On June 9, 2011, the SEC issued an Investor Bulletin detailing the risks of investing in companies that "go public" by utilizing a reverse merger. Reverse mergers enable a private operating company to merge with an existing public company and access the U.S. capital markets without having to go through the process of an IPO. Generally, in a reverse merger, the public shell company survives the merger, but the private operating company's shareholders and management take over the public shell company. The reverse merger is perceived as a less costly way for a private company to gain access to the U.S. capital markets since there is no registration statement required and the public shell company is only required to report the reverse merger in a Form 8-K filing with the SEC.
In its Investor Bulletin, the SEC warns of the specific risks associated with investing in reverse merger companies and includes the following examples of risk factor disclosures made by reverse merger companies in their SEC filings:
- Because we became public by means of a "reverse merger," we may not be able to attract the attention of major brokerage firms.
- Additional risks may exist since we will become public through a "reverse merger." Securities analysts of major brokerage firms may not provide coverage of us since there is little incentive to brokerage firms to recommend the purchase of our common stock. We cannot assure you that brokerage firms will want to conduct any secondary offerings on behalf of our company in the future.
- The transaction involves a reverse merger of a foreign company into a domestic shell company; as a result, there is no history of compliance with United States securities laws and accounting rules.
- Our management has no experience in managing and operating a public company. Any failure to comply or adequately comply with federal securities laws, rules or regulations could subject us to fines or regulatory actions, which may materially adversely affect our business, results of operations and financial condition.
- We will incur significant costs to ensure compliance with United States corporate governance and accounting requirements.
- We may not be able to meet the filing and internal control reporting requirements imposed by the SEC resulting in a possible decline in the price of our common stock and our inability to obtain future financing.
- As a public company, we are obligated to maintain effective internal controls over financial reporting. Our internal controls may not be determined to be effective, which may adversely affect investor confidence in us and, as a result, decrease the value of our ordinary shares.
- The relative lack of public company experience of our management team may put us at a competitive disadvantage.
In addition, the SEC noted that it has suspended trading in the securities of six reverse merger companies and has revoked the securities registration of multiple reverse merger companies.
Additionally, on June 8, 2011, the SEC issued a release addressing NASDAQ's proposed rule change to adopt additional listing requirements for reverse merger companies. Currently, while NASDAQ does impose heightened review procedures on reverse merger companies, NASDAQ does not have any formal rules governing listing of these companies, which enables these companies to become listed if they comply with the general listing requirements.
The proposed rule change would prohibit a reverse merger company from applying for listing until at least six months after it submitted all required information about the transaction, including audited financial statements, with the SEC. In addition, the proposed rule change would require the company to maintain a bid price of $4 per share or higher in at least 30 of the 60 days before filing its initial listing application. Finally, NASDAQ would not approve a reverse merger company for listing until the company had timely filed its most recent two required periodic financial reports with the SEC in the case of a domestic issuer, or comparable reports in the case of a foreign private issuer.
NASDAQ justifies this proposed rule change under Section 6(b)(5) of the Exchange Act as preventing fraudulent and manipulative practices and promoting equitable principles of trade. NASDAQ claims there have been allegations of widespread fraudulent behavior associated with reverse merger companies and concerns that the individuals promoting reverse merger transactions are disproportionately benefitting from them at the expense of the public shareholders. NASDAQ also suggests that it is aware of situations where reverse merger companies have manipulated their prices higher to satisfy NASDAQ's initial listing bid price requirement. NASDAQ believes that the six month requirement will allow regulators to view trading patterns and uncover potentially manipulative trading and that these regulations will discourage inappropriate behavior of the companies and their promoters.
To see the Investor Bulletin, go to:
To see the SEC release addressing NASDAQ's proposed rule change, go to: