Proposed rule changes could ease reporting burdens for smaller companies

On May 23, the Securities and Exchange Commission held an open meeting at which a number of proposed rule changes were presented. The proposals are substantially the work of the Advisory Committee on Smaller Public Companies (Advisory Committee), which was chartered by the SEC in March 2005 to assess the regulatory system for smaller companies under the federal securities laws and to make recommendations for changes.
The proposals offered by the SEC are aimed at improving the reporting process for smaller companies. Among the changes proposed by the SEC are changes to Rule 144, which governs the resale of restricted securities. The analysis below is based on the proposed changes described at the SEC open meeting.

Current rule
Under Section 5 of the Securities Act of 1933, as amended (Securities Act), the general rule is that any offering or sale of securities must be registered. Various exemptions from registration have been developed over the years.
Rule 144, promulgated under the Securities Act, operates as a “safe harbor” for the resale of restricted securities from the registration requirements of the Act. The current version of Rule 144 was adopted in 1972, and has been amended several times since its adoption, most recently in 1997.
“Restricted securities” are securities acquired in unregistered, private sales from the issuer or from an affiliate of the issuer. Investors typically receive restricted securities through Regulation D or other private placement offerings, employee stock benefit plans, as compensation for professional services, or in exchange for providing “seed money” or start-up capital to the company.
Rule 144(a)(3) identifies what sales produce restricted securities.
Control securities are those held by an affiliate of the issuer. An affiliate is a person, such as a director or large shareholder, in a relationship of control with the issuer. “Control” means the power to direct the management and policies of the company in question, whether through the ownership of voting securities, by contract, or otherwise.
Anyone that purchases securities from a controlling person or affiliate takes restricted securities, even if they were not restricted in the affiliate’s hands.
Under Rule 144, five conditions must be met in order to sell restricted securities without
registration.
1. Holding period must be satisfied. The current version of Rule 144 requires that both affiliates and non-affiliates of the issuer hold the subject securities for a period of at least one year before resale. The holding period begins when the securities are bought and fully paid.
Additional securities purchased from the issuer do not affect the holding period of previously purchased securities of the same class. If the restricted securities are purchased by a non-affiliate from another non-affiliate, the purchaser can “tack on” that non-affiliate’s holding period to the purchaser’s holding period.
For gifts made by an affiliate, the holding period begins when the affiliate acquired the securities and not on the date of the gift. In the case of a stock option, the holding period always begins as of the date the option is exercised and not the date it is granted.
After the one year holding period has run, the securities can be resold by both affiliates and non-affiliates, subject to satisfying the other requirements (in particular the volume trading limitations) of Rule 144. After two years, non-affiliates can resell the securities without restrictions. However, under the current Rule 144 scheme, affiliates are always subject to the volume trading limitations.
2. Adequate current information. There must be adequate current information available about the issuer of the securities before the sale can be made. This generally means the issuer has complied with the periodic reporting requirements of the Securities Exchange Act of 1934.
3. Trading volume formula. After the one-year holding period, the number of shares sold during any three-month period cannot exceed the greater of: (i) 1 percent of the outstanding shares of the issuer of the same class being sold; or (ii) if the class being sold is listed on a stock exchange or quoted on NASDAQ, the average reported weekly trading volume during the four weeks preceding the filing a notice of the sale on Form 144.
4. Ordinary brokerage transactions. The sales must be handled in all respects as routine trading transactions, and brokers may not receive more than a normal commission. Neither the seller nor the broker can solicit orders to buy the securities.
5. Filing Form 144 with the SEC. The seller must file a notice (Form 144) with the SEC if the sale involves more than 500 shares or the aggregate dollar amount is greater than $10,000 in any three-month period.

Proposed changes
The SEC recommended reducing the initial holding period for both affiliates and non-affiliates to six months (from one year). After six months, if information about the issuer is current, affiliates could resell the restricted securities subject to the volume limitations, and non-affiliates could resell the restricted securities without volume limitations, and without having to comply with the Form 144 or ordinary brokerage transaction requirements.
Under the proposals, if current information was not available about the issuer, non-affiliates would have to wait one year before reselling without restrictions. Affiliates would always be subject to the volume trading and other restrictions.
The proposed changes should lessen the reporting burden for issuers and sellers under Rule 144, and enable smaller companies to raise capital more efficiently.
Some commentators believe the discount typically offered by issuers to investors that purchase restricted securities will be reduced, since the investor will not have to hold the securities for as long a period of time.
As SEC Chairman Christopher Cox noted, “[t]his focus on capital formation and the removal of obstacles to the growth of smaller companies goes hand-in-hand with our responsibility to protect investors.”
Mark Tarallo practices corporate and securities law with Morse, Barnes-Brown & Pendleton, PC. He represents both buyers and sellers in mergers and acquisitions, and counsels clients in connection with public and private offerings of securities. He is co-chair of the Mergers & Acquisitions Committee of the Boston Bar Association. He can be reached at [email protected].