Going Public Direct Reverse

By: Brenda Hamilton, Securities Lawyer We’ve written several times about going public, reverse mergers and Operation Shell Expel. Shell Expel is one of the Securities and Exchange Commission’s most successful enforcement initiatives to combat the use of shell companies for reverse mergers. Its object is to render useless and worthless dormant shell companies that might otherwise be hijacked, used in reverse mergers, and ultimately pumped and dumped. These companies are a real problem for the agency. If an issuer that’s an SEC registrant is abandoned by management, after a couple of years the SEC’s Enforcement Division can bring an administrative proceeding to revoke registration.

Most targeted companies find they can’t really object, and when an initial order becomes effective, the public shell company becomes a private entity.

Reverse Mergers Targeted By SEChttp://www.sec.gov Dormant shells on the OTC Markets (“OTC Shells”) are sometimes different. They have no management, no business, no assets, and their corporate charters have been revoked in their home states. These companies, often called “zombie tickers,” will tick on and on. They have no value except as vehicles for reverse mergers or pump and dump schemes. Most often these types of shell companies appear on the OTC Markets OTC Pink or lower disclosure tiers.

Operation Shell Expel was designed to address the zombie ticker problem. It debuted with a bang on May 14, 2012, when the SEC suspended 379 shell companies. to prevent their use in reverse mergers It was the largest mass trading suspension in agency history. Nearly all of the affected tickers were OTC Markets shells, though a few registrants were caught in the action as well. The suspension notice explained the benefits:

“The existence of empty shell companies can be a financial boon to stock manipulators who will pay as much as $750,000 to assume control of the company in order to pump and dump the stock for illegal proceeds to the detriment of investors. But with this trading suspension’s obligation to provide updated financial information, these shell companies have been rendered essentially worthless and useless to scam artists”.

These zombie tickers would not, unfortunately, disappear completely. By law, the SEC can suspend trading in an issue for ten days only. Once a suspension ends, the stock returns to trading on what’s called the Grey Market. When a stock is hit with a trading suspension, the SEC warns that: “Brokers and dealers should be alert to the fact that, pursuant to Rule 15c2-11 under the Exchange Act, at the termination of the trading suspension, no quotation may be entered unless and until they have strictly complied with all of the provisions of the rule.”

That means the shell company must find a sponsoring market maker willing to file a Form 211 with the Financial Industry Regulatory Authority (“FINRA”). FINRA must review and process the 211 before the stock can leave the Greys and trade again as a normal OTC Pink company. FINRA is extremely reluctant to process 211s for previously suspended companies particularly where reverse mergers are present. For that matter, market makers, who cannot accept compensation for compiling and submitting a Form 211 to FINRA, usually have no interest in becoming involved in the process. They would prefer to handle 211s for fresh new companies and not process Form 211’s for suspended issuers involved in reverse mergers. In the unlikely event that an issuer with a suspended ticker locates a sponsoring market maker, it will be difficult for its shareholders to find a broker-dealer that will allow them to deposit their shares. It should be noted that none of the 379 companies whose stock was suspended in May 2012 ever filed a new 211. Most had been dead for quite a while; some for more than a decade. Probably a fair number were controlled by shell vendors who’d hoped to sell them for reverse mergers, but the suspension rendered them worthless, as the SEC had intended.

Operation Shell Expel Runs Out of Steam Shell Expel, which in 2013 became the responsibility of the newly-formed Microcap Task Force, continued to root out and disable dormant OTC shells for several years. The Task Force had a lot on its plate: “The principal goal of the Task Force will be to develop and implement long-term strategies for detecting and combating fraud in the microcap market, especially by targeting “gatekeepers,” such as attorneys, auditors, broker-dealers, and

transfer agents, and other significant participants, such as stock promoters and purveyors of shell companies.”

Shell Expel affected both shell peddlers and stock promoters who might one day be hired to tout revived shells after the completion of the reverse mergers. It selectively resulted in charges against some attorneys who sold or provided services to Shell Companies. The SEC suspended 61 shells in 2013, 255 in 2014, and 128 in 2015. And then, inexplicably, it seemed to lose interest in the program. In 2016, there were only 19 Shell Expel suspensions. Nothing that could really be described as a mass suspension occurred in 2017 or for most of 2018. It’s not as though the Task Force ran out of shells to kill. There are still hundreds, perhaps thousands, out there being sold by known shell brokers.

The shelving of the program was all the more puzzling because it had been successful.

Between 2012 and 2016, shell vendors became less active, and some got out of the business entirely. It had become dangerous to hold OTC Pink shells in inventory for reverse mergers, because Shell Expel might make them worthless in the blink of an eye. It was also dangerous to hold OTCBB shells, which are SEC registrants, in inventory unless they were current, or nearly current, with their periodic financial reports, because they could be hit by actions to revoke registration. Obviously, it made less sense for a shell company purveyor to spend time on a custodianship petition or make a cash outlay for a shell that might soon lose all its value, than it had a few years earlier.

But as the Shell Expel Task Force shifted its focus to other enforcement objectives, the shell peddlers began to return, as surely as mosquitoes to a pond that hasn’t been visited by Pest Control. Reverse Merger vendors who’d sharply reduced their activity returned to the marketplace, and new players entered the fray. By 2017, some of them had amassed inventory of dozens of shells for reverse mergers, and sales were brisk.

Vendors took different approaches to pricing. Shell vendors who were lawyers often sold their shells at what seemed like modest prices but made up for that by charging additional legal fees for subsequent work that had to be done in the issuer’s home state, and with OTC Markets. Others advertised their wares as quality products: completely “clean” shells for reverse mergers worth their $175,000-$250,000 price tag.

However, it was conducted, it was a lucrative business. A competent shell peddler could net $100,000 or more on every shell he sold. The vendors got unexpected help from penny players active on financial message boards and the social media. During this period, traders became keenly interested in shells, because they knew that once one was sold to a private company wanting to do a reverse merger, the stock price was likely to pop. Those who got in quickly when the news was announced could sell for a nice profit, if they were nimble enough to exit before interest died down. Given the sharp rise in the number of petitions, especially in Nevada, for custodianship of dormant public shells to create reverse merger inventory, penny players began tracking the activity of known shell vendors, buying stock in the company in question as soon as notice of the application hit the docket of the Clark County Court.

That method worked—and still does work—well enough for momentum traders, who were able to profit on short term runs. The shell vendors also cleaned up, but the penny market was less well-served. Where had the Microcap Task Force gone?

The SEC Trading Suspensions Begin Again Late last year, there was finally a sign the SEC hadn’t entirely given up on suspending dormant shells. On December 14, it pulled the plug on 49 tickers, citing the usual “questions regarding the adequacy and accuracy of information about the companies.”

One—ZaZa Energy Corp (ZAZA)–was a former Nasdaq company that had been delisted in 2015 and had failed to flourish on the OTC. A few, like Turbodyne Technologies (TRBD), Golden Phoenix Minerals, Inc (GPXM), and Everock (EVRN), were ordinary Pinks that had been dormant for years. IMRIS Inc (IMRSQ) and Lexicon Building Systems Ltd (AILFQ) were bankrupts. AILFQ was particularly unsavory. It had been the subject of a Cease Trade Order imposed by the British Columbia Securities Commission since 2009, and in 2017, the BCSC slapped large fines on two individuals who’d made illegal securities offerings in Lexicon some years earlier.

The rest of the SEC’s targets were foreign issuers, most of which had never been particularly active on the US OTC. Since as foreign companies they weren’t incorporated in the United States, they wouldn’t have been in danger of hijacking by a shell peddler, and so posed little danger to investors. But they were dead wood, and the market is better off without them.

Finally, on May 10, 2019, the SEC suspended 56 OTC shells to prevent reverse mergers. Though the action wasn’t described as an Operation Shell Expel effort, and wasn’t accompanied by an explanatory press release, as the earlier mass suspensions had been, the three SEC attorneys referenced in the SEC trading suspension notice head up the Microcap Task Force.

These shells are like those suspended in earlier sweeps in that most have been dormant for a long time. A few, but very few, have enjoyed brief flurries of trading activity within the past few years, but none has actually conducted business. Nearly all are non-registrants, but nine—AVTO, CPEU, GSNC (as Global Games Corporation, not its current Global eScience Corp), GRNO, MMTV, MSSI, PHSL, SOYO, and STAI—are delinquent filers. Some have been delinquent since the 1990s.

A few are mildly interesting because of their history. Modtech Holdings (MODTQ) is a former Nasdaq issuer that filed for Chapter 11 bankruptcy in 2008; the bankruptcy was converted to Chapter 7 in 2011, and the case was finally closed in late 2017.

Understandably, it had been mostly inactive in recent years; the last trade before it was suspended went off at $0.0003. Soyo Group (SOYO), once a California-based consumer electronics and computer parts company, filed for Chapter 7 bankruptcy in May 2009, and ceased operations. In 2011, the SEC sued the company, its former CFO, and two members of the Soyo accounting staff, alleging an elaborate and longrunning accounting fraud. Its stock nonetheless continued to trade sporadically; its last recorded price was $0.0014, rather surprisingly. The SEC didn’t bother to suspend trading in the company when it sued, and so it limped on as a zombie ticker. General

Media Communications, Inc. (PHSL), once known as Penthouse International, had been the company of which Penthouse magazine was a part. Though Penthouse founder Bob Guccione died in 2010, the stock traded more actively than many zombies, evidently on the strength of occasional rumors that someone new would make good use of the famous name.

Some of the companies whose stock is on the list were story stocks years ago.

Blackout Media (BKMP) began life as notorious Canadian fraudster Sandy Winick’s First Canadian American Holding Corporation, from which he spun off 59 public shells.

In 2009, the SEC charged Winick and BKMP with illegal stock distribution through those spinoffs. Inexplicably, the SEC did not suspend BKMP or any of the spinoffs, many of which were dead or moribund. Winick was charged again in 2013, this time criminally, and was extradited from Thailand, where he’d been living for several years. His offenses this time were running pump and dump schemes on countless penny stocks, operating boiler rooms in four countries, and running an advance fee scheme. The last featured an ingenious plan to contact people he’d defrauded in the pump and dump operations and promise to help them “recover” some of their funds for a fee. Winick was held without bail in New York, eventually pled guilty, and was sentenced to 78 months in prison and was ordered to pay $7.4 million in restitution and forfeiture in August 2016. Time served while awaiting trial counted as part of his total incarceration, and he was released in April of this year. The SEC still did not suspend any of the many pennies with Winick connections, probably because he was no longer involved with most of them.

Hard to Treat Diseases (HTDS) was massively pumped in late 2009 and 2010 on the strength of (false) rumors that it was formulating vaccines in China and would be bought out by—or at least strike some kind of deal with—Novartis. At that time, the company had links to a major promotional group/shell factory. Once the hype died down, the shell was taken over by the promotional group, and was resold by it in 2014. Several more pumps were attempted, but without an even minimally convincing story, and failed to make any real impression on the market.

Green Oasis Environmental (GRNO), a delinquent filer whose last required financial report covers the period ended September 30, 1999, was not a dormant shell when that filing was submitted to Edgar in 2010. It was in fact quite active, and claimed it intended to catch up with 10 years of reports. GRNO was a Canadian company that had the great good luck to be chosen as one of the stocks on the “float lock down” list of promoter Jerry Williams, also known as “Monk.” Williams gave seminars, called “Monkinars,” at which he taught basic charting to groups of followers all over the United States; he once even ventured as far as Germany. Unlike most penny stock gurus, he wasn’t aggressive or overbearing, and didn’t seek to appeal chiefly to young men.

Instead, he preferred to interact with couples, sometimes retired, and others who didn’t consider trading a large part of their lives. He sold them a story about himself as the head of a “family” who was working to assure them a comfortable life and a secure retirement. That, he said, could be managed if they’d buy as much as they could of a handful of stocks he chose. The idea was to reach a point at which the public float

would be “locked down”—no shares would be available in the marketplace—which would in turn spark a “MOASS”: a “mother of all short squeezes.”

Unfortunately for Monk and his followers, he didn’t know very much about how shorting works. Worse, it turned out that as he was advising those followers to hold, or stay “long and strong,” he himself was selling. His flagship play, 8000 Incorporated (EIGH) was suspended in the fall of 2010, and another, Cascadia Investments (CDIV), in June 2011. In July 2012, the SEC sued him, and in February 2014 he was ordered to pay more than $9.6 million for his touting and scalping of CDIV and GRNO. Why GRNO wasn’t suspended back then, especially given its outrageous delinquency, remains a mystery.

All 56 of the stocks suspended on May 10 now reside on the Gray Market, often called the graveyard of penny issuers. The market makers aren’t permitted to publish quotes for Greys. The suspension will expire next week, and trading will resume. Probably most of the stocks won’t experience the sharp drop in price that affects many other suspended issues, because none of them has been trading actively for some time. But the SEC’s purpose will have been served: none will ever again be attractive to a promotional group, amateur or professional, nor will a shell vendor ever seek to gain control of any with an eye to selling it for use in a pump and dump operation.

A Change in SEC Policy Anyone who follows SEC enforcement actions is likely to have noticed that starting in the fourth quarter of 2018, the agency’s policy regarding trading suspensions appears to have changed. The “Trading Suspensions” page of the SEC website shows 61 suspensions, many of them for five or six companies, for 2018. Those multi-ticker suspensions are—or were—typically used by the agency for delinquent filers.

Yet in the fourth quarter, only three issuers were suspended for delinquency: Hua Yang Investment Group, Inc, better known as Tarheel Billboard, Inc (THEE); TAMM Oil and Gas Corp (TAMO); and Titan Oil & Gas (TNGS). By contrast, in Q3, 128 companies were suspended for delinquency. In the first two quarters of 2019, apart from the 56 dormant shells disposed of by Operation Shell Expel, only five other companies have been suspended, all of them for cause, although one, Cardinal Energy Group (CEGX) was also a delinquent filer.

That does not mean the SEC has given up on enforcement actions against delinquent filers. It just appears the SEC has decided to save itself a little time and trouble by bringing only one enforcement action rather than two against registrants who fail to meet their filing obligations. In the past, the regulator would simultaneously suspend the issuer’s stock and serve an OIP to revoke registration on him. Now it only initiates the administrative proceeding. No matter how many financial reports the company has missed, it will be offered the same deal, which is essentially no deal. It can accept revocation of registration without making a fuss, or it can demand a hearing. There’s no point in insisting on the latter, because the SEC cares about one thing only: whether or

not the company is current with its filing obligations. Since an OIP has been served, obviously it is not current. Some companies have tried to deregister voluntarily by filing a Form 15 after the admin proceeding has begun. That is be acceptable. At that point, the SEC doesn’t want to hear excuses, and will revoke registration anyway.

Throughout the revocation process, which usually takes two or three months, but may be quicker, the stock will continue to trade normally, to the extent it trades at all; many delinquent filers are also dormant. One day the administrative law judge’s initial decision will be made final by the Commission. The next day, the stock will cease trading and its ticker will disappear. The issuer will become a private company. Though private transactions in its securities will be possible, they won’t be easy or convenient, because there’ll no longer be a market for the stock. If the company wishes to become a public issuer once again, it will have the option of reregistering by filing a Form 10 or Form S-1 registration statement. Quite a few companies promise shareholders they’ll do that, but not many get around to it.

Reverse Mergers and the Going Public Process As for the non-reporting dormant shells, we hope the SEC won’t wait till next year to impose another mass suspension. There’s no shortage of shells. Large numbers of them exist, waiting to be snapped up on the cheap by shell vendors and resold to anyone interested. While some of the buyers may be unscrupulous penny fraudsters who want to set up a pump and dump operation, honest small businessmen with no practical knowledge of securities law may become victims. They correctly believe that going public is a good way to grow their companies but fail to realize while buying a shell and using a reverse merger to go public may seem easy and quick, in reality the process is not necessarily straightforward. The vendor in the reverse merger may conceal skeletons in the closet. Those may include old toxic debt, former insiders who still hold large positions, old legal judgments, and regulatory problems in individual states, or in foreign countries. Yes, foreign countries: a fair number of U.S. penny stocks have Canadian Cease Trade orders. Some of the CTOs were issued back in the 1990s, but they won’t be lifted until the problem, whatever it is, has been fixed.

FINRA’s Role In Reverse Mergers These problems with reverse mergers can in some cases result in a refusal by the Financial Industry Regulatory Authority (FINRA) to process corporate actions for a company. Corporate actions include name and ticker changes, splits and dividends, and more. Every shell company needs to do one or more from time to time; objections from FINRA can cause serious difficulties. Finally, nearly all the OTC reverse merger companies are shell companies by the SEC’s definition. Rule 405 of the Securities Act defines a Shell Company as a company with no or nominal operations that has no or nominal assets, assets consisting solely of cash and cash equivalents, or assets consisting of any amount of cash and cash equivalents and nominal other assets. Rule 144 is not available to holders of restricted stock of a shell company even after a revere merger, which makes obtaining financing in the form of private placements of equity or

debt, extremely difficult. The only way for a non-reporting company to remedy the problem with shell status is to file a Form 10 or an S-1 and thereafter take care not to become delinquent with its required periodic financial reports.

A Better Way to Go Public There are better ways to go public than to buy a shell for a reverse merger. With the right guidance, it’s no more difficult or expensive to go public direct, and it can be less expensive. Nor does it cost a fortune to go public as an SEC registrant. Some say an IPO is “too costly.” Of course, an IPO underwritten by Morgan Stanley and Goldman Sachs is not only too costly but also inappropriate and unavailable for microcap companies, but all that’s really needed it for the microcap in question to go public is to file a Regulation A Offering or a registration statement on Form S-1. In some companies, a Form 10 might also work. The help of an attorney and an auditor is required, and the process will take several months. But it will establish a strong foundation on which to build for the future for legitimate companies without the stigma and risk of a reverse merger into a shell company.

This securities law blog post is provided as a general informational service to clients and friends of Hamilton & Associates Law Group and should not be construed as, and does not constitute, legal and compliance advice on any specific matter, nor does this message create an attorney-client relationship. Please note that the prior results discussed herein do not guarantee similar outcomes.

Hamilton & Associates Law Group, P.A provides ongoing corporate and securities counsel to private companies and public companies listed and publicly traded on the NASDAQ Stock Market, the New York Stock Exchange (NYSE) and OTC Markets. For two decades Hamilton & Associates Law Group, P.A p has served private and public companies and other market participants in SEC reporting requirements, corporate law matters, securities law and going public matters. The firm’s practice areas include, but are not limited to, forensic law and investigations, SEC investigations and SEC defense, corporate law matters, compliance with the Securities Act of 1933 securities offer and sale and registration statement requirements, including Regulation A/ Regulation A+ , private placement offerings under Regulation D including Rule 504 and Rule 506 Transactions as well as registration statements on Forms S-1, Form F-1, Form S-8 and Form S-4; compliance with the reporting requirements of the Securities Exchange Act of 1934, including Form 8-A and Form 10 registration statements, reporting on Forms 10Q, Form 10-K and Form 8-K, Form 6-K and SEC Schedule 14C Information and SEC Schedule 14A Proxy Statements; Regulation A / Regulation A+ offerings; all forms of going public transactions; mergers and acquisitions; applications to and compliance with the corporate governance requirements of national securities exchanges including NASDAQ, NYSE and foreign exchange listings; crowdfunding; corporate; and general contract and business transactions. The firm represents clients in Israel, Columbia, Germany, London, Dubai, India, France, Canada and throughout the U.S. Hamilton & Associates Law Group 101 Plaza Real S, Suite 202 N

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