The shell company: going public with a Pandora's box.

Beware the offer to take your firm public by mating with a shell company.

From a legal standpoint, you may be buying yourself a headache.

With Black Monday more than three years past and the market still suffering the aftershocks of the junk-bond debacle, companies large and small are capital hungry. Facing severe contraction in the capital markets, including a poor environment for initial public offerings, financial officers are seeking alternatives.

Accompanying these trends are catchy ads that promise a creative financing panacea. The ads promise that you can avoid the rigors of an SEC filing, roll up partnerships, consolidate debt, and, yes, go public just by buying a public shell. These shells, typically Utah or Nevada corporations, are marketed to legitimate corporations as merger candidates. Too often, through this creative financing, the buyer ends up with a company that is not public and feloniously sells securities-risking investor and regulatory litigation. The post-merger shell companies are liability minefields for larger corporations that may acquire them.

Many people harbor the misconception that stock in a public company may be freely bought and sold without compliance with Federal and state securities laws. The purveyors of the shells prey on that misconception. Often, they deliver shells that are not even public companies in the jurisdictions in which they are sold. They succeed in their deception due to consumer ignorance.

The shell-company deal

The shell-company promoter begins by packaging his product-a blank-check, blind-pool offering. Warning companies about accepting such offerings, the North American Securities Administrators Association (NASAA) and the Council of Better Business Bureaus (BBB) noted in their April 1987 joint Investor Alert that "blank-check offerings do not identify any proposed intent whatsoever. They are literally `blank checks' that the promoter can use at his whim."

In the initial blank-check offering, investors are brought into the offering to establish shareholder base or float." Often they buy into the shell company hoping that the share price will rise after merger with an operating company.

In the U.S. securities industry, a public company is often thought to be synonymous with a reporting company. A reporting company is subject to and complies with the reporting requirements of the Securities Exchange Act of 1934; it generally has shares outstanding in public hands and the concomitant availability of a secondary trading exemption. These companies file annual and quarterly financial reports (10-Ks and 10-Qs) with the Securities and Exchange Commission, and that information is open to the public.

The typical route for a company to go public is to file a registration statement and prospectus with the SEC and with the states that have jurisdiction over the transaction. This, of course, registers the sale of the stock. To provide companies access on a limited basis to capital markets, the SEC has provided exemptions from the requirements for filing a registration statement and prospectus if compliance with certain rules is present. One of those rules is Rule 504 of SEC Regulation D. Some of the shells being sold as "public companies" established their shareholder float through Rule 504 offerings. However, by definition, Rule 504 is available only to companies that are not SEC reporting companies. Therefore, businesses that are considering the shell route to go public should beware of the Rule 504 company because, unless it has subsequently become a reporting company, it is not a true public company. The public reference branch of the SEC in Washington, D.C., will answer inquiries concerning whether a company is a reporting company or merely a Regulation D company.

In the traditional method of going public, a company typically engages an investment banking firm to underwrite its securities, accountants to audit its books, securities attorneys to draft the legal documents that disclose the pros and cons of the investment and effect the transfer of securities, and other experts as needed (for example, a petroleum engineer or geologist in an oil and gas offering). This team has an obligation to investigate the company and its management in a process known as "due diligence." While the due diligence process does not guarantee investment results, it does provide additional protection that is generally lacking in the shell merger process for both the shell company and the acquiring operating company. By contrast, when a shell company is used as a vehicle to go public, the operating company purchases the shell and merges with the shell. The shell is then the surviving corporation.

To market the shell company, the promoter entices purchasers with the hide-your-dirty-laundry promise and the cost-cutting myth. Some companies, whose management believes they could not undergo the scrutiny involved in the usual due diligence process and registration with the SEC and the states, are victims (some say accomplices) who buy shells to hide information. Other companies buy in because of the hype the promoters push, including the claim to take the purchasing company public in three days at one-third the cost of a traditional public offering.

The financial officer may face the shell-company problem at several junctures: when he is considering taking public his company or an affiliate, such as a subsidiary; when he is considering acquiring a company that has used the shell-company merger process,, or when his company holds stock in a shell company and desires to sell such stock in the secondary market.

Since the shell company is the survivor in the initial reverse merger process, under most states' corporate laws, the liabilities of the shell, including undisclosed and contingent liabilities (such as securities law violations), survive the merger. These liabilities can consume the assets that the operating company placed in the new company in the merger and detrimentally affect future prospects. The same liabilities can wreak havoc if a third company seeks to acquire the post-merger shell company in either a merger or consolidation because, under most states' laws, the liabilities will survive that second merger or consolidation.

Where are the pitfalls?

The shell-company process doesn't work for several reasons. The major problem is that it fails to provide new capital to the purchaser of the shell. In so doing, the major motivation of going public, i.e., acquiring an infusion of capital, is not achieved. In most cases, even if a company is a reporting company, to sell its stock publicly, the company must comply with the registration and prospectus filing requirements of both the SEC and the individual states that have jurisdiction over the offer and sale of the stock. Therefore, the purchase of a shell and subsequent merger of an operating company into that shell do not provide the means for a company to sell publicly its stock.

Furthermore, the shareholders of the post-merger corporation in these shell deals often have illiquid stock. if a shareholder's sale of his own stock is not covered by an exemption from Federal and state securities registration requirements, the sale will be illegal. Additionally, persons who make a market to sell stock in unregistered, nonexempt transactions are breaking the law.

Violations of Federal and state securities laws, including an illegal sale of unregistered stock, are felonies. Furthermore, ignorance of the law is no excuse. Therefore, when the seller of the shell leads the buyer to believe stock can immediately be sold without securities law compliance, the buyer has paid hard cash, often $50,000 or more, for the privilege of committing a serious crime. Intent to commit a crime is unnecessary; only the intent to sell the stock and the offer or sale need be present when compliance is lacking.

Additionally, when stock is sold in violation of securities laws, investors have a right to sue to receive their investment back. Unfortunately for the unwary company and its management, as well as the subsequent purchaser of the post-merger shell company, these investor lawsuits may come when the surviving company is suffering financial problems or seeking to raise additional capital through traditional means.

In the shell-merger process, the buying company also acquires the baggage of the shell company's shareholders. Since those shareholders typically buy in at low "penny stock" prices, in the merger process, the acquiring company is likely to suffer immediate dilution in the value of its shares.

Worse yet, some shell-company shareholders have been known to participate in postmerger market manipulation to drive up the price of the stock so they can dump their shares at a handy profit. They may also retain stock registration rights or warrants that will impact future financing.

Attempts to regulate

Given the major abuses in the shell-company process, the presence of a shell company in a company's history will often raise a red flag to securities regulators. This could delay or imperil a subsequent public offering by a surviving corporation.

The SEC has been aggressively pursuing enforcement actions against blank-check offerings. In September of 1988, The Wall Street Journal reported that the Denver regional office of the SEC had brought 32 enforcement actions and civil suits against blank checks in the prior year. These actions included allegations that prearranged mergers were not disclosed and that funds were misappropriated.

The SEC is continuing to pursue enforcement actions. In contrast to its aggressive enforcement position and the position of many of the states to deny state securities registration of blank-check offerings, the SEC will register blank-check securities offerings provided that acquisitions and mergers to the extent known are disclosed. The SEC's willingness to register such offerings was the subject of heated debate at NASAA's annual meeting in October of 1988 during a panel discussion on blank-check offerings.

In the spring of 1989, NASAA through its Corporation Finance Section and Disclosure Standards Committee adopted a resolution declaring blank-check, blind-pool offerings to be fraudulent practices. The resolution addresses the stock offerings used to establish the float for the pre-merger shell companies. NASAA found that the offerings cannot be justified for any useful economic purpose. The resolution, which replaced proposed regulations for registration of such blank-check offerings, foreshadowed a more aggressive state regulatory stance.

The NASAA resolution states: "Blankcheck, blind-pool offerings are inherently defective because of failure to disclose material facts concerning the offering and issuer, and such offerings have been the subject of pervasive, recurrent, abusive and fraudulent practices in the sale of securities, including but not limited to manipulation of the price of such securities, sales of securities at prices not reasonably related to the fair value of such securities, and fraudulent representations concerning the business plans and purposes of the issuers. . ." The resolution also states that "sales of blank-check, blind-pool securities per se constitute fraudulent business practices..."

To the extent that the resolution sets or will set a regulatory standard, it creates an additional risk for those who become involved in these shell offerings. Later that same year, in September of 1989, NASAA issued to the House of Representatives' Subcommittee on Telecommunications and Finance "The NASAA Report on Fraud and Abuse in the Penny Stock Industry." That report warned against blank-check blind pools and noted that ZZZZ Best, in which banks and investors lost about $70 million in a massive stock fraud scheme, went public in 1986 through a merger with a Utah blank-check blind pool.

While many states will not register blank-check, blind-pool offerings, some states, including Utah and Colorado, have less restrictive laws. This led to those states being hotbeds for the formation of shell companies. The April 1987 joint Investor Ale from NASAA and the BBB noted Utah's efforts to curb abuses: "In Utah, where blank checks were said to `roam the land in herds,' the state securities division issued a new regulation in 1986 to combat abuses. The ruling will require future blank-check offerings to keep 80 percent of the initial proceeds of the offering in an escrow account until the promoter declares what business they will be entering into. At that time, they will he required to offer shareholders an opportunity to back out of the investment or, given full disclosure about the intended use of proceeds, the right to continue their investment. No stock certificates will be issued until that point and thus the shareholders are locked into their purchase until that time. " That 1986 rule resulted in a substantial drop in Utah registration filings for shell companies and a shift of blank-check activity to Colorado. in 1990, Colorado followed Utah's lead and passed a regulation requiring escrow of blank-check offering proceeds.

In the summer of 1990, Texas issued a cease-and-desist order by consent against Texas corporations and their management accused of dealing in securities through newspaper advertisements in violation of Texas law. The Texas order included citation of an ad reading "PUBLIC COMPANY 97% CONTROL AVAILABLE. No assets, no liabilities. Go public in three days with your existing business. Turnkey price includes legal, accounting, transfer agent, market makers, growth and capital formation ideas...."

The order followed an earlier Texas rule change to substantially restrict the ability to engage in secondary trading of shell-company securities. This change impacts holders of shell-company securities, because if they sell those securities in violation of Texas law, they have committed a felony. The Texas rule reads as such: "The secondary trading exemption under the (Texas Securities) Act ... is not available for the securities of an issuer formed in a manner that constitutes part of a scheme to violate or evade the securities registration provisions of the Act. Depending upon all the facts and circumstances, such a scheme may include the merger of a private corporation with a corporation which has no substantive operations or assets (`shell corporation') when as a result of the merger trading in the secondary market of the shares of the post-merger corporation may be at prices which bear no relationship to the underlying financial condition or operations of the post-merger corporation, and such trading may occur within two years of the date of such merger."

Some shell promoters do not bother with the registration process, or even the Rule 504 process, to establish shareholder float. One method they use is to give away shell stock, arguing their "gifts" are not subject to the securities laws because no sales are involved. The states of Oregon and Utah have rejected this gifting scheme, finding it to be an illegal attempted circumvention of their state securities laws. In contrast, in 1988, prior to the passage of the NASAA resolution discussed above, the state of Kentucky issued a no-action enforcement position on the gifts of shares of a Nevada shell company to 300 persons, provided strict stock-transfer restrictions through stock certificate legends and the transfer agent were used.

The National Association of Securities Dealers, Inc., does not have rules that specifically address blank-check offerings by shell companies. However, to the extent that these offerings would involve NASD brokers and violate other rules of the NASD-for example, rules on market manipulation-the NASD could take action.

For your part

Financial officers advising companies seeking to go public should encourage them to exercise vigilance and strive to be informed consumers. if the companies are considering going public through the purchase of a shell, the best advice would be to choose the traditional route to go public and forego the shell purchase. if the financial officer is advising companies that are evaluating the acquisition of an operating company that used the shell-company process, he should exercise extreme caution. While it is possible to go public using a shell, the probability of liabilities existing for violations of the securities laws-even contingent liabilities-is very high.

Ms. Lebman is a securities attorney in Austin, Texas. She was formerly a senior securities analyst in the Securities Registration Division of the Texas State Securities Board.