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Rule 144 – a Deep Dive – Part 2 – Definitions

Rule 144 Definitions

Rule 144 only has four definitions, but there is a lot to discuss on each of these definitions.

Affiliate

Rule 144 sets forth different conditions for sellers that are “affiliates” or a person that has been an affiliate in the past 90 days then for those that are non-affiliates.  Sales by affiliates always require that a company have current public information, are subject to volume limitations (the drip rules), are subject to manner of sale requirements (sales must be made through a broker-dealer) and require the filing of a Form 144.  Sales by non-affiliates only require current public information when effectuated after six months but prior to a one year holding period and are never subject to the volume limitations, manner of sale requirements, or the filing of a Form 144.  Accordingly, determination of affiliate status, including when such status begins and ends, has a significant impact on the proper use of Rule 144.

Rule 144 defines an “affiliate” of an issuer as a person that directly, or indirectly through one or more intermediaries, controls, or is controlled by, or is under common control with, such issuer.  The definition of an affiliate is so complex and important in the context of securities laws that back in 2023, I wrote a three-part blog on the subject (see https://securities-law-blog.com/2023/08/08/who-is-an-affiliate-and-why-does-it-matter-part-1/?hilite=affiliate; https://securities-law-blog.com/2023/08/15/who-is-an-affiliate-and-why-does-it-matter-primary-vs-secondary-offering/?hilite=affiliate; and https://securities-law-blog.com/2023/08/22/who-is-an-affiliate-and-why-does-it-matter-exchange-act-determining-filer-status/?hilite=affiliate.) 

What constitutes “control” or “common control” has been the subject of numerous judicial decisions, SEC no-action letters, comment letter responses and practitioner discussions.  The SEC and the judicial decisions have consistently taken the position that the determination of “control” status is dependent in large part on the facts and circumstances involved and, therefore, has declined to state definitively what circumstances will result in a person being deemed to be in “control” of an issuer.

The clearest indication of “control” is where a person or group owns a simple majority of the outstanding voting shares of a corporation.  Share ownership of less than 51% may also be sufficient to establish that a person or group is in control of an issuer.  In United States v. Wolfson, the court found that a corporation’s largest individual stockholder was in “control” where, in conjunction with his family and “right-hand man,” he owned over 40% of the outstanding shares.

Over the years, 10% ownership has become a standard rule of thumb as an indicia of control, at least partially because a 10% or greater shareholder is subject to the reporting and short swing prohibition rules under Exchange Act Section 16.  However, again, the analysis is one of facts and circumstances.  Generally, case law and SEC no-action letters have found that a person was not in control, despite owning in excess of 10%, where they could not exercise control because another group or groups owned more than that amount or when other ownership groups supported management.

Practitioners generally count executive officers and directors as control persons and thus affiliates, but that is not the law.  Several cases have found that being an officer or director may certainly be a factor in determining control but is not dispositive of the issue.  Moreover, in response to a direct inquiry from a company as to whether a person’s status as an officer or director, without more, was enough to establish control for purposes of Rule 144, the SEC stated, “a person’s status as an officer, director, or owner of 10% of the voting securities of a company is not necessarily determinative of whether such person is a control person or member of a controlling group of persons. His status as an officer, director or 10% shareholder is one fact which must be taken into consideration, but, as you recognize, an individual’s status as a control person or as a member of a controlling group is still a factual question which must be determined by considering other relevant facts in accordance with the test set forth in Rule 405 under the Act.” (American Standard SEC No Action Letter).

Control resulting from other less formal relationships is even trickier to determine and can be based on familial, business or even social ties.  Courts and the SEC have been consistent that a person that is part of a group who collectively has the ability directly or indirectly to affect a company’s management or policies are each individually control persons as well. In Pennaluna & Co. v. SEC., the court found that it was not necessary to be a shareholder at all to be a control person where relationships with the company or other shareholders result in factual control.  A control group can be completely informal, rather only requiring that they act together and in concert for a common purpose.

Although all facts and circumstances should be reviewed, the following factors should be analyzed in evaluation “control” and thus affiliation:

  • Share ownership, including whether others have greater ownership or access to greater ownership through convertible securities.
  • The effect of any re-sales or planned new issuances.
  • Officer/director or similar positions with the company.
  • Voting control – voting control also includes the ability to influence other shareholder votes, to act as a group, to secure proxies, the effect of abstention on quorum, etc.
  • Substantial business relationships with the company – for example, control has been found where one company was the source of 70% of another company’s revenues.
  • Familial or social relationships with officers, directors or key shareholders.
  • Debtor and credit relationships – such as being a major creditor with the ability to foreclose on assets.
  • Original incorporator or founder.
  • The intent of a shareholder as evidenced by the filing of either a Schedule 13G (passive investor) or 13D and if 13D, reported efforts to exercise control (for more on Schedule 13D and 13G, see my two part blog series here https://securities-law-blog.com/2024/02/13/section-13-beneficial-shareholder-reporting-requirements-part-1/?hilite=section+13 and https://securities-law-blog.com/2024/02/20/section-13-beneficial-shareholder-reporting-requirements-part-ii/?hilite=section+13). 
  • Whether a person has sought to consult on management activities of the company or otherwise makes efforts to assert control and the results of those efforts.

With that as a backdrop, in one comment letter process, the company successfully argued that a 35% owner was not an affiliate for purposes of calculating the company’s public float for determining full shelf S-3 eligibility.  In another case, a company successfully argued that a 30% shareholder was not an affiliate for purposes of being named an underwriter in a re-sale registration statement.

Person

Rule 144 defines a “person” to include the actual person for whose account securities will be sold in reliance on Rule 144, and in addition to that person, to also include: (i) any relative or spouse of such person, or any relative of such spouse, any one of whom has the same home as such person; (ii) any trust or estate in which such person or any of the persons specified in (i) collectively own 10% or more of the total beneficial interest or of which any of such persons serve as trustee, executor or in any similar capacity; and (iii) any corporation or other organization (other than the issuer) in which such person or any of the persons specified in (i) are the beneficial owners collectively of 10% or more of any class of equity securities or 10% or more of the equity interest.  

Accordingly, if a person is deemed an affiliate, each of these persons and entities would also be an affiliate.

Restricted Securities

Rule 144 is only applicable for the sale of restricted (or control/affiliate) securities.  The term “restricted securities” means:

(i) Securities acquired directly or indirectly from the issuer, or from an affiliate of the issuer (keeping in mind the definition of a “person” above in determining affiliation), in a transaction or chain of transactions not involving a public offering;
(ii) Securities acquired from the issuer in a Regulation D offering;
(iii) Securities acquired from the issuer in a Rule 701 issuance (i.e. under written compensatory benefit plans) (for more on Rule 701 see https://securities-law-blog.com/2018/08/28/sec-amends-rule-701-and-issues-a-concept-release-on-rule-701-and-form-s-8-part-i/?hilite=Rule+701 and https://securities-law-blog.com/2018/09/04/sec-amends-rule-701-and-issues-a-concept-release-on-rule-701-and-form-s-8-part-ii/?hilite=Rule+701);
(iv) Securities acquired in a Rule 144A transaction (restricted securities sold to a qualified institutional buyer in the U.S.)
(v) Securities acquired from the issuer in a Rule 1001 transaction (not often used rule for a California specific private placement transaction);
(vi) Equity securities of a U.S. (domestic) company acquired in a transaction or chain of transactions under Regulation S;
(vii) Securities issued in a Rule 801 rights offering by a foreign private issuer – for more on Rule 801 see https://securities-law-blog.com/2024/10/15/foreign-private-issuers-sec-registration-and-reporting-and-nasdaq-corporate-governance-part-2/;
(viii) Securities issued in a Rule 802 tender offer by a foreign private issuer – for more on Rule 802 see https://securities-law-blog.com/2024/10/15/foreign-private-issuers-sec-registration-and-reporting-and-nasdaq-corporate-governance-part-2/; and
(ix) Securities acquired from the issuer in a Section 4(a)(5) (not often used offering to accredited investors) – for more on Section 4(a)(5) see https://securities-law-blog.com/2021/09/21/consequences-of-failing-to-file-a-form-d/?hilite=section+4%28a%29%285%29.

Securities that are registered are not restricted securities, even if the selling stockholder is an underwriter (though they would need to be named as an underwriter in the registration statement).  However, registered securities may be “control securities.”  Where registered securities, such as securities purchased in the open market, are sold or transferred by an affiliate, the recipient receives restricted securities.  However, if those securities are only restricted because they are “control” securities, the recipient would only have to satisfy the current information requirement under Rule 144 and not start a new holding period. 

Debt Securities

The definition of debt securities becomes important in the context of Rule 144 when determining holding periods as will be discussed in a future installment of this blog series.  In the meantime, Rule 144 defines “debt securities” to mean:

(i) Any securities other than an equity securities;
(ii) Non-participatory preferred stock, which is non-convertible capital stock, the holders of which are entitled to a preference in payment of dividends and distributions of assets upon liquidation, dissolution, or winding up of the company, but are not entitled to participate in residual earnings or assets of the company; and 
(iii) Asset-backed securities. 

We Help You Comply with Rule 144

At ANTHONY, LINDER & CACOMANOLIS, PLLC, we know the rules! Call us at 877-541-3263 or complete our contact form to set up an initial consultation today.