America's Public Shell Trafficking Problem: Ripe for Reprocessing

• Jurisdiction: United States,Federal
• Citation: Vol. 39 No. 2
• Publication year: 2023

America's Public Shell Trafficking Problem: Ripe for Reprocessing

Harrison Lipsky

AMERICA'S PUBLIC SHELL TRAFFICKING PROBLEM: RIPE FOR REPROCESSING Abstract

The scourge of public shell trafficking has led to fraudsters taking advantage of and pilfering the hard-earned dollars of the American investing public for decades. These fraudsters seek to abuse the chapter 11 bankruptcy process by discharging the debt of such public shells, so that they can increase the profitability of schemes that target innocent investors, such as reverse mergers and pump-and-dump schemes. Regulators and lawmakers alike have fought back against this phenomenon through statutory reform and targeted regulatory programs; recently, their principal method of fighting back has been to consistently object to chapter 11 plans of reorganization that could potentially be used in such schemes. This Comment analyzes the strengths and weaknesses of the current regulatory approaches to combat public shell trafficking and proposes a new solution: the Shell Reprocessing Approach ("SRP Approach" or "Approach"). The SRP Approach involves regulators taking a more active role in debtor reorganization by moving for the appointment of a chapter 11 trustee and/or filing a competing plan as a party in interest. The Approach has the potential to enable regulators to stop bad actors seeking to abuse the bankruptcy process in a potentially more effective and innovative manner and to better protect the American public from fraudulent investment schemes. Ultimately, unlike objections to confirmation, the Approach promises to preserve the economic value of a debtor public shell by repurposing its ticker and to close the information gap by subjecting the entity to greater regulatory scrutiny via existing Special Purpose Acquisition Company ("SPAC") regulations.

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Table of Contents

Introduction..........................................................................................410

I. Efficacy of Current Regulatory Approaches to Public Shell Trafficking..........................................................415

A. Section 1141(d)(3) ..................................................................416
B. Good Faith Under Section 1129(a)(1) and Section 1129(a)(3) .................................................................. 419
C. Feasibility Under Section 1129(a)(11) .................................... 420
D. The "Tax Law Avoidance" Side of Section 1129(d) ................. 423
E. The "Securities Law Avoidance" Side of Section 1129(d)........ 425

II. Making the Case For Change: Defining "Desirable".............428
III. Proposed Solution: The Shell Reprocessing Approach.........432

A. Overview of the SRP Approach ............................................... 432
B. Defining the SRP Approach Step-by-Step ................................ 434
C. The Role of SPACs in the SRP Approach ................................. 436
D. Congressional Intervention to Solve the Bankruptcy Problem.................................................................................. 442

Conclusion.............................................................................................442

Introduction

A public shell is a publicly traded company that generally has no active business operations and no significant assets.¹ Public shells are often microcapital companies ("microcap"), which means that the value of their stock is less than $300 million.² Microcap stock is frequently sold on the over-the-counter ("OTC") market.³ The OTC market includes the OTC Pink marketplace, which is "an open marketplace for a broad spectrum of equity securities, with no financial standards or reporting requirements."⁴ Such an unregulated market

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creates the ideal environment for bad actors seeking to exploit public shells in fraudulent schemes.⁵

One such fraudulent scheme by which individuals can exploit these public shells is through reverse mergers.⁶ A reverse merger involves a public shell ("the buyer") acquiring a private company, usually one seeking access to funding in the United States capital markets.⁷ In the transaction, the shareholders of the private company will typically capture a controlling majority of the shares of the buyer, increasing these shareholders' voting power and potentially permitting them to take over the board of directors and management of the buyer.⁸ Reverse mergers allow said private companies to enjoy the benefits of the capital markets, such as the liquidity that comes with having their shares priced on a stock exchange, that allow them to potentially increase their funding by accessing a wider pool of public investors.⁹ Moreover, reverse mergers are very attractive because they are considered to be a "quick and dirty" method of "going public" compared to the often expensive and lengthy process associated with an initial public offering ("IPO").¹⁰

In order to make public shells more attractive candidates for reverse mergers, corporate actors will attempt to use chapter 11 bankruptcy to discharge a public shell of all its liabilities in order to create a "clean" public shell. The clean public shell can then be marketed to private companies seeking the advantages of the public trading status of a public shell, while avoiding the demands of securities registration requirements and other laws.¹¹ To achieve this, the public shell first

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files for bankruptcy under chapter 11. The debtor public shell must then have its chapter 11 plan of reorganization approved by a court at a confirmation hearing, among other requirements imposed by the Bankruptcy Code (the "Code").¹² If a court approves a chapter 11 reorganization plan by entering a confirmation order,¹³ then the confirmed plan is binding on the debtor, creditors, and other parties, regardless of the effects of its terms; the plan will satisfy all claims of all parties according to the approved plan of reorganization.¹⁴

Public shell trafficking and its use in schemes like reverse mergers and pump-and-dumps¹⁵ is worrisome due to the nefarious effects such schemes can wreak upon the American investor.¹⁶ When investors invest in any stock, information is the investor's "best tool" for "investing wisely."¹⁷ Any rational investor would want to know as much as possible about an investment opportunity before investing their hard-earned money. Ample information is typically available when investing in the most "dominant" or well-known U.S. stock exchanges, such as the Dow Jones or the S&P 500, due to the relatively rigorous reporting requirements of the Securities and Exchange Commission (the "Commission" or the "SEC" ).¹⁸ However, when investors seek to invest in penny stocks¹⁹ of microcap companies on the OTC markets, accurate information is often difficult to find,²⁰ creating havens for suspicious actors who use public shells to perpetrate their schemes through reverse mergers or pump-and-dumps.²¹ When information is scarce or unavailable, suspicious actors can

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take advantage of the investing public's lack of knowledge of even the most basic facts of a company, such as the company's management or what the company even purports to do, which permits such actors to spread misinformation and take advantage of the "unsuspecting" investing public.²² As a result, said actors profit by swindling away investors' hard-earned dollars.²³

These risks are heightened even further through public shell trafficking via reverse mergers because the suspicious actors can remain largely anonymous and hide behind the shell as they utilize it in their schemes.²⁴ These shells are powerful tools; because they have "less than $10 million in assets or fewer than 2,000 shareholders of record[,]" they do not have to file reports with the Commission.²⁵ If these shells have been cleansed through chapter 11 bankruptcy, they become the perfect debt-free vehicle to prey on investors, largely unseen by the watchful eye of the Commission.²⁶

For over four decades, Congress has been concerned with potential abuses of the chapter 11 bankruptcy process via public shell trafficking,²⁷ and took action in 1978 to revise the Code to remedy this very issue.²⁸ The most direct attempt to curb this problem from Congress came in the form of section 1141(d)(3).²⁹ Congress "clearly" indicated in the legislative history that it added that statutory provision to address concerns about public shell corporations exploiting the bankruptcy process in order to be marketed as "shell corporation[s] cleansed of [their] public debt."³⁰ This section operates primarily through the provision acting as a "corollary provision to [section] 727(a)(1)[,]"

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which prohibits non-individual debtors, such as corporations, from receiving a chapter 7 discharge."³¹ Section 1141(d)(3) was intended to ensure that corporations that are liquidating and trying to avoid the application of section 727(a)(1) are prevented from obtaining a discharge of their debt in a chapter 11 case.³² By preventing a discharge for public shells under the Code, public shells remain "subject to the debts and liabilities of a failed business venture" which "mak[e] the shell unattractive as a merger target."³³ Despite such anti-trafficking provisions in the Code, bankruptcy courts still approve chapter 11 plans of reorganization which "contemplate" reverse mergers or "motions for the sale of a bankrupt corporate debtor's shell to parties seeking to use shells for reverse mergers in the future."³⁴

Two key problems exist based on the public shell trafficking schemes decried above: one that exists in bankruptcy (the "Bankruptcy Problem") and one that exists in market regulation (the "Market Regulation Problem") (collectively, the "Problems"). The Bankruptcy Problem threatens the integrity of the entire bankruptcy system; actors are presently able to rely on the Code itself to perpetrate public shell trafficking schemes. In doing so, they are circumventing the Code's...