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SEC Trends & Developments - Winter 2011 - SEC Tightens Listing Standards for Reverse Mergers

A reverse merger/acquisition is a transaction, typically, where private company shareholders gain control of a public company through a merger.  In the transaction, the private company shareholders receive a substantial majority of the shares of the public company and control the board of directors in exchange for cash and/or the contribution of their shares in the private company.  Most of the public companies involved in reverse mergers are “shell companies,” companies with little or no operations.  After the transaction, the newly merged entity, which is a combination of the public shell and the private company, is the publicly-traded entity.

Over the past several years, these transaction have become more common.  As raising capital in the current economic environment continues to be a challenge, more and more of these transactions have become the method many private companies have used to become public.  In the summer of 2010, the SEC began looking into whether these companies were reporting results accurately and whether their audits were being conducted properly.  This process took on a greater importance with the suspension, halted trading, or enforcement actions concerning more than 35 companies resulting from what was determined by the SEC to be “a lack of current and accurate information about the firms and their finances.”  More specifically, many Chinese companies have taken advantage of reverse mergers and a number of these companies have had their securities removed from U.S. exchanges.   The affected companies have been accused of financial fraud and improper accounting and, in lesser cases, with questions on their financial disclosures and on the firms conducting their audits. 

In June 2010, the SEC issued an Investor Bulletin warning investors about the risks related to reverse mergers. “Given the potential risks, investors should be especially careful when considering investing in the stock of reverse merger companies,” said Lori J. Schock, Director of the SEC's Office of Investor Education and Advocacy in the SEC release.  The Investor Bulletin warned investors that many of these companies “fail or struggle to remain viable.”  The SEC also warned investors of the risk that some of these reverse merger companies were being audited by small auditing firms that did not have adequate resources to conduct an audit when all or a substantial amount of the entities operations were in another country.  The Investor Bulletin suggested that, before investing in a reverse merger company, investors should, at a minimum, research the company, review their SEC filings, be aware that some companies are not required to file reports with the SEC, and be skeptical.

The SEC has now approved new rules for the Nasdaq, NYSE and NYSE Amex that could make it more difficult for a company that has completed a reverse merger to be listed on those exchanges.  Under these new rules, the exchanges will prohibit a company that has recently completed a reverse merger from applying to be listed until the company has completed a one-year “seasoning period” by trading in the U.S. over-the-counter market or on another regulated U.S. or foreign exchange following the reverse merger, and filed all required reports with the SEC, including audited financial statements.  In addition, the company must maintain a required minimum share price for a sustained period, and for at least 30 of the 60 trading days immediately prior to its listing application and its decision to list.

A reverse merger company would, generally, be exempt from these requirements if it is listing in connection with a substantial firm commitment underwritten public offering, or the reverse merger occurred long ago and at least four annual reports with audited financial information have been filed with the SEC.

SEC Trends & Developments - Winter 2011 Issue  

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