Reverse Mergers – A Shell Game

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For months there has been speculation that the S.E.C. will be suspending trading of shell companies that have not filed the required reports with the S.E.C. Shell companies are public companies that have become defunct, yet remain a public corporate entity. On June 9, 2004 the threat became a reality. The S.E.C. halted trading in the securities of roughly 25 shell companies that failed to disclose the appropriate information.

Shell companies represent the raw material for a back-door way to take a private company public, without going through the usual IPO process. This back-door method is called a reverse merger. The procedure is for a private company to acquire a public listed company and take over as the controlling entity in the shell company. The public company issues a large enough amount of shares to the private company to transfer the controlling interest of the public company to the private company. By doing this, the private company can become public without the intense regulatory scrutiny and the expense associated with IPOs.

In recent years, the IPO market has dried up for all companies, but it has become almost impossible for micro-cap companies to go public in this manner. Not the least of which is the fact that it makes no economic sense for an investment bank-given recent regulatory changes– to offer IPOs to micro-caps. As with any legislation, there is the intended impact of the rule changes and the unintended impact. One such unintended impact is the fact that smaller companies have a more difficult time raising capital and becoming public companies. Reverse mergers offer a viable and affordable way for them to do so.

Shell companies can not be created from scratch, they must be gleaned from the mass of defunct companies which are still listed, but have little or no assets and/or sales. Should there be an interest in pursuing a reverse merger, it is best to go to an expert, who will have identified conforming shell companies ahead of time.

Given the trading suspensions doled out yesterday, it is safe to say that the S.E.C. is serious about controlling the reverse merger industry. This does not imply that the industry is washed up, nor does it remove the economic rationale for going public by this route. What is does indicate is that reverse mergers should be executed using a qualifying shell corporation in an above-board manner and in consultation with an industry expert.

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