New Paradigms In Investor Liquidity: Private And 'Off-Market' Resales Of Securities Under Rule 144 And Beyond

1. Introduction

   Over the past decade, a paradigm shift has been occurring in the capital markets that has opened a new panoply of options for security holders desiring liquidity. The convergence of the Securities and Exchange Commission's (SEC) 2005 Securities Offering Reforms, most notably the automatically - and permanently - effective shelf registration by well-known seasoned issuers, the 2008 shortening of holding periods required by SEC Rule 144, the proliferation of alternative trading platforms and the direct engagement of mutual funds, hedge funds, private equity funds, exchange-traded funds (ETFs) and other large market players with distribution portals has enabled shareholders, their brokers and investment banks to be more creative and efficient than ever before in obtaining liquidity for investors.

   Traditionally, there were two dominant scenarios for an investor holding exempt, restricted or control securities who wished to sell some or all of his or her position: either the securities were, or could be registered, or he or she would wait a year from the time of acquisition and rely on Rule 144 for resale into the market. In contrast, evolving practice and law now feature more accelerated and diverse avenues for reselling restricted or control securities than the largely binary choice of the past.

   For registered securities, the convenience of automatic shelf registrations (providing for both primary offerings and secondary sales) facilitates liquidity more than ever before. 1 For exempt securities, resales through the private placement format and the now-accepted "Section 4(a)(1½)" offer an alternative to Rule 144, including Rule 144A 2 institutional resales and Regulation S offshore trades. "Free stock blocks" and other block trade formats have also been developed for investors, while "dark pools" of liquidity 3 via the sale of a large holding of securities to a small number of hedge funds offer an alternative for investors and broker-dealers to avoid the disruptive potential (and possible liability) such resales could bring if executed on the open market. With respect to the use of dark pools or the "upstairs market," market participants must maintain a difficult balance between transactions that risk characterization as offering an unfair advantage to a small group of buyers and sales that run counter to the obligation to maintain an orderly market. At the same time, Rule 144 remains an important tool for investors, investment banks and their counsel, particularly since the revisions to the rule effective in 2008 which now provide for an accelerated timetable for resales of restricted securities (six months for securities of reporting companies under the Securities Exchange Act of 1934 (the Exchange Act or 1934 Act)). 4

2. Securities Act Registration Requirement and Exemptions

   Under the Securities Act of 1933 (the Securities Act or 1933 Act), securities may be legally offered for sale, or sold, only if covered by an effective registration statement filed with the SEC 5 and, generally, accompanied by a prospectus, or pursuant to an exemption from the registration requirement under Sections 3 or 4 of the act. By imposing registration and concomitant disclosure requirements, Congress sought to protect prospective investors by ensuring the availability of information regarding the issuer and its business. With respect to securities not required to be registered, the 1933 Act describes "exempted securities" in Section 3. Section 3(a) includes securities issued by federal, state or local authorities, securities of certain financial institutions, insurance policies and annuities, and bankruptcy securities. Section 3(b)(1) contains the "Small Issues Exemptive Authority" for issues of up to $5 million underlying Regulation A, while Section 3(b)(2), inserted by the Jumpstart Our Business Startups Act of 2012, or "JOBS Act," allows the SEC to enact a new alternative for issuances of up to $50 million, commonly referred to as "Regulation A+." Also of note, Section 3(a)(9) exempts exchanges of securities by an issuer with its existing securityholders.

   Section 4 lays out "exempted transactions" under which securities may be issued without registration. Section 4(a)(1) exempts "transactions by any person other than an issuer, underwriter, or dealer," permitting holders of securities to undertake "routine trading" in the secondary market so long as they are not engaged in a "distribution" of securities, 6 which would result in their being deemed "underwriters" under the statutory definition. 7 As noted below in Part IV.C, investors seek to avoid conduct that could contribute to their being deemed an "underwriter," lest they risk violation of Section 5 (absent registration or an exemption). This potential is magnified by the fact that the 1933 Act's definition of "underwriter" encompasses not only persons who purchase from an issuer but also those who purchase from an affiliate or control person of the issuer.

   Section 4(a)(2), the "issuers' exemption" or "private placement exemption," allows companies to issue and sell securities to investors without registration or the use of a prospectus to the extent not constituting a "public offering." Nonetheless, the complexity of ascertaining the boundaries of a transaction "not involving any public offering" has prompted the SEC's establishment of safe harbors such as Regulation D. 8 Finally, Sections 4(a)(3)-(4) exempt certain broker and dealer transactions, respectively, Section 4(a)(5) permits small offerings made solely to accredited investors and Section 4(a)(6), added by the JOBS Act, sets out the framework for exempt crowdfunding transactions.

3. Rule 144: Resales of Restricted and Control Securities - Overview

   Rule 144 under the Securities Act, first adopted in 1972, establishes a safe harbor providing liquidity primarily to directors, officers, large shareholders and other affiliates of issuers, as well as investors in securities acquired in exempt offerings. Through its direct and indirect effects on exempt and restricted securities and their issuers' access to financing, the rule is something of an unsung cornerstone in the federal securities laws and the integrated scheme of regulation that forms the backdrop for capital formation in the United States. By mandating, among other things, the length of time investors must hold securities issued under most exempt offerings (representing a significant proportion of financing activity in the United States 9), Rule 144 affects the desirability of investing in such offerings in the eyes of individuals and financial institutions and, thus, the ease with which businesses large and small can raise funds for growth or operations through private transactions. 10 Key among the factors affecting the desirability of such financing techniques is the illiquidity discount that investors generally demand due to the securities' restricted status. 11

   These issues shape the opportunity costs associated with public and private forms of financing, 12 thus helping to determine the demand for exempt transactions, such as those under Regulation D and Rule 144A, and overall capital formation levels across the country. Rule 144 also affects the financial position of myriad individuals and institutions by determining how soon they can turn securities into cash so as to reallocate their investment dollars where they will obtain the greatest return or make consumption decisions that, in turn, stimulate other sectors of the economy.

   The evolution of the rule over time marks a trend of increasing liberalization of the holding period requirement, enhancing investor liquidity and indirectly promoting private issuances. 13 Adopted in 1972, Rule 144 initially required that security holders wait two years before reselling restricted securities (subject to limitations), and permitted resales with no limitations only after three years. 14 Changes enacted in 1997 established one- and two-year holding periods for restricted and unrestricted resales, respectively. 15 Subsequently, in the amendments effective in 2008, the SEC authorized certain resales after a period as brief as six months. 16 Moreover, in shortening the timeframe before resale, the amended Rule 144 may act to reduce investors' need to require registration rights provisions as a sweetener in executing financing transactions, though registration rights have still remained common in practice.

   Rule 144 is also unique in the securities laws in that it allows securities to change character from restricted to unrestricted without undergoing SEC registration. In most contexts, a buyer receives securities with the same level of restriction as the seller. However, in sales under Rule 144, a restricted security in the hands of the seller can transform into an unrestricted security in the hands of the buyer. This "hocus pocus" mechanism has captivated the imagination of investors since the rule's adoption. But the 2008 amendments that reduce the required holding period to a very short period really served to drive home the magical quality of Rule 144 and have taken much of the investor headaches away from purchasing restricted securities.

4. Rule 144: Resales by Affiliates

   1. General

      To explore the current Rule 144 and its application in practice, let us examine a hypothetical resale of securities by an affiliate of the issuer. Sheila Smith, a director of Acme, Inc., holds 20,000 shares of common stock of Acme, Inc., a 1934 Act reporting company whose shares trade on NASDAQ. If Smith decides to sell some or all of her Acme stock, what options are available to her?

      Several possibilities may be applicable. First, Smith may be able to sell them immediately in the public market (subject to restrictions on transactions by "control" persons), if the shares were freely tradable when she acquired them. For example, she may have bought them in an ordinary market purchase, or the shares may have...