December 21, 2007

Lawyer Praises Shortened Holding Period

By Christopher Faille, Senior Financial Correspondent

WASHINGTON (HedgeWorld.com)— David Danovitch, a partner at the New York corporate finance law firm Gersten Savage, said the SEC's recent rule change shortening the holding period for restricted securities is a good thing.

Mr. Danovitch, who has been with Gersten for four years, acknowledged that there's some wariness about the rule, especially on the part of state securities officials. But he takes an optimistic view. "I'm not sure I agree with the states on this one. I think this is a good move for small companies, easing their access to the capital markets. You're taking the registration risk out of the equation."

The SEC adopted amendments to rule 144 in November Previous HedgeWorld Story, but the amendments weren't published in the Federal Register until last week, and they're due to go into effect in February—60 days after that publication.

Mr. Danovitch said that there will likely be observable consequences of the new rule soon after the holidays, when people come back from vacation and start thinking seriously about the changes and the possibilities it opens.

The new rule has been a matter of great interest to the alternative investments industry in that it might affect the valuation of private investments in public equities (PIPEs): increasing their value by reducing the "illiquidity discount" with the reduction of the mandatory holding period from one year to six months.

The Managed Funds Association, the International Swaps & Derivatives Association and the Securities Industry and Financial Markets Association all support the change. The three industry associations jointly filed a comment with the SEC praising the "potentially significant incremental liberalization," and discussing the important role that they see rule 144 playing in the U.S. capital markets, thus streamlined and simplified.

The wariness on the part of state securities officials comes about for a related reason. They're concerned that the greater ease with which companies can issue new stock will have a diluting effect upon the value of the shares held by existing shareholders.

A comment filed with the SEC by the North American Securities Administrators Association listed three major negative impacts, as the NASAA's members see it:

• The ease of private placement will encourage companies to use it more often, lessening the beneficial discipline and transparency of registration.
• Insiders who should stay in the management of the company and help build it may instead go for the quick cash-out, "or, at the least, [the amendment] will lower insiders' incentives to manage.
• Reducing the holding periods, and allowing unlimited sales to commence earlier than previous rules allowed, will accelerate the amount of shares coming to market, thereby potentially depressing the price of shares.

Mr. Danovitch is confident, on the other hand, that by increasing companies' flexibility, the rule will help companies grow, to the benefit of all investors.

As to the threat of an insiders' cash-out, he said that a crucial safeguard in that respect is that control people will still be required to file a Form 144 to report the proposed sale of any restricted stock. The market takes account of this information, and insiders who try for a quick cash-out may not get it, because "people are going to know what's going on."

One controversial aspect of the new rule is that it requires that the ticking of the clock on that six-month holding period is frozen (or "tolled,") when the holders of the restricted stock engage in certain hedging transactions. The MFA, the ISDA and the SIFMA objected to this tolling requirement in their joint comment.
"[M]arket participants are likely to have multiple, dynamic holdings, short and other derivative positions in individual issues that they would need to monitor (and analyze) on a daily basis for this specific purpose if tolling were to be reintroduced," the three associations said. This would impose significant costs and might chill the very flexibility that the shortening of the holding period should otherwise create.

Mr. Danovitch doesn't seem to share this concern. The point of the holding period, he said, whatever its length, is to assure that the buyer of stock has assumed some economic risk associated with that stock prior to selling it. "If you have a hedge on that position, then you haven't assumed the risk of the position—you're more like an underwriter."

The tolling requirement may continue to be a subject of controversy, he said, but the SEC is going to take its time before making any further change in that direction.

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