The Securities and Exchange Commission is taking a major step to assure that investors in tiny over-the-counter companies have access to material information about those businesses and the people who run them.

The SEC is also halting a practice that has allowed many obscure, insubstantial public companies to flood the marketplace with shares.

These developments reflect the SEC’s latest effort to increase transparency in a microcap market that has been a fertile ground for deceptive practices and stock fraud. A series of new rules are directed at public shell companies, which have used existing federal regulations and procedures to avoid disclosure and keep investors in the dark.

On the surface, shell companies can offer an appealing alternative for small private companies that want to become public but are unable to find an underwriter who is willing to handle their Initial Public Offering (IPO). See The Shell Game. They enter into a reverse-merger with the shell that leaves them in control of the surviving public entity.

There are, however, companies that choose a reverse-merger over an IPO for other reasons. These companies are seeking to avoid the exhaustive disclosure that comes with a public offering. In an IPO they would be required to file a registration statement detailing the history of their business, the background of their management team, and the identity of each controlling shareholder. That registration statement also would include extensive audited financial information. In effect, the company and its insiders would be laid naked to the world.

Not every business is eager to make those disclosures, since in some cases the information could motivate the SEC to delay or stop the offering.

Until now, the reverse-merger has enabled private companies to circumvent the disclosure process. The private company gains control of a public entity, but investors are generally flying blind. Historically, companies that merge into shells have not been required to make detailed material disclosures about their business history, management or controlling shareholders. And while public companies that file regular reports with the SEC (which would include every company listed on the OTC Bulletin Board) have been required to file a Form 8-K including audited financial information on the newly acquired private business, all too often that information is delayed, incomplete, or non-existent.

That practice is about to end, thanks to new rules proposed by the SEC on April 13, 2004. Now, after a reverse-merger, the former shell will be required to file a Form 8-K that includes all of the disclosures that would be required if it were registering a class of securities under the Securities and Exchange Act of 1934. In other words, a reverse-merger will no longer be a method for evading disclosure. The curtain will be lifted and investors will have access to material information that is likely to affect their investment decision.

It is about time.

There is yet another reason for investors to rejoice. The SEC has struck a decisive blow against an insidious tool that has been utilized by stock schemers to obtain registered shares that can easily be dumped on an unsuspecting marketplace.

Over the past several years, Form S-8 Registration Statements have been overused, misused, and often abused. The Form S-8 differs from most other registration statements in one fundamental respect – it becomes effective immediately after it is filed with the SEC. Traditional registration statements – such as those used in connection with IPOs – are subject to rigorous review by the SEC, and must be revised, sometimes several times, in response to SEC comments and concerns before they are declared effective. Until that time, the stock being registered may not be sold.

Not so with the Form S-8 – which becomes effective without any advance SEC review.

The absence of a review is even more startling in light of the abbreviated nature of a Form S-8, and the broad – vaguely defined – category of potential stock recipients. In short, a Form S-8 can be used to register shares that are issued to an “employee” under an employee benefit plan.

The real rub, however, lies in the definition of “employee,” which includes officers, directors, consultants, advisors – and yes – attorneys. The definition of “employee benefit plan” is equally broad. Rule 405 of the Securities Act of 1933 defines an “employee benefit plan” as:

any written purchase, savings, option, bonus, appreciation, profit sharing, thrift, incentive, pension or similar plan or written compensation contract solely for employees, directors, general partners, trustees (where the registrant is a business trust), officers, or consultants or advisors. However, consultants or advisors may participate in an employee benefit plan only if:

They are natural persons;

They provide bona fide services to the registrant; and

The services are not in connection with the offer or sale of securities in a capital-raising transaction, and do not directly or indirectly promote or maintain a market for the registrant's securities.

In other words, virtually anyone can fall within the definition of an “employee,” and there are few obstacles to constructing an “employee benefit plan.”

As StockPatrol.com has repeatedly noted, tiny companies with virtually no assets, no operations and no revenues utilize Forms S-8 to hand millions of shares to employees and consultants – many of whom are not even identified. Remarkably, Form S-8 does not even require the recipients of shares to be named. The company may simply register as many shares as it wishes for an employee benefit plan, and later hand them out to unnamed individuals whose identity, background, and services are never described. And while companies are supposed to amend the Form S-8, and name those new shareholders once the shares have been distributed, few ever do.

As a result, shares can be issued to company insiders, their friends and associates and so-called consultants who render no discernible services. Investors, and regulators, do not know who is receiving the stock, or if it is going into the hands of individuals who merit further scrutiny.

Some of the potential for these abuses is about to stop. Under the SEC’s newly proposed rules, shell companies will be prohibited from using Form S-8 to register shares for employee benefit plans. Consequently, those anonymous employees and consultants will no longer have a free flowing pipeline of registered stock.

These important rule changes should prove critical to investors. Former shell companies will be required to provide material information about their new operations, on a timely basis, and will be unable to use Form S-8 to register shares that can be dumped immediately after the reverse-merger. In addition, in the absence of a reverse-merger, shell companies will now be prevented from saturating the market with shares of worthless stock in an insignificant enterprise.

The new rules represent an important, even historic step for the SEC, but regulatory efforts should not stop here. The SEC must commit itself to the process of reviewing each Form 8-K and S-8 in order to assure full compliance – and companies that fail to meet these standards should have registration of their shares revoked.

In any case, the architects of stock schemes should be losing plenty of sleep over these developments.