What You Should Know About Reselling Private Stock
If you purchased stock from a startup in a “friends and family” round, can you sell it to someone else without violating securities laws? The answer to that question probably depends on whether you’re in compliance with Rule 144, which provides requirements that if satisfied, allow people to re-sell privately issued stock.
There’s a general rule in the Securities Act of 1933 that if you sell a non-exempt security to another person, the sale must be registered unless an exemption from registration applies.
There’s a few things to unpack here. First, what is a non-exempt security? Second, what does it mean for the sale to be registered? Third what are the exemptions from registering the sale?
Section 3 of the Securities Act lists 12 categories of exempt securities. The categories of exempt securities include securities issued by the government, public utilities, railroads, foreign governments, certain securities issued by banks, insurance companies, and non profits, and securities that are part of an intra-state offering. The vast majority of startups are not going to have exempt securities.
Rather than issuing exempt securities, startups almost always issue restricted securities, which are securities acquired in unregistered private sales from the issuing company. Angel investors, venture capitalists, and other investors of startups are, in a vast majority of cases, issued restricted securities. The securities issued to founders are also almost always considered restricted securities.
If the securities were issued to the seller of the securities pursuant to a public offering and are traded on a national stock exchange, they would not be considered restricted securities, but might still be subject to resale restrictions if the securities are being resold by an officer, director, or other person with control of the corporation.
Registration of Sale of Securities
Registration is the official term for the process of having a public offering. A company’s initial public offering, or IPO, is cost-prohibitive for most startups. If you’re just trying to sell a chunk of privately held stock, it’s highly likely that the costs of completing a compliant registration would exceed the proceeds you’re raising from selling the stock. Bottom line: you want to find an exemption from registration.
Rule 144—An Exemption from Registration
One exemption from registration of a sale is found in Section 4(1) of the Securities Act, which provides an exemption for transactions “by a person other than an issuer, underwriter, or dealer.”
To understand the Rule 144 exemption, it’s helpful to understand what an issuer, an underwriter, and a dealer are.
An issuer is the company whose stock is being offered. A dealer is a person who is engaged in the business of buying and selling securities for their own account.
An underwriter is defined broadly in Section 2(a)(11) of the Securities Act to mean any person who has purchased from an issuer with a view to distribution of the securities. A traditional underwriter is an investment banking firm that arranges with the issuer for the public sales of its securities. But the term “underwriter” can also apply to individuals who purchase securities with the goal of reselling them.
It’s difficult to know a person’s state of mind when they purchase securities, so subsequent acts of the purchaser are looked at in order to determine whether the initial acquisition was made with a view to distribution. The emphasis is usually placed on factors such as the length of time the purchaser held the securities and whether the purchaser had any change in circumstances that would have led the person to sell what he or she was otherwise planning on keeping.
In effect, Rule 144 is a safe harbor from the definition of “underwriter.” In other words if (A) you comply with Rule 144, and (B) you are neither an issuer nor a dealer, then you can resell the securities.
There are a number of conditions you have to meet to fall within the safe harbor of Rule 144. In order to discuss these conditions, it’s helpful to have an understanding of a few key terms, namely “control securities” and “affiliate.”
Special rules apply to certain securities called control securities. Control securities are securities held by an affiliate of the company issuing the stock.
An affiliate is a person, like an executive officer, a director, or a large shareholder, who has some control over the company issuing the stock. Control, as it’s used here, means the power to direct the management and policies of the company in question, whether that’s through ownership of voting stock, by contract, or status as an officer or director.
If you’re not an affiliate of the company, it’s easier to comply with Rule 144.
Rule 144 excludes you from the definition of “underwriter” if:
- the issuer has not been a reporting (public) company for at least 90 days;
- you haven’t been an affiliate for at least three months;
- you only sell for your own account (you’re not selling on someone else’s behalf); and
- you hold the securities for at least a year before you sell them.
Most companies will not be “reporting” companies, and thus they will be subject to these requirements to fall within the Rule 144 exemption. If the issuer is a reporting company with current public information, the securities may still fit within the Rule 144 exemption under a slightly modified set of requirements.
If you’re an affiliate of the issuer, the Rule 144 calculus gets more complex. There are five key factors to look at, which can be broken down into a four-step decision tree. But rather than go into all the if/then permutations, I’ll just discuss the basic factors a bit. (If you want more information, feel free to give us a call or use the comment feature at the end of this post.)
First, depending on the other factors, a holding period may apply where you’re restricted from selling the securities for a certain length of time.
Second, there must be adequate information about the company publicly available before the sale can be made. This means that certain company information, including information on the nature of the business, the identity of officers and directors, and financial statements are publicly available.
Third, if you’re someone like an officer or director who controls the company whose stock you’re selling, then you cannot sell more than 1% of the outstanding shares of the stock being transferred during a 3 month period.
Fourth, If you’re using a broker, the broker may not receive more than a normal commission, and neither the seller nor the broker can solicit orders to buy the securities.
Fifth, if you’re someone like an officer or director who controls the company, you must file a notice with the SEC on Form 144 if the sale involves 5,000 or more sharers or more than $50,000, during any three-month period.
A Company’s Obligation to Monitor Compliance with Rule 144
Even if the company is not directly involved in the transaction, it should be concerned about compliance with restrictions on the resale of its securities. The SEC expects issuers to maintain processes to prevent securities violations by its directors, officers, and employees.
Penalties for Non-Compliance with Rule 144
Someone who resells securities and is not in compliance with Rule 144 may be found to be an underwriter, and may therefore be violating the requirement to register the securities offerings. Penalties for non-compliance can range from rescission (where the purchaser of the securities can “undo” the transaction and get their money back), civil liability, and even criminal liability.
Tacking Holding Periods
You may be able to “tack,” or add, the amount of time others have held the restricted securities prior to you if you are reselling securities that someone resold to you. An analysis of whether you can tack time in a given situation can be complex, but I want to put it out there as a possibility for our readers to consider.
If you have questions about reselling the stock of private companies or compliance with Rule 144, feel free to comment below or to contact us.