years as special counsel
in the Office of Mergers & Acquisitions.
Moloney said the Footnote 32 trap
could easily go unnoticed by the SEC
for years. He said the passage of
time offers absolutely no protection
for the unsuspecting company that
has reverse merged into what turns
out to be a Footnote 32 shell. The
filing of every new SEC form increases
the chance of the SEC staff comparing
the most recent action with earlier
filings that describe precisely how
the company became public Maloney
said.
"At the very least, this is rescission
event, he said. "Every single person
who purchased stock after the improper
going-public event is entitled to
rescind their purchase. The company
is required to pay back the money
and disgorge any profit gained as
a result of the stock sale." After
that, it gets worse. Moloney said
the SEC has a variety of additional
tools available to deal with a company
caught in a Footnote 32 shell, including
seeking criminal prosecution.
So, exactly what is the Footnote 32
and what makes it so dangerous?
Footnote 32 was included in the SEC
rule-making in June 2005 that tied
up several regulatory loose ends for
the reverse merger business. The provision
that stands out is the requirement
for the filing of a complete disclosure
document four days after a company
completes a reverse merger into a
shell.
The entire final rule, including commentary
and footnotes, was published in the
Federal Register on July 21, 2005.
Footnote 32 isn't terribly long or
difficult to follow, but worth viewing
in its entirety:
"We have become aware of
a practice in which the promoter of
a company and/or affiliates of the
promoter appear to place assets or
operations within an entity with the
intent of causing that entity to fall
outside of the definition of blank
check companies in Securities Act
Rule 419. The promoter will then seek
a business combination transaction
for the company, with the assets or
operations being returned to the promoter
or affiliate upon the completion of
that business combination transaction.
"It is likely that similar schemes
will be undertaken with the intention
of evading the definition of shell
company that we are adopting today.
In our view, when promoters (or their
affiliates) of a company that would
otherwise be a shell company place
assets or operations in that company
and those assets or operations are
returned to the promoter or to its
affiliates (or an agreement is made
to return those assets or operations
to the promoter or its affiliates)
before, upon completion of, or shortly
after a business combination transaction
by that company, those assets or operations
would be considered 'nominal' for
purposes of the definition of shell
company."
Although nominal is commonly defined
by laymen as existing in name only,
the SEC refused to define the word in
the regulation. It said establishing
a quantitative threshold would make
sidestepping the intent of its regulations
and the misuse of shell companies easier.
In other words, if the SEC were to set
a dollar value test, the scammers would
come in with one dollar more.
Thus, the rule doesn't say exactly what
will trigger an SEC challenge to a company's
claim that it is outside the Rule 419
definition of a blank check company.
But it does put the reverse merger industry
on notice that it is on the lookout
for schemes that have the intention
to evade being defined as a shell company.
Securities lawyer David N. Feldman,
with Feldman Weinstein & Smith,
said dishonest shell promoters try to
get around Rule 419, which lays down
the procedures for IPOs by blank check
companies, because the rule is highly
restrictive.
"Those who comply with Rule
419 are at a disadvantage because, under
this rule, the stock issued in an IPO
of a shell cannot trade, and promoters
believe it is important for their shell's
tock to trade," Feldman said. On the
other hand, he said, operating businesses
and start-up ventures are example from
Rule 419. From the shell buyer's perspective,
Feldman said he personally doesn't agree
that a trading shell is worth a lot
more than a non-trading shell. But
many buyers of trading shells see things
differently. The words "trading shell"
are magic n the marketplace today. And
that is what drives promoters to continue
offering Footnote 32 shells to unsuspecting
buyers, even in the face of the SEC's
not-so-subtle warning.
Tim Keating, founder and president of
Keating Investments, said shell buyers
today will pay $600,000 to $1 million
for a trading shell that would have
sold for $200,000 just a few years ago.
He said the pieces of trading shells
have been driver sky high by the acceptance
of the combined reverse merger and PIPE,
commonly known as an APO, as well as
the seemingly insatiable demand from
private Chinese companies eager to go
public in the U.S.
The cost of creating a legitimate trading
shell is somewhere in the vicinity of
$100,000, while a bogus trading shell
might be launched with as little as
$50,000, Keating said. That's not exactly
chopped liver in itself. But the really
big payoff for the promoter is on the
back-end of the deal. The seller of
a Footnote 32 trading shell could easily
get $550,000 for the controlling stake
in the shell.
"This $500,000 windfall is money for
nothing," Keating said. "Who can blame
the private company that is attracted
to the 'failed' Internet consulting
business that only had three months
of operations, no revenue, no employees,
no real business, etc.? Why wait six
months to a year to get a ticker symbol
when a 'clean' Footnote 32 shell has
a symbol that is available today?"
Keating answered his own question: "I
am confident that the SEC will continue
to closely review and monitor all reverse
mergers," he said. "Among other things,
I believe the commission will be on
the lookout for 'serial business creators
whose companies coincidentally all happen
to become shells. It will only take
one strong enforcement action to act
as a major deterrent to this kind of
bogus shell creation activity."
Asked directly what it intendeds to
do about abusive Footnote 32 shells,
an SEC spokesperson would only say that
no enforcement or regulatory actions
were currently underway.
Nimish Patel, a partner in the Richardson
& Patel law firm, said it is customary
for the SEC to be closed-mouthed about
an issue while it is getting ready to
make an example of an offending company.
The filing of a Form 8-K announcing
a reverse merger a short time after
a company's going public event is one
dead giveaway that the company is going
to run afoul of Footnote 32, he said.
"Say a company is doing a reverse merger
and just a few months ago they went
public," Patel said. "Before, they were
eager to start a company and now they
want to get rid of it as a shell. You've
got to ask what's going on. The SEC
staff is going to see that, too. I think
the SEC staff is waiting until they
have enough data points to know they
have the perfect case. And then they'll
starting writing letters. And then they'll
start making examples of companies.
And they'll start putting out press
releases about Footnote 32 shells."
Meanwhile, what can legitimate
companies do to avoid becoming entangled
in bogus trading shells? Securities
lawyer Feldman has put together a list
of seven telltale signs of a Footnote
32 shell:
A start-up or very early stage
company is doing an IPO or other
going public event and allowing
shareholders to resell their stock
in the public market.
The filing is completed less
than one year after the company
is started.
The IPO is seeking to raise very
few dollars (maybe $100,000) and
usually ends up raising much less.
Management of the company has
little or no experience in the supposed
business they are creating -- or
have experience in securities, corporate
consulting or other specialties
closely associated with Wall Street.
The company claims to be based
in Utah, Nevada or Canada.
The company intends to engage
in a business relation to oil, gas
or mineral rights, or owns rights
in entertainment projects that have
no been developed.
The officers, directors, large
shareholders or consultants have
launched small companies of the
sort described above many times
before.
Feldman said he advises his clients
to avoid, at all costs, getting involved
with any company that has the slightest
change of being identified by the SEC
as a Footnote 32 shell. "For an innocent,
unsuspecting company, a Footnote 32
shell is a ticking time bomb just waiting
to go off," he said.
A quick look at trading shells now being
marketed for use in reverse mergers
confirms that the industry retains much
of its carnival atmosphere. That includes
the marketing of supposedly "trading
shells" that have absolutely no operations
or assets.
In what might be a new twist, a trading
shell was recently offered on eBay online
auction and shopping website with an
asking price of $150,000. The eBay listing
described the company as a public trading
shell with no assets or operations --
yet ready to list on the Bulletin Board.
Internet marketers of shells routinely
offer potential buyers no more information
about themselves than their web address,
e-mail address and a telephone number
that is difficult or impossible to trace.
The shell promoter using eBay took the
process one step further, using the
eBay system to conceal all of his contact
information and make the offering under
an alias, "Analoxide." The only option
available to a purchaser willing to
ask for more information was to send
questions through the eBay messaging
system.
"Analoxide" described the shell as a
public shell trading on the Pink Sheets.
However, the promoter did not include
the company's name or trading symbol.
"I normally broker diamonds and precious
metals along with fine jewelry but am
known in the tight knit shell community
for being able to raise money for public
companies that previously reversed into
the company they are currently running."
the promoter's pitch said.
The promoter said that in the past two
years he has acted as a consultant for
a shell company that raised over $3.5
million. He said the trading shell offered
for sale on eBay had no operations,
no assets and no debts. The promoter
added: "The shell is [Rule] 504 qualified
and all you need is a [Form] 15c2-11
on file to jump to the OTCBB!"
The promoter responded to an inquiry
from RMR through the eBay messaging
system, identifying himself only as
Scott. "I do not want to provide my
contact info or more specific information
on myself, due to wanting to stay off
the SEC radar," he said. "...If you
have ever had the experience of sitting
in the Washington, D.C. headquarters
of the SEC then you would know that
being grilled by up to six agents plus
a Justice Department investigator is
about as much fun as drinking your own
blood. It's extremely costly , too,
since SEC attorneys are some of the
most expensive ones/
Responding to one of RMRs questions,
Scott said he was confident the shell
would survive any SEC review under Footnote
32 with no problems. "I did not create
the shell six months ago or anything
like that," he said. "I bought it a
couple of years ago to put a business
into. I got involved with another company
that was listed on the OTC at the time
and never got around to doing anything
with it." He said he also has another
shell company available for sale and
possesses all the relevant records for
"all the reverse mergers since the shell
was created in the early '90s."
Scott answered RMR's inquiry
from an email address associated with
Gemrush.com, an online marketer of jewelry,
precious stones and precious metals.
The domain registration record for Gemrush.com
lists the registrant contact, technical
contact and administrative contact as
Stealth Enterprises Inc. and Scott Gold
of Lake Villa, Ill.
Despite Scott's confidence that his
trading shell with no assets or operations
would have no difficulty getting the
SEC's blessings, that's not how it always
goes when a company starts making filings
with the SEC in preparation for raising
money. As it turns out the SEC is, in
fact, quietly watching for shell companies
masquerading as operating companies
and they are catching them.
Nevada corporation Knickerbocker Capital
Corp., which has its home office in
California, learned that lesson after
it took the position that it was a going
concern in its Jan. 3, 2006, Form 10-SB
filing. On the same form it showed no
operations or assets of any consequence.
The filing also raised the possibility
of selling Knickerbocker shares under
a SEC Rule 144 exemption.
The SEC staff responded that Knickerbocker
Capital Corp. was really a blank check
company and that the Rule 144 exemption
to registration was not available to
it. The Jan. 11, 2006 SEC letter said
that a blank check's shares must be
registered under the Securities Act
of 1933 before they may be sold.
Knickerbocker's president Dempsey K.
Mork argued in a response to the SEC
staff that the company at one time had
operations.
"Knickerbocker completed an S-18 registered
offering of its common stock on April
7, 1988, raising $300,000," Mork said.
"On June 10, 19888 Knickerbocker acquired
a concrete formula and rights to produce
and sell a concrete product by acquiring
the stock of the owning corporation.
Knickerbocker issued common stock to
the owners of this corporation and the
developer of the formula."
The SEC staff didn't buy it. Knickerbocker
gave in and declared its shell status
on a subsequent Form 10-KSB. At the
SEC's insistence, the company's later
filings disclosed the fact that all
but 24,090 of Knickerbocker's two million
outstanding shares were prohibited from
being sold until they are registered.
Nevertheless, today Knickerbocker Capital
Corp. is being marketed on the website
Publicshellmergers.com as a "fully reporting
public shell company" trading on the
Bulletin board under the symbol KNIK.
As it turns out, Knickerbocker hasn't
filed anything with the SEC since it
submitted a Form 10-QSB back in August
2006. The company's prior SEC filings
clearly state that Knickerbocker has
not had a public market or listing anywhere
since 2005.
Mork did not respond to RMR's request
for an explanation. Identical requests
submitted to Publicshellmergers.com
were not answered.
