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

New SPAC and shell company rules have prompted discussions on the concept of a “shell company” in reverse mergers. These rules may lead to unintended consequences, some of which could be problematic. The new rules apply to any reverse merger with a shell company, not just a SPAC shell company.

The Florida securities lawyers at ANTHONY, LINDER & CACOMANOLIS, PLLC, diligently follow and interpret the ever-changing SEC regulations with respect to reverse mergers.

Rule 145a And The Filing Of A Registration Statement

According to Rule 145a, a reporting shell company merging with a nonshell entity constitutes a securities sale to its shareholders. The rule doesn’t prevent using valid exemptions for deemed securities sales, if available. However, no known exemptions exist, and the SEC clarifies that Section 3(a)(9) isn’t available.

Every reverse merger with a public shell company, including SPACs, needs a registration statement on Form S-4 or F-4. For more on new Rule 145a, see this blog. Interestingly, a scenario arose since that blog’s publication, leaving us questioning if an S-4 will always be necessary. A discussion follows further below.

New Financial Statement Requirements

New Rule 15-01(a), amended Rule 1-02(d), and changes to form instructions align merger financial statement requirements with IPO standards. These requirements apply to Forms S-1 or F-1, ensuring consistency between mergers and IPOs. For more on the new financial statement requirements, see this blog.

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

The Statutory Definition Of A Shell Company

Securities Act Rules 405 and 144 define a “shell company” as any issuer with no or nominal operations. Exchange Act Rule 12b-2 adds that such a company has nominal assets or assets only in cash or cash equivalents. 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 the Nasdaq and the NYSE/NYSE American. Many companies have struggled with depressed valuations and the ability to maintain continued listing requirements. The SEC treats a public company as a shell company if a reverse merger primarily provides cash and a stock listing. This policy is especially applicable when the reverse merger accounts as a reverse capitalization.

More recently, SEC Division of Corporation Finance Chief Counsel Michael P. Seaman participated in a panel at the annual SEC Speaks in 2024. He discussed the staff’s interpretation of the definition of “shell company” in reverse mergers. The SEC uses comment letters and public comments to determine if a public company is a shell company. Factors taken into consideration include whether the:

• Purpose of the reverse merger is to provide cash and a stock exchange listing to a private company
• Transaction is a reverse capitalization
• Prior operations of the public company will continue post-business combination and to what extent
• Combined company will maintain employees, offices or other operational aspects of the premerger public company post-business combination
• Preclosing public company assets will be sold or otherwise divested
• Preclosing public company stockholders will receive a CVR for legacy asset value after the business combination closes

The Implications Of A Public Company Being Deemed A Shell Company

Shell company status has implications. The new combined entity is often positioned similarly to a company post-IPO, yet unintended consequences may necessitate rule amendments or guidance. Several compliance requirements and restrictions apply:

• The company must follow Rule 145(c), filing a registration statement for all reverse merger transactions. Compliance with New Rule 15-01(a) and amended Rule 1-02(d) regarding financial statements in the business combination registration statement is required.
• Financial statements and Form 10 information for the acquired business must be filed within four business days post-business combination in a Super 8-K, whereas a nonshell entity has 71 days post-initial closing 8-K.
• A shell company and post-business combination entity are ineligible issuers for three years after the combination, preventing use of free writing prospectuses in IPOs or subsequent offerings. They cannot qualify as a well-known seasoned issuer (WKSI) or use certain free writing prospectuses. The law prohibits road shows that constitute free writing prospectuses, and reliance on Rule 163A’s safe harbor is unavailable.
• These companies cannot use incorporation by reference in Exchange Act reports, proxy or information statements, or Form S-1 until three years post-business combination completion.
• Form S-8 registration for management equity plans is restricted until 60 days after completing a business combination and filing Form 10 information.
• They may not file an S-3 under Instruction I.B.1 or I.B.6 until 12 months post-shell status cessation and filing “Form 10” information.
• Holders of shell company securities cannot use Rule 144 for resales until one year after the combination, provided they file current “Form 10” information with the SEC.
• Rule 145(c) is unavailable on Form S-1 resale registration statements. Affiliates receiving public company securities in the combination are statutory underwriters, requiring fixed price offerings with named underwriters in the prospectus.

These implications underscore the complexities and compliance challenges faced by companies deemed shell entities.

Potential Unintended Consequences: The Seasoning Rule

Although all the unintended consequences cannot be known, there is one that stands out. A reverse merger with a “deemed shell” public company is treated differently than one with a SPAC. Nasdaq, NYSE and NYSE American have “change of control” rules requiring shareholder approval before issuing securities that change company control.

Exchanges require new initial listing applications when business combinations with nonlisted entities result in changes of control. Nasdaq Rule 5110(a) mandates companies apply for initial listing when merging with non-Nasdaq entities, potentially allowing non-Nasdaq entities to obtain a Nasdaq listing.

In determining whether a change of control has occurred, Nasdaq considers factors like management, board of directors, voting power, ownership and financial structure changes. Nasdaq also evaluates the nature and size of the Nasdaq companies and non-Nasdaq entities.

The company must submit an application for the post-transaction entity with sufficient time for Nasdaq’s review before closing. If the application does not receive approval before consummation, Nasdaq will issue a Staff Determination Letter as per Rule 5810 and begin delisting proceedings under Rule 5800 Series.

This provision applies regardless of shareholder approval, demanding qualification under initial listing standards for control-altering combinations.

Companies should realize that Future Priced Security conversion may implicate this provision. If there’s no limit on common shares issuable upon conversion or if the limit is high, conversion rights under a Future Priced Security could result in a control shift. In such cases, reapplication for initial listing may be required.

NYSE American Company Guide Section 341 Provisions

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

In this provision, a “reverse merger” is a transaction whereby a listed issuer combines with 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.

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 that could constitute a reverse merger. If the exchange determines that a transaction constitutes 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 does not receive approval before 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.

Understanding The Seasoning Rule: Navigating Reverse Mergers And Shell Company Listings

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 with a reverse merger with a shell company, other than a listed SPAC, is only eligible to submit an application for initial listing and thereafter qualify for listing, 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 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.

Will a reverse merger with an exchange-listed public company 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.

Our securities lawyers at ANTHONY, LINDER & CACOMANOLIS, PLLC, can help your organization navigate evolving SEC regulations in applicable merger and acquisition scenarios.

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