Resales Of Restricted And Control Securities Under Rule 144

By progressively shortening the Rule 144 holding period for resales of restricted securities, the Securities and Exchange Commission has enhanced such securities' liquidity and reduced the overall cost of raising capital. The authors discuss this and related requirements, the provisions of the rule for affiliates and non-affiliates of the issuer, and the SEC's numerous interpretations of its conditions as to holding period, issuer information, manner of sale, volume, and filing requirements.

With private issuances of securities representing a vast and critically important segment of capital markets activity in the United States - surpassing the value of securities sold by or on behalf of issuers on public exchanges in recent years1 - investors continue to place great weight on the degree to which they can freely exit a given position and retain flexibility to respond to market trends when selecting the companies who will receive their investment dollars. Similarly, persons deemed "affiliates" of an issuer due to their role on its board of directors or management or their large holdings of shares must keep in mind a range of restrictions and compliance obligations that may apply should they wish to resell their shares. In light of such potential constraints on liquidity, Rule 144 remains an important tool for investors, investment banks, and their counsel, particularly as the revisions to the rule in effect since 2008 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)).

Rule 144: Overview and Impact

Rule 144, first adopted in 1972, establishes a safe harbor under the Securities Act of 1933 (the Securities Act), offering liquidity to directors, officers, large shareholders, and other affiliates, as well as holders of securities acquired in exempt offerings. Through its direct and indirect effects on exempt and restricted securities and issuers' access to financing, the provision 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, the rule enhances the value of investing in such offerings in the eyes of individuals and institutions and, thus, the ease with which businesses, large and small, can raise funds for growth or operations through private transactions. The securities' restricted status typically extracts an illiquidity discount from investors.2

These issues shape the opportunity costs associated with public and private forms of financing,3 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 entities and individuals by regulating 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.4 When 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.5 Changes enacted in 1997 established one- and two-year holding periods for restricted and unrestricted resales, respectively.6 Subsequently, in the amendments effective in 2008, the SEC authorized certain resales after a period as brief as six months.7 Moreover, in shortening the timeframe before resale, the amended Rule 144 may act to reduce investors' need to require registration rights 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 inception. But the 2008 amendments that reduce the required holding time 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.

Resales by Affiliates

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., an Exchange 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 been registered for resale by Acme using Form S-1, S-3, S-8, or S-11. Under such a scenario, Smith could order her stockbroker to sell the shares in the open market, or, if necessary, she could pursue a "free stock block" trade - essentially a distribution of freely tradable shares using the special selling efforts of a bank's syndicate desk. Second, if Smith's securities are not covered by an effective registration statement or are "control" securities, Smith could still attempt to rely on the Section 4(a)(1) statutory exemption applicable to persons other than issuers, underwriters, and dealers - especially if she has held the shares for a lengthy period of time - or a "Section 4(a)(1½)" reseller private placement. A third option is Rule 144, while a fourth could be Rule 144A, which permits resales to "qualified institutional buyers" (QIBs). In this instance, Rule 144A is probably not available because Smith's shares are likely of the same class as Acme's listed securities, thereby running afoul of the "fungibility" restriction under that rule. Furthermore, although not applicable in this case, as Acme is publicly listed, Regulation A, intended for small issues, permits resales of securities by affiliates without full-scale registration under Section 5. However, such resales are limited to an aggregate maximum of $1.5 million by all selling holders.8

Definition of 'Affiliate' and 'Control' under Rule 144

In considering such possible avenues for resale, at least two significant factors must be considered. First, as a director, is Smith an "affiliate," subjecting her resale efforts to the Rule 144 requirements for affiliates of an issuer? The rule defines "affiliate" of an issuer as any person that "directly, or indirectly through one or more intermediaries, controls, or is controlled by, or is under common control with, such issuer."9 The question thus becomes whether Smith "controls" the issuer (either individually or as part of a "control group"). It should be noted that control status is a factual determination, and the SEC generally declines to provide interpretive assistance in particular cases.10 Factors the SEC has indicated as relevant to the determination of "control" include an individual's status as a director, officer, or 10% shareholder,11 though none of these alone is dispositive.12 Moreover, under SEC no-action relief there is a rebuttable presumption that directors, officers, and 10% stockholders are control persons and anyone claiming an exemption as a non-affiliate bears the burden of proof on the issue.13 For...