Increased regulation is weeding out a lot of the less-scrupulous practitioners of reverse mergers. In the process, what has long been the 'ugly stepchild' of public listing procedures may be gaining a measure of respectability.

But private companies that view reverse mergers as a short-cut to public listing still risk headaches if their due diligence is inadequate.

According to a study commissioned by reverse merger consulting firm Halter Financial Group Inc. of Irving, Texas, nearly half the U.S. companies that listed as public companies over the past five years did so through reverse mergers rather than through traditional IPOs. In 1995, the percentage of reverse mergers reached 54.3% - last year they made up only 36% of the listings.

Granted, a large percentage of reverse merger companies end up on the over-the-counter bulletin board or pink sheets, yet a substantial number of companies become publicly traded through a method that receives little publicity and is not widely understood.

Piranha Inc., a Dallas technology company, is a typical product of a reverse merger. CEO Ed Sample had what he considered a valuable idea for developing data compression technologies in late 1999, but he needed a company to implement it.

IPOs are expensive and time-consuming

Sample formed a business plan for a private company called Zideo.com Inc., which had three principals, including Sample, but no technology. His business plan included acquiring other companies to provide the science, and going public would provide the company with shares as a form of currency to acquire the necessary companies, as well as access to a wider range of funding. A standard IPO, however, was expensive and time-consuming.

'In late 1999 the markets were volatile,' Sample said. 'There was a lot of money around, and we wanted to get into the market quickly while the timing was right.'

As it happened, a business associate, Richard Berger, was chairman of a company called Classics International Entertainment Inc., which was public but dormant as a result of financial difficulties. CIE had 2,500 shareholders as well as brokers and market-makers - all it needed was a business.

Berger proposed a reverse merger to Sample, who had never heard of the process. Sample learned that reverse mergers could save much of the time and expense of a public listing, and that some major business figures, such as Ted Turner, Armand Hammer and Muriel Seibert had used them.

On Dec. 9, CIE filed to acquire Zideo and change its name to Piranha Inc. for listing on the over-the-counter bulletin board. In quick succession, the new company acquired two companies and established a subsidiary, then appointed an experienced board of directors and a well-connected and credible advisory board.

The fast track to going public

Piranha is now developing three lines of products for which it has received investment and orders from some major companies, is trading around $10 and has filed for a listing on Nasdaq.

Sample believes Piranha could not have acquired the necessary technology, attracted its experienced board of directors or obtained funding without the status of a public company, which was greatly facilitated by the reverse merger with CIE.

As reverse mergers have become more popular, they've spawned a kind of cottage industry. Inevitably, some of the method's proponents are more trustworthy than others.

The different types of public companies available for reverse mergers entail different kinds of risk.

According to Steven Chapman of Southward Investments llc in Rochester, N.Y., the most desired merger target is a trading and reporting shell company - a company with up-to-date filings and a wide shareholder base.

Describing such companies as 'unicorns,' Chapman said they've been virtually non-existent since 1988, when new federal regulations stipulated that any corporation going from Chapter 11 to Chapter 7 bankruptcy was obliged to liquidate.

Clean shell companies are hard to find

Chapman said he's been contacted by a number of brokers and clients whose customers want a trading and reporting shell company, but 'clean' ones are extremely hard to find. He has seen at least two companies in the Rochester area that merged with trading and reporting shells and subsequently inherited nightmarish legal issues or mutinous shareholders who virtually nullified any benefit from the streamlined listing process.

Southward handles a number of older shells that went bankrupt before the 1988 change in regulations. These companies may have hundreds of shareholders and are typically free of debt or other complications. Unlike the trading and reporting shells, these dormant shells require filing updates before they can resume trading, and some private companies prefer to avoid the effort and delay involved in merging with them.

Given the complications of merging with 'real' companies, the market periodically encourages formation of 'blank check' or 'blind pool' companies that have no assets or liabilities, and often as few as one or two shareholders. In the 1980s blind-pool companies became notorious as vehicles for pump-and-dump fraud.

More recently, blank-check companies have made a major comeback. A filing for a company called Klamath Falls Corp., for example, states that the company's officer, Daniel L. Hodges, is or has been involved with 130 shell companies, 110 of which are looking for merger or acquisition opportunities.

An examination of SEC filings from July through September indicates that about 400 blank-check or blind-pool companies are listed on the over-the-counter bulletin board, with at most a handful of shareholders, no assets and no business other than awaiting merger opportunities.

Waiting for a buyer

According to Tim Halter of the Halter Financial Group, many of the newer shell companies were formed as incubators. A company was established with no business or assets and its shares were gifted or sold at a nominal price to a large group of people through a private transaction. The idea was that after two years, these shares would be exempted from registration and qualify as freely tradable stock, allowing the company to become a public entity for merger purposes.

A more recent inspiration for forming shells with only one or two shareholders was to merge with other listed companies that fell afoul of the National Association of Securities Dealers' recent scouring of the over-the-counter bulletin board. Last year the NASD imposed new regulations requiring all bulletin-board companies to file with the SEC. Some companies attempted to evade the requirement by merging with shell companies that had completed the necessary paperwork.

In the end, 60% of the companies listed on the bulletin board were demoted to the pink sheets because of failure to make the necessary filings.

In January, Richard Wulff, chief of the SEC's Office of Small Business, stated that the various methods used by incubator-type blank check companies were 'not the kind of ordinary trading transactions between individual investors of securities already issued' that would be exempted from registration. In other words, the shares of the incubator shell will remain subject to the SEC's onerous registration requirements rather than being considered freely tradable.

With respect to the one-man shells, Wulff said in April that the SEC disagreed with the claim that a non-reporting company could become a successor issuer to a blank check company as a result of a merger. As a result, the non-reporting company still has to file the documentation required by the new NASD regulations and gains nothing from merging with the shell.

Trying to ensure disclosure

In an interview last week, Wulff said the SEC needs to clarify existing regulatory policy in light of recent activities by promoters to market blank check companies as a means of circumventing regulatory requirements. 'All we're doing is trying to ensure disclosure so people can have a complete picture of the actual operating company rather than of a non-operating shell,' he said.

In Halter's opinion, 'As a practical matter these regulations have made it all but impossible to create shells for reverse merger purposes. Technically they're still allowed, but if you look at the filings, you'll see very few have been created this year.'

Southward's Chapman believes that companies involved in reverse mergers are no more prone to pump-and-dump than traditional IPOs, where institutional brokers and investment bankers are allotted cheap shares in a private company prior to the public float.

'The stigma about shells is from the new people who come in and abuse the system,' Chapman said. 'That's what people read about. They don't read about the legitimate companies that use this structure to advance their business, even though these make up the majority. Now the regulators are cracking down. I'm the first to say, 'Good!'

Reporter E-mail Address: smosher@thedailydeal.com