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Shell Game

by Michael W. Stocker and Yoko Goto
The Deal |
A boon for private companies seeking access to capital markets, reverse mergers offer little benefit for investors

While reverse mergers are becoming an increasingly popular way for companies to introduce themselves to U.S. capital markets,they may be more notable for what they hide than for what they reveal.

Simply put, a reverse merger is a method for a private company to raise capital on U.S. markets without undergoing the intense scrutiny associated with an initial public offering.

When companies go public via an IPO, Securities and Exchange Commission regulations require the filing of registration material containing robust disclosures regarding company business and financial performance.

Regulations also require that underwriters and auditors engage in due diligence that enhances the quality of such disclosures.

These requirements are intended to ensure that potential investors are provided with ample information to assess the risk of investing their capital. By making well-informed investment decisions, investors not only protect themselves, but ensure that market capital is allocated efficiently, adding to growth in the real economy.

In a reverse merger, a private company acquires, and then merges, with a pre-existing "shell" public company -- a company that, while public, is inactive or dormant, and lacks assets or operations of its own. Instead of hiring an underwriter to market and sell the company's shares as in an IPO, a private operating company works with a "shell promoter" to locate a suitable non-operating or shell public company.

Once a suitable shell company with no substantial operating business is found, the private operating company merges with the shell company by acquiring a majority stake in it in exchange for its operating company shares. Post-merger, the shell company contains the assets and liabilities of the operating company and is controlled by the former operating company shareholders. The shell company's directors and officers are replaced by those of the operating company, and its shares continue to trade on whichever stock market they were trading before the merger. Thus, the operating company's business is still controlled by the same group of shareholders and managed by the same directors and officers, but it is now contained within a public company.

Reverse mergers have obvious benefits for private companies, which can gain entry to U.S. exchanges without having to go through the expensive and time-consuming process for IPOs.

While the process for a conventional IPO can last a year or more, a reverse merger can be completed in as little as 30 days. This fast turnaround helps eliminate some risks arising from the long process involved in preparing for an IPO, such as weakening market conditions or deterioration of company performance upon which the offering is predicated.

While a boon for private companies seeking access to public markets, reverse mergers offer little benefit for investors. Most importantly, because no registration statement is required, the markets are deprived of key information about company performance and prospects that help mitigate risk.

In effect, as SEC Commissioner Luis Aguilar put it in a speech in April, reverse mergers give the formerly private companies the "credibility and access to capital of being registered as a public company" without involving the "vetting from underwriters and investors" that companies undergo in a traditional IPO process.

Troublingly, reverse mergers in recent years have become increasingly popular as a way of raising capital. According to a March 14 research note issued by the Public Company Accounting Oversight Board, more than 600 companies had used this method to access the U.S. capital markets from Jan. 1, 2007, to March 31, 2010. There are already signs of trouble in this new crop of public companies. In recent months, the SEC suspended trading or revoked the registrations of at least 11 entities formed through reverse mergers.

In response to growing concerns, on April 18 the Nasdaq filed a proposed rule change with the SEC designed to impose additional listing requirements on companies that become public through reverse mergers. The rule provides for a six-month wait period for all post-reverse merged companies to uplist to Nasdaq. During this six-month period, they must trade over the counter at a minimum of $4 a share, and the company must have completed several periodic filings with the SEC.

These rules, if enacted, may help provide investors with additional track records for companies undergoing reverse mergers, but prudent investors should remember that not all publicly traded companies are born equal.