By Julia K. O'Neill
Even if you know almost nothing about securities law, you have probably heard of Rule 144. You may have some vague idea that it has something to do with "restricted stock." Therein lies the next question: what is "restricted stock?" This article explains some of the basics about Rule 144 and restricted stock.
The Federal Securities Act of 1933 (the "Securities Act") generally requires that stock and other securities must be registered with the Securities and Exchange Commission (the "S.E.C.") prior to their offer or sale, unless the transaction or the securities themselves are exempt from registration. Registering securities with the S.E.C. can be expensive and time-consuming.
One transactional exemption from registration pertains to transactions by a "person other than an issuer, underwriter or dealer." Securities Act, Section 4(1). The definition of "underwriter" in the Securities Act includes any person (which can be an individual or an entity) who has purchased securities from an issuer "with a view to, or offers or sells for an issuer in connection with, the distribution of any security, or participates or has a direct or indirect participation in any such undertaking, or participates or has a participation in the direct or indirect underwriting of any such undertaking." Securities Act, Section 2(11). This means that if one had the current intent to resell stock when he purchased it, he could be deemed an underwriter in Securities Act terms, and thus the transactional exemption contained in Section 4(1) would be unavailable to him. The definition of "issuer" includes, in addition to the entity issuing the securities, "any person directly or indirectly controlling or controlled by the issuer, or any person under direct or indirect control with the issuer." Thus affiliates of an issuer owning the issuer's securities would be deemed underwriters in connection with the sale of those securities.
Over the years, the S.E.C. developed certain guidelines about such things as the length of time a person held securities prior to sale and the manner of resale which were used to determine whether a person was a statutory underwriter. In 1972 the S.E.C. formally adopted these guidelines by promulgating Rule 144, entitled "Persons Deemed Not to Be Engaged in a Distribution and Therefore Not Underwriters." The Rule provides a safe harbor for persons selling restricted securities in both public and private transactions and for affiliates (meaning individuals or entities controlling the issuer, controlled by the issuer, or under common control with the issuer) selling both restricted and unrestricted securities in public transactions. If the transaction complies with Rule 144, then the seller can be sure that he will not be deemed a statutory underwriter; in other words, that the sale is exempt from S.E.C. registration. In addition, the buyer will receive unrestricted stock.
Note that Rule 144 only comes into play when one is seeking an exemption from registration. If stock is registered and unrestricted and one is not an affiliate, one is free to sell it without reference to the conditions of Rule 144. If stock is registered when it is originally issued and later becomes restricted (as explained below), a sale transaction will require registration (often referred to as "registration for resale") anew, or an exemption from registration.
Normally, if securities are registered when they are first issued, then they do not bear any restrictive legend and are not deemed restricted securities. Restricted securities are generally those which are first issued in a private placement exempt from registration and which bear a restrictive legend. The legend commonly states that the securities are not registered and cannot be offered or sold unless they are registered with the S.E.C. or exempt from registration. The restrictive legend serves to ensure that the initial, unregistered sale is not part of a scheme to avoid registration while effectuating some broader distribution than the initial sale.
Securities which are acquired from the issuer or an affiliate in a "transaction or chain of transactions not involving any public offering," are also deemed restricted securities for purposes of Rule 144, whether or not they bear a restrictive legend.
Thus if a director (an affiliate) of General Electric buys G.E. stock in the open market, that stock is deemed not to be restricted, because it was acquired in a "public" transaction. Even so, the director would have to comply with Rule 144 to sell the stock on the open market to avoid underwriter status simply because he is an affiliate. If the director instead sells the stock in a private sale to a non-affiliate, the stock becomes restricted in the hands of the buyer, because he has purchased from an affiliate in a transaction not involving any public offering. The buyer would have to comply with Rule 144 in order to resell the stock on the open market without registration.
The SEC revised Rule 144 effective February 15, 2008. The revisions have significantly reduced the limitations on resale of restricted securities of reporting companies.
Rule 144 now allows non-affiliates of a reporting company to resell restricted securities after a six-month holding period and without any volume limitations or manner-of-sale limitations. Previously, the Rule imposed volume limitations, required a one-year holding period and required that the sale be made in a broker’s transaction. If non-affiliates held the stock for at least two years they would be allowed to sell under the prior rule without volume limitations or manner of sale requirements. Now, just a six-month holding period allows a sale by a non-affiliate of a reporting company without those restrictions. To qualify as a "reporting" company, the issuer of the securities must be, and must have been for at least 90 days prior to the sale, subject to the reporting requirements of section 13 or 15(d) of the Securities Act of 1934. To qualify as a non-affiliate, one must not be an affiliate of the issuer at the time of sale and must not have been an affiliate during the preceding three months.
For non-affiliates of non-reporting companies, the new Rule 144 still requires a one-year holding period, but eliminates the previous volume limitation and manner-of-sale requirements.
Affiliates remain subject to volume limitations under the new Rule as well as the public information and manner-of-sale requirements, although debt securities and non-participating preferred stock are not subject to the manner-of-sale requirements. The holding period for affiliates with respect to securities of reporting companies has been decreased to six months. For non-reporting companies, the holding period for affiliates, if the stock is restricted, remains one year. Unrestricted stock held by affiliates does not have a holding period requirement under the Rule. Affiliates are permitted to sell, during any three-month period, an amount not exceeding the greater of (i) one percent of the total number of outstanding shares of the class of securities and (ii) the average weekly trading volume of such securities for the four week period immediately preceding the sale. Affiliate sales must be generally made in broker’s or market maker’s transactions.
There are extensive rules and case law interpretations concerning when one may "tack" onto his own holding period the length of time a previous owner held the securities.
Many people who have extensive experience with both public and private companies and their securities, including experienced brokers, believe that even if an affiliate's entire block of stock is registered for resale with the S.E.C., the affiliate is still subject to the volume limitations of Rule 144. This is not the case. Once the affiliate's shares are registered for resale by the affiliate, Rule 144 has no applicability. The Rule is used only for determining whether one safely falls into an exemption from registration by virtue of non-underwriter status. Where the securities or the transaction are registered as required, the Rule does not apply.
Note that for affiliate transactions, Rule 144 is used only for "public sales." Where the owner of a controlling block of stock in a public company negotiates a private sale of his entire block with a buyer, the Rule does not come into play. In that event the buyer, who must have access to adequate information about the issuer and qualify as a "sophisticated investor," would receive restricted shares, since the shares would be acquired in a transaction not involving a public offering.
One should also note that Rule 144 is technically a "safe harbor," and under some circumstances, resales may be exempt from registration even though they do not comply with the requirements of the Rule.
The recent changes to Rule 144 have substantially eased the resale limitations with respect to restricted stock, hopefully making the small cap market more attractive to potential investors.
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