Legal Opinions on Section 4(1½) Resale Transactions

I. Introduction

This report addresses legal opinions regarding the resale of securities conducted in reliance on the so-called “Section 4(1½)” exemption from the registration requirements of the Securities Act of 1933, as amended (the “Securities Act”). The Section 4(1½) exemption, which does not appear in the Securities Act, has been developed by applying some of the elements of Section 4(a)(2) of the Securities Act to the exemption provided by Section 4(a)(1) of the Securities Act.

Section 5 of the Securities Act requires offers and sales of securities to be registered with the Securities and Exchange Commission (“SEC”) unless an exemption from registration is available. Section 4(a)(2) exempts from registration offers and sales of securities by issuers in transactions “not involving a public offering” (i.e., private offerings). Section 4(a)(1) exempts resales of securities “by any person other than an issuer, underwriter, or dealer.”

Today, many unregistered resales are conducted pursuant to Securities Act Rule 144. Under Rule 144, a person who resells securities in compliance with its conditions is deemed not to be engaged in a “distribution” of securities and, therefore, not to be an “underwriter” for purposes of the Section 4(a)(1) exemption. Rule 144 permits resales by non-affiliates of “restricted securities” that have been held for at least six months if the issuer has been subject to the reporting requirements of the Securities Exchange Act of 1934, as amended (the “Exchange Act”) and is current in its reports or for at least one year in all other cases. Importantly, Rule 144 also permits resales of securities by affiliates, subject to compliance with holding period, volume and manner of sale limitations, and Form 144 filing requirements. The availability of the Rule 144 safe harbor has significantly reduced the need for resales apart from Rule 144.

Rule 144 is not, however, the only exemption available for unregistered resales of securities. In addition to other exemptions provided in the Securities Act and SEC rules, holders of restricted securities and affiliates also may rely on the Section 4(1½) exemption. Although not expressly provided in the Securities Act or an SEC rule, Section 4(1½) “‘allows … private sales of securities … so long as some of the established criteria for sales under both Section 4(1) and Section 4(2) of the [Securities] Act are satisfied.’” The challenge presented by the Section 4(1½) exemption—as reflected in this quotation—is knowing which and how many of, as well as the extent to which, these “established criteria” will need to be satisfied in any particular case.

The Subcommittee has issued this report to assist lawyers in preparing Section 4(1½) opinions. This report first discusses the statutory and analytical basis for the Section 4(1½) exemption. It then discusses legal issues that commonly arise with respect to compliance with the exemption and related matters for counsel to consider in connection with the preparation of a Section 4(1½) opinion. Included in this report is an illustrative form of opinion that may be used as a starting point in drafting a Section 4(1½) opinion, as well as illustrative forms of supporting holder and purchaser certificates.

II. Statutory and Analytical Basis for Section 4(1½)

The SEC has not issued any guidelines for the use of the Section 4(1½) exemption, apart from no-action letters issued by the Division of Corporation Finance prior to the adoption of Rule 144 in 1972, and judicial opinions and administrative decisions discussing the exemption are infrequent and sometimes contradictory in their legal analysis.

By its terms, Section 4(a)(2) is available only to an “issuer,” which Section 2(a)(4) of the Securities Act defines as a “person who issues or proposes to issue any security.” Accordingly, while Section 4(a)(2) principles inform the analysis, the Section 4(1½) exemption is grounded in the exemption from registration provided by Section 4(a)(1). As noted above, Section 4(a)(1) provides an exemption from registration for “transactions by any person other than an issuer, underwriter, or dealer.” Given that a holder of securities is not an “issuer,” and assuming that the holder is not a “dealer,” the availability of a Section 4(a)(1) exemption turns on the question of whether the holder will be treated as an “underwriter,” as defined in Section 2(a)(11) of the Securities Act.

Section 2(a)(11) defines an “underwriter” as a holder who acquires securities from an issuer (or, through the definition of “issuer” for purposes of that section, from an affiliate) with a “view to … distribution” or who sells securities “for an issuer in connection with [a] distribution.” To determine the existence of a distribution under Section 2(a)(11), courts and commentators have long turned to Section 4(a)(2) jurisprudence, which treats a distribution as substantially equivalent to a public offering. As a result, the analysis of whether a holder is an underwriter for purposes of the Section 4(a)(1) exemption “necessarily entails an inquiry into whether the transaction involves a public offering.”

If a holder of restricted securities or an affiliate cannot resell its securities pursuant to another exemption from registration and its resale is not registered, then its resale must take on certain elements of a private offering under Section 4(a)(2). This is because, if the applicable elements of Section 4(a)(2) are satisfied, then the resale will not constitute a public offering and this, in turn, will mean that the resale will not be part of a distribution and the holder will not be an “underwriter.” Therefore, the resale will be eligible for the exemption provided by Section 4(a)(1) by way of Section 4(a)(2)—in other words, Section 4(1½).

III. Legal Issues Arising Under Section 4(1½) and Opinion Considerations

A. Not Engaged in a “Distribution”

The critical inquiry in determining the availability of the Section 4(1½) exemption is whether the holder is engaged in a “distribution.” As noted above, a distribution is effectively synonymous with a “public offering,” the existence of which has been analyzed by the courts in accordance with the U.S. Supreme Court’s decision in Ralston Purina, which focused on “the needs of the offerees for the protections afforded by registration.” Accordingly, a holder’s resale to purchasers who can “fend for themselves” without registration is a relevant factor in establishing that a transaction does not involve a “public offering.” In evaluating this factor, courts typically look to the type of information about the issuer made available to a purchaser and attributes or qualifications of a purchaser that suggest its sophistication and its ability to gain access to and evaluate information about the issuer.

The ABA Private Placement Report suggests that the following four factors be used by lawyers and the courts in determining the availability of the Section 4(a)(2) exemption:

1. Manner of offering—how the purchasers of the particular securities offered are found —whether through a public process (e.g., general solicitation, advertising, seminars, etc.) or a non-public process.
2. Eligibility of the purchasers—whether each purchaser (not all offerees), either alone or with a qualified adviser, has such knowledge and experience in financial and business matters as to be capable of evaluating the merits and risks of the prospective investment.
3. Information—whether each purchaser (or its qualified adviser) receives, or has meaningful access to, such information as that purchaser needs to make an informed investment decision.
4. Resales—whether steps appropriate in the circumstances are taken to prevent resales that are not registered or exempt from registration.

The following subsections discuss the third and fourth factors noted above and other considerations relevant to the availability of the Section 4(1½) exemption.

B. Availability of Information

Because the holder is not an issuer or in the same position as an issuer to provide information, the information requirements of Section 4(a)(2) do not apply to the same extent to the Section 4(1½) exemption. The extent to which such information requirements do apply will depend on a number of factors. Some factors bearing consideration include:

• Whether the issuer of the securities is a reporting company under the Exchange Act and is current in its reporting obligations. If the issuer is not a reporting company, whether sufficient information about the issuer is nonetheless publicly available.
• Whether the relationship of the holder to the issuer of the securities provides the holder with access to information about the issuer that the holder is permitted to share with the purchaser (for example, an affiliate of the issuer, such as a director or officer, may have access to information about the issuer that it is permitted to share).
• Whether the holder, even if it does not have ongoing access to information about the issuer, has received information from the issuer in connection with its purchase of the securities that is still current and that it is permitted to share with the purchaser.
• Whether the purchaser is a sophisticated investor and is willing to purchase the securities without receiving information about the issuer from the holder.

What information needs to be provided for the Section 4(1½) exemption to be available will depend on the totality of the circumstances. In many cases, a holder will be able to rely on the Section 4(1½) exemption without having to provide the purchaser information about the issuer. A holder and, in giving a legal opinion, its counsel will usually be able to rely on a purchaser’s representation as to its ‎status as a sophisticated investor and the adequacy of the information it has received or has access to for its decision to purchase the securities. ‎

C. Restrictions on Further Resale

Obtaining appropriate representations and imposing transfer restrictions, such as restrictive legends on stock certificates, will help a holder meet its burden of “establishing that [its] sales do not constitute a disguised public distribution.” The representations and transfer restrictions used by an issuer in a private offering relying on the Section 4(a)(2) exemption may provide a model for a holder to use in a Section 4(1½) resale.

D. Initial Issuance and Prior Resales

Because “individual investors who are not professionals in the securities business also may be ‘underwriters’ if they act as links in a chain of transactions through which securities move from an issuer to the public”—in other words, are links in a distribution—the circumstances surrounding the initial issuance of the securities by the issuer and any resales of the securities before their acquisition by the current holder can be relevant to the availability of the Section 4(1½) exemption for resales by the current holder. Their relevance primarily turns on whether the initial issuance and any subsequent resales, taken together, can be viewed as being “connected” to each other as part of a “scheme” or “plan” to distribute the securities publicly. For this reason, counsel opining on the availability of the Section 4(1½) exemption ordinarily should seek information from the client regarding the circumstances surrounding the client’s acquisition of the securities.

IV. Form of Section 4(1½) Opinion and Related Certificates

A. Form of Legal Opinion

Following receipt of satisfactory confirmations as to the factual matters set forth below (as appropriate under the circumstances) and in reliance on those confirmations, counsel may deliver an opinion such as the following:

Based on such matters of law as we have considered appropriate and, as to matters of fact, Certificates of Holder and Purchaser, we are of the opinion that the offer and sale of the Securities by Holder do not require registration under the Securities Act.

B. Form of Holder Certificate

Given the importance of establishing the factual “requirements” for a Section 4(1½) exemption as a basis for the opinion, counsel should seek certificates from the holder of the securities and the purchaser of the securities confirming the facts that form the basis for the opinion. Counsel may use the following language as a starting point in drafting a certificate from the holder, tailored as appropriate to the applicable facts:

Holder hereby represents as follows:

1. Holder understands that the offer and sale of the Securities to Purchaser has not been registered under the Securities Act by reason of an exemption from the Securities Act’s registration requirements and that the availability of that exemption depends, among other things, on the accuracy of the representations in this certificate.
2. The offer and sale of the Securities to Purchaser is not being effected for, on behalf of or in concert with the Issuer or any other person.
3. Holder has not offered or sold the Securities pursuant to any form of general solicitation or general advertising.
4. Immediately prior to making the offer of the Securities to the Purchaser and as of the date of this certificate, Holder had and has reasonable grounds to believe, and did and does believe, that Purchaser is an “accredited investor” as defined in Rule 501(a) of Regulation D under the Securities Act or a “qualified institutional buyer” as defined in Rule 144A under the Securities Act.
5. Holder has made available to Purchaser all material information about the Issuer within Holder’s possession or to which it has access.

C. Form of Purchaser Certificate

Counsel may use the following language as a starting point in drafting a certificate from the purchaser, tailored as appropriate to the applicable facts.

Purchaser hereby represents as follows:

1. Purchaser understands that the offer and sale of Securities have not been registered under the Securities Act by reason of an exemption from the Securities Act’s registration requirements and that the availability of that exemption depends, among other things, on the accuracy of the representations in this certificate.
2. Purchaser is an “accredited investor” as defined in Rule 501(a) of Regulation D under the Securities Act or a “qualified institutional buyer” as defined in Rule 144A under the Securities Act.
3. Purchaser understands that the Securities are “restricted securities” as that term is defined in Rule 144 under the Securities Act.
4. Purchaser has no present intention to resell the Securities, and Purchaser will not resell or otherwise transfer the Securities except pursuant to an exemption from the registration requirements of the Securities Act or in a transaction registered under the Securities Act.
5. Purchaser is able to bear the economic risk of an investment in the Securities and has sufficient financial resources to incur and sustain a loss of a portion or all of its investment in the Securities without economic hardship.
6. Purchaser has received or has access to information about the Issuer that it considers sufficient to make an informed investment decision.