Restricted Securities

Restricted securities are securities acquired in an unregistered, private transaction from the issuing company or from an affiliate of it, which therefore cannot simply be resold into the public market. The classification comes from SEC Rule 144, at 17 CFR 230.144(a)(3), whose first and most common limb covers "securities acquired directly or indirectly from the issuer, or from an affiliate of the issuer, in a transaction or chain of transactions not involving any public offering". Investors typically end up holding them through a private placement, an employee stock plan, or payment in shares for services.

The rule and the class are not the same thing, which is worth a sentence because the rule is the far more searched name. Rule 144 is a safe harbor: its Preliminary Note explains that it "creates a safe harbor from the Section 2(a)(11) definition of 'underwriter'", so a seller who meets its conditions is deemed not to be engaged in a distribution and can rely on the ordinary exemption for transactions by a person other than an issuer, underwriter or dealer. That safe harbor covers two categories: restricted securities, defined by how they were acquired, and control securities, which the SEC describes as shares held by an affiliate of the issuer regardless of how they were acquired. This page is about the first. A third thing, Rule 144A at 17 CFR 230.144A, is a separate rule governing private resales to large institutions, and it is not what "Rule 144" means.

One more distinction traps people constantly. Restricted securities are not "restricted stock." Restricted stock is compensation: shares granted to an employee that are forfeitable until they vest, taxed under Internal Revenue Code Section 83. Restricted securities are defined by acquisition, not by vesting, and the restriction is a securities-law resale limit rather than a forfeiture condition. The same shares can be both, but the two words describe different problems.

What the rule asks of a seller. Rule 144 sets five conditions, and which ones apply depends on whether the seller is an affiliate of the issuer.

Current public information, at 230.144(c). For a reporting company this generally means it has been subject to Exchange Act reporting for at least 90 days and has filed all required reports for the preceding 12 months, "other than Form 8-K reports". For a non-reporting company it means specified information about the business, its officers and directors and its financials is publicly available.

Holding period, at 230.144(d)(1). If the issuer is, and has been for at least 90 days, an Exchange Act reporting company, "a minimum of six months must elapse" between acquiring the securities from the issuer or an affiliate and reselling them under the rule. If it is not, the minimum is one year. Paragraph (d)(1)(iii) adds that when the acquirer buys the securities, the clock does not start "until the full purchase price or other consideration is paid". Paragraph (d)(3) then handles the awkward cases, including stock splits and recapitalizations, conversions and exchanges, pledges, gifts, trusts and estates, generally by tacking the earlier holder's period.

Volume limitation, at 230.144(e), which applies only to sales for an affiliate's account. Sales in any three months, aggregated with the prior three months' sales of the same class, may not exceed the greatest of one percent of the shares outstanding as shown by the issuer's most recent report; the average weekly reported volume on all national securities exchanges and through a registered securities association's automated quotation system during the four calendar weeks preceding the Form 144 filing; or the average weekly volume reported under an effective transaction reporting plan or national market system plan over the same four weeks.

Manner of sale, at 230.144(f). Affiliate sales must be brokers' transactions, transactions directly with a market maker, or qualifying riskless principal transactions, and the seller may not solicit buy orders or pay anyone other than the executing broker. The paragraph does not apply to debt securities or to securities sold for a non-affiliate estate.

Notice, at 230.144(h). If more than 5,000 shares, or more than $50,000 worth, will be sold in any three-month period, a notice on Form 144 must be filed, transmitted concurrently with placing the order, and the filer must have a bona fide intention to sell within a reasonable time.

The two paths, side by side. Under 230.144(b)(1), a person who is not an affiliate and has not been one for three months may resell restricted securities of a reporting company once the holding period is satisfied and the current-public-information condition is met, and that information condition falls away entirely "provided a period of one year has elapsed" since acquisition. For a non-reporting company, the only condition for such a person is the one-year holding period. An affiliate, by contrast, is covered by 230.144(b)(2) and must meet all of the conditions on every sale, which is the practical reason an executive's selling is slow and documented even years after the shares were acquired.

The legend, and who can lift it. Because the shares cannot be resold freely, the certificate or book-entry position normally carries a restrictive legend. The SEC's own investor publication is unusually direct about what follows: even after the Rule 144 conditions are satisfied, "you can't sell your restricted securities to the public until you've gotten the legend removed from the certificate", only a transfer agent can remove it, and the transfer agent will not act "unless you've obtained the consent of the issuer, usually in the form of an opinion letter from the issuer's counsel". If a dispute arises, the SEC "will not intervene"; removal "is a matter solely in the discretion of the issuer", and any dispute is governed by state law. For a shareholder in a private company that has soured, this is often a more binding constraint than the holding period.

Two limits on the safe harbor. Rule 144 "is not an exclusive safe harbor", so a seller who cannot meet its conditions may still claim another available exemption; and the safe harbor is unavailable "to any person with respect to any transaction or series of transactions that, although in technical compliance with Rule 144, is part of a plan or scheme to evade the registration requirements". Paragraph (i) separately makes the rule unavailable for the resale of securities initially issued by shell companies with no or nominal operations, a provision aimed squarely at a recurring fraud pattern.

Start with the acquisition. A company sells shares privately to a small group of investors. Because the shares came directly from the issuer in a transaction not involving a public offering, Rule 144(a)(3)(i) makes them restricted securities in every buyer's hands, and each certificate is issued with a restrictive legend.

Suppose the company is an Exchange Act reporting company and has been for years. An investor who is not an affiliate has to let six months elapse from the date the purchase price was fully paid before selling under the rule, and during the period from six months to one year she must also satisfy the current-public-information condition, which for a reporting company simply means the company is up to date on its filings. After one year that condition falls away too, and her sales are unconditioned by the rule.

Take an example of what an affiliate faces instead, using round numbers. The company has 40,000,000 shares of common stock outstanding, so one percent is 400,000 shares. Reported trading has been averaging 250,000 shares a week over the past four weeks. The volume limitation takes the greatest of the available measures, so the affiliate's ceiling for the next three months is 400,000 shares rather than 250,000. If she has already sold 150,000 shares in the preceding three months, those count against the cap, leaving 400,000 − 150,000 = 250,000 shares she may sell now. At $25 a share that is 250,000 × $25 = $6,250,000, far past both Form 144 triggers of 5,000 shares and $50,000, so a Form 144 must be filed and transmitted when the order is placed. The sale itself must go through a broker in an ordinary brokers' transaction or directly with a market maker.

Finish with the mechanical step people forget. Satisfying every condition does not clear the legend. The holder asks the company or its transfer agent about the removal procedure, the company's counsel issues an opinion that the legend can come off, the transfer agent removes it, and only then can the shares settle in an ordinary market sale. Building that step into the timeline is the difference between selling in the week you planned and selling a month later.

Pros

• The definition is mechanical: it turns on how the securities were acquired, so a holder can usually tell with certainty whether it applies.
• Rule 144 converts an open-ended legal question about being an "underwriter" into a checklist with dates and numbers.
• A non-affiliate of a reporting company is fully free after one year, which is a genuinely short leash for a private-market investment.
• The restrictions apply to resale, not to ownership, so the holder keeps every economic and voting right in the meantime.

Cons

• The shares are illiquid for the whole holding period, and the price can move a long way before a sale is possible.
• An affiliate never escapes the conditions, so a founder or executive plans sales around a volume formula and a filing rather than around the market.
• Legend removal depends on the issuer's cooperation, and the SEC has said plainly that it will not intervene in a dispute about it.
• The rule is unavailable for securities originally issued by shell companies, which can trap a holder who acquired shares without knowing the issuer's history.