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.

Aged Debt in Pink Sheet and OTCBB Public Shells -- Rule 144 Issues

Aged Debt in Pink Sheet and OTCBB Public Shells -- Rule 144 Issues

In Pink Sheet and OTCBB stocks, there may be convertible debt that is usually called “aged debt.”

This convertible debt can be converted into common stock. For example, it could be a three year note from the company convertible into stock at $0.01 per share.

The conversion price could also be stated in terms of a percentage of market price, for example, the debt could convert at 50% of the market price.

Aged debt means that the debt was issued long enough ago that the holding period requirements of Rule 144 have been satisfied. The holding period, as you may know, for Rule 144 is one year for Pink Sheet companies and six months for OTC BB and other SEC registered companies.

Now we can consider what this means to the company and the holder of the aged debt. Aged debt usually trades at a discount to face value. Suppose you can buy $100,000 of aged debt for $50,000. If it converts into stock at $0.01 and the stock rises in the market to 0.05 per share, you can convert into 10,000,000 shares. At five cents per share, this is worth $500,000 you paid $50,000. Hmmm......

What this means to a shareholder of the company's stock who is hoping for appreciation is that there is going to be a ton of stock on the market keeping the price down. So be sure to look for convertible debt when you do your stock picking. You will find that the existence of this debt is not often featured to stock buyers by stock promoters. They try to hide this. So in addition to all the enormous dangers of speculating in penny stocks, we have this one.

When converting the aged debt, the debt holder is careful to convert only a portion of the debt at any one time so he does not go to 10% of the outstanding and become a control person. However, he can convert and sell and convert and sell and convert and sell and never go over 10% and still dump all the stock he can convert into. If the debt holder goes over 10% of the outstanding, he will be considered to be an insider and subject to limitations on the volume of stock that can be sold, like 1%, and limits on the manner of sale.

You will see OTC shells advertised for reverse mergers that feature aged debt as one of the sales features of that shell.

However, here is where the aged debt players can make a fatal mistake. If one promoter buys control of the reverse merger public shell, and also buys the aged debt at the same time, then he is an insider as he has control. This limits what he can sell under Rule 144. If the promoter uses the aged debt himself, or then gives or sells the aged debt to someone else, the debt is subject to the holding period rules of Rule 144 and the holding period starts to run from the time of the transfer to the associate, not the date of creation of the debt. The promoter may overlook this point either because of ignorance of the law or by deliberately violating the law.

The same problem exists if the debt was in the hands of an insider or affiliate. The holding period for the new buyer starts when the affiliate sells the stock to the new buyer who is not an affiliate.

If another party independent of the promoter bought the debt, and the previous debt holder was not an insider, then the buyer could tack the holding period of the previous holder. Assuming the previous holder had the aged debt for more than a year, the new buyer would have satisfied the holding period rules of Rule 144.

A greedy promoter may give the debt to an associate who will secretly sell the stock and give the proceeds of that sale to the promoter. This is a violation as a false name of the owner was used and because the stock would be attributed to the promoter whose holding period started when he bought the shell and who is subject to the volume and manner of sale restrictions of Rule 144.

Another problem that these promoters run into is that they seem to think that any debt can be converted into stock. Typically an OTC shell company winds up as a shell with some debts. One of these debts is almost always back salary to the company president who was not taking pay because of the bad condition of the company. However, this is a straight debt, not a convertible debt. Thus it cannot be magically transformed into immediate stock. In order to use this, the directors would have to exchange it for a convertible note and the holding period for the note for Rule 144 purposes will start when the conversion feature is created. Straight debt is not a security for these purposes.

Also as all 144 stock has to be paid for in full to start the holding period, debts created for services have to have all of the services fully performed before the stock or securities are fully paid for and the holding period started.

As some unscrupulous characters may attempt to “age” the debt by simply forging and backdating, I recommend that you take your convertible notes to a notary who can certify as to the date it was created and who signed it. Then you will be able to prove your aged debt is legitimate.

One final point, Rule 144 is a tool to allow investors to sell their stock. It is not a rule for financing the company. If you are the company, do not make a deal with a seller of 144 stock to put the proceeds of his sales into the company.