Buyers beware: Look under the hood before buying a publicly traded shell company.
Some are Ferraris. Others are Pintos.
An estimated 10 or so shells have popped up in Orange County. These shells make regular filings with the Securities and Exchange Commission to maintain their status as publicly traded companies.
Shells had business operations in their previous life. They were either bought, went bankrupt or dissolved in some other way.
Despite their dormant status, shells have become hot acquisition targets by privately held companies looking for a cheap way to gain access to capital to fund growth.
In a reverse merger, a private company buys all or most of the stock of a publicly traded shell. Small companies find it’s a low-cost, quick and easy way to instantly become a public company, often without the regulatory paperwork required for a conventional initial public offering of shares.
Roughly 130 shell companies have filed with the SEC to keep their status since last summer, according to the Reverse Merger Report, a sister publication of Jericho, N.Y.-based DealFlow Media Inc. The Reverse Merger report launched about a year ago after investment bankers began clamoring for more information.
Shells typically trade on the low-profile over-the-counter bulletin board or Pink Sheets, a largely unregulated electronic quotation system that long has been considered the Wild West of public companies.
Many shells fly below the radar screen. They don’t have household names,Irvine-based Matrix Concepts Inc. and Anaheim-based SaVi Media Group Inc. are a couple in the area.
Planetwide Games Inc. in Aliso Viejo is looking to complete a reverse merger. Planetwide plans to combine with SP Holding Corp., a publicly held shell company, in order to get its listing on the over-the-counter bulletin board.
Planetwide makes Comic Book Creator, a software program that lets users create custom comic books and then publish them for friends online or in print. The company’s chief executive is Marvin Winkler, former owner of Newport Beach-based apparel maker Gotcha International LP, which filed for bankruptcy in 2002, but since emerged and was sold to Miami-based Perry Ellis International Inc. late last year.
Planetwide hopes to get shareholder approval for the reverse merger by April 15, according to regulatory filings.
“We want to raise additional capital and grow,” said Tom Schiff, chief financial officer of Planetwide. “We think this would take us to the next level. It’s easier to buy a shell company, though there are pitfalls.”
The biggest potential landmine is buying someone else’s financial mess.
A shell company might have liabilities leftover from shareholder suits stemming from the shell’s previous line of business, Schiff said.
Prospective buyers of shell companies should do background checks on executives and make sure the company doesn’t have any outstanding debts, Schiff said.
One local shell deal that went bad involved Filtering Associates Inc., an Irvine-based company that claims it was putting together a marketing plan to distribute computer devices.
Filtering Associates has accumulated losses of $306,511 since its inception in 2001, according to regulatory filings.
Last June, Filtering Associates was set to give up about 95% of its shares to Hawaii Biotech Inc. in a reverse merger. Filtering Associates was set to get roughly $200,000 in cash in exchange for its listing.
The proposed deal collapsed in October. Officials familiar with the situation declined to comment. Filtering Associates continues to make filings with the SEC to keep up its shell status.
Sometimes a company will slip into “shell” status while it winds down its business over several years. During this period, the company cleans up its balance sheet, settles litigation and does whatever else is needed to streamline operations.
One example: Maxicare Health Plans Inc., a onetime La Mirada-based health maintenance organization. Five years ago, mounting losses forced Maxicare to file for bankruptcy protection.
The company’s HMO was eventually placed under the control of California regulators. Due to continued losses, the company terminated its operations in January of 2002, and now is in the process of liquidating assets worth a few million dollars.
Maxicare still files regular statements with the SEC to keep its shell status.
Observers of the reverse merger industry have seen an uptick in local deals as private equity firms and hedge funds are flush with cash and want to make corporate buys of small companies with a market capitalization of less than $200 million.
Startups see a stock listing as a path to being bought. IPOs aren’t always an option.
“Ever since the dot-com crash, big banks on Wall Street pretty much deserted the market for small IPOs,” said Brett Goetschius, executive editor of DealFlow Media in Petaluma. “This is hardly the land of blue chips.”
There’s another explanation for the increase in deals: The quality of shells greatly improved since the SEC adopted a new set of rules last summer to clean up scams in the industry.
“Investment bankers see that the company is not ready to be public, and the reverse merger is the way to avoid that vetting process for companies seeking to go public through the traditional IPO,” Goetschius said.
Big Gainer
The Costa Mesa office of Rutan & Tucker LLP has been involved in one of the past year’s most successful reverse mergers.
It helped Fresno-based Pacific Ethanol Inc., a privately owned company founded by former California Secretary of State Bill Jones, a Republican candidate for U.S. Senate, complete a reverse merger with a Florida shell company.
The shell company, called Accessity Corp., once was a healthcare services holding company. Shares of the ethanol company are up 91% since going public.
Rutan partner Larry Cerutti said his law firm generally steers clear of reverse mergers.
“Usually we get involved when it goes sideways and it needs somebody to fix it,” said Cerutti, who heads Rutan’s corporate practice. “It’s rare when they come together as nicely as Pacific Ethanol.”
Pacific Ethanol has raised more than $111 million since going public.
