February 14, 2008

Law and Reg

Restricted stock eligible for trading

by Ron Orol in Washington

On Friday, Feb. 15, billions of dollars in restricted stock will become eligible for trading on the open market as new Securities and Exchange Commission rules take effect.

The commission in November eased restrictions on private placements and other restricted securities, which hedge fund managers and other institutional investors buy directly from corporations.

By one estimate, the new rules will put on the order of $35 billion in previously restricted shares on the market in one day, and many observers will see whether a flood of shares will hit the market at once.
At issue is the SEC's Rule 144, which permits sophisticated investors to bypass the public markets.

Hundreds of millions of dollars in restricted stock is issued annually, but until now holders of the shares have been prohibited from selling them for between one and two years.

But pressed by financiers and fueled by technology and globalization, the SEC is allowing investors to sell those securities as soon as six months after the placement. This step, securities lawyers, underwriters and hedge fund mangers generally agree, will drive additional investment to the capital markets by way of institutional investors.

"It provides greater flexibility to both investors and corporations," said David Danovitch, partner at Gersten Savage LLP in New York. "If I am an investor and I know that I can start selling a little bit of my investment commencing in six months rather than one year, I might get involved, and I might be willing to pay more."

Danovitch added that corporations, particularly smaller capitalization companies that use private placements more frequently, are enthusiastic about the prospect of added investment.

The SEC permits corporations to issue restricted stock only when they are current with regulatory filings, including quarterly and annual reports. The SEC reviews restricted stock deals to make sure corporations give a true picture of the company and the risks that come with investing there.

Until now, investors in private placements also have been limited in the amount of shares they could sell at one time. After one year, managers were able to sell every three months securities amounting to either 1% of the company's outstanding shares or as much as the average weekly trading volume during the four weeks prior to the sale. After two years, investors were able to sell the whole restricted stake. With the new rule, institutions with less than 10% stakes can sell all their securities after six months. The new regulation also eases restrictions on other transactions that fall under the purview of Rule 144, including warrants and private investments in public equities, or PIPEs.

According to Barry Silbert, CEO at Restricted Stock Partners in New York, any private placements sold or issued between Feb. 15 and Aug. 15 will become saleable on Friday. The SEC estimated that in 2006 roughly $71 billion in private placement and other restricted securities were sold under Rule 144. If the same number were sold in 2007, roughly half that amount, or $35 billion, could become available on Friday. Silbert, however, acknowledges that the stock market's poor performance of late could discourage fund managers from selling shares. Silbert discussed this scenario in a statement he issued this week where he asked, "What happens when billions of shares of unregistered stock become salable into the public market all on the same day?"

Silbert, who operates Restricted Securities Trading Network, an online marketplace for restricted securities, said he expects there to be downward pressure on the stock value of many companies on Friday as large amounts of stock becomes available for sale without a sufficient number of buyers.

Typically, hedge fund managers and other investors will agree to buy a private placement in a company at a price discounted to that day's share price. The discount is based on risks associated with the amount of time the investor must hold the shares.

Buzz Heidtke, president of Midsouth Investor Fund of Nashville, points out that cutting that time in half means investors will accept a smaller discount. "A holding period of six months, it helps us out quite a bit," said Heidtke, who manages a fund that has $135 million in assets under management. He expects that corporations will start issuing more private placements because of the changes.

The agency retained a six-month restriction to block small public companies from attempting so-called "backdoor public offerings." The agency does not want a corporation badly in need of money selling restricted stock to a large investor who would quickly resell the securities in an open-market transaction, acting as an underwriter or conduit to the average retail investors who need protections of disclosure requirements and SEC vetting of a public-market stock.

The agency considered but ultimately chose not to prohibit some risk-reducing strategies hedge fund managers often employ when buying private placements. To hedge risk from buying illiquid restricted securities, many hedge fund managers short stock of the same company on the open market. The agency considered limiting this strategy in 1997, suggesting that such short sales constituted the sale of the underlying restricted securities, but in the end decided not to block it.

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