Understanding Restricted and Control Securities Growing Sales in the Post Great Recession Era Agenda

BUY-SIDE BLUEPRINT

Our Discussion Presenters

Bob Carney • SEC’s continuing crackdown on Chief Operating Officer unregistered issuances, and fraud American Stock Transfer & Trust Company, LLC

in the offerings David Becker Chief Compliance Officer • Overview of Securities Act of 1933 American Stock Transfer & Trust Company, LLC

• Original Issuance of Securities Merrill Stone Partner • Transfers Kelley Drye & Warren LLP • Legend Removal Carol Weiss Sherman (without immediate sale) Special Counsel • Legal opinions Kelley Drye & Warren LLP • What to Look For to Avoid Jill Fieldstein Principal Improper Transfers The Law office of Jill G. Fieldstein, PC

Restricted Securities: Securities acquired in unregistered, private sales from the issuer or from an affiliate of the issuer. Typically received through Regulation D offerings, employee stock benefit plans, or as compensation for professional services. • Restricted securities are subject to resale limitations. • They typically bear a “restrictive” legend clearly stating that you may not resell them in the public marketplace unless the sale is exempt from the SEC’s registration requirements.

Control Securities: Securities held by or on behalf of an affiliate of the issuer.

Who is an affiliate? Affiliate – a person that, directly or indirectly through one of more intermediaries, controls or is controlled by or is under common control with the issuer – usually an officer, director or large shareholder (rule of thumb = 10% holder).

JOBS ACT: SEC charged with writing rules to make it easier for small businesses to raise capital in private offerings.

• SEC Charges 34 Defendants in Microcap Market Manipulation Schemes.

• SEC Settles Civil Action Against Penny Stock Company, Its Former Chief Executive Officer, and Two Penny Stock Financiers for Their Roles in Illegal Unregistered Stock Distributions and Will Continue to Litigate with a Third Penny Stock Financier.

• SEC Charges Microcap Promoter with Illegally Selling Penny Stock Shares.

• SEC Charges Microcap Oil Company, CEO, and Stock Promoter With Defrauding Investors.

• SEC Charges Two Stock Promoters With Conducting Market Manipulation Schemes.

• SEC Announces Charges Against Attorneys and Auditors in Microcap Scheme Involving Purported Mining Companies.

Microcap Fraud includes:

• Pump and dump schemes involving the use of false or misleading statements to hype the stocks, which are then dumped at inflated prices; and

• Dump and dilute schemes, where companies repeatedly issues shares for the sole purpose of taking investors’ money and not because they are seeking capital to grow their company.

Regulators expect brokers to conduct a “searching inquiry” of large blocks of unregistered stock presented for resale

Must understand: • How the security was issued. • When the security was issued. • How the account holder obtained the security. • Has the account holder held the security for a sufficient period of time? • If control securities, are they trying to sell too large a percentage of securities? • Is the stock being heavily promoted?

• FINRA Fines Oppenheimer & Co., Inc. $1.4 Million for Sale of Unregistered Penny Stocks and Anti-Money Laundering Violations.

• FINRA Fines Brown Brothers Harriman A Record $8 Million for Substantial Anti- Money Laundering Compliance Failures.

• FINRA Expels Barron Moore and Takes Disciplinary Actions Against Seven Individuals for Illegal Sales of Unregistered Penny Stocks.

Transfer Agents as “Critical Gatekeepers"

SEC charged a transfer agent (TA) with enabling a microcap issuers’ unregistered distribution of billions of shares of unregistered and non- exempt securities.

• The TA ignored numerous red flags including the fact that the company’s CEO requested 54 share issuances in a two year period.

• Ignored that the legal opinions for each of the share issuances did not relate to the shares to be issued.

• The TA issued more than a billion unrestricted shares to the CEO even though the TA’s policies prohibited the firm from honoring requests from company officers to issue unrestricted shares to themselves.

• The TA settled with the SEC by paying a $100,000 fine and disgorging $25,000 in profits.

• 100+ year institution exited the industry and was acquired by a competitor.

Charged with fraud and engaging in an unlawful unregistered offering in relation to a pump and dump scheme.

• CEO issued press releases touting false projected earnings and purported business developments.

• On 54 occasions, CEO directed TA to issue large quantities of unrestricted shares of securities to himself and to others. – The shares were unregistered and required restrictions.

• Presented TA with attorney opinions letters that had nothing to do with the stocks being issued.

• Typically sold shares of the stock after issuing a false press release.

• Securities Act of 1933 or the “33 Act”

• Enacted May 27, 1933

• Shortly after crash of 1929 – President Franklin Roosevelt

• 1st Federal consumer protection statue related to securities • The Securities Act regulates offers and sales of securities in the United States or that use the means of interstate commerce, such as the internet, U.S. telephone lines or the U.S mail. For offerings to the public, the Securities Act generally requires the company to file a registration statement containing information about itself, the securities it is offering and the offering. It also sets conditions for exemptions from registration. 3 SECTIONS THAT MATTER Describes the types of SECURITIES that are statutorily exempt from the registration Section 3 requirements of the Act. Describes the types of TRANSACTIONS that are statutorily exempt from the registration Section 4 requirements of the Act. Section 5 Details the core PROHIBITIONS and requirements of the Act.

REGISTERED SECURITIES EXEMPT SECURITIES

• Issued via a registration • Not subject to registration statement filed with SEC

• Reviewed by and passed upon • The SEC does not review or pass by the SEC – ready to use when upon any offering materials SEC declares it effective

• Securities are not restricted upon • Securities are typically restricted issuance upon issuance • Securities will not need • Securities will need registration or registration or exemption exemption therefrom for therefrom for subsequent subsequent transactions transactions (generally)

REGISTRATION STATEMENTS EXEMPTIONS Registration Statements Exemptions

Form S-1 – catch-all general form Regulation D – private placements Form S-1 – catch-all general form Regulation D – private placements

FormForm S-3 S-3 – abbreviated,– abbreviated, issuer issuer and and Regulation A – limited private Regulation A – limited private placements transactiontransaction eligibility eligibility conditions conditions placements

Form S-8 – for employee benefit plans, Regulation S – sales outside of the U.S. including consultants (natural persons)

Bank and Government Securities Private Offering Exemption Mortgage transactions Short-term Notes & Other Debt Instruments (participating interests) Transactions by persons other than Issuers, Charitable Organizations Underwriters or Dealers Savings & Loan Associations Dealer Transactions (post distribution period) Railroad Equipment Trusts Broker Transactions (acting only as a broker)

Bankruptcy Small Issue (dollar amount) Exemption

Insurance Policies & Fixed Annuities

EXEMPT SECURITIES VS EXEMPT TRANSACTIONS If the security itself is exempted, it can be sold and resold without ever being subject to the registration requirements of Section 5 of the Act. If only the transaction is exempt, that transaction is not subject to the registration requirements of Section 5, but a later transaction involving the same security might be.

Exempts "transactions by an issuer not involving any public offering” from the registration requirements.

• § 4(a)(2) exemption focuses on “offerees” and not actual purchasers of the securities.

• Availability of §4(a)(2) exemption “should turn on whether the particular class of persons…need the protection of the [’33] Act” and whether the offerees “are shown to be able to fend for themselves.”

Regulation A Conditional small issues exemption Rules 251 - 263

Rules governing the limited offer and sale of securities without registration under the Securities Act. Regulation D Rules 501 – 508 Includes Rule 504, 505 and 506 covering different sizes of offerings.

Regulation S Rules governing offers and sales made outside the United Rules 901 – 905 States without registration under the Securities Act.

Regulation CE Coordinated exemptions for certain issuers of securities Rule 1001 exempt under state law.

Exemptions for American depositary receipts and certain Rule 12g3-2 foreign securities.

Most common safe harbor, relies on Rule 4(a)(2) exemption

Conditions to be met:

• Size – dollar value of offering depends on applicable rule

• Sufficient disclosure made available to offerees

• Investors must not “have a view to distribution” of the securities

• Investors must be sophisticated in order to make investment decision, either alone or with a purchaser representative – often accredited investors

• Securities are generally restricted upon issuance and legended

• No general solicitation, except under certain circumstances

Detailed instructions to transfer agent:

• Name of holder

• Number of securities

• Source of shares, if from a reserved pool (e.g., employee benefit plan)

• Date of issuance

• Requirements for the transfer agent – Board resolutions – Legal opinion

Registration:

• Provide Registration Statement number

• Indicate that it is effective

Exemption:

• Identify applicable exemption

• Indicate applicable restrictive legend

THE SHARES REPRESENTED HEREBY HAVE NOT BEEN REGISTERED UNDER THE SECURITIES ACT OF 1933, AS AMENDED (THE “ACT”), OR UNDER THE SECURITIES LAWS OF CERTAIN STATES. THESE SECURITIES MAY NOT BE OFFERED, SOLD OR OTHERWISE TRANSFERRED, PLEDGED OR HYPOTHECATED EXCEPT AS PERMITTED UNDER THE ACT AND APPLICABLE STATE SECURITIES LAWS PURSUANT TO REGISTRATION OR AN EXEMPTION THEREFROM. THE ISSUER OF THESE SECURITIES MAY REQUIRE AN OPINION OF COUNSEL REASONABLY SATISFACTORY TO THE ISSUER THAT SUCH OFFER, SALE OR TRANSFER, PLEDGE OR HYPOTHECATION OTHERWISE COMPLIES WITH THE ACT AND ANY APPLICABLE STATE SECURITIES LAWS.

THE SHARES REPRESENTED BY THIS CERTIFICATE ARE HELD BY AN AFFILIATE OF THE CORPORATION AND MAY NOT BE SOLD, TRANSFERRED OR OTHERWISE DISPOSED OF IN THE ABSENCE OF AN EFFECTIVE REGISTRATION STATEMENT FOR THE SHARES UNDER THE SECURITIES ACT OF 1933, AS AMENDED (THE "ACT"), OR THE CORPORATION HAS RECEIVED AN OPINION OF COUNSEL SATISFACTORY TO IT THAT THE SHARES MAY BE SOLD PURSUANT TO RULE 144 OR ANOTHER AVAILABLE EXEMPTION UNDER SUCH ACT AND THE RULES AND REGULATIONS THEREUNDER.

§ 8-204. EFFECT OF ISSUER‘S RESTRICTION ON TRANSFER. A restriction on transfer of a security imposed by the issuer, even if otherwise lawful, is ineffective against a person without knowledge of the restriction unless:

1. The security is certificated and the restriction is noted conspicuously on the security certificate; or

2. The security is uncertificated and the registered owner has been notified of the restriction.

• The issuer authorizes the issuance of multiple tranches of shares to the same investor

• Issuer fails to represent that the investor is not an affiliate

• Issuer directs transfer agent to issues shares in amounts that are just under the control amount

• Issuer directs transfer agent to issue unlegended shares

• Issuer represents that the stock is free trading pursuant to Rule 504 of Regulation D

• Issuer provides information indicating that a Regulation D investor is not accredited

• The substance or appearance of the legal opinion raises issues

• Large number of shares issued to insiders

Section 4(a)(1) of Securities Act:

• Exempts “transactions by any person other than an issuer, underwriter, or dealer” from the registration requirements.

• "Underwriter" is defined in section 2(a)(11) as any person who has purchased from an issuer with a view to the distribution of any security, or participates directly or indirectly in the distribution of the security.

• “Distribution” is not defined in the Securities Act, but case law indicates that it refers to “the entire process in a PUBLIC OFFERING through which a block of securities is dispersed and ultimately comes to rest in the hands of the investing public.”

Rule 144 under the Securities Act is most commonly used safe harbor to ensure transaction is not deemed to be a distribution by an underwriter; relies on Rule 4(a)(1) exemption.

Applies to resales of both restricted and control securities:

• Resales by affiliates of restricted or unrestricted securities (control shares)

• Resales by non-affiliates of restricted securities

Not available to shell companies.

CONDITIONS AFFILIATE NON-AFFILIATE

Holding Period 

Current Public After 6 months but Information  before one year

Volume Limitation 

Manner of Sale 

Notice of Proposed Sale – Form 144 

Unrestricted Securities (no legend): • If transferor is a non-affiliate, no legal opinion is needed

• If transferor is an affiliate, legal opinion is needed with either registration or exemption

Restricted Securities: • Legal opinion is needed whether transfer is registered or exempt and whether transferor is affiliate or non-affiliate

• If resale is pursuant to Rule 144, need these for legal opinion: – Seller’s representation letter (for any seller) – Broker’s representation letter (for sale by affiliate) – Form 144 (for sale by affiliate) – Copy of stock certificate to review legend(s) (for any seller)

• Holders want to have legends removed to facilitate future sales.

• Legends can only be removed if the holding period under Rule 144 has been met and no other conditions are required to be met. – Affiliates – legends cannot be removed (including during the three months after affiliate status ceases while Rule 144 conditions must still be met). – Non-affiliates – legends can be removed after the one year holding period has been met.

• Required documents for legend removal opinion: – Seller’s representation letter – Copy of stock certificate to review legend(s)

Should come from reputable counsel – typically issuer’s counsel • Issuer’s counsel is responsible for determining whether an exemption applies

When appropriate to come from other counsel: • Atypical sale situation, such as large investor selling down position

Legal opinion should include recitation of: • Issuer, class and number of security, stock certificate number, relationship of counsel to issuer • Facts of issuance, transfer or legend removal, as appropriate • Independent investigation made as to factual support of issuance/transfer circumstances • Registration statement number or exemption relied upon, as appropriate

• Opinion language should contain authorization for issuance, transfer, legend removal, as appropriate.

• Include special circumstances relevant to the specific transaction.

• Should indicate whether shares, upon issuance/transfer, are subject to further restrictions.

• Must have signature of actual attorney or law firm.

• Must be printed on letterhead.

• Should be addressed to transfer agent.

• Should be dated within 90 days of the date presented to transfer agent.

• Blanket opinions can be used to cover situations with multiple issuances or transfers. – Example: resales by various selling stockholders of restricted shares under an effective resale registration statement – Blanket opinions must be refreshed after one year

• Issuer authorizes the lifting of a restriction on an investor’s shares even though the company is or may be a shell company.

• Issuer represents that the investor is not an affiliate when there is contradictory public information.

• An affiliate holds unrestricted stock and gifts or sells that stock to a non-affiliate – restricted or unrestricted?

• A company issues S-8 shares to a consultant – restricted or unrestricted?

• A company issues stock pursuant to Rule 504 of Regulation D – restricted or unrestricted?

Q & A

• Securities Act http://www.sec.gov/about/laws/sa33.pdf

• Regulation D (Rules 501-508) http://www.ecfr.gov/cgi-bin/text-idx?node=sg17.3.230_1498.sg11

• SEC Fast Answers - Regulation D http://www.sec.gov/answers/regd.htm

• Rule 144 https://www.law.cornell.edu/cfr/text/17/230.144

• SEC Investor Publications - Rule 144: Selling Restricted and Control Securities http://www.sec.gov/investor/pubs/rule144.htm

Bob Carney Carol Weiss Sherman Chief Operating Officer Special Counsel American Stock Transfer & Trust Company, LLC Kelley Drye & Warren LLP 718.921.8215 212.808.5038 [email protected] [email protected]

David Becker Jill Fieldstein Chief Compliance Officer Principal American Stock Transfer & Trust Company, LLC The Law office of Jill G. Fieldstein, PC 718.921.8209 718.986.0922 [email protected] [email protected]

Merrill Stone Partner Kelley Drye & Warren LLP 212.808.7543 [email protected]

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