What are the Practical Implications of the Recent Amendments to Rules 144 and Rule 145?
Effective February 15, 2008, recent SEC amendments to Rules 144 and 145 should increase the liquidity of privately issued securities held by a private equity or hedge fund, potentially making private placements more attractive for investors and issuers. Securities acquired in private transactions may now be sold to the public in reliance on the more relaxed requirements of Rule 144, as described below. A non-affiliate purchaser of these securities (after the required holding period) would then have freely tradable stock.
1. Why is Rule 144 important to us?
Rule 144 is an important tool for investors, such as private equity investors, because it allows investors to sell securities to the public without registration of the sale under the U.S. Securities Act of 1933, even though the securities (1) were acquired in a private placement ("restricted securities") or (2) are held by an affiliate of the issuer ("control securities"). Under the Securities Act generally, these types of restricted securities may be sold only if the sale is registered with the SEC unless an exemption from registration, such as Rule 144, is available.
Private investors often rely on Rule 144 when selling restricted securities in the open market and when making in-kind distributions of restricted portfolio company securities to fund investors. Funds also rely on Rule 144 as a way to monetize their control securities following an initial public offering of a portfolio company or their restricted securities received in a sale of a portfolio company for stock of another company.
2. How will the amendments affect sales by non-affiliates?
The SEC has relaxed the requirements of Rule 144 in a way that significantly helps non-affiliates. Prior to the rule change, sellers of restricted securities availing themselves of the safe harbor were required to satisfy public information, holding period, volume, manner of sale and notice requirements. Going forward, sales by non-affiliates under Rule 144 can be made after a holding period requirement of six months, so long as the issuer of the security is a public reporting company and adequate current public information about the issuer is available.1 The volume, manner of sale and notice requirements that previously limited the sale of restricted securities are no longer applicable to sales by non-affiliates.
3. How will the amendments affect sales by affiliates?
Affiliates also benefit from the shorter holding period requirement (six months for reporting companies and one year for non-reporting companies). Affiliates, however, continue to remain subject to the Rule's volume and notice requirements and a modified manner of sale requirement. The manner of sale requirement for affiliates was eliminated for sales of debt securities and broadened for sales of equity securities to include riskless principal transactions and to allow for the posting of bid-and-ask quotations in alternative trading systems.
For a more complete description of the amendments, please refer to our memo ["SEC Publishes Final Rule 144 and Rule 145 Amendments," dated December 21, 2007].
4. Will the new rules affect the need for registration rights?
One effect of this increased liquidity may be to reduce the need for registration rights for investors who purchase restricted securities in exempt offerings.
In private acquisitions of securities, investors have traditionally required the issuer to agree to register the securities with the SEC at some future time, so they can publicly sell the shares without being subject to the volume and manner of sale restrictions previously imposed by Rule 144.
Registration with the SEC entails significant burdens and costs for the issuer. The process involved in registering securities, including the time involved in finalizing the prospectus with the SEC in order to make it effective for resales of the securities, often takes at least six months. Because non-affiliates may now freely sell restricted securities after six months (or a year at the most) under the new rule, there may be situations in which an issuer could resist agreeing to registration rights. However, we suspect that well-advised investors will still want registration rights when they acquire a large stake in the issuer to permit underwritten sales (which cannot be accomplished under Rule 144) or when they are at risk of being deemed affiliates of the issuer.
5. Did the Rule 144 amendments affect the application of the rules used to determine when an investor is an affiliate?
How the new rules will affect a fund's ability to exit its investment post-IPO depends on whether the fund is an affiliate of the issuer. The amendments to Rule 144 did not affect this determination.
As part of the terms of their continued investment in the company, private equity fund sponsors may retain governance rights in the post-IPO company, such as the right to designate director nominees and, sometimes, veto rights over certain significant matters or rights of first refusal on sales of shares by other investors. The existence of these rights, among other things, may result in the fund being deemed an affiliate for purposes of Rule 144, requiring it to comply with the volume, manner of sale and notice restrictions of the rule that would not otherwise apply if the fund were not an affiliate. Sales by affiliates relying on Rule 144 will continue to be generally limited, during any three-month period, to the greater of 1% of the shares outstanding and the average weekly volume of trading in the company's shares. Assuming the six-month holding period has been satisfied, an affiliate who ceases to be an affiliate of an issuer would, after a 90 day "cooling off" period, be able to sell issuer securities without complying with the volume or manner of sale restrictions.
Funds that would be limited by the Rule's volume restrictions because of the size of their own investment or because their investment would be aggregated with the securities owned by other investors,2 would not be able to sell their securities freely under Rule 144 without complying with volume limits, and may continue to require registration rights post-IPO.
6. How do the new rules affect a fund's ability to make a distribution-in-kind of portfolio company securities to fund investors?
Previously, an affiliated fund was required to hold securities for at least two years before it could effect a distribution-in-kind of issuer securities to fund investors. Under SEC no-action letters, non-affiliated investors in a fund who received securities pursuant to such a distribution-in-kind held free securities, and could sell such securities immediately in the open market. As a result of the shortened one-year Rule 144 holding period for affiliates, funds should now only have to wait one year (rather than two years) before effecting a distribution in kind to fund investors, with non-affiliated fund investors receiving freely tradeable securities. If a fund effects a distribution in kind after a six-month holding period, sales by fund investors would be aggregated for purposes of Rule 144 volume limitations until the one year holding period is met, severely limiting the benefits of a distribution-in-kind.
7. How do the amendments to Rule 145 affect a fund's ability to exit an investment by selling the portfolio company for stock?
The SEC rules were recently amended to make stock deals more attractive for a fund investor in which a portfolio company is sold for acquiror stock registered with the SEC.
Prior to the amendments, if the fund investor was affiliated with the portfolio company being sold in exchange for stock registered with the SEC in a transaction voted on by shareholders, then under Rule 145 the stock received by the fund (even if the fund were not an affiliate of the combined company post transaction) could not be sold during the first year without complying with the volume and manner of sale requirements of Rule 144.
Under the amendments to Rule 145, so long as the fund is not an affiliate of the combined company post transaction, the fund would be permitted to immediately resell, without restriction, any shares received in the registered transaction. 3
This change should increase the attractiveness of stock as a form of consideration for private equity investors in a registered stock-for-stock sale, potentially increasing the number of deals made with strategic investors.
8. Do the amended rules still permit tacking of holding periods upon the cashless exercise of warrants?
Rule 144 has now codified prior no-action letters which permit investors to tack the holding period of warrants or options to securities issued upon the cashless exercise of these warrants or options. In effect, the underlying securities are deemed to have been acquired at the time the warrants or options were acquired. If an investor exercises its warrants or option for cash, a new holding period begins with respect to the newly issued securities for purposes of Rule 144.
1. The holding period for sales by non-affiliates of shares in non-reporting companies has not changed. Securities of non-reporting companies must be held for at least one-year under the Rule. After one year, such securities are freely tradeable.
2. In a [previous newsletter], we noted the principle of aggregation of Rule 144 sales for purposes of determining whether the sales exceed Rule 144's volume limitation. When stockholders "agree to act in concert for the purpose of selling securities of an issuer," those stockholders are required to aggregate all of their sales within the preceding three months. Aggregation may be required, for example, if sales by one stockholder require the consent of one or more other stockholders or if tag-along, drag-along, transfer restrictions and other sale coordination mechanisms restrict the ability of a stockholder to sell its shares independently. If a volume limitation applies to a given sale, the aggregation requirement would act to limit the ability of a "club member" to sell shares in the open market in reliance on Rule 144. 3. An investor may also sell a portfolio company in a private transaction either for cash or stock without registration, in reliance on a different exemption under the Securities Act called the private placement exemption. This may be accomplished by limiting the sale to a small number of sophisticated investors who agree not to resell the securities to the public unless the resale is registered or an exemption from registration is available. Shares received in such a transaction where the consideration is stock, however, will be restricted and may be resold in reliance on Rule 144, as previously described.