The Rise of Reverse Mergers

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1 Vol. 1 No. 5 September 2003 In this issue: Rise of Reverse Mergers Recent Changes in Delaware General Corporation Law Indemnification of Attorney Fees in New York In this weak economy many companies are trying to gain the stability and credibility that is normally associated with the status of a public company but without the costly and timely process of conducting an initial public offering. As such, we have seen a recent increase in reverse mergers as an attractive alternative to the IPO. Our first article details the process, along with the pros and cons of the reverse merger. The second article details several significant changes to the Delaware General Corporation Law that recently became effective and the impact for companies incorporated in Delaware. The third article addressees the commonly used indemnification provision granting a party the right to recover attorney fees under New York law. The article serves as a reminder for contracting parties of the necessary language to be included in contracts in order for such a provision to be upheld by the courts. The Rise of Reverse Mergers The recent economic environment has forced many enterprises to look for methods of going public other than through an initial public offering. A popular alternative is the reverse merger. A reverse merger is a transaction wherein a private company merges with and into a public shell company in order to become publicly listed. There are two leading motivations behind these mergers: first, the private company does not want to spend the time or the money to undergo an IPO; or second, it cannot find an underwriter for its stock, but wants to enter the United States capital market. The public company is usually a shell company with little or no active operations, assets or liabilities, that is listed but not necessarily traded on a nationally recognized stock exchange. Undertaking a reverse merger eliminates the timely and costly necessity of engaging an underwriter and preparing and filing a registration statement and prospectus with the Securities and Exchange Commission. A principal assumption in the success of these transactions, however, is that the private company does not need capital immediately. A reverse merger is not a money-raising endeavor. In a reverse merger, a private company identifies a public shell company that is willing to undergo a merger. Through a share exchange or a similar arrangement the private company receives a majority (usually 90%) of the shares of the public company and control of the board of directors, often for a nominal cost. The shareholders of the former public company will thereafter benefit by owning shares of a company with growth potential, as opposed to a defunct corporate shell. The transaction can usually M&A Advisor TM is intended as an information source for the clients and friends of Nixon Peabody LLP. Its contents should not be construed as legal advice, and readers should not act upon information in this publication without professional counsel.

2 be accomplished in as few as two weeks for as little as $100,000 $150,000 making it very attractive. Since the public shell company has already undergone the rigorous and timely state and federal review process associated with going public, the transaction does not have to be approved by state and federal regulators. Upon completion of the merger, the business operations of the private company are carried out through the public corporation with the public company changing its name and trading symbol to reflect the merger. By going public through a reverse merger, a private company gains the advantages of being a public company, including creating liquidity for its shares, and gaining the ability to use its publicly traded shares as an alternative to cash for acquisitions or other business transactions. Further, going public increases the company s visibility and credibility among investors and customers. Other advantages of a reverse merger include: Reduced cost it is cheaper than an IPO Reduced time it is faster than an IPO Fewer business requirements underwriters like to see long stable earnings history Less dilution of ownership control than in an IPO Increased valuation Ease of raising future capital Public stock is more attractive to management and employees for options and other incentives Such transactions have become increasingly popular among Chinese and other international companies that often find a higher stock price for their companies in the United States than they do in their home markets. Consulting firms that specialize in helping private companies go public have recently noted witnessing an increased interest in reverse mergers in the past six months. Even though reverse mergers are gaining credibility in the mainstream markets, the process still has its share of critics and potential pitfalls. There are many who maintain that the process is too open because it allows companies that never would have been able to pass muster with an underwriter or investors on a roadshow to go public. Also, since the transaction is structured as a merger, the acquiring company runs the risk of succeeding to unknown liabilities based on prior activities of the public company. Some protection is often obtained through appropriate representations and warranties and due diligence, but the risk cannot be completely eliminated. Another consideration is the amount of authorized but unissued stock that the public company has available for issuance. The private company will often want to gain a significant majority (as much as 80 or 90%) of the outstanding stock of the public company. If there is not enough authorized but unissued stock available for the private entity to purchase, the public company will have to authorize additional shares by amending its charter. A charter amendment usually requires shareholder approval and may require proxy solicitation or delivery of an informational statement. Such a process may trigger complicated and costly SEC review. In the end, if structured properly, with the assistance of knowledgeable securities and mergers and acquisitions counsel, a reverse merger can provide the same stability and credibility that is associated with being a public company; and along with public status comes the requisite reporting and disclosure requirements imposed by the SEC and the securities laws. However, if the key objective of going public is raising capital then the IPO is a more aptly suited vehicle. But if raising capital is a more distant concern, the reverse merger can provide equivalent stability and credibility. Although the reverse merger will never replace the IPO as a means of going public, for certain small private companies looking for growth and not immediate capital, it may be a suitable transaction.

3 Recent Changes to the Delaware General Corporation Law In recent months there have been several significant amendments to the Delaware General Corporation Law. Below is a description of these amendments and what the practical impact for companies incorporated in Delaware. Subject Matter Jurisdiction. Section 111 was deleted in its entirety and replaced with new paragraphs that significantly expanded the subject matter jurisdiction of the Court of Chancery. The new Section 111 allows the court to entertain almost any action involving a Delaware corporation including, agreements for the sale of stock, written restrictions on the transfer or ownership of securities, proxies, voting trusts, agreements of merger or consolidation, certificates of conversion, certificates of domestication, transfer or continuance, or any other instrument, document, agreement, or certificate required by the General Corporation Law. Previously, the court s jurisdiction was limited to matters involving a corporation s certificate of incorporation or bylaws. Board Committees. Section 141(c) was amended to clarify that a committee of the board of directors may create subcommittees consisting of committee members unless the authority to create a subcommittee has been restricted by the certificate of incorporation, the bylaws or the resolution of the board of directors designating the committee. The committee may delegate to the subcommittee any or all of the powers and authority of the committee. Submission of a Matter to Stockholder Vote. A new Section 146 was added which allows a corporation to agree to submit a matter to stockholder vote whether or not the board of directors determines that such matter is no longer advisable and recommends that the stockholders reject it. Section 146 clarifies similar language which was previously contained in Section 251(c). Stockholders Entitled to Vote. Section 219(c) was deleted in its entirety and replaced with a new language that provides that the stock ledger be the only evidence as to who are the stockholders that are entitled to (i) vote, in person or by proxy, at a stockholders meeting, or (ii) view the list of stockholders entitled to vote. Former Section 219(c) provided that the stock ledger be the only evidence of who are the stockholders entitled to examine the stock ledger, the voting list, the books of the corporation, or the stockholders entitled to vote at any meeting of stockholders. The adoption of new Section 219(c) was consistent with the amendments to Section 220 discussed below. Stockholder Inspection Rights. Several amendments were made to Section 220. Section 220(a) expanded the definition of stockholder to include a person who is a beneficial owner of shares of stock held in a voting trust or by a nominee. Section 220(b) was deleted in its entirety and replaced with a new Section 220(b) that adds a corporation s list of stockholders and its subsidiary s books and records to the list of items any stockholder may inspect and make copies or extracts from, during normal business hours and upon written demand under oath. Section 220(c) was amended by deleting the fourth and fifth sentences and replacing them with new sentences which provide that prior to inspecting the books and records a stockholder must first establish that he, she or it is a stockholder. The further requirements that written demand under oath be made and that such inspection is for a proper purpose remain unchanged in Section 220(c). Section 220(d) was amended to create the presumption that a director s purpose for inspection is proper. This section places the burden of proof upon the corporation to establish that the inspection such director seeks is for an improper purpose. Contest of Election. Section 225(a) was amended to clarify that the Court of Chancery has jurisdiction to hear and determine controversies regarding the right of any person to hold or continue to hold office as a director, officer or member of the governing body of a Delaware corporation, irrespective of whether the controversy arose from the conduct of an election. The amended section reads, Upon application of any stockholder or director, or any officer whose title to office is contested, or any member of a corporation without capital stock, the Court of Chancery may hear and determine the validity of any election, appointment, removal or resignation of any director, member of the governing body, or officer

4 of any corporation, and the right of any person to hold or continue to hold such office, and, in case any such office is claimed by more than one person, may determine the person entitled thereto; and to that end make such order or decree in any such case as may be just and proper, with power to enforce the production of any books, papers and records of the corporation relating to the issue. (amendments in italics). Mergers. Each of Sections 251(b), 252(b), 253(a), 254(c), 255(b), 256(b), 257(b), 263(b), and 264(b) dealing with merger, consolidation or conversion under Delaware law was amended to clarify that shares or other interests of a constituent corporation may, in addition to being converted or exchanged for consideration in a merger, be cancelled. The allowance for cancellation of shares without consideration is a new addition to these sections. Conversion of Domestic Corporation to Other Entities. Section 266(c) was amended to clarify that a Delaware corporation that desires to convert to another form of a Delaware business entity such as a Delaware limited liability company, general partnership, limited partnership or statutory trust must also comply with the applicable requirements of the statutes governing the formation of those entities as part of the conversion process. These changes became effective as of August 1, Indemnification of Attorney Fees in New York It s not uncommon to see an indemnification provision in a contract granting a party the right to recover attorney fees. Although the language granting such rights may be common, the law in New York governing such clauses is probably much less familiar. The rules in New York are not new, but stem from a case from 1989 in which the claim of one party to a contract for attorney fees in connection with a suit with the other party to the contract was denied. The case serves as a reminder when drafting or negotiating indemnification provisions. The general rule in New York is that attorney fees are incidents of litigation and a prevailing party may not recover them from the losing party unless an award of such fees is authorized by agreement between the parties, statute or court rule. Parties to a contract, however, may provide for indemnification of attorney fees. In the case Hooper Associates, Ltd. v. AGS Computers, Inc., plaintiff, Hooper Associates Ltd., and defendant, AGS Computers, Inc., included in a contract between them the following clause requiring the defendant to indemnify the plaintiff for damages, including reasonable counsel fees : (A) AGS shall at all times indemnify and hold harmless HLTD [Hooper], its successors and assigns and any of its officers, directors, employees representatives, and/or agents, and their heirs, executors, administrators, successors and assigns or each of them against and from any and all claims, damages, liabilities, costs and expenses, including reasonable counsel fees arising out of: (i) Any breach by AGS of any express or implied warranty hereunder and any express representation or provision hereof; (ii) The performance of any service to be performed hereunder; (iii) Infringement of the patent rights, copyright or trademark (of which AGS is not the patentee or assignee or has not the lawful right to use or transfer same) of any person, firm corporation as a result of any use by HLTD, its successors and assigns and any of its officers, directors, employees, representatives, and/or agents of the system hereunder;

5 (iv) The installation, operation, and maintenance of the system; or (v) Mechanic's liens for labor and materials. In an action against defendant for breach of contract, the plaintiff asserted an indemnity claim under the contract for attorney fees. The court noted the general rule permitting indemnification by contract, but also stated that a contract in which a party assumes the obligation to indemnify must be strictly construed to avoid reading into it a duty which the parties did not intend to be assumed. Also, an agreement by one party to indemnify another for attorney fees incurred in litigation is contrary to the established rule that parties to a lawsuit are each responsible for their own attorney fees and that the court should not assume that a party intended to waive the benefit of that rule unless the agreement is unmistakably clear. The court ruled that the contract in question did not contain language clear enough to permit the plaintiff to recover attorney fees from the defendant in connection with a suit between the contracting parties, but was rather applicable only if such fees arose as a result of a third-party action. The contract did not expressly prohibit the plaintiff from recovering attorney fees from defendant in a breach of contract action, but was not unequivocal that such fees were to be indemnified. In reaching its decision, the court referenced a notice provision in the contract which required the plaintiff to promptly notify the defendant of any claim or litigation to which the indemnification would apply. The court found that the notice language would be rendered meaningless in connection with suits between the two contracting parties and that reading the indemnification as applying only where a third party claim was brought against the plaintiff would give force and effect to the notice provisions. However, the addition of the following language, whether incurred in a third party action or in an action to enforce this Agreement, subsequent to the mention of attorney fees would have solved the problem addressed by the Hooper court. The additional language provides the unmistakable intent of the parties to be indemnified for attorney fees in both direct and third party actions. The rule to remember in New York is that the courts will not read into an indemnification agreement the right of one party to a contract to recover attorney fees from another in an action under the contract unless that right is unequivocal. If such right is not clear then other provisions of the contract may be used to discern the agreement of the parties, which may lead to unintended or unexpected results.

6 If you have any questions or require further information regarding these or any other matters, please call your regular Nixon Peabody contact or feel free to contact one of the attorneys listed below: in our Boston office, Brian Crush (617) in our Buffalo office, Martha Anderson (716) in our Long Island office, Allan Cohen (516) in our Manchester office, Philip Taub (603) in our New York City office, Greg Blasi (212) in our Providence office, Joe White (401) in our Rochester office, Lori Green (585) in our San Francisco office, John Duncan (415) in our Washington, D.C. office, Jeff Cohen (202) or John Partigan (202) For a complete list of the partners and counsel in our M&A practice group, please refer to the final page of this M&A Advisor. The foregoing summary of recent developments in the law and practice of mergers and acquisitions is provided by Nixon Peabody for education and informational purposes only. It is not a full analysis of the matters summarized and is not intended and should not be construed as legal advice. This publication may be considered advertising under applicable laws. If you are not currently on our mailing list and would like to receive future publications of our M&A Advisor, please send your contact information, including your address, to nppublications@nixonpeabody.com.

7 M&A Practice Team Please feel free to call or your usual contact or any of the partners or counsel in our M&A team listed below. ATTORNEY NAME PHONE Veronica Ahern vahern (202) Martha Anderson manderson (716) Carter Bacon cbacon (617) David Barbash dbarbash (617) John Beals jbeals (603) Roger Berg rberg (212) Greg Blasi gblasi (212) Bob Bodansky rbodansky (202) Stefan Boshkov sboshkov (212) Roger Byrd rbyrd (585) Charles Claeys cclaeys (617) Allan Cohen acohen (516) Jeff Cohen jcohen (202) Scott Cristman scristman (585) Brian Crush bcrush (617) Joseph Cuomo jcuomo (516) Justin Doyle jdoyle (585) John Duncan jbduncan (415) Rob Edwards redwards (401) Jack Fainberg jfainberg (617) David Gluck dgluck (617) Lori Green lgreen (585) Fred Grein fgrein (617) Ripley Hastings rhastings (617) Jim Hood jchood (603) Charley Jacobs cjacobs (716) Alexander Jordan ajordan (617) William Kelly wkelly (617) Brian Kopp bkopp (585) William Lance wlance (617) Dick Langan rlangan (212) James Locke jlocke (585) Staffan Lundback slundback (585) Michael Manning mmanning (617) David Martland dmartland (617) Tom McCord tmccord (617) John Partigan jpartigan (202) Deborah Quinn dquinn (585) Ernie Reddick ereddick (415) Joe Reynolds jreynolds (202) Bruce Rosenthal brosenthal (212) Paul Schrier pschrier (415) Andrew Sheldrick asheldrick (212) Richard Stein rstein (617) Philip Taub ptaub (603) Robert Thompson rthompson (617) Kendal Tyre ktyre (202) Joe White jbwhite (401) Lauren Wiesenberg lwiesenberg (212) Robert Wild rwild (585) Visit our website at ALBANY, NY Omni Plaza 30 South Pearl Street Albany, NY (518) Fax: (518) BOSTON, MA 101 Federal Street Boston, MA (617) Fax: (617) BUFFALO, NY 1600 Main Place Tower Buffalo, NY (716) Fax: (716) LONG ISLAND, NY 990 Stewart Avenue Garden City, NY (516) Fax: (516) MANCHESTER, NH 889 Elm Street Manchester, NH (603) Fax: (603) NEW YORK, NY 437 Madison Avenue New York, NY (212) Fax: (212) NORTHERN VIRGINIA Suite Greensboro Drive McLean, VA (703) Fax: (703) ORANGE COUNTY, CA Suite Main Street Irvine, CA (949) Fax: (949) PHILADELPHIA, PA Suite 200 Two Penn Center Plaza Philadelphia, PA (215) PROVIDENCE, RI One Citizens Plaza Providence, RI (401) Fax: (401) ROCHESTER, NY Clinton Square P.O. Box Rochester, NY (585) Fax: (585) SAN FRANCISCO, CA Two Embarcadero Center San Francisco, CA (415) Fax: (415) WASHINGTON, D.C. Suite th Street, N.W. Washington, D.C (202) Fax: (202)