In an opinion letter to the Delaware Court of Chancery, the SEC informed the court that although reverse mergers are not per se illegal under federal securities laws, they raise significant investor protection and market manipulation concerns. The SEC pointed to recent enforcement actions in this area, indicating it is watching this space (In re: Forum Mobile, Inc., October 29, 2021).
Delaware Chancery had sought the SEC’s view to help it determine whether to grant a petition by a management firm to be appointed custodian of a defunct but still publicly traded penny stock company called Forum Mobile, Inc. The move would allow the management firm to move forward with identifying private companies to engage in a reverse merger with Forum, essentially using Forum as a blank check company as a means to go public.
The court appeared concerned because reverse mergers have historically been frowned on under Delaware public policy, and the management firm has filed a “raft” of similar petitions.
Intended reverse merger. Forum Mobile, Inc. was incorporated in Delaware in 1995. Sometime after its public listing, the company appeared to abandon the business. Although Forum’s shares continued to trade on the over-the-counter quotation board at around 0.02 per share as of March 2021, the company no longer complies with basic requirements of Delaware and federal securities laws, including maintaining current publicly available information, maintaining a registered agent and filing annual reports in Delaware, and holding an annual stockholder meeting.
Synergy Management Group LLC began to explore the possibility of reviving Forum to use as a blank check company. Synergy tried to locate Forum’s officers and directors but received no response. Synergy then petitioned the Delaware Chancery Court in May 2020 to appoint Synergy’s president, Benjamin Berry, as custodian of Forum Mobile, Inc. under Section 226(a)(3) of the Delaware General Corporation Law (DGCL). Synergy has also filed multiple other virtually identical petitions relating to other defunct companies.
Appointment of amicus. Although the petition was unopposed, it nevertheless presented “significant issues of Delaware public policy,” said the court. Reviewing years of Delaware Chancery precedent, the court explained, “The Delaware authorities addressing efforts to revive defunct entities for use as blank check companies reflect a consistent Delaware public policy against allowing capital-markets entrepreneurs to deploy Delaware law to bypass the federal securities laws that govern stock offerings.” The court added that this policy was particularly at issue in this case because Synergy and another firm have filed “a raft” of these petitions.
Accordingly, the court decided to appoint an amicus curiae to consult with the SEC and provide an independent view regarding whether the petition should be granted. The court appointed attorney Mark J. Gentile of Richards, Layton & Finger, P.A., to serve as amicus curiae. The SEC then issued a letter setting forth its views on the applicability of the federal securities laws on Synergy’s petition to revive Forum for use in a reverse merger. The SEC’s letter was signed by Jeffrey A. Berger, senior litigation counsel.
SEC analysis. Although the SEC did not signal outright disapproval of the intended reverse merger, the agency effectively communicated a significant “caveat emptor” of its own, noting its record of active enforcement in this area. The SEC further observed that regardless whether the court grants the petition, Forum and Synergy must follow all federal securities laws and regulations. Compliance with Delaware law will not allow Forum or Synergy to circumvent federal law, the SEC said.
First, the SEC explained that reverse mergers are not per se illegal under the federal securities laws. The SEC defined a reverse merger as “a transaction or series of transactions in which a privately held corporation merges with and into a publicly traded corporation, thereby allowing the private corporation to transform into a publicly traded corporation without the necessity of making an initial stock offering.” There is no statute or regulation that precludes a privately held corporation from merging with a shell company in order to obtain access to the capital markets and the investing public, said the SEC.
The SEC noted that Forum is a shell company and a non-reporting issuer that is not required to comply with the reporting requirements of the federal securities laws. Its shares are not listed and do not trade on a registered national securities exchange. Further, there is no evidence that it had any assets, shareholders of record, or history of having offered and sold securities pursuant to a registration statement that would trigger Section 12(g) registration or a Section 15(d) reporting obligation.
Investor protection and manipulation concerns. Due to this lack of publicly available information, reverse mergers like the one contemplated raise investor protection and market manipulation concerns, said the SEC. Especially for retail investors, investments in these types of securities are associated with negative and volatile returns, as well as illiquidity. Studies have also shown that a significant percentage of market manipulation cases involve securities trading on the OTC markets.
In particular, the SEC noted the following deficits:
- Because Forum does not appear to have filed any quarterly or annual reports for at least a decade, investors in Forum will not be able to readily obtain publicly available historical or current information about the company, including its financial status, its management, its ownership, or the risks it faces.
- Because Forum is a non-reporting company, it would not be required to file a report regarding any reverse merger that it completes in the future (assuming the reverse merger does not involve the offer and sale of securities).
- Because Forum does not trade on a registered national securities exchange and there is no evidence of intent to seek such listing, it would not need to satisfy the more stringent listing requirements imposed by exchanges for shell companies that combine with private companies in reverse mergers. For example, Forum would not need to comply with a NYSE requirement that a reverse-merger company have produced at least one year of audited financial statements and other material information before listing on the NYSE.
Enforcement and other SEC actions. The letter noted that the Commission has taken steps and staff has issued guidance to shore up protections for investors in the reverse merger context. The amendments to Rule 15c2-11 were designed to prevent fraudulent, deceptive, or manipulative acts or practices. Further, the Office of Investor Education and Advocacy issued an investor bulletin that discussed the risks associated with reverse mergers.
In addition, the SEC has undertaken enforcement actions in this area, including procuring a $700,000 disgorgement order against a biofuels company founder in SEC v. Zenergy International, Inc. and an $80,000 penalty against the orchestrator of a pump-and-dump scheme in SEC v. Madsen.
Despite these actions, there are still significant risks associated with reverse mergers, said the SEC. On a parting note, the letter stated that any offer or registration of securities by a revived Forum would be subject to the registration and antifraud provisions of the federal securities laws, including the private rights of action provided by Sections 11 and 12 of the Securities Act.
This is Docket No. C.A. No. 2020-0346-JTL.