Shell companies are still alive and causing problems, even though the increased costs of being a public company following Sarbanes-Oxley should have driven these shady operations out of business.

The basic rule remains: If someone approaches your client with a transaction involving a “shell company” — don't do it.

The rationales offered by shell company promoters vary in specifics, but the general pitches are:

A promise to a company founder who is looking for capital that a merger with a public shell will let the company “gain access to capital markets.”

A pitch to an investor to put money into the shares of a company trading at a sub-$1 price per share in the pink sheets, because “the stock is just about to go up.”

A deal that provides a bona fide operating company with near-term cash, but burdens it long-term with the costs and obligations of SEC reporting while the company is still trying to develop its business.

For some reason, I have encountered a number of people recently who all have stories to tell about what has happened to them with shell companies. The stories are similar to the ones that I have heard over the years in practicing securities law. These are not success stories. In the cases in which a shell company deal was not an outright fraud, it was still a headache.

The only winners in the shell company game are the promoters and insiders who sell their own shares after they induce the public to start buying the stock.

A shell company is a company that has no real operating business, but which nonetheless has a class of shares registered with the Securities and Exchange Commission, makes public company filings, and has shares that trade on the pink sheets or a small stock exchange such as the Vancouver Stock Exchange or the Denver Stock Exchange. When shell company shares are traded, the trading is thin (a small number of shares trade each day). The shares often trade for prices below $1 per share.

The shell company scheme typically takes this form: A promoter gains control of the shares of a company that has publicly traded shares, but for whatever reason is not currently operating, or has very marginal operations. The promoter amasses a quantity of shares, then works to inflate the share price.

Sometimes the method is a “pump and dump” promotion, in which the promoter “pumps” the stock with promotional stories or Internet investment chat room tips, then “dumps” his own shares as outside investors enter the market and bid up the stock price. Sometimes the promoters bid up the price themselves with small dummy purchases, then tout the fast rise in price as a reason for investors to come in, at which time they dump their own holdings.

Sometimes the promoters find an operating company that falls for the promoters' pitch and merges a real company with the shell, letting the promoters use the existence of the real company as a reason to pump the stock.

Shell company promoters also sometimes roll up a group of small companies in an industry and then tout the combined entity to investors.

Investors and company owners who are approached with these transactions should be very wary.

Shell company schemes have nothing to do with the real increase of enterprise value or real shareholder wealth. They have everything to do with the promoters triggering an upward spike in the price that permits them to sell out and leave innocent investors holding the bag.

The promoters sometimes prey on owners of legitimate businesses who do not understand the operations of the securities markets. A company that lacks hard assets for bank financing or fast growth for venture capital equity investments might be wooed into a shell company merger on the promise that capital would be available once the company's shares could be publicly traded.

Nothing is further from the truth. The costs of securities compliance, particularly after the Sarbanes Oxley Act, are significant, and there mere existence of a trading market for shares does not make a company by a better candidate for debt or equity financing.

In the past, there was a good chance that a stock that sold for less than $1 per share was a shell company or “penny stock” name rather than a bona fide operating company. In the past couple of years, stock market prices have declined significantly so that shares in some companies wound up selling near or below the $1 per share range, even though the companies were bona fide businesses.

One way to know whether a publicly traded company is a “shell” is to check its SEC filings online on the SEC's EDGAR database. If a company had originally registered with the SEC under another name, or in an industry different from the one in which it currently claims to operate, it probably is a publicly traded shell company that merged with another company.

Bruce Dravis is a partner at Downey Brand LLP, operating primarily in the firm's Sacramento and Roseville offices, specializing in corporate, securities and business law. His column appears in The Daily Recorder on the third Monday of each month.