Part IV: Corporate Governance after Sarbanes-Oxley and a Word on Alternative Markets
The Possibilities of Rule 144A
Rule 144A establishes the framework for a limited private placement market of large institutional investors, “qualified institutional buyers” (QIBs). Only QIBs can play. Any size issue can be sold in this market so long as it is not the same as an issue listed on a securities exchange or on NASDAQ. The legally required disclosures are minimal. The key to using this rule is not the characteristics of the issuer, but the assumed ability of the QIBs to fend for themselves. A QIB is an institutional investor that owns or invests on a discretionary basis at leas t $100 million in securities, or a registered broker-dealer which buys for purposes of investment or acts as an intermediary. In addition to meeting the $100 million test, banks and savings and loan associations must have a net worth of at least $25 million to be a QIB. Rule 144A ties into Rule 144. By “tacking” to fulfill Rule 144’s two-year holding period, buyers in this market can sell their stock into the general public market. The usefulness of the rule to venture capitalists is conjectural.
Rule 144: How Controlling Persons, Affiliates Sell to the Public Without Registration
Normally, the venture capitalist acquires its securities in a private transaction, and therefore its securities are restricted from sale to the public, even after an initial registration by the Company. Indeed, they usually bear a legend to that effect. However, the venture capitalist may sell his restricted securities to the public under Rule 144 if he has owned them (and they are fully paid) for a specified period of time. This rule was promulgated by the SEC to provide an objective test of “persons deemed not to be engaged in a distribution and therefore not underwriters.” The sale of securities to the public in such a transaction is exempt by statute from registration. It is the major avenue through which sales of “insider” stock can be made to the public without going through the registration process.
The rule distinguishes between sales by “affiliates” and non-affiliates. In most instances, the SEC would maintain the venture capitalist was, by contract, share holdings, board positions, or otherwise in fact, directly or indirectly in control of the issuer or part of a group controlling the issuer and therefore deemed an “affiliate” of the issuer. In addition, if the SEC concludes that shares were issued to so many people that the so-called private placement was really a backdoor public offering done in a manner intended to avoid registration, the use of Rule 144 to sell to the public would be subject to enforcement actions by the SEC. Special rules apply for shell companies. These issues require careful study by counsel.
Rule 144 has five basic requirements:
- A holding period is required after the securities are fully paid for. The holding period can sometimes be satisfied by “tacking” the holding periods of private investors in a sequential chain. Any holder who holds for one year, whether the holder is an affiliate or a non-affiliate, can sell a limited amount of securities to the public within the conditions of the rule. (See items 2 through 5 below.)
- Specified current information about the issuer must be publicly available for a period of time prior to and at the time of sale.
- The securities may only be sold to the public in unsolicited “brokers’ transactions,” or directly with a “market maker.”
- The seller must file a Form 144, a simple notice form, with the SEC at the time either the order is placed with the broker or execution is made with a “market maker.”
- The amount of securities which can be sold in a three-month period is limited to the greater of: a) one percent of the outstanding securities of that class of the issuer; or b) the average weekly trading volume during the four calendar weeks preceding the filing of the Form 144.
The Two-Year Rule: After holding the securities for two years, non-affiliates get a break. If the seller is not an affiliate, and has not been one during the three months preceding the sale, and if the seller has beneficially owned (fully paid for) the securities for two years, then the above noted conditions, item 2 (information availability), item 3 (manner of sale), item 4 (notice of sale), and item 5 (volume limitations) do not apply. That means that once a non-affiliated holder has held “restricted securities” for two years fully paid for, he is deemed to have held “for investment and not with a view to distribution,” and may sell those particular securities into the public market without registration. Special liberal 144 provisions apply for sales by non-affiliate estates and their beneficiaries. If the number of shares outstanding or the volume is high enough, item 5 may not present a very large obstacle for holders.
In a Rule 144 transaction the issuer and any selling broker, or market maker, may require that the securities be accompanied by an opinion of counsel satisfactory to the issuer or its counsel that Rule 144 has been satisfied prior to recognizing the transaction by transferring the securities to the buyer. Before rendering its opinion, counsel will insist on a “seller’s representation” and may want a “broker’s representation” so it is assured of compliance with the rule.
In a companion release to the one reducing the holding period as noted here, the SEC requested comments on a proposal to further reduce the holding periods to one year and six months, respectively. It also requested comments on a proposal to further define “restricted” securities to expressly cover Regulation S offerings and to define “affiliate” to refer only to insiders as that term is used under Section 16 of the 1934 Act. That would mean “affiliates” for Rule 144 purposes would only be 10% holders (or members of such groups) and certain officers and directors of the company.
Proposed Rule Changes
The SEC has proposed a number of far reaching rule changes.
SEC Proposed Changes in Rule 144: The SEC has issued a release in which it proposes to change the holding periods in Rule 144 regarding the securities of periodic reporting companies from one year to six months, and from two years to one year for control stock. Under the proposal, if a holder holds the security of such a company for six months (without hedging – a new express requirement) and otherwise complies with the rule, he would be able to sell restricted stock into the public market but only in compliance with the restrictions noted in items 3 through 5 above. And once a non-affiliate holds the restricted securities for twelve months he would be above to sell without regard to those restrictions.
Item 2 above would be somewhat modified: for sales after the six months’ period, there would have to be current information of periodic reporting companies available for at least one year after the holder had acquired the security. Presumably that means that if one started to sell into the market after one held for six months and then the company stopped filing its periodic reports on time, the holder would have to stop selling.
Note the proposed changes only deal with sales of securities of reporting company. The present one-year period would remain for securities of non-reporting companies.
At present, Reg S, a regulation dealing with sales outside U.S. territory, requires that equity securities in Category 3 be held for one year. The 144 release asks for comments as to whether that time period should be changed to six months. Securities sold pursuant to Reg S are expressly defined as “restricted securities” in Rule 144. Many of those securities fit into other parts of the definition of restricted security. Therefore many securities sold under Reg S Category 3 may automatically have their holding periods reduced.
Shell Companies: Special rules would apply. Currently, Rule 144 is not available for the securities of blank check companies. As proposed it would become available for the securities of shell companies, whether they were blank check companies or had become shell companies by virtue of adverse events, once they acquired (or had been acquired by) a real business and had filed information on the reconstituted company equivalent to a ’34 Act registration.
Proposed Changes in Rule 145: This Rule is quite important to venture capitalists. In part, Rule 145 deals with when securities resulting from mergers can be sold using Rule 144. The proposal eliminates it presumption that securities in the transactions covered by the rule are involved in a distribution (i.e., a sale to the public) and would allow the use of Rule 144 for resales by holders of shell company’s shares if the reconstituted company filed information equivalent to a ’34 Act registration and waited 90 days after the deal closed.
Proposed Changes in Reg D: This is the principal legal vehicle used by venture capitalists to make private investments in companies which they hope will go public or which are already public. The proposal would establish an entirely new category of Reg D offering available to investments by “large accredited investors” and would permit limited written tombstone advertising to attract these investors so long as the ultimate purchasers were large accredited investors. It would also add a new category of accredited investor, an investor with $750,000 in “investments,” a defined term which excludes the investor’s residence or principal place of business. And it would open up the accredited investor standard to certain pooled investment entities. The proposal would also ease the rules of integration of private offerings with other offerings thus making it easier to raise money privately while undertaking a public offering shortly thereafter. It would also provide for adjustment of some of the dollar criteria every five years so that they would not become outmoded by increases in the wealth of the country and inflationary factors.
Goodbye “Small Business Issuer”; Hello “Smaller Reporting Companies”: “Small business issuers” are essentially public reporting companies with less than $25 million in revenues or in public float. About 3,749 of the 11,898 companies that file annual reports are “small business issuers.” The proposal would abolish the “small business issuer” rules, meaning that Regulation S-B would be withdrawn along with all the filing forms designated as SB forms, 10KSB, SB-2, etc. Instead the small business regulations would be integrated into the standard disclosure rules in Regulation S-K but provision would be made to relieve “smaller reporting companies” of the extensive disclosure required by S-K, 10-K, Form S-1, etc. The new small reporting company category would expand the availability of simplified disclosure to most companies with a float of less than $75 million. The system would also establish scalable disclosure based on whether the reporting company was a micro cap or smallcap companies. These would be the lowest 1% and 1-5% respectively of the total U.S. equity market capitalization. Foreign reporting companies meeting the standard could use the smaller reporting companies available to domestic smaller reporting companies but would be required to use U.S. GAAP. Smaller reporting companies could chose from the S-K menu whether to use the smaller reporting company standard or the full S-K model for that filing. However financial statements would have to stick to one or the other for the full fiscal year.
Expansion of Use of S-3: The SEC has proposed to expand the permitted registrations on Form S-3 of sales of securities by certain primary issuers, i.e. investees, who are periodic filers even down to the Pink Sheet level. The proposal would set up a new category of issuer; one which does not have a $75 million market cap but is not selling more than 20% of its equity in the offering. S-3 is considerably simpler than Form S-1 or Form SB-2. Its beauty is that it not only permits incorporation of documents previously filed on EDGAR by reference (as does S-1), but also incorporation by reference of documents filed on EDGAR after the S-3 registration has become effective. Form S-3 would not be available to “shell companies” until they were not shells for at least twelve months. Form S-3 would continue to be available for secondary offerings, offerings of the securities of control persons only if the class of securities was listed on a national stock exchange or NASDAQ.
The proposed regulatory changes, especially those in Rule 144 should facilitate “exiting” through the public market. However, there still remains the depressing effect on price that major shareholders trying to sell a substantial block of shares in all but the most successful ventures will have. Therefore, most venture capital investors will prefer that the issuer register their shares on Form SB-2. This will permit them to arrange for an underwriter or some other kind of market support so that all the people who want to sell will not be competing with each other in the market place. In the words of the Street, it will be an organized market. However, most venture capitalists will continue to dispose of the majority of their positions through a sale or merger into a larger company.