“Back Door” SEC registration – Some Filing Issues

“Back door” registration occurs when a private operating company acquires a SEC-registered public shell company and then the parties enter into a “reverse merger”, i.e., the acquiring company (the private operating company) merges into the acquired company (the SEC reporting shell company).   Note, however, that post-merger the private operating company is the acquirer for accounting purposes and the public shell becomes the acquiree for accounting purposes under SEC rules. These transactions are done as a quick and cost-effective way for a private operating company to become public.  That said, the SEC reporting requirements for these transactions are not obvious from a reading of the SEC regulations and errors in accounting treatment or registration procedures, which are quite common, can be difficult and burdensome to resolve.    Back-door registration is reported on a Form 8-K rather than a 1933 Act registration statement, such as an S-1, S-2 or S-3.  Thus, SEC staff review occurs after the 8-K has been filed, not by means of staff comments prior to the effectiveness of a pre-effective registration statement.   Correcting mistakes after an 8-K filing has been made can complex and time-consuming.

 Unless the same audit firm audited both the public shell and the private operating company, a reverse merger always results in change of accountants for purposes of Item 4.01 of Form 8-K.  If the due date or filing date of the Form 8-K, whichever is earlier, occurs after the end of the private operating company’s most recently completed annual or quarterly period, but before financial statements for that annual or quarterly period would be required to be presented in a Form 10, the financial statements of the private operating company required by Items 2.01(f) and 9.01 of Form 8-K may not include the private company’s most recently completed annual or quarterly period. The public shell company, however, remains subject to Exchange Act Rules 13a-1 and 13a-13, or 15d-1 and 15d- 13, requiring annual and quarterly reports, respectively. The public shell company must file its applicable annual and quarterly reports. Additionally, the public shell company must file an amended Form 8-K with the financial statements of the private operating company’s most recently completed annual or quarterly period prior to the date of the reverse recapitalization, as applicable, within 90 or 45 days, respectively, after the private operating company’s period end.

 While the historical financial reporting for pre-transaction periods may change to that of the private operating company once the transaction has occurred, the SEC registrant does not change in this type of transaction. The SEC registrant is still the public shell company (now with new assets and liabilities), and therefore it is not a newly public company for purposes of SOX 404.  However, the SEC staff has issued a Compliance and Disclosure Interpretation (“CDI”) to provide guidance to companies in this situation. It acknowledges that it might not always be possible to conduct an assessment of the private operating company or public shell’s internal control over financial reporting in the period between the consummation date of a reverse acquisition and the date of management’s assessment of internal control over financial reporting required by Item 308(a) of Regulation S-K.  The CDI also recognizes that in many of these transactions, such as those in which the legal acquirer is a non-operating public shell company, the internal controls of the shell company may no longer exist as of the assessment date or the assets, liabilities, and operations may be may be insignificant when compared to the consolidated entity. Therefore, the SEC staff does not object if the registrant excludes management’s assessment of Internal Controls over Financial Reporting (“ICFR”) in the Form 10-K covering the fiscal year in which the transaction was consummated. However, this CDI would not apply if the company had to file an amended Form 8- K under the Rule 13a-1 interpretation discussed above in the second paragraph.

 Example of SEC staff interpretation of Rule 13a-1:

  • Reverse merger occurs on February 1, 2012
  • Shell company (accounting acquiree) and non-public operating company (accounting acquirer) each have a fiscal year-end of December 31
  • Audited financial states of the private operating company for the year-end December 31, 2010 and the unaudited financial statements for the interim period ended September 30, 2011 and comparable prior periods would be filed on Form 8-K
  • The SEC registrant would file its annual report on Form 10-K for the year ended December 31, 2011 within 90 days of that date.
  • The SEC registrant would file an amended 8-K within 90 days of December 31, 2011 containing the same information for the private operating company required in a 10-K. 

In SEC Release No. 33-8587, the SEC said that investors in operating businesses newly merged with shell companies should receive the same level of information as provided for reporting companies that did not originate as shell companies. Therefore, such companies are required to include equivalent information as if they were registering under the Exchange Act.

Under current accounting literature, the acquisition of a private operating company by a non-operating public shell company is considered by the SEC Staff to be a capital transaction in substance rather than a business combination (it is outside the scope of FASB ASC Topic 805). That is, the transaction may be viewed as a reverse recapitalization — issuance of stock by the private operating company for the net monetary assets of the public shell company accompanied by a recapitalization. In order to reflect the change in capitalization, earnings per share should be recast for all historical periods to reflect the exchange ratio. The common stock account of the public shell continues post-merger, while the retained earnings of the shell company should be eliminated as the historical operations are deemed to be those of the private operating company.

Recapitalization example:

  • The reverse merger was consummated on April 10, 2011
  • At March 31, 2011, the public shell had 100,000 shares outstanding (par value $1.00 per share)
  • At March 31, 2011, the private operating company had 100,000 shares outstanding (par value $2.00 per share)
  • The public shell issues 400,000 shares for 100% of the private operating company
  • No other equity transactions occurred between April 10, 2011 and June 30, 2011
  • The post-merger Registrant has net income of $300,000 for the period from April 1, 2011 to June 30, 2011

Back-door SEC registration has been used by a number of Chinese companies that wanted to become publicly traded on an expedited basis.  Some of these transactions did not turn out well for investors.  It is fair to say that the SEC staff will carefully review the disclosure and accounting procedures in these filings.

 

 

 

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