Are Rule 419 Companies poised to be the next big thing in the small-cap sector?

Recently, the small-cap and reverse merger market has diminished substantially. Operating businesses are wary of completing reverse mergers, and PIPE investors are harder to come by. The reasons for this are easily identifiable.

First – The General State of the Economy

Simply stated, it’s not good.

Second – The Backlash from a Series of Fraud Allegations, SEC Enforcement Actions, and Trading Suspensions of Chinese Company’s Following Reverse Mergers

Chinese company reverse mergers dominated the shell company business for years; now there are none.  Moreover, it is unlikely that this area will recover any time soon. The Chinese government and US regulators must reach agreement and a mutual understanding regarding PCAOB review of Chinese audits.  Even then, it may take years for the stigma to fade.

Third – The Rule 144 Changes Enacted in 2008

As discussed in previous blogs Rule 144(i), as amended, provides in pertinent part that the Rule is unavailable to issuers with no or nominal operations or no or nominal non-cash assets.  That is the rule is unavailable for the use by shareholders of any company that is or was at any time previously, a shell company.  In order to use Rule 144, a Company must have ceased to be a shell company, be subject to the reporting requirements of section 13 or 15(d) of the Exchange Act; filed all reports and other materials required to be filed by 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 file such reports and materials), other than Form 8-K reports; and have filed current “Form 10 information” with the Commission reflecting its status as an entity that is no longer a shell company, then those securities may be sold subject to the requirements of Rule 144 after one year has elapsed from the date that the issuer filed “Form 10 information” with the SEC.

Accordingly, former shell companies must always remain current in their filings (even 20 years after a merger) and the rule will never be available to former shell non-reporting pink sheet company shareholders.

Fourth – The Problems Clearing Penny Stock with Broker Dealers

Most (almost all) small cap companies are penny stocks as defined by federal regulations.  A penny stock is a stock that trades below $5.00.  In January 2009, FINRA sent a regulatory notice to its member broker dealers warning that they are obligated to trace the origin of stock certificates back to the original issuers or face hefty fines for failing to complete the due diligence. This process is expensive and time consuming and many broker dealers are just not willing to go through the trouble for a penny stock.  Following the regulatory notice,

Penson Financial Services, one of the nation’s largest clearing firms, enacted a policy in response to this and will not clear a stock trading below $.10. In addition to this chilling the clearing process, it has had a negative effect on PIPE investors who are concerned about getting their stock cleared and sold.

Fifth – Issues with DTCC, The Depository Trust & Clearing Corporations

DTC controls the clearing of all stock in street name and through electronic transfers.  If a company’s stock is not DTC eligible it will be illiquid.  Although DTC has not technically changed its rules, they are enforcing them differently.  DTC is now requiring documents which may not exist or which may be impossible to obtain.  For example, DTC requires the original offering document for public issuances.  For a company that went public 10 years ago, subsequently failed and became a shell, and changed management a dozen times in between such offering document can be unattainable.

When that same company now wants to complete a reverse merger with a solid operating business, file a registration statement and become fully reporting and transparent, they may not be able to become DTC eligible.  In addition, DTC has been taking a very long time to clear penny stocks, even when the paper work is in order.  Many months or more can go by without communication. DTC has no time limit requirements so an applicant is at their mercy.

Sixth – Increasing Cost of Reporting Requirements

As of June of this year, all reporting companies must file their reports using XBRL.  XBRL is an interactive tagging system to provide in-depth information on financial statements.  However, for a shell company, or small public company it may simply be a matter of too much information.  No one will look at it and the cost is high, averaging about $10,000 in the first two years alone.

Seventh – New Listing Requirements Imposed by NYSE, AMEX and NASDAQ

The NYSE AMEX and NASDAQ amended its rules so that a Company that goes public via a reverse merger with a shell company must wait at least one year to apply for listing on the NYSE exchange.  The new rule requires that the reverse merger company maintain a post-exchange trading stock price for at least 30 of the most recent 60 trading days prior to the filing of the initial listing application.  In addition to the specific additional listing requirements contained in the new rule, the Exchange may “in its discretion impose more stringent requirements than those set forth above if the Exchange believes it is warranted in the case of a particular reverse merger company based on, among other things, an inactive trading market in the reverse merger company’s securities, the existence of a low number of publicly held shares that are not subject to transfer restrictions, if the reverse merger company has not had a Securities Act registration statement or other filing subjected to a comprehensive review by the SEC, or if the reverse merger company has disclosed that it has material weaknesses in its internal controls which have been identified by management and/or the reverse merger company’s independent auditor and has not yet implemented an appropriate corrective action plan.”  The new listing standards may increase the use of the over the counter markets in a “what else can we do” sort of way, but it also may have a further chilling effect, with operating businesses deciding to go public directly or not going public at all.

Going Public Direct

Going public directly may seem like an obvious response to these issues, but it isn’t that easy.  The days of the mid size NASDAQ broker dealers acting as underwriter for any company with revenues are long over.  Most mid size broker dealers won’t underwrite an IPO for a company with less than $40 mil in revenues and even that is a long shot.  Without an underwriter a company going public directly must complete a DPO (direct public offering).  These offerings are extremely difficult to complete.  Public offerings may not be generally advertised and the ability to solicit investors is highly regulated, and restricted.

Moreover, since a market maker can be deemed an underwriter for filing a 15c2-11 application on behalf of a company completing a DPO, most won’t proceed until the DPO is completely closed out.  A 15c2-11 application is necessary to obtain a trading symbol and have your stock quoted in the aftermarket.  That is, in addition to being limited on who they solicit, the company completing a DPO has to convince investors that eventually, there will be an aftermarket and exit strategy for the investment they make today.

Going Public by Private Placement

The same issues are faced by a Company going public directly by completing a private placement following by S-1 resale registration statement.  The investor is taking the chance that the company will never complete the registration statement and an aftermarket will never develop.  Moreover, the SEC has made it clear that a company cannot sell a private placement with the promise of going public.  The SEC has good reasons for this, many of these companies never do and never intend to go public, but for those that are the real deal, it makes the process difficult.

Rule 419 may provide a good answer.  It won’t solve all the problems, and in particular it doesn’t address the first and second issues discussed above, but it provides a very real solution for the rest.

As discussed in previous blogs, 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.

Form 10 Registration Statements

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 a reconfirmation offering allowing the initial investors to decide whether or not to stay in the deal following receipt of the Form 10 information on the operating business.  If 80% of the shareholders do not agree to the merger and stay in the deal, it does not go though.  Rule 419 is the only way to create a blank check company for the purpose of completing a reverse merger with an operating business.

Eliminating the first two issues discussed above, and the issue of reporting expenses, here is how Rule 419 can address the other problems.  I will say upfront, Rule 419 does not solve the issue of reporting costs, and in fact, they are a further deterrence as the Rule 419 Company will be subject to reporting requirements, even while the offering proceeds remain in escrow pending a reverse merger.

Rule 419 Companies Are Not Subject to Shell Company Prohibitions of Rule 144

First, although technically a shell prior to the completion of a reverse merger, most Rule 419 companies are not subject to the shell company prohibitions in Rule 144(i).  The prohibitions for the use of Rule 144 by shell companies, or former shell companies, do not apply to “a business combination related shell company, as defined in Rule 230.405” (see Rule 144(i)(1)(i)).  A business combination related shell company, is defined in Rule 230.405 as a shell company that is “… (2) Formed by an entity that is not a shell company solely for the purpose of completing a business combination transaction (as defined in Rule 230.165(f)) among one or more entities other than the shell company, none of which is a shell company.”  It seems that a Rule 419 company could easily be created that meets the definition of Rule 230.405 and is thus exempted from the provisions of Rule 144(i).

Second, a Rule 419 company can easily provide the necessary paperwork to a broker dealer to meet FINRA requirements.  It is a new company, and all shareholders will either have purchased in the 419 offering itself, or will have received their shares directly from the Issuer in the reverse merger transaction.

Third, and for the same reasons as stated above, DTC clearance should be much easier.  All the documents will be available and easily provided.  All shares traceable and accounted for.   All shares will be registered under the Securities Act of 1933, rather than seeking to trade through an exemption.

The biggest problem with Rule 419 is the legal and accounting expenses of completing the offering, and post effective requirements to complete the reverse merger.  However, with a knowledgeable attorney and reasonable auditor, the process should go smoothly.

However, with all of that being said, the boom in 419 Companies may be just around the corner.

The Author

Attorney Laura Anthony,
Founding Partner, Legal & Compliance, LLC
Securities, Reverse Mergers, Corporate Transactions

Securities attorney Laura Anthony provides ongoing corporate counsel to small and mid-size public Companies as well as private Companies intending to go public on the Over the Counter Bulletin Board (OTCBB), now known as the OTCQB. For more than a decade Ms. Anthony has dedicated her securities law practice towards being “the big firm alternative.” Clients receive fast and efficient cutting-edge legal service without the inherent delays and unnecessary expense of “partner-heavy” securities law firms.

Ms. Anthony’s focus includes but is not limited to compliance with the reporting requirements of the Securities Exchange Act of 1934, as amended, (”Exchange Act”) including Forms 10-Q, 10-K and 8-K and the proxy requirements of Section 14. In addition, Ms. Anthony prepares private placement memorandums, registration statements under both the Exchange Act and Securities Act of 1933, as amended (”Securities Act”). Moreover, Ms. Anthony represents both target and acquiring companies in reverse mergers and forward mergers, including preparation of deal documents such as Merger Agreements, Stock Purchase Agreements, Asset Purchase Agreements and Reorganization Agreements. Ms. Anthony prepares the necessary documentation and assists in completing the requirements of the Exchange Act, state law and FINRA for corporate changes such as name changes, reverse and forward splits and change of domicile.

Contact Legal & Compliance LLC for a free initial consultation or second opinion on an existing matter.

This is the third in a series of articles I am writing regarding DTC (Depository Trust Company) eligibility for OTC (Over the Counter) Issuers. OTC Issuers include all companies whose securities trade on the over the counter market, including the OTCBB, OTCQB and Pink Sheets.  All technical information in this article comes from the DTC website.

DTC Eligibility

As detailed in my first two articles in this series, in order to become and remain DTC eligible, and Issuer must have a transfer agent that has completed and has on file with DTC a DTC Operational Arrangements Agent Letter.  In addition, all Issuers must meet the requirements set forth in the DTC Operational Arrangements (OA).  This article begins to discuss the OA necessary for an Issue to become and remain eligible for DTC service.  Moreover, the OA rules relate to and regard all Issuers.  This article will only discuss those rules and requirements for OTC Issuers.

The DTC OA states:

“Generally, the issues that may be eligible for DTC’s book-entry delivery and depository services are those that: (1) have been registered with the United States Securities and Exchange Commission (‘SEC”) pursuant to the Securities Act of 1933, as amended (“Securities Act”); (ii) are exempt from registration pursuant to a Securities Act exemption that does not involve transfer or ownership restrictions; or (iii) are eligible for resale pursuant to Rule 144A or Regulation S (and otherwise meet DTC’s eligibility criteria).”

Applying to DTC

To be eligible, all Issuers, through their applying Participant, must submit the following minimal documentation: (i) an offering document; and (ii) a completed eligibility questionnaire signed by a Participant.

For Book-Entry-Only (“BEO”) securities, in addition to the 2 documents above, an Issuer must provide a DTC Letter of Representation among the Issuer, its transfer agent and DTC.  The Letter of Representation may be a blanket letter, which is Issuer specific and covers all securities by that Issuer or an Issuer Letter of Representation which is used for one time only issuances. Book-Entry-Only (“BEO”) securities are securities for which no physical certs are made available and all securities are maintained by DTC in a Cede & Co, account.  Transactions are made through the FAST program.  Most OTC Issuer securities are not BEO.

DTC Legal Opinion Letters

DTC may request a legal opinion.  Generally such opinion is to confirm either (i) that the SEC registration requirements have been met, or (2) that the security was exempt from SEC registration when issued and is not freely tradeable.  However, DTC can request opinions on other matters, such as when an Issuer changes its name or goes through a reorganization such as a reverse merger.  Foreign Issuers are generally required to provide legal opinion letters.

Although many practitioners believe that DTC rules and eligibility requirements have changed in the past year, in actuality the current rules have been in effect since October 2009.  It is my belief that the examiners response to applications, including the review and comment of applications, has become stricter and more particular in the past year.   That is, the rules haven’t changed, but the application and enforcement of such rules certainly has.

Satisfying DTC Requirements

In particular, Issuer’s are now being required to produce the offering document.  For Issuer’s attempting to make existing securities DTC eligible, it may be difficult, if not impossible, to obtain a copy of an initial offering document.  For example, if an Issuer went public via 504 prior to the 1999 rule changes and subsequently became reporting via a Form 10 (which is not an offering document), the original offering document may have been destroyed, if one ever existed.  In this case, the Issuer will have to work with DTC to provide information satisfactory to their counsel that the securities are indeed free trading and therefore DTC eligible.

Accordingly, it is very important for an Issuer to hire professionals that are familiar with the rules, and who will assist in making sure applications are thorough and complete.

The Author

Attorney Laura Anthony,
Founding Partner, Legal & Compliance, LLC
Securities, Reverse Mergers, Corporate Transactions

Securities attorney Laura Anthony provides ongoing corporate counsel to small and mid-size public Companies as well as private Companies intending to go public on the Over the Counter Bulletin Board (OTCBB), now known as the OTCQB. For more than a decade Ms. Anthony has dedicated her securities law practice towards being “the big firm alternative.” Clients receive fast and efficient cutting-edge legal service without the inherent delays and unnecessary expense of “partner-heavy” securities law firms.

Ms. Anthony’s focus includes but is not limited to compliance with the reporting requirements of the Securities Exchange Act of 1934, as amended, (”Exchange Act”) including Forms 10-Q, 10-K and 8-K and the proxy requirements of Section 14. In addition, Ms. Anthony prepares private placement memorandums, registration statements under both the Exchange Act and Securities Act of 1933, as amended (”Securities Act”). Moreover, Ms. Anthony represents both target and acquiring companies in reverse mergers and forward mergers, including preparation of deal documents such as Merger Agreements, Stock Purchase Agreements, Asset Purchase Agreements and Reorganization Agreements. Ms. Anthony prepares the necessary documentation and assists in completing the requirements of the Exchange Act, state law and FINRA for corporate changes such as name changes, reverse and forward splits and change of domicile.

Contact Legal & Compliance LLC for a free initial consultation or second opinion on an existing matter.