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If you hold stock in a start-up company, you may have noticed that your stock certificate has a daunting message in all capital letters that reads something like:


Whoa! Does this legend mean that you can’t sell your stock until after your start-up completes its IPO?  Not exactly.  Even in the absence of an IPO, there are a few exemptions from the registration requirement under federal securities laws that can be used for purposes of issuing an opinion that your sale does not require registration under the Securities Act of 1933, as amended (the “Securities Act”).

Prior to December 2015, the available exemptions were (1) the “ordinary trading” exemption (section 4(a)(1)) for publicly traded shares, (2) the so-called “4(a)(1½) exemption” (the “hybrid” exemption sometimes used for private resales) and (3) a safe harbor under SEC Rule 144. But in December 2015, Congress passed the Fixing America’s Surface Transportation Act (the “FAST Act”), which creates what amounts to a statutory safe harbor of the hybrid exemption with the creation of section 4(a)(7) of the Securities Act.

Before we get into the details of the new exemption, below is a description of why Congress purportedly adopted the new section 4(a)(7) exemption and a description of the securities exemptions that existed prior to adoption of the FAST Act. Then we describe the requirements of the new section 4(a)(7) exemption, and analyze how the new exemption will likely impact start-up companies and its stockholders.

Why Congress Adopted the New Section 4(a)(7) Exemption

Before it was part of the FAST Act, the new section 4(a)(7) exemption was included in a stand-alone bill known as the “Reforming Access for Investments in Startup Enterprises” or “RAISE Act.” As part of Congress’s background investigation for the RAISE Act, Congress found that SEC Rule 144 provided a sufficient exemption from registration for public resale of restricted securities (i.e., securities initially issued under an issuer’s exemption from registration) and control securities (i.e., securities held by individuals who control the company).  However, there was not a codified exemption for the private resale of restricted securities.  Because there was no codified exemption for private resales, investors in private companies may have been uncertain about liquidity of private company securities and therefore create additional hurdles for private companies to raise primary capital. To fill this gap Congress adopted the new section 4(a)(7) exemption, based on the so-called section 4(a)(1½) exemption, for the purpose of increasing market liquidity and resolving legal uncertainty that impedes employees (and other investors) of private companies from selling their company-issued securities

Securities Exemptions in Existence Prior to the FAST Act

To understand the gap that Congress sought to fill with the new section 4(a)(7) exemption it is helpful to understand the exemptions from registration that were available prior to the FAST Act for stockholders who wanted to sell shares of stock that they held in private, start-up companies.

Section 4(a)(1) and the so-called “4(a)(1½) exemption”

Section 4(a)(1) of the Securities Act provides an exemption from registration for “transactions by any person other than an issuer, underwriter or dealer.” This exemption clearly applies to ordinary trading of securities on a stock exchange by normal people, but due to the term “underwriter,” it is not clear if this exemption is available for other types of secondary market transactions.  Under the Securities Act, an “underwriter” may be “any person who has purchased from an issuer with a view to, or offers or sells for an issuer in connection with, the distribution of any security.”  What does it mean to purchase securities from an issuer with a view to distribution?  What about offers or sales for an issuer in connection with a distribution?  The answers are murky and the interpretations of these terms have taken the courts decades.

Purchasing securities with “a view to distribution” suggests a subjective intent of an investor, that they buy shares from the issuer intending to then sell the shares to many people. However, since the courts cannot in most instances infer the subjective intent of an individual, the courts became comfortable that if an investor purchased shares from the issuer and held them for two years, the shares “came to rest” with the initial investor.  After the two-year holding period, the stockholder could resell the shares in a private sale.  But two-years may be a long time for some stockholders.  What happens if the stockholder becomes ill and needs additional cash to pay for medical expenses?  The stockholder did not have a “view to distribution” when she originally purchased the shares from the issuer, but she needed to sell the securities before two years elapsed.  Eventually, the courts created several exceptions to the two-year holding period that required stockholders to guess whether their justification was sufficient to fall within an exception to the two-year holding period required under the Section 4(a)(1) exemption.

Similarly, the phrase “in connection with the distribution of any security” has been interpreted by the courts in a non-intuitive manner. Generally, the courts have interpreted “distribution” to mean the same thing as “public offering,” despite Congress using “distribution” and “public offering” separately in the Securities Act.  The Supreme Court has interpreted the phrase “not involving any public offering” in connection with the meaning of the issuer’s “private placement” exemption under section 4(a)(2) of the Securities Act to mean an offering not involving general solicitation, in which the purchaser does not require the protections because of their sophistication in such matters and access to the type of information generally available in a registered public offering.  The meshing of “distribution” and “public offering” has resulted in what is known as the “section 4(a)(1½) exemption.”  This exemption is typically relied on by individuals who purchase shares in a private placement and held them for at least two years and then wish to sell them to other sophisticated investors.  However, because the purchaser must have access to information about the issuer, the exemption was most often utilized by control persons, such as officers, directors or large stockholder, who could persuade the company to produce the necessary information.  In the case of control persons, the definition of “underwriter” provides an additional limitation.  Within the definition of “underwriter,” control persons are deemed to be the issuer.  Accordingly, the purchaser of securities from a control person must not purchase the securities with a view to distribution or have purchased the securities in connection with a distribution.

Since many holders of restricted securities and control securities were uncertain whether there was an exemption available for secondary market transactions, or found existing law difficult to navigate, the SEC stepped in in the ‘70s to provide certainty through a new safe harbor, Rule 144.

Rule 144

Given the complexity of the section 4(a)(1) exemption and the section 4(a)(1½) exemption, along with the uncertainty that a seller may actually be in compliance, the SEC created a new safe harbor under Rule 144 in 1972 and has revised the Rule several times to liberalize its requirements.

If a seller of restricted securities (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 (in other words, in a private placement) or control securities (basically, securities where the seller is or was an affiliate of the company within certain periods specified in Rule 144) complies will Rule 144, the seller will fall within the safe harbor and will be deemed not to be an underwriter for purposes of the Section 4(a)(1) exemption.  Rule 144 has five requirements, which are applied to sellers of private, non-reporting company securities based on whether the seller is a control person holding “control securities” or a non-control person holding “restricted securities.” The requirements are summarized below:

Control Securities Restricted Securities
  • Holding Requirement: During one-year holding period, no resales under Rule 144 are permitted; after one-year holding period, resales are permitted in accordance with certain other Rule 144 requirements.
  • Holding Requirement: During one-year holding period, no resales under Rule 144 are permitted; after one-year holding period, unlimited public resales under Rule 144.
  • Current public information.
  • Volume limitations.
  • Manner of sale requirements for equity securities.
  • Filing of Form 144.

For non-control persons holding restricted securities of a private, non-reporting issuer, compliance with Rule 144 is generally straight forward.  Non-control persons must hold restricted securities of a private, non-reporting issuer for at least one-year before they can rely on Rule 144.  The holding period generally begins on the date the issuer or a control person sells the security to a non-control person and does not restart if the restricted securities are transferred to another non-control person.

Control persons (typically, directors, management and large stockholders) holding control securities of private, non-reporting companies face a more stringent compliance hurdle to use Rule 144, because the issuer must provide the information necessary for compliance with the current public information requirement. Under the current public information requirement, the issuer would have to provide many of the financial statements that public companies have to provide.  As a result, many affiliates of a non-reporting issuer do not rely on the safe harbor under Rule 144 and instead rely on the so-called Section 4(a)(1½) exemption, despite any uncertainty about its availability to the seller.

Thus, subject to some limitations, a broad group of stockholders of private, non-reporting companies can rely on the existing registration exemptions without significant concerns.  But a narrow set of individuals who hold securities in a start-up company would not be covered by the Rule 144 safe harbor: individuals who held restricted securities for less than one year and individuals who hold control securities.  The new exemption under section 4(a)(7) of the Securities Act attempts to address the concerns of these individuals.

The Requirements of New Section 4(a)(7) Securities Exemption

A seller may, generally, rely on the new exemption provided under section 4(a)(7) of the Securities Act, if the transaction involves a private placement to an accredited investor  and certain limited information is provided to the purchaser.  This exemption follows a general liberalization under the securities laws that permit wealthy persons to purchase securities in private transactions.  To rely on the new exemption, which will cover both federal securities laws and state blue sky law, a holder of restricted securities or control securities must specifically comply with each of the following requirements under section 4(a)(7):

  • Accredited Investor Requirement: The purchaser must be an “accredited investor,” as defined in Rule 501(a) promulgated under the Securities Act.
  • Prohibition on General Solicitation or Advertising: The seller (or anybody working on the seller’s behalf) may not offer or sell securities by general solicitation or general advertising.
  • Information Requirement: The seller must provide basic information regarding the issuer (including GAAP-compliant financial statement for the prior two-fiscal years); the securities being sold in the transaction; and any broker, dealer or agent receiving remuneration in the transaction. If the issuer is a non-reporting issuer, the seller must request information regarding the issuer and securities from the issuer. Additionally, if the seller is a control person of the issuer, the seller must include a description of his or her affiliation with the issuer and a certification from the seller that he or she has no reasonable grounds to believe the issuer is in violation of the securities laws or regulations.
  • Issuers Disqualified: The seller cannot be the issuer or a subsidiary of the issuer.
  • Bad Actor Prohibition: The seller (or anybody working on the seller’s behalf who will receive remuneration in connection with the transact) cannot be a “bad actor” as defined in Rule 506(d)(1) of Regulation D.
  • Business Requirement: A seller cannot rely on this exemption with respect to securities of certain issuers that are in the organizational stage, in bankruptcy or receivership, or do not have ongoing business operations.
  • Underwriter Prohibition: The transaction will not cover the sale of a security by a broker or dealer in its capacity as an underwriter of the security or a redistribution.
  • Outstanding Class Requirement: The security must be of a class of securities that has been authorized and outstanding for at least 90 days prior to the date of the transaction.

Following a transaction that is exempted under Section 4(a)(7) the purchaser will hold restricted securities for purposes of Rule 144 or any future transaction exempted under Section 4(a)(7).  Therefore, the purchaser will have to seek further exemptions for any future resales of the securities.

The Impact of New Section 4(a)(7) Securities Exemption on Start-up Companies

The new securities exemption under section 4(a)(7) of the Securities Act may fill some of the gaps left by Rule 144, but it does not necessarily completely fill the gap left by Rule 144.  First, the benefits of section 4(a)(7) include the availability of an exemption for individuals who have held restricted securities of a non-reporting company for less than one year, provided the securities are of a class that have been issued and outstanding for more than 90 days. Most likely the outstanding class requirement is not an issue for most holders. Occasionally, a founder holding vested shares or investor holding a new series of preferred stock will need to exit their position within 90 days of purchasing shares, but this is a fairly rare event.

While the new exemption is relatively easy to comply with, non-control persons holding restricted securities may still find challenges complying with it.  Most importantly, issuers do not have a duty to provide the necessary information regarding the company (including financial statements) and the securities.  Many private companies are reluctant to disclose financial information to non-control persons, except as required by law, and may refuse to provide the information to a third-party purchaser.  For rank-and-file stockholders, many issuers may push the non-control persons to hold the securities for one year and rely on the safe harbor under Rule 144, which does not have an information requirement.

Similarly, control person holding control securities may wish rely on the section 4(a)(7) exemption, which calls for much less information than similar requirements under Rule 144.  Issuers may be willing to provide necessary information to control persons (who typically already have access to this type of information) under this less stringent information requirement, especially if the financial information has already been prepared in connection with ongoing information requirements to preferred stock investors.  However, purchasers and sellers who are aware of material nonpublic information, which most likely includes control persons of the issuer, are broadly prohibited from purchasing or selling securities under the anti-fraud requirements of Rule 10b5-1.  Accordingly, despite having an exemption from registration available under section 4(a)(7), control persons still should not engage in a purchase or sale of a security while in possession of material nonpublic information.  As a result, control persons of non-reporting, start-up companies may find that they never have an opportunity to sell securities of the issuer while they remain a control person.

Given these limitations to section 4(a)(7), despite its promise to broaden the availability of private secondary markets to new sellers, the benefits will only be recognized by an occasional seller.  While section 4(a)(7) does close some of the gaps left open by Rule 144, the requirements of the new exemption and the anti-fraud provisions of the securities laws continue to leave some holders without a reliable method of selling securities in private secondary transactions.