Death Spiral Loan Securities Fraud

Death Spiral Loan Securities Fraud

Footnote 32 Shells not good for Reverse Mergers

Reverse merger shell promoters have learned that they can create small public companies at a very low cost.

In order, they think, to escape being called "shell companies" they put in small businesses. 

However, the real intention to be a reverse merger shell but the SEC is aware of this scam.

They want to avoid this section of Rule 144:

i) Unavailability to securities of issuers with no or nominal operations and no or nominal non-cash assets.

(1) This section is not available for the resale of securities initially issued by an issuer defined below:

(i) An issuer, other than a business combination related shell company, as defined in §230.405, or an asset-backed issuer, as defined in Item 1101(b) of Regulation AB (§229.1101(b) of this chapter), that has:

(A) No or nominal operations; and

(B) Either:

(1) No or nominal assets;

(2) Assets consisting solely of cash and cash equivalents; or

(3) Assets consisting of any amount of cash and cash equivalents and nominal other assets; or

(ii) An issuer that has been at any time previously an issuer described in paragraph (i)(1)(i).

(2) Notwithstanding paragraph (i)(1), if the issuer of the securities previously had been an issuer described in paragraph (i)(1)(i) but has ceased to be an issuer described in paragraph (i)(1)(i); is subject to the reporting requirements of section 13 or 15(d) of the Exchange Act; has 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 (§ 249.308 of this chapter); and has filed current “Form 10 information” with the Commission reflecting its status as an entity that is no longer an issuer described in paragraph (i)(1)(i), then those securities may be sold subject to the requirements of this section after one year has elapsed from the date that the issuer filed “Form 10 information” with the Commission.

(3) The term “Form 10 information” means the information that is required by Form 10 or Form 20-F (§ 249.210 or § 249.220f of this chapter), as applicable to the issuer of the securities, to register under the Exchange Act each class of securities being sold under this rule. The issuer may provide the Form 10 information in any filing of the issuer with the Commission. The Form 10 information is deemed filed when the initial filing is made with the Commission.

The SEC in Release 33-8587 requires shell companies that merge with operating companies to file a “Super 8-K” shortly after the merger.

Footnote 32 of this release says:

We have become aware of a practice in which a 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 company” 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, where 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 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.

The SEC is saying that where the promoters of a public company that has assets or operations in that company that are returned to those promoters on or shortly after the reverse merger with a surviving operating or target company, the SEC will consider those asset or operations to be “nominal” and that public company would therefore be considered a shell.

This is important as Rule 144 provides that Pink Sheet shells cannot use Rule 144 and reporting companies have to file Form 10 information for a year before using Rule 144.

Therefore, a transaction where the existing assets of a small public company are sold back to the promoters, or an agreement to sell them back to the promoters, is to be avoided.

Look also at Footnote 31 in the same Release:

One commenter discussed the application of the proposals to “living dead” companies. See letter from Mike Liles, Jr. As described in this comment letter, a “living dead” company is a former operating company with minimal or limited operations. We believe that a former operating company that meets the assets and operations standards in the definition of shell company would be subject to the rules and rule amendments that we are adopting today.

As I read this, the SEC will also see a “living dead” company as a shell. However, this is nothing more than reiterating the guidelines of Rule 144 as to what is a shell company – minimal operations or assets.

Rule 144 -- Are You an Affiliate?

This is from the SEC website:

“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, even if they were not restricted in the affiliate's hands.”

Unfortunately, the 1933 Act does not define the terms "control person" or "control relationship". However, the SEC in Rule 405 sets forth a definition of control as follows:

"The term "control" (including the terms "controlling," "controlled by," and "under common control with," means the possession, direct or indirect, of the power to direct or cause the direction of the management and policies of a person, whether through the ownership of voting securities, by contract, or otherwise.”

The SEC staff and the courts utilize two rather imprecise tests in determining who is a control person, or - using the terminology of Rule 144 - an "affiliate.

First, does the person in question have the power to direct corporate management and policies?

Second, does the individual have the power to compel the Issuer to file a 1933 Act registration statement covering a proposed sale?

Obviously these tests are largely subjective. Most securities lawyers take the position that, generally, all corporate directors as well as senior officers of a corporation are control persons of that corporation for 1933 Act purposes. Corporate officers below that level, as well as officers and directors of subsidiaries are, generally, not presumed to be control persons. The identity and number of 1933 Act control persons will vary from company to company.

With regard to 1933 Act control status, it is clear that corporate officers or directors positions are not the only defining characteristic in determining whether or not one is considered a control person. Large share ownership is also indicative of control status.

However, again, there is no precise test such as the 10% test applied to certain insiders under the Securities Exchange act of 1934. It largely depends upon the conditions surrounding each case.

For example, persons occupying a certain relationship with a control person may themselves be treated as control persons. A relative or spouse of a control person living in the same home is also a control person. Any relative of a control person's spouse -- for instance, a mother-in-law sharing the same home -- may also be found to be a control person.

Therefore, you may or may not be considered a control person depending upon your ongoing relationship with the company, your relationship with other control persons, or your continued ownership of a large block of the company's shares.

The SEC advises that beneficial ownership of more than 10% percent of an issuer’s outstanding equity securities generally gives rise to presumptive affiliate status.

In addition, affiliate status could be attributed through other indicia of control, such as board representation and negative control rights. 

Although the presumption is rebuttable, a person who claims that he is not an affiliate in order to use the exemption from registration has the burden of proving the availability of the exemption.

While there is not a substantial body of law surrounding this issue for Rule 144, there are a number of cases discussing this issue under Sections 15 and 20(a) of the Securities and Exchange Act.

In looking at these cases, we are concerned here only with what fact patterns establish control.

Actual control or the ability to control is certainly enough. In some cases, the courts have ruled that indirect means of discipline or influence is enough.

Some cases have found possession of potential power, to control is enough, not actual use of that control.

Inaction by a defendant is enough where it is willful or done intent to further some misconduct.

Outside directors have on occasion found to be liable. Outside directors who own stock have been found to be liable.

Officers and directors have been found to have control, naturally. Officers and directors with significant stock holdings obviously have control. People who make or sign misleading statements may be found liable. Other employees of an issuer have been found to have control, as have persons acting in disguised capacities, nominal, figurehead or de facto office holders.

 Rule 405, by its language, refers to control broadly as "the possession, direct or indirect, of the power to direct or cause the direction of the management and policies of a person whether through ownership of voting securities, contract, or otherwise."

Control depends in part on the influence of an individual.

Control can be inferred from a result. For example, one court held that where the controlling persons so dominated those controlled as to be able to gain upwards of 90% of the stock from the owners, those facts demonstrated control.

We suggest that if you own at least 10% of the stock or if you are a director or are in senior management you should consider yourself to be a control person and an affiliate. If members of your immediate family are any of the foregoing you are an affiliate or control person.

Form 10 Shell Danger

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Form 10 Shell Danger

There are many people who create "Form 10 shells" and sell them to people as reverse merger vehicles to go public with a reverse merger.  These are sometimes called "blank check" shells or "virgin shells."

A Form 10 shell is created a company with limited assets and no business, files a Form 10 with the SEC to register the company.   Form 10 registers a company with the SEC under the Securities and Exchange Act of 1934, but does not allow the company to issue any trading securities publicly.  Free trading stock is accomplished by a registration under the Securities Act of 1933, a different statute than the Securities and Exchange Act of 1934.

The game plan of the Form 10 shell is apparently to get the company registered with the SEC so that subsequent filings to register the stock proceed more rapidly.

The procedure is that a Form 10 shell merchant creates a new company, gives it enough money to withstand the initial expenses of an audit and filing, gets an audit that qualifies under SEC rules and files Form 10 with the SEC. The SEC may or may not comment on the filing. Once the filing has been accepted the Form 10 shell merchant seeks a merger partner, an operating company, for a reverse merger.

Note that up to this point, there are no securities in the public market and the stock of the company does not trade. There is no market maker and no trading volume. The stock is not listed anywhere.

The Form 10 shell company may have a limited number of shareholders, say 50-100, but the shares of these minority shareholders are not registered and do not trade. The Form 10 shell has no business except to find a reverse merger.

When a reverse merger is done, the combined companies file a "Super 8-K"  with the SEC. The company must also find a market maker to file a Form 211 with FINRA.
There are various issues with Form 10 shells and in some circumstances they may have their uses.

We focus here on one problem that seems to be entirely overlooked.

The Form 10 shell is controlled by its promoters, who are usually the officers, directors and control shareholders. These promoters may own 80% or so of the outstanding stock. They are the control persons and affiliates.
The minority shareholders are often friends and associates of the promoters. As a factual matter, these minority shareholders are often under the control of the promoters. The minority shareholders will listen to what the promoters ask them to do.

Because the company and the minority shareholders are under common control, the minority shareholders may be deemed to be affiliates. As affiliates, their stock is restricted and not free trading.

Thus, any Form 10 shell merchant, or any other shell merchant, who sells "99%" of the shell may be saying that the minority shareholders are selling free trading stock, when in fact it may be restricted.

SEC v. Kern, 425 F.2d 143 (2nd  Cir. 2005) holds that the stock held by minority shareholders of a shell was restricted because those minority shareholders are under the "common control" of the promoters of the shell (page 149 and page 150). The Court amalgamated the minority stock in that shell with the control stock because the SEC rules amalgamate stock under common control. The Court said "Indeed, this transaction -- attempting to garner large quantities of closely held companies' stock in anticipation of a public distribution -- is exactly the type of transaction for which the Act was intended to require disclosure."

As the defendants in Kern learned, buying up the stock in a Form 10 shell can be a very expensive thing to do if not done in compliance with the rules. This can be an issue with other shells  as well.

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SEC Rule 144 Trap for the Unwary

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 SEC Rule 144  Trap for the Unwary

The doctrine of "Acting in Concert" can be a trap for the unwary under SEC Rule 144.

SEC Rule 144 is the primary tool for making sales in the public market of securities acquired from a public company or its affiliates in a transaction that did not involve a public offering.

If you bought stock in a public company in a private transaction, you may sell into the public market if you meet certain conditions.

Rule 144 has different requirements for affiliates and non-affiliates. Generally, affiliates are persons that directly, or indirectly control or are controlled by the issuer.

For non-affiliates, these limitations generally involve adequate current public information on the company and an adequate holding period after the securities are acquired and fully paid for.

For affiliates there are also restrictions on the manner of sale, volume limitations and a notice requirement.

We focus here  on the volume limitations.

Rule 144(3)(e )(vi) provides that "When two or more affiliates or other persons agree to act in concert for the purpose of selling securities of an issuer, all securities of the same class sold for the account of all such persons during any three-month period shall be aggregated for the purpose of determining the limitation on the amount of securities sold; . . . ."

In other words, when two or more persons agree to act in concert to sell securities, all securities sold by them during any three-month period are aggregated for the volume limitations.

We find that affiliates may overlook the fact that their sales will be aggregated with sales of others with whom they are "acting in concert"

There are many fact situations where people would be acting in concert.  For example, two persons coordinating the timing of sales of their securities might be deemed to be acting in concert.  More subtly, if both sellers' accounts were run by the same investment advisor, these sellers might be deemed to be acting in concert.

If an affiliate of an issuer is the general partner of limited partnerships which hold or held restricted securities of the issuer the affiliate may be aggregated with the partnerships and their partners.

Further aggregation may also be required if the affiliate is "acting in concert" with other persons under Rule 144(e)(3)(vi)

We therefore warn you to be aware of this provision of Rule 144 and act accordingly.

Violating Rule 144 is selling restricted stock as free trading stock and the penalties are severe.

Non-affiliates can be aggregated with other holders so they control enough stock to be affiliates.

Seek competent legal counsel to make sure you are in compliance.

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Gypsy Swap -- Rule 144 Issue for Pink Sheet Companies

One of the most important issues in a Pink Sheet company is to find paths to raise new money. Naturally, free trading stock has more marketability than restricted stock. A Pink Sheet company cannot file a registration statement with the SEC because they lack the necessary PCAOB audited financials.

In fact, if it was a former shell company, it cannot even sell stock privately to investors and ask them to wait a year to sell under Rule 144 because Rule 144 is not available for a former shell company.

One innovative solution some companies have tried is to do what is called a "Gypsy Swap."

In a Gypsy Swap, the company has a shareholder with free trading stock to sell his stock to a new, cash investor. The money goes to the company and the company issues restricted stock to the shareholder who had the free trading stock originally. The old shareholder keeps his stock position, the new investor gets free trading stock, and the company gets the money.

The SEC does not look kindly on end runs around Section 5 of the Securities Act of 1933. This is the section that requires new sales of stock to be registered with the SEC. Consequently, the SEC has taken the position for a number of years that Gypsy Swaps are violations of Section 5 and the shares received by the new investor are restricted securities under Rule 144(a)(3).

In Zacharais v. SEC, the Circuit Court of D.C. agreed with the SEC, finding that the new investor and the original shareholder were "underwriters," or participants in the distribution.

 A majority of the Court held that the appropriate measure of the disgorgement penalty is 100% of the proceeds of the sales.

The Court found that as the securities in question had appreciated, the company may not have had to disclose the risk that the buyers would rescind the transaction, causing the company material liability. The Court remanded this issue to the SEC.

What is important to you here? Easy, do not do Gypsy Swaps. If you do, you may face rescission if the stock is down, disgorgement penalties and SEC sanctions.