Duties of Affiliates of Fully-Reporting Issuers

New directors and executive officers of public companies are often dismayed at the number of rules and regulations to which their new status has subjected them.  Since corporate management is frequently not well-versed in the intricacies of federal securities law, it is incumbent on securities counsel to advise new directors and officers of their new responsibilities as early in the process as possible.  The following is a memorandum that we have provided to new management and Board members to help them understand these duties.   The information below is a general summary and is not intended to address any specific situation in which any affiliate of a fully-reporting may find himself or herself.  We urge our clients to seek advice of securities counsel with respect to any specific transaction or event that may implicate any of the duties below so that they may determine the best course of action for their own circumstances.


            For purposes of this memorandum I am using the Securities and Exchange Commission’s (the “Commission’s”) Rule 405 definition of an “affiliate” as “a person that directly, or indirectly through one or more intermediaries, controls or is controlled by, or is under common control with” an issuer, and this is the same definition set forth in Rule 144(a)(1) of the Commission.  As a practical matter, directors, executive officers and the beneficial owners of 10 percent or more of an issuer’s voting securities have long been presumed to be affiliates of such issuers, and the analysis below will also rely on that presumption.  Beneficial ownership includes shares held by close family members such as spouses as well as shares owned by trusts, corporations and other entities controlled by the affiliate.

             For purposes hereof, I will treat all issuers with securities registered under Section 12(b) or Section 12(g) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), as “fully-reporting issuers.” 

            “Affiliate” status with respect to a fully-reporting issuer raises four principal types of obligations:  (i) Commission reporting obligations, both by the affiliate and by the issuer; (ii) avoidance of short-swing profits; (iii) avoidance of trading on inside information (this obligation applies to all participants in the public securities markets, not just to affiliates); and (iv) restrictions on the ability to transfer securities of such issuers.

Reporting Obligations

            Becoming an affiliate of a fully-reporting issuer will trigger several reporting obligations with the Commission:

  • Disclosure of the affiliate’s beneficial ownership of the issuer’s securities in the “Security Ownership of Certain Beneficial Owners and Management” section of the issuer’s Form 10-K Annual Reports and any registration statements filed with the Commission;
  • Section 16(a) of the Exchange Act requires directors, executive officers and 10 percent stockholders of fully-reporting issuers to file a Form 3 Initial Statement of Beneficial Ownership of Securities within 10 days of the event by which they achieve such status.  Form 3 requires the disclosure, among other things, of the number of the issuer’s securities held by the affiliate, either directly or indirectly, and is filed with the Commission electronically;
  • Section 16(a) also requires such affiliates to file electronically a Form 4 Statement of Changes of Beneficial Ownership of Securities within two business days of the date of any transaction resulting in a change of the affiliate’s direct or indirect beneficial ownership of the issuer’s securities;
  • A Form 5 Annual Statement of Beneficial Ownership of Securities must be electronically filed with the Commission no later than 45 days after the end of the issuer’s fiscal year to report certain transactions that are not otherwise reportable on Form 4.  These include, for example, certain transactions that are exempt from Section 16(b) of the Exchange Act and acquisitions not exceeding $10,000 in any six-month period.

            These Section 16(a) filings also require disclosure of ownership, and changes in ownership, of derivative securities such as warrants, options and convertible securities.  For issuers that maintain a corporate website, Rule 16a-3(k) requires that each Form 3, 4 or 5 that is filed with the Commission must also be posted on the corporate website for one year.

            In order to ensure timely filing of these Section 16 reports, affiliates of fully-reporting issuers should contact their securities counsel well in advance of any event that may trigger the filing of such a report.  This is particularly true when there are changes in the affiliate’s beneficial ownership of securities, so that counsel may determine whether a

Form 4 or a Form 5 must be filed.  Since Section 16 forms are filed electronically, the reporting person must also allow sufficient time to obtain the Commission codes that are necessary for electronic filing.  One week is a reasonable estimate of the time required to get these codes.  Timely filing of Section 16 forms is doubly important because any late Section 16(a) filings must be disclosed in the issuer’s next Annual Report on Form 10-K and in its next proxy statement.

            In addition to the foregoing filing requirements, Regulation 13D-G of the Commission requires the filing of a Schedule 13D within 10 days of any event by which a person acquires, directly or indirectly, beneficial ownership of more than five percent of a class of a fully-reporting issuer’s equity securities.  If the securities were acquired in the ordinary course of business and not with the purpose or effect of changing or influencing the control of the issuer, the acquiring person may instead file a Schedule 13G within 45 days of the end of the calendar year in which he or she made the triggering acquisition.  As with the Section 16 forms discussed above, it is strongly recommended that any person who may be making such an acquisition contact securities counsel well in advance of the transaction so that counsel can determine which Schedule must be filed and ensure its timely preparation and filing.

Short-swing Profits

            Section 16(b) of the Exchange Act prohibits directors, officers and 10 percent stockholders of a fully-reporting issuer from profiting on any purchase and subsequent sale, or sale and subsequent purchase, of the issuer’s securities in any six-month period.  Any profit made is subject to disgorgement to the issuer, and the calculation of profit is meant to ensure the largest profit possible; i.e., the lowest purchase price will be matched against the highest sales price.  Transactions by an insider may also be matched with transactions by a spouse and private transactions may be matched with public transactions for purposes of determining Section 16(b) liability.  Short-swing profits are a strict liability violation; the intent of the offending party is irrelevant.

            Due to the broad definition of short-swing profits and the potential for significant monetary penalties, it is important that affiliates of fully-reporting issuers consult with securities counsel before engaging in any transaction that may possibly trigger Section 16(b) liability.

Insider Trading

            Short-swing profits liability is premised on the idea that affiliates of an issuer have access to material corporate information that is not available to the public and that they should not be permitted to profit from that information.  However, compliance with the short-swing profits rules does not ensure that an affiliate will escape liability for insider trading under Section 10(b) of the Securities Act and Rules 10b-5 and 10b5-1 of the Commission.  For insiders who plan to engage in public resales of their issuer’s securities, it is advisable to adopt a so-called “10b5-1 plan” in advance of such sales.  A

10b5-1 plan sets out the parameters for the affiliate’s broker to make sales over a period of time (typically up to two years) without any input from the affiliate.  Orderly sales under a duly-adopted 10b5-1 plan will help the affiliate to limit the risk of liability for insider trading since such sales are:  (i) planned out and executed well in advance of material developments that may affect the stock price at the time of sale; and (ii) beyond the discretion of the seller.

Transfers of Securities

            Several factors will affect an affiliate’s ability to transfer an issuer’s securities.  In cases where the securities are registered on an effective registration statement, all sales must be made in compliance with the requirements of the registration statement and prospectus.  Most of these requirements will usually be set forth under the heading “Selling Stockholders” of the final prospectus. 

            Unlike relatively straightforward sales under an effective registration statement, affiliates’ public or private resales of unregistered securities raise numerous potential issues.  The law relating to such resales is summarized below.

            Public resales of restricted securities.  Rule 144 will govern most affiliates’ public resales of “restricted” securities.   Affiliates are barred from selling restricted securities of reporting issuers for a period of six months.  Once six months have elapsed from the acquisition date, affiliates may make Rule 144 sales subject to the following restrictions:

  • The issuer must have “current public information,” meaning that it has filed all Section 13 reports (i.e., annual reports on Form 10-K and quarterly reports on Form 10-Q) during the preceding 12 months, including the submission of every Interactive Data File that is required to be submitted with these reports;
  • During any three month period, affiliates of an issuer may not sell any securities, restricted or unrestricted, if such sales exceed the greater of:  (i) one percent of the number of outstanding shares of such class of security as shown by the most recent report or statement published by the issuer; or (ii) the average weekly reported trading volume of such security during the four calendar weeks preceding the filing of the affiliate’s Form 144 (see below) or, if no Form 144 is required, the date of the broker’s receipt of the order to execute the transaction or the date of execution of the transaction directly with a market maker;
  • All sales must be made in broker’s transactions and the seller must not solicit or arrange for the solicitation of orders to buy the securities in anticipation of such sales.  The seller is also prohibited from making any payment in connection with the offer or sale of the securities to any person other than the broker or dealer executing the order to sell the securities.
  • If the amount of securities to be sold in any three-month period exceeds 5,000 shares or they have an aggregate sales price in excess of $50,000, the seller must file a Form 144 with the Commission no later than the date that the sales order is placed with the selling broker.

            Rule 144(a)(3) includes “[s]ecurities acquired directly or indirectly from . . . an affiliate of the issuer, in a transaction or chain of transactions not involving any public offering” within the definition of “restricted securities.”  Therefore, an acquiror of unregistered securities from an affiliate of the issuer will not be able to “tack” his or her holding period to the affiliate’s holding period for purposes of the Rule 144 six-month holding period but will need to establish his or her own holding period.  Any person who acquires securities from an affiliate in these types of transactions will need to:  (i) resell only pursuant to an effective registration statement; or (ii) obtain an opinion of counsel as to the availability of Rule 144 or the Section 4(a)(1) exemption as discussed below in order to resell these securities.

            It is also important to remember the additional restrictions that Rule 144 imposes on sales of restricted securities of former “shell companies” (i.e., issuers with no or nominal operations and no or nominal non-cash assets).  Rule 144 flatly prohibits such sales at any time that an issuer is deemed to be a shell company.  For former shell companies, Rule 144 sales are permitted only if the issuer is a reporting issuer and has filed all of its periodic reports during the preceding 12 months.  In addition, one year must have elapsed since the filing of “Form 10 information” reflecting the issuer’s status as a non-shell company.

            By its own terms, Rule 144 is a non-exclusive safe harbor for resales under the registration exemption provided by Section 4(a)(1) of the Securities Act.  According to the Preliminary Note to Rule 144 “[a] person who does not meet all of the applicable conditions of Rule 144 may still claim any other available exemption under the [Securities] Act for the sale of the securities,” and in most such cases sellers will rely on the statutory Section 4(a)(1) exemption for resales by persons other than issuers, underwriters or dealers.  The Preliminary Note’s use of the broad term “person” in this context would seem to suggest that Section 4(a)(1) may be available for resales by affiliates in certain cases.  However, in 2006 the Second Circuit Court of Appeals opined that selling affiliates face a “substantial burden of proof” in establishing the availability of the statutory exemption for their resales.  See SEC v. Cavanagh, 445 F.3d 105, 114, Fed. Sec. L. Rep. (CCH) Paragraph 93741 (2d Cir. 2006).  The Commission has also taken the position that the Section 4(a)(1) exemption is not available for the resale of securities of an issuer that is or was a “shell company” by directors, executive officers, promoters or founders or their transferees.  See NASD Regulation, Inc., CCH Federal Securities Law Reporter, 1990-2000 Decisions, Paragraph No. 77,861 (the so-called “Worm-Wulff Letter”).  As a result, many law firms, including the Burningham Law Group, will not render Section 4(a)(1) opinions for resales of restricted securities by affiliates. 

            Private resales of restricted and unrestricted securities.  Securities regulators and practitioners have long recognized that private resales of securities are exempt from registration, although neither Congress nor the Commission has promulgated any specific statute or regulation formalizing this exemption.  The authorities have instead acknowledged the so-called “Section 4(a)(1-1/2)” exemption, which combines Section 4(a)(1)’s exemption for sales by non-underwriters (including the interpretation that Section 4(a)(1) requires that the seller has held the securities for a sufficiently long time to rebut any presumption that they were not acquired with investment intent) with Section

4(a)(2)’s exemption for “transactions by an issuer not involving any public offering.”  Because resales of securities by stockholders are clearly not “transactions by an issuer,” Section 4(a)(2) is not a precise fit for such transactions and securities practitioners have had to muddle through with the non-statutory “Section 4(a)(1-1/2)” exemption for many years.

            This unsatisfactory situation ended in December, 2015, with the passage of the FAST Act.  This statute formalized the Section 4(a)(1-1/2) exemption by adding new Sections 4(a)(7) and 4(d) to the Securities Act.  According to the statute, compliance with these new provisions will ensure that the transferred securities will be deemed to have been acquired in a transaction that:  (i) does not constitute a public offering; and (ii) is not a public distribution as defined in Section 2(a)(11) of the Securities Act.  It is important to note that all securities acquired from an affiliate in a Section 4(a)(1-1/2) or Section 4(a)(7) transaction will be deemed to be restricted securities and that the acquiror will need to:  (i) resell the shares pursuant to an effective registration statement; or (ii) obtain an opinion of counsel that an available exemption will permit the removal of the restrictive legend on the subject securities.        

            The Section 4(a)(7) exemption contains the following additional requirements applicable to private resales of securities of fully-reporting issuers:

  • The purchaser is an “accredited investor” as defined in Rule 501(a) of the Commission;
  • The securities are not sold through any general solicitation or advertising;
  • The issuer must not be the seller of the security in question, either directly or indirectly;
  • Neither the seller nor anyone receiving a commission for the sale of the securities is subject to the “bad actor” disqualifications of Rule 506(d)(1) or the statutory disqualification described in Section 3(a)(39) of the Exchange Act;
  • The issuer must be engaged in business, is not in the organizational stage or in bankruptcy or receivership, and is not a blank check, blind pool or shell company;
  • The securities being sold are not either all or part of an unsold allotment to, or a subscription by a broker or dealer as an underwriter in the securities or a redistribution; and
  • The class of securities in question has been authorized and outstanding for at least 90 days prior to the date of the transaction.

            As stated above, the foregoing is only a summary of the duties of affiliates of fully-reporting issuers.  Please contact securities counsel with respect to your own particular circumstances.