Reverse Mergers and Rule 144: Substance Is The Key

The SEC has long sought to close avenues through which companies gain access to the capital markets without going through the usual Securities Act registration process and by which promoters and others acquire unregistered shares which can be traded. One popular method is a reverse merger in which a privately held company acquires a publicly traded corporation thereby allowing the private company to become public without going through the registration process. Promoters and others frequently acquire shares from former affiliates in these transactions which can be traded following the merger without registration.

In SEC v. M&A West Inc., Case No. 06-15165 (9th Cir. August 12, 2008), the Ninth Circuit aided the SEC’s cause. The court affirmed a grant of summary judgment by the district court in favor of the Commission, concluding that the promoter of three reverse mergers violated Section 5 when he sold stock acquired as compensation in the deals.

The ruling is predicated on three reverse mergers. While there are variations in the deals, essentially each involved the merger of a public shell company into a private company. Under the terms of the agreements, the affiliates of the public company became non-affiliates at the closing when they were replaced by persons from the private company. Defendant Stanley Medley, who arranged the deals, was paid in shares that he later sold. All of this occurred at the closing.

The SEC argued that Mr. Medley, in practical terms, received his shares from affiliates despite the structure of the deals. Mr. Medley contended however, that under the terms of the transactions, the public company affiliates of the issuer were first replaced thus becoming non-affiliates. Then, in a second step the new non-affiliates transferred stock to him. According to Mr. Medley his shares were not restricted because Rule 144(k) permits a person who is not an affiliate of the issuer, and who has not been an affiliate for the past three months (such as him) to sell the shares. Here, all of the terms of Rule 144 were fully complied with in all three transactions, according to Mr. Medley.

The court rejected defendant’s argument, concluding that despite the two-step structure of the transactions, in substance Mr. Medley received shares from affiliates and thus could not avail himself of Rule 144. Citing the Supreme Courts seminal decision in SEC v. W.J. Howey Co., 328 U.S. 293 (1946), the court concluded that “[w]here a single transaction accomplishes both a change in status from an affiliate to a non-affiliate and a transfer of stock from that person or entity, the transfer must be viewed as a transfer from an affiliate for the purposes of determining Rule 144(k) eligibility. The existence of multiple agreements bears little effect when the agreements collectively constitute a single transaction.” This conclusion is bolstered by the purpose of Section 5, the court noted, which is intended to ensure that adequate information was available to the investing public, something not present here.

Judge Ikuta dissented from the ruling of the majority on two of the transactions. Those two transactions involved multiple agreements to complete the transaction rather than just one. Judge Ikuta argued that parties are entitled to structure transactions based on the plain language of a Rule such as 144.

Rule 144 has been amended since this case was litigated. Now excluded from its safe harbor are shares of companies with no or nominal operations and assets consisting solely of cash or cash equivalents. The revised Rule may in effect preclude transactions such as this. Nevertheless, the ruling is important for those structuring transactions. Clearly more attention must be paid to the substance as well as the structure. This will be particularly true for transactions designed to avoid statutory and regulatory requirements.

The Ninth Circuit, Twombly and Dura

The Ninth Circuit handed down a decision in In re: Gilead Sciences Securities Litigation, Case No. 06-16185 (9th Cir. Aug. 11, 2008) which raises significant questions about the Circuit’s application of two key Supreme Court decisions — Bell Atlantic. Corp. v. Twombly, 127 S. Ct. 1955 (2007) (complaint must be plausible) and Dura Pharmaceuticals, Inc. v. Broudo, 544 U.S. 336 (2005) (requiring loss causation). In Gilead Sciences, the Court reversed a district court determination which concluded that plaintiffs’ complaint failed to comply with Dura and was not plausible because of a gap of months between the time of an FDA letter disclosing defendant’s improper sales practices that fueled its revenue and a drop in the share price that followed publication of poor financials statements.

The complaint alleged a scheme which hinged on the ability of Gilead Sciences to improperly increase sales for one of its leading drugs by selling them in violation of FDA regulations regarding off-label marketing. Those regulations essentially limit marketing a drug to uses approved by the agency, not those which are not approved or off-label. Specifically, the complaint alleged that Wall Street analysts for Gilead Sciences looked to sales of its most important and promoted drug, Viread, to determine if the company was growing as expected. A failure to report good sales for this drug would result in a drop in the price of the stock.

Gilead Sciences aggressively marketed Viread sales by promoting off-label uses. As a result, in March 2002, the FDA issued a warning label to the company about these practices. Nevertheless, off-label marketing increased and the company raised the price of the drug to its wholesales.

Subsequently, in July 2003 the company issued a press release announcing that its second quarter results would exceed expectations. By the end of the month however, the FDA served a second warning letter to the company about off-label marketing for Viread. Not only did the FDA require the company to publicly correct its incorrect marketing statements about the use of the drug at a conference where those statements were made, but the agency subsequently published the letter. While the complaint claims that the public did not understand the action by the FDA, it was clear that wholesalers did. According to plaintiffs, the wholesalers drew down their excess inventory of the drug and let those levels fall below industry averages.

At the end of October, the company announced its results for the period, revealing lower Viread sales. Analysts concluded that there was lower consumer demand for the drug. Trading volume increased 1,400% the next day and the share price fell 12%.

In reversing the district court, the Ninth Circuit concluded that “the complaint sufficiently alleges a causal relationship between (1) the increase in sales resulting from the off-label marketing, (2) the Warning Letter’s effect on Viread orders, and (3) the Warning Letter’s effect on Gilead’s stock price.”

In its opinion, the Circuit Court rejected what it viewed as the district court’s skepticism about the plausibility of plaintiffs’ claims. Under Twombly, a complaint can proceed if it alleges facts to support a plausible theory. Here, despite the month’s long gap between the disclosure of the FDA warning letter and the price drop, the theory is plausible, the Court concluded.

Under Dura, the cause alleged need only be a “substantial” cause and not the only one, according to the Ninth Circuit. After emphasizing that loss causation is much more critical at trial, the opinion concludes that the link between the publication of the warning letter in July, the subsequent actions of the wholesalers and the disclosure of the poor sales in the late November is sufficient.

The Ninth Circuit’s opinion raises significant questions about its application of both Twombly and Dura. Clearly, Twombly permits a plausible, factually supported complaint to proceed despite the skepticism of the court as the opinion notes. Yet, the long delay between the disclosure of the FDA letter and the price drop presents a clear question of plausibility for which the court offers little analysis.

Similarly, the Court’s Dura analysis seems deficient. By emphasizing that loss causation is critical at trial, the Court seems to have shifted the issue from the beginning of the case to the end. This however, is at odds with the front-end loaded, gate-keeper role given to the district courts under the PSLRA and the Supreme Court’s decisions in Tellabs, Inc. v. Makor Issues & Rights, Ltd., 127 S.Ct. 2499 (2007) (discussed here) and Stoneridge Investment Partners, LLC v. Scientific-Atlantic, Inc., 128 S.Ct. 761 (Jan. 15, 2008) (discussed here), all of which combine to screen cases before they can reach discovery.

Perhaps more importantly, the Court’s opinion fails to offer any real analysis of the causation issue. The key question should be when did the facts about the fraud materialize? See, e.g., In re Initial IPO Sec. Litig., 399 F. Supp. 2d 261 (S.D.N.Y. 2006). If that occurred at the time of the FDA letter, then the district court was correct. If however, it happened at the time the financial results were released then the Ninth Circuit may be correct. Unfortunately, as with the Twombly question, the Court’s discussion of Dura fails to analyze the question or include sufficient facts to assess it.