Where a founder of a publicly traded company pledged unregistered, “control securities” to a bank to collateralize a personal loan, if the bank foreclosed on the control securities, would it be required to comply with the Securities Exchange Commission’s Rule 144 (17 C.F.R. § 230.144)? 
- The facts of the transaction
In one of the cases handled by Sidkoff, Pincus & Green P.C., a client I will call “Mr. Founder,” retained forty percent of the shares of his company (“COMPANY”) when it had its initial public offering (“IPO”). As is customary, his shares were not registered with the SEC and were not part of the IPO, thus making them untradeable on the NASDAQ where the COMPANY was listed. Mr. Founder then borrowed $50 million from a bank (“THE BANK”) and pledges his unregistered shares in the COMPANY as collateral for the loan. The loan documents stated that if the share price dropped below $5, the bank could seize the pledged shares. Due to a computerized trading glitch, the stock market crashed, and the shares of the COMPANY, which had always traded at over $10, had a brief few minutes where they (along with almost all other shares being traded the stock market that day) reached a new low when it’s shares traded at $4.25. Later in the day, the shares recovered somewhat, and closed at $7.12. When THE BANK sought to exercise its rights to foreclose on the collateral, Mr. Founder asked us to help. We began to negotiate a new loan with the loan specialist at THE BANK to replace the loan where it had called in the collateral. One thing was evident: a new loan would need to avoid an automatic call of the collateral if there was a temporary drop in the price. In discussions, we learned that the THE BANK’s lawyers had convinced it that a trigger price to call the collateral was needed because the shares were not tradeable because the lawyers were convinced the shares were restricted, and after THE BANK seized them, it would be required to comply with SEC Rule 144 (17 C.F.R. § 230.144).. We disagreed and presented the following argument in an effort to persuade the bank that once it obtained the shares, they would not be subject to Rule 144, and could be traded freely. Therefore, we argued, the trigger price was not necessary to protect THE BANK.
- Analysis of whether pledged shares are considered control shares after foreclosure
As adopted and interpreted by the Securities Exchange Commission, Rule 144 is concerned with the distribution of restricted securities, both in private companies and companies that have stock that is publicly traded. While the issue here is the application of Rule 144 to the COMPANY shares pledged to THE BANK, Rule 144 was actually designed to provide a method for a CEO of a public company who obtained his shares from a source other than buying them on a stock exchange or through a stockbroker (such as in an IPO) to sell their shares. The scheme of Rule 144 allows the CEO to sell his shares without being considered an “underwriter”, a term broadly defined by the Securities Act of 1933 (15 U.S.C. § 77a et seq. Section 2(11)) to include one who “has purchased from an issuer [or from one who controls an issuer] with a view to … the distribution of any security” as well as one who “sells for an issuer [or for one who controls an issuer].” Id. at § 77b (11) (which generally means a person or entity involved in the market for a security and its distribution). Under § 5 of the Securities Act of 1933 (15 U.S.C., at § 77), an underwriter must comply with the requirement of registering the stock under the Securities Act of 1933, and essentially pursue an IPO or secondary offering. While Rule 144 generally treats an “issuer” (i.e., COMPANY) as if it were an underwriter, it provides a path for the issuer’s CEO to dribble out a small amount of the stock in the first six months (the “holding period” established under Rule 144(b) for listed companies). However, Rule 144 establishes hurdles and limitations on when, and how many shares can be sold; and also what kind of notice of the sale must be filed with the SEC to inform the public of the intended sale. Rule 144 focuses on the words “restricted security” and its definition is broad. For purposes of Rule 144, and as is pertinent here, an “affiliate” of an issuer is defined as “a person that directly, or indirectly controls the issuer.”
In the hypothetical sale (not the actual pledge situation), because the CEO is the founder and president of COMPANY, he would be deemed by Rule 144 to be an affiliate of COMPANY, and subject to Rule 144. (See, 17 C.F.R. § 230.144). Further, the shares that the CEO were deemed “control securities” (See the definition of “person” at § 230.144 (3) (a) (2).) In other words, using a hypothetical sale scenario for purposes of analyzing what the typical and anticipated Rule 144 case looks like, the CEO’s shares would be viewed as control securities. If there had been no pledge of these shares to THE BANK, and if the CEO proposed to sell the shares, Rule 144 would oblige the CEO to file papers with the SEC, at a minimum, to comply with the public information and notice of sale requirements of Rule 144(c). That notice would state that the shares satisfied the holding period of Rule 144(b), and otherwise meet all of the other requirements of Rule 144 (i.e., COMPANY has filed its reports with the SEC, and trades robustly on NASDAQ). The shares could then be sold in accordance with volume requirements of Rule 144.
- Under the better legal authority, Rule 144 does not apply to the COMPANY shares pledged to THE BANK once they are seized
With these definitions and interpretations of the various SEC rules in mind, we now turn to the unique circumstances here that distinguish this case. The most critical fact in this case is that the shares have been pledged as collateral, not sold to THE BANK; and if THE BANK should have the need to foreclose on them and then resell them, THE BANK would not be an “affiliate” of COMPANY, and would not be subject to the SEC Rules. Furthermore, it would be almost impossible for THE BANK to attempt to obtain approval under Rule 144 for the sale of the COMPANY shares when it took the collateral, before there was a default, and to also satisfy Rule 144(i) since it would require that THE BANK have a bona fide intention to sell within a reasonable time. The awkwardness demonstrates why THE BANK would not be deemed reasonably to be subject to Rule 144.
Hence, on its face, THE BANK, by accepting as collateral, shares in COMPANY, does not fit the definition of “underwriter” as set forth in the Securities Act of 1933, 15 U.S.C. § 77a et seq. which defines “underwriter” broadly to include one who “has purchased from an issuer [or from one who controls an issuer] with a view to … the distribution of any security” as well as one who “sells for an issuer [or for one who controls an issuer].” Id. at § 77b(11) (Emphasis added). Section 4 of the Act creates a number of exemptions from this general rule. Id. § 77d. The exemption in Section 4(1) exempts “transactions by any person other than an issuer, underwriter, or dealer.” Id. § 77d(1). As noted, an underwriter is defined in relevant part in Section 2(a)(11) as “any person who has purchased from an issuer with a view to, or offers or sells for an issuer in connection with, the distribution of any security, or participates or has a direct or indirect participation in any such undertaking, or participates or has a participation in the direct or indirect underwriting of any such undertaking.” Id. § 77b(a)(11). For purposes of the underwriter definition only, an issuer includes any person controlling, controlled by, or under common control with the issuer of the securities. Id. In light of the purpose of the Act, exemptions generally are to be interpreted to promote full disclosure of information necessary to protect the investing public. SEC v. Ralston Purina Co., 346 U.S. 119, 124-25 (1953). None of these factors or the reasoning, applies to THE BANK, which had no interest in purchasing COMPANY shares from COMPANY to help sell the shares in connection with the distribution of the shares.
There is considerable legal support holding that a pledgee such as THE BANK, that took a pledge of restricted shares as collateral for a loan, and might have to sell that collateral at a foreclosure sale, would not be an underwriter. A.D.M. Corp. v. Thompson, 707 F.2d 25, 26-27 (1st Cir. 1983). In A.D.M., the Court held that the bank had a direct and separate economic interest in the restricted, control shares from the interest of the borrowers; and that it was not an underwriter since it did not directly or indirectly participate in the distribution of the asset. See, Rule 144(d)(3)(iv) and (e)(3)(ii); SEC Release No. 33–6099 (August 2, 1979), Q.49 (SEC treated estate as separate from its beneficiaries for purposes of determining the volume limitation). While recognizing a contrary view in the dicta of SEC v. Guild Films Co., 279 F.2d 485, 489-90 (2d Cir. 1950), the Court was persuaded by the criticism of the position taken there, citing Fox v. Glickman Corp., 253 F. Supp. 1005, 1011-12 (S.D.N.Y. 1966) as well as the leading experts whose treatises on securities law was then, and still is, found by courts to be persuasive: 1 L. Loss, Securities Regulation 645-51 (2d ed. 1961); 11 H. Sowards, Business Organizations, § 4.01[b] & [c]. See, also, Getz v. Cent. Bank of Greencastle, 147 Ind. App. 356 (1970).
It likewise has been the position of the SEC for many years that a bank in the shoes of THE BANK is not obliged to comply with the requirements of filing a prospectus or obtaining an exemption under Rule 144 when accepting unregistered or controlled shares as collateral for a loan; and there are numerous SEC staff, “no-action letters” declining to bring enforcement actions in scenarios where banks and creditors took as collateral unregistered securities, and then sought to seize and sell the shares but were not considered to be underwriters. See, Russell Ranch, SEC No-Action Letter, 1995 WL 476256 (Aug. 11, 1995); Angelo K. Tsakopoulos, SEC No-Action Letter, 1993 WL 31695 (Feb. 5, 1993); Sec. Pac. Bank Ariz., SEC No-Action Letter, 1992 WL 159159 (June 26, 1992); Albuquerque Fed. Sav. & Loan Ass’n., SEC No-Action Letter, 1987 WL 108519 (Oct. 26, 1987); Harbor Properties Inc., SEC No-Action Letter, 1983 WL 28691 (Sept. 22, 1983); In the Matter of Otc Live, Inc. & Mark A. Suleymanov, SEC No-Action Letter, Release No. 261 (Sept. 30, 2004).
In each of these cases, a bank or other creditor sought to seize unregistered or otherwise restricted shares and to then resell the shares to satisfy the debt for which the shares provided security. In each case the Court or the SEC found that a creditor does not fit the definition of an “underwriter” on the one hand, and on the other, there was no policy gain to distort the language of the SEC Rules to transform the creditor into an underwriter. The gist of these holdings and SEC-No Action Letters was that the banks, accepted the unregistered, restricted stock as collateral for loans. If a bank foreclosed on the collateral, it seeks to mitigate its loss on the loan through sale of the collateral. The bank never intended to participate in a public distribution of unregistered securities, thus differentiating a bank from an underwriter.
Accordingly, when we presented the weight of the authority and our view that it compelled the conclusion that the COMPANY shares pledged by the FLP would not be Rule 144 shares (as that term is commonly used) if they were seized, loan was renegotiated with terms that were favorable to our client.
For more information, call our Philadelphia business lawyers at 215-574-0600 or contact us online.
 Obviously, Rule 144 applies to owners of shares in addition to those who are the CEO of an issuer; but because the CEO’s issue was what we dealt with, we will use his status in this discussion for the sake of clarity.
 Although it is not a term defined in Rule 144, “control securities” is used commonly to refer to securities held by an affiliate of the issue regardless of how the affiliate acquired the securities. See, REVISIONS TO RULES 144 AND 145 Release No. 8869 FILE S7-11-07 December 6, 2007.