February 15, 2008

What are the Practical Implications of the Recent Amendments to Rules 144 and 145?

Effective February 15, 2008, recent SEC amendments to Rules 144 and 145 should increase the liquidity of privately issued securities held by a private equity or hedge fund, potentially making private placements more attractive for investors and issuers. Securities acquired in private transactions may now be resold to the public in reliance on the more relaxed requirements of Rule 144, as described below. A non-affiliate purchaser of these securities (after the required holding period) would then have freely tradable stock.

1.  Why are Rules 144 and 145 important to private equity and hedge funds?

Rule 144 is an important tool for investors, such as private equity and hedge funds, because it allows investors to sell securities to the public without registration of the sale under the U.S. Securities Act of 1933, even though (1) the securities were acquired in a private placement ("restricted securities") and/or (2) the investor is an affiliate of the issuer ("control securities"). Under the Securities Act generally, these types of securities may be sold only after the sale has been registered with the SEC unless an exemption from registration, such as Rule 144, is available.

Private equity and hedge funds often rely on Rule 144 when selling restricted securities in the open market and when making in-kind distributions of restricted portfolio company securities to fund investors. Funds also rely on Rule 144 as a way to monetize control securities following the initial public offering of a portfolio company, and on Rules 144 and 145 when selling securities received in a stock-for-stock sale of a portfolio company to a public company.

2.  How will the amendments affect sales by non-affiliates?

The SEC has relaxed the requirements of Rule 144 in a way that significantly helps non-affiliates. Prior to the rule changes, sellers of restricted securities availing themselves of the safe harbor were required to satisfy public information, holding period, volume, manner of sale and notice requirements. Going forward, sales by non-affiliates can be made under Rule 144 after a holding period requirement of six months, so long as the issuer of the security is a public reporting company and complying with its reporting requirements.1  The volume, manner of sale and notice requirements that previously limited the sale of restricted securities are no longer applicable to sales by non-affiliates.

3.  How will the amendments affect sales by affiliates?

Affiliates also benefit from the shorter holding period requirement (six months for reporting companies and one year for non-reporting companies). Affiliates, however, continue to remain subject to the Rule's volume and notice requirements and a modified manner of sale requirement.

Perhaps most importantly for fund investors, sales by affiliates relying on Rule 144 will continue to be generally limited, during any three-month period, to the greater of 1% of the shares outstanding and the average weekly volume of trading in the company's shares.

The manner of sale requirement for affiliates was eliminated for sales of debt securities and broadened for sales of equity securities to include riskless principal transactions and to allow for the posting of bid-and-ask quotations in alternative trading systems.

We have attached to this newsletter a chart summarizing the holding period and other requirements imposed by Rule 144. For a more complete description of the amendments to Rules 144 and 145, please refer to our memo SEC Publishes Final Rule 144 and Rule 145 Amendments, dated December 21, 2007

4.  Will the new rules affect the need for registration rights?

One effect of this increased liquidity may be to reduce the need for registration rights.

In private acquisitions of securities, investors have traditionally insisted upon registration rights, to require the issuer to register resales of their securities with the SEC at a future time, which would then allow public sales of their securities without being subject to the volume and manner of sale restrictions previously imposed by Rule 144.

Registration with the SEC entails significant burdens and costs. The process of registering securities transactions, including the time required to finalize the prospectus with the SEC to make it effective for resales of securities, often takes six months or more. Because non-affiliates may now freely sell restricted securities after six months (or one year at the most) under the new rule, there may be situations in which issuers refuse to grant registration rights. However, we suspect that well-advised investors will continue to require registration rights to permit underwritten sales (which cannot be accomplished under Rule 144) or when they are at risk of being deemed an affiliate of the issuer.

5.  Did the Rule 144 amendments affect the application of the rules used to determine when an investor is an affiliate?

How the new rules will affect a fund's ability to exit its investment post-IPO depends on whether the fund is an affiliate of the issuer. The amendments to Rule 144 did not affect this determination.

An investor may be subject to the rules applicable to affiliates, for example, because of the size of its own investment or because its investment would be aggregated with the securities owned by other investors.2 In addition, private equity fund sponsors may retain governance rights in their post-IPO portfolio companies, such as the right to designate director nominees and, sometimes, veto rights over certain significant matters or rights of first refusal on sales of shares by other investors. The existence of these rights, among other things, may also result in the fund being deemed an affiliate for purposes of Rule 144, requiring it to comply with the volume, manner of sale and notice restrictions of the rule that would not otherwise apply if the fund were not an affiliate.

Once an investor ceases to be an affiliate of the issuer and there has been a three-month "cooling off" period, assuming the six-month holding period has been satisfied, the investor would be able to sell its securities under Rule 144 as a non-affiliate and thus without complying with the volume, manner of sale and notice period restrictions.

6. How do the new rules affect a fund's ability to make a distribution-in-kind of portfolio company securities to fund investors?

Previously, an affiliated fund was required to hold securities for at least two years before it could effect a distribution-in-kind of issuer securities to fund investors. Under SEC no-action letters, non-affiliated investors in a fund who received securities pursuant to such a distribution-in-kind held free securities, and could sell such securities immediately in the open market. As a result of the shortened one-year Rule 144 holding period for affiliates, funds should now have to wait only one year (rather than two years) before effecting a distribution-in-kind to fund investors, with non-affiliated fund investors receiving freely tradeable securities. If a fund effects a distribution-in-kind after a six-month holding period, sales by fund investors would be aggregated for purposes of the Rule 144 volume limitations until the one-year holding period is met, severely limiting the benefits of a distribution-in-kind.

7.  How do the amendments to Rule 145 affect a fund's ability to exit an investment by selling the portfolio company for stock?

The amendments to Rule 145 make it more attractive for private equity and hedge funds to sell their portfolio companies for acquiror stock in transactions registered with the SEC.

Prior to the amendments, if the fund investor was affiliated with the portfolio company being sold in exchange for registered stock in a transaction voted on by shareholders, then under Rule 145 the stock received by the fund (even if the fund were not an affiliate of the combined company post-transaction) could not be sold during the first year without complying with the volume and manner of sale requirements of Rule 144.

Under amended Rule 145, so long as the fund is not an affiliate of the combined company post-transaction, the fund would be permitted to immediately resell, without restriction, any shares received in the registered transaction.3

This change should increase the attractiveness of stock-for-stock sales of portfolio companies. Because registered acquiror stock received in consideration for the sale of a portfolio company would be freely tradeable (if the fund is not an affiliate of the combined company), the number of deals made with strategic investors may increase.

8.  Do the amended rules still permit tacking of holding periods upon the cashless exercise of warrants?

Rule 144 has now codified prior no-action letters that permit investors to tack the holding period of warrants or options to securities issued upon the cashless exercise of those warrants or options. In effect, the underlying securities are deemed to have been acquired at the time the warrants or options were acquired. If an investor exercises its warrants or option for cash, a new holding period begins for the newly issued securities for purposes of Rule 144.

Summary of Amendments

 Affiliate or Person Selling on Behalf of an Affiliate Non-Affiliate (and Has Not Been an Affiliate During the Prior Three Months)
Restricted Securities of Reporting Companies During six-month holding period - no resales under Rule 144 permitted.
After six-month holding period - may resell in accordance with all Rule 144 requirements including:
• Current public information,
• Volume limitations,
• Manner of sale requirement for equity securities, and
• Filing of Form 144.
During six-month holding period - no resales under Rule 144 permitted.
After six-month holding period but before one year - unlimited public resales under Rule 144 except that the current public information requirement still applies.
After one year - unlimited public resale under Rule 144; need not comply with other Rule 144 requirements.
Restricted Securities of Non-Reporting CompaniesDuring one-year holding period - no resales under Rule 144 permitted.
After one-year holding period - may resell in accordance with all Rule 144 requirements except holding period, including:
• Current public information,
• Volume limitations,
• Manner of sale requirements for equity securities, and
• Filing of Form 144.
During one-year holding period - no resales under Rule 144 permitted.
After one-year holding period - unlimited public resale under Rule 144; need not comply with other Rule 144 requirements

1. The holding period for sales by non-affiliates of shares in non-reporting companies has not changed. Securities of non-reporting companies must be held for at least one-year under Rule 144. After one year, these securities are freely tradeable.

2. In our November 2005 newsletter, we noted the principle of aggregation of Rule 144 sales for purposes of determining whether the sales exceed Rule 144's volume limitation. When stockholders "agree to act in concert for the purpose of selling securities of an issuer," those stockholders are required to aggregate all of their sales within the preceding three months. Aggregation may be required, for example, if sales by one stockholder require the consent of one or more other stockholders or if tag-along, drag-along, transfer restrictions and other sale coordination mechanisms restrict the ability of a stockholder to sell its shares independently. If a volume limitation applies to a given sale, the aggregation requirement would act to limit the ability of a "club member" to sell shares in the open market in reliance on Rule 144.

3. An investor may also sell a portfolio company in a private transaction either for cash or stock without registration, in reliance on a different exemption under the Securities Act called the private placement exemption. This may be accomplished by limiting the sale to a small number of sophisticated investors who agree not to resell the securities to the public unless the resale is registered or an exemption from registration is available. Shares received in such a transaction where the consideration is stock, however, will be restricted and may be resold in reliance on Rule 144, as previously described.