All the Securities and Exchange Commission wants to do is eliminate a hotbed of fraud arising from trading shares of "shell corporations." You might think that such an admirable task would be universally endorsed. You would be wrong.
"Shell" corporations have public stockholders and no current business. These shells come in two flavors: Newly minted shells built for the sole purpose of acquiring a private company, or former operating companies without any current business (either because their idea failed or because their prior business was acquired).
Typically, a private company is merged into the shell. The owners of the private company control a majority of the shell’s shares, but the original shell shareholders retain some equity ownership.
The private company benefits from becoming immediately "public," being able more easily to raise funds, compensate executives, deliver public stock in acquisitions, and provide liquidity to founders. Such a "shell transaction" assists smaller businesses that may not qualify for an IPO under then-current market conditions.
(A second method involves merging the shell into the private company. Technically the surviving private company thereupon is treated as a public company in much the fashion of a typical shell transaction).
Because the present regulatory scheme requires after-the-fact filing of information about shell transactions, shells became vehicles for fraud. Sometimes the promoters issued substantial numbers of shares to themselves, and sold those shares at inflated prices prior to the filing of financial information.
Sometimes new shares were issued pursuant to abbreviated registration statements on SEC Form S-8, which registers shares issued to officers, directors, employees and consultants without preparing a detailed prospectus containing financial information. Promoters sold their shares at high prices based upon misleading optimistic statements, and then when the financial statements were required to be filed, the value of the shares fell like a stone.
The promoters were nowhere to be seen. The marketplace adopted a charming euphemism for such schemes: "pump and dump."
Under existing practice, a public company involved in a shell transaction has 15 days to report the "significant acquisition of assets" on a simple Form 8-K, and an additional 60 days to file audited financial statements of the acquired business.
Under previously approved 8-K amendments (effective Aug. 23), that general format is retained, although the report of the acquisition itself is accelerated to four business days after the transaction, with the financial statements now due 71 days thereafter, retaining the aggregate 75 day window.
The SEC Responses
On June 9, in a highly unusual administrative action against 26 "shell" companies, the SEC suspended public trading due to lack of current information. These companies, typical of many shells awaiting an acquisition of an operating private company, had failed to file current SEC reporting forms. If any one of them had acquired a private company, trading could have continued for 75 days before meaningful financial disclosure became available.
Such action, however, addressed only the symptom, not the root regulatory weakness of present shell regulation.
On April 15, the SEC had proposed two simple new "rules" designed to alter the shell regulatory context, and solicited public comment by June 7.
First, since Form S-8 permitted the issuance of shares without providing extensive information, and since in shell transactions there is not sufficient public information otherwise available, companies involved in shell transactions would be prohibited from utilizing Form S-8 for 60 days after a shell transaction.
Second, because of speculative trading in shell shares during the 75-day period prior to filing financial information, the disclosure requirements would be changed to demand filing of full information, including financial statements, within four days after the consummation of a shell transaction.
On the surface, these proposed two rules seem logical. It’s not like any significantly different information is required; it’s just that the timing of that information is accelerated. Parties could delay effectuation of the shell transaction until disclosure was available for filing.
Simple enough, but the public’s written commentary, filed with the SEC, has disclosed substantial disagreement as to the wisdom of these proposed Rules.
Definition Of A Shell
The definition of a "shell" was attacked from every direction. The SEC proposed a somewhat soft definition: An entity with no or "nominal" operations and with no or "nominal" assets (or assets consisting solely of cash and cash equivalents). Some commentary stated that this was too vague, and that a bright-line test was required.
Others stated that no bright-line test is possible, because you must look at the behavior of a company. If a company abandons its business idea, infuses new assets and adopts a new business idea, and/or changes its management team, then you have gone through a shell transaction. The fact that a company for a moment has nominal operating assets, or was holding cash, is irrelevant.
The American Society of Corporate Secretaries, with a membership consisting mostly of lawyers serving over 3,000 issuers, argued to exclude from the definition of "shell" any company that had sold its business in the last 18 months and had bona fide employees who were seeking another business. The intent was to differentiate between legitimate public companies momentarily without operations, and shells established by promoters with a more cynical agenda.
Many commentators feared that a pure start-up could accidentally drift into the "shell" definition. A start-up doing research might have nominal operations, and could indeed have either nominal assets or assets consisting only of cash. Why should such a company find itself subject to shell company regulation?
The Four-Day Filing Requirement
Since the main problem was a failure to promptly provide information to the public following a shell transaction, allowing promoters time to hype and sell their stock, the proposed rule would require that complete information be filed within four business days after a shell transaction.
Not only would the company be required to file information concerning the acquisition (presently due in 15 days and soon to be due within four days when the Aug. 23 amendments to Form 8-K become effective), but full financial information also would be filed at the same time.
Additionally, the company would file such other information as would be required to register a new class of securities under the Securities Exchange Act of 1934. Although such additional disclosures are informative, the point that would impact shell transactions the most is requiring prompt financial information.
Several commentators claimed that since the rule creates only a timing difference, and not a very significant one at that, little impact should be felt on legitimate transactions. On the other extreme, one small business group excoriated the Commission for increasing costs and placing roadblocks in the way of legitimate capital formation for small businesses.
Others reasoned that the sin was not the absence of information per se, but rather the trading of shares in the absence of information. Consequently, one could retain the 75-day filing period so long as trading was prohibited. Consequently, proposals were made to prevent trading by consultants, or trading by individuals closely affiliated with the shell company, or to suspend the operation of the rule if in fact there is no trading market for the stock or if the company agrees to halt trading.
Some comments addressed the primary evil of pump and dump, but would otherwise leave the existing public shareholder base in possession of transferable securities absent adequate information. Any securities sale might either be unfair to the seller or the buyer, depending upon the facts disclosed by subsequent filings.
Delaying S-8 Availability
The SEC proposed to deny utilization of S-8 because it was the mechanism by which promoters obtained additional shares, whereupon those shares could be pumped and dumped.
The SEC solution was simple: Don’t allow S-8s until 60 calendar days after a full informational filing. Although there was modest support for such a proposal, other commentary reached apoplectic proportions.
Some commentators noted that abusive capital raises through S-8 offerings are not restricted to shells, and that the rule would not reduce non-shell-related fraud. It is difficult to understand how such an argument would deter the SEC from adopting the proposed Rule. Rather, the logical response would be to further regulate S-8s in other arenas.
Six commentators stated that S-8 should continue to be available to employees, officers and directors at all times following a shell transaction, since such persons in fact continue to be working for the benefit of a legitimate shell. The presumably evil consultant, not on the payroll, would not have S-8 available during this period. Such an approach appears simplistic. Why would evil consultants not simply structure future transactions so as to make themselves part of the eligible class?
Some commentary revolved around the practice of issuing vast numbers of shares under S-8s, and suggested limiting the number of shares allowed under an S-8 to a modest additional issuance (say 20 percent of the previously issued shares), thus allowing enough room to fairly compensate employees, but preventing promoters from dumping a huge quantity of stock.
Such a solution has a surface appeal, but assumes that future fraud will follow in the track of prior fraud, an assumption that must be viewed even in the kindest of lights as simply naïve. Looked at another way: If you can pump a stock up high enough, you can do a lot of damage to the investing public by selling "only" 20 percent of the shares at hyped prices.
Several factors are at play here.
In the face of clear abuse, the SEC must act. Every regulatory format impinges some activity. Definitions are difficult and parties working legitimately but near the edge of those definitions are placed at risk. To some, any new regulation is anti-small business. Few large businesses will go anywhere near shell transactions, and the perception of bias against small business is heightened.
On a broader note, what is happening here is the testing of the wisdom of "front-end" regulation. Attempting to eliminate fraud by regulating it out of existence is a difficult undertaking (the fraud will just reshape itself around the new regulatory restrictions). The SEC here is coming perilously close to negatively impacting practices that many attorneys consider to be wholly legal (if not mainstream). Yet, shrinking the scope of the SEC proposals creates large loopholes.
The problem shared by both the public and the SEC is that if you’re a crook, governmental rules and regulations are not guidelines, merely speed bumps in the road.
Stephen M. Honig is a member of Duane Morris’ corporate department, and is a resident in its Boston office. His practice includes counseling public companies in matters of SEC compliance and corporate governance.