Resale of Restricted Securities

Securities sold by an issuer in a private placement are restricted and cannot be legally re-sold unless registered or unless an exemption applies. So let’s say you’re conducting a private placement to raise capital and your investors say to you, “I really want to invest in your business but I’m nervous. What if I have a family emergency and I want to sell my shares to someone else so I can get my money (or at least some of it) back? Or what if the company does really well and the demand for the securities goes up? Can I sell my securities to someone else at a profit in the same way that people can buy and sell securities on the public stock market?” Most investors like to have “liquidity,” which means the ability to liquidate (sell) an investment whenever they choose.

Your investors need to understand the restrictions on resale of securities purchased in a private placement. The SEC does not want your investors buying shares in your company and then immediately turning around and selling them to someone else. That would make the private nature of the initial offering meaningless as your shares spread far and wide to people you have no relationship with. So before your investors can re-sell their securities, they need to find an exemption to the general rule that they cannot be re-sold.

The most commonly used exemption for the resale of restricted securities is Section 4(1) of the 1933 Act, which exempts a transaction “by a person other than an issuer, underwriter, or dealer.”

Section 2(a)(11) of the 1933 Act states, “The term ‘underwriter’ means 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 . . . .” This is why it is a good practice for issuers to have their investors sign a document that includes a representation like the following:

I am purchasing the securities solely for investment purposes, and not for further distribution. I am not a party to, and do not presently intend to enter into, any contract or other arrangement with any other person or entity involving the resale, transfer, or other distribution of any of the securities. My investment intent is not limited to my present intention to hold the shares for the minimum capital gains period specified under any applicable tax law, for a deferred sale, for a specified increase or decrease in the market price of the shares, or for any other fixed period in the future.

If your investors did not invest in your company with the intent to further distribute the securities, your investors will not fall within the definition of an underwriter and therefore are exempt from the registration requirement under Section 4(1). Simply having your investors make the representation that they are not underwriters is not enough. Generally, courts will consider the length of time securities are held to determine whether a resale was permissible under Section 4(1). After several years have passed, it is difficult to claim that the person purchased with the intent to re-sell into the public market.

Rule 144

To decrease the uncertainty regarding when it is okay to re-sell a restricted security, the SEC adopted Rule 144, a safe harbor under Section 4(1). If securities are sold in compliance with Rule 144, they become unrestricted. Rule 144 is fairly complicated, especially when the person who wants to resell the security is an affiliate1 of the issuer. The simplest way to comply with Rule 144 is to hold the securities for at least two years before re-selling them. The reasoning behind this is that if you hold the securities for two years, you must not have had the intention to re-sell them and therefore you are not an underwriter! But you have to be careful with this. If you purchase the securities and make it clear that your intention is to re-sell them as soon as you can possibly qualify under Rule 144, you are showing that you do have the intention to re-sell the securities and therefore you do meet the definition of an underwriter!

Secondary Trading

Let’s say the securities in your company are unrestricted. This could be because you sold them pursuant to a registration/qualification that generally does not require you to restrict resales, or it could be because two years have passed since you completed the initial offering in a private placement. You would like your investors to have the opportunity to buy and sell your securities on a secondary market. What can you do?

Unless you have restricted your investors’ rights to buy and sell your securities in some way (some issuers impose restrictions for various reasons), your investors already have the right to buy and sell. But how can you facilitate buyers and sellers finding each other? The largest companies list their securities on an exchange like NASDAQ or the New York Stock Exchange, but very few companies can meet the listing standards for these exchanges. Under some circumstances, you may be able to have your securities “listed” on something called a quotation service (OTCBB or pink sheets).

Exchanges

What if you want to create your own “exchange” platform? You need to be very careful that any platform or facility you create does not fall under the federal definition of an exchange. Exchanges are highly regulated under the 1934 Securities and Exchange Act. The legal definition of an exchange is an organization, association, or group of persons that

(1) Brings together the orders for securities of multiple buyers and sellers; and (2) Uses established, non-discretionary methods (whether by providing a trading facility or by setting rules) under which such orders interact with each other, and the buyers and sellers entering such orders agree to the terms of a trade.2

This means that if you merely provide a platform for buyers and sellers to meet each other and to negotiate their own trades, you probably will not fall within the definition of an exchange. This was done by a company called Real Goods in California. Real Goods did the necessary compliance work to be able to sell securities to the public, advertising the investment opportunity in its product catalog. The owner of Real Goods wanted the purchasers of the securities to be able to buy and sell them conveniently, so he set up a bulletin board on his website to facilitate buyers and sellers funding each other. He was smart enough to run this by the Securities and Exchange Commission, and he actually got a no action letter for his “exchange” platform.3 It is unclear whether the SEC would grant a no action letter for similar activities today. That is why it is probably safer to set up an Alternative Trading System (described below).

How can you legally create something that looks more like an actual exchange? You could apply to the SEC for permission to create a new exchange. The application would have to describe the listing standards you would impose, i.e., what standards must be met by companies that want to be listed on your exchange, and you would need to clearly explain how the exchange will prevent fraud and abuse. This process is extremely difficult and would take several years and millions of dollars in legal fees. And there is no guarantee the SEC would grant permission for a new exchange.

Alternative Trading System

Another option is to set something up called an Alternative Trading System (ATS). The way this is done is that a company that is already a federally licensed broker-dealer applies to the SEC for designation as an ATS under Regulation ATS.

Under Regulation ATS, “Alternative trading system means any organization, association, person, group of persons, or system (1) That constitutes, maintains, or provides a market place or facilities for bringing together purchasers and sellers of securities or for otherwise performing with respect to securities the functions commonly performed by a stock exchange . . . ; and (2) That does not: (i) Set rules governing the conduct of subscribers other than the conduct of such subscribers’ trading on such organization, association, person, group of persons, or system; or (ii) Discipline subscribers other than by exclusion from trading.”4

Rule 301(b) of Regulation ATS contains detailed requirements for an Alternative Trading System.

  1. 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.”
  2. Rule 3b-16.
  3. The no action letter is available at http://www.sec.gov/divisions/investment/noaction/1996/realgoods062496.pdf.
  4. Regulation ATS Rule 300(a).