Reverse Merger: Have They Taken the Reverse out of Reverse Merger?
It's no secret that in the past, a reverse merger was one of the most common ways for a company to go public. So it may be surprising to find out that this type of corporate structure is now under serious scrutiny and regulation.
This post will discuss what exactly reverse mergers are, why they're being heavily regulated, and how they've evolved over time. It'll also analyze who really loses from these buyouts and why regulators are coming down hard on them. Get our latest insights on one of Wall Street's most notorious transactions!
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Reverse Mergers: The Basics
A reverse merger is basically a type of corporate transaction where an already-public company acquires a private one. This basically means that the private company "goes public" by merging with, or being acquired by, a public shell.
The most important thing to keep in mind is that this isn't your everyday initial public offering, where a company launches and immediately begins trading on the markets. A reverse merger is actually more similar to an acquisition between two companies.
The basic reverse merger structure goes something like this:
Private Company A: does whatever it wants, business is going great, etc. Private Company B acquires company A and takes it private. A new public shell is then formed to take advantage of the newly acquired company's name and assets. (More on that in a moment.) The public shell takes on all of the liabilities and investment bank debt from the private company, which is now essentially debt-free. The public shell then announces some type of IPO in order for investors to get involved (a stock offering). The public shell starts trading through an initial public offering (IPO) with stock. Investors start buying shares/shares, etc., from the IPO. The reverse merger is essentially complete. The public shell pays off the private company, it becomes compliant with the SEC, and it starts trading on the public markets.
Why Reverse Mergers Are Being Regulated?
Typically, a reverse merger has been something of a black box for investors and stock holders. There's no real way to find out how much money is being made as a result of the consolidation or how many jobs were saved or lost as a result of the consolidation (since these dual companies are typically merged into one). It can be difficult to even figure out exactly who owns or runs these private companies that are being taken private by the public shell.
That's what makes this type of transaction very attractive for corporations. By going private, they get to keep all of the profits that they were making without the scrutiny of the public markets. And since these companies are now private, there's no way for investors, employees or customers to know who is running them. It's as if they've been swallowed up by some parent company.
However, this also makes it very difficult for securities regulators to root out this type of transaction and enforce rules and regulations that are already in place for public stock offerings and IPOs.
Reverse Mergers Have Gone Through Many Evolutions Over Time
A reverse merger was originally a common way that corporations go public. But throughout their history, the rules and regulations surrounding reverse mergers have changed more than once.
In 1996, the Clinton administration passed a law that required all companies going public to complete Reg. A+ filings with the SEC. These filings are essentially blueprints for going public and explain how the company plans to adhere to all of the regulations that apply to public offerings. The idea behind these new rules was to level the playing field for markets and ensure that everyone was complying with regulations during a time when corporate accounting was very opaque (think Enron).
In 1998 came another set of regulations for Reg. A+ IPOs, which further required companies and at least one executive officer to meet certain disclosure requirements.
In the mid 2000s, the SEC revised their rules again because they were having difficulty enforcing these regulations. They were struggling to track all of the different companies that were going public as a result of Reg. A+ offerings, particularly ones that were formed after buying out an older company using Reg. A+. These types of transactions became very popular during the technology bubble years and many investors would take advantage of them by buying up stock right before it went public, then selling it right after it was issued on the markets.
In response to these problems, in 2008 came another set of revisions and revisions to Reg. A+, which not only required company executives to meet a new set of disclosure standards, but also required all companies that employed at least two senior executives to meet a similar requirement. (This would later be expanded to companies of 4 or more senior executive officers.)
That same year in 2008, the SEC specifically stated that they would be strictly enforcing these rules and regulations for reverse mergers. And as you might have guessed, they are currently doing just that.
You can see how this has played out for companies and investors involved in reverse mergers.
The History of a Reverse Merger: Hovnanian Homes (HOM)
The current, most famous result of an SEC crackdown on reverse mergers is the recently completed transaction between Hovnanian Homes (HOM) and Starwood Capital Group (WIX). The transaction was halted in early July 2014 after several compliance issues were discovered by the SEC.
This deal was so significant because it would have been the first time that a homebuilder was going public on the public markets after being acquired by another homebuilder company. In this case, Hovnanian Homes had become a shell for Starwood Capital Group to take Hovnanian Homes private.
In late 2012, Starwood Capital Group ("Starwood") acquired approximately 99% of Hovnanian's stock from Lennar Corporation (LEN). Hovnanian was still operating as a company and continued to operate their business throughout the transaction, but soon after its completion, Starwood took it private.
Conclusion: The SEC Is Holding Corporations Accountable For Their Actions
The situation with Hovnanian Homes shows that this type of transaction is now being actively scrutinized by the SEC. Although it was a rare occurrence for a public shell to acquire a private company, it's not at all uncommon for companies that are publicly traded to take companies private. In fact, last month the SEC fined Vanguard Group (Vanguard) $50 million for violating these regulations in order to gain a competitive advantage in stock trading and share prices.
So it's important to remember that the rules and regulations regarding reverse mergers are very strict and being enforced with an iron fist by the SEC right now.