summary
Control & Restricted
Stock: More Flexible
Than Ever?
Start out with this basic understanding: It is unlawful for a company (also known as the “issuer”), or anyone acting on
behalf of an issuer (also known as an “underwriter”), to sell shares to the public without first registering the shares with the SEC or finding an exemption from registration. Now focus on the underwriter: Anyone who could be an underwriter risks “underwriter’s liability” if he or she sells unregistered shares to the public, meaning that person could face fines, private
lawsuits — even jail. Who could be an under-writer? Unfortunately, anyone who acquires shares directly from an issuer or from another
underwriter of the issuer (called “restricted shares”), and anyone who is in a position to control the issuer (also known as an “affiliate”) holding “control shares” could be an underwriter. So, you can see that the key to being able to sell your restricted or control shares without fear of underwriter’s liability is to be sure you can’t ever be considered an underwriter in the first place.
Rule 144 is the principal “safe harbor” for sales of control or restricted securities. As long as you comply with Rule 144’s provisions, the SEC assures that you will not be considered an underwriter. Of course, if you are not an underwriter, you can sell your
Yes, the world of control and restricted
securities tends to get a bit technical,
but it's not as hard as you think.
Most restricted
and control
stock is held
by corporate
executives who
have a few other
things to think
about as well.
shares without fear of underwriter’s liability. With Rule 144’s protection, you can treat control and restricted shares almost as you would any other shares. You just have to make sure to follow the Rule.
Most restricted and control stock is held by corporate executives who have a few other things to think about as well. Some corporate executives must report their stock transactions to the SEC, for example, those deemed Section 16 “insiders.” Company trading policies may further limit their ability to sell or otherwise deal with their company shares. If these additional issues apply to you, then you have to take them into account to manage your employer stock positions safely.
question and answer
Q. Do you own control stock? That depends on who you are.
A. “Control stock” is very different from restricted stock. Control stock is considered to be any stock of an is-suer held by a “control person” (also known as an “affiliate”) of the issuer, even if purchased on the open market. So, who’s a “control person”? Any-one who directly or indirectly controls
the actions of a corporation is a con-trol person or affiliate of that issuer. While there is no hard and fast rule, directors, executive officers or oth-ers who own a high percentage of the company’s outstanding shares typi-cally fit the bill. The issuer’s counsel usually makes the final determina-tion as to who is a control person or affiliate of the issuer. Spouses and cer-tain family members of affiliates are treated as affiliates as well.
The key to understanding control stock is that unlike restricted stock, it doesn’t matter how the affiliate acquired the stock. Again, even if an
affiliate buys his company’s shares on the open market, those shares instantly become control shares just because the affiliate is a control per-son. Typically, affiliates end up with control stock as compensation for ser-vices rendered, or upon the exercise of stock options. Control stock can also be “restricted stock.” For example, if an affiliate acquired the stock from the company in an unregistered sale, it is both restricted and control stock.
Don’t forget restrictions based on company policies.
Company trading policies are anoth-er factor to considanoth-er when managing company stock that you own. Many companies have restrictions on trad-ing by “key employees” who may be neither affiliates nor Section 16 “in-siders,” but may have access to infor-mation about the company that isn’t public. (See definition of an “insider” on next page.) Some examples of key employees are high-ranking managers or the CEO’s assistant. Their ability to sell shares may be monitored by the company. Your company may also have a policy against pledging com-pany stock for a margin loan. If it does, then you can’t do it even if the SEC is fine with it and even if Morgan Stanley Smith Barney were otherwise willing to make the loan. Also, if your com-pany’s insider trading policy allows you to sell shares only during open trading windows, then you can only sell during those periods regardless of other considerations.
Q. So what can you do?
A. You still have several alternatives for managing your restricted and con-trol stock holdings and concentrated positions, including the possibility of generating cash from your stock, di-versifying those holdings or
transfer-Q. Do you own restricted
stock? That depends on how
you acquired the securities.
A. In general, any stock you acquired
from an issuer or an affiliate of an issuer
in a transaction that wasn’t registered
with the SEC is considered to be
“restricted stock.” Shareholders typically
get restricted stock through a private
sale or as compensation for services.
Stock certificates representing restricted
stock will usually (but not always) have
a “legend” stamped on them warning
that the stock is not registered and
may not be sold publicly unless it is
registered under applicable federal and
state securities laws, or is exempt from
such requirements.
writer if you sell restricted or control stock to the public, but that Rule 144 provides a safe harbor against being considered an underwriter. That makes Rule 144 the safest and most common way for holders of restricted and control shares to sell their shares. You get the Rule 144 protections simply by follow-ing the provisions of the Rule: If you are holding restricted stock, you must have held it for at least one year (or six months if the issuer is a “reporting company” that is current in its SEC fil-ings). If you are also an affiliate, then: (i) you can only sell if the issuer has current public information available at the time of sale; (ii) you can only sell a maximum number of shares based upon the Rule’s volume limitations; (iii) your sale must be made by your broker in a manner permitted by the Rule, and: (iv) you must file a Form 144 with the SEC if you exceed certain threshold amounts.
Selling under SEC Rule 145: If you were an affiliate of a company that was a party to a registered (under an S-4 registration statement) merger, acquisition or business combination involving a “shell” company (other than one created just to facilitate the transaction), SEC Rule 145 may provide a safe harbor against under-writer liability for sales as early as 90 days after the issuer ceases to be a shell company. Rule 145 cannot be re-lied on by affiliates of the issuer at the time of sale; they should instead use Rule 144. Also, Rule 145 is not needed if the merger parties were both
oper-affiliate of either party at the time of the merger — those shares are fully registered by the S-4 and can be sold without restrictions.
Sales under SEC Rule 701: Compa-nies that are not publicly traded are typically exempt from the SEC’s fi-nancial reporting requirements. Often, these companies grant stock options to employees before they go public as part of the employees’ compensation. These options may be exercised and the shares sold 90 days after the com-pany goes public, subject to some of the
Sales under an S-3: One obvious way to avoid selling unregistered shares is to have the sales registered. Of course, this can only be done by the issuer and not the individual. But, the S-3 form registration (SB-2 for smaller compa-nies), also known as a “shelf registra-tion,” allows holders of restricted stock to sell registered shares without having to rely on an exemption to registration or the “safe harbor” of Rule 144. Sales Upon Exercise of Executive
Stock Options:Stock options give
ex-ecutives the right to purchase company
question and answer
An option writer may be assigned at any time during the life of the option, including the day written, regardless of the in- or out-of-the-money status of the position.
If the short call is assigned, the writer must deliver the under-lying security.
The writer of a covered call forgoes the oppor-tunity to benefit from an increase in the value of the underlying security above the option strike price, but continues to bear the risk of a decline in the value of the un-derlying security.
Buying back a call to close an existing position and writing another call with a different strike price and/or expiration, also known as rolling, can have an adverse im-pact on the profitability of the account. Rolling may result in added, transaction costs, which can reduce returns or add to any losses. Note: It may not be prudent to continually roll posi-tions at a loss.
If a secondary market in options becomes un-available and prevents a closing transaction, the options writer's obligation would remain until expiration or assignment.
The sale of the stock through an option assignment or the closing/expiration of an option position may produce a tax conse-quence. Please consult with your Tax Advisor prior into entering any transactions.
Covered Call Risks
1
2
3
taxes without paying for them out-of-pocket. Shares issued under stock op-tion plans are usually registered for sale under an S-8 registration statement. However, affiliates cannot sell their option shares under an S-8 registra-tion statement, so they will generally still have to sell under the provisions of Rule 144 (except for the holding period requirement), to be safe from potential underwriter liability,
and of course they must sell during an open trading window and otherwise be in compliance with company policies.
Sales through
10b5-1 Trading Plans: These are plans ad-opted by corporate insiders, affiliates and key employees during open
trad-ing windows, when they are not in possession of inside information. The plans allow you to trade your com-pany stock or exercise your stock op-tions according to a pre-established trading schedule, which can extend into and through closed window pe-riods. Trading plans provide you with an affirmative defense against
allega-10b5-1 plans, blind trusts provide a defense against perceptions of self-dealing or insider trading. However, unlike a 10b5-1 plan, a blind trust is managed by an independent trustee, who is given discretion to buy and sell shares without your input or even knowledge. To preserve independence, the trustee will sell shares without pro-viding any details of the sale, other than
as may be necessary to file tax returns and comply with applicable securi-ties laws. Hedging Transac-tions: Derivative transactions such as prepaid forward sales and equity collars combine features of sales or loans with various put and call op-tions to give an investor liquidity or a regular cash flow from a restricted or concentrated stock position, while at the same time providing downside protection (but often limited upside potential), and sometimes a deferral of income taxes. Equity collars are not available to affiliates.1
1 Option Disclosures: Options are not
rights and obligations and be aware of the risks involved, including, without limitation, the risks pertaining to the business and financial condition of the issuer of the underlying security or in-strument. Options investing, like other forms of investing, involves tax con-siderations, and transaction costs that can significantly affect the profit and loss of buying and writing options. The transaction costs of options investing primarily of commissions (which are imposed in the opening, closing, exer-cise and assignment transactions), but may also include exchange fees in par-ticular transactions. Transaction costs are especially significant in option strategies calling for multiple purchase and sales of options, such as multiple leg strategies, including spreads (in-cluding rolling), straddles and collars. A copy of the Option Disclosure Document can be found at the follow-ing website: http://www.theocc.com/ about/publications/character-risks.jsp
Borrowing Against Restricted or
Control Stock Positions:Morgan Stanley
Smith Barney is one of the leaders in lending against restricted and control stock and concentrated stock posi-tions. These are generally structured as “margin” loans, and they can be ei-ther “purpose” or “non-purpose” loans.
You may decide to
establish an Irrevocable
Trust, Limited
Partnership or Limited
Liability Company
and fund it with your
restricted stock as
a wealth transfer
question and answer
for purchasing securities. But, you can use purpose loans for buying securities as well as to pay taxes, finance a home, free up cash for investing in other as-sets, or merely to increase your liquid-ity and cash flow.2
2 Margin can be very risky, and is not suitable for all investors. Before open-ing an account, you should fully under-stand the risks associated with margin. These risks include: You can lose more money than invested (deposited), you may have to deposit additional cash or marginable securities on short no-tice to cover market losses, you may be forced to sell some or all securities when there is a decline in account eq-uity value, some or all of your securi-ties may be sold without prior notice in order to maintain account equity at required maintenance levels, You are not entitled to choose which securi-ties or other assets in your account(s)
are liquidated or sold to meet margin call, The firm can increase its “house” maintenance margin requirements at any time and is, not required to provide you advance written notice, and you are not entitled to an extension of time on a margin call.
Exchange Funds: An exchange
fund offers diversification and tax-sensitive management to executives with significant positions in a single company stock. Contributions of ap-preciated stock to a properly struc-tured exchange fund are generally tax deferred, not avoided, under current federal tax law. Clients should discuss such strategies with their tax advisor before entering into such arrangement. Fund assumes investor’s tax cost ba-sis in contributed stock and investor’s cost basis in fund shares equals basis of contributed stock. In a complete re-demption of fund shares, basis in fund
shares is transferred to distributed stocks. Many lenders accept shares in exchange funds as loan collateral. Note that exchange funds provide no protec-tion in a market decline, are illiquid and may involve high expenses.
Using Your Shares To
Transfer Wealth
The gift tax rules allow you to transfer a certain amount each year to as many individuals as you wish free of gift tax (the “annual exclusion”). This can help with tax planning and with your estate planning and philanthropic goals.
Giving it to Family Members:
Indi-viduals are allowed to transfer a certain amount each year free of gift tax (the “annual exclusion”). You may gift re-stricted stock to anyone you choose in an amount equal to this annual exclu-sion ($13,000 per person, per recipi-ent in 2010). If the holding period has been met prior to the gift (generally 6 months or one year), the recipient, the recipient will not be considered an underwriter even without complying with Rule 144 (unless the recipient is himself an “affiliate” of the issuer). The gift may trigger reporting obligations under Section 16 if you’re an affiliate of the company.
Transfer Shares to an Irrevocable Trust, Family Limited Partnership or Limited Liability Company: You may decide to establish an Irrevocable Trust, Limited Partnership or Lim-ited Liability Company and fund it
An exchange fund offers
transfer of assets assumed to have potential for significant apprecia-tion to a grantor retained annuity trust (“GRAT”) is a common wealth transfer technique. You, as the grant-or, may transfer restricted or control stock to a GRAT and receive annual annuity payments for the term of the GRAT. Any stock remaining at the end of the GRAT’s term is distributed to the beneficiary named in the GRAT free of gift tax.
Giving Shares to a Private
Fam-ily Foundation: Restricted or Control
Stock may also be transferred to private family foundations set up to advance family philanthropic goals. Regardless of the donor’s status, the foundation will not be considered an affiliate and will not be subject to Section 16 rules, but should sell under Rule 144 if the shares are restricted and the donor has not met the holding period set forth under Rule 144.
Giving Shares to Charity: Many char-ities and other nonprofit organizations accept donations of restricted stock. A gift of restricted stock could qualify for an immediate charitable income tax de-duction based on the fair market value of the stock on the date of the gift. And do-nating it would allow the donor to avoid paying capital gains on any appreciation in the shares. As with other donees, the charity will tack on to donor's holding period and can sell the stock once the holding period has been met.
Giving Shares to a Charitable Trust:
stock to a Charitable Remainder Trust (“CRT”) allows you, as the donor, to contribute assets to the CRT, receive an immediate income tax deduction, and receive annual payments for the term of the trust (generally your life or a number of years not to exceed 20). At the end of the trust’s term, any remaining as-sets go to the charitable beneficiary named in the trust. If you are an af-filiate, and are also the Trustee of the CRT, then the CRT will also be considered an affiliate. Similarly, the transfer of control or restricted stock to a Charitable Lead Trust (“CLTs”) allows you, as the donor, to gift as-sets to a CLT in which a charity or charities receive annual payments
beneficiaries named in the trust (gener-ally your family members or trusts for their benefit) receive any assets remain-ing at the end of the trust term. Depend-ing upon how the trust is structured you may or may not receive an income de-duction for your contribution of stock to the CLT. At the end of the trust’s term, any remaining assets go to the named noncharitable beneficiaries, generally the donor’s family members or trusts for their benefit.
Sales of Restricted Stock by Estates:
Restricted stock may end up in a de-cedent’s estate. The estate might be considered an affiliate in certain cir-cumstances and if so, sales should comply with Rule 144. Otherwise, estates are generally free to sell their