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
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) 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.
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.
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 .
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