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Determining Whether the Sale of Restricted or Control Securities by an Executive Qualifies Under the Private Placement Exemption of Rule 144

When an executive contemplates the sale of restricted securities, he or she must determine whether to file a Form 144 with the Securities & Exchange Commission (SEC) or qualify for an exemption under Rule 144 of the Securities Act of 1933. If the executive qualifies for entitlement to the exemption, the sale of securities is often called a “private placement.”

Executives will typically acquire ownership shares in a corporate employer either through deferred compensation plans or outright grants of restricted stock. Generally, when such securities are awarded to the executive, the stock certificate bears a restricted legend on the face of the instrument. In order to sell such restricted securities, the executive must make an attempt to remove the restricted legend with the company’s transfer agent. There are several steps that must be taken in order to request the restriction be lifted. Otherwise, the securities must be registered with the SEC using Form 144.

The SEC promulgated Rule 144 to clarify the statutory definition of “underwriter” for the purposes of the Section 4(1) exemption. The rule provides that an individual who sells restricted shares will not be considered an underwriter or involved in a distribution if the following conditions are met: adequate current public information is available concerning the issuer; the restricted securities have been held at least one year; no more than 1 percent of outstanding shares are being sold within a three month period; the shares are sold as “brokers’ transactions” within the meaning of Section 494) of the Securities Act; and if the amount of securities sold in any three month period exceeds 500 shares or has an aggregate price in excess of $10,000, notice of such proposed sales has been given to the SEC. See 17 C.F.R. Sec.230.144(c)-(f),(h).

Rule 144(k) provides the strongest catchall exemption under the 1933 Act. The burden of proving entitlement to an exemption is on the party claiming entitlement. SEC v. Ralston Purina Co., 346 U.S. 119 (1953). The public policy behind Rule 144 is, “the need of the offerees for the protections afforded by registration…If the offerees have access to such information, registration is unnecessary, and the section 4(2) exemption should apply.” Van Dyke v. Coburn Enter., Inc., 873 F.2d 1094, 1098 (8th Cir.1989). See also, Sorrel v. SEC, 679 F.2d 1323, 1326 (9th Cir.1982)(“The offeree’s access to financial information about the investment, similar to what would be found in a registration statement, is crucial.”). “The design of the Act (1933 Act) is to protect investors by promoting full disclosure of information thought necessary to make informed investment decisions.” Van Dyke, 873 F.2d at 1097.

Section (k) (Termination of certain restrictions on sales of restricted securities by persons other than affiliates) provides:

The requirements of paragraphs (c)[filing current pubic information],(e)[limitation on amount of securities sold], (f)[manner of sale-broker] and (h)[notice of proposed sale-500 shares or $10,000] of the this section shall not apply to restricted securities sold for the account of a person who is not an affiliate of the issuer at the time of the sale and has not been an affiliate during the preceding three months, provided a period of at least two years has elapsed since the later of the date the securities were acquired from the issuer or from an affiliate of the issuer. The two year period shall be calculated as described in paragraph (d) of this section.

Pursuant to Rule 144, the executive must determine first if he is an “affiliate” of the issuing company. Under Rule 144, an affiliate "is a person that directly, or indirectly through one or more intermediaries, controls, or is controlled by, or is under common control with, such issuer.” Id. “Control” means the “the possession, direct or indirect, of the power to direct or cause the direction of management and policies of a person, whether through the ownership of voting securities, by contract or otherwise.” 17 C.F.R. § 230.405. Here the analysis focuses on the executive’s degree of ownership interest. Generally, a 10% holding will qualify the executive as a control person under Rule 144. “The determination of whether a person occupies a “control” position does not turn upon a single factor such as stock ownership, but rather ‘depends upon the totality of the circumstances, including an appraisal of the influence the individual has on the management and policies of a company.’” SEC v. Lybrand, 200 F.Supp.2d 384, 393 (SDNY 2002)(citing SEC v. Cavanagh, 1 F.Supp.2d 337, 366 (S.D.N.Y).

Under 144(k), the executive must evaluate whether he is a control person by virtue of his existing employment and possible directorship with the issuing company. If so, the control status will be a prima facie reality, causing the executive to lose the exemption. If the executive has resigned from the company and the board of directors, his status as a control person will be substantially diminished.

Section 2(4) defines an “issuer” as “any person who issues or proposes to issue any security.” 15 U.S.C. § 77b(a)(4). The issuer is generally the company that issues a security. Section 2(11) defines the term “underwriter” as “any person who has purchased 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.” 15 U.S.C. 77b(a)(11). For purposes of the definition of underwriter, the term “issuer” is defined as including, “any persons directly or indirectly controlling or controlled by the issuer, or any person under direct or common control with the issuer.” Id. The congressional intent in defining “underwriter” was to cover all persons who might operate as conduits for the transfer of securities to the public. T. Hazen, The Law of Securities Regulation, Section 4.24, at 141 (1985)(quoting H.R. Rep. No. 85, 73d Cong., 1st Sess. 13-14 (1933)). The term underwriter is closing connected with the definition and meaning of the term “distribution.” Relevant to both inquiries are whether the securities have come to rest in the hands of the security holder and whether the sale involves a public offering. Ackerberg v. Johnson, 892 F.2d 1328, 1336 (8th Cir.1989).

“Security holders may be considered ‘underwriters’ and thus ineligible for the Section 4(1) exemption if they either 1) purchase securities from an issuer ‘with a view to’ offering the securities in a distribution or 2) sell securities ‘for an issuer in connection with’ a distribution. A ‘distribution’ is equivalent to a public offering of securities.” SEC v. Lybrand, 200 F.Supp.2d at 393(citing Ackerberg, 892 F.2d at 1336). A holder of securities may not be considered to have engaged in a distribution, if the facts demonstrate he or she held the securities for investment purposes. “The courts look to whether the security holder has held the securities long enough to negate any inference that his intention at the time of acquisition was to distribute them to the public. Many courts have accepted a two-year rule of thumb to determine whether the securities have come to rest. Ackerberg, 892 F.2d at 1336; See United States v. Sherwood, 175 F.Supp.480, 483 (S.D.N.Y.1959)(“The passage of two years before the commencement of distribution of any of these shares is an insuperable obstacle to my finding that Sherwood took these shares with a view to distribution thereof.”); See Rule 144(k).

Rule 144(k) requires a three month and two-year look back period from the date the securities were acquired by the executive from issuing company. The executive will need to closely examine the various traunches of securities provided over the last several years. The transfer agent will examine the exact date upon which the executive obtained physical ownership of the restricted securities. A stock grant date is not the same as the vesting date for purposes of Rule 144(k). The grant date is the date upon which the award was made by the company, however, the vesting date is the actual date used to determine the two year look back when qualifying for the Rule 144(k) exemption. Some commentators suggest that the grant date could be viewed as providing the executive with “constructive receipt” of the securities, especially when he files a Section 83 election soon after the grant date.

The executive claiming entitlement to the exemption must also establish his reasonable due diligence, not only as to the entire transaction, but also as to the sophistication of the purchasers. The executive must ascertain the backgrounds of each purchaser, in order to demonstrate their relative sophistication in securities transactions. Due diligence also involves establishing a paper trail of the transaction, to create demonstrative proof when confronted by an investigation initiated by the SEC. Prior to the changes to Form 8K disclosures, the SEC only discovered fraudulent private placements when the purchasers filed complaints with the commission or instigated litigation against the seller. Today, 8K disclosure rules require companies, the original issuer, to file a disclosure statement reporting the material transaction of a private placement, within four days of the occurrence.

This article only addressed the broader issues involved in the Rule 144 exemption. This article intentionally does not address the “4 ½” exemption, which is not codified under the Act or regulations promulgated by the SEC. Such a discussion is more deserving of a separate article on the subject.