On Nov. 15, the Securities and Exchange Commission adopted final amendments to Rule 144, consistent with its original proposals concerning holding periods and manner of sale.
Thus, the SEC has renewed its march towards continuous registration based on full 1934 Act disclosure.
The final text, effective 60 days after publication in the Federal Register, was not available when this article went to press. Consequently, it’s unclear whether all details of the original proposals were adopted.
Below is a discussion of the proposed changes to Rules 144 and 145, which are designed to ease restrictions on the resale of stock obtained in so-called private placements.
Purchasers of stock in private placements, or recipients of stock in mergers or other corporate combinations, would be required to hold their shares for a shorter period of time, and deal with fewer technical restrictions upon the resale of those shares.
The SEC solicited comments during the following 60 days, and over 30 publicly available comments were filed.
What doesn’t appear in the SEC Release (33-8813), in the comments, or in extensive published analysis, is recognition of what is really happening here. Wholly arbitrary rules – originally instituted to encourage companies to file registration statements under the Securities Act of 1933 to protect uninformed investors – are being slowly gutted.
Securities are sold in transactions that are or are not registered with the SEC. Although the nomenclature is commonplace, we don’t really “register stock.” We register “transactions.” If the transaction is effected legally but is not covered by a registration statement, it is a “private placement.”
This distinction becomes clear when we recognize that the resale of securities, regardless of whether they were originally issued pursuant to a registered transaction, must proceed under Section 4(1) of the ’33 Act, which exempts “transactions not involving an issuer, underwriter or dealer.”
Imagine a typical purchaser of “unregistered stock” seeking to resell those shares. That purchaser is not himself the issuer or a dealer. The exemption for resale has almost been achieved. All that purchaser needs to further demonstrate is that he is not an “underwriter.”
An underwriter takes securities directly or indirectly from an issuer intending to redistribute them by resale. When our typical investor obtained these securities, what indeed was his “intention”? Intention is, after all, subjective.
What is investment intent? And what are the outward manifestations of this subjective “investing” mentality? Presumably, if you resell the shares immediately no one will believe that you originally intended to hold them for investment. Conversely, if you resell them 10 years later, it feels like an “investment” to the outside observer.
Where is the point between a quick resale and holding securities for 10 years at which we should believe our purchaser originally intended to hold for investment?
Ancient practice (prior to Rule 144’s promulgation) was paranoid. Some practitioners maintained that no specific holding period was enough to justify public resale. Notwithstanding, other experienced practitioners would render a written opinion that securities held for four years, and indeed three years (the SEC view), clearly were held for investment, and that the investor was not an underwriter. More daring counsel would write that letter after two years.
The concept of “change of circumstances” plays a part in the analysis. For example, say you buy securities on day one intending to hold them for investment, theoretically forever. Something dramatic happens on day two making you want to sell those securities.
A sale based on change of circumstances would be permitted, because the investor originally did not take the securities with an intention to sell them.
Could the change of circumstance be a change of personal circumstance? Or, must it be a change in the circumstances of the company you invested in? And how do you measure whether that change is sufficient to justify a resale?
The SEC in 1972 promulgated Rule 144 to deal with these questions. The Rule eliminated entirely any need for change of circumstance. Instead, the ticking clock gives you your answer. Affiliates of the issuer must wait three years, and non-affiliates must wait two years. Thereafter, shares must be sold only in brokered transactions, with volume limitations and the filing of Form 144 (“Sales Procedures”).
Many practitioners fail to focus on the Preliminary Note to Rule 144, stating that the Rule is a safe harbor and is not the sole articulation of the Section 4(1) resale exemption. But the safety of that harbor, its predictability, and the standardization of brokerage sales under Rule 144 effectively drove out all other methodologies for the resale of restricted securities.
Few law firms wrote non-Rule 144 “free up” opinions. Brokerage firms did not want to deal with customized transactions, In-house counsel did not want to see complex analysis. Everyone just wanted to see the standard Rule 144 resale paperwork.
No sky falling
During the following 25 years, nothing terrible happened in the securities markets that could be traced to Rule 144 (and the analogous Rule 145 provisions relating to restricted securities obtained in mergers and acquisitions).
In 1997, the SEC amended these Rules to reduce the holding periods. Affiliates now needed to hold the securities for two years and not three, and non-affiliates needed to hold the securities for one year and not two. Other technical changes permitted greater “tacking” (the addition of the holding periods of prior owners) to the holding period of the seller.
In 2007, faced with the quickening pace of capital formation and competition from overseas capital markets, the SEC again proposes to speed up private placement resales so that investors presumably can recycle their monies into subsequent deals.
The proposed rules would have the following effect on resales:
The broader trend
When the SEC first thought about the resale of privately placed shares, there was not nearly so robust a reporting system as now exists under the ’34 Act. As the SEC has moved toward “continuous registration,” with reliance on current comprehensive ’34 Act filings, the pressure to utilize ’33 Act registration statements as disclosure mechanisms has eased, as has the pressure to control “leakage” of restricted shares into the marketplace.
The theory seems to be: “If the marketplace has all current issuer information all the time, including at time of proposed resale, that is equivalent to filing a ’33 Act registration statement, why not let the private placement shares be resold?”
There likely will come a time when all companies that are current in their ’34 Act filings will be able to sell shares at any time, and the holders of privately placed shares also will be able to resell their shares at any time. At that moment, the need for a registration statement filed by a reporting issuer will have disappeared, nor will there be a concept of restricted shares for reporting companies.
The commentary filed with the SEC concerning the proposed rules is detailed, professional and predictable. As befits the subject, many are highly technical, addressing nuances not the subject of this column.
A battle continues, however, between those who would liberalize resales and the more traditional approach of tying up privately placed securities for long periods of time.
The ABA’s Committee on Federal Regulation of Securities, in its extensive analysis endorsed virtually all the liberalizing aspects of the proposed Rules. The ABA committee would go further, permitting shareholders to fully hedge their position during the holding period (notwithstanding that by reason of the hedge the investor is not at the risk of the investment), citing lack of empirical evidence that tolling the running of the time period for up to six months due to hedging, as the new rules sometime require, cures any market abuse. The committee would also eliminate entirely the necessity of filing Form 144 (conceding as an alternative that executive officers, directors and 10 percent shareholders might have a filing duty under current law).
The ABA’s “pro-business” approach is echoed in the Sullivan & Cromwell comment letter, which proposes elimination of any requirement with respect to manner of sale. In its letter, Sullivan & Cromwell states: “There is no reason to discourage privately negotiated transactions that are otherwise in compliance with the Rule. It is our view that there is no particular risk of abuse.”
The traditionally more conservative North American Securities Administrators Association, which is the organization of state securities regulators, said that shortened holding periods may “have a dramatic effect upon the market price valuation and volatility of the company’s shares.” The Association argues as follows.
First, reduced holding periods will cause companies to avoid registration, allowing more securities to leak out through private placement resales without the “transparency” of registration.
Second, there is an increased risk that insiders who “should” stay in company management will sell their shares quickly and leave, lowering insider incentives to manage.
Third, these changes accelerate the amount of shares coming to market, thus potentially depressing share price.
NASAA’s arguments easily can be challenged on logical grounds. The first and third points really are matters of timing and not substance, and the second point can be addressed easily by employment agreements if such is the business deal.
Even if NASAA claims the new rules contain “extreme reductions [in time which] are improvidently large,” the SEC nonetheless seems well on its way toward speeding the flow of privately placed securities into the public markets.
This trend is justifiable in the case of public companies with robust ’34 Act filings, but even non-reporting companies seem to buoyed by this incoming tide. NASAA must feel much like King Canute, standing vainly on the beach exhorting the waves to recede.
Stephen M. Honig is a member of Duane Morris’ corporate department in the firm’s Boston office. You can reach him at email@example.com.