Alerts and Updates
SEC Adopts New Rules Governing Public Shells
July 29, 2005
On June 30, 2005, the Securities and Exchange Commission (SEC) adopted rules regarding publicly reporting "shell companies." The rules are designed to ensure that investors in shell companies that acquire operations have timely access to the same type of information as is available to investors in public companies generally. The rules will become effective on August 22, 2005, except new Item 5.06 to Form 8-K, which will become effective on November 7, 2005.
As adopted, the rules will:
- require a public shell company to report on Form 8-K an event that causes it to cease being a shell company and to include in that Form 8-K the same type of detailed financial and other information about the company as is required to register a class of securities under the Securities Exchange Act of 1934 (Exchange Act);
- prohibit a public shell company from using Form S-8 (the abbreviated registration statement used to register securities issued under employee benefit plans) until 60 days after it ceases to be a shell company; and
- require every public company to check a box on the cover of all annual and quarterly reports to identify whether or not it is a shell company.
Why
While the SEC continues to recognize that shell companies can serve valuable purposes, the SEC has long been concerned with abuse involving public shells, particularly "pump-and-dump" schemes. In these schemes, shell promoters are issued large quantities of securities, typically under a Form S-8. The shell then acquires or merges with a private operating company in a "reverse merger" in which the owners of the private company receive a significant majority of the stock of the public shell. Prior to the new rules, financial statements of the acquired private company were not required to be filed until 75 days after completion of the merger and detailed information about the business and management of the acquired private company was not required until the shell filed its next annual report on Form 10-K. As a result, securities of the former shell could be traded for up to 75 days with investors having little or no access to vital information about the acquired private company. During this time, the promoters "pump" up the stock to artificially high prices, through press releases, Internet postings and similar means, then "dump" their stock and stop their promotional activities, causing the stock price to fall after they have realized substantial profits.
What It Means
The rules represent the SEC's most comprehensive and direct action to prevent abuses involving public shell companies. By requiring prompt disclosure of substantially the same type of financial and other information as is required in an initial public offering or to register shares under the Exchange Act, the SEC has substantially increased the time required to complete these transactions, while also reducing the time period during which shares of public shell companies can be traded before full and complete information is disseminated to the public - thus increasing the costs and reducing the incentive for unscrupulous market participants to promote such transactions. While reverse mergers will continue to serve legitimate corporate purposes, particularly during periods when the market for initial public offerings is closed, it will be interesting to see what effect the new rules will have on the number or quality of such transactions.
Definition of Shell Company
The new rules define a "shell company" as any company that files periodic reports under the Exchange Act that has
- no or nominal operations and either
- no or nominal assets or
- assets consisting solely of any amount of cash and cash equivalents and nominal other assets.
The SEC did not further define the term "nominal" and specifically rejected any quantitative threshold, concluding that a specific threshold would provide an easy way to circumvent the definition of "shell company" and avoid application of the new rules. The adopting release suggests that an evaluation of the term "nominal" encompasses more than merely a quantitative inquiry. For example, the SEC described a scenario in which a promoter or affiliate of a shell company, to avoid application of the "blank check company" rules, places assets or operations into a shell and, after completing a business combination, transfers the assets or operations back out of the shell. The SEC would consider such assets or operations to be "nominal" for the purpose of the definition of a shell company.
The definition of "shell company" excludes companies that are "business combination related shell companies" used to structure corporate transactions. These consist of:
- a shell company formed by an entity that is not a shell company solely for the purpose of changing that entity's domicile within the United States; and
- a shell company formed by an entity that is not a shell company solely for the purpose of completing a business combination transaction among one or more entities, none of which is a shell company.
Enhanced and Accelerated Disclosure on Form 8-K
The new rules include the following amendments to Form 8-K:
- Item 2.01 - Completion of Acquisition or Disposition of Assets has been amended to require substantial additional disclosure for shell companies;
- Item 5.01 - Changes In Control of Registrant has been amended to require substantial additional disclosure for shell companies;
- Item 9.01 - Financial Statements and Exhibits has been amended to require shell companies to file audited financial statements and pro forma financial information at the same time the initial Form 8-K is filed; and
- New Item 5.06 - Change In Shell Company Status has been added to require a shell company to report when it ceases to be a shell company.
Acquisitions
Items 2.01 and 9.01 of Form 8-K currently apply to shell transactions in which the public shell acquires a private operating company. Amended Item 2.01 requires a shell company to make a detailed filing on Form 8-K within four business days after completing such an acquisition. The Form 8-K must contain the same detailed information about the surviving company as would be required to register a class of securities under the Exchange Act (similar to the information required to register securities in an initial public offering). This includes a detailed description of the company's business and properties, management, executive compensation, related party transactions, legal proceedings and historical market price information, as well as management's discussion and analysis of results of operations. The SEC believes that such "prompt and proper" disclosure will deter abuse and provide investors with the information necessary to make informed investment decisions.
Item 9.01 of Form 8-K currently requires public companies that complete significant acquisitions to file audited financial statements of the acquired company not later than 75 days after completion of the acquisition. Amended Item 9.01 closes this window for shell companies by requiring that audited financial statements of the operating company and pro forma financial information be included in a single Form 8-K filed within four business days after completion of the transaction. The SEC stated that obtaining audited financial statements for the acquired operating company does not present the same difficulties that led it to provide the long window for other business combinations. In a typical shell company transaction, management of the continuing operating business is in control of the transaction and has the power to control the timing and preparation of the required financial and other information. As a result, the SEC concluded that management should not need the additional time to produce audited financial statements.
Change in Control Transactions
Item 5.01 of Form 8-K applies to shell transactions in which a private operating company acquires a public shell resulting in a change in control of the shell. Such transactions are sometimes referred to as "back-door registrations." Existing SEC interpretations permit the private company to succeed to the periodic reporting requirements of the public shell without the necessity of filing a registration statement under the Exchange Act. The new rules make this explicit by amending the definition of "succession" in Exchange Act Rule 12b-2 to include a change in control of a shell company that is required to be reported under Item 5.01 of Form 8-K or Rule 13a-19 or 15d-19 of the Exchange Act (in the case of a foreign private issuer). As a result, when a private operating company acquires a public shell, it will succeed to the reporting obligations of the shell company. Amended Item 5.01, like amended Item 2.01, requires the surviving company to file a Form 8-K within four business days after completion of such a transaction, setting forth the same detailed information about the surviving company, including audited financial statements and pro forma financial information, as would be required to register a class of securities under the Exchange Act.
Prohibition on Use of Form S-8
The new rules prohibit the use of Form S-8 by a shell company. Because, shell companies have only nominal operations, the sole function of their few employees and consultants is typically to identify potential acquisition or merger candidates or assist in capital raising. Since Form S-8 cannot be used to compensate consultants or advisors for providing services in connection with the offer or sale of securities in a capital-raising transaction, use of Form S-8 prior to adoption of the new rules was likely prohibited. The new rules make this prohibition explicit.
A company that ceases to be a shell company becomes eligible to use Form S-8 60 calendar days after it has filed its Form 8-K containing the detailed information that would be required to be filed to register a class of securities under the Exchange Act. The 60-day delay is consistent with the 60-day period between filing and effectiveness of the registration of a class of securities under the Exchange Act. The 60-day period does not apply to "business combination related shell companies."
Increased Scrutiny
New Item 5.06 of Form 8-K requires a shell company that completes a transaction in which it ceases to be a shell to report the material terms of the transaction. Similarly, Forms 10-K, 10-KSB, 10-Q and 10-QSB have been amended to include a check box on the cover sheet to indicate whether or not the filer is a shell company. The purpose of these amendments is to allow market participants and regulators to more quickly identify shell companies and transactions involving shell companies, and to more completely understand the terms of such transactions.
Foreign Private Issuers
If a shell company that is a foreign private issuer engages in a transaction with a domestic operating business that resulted in the shell company's loss of foreign private issuer status upon completion of the transaction, the surviving entity must file a Form 8-K upon completion of the transaction. The Form 8-K report must contain the same information as is required for domestic shell companies and must be filed within four business days after completion of the transaction.
Foreign private issuer shell companies that remain foreign private issuers after engaging in a transaction with a domestic operating business must also file detailed information, albeit on a different form. Since foreign private issuers are not subject to the Form 8-K rules, the required disclosure must be included on Form 20-F within four business days after completion of the transaction. Foreign private issuers are required to disclose on Form 20-F the same type of information as would be required to register a class of securities of a foreign private issuer that are subject to the reporting requirements of the Exchange Act. Rule 12b-25, which provides for extensions for the filing of periodic reports under the Exchange Act, has been amended to make it inapplicable to a Form 20-F filed for the purpose of reporting such transactions.
Shell companies that are foreign private issuers also are subject to the new rules regarding use of Form S-8. Accordingly, as with a domestic shell company, a foreign private issuer shell company is not eligible to file a registration statement on Form S-8 until 60 days after it files the information that it would be required to file if it were registering a class of securities under the Exchange Act.
For More Information
If you have any questions regarding these new rules, including how they may affect your company, please contact one of the attorneys of the Securities Law Practice Group or the Duane Morris attorney with whom you are regularly in contact.
Disclaimer: This Alert has been prepared and published for informational purposes only and is not offered, nor should be construed, as legal advice. For more information, please see the firm's full disclaimer.
