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.