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Articles in this archive were authored by David T. Shaheen, Esq. an experienced business attorney who has practiced law for 22 years as a member of private law firms and as in-house counsel for SEC-reporting and non-reporting companies.  He began his legal career with the Securities and Exchange Commission as an intern and since then has guided entrepreneurs and growing companies in various stages of development from start-up to public registration. As a partner of the Washington, D.C. firm of Burk & Reedy, LLP, David Shaheen’s legal practice includes SEC filings and Reg D offerings, private funding and venture capital transactions and the negotiation of a wide range of other business transactions and contracts. Mr. Shaheen is the Chairman of the Corporate Law Committee of the Bar Association of the District of Columbia, a published author and a frequent lecturer on business transactions and legal issues related to the structure, finance and operation of business ventures. See Profile of David Shaheen for more information.

March 25, 2008

Public Without an IPO – Strategies and Considerations

-- Part 1 of a Series of Articles --

By: David T. Shaheen, Esq. - Partner, Burk & Reedy, LLP   

I’ve received numerous inquiries and had many discussions regarding which way is the best way to become a public company. As the title to this latest article plainly suggests, there are indeed many considerations – more than can be covered in one article. This first article is a step though and will be followed by additional articles building on the information here.   

Bucking the IPO System 

When I first expanded my securities practice years ago to include reverse mergers and shell company transactions, I occasionally encountered skepticism from entrepreneurs and their lawyers from time to time regarding various alternative methods that allowed a company to become public without the traditional Initial Public Offering filing with the SEC (I’ll refer to these various methods and other going public strategies that don’t rely on an IPO as “IPO Alternatives”).  

Even straightforward self-filings using an experienced securities attorney were considered out of the mainstream. This occasional skepticism and overly cautious view of IPO Alternatives was a result of several factors.  

1. Going Public Raises Money for Operations. First, conventional wisdom had it that “going public” was to accomplish various goals – a primary one being the raising of money for operations and growth. Not only is the company registered with the SEC but shares of the company are also registered so that they may be legally sold to investors by one or more underwriters. IPO alternatives, like reverse mergers and self-filings, include the first element (the company is registered with the SEC) but financing is a separate element which, if needed, must be arranged. This may be a PIPE financing at the time of the transaction or shortly after, a Regulation D private offering beforehand (refer to my articles in the archive on Reg D) or market makers lined up and in place to handle the sale of shares following a self-filing.   

2. Shareholder Base. In addition, a successful IPO creates a broad shareholder base as a result of the distribution of the shares by the syndicate of underwriters. This type of broad share distribution generally creates a diverse “float” of public shareholders and a healthy trading market. A self-filing or a reverse merger (which may also take the form of a share exchange or asset acquisition) doesn’t create new shareholders.   The company needs to have enough shareholders to have a float and trading market following completion of documentation and filing with the SEC. While the shareholder base can be grown over time, regulator preferences and market realities require a sufficient shareholder base to make your efforts worthwhile.    

3. IPO Legitimacy. Finally, an IPO has always had legitimacy because that was the clear roadmap laid out and supported by the SEC and custom-made for the SEC’s integrated disclosure and reporting framework. Further, it way it was done by the big players – the large brokerage houses and investment bankers – and they earned huge fees along the way for underwriting a conventional IPO. Creative entrepreneurs who didn’t have access to Wall Street, or whose businesses were not mature enough to justify even a “best efforts” commitment by underwriters, or didn’t have adequate revenue or capital for the going-public process, had to find other ways to provide their investors with free trading stock. 

Initial SEC Distrust 

Unlike an IPO, the SEC had some real and often justified concerns with the way some IPO Alternatives were being implemented. Beginning in the 1970’s and 1980’s, entrepreneurs, investment bankers and their attorneys began using Rule 504 of Regulation D and/or various state and federal securities laws to sell stock that would be able to trade without  restrictions. Even if there was no public market for the stock, the trading could eventually develop if a good company continued to have positive developments and it found support among market makers. Another strategy was to simply form a company with a basic business plan and attempt to raise money with a public offering (sometimes with every intention of continuing the business and sometimes with the intention to acquire a company with more substance to be identified in the future).  

From the SEC’s point of view, many of the transactions employing these under-regulated alternatives were used simply to avoid the SEC’s securities registration requirements and they resulted in complaints from investors claiming securities fraud. A typical example might involve a promoter who raised money for a company, but since it was not underwritten it was not nearly enough for the company to truly carry out its business plan or to have a healthy public market. Over time, the money raised is depleted paying fees or salary to the promoter while he is seeking other sources of financing or has moved on to other deals. 

Heightened SEC Regulation  

Much to the chagrin of those companies who were trying to do things right, the SEC decided it needed to step in and regulate IPO Alternatives more directly. Among other things, the SEC’s Rule 419 in 1992 required promoters of “blank check companies” to keep all money raised in escrow until a merger or acquisition was generally approved by the shareholders and appropriate filings were made with the SEC. (A “blank check company” was defined by the SEC as “a development stage company that has no specific business plan or purpose or has indicated its business plan is to engage in a merger or acquisition with an unidentified company…”)  If no acquisition was found or approved within 18 months, the funds had to be returned to investors with interest. Some readers may note the resemblance to a modern day specific purpose acquisition company, or “SPAC”, however SPACs, while structured generally in the same manner, raise well over $5 million dollars and are therefore outside the purview of Rule 419.  

As reverse mergers increased in popularity, further problem areas inherent in the use of IPO Alternatives were addressed by the SEC. On January 21, 2000, Richard Wulff of the SEC wrote a letter in response to an earlier letter from Ken Worm of the NASD (now known as the “Worm-Wulff letters”) advising that Rule 144 was not available for the resale of securities initially issued by companies that are, or previously were, “blank check” companies. Since 2000, therefore, no resales of shares issued in connection with a reverse merger have been permitted without registration of the shares (as opposed to registration of the company) with the SEC. This became applicable to all holders of restricted and non-restricted shares of trading shells and non-trading shells, regardless of whether they were reporting or non-reporting (although see my recent article on Rule 144 - with recent changes to Rule 144 in 2008, holders of shares issued in shell transactions have a very narrow way out of the Worm-Wulff restrictions if the company is no longer a shell files its required reports for 12 months).  

Following the Worm-Wulff letters of 2000, the SEC adopted much more detailed filing requirements for reverse mergers in 2005 and prohibited shells from using  Form S-8 (which had become commonly used in shell transactions as another form of compensation for insiders instead of its intended purpose related to employee-director stock grants).(See http://www.sec.gov/rules/final/33-8587.pdf.)  

Finally Respectable 

Even given the various limitations on IPO Alternatives which have been imposed along the way by the SEC, it is important to note that the SEC never prohibited shell company transactions – for the most part they have made promoters more forthcoming regarding transaction details. In its 2005 rulemaking, the SEC actually acknowledged there were legitimate purposes for the use of shells:  

“The rules and rule amendments we are adopting today do not address the relative merits of shell companies. We recognize that companies and their professional advisors often use shell companies for many legitimate corporate structuring purposes. Similarly, our definition and use of the term “shell company” is not intended to imply that shell companies are inherently fraudulent. Rather, these rules target regulatory problems that we have identified where shell companies have been used as vehicles to commit fraud and abuse our regulatory processes.”

SEC respectability has accompanied acknowledgement from the big players on Wall Street that IPO Alternatives should be considered along with the traditional IPO approach. The term “reverse merger” gained new respect when the venerable 215 year-old New York Stock Exchange concluded a reverse merger with the registered upstart Archipelago Holdings rather than select a traditional IPO. While not perfect, Google’s “Dutch Auction” strategy worked impressively despite an initial push towards going the traditional IPO route. There are a multitude of self-filings and other IPO Alternatives as well that have firmly established the notion that a conventional IPO is not the only way to go. 

Choosing the best IPO Alternative  

If you can get an underwriter’s commitment to take you public going the IPO route, you should seriously consider it and its costs. If you don’t have the luxury of a major brokerage house waiting to underwrite your deal, how do you choose the best IPO Alternative? These transactions are all complex and not for the faint of heart. You need experienced legal and financial professionals to discuss the multiple pros and cons of the different IPO Alternatives before you even start to consider those alternative ways for your company to become public. Regardless of what anyone says, this is not a situation where there are a couple of quick documents you can sign and then you are on your way.  

Your company might be ideal for a straightforward self-filing. Your company might also be offered opportunities to merge with an existing public company. (Just be conscious of the numerous restrictions applicable if the merger partner is a shell.) There are a various IPO Alternatives that can be used to accomplish your objectives and with the cost ranging from under $100,000 for self-filings to over $1 Million for other options, there is ample reason to consider the pros and cons of each alternative suitable to your company. (As an example, the fact that a company already has a trading symbol is only one aspect to consider – but clearly not enough upon which to base a decision on how you will achieve your objectives for your company.)  

In follow-up articles, I hope to explore some of those various considerations with you. Be sure to send me an e-mail and let me know if this article was helpful to you or if you have other questions before continuing further in your own ventures. 

David T. Shaheen, Esq.

dshaheen@burkreedy.com  

This article provides general information only. It should not be construed as legal advice. We provide legal advice only to clients of the firm. Due to the complexities of securities law, the specific facts and circumstances must always be carefully considered and similar situations may lead to different conclusions.    

All rights reserved. Reproduction of this article, in whole or in part, in any form or medium without express written permission from David T. Shaheen, Esq. is strictly forbidden.

SEC AMENDS RULE 144 (AND MORE)

 Good News for Self-Filers, PIPE Investors,

Reporting Start-Ups and even Shells

By: David T. Shaheen, Esq. - Partner, Burk & Reedy, LLP  

Long-Awaited Revisions Finally Here 

Following proposed changes in July 2007 and a flurry of subsequent formal comments, the Securities and Exchange Commission issued a release on December 6, 2007 detailing amendments to Rule 144 and Rule 145 (although the release also addresses important related issues). One of the SEC’s primary objectives in adopting these amendments was to facilitate capital formation. In large part, the SEC accomplished this and several of its other objectives.  

Thinking through my experiences in past shell transactions, reverse mergers and other going public alternatives, I have to say there are certainly some revisions that could be expanded further. Don’t get me wrong though – there are plenty of reasons to be pleased with this release as is. In addition to shortened holding periods for Rule 144 stock, there are advances for shareholders of companies that are or used to be shell companies as well as companies that may fit the technical definition of “shell company” but are, in fact, bona fide small operating companies. 

Some of the most significant changes are summarized below but bear in mind that the release is well over 100 pages long (and references hundreds of pages of related releases and commentary). Many of the changes are subtle and a full understanding requires a broader knowledge of securities law beyond what is written in the release. (Translated: Keep your securities attorney on speed dial when venturing into these areas, especially where anyone else’s cash might be on the line.) 

Concepts and Terms  

A quick review of some concepts and terms will be helpful.  

Restricted Securities. Generally, if you acquire securities that are not registered with the SEC, they are deemed restricted securities and you must find an exemption from the SEC's registration requirements to sell them in the marketplace. Restricted securities are securities acquired in unregistered, private sales from the issuer or from an affiliate of the issuer. Investors typically receive restricted securities through private placement offerings, Regulation D offerings, as compensation for professional services or in exchange for providing "seed money" or start-up capital to a company.  

Control Securities. If you acquire control securities, you must also find an exemption from the SEC's registration requirements to sell them in the marketplace, even if those securities are registered, since they are deemed restricted for other reasons (e.g. stock held by those presumed to have insider knowledge has restrictions). Control securities are those held by an affiliate of the issuing company. An affiliate is a person, such as a director or large shareholder, in a relationship of control with the issuer. Control means the power to direct the management and policies of the company in question, whether through the ownership of voting securities, by contract, or otherwise. If you buy securities from a controlling person or affiliate, you take restricted securities. 

Section 4(1) and the Underwriter Presumption. Section 4(1) of the Securities Act of 1933 (the “Securities Act”) provides that the registration requirements of the Securities Act “shall not apply to transactions by any person other than an issuer, underwriter, or dealer.” Section 4(1) was intended to exempt only routine trading transactions between individual investors with respect to securities already issued and not to exempt distributions by issuers or acts of other individuals who engage in steps necessary to such distributions. If you receive newly-issued securities directly from the issuer (or an affiliate), or receive securities as a result of a business combination or similar transaction, you would likely fall under the SEC’s broad definition of an underwriter if you attempted to sell shares into the market without registration. (Even individual investors may be deemed to be “underwriters” within the meaning of the statute if they act as links in a chain of transactions through which securities move from an issuer to the public.) 

Rule 144 Safe Harbor. Given the difficulty of proving that you are not a statutory underwriter, the SEC created Rule 144.  Rule 144 provides a
“safe harbor” for the resale of restricted and control securities because if you hold the securities for the period of time required by Rule 144, 
and satisfy a number of other conditions of the rule, the SEC will presume that you do not fall within the definition of an underwriter under the
statute. If so, you are permitted to sell the securities publicly without registration. The SEC amendments recently made it much easier to comply
with those conditions.  

Amendments to Rule 144 

For both affiliates and non-affiliates, the Rule 144 amendments significantly shorten the holding periods applicable to resales of securities and lessen or reduce other requirements of Rule 144 as well. 

Affiliates. If you are an affiliate of a reporting company, you may resell restricted securities after a six-month holding period (previously one year), subject to the public information, volume, manner of sale and Form 144 filing requirements. These requirements apply as long as you remain an affiliate. The time period increases by six months if the company is non-reporting.  

Non-Affiliates. If you are a non-affiliate of a reporting company, you may resell restricted securities after a six-month holding period, subject only to the public information requirement. If the company is non-reporting, no sales are permitted for 12 months.  After holding restricted securities of both reporting and non-reporting companies for 12 months, non-affiliates may resell their securities without restriction. 

The SEC’s revised holding periods and resale restrictions are summarized in the following chart:

In addition, the amendments changed additional parts of Rule 144 and raised the thresholds that trigger the requirement to file Form 144 to trades of 5,000 shares or $50,000 within a three-month period for affiliates. Of course, restrictive legends on stock certificates will still have to be removed to enable trading and issuer placement agents will likely continue to demand opinions of counsel acceptable to the company that all Rule 144 requirements have been met before they remove the legends.  

Amendments to Rule 145 

Rule 145 of the Securities Act provides that exchanges of securities in connection with business combination transactions subject to shareholder approval constitute sales of those securities, which must be registered under the Securities Act. Prior to the current amendments, shares received by certain shareholders of an acquired company in a stock-for-stock transaction were subject to resale restrictions because they were presumed to be statutory underwriters. The Rule 145 amendments eliminate the "presumptive underwriter" doctrine with regard to these business combination transactions except with regard to transactions involving blank-check or shell companies.  

Other Significant Changes 

Shell Companies / Reverse Mergers. The past seven years have required some extra work and creativity for entrepreneurs and attorneys structuring transactions with newly-formed and trading shells. On January 21, 2000, Richard Wulff of the SEC wrote a letter in response to an earlier letter from Ken Worm of the NASD (now known as the “Worm-Wulff letters”) advising that Rule 144 was not available for the resale of securities initially issued by companies that are, or previously were, “blank check” companies (defined by the SEC as “a development stage company that has no specific business plan or purpose or has indicated its business plan is to engage in a merger or acquisition with an unidentified company…” The SEC didn’t actually define the term “shell company” until later).  

Remember the “presumed underwriter” issue discussed earlier in this article? It was the SEC’s view that “transactions in blank check company securities by their promoter or affiliates….are not the kind of ordinary trading transactions between individual investors of securities already issued that Section 4(1) [of the Securities Act] was designed to exempt.” Given that analysis, the SEC stated that “both before and after the [reverse merger], the promoters or affiliates of blank check companies, as well as their transferees, are “underwriters” of the securities issued. Accordingly, we are also of the view that the securities involved can only be resold through registration under the Securities Act.”  

Therefore, the safe harbor exemption of Rule 144 was not available, even if there was technical compliance with the rule, because the resale transactions appeared to be “designed to distribute or redistribute securities to the public without compliance with the registration requirements of the Securities Act.” This has generally been the prevailing law since 2000 – no resales of shares issued in connection with a reverse merger have been permitted without registration of the shares (as opposed to registration of the company) with the SEC. This became applicable to all holders of restricted and non-restricted shares of trading shells and non-trading shells, regardless of whether they were reporting or non-reporting.    

With its December 2007 release, the SEC has reversed its “registration or hold” policy with respect to shell transactions and has opened a window for purchasers of shell securities. Upon the February 15, 2008 effective date of the release, a security holder may resell securities subject to the Rule 144 if the following conditions are met: 

a) The issuer of securities that was formerly a reporting or non-reporting shell company has ceased to be a shell;

b) The issuer of the securities is subject to the reporting requirements of Section 13 or 15(d) of the Exchange Act;

c) The issuer of the securities has filed all reports and material required to be filed under 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 filed such reports and materials), other than Form 8-K reports; and

d) At least one year has elapsed from the time the issuer filed current Form 10 type information with the SEC reflecting its status as an entity that is not a shell company. 

While many of us in the industry had hoped that we would also see a six-month holding period applied to these transactions as well, there is still reason to be pleased. Rule 144 is now available for the resale of restricted and non-restricted securities that were initially issued by (i) a reporting or non-reporting shell company or affiliate; or (ii) an issuer that has been at any time previously a reporting or non-reporting shell company or affiliate. Be aware, however, that numerous subtleties exist and your factual situation is often not as clear cut as you would like. Issues regarding shares of companies that had been legitimate public companies but later became shells, late filings during the one-year period, when the clock starts ticking, and other twists are subjects for another article. In fact, one of the most important “twists” facing shareholders of a company that has ever been a shell company involves the cancellation of share certificates bearing restrictive legends and the issuance by the transfer agent of new share certificates from share certificates. The process has become significantly more complicated for transfer agents, and attorneys who must give Rule 144 opinions, due to a variety of issues raised by the new rule and holders of shares of former shells may find that, while their shares may finally qualify under Rule 144, the holders might not be able to obtain non-legend share certificates. 

PIPE Financing. Investment through a PIPE transaction (private investment in public equity) in a company that originated as a merger with a public shell faced the same prohibitions resulting from the Worm-Wulff letters. The securities had to be registered before they could be traded so detailed “registration rights” agreements were required as part of the transaction.  

Registration agreements are typically accompanied by harsh penalties such as liquidated damages to make sure the company performed on its promises to register the PIPE investor’s securities for resale. In addition, because of the initial restrictions on share registration and concerns regarding what percentage of shares would be permitted by the SEC given certain other SEC rules and factors, shells often needed to accept the investment at a significant discount to value in the case of a trading shell.

While PIPE investors will continue to insist on registration rights agreements and other protections, the current amendments will generally provide earlier liquidity for PIPE investments in companies that have not been shells. With respect to investment in companies that were shells, there is at least the chance of some liquidity assuming the company has met the SEC requirements over the past year and it continues to remain current so long as the PIPE investor owns shares.  

Self-Registrations. The BIG winners with regard to these recent amendments are companies planning a self-filing (when a company registers directly with the SEC).  In a self-filing, not only does the company become a publicly reporting, but the company also registers shares of its recent investors, management or its other private shareholders, unlike a the filing involved with a reverse shell merger.  

Since the self-filing company was never a shell company, it benefits greatly from the new Rule 144 holding period. Holders of shares that were not registered by the company in the initial round will be able to request that the restrictive legends on their share certificates be removed after only six months. Assuming the company is current in its SEC information reporting filings and that there is not another restriction on trading (e.g. insiders are subject to certain restrictions), the holders generally will be able to sell their shares on the open market after their six month holding period. Be sure to engage an experienced securities attorney to strategize with you regarding the best structure and timetable to accomplish your self-filing.  

Start-Up Companies. For a number of years, companies in the start-up or development stages that want to be publicly-registered for valid purposes (e.g. to be in a position to attract financing needed to accomplish their business plan) have faced a significant SEC problem. There is a risk of being categorized as a “Footnote 32 shell” (so dubbed because of a footnote in SEC rulemaking related to reverse mergers in 2005). In Footnote 32, the SEC refers to transactions where the company filing with the SEC is actually not a legitimate business, or where it is a legitimate business with only nominal assets. In either case, the intent of the promoters or affiliates is to find a private company with which to merge with a new business resulting. In Footnote 32 scenarios, however, none of this is disclosed to the SEC, thereby avoiding the characterization of the company as a shell and the numerous restrictions on shells.  

Start-up companies have faced the risk of being characterized as a shell because of their limited operations or nominal assets. With the recent December 2007 release, however, the SEC indicated (interestingly in another footnote) that “Rule 144(i)(1)(i) is not intended to capture a “startup company,” or, in other words, a company with a limited operating history, in the definition of a reporting or non-reporting shell company, as we believe that such a company does not meet the condition of having “no or nominal operations.” Therefore, in the event a company is a legitimate business and that business continues into the future, the new six-month holding period should apply. (Warning however: Footnote 32 is very much alive at the SEC with regard to shell companies that are masquerading as start-ups but never hire employees or even open bank accounts - in actuality, they often use the company’s cash to pay salaries and search for public shell companies with which to merge. Even a company that has ceased being a shell and has been trading for some time has significant risk if at some point in the past it was a Footnote 32 shell.)

Conclusion

For the most part, the SEC has taken significant steps to facilitate a company’s capital formation needs. Companies that work experienced securities counsel to self-file with the SEC are the big winners this time. Because of the recent amendments, they can now offer potential investors faster liquidity and improved information in most circumstances. Generally the amendments to Rule 144 should make capital raising and stock-for-stock acquisitions easier and less costly.  Further, the revised holding periods and other amendments that have been adopted are “retroactive,” meaning that they are applicable to securities acquired before or after the effective date of February 15, 2008.

Regardless of the new amendments, however, continue to bear in mind that SEC rules are not available with respect to any transaction or series of transactions that, although in technical compliance, is part of a plan or scheme to evade the registration provisions of the Securities Act. In such cases, registration under the Act is required. The final release is available at http://www.sec.gov/rules/final/2007/33-8869.pdf. Many other issues are addressed in the release. Perhaps I will deal with some of them in a future article. Be sure to send me an e-mail and let me know if this article was helpful to you or if you have other questions before continuing further in your own ventures. 

  David T. Shaheen, Esq.

This article provides general information only. It should not be construed as legal advice. We provide legal advice only to clients of the firm. Due to the complexities of securities law, the specific facts and circumstances must always be carefully considered and similar situations may lead to different conclusions.  

All rights reserved. Reproduction of this article, in whole or in part, in any form or medium without express written permission from David