On Dec. 22, 2020, the U.S. Securities and Exchange Commission (SEC) proposed rule changes that would require the mandatory six-month holding period under Rule 144 to begin at the time of conversion or exchange of a security rather than at the time the convertible or exchangeable security was originally acquired.
Under federal securities laws, a transaction in a security by “any person other than an issuer, underwriter or dealer” is exempt from the registration requirements of the Securities Act of 1933, as amended. Since 1972, the SEC’s Rule 144 provides a non-exclusive safe harbor from the statute’s definition of “underwriter” to assist security holders in determining whether the exemption is available to them. Without this, resellers of unregistered securities would be at risk of being determined to be engaged in a distribution of securities, and therefore, an underwriter involved in an unlawful, unregistered public offering.
To satisfy the requirements of Rule 144, holders must, among other things, hold the securities for a specified period of time before resale — namely, six months for securities of reporting issuers and 12 months for other issuers. In its proposed rule release, the SEC reiterated that this condition helps ensure that a holder who wants to use the exemption has assumed the full economic risks of an investment, and is thus not acting as a conduit on behalf of an issuer for the sale of unregistered securities to the public.
Under current Rule 144, holders may “tack,” or combine, the period of time that it holds a convertible or exchangeable security with the period of time that it holds the security issuable upon conversion or exchange. That is, the holding period effectively starts at the time the convertible security was issued. Most convertible securities have a fixed conversion formula, with mechanical adjustments to the ratio occurring only for events like stock splits, dividends or other distributions on the underlying securities. Variable-rate or market-adjustable securities, however, contain provisions that protect the holder against decreases in the market value of the underlying securities, often by permitting conversion of the principal amount (if a convertible note) into common stock through a formula that applies a discount to the trading price of the common stock at the time of conversion.
In its proposing release, the SEC states its belief that these provisions result in the holder not being subject to the economic risks of holding the security. Additionally, if the securities are converted or exchanged after the holding period is satisfied, the underlying securities, usually common stock, can be quickly sold at prices above the price at which they were acquired, giving holders an incentive to purchase variable-rate convertible securities with a view to distribution after conversion to capture the built-in spread between the discounted conversion price and market value of the underlying securities. In the SEC’s view, when a holder purchases with a view to distribution, it is acting as an underwriter and should therefore be unable to rely on the exemption for transactions not involving an issuer, underwriter or dealer. The SEC further stated that it is essential for the rules to assure that purchasers have assumed the economic risks of investment, and that holders of these types of securities are not bearing any economic risk prior to conversion.
This rule change would, if adopted, apply only to companies whose securities are not listed on a stock exchange and would not apply with respect to conventional fixed-rate convertible securities.
This proposed rule represents a hardening of the SEC’s position on variable-rate convertible securities. While the proposing release contained a balanced examination of the market for such securities, it has in past publicationsreferred to these securities as “death spiral” or “toxic” convertibles. Nevertheless, the SEC acknowledged that as a result of this rule, the costs of financing may increase and may result in a decrease in total access to financing for unlisted issuers, especially for financially distressed firms, other low- or no-revenue firms or those approaching bankruptcy. That is, the change in the holding period would reduce the liquidity of these securities, and thus their demand, potentially preventing some issuers from obtaining “last resort” financing.
The proposed rule will be open for comments for 60 days, and the SEC could determine to adopt the rule as proposed, adopt the rule with revisions or abandon the rule change altogether.
For additional guidance on the information in this alert, please contact any of the authors, any member of McGuireWoods’ securities complianceor securities enforcementteams, or your primary McGuireWoods contact.
McGuireWoods’securities and compliance teamassists private and public companies in capital raising efforts through private and public offerings, and also assists public companies with their reporting obligations under the Securities Exchange Act of 1934, including Forms 10-K, 10-Q and 8-K, Section 16 reports and DEF 14A (proxy statements), as well as with Regulation FD and Regulation G compliance. We prepare insider trading policies, develop training programs and assist with other aspects of securities transactions engaged in by company officers, directors and significant security holders, including 10b5-1 plans and Rule 144 compliance.
