Understanding SEC Rule 144: What It is and How It Impacts Your Securities

Casey Fenton

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Remember the buzz in 2013 when Facebook's earliest employees became instant millionaires after selling their stock? The road to this financial windfall wasn't straightforward. Many of these shares were subject to SEC Rule 144, which dictated when and how they could be sold. 

Such high-profile cases shed light on the importance of understanding this rule. Whether you're a budding startup or an established business, dissecting the intricacies of SEC Rule 144 can guide your financial decisions, ensuring you're both compliant and poised for success.

What is SEC Rule 144?

SEC Rule 144, often referred to simply as "Rule 144," is not just another regulatory mandate—it's a guiding compass for investors, business owners, and startup aficionados alike. Established by the U.S. Securities and Exchange Commission (SEC) in 1972, this rule was designed to strike a balance in the financial market.

Rule 144 offers a regulatory framework for the sale of two specific types of securities: "restricted" and "control." These securities are distinct in that they are not initially registered with the SEC but instead emerge from specific, non-public scenarios like private company offerings or inheritance.

But why did the SEC feel the need for such a rule in the first place? The answer lies in the market's demand for transparency and the prevention of illicit activities. Without a clear structure in place, the potential for unfair sales or market manipulation from inside information would have been a real threat. Rule 144 addresses this by setting forth stringent conditions that must be met for these securities to see the light of the public market.

Now, while this may sound restrictive, the rule isn't just about imposing barriers. It also provides a clear path for holders of these securities to eventually transition them to public markets, fostering financial growth opportunities. And as the financial market evolves, so does Rule 144, continually adapting to offer clarity amidst market complexities.

Purpose and Importance of SEC Rule 144

The financial market, much like any other system, requires balance. This balance is achieved by ensuring that all players, from mammoth corporations to the average individual investor, operate on a level playing field. Rule 144 emerged from a necessity to maintain this equilibrium.

1. Protecting the Individual Investor

Rule 144 aims to protect individual investors. Without it, insiders or affiliates with non-public information could potentially offload their unregistered securities onto unsuspecting buyers, leaving them with illiquid assets that can't easily be resold.

2. Ensuring Transparency

One of the pillars of any strong financial market is transparency. Rule 144 mandates that detailed, current public information about the issuer be available. This ensures that potential investors have access to all the necessary data to make informed decisions.

3. Preventing Market Manipulation

There's always the danger of certain entities taking undue advantage of their position or insider knowledge. By setting limitations and conditions for the sale of restricted and control securities, Rule 144 reduces the risk of stock prices being artificially manipulated, fostering trust in the market's integrity.

4. Facilitating Capital Formation

While it might appear restrictive, Rule 144 serves an economic purpose by providing a route to liquidity. By giving investors a mechanism to sell previously illiquid assets, it indirectly encourages investment in private offerings, fueling capital formation and economic growth.

Hence, while Rule 144 does set boundaries, these are not arbitrary. Each facet of this regulation has been meticulously designed to cultivate a healthy, transparent, and trustworthy financial environment. For startup founders and business owners, understanding its importance translates not just to compliance but to actively fostering a reliable market reputation.

Who Are Eligible to Register Under SEC Rule 144?

When navigating the realm of securities and equity, determining one's position in relation to SEC Rule 144 is pivotal. The rule doesn't apply universally; it focuses on particular sets of securities and the individuals or entities holding them.

1. Affiliates and Insiders

The term "affiliate" in the context of Rule 144 denotes an individual or entity that, directly or indirectly, exerts control over the issuing company. This could be through stock ownership, board membership, or other means. Company insiders, such as executive officers or directors, fall under this bracket. The rule recognizes that these individuals have access to non-public, potentially market-moving information, and thus governs the sale of their securities to ensure fair play.

2. Non-affiliates with Restricted Securities

It isn't just the insiders or high-powered executives that come under the umbrella of Rule 144. Any investor who has acquired securities directly from the issuer or from an affiliate in a scenario that wasn't accompanied by an SEC registration finds themselves in possession of "restricted securities." These holders, even if they're not affiliates, must still adhere to the rule's provisions.

3. The Inherited Position

Inheritance can often lead to an individual unwittingly finding themselves holding restricted or control securities. In such scenarios, the inheritor, whether an individual or an institution, becomes bound by the constraints and opportunities of Rule 144.

4. Beyond Direct Ownership

It's not just about who holds the securities; it's also about who has the power to direct their sale or transfer. Individuals or entities with this power—even if they don't directly own the securities—are still subject to the provisions of Rule 144.

Restricted Securities Vs. Control Securities

Understanding the distinction between "Restricted Securities" and "Control Securities" is essential for anyone navigating the provisions of SEC Rule 144. 

1. Restricted Securities

Restricted securities are those acquired directly from the issuer or an affiliate without a specific SEC registration. They are called "restricted" because there are limitations on their resale, especially within a specified time frame. These limitations aim to prevent a sudden, unregulated influx of these securities into the market, ensuring transparency and fairness.

2. Control Securities

Control securities refer to any securities held by an affiliate of the issuing company, regardless of how they were acquired. This means that even securities purchased in the open market by an affiliate fall under the category of control securities. Given the potential influence affiliates might have over the issuing company, Rule 144 places restrictions on the resale of these securities to ensure that transactions are conducted without unfair advantage or the use of non-public information.

Implications for the Holder

Holders of restricted securities must be aware of the mandatory holding periods before they can be sold publicly. On the other hand, holders of control securities, because of their affiliation with the issuer, are subject to specific sale limitations to prevent market manipulation or unfair trading.

It's possible for security to be both restricted and control. For example, if an affiliate acquires securities directly from the issuer without SEC registration, those securities would be both restricted and control securities. As such, holders must be mindful of complying with the regulations pertaining to both categories.

In other words, the distinction between restricted and control securities is based on their origin and the relationship of the holder to the issuing company. Recognizing the type of securities you hold is important to ensure compliance with SEC Rule 144 and to make informed decisions regarding their sale.

Which Types of Sales Produce Restricted Securities?

Restricted securities, by definition, come with limitations on their public resale, and understanding their origin is essential for issuers and investors alike. Here are the types of sales that produce these securities.

1. Private Placements

This is one of the most common origins of restricted securities. In a private placement, a company issues securities directly to investors without undergoing a public offering. These transactions are typically devoid of the stringent regulatory requirements of public sales, leading to the securities being labeled as "restricted."

2. Employee Stock Option Plans (ESOPs)

Employees often receive shares or options as part of their compensation. When these shares or options are exercised, the resultant securities are typically restricted. Companies use ESOPs to incentivize employees, but to ensure market integrity, the resultant securities carry the restricted label until certain conditions are met.

3. Regulation D Offerings

Under the SEC's Regulation D, companies can raise capital through the sale of securities without registering the offering. This exemption speeds up the fundraising process but results in the issuance of restricted securities to the investors.

4. Convertible Securities Transactions

When debt instruments or preferred shares are converted into common shares, the newly converted shares often fall under the category of restricted securities. These conversions allow holders to switch their investment type, but the resultant common shares usually come with a restricted label.

5. Gifts and Inheritance

While not a "sale" in the traditional sense, securities received as gifts or through inheritance may also be restricted. The nature of these acquisitions, given they are outside standard transactional channels, often means they carry the restricted tag.

6. Founders' Shares

Shares issued to founders during a company's inception or early stages are frequently categorized as restricted. Even if founders possess a deep understanding of the company's operations, these shares are restricted to ensure fair market practices.

What is a Restrictive Legend?

A Restrictive Legend is a statement or notation placed directly on the certificate of a security or, in the case of uncertificated securities, associated with digital or electronic records. This notation indicates that the security in question has not been registered with the SEC and, therefore, cannot be sold in the public marketplace unless it's either registered or falls under an exemption from registration.

The presence of a Restrictive Legend serves as a clear indication that there are limitations on the transfer or sale of the security. As a holder, you need to be aware of this as it affects the liquidity and potential sale conditions of the security.

If you've acquired securities through private sales or other means without them being registered with the SEC, they will typically bear this legend. It acts as a regulatory requirement to prevent unregistered public offerings.

Should you wish to sell the securities in the public market, you'll need to either ensure the securities are registered with the SEC or qualify for an exemption. Once that's achieved, you can approach the issuer to have the Restrictive Legend removed, facilitating the sale. Remember, you'll typically need an opinion from legal counsel affirming the securities can be sold without registration before the legend can be removed.

As the world shifts more towards electronic and digital record-keeping, while you may not physically see a "legend" on a paper certificate, the restrictions still apply. Brokerage firms and electronic trading platforms will have records indicating the restricted nature of the security.

Conditions for Selling Restricted or Control Securities

When holding restricted or control securities, the pathway to selling them isn't as straightforward as it might be for other securities. The SEC, through Rule 144, has set specific conditions that you must adhere to before these securities can be sold in the public marketplace. Here's a breakdown of these conditions:

1. Holding Period

For restricted securities, there's a mandated holding period that you must respect. This ensures that holders maintain their securities for a minimum duration, typically six months or one year, depending on the company's reporting status with the SEC, before any public resale. The holding period begins from the date you fully pay for the securities.

2. Current Public Information

If you're an affiliate, it's essential that the issuing company has complied with the SEC's current public information requirements. This means the company must have filed all necessary reports, like annual and quarterly statements, giving potential buyers access to adequate information about the company.

3. Trading Volume and Manner of Sale

For affiliates selling their control securities, Rule 144 imposes limitations based on the trading volume. The amount you can sell during any three-month period is the greater of 1% of the outstanding shares of the same class being sold or the average weekly trading volume during the four weeks preceding the sale. Additionally, sales must be conducted in "brokers' transactions" or directly with a market maker.

4. Notice of Sale for Affiliates

If you're an affiliate and intend to sell more than 5,000 shares or securities worth over $50,000 within a three-month period, you need to file a notice with the SEC, typically using Form 144.

5. Removal of Restrictive Legend

Before selling restricted securities, you may need to have the Restrictive Legend removed from the certificate or electronic record. This involves approaching the issuer with a legal opinion stating that the sale is exempt from registration.

6. Non-Affiliate Conditions

If you're not an affiliate of the issuing company and have held the restricted securities for over a year, many of the above conditions, like filing Form 144 or adhering to volume limitations, may not apply to you.

Removing Restricted Legend Before Selling Securities

The Restrictive Legend, while a vital indicator of a security's status, isn't permanent. When the time comes for you to sell, and conditions are met, it's possible—and necessary—to remove this legend from your securities. Here's a step-by-step guide on the process:

  1. Consult with Legal Counsel: Before initiating the removal process, you should consult with a lawyer who specializes in securities law. They can provide guidance on whether you meet the conditions stipulated under Rule 144 or other relevant exemptions to justify the legend's removal.

  1. Obtain a Legal Opinion: Typically, the transfer agent will require a legal opinion stating that the conditions for removing the legend have been met. Your attorney can draft and provide this opinion, asserting that the securities can be sold without registration under a valid exemption.

  1. Submit Required Documents: Once you have the legal opinion in hand, approach the transfer agent with the necessary documentation. Along with the legal opinion, you might need to provide the original certificate bearing the Restrictive Legend, a request for the issuance of a new certificate without the legend, and possibly other company-specific documents.

  1. Issuer's Role: The issuing company often has a say in the removal of the legend. They will review the submitted documents and, if in agreement, will instruct the transfer agent to issue a new certificate without the legend.

  1. Electronic Securities: If your securities are held electronically, the process may vary slightly. Instead of replacing a physical certificate, the transfer agent updates the electronic records to indicate that the securities are no longer restricted.

  1. Sale After Removal: Once the Restrictive Legend is removed, you are free to sell the securities, provided you adhere to any other relevant regulations and guidelines. However, always ensure that the legend removal was validly executed to avoid potential regulatory complications down the line.

It's worth noting that even after the removal of the Restrictive Legend, you should be aware of any other potential selling restrictions or reporting obligations, especially if you are an affiliate of the issuing company.

Disputing Removal of the Restrictive Legend

But what if there's a dispute? If the issuer refuses to remove the restrictive legend, even when you believe you've met the conditions of Rule 144, you can enlist legal help. Your attorney can provide a legal opinion to the transfer agent, giving them the confidence to remove the legend without the issuer's direct consent.

Importance of Compliance to SEC Rule 144

Lastly, why is compliance so necessary? The implications of not adhering to Rule 144 can be severe. You could face regulatory sanctions, financial penalties, or legal actions. Moreover, it could damage your reputation and that of your company in the financial community.

In conclusion, as a startup founder or business owner, understanding and complying with SEC Rule 144 is not just a regulatory obligation—it's an integral part of maintaining transparency and trust in your financial dealings. Keeping these guidelines in mind allows you to be well-prepared to navigate the intricacies of securities transactions and protect both your interests and those of your shareholders.

Thankfully, there’s a platform like Upstock where you’ll breeze through the regulatory filings and legal agreements on your equity offerings. If you want to know more about how Upstock manages restricted stock units (RSUs), book a demo today.

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ABOUT THE AUTHOR

Casey Fenton

Founder, Upstock & Couchsurfing, AI and Equity Innovator

Casey Fenton, the founder of Upstock & Couchsurfing and an AI and equity innovator, has revolutionized how we perceive and implement equity in the workplace. His foresight in creating platforms that not only connect people but also align their interests towards communal and corporate prosperity has established him as a pivotal figure in technology and community building. Casey speaks worldwide on topics including ownership mindset, worker equity, With Upstock and Couchsurfing, he has demonstrated an unparalleled expertise in harnessing technology for the betterment of community interaction and organizational benefits.

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