stockpatrol.com
THE SHELL GAME
They play it on street corners in big cities and small towns. Three shells are
placed in a row on a table. The dealer shows you a pea, places it under one of
the shells (or at least appears to) and quickly shuffles them. You bet that you
can guess which shell the pea is under. Occasionally, one of your fellow
players (the "shill") will guess correctly and win the bet, encouraging you to
play on. When it's your turn to guess the shill remains silent. You guess wrong
and lose your money. Sometimes you try again because it seems so easy.
The shell game they play on the street is an exercise in misdirection – getting
players to look in the wrong place at the right time.
The shell game they play on Wall Street carries even greater risk because the
stakes are much higher. It begins with a public company, a shell that has little
or no business and virtually no assets of consequence. But the shell has one
significant value – it is public. And, if it finds the right business to acquire,
promoters can hype the stock by trumpeting the company's future prospects.
So the people running the shell set about finding a business for their company.
Once they do, they arrange for a merger, usually between the shell and a
private company. More often than not that private company is long on plans
but short on a proven track record. Then the shuffling begins. When it is
completed the surviving company is public (courtesy of the shell) but it
conducts the business of the formerly private company. This is commonly
known as a reverse-merger because the officers and directors of the old
private company end up running the public company and the shareholders of
the private company wind up with most of the stock of the public company. At
the end of the day the private business, and the people running it, have taken
over a public company without going through the scrutiny of the regulators or
providing investors with the kind of disclosure they can expect when a
company goes public through the IPO process. And the insiders and
promoters who used to control the shell – they get to tell a story that is
designed to increase the price of their stock.
Of course if the process ended here it would have little attraction for schemers
and scam artists. The shuffling, however, often has another purpose. With few
exceptions, the reverse merger is designed to create a new business, generate
a buzz about the company and result in increased stock prices. As part of this
process the merger is almost always followed by press releases extolling the
prospects of the new business. The idea is to generate investor interest.
Question is, is there real value to the surviving company, or are they just trying
to get the public to look in the wrong place at the right time?
The investor must decide whether a shell company has been transformed into a
valuable investment or remains an empty vessel. How do you make that
judgment? Well, it certainly helps to consider the reasons why a private
company might decide to go this route rather than hold out for an IPO.
Reason No. 1 - Flying Under the Radar. A private company can
become public without regulatory scrutiny. How's that for a scary
concept? Consider the strict criteria for a public offering. Before an IPO
can go forward a detailed Registration Statement must be filed with the
SEC (and generally, with various states in which the stock will be
offered). These regulatory agencies will then look carefully at what the
company has disclosed and ask for appropriate clarifications and
changes to assure that the investing public is adequately informed. The
IPO will not proceed, and the stock cannot be traded, until adequate
disclosure has been made about the company's business, its principal
stockholders, its officers and directors, its financial condition, the
underwriter and the risks to investors.
The scrutiny doesn't stop there. The company will have to satisfy certain
requirements before it can be traded on the NYSE, NASDAQ,
AMEX, regional stock exchange or the OTC Bulletin Board (yes, even
the OTC Bulletin Board has listing criteria, although the Bulletin Board
will not examine the content of the offering to the extent of most of the
other exchanges). The goal of this process – to make sure the public has
all of the information it needs before investing in a company.
The shell shuffle avoids virtually all of these obstacles. The merger
becomes effective once the directors and shareholders of both the
private and public companies approve it. This is generally a simple task
(although the specific process will vary depending upon the states where
each company is incorporated) since these are probably the same
people who negotiated the merger in the first place. In most cases a
majority of the shares of the public shell are held by the promoters and
insiders (and their friends) who brought about the merger. They
determine the outcome of the vote. And the remaining shareholders of
the public company? Like the regulators they are advised after the fact.
In recent years this scenario has been affected somewhat by
NASDAQ's insistence that a NASDAQ listed company file with
NASDAQ prior to the issuance of additional shares (as would be the
case in a reverse-merger). Still, the OTC Bulletin Board (which is home
to many shells) has no such advance notice requirement. For the most
part, notification to regulators comes after the reverse-merger, and even
then lacks the details of an IPO registration statement.
Reason Number 2 - It's Faster and Cheaper. An IPO takes months
to complete – starting with the preparation of registration documents
and financial statements by lawyers and accountants, and continuing
through the review of those documents by the SEC, NASD and state
regulators, the amendment of the Registration Statement to assure that
the company has made all material public disclosures, and the eventual
timing of the offering by the underwriter. The reverse-merger process
moves much faster since it dispenses with this review and disclosure
process. Documents can be produced and finalized quickly since, in
many cases, lawyers can use boilerplate forms that require only minor
tweaking to reflect the terms of the deal.
It follows that the reverse-merger is a lot less expensive too. Attorneys'
and accountants' fees are significantly lower and the company avoids
the registration charges and printing costs of an IPO – a difference that
can save hundreds of thousands of dollars.
Reason Number 3 - Secret Identities. Filing with the SEC doesn't
just mean more time and money. For the company it also means more
disclosure. Before a company can go ahead with an IPO it has to
distribute a prospectus disclosing the names of officers, directors,
promoters, founders, and significant stockholders, and all kinds of
material information about those people. The company is required to tell
prospective investors about the backgrounds of these individuals,
including whether they have had criminal or regulatory problems. When
a private company becomes public through a reverse-merger it avoids
that level of disclosure – at least in the short term and as a practical
matter maybe forever. As a consequence, if the new management and
controlling stockholders have had problems with regulators or law
enforcement authorities in the past, investors will not find out until future
public filings are required. If individuals with past problems want to
deceive investors and scam the public, the shell shuffle can help them
camouflage their intentions. By virtue of the reverse-merger they can
control a public company, buy and sell stock, and operate without either
regulatory review or investor awareness. If they are intent upon profiting
from the increase in stock value which routinely follows a
reverse-merger (See "Reason Number 6 - Pump and Dump" below)
they will be gone long before any disclosure of their identities is
required.
Reason Number 4 - Risky Business. Since a prospectus contains a
lengthy list of risk factors every investor has an opportunity to review
the potential risks before deciding whether to purchase shares. No such
safety net protects the investor who buys shares after a reverse-merger.
The new company is able to proceed with its plans without warning
potential investors of risks, such as a lack of track record, historical
losses, or potential competition. To the contrary, the reverse-merger is
usually accompanied by a press release, or series of releases, exalting
the virtues of the new company's business, often in highly exaggerated
terms.
Reason Number 5 - Financial Disclosure. After a merger the
surviving company is required to file consolidated audited financial
statements reflecting the new acquisition. But there's a hitch here too
since the company has more than 60 days to file those financial
statements with the SEC. That leaves plenty of time for promoters and
insiders to sell stock based on hyped-up prospects for the new
company. They may be long gone before financial statements are ever
filed. Sometimes the financial statements will be filed even later than
required, or not at all. This can cause the merger to fail. In that case it is
the public investors who are left holding the bag – and the stock.
Reason No. 6 - Pump and Dump. This technique is employed by those
promoters and brokers who want to inflate the value of a stock,
stimulate investor interest, and bail out of their own holdings. The former
shell company, with its "exciting" new business, is an ideal candidate. In
order to "pump" the value of the stock the company and its promoters
will generate a series of positive press releases highlighting the merger
and new developments and plans. Analysts may be paid to recommend
the stock and brokers may tout the company's future prospects, often in
overinflated terms. If a brokerage firm has been instrumental in the
merger (which is frequently the case) its brokers and cold callers will
begin to solicit new investors by recommending the stock. As stock
prices move upward based upon these "news items" inside stockholders
dump their shares on an unsuspecting public. And who are these
insiders? They can include the major inside stockholders and promoters
who put the deal together, the analysts who recommend the stock,
consultants who generate public interest and the former owners of the
private company.
Recent efforts by the SEC have been directed at thwarting the "pump
and dump." In particular, the SEC recently amended the rules governing
the use of Form S-8 to register securities. Form S-8 is a short form of
registration that contains little disclosure about the company. It was
designed for use by companies in connection with the issuance of stock
and options to employees. Over the years the definition of "employees"
expanded to include consultants and outside contractors (like attorneys)
who performed services for the company. In its recent amendments the
SEC expressed concern that companies had used Form S-8 to register
stock issued on a reverse-merger to "consultants," including promoters,
finders, and their friends who are involved in conditioning the market for
the company's securities by promoting the stock. Those individuals
sometimes make the registered shares available to brokers who are part
of a "pump and dump" scheme. Under the amended rules, Form S-8
may not be used to register shares given to consultants for their work in
connection with a capital raising transaction or their efforts, either
directly or indirectly, to promote or maintain a market for the
company's securities. While this change may force the pump and
dumpsters to be more creative, rest assured, such schemes will persist.
Companies will continue to issue shares to consultants for services that
remain permissible under S-8. Shell insiders may register shares before
a reverse-merger to assure a ready supply. They will also take
advantage of Rule 144 which permits certain sales of unregistered stock
after a one-year holding period. If all else fails you can expect that
serious scamsters will simply ignore the S-8 amendments, register the
shares issued to "consultants" and disappear from the scene leaving the
company and its new management to face the regulatory music.
THAT ELUSIVE PEA
And what does all of this mean? Simple. The investor is buying on faith. In the
shell shuffle an investor must rely upon the company and its promoters for
information. Sort of like guessing where the pea is. Still want to put your
money on the table?
©1999 Stock Patrol.com. All rights reserved. |
