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The New Section 4(a)(7) Exemption for Private Resales of Securities: What Does it Mean for Hedge Funds?
January 2016 | Scott C. Budlong, Richards Kibbe & Orbe LLP

On December 4, 2015, President Obama signed into law the Fixing America’s Surface Transportation Act (the ’FAST Act’). The legislation primarily related to the federal transportation matters, but lurking toward its end is an amendment to the Securities Act of 1933 (the ‘Securities Act’) establishing a new registration exemption for private resales of securities. The exemption is embodied in new §4(a)(7) of the Securities Act. It is largely based on (but does not replace) the so-called ‘Section 4(a)(1-½) exemption’ that securities lawyers have developed over time under the SEC’s eye. 1

Below we summarise the contours of new §4(a)(7) and compare it to the traditional §4(a)(1-½) approach. We believe that in some situations the new exemption may provide liquidity improvements for hedge funds that wish to resell restricted and/or control securities. We do not, however, anticipate §4(a)(7) having a dramatic impact on the hedge fund community. This is partly because the new exemption contains elements that will limit its use, and partly because in most cases it is not objectively more attractive than §4(a)(1-½) or other existing resale registration exemptions.2

Background

Before considering the new §4(a)(7) exemption, it is useful to recall why the traditional §4(a)(1-½) resale technique arose and what conditions have been developed for its use.

Restricted and Control Securities

Restricted securities are, among other possibilities, “securities acquired directly or indirectly from the issuer, or from an affiliate of the issuer, in a transaction or chain of transactions not involving any public offering.”3 Most typically, this means securities that a company has issued in a private placement and that have not since been resold into the public market via a resale registration statement or Rule 144. A hedge fund may hold restricted securities in a private company as a result of buying newly issued securities from the company or purchasing outstanding securities from existing holders. A hedge fund also may hold restricted securities of a publicly traded company if the specific securities held were issued by the company in a private offering.

So-called ’control securities’ are securities owned by a person who is an affiliate of the issuer. A hedge fund may be an affiliate of an issuer, for example, through significant ownership of voting stock or by having a board seat.4 Control securities can – but need not – be restricted securities.5

Section 5 of the Securities Act requires that any sale of a security must be registered under the Securities Act or made pursuant to an available registration exemption. Therefore, when a holder of restricted and/or control securities wishes to resell them, the holder must – unless it has the benefit of a resale registration statement filed by the issuer – identify an exemption to cover the transaction.

The classic resale exemption is §4(a)(1) of the Securities Act, which is available to any seller that is not the issuer, an underwriter or a dealer. The problem with §4(a)(1) in the case of restricted and control securities is that it may be difficult for the reselling holder (or an intermediary facilitating the resale on its behalf) to determine that it is not an ’underwriter’. That term is defined in §2(a)(11) of the Securities Act as “any person who has purchased from an issuer [or an affiliate of the issuer] with a view to, or offers or sells for an issuer [or an affiliate of the issuer] in connection with, the distribution of any security.” The term ‘distribution’ is not defined, but is generally understood to mean a public offering and sale of securities. The SEC pointed out that, depending on circumstances, an investor or an intermediary may have underwriter status by “acting as a link in a chain of transactions through which securities move from an issuer to the public.”6

As a result of the broad and somewhat indefinite meaning of ‘underwriter’, reselling holders of restricted and control securities are often reluctant to conclude that they are not captured by the definition. The §4(a)(1-½) approach has been developed to address this conundrum.7

Section 4(a)(1-½)

Section 4(a)(1-½) is a set of procedure developed by the securities bar and recognised by the SEC.8 The procedures deploy in the context of unregistered resales the private placement safeguards that an issuer would use when making an unregistered offering under §4(a)(2) of the Securities Act. This technique allows a seller to conclude that no distribution is occurring, and consequently that the seller is not an underwriter and may effect the resale under §4(a)(1). Securities transferred under §4(a)(1-½) are restricted securities in the hands of the purchaser.

In general, §4(a)(1-½) transactions are conducted in a manner that mirrors a §4(a)(2) private placement effected outside the safe harbour of Regulation D under the Securities Act. Accordingly, the reselling holder must ensure that the transaction involves no publicity that might connote a public offering, including by avoiding general solicitation and general advertising and by transacting on negotiated terms with no more than a limited number of purchasers. The reselling holder also will take steps to ascertain (including by requiring contractual representations) that each purchaser satisfies the subjective elements of a §4(a)(2) private placement, i.e., that each purchaser is able to ‘fend for itself’. This means establishing that each purchaser has a degree of sophistication enabling it to evaluate the risks of the prospective investment and has access to relevant issuer information sufficient to permit an informed investment decision. In order to guard against the possibility of the resale being seen as a link in a distribution, the reselling holder typically requires each purchaser to represent that it is acquiring the securities with investment intent (i.e., with no plan to distribute them) and to agree not to transfer the securities subsequently except in an SEC-registered transaction or in compliance with a registration exemption.

Resales exempted under new section 4(a)(7)

Section 4(a)(7) resembles §4(a)(1-½) in the sense that is enables unregistered resales into the private market to individuals and to entities of varying size. Congress did not intend that §4(a)(7) should actually replace §4(a)(1-½), however. The FAST Act makes clear that §4(a)(7) is a non-exclusive provision that stands alongside all previously existing resale exemptions.

Transaction Requirements

Section 4(a)(7) is available for a seller that is not the issuer or a direct or indirect subsidiary of the issuer. It may be used for any resale meeting the following requirements, which are specified in new §4(d) of the Securities Act:

  • Purchasers are accredited investors. Each purchaser is an “accredited investor,” as defined in Rule 501(a) under the Securities Act.9
  • No general solicitation or general advertising. Neither the seller, nor any person acting on its behalf, offers or sells the securities by means of general solicitation or general advertising.10
  • Company information requirement for non-reporting issuers. If the issuer of the securities being resold is neither subject to the reporting requirements of the Securities Exchange Act of 1934 nor exempt from reporting as a foreign private issuer pursuant to Rule 12g3-2(b) thereunder (a ’Non-Reporting Issuer’), the issuer must provide certain information to the seller and the prospective purchaser.11 The required information includes, among other items: a description of the issuer’s business; the issuer’s most recent balance sheet and income statement for such part of the two preceding fiscal years as the issuer has been in operation, prepared in accordance with U.S. GAAP (or IFRS, in the case of a foreign private issuer) and reasonably current in relation to the resale date (but which need not be audited or reviewed);12 and, if the seller is a control person of the issuer, a brief statement regarding the nature of the affiliation, and a statement certified by the seller that is has no reasonable grounds to believe that the issuer is in violation of securities laws or regulations.13
  • No bad actors. Neither the seller, nor any person being remunerated or paid a commission for participating in the offer or sale of the securities, is subject to a ‘bad actor’ disqualification pursuant to Rule 506(d)(1) under the Securities Act.14
  • Issuer engaged in a business. The issuer is engaged in a business, is not in the organisational stage or in bankruptcy, and is not a blank check, blind pool or shell company that has no specific business plan or purpose or has the primary business plan of engaging in a business combination with or an acquisition of an unidentified person.15
  • Underwriter prohibition. The securities being resold are not part of an underwriter’s unsold allotment.16
  • Outstanding class requirement. The securities being resold are of a class that has been authorised and outstanding for at least 90 days prior to the resale.17

    • A resale of securities under §4(a)(7) is deemed to be a transaction not involving any public offering and not a distribution. Securities transferred under §4(a)(7) are restricted securities in the hands of their purchaser.18

    In addition, the FAST Act provides that securities resold under §4(a)(7) are ‘covered securities’ for purposes of Section 18(b) of the Securities Act (NSMIA). This means that states are preempted from imposing ‘blue sky’ registration or qualification requirements on the resale.

    Practical comparison of §4(a)(7) To §4(a)(1-½)

    Attached to this memorandum is a table summarising key points of comparison between §4(a)(7) and §4(a)(1-½). We expect that §4(a)(7) will have a modestly positive impact on liquidity for hedge funds that hold restricted and/or control securities. In particular, the new exemption may offer hedge funds improved certainty as to the exempt status of certain private resales in situations where the availability of §4(a)(1-½) is doubtful. At the same time, there are circumstances in which §4(a)(7) appears unlikely to add much utility.

    Improved certainty that some private resales are exempt from registration

    The main liquidity enhancement that §4(a)(7) offers hedge funds will be increased certainty, compared to §4(a)(1-½), that certain proposed private resales are exempt from registration. While the §4(a)(1-½) private resale technique has been developed carefully over time and is generally credible to the SEC, it is not an actual safe harbor from registration under §5 of the Securities Act and there is no formal roadmap for its satisfaction. There may be circumstances in which a hedge fund seller has doubt about its ability to avoid registration in reliance on §4(a)(1-½), and new §4(a)(7) may prove a useful alternative in that situation.

    For example, where a hedge fund is disposing of securities to multiple purchasers, either in a single transaction or in a series of transactions in the same timeframe, doubt may arise about whether the transaction is sufficiently ‘private’ (i.e., clearly does not involve a public offering) to satisfy §4(a)(1-½). Section 4(a)(7) alleviates this concern by not imposing any numerical limit on offerees or purchasers—the requirement is just that all purchasers be accredited investors.

    Similarly, there sometimes may be doubt about the availability of §4(a)(1-½) if the issuer or other sellers of securities are engaged in publicity or other market communications that call into question the asserted absence of a public offering. Section 4(a)(7) skirts this issue by requiring only that the seller and any person acting on its behalf refrain from general solicitation and general advertising—publicity independently generated by other sources cannot undermine the seller’s claim to the exemption.

    Section 4(a)(7) also may be useful in cases where the purchaser’s ability to satisfy the subjective elements of §4(a)(1-½)—sophistication and knowledge—is in doubt. Because it dispenses with the need for subjective analysis, the new exemption may prove useful in this type of situation. We would not expect this potential advantage to be very meaningful for hedge funds, though, given that they typically employ §4(a)(1-½) to sell to other sophisticated institutions.19

    Limits on the New Exemption’s Utility

    On the other hand, there are situations in which §4(a)(7) appears unlikely to provide an advantage over §4(a)(1-½). One such situation relates to resales of securities of Non-Reporting Issuers. Section 4(a)(7) requires a Non-Reporting Issuer to provide the seller and buyer with specified financial information, of a type that the issuer may not be willing to share or simply may not have. Since §4(a)(1-½) has no prescriptive information-provision requirement, it likely will remain more appealing than §4(a)(7) in the case of Non-Reporting Issuers that cannot or do not wish to fulfill the §4(a)(7) information mandate.

    It also remains to be seen how sellers that are affiliates of Non-Reporting Issuers will address the requirement to certify that they have no reasonable grounds to believe that the issuer is in violation of securities laws or regulations. In particular, there is no materiality standard associated with potential violations; the mandated certification is not limited to U.S. law; and the statute offers no guidance on what constitutes reasonable grounds of belief.

    The ‘no-bad-actor’ requirement of §4(a)(7) also may pose challenges to use of the exemption, in the sense that it may entail uncertain and time-consuming diligence requirements on sellers who are using an intermediary to facilitate the resale. One notes that §4(a)(7)—unlike Rule 506 under the Securities Act—does not contain an exception to disqualification if the “bad act” could not have been discovered through the seller’s exercise of reasonable care. Law firms providing no-registration opinions in connection with §4(a)(7) transactions also will have to grapple with this issue.

    It is also worth noting that some commentators are pointing to §4(a)(7) as particularly useful to holders of restricted securities who wish to resell before the Rule 144 holding period has lapsed, or to affiliate resellers bumping up against the Rule 144 volume thresholds. In fact, however, §4(a)(7) provides no per se advantages on these points compared to §4(a)(1-½). Neither exemption entails a holding period for resales of restricted securities; and securities resold under either exemption will be outside the Rule 144 volume limit. The new exemption is thus not generically preferable to §4(a)(1-½) as an alternative when Rule 144 is unavailable.

    Conclusion

    It remains to be seen how securities market participants will adapt to and make use of the new §4(a)(7) resale registration exemption. In the near term at least, we expect the main utility of §4(a)(7) to hedge funds will be the new exemption’s occasional availability to facilitate private resales that a fund would not feel comfortable executing under §4(a)(1-½). We do not believe the new exemption will generally supplant §4(a)(1-½), and there may be situations in which the latter remains affirmatively more appealing.

     

    Scott C. Budlong provides securities law advice to private investment funds, investment banks and other financial market participants. His practice encompasses investment and trading issues under the Securities Act; SEC reporting, trading and numerous other regulatory matters under the Securities Exchange Act; and registration, reporting and compliance under the Investment Advisers Act. Mr. Budlong participates primarily in RK&O's Securities Transactions and Regulation & Compliance practices. He also has been active in developing the firm's Marketplace Lending practice, in which he represents clients establishing both online lending platforms and investment vehicles designed to invest in platform loans.

    Richards Kibbe & Orbe LLP is a dynamic and entrepreneurial firm with deep experience and relationships in the financial markets and the business community. RK&O conducts a highly collaborative practice through approximately 65 lawyers based in New York, Washington, D.C. and London. We routinely represent financial institutions and investment funds in high-value corporate transactions and complex litigation matters. RK&O’s key attribute is the ability to find thoughtful, creative solutions to the hardest legal problems, in a manner carefully tailored to our clients’ objectives. We always seek to provide precisely the technically excellent, informed and efficient service we would want to receive as a client. For more information, please visit www.rkollp.com .

    Footnote
    1 FAST Act Title LXXVI, Section 76001. Section 4(a)(7) is effective immediately.
    2 We do not focus on comparing §4(a)(7) to Rule 144 or Rule 144A. Those resale exemptions, while also relating to transactions in restricted and control securities, are quite distinct from §4(a)(7) in their requirements and use. For example, Rule 144, unlike §4(a)(7), allows the public resale of restricted and control securities and securities sold under the rule do not have restricted status in their purchaser’s hands. Therefore, the Rule 144 resale option, when available, will always be preferable to §4(a)(7), just as it has always been preferable to §4(a)(1-½). Rule 144A is also distinct from §4(a)(7) in that its use is limited to the large institutional trading market.
    3 Rule 144(a)(3) under the Securities Act.
    4 “Affiliate” status hinges on having direct or indirect “control” of the issuer. See, Rule 405 under the Securities Act. An investor with representation on the issuer’s board of directors almost certainly has control over the issuer. Securities practitioners also tend to view ownership of 10% or more of an issuer’s voting equity as rebuttably indicating control. See, e.g., American Standard (SEC No Action Letter 1972).
    5 For instance, a public company affiliate who has acquired its shares through stock exchange purchases will hold control securities but not restricted securities. An affiliate of a private company will hold both control and restricted securities.
    6 See, preliminary note 2 to Rule 144 under the Securities Act.
    7 As noted above, Rules 144 and 144A also address the “underwriter” problem in connection with unregistered resales of restricted and control securities. These provisions are safe harbors under §4(a)(1) promulgated by the SEC and have their own specific conditions. Rule 144 allows non-affiliates of the issuer to resell restricted securities after a six month holding period if the issuer is providing “current public information,” and after a one-year holding period in any event. Rule 144 also allows affiliates of the issuer to resell control securities, subject to volume limits, manner-of-sale restrictions and the issuer’s provision of current public information. Rule 144A allows unregistered resales to “qualified institutional buyers,” or QIBs (generally meaning an entity that owns and invests at least $100 million in securities of unaffiliated issuers).
    8 See, e.g., In the Matter of John A. Carley, et al., Securities Act Release No. 8888 (Jan 31, 2008).
    9 §4(d)(1). Rule 501(a) defines an accredited investor as an individual or an entity who meets the criteria set forth in any of several enumerated categories, or who “the issuer reasonably believes” meets those criteria. While §4(a)(7) transaction – where a security holder rather than the issuer is making the sale – we believe the spirit of the new exemption supports the view that it does. It would not be surprising if the SEC staff issued interpretive guidance on this point.
    10 §4(d)(2)
    11 §4(d)(3). These information requirement for Non-Reporting Issuers are similar in some respects to the information requirements of Rule 144A(d)(4). Unlike Rule 144A, however, §4(a)(7) affirmatively requires the seller to provide the information to the prospective purchaser, rather than to make it available upon request. It will be interesting to observe whether standard private placement documentation evolved to feature convenants by Non-Reporting Issuers to make available to prospective resellers the financial and other information required by §4(a)(7), in the same way that documentation for Rule 144A offerings contains an issuer commitment to maked available the information required by Rule 144A(d)(4).
    12 The required financial statements are deemed reasonably current if the balance sheet is as of a date less than 16 months before the resale, and the income statement is for the 12-month period preceding the balance sheet date. If the balance sheet is not as of a date within the six months before the resale, the financial statements must include an income statement for a period beginning with the balance sheet date and ending on a date less than six months before the resale.
    13 Note that §4(a)(7) is silent on the affiliate seller’s duty of inquiry as to the absence of issuer securities law violations, and that there is no materiality threshold relating to such violations.
    14 §4(d)(5).
    15 §4(d)(6).
    16 §4(d)(7).
    17 §4(d)(8).
    18 §4(e)(1).
    19 This reason for using §4(a)(7) rather than §4(a)(1-½) may be quite relevant, however, to non-hedge fund sellers. For instance, if one natural person shareholder of a private company (perhaps a founder or employee) wishes to sell shares to another individual who is an accredited investor but otherwise unsophisticated or unable independently to access information about the company, the §4(a)(7) safe harbor may offer a welcome path for the transaction.

     

    Appendix

    To view the Appendix, please download the full version of the pdf.

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