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INTRODUCTION:

In todays economic world of corporate sector the world is changing at an overwhelming


pace. Mergers and demergers are the methods adopted by majority of companies in the
modern time to increase or enhance their profits and to streamline their functioning. Merger is
one of the most common forms of corporate restructuring programmes that is used by the
corporate world so as to achieve growth for the company as a whole. In strict economic sense
of the word it means the union of two or more commercial interests, corporations,
undertakings, bodies or any other entities. In corporate business it means, blending or
amalgamation of two or more corporations by the transfer of all property to a single
corporation. Generally, a company with record of having a less profit earning or loss making
blends or amalgamates with a viable company to have benefits of economies of scale of
production and marketing network etc of that viable company. As a consequence of this
merger the profit earning company survives and the loss making company extinguishes its
existence. But, in many cases, the sick companys survival becomes more important for many
strategic reasons and to conserve community interest. This type of non-routine merger is
called Reverse Merger.

CONCEPT OF RM:

Reverse Merger may be defined in two ways first where a holding company blend/merges
with a subsidiary or investee company and secondly where a profit making company merges
with the loss making company. The term Reverse merger has not been defined under any of
the statutes However, High Court has discussed three tests for reverse merger-

i) Assets of Transferor Company being greater than Transferee Company.


ii) Equity capital to be issued by the transferee company pursuant to the acquisition
exceeds its original issued capital.
iii) The change of control in the transferee company clearly indicated that the present
arrangement was an arrangement, which was a typical illustration of takeover by
reverse bid.

Court held that prima facie scheme of merging a prosperous unit with a sick unit cant be
said to be offending the provisions of section 72 A of the Income Tax Act, 1961 since the
object of this provision is to facilitate the merger of sick industrial unit with a sound one.
The Reverse merger is generally adopted for two main reasons-
i. It is an alternative method for private companies to go public, without going
through the long and complex process of traditional IPO. In this a private
company acquires a public entity by owning the majority shares of the public
company. The public shell is a vital aspect of reverse merger transactions which
is a publicly listed company with no assets or liabilities. It is called shell
because the only thing remaining from the current company is its corporate shell
structure.
ii. Tax saving is another advantage of Reverse Mergers. Section 72A of Income tax
Act 1961 provides tax relief for amalgamation of sick companies with a healthy
and profitable companies to take the advantage of the carry forward of losses.

I. RM AS ALTERNATIVE METHOD TO BECOME PUBLIC:

Companies instead of hiring an underwriter to sell the companys shares in an initial public
offering, a private company works with a shell promoter to locate a suitable non-operating
or shell public company, private company merges with the shell company (or a newly-formed
subsidiary of the shell company). In this merger, the operating companys shareholders are
issued a majority stake in the shell company in exchange for their operating company shares.
Then after merger the shell company contains the assets and liabilities of the operating
company and is then controlled by the former operating company shareholders. The shell
companys name is changed to the name of the operating company, its directors and officers
are replaced by the directors and officers of the operating company, and its shares continue to
trade on whichever stock market they were trading prior to the merger, indirectly the
companys corporate shell structure is retained. Hence, the operating companys business is
still controlled by the same group of shareholders and managed by the same directors and
officers, but it is now contained within a public company. In effect, the operating company
succeeds the shell companys public status and therefore indirectly goes public.

Reverse Mergers features:

Presently Reverse merger in India is still in its infancy stage so we may discuss the features
of RM according to the concepts made and settled in US.

A. Shell Characteristics

A public shell company is a company that has a class of securities registered under the
Securities Exchange Act of 19341 (the Exchange Act) but has only nominal operations
and no or nominal assets other than cash and cash equivalents.2 A public shell company
exists because either
(1) It was a former operating company that went public and then for some reason ceased
operations and liquidated its assets or
(2) It never had any operations but was formed from scratch for the specific purpose of
creating a public shell.3
In the former situation, shell promoters gain control of defunct operating companies by
buying up a majority of their shares. 4 In the latter situation, shell promoters incubate the
shellsthey incorporate a company, voluntarily register its shares under the Exchange Act,
and then timely file with the Securities and Exchange Commission (SEC) the required
quarterly, annual and other reports.5 Because the shell has no operations, it is fairly simple
and inexpensive to make these filings.6 In exchange for letting an operating company merge
into a shell, the promoter charges the operating company a fee and retains an ownership
interest in the shell post-merger.7
Shells may or may not have stock that trades publicly. Typically, the stock of a former
operating company does trade publicly.8 The company will have listed its stock or otherwise
facilitated trading on a public market back when it completed its IPO. A shell formed from
scratch by a shell promoter typically does not have publicly traded stock.9

B. Legal Structure and Compliance

1 Securities Exchange Act of 1934 1, 15 U.S.C. 78a (2006)

2 Securities Exchange Act of 1934 1, 15 U.S.C. 78a (2006)

3 FELDMAN, Aden R. Pavkov, Ghouls and Godsends? A Critique of "Reverse Merger" Policy

4 FELDMAN

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9 FELDMAN
An RM is typically structured as a reverse triangular merger.10 Specifically, the public shell
(Shell Co) forms a new, wholly-owned empty subsidiary (Merger Sub). 11 Merger Sub
then merges into the private operating company (Op Co) pursuant to the applicable state
corporate statute.12 Upon consummation of the merger, Op Co.s shares are converted into
shares of Shell Co constituting a majority stake in Shell Co (typically an 80 to 90 percent
stake).13 Following consummation of the merger, Op Co is a wholly-owned subsidiary of
Shell Co and Op Cos former shareholders own a majority of the outstanding shares of Shell
Co.14
Alternatively, the transaction could be (and sometimes is) structured as a direct merger
where Shell Co merges directly into Op Co.15 The reverse triangular merger structure is
preferable, however, because it reduces transaction costs.16 Since Op Co survives the
transaction, there is no need to change vendor numbers, employer identification numbers,
bank accounts, real estate titles, etc.17 Additionally, structuring the transaction as a reverse
triangular merger may eliminate the requirement of getting Shell Co shareholder approval to
close the transaction. This would allow Shell Co to avoid holding a shareholders meeting
and therefore the time and expense associated with filing with the SEC for review and
mailing to its shareholders a detailed proxy statement and other materials as required by
SEC proxy regulations.18
Whether shareholder approval of Shell Co is required depends on Shell Cos state of
incorporation and whether its shares are listed on an exchange. The general rule under state

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corporate law is that approval is required only from the shareholders of the companies that
will merge in the transaction. In an RM structured as a reverse triangular merger, Shell Co
shareholder approval would not be required because Merger Sub and not Shell Co will be
merging with Op Co in the transaction. 19 However, many states and the stock exchanges
also require shareholder approval before a company can issue shares constituting more than
20% of its pre-transaction outstanding shares. Shell Co would fall under these rules, if
applicable, because it will be issuing well over 20% of its pre-transaction outstanding shares
as part of the RM. Note, however, that Delaware, among other states, does not have a 20%
rule. Hence, if Shell Co is a Delaware corporation and does not have shares listed on an
exchange, Shell Co shareholder approval is not required. Merger Sub shareholder approval
is obtained from its sole shareholder, Shell Co, acting through its board. 20 Shareholder
approval by Op Co is required, but since Op Co is private, it is not subject to SEC proxy
regulations; normally it can obtain the requisite shareholder approval quickly through
written shareholder consent in lieu of a meeting.21
Reverse Mergers vs. IPOs:

In this section we will explain what a reverse merger is, why it might be beneficial for some
firms and what circumstances warrant its use, as well as what constitutes a shell company in
the RM process.

In his book, Reverse Mergers, David Feldman (2009) describes the reverse merger process
in-depth and explains why it is a viable option for small firms. Much of the material in this
section is taken from his book. Surprisingly, this is one of the only books written on the
subject and although it is aimed at an American audience it is nevertheless relevant even to
the Indian market, as the process is similar. Differences between the two are mainly found in
regulatory requirements and legislation.

A reverse merger is when a private company purchases control of a public one, merges into
it, and when the merger is complete becomes a publicly traded company in its own right 22. If
the public company has no real ongoing business then it is often referred to as a shell. The

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22 Feldman, 2009
reasons for going public this way will become apparent as we go through the advantages and
disadvantages below. Feldman names seven advantages and two disadvantages of RMs when
compared to IPOs. We cover each briefly.

Advantages vs. IPOs:

1. Lower cost. One of the puzzles of IPOs is the high underwriting costs 23. This is avoided in
the RM process. RMs are much less costly and the total cost can often be pre-determined 24. In
his experience, most RMs cost less than $1 million whereas an IPO will cost at least three or
four times that much, excluding underwriting commissions (2009). For a RM the biggest cost
is generally the price of the shell.

2. Speedier Process. RM takes two to three months; an IPO takes nine to twelve. There are
fewer steps and fewer parties involved. There is also no disclosure document that needs to be
approved by the SEC.

3. Not Dependent on IPO Market for Success As discussed earlier, IPOs follow a wave-like
pattern and prefer to go public when the economy is doing well 25. This is not an issue for
RMs, because they are not sensitive to the market and that makes them a good choice in any
market condition.

4. Not Susceptible to Changes from Underwriters Regarding Initial Stock Price Underwriters
can choose to change the price at the last minute if the market sentiment drops just before the
IPO. Cancellations of IPOs are also not uncommon.

5. Less Time-Consuming for Company Executives IPOs take time, time that could be used to
run the business. RM is less time- consuming as mentioned earlier and no new investors need
to be found. That means more time for business decisions.

6. Less Dilution, RM less money is raised, during a time when the company supposedly is
undervalued26. It is better to raise money when the stock price is higher, because it doesnt
dilute ownership. Theoretically, new companies on the public market should trade higher

23 rittler 1991

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25 Rittler 1991

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after six months or so if the business grows. That is a big if however. Additionally,
underwriters tend to try to take in as much money as possible without regard to how much the
company doing the IPO actually needs (what you might call a good problem). This is
because the underwriter takes a percentage fee of what is raised.

7. Underwriters Unnecessary, underwriters try to make a company look as profitable as


possible before the IPO, which sometimes means selling off new subsidiaries that have not
yet started making money27. RMs do not have that problem as there are no underwriters
involved.

Diadvanteges vs. IPOs:

1. Less Funding RMs bring in less money than IPOs but that may not be relevant criticism of
the method. Nothing stops the company from taking in new capital once they are public. This
may even be beneficial if the stock price is higher at that point.

2. Market Support is harder to Obtain Underwriters will for some time after the IPO of a firm
act as market makers, as well as trying to hype the stock during and after the offering. This
often results in what Feldman calls a pop in the stock price which is unlikely in a RM
because no one is covering the stock. A rise is more likely to come from years of improved
performance rather than what he calls manufactured support.

To sum up, the main situations in which RMs are preferable to IPOs is when firms are small,
markets are down, initial injection of money is not the main aim, time is of importance, or
simply when hefty fees wish to be avoided. These are definitely compelling reasons to
perform RMs.

RM IN TAX:

Section 72A of the Income tax, 1961 is there to facilitate for recovery of sick industrial
undertakings by merging them with sound industrial companies having incentive of tax
savings devising with the sole intention to benefit of the general public through continuing
productive activities, increased employment avenues and revenue generation. Sickness
among the industrial undertakings is matter of grave concern and the section 72A provides for
rekindling financially unfeasible business undertakings. The section provides for the effective
course to facilitate the merger of sick industrial units with healthier ones by providing

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incentives and removing impediments in the way of such amalgamation. To save the
government from costs in terms of loss of production and employment and uneconomical
burden of taking over and running unhealthy industrial units are some of the motivating
factors for introducing section 72A.

Provisions of section 72A:

1) Amalgamation should be between companies and none of them should be a firm of


partners or sole proprietor.

2) The companies entering into amalgamation should be engaged in either industrial activity
or shipping business, thus companies engaged in trading activities or services shall not be
entitled for taxation benefits under section 72A.

3) After amalgamation the sick or financially unviable company shall survive and other
income generating company shall extinct.

4) One of the merger partners should be financially unviable and have accumulated losses to
qualify for the merger and the other merger partner should be profit earning so that tax relief
to the maximum extent could be had.

5) Amalgamation should be in the public interest.

6) Accumulated loss should arise from Profits and gains from business or profession and not
be loss under the heading Capital gains or speculation.

7) Merger must result into following benefits: a) Carry forward of accumulated losses of the
amalgamated company. b) Carry forward of unabsorbed depreciation of the amalgamated
company. c) Accumulated loss would be allowed to carry forward for eight consecutive years.
8) For qualifying, carry forward of losses, the provisions of section 72 should have not been
contravened.

9) Similarly for carry forward of unabsorbed depreciation the conditions of section 32 should
not have been violated.

10) Specified authority has to be satisfied of the eligibility of the company for the relief under
section 72 of the Income Tax Act. It is only on the recommendation of the specified authority
that Central Government may allow the relief.
11) The company should make an application to a specified authority for requisite
recommendation of the case to the Central Government for granting the relief.

Prevalence of Reverse Merger in Indian Industries:

Presently in India Reverse merger is still in its infancy stage, however slowly and steadily it
is gathering its popularity in Indian corporate sector.

CASE STUDIES:

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