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The Definition Of A Shell Company In A Reverse Merger: Implications And Change Of Control

Ten weeks of blogs on the new SPAC and shell company rules provide the perfect segue to discuss exactly what a “shell company” is in the context of a reverse merger and its implications – including one heartburn-inducing unintended consequence. As has been discussed over the past few weeks, the new rules specifically apply to any reverse merger with a shell company, not just a SPAC shell company.

Our securities lawyers at ANTHONY, LINDER & CACOMANOLIS, PLLC, based in West Palm Beach, diligently follow and interpret the ever-changing SEC regulations with respect to reverse mergers.

Rule 145a And The Filing Of A Registration Statement

New Rule 145a deems any business combination of a reporting shell company involving another entity that is not a shell company to entail a sale of securities to the reporting shell company’s shareholders. Nothing in Rule 145a would prevent or prohibit the use of a valid exemption, if available, for the deemed sale of securities; however, there is no such known available exemption, and the SEC rule release not only does not suggest one but also specifically clarifies that Section 3(a)(9) would not be available.

As a result, the SEC release suggests that every reverse merger with a publicly reporting (and trading) shell company, including SPACs, will require the filing of a registration statement on Form S-4 or F-4. For more on new Rule 145a, see https://securities-law-blog.com/2024/04/09/sec-adopts-final-rules-on-spacs-shell-companies-and-the-use-of-projections-part-7/. Interestingly, a scenario has arisen in the weeks since that blog was written, which leaves us to question if an S-4 will always be necessary. A discussion follows further below:

New Financial Statement Requirements

Similarly, New Rule 15-01(a), amended Rule 1-02(d) and amendments to the instructions to Forms S-4 and F-4 align the financial statement requirements in a merger with those required in an IPO on Forms S-1 or F-1. For more on the new financial statement requirements, see https://securities-law-blog.com/2024/04/16/sec-adopts-final-rules-on-spacs-shell-companies-and-the-use-of-projections-part-8/.

The new rules certainly do not have the only implications for shell company reverse mergers. Over the years, the SEC has created many rules and policies that impose limitations on public companies that are or ever were shell companies, and that has resulted in reverse mergers with public shell companies. A review of these limitations and shell company implications is included below.

The Statutory Definition Of A Shell Company

Securities Act Rules 405 and 144 and Exchange Act Rule 12b-2 define a “shell company” as any issuer, other than a business combination related shell company as defined in Rule 405 or an asset-backed issuer, that has: (i) no or nominal operations; and (ii) either no or nominal assets or assets consisting solely of cash or cash equivalents or assets consisting of any amount of cash and cash equivalents and nominal other assets. A company will not be considered a shell simply because it is a startup or has a limited operating history.

The SEC’s Recent Guidance On Shell Companies

The reverse merger marketplace has always been very active on OTC Markets, but in the last few years, it has become much more active on Nasdaq and NYSE/NYSE American, as well as many companies have struggled with depressed valuations and the ability to maintain continued listing requirements. Through consistent comment letters issued as part of these transactions, the SEC has communicated a policy whereby they are treating a public company as a shell company if the primary purpose of the reverse merger is to provide cash and a stock exchange listing to a private company and especially so where the reverse merger is accounted for as a reverse capitalization.

More recently, SEC Division of Corporation Finance Chief Counsel Michael P. Seaman participated in a panel at the annual The SEC Speaks in 2024 and discussed the staff’s interpretation of the definition of “shell company,” particularly in the context of reverse mergers. The comment letters and SEC public comments are forming the foundation of an SEC policy whereby the SEC will analyze whether a public company is a shell company, considering:

Whether the primary purpose of the reverse merger is to provide cash and a stock exchange listing to a private company
Whether the transaction is accounted for as a reverse capitalization
Whether the prior operations of the public company will continue post-business combination and to what extent
Whether the combined company will maintain employees, offices or other operational aspects of the pre-merger public company for a meaningful period of time post-business combination
Whether the pre-closing public company assets will be sold or otherwise divested
Whether the pre-closing public company stockholders receive a contingent value right (CVR) entitling them to the value of legacy assets of the public company to be sold following the closing of the business combination

The Implications Of A Public Company Being Deemed A Shell Company

The implications of being deemed a shell company are numerous and, in general, merely align the new combined company to the same position it would be in as if it had completed an initial public offering (IPO). However, there could be unintended consequences that require either rule amendments or guidance for correction. In particular:

Must comply with new Rule 145(c) and file a registration statement as to all reverse merger transactions.
Must comply with New Rule 15-01(a), amended Rule 1-02(d) as to the financial statements included in the business combination registration statement.
Financial statements and Form 10 information for the acquired business must be filed within four business days of the completion of the business combination in a Super 8-K (financial statements for an acquired business by a nonshell are not due until 71 days following the filing of the initial closing 8-K).
A shell company and post-business combination company will be an ineligible issuer for three years following completing a business combination and, as such, (i) is not entitled to use a free writing prospectus in its IPO or subsequent offerings; (ii) cannot qualify as a well-known seasoned issuer (WKSI); (iii) may not use a term sheet free writing prospectus available to other ineligible issuers; (iv) may not conduct a road show that constitutes a free writing prospectus, including an electronic road show (see https://securities-law-blog.com/2020/09/29/the-virtual-roadshow/ for more on road shows and eligibility considerations); and (v) may not rely on the safe harbor of Rule 163A from Securities Act Section 5(c) for pre-filing communications made more than 30 days prior to the filing of the registration statement (see https://securities-law-blog.com/2014/08/12/public-offering-process-avoid-gun-jumping/ for more on gun jumping).
A shell company and post-business combination company don’t qualify to use incorporation by reference in Exchange Act reports, proxy or information statements or Form S-1 (including forward incorporation by reference) until three years after completing a business combination (see https://securities-law-blog.com/2019/10/29/incorporation-by-reference/ for more on incorporation by reference).
A shell company and post-business combination company cannot use Form S8 to register any management equity plans until 60 days after completing a business combination and filing Form 10 information.
A shell company and post-business combination company may not file an S-3 in reliance on Instruction I.B.1 (full shelf) or 1.B.6 (the baby shelf rule) until 12 months after it ceases to be a shell and has filed “Form 10” information (i.e., the information that would be required if the company was filing a Form 10 registration statement) with the SEC reflecting its status as an entity that is no longer a shell company.
Holders of shell company securities may not rely on Rule 144 for resales of their securities until one year after the company completes a business combination and has filed current “Form 10” information with the SEC reflecting its status as an entity that is no longer a shell company and so long as such a company remains current in its SEC reporting obligations.
The unavailability of Rule 145(c) on a Form S-1 resale registration statement. That is, affiliates of the private company who received securities of the public company in the business combination will be statutory underwriters with respect to resales of those securities, and as such, they may be sold only in a fixed price offering in which such investors are named as underwriters in the prospectus.

Potential Unintended Consequences: The Seasoning Rule

Although all the unintended consequences cannot be known, there is one that stands out front and center, and it would result in a reverse merger with a public company “deemed a shell” being treated completely differently than a reverse merger with a SPAC. Nasdaq, NYSE and NYSE American all have “change of control” rules. In general, the exchanges require shareholder approval prior to the issuance of securities when the issuance or potential issuance will result in a change of control of the company (for more on the change of control shareholder voting rules, see https://securities-law-blog.com/2019/04/09/nasdaq-and-nyse-american-shareholder-approval-requirements-change-of-control/). This is innocuous enough.

However, each of the exchanges also has rules requiring that a new initial listing application be filed where there is a change of control as a result of a business combination with a nonlisted entity. Nasdaq Rule 5110(a) provides:

A company must apply for an initial listing in connection with a transaction whereby the company combines with a nonNasdaq entity, resulting in a change of control of the company and potentially allowing the nonNasdaq entity to obtain a Nasdaq listing. In determining whether a change of control has occurred, Nasdaq shall consider all relevant factors, including, but not limited to, changes in the management, board of directors, voting power, ownership and financial structure of the company. Nasdaq shall also consider the nature of the businesses and the relative size of the Nasdaq company and nonNasdaq entity. The company must submit an application for the post-transaction entity with sufficient time to allow Nasdaq to complete its review before the transaction is completed. If the company’s application for initial listing has not been approved prior to consummation of the transaction, Nasdaq will issue a Staff Determination Letter as set forth in Rule 5810 and begin delisting proceedings pursuant to Rule 5800 Series.

This provision, which applies regardless of whether the company obtains shareholder approval for the transaction, requires companies to qualify under the initial listing standards in connection with a combination that results in a change of control. It is important for companies to realize that, in certain instances, the conversion of a Future Priced Security may implicate this provision. For example, if there is no limit on the number of common shares issuable upon conversion or if the limit is set high enough, the exercise of conversion rights under a Future Priced Security could result in the holders of the Future Priced Securities obtaining control of the listed company. In such an event, a company may be required to reapply for the initial listing and satisfy all initial listing requirements.

NYSE American Company Guide Section 341 Provides:

If a listed issuer engages in a reverse merger (as defined below), it will be eligible for continued listing on the exchange only if the post-transaction entity meets the standards for initial listing.

For the purposes of this provision, a “reverse merger” is a transaction or series of transactions whereby a listed issuer combines with, or into, an entity not listed on the exchange, resulting in a change of control of the listed issuer and potentially allowing such an unlisted entity to obtain an exchange listing. In determining whether a change of control constitutes a reverse merger, the exchange will consider all relevant factors, including, but not limited to, changes in the management, board of directors, voting power, ownership and financial structure of the listed issuer. The exchange will also consider the nature of the businesses and the relative size of both the listed issuer and the unlisted entity.

The exchange will refuse to list additional securities of a listed issuer in connection with a reverse merger unless the post-transaction entity meets the standards for initial listing and the listed issuer obtains shareholder approval of the issuance of such securities as required by Section 713(b). In addition to the applicable per-share fee for additional listings set forth in Section 142, there is a one-time charge of $10,000 for listings of additional securities in connection with reverse mergers unless the effective date of the reverse merger occurs within 24 months following the initial listing on the exchange, in which case there is a one-time charge of $5,000 for listings of additional securities and no per share fee for additional listings.

The exchange should be consulted whenever a listed issuer is contemplating a transaction or series of transactions that could constitute a reverse merger. If the exchange determines that a transaction or series of transactions constitute a reverse merger, the listed issuer must submit an initial listing application for the post-transaction entity with sufficient time to allow the exchange to complete its review before the effective date of the reverse merger. If the initial listing application has not been approved prior to the effective date of the reverse merger, the exchange will issue a Staff Determination Letter as set forth in Section 1202 and begin delisting proceedings pursuant to Part 12.

Our firm has completed numerous reverse mergers with listed companies, including the initial listing application process. But what happens if the public company is deemed a shell as part of the process? Nasdaq, NYSE and NYSE American all have a listing standard known as the seasoning rule. The seasoning rule is substantially the same for each exchange and provides that:

A company that is formed by a reverse merger with a shell company, other than a listed SPAC, will only be eligible to submit an application for initial listing and thereafter qualify to be listed if, immediately preceding the filing of the initial listing application, the post-business combination company:

Has traded for at least one year in the U.S. over-the-counter market, on another national securities exchange, or on a regulated foreign exchange, following the filing with the SEC or Other Regulatory Authority of all required information about the transaction, including audited financial statements for the combined entity (a Super 8-K)
Timely filed with the SEC of all reports since the consummation of the reverse merger for a period of one year
Filed at least one annual report with a full-year audit of the post-closing combined company financial statements
Maintained a closing price equal to the share price requirement applicable to the initial listing standard under which the reverse merger company is qualifying to list for a sustained period of time, but in no event for less than 30 of the most recent 60 trading days prior to approval

The rule includes an exception for companies that complete a firm commitment offering resulting in net proceeds of at least $40 million.

Connecting the dots, will a reverse merger with an exchange listed public company that is deemed a shell prohibit a continued listing unless there is a concurrent firm commitment to a public offering of $40 million or more? Certainly, the exchanges are not bound by the SEC policy of deeming a company a shell for purposes of reverse merger transactions, but we can tell you that they look closely at the satisfaction of the seasoning rule in an uplisting from OTC Markets following a reverse merger.

The seasoning rule specifically exempts SPACs, so they are in the clear. Hopefully, the exchanges will provide guidance and clarity on this potential issue sooner rather than later.

Meanwhile, our securities lawyers at ANTHONY, LINDER & CACOMANOLIS, PLLC, can provide counsel and advice to help your organization navigate the ever-evolving SEC regulations in any applicable merger and acquisition scenario.

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