Tier 1 Zombies: a Regulation A scam to watch out for

We’ve noticed something interesting recently: Regulation A filings by companies that used to be SEC-reporting companies with quotes on the OTC Pink market, who have ceased to file reports with the SEC and whose trading activity on OTC has flatlined. Why would such companies file for a Reg A offering? Especially since so many of them are complete losers with weird agglomerations of business lines resulting from multiple reverse mergers (“We are a holding company operating in the mattress, muffin and blockchain businesses”)?

Because someone can make money, and it’s not the issuer and it’s not investors.

Here’s how. You start with an existing OTC-quoted shell company (“Company”). (I’m using the term “shell” here broadly, as some of them do have limited as opposed to nominal operations.) It might have existing management who are willing to play along, or you can install new management, or you can take a company wanting to make a Reg A offering and reverse merge it into the shell.

You enter into a purchase agreement whereby a financial institution (the “Fund”) agrees to buy shares from Company, ostensibly in the Reg A offering. In the early versions of this scheme, this agreement was filed with the SEC as part of the Reg A offering statement. The SEC staff challenged this arrangement as the Fund acting as underwriter (without disclosing that fact, or being registered as a broker). Subsequent filings have not included purchase agreements, but we believe that undisclosed or tacit agreements to purchase securities continue to be a part of the arrangement.

A typical element of this sort of scheme is that there may be a large payment made by Company to some entity affiliated with Fund for services that don’t usually cost that much; $100k payment to a technology platform posting the offering, for example.

These arrangements are reflected (more or less) on an offering statement filed under Tier 1 of Regulation A. Tier 1 requires that you meet the disclosure requirements of both the SEC and the states in which the offering is made. The offering statements implementing this scheme say that the offerings are being made in New York State only (this is not true). New York is selected because New York does not review the substance of Regulation A filings and the SEC generally defers to the states with respect to Tier 1 offerings and only applies a light touch review.

Company will issue some press releases prior to and after qualification (“We’ve filed for a Reg A offering, the first company in the cannabis, mattress and blockchain space to do so!”).

The price for the shares offered under Reg A will be something like $0.001. It will be well below the last trading price on OTC.  Some time after qualification, when the quote on OTC has shown some sign of life, Fund will buy some shares of the company at $0.001 and sell them at the higher trading price. Rinse and repeat. Fund has only agreed to buy the shares depending on trading volumes, so it’s pretty risk-free for Fund.

As we reviewed these filings we saw later filings getting a bit more sophisticated than the earlier ones. Clearly, the SEC examiners have begun focusing on some of the more problematic aspects of these offerings. As the disclosure for the scheme has evolved, it has become harder to identify issuers undertaking the standard scheme. However, in some cases, the Company gives some insight as to what is happening, as when one of them published a press release saying that they decided to hire a lawyer to file the offering statement when Fund agreed to buy $2 million shares in their offering.

Why is all this a problem? There are several problematic aspects to these schemes, not all of which will apply to all offerings:

  • The “undisclosed underwriter.” The Fund is acting as an underwriter, that is, an intermediary in the flow of securities from issuer to public. It needs to have an available exemption from registration under the Securities Act to do that, it doesn’t have one and the securities are thus sold in violation of Section 5 of the Securities Act and subject to rescission. That is, the Fund (and probably the Company) has to offer to buy back the securities at the sale price, plus interest.
  • Misleading statements and omissions. The offering is not being made in New York only; it’s being made in all states, via the internet. The real “offering” is what happens when Fund sells the shares on the secondary market. And if you have a “material contract” such as a securities purchase agreement, and don’t file it, that’s an omission of a material fact necessary to make your filing not misleading.  Rule 10b-5 issue there. Plus, some of these offering statements seem to have been assembled by monkeys. They are rife with inconsistencies. They aren’t intended to be genuine offering documents.
  • And then there’s the “pump” element of the classic pump and dump scheme. 10b-5 again.

OTC Markets is constantly on the alert for this kind of thing. But even before they or the regulators take action, potential Reg A issuers and investors should pay attention. Issuers: we know it sounds attractive to have your Reg A offering fully funded and to get a quote on OTC without the usual hassle. But beware of the liabilities that you will trigger. And investors: we know that some of you actually search out apparent pump and dump schemes in order to get ahead of the dump. But watch out for these structures.

We’ve spotted about a dozen with this pattern and may find more. Don’t touch them.

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