“Back door” initial public offerings, or IPOs, have long been subject to heightened scrutiny by the Securities and Exchange Commission (the “SEC”), particularly where the IPO is effected through a combination with a public “shell company”, whether through a reverse merger, exchange offer or otherwise. The SEC has also looked hard at Special Purpose Acquisition Companies (“SPACs”), companies with no current business activities but who have a business plan to raise capital in an IPO and subsequently engage in a merger or other acquisition transaction with one or more other companies not identified at the time of the IPO. The recent actions by the SEC and the NASDAQ Stock Market LLC (“NASDAQ”) discussed below make clear that back door IPOs will continue to attract heightened regulatory scrutiny but may also reflect greater acceptance of SPACs.

Proposed NASDAQ Additional Listing Requirements

On May 26, 2011, NASDAQ proposed additional listing requirements for companies going public by way of a reverse merger or other back door IPOs.1 In a typical reverse merger transaction, an existing public “shell company,” a public reporting company with few or no operations, acquires all of the equity of a private operating company. The shareholders of the private operating company exchange their shares for a negotiated percentage of the shares of the public shell company. Although the public shell company is the surviving corporation in the reverse merger, the private operating company’s shareholders often obtain a controlling interest in the public shell company as a result of the reverse merger. Consequently, the former officers and directors of the private operating company typically assume control of the board of directors and management of the public shell company. In effect, the private operating company has “gone public” without conducting a traditional underwritten IPO.

NASDAQ’s proposed additional listing requirements for companies going public in this manner comes at a time of heightened scrutiny of reverse merger transactions. The SEC has released an Investor Bulletin dated June 9, 2011 in which it advised that “investors should proceed with caution when considering whether to invest in reverse merger companies” because, among other reasons, “there have been instances of fraud and other abuses involving reverse merger companies.” Additionally, the SEC has over the past several months taken enforcement actions against a number of reverse merger entities alleging, among other things, concerns regarding the accuracy and completeness of information contained in their public filings. The Public Company Accounting Oversight Board has also over the past year issued both an “Audit Practice Alert” and a “Staff Research Note” cautioning registered accounting firms to follow certain specified auditing practices when auditing reverse merger companies.

In response to concerns that promoters and other individuals have attempted price and other forms of manipulation to artificially satisfy the applicable NASDAQ listing requirements, including the initial listing bid price requirement, NASDAQ had previously adopted heightened review procedures for reverse merger applicants. Given the continuing concerns regarding companies going public by way of a reverse merger, however, NASDAQ now believes that additional listing requirements for reverse merger companies are warranted.  

Accordingly, NASDAQ has proposed “seasoning” requirements whereby a company that is formed by a reverse merger would be eligible to apply for an initial NASDAQ listing only after the combined entity has, immediately preceding the filing of the initial listing application:  

  • traded for at least six months in the U.S. over-the-counter market, on another national securities exchange, or on a 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; and  
  • maintained a bid price of $4 per share or higher on at least 30 of the most recent 60 trading days.

In addition, a company subject to the new listing requirements would only be approved for listing if, at the time of approval, the company has timely filed:  

  • in the case of a domestic issuer, its most recent two required periodic financial reports with the SEC or other regulatory authority (i.e., Forms 10-Q or 10-K) containing at least six months of information about the combined company; or  
  • in the case of a foreign private issuer, comparable information as described in (1) above on Forms 6-K, 20-F or 40-F.  

NASDAQ states that it believes these additional listing requirements will result in increased investor protection. Specifically, the six-month seasoning requirement will allow the Financial Industry Regulatory Authority, Inc. and other regulators more time to review trading patterns and uncover manipulative trading, result in a more bona fide shareholder base and assure that the $4 bid price was not satisfied through manipulation. The requirement for additional SEC filings is designed to improve the reliability of the reported financial statements, given that auditors and the audit committee will have reviewed at least several quarters of financial statements.  

SPACs Not Affected by Proposed New Requirements

NASDAQ’s proposed definition of what constitutes a reverse merger does not include the acquisition of an operating company by a listed company satisfying the requirements of IM-5101-2 (Listing of Companies Whose Business Plan is to Complete One or More Acquisitions). SPACs are designed to satisfy the requirements of IM-5101-2 and therefore will not be affected by NASDAQ’s proposed additional listing requirements with respect to reverse merger companies.  

While a SPAC is similar in some respects to a public shell company that engages in a reverse merger, there are important differences. For example, SPACs are not generally formed with a specified target company in mind, although SPACs generally do have a specified industry focus. Further, unlike the existing public shell company typically utilized in a reverse merger transaction, a SPAC utilizes a newly organized company without historical operations. Finally, SPACs are specifically designed to acquire private businesses and thus tend to have better economics, a management team composed of individuals who have demonstrated success in acquiring growing businesses or have experience in a specific industry, and an institutional investor base. In addition, references to SPACs are noticeably absent from any of the recent pronouncements expressing concern about reverse mergers and reverse merger companies.  

Conclusion

At this time none of the other national securities exchanges has proposed rules similar to those being proposed by NASDAQ. Given the current regulatory environment, however, it would be surprising if the other exchanges failed to take similar action at some point.