Archive

Rule 144

This is taken from a recent Quora answer which I felt was material enough to warrant a blog post as well 😉

If you want to sell shares of a private company you will have to take applicable financial regulations into account, as well as the contractual rights of the company and other shareholders (Right of First Refusal). I won’t go into the rarely exercised Right of Co-sale.

Regarding the contractual rights: The contractual rights (ROFR) entail that the company whose shares you hold and/or your fellow shareholders have a right but not an obligation to preemptively purchase the shares that you want to sell to an outsider. So in fact you should usually first find a willing buyer at a particular price, then go to the company and give them notice of your intent to sell. Then the company will go through the procedure and notify you out its outcome. ROFR usually have to be exercised at the same price as whatever the outside buyer is willing to pay. So in case the ROFR are exercised you don’t really lose out, however the outside buyer does not get to purchase the shares he wanted.

These are the usual steps to go through:

  • Best thing for you to do is first sign an Stock Purchase Agreement(SPA) with the buyer. The SPA should take the existence of the ROFR into account of course (you can’t really promise to sell shares until you know the outcome of the ROFR). So it should be a contract were you and the buyer agree to transact subject to the outcome of the ROFR procedure.
  • Next you need to notify the company of your intent to sell. The company usually has up to a month to go through the procedure, and will then notify you of its outcome.
  • At this point you know how many shares you can sell to the outside buyers, and it would be best to retain a lawyer and get a legal opinion about the compliance of this prospective transaction with applicable financial regulations. The company is likely to request such an opinion before transferring the shares.
  • You should then sign a Stock Power directing the company to transfer your shares in the name of the buyer, and send it along with the legal opinion to the company. You should also send a copy of those to the buyer, along with a copy of your stock certificate.
  • I would say that at this point the buyer should wire you the funds.
  • Once the company has received the Stock power and legal opinion and is satisfied of the legality of the transfer, they will change the name of the shareholder in their registry and issue a new stock certificate in the name of the buyer.

The cost of the above is likely to run into the hundreds of dollars, mainly to obtain the legal opinion. If you go through Secondmarket or Sharespost or another broker you will have to pay them a fee as well, I believe its around 3% of the transaction. If you go through a broker, then obviously the above process will be slightly different as you will be assisted by the broker, but the steps will still have to be walked through.

Regarding financial regulations:
I can’t tell you everything on this topic, as it will also involve complying with State ‘blue sky’ laws and also with insider trading laws, but here are the main points:

  • private shares are likely to qualify as ‘restricted’ or ‘control’ securities (control securities are the same as restricted, but are called control securies when in the hands of an affiliate of the company, i.e. someone with a form of control of company management). This means that they can’t be sold without first being registered with the SEC, unless an exemption from registration is found.
  • Such an exemption is found in Section 4 (1) of the Securities Act of 1933 ( see here). It is available to anyone who is not an issuer, a dealer or an underwriter.
  • You are unlikely to qualify as an issuer(the company itself) or a dealer(a professional involved in the buying and selling of securities).
  • The main risk is to act as an Underwriter. This is because the definition is very broad and includes anyone involved in the ‘public offer’ of securities.There are two ways to avoid the status of underwrite, one is Rule 144, the other is the so-called Section 4 (1 1/2) type of transaction.
  • Rule 144 is a rule promulgated by the SEC to provide a ‘safe harbor’ for compliance under Section 4(1). It’s not exclusive and you should see it as one concrete example of avoiding the status of underwriter. If you are an affiliate, you will need to comply with quite a few requirements, however if you are not an affiliate you will only need to comply with the holding requirements. This is in most cases one year, meaning that you should have held the actual shares(not the options) for one year before being able to rely on Rule 144. If you did held your shares for one year and are not an affiliate, then it’s relatively simple to sell you shares relying on this rule. If you do not fufill with the requirements of Rule 144, you could still try to do a Section 4 (1 1/2) transaction.
  • Section 4 (1 1/2) type of transactions are an invention of lawyer to allow people to sell private shares without having to rely on Rule 144. It’s useful if you didn’t hold your shares for long enough or if you otherwise are unsure of complying with the requirements of Rule 144. There is no Section 4 and a half in the Securities Act, there is only Section 4 (1) and (2). (1) deals with secondary transactions and we discussed it above, (2) deals with private placements by companies (primary transactions). The thinking goes that since an underwriter is someone involved in the public offer of securities, to comply with 4 (1) you need to avoid doing anything that could be a public offer. Since a private placement is the opposite of a public offer, the best way to do avoid the underwriter status is to make sure that you comply with the appropriate requirements of 4 (2), even though these are in fact meant for primary offerings. This is what people refer to as a Section 4 and a half type of transaction, as you are relying on the requirements of 4(2) to secure compliance under 4(1). So essentially you need to take the same precautions as a company when doing a private placement, even though you are not a company and are actually doing a secondary transaction.

So that’s it. I’m not a lawyer so I hope this is all close to the facts as it can be. If any lawyer could help correct any mistakes or elaborate it would be greatly appreciated. I still haven’t covered compliance with State ‘blue sky’ securities law or with the potential risk of insider trading. For that last point you can look at this quora answer.

Regarding a company’s involvement in the process: Brokers such as Secondmarket have started offering tailored ‘liquidity programs’ which gives a company control over and involvement in the trading of their shares via the Secondmarket platform. I would however argue that companies need to start thinking of adopting investor relations(IR) programs independently of brokers, as this will best ensure that they meet their own IR goals, which not necessarily match that of the broker. If companies really want to promote liquidity in their stock, they can also provide an infrastructure to their shareholders and selected investors without necessarily relying on a broker either.

Advertisements

Rule 144

Rule 144 was promulgated by the SEC to offer a ‘safe harbor’ for the resale of private securities under Section 4 (1). Essentially the SEC is saying “yes it can be tough to know for sure how to avoid the status of underwriter, so we are going to create an example for you of how to do it”. Rule 144 contains a set of requirements, and meeting those requirements can assure you that you are complying with Section 4(1). It is not exclusive, therefore there are other ways to comply, but it’s one clear way of doing so.

Rule 144 is especially useful for small shareholders that are not corporate officers or directors. This is because of the concept of company ‘affiliate’. An affiliate is someone who has a form of control over the company. Usually you can be an affiliate if you onw 10% or more of the shares, or if you are a director of officer.

Affiliates must comply with the requirements that adequate information about the company is available and must also file notice of sale with the SEC, among others. Non-affiliates only have to comply with the holding period requirements. That is in most cases 1 year. Yes, 1 year. That means after exercising your shares options, you must wait one year before being able to rely on Rule 144.

What if you want to sell your shares before having held them for one year? That is where Section 4 (1 1/2) comes in.

I will discuss Section 4 (1 1/2) in the next post…

Templates for SPA are available

Selling private shares is not the same as selling shares of public companies through the click of your mouse or tab of your finger via an online broker. The seller will have to ascertain for himself that he is complying with financial regulations when selling. The buyer will have to be an accredited investor. And both parties and the company involved will have to go through some paperwork to effectuate the transfer of shares from seller to buyer.

When is a seller allowed to sell private shares?

Shares in private companies often qualify as so-called ‘restricted securities’, which means that they cannot be sold without registering the shares with the SEC, unless an exemption from registration is available. This is stated in the prohibition of Section 5 of the Securities Act of 1933.

So what’s the exemption? It’s something called Section 4 (1) of the Securities Act of 1933. This section states that the prohibition of section 5 shall not apply to ‘transactions by any person other than an issuer, underwriter, or dealer‘. This means that if you are not an issuer, underwrite or dealer, you can sell your private shares without registering them.

As a employee, angel investor or founder of a private company, you are unlikely to qualify as an issuer(that’s the company itself) or an underwriter (a professional buyer and seller of securities). However the risk exists that you will qualify as an underwriter when selling your shares if you are not careful. Why is that? Because an underwriter is anyone involved in the ‘public offer’ of securities. If you put in an ad in the WSJ that you are selling x amount of shares for x price, you are involved in a public offer and if you sell your shares you are likely to be doing so in violation of the Section 5 prohibition.

So how can a seller avoid being qualified as an underwriter? The answer to that is twofold: there is something called Rule 144, and another called Section 4 (1 1/2). If you want to sell your private shares, whether on any of the established marketplaces or directly to your neighbor in Palo Alto, you will have to rely on either one of those.

A discussion of Rule 144 to follow in the next post…

Templates for SPA are available

Selling private shares is not the same as selling shares of public companies through the click of your mouse or tab of your finger via an online broker. The seller will have to ascertain for himself that he is complying with financial regulations when selling. The buyer will have to be an accredited investor. And both parties and the company involved will have to go through some paperwork to effectuate the transfer of shares from seller to buyer.

The below is going to involve going through some legal stuff, but don’t worry it’s actually quite simple.

When is a seller allowed to sell private shares?

Shares in private companies often qualify as so-called ‘restricted securities’, which means that they cannot be sold without registering the shares with the SEC, unless an exemption from registration is available. This is stated in the prohibition of  Section 5 of the Securities Act of 1933.

So what’s the exemption? It’s something called Section 4 (1) of the Securities Act of 1933. This section states that the prohibition of section 5 shall not apply to ‘transactions by any person other than an issuer, underwriter, or dealer‘. This means that if you are not an issuer, underwrite or dealer, you can sell your private shares without registering them.

As a employee, angel investor or founder of a private company, you are unlikely to qualify as an issuer(that’s the company itself) or an underwriter (a professional buyer and seller of securities).  However the risk exists that you will qualify as an underwriter when selling your shares if you are not careful. Why is that? Because an underwriter is anyone involved in the ‘public offer’ of securities. If you put in an AD in the WSJ that you are selling x amount of shares for x price, you are involved in a public offer and if you sell your shares you are likely to be doing so in violation of the Section 5 prohibition.

So how can a seller avoid being qualified as an underwriter? The answer to that is twofold: there is something called Rule 144, and another called Section 4 (1 1/2). If you want to sell your private shares,  whether on any of the established marketplaces or directly to your neighbor in Palo Alto, you will have to rely on either one of those.

Rule 144

Rule 144 was promulgated by the SEC to offer a ‘safe harbor’ for the resale of private securities under Section 4 (1). Essentially the SEC is saying “yes it can be tough to know for sure how to avoid the status of underwriter, so we are going to create an example for you of how to do it”. Rule 144 contains a set of requirements, and meeting those requirements can assure you that you are complying with Section 4(1). It is not exclusive, therefore there are other ways to comply, but it’s one clear way of doing so.

Rule 144 is especially useful for small shareholders that are not corporate officers or directors. This is because of the concept of company ‘affiliate’. An affiliate is someone who has a form of control over the company. Usually you can be an affiliate if you onw 10% or more of the shares, or if you are a director of officer.

Affiliates must comply with the requirements that adequate information about the company is available and must also file notice of sale with the SEC, among others. Non-affiliates only have to comply with the holding period requirements. That is in most cases 1 year. Yes, 1 year. That means after exercising your shares options, you must wait one year before being able to rely on Rule 144.

What if you want to sell your shares before having held them for one year? That is where Section 4 (1 1/2) comes in.

Section 4 (1 1/2)

First of all, there is no such thing as a Section 4 (1 1/2) in the Securities Act. It is something that was made up by lawyers. We discussed Section 4 (1) already above, and there is a section 4 (2). That is the section that grants exemptions to private companies that are raising capital in a private placement. Ever heard of Regulation D? If you have ever raised funds for a start-up using regulation D, you have used Section 4(2). In fact Regulation D is to Section 4(2) what Rule 144 is to section 4(1), a safe harbor.

So what’s this non-existent Section 4(1 1/2)? Well, lawyers have figured out that the best way to avoid the status of underwriter and comply with Section 4(1), without relying on Rule 144, is to avoid anything that could be qualified as a public offer. The opposite of a public offer is a private placement. Section 4(2) deals with private placements (primary deals), therefore if you want to make sure you are not making a public offer when selling your shares in the secondary market, then you should make sure you are doing something that resembles a private placement. Therefore for comply with Section 4(1) you should look at the requirements of Section 4(2) and comply with those that are appropriate for a secondary deal. This is what is referred to as a Section 4(1 1/2) transaction.

The Key requirements for a Section 4 (1 1/2) transaction is that no general solicitation should occur (only sell to people you have a pre-existing relationship with) and that the buyer should be an accredited investor.

%d bloggers like this: