Retail and Rule 144: Allowing US Non-Accredited Investment in your Offering

Private securities markets have always been an asset class that is restricted to the public investor. Historically, investors in these industries have performed much better than public markets, and the difference in these returns has been exacerbated in recent years, as private investors have forced swollen valuations on private companies to maximize their profit before attempting to shift these overvalued businesses onto the public balance sheet, leaving the retail investors with the losses. We’ve seen examples of this like SNAP, CSPR, or infamously, WeWork.

Accredited investor laws contribute to this divide by restricting access to investment, which only caters to the top 8.25% of Americans, leaving 91.75% of American citizens unable to access investment opportunities that provide the highest investment returns. That’s why retail, non-accredited investor access into security tokens has become the “holy grail” of the industry. It seemed to be the most difficult feature to implement but is a defining characteristic in creating financial equality.

Unlike the other exemptions ratified through the JOBS Act of 2012, the Reg A+ exemption showed promise to allow non-accredited retail participation for up to a $50M fundraise. The other exemptions precluded these investment opportunities from the public. Despite Reg A+’s relative success in some traditional markets, it has become a pipe dream for security tokens. The process has resulted in hundreds of tokens “under review,” with tokens waiting for years with no conclusion or approval. Two tokens, Blockstack and YouNow, were simultaneously approved in 2019, but they are utility tokens aiming for “sufficient decentralization” to prove they aren’t securities. From audits on these firms, the Reg A+ process was incredibly expensive and took almost two full years of litigation. This is not realistic for most issuers.

At the time of writing this article, Reg A+ doesn’t seem to be the immediate answer.

Everything in this analysis is for entertainment purposes only. Nothing in this post should be taken as financial advice or as an inducement to purchase or sell any security. Nothing in this market report should be used as legal advice. Always do your own research and contact your attorney before making any decisions regarding financial transactions of securities.

Fast forward to August 2019, when tZERO announced retail trading had been enabled for its TZROP token on the Dinosaur ATS. At the time this declaration seemed incredibly progressive, and to be honest, totally unexpected. Reg A+ was all the rage, and all of a sudden, tZERO had figured out how to use a mysterious Rule 144 exemption to allow for retail trading. After conversations in my circles, we figured that Overstock.com (NASDAQ:OSTK), the public parent company of tZERO, was able to leverage its arduous public disclosure requirements to allow for an exemption regarding public trading of the TZROP security token.

This answer seemed to be sufficient until this week when OpenFinance Network announced that non-accredited investors can freely trade the LDCC token on their ATS. OpenFinance is not a reporting company. Clearly my understanding was incomplete, so today I decided to do a little digging on what Rule 144 is, and how it can be leveraged for security token issuers, lawyers, and technology providers.

Rule 144 as defined by the SEC:

Rule 144 provides an exemption and permits the public resale of restricted or control securities if a number of conditions are met.

Essentially, it’s a separate set of rules that can allow for resale to public (retail) investors. Reg D and Reg S have rules that you need to comply with regarding the onboarding of investors — Reg D focuses on investors based in the United States, and Reg S addresses the standards for international investors. Both exemptions restrict access to US non-accredited investors, and while Reg S does enable access to some non-accredited investors in certain countries, retail US investors are excluded.

However, TZROP and LDCC only accepted accredited investors during their fundraise process, and are both now trading to a separate set of retail investors. Based on this description and context, it seems that there is a second set of rules, irrespective of how the initial investors were onboarded, that can enable full retail trading for select private securities. Let’s dive into the conditions that need to be met:

I feel that I need to add an obligatory, “including but not limited to:”

- How long the securities are held,

- The way in which they are sold,

- The amount that can be sold at any one time.

But even if you’ve met the conditions of the rule, you can’t sell your restricted securities to the public until you’ve gotten a transfer agent to remove the legend.

From this passage, we can see a few outlined trading restrictions as well as an additional condition regarding transfer agents managing a legend. After researching further in the SEC’s public database, I found an expansive definition for each condition.

Before selling a private security, you must be mindful of lockup periods. The first condition revolves around this restriction, noting that for any traditional restricted security, investors face a full year lockup period before being able to trade their assets. The only exception is for reporting companies, in which investors only face a six-month restriction.

The second condition details the disclosure standards. For public companies, they complete this process through publicly reporting via forms 10-Q, 8-K, and 10-K, but for private companies that are not required to publicly report financial information, they must provide “certain company information, including information regarding the nature of its business, the identity of its officers and directors, and its financial statements, [if] publicly available.”

The third condition establishes the trading formula, determining the volume of securities that may be traded over a given time period:

• If you are an affiliate, the number of equity securities you may sell during any three-month period cannot exceed the greater of 1% of the outstanding shares of the same class being sold, or
• If the class is listed on a stock exchange, the greater of 1% or the average reported weekly trading volume during the four weeks preceding the filing of a notice of sale on Form 144.

It concludes this condition by confirming that over-the-counter stocks, including shares quoted on the OTC Bulletin Board and Pink Sheets, also comply to the 1% measurement. While this limit seems strict, these restrictions are placed only on affiliates of the issuer. According to Cornell’s Law Department, an affiliate of an issuer is 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 intention of this trading formula is to prevent insiders from egregious liquidity post-issuance. The SEC does not want to provide a liquidity solution for solely for insiders (directors, officers, employees, etc), so affiliates are restricted from dumping large portions of their shares onto the public in a reckless manner (re: ICOs).

The final two conditions also apply to affiliates of the issuer:

• If you are an affiliate, the sales must be handled in all respects as routine trading transactions, and brokers may not receive more than a normal commission. Neither the seller nor the broker can solicit orders to buy the securities.
• If you are an affiliate, you must file a notice with the SEC on Form 144 if the sale involves more than 5,000 shares or the aggregate dollar amount is greater than $50,000 in any three-month period.

All in all, these conditions do not seem incredibly difficult to comply with, but on the surface, it would seem that they may hinder these securities from entertaining investor interest and volume sizes comparable to the public markets, despite many security token offerings representing asset classes that have no public market equivalent. By preventing the sale of greater than 1% of the outstanding shares in any three-month period, an artificial speed limit has been imposed for affiliates, that if applied to the public, could prevent the markets from achieving any level of liquidity, regardless of investor demand.

However, the next section of Rule 144 is what really brings the excitement.

If you are not (and have not been for at least three months) an affiliate of the company issuing the securities and have held the restricted securities for at least one year, you can sell the securities without regard to the conditions in Rule 144 discussed above. If the issuer of the securities is subject to the Exchange Act reporting requirements and you have held the securities for at least six months but less than one year, you may sell the securities as long as you satisfy the current public information condition.

This codicil provides liquidity exceptions for nonaffiliates of an issuer to sell securities without adherence to the volume restrictions described above.

So as long as the marketplace, ATS, or Exchange is not controlled directly or indirectly by the issuer, they are not subject to the volume restrictions imposed by Rule 144. This “affiliate” distinction would seem to encompass an equity investment in the liquidity provider, common intermediaries, board members, or employees, along with other symbiotic relationships. Provided that these relationships are avoided, the marketplace is given a free pass on the stringent insider rules.

The one other condition that is included in the requirements to comply by Rule 144 is that the private security’s legend must be removed from the certificate. This process is completed by a transfer agent on behalf of the marketplace — not the issuer. The marketplace must have the issuer’s approval, at which time:

“an investor [can] contact the company that issued the securities, or the transfer agent for the securities, to ask about the procedures for removing a legend. Removing the legend can be a complicated process requiring you to work with an attorney who specializes in securities law.”

The article concludes by addressing enforcement of the removal of a legend from a private security: “Removal of a legend is a matter solely in the discretion of the issuer of the securities. State law, not federal law, covers disputes about the removal of legends. Thus, the SEC will not take action in any decision or dispute about removing a restrictive legend.”

Rule 144 seems to be a very viable option for issuers to provide additional liquidity for their investors by allowing for additional access to new investors — more specifically, over 90% more investors just here in the United States. Lockup periods can be tedious but are only a short term problem, and the volume restrictions can be resolved through transfer agents that are increasingly popping up in the industry for reasons which were not immediately clear.

Could this be one of the main reasons we’ve seen firms like Securitize, TokenSoft, and Vertalo file for transfer agents in the last few months? As the issuance platform of the underlying security, they may be the ones responsible for granting access to remove the ledger and may be able to decouple this ledger at issuance, providing a seamless transition into secondary markets. We’ve now seen two private securities leveraging this rule to allow for increased investor access. tZERO issued the TZROP token themselves, and Securitize was responsible for the issuance of the LDCC token trading on OpenFinance. If this rule proves to be a scalable solution for advanced liquidity for both newly issued offerings, as well as a retroactive process for outstanding issuers, the market could see an incredible expansion of interest, access, and market value in the immediate future.

Written and published by Kyle Sonlin. Follow me on Twitter or LinkedIn. Read more here.