United States: FAST Act Codifies The Rules For Secondary Private Placements

On December 4, 2015, President Obama signed the Fixing America's Surface Transportation Act (the "FAST Act") into law.  Primarily a transportation bill, the FAST Act also modifies several financial services laws.  Most significantly, it codifies the long-standing practice of conducting secondary private placements under the so-called "Section 4 1-1/2" exemption.  The new law became effective at signing and the Securities and Exchange Commission (the "Commission") has confirmed that the provisions concerning secondary private placements will not require any rulemaking.

Under Section 5 of the Securities Act of 1933 (the "Securities Act"), every offer and sale of a security is required to be registered, subject to the availability of an exemption.  Section 4(a)(2) exempts "transactions by an issuer not involving any public offering," which is the basis for private placements by issuers of their securities.  However, Section 4(a)(2) does not exempt private offers and sales by existing security holders, i.e. secondary private placements.

Ordinarily, a security holder may offer and sell its securities without registration in reliance on Section 4(a)(1), which exempts the offer and sale of a security by anyone other than an issuer, underwriter or dealer.  However, when the security holder is in a control relationship with the issuer, or when the security holder previously obtained the securities from the issuer in a private transaction, questions arise with respect to the availability of the Section 4(a)(1) exemption.  The Securities Act includes within the definition of "underwriter," "any person who has purchased [a security] from an issuer with a view to...the distribution of any security."  If the facts and circumstances surrounding a resale of a privately sold security suggest that the security holder initially purchased the security "with a view to distribution," the security holder may be deemed to be an underwriter and the resale may not be exempt under Section 4(a)(1).  

Over the years, practitioners have addressed this concern by constructing a common law exemption, generally referred to as the "Section 4 1-1/2 Exemption."  This exemption imposes upon secondary private placements most of the restrictions applicable to issuer private placements under Section 4(a)(2).  Today, most of the rules governing issuer private placements, also formulated at common law, are codified in Regulation D. 

The FAST Act has now codified the rules for secondary private placements in newly enacted Section 4(a)(7) of the Securities Act.  Section 4(a)(7) draws on Regulation D for the concept of an "accredited investor," but limits secondary private placements in their entirety to accredited investors.  In contrast, Regulation D allows, in limited circumstances, private sales by an issuer to unaccredited investors.  Section 4(a)(7) also prohibits general solicitation and advertising entirely, while Regulation D has recently been amended to permit general solicitation and advertising under limited circumstances.  Bad actors are disqualified from participation in private placements under both Section 4(a)(7) and Regulation D.

Section 4(a)(7) goes beyond Regulation D to impose further restrictions on secondary private placements.  Specifically:

1) There is an affirmative disclosure requirement to prospective investors, which will require the cooperation of the issuer;

2) Secondary private placements are limited to placements of securities of issuers that are engaged in a business and not in the organizational stage, in bankruptcy or receivership; a special purpose acquisition vehicle; or a blank check, blind pool or shell company that does not have a specific business plan or purpose;

3) There can be no secondary private placements of securities that are part of an unsold allotment to, or subscription or participation by, a broker or dealer as an underwriter of the securities or redistribution; and

4) The securities offered in secondary private placements must be part of a class that has been authorized and outstanding for 90 days.

Despite its similarities to Regulation D, Section 4(a)(7) is, in fact, fundamentally different.  Regulation D is a non-exclusive, safe harbor rule, promulgated under the broad provisions of Section 4(a)(2).  An issuer is free to conduct its private placement in reliance upon Section 4(a)(2), utilizing the common law guidance available prior to the adoption of Regulation D.  By contrast, Section 4(a)(7) is not a safe harbor rule—rather, it is a statute which purports to regulate secondary private placements. 

Whether a security holder whose proposed private resale does not fit under Section 4(a)(7) may still rely on the common law exemption known as Section 4 1-1/2, is an open-ended question.  There is no dispositive legislative history on point and the Commission has not addressed the question.  Before clarification is obtained, the prudent investor who wishes to resell unregistered securities will do so in reliance upon Rule 144¹ or Rule 144A².

Footnotes

1 Securities Act Rule 144 permits resales of eligible unregistered securities after certain holding periods have expired.

2 Securities Act Rule 144A permits resales of eligible unregistered securities to "qualified institutional buyers."

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.