This article was written by Edward H. Weave and appeared in a recent Newsletter I received from The Lebrecht Group, APLC.

Ever since the Securities and Exchange Commission (the “SEC”) amended Rule 144 of the Securities Act of 1933 (“Rule 144”) on February 15, 2008, we have noticed that during the comment phase of the application process to initiate or resume quotations in the OTC Bulletin Board, the Financial Industry Regulatory Authority (“FINRA”) has been more liberal in issuing the “shell” comment to small startup companies, especially companies without revenues. The FINRA comment typically includes a statement that the issuer appears to be a shell company or was a shell company when it issued its shares because of its limited operations and nominal assets. In the same comment, FINRA usually states that the resale of the issuer’s shares is restricted and shares cannot be sold until the provisions of Rule 144(i) are met. Additionally, if the issuer is already a reporting company, FINRA will suggest that the issuer amend its SEC filings to check the box on the facing page to reflect its shell status. Accepting FINRA’s presumption that the issuer is a shell company can have devastating consequences for an issuer and its shareholders because, under the revised Rule 144(i), no shareholder can utilize the to sell his shares if the issuer is, or ever was, a shell company unless the issuer has met the requirements to cure its shell status under Rule 144(i)(2).

To “cure” its shell status under Rule 144(i)(2), the issuer must meet the following requirements:

* is no longer a shell company as defined in Rule 144(i)(1);
* has filed all reports (other than Form 8-K reports) required under the Securities Exchange Act of 1934 for the preceding 12 months (or for a shorter period that the issuer was required to file such reports and materials); and
* has filed current “Form 10 information” with the SEC reflecting its status as an entity that is no longer an issuer described in Rule 144(i)(1), and at least one year has elapsed since the issuer filed that information with the SEC.

Rule 144 is the exclusive means, absent registration, by which affiliates of an issuer as well as holders of “restricted” stock (i.e., stock received in an unregistered private placement or an equivalent transaction) may effect public sales of their stock. Without the ability to utilize the Rule 144 exemption, current and prospective holders of restricted stock are stuck with an illiquid investment for at least one year from the date the issuer files current “Form 10 information” with the SEC unless the issuer is willing to divert valuable resources to pursue the costly and time-consuming process of filing a resale registration statement with the SEC. This prolonged period of illiquidity repels investors, and, therefore, shell companies face difficulties raising capital in the equity markets until they cure their shell status.

Thus, to avoid the foregoing consequences, prior to allowing a market maker to submit a Form 211 application on its behalf to initiate or resume quotations in the OTC Bulletin Board, a small startup company should make sure it can provide sufficient evidence to FINRA to prove it is not a shell company.

The SEC, in Release No. 33-8869[1] (the “Release”), defines a “shell company” to mean a registrant, other than an asset-backed issuer, that has:

1. no or nominal operations; and
2. either:

* 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.

The SEC did not define the terms “nominal operations” or “nominal assets” in the Release, and, therefore, FINRA interprets the meaning of these terms on a case-by-case basis. For example, “nominal assets” and “nominal operations” for a software development company and an automobile dealership would likely have completely different meanings.

However, because of the “and” after (1) above, a company must have “no or nominal operations” before the analysis even gets to “no or nominal assets” and the other items in (2). In other words, if a company can prove it has more than nominal operations, it cannot be considered a shell company as defined in the Release. However, this can be a difficult proposition for a company in the early stages of development that has not generated revenues yet.

In the Release, several commenter’s were concerned that the definition of a shell company set forth above would capture virtually every company during its start-up phase and that the definition was therefore too broad. The SEC specifically addressed this situation in footnote 172 to the Release (although they are addressing it in the context of Rule 144) by saying, in applicable part:

Contrary to commenter’s’ concerns, Rule 144(i)(1)(i) is not intended to capture a “startup company,” or in other words, a company with a limited operating history, in the definition of a reporting or non-reporting shell company, as we believe that such a company does not meet the condition of having “no or nominal operations.” (emphasis added)

Therefore, a startup company desiring to initiate or resume quotations in the OTC Bulletin Board must be prepared to convince FINRA that it is a company with a limited operating history rather than a company with nominal operations, and, as a result, does not meet the condition of having “no or nominal operations” as set forth in the Release.

Based on our firm’s experience and calls with FINRA examiners, it appears that FINRA analyzes a startup company’s business activities during its “limited operating history” to determine whether the company has engaged in activities that are, at a minimum, sufficient to manifest a strong commitment to developing a legitimate business. These activities include, but are not limited to, the following:

1. entering into agreements with customers, vendors, manufacturers, etc.;
2. filing patent, trademark, and copyright applications with respect to the company’s intellectual property;
3. executing license or sublicense agreements with respect to the company’s intellectual property;
4. entering into product development agreements or similar agreements for the development of a product or service;
5. hiring employees;
6. incurring material operating expenses such as research and development expenses; and
7. entering into a lease agreement for office space.

For officers and directors of small companies with limited operating histories, engaging in these activities is no guarantee that FINRA will approve the Form 211 application submitted on behalf of your company. As discussed above, FINRA performs its analysis on a case-by-case basis and will take the abovementioned activities and many other factors into consideration. If the facts are sufficient to convince FINRA that you are developing a real business, the Form 211 application process will not be too painful. If your company’s business activities do not demonstrate a sufficient level of commitment to developing a legitimate business, FINRA may suspect you are attempting to create what industry insiders call a shell – a non-operating publicly traded company whose only purpose is to serve as a vehicle for acquiring or merging with a private company whose management desires to go public without the burden of registration with the SEC – not to be confused with the SEC’s definition of a shell in the Release.

If FINRA suspects you have the “shell” intentions, it will likely make the comment phase of the Form 211 application process very long and difficult. This protracted comment phase can last over a year leaving your small company “shell” shocked and leaving you reluctant to continue a seemingly endless battle with FINRA.

This article is not a complete and thorough discussion of Rule 144 or the Form 211 application process. This article is intended only as a general discussion of these issues. It should not be regarded as legal advice.

Edward H. Weaver is an attorney with The Lebrecht Group, APLC, located in Irvine, California and Salt Lake City, Utah. He can be reached at (801) 983-4948 or eweaver@thelebrechtgroup.com

Please visit our website at www.thelebrechtgroup.com for further information.

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