They play it on street corners in big cities and small towns. Three shells are placed in a row on a table. The dealer shows you a pea, places it under one of the shells (or at least appears to) and quickly shuffles them. You bet that you can guess which shell the pea is under. Occasionally, one of your fellow players (the "shill") will guess correctly and win the bet, encouraging you to play on. When it’s your turn to guess the shill remains silent. You guess wrong and lose your money. Sometimes you try again because it seems so easy.
The shell game they play on the street is an exercise in misdirection – getting players to look in the wrong place at the right time.
The shell game they play on Wall Street carries even greater risk because the stakes are much higher. It begins with a public company, a shell that has little or no business and virtually no assets of consequence. But the shell has one significant value – it is public. And, if it finds the right business to acquire, promoters can hype the stock by trumpeting the company’s future prospects. So the people running the shell set about finding a business for their company. Once they do, they arrange for a merger, usually between the shell and a private company. More often than not that private company is long on plans but short on a proven track record. Then the shuffling begins. When it is completed the surviving company is public (courtesy of the shell) but it conducts the business of the formerly private company. This is commonly known as a reverse-merger because the officers and directors of the old private company end up running the public company and the shareholders of the private company wind up with most of the stock of the public company. At the end of the day the private business, and the people running it, have taken over a public company without going through the scrutiny of the regulators or providing investors with the kind of disclosure they can expect when a company goes public through the IPO process. And the insiders and promoters who used to control the shell – they get to tell a story that is designed to increase the price of their stock.
Of course if the process ended here it would have little attraction for schemers and scam artists. The shuffling, however, often has another purpose. With few exceptions, the reverse merger is designed to create a new business, generate a buzz about the company and result in increased stock prices. As part of this process the merger is almost always followed by press releases extolling the prospects of the new business. The idea is to generate investor interest. Question is, is there real value to the surviving company, or are they just trying to get the public to look in the wrong place at the right time?
The investor must decide whether a shell company has been transformed into a valuable investment or remains an empty vessel. How do you make that judgment? Well, it certainly helps to consider the reasons why a private company might decide to go this route rather than hold out for an IPO.
Reason No. 1 - Flying Under the Radar. A private company can become public without regulatory scrutiny. How’s that for a scary concept? Consider the strict criteria for a public offering. Before an IPO can go forward a detailed Registration Statement must be filed with the SEC (and generally, with various states in which the stock will be offered). These regulatory agencies will then look carefully at what the company has disclosed and ask for appropriate clarifications and changes to assure that the investing public is adequately informed. The IPO will not proceed, and the stock cannot be traded, until adequate disclosure has been made about the company’s business, its principal stockholders, its officers and directors, its financial condition, the underwriter and the risks to investors.
And what does all of this mean? Simple. The investor is buying on faith. In the shell shuffle an investor must rely upon the company and its promoters for information. Sort of like guessing where the pea is. Still want to put your money on the table?
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