Little-known to those unstudied in reverse merger deals is the fact that if an investment bank or other source of money provides the shell company for the deal, they obtain an additional interest in the merged company.  It is also customary practice to compensate the intermediary who introduces the shell company to the private company.  For both of these reasons, banks and other sources of capital have an incentive to take part in reverse mergers, which can help attract the financing you need.

            Although financing may be easier to come by, this is not to disregard the fact that all private companies should ask themselves why they want to go public, and the answer should never be to raise one round of financing.  Going public for the sole purpose of raising only one round of financing without considering or seeking other benefit is almost always a flawed strategy.  It should be standard practice to perform the concomitant analysis of whether that specific company can benefit from being public and bear the costs of doing so before going public.  By not assessing this, you take on many risks including making the mistake of going public prematurely.  Again, revisiting the pros and cons of going public through a reverse merger needs to be assessed before proceeding, despite the allure of future financing.

Sen. Chris Dodd (D-CT) has just today introduced a version of his “Restoring American Financial Stability Act of 2010,” which now includes “Authority of State Regulators over Regulation D Offerings,” which would diminish the “covered security” preemption of 1933 Act Sec. 18(b)(4)(D). That preemption made many Reg. D offerings much easier. Some points of interest at Section 926 include:

• the SEC may designate certain Rule 506 offerings as not qualifying as “covered securities,” considering the size of the offering, the number of States in which the security is being offered, and the nature of the offerees;
• the SEC then needs to review filings made under Rule 506 within 120 days
• any filing which is not reviewed within the 120 day period would not be a covered security unless a state securities commissioner determines that (a) there’s been a good faith and reasonable attempt by the issuer to comply with all applicable terms, conditions and requirements of the filing, and (b) any failure to comply with such terms, conditions and requirements “are insignificant to the offering as a whole”;
• states may impose notice filing requirements “substantially similar to filing requirements required by rule or regulation under section 4(4) [citation is probably incorrect] that were in effect on September 1, 1996″
• the SEC is to notify States upon completion of its review of Rule 506 filings.

Remember that these are smaller transactions which raise very little money for earlier stage companies. Those that are completing financings seem to be raising between $2 and $5 million.

All that said, a number of deals do not make it. Just a month ago, the RMR noted that a number of CPCs were having challenges in raising money, and that others were facing regulatory issues. One quote suggested that CPC sponsors were having difficulty convincing investors to participate in financings. And with smaller deals sometimes comes simple mistakes. One company, for example, submitted its financial statements to the regulatory authorities, only to learn that they did not meet the standards for a Canadian public company. They then shelved their deal. Others are turning their CPCs into investment companies.

We’ll continue to monitor this fascinating emerging trend.

A corporation that is not in good standing might not be legally able to enter into binding agreements. Usually failure to be in good standing results from not paying franchise or other taxes, or filing required reports, and usually this failure can be remedied by paying the delinquent taxes or filing the delinquent reports. But sometimes a state will simply de-certify a corporation and it’s a much more laborious process to resurrect the company.

Another thing that I have seen happen when things are not checked carefully enough. Some states, even the venerable Delaware, make mistakes. They might not have inputted the name of your corporation correctly originally when you submitted your certificate of incorporation. When you pull a good standing certificate, this is verified. We even had a situation where a snowstorm closed the Delaware state offices and a deal needed to close and no good standing was available! This shows you the importance of the item and the need to plan in advance to get it.

Most importantly, in general the CPC’s shareholders do not have to approve the proposed merger (called a “qualifying transaction” or QT). In a SPAC, shareholder approval is generally required and involves a detailed proxy statement that takes months to get approved by the SEC. Plus there is always concern about whether shareholders will actually approve the SPAC merger transaction. Without this burden, CPCs can close deals much more quickly. However, the QT in the CPC has to be approved by the TSX Venture Exchange. There are other interesting differences. The money raised is not held in escrow in a CPC, as it is in a SPAC, to protect investors. However, there are strict rules on the TSX about how the proceeds from the various financings in the CPC can be used. In particular it bans certain types of non-arm’s length transactions.

SPAC management theoretically can be anyone, but in general SPAC sponsors have been experts in the industry in which the particular SPAC is seeking an acquisition. However, the SEC does not regulate who can be SPAC sponsors. The CPC program actually requires that its management be acceptable to the exchange. They also must be a resident of Canada or the US. I have seen the paperwork and it is a pretty detailed disclosure that is required by each proposed director of a CPC. Rules also limit how much can be raised in seed stage, private offering before the IPO and in the IPO itself, none of which are applicable to SPACs. In the CPC, shares that were issued below the IPO price, management shares and shares owned by certain brokers are put in escrow and are released over a 36 month period following the QT. This is not applicable for SPACs. Also, trading in the CPC is halted before an agreement in principle for a QT is announced and it stays halted until certain documentation is filed.

So basically the TSX has said, we will help your deal get done quickly so long as we watch the entire process and feel comfortable. As we will talk about in a future part of this series, lately some deals have had trouble getting completed. More to come….

So these are not like SPACs in the US, which operate under an exemption from SEC limitations on IPOs of shell companies, because the company must raise at least $5 million to qualify for the exemption. As we know, most SPACs (when they were popular) raised more than $30 million and a good number raised well over $100 million. And clearly SPACs were intended to combine with successful, well-established companies, not venture stage. There are some similarities to SPACs, however. For example, the CPC must find a deal within two years or the TSX can suspend trading or delist the shares. But there are a number of interesting differences between the CPC program and typical SPACs. We will get into this in part II of this series.

The reverse merger is known as a “qualifying transaction” and has to meet certain TSX requirements.  Given the various protections the exchange has provided, this seems like quite an interesting technique indeed. More specifics to come.

Right up front: I’m not an expert in this, and the information here results from research I have done on the program. I am hoping to soon have some Canadian friends provide me with more perspective from “out in the field” where these are happening. In the meantime, I’ll provide my humble armchair point of view of this emerging program.

In 2004 guidance put out in part in connection with rolling out Sarbanes-Oxley and PCAOB registration of accounting firms, the SEC noted: ”A foreign audit firm’s registration with the PCAOB does not supercede existing means by which a firm demonstrates its knowledge and experience in applying US GAAP, PCAOB Standards, SEC financial reporting rules, and SEC independence requirements. Foreign auditors are still expected to demonstrate their knowledge and experience..” You can find this at http://www.sec.gov/divisions/corpfin/internatl/cfirdissues1104.htm#P313_42976. This approval generally comes from the SEC Office of Chief Accountant.

So just a little tip for all you professionals involved with international transactions. Have a great weekend all.

Other investment banks, such as Rodman & Renshaw, Maxim Group and Broadband Capital, have become involved in transactions with a similar structure. More and more Form 10 shells are now being created, including several groups set up by law firms active in this space. While of course the Form 10s are not for every deal, their utility in WRASP type deals is undeniable. Disclaimer: Our law firm has done work for all the firms mentioned in this post.

Some expressed concern about moving directly to the higher exchange. They like the idea of “practicing” being a public company on the OTCBB, where governance and other restrictions are not quite as stringent. Others watch many of these companies languish without an ability to uplist without great difficulty. You say potato, I say potato…

Thanks, RMR, for a more balanced piece than those you have written in the past about these clean shells.

This is pretty straightforward. If you combine with a shell that trades on the Pink Sheets or the OTC Bulletin Board, when you complete the reverse merger, trading simply continues. The same people who had tradable shares before the merger continue to have their shares after and can trade them. The thing is, though, if those people represented maybe 30-40% of the total shares outstanding of the shell (because the balance is typically controlled by a majority shareholder whose shares generally are not tradable), following the transaction they may only represent 1-2% of the total shares outstanding. Thus, the entire “public float” of a company immediately after merging with a trading OTCBB shell is very small indeed. Until more shares become tradable either by being registered with the SEC or applying an exemption from registration, that small float, which rarely trades much at all, will be the company’s entire float. But more about getting to “real” trading in the next installment. But yes, there is technically a trading market immediately after the merger in this situation.

If you start with a Form 10 shell, no trading takes place before or immediately after the reverse merger. Until shares become tradable, through registration or exemption, no trading will start. This usually takes 2-3 months from the merger. This is one of the reasons Form 10 shells are much less expensive to acquire than an OTCBB shell. Put a placeholder on this for the next installment.

In a self-filing, trading does not commence until the SEC approves the company’s registration statement, which usually takes 2-4 months from filing with the SEC. Trading is limited to those whose shares are registered, typically not a large number.

OK, the most important question, when does real trading begin, answered next time.