Lock Ups And Other Obstacles To Liquidity
Joseph W. Bartlett, Special Counsel, McCarter & English LLP, Co-Founder of VCExperts
McCarter & English LLP
2002-08-02
The final act in the IPO drama has to do with stock that is not offered in the initial floatation, but held by the insiders and not scheduled to be sold into the public markets until after the registration statement has become effective. Stock that does not flow through the public offering process is, in the jargon of the trade, "restricted," meaning that it has never been registered but it is nonetheless eligible for sale by the holders subject to certain constraints, the first of which is a contractual constraint imposed generally on the company and its underwriters and called the "lock up." A lock up, as discussed earlier, means that, for a period of time (usually 180 days) following the effective date of the IPO, major insiders of the company (the founders, the angel investors, key employees who obtain stock either directly or through the exercise of options, and the VCs), are committed by contract to withhold any shares from the market. The ideas is that selling pressure from insiders could depress prices and create an overhang that would inhibit potential buyers of the stock offered in the IPO from purchasing shares.
Rule 144
The second constraint is created by rule, and specifically Rule 144. Since this rule comes into play whenever restricted stock is being sold into the public markets, a discussion in some detail is called for.
The SEC published Rule 144 in 1972 to clarify the rules governing the ability of a holder of restricted securities to resell his shares to the public. The problem is as old as the unhappy draftsmanship that went into the original Securities Act of 1933. That statute appears to provide that every sale of stock must be registered under the '33 Act, an absurd proposition; the New York Stock Exchange, where transactions take place in microseconds, would close down. Section 4(1) of the '33 Act comes to the rescue by exempting transactions by persons other than the "issuer" (primary transactions) or an "underwriter." This appears simple enough; all secondary (i.e., non-issuer) transactions are exempt. The drafters, however, elected to put the substance of the rule in the definition of the term "underwriter." That term includes the types of entities and people common sense would denote as underwriters, the members of the investment-banking syndicate underwriting the placement, plus two additional types, called "statutory" underwriters, namely: (1) persons who purchased their stock from an issuer "with a view to … the distribution of any security," and (2) persons "directly or indirectly controlling" the issuer. (The term "distribution" means public distribution.) Using this language, the SEC spread its jurisdiction over secondary transactions in two principal situations: the stock sold had never been registered under the '33 Act (so-called investment-letter or restricted stock), and/or the seller controlled the issuer (so-called control stock). As the SEC reads the §4(1) and the definition of "underwriter," all secondary transactions should not be exempt, rather only those involving trades of stock other than "letter" stock or control stock.
The fear, of course, was that the registration and disclosure provisions of the '33 Act could otherwise be eroded. If all secondary transactions were exempt, a nonregistered public offering could occur whenever the issuer could find someone to buy the stock, hold it for a little while, and then "decide" to sell it publicly; or the owner of a controlling interest in the firm could start to sell off his position, acting as the "alter ego" of the issuer.
To close what it perceived as loopholes, the staff took a long view of the phrase, "with a view to." If Start-up, Inc. sells stock in an exempt private transaction to Smith (under, say, §4(2) of the '33 Act), Smith resells in a private transaction to Brown, and Brown wants to sell to the public, the sale by Brown is nonexempt because Smith and Brown, taken collectively, purchased from the issuer "with a view to" a distribution. This notion involves a tortured reading of the language of the Act (by way of contrast, the definition of "restricted securities" in Rule 144 expressly uses the terms "directly or indirectly from the issuer … in a transaction or chain of transactions") but was an obvious follow-up step if the SEC did not want unregistered offerings escaping the net.
The awkwardness of the drafting did not, in the final analysis, chill the secondary market. The SEC and the courts worked the language around until it made some modicum of sense. While the statutory language related the registration requirements to the nature of the transaction, the real initial inquiry focused on what kind of stock the holder was trying to sell. Was it letter stock because it had never been registered, and/or was it control stock because of who was the holder? A controlling person? If the stock one held was tainted, then the question was not so much whether but when the stock could be sold under §4(l) of the '33 Act as a non-evasive secondary sale without the necessity either of imposing investment-letter restrictions on the new buyer (maintaining illiquidity and thereby lowering the price), or registering the stock publicly (thereby incurring expense). It was obvious that at some point the regulators should be able to relax, to allow a secondary sale to progress under §4(l) regardless of the control status of the holder or the unregistered status of the stock, because the fear of evasion had abated with the passage of time. And that question was frequently addressed, albeit in some of the unhappiest stories in securities regulation. On occasion, the securities bar actually had to work with subjective tests. What was the "intent" (the "view") of Smith when he bought his shares from Start-up, Inc.? Did he truly "intend" to hold for "investment purposes"? If he later said he was changing his mind, did he do so just because he didn't like the stock anymore or because of a valid "change of circumstances," perhaps the loss of his job or a dreaded disease? Nonsense piled upon nonsense as counsel struggled with a series of no-action letters issued by the SEC staff, reading the tea leaves to figure out when their clients could sell without registration and without continuing the investment-letter restrictions.
Finally, the so-called Wheat Report (an SEC report from a blue-ribbon commission headed by Frank Wheat) engendered Commission action, leading to the promulgation in 1972 of Rule 144, a rule which allows the holders of control or letter stock to sell their shares publicly (no registration and no investment letters) in accordance with the provision of the Rule. The problem of letter stock is now more or less at rest, the qualifier required by the fact that staff interpretations now number more than one thousand and deal with exotic situations the Rule does not decide explicitly.
Rule 144 has one important threshold: it is not a backhanded opening through which shareholders can drive an unregistered IPO. Thus, Rule 144 generally applies only to stock in a company that is already publicly held. (That does not necessarily mean that the securities of the issuer have been registered and sold under §5 of the '33 Act; a company can, indeed must, become public over time if and as the number of shareholders of record exceeds five hundred.) The emphasis in the Wheat Report is away from the big-bang theory, which placed so much stock in the contents of a public registration statement. If the information is out in the marketplace, Rule 144 suggests, investors can trade. Indeed, a company with fewer than five hundred shareholders of record may voluntarily supply the requisite information so as to bring Rule 144 into play, but the absence of any public float makes it unlikely many would go that route (and Rule 144 is not available to issuers). If the information must be assembled and published to accommodate a secondary seller, why not create a real public offering with an IPO?
Non-control Not subject to the Rule at all
For the non- affiliate who has held unregistered stock for 6 months or more, and assuming the issue is current in its reporting to the SEC and has been for 90 days, the stock can be sold. For affiliates, the sales are subject to tax "volume" (1% of the outstanding or the average weekly trading volume) and "manner of sale" restrictions in a brokered transaction and, after a holding period of one year, without manner of sale or volume restrictions.