A Private Stock Resale Exemption for Founders and Affiliates is Finally Codified as Section 4(a)(7)

In a post last year, I discussed that up till now Congress had neglected to provide an exemption from registration for resales of stock in a private corporation by a founder or other person affiliated with (or in control of) that corporation.  Of course that didn’t stop these resales from taking place, and in the inevitably ensuing litigation judges crafted an exemption referred to as “Section 4(1½)”.  In these cases, courts decided that founders or other affiliates are entitled to resell under Section 4(1) as long as they ensure that the sales take the form of 4(2) private placements, including the disclosure that an investor would expect if he bought directly from the issuer. 

[Note: In the 1990s, various subsections of the Securities Act were re-designated to ensure consistency in numbering throughout the statute. As a result, Section 4(1) is now referred to as Section 4(a)(1) and Section 4(2) is now referred to as Section 4(a)(2).  Since we will be talking about statutes and not old court cases, I’m switching to the current nomenclature for the remainder of this post.]

In my earlier post I asked what happens if the issuer doesn’t cooperate with the affiliate or founder who wants to sell some of his stock. Perhaps the board decides that they want to raise money for the corporation, and the founder ought to wait a few more years before he tries to sell stock.   Fine and good, but if the founder nevertheless finds an interested buyer, how can he pull a disclosure packet together without help from management?

On December 4, 2015, a new provision was added to the Securities Act that may help.  Under Section 4(a)(7) resales of private company securities that meet certain requirements are exempt from registration under the Securities Act and pre-empt the registration or qualification requirements of state “blue-sky” law.  The securities will remain restricted, which means that the buyer can’t sell them to another person without reference to an exemption.  Presumably, however, the buyer won’t be affiliated with the issuer and thus can readily sell under Section 4(a)(1), Rule 144 or even Section 4(a)(7) itself.

Under Section 4(a)(7), the seller may not publicly solicit for buyers and he can only sell to accredited investors.  The seller will have to provide the buyer with certain information, including the issuer’s most recent balance sheet and income statement.  If the seller is a control person, he will also need to certify that he has no reasonable grounds to believe the issuer is in violation of US securities law.

In many ways, Section 4(a)(7) will be easier to comply with than Section 4(a)(1) and 4(a)(2). Because the seller is not charged with adhering to the standards of a Section 4(a)(2) private placement, he will not be required to limit the number of offerees.  Because the seller is not charged with adhering to the standards of a Section 4(a)(1) resale, he will not have to worry about exercising reasonable care that the buyers are acquiring for investment purposes and not acting as brokers or underwriters for others to buy from them.  In addition, Section 4(a)(1) is harder to comply with because it does not pre-empt state securities laws and the parties will need to find a state law exemption in the buyer’s state.  

Therefore, I believe that this new exemption will be quite useful to founders and other affiliates seeking to resell stock and that Section 4(a)(7) may well all but replace the judicially crafted doctrine of “Section 4(1½)”.  Further, there is reason to use Section 4(a)(7) rather Section 4(a)(1) in sales by persons not affiliated or no longer affiliated with the issuer.  Because these sellers are not affiliated with the issuer, they won’t have to certify that they have no reasonable grounds to believe the issuer is in violation of US securities law.  If these non-affiliated sellers have access to current financial reports (and many issuers are contractually required to share such information with their shareholders), complying with Section 4(a)(7) in a sale to an accredited investor would seem easier than selling under Section 4(a)(1). Under Section 4(a)(1), the parties would need to establish the investment intent by the buyer and find an exemption under state law (which might involve the seller having to retain counsel in the state of the buyer).  Under Section 4(a)(7), state “blue sky” laws are pre-empted. Further, many of the buyers of start-up corporation stock are Venture Capital firms, and these are of course accredited.  

Section 4(a)(7) may have a bright future indeed.

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