Pitfalls of Reverse Mergers Into Public Shell Companies

Client Advisory

April 2005


Owners of well developing and growing private companies are often advised by financial advisors that they can go public without going through an extensive SEC review process and incurring the expenses of an IPO by using the so called “reverse shell merger” technique.  For example, they might be attracted by a statement like this:

The transaction can be accomplished in as little as two weeks, resulting in the private company becoming a public company. The transaction does not go through a review process with state and federal regulators because the public company has already completed the process.[1]

Such statements appear reminiscent of alchemy.  The purpose of this article is to analyze in greater detail the legal structure, SEC filing requirements, reporting obligations and other aspects of a reverse shell merger.  First, this article will provide the reader with a general understanding of reverse shell mergers by defining the term Public Shell and explaining the purposes and disadvantages of going public through a reverse shell merger (Part I).  In Part II, certain corporate law issues related to a reverse shell merger, in particular the typical structure of such mergers and capital structure related issues, will be reviewed.  Part III, the core of this article, contains a detailed analysis of securities law related issues and pitfalls.  Part IV provides a brief summary of due diligence aspects that one should be aware of when working on a reverse shell merger.   Finally, the results of this article shall be summarized briefly in Part V. 

Part I.  General Aspects

1. Definition of Public Shell

Generally speaking, a public shell company (heretofore referred to as “Public Shell”) is a non-operating public company, which means a company registered, and filing periodic reports under, the Securities Exchange Act of 1934 (the “34 Act”).  Typically, Public Shells are listed on The Nasdaq Small Cap Market, the Nasdaq Bulletin Board or the Pink Sheets.  Public Shells can exist in three possible forms, and for due diligence purposes it is important to qualify them correctly, as will be discussed in Section IV.1.  The first form a Public Shell could take is as a start-up company that never achieved significant revenues.  This category generally includes Internet companies with (looking back) uninspired business ideas and models that have failed to achieve profitability.  Normally, these companies have a rather short business history and have never acquired or managed substantial assets.  The second category is that of a former operating company that went out of business or sold all of its operations.  This form spans the business spectrum, including any company whose management and major shareholders decided at some point to sell all assets but keep the company’s 34 Act registration alive to pursue a possible lucrative reverse shell merger.  Generally, these companies have a long business history and have owned substantial assets at some point in their history.  Finally and rarely, a Public Shell could be a company that was specifically formed and registered for the purpose of being sold in a reverse shell merger (also referred to as “Blank Check Company”).  These companies have normally no business history and have never acquired any assets. 

2. Purposes and Disadvantages of Reverse Shell Mergers

In a reverse shell merger, a privately held company (“Private Company”) merges into the Public Shell, or vice versa, for the following reasons:

  • it is supposedly a quick way for the Private Company to go public;
  • raising capital is supposedly easier for the post-merger surviving entity (assuming that the Public Shell had an adequate public float);
  • the surviving entity can grant stock incentives to employees;
  • the surviving entity may be able to accomplish corporate acquisitions in the future through the issuance of its stock; and
  • no underwriter is needed to go public through a reverse shell merger.

However, disadvantages of going public (including through a reverse shell merger) are:

  • complete (and expensive) financial disclosure is required for publicly-held companies under the 34 Act;
  • there are substantially higher costs of regulatory compliance for the audit, legal and investor relations work;
  • owners of the Private Company give up some equity percentage in the merger (usually between 15% and 20%);
  • management must devote additional time to public company activities; and
  • additional company visibility brings a higher level of liability exposure.

Part II. Corporate Law Aspects

1. Structure of Merger

Typically, the transaction will be structured in the following way:  The Public Shell will have to form a subsidiary (“Sub”), usually under Delaware law, which, pursuant to a merger agreement among the Public Shell, the Private Company and the Sub, shall then merge with the Private Company, with the Sub being the surviving entity.  The shareholders of the Private Company, under the merger agreement, will usually receive 80-85% of the stock to be issued in the merger by the Public Shell in consideration for giving up their shares in the Private Company.  The merger agreement also typically provides that within a specified time frame post-merger, the Sub (now the legal successor of the Private Company) will have to be merged into the Public Shell (“Upstream Merger”).  By using this triangular structure, only the Public Shell - as the sole shareholder of the Sub - through an authorized officer, will have to approve the transaction on the Public Shell’s side.  No shareholder approval by the Public Shell is required since the Public Shell is not a constituent entity in the merger.  Also, the Upstream Merger will usually not require shareholder approval by the Public Shell.[2] This constitutes a major advantage because a shareholders’ meeting or written consent of the majority shareholder(s) (if allowed under the by-laws) of the Public Shell could, in light of the securities law aspects stated below in Part III., significantly delay the transaction.  Naturally, the shareholders of the Private Company will also have to approve the merger, but since the number of shareholders is typically very small and securities law restrictions do not apply, this is usually not a problem.

2. Capital Structure Issues

The first issue one might encounter is that the Public Shell might not have enough authorized shares of common stock to enable it to issue 80%-85% of common shares to the shareholders of the Private Company.  For instance, the Public Shell might already have 50% of its authorized common shares issued to its current shareholders.  There are several possible solutions to this problem:

a) Increase of Number of Authorized Common Shares or Reverse Stock Split Pre-Closing 

The easiest ways to enable Public Shells to issue enough common shares to the shareholders of the Private Company to accomplish the reverse shell merger are: (i) the increase in the number of its authorized common shares; or (ii) a reverse stock split before the merger is consummated.  Pursuant to Section 242 of the Delaware General Corporation Law (“DGCL”),[3] each of these alternatives requires an amendment to the certificate of incorporation (CoI) of the Public Shell.  Pursuant to the same provision, shareholder approval is necessary to amend the CoI. Whether such shareholder approval can be obtained by written consent of the majority shareholder(s) depends on the applicable corporate statute and the Public Shell’s by-laws.  For instance, under DGCL 228, majority shareholder consent is possible unless the by-laws state otherwise; under Section 615 of the New York Business Corporation Law, generally unanimous shareholder consent is required, unless the CoI provides otherwise.  Depending on the outcome of the analysis of the applicable corporate law, the CoI, and the by-laws, a shareholders’ meeting might be required prior to closing.  However, both a shareholders’ meeting and a majority shareholder written consent will trigger time consuming procedures mandated by federal securities laws as set forth in Section III.1., which will delay a closing substantially.

b) Increase of Number of Authorized Common Shares Post-Closing

To avoid the timing problem set forth under (a), practitioners have developed a technique by which the transaction closes before the number of authorized common shares is increased or the reverse split is accomplished.  This might appear puzzling because, after all, one closing condition is the payment of consideration in the form of the issuance of shares of common stock to the Private Company’s shareholders, which is in turn impossible without enough authorized common shares.    The solution to the problem is referred to as the “Preferred Stock Solution”.  A “good” Public Shell will generally have authorized but unissued preferred shares.  In such a case, the Public Shell Board of Directors can file a Certificate of Designations with the Secretary of State (assuming that, as will generally be the case, the CoI vests corresponding powers in the board [4]) determining that each preferred share shall be convertible into a certain number of common shares so that after the conversion, the shareholders of the Private Company will hold the percentage of common shares in the Public Shell they are supposed to hold under the terms of the deal. 

A Public Shell has 10,000,000 shares of common stock authorized, of which 5,000,000 are issued to its 200 shareholders.  In the merger with a Private Company, the shareholders of the Private Company are supposed to receive 80% of the Public Shell’s stock, which is impossible without an increase in the authorized number of common shares or a reverse split of the outstanding common shares, both of which would require shareholder approval before closing.  However, the Public Shell also has 1,000 preferred shares authorized.  At the closing of the merger, it can issue 5,000,000 common shares and 1,000 preferred shares, with each preferred share convertible into 15,000 common shares upon authorization of a sufficient number of the underlying common shares and each preferred share having 15,000 voting and other rights incidental to common shares.  After the closing, an increase in the number of authorized common shares by shareholder approval can take place and 15,000,000 additional common shares can be issued for the Private Company’s shareholders so that they end up with 20,000,000 common shares, which equals 80% of the then total outstanding number of common shares.

Advantage:  The closing of the reverse shell merger can take place prior to a shareholders’ meeting or adoption of a shareholders’ consent (with all its time consuming security law implications described in Section III.1.), which is necessary for the authorization of additional shares of common stock.  Naturally, the necessity for such a shareholders’ meeting or shareholder consent is only postponed, not avoided, through the Preferred Stock Solution.

Part III. Securities Law Aspects

1. Timeline and Scope of Proxy or Information Statement          

As stated above in Section II.2, if the capital structure of a Public Shell is not adequate to accomplish the merger, the capital structure will have to be altered by effecting either an increase in the authorized number of shares or a reverse split of the outstanding shares, with both options generally requiring Public Shell shareholder approval.  Depending on the applicable corporate statute and the bylaws, such shareholder approval can be obtained by either majority consent or by vote in a shareholders’ meeting.  In the first case, a proxy statement complying with Schedule 14A under the 34 Act is required.  In the second case, an information statement complying with Schedule 14C under the 34 Act is required.  The filing, review and distribution procedure for a proxy or information statement can be delayed until after the closing by utilizing the Preferred Stock Solution, if possible.  However, a proxy or information statement can only be avoided entirely if the Public Shell already has the necessary capital structure in place to accomplish the merger, which in our experience is rarely the case.

a) Timeline

A preliminary Schedule 14A proxy statement must be filed with the SEC at least ten calendar days before a final proxy statement is to be sent out to the Public Shell shareholders in preparation of the shareholders’ meeting.[5] The period between the mailing of the definitive proxy statement and the shareholders’ meeting is usually determined in the by-laws.  It is usually at least 20 days.  It would be erroneous, however, to assume that based on these two time periods, the necessary capital restructuring could be accomplished within 10 days plus the notice period specified in the by-laws.  The SEC can, and for reasons stated below in (b) almost certainly will, give the preliminary proxy statement a full review, and this process can take weeks, if not months.  Accordingly, if a capital restructuring is to be accomplished before the closing, the parties to the reverse shell merger are well advised to assume that the closing will not take place before at least three months after the merger agreement has been signed, if not later. 

The timeline for a Schedule 14C information statement is similar.  A preliminary information statement must be filed with the SEC at least 10 calendar days prior to the date the definitive information statement is to be distributed to the shareholders.[6] The definitive information statement, in turn, must be sent to the shareholders at least 20 days before the shareholder consent can be adopted.  Again, because an SEC review of the preliminary information statement is likely, the parties should assume that shareholder action cannot be taken for at least three months after the filing of the preliminary information statement.

b)  Scope

The subject of the required content of the Schedule 14A or 14C is a trap for the unwary.  Since technically the restructuring of the Public Company’s capital only requires an amendment of the CoI, it would be tempting to include only the very limited information required under Item 19 of Schedule 14A (which is also applicable to Schedule 14C), which states:

If action is to be taken with respect to any amendment of the registrant’s charter, by-laws or other documents as to which information is not required above, state briefly the reasons for and general effect of such amendment.

First, the language “as to which information is not required above” necessitates providing any information required by any other applicable items.  For example, item 11, which deals with the authorization or issuance of securities otherwise than for exchange, would certainly be applicable where the Public Shell needs to increase its number of authorized shares to accomplish the merger.  Therefore, such a situation would require a detailed description of the Public Shell’s securities in question. 

Second, and more importantly, Note A to Schedule 14A (also applicable to Schedule 14C) states:

Where any item calls for information with respect to any matter to be acted upon and such matter involves other matters with respect to which information is called for by other items of this schedule, the information called for by such other items shall also be given.  For example, where a solicitation of security holders is for the purpose of approving the authorization of additional securities which are to be used to acquire another specified company, and the registrant’s security holders will not have a separate opportunity to vote upon the transaction, the solicitation to authorize the securities is also a solicitation with respect to the acquisition.  Under those facts, information required by items 11, 13, and 14 shall be furnished. 

This Note, although addressing directly only the situation in which an increase in the authorized number of shares is contemplated to accomplish a merger, is certainly also applicable to situations where the Public Shell intends to perform a reverse share split for the same purpose.  The Note is applicable because, as stated above in Section II.1., no Public Shell shareholder approval is necessary for the merger.  The implications - inclusion of the information required by items 11, 13, and 14 - are substantial.  We have already explained the information required by Item 11.  In addition, Item 13 requires financial information for both the Public Shell and the Private Company, as well as pro forma financial statements giving effect to the merger and related transactions, as required by Article 11 of Regulation S-X.  Finally, in a reverse shell merger scenario, Item 14 requires all the information required under an S-4 registration statement, including, for instance, a description of the businesses of the Public Shell and the Private Company, risk factors and a Management’s Discussion and Analysis (“MD&A”). 

Essentially, the proxy statement and information statement require the same effort as a registration statement on Form S-1, which is generally used for an initial public offering.  Also, we believe this would apply even though the capital restructuring is supposed to occur pre- or post-closing.  Therefore, one of the major advantages of a reverse shell merger, - to be a quick way to go public - disappears. 

It should be mentioned here that in our experience the SEC staff does not favor the technique of reverse shell mergers because, as shall be explained in Section III.2.(c), this technique is often utilized to the detriment of the shareholders of the Public Shell.  Accordingly, the SEC staff will seize any opportunity to scrutinize a reverse shell merger, and consequently shall in all likelihood give a full review to any preliminary proxy or information statement.  Due to the described scope of the required proxy or information statement, the SEC review will generally be a time consuming and expensive process involving management, accountants, auditors and legal advisors. 

2. Issuance and Resale of Public Shell Shares

The consideration to be issued to the shareholders of the Private Company consists of shares of common stock in the Public Shell.  Pursuant to Section 5 of the Securities Act of 1933 (the “33 Act”), such issuance must either be registered under the 33 Act or be exempt from registration. 

a) Exemptions from Registration

The parties involved could try to structure the issuance of Public Shell common shares as a private placement under Regulation D under the 33 Act.  If all shareholders of the Private Company can be deemed to be “accredited investors” (as defined in Rule 501 of Regulation D)[7], this can be a time efficient and easy process without particular information requirements, requiring only blue sky filings, generally within 15 days after closing.  Alternatively, if the shareholders of the Private Company are located outside the United States, Regulation S, which exempts sales of securities that occur outside the United States,[8] can provide an exemption from registration.  In both cases, the parties are well advised to demand corresponding representation letters from the shareholders involved. 

Even if these exemptions are applicable, they will typically not be of any economic use since the purpose of a reverse shell merger is generally to create a company with a substantial public float to add liquidity for investors.  Shares that are issued pursuant to Regulations D or S, however, are subject to the resale restrictions imposed by Rule 144 under the 33 Act, which generally means that such shares are not tradable at all for one year, and thereafter limited to an amount of 1% of the outstanding class of shares in any three month period.[9]  Only two years after the acquisition do shares held by non-affiliates become freely tradable.[10]  The shares held by the shareholders of the Public Shell might have been previously registered.  However, typically a majority of these shares are held by affiliates of the Public Shell and are therefore, as will be described below under (c), not freely tradeable either.  Consequently, typically not more than 10% of the surviving entity’s outstanding shares are freely tradeable.  Therefore, it will be impossible to accomplish a large public float of the shares issued to the Private Company shareholders in a short time period. 

b) Registrations

There are several ways to accomplish a registration of the shares issued in a reverse shell merger.  First, the issuance of the shares of the Public Shell could be registered in a registration statement on Form S-4.  If the parties have concluded that a proxy statement must be filed to accomplish a necessary capital structure change in the first place (see above III.1.(b)), such proxy statement under cover of Form S-4 can at the same time also serve to register the shares to be issued in the merger.  We have already explained that this will be a time consuming and expensive process. 

Second, if the closing does not require a capital restructuring of the Public Shell and therefore a proxy or information statement is not necessary, and Regulation D or S is available for the issuance of the shares, the merger could close without any SEC filing being required.  To create a substantial public float, however, the resale of the shares issued in the merger would have to be registered.  In such a scenario, it is tempting, but inaccurate, to assume that such a resale registration could be accomplished quickly and cost efficiently through a short Form S-3 registration statement.  The basic advantage of a registration statement on Form S-3 is that the issuer’s annual reports on Form 10-K and quarterly reports on Form 10-Q (“34 Act Reports”) from the date of the last annual report are incorporated by reference.  The S-3 registration statement is consequently a rather quickly and easily prepared filing.  However, the 34 Act Reports incorporated by reference into an S-3 registration statement in a reverse shell merger are 34 Act Reports of the Public Shell and do not reflect the business or financial situation of the Private Company, which by way of merger is stepping into the shoes of the Public Shell and is the real predecessor of the post-merger surviving entity.  It would therefore be misleading to investors to refer to such 34 Act Reports, and consequently we would advise not to use this form of registration statement.  Instead, it would be adequate to use a registration statement on Form S-1 or the slightly simpler Form S-2, both of which are similar in content to a Form S-4 registration statement, including risk factors, MD&A, financial statements (including pro forma financial statements), business description and description of the merger.  Therefore, even if the closing does not require a capital restructuring and a cumbersome proxy statement, the following registration of the resale of the shares issued in the merger will cause substantial, time consuming and expensive legal and accounting work in connection with the preparation of the necessary registration statement. 

c) Creation of a Public Float Without Registration Statement or Through a Registration Statement on Form S-8

In our experience, parties to a reverse shell merger often want to use one or both of the following methods to create a public float without engaging in the process of preparing and filing a registration statement and its cumbersome review process.

(1) Rule 144

A few shareholders who hold a majority of the outstanding shares of the Public Shell (usually some of the directors and officers of the Public Shell, who should be deemed “affiliates” as used in Rule 144) intend to sell their shares in compliance with Rule 144 after the merger has closed.  Technically, under Rule 144(k), an affiliate of the Public Shell could start selling securities without being subject to the volume limitation if he ceased to be an affiliate at the closing of the merger, a period of three months since he ceased to be an affiliate has lapsed, and he has held his shares for more than two years.  If that is the case, the transfer agent will, upon receipt of a corresponding opinion of legal counsel, remove any restrictive legend on the share certificates, thereby creating freely tradable stock.  However, the SEC staff has expressly prohibited this method of creating a public float in its no-action letter dated January 21, 2000[11] (“Worm Letter”).  The SEC stated:

It is our view that, both before and after the [reverse shell merger], the promoters or affiliates of blank check[12] companies, as well as their transferees, are “underwriters” of the securities issued.  Accordingly, we are also of the view that the securities involved can only be resold through registration under the Securities Act.  [Citation omitted] Similarly, Rule 144 would not be available for resale transactions in this situation, regardless of technical compliance with that rule, because these resale transactions appear to be designed to distribute or redistribute securities to the public without compliance with the registration requirements of the Securities Act. [Citation omitted]

Based on the Worm Letter, it is not possible ever to use Rule 144 to create a public float without a registration statement.

(2) Registration Statements on Form S-8

The second method that has developed is to use Form S-8 to register the issuance of Public Shell shares to “consultants” who can then engage in the resale of such shares without having to register such resale.[13] Typically, the parties will try to structure the merger in a fashion that contemplates the issuance of approximately 5% of the issuable shares to a financial advisor who has introduced the parties to each other and structured the merger, which issuance shall to be registered through Form S-8.  Sometimes, the parties also contemplate the issuance of a substantial number of shares to third party investors (likely using fake services or consulting agreements) who have provided marginal or no services to the merged entity, which issuance is then also supposed to be registered on Form S-8. 

Generally, Form S-8, which is an easily prepared registration statement with little information requirements and which goes effective immediately upon filing, may be used to register the issuance of shares under an employee benefit plan to the registrant’s employees.[14] The term “employee benefit plan” is defined very broadly to include, for instance, any compensation contracts for consultants.[15]  The term “employee” is also defined broadly to include consultants.[16]  However, both terms are limited to persons who provide “bona fide” services to the registrant.[17]  Additionally, the services rendered by the consultant must not be in connection with the offer or sale of securities in a capital-raising transaction, and may not directly or indirectly promote or maintain a market for the registrant’s securities.[18] In its Release adopting amendments to Form S-8, the SEC has elaborated on this requirement by stating the following with respect to reverse shell mergers:

We also will interpret the amendment to prohibit the issuance of securities registered on Form S-8 to persons who arrange or effect mergers that take private companies public.  For example, a merger into a thinly capitalized “shell” company with a class of securities registered under the Exchange Act, or a subsidiary of such a company, will fall in this category.  These mergers commonly are used to develop a market for the merged entity’s securities often as part of a scheme to “pump and dump” those securities.

SEC Release Nos. 33-7646, 34-41109, 1999 SEC LEXIS 404 (February 26, 1999).

The SEC’s dislike of the reverse shell merger technique becomes evident here again.  Based on this SEC Release, we see no basis to register the issuance of shares to the financial advisor involved since he must be considered as a person who is engaged in taking the Private Company public.  Evidently, issuances of shares to investors who have not provided any services are also not registrable on Form S-8.  

Our view on this topic has recently been confirmed in the SEC’s release entitled “Proposed Rule:  Use of Form S-8 and Form 8-K by Shell Companies” (the “Public Shell Release”),[19]  in which the SEC proposes to prohibit a Public Shell from using Form S-8 until 60 calendar days after it has filed on a Form 8-K the information equivalent to what it would be required to file if it went public the regular way (i.e. on a 34 Act Form 10). The SEC states in that release that Form S-8 is intended to be used only to register securities for offers and sales in connection with employee benefit plans. The use of Form S-8 by registrants to raise capital is prohibited. Further, Form S-8 may not be used to compensate consultants or advisors for providing capital raising or market making services. To the extent a Public Shell has any employees, the SEC believes that they are usually engaged in such capital raising or market making services. Nevertheless, according to the SEC, some Public Shells with barely any employees have used Form S-8 registration statements improperly to register sales of a majority of their outstanding securities that, while fashioned as sales under employee benefit plans, are in fact capital-raising transactions. In substance, the SEC views the sale by Public Shells of its shares to is employees as a sale  to “purported” employees who act as underwriters to distribute the securities to the public without the required registration and prospectus delivery.

Therefore, any suggestion by any of the parties involved in a reverse shell merger to issue shares to be registered on Form S-8 must be analyzed with utmost precaution. 

3. Other SEC Filings

So far, we have seen that a reverse shell merger will require (i) a cumbersome proxy or information statement if a capital restructuring is required (III.1.) and (ii) the filing of a registration statement to either register the issuance or the resale of the issued shares (III.2.) if a public float is to be created.  In addition to these filings, the parties must also be aware of other SEC filings which will have to be made prior to and following the closing of the merger.  These filings are summarized in the chart below:

Due Date


10 Calendar Days before Closing

Schedule 14F to announce appointment of Private Company designees to Board of Directors of merged entity.  This form must only be filed if the transaction is subject to Section 13(d) of the 34 Act, which in turn requires that a shareholder of the Private Company is to acquire more than 5% of the Public Shell Company.

Within 10 Calendar Days after Closing

Any director, executive officer or 10% shareholder of the merged entity has to file an Initial Statement of Beneficial Ownership on Form 3 to report ownership of shares in the Public Shell.

Within 2 Business Days after Closing

Any director, executive officer or 10% shareholder of the Public Shell who is not continuing as such after the merger must file a Form 4 exit form.

Within 10 Calendar Days after Closing

A Schedule 13D must be filed to report an acquisition by any Private Company shareholder (or “Group” of shareholders) of more than 5% of any class of the Public Shell’s equity securities.

Since 8/23/04:[20]
Within 4 Business Days after Closing

Form 8-K (Items 1.01 (material agreement), 2.01 (completion of acquisition) and/or 5 (change of control)).  

Since 8.23/04:[21]
Within 71 Calendar Days after previous Form 8-K was filed

Form 8-K (Item 9.01) to include financial statements of Private Company (i) for the periods specified in Rule 3-05(b) of Regulation S-X, (ii) prepared in accordance with Regulation S-X and (iii) accompanied by an auditors’ report.  In addition, pro forma financial information must be included.

We note that with respect to the Form 8-K filing requirements referred to above, the SEC has stated in its Public Shell Release that  the information required by the Form 8-K reporting the merger is inappropriate for introducing a business that is coming to the public market for the first time. Form 8-K focuses on the shareholders and the transaction that caused the acquisition to take place rather than on a detailed description of the new business itself. These Form 8-K filings often do not contain much of the information useful to investors in making informed decisions about investing in the company, such as the information contained in the MD&A included in long form registration statements.  In addition, some companies going public through a reverse shell merger have taken advantage of the concession available under Form 8-K which permits public companies that acquire private companies to postpone the filing of audited financial statements and pro forma financial information of the acquired business until up to 71 days[22] following the filing of the Form 8-K reporting the acquisition.  In the context of reverse shell mergers, during this 71-day grace period, the stock of the company going public through a reverse shell merger trades in the market without vital financial information being available to investors.  According to the SEC, in certain cases, certain promoters during this period have caused the shell company to issue  them stock and  register it under a Form S-8, and have then proceeded to hype the business of the company through bullish press releases and internet postings. Then, by using aggressive sales tactics, they have managed to sell their shares to an unsuspecting public within the 71-day grace period before the financial statements showing the true picture of the company are released. Upon filing of the audited financial statements showing the business of the company to be less substantial than it was purported to be, the value of the stock in the hands of the public buyers plummets after the promoters walk away with their gains.  In response to this abusive “pump and dump” technique, the SEC proposes in the Public Shell Release to require Public Shells, when reporting an event on a Form 8-K that causes it to cease being a Public Shell (such as a reverse shell merger), to include the same type of information that it would be required to include on a Form 10 under Section 12 of the 34 Act listed on a U.S. Exchange. Although not as comprehensive as the information required on a Form S-1, the information required on a Form 10 contains substantially more information about the  business of the company coming to market than currently required by Form 8-K.  This information would be required to be filed within 4 business days of the completion of the acquisition.

Part IV. Due Diligence Aspects

Economically, in a reverse shell merger, the shareholders of the Private Company are acquiring the Public Shell and are granting a certain percentage of the merged entity to the Public Shell shareholders in consideration therefor..  Keeping in mind that the Public Shell has no assets, the Private Company shareholders are giving up a share in the merged entity in exchange for the privilege of becoming a 34 Act reporting company.  Since no actual value is given by the Public Shell or its shareholders, it is particularly important to ensure that no hidden liabilities exist that will diminish the value of the ongoing entity in the future.  This is even more important in light of the fact that after the closing, there is no one who can be held liable by the shareholders of the Private Company, which now owns a majority (usually around 80% to 85%) of the merged entity.  Shareholders and management of the Public Shell are in most cases not willing to stand personally behind any representations or warranties given by the Public Shell in the merger agreement.  Therefore, any due diligence of the Public Shell must focus on the possibility of hidden liabilities or other impediments to the transaction.  Below are some factors that should be taken into consideration.

1. Nature of Business

Companies with a long business history or with a business history of activities which were likely to cause liabilities, such as oil, mining, manufacturing or healthcare - related industries, are usually not appropriate for a reverse shell merger transaction.  On the other hand, companies that never developed any significant business, never owned real estate or were engaged in business activities unlikely to cause any liabilities, such as the Internet industry, are usually more apt for reverse shell mergers.  Naturally, the rare real Blank Check Companies as defined in Section I.1. are the best targets for a reverse shell merger because they never owned any assets or liabilities. 

2. Contractual Relationships

By definition, the Public Shell is supposed to be a clean company without any employees, customer or supply agreements, leases or financial obligations.  However, the 34 Act Reports will often disclose that such contractual relationships have existed during the active time of the Public Shell.  The due diligence exercise should therefore focus on detecting any contracts which might not have been fully terminated or any contracts under which any obligations might be outstanding.  Waivers and releases by any identifiable persons who might have a claim against the Public Shell should be demanded as a condition to a closing of the merger. 

3. Effective Corporate Actions

As stated above (III.1.), a cumbersome proxy or information statement is required if the Public Shell’s capital structure must be revised to accomplish the merger.  If the management of the Public Shell promises to have the right capital structure already in place, very often the necessary adjustments to the capital structure have been made in the past in the abstract contemplation of a possible reverse shell merger in the not too distant future.  For instance, if a Public Shell at some point had 10 million shares of common stock authorized, 8 million of which were outstanding, management might have decided to increase the number of authorized shares to 100 million to make the Public Shell more attractive for a possible reverse shell merger.  Since at that time no particular merger was contemplated, the necessary proxy or information statement in connection with such a capital restructuring would have been an easy undertaking since none of the factors illustrated in Section III.1.(b) would have been of any concern.  A due diligence exercise must, however, ensure that all corporate formalities necessary for the capital restructuring were complied with.  For instance, if the due diligence reveals that the majority shareholder of the Public Shell simply approved the increase of the authorized number of shares by written consent, while the by-laws and the applicable corporate statute required shareholder vote, the merger cannot be accomplished without ratifying the invalid corporate action, which in turn will require shareholder approval and therefore a new proxy or information statement.  Now, however, the ratification of the capital restructuring will occur in light of the contemplated merger, which means that a full blown proxy or information statement as described in Section III.1.(b) will be necessary - a nasty surprise for all parties involved!

Part V. Conclusions

In spite of all the impediments described in III. and IV., a reverse shell merger is still legally and practically possible.  If, and only if, the Public Shell has the right capital structure in place, such a merger can be accomplished quickly without the preparation of a cumbersome proxy statement.  Also, the issuance of shares to the Private Company shareholders need not be registered if an exemption from registration is applicable. However, if it is also intended to create a substantial public float for the shares of the merged entity, as is usually the case and the main purpose of the transaction, there is no trustworthy way to avoid the requirement to prepare an extensive resale registration statement, which will be subject to SEC review and require substantial time consuming and expensive work by legal counsel, accountants, auditors and management. Additional harsh filing requirements will be imposed if the SEC implements the rules proposed in its recent Public Shell Release.

Questions regarding public shell reverse mergers may be directed to Raphael S. Grunfeld (, Steven J. Glusband (, Stephen V. Burger (, Alan J. Bernstein ( or Peter Flägel ( or any other member of our corporate department in our New York Office (212-732-3200).



[2]  Assuming that the applicable corporate statute is similar to Delaware corporate law.  See Section 253 of the Delaware General Corporation Law. 

[3]  The reference to the DGCL is an arbitrary one.  Unlike the Sub, the Public Shell will usually not be a Delaware corporation.  In fact, it is our experience, that Public Shells are normally incorporated in Colorado, Arizona, Nevada or similar States.  However, the corporate statutes of these States are often similar, if not identical, to the DGCL.

[4]  See DGCL Section 151.

[5]  Rule 14a-6 under the 34 Act.

[6]  Rule 14c-5.

[7]  Rule 501(a) of Regulation D.

[8]  Rule 901 of Regulation S.

[9]  See Rule 144(e)(1)(i).  Another possible volume limitation, the average weekly trading volume for the last four calendar weeks proceeding the sale (see Rule 144(e)(1)(ii)) will normally not be applicable, because Public Shells have a very small trading volume. 

[10]  Rule 144(k).

[11]  2000 SEC No-Act. LEXIS 42 (SEC No-Action Letter, dated January 21, 2000 to Mr. Ken Worm). 

[12]  The SEC staff defines the term “blank check company” to include all types of Public Shells as described in I.1.

[13]  Unless such shares are held by affiliates, in which event a resale registration will be required, see General Instruction C to Form S-8. 

[14]  Instruction A.1.(a) to Form S-8.

[15]  Rule 405 of Regulation C.

[16]  Instruction A.1(a)(1) to Form S-8.

[17]  Rule 405 and Instruction A.1(a)(1)(ii).

[18]  Instruction A.1(a)(1)(iii).

[19]  SEC Release Nos. 33-8407; 34-49566 (April 15, 2004).

[20]  Revised Form 8-K became effective on August 23, 2004.  See SEC Release No. 33-8400 (March 16, 2004)

[21]  Id.

[22]  Under revised Form 8-K.

Carter Ledyard & Milburn LLP uses Client Advisories to inform clients and other interested parties of noteworthy issues, decisions and legislation which may affect them or their businesses. A Client Advisory does not constitute legal advice or an opinion. This document was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. © 2020 Carter Ledyard & Milburn LLP.
© Copyright 2005

Related practice area:

© Copyright 2020 Carter Ledyard & Milburn LLP