Mergers by Members With Blind-Pool Companies

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EXECUTIVE SUMMARY

NASD members are advised that their participation in certain transactions with blind-pool companies may be inconsistent with the provisions of Schedule E to the NASD By-Laws. The merger or acquisition of an NASD member firm or its parent by or with a blind-pool company that results in the direct or indirect public ownership of an NASD member or its parent must comply with the provisions of Schedule E. A "blind-pool" company is formed by a public offering of equity securities of a corporate entity in which the issuer discloses that the net proceeds of the offering will be used to search for and acquire as yet unidentified existing businesses. Because of the importance that the NASD places on the investor protection provisions of Schedule E, the NASD is publishing its views on the application of Schedule E to the By-Laws, the disclosure provisions of the Securities Act of 1933, and the anti-fraud provisions of Securities Exchange Act of 1934 to such transactions.

BACKGROUND

Recently, the NASD Corporate Financing Department has reviewed a number of public offerings of equity securities of recently formed corporations that raised between $400,000 and $800,000 from the public. In such offerings, the public offering document does not disclose a business plan for investment of the capital raised by the corporation. Rather, the offering document discloses that the corporation has been formed for the purpose of seeking business opportunities believed to hold a potential for profit. Such business opportunities include merging with or into existing businesses or acquiring assets to establish subsidiary businesses. The companies' officers and directors have complete discretion in the use of the proceeds they receive from the public. Such offerings are generally referred to as "blind-pool" or "blank-check" corporate offerings.

In a number of instances, the NASD has learned that certain shell companies that became public through blind-pool public offerings have merged with or been acquired by an NASD member or the member's parent. These transactions are usually effected through the issuance of additional shares of stock of the blind-pool company to the owners of the private member firm or its parent.

For example, one blind-pool company was formed in November, 1985 and began its initial public offering in late 1986. It concluded the public offering on February 17, 1987, with net proceeds of $130,000, and acquired an inactive broker/dealer March 2, 1987. It acquired the broker/dealer by issuing 10.8 million shares of common stock that had a stated value of $54,000. In this acquisition, the board of directors of the blind-pool company did not engage an independent accountant or investment banker to verify the stated value that it had set for the common stock.

In another instance, a blind-pool company effected a reorganization with a member. Approval of the reorganization was accomplished by the issuance and solicitation of proxies to the holders of the common stock of the blind-pool company. The terms of the reorganization called for the issuance of 20 million shares of common stock of the blind-pool company to the three shareholders of the member, and for three persons associated with the member to be elected directors of the blind-pool company after the close of the reorganization. Additionally, the terms of the reorganization provided for the officers of the blind-pool company to be replaced by the officers of the member. In this transaction, no independent appraisals were used to determine the exchange ratio of the stock.

EXPLANATION OF SCHEDULE E TO THE BY-LAWS OF THE ASSOCIATION

In the merger and corporate reorganization described above, two member firms became publicly owned without compliance with Schedule E to the NASD By-Laws. The NASD adopted Schedule E in 1972 to address the NASD's special concerns in ensuring that public investors are protected adequately when investing in a member or its parent that is going public. Schedule E contains provisions that are designed to ensure investors that the price of the equity securities that are offered is no higher than the price recommended by a qualified independent underwriter (i.e. a member with a background in underwriting and a history of profitable operations) who has also conducted due diligence and participated in the preparation of the prospectus, offering memorandum, or similar document. These provisions provide investors protection from the conflicts of interest that exist when a member or a parent of a member offers its own securities to the public. The NASD has always believed that any offering of securities resulting in the direct or indirect public ownership of a member is subject to Schedule E and should be filed with the Corporate Financing Department for review, regardless of whether such offering is made pursuant to a registration statement or offering circular. The NASD clarified this view when it published proposed amendments to Schedule E in Notice to Members 80-39, dated August 11, 1980¹ and in SEC rule filing SR-NASD 80-29².

ISSUES RAISED BY A MERGER WITH A BLIND-POOL COMPANY

Section 9 of Schedule E is designed to ensure that an offering by an issuer that is not an affiliate of a member at the time of the offering, but as a result of the offering will be a member's affiliate, is conducted in compliance with Schedule E. Section 9 sets forth a number of types of transactions resulting in public ownership of a member and clarifies that Schedule E is applicable in such specified instances. Section 9 goes on, however, to make clear that:

"If an issuer proposes to engage in any offering which . .. results in the public ownership of a member ... the offering shall be subject to the provisions of Schedule E . .. "(emphasis provided).

Thus, if a publicly owned issuer merges with a member, or a publicly owned issuer is acquired by a member or a parent of a member, the merger transaction would be subject to Schedule E since it would constitute an offering that results in the direct or indirect public ownership of the member. Members are cautioned that mergers or acquisitions involving an issuer and a member or its parent that result in the public ownership of the member or its parent are subject to Schedule E regardless of whether the merger or acquisition occurs subsequent to the public offering.

Schedule E also applies to corporate reorganizations similar to the example cited in which a blind-pool company issues a proxy statement to investors. The proxy statement solicits their consent to a reorganization that results in the acquisition of a member or its parent, and previously authorized, but unissued, shares are to be issued to the owners of the member or its parent as a result of the affirmative action of the shareholders of the blind-pool company. Section 9 of Schedule E requires that the reorganization that is the subject of the proxy be carried out in compliance with Schedule E.

Therefore, members are cautioned that pursuant to Section 14 of Schedule E, proxy materials filed with the SEC under SEC rules that involve a reorganization to acquire a member or its parent must be filed with the NASD Corporate Financing Department for review and must be in compliance with the provisions of Schedule E prior to the effective date of the reorganization. In addition, if a business combination between a member or its parent and a blind-pool company should be proposed and the result of the transaction would be that the member or its parent would be publicly held, the documents relating to that transaction must be filed with the NASD for review under Schedule E.

The NASD also believes that where there is a short time period between the close of a public offering and the close of a merger, (in the case noted above, nine business days) serious questions arise concerning whether the member and the issuer provided adequate disclosure to the public with respect to merger negotiations that may have been in progress prior to the closing of the offering. If such merger negotiations were in progress and the prospectus was not amended to disclose them, serious violations of the Securities Act of 1933 and the anti-fraud provisions of the Securities Exchange Act of 1934 may have occurred.

Questions regarding this notice can be directed to Charles L. Bennett, Assistant Director, NASD Corporate Financing Department, at (202) 728-8258.

¹ NASD Notice to Members 80-39, published August 11, 1980, at page 13 proposed that then Section 2(o) be revised to "... make it clear that public offerings whose proceeds are received by a member and public exchange offers for interests in members are subject to Schedule E. It would also be clarified that any other offering that results in the public ownership of a member would be subject to Schedule E ..."

² SR-NASD-80-29, filed with the SEC December 31,1980, at page 52 proposed that Section 9 (then Section 8) be revised to "... clarify that any other type of offering which results in the public ownership of a member would also be subject to Schedule E ..." The rule filing goes on to state that "Section [9] of the proposed rule change broadens the scope of former Section 2(o) with the purpose of inhibiting circumvention of Schedule E."