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October 4, 2014
THE LONG TAIL OF A SCANDAL: REVERSE MERGER RULES TIGHTENED ON THE MAIN TORONTO EXCHANGE

On 25 September the TMX Group, operators of the Toronto Stock Exchange, announced new rules governing reverse mergers (also known as reverse takeovers). A reverse merger is the process by which a larger private company is “acquired” by a publicly-traded company (typically with few assets, and often a so-called “shell”), the resulting entity being listed on the stock exchange. Such a transaction involves the shareholders of the public company owning less than 50% (voting control) of the resultant entity. At the most fundamental level reverse mergers allow for a private company to secure a public listing, and therefore the potential access to both liquidity and additional equity capital, without the cost, effort, due diligence and marketing process associated with an initial public offering.  As the leading law firm Oslers put it in a June 2010 bulletin; “Reverse Take-Overs: An Alternative Entrance To Canadian Capital Markets.”

Interestingly the new  rules apply only on the main board – the TSX Exchange; the TSX Venture Exchange is exempted from the new, more stringent approach.

This fresh way of looking at reverse mergers on the main exchange seems to have resulted, at least in part, from the consequences of the Sino-Forest Corp. debacle that unfolded on the TSX in 2011-2012.

Sino-Forest Corp. billed itself as an owner of forestry assets in China and a firm therefore ideally positioned to benefit from that country’s spectacular economic growth. Sino-Forest went public through a reverse merger with Mt. Kearsarge Minerals Inc.: a shell company named after a New Hampshire mountain located to the north and west of Concord.  The trajectory of Sino-Forest was in a sense impressive: from reverse merger to a $6 billion market capitalisation and onwards to a messy and destructive accusation of fraud and a bankruptcy filing.

Sino-Forest unspooled some months after the Ontario Securities Commission had determined that reverse mergers are “not specifically problematic”.  At the time Canada was out of step with the US and the UK, where the respective regulators – the Securities and Exchange Commission and the Financial Conduct Authority – had both moved to substantially curtail reverse mergers. The U.S. had led the process off in 2011 in the wake of a number of problematic, China-related reverse mergers.

The new rules now bring Canada closer to the US and UK model of heavier oversight and regulation, though Canada seems to have decided that to completely adopt the approach of the US and UK regulators would be heavy-handed and counter-productive.

The Toronto Exchange’s new rules now allow for a more formal and structured review process studying the resulting capitalisation structure, exchange ratios, dilution, size, industry, and post transaction leadership. The rules also allow for the TSX deploy its judgement to block a transaction as a result of such a review. The message would appear to be that “the TMX will be a much more demanding gatekeeper for the main board in a quest to avoid another error along the lines of Sino-Forest”.

Indeed some securities lawyers have identified the Exchange review as starting to give the same appearance of weightiness of process as an initial public offering.  Legal fees under the new rules will certainly climb. That being said, if a private company is well-capitalised, strategically viable and seeks a public listing for reasons other than an immediate need to raise capital, then the TSX rules seem to make room for a reverse merger.

The impact of the new rules can be overstated. As was noted above, this framework will apply to companies seeking a reverse merger on the TSX: something that has happened on average 2-3 times per annum. The TSX Venture Exchange – the natural milieu of the reverse merger – sees a much higher volume (dozens in an average year), and here the original, more free-wheeling framework will remain.

The TMX still lists Reverse Take-Over as “another way to list your company” (http://www.tmx.com/en/listings/listing_with_us/ways/reverse_over.html); moreover, given the importance to Canadian capital markets of resource companies and firms seeking to develop assets in “frontier markets, we expect that Canada will retain its status as a jurisdiction wherein a reverse merger relatively straightforward. That said, the new framework signposts that a more careful and deliberative approach will be required by a company seeking a reverse merger. Such a firm should consider engaging an independent adviser conversant with both the Canadian capital markets as well as how to define and articulate the underlying capital structure and strategic rationales of a reverse merger.