The SEC Issues Alert For Reverse Mergers

On June 9, 2011, the Securities and Exchange Commission (the “SEC”) issued an Investor Bulletin (the “Bulletin”) cautioning the public about risks associated with issuers that enter U.S. markets through reverse mergers with public shell companies.

In the news release announcing the Bulletin, Lori J. Schock, the Director of the SEC’s Office of Investor Education and Advocacy was quoted as saying, “Given the potential risks, investors should be especially careful when considering investing in the stock of reverse merger companies … As with any investment, investors should thoroughly research the company – including ensuring there is accurate and up-to-date information – before making a decision to invest.”

Reverse mergers permit private companies, including those located outside the U.S., to access U.S. investors and markets by merging with an existing public shell company. The SEC and U.S. stock exchanges frequently suspend trading in reverse merger companies due to a lack of current and accurate information about them, particularly about their  financial condition. In a reverse merger transaction, an existing public “shell company,” which is a publicly traded SEC reporting company with few or no operations, acquires a private operating company that wants its securities to be publicly traded. Most often, the shareholders of the private operating company exchange their shares for a large majority of the shares of the public company. Although the public shell company survives the merger, the private operating company’s shareholders gain control of the public entity including its management and outstanding securities.  The assets and business operations of the post-reverse merger entity are those of the private company.

The SEC’s Investor Bulletin is summarized below.

Perceived Benefits of Reverse Mergers

A private operating company may seek a reverse merger with a public shell because:

♦ To gain access to the public markets because publicly traded companies potentially have access to funding from a broader pool of investors;

♦ A reverse merger is perceived to be a quicker method of “going public” than an initial public offering (IPO);

♦ The legal and accounting fees associated with a reverse merger are typically lower than for an IPO; and

♦ While the public shell company is required to report the reverse merger in a Form 8-K filing with the SEC, there are no registration requirements under the Securities Act of 1933 as there would be for an IPO.

♦ Being public may give a company in­creased value in the eyes of potential acquirers.

 Trading of Reverse Merger Companies

Shares of reverse merger companies are traded on both stock exchanges and the over-the-counter market (“OTC Market”).

 Exchange Markets

If the reverse merger company’s securities are listed and traded on an exchange, the listed company must meet the exchange’s initial listing standards to be eligible for listing. The listed company must also satisfy the exchange’s maintenance or continued listing standards to remain listed and must comply with the its rules, federal securities laws, and other applicable provisions of the law.

When certain market or company events occur, an exchange may halt trading in the securities of a listed company, and if the company fails to meet the exchange’s continued listing standards the exchange may initiate proceedings to delist its securities.

 Over-the-Counter

The OTC Markets Group operates on a decentralized, interdealer quotation system. In order to be quoted, a market maker must file a Form 211 with the Financial Industry Regulatory Authority (FINRA) and demonstrate that the com­pany meets the requirements of Rule 15c2-11 under the Securities Exchange Act of 1934 (Exchange Act) as well as FINRA’s rules.

Risks of Investing in Reverse Merger Companies

Investors should proceed cautiously when considering whether to invest in reverse merger companies because:

♦ Many companies either fail or struggle to remain viable following a reverse merger;

♦ There have been numerous instances of fraud involving reverse mergers with public shell companies;

♦ Many foreign issuers that access the U.S. markets using a reverse merger with a public shell engage insufficient au­diting firms, causing accounting failures.

Risk Disclosure