SEC, Nasdaq and NYSE Increasing Oversight of Reverse Mergers

Corporate / Financial Institutions Alert

October 18, 2011
Corporate / Financial Institutions Alert

What Is a Reverse Merger
Many private companies seek to access U.S. capital markets by acquiring control of existing public companies. These transactions are commonly referred to as “reverse mergers.”

In a reverse merger, an existing public “shell company,” which is a public reporting company with few or no operations, is in effect acquired by a private operating company. The shareholders of the private operating company exchange their shares for most of the shares of the public company, thereby gaining a controlling interest in the public shell company. The private operating company replaces the board of directors and management of the public shell company. The post-merger surviving public company’s assets and business operations are primarily, if not solely, those of the former private operating company.

The U.S. Securities and Exchange Commission (SEC) has expressed concern about reverse mergers, most recently having issued an Investor Bulletin on June 9, 2001, warning investors about the risks involved in investing in such entities, especially those involving foreign private operating companies. Risks associated with such entities include their not being able to comply with the SEC’s filing and internal control requirements and a lack of history of complying with SEC regulations and public company accounting rules.

In the last year, the SEC has suspended trading in a number of reverse merger entities and revoked the registration of a number of these companies. The revocations occurred due to a failure of the entities to make required filings with the SEC. 
Significant concerns have also arisen relating to accounting fraud allegations with respect to a number of companies following reverse mergers. The SEC recently brought an enforcement proceeding against an audit firm relating to its work for companies surviving a reverse merger.

The SEC is seeking comment on whether it should approve rule changes proposed by The NASDAQ Stock Market LLC (Nasdaq) which would add additional listing requirements for a company that has become public through a reverse merger. The SEC is also seeking comment on the New York Stock Exchange reverse merger rule changes discussed below.

Under the Nasdaq proposal, Nasdaq would treat as a reverse merger any transaction whereby an operating company becomes public by combining with a public shell, whether through a reverse merger, exchange offer or otherwise. A reverse merger would not include:

Nasdaq has proposed certain “seasoning” requirements in connection with the listing of reverse merger companies:

The six-month period referenced above would not begin to run until the filing of a Form 8-K. A company must file a Form 8-K within four days of completing a reverse merger. The Form 8-K must contain audited financial statements and information comparable to the information provided in a Form 10 for the registration of securities.

The New York Stock Exchange LLC and the NYSE Amex LLC (collectively, the “NYSE”) have filed with the SEC proposals to adopt additional listing requirements for a company that has become public through a reverse merger. Because of the differences between the proposals, the SEC is seeking comment on these rule changes along with the rule changes proposed by Nasdaq.

The NYSE proposed listing requirements would apply to combinations with a “shell company” that is a public company, through a reverse merger, exchange offer or otherwise. In determining whether a company is a shell company, the NYSE would consider, among other factors:

The company surviving the reverse merger would not be eligible for listing on the NYSE (or AMEX) unless the combined entity had, immediately preceding the filing of the initial listing application:

The NYSE would have the discretion to impose more stringent requirements than those set forth above. Factors that would be considered include:

In addition to meeting the criteria set forth above, a company that was formed by a reverse merger would be required to comply with one of the initial listing standards for operating companies set forth in Section 102.01C or 103.01B of the NYSE Listed Company Manual (Manual) and the applicable distribution, stock price and market value requirements of Sections 102.01A and 102.01B of the Manual (in the case of companies listing pursuant to Section 102.01) and Section 103.01A (in the case of companies listing pursuant to Section 103.01). 

A reverse merger company would not have to comply with the proposed requirements if it was listing on the NYSE in connection with an initial firm commitment underwritten public offering (as defined in the NYSE rules). In such an offering the proceeds to the company would have to be sufficient on a stand-alone basis to generate $40 million in aggregate market value of publicly held shares. Furthermore, the offering must be made subsequent to or concurrently with the reverse merger. A company may list with the NYSE in connection with its initial firm commitment underwritten public offering if:

The prospectus and registration statement covering the offering would thus need to relate to the combined financial statements and operations of the reverse merger company. 

Comparison of Nasdaq and NYSE Proposals
Although similar to the Nasdaq proposal in many respects, the NYSE proposal contains certain provisions that materially differ from it. For example, the NYSE proposal would:

The NYSE proposal includes an exemption from the proposed listing requirements for reverse merger companies when the listing is in connection with an initial firm commitment underwritten public offering where the proceeds will be at least $40 million and the offering is occurring subsequent to or concurrently with the reverse merger. The Nasdaq proposal does not include such an exemption.

The SEC believes that the Nasdaq proposal should be considered together with the NYSE proposal to assure that the exchanges develop and implement consistent and effective enhancements to their listing standards, to best address the serious concerns that have arisen with respect to the listing of reverse merger companies. 

For further information, please contact Timothy M. Sullivan or your regular Hinshaw attorney.

Tax Advice Disclosure: To ensure compliance with the Internal Revenue Service regulations governing the issuance of advice on Federal tax issues, we advise you that any tax advice in this communication (and any attachments) is not written with the intent that it be used, and cannot be used, to avoid penalties that may be imposed under the Internal Revenue Code.

This alert has been prepared by Hinshaw & Culbertson LLP to provide information on recent legal developments of interest to our readers. It is not intended to provide legal advice for a specific situation or to create an attorney-client relationship.