Any stock purchased in a private offering is transformed into restricted stock and therefore, becomes a restricted security. Restricted securities must be sold in compliance with Rule 144, The Section 4(1.5) Exemption, or must be properly registered for resale. Most often restricted stock can be identified via a legend on the back that states the securities are restricted. However, it is the seller’s responsibility to know whether the stock is restricted or not and if it was purchased via a private offering, the stock is restricted even if it does not bear a legend indicating so upon its back.
There are essentially two sub-classifications within Rule 144 for resale of restricted securities: one for non-affiliates and one for affiliates. An affiliate is generally defined as any person who can exercise control over an issuer – i.e. a director or large shareholder.
Non-Affiliate Investors. Non-affiliate investors purchasing stock from a private company must hold restricted securities for a period of 1 year and must not have been an affiliate of the company for 3 months prior to the resale. If the stock is from a public reporting company (i.e. issuer is current in filings with the SEC), non-affiliates need only hold the stock for a period of 6 months.
Affiliate Investors. Affiliate investors have the same holding period requirements as non-affiliates: 1 year for private companies and 6 months for public reporting companies. However, affiliates must comply with four additional conditions:
- Large sales of stock will require the affiliate file Form 144.
- The issuer must be in compliance with all reporting requirements of the Exchange Act.
- There is a restriction on the volume of shares an affiliate can sell at one time.
- A properly licensed broker must be used for the sale and the normal commissions must be paid to said broker.
Compliance with Rule 144 Creates Unrestricted Stock. An investor that complies with Rule 144 in selling his stock may sell the stock as he chooses – in other words, the purchaser will take the stock as unrestricted securities. It should be noted, however, that if the stock bears the restricted legend, the purchaser will have to petition the issuer for a new certificate without the legend.
Using the Section 4(1.5) Exemption. Section 4(1.5) deals with an investor’s private resale of restricted securities. Case law has developed the Exemption over the years. Essentially, the Exemption requires the seller to find a purchaser who is “sophisticated” and has access to similar information about the stock as would be available if the securities were registered. Under this exemption, the holding period on the restricted securities does not start over upon the sale but instead can be “tacked” on to the new investor’s holding period as long as the initial investor was not an affiliate.