a case for modernizing Rule 419 under the Securities Act of 1933
First I will outline the rule briefly, then talk about
what happened after the rule was passed, then discuss why modernizing the rule
makes sense given both market and regulatory developments. As the regulators
look at ways to make reverse mergers less subject to fraud but still attractive
as a method of capital formation, I hope these thoughts will be helpful.
What is Rule 419? For those who have not read my book, my
glossary states, "This SEC rule, passed in 1992, requires significant
safeguards in connection with an IPO or other registration under the Securities
Act of 1933 of shares of a blank check. These safeguards include requiring almost
all funds raised and shares issued to be placed in escrow pending a merger;
imposing an eighteen-month time limit to complete a merger; mandating investor
reconfirmation of an investment prior to a merger, and other stipulations. An
IPO is exempt from this rule if it raises more than $5 million, as a result,
all SPACs are exempt from Rule 419." Not a bad summary if I do say so myself.
Prior to the rule passing, one could complete an IPO of a
shell company and raise some money with the stock trading. Unfortunately, there
was fairly widespread fraud where promoters simply milked the shells for the
cash and engaged in questionable trading. After the rule, you could complete an
IPO of a shell, but you could not take the cash out or have any trading until a
reverse merger was completed.
What did regulators expect? That players would switch to
shells under the Rule 419 limitations, thereby protecting investors. Many
tried. But frankly the SEC did not make it easy, providing a tremendous amount
of comments to those trying to complete a 419 IPO. Also, many players were
soured from trying 419 because of the time limit, and the delay caused by a
detailed proxy required to be SEC approved before closing a merger.
did shells come from when 419 became impractical?
Once Rule 419 passed, as mentioned above players tried
but grew frustrated setting up shells and completing reverse mergers under the
rule. So what happened?
Three things. First, players discovered that a shell
could be created from the carcass of a former operating public company that was
sold or went out of business. Their stock continues to trade and the SEC
filings are kept up, but the company is empty. While there are various issues
with these "legacy" shells, they became a popular way to complete a reverse
merger without any of the Rule 419 restrictions.
Second, since Rule 419 did not apply to registrations
under the Securities Exchange Act of 1934, people started creating shells by
filing Form 10 to register a class of securities with the SEC. No shares are
tradable in these shells until a merger and subsequent registration (or one
year wait under Rule 144) takes place, but the Form 10s are very clean and much
less expensive than the trading shells. The SEC initially resisted efforts to
set up Form 10 shells, but eventually realized that the lack of trading is
actually a positive and they no longer resist their creation. I have been hired
to create nearly 300 Form 10 shells since 2005.
Third, unfortunately some promoters tried to avoid
limitations of being a shell (no trading if a Form 10, filing "super" 8-K if an
admitted shell) by taking public "startups" that are not considered blank
checks but have an undisclosed intention of marketing them as shells
immediately upon going public.
Thus, while Rule 419 stopped the direct IPOs of shells,
players basically got around this by acquiring remants of operating public
companies and taking tiny companies public to then use as shells.
regulatory changes have strengthened investor protection since 1992?
As mentioned above, as a practical matter shells could be
inherited or created without the restrictions of Rule 419. But each has its
limitations. Stock in Form 10 shells cannot trade until a registration is
completed post-merger. "Legacy" shells face risk of undisclosed liabilities
from the past and an unknown shareholder base. Shells masking as startups risk
being outed as potential frauds.
But currently, through a Form 10 or legacy shell, one can
move forward with a reverse merger without a time limit, shareholder approval
of a deal or right to return money, all restrictions under Rule 419. So as
a practical matter Rule 419 has become essentially meaningless from an investor
protection standpoint since it is not used and legitimate players can
easily avoid its restrictions.
In addition to these 419 alternatives, the SEC has
tightened up regulation of reverse mergers. In 2005, the "super" 8-K was
introduced as a full disclosure document required to be filed within 4 days
after a reverse merger with a reporting shell company. This was not previously
required and brought greater transparency and legitimacy to these transactions.
In 2008, while adding certain other restrictions, they reversed a long-standing
position to now allow shareholders of a shell the right to sell their shares without
registration under Rule 144 one year after a reverse merger.
Rule 419 be fixed to become an attractive and investor protective method of
Yes I believe it can. Here is my suggested proposal:
1. Maintain the requirement to put money raised in a 419
IPO in escrow, minus underwriters compensation and 10% for expenses as
2. Maintain the requirement to put stock issued in the
IPO in escrow until a merger is consummated. So no trading of the shell while
it is a shell.
3. Maintain the requirement of finding a deal within a
certain time, but increase it to three years.
4. Eliminate the requirement that deal size have some
relationship to the amount raised, there really is no rational need for this.
5. Replace shareholder confirmation and the related proxy
6. To benefit from these reduced burdens, the
shell would be limited to offering shares in the IPO to accredited
7. Lower the threshhold for being exempt from Rule 419
completely from $5 million to $2.5 million, but again only if the
offering between $2.5 million and $5 million is limited to accredited
This proposed change provides strong protection for
investors, full disclosure similar to what is currently required for shell
mergers, and a complete right to opt out of the transaction. There is also no
trading while the company is a shell and assurance that only wealthier
investors are involved. It will also all but eliminate the benefit of shells
masking as startups, because a deal could be closed quickly and trading
commence immediately thereupon. And the troublesome "legacy" shells would not
have any advantages over this clean approach and would retain their unique
For additional insights on reverse mergers,
SPACs, other alternatives to traditional initial public offerings, the small
and microcap markets and the economy, visit the Reverse Merger and
SPAC Blog by David N. Feldman, Esq., Partner of Richardson &
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