In recent years, equity securities have become an increasingly important component of the financial portfolios of individuals. Many of these securities are "restricted" for purposes of the Securities Act of 1933 because they were obtained in an offering that was not registered with the SEC under the 1933 Act. Other such securities are "control" securities because they are held by persons who are deemed to be "control persons" of the issuer. As a consequence, derivative transactions designed to hedge and monetize restricted or control securities are becoming increasingly popular. Certain of these transactions have prompted significant discussions concerning their treatment under SEC Rule 144 and Section 5 of the 1933 Act.
No-Action Letter
On December 20, 1999, the Division of Corporation Finance of the SEC issued a no-action letter which concerns a type of derivative contract known as pre-paid forward contracts. The contracts in question were between a customer owning the restricted or control securities and a broker-dealer or derivatives dealer. From the customer's perspective, the economic effect of the contracts is to hedge and monetize the securities in a tax-efficient manner. Rather than sell these restricted or control securities outright under Rule 144, the customer achieves economic benefits similar to a sale through the use of a contract. The dealer "prepays" the customer for its securities in full at the time of entering into the contract and the customer pledges the maximum number of securities deliverable under the contract to the dealer to secure the delivery obligation to the dealer.
The price for the securities under the contract is a fixed price determined directly or indirectly by reference to the dealer's execution prices for the sale in the public markets of a quantity of securities of the same class equal to the maximum number of shares subject to the contract (but not the actual restricted or control securities). Subject to a minimum and maximum delivery obligation, the number of securities deliverable under a contract typically depends upon the market price of the securities during an averaging period prior to the maturity of the contract.
The customer would represent that the maximum number of securities deliverable under the contract would fall within the volume limitation of Rule 144 applicable to the customer. The customer also would file notice on Form 144 when it entered into the contract. The dealer represented that its public market transactions in securities of the same class as the securities subject to the contract would not exceed the maximum number of shares deliverable under the contracts and would comply with the manner-of-sale conditions described in Rule 144 -- the dealer would effect its hedge without solicitation and in brokers' transactions or in transactions involving a "market maker."
Under these circumstances, the Division of Corporation Finance agreed that the dealer's sales could be viewed as sales of the related restricted or control securities, even though those securities were not delivered against the dealer's sales. Accordingly, the Division of Corporation Finance agreed that restricted or control securities that are the subject of the pledge to the dealer may be treated as securities that are neither restricted nor control securities in transactions for the dealer's own account.
Relation to the Doctrine of Fungibility
In its request for relief, the dealer maintained that, for purposes of the registration requirements of Section 5 of the 1933 Act, entering into a contract constitutes a sale at that time of the maximum number of securities deliverable under the contract. The dealer further reasoned that entering into a contract, combined with the consequent introduction into the public markets of securities of the same class by the dealer, would be treated as a sale of the restricted or control securities for purposes of Rule 144.
The doctrine of fungibility provides that freely saleable securities and restricted securities may take on the attributes of one another because each share is deemed to represent the same economic interest as any other share. The SEC, however, largely abandoned this doctrine when it adopted Rule 144 in 1972. The decision to exclude the doctrine of fungibility in Rule 144 derived from the results of the Wheat Report, an SEC-sponsored report which examined the doctrine and rejected it. While in recent years the SEC has solicited comments whether the doctrine of fungibility should apply in the context of hedging transactions, the SEC has not yet articulated its position in the context of Rule 144.
By concluding implicitly that the freely saleable securities sold in the public markets could be treated as restricted or control securities subject to Rule 144 and that the restricted or control securities pledged to the dealer would, in turn, be freely saleable securities, the Division of Corporation Finance effectively concluded that the two types of securities were "fungible." This conclusion may represent insights on the future treatment of these hedging transactions for purposes of Rule 144 and Section 5. *