<img height="1" width="1" style="display:none" src="https://www.facebook.com/tr?id=533208126839177&amp;ev=PageView&amp;noscript=1">

Selling Unregistered Securities: Are More Requirements a Good Thing?

Post on: October 27, 2016 | Chris Rohde | 0


So you’re the new owner of unregistered securities in a private company or fund. What’s next? Maybe there’s a preferred return that you’ll be receiving on a regular basis. Maybe you plan to wait for some sort of liquidation event, such as an acquisition or IPO. But what if you want to sell your shares? There is no liquid secondary market for private unregistered securities. So what are you to do?

The sale of any security must be registered, or be made under a valid exemption.1 Historically, sellers have been able to rely upon two potential exemptions, Rule 144 and the so-called 4(a)(1 ½). But in December 2015, a new option arose.

On December 4, 2015, President Obama signed the Fixing America’s Surface Transportation Act (the “FAST Act”) into law.2 Included within this transportation law was a new section added to section 4 of the Securities Act of 1933 to allow for secondary sales of unregistered securities under a specific set of circumstances. For the most part, the section takes the procedures from 4(a)(1½) and codifies them into law, but Congress also introduced a few new requirements that may serve as a slight deterrent to the use of this exemption by the market. To better understand this, first we’ll review the requirements of the "traditional" Rule 144 and the 4(a)(1½).

The Traditional: Rule 144 and 4(a)(1½)

Traditionally, holders of restricted securities have often relied upon either Rule 144 or the 4(a)(1 ½) procedures to execute an exempt resale of a private security. Rule 144 provides a safe harbor for resales by non-affiliates of "restricted securities" that have been outstanding for six months as long as there is adequate current public information about the issuing company, a requirement that often requires further disclosure from non-reporting companies.3 If the selling shareholder is an affiliate of the issuing company, Rule 144 has additional restrictions around an individual selling shares.

In the past, when a selling shareholder was unable to rely on the 144 safe harbor, that shareholder would often turn to the "4(a)(1½) exemption." This "exemption" is actually just a set of procedures for resale transactions developed by the securities bar that has been recognized by the SEC. In particular, this approach is built around conducting the transaction in a manner that matches an issuer private placement under Section 4(a)(2) of the Securities Act of 1933. The hallmarks of this approach are that the transactions should avoid general solicitation or general advertising and should be made with a limited number of sophisticated purchasers. These transactions usually include contractual representations that the purchasers have the necessary degree of sophistication to evaluate the risks of the investment for himself, has access to relevant issuer information needed to make an informed investment decision, that he is not acquiring the securities with the intent to distribute them, and if he does attempt to transfer the shares, that he will do so in an SEC-registered transaction or under a valid exemption from registration. If the sale follows these requirements, historically the SEC has considered the transaction to be exempt from registration.

The New Frontier: Rule 4(a)(7)

As part of the FAST Act, Congress created a new exemption for the resale of private securities. The new section 4(a)(7) takes many of the components of 4(a)(1½) and codifies them into the securities laws, with a few adjustments. Let’s take a look at a few of these requirements:

  • Purchasers Must Be Accredited Investors: This means that the purchaser must fall within one of the definitions contained in Rule 501—the most common categories being that he or she is an individual with income of $200,000 for the last two years (or $300,000 of joint income with a spouse) and has a reasonable expectation of reaching the same income level in the current year or has a net worth of $1,000,000, excluding their primary residence. What is not clear from the statute is whether the standard for meeting this requirement is the traditional private placement standard of reasonable belief of accredited status or the SEC expects the seller to verify the status of the purchaser, similar to the requirements of a 506(c) offering. If the expectation is verification, that could be a significant burden, especially on an individual shareholder.
  • No General Solicitation: A traditional aspect of both 4(a)(1½) and 4(a)(2) is the ban on general solicitation. This means that the selling shareholder, or issuer in a 4(a)(2) transaction, may not advertise that securities are being sold. The selling shareholder may not generally advertise that he or she is looking to sell the shares in any manner, which includes posting ads online, mass email blasts, social media posts, etc. In order to avoid generally soliciting, one would likely need to use a broker who has a network of accredited investors, or with whom the broker has a substantial relationship. Because the selling shareholder is likely not an expert on the rules around reselling unlisted securities in compliance with the ban on general solicitation, he or she would need to rely on the expertise of either an attorney or a broker-dealer to help navigate this issue.
  • Information Requirements: The new safe harbor has certain information requirements that the selling shareholder must provide to the purchaser. In particular, the seller has to provide certain financial information on the issuer of the securities. This information includes the most recent balance sheet and profit and loss statement and similar financial statements for the past two years prepared in accordance with GAAP (or IFRS if international). These are hefty requirements, especially for private companies who may not have GAAP financials. Additionally, the seller may not have those records. While I wholeheartedly think these information requirements are important to ensure the purchaser is adequately informed prior to his purchase, they may also act as a substantial speed bump in the process.
  • Ban on Bad Actors: As with most revisions to rules around private securities, Congress saw fit to include a ban on bad actors acting as a seller or receiving compensation. As a reminder, there are several ways to land yourself in the bad actor category, including being convicted of a securities-related crime, being barred or suspended from the securities industry, or having been found to have violated a rule of a self-regulatory organization or state securities commission.4 If the seller or broker who is receiving compensation is a bad actor than they may not avail themselves of the exemption in 4(a)(7). So the seller should ensure that anyone receiving compensation is not barred as a bad actor or else he could find himself without an exemption. 

As you can see, the new 4(a)(7) exemption provides concrete requirements and a very clearly defined safe harbor, but are these requirements so hefty that they actually hamstring the exemption’s use? Maybe not.

Benefits of the New Rule

The two main exemptions, 4(a)(1 ½) and 4(a)(7),  share the same core requirements. But despite its more stringent and defined requirements, it’s my belief that 4(a)(7) will become the standard exemption used by individuals seeking to resell private securities.

First, as individuals begin to use the new exemption and its requirements become more clear, attorneys will begin to become comfortable with it. Just look at the steadily increasing adoption of the 506(c) exemption to conduct private placements. As issuers and attorneys become more comfortable with 506(c) and its benefits, we’re seeing it used more and more in lieu of 506(b).

Second, 4(a)(7) is a statutory exemption instead of a common law exemption. This could be a personal preference on my part, but I generally feel that statutes, or regulations, give far more protection than common law. They tend to be more clearly defined as a result of requirements being specifically written out, as well as the court cases that eventually help fill out the less defined aspects of the rules. As 4(a)(7) is used, it will be challenged and any fuzzy areas will become even more defined.

Third, the requirements are already pretty well defined. For example, the information that must be provided to the purchaser under 4(a)(1½) is "relevant issuer information needed to make an informed investment decision" whereas 4(a)(7) has very specific information requirements. The 4(a)(1½) standard is loose, which can be problematic if a purchaser gets buyer’s remorse and decides to sue the seller. Juxtapose that with a purchaser suing a selling shareholder who provided all of the required information in 4(a)(7). That purchaser is going to have a hard time claiming he was not provided the correct information. In addition to protecting sellers, these requirements also protect purchasers. 4(a)(7)’s information requirements provide the purchaser with quite a bit of detailed information to aid in his decision to purchase or not. Clearly defined requirements protect everyone involved.

The new 4(a)(7) exemption is not a game-changer in the private securities marketplace, but as it is adopted by selling shareholders and attorneys, I believe it will replace 4(a)(1½) as the preferred exemption for use in the resale of private securities.


Considering creating your own broker-dealer?

Learn about the regulatory process, how much it costs, and when you should outsource. Download our "Building a Broker-Dealer" E-guide.


15 U.S.C. §77e
Rule 144: Selling Restricted and Control Securities.
17 C.F.R. 230.506(d), available at https://www.law.cornell.edu/cfr/text/17/230.506

Disclaimer: WealthForge provides this information to our clients and other friends for educational purposes only. It should not be construed or relied upon as legal advice.

Share on

About author

Chris Rohde

Chris serves as Associate Corporate Counsel at WealthForge where he advises on an array of areas, including both federal and state securities laws, broker-dealer law, general corporate law matters, and cybersecurity.
Find me on:

Related articles