The California Department of Corporations recently issued a release indicating it will exercise its discretion to deny requests for fairness hearings with respect to "reverse merger" transactions, which occur when a private company becomes publicly traded through a merger with a publicly held "shell" company (see California Corporations Commissioner Release No. 117-C).
California is one of few states providing a forum for issuers that seek the exemption from federal registration under section 3(a)(10) of the Securities Act of 1933, as amended. An applicant for qualification of issuance of securities in California may request a hearing on the fairness of the terms of the proposed issuance or exchange of securities. If the hearing is granted and the transaction in question is found by the California Department of Corporations to be fair, the issuance of the securities in the transaction is exempt under section 3(a)(10). The California Department promotes the process as a fast and cost-effective alternative to federal registration.
In its release, the California Department noted that the U.S. Securities and Exchange Commission (SEC) now requires shell companies, upon ceasing to be shells, to file current reports on Form 8-K containing substantially the same information that would be required in an application for registration on Form 10 or Form 10-SB. Citing California regulations instructing mergers should provide for the issuance of securities that fairly reflect the relative values of the constituent corporations, the California Department noted that generally in reverse mergers the promoters of the public shell receive ownership interest in the resulting entity, which dilutes the owners of the private operating company. The California Department reasoned that the private operating company could, as an alternative to the reverse merger, register its securities by filing Form 10 or Form 10-SB without dilution to its existing security holders or potentially assuming unknown or contingent liabilities of a shell company. Accordingly, the California Department will exercise its discretion to decline to hold fairness hearings on applications regarding reverse mergers in the absence of other countervailing benefits to the private operating company.
The fairness hearing procedure remains a viable option for transactions not involving shell companies. The California Department has granted fairness hearings when a single shareholder residing in California receives shares in the transaction.
One of the benefits of receiving securities in a section 3(a)(10) transaction is that the securities are not restricted. However, the nature of the reseller determines the restrictions on resales.