Caught in a web of spinoffs: Inside Canada’s expanding universe of ‘shell’ companies; the concern over the use of shell companies for unscrupulous purposes prompted the U.S. SEC to launch Operation Shell Expel. The idea is to flush out “pump and dump” schemes, where stock is heavily and sometimes falsely promoted to unknowing investors, while the perpetrators sell at high prices before the stock crashes. The SEC has ejected more than 800 dormant companies from the market since 2012.

http://business.financialpost.com/2015/03/06/caught-in-a-web-of-spinoffs-inside-canadas-expanding-universe-of-shell-companies/

http://business.financialpost.com/2015/03/06/the-spinoff-frenzy-that-started-with-tiny-noor-energy/

Caught in a web of spinoffs: Inside Canada’s expanding universe of ‘shell’ companies

Barbara Shecter and Peter Koven | March 6, 2015 | Last Updated: Mar 6 2:40 PM ET

In the grand scheme of up-and-coming Canadian business stories, Danny Wettreich’s company, Winston Resources Inc., barely registers. It trades for half-a-penny per share, with a market capitalization of less than $50,000. Almost nobody’s heard of it. Still, with a fruitfulness that could rival the hottest Silicon Valley incubators, Winston Resources is the root company in a network that has spawned more than 50 spinoff firms — many of which have obtained coveted public stock listings on the Canadian Securities Exchange, an upstart competitor to the Toronto Stock Exchange.

Creating spinoff companies and getting them approved via plan of arrangement is a way to potentially create something out of very little. Take Noor Energy Corp., a tiny company created in 2012.

Despite its small size, Noor has gone into a spinoff frenzy over the last year, creating several new reporting issuers via plans of arrangement. In each case, Noor spun off the subsidiary and combined it with a private company. Four of these new reporting issuers now trade publicly on the Canadian Securities Exchange. Three of them are focused on medical marijuana, while the fourth is involved in cancer research. Keep reading.

The proliferation of these companies has happened so far below the radar that Mr. Wettreich himself professed to have no idea all these companies, whose details can be found in regulatory filings, exist.

“I assure you that’s nothing to do with me,” Mr. Wettreich said, when told about the long list of Winston’s progenies, noting that he personally only handled five spinoffs from Winston.

Still, somewhere along the line, the people in control of those spinoffs, created more spinoffs, which created more spinoffs. They are companies involved in everything from mining to medical marijuana to biotech research to financial services. Some have no discernible business plan, and very few have much cash to fund a serious business. But many of them have one important thing in common: They were born into the world as ready-to-go reporting issuers in Canada — a stepping stone to an exchange listing — without having ever gone through the traditional regulatory rigmarole of filing a detailed prospectus outlining their business, or appearing before one of Canada’s securities regulators.

They, like a growing number of companies being spun off as reporting issuers in Canada, are the product of an increasingly popular legal maneuver known as a plan of arrangement: a court-supervised process that has traditionally been used by lawyers handling enormous mergers, bankruptcies and other financial restructurings. The plan allows companies to isolate certain assets that may have exceptional value, relative to other assets, into standalone entities. For example, it was used when EnCana Corp. split itself into separate oil and gas companies in 2009.

But plans of arrangement are just as useful, as some astute legal navigators have discovered, at spinning off micro-cap companies from other micro-cap companies, with each offspring taking with it the regulatory bona fides of its progenitor. From just one little company with reporting-issuer status, dozens more can be spun off, just a few steps away from being ready to trade on public markets and after little more than two court hearings and a meeting of the handful of shareholders backing the new spinoff.

“Through using this mechanism and the past history [of the progenitor corporation], you’re able to get essentially an empty shell listed,” said Richard Peters, a Calgary-based lawyer who wrote about the versatility of such plans a few years ago when he was practicing at McMillan LLP.

It has proven to be a highly effective way of sidestepping the costly and burdensome hassles that come with winning approval to become a reporting issuer, which can give a huge helping hand to startup firms who are in a hurry or have little capital. Corporate filings show some of the companies have been capitalized with as little as $1,000.

But it’s that very benefit that has regulators on high alert; to them, all that regulatory red tape has a purpose. The way regulators see it, reporting issuers who haven’t first been vetted as having legitimate and sound business plans are putting the integrity of public markets at risk. Clearing those regulatory bars is what earns a company the privilege of accessing investor capital. Those companies able to pitch their stock without that scrutiny could be up to any number of things, possibly putting investors, who may feel reassured by the reporting issuer status, at heightened risk.

It’s a way of going public without seeing the [regulating securities] commission

There is nothing illegal or improper about the plan of arrangement tactic, but with few assets and little scrutiny or disclosure, the potential for abuse, experts say, is clearly there.

“It’s a way of going public without seeing the [regulating securities] commission… It’s not really a business,” says Jeffrey Stanger, whose firm ITB Solutions helps startups come to market, and also assists the Canadian Securities Exchange with marketing the listing and trading venue to potential public companies.

The judges who approve these arrangements (the vast majority seem to go through the Supreme Court of British Columbia) are tasked with ensuring the proper legal steps have been taken to recognize shareholders’ rights, and “are not going to do too much digging into whether this is a good deal or a bad deal,” said Mr. Peters, now general counsel at technology firm Kymbask Management Inc. Because there is often just one person or a small group that controls a majority of the shares, it usually takes just a day or two to get court approval. “The fact that the [court and shareholder meeting] process was fair means the result is fair,” Mr. Peters said.

Once the court signs off on the deal, the spinoffs are deemed to be reporting issuers under Canadian securities law, and will often quickly seek public listings.

Mr. Peters has referred to the plan of arrangement as a “corporate Swiss army knife,” given the number of flexible applications it could be used for.

“The advantage of plans of arrangement [is] they’re really only limited by your imagination in terms of how you’re going to restructure things — provided that a judge at the end of the day is satisfied that the process for approval has been fair,” said Mr. Peters.

To be sure, plans of arrangement aren’t the only way to obtain a public stock listing without filing a prospectus. But more traditional reverse-takeover transactions that combine private businesses with dormant public firms require both a review and final approval by a provincial securities commission. Often, some prospectus-level disclosure must be included in a management information circular document filed in connection with traditional reverse takeovers. Companies started through a plan of arrangement spinoff require none of those things.

Mr. Wettreich’s Winston Resources in only one of many companies that has been at the centre of a plan-of-arrangement web of multiple spinouts. But what happened with one of the companies within the Winston network provides an example of the sort of scenario that regulators are nervous about.

Just before Mr. Wettreich took control of it in 2012, Winston Resources spun out a company called Gorilla Minerals Inc. Gorilla then broke off at least 10 companies on its own, and those spinoffs have spawned even more. One Gorilla spinoff, Salient Corporate Services Inc., has itself spun off around 25 companies in the last seven months, according to regulatory filings. Salient founder Karl Antonius could not recall the precise number off the top of his head when reached by the Financial Post.

Orca Touchscreen Technologies Ltd., one of the Gorilla spinoffs, is now under scrutiny. In early February, Canadian regulators temporarily halted trading of Orca stock on the Canadian Securities Exchange. This was after Orca trades were suspended on the Frankfurt Stock Exchange in response to allegations of “improper investor solicitation.” Germany’s Federal Financial Supervisory Authority issued a warning to investors about unsolicited phone calls, or cold calls, recommending purchasing the shares, which made a stunning climb on the CSE from 5.5 cents last year to 59 cents in December and $1.08 in February, days before trading was halted.

In a statement in response to the regulatory suspension, Orca said the company is not aware of any improper investor solicitation, nor has it authorized any. The trading halt was lifted in Canada on Feb. 11th, and Orca’s share price began a steady fall to 18 cents. Earlier this week, it leaped back to 55¢ on very thin trading.

While a few companies in this galaxy of spinoffs have decent market capitalizations — for example, cancer research firm Biomark Diagnostics Inc., a Gorilla Minerals spinoff, is worth more than $20-million — most are worth next to nothing, and have minimal cash to carry out a business plan and make money.

“A lot of these companies are early stage and their business plans are in development,” Gorilla Minerals director Scott Sheldon said.

The CSE, an 11-year-old exchange where more than two billion shares changed hands last year, has become the preferred destination for these companies. That is because the court approval makes them automatically eligible for a listing, said Richard Carleton, chief executive of the CSE (the TSX Venture Exchange has stricter requirements).

In turn, a listing on the CSE automatically makes a company a reporting issuer in Ontario.

The CSE was home to 244 companies last year, a 35% increase from 2013. The value of combined financings by companies listed on the exchange almost doubled, to $155 million. But it became clear to exchange officials that some of the issuers seeking listings in the past year did not have any sort of credible business model, Mr. Carleton said.

In recent months, the CSE has been attempting to block any attempts by issuers who try to list firms doing the “absolute bare minimum” necessary, Mr. Carleton said. They are trying to weed out the ones that are shell companies by design.

“We share these concerns, specifically any attempts to circumvent a regulatory process,” said Huston Loke, director of corporate finance at the Ontario Securities Commission.

There are strong incentives to spinning off as many tiny firms as possible through a plan of arrangement. A clean shell company — meaning it has been created without any previous liabilities like residual environmental liabilities or historic debt — can sell for a negotiated price as high as $1 million, according to Mr. Stanger.

The creator of a shell can also link up with a promising entrepreneur, rather than walking away from the shell after they sell it. By vending in the entrepreneur’s company and becoming an equity holder, the shell creator stands to make a lot of money if the business takes off.

Across the border, the concern over the use of shell companies for unscrupulous purposes prompted the U.S. Securities and Exchange Commission to launch a program called Operation Shell Expel. The idea is to flush out “pump and dump” schemes, where stock is heavily and sometimes falsely promoted to unknowing investors, while the perpetrators sell at high prices before the stock crashes.

The SEC has ejected more than 800 dormant companies from the market since 2012.

It’s kind of like a vacant house on your street, a bunch of bad things can start to happen there

The CSE is also on the lookout for firms trying to list with no operating business or hard assets, and with little cash. Mr. Carleton said the exchange has blocked far more of these shells created via plan of arrangement than it has approved. And in January, the CSE issued guidance aimed at reining in the growth of shells. For example, the exchange said it is cracking down on reporting issuers trying to go public where management has no apparent operating history, and rejecting companies with proposed capital structures in which shares are issued at absurdly low levels (such as fractions of a penny).

But even if these shell companies never receive a public listing, regulators are troubled by their status as official reporting issuers, which gives them inherent advantages: their shares have fewer restrictions on trading than do other private companies, which tends to raise the price people are willing to pay for the issuer’s shares.

Mr. Peters thinks exchanges have a strong rationale for trying to tamp down on shells listing via a regulatory status “inherited” though a court process.

“It’s kind of like a vacant house on your street, a bunch of bad things can start to happen there,” he said. “It kind of lowers the value of the neighbourhood.”

 

The spinoff frenzy that started with tiny Noor Energy

Peter Koven | March 6, 2015 2:19 PM ET
Creating spinoff companies and getting them approved via plan of arrangement is a way to potentially create something out of very little. Take Noor Energy Corp., a tiny company created in 2012.

From just one little company with reporting-issuer status, dozens more can be spun off, just a few steps away from being ready to trade on public markets and after little more than two court hearings and a meeting of the handful of shareholders backing the new spinoff. Keep reading.

Noor, which does not have a public listing, describes itself as being in the business of acquiring private enterprises in a “variety of industries.” But it never had the capital to do much of that. As of Dec. 31st, the company had no cash, $5,000 of receivables, $41,240 of accounts payable and accrued liabilities, and “available for sale investments” valued at two bucks.

Despite its small size, Noor has gone into a spinoff frenzy over the last year, creating several new reporting issuers via plans of arrangement. In each case, Noor spun off the subsidiary and combined it with a private company. Four of these new reporting issuers now trade publicly on the CSE. Three of them are focused on medical marijuana (Medipure Holdings Inc., True Leaf Medicine International Ltd. and Seashore Organic Marijuana Corp.), while the fourth is involved in cancer research (Biomark Diagnostics Inc.).

Noor received shares in each of these companies for its efforts, as well as cash to cover the costs. President Kyle Stevenson said these spinoffs have not been a real moneymaker for him and he does not plan to do more.

But if any of them were to take off, it could be a huge win for Noor. They are all penny stocks, so even a minor bump in liquidity could lead to a major price increase.

The medical marijuana stocks have performed poorly so far, but Biomark looks like a potential success. The company, which claims to have advanced stage diagnostic technologies, has decent liquidity and a market value of about $20 million.

Noor’s shareholders received 310,000 shares of Biomark in the go-public transaction. Mr. Stevenson is the majority shareholder, but he said he has more than 200 minority investors as well.

From Biomark’s perspective, getting listed through the court-approved plan of arrangement made a lot of sense, chief executive Rashad Ahmed Bux said in an interview. The company wanted to go public as fast as possible to take advantage of a hot biotech market in the United States. Management did some due diligence on Noor’s shell and spoke with professional valuators before going ahead with the deal.

“We found a good shell with a good structure in place,” he said.

Noor, meanwhile, is planning to merge with a company called Ruralcom Networks and has applied for a CSE listing.

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