Merger, Acquisition & Transaction Consultants

King & Associates, P.C.

What is the Sarbanes-Oxley Act and What Effect Does It Have on Reverse Mergers

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Weatherford, TX 76086

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Phone: 817-598-1007

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E-mail: Doug@ReverseMergersHome.com

(C) Copyright 2006-08

In response to numerous corporate failures arising from corporate mismanagement and fraud, Congress passed the Sarbanes-Oxley Act of 2002. Generally recognized as one of the most significant market reforms since the passage of the securities legislation of the 1930s, the act is intended to help protect investors and restore investor confidence by improving the accuracy, reliability, and transparency of corporate financial reporting and disclosures, and reinforce the importance of corporate ethical standards. Public and investor confidence in the fairness of financial reporting and corporate ethics is critical to the effective functioning of our capital markets. The act's requirements apply to all public companies regardless of size and the public accounting firms that audit them.

 

The act established the Public Company Accounting Oversight Board (PCAOB) as a private-sector non-profit organization to oversee the audits of public companies that are subject to securities laws. PCAOB, which is subject to oversight by the Securities and Exchange Commission (SEC), is responsible for establishing related auditing, quality control, ethics, and auditor independence standards. The act also addresses auditor independence and the relationship between auditors and the public companies they audit. The act requires public companies to assess the effectiveness of their internal control over financial reporting and for their external auditors to report on management's assessment and the effectiveness of internal controls. The act also contains provisions intended to make chief executive officers (CEO) and chief financial officers (CFO) more accountable, improve the oversight role of boards of directors and audit committees, and provide whistleblower protection. Finally, the act expanded the SECs oversight powers and mandated new and expanded criminal penalties for securities fraud and other corporate violations.

On May 8, 2006, the Government Accounting Office (GAO) released a report to the public its opinion of the

effect and successfulness of the Sarbanes Act, or lack thereof:

GAO report number GAO-06-361 

Entitled 'Sarbanes-Oxley Act: Consideration of Key Principles Needed in 

Addressing Implementation for Smaller Public Companies' which was 

released on May 8, 2006.

What the GAO Found: 

Regulators, public companies, audit firms, and investors generally agree that the Sarbanes-Oxley Act of 2002

has had a positive and significant impact on investor protection and confidence. However, for smaller public 

companies (defined in this report as $700 million or less in market capitalization), the cost of compliance has 

been disproportionately higher (as a percentage of revenues) than for large public companies, particularly with 

respect to the internal control reporting provisions in section 404 and related audit fees. Smaller public 

companies noted that resource limitations and questions regarding the application of existing internal control 

over financial reporting guidance to smaller public companies contributed to challenges they face in 

implementing section 404. The costs associated with complying with the act, along with other market factors, 

may be encouraging some companies to become private. The companies going private were small by any 

measure and represented 2 percent of public companies in 2004. The full impact of the act on smaller public 

companies remains unclear because the majority of smaller public companies have not fully implemented 

section 404. To address concerns from smaller public companies, SEC extended the section 404 deadline for 

smaller companies with less than $75 million in market capitalization, with the latest extension to 2007. 

Additionally, SEC and PCAOB issued guidance intended to make the section 404 compliance process more 

economical, efficient, and effective. SEC also encouraged the Committee of Sponsoring Organizations of the 

Treadway Commission (COSO), to develop guidance for smaller public companies in implementing internal 

control over financial reporting in a cost-effective manner. COSO guidance had not been finalized as of March 

2006. SEC also formed an advisory committee to examine, among other things, the impact of the act on smaller 

public companies. The committee plans to issue a report in April 2006 that will recommend, in effect, a tiered 

approach with certain smaller public companies partially or fully exempt from section 404, unless and until a 

framework for assessing internal control over financial reporting is developed that recognizes the 

characteristics and needs of smaller public companies. As SEC considers these recommendations, it is essential 

that the overriding purpose of the Sarbanes-Oxley Act investor protection is preserved and that SEC assess 

available guidance to determine if additional supplemental or clarifying guidance for smaller public companies 

is needed.

Smaller public companies have been able to obtain access to needed audit services and many moved from the

largest accounting firms to mid-sized and small firms. The reasons for these changes range from audit cost and 

service concerns cited by companies to client profitability and risk concerns cited by accounting firms, including 

capacity constraints and assessments of client risk. Overall, mid-sized and small accounting firms conducted 30 

percent of total public company audits in 2004 up from 22 percent in 2002. However, large accounting firms 

continue to dominate the overall market, auditing 98 percent of U.S. publicly traded company sales or 

revenues.

What the GAO Recommends: 

The SEC should (1) assess sufficiency of internal control guidance for smaller public companies, (2) coordinate 

with PCAOB to ensure consistency of section 404 auditing standards with any additional internal control 

guidance for public companies, and (3) if further relief is deemed appropriate, analyze the unique 

characteristics of smaller public companies and their investors to ensure that the objectives of investor 

protection are met and any relief provided is targeted and limited. 

In our opinion at King & Associates, P.C., the new Sarbanes-Oxley Act has considerably upped the ante

for management of public companies by requiring personal certification of financial statements and expanding 

exposure to potential civil and criminal liability. With the enhanced scrutiny on corporate governance

irregularities, Directors and Officers insurance has become increasingly unavailable to protect

management from personal exposure to shareholder suits. As noted by the GAO above, the audit fees for

small-cap companies may be unfairly high as a percentage of revenue compared to large-cap companies,

but if a company can not afford an audit, it probably should not be public in the first place.

 

The Sarbanes-Oxley Act influences the corporate governance of the public shell after the reverse merger in the same way it influences every reporting pubic company. It is more important then ever to have a good and experienced securities lawyer and CPA. So, while the increase reporting burdens of the Act are manageable, it does definitely increase the cost of legal and accounting fees. However, the Act does not directly address reverse mergers specifically, but the Act does have impact on the reverse merger process such as speeding up the filing of the 8-K with the SEC to just four days. Additional burdens of the Act on Reverse Mergers include that 8-Ks now require the acquiring company to file an audited financial statement for the fiscal year before the reverse merger and pro-formas for the combined business. However, if the acquiring company has been in existence for less then a year, the audited financial statements have to only cover the period since formation. So, it is possible to form a new corporation, solely for the purpose of acquiring the public shell, but you can not sign the closing documents until a complete audit is done of the new company. This means the deal cannot close until these, and all documents required to be filed with the 8-K, are complete and available. While it is possible to wait 71 days to file the audited financial statements of the acquiring corporation with an 8-K/A, you can not register and sale common shares until you do so. Also, public shells can no longer file an 8-K until 60 days after ceasing to be a public shell. The public shell must first file an 8-K giving the SEC notice it is no longer a public shell which starts a 60 day wait period before it can file the 8-K notifying the SEC of the reverse merger. If the public shell is not registered, it must file a registration, wait for its approval, and then wait for 60 days before it can file the 8-K To speed the process up, try to do a reverse merger with a pubic shell already registered with the SEC. Further, common shares received by promoters and underwriters, for the transaction, are now non-transferable on the public exchanges until the shares have been registered along with the transferees and their affiliates has had always been the case and the promoters and underwriters can no longer rely on Section 4(1) to exempt them. Once the stock is registered, the stock of everyone involved in the reverse merger transaction will be restricted under rule 144. But, rule 144 does not restrict your stock forever. You will be allowed to sale controlled, and usually small (unless your public company has a very high trading volume), percentages of it during every quarter and after you are no longer affiliated with the public company, rule 144 goes away after two years.

 

You might think that a purchaser of securities of a public shell should be permitted to rely on Section 4(1) of the Securities Act following a business combination between the public shell and a real operating company. Two years following such a business combination, you might think that the initial purchaser of the securities of the public shell, if he is not, and never was, an affiliate, should be able to rely on Rule 144(k) and be entitled to resell his securities without restriction.

 

However, one theory behind the Worm/Wulff Letters (from the SEC) is that purchasers of securities of public shells are mere conduits for a wider distribution of those securities and are therefore underwriters. So, if these persons are underwriters, then they can never rely on Section 4(1), which exempts from the registration requirements of the Securities Act transactions by any person other than an issuer, underwriter, or dealer.

 

The Worm/Wulff letters clearly states that "Both before and after the business combination or transaction with an operating entity or other person, the promoters or affiliates of public shells, as well as their transferees, are 'underwriters' of the securities issued." This position has since expanded (or been clarified) to apply to all purchasers of securities of public shells and not just promoters, affiliates and their transferees. And the position applies regardless of the amount of time that has passed since the business combination.

 

A purchaser of securities of public shells is exposed to serious investment risk if the purchaser cannot cause the issuer to register his or her securities. According to the Worm/Wulff Letters, unregistered securities of a public shell can never be resold.  However, during the first quarter of 2008, the SEC shocked the securities industry when it announced it intended to formally review the Worm/Wulff letters with the intention of reducing it’s pressure on small cap companies. The SEC made no promises concerning when they would review the letters.

 

However, the risks associated with the Worm/Wulff letters in a reverse merger can be mitigated through careful due diligence. For an outline of the due diligence process please read the Professional Services Provided page of this website.

 

It should be noted, that because non-reporting pink sheets do not report, once the reverse merger is complete, they are not affected by the Act at all until they begin reporting, if ever. However, given that investors seriously discount the value of any public company that does not report and you would have to expect a much lower trading price. But, pink sheets can be a good learning ground for those managers who have no public company experience. They can start slowly and begin reporting once they get a handle on it. And, when they are ready, they can always move to the Bulletin Board if, and when, they qualify.