Tuesday, September 2, 2008

A Very Good "IDEA"

The SEC has announced a new system which will eventually replace EDGAR, the electronic data gathering, analysis and retrieval program under which SEC filings are made electronically. IDEA, which stands for Interactive Data Electronic Applications, will allow investors to quickly and easily search financial information. SEC Chairman Christopher Cox recently led a press conference detailing the new system and its advantages.

When it was phased in back in 1996, EDGAR was, frankly, already obsolete. It took years of back and forth before the very complex regulation explaining how it was to work was completed and adopted. The ASCII-based system nevertheless represented a sea change in the availability of information about public companies. Previously one had to send a researcher to the SEC offices who would stand there and copy paper versions of public filings for you. If you wanted to search a particular item, the researcher would do it for a very expensive fee. And it would take quite a bit of time.

Now with the click of a mouse from anywhere in the world you can access information about any public company, or with the help of search engines such as www.tenkwizard.com, search for people, topics and the like. Want to find every shell? Every PIPE? No problem now. But the system is indeed antiquated.

Cox states that unlike EDGAR, this new system will rely on information rather than specific forms and transactions. During the press conference, Cox led an on-screen presentation comparing the new program to its predecessor, emphasizing EDGAR’s lengthy and time consuming steps to access information about financial companies and mutual funds. IDEA will allow better and up-to-date information to be freely available to investors. Instead of examining one form at a time, investors can instantly collect information from thousands of companies and forms. “Data tags,” which are similar to barcodes, allow for investors to view single items in a company’s financial disclosures. IDEA will also include a financial explorer feature and offer clearance to export information to other software (i.e. spreadsheets, databases or comparative and analytical programs.)

IDEA will include a trio of new features which Cox rightfully dubs “21st century SEC.” The first addition, HUB, will allow enforcement resources to be used more effectively, which simply means more bad guys will be caught. RADAR will allow for risk analysis, while the Phoenix feature will track and distribute millions of dollars.

Cox uses a relatable analogy during his presentation as he pulls up a carfax type website, which compares makes and models, prices and vehicle history. Cox believes that in today’s world, financial information should be as easily accessible and helpful as comparison shopping. Not only will this new system prove advantageous to EDGAR users, those utilizing Yahoo Finance, Google and Morning Star are expected to see an information enhancement because of IDEA.

The SEC launched a pilot program of IDEA, which allowed for company feedback. IDEA is dependent on a rulemaking which Cox believes will be passed by the end of this year. The program received about 96 comment letters which are now under review. The current EDGAR system will adopt some of IDEA’s features until its implementation. Cox believes the new program will be up and running in three years.

My two cents: About time!

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Thursday, August 28, 2008

Can a Securities Act Section 4(1) Opinion Remove a Restrictive Legend Despite the Rule 144 Evergreen Requirement?

The seminal Securities Act of 1933 provides that in order for shares of stock to become tradable, a registration process with the SEC must be undertaken. There are several exemptions to the requirement to register, including Section 4(1) of the Securities Act, which very simply provides that the requirements of registration do not apply to "transactions by any person other than an issuer, underwriter, or dealer." It has become convention to apply this to resales of shares as well, under what is often called the "Section 4(1-1/2) exemption." Assuming the typical seller of unregistered shares, say a PIPE investor, is neither the issuer or dealer, the issue becomes whether he is an underwriter.

The definition of underwriter is in Section 2(a)(11) of the Securities Act and provides as follows:

"The term 'underwriter' means any person who has purchased from an issuer with a view to, or offers or sells for an issuer in connection with, the distribution of any security, or participates or has a direct or indirect participation in any such undertaking, or participates or has a participation in the direct or indirect underwriting of any such undertaking..."

The key phrase is "purchased...with a view to...the distibution of any security." Prior to 1972 when Rule 144 was originally passed, the courts were not clear in interpreting this language. In the end, the question is what was the intention of the purchaser when they bought the stock? If it was "with a view to" public distribution you are an underwriter regardless of any other facts. But how to prove intent? Lawyers back then tried to give opinions stating that shares can be sold without restriction but it was difficult.

Rule 144 came about in 1972 in part because the courts were not providing clear enough guidance. The SEC said, we will provide a safe harbor that makes clear that if you follow Rule 144 you are not an underwriter. Essentially the rule focused on holding periods, and whether or not you are an affiliate. It assumed that holding stock for a certain period of time meant at the end of that period you have proven you are not an underwriter.

Prior to the recent rule changes, after two years you were permitted to sell without any restrictions whatsoever (there were volume limits on sale during the second year prior to that). Now, if the company was never a shell or hasn't been one for at least six months, once you have held securities for six months there are no volume limits, but the company must remain current in its SEC filings until one year after acquiring securities, so it is not until one year that all restrictions go away.

At the end of this one year, lawyers will be able to give opinions to non-affiliates under Rule 144 that no restrictions exist and the restrictive legend on the back of the stock, saying it can't be sold without registration or an exemption, can be removed. At this point whenever the holder wishes to sell, he can simply deliver the certificate to his broker who will effect a public sale. The broker cannot do that if the legend is still on the back.

However, as we have written in previous entries, in shell situations, starting one year after ceasing to be a shell, sales can be made under Rule 144 with no volume limits. But because the SEC now requires the company to be current for the 12 months preceding a sale, the legend can never be removed. That is because one cannot know in advance whether the company will be current at the time of sale in the future. Thus, an opinion cannot be given that all Rule 144 limits have gone away and the legend cannot be removed prior to an actual sale. See prior entries for why this is a legitimate and real concern for investors, particularly PIPE investors.

This is a long explanation to get to the simple question: Do we really need to rely on Rule 144 as the sole way to get a legend removed on stock? Answer: no. A lawyer could go to pre-1972 days, reminisce about the Brady Bunch, Woodstock and really loud ties, and issue an opinion under good old Section 4(1) that the holder is not an underwriter. Remember, Rule 144 is not an exclusive exemption from registration, it is simply one way to ensure you are not required to register, and indeed is an exemption under 4(1).

Since very few of us were in the business world in 1972 (I was in sixth grade and yes, wore bellbottoms), obviously we're not sure exactly how to do this. Let's start with an easy one. Say a PIPE investor in a former shell is not and has never been an affiliate of the company he invested in and is not in the securities business in any respect other than as an investor. He has held shares of common stock for two years. Even under old Rule 144, before the holding periods were shortened, one could sell without any limits whatsoever after two years. With these facts, it would seem not difficult at all for an attorney to conclude that this investor is not an underwriter, and give an opinion, despite the continuing Rule 144 restriction on staying current, to remove the legend. Of course each situation is different and has to be examined. But with these facts it would seem to me to be virtually impossible for the SEC or anyone else to argue that after holding two years this investor still might be deemed to have bought with a view to public distribution.

Now let's go further. The SEC now says, one year after ceasing to be a shell, Rule 144 is available in some form for everyone. A nonaffiliate has the unfettered right to sell without any volume limits at all. Again, the only issue is the need to remain current under the troublesome evergreen requirement, so a legend cannot be removed if one is relying on Rule 144.

But think about this. Is the determination of underwriter status dependent on whether the company is current in its filings? The evergreen requirement, it seems, was not intended to suggest that it affects underwriter status, but I believe was meant to discourage shell players from taking companies public, raising money and then abandoning their SEC filing obligations. But arguably none of this should affect an analysis of an investor's intent to distribute when he acquired his shares. One could posit the argument that after this one year period, regardless of the Rule 144 requirement to stay current, a PIPE investor similar to the one above but who has held for this one year period, also is not an underwriter and a legend could potentially be removed.

This is NOT a long-term solution to the evergreen problem. These 4(1) opinions, if lawyers start giving them, are not going to be easy or simple and will be in some cases fact-specific. Rule 144 opinions are easy as generally all one needs to review is holding period and affiliate status. That is the beauty of 144, and I still believe the SEC should revisit the evergreen requirement and eliminate it.

But while we await this hoped-for change, it may well be that we can counter some who suggest the sky is falling on former shells with the possibility that, at worst, we can ensure that legend removal is available in the same two-year period as it was prior to the rule change and some bold attorneys might be able to get there in the one-year period as well.

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Thursday, August 21, 2008

Off We Go

For just a moment, never mind 144(i), evergreen requirements, SPAC doldrums, Worm/Wulff yada yada yada. Sunday is the big day. We are taking my daughter to begin her freshman year at a prestigious university in the Northeast, less than four hours from our home. I think I am ready. I know she is ready though naturally a little nervous. Yet of course there is this sadness. That someone whom we have laughed with, cried with, been amazed, impressed and astounded by and yes someone who has sometimes frustrated and befuddled us for the last 18 years and 5 months (plus the 7.5 months in the womb- yes she was born nearly 6 weeks early), is ready to move on with her life.


As she is our oldest, we are experiencing this for the first time, and it is indeed quite traumatic. A sense of foreboding has engulfed our home for weeks. She is rushing to spend as much time as she can with her 6-year old brother, while also packing, finishing up the incredible charity work she does all summer (check her out at http://www.kidzz4kidzz.org/), and spending time with her friends (and learning this is the time one discovers who one's real friends are). In the meantime, we need to get the little one ready for 1st grade, also a big step, but it is for now taking a back seat to "the big move."

Change is good we are told. I joke with her that I am transforming her room into an "office slash den," she tells me that's fine as long as I switch it back every time she is coming home. As proud as I am and excited for her, this change is gonna take some getting used to.

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SEC Response to my Request for Interpretive Guidance

I received a telephonic response to my request for interpretive guidance on Rule 144(i). See prior blog entries for the request itself.

The bad part of the response: the Staff believes that 144(i) is retroactive to issuers who stopped being shells before the effectiveness of the rule. Thus, every company that was ever a shell, even in the past, is subject to its restrictions. We were hoping they would exempt companies that completed reverse mergers before the new rule was adopted.

The good part of the response: the Staff went out of its way to state that they "share my concerns" raised in the letter.

Here's what I think: I pushed to get them to interpret the rule in a way that was not that easy to do, but could have been done. But in doing so, they could have easily said, "We disagree, it is retroactive, sorry you are out of luck." But by going out of their way to say that they understand and share the concerns raised, one hopes that means continuing advocacy efforts are not yet hopeless on this issue.

I have several thoughts on how to proceed from here, and I will start sharing them with some of the RM "braintrust" that I have come to rely on in recent years. That glass, friend Tim, respectfully, is still 80% full.

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Monday, August 18, 2008

Tip of the Week: Beware the IPO Myth

Myth: Strong market support for a stock always follows a traditional IPO.

You have probably heard this line a million times; however, nothing can be further from the truth.

The basics of an IPO work like this. A company hires an investment banking firm to serve as lead underwriter of the stock offering. A prospectus is put together to be approved by the SEC and FINRA. Next, the underwriter enlists the help of other brokerage firms, each receiving a commission upon the sale of stock to its customer. The underwriters technically purchase the shares from the company at a discounted price and then resell the shares to its customers, pocketing the difference.

What you may not have heard is that brokerage firms are encouraged to continue participation in the aftermarket if they want to be included in the initial sale and receive commissions. This ensures that people buy and sell the stock for sometime while the initial group of buyers can get out of the stock and make a swift profit. Without this aftermarket support, the stock crumbles, which can happen more often that you think in IPO stocks.

Sometimes the newly public company may be strong, gaining legitimate support; however, this manufactured support drives the stock in its early stages. There is no guarantee that this support will continue on after a few months, if at all.

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Friday, August 15, 2008

Heard Better Medleys Than This

A new US Court of Appeals case known as SEC vs. M&A West, Inc. et al provides important reminders about how not to structure reverse mergers and compensate intermediaries. Thanks to our friend Sam Krieger, who sent a note out to his blast list about the case. OK here we go, haven't had to brief a case in quite awhile!

For you fellow members of the bar, the case can be found at Case No. 06-15165 (9th Cir. August 12, 2008). The main protaganist in the case is one Stanley R. Medley, and the case involves several reverse mergers dating back to the late 1990s and an SEC case originally brought in California in 2001.

Basically, Medley introduced three affiliated private companies to three different shells, and reverse mergers were completed in each case. Medley was compensated with cash and also with stock "sold" to him and his buddies by the controlling shareholders of what was the shell. He paid a few thousand dollars and resold the shares less than nine months later and earned several million dollars in profit on the three deals.

Apparently Medley didn't stop to review securities law before he made his sales. The trial court, granting part of a request for summary judgment by the SEC, ruled that he violated Section 5 of the Securities Act for selling shares to the public that were not registered, because he had purchased them from affiliates of the company. That made him a presumed statutory underwriter with the ability to sell only with registration or waiting out the appropriate holding period under Rule 144, neither of which he did.

Medley tried to argue that the affiliates he bought the shares from stopped being affiliates on the closing date, when the private company took over the former shell. The district court didn't buy it (and the appeals court agreed, saying he did violate Section 5) and said he had to disgorge over $2 million in profits and interest (the appeals court also affirmed this) as well as more severe "second tier" penalties for particularly egregious acts (the appeals court sent this determination back to the trial court for more fact finding).

Essentially the court ruled that, even if the closing of his purchase of the shares happened after the closing of the reverse merger, and pursuant to an agreement separate from the main merger agreement, and at a time when the sellers were not technically affiliates, it was all part of a "single actual transaction with multiple stages." Since the agreements were contingent on each other, and the failure of Medley to get his shares would give him the right to undo the reverse merger, and the agreements were entered into when they were still affiliates, the appeals court, agreeing with the district court, said they effectively sold to him while still affiliates. They pointed out that prior court rulings make clear you can't get a Section 4(1) exemption just by giving up affiliate status shortly before completing a transaction.

One judge dissented in the case. He felt that the plain language of Rule 144 must be honored even if it doesn't clearly follow SEC policy goals, and even though the sellers entered into the contract while affiliates, it was performed when they were not. He felt the majority improperly took an old case interpreting Section 4(1) and applied it to Rule 144, which has different language. He said the SEC is free to change its rules to make this more clear, then pointed out that shortly after this case was argued, the SEC did indeed revise Rule 144 (as we know) exactly "to target the precise sort of reverse merger transactions at issue here."

Bottom line? Probably some of you just skipped right down here, that's ok. First, we have at least one Federal circuit saying you can't buy from a guy who just stopped being an affiliate in facts that are similar to these. If it's contingent on the reverse merger (even as a condition subsequent), and you enter into the agreement while still an affiliate, it won't fly and you have to wait for the applicable Rule 144 holding period without "tacking" the holding period of the seller.

Second, unfortunately this probably gives those at the SEC who may wish to defend their decision to put in the new Rule 144(i) restrictions a place to hang their hat and say "see?" But remember this involves deals that happened almost 10 years ago. The RM landscape has changed so much since then, and I hope this case will not affect our advocacy efforts to get the SEC to take another look at all this.

What's the right way to do this? Ironically, most legitimate players have long since abandoned structuring transactions this way. Some players purchase a shell long in advance of a deal to avoid receiving shares for any reason at the closing. Others receive newly issued shares of the company and understand they have at least a one year wait (or registration) following the reverse merger. Others acquire shares from affiliates but again understand they need to wait a year.

Another way: the Medleys of the world can arrange to acquire shares from a variety of non-affiliates, eliminating this issue completely. Of course this is harder, but in some deals the affiliates are familiar enough with other shareholders who are not affiliates to arrange this. Of course the non-affiliate sellers need to get something for their generosity of selling shares basically for nothing to the intermediary. One way: if the non-affiliate agrees to sell, say 100,000 unrestricted tradable shares for nothing to the intermediary, the company then issues the non-affiliate seller 200,000 new shares which are restricted and have to be held for the applicable Rule 144 period. I don't see anything improper in doing this.

One warning I always give clients who are intermediaries and acquire shares for basically nothing at the time of a reverse merger. The IRS could conclude that the difference between the price the intermediary pays for the stock and its real value represents compensation to the intermediary and must be taxed. In some deals this risk can be a significant problem.

Oh and by the way, the court hadn't even gotten to another big issue, whether Medley should have been registered as a broker-dealer with the SEC and FINRA to be able to do what he did. That's another risk which has continued to dog the small and microcap worlds when deals are being put together.

Anyway, never a dull moment in the RM world! By the way, several have asked: I still have not received a response from the SEC to my request for interpretive guidance regarding the retroactivity of the "evergreen" aspect of new Rule 144(i).

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Sunday, August 10, 2008

Solid Second Quarter for RM

The Reverse Merger Report is a great source of data and industry information, and I urge you all to subscribe at www.dealflowmedia.com. Their second quarter review has many of us feeling good about RM, despite a few roadblocks making some deals a bit harder in this market and regulatory environment.

Second quarter deal flow was consistent with the second quarter last year, which was a great year. Forty-one reverse mergers were completed in the second quarter, this against only 13 IPOs. And as mentioned in an earlier post, this was the first time since 1978 that not a single venture-backed company completed an IPO.

Some had predicted a much stronger quarter because of the virtually non-existent IPO market, but instead RM held steady, which in this market I think is pretty amazing in itself.

China stayed strong representing 40% of closed deals. Investment banks are reporting interest from funds that previously weren't interested in the APO model because of the high-flying Chinese company stocks.

However, there are fewer RM transactions with contemporaneous financings, and those financings are a bit smaller than previous quarters. Some funds are facing redemptions so doing fewer deals. And a number of Chinese companies do not seek immediate financing when they complete a reverse merger in the US. Some also feel that the Rule 144 changes, which treated former shells more negatively than other public companies, are causing some to rethink their approach to going public, or going public at all.

All that said, while many on Wall Street are forced to adjust to a limo ride to the Hamptons rather than the helicopter, RM is holding up just fine thanks.

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