Founders and other Affiliates resell Private Stock under “Section 4(1½)”

In a recent post, I discussed the legal requirements that an investor would have to follow in a sale of stock in a private company to another investor.  Regrettably, this doesn’t work for shareholders who are founders or otherwise affiliated with the issuer of the stock. While there is no bright line test for affiliation, a person who would be an insider if the company were public is presumed to be an affiliate of a private company. Insiders of public companies are persons who have to report their trades under Section 16 of the Securities Exchange Act of 1934, as amended. This group consists of directors, executive officers and shareholders who own 10% or more of the issuer.

In my earlier post I discussed the definition of “underwriter” found in Section 2(a)(11) of the Securities Act of 1933, as amended. Underwriters are persons who purchase securities from an issuer with the intent of selling them publicly either directly or through one or more intermediaries. For the purposes of this definition, affiliates are treated as if they were the issuer themselves. That implies that an investor can’t buy stock from an affiliate without worrying about whether someone down the chain from the investor has the intent to sell the stock publicly. That in turn implies, that Section 4(1) is not readily available for a sale by an affiliate of the issuer.

A founder or other affiliate also can’t readily use Section 4(2) to sell stock. That section only exempts private placements by the issuer itself. And as we all know, issuers overwhelmingly avail themselves of the safe harbor provided by Rule 506 of Regulation D to conduct such private placements. But that rule too only applies to sales by the issuer itself. It’s almost as if Congress and the SEC forgot about private resales by affiliates.

Luckily, there are sources of law other than statutes and regulations. In one of the relevant court cases, Ackerberg v. Johnson 892 F.2d 1328 (1989), the chairman of the board had more shares than he wanted and he resold some to a new investor to make some money. The court ultimately held that there was no public offering because the chairman had provided the buyer with sufficient disclosures about the company. Thus, the chairman was found not to be an underwriter, and the transaction was entitled to the exemption provided in Section 4(1).

The rule that emerged is that a founder or other affiliate is entitled to resell under Section 4(1) as long as he ensures that the sale takes the form of a 4(2) private placement, including the disclosure that an investor would expect if he bought directly from the issuer. In the secondary literature, such a transaction is referred to as falling under Section 4(1½). It really isn’t a 4(2) private placement, nor is it a 4(1) resale. It falls somewhere in between.

Of course, the affiliate would also need to follow all the other steps that I discussed in my recent post on this topic. As to disclosure, that customarily takes the form of an offering memorandum, but a good investor slide deck, a set of comprehensive risk factors and recent financial statements might do as well.

What if the issuer won’t cooperate with the founder? How is the founder supposed to pull a disclosure packet together without help from the company? Well if the founder truly can’t get the company to do what he wants, then he probably isn’t in control of the company, and if he’s not in control of the company, he isn’t really an affiliate. Good luck convincing counsel for the buyer of that.

Note: Until recently, Section 4(a)(1) of the Securities Act was referred to as Section 4(1). Likewise, Section 4(a)(2) was referred to as Section 4(2). I’m using the old nomenclature here so that the term “Section 4(1½)” can be understood in context.

John A. Myer is a corporate and securities lawyer with Myer Law PLLC in Seattle, Washington.   This posting does not constitute legal advice.