For my 15th birthday, my parents gave me the choice of a gift of a new violin I could pick out myself right away or a new car when I got my driver’s license. I chose the violin.
In hindsight, I think this was a setup. I wanted to have a new violin when I attended Interlochen Arts Comp during the upcoming summer. But it would be nearly 18 months before I would be able to use a car; I wouldn’t even be able to get my learner’s permit until a year later when I turned 16.
However, having accepted the gift of a new violin when I was 15, it would be a decade before I had a car of my own. I used my sign-on bonus from my first attorney job to pay the down payment on a new car.
My son also received his first full-size violin as a gift. But the situation was different. Instead of his parents buying him a violin and immediately giving it to him, his grandfather gave him a violin that had been in his family for nearly a century.
It doesn’t matter whether a family member buys a violin and immediately gives it to a young violinist or the family member instead gives the violinist an instrument that has been in the family for years. However, that distinction can be critical when the gift is securities. This article discusses how someone can become a presumptive underwriter by gifting or selling certain securities soon after acquiring them.
Who is an “Underwriter”
Most of us think of an underwriter as a brokerage company that helps an issuer with their initial public offering (IPO). Underwriters use their knowledge of the securities market to structure, price, and sell the securities. Typically, an underwriter will agree to buy the entire IPO at a fixed price, and the underwriter assumes the risk of market fluctuations with the IPO.
The Securities Act of 1933 (Securities Act) has a broader definition of underwriter. Under the Securities Act, an underwriter is anyone who acquires unregistered securities directly from the issuer (or an issuer affiliate) with a “view to distribution” of the securities. Parties who fall under the definition of “underwriter” are presumptive underwriters.
It’s usually easy to tell whether someone acquired their securities from the issuer. It’s more challenging to evaluate whether that individual acquired them “with a view to distribution.”
When a purchaser immediately sells their securities, like the IPO underwriter, it may be clear they acquired the securities “with a view to distribution.” But the Securities Act isn’t clear about how long someone must hold the securities to establish they didn’t acquire them “with a view to distribution.” It’s especially important that real estate sponsors and investors understand because many real estate securities are sold in private placements where investors purchase securities directly from the sponsor or issuer.
The Securities and Exchange Commission (SEC) adopted Rule 144 to remove this uncertainty. Rule 144 creates a non-exclusive “safe harbor” establishing how long someone must hold securities to rebut the presumption they acquired the securities “with a view to distribution.”
Rule 144 uses two factors to determine how long someone must hold the securities under the safe harbor: whether the individual is an affiliate of the issuer and whether the issuer is a reporting company under the Securities Exchange Act of 1934. There are additional rules for shell companies, which are beyond the scope of this article.
Under Rule 144, an affiliate is anyone, such as a board member, officer, or major shareholder, who has the power to direct the issuer’s management and policies. Anyone who has held such a position without the previous three months is also considered an “affiliate.”
The holding periods for the safe harbor are longer for non-reporting companies than for non-reporting companies. Likewise, to qualify for the safe harbor, issuer affiliates must hold their securities for a longer period than parties who aren’t affiliated with the issue. Securities that don’t fall under the safe harbor are “restricted securities” because they can’t be transferred without registering the securities or qualifying for an exemption from registration.
For reporting companies, the holding period for both affiliates and non-affiliates is six months. For non-reporting companies, the holding period is one year. However, affiliates have limitations on sales and must file certain notices with the SEC if their sales exceed certain thresholds. Parties who are issuer affiliates should work with a securities attorney to ensure they comply with these and other requirements before selling or transferring securities.
It’s unclear whether securities acquired under Regulation CF (crowdfunding) are subject to Rule 144. However, they are subject to resale restrictions under Regulation CF.
Exceptions to the Rule 144 Holding Periods
Rule 144 is a non-exclusive safe harbor, so there are possible exceptions to the holding periods under the rule. The most common exception is when the purchaser experiences an unexpected change in circumstances.
Under this exception, the purchaser’s estate may transfer the securities to heirs after the purchaser’s death. However, living purchasers also may qualify for the “unexpected change in circumstances exception.”
Someone who acquires securities from the issuer and unexpectedly loses their job two months later and needs to sell the securities to pay living expenses likely would fall under the exception. But if the person who lost their job had non-restricted sources of funds to pay living expenses, it’s less clear where the exception would apply. As another example, someone who, after holding the securities for four months, must transfer securities to a spouse under a decree in a divorce initiated after the purchase might qualify.
However, poor planning is usually insufficient to satisfy the “unexpected change in circumstances exception.” So a purchaser who buys securities from the issuer knowing they don’t have the liquidity or refinancing necessary to make a balloon payment on their mortgage the following month wouldn’t qualify. And a parent who buys securities in June, knowing they are facing a huge college tuition bill for their child in August couldn’t claim “unexpected change in circumstances” to avoid the Rule 144 holding period.
What About Gifts?
Restricted securities retain their restricted status if the original purchaser gives them to a third person. So the donee must hold the securities for the same period the original owner was required to hold them.
People who want to give restricted securities to a charity may find that the value of their securities (and the amount of any tax deduction) is lower than their usual market value due to their restricted status. That’s because securities that can’t be sold until a future date usually are worth less than securities that can readily be converted to cash.
Donors should be aware that Rule 144 might not be the only limitation on their ability to gift securities. For instance, an accredited investor usually may not purchase Rule 506(c) securities only to “give” them to an unaccredited family member shortly after purchase. That “gift” would appear to circumvent securities laws that restrict the sale of Rule 506(c) offerings to accredited investors. But a transfer to a revocable grantor trust shortly after purchase might be acceptable since the original purchaser would retain control over and be the beneficiary of the securities.
Stock Legends and Issuer Obligations
Certificates for restricted stock generally bear a legend that limits them from being transferred. Even where the Rule 144 time limit has expired, owners probably won’t be able to sell their stock until any legends are removed. Especially where issuer affiliates are involved, issuers should similarly restrict transfers other than those in compliance with Rule 144 or under unexpected circumstances.
Issuers should also inform parties who acquire their stock that they may not sell it without registration or an exemption from registration. In addition, issuers may also want to direct those parties to Rule 144 and advise them to consult with legal counsel before selling.
The main takeaway is that securities aren’t like violins. Securities are heavily regulated and are subject to restrictions that may not be intuitive. Anyone who obtained securities other than from an established securities market should consult with a securities attorney before selling to ensure they aren’t running afoul of securities regulations.
© 2022 by Elizabeth A. Whitman
Any references clients or other individuals or their circumstances have been modified and names have been changed to protect confidentiality.
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