We use the term “secondary sales” to refer to sales of securities by anyone other than the issuer, and the term “secondary market” to refer to a marketplace where those sales take place.
Suppose NewCo, LLC, a private (non-public) company, raises money by issuing limited liability company interests under Rule 506(c). One investor, Amanda Sakaguri, later sells her limited liability company interest to a third party. The sale by Ms. Sakaguri is what we refer to as “secondary sale.” If Ms. Sakaguri sold her limited liability company interest on a marketplace – as opposed to a private sale – we call that a “secondary market.”
The Basic Legal Rules for Secondary Sales
All offers of securities must be fully registered with the SEC, under section 5 of the Securities Act of 1933. If there were no exceptions to section 5, Ms. Sakaguri would have to register with the the SEC before selling her limited liability company interest. But of course, this being the securities laws, there are lots of exceptions. For example:
- If Ms. Sakaguri bought her limited liability company interest in a Regulation A offering, she could sell it to anyone right away.
- If Ms. Sakaguri bought her limited liability company interest in a Regulation CF offering, she could sell it to some buyers right away, and to anyone after one year.
Ms. Sakaguri bought her limited liability company interest under Rule 506(c), so she isn’t eligible for either of those exceptions. For Ms. Sakaguri and other owners of private securities, the most likely potential exception is in section 4(a)(1) of the Securities Act, which exempts “[Sales] by any person other than an issuer, underwriter, or dealer.”
We know Ms. Sakaguri isn’t the issuer. How about a dealer or an underwriter?
A dealer is “[A]ny person engaged in the business of buying and selling securities . . . .for such person’s own account. . . .” but does not include “. . . .a person that buys or sells securities. . . . but not as a part of a regular business.” Provided she isn’t buying and selling securities as a business, Ms. Sakaguri isn’t a dealer.
Whether she’s an underwriter is a harder question, believe it or not. We think of underwriters as big Wall Street firms in gleaming towers, but the definition is much broader than that: “[A]ny person who has purchased from an issuer with a view to. . . .the distribution of any security. . . .” If Ms. Sakaguri expected to sell her limited liability company interest from NewCo when she bought it, she might be an underwriter, ineligible for the exception.
Whether the seller of a security is an underwriter once caused so much confusion that the SEC adopted a long rule on that topic.
Rule 144 provides a “safe harbor” for sellers. If a seller satisfies all the conditions of Rule 144, the seller will definitely not be treated as an underwriter for purposes of section 4(a)(1). If a seller doesn’t satisfy all the conditions, it doesn’t mean she will be treated as an underwriter. It just means she’s taking her chances.
Rule 144 imposes different requirements on sellers depending on whether:
- The issuer is a private or a publicly-reporting company;
- The seller is an “affiliate” of the issuer (generally meaning under common control); and
- How the seller acquired the securities in the first place.
We’re going to focus only on private companies, like NewCo, and situations where the seller acquired her interest directly from the issuer.
If Ms. Sakaguri were an affiliate of NewCo, she would be subject to four requirements:
- She would have to provide current information about the issuer, including its name, its business, its CEO and Directors, and two years’ of financial statements.
- She would have to hold the securities for at least one year.
- She would be limited in the volume of securities she could sell.
- She would be limited in the manner in which she sells the securities.
On the other hand, because Ms. Sakaguri isn’t an affiliate of NewCo, but just an ordinary investor, she’s subject to only one requirement: she has must hold her limited liability company in NewCo for at least one year. That means:
- She’s not required to provide any information about NewCo to the buyer.
- She can sell as much of her limited liability company interest as she wants.
- She can sell it to anyone, accredited or non-accredited.
- She can sell it in any manner she want, including on a website.
(Remember, Rule 144 is a safe harbor, not a legal rule. If Ms. Sakaguri is a minority investor in a private company and sells her limited liability company interest after four months because she lost her job and needs the cash, nobody thinks she’s an underwriter. At worst, she’d be sentenced to a week of Fox News.)
Where are the Secondary Markets?
There are lots of investors in the same shoes as Ms. Sakaguri: everyone who owns an interest in a real estate limited partnership, or a tech startup, or even a family business. If it’s so easy legally for them to sell their interests, why aren’t there lots of places where they can sell them?
A place – a website, for example – where investors could sell their privately-owned securities would probably be treated as an “exchange” under the Securities Exchange Act of 1934 (“[A]ny organization. . . .which. . . .provides a market place. . . .for bringing together purchasers and sellers of securities. . . .”). Section 5 of the Exchange Act makes it illegal for any exchange to operate unless it is either a registered “national securities exchange” under section 6 of the Exchange Act (like NASDAQ or the NYSE) or exempt from registration under SEC rules. The typical private security couldn’t qualify for listing on a national exchange, so Ms. Sakaguri and others in her shoes would be looking for something else.
Fortunately, that something else exists in the form of an “alternative trading system,” or ATS, authorized by the SEC in 17 CFR 240.3a1-1(a)(2) and defined in 17 CFR 242.300 – 303. Today there are dozens of alternative trading systems operating in the United States for many different purposes, including several operated by OTC Markets, Inc. Any broker-dealer can create an ATS without much difficulty, and for that matter anyone can create a broker-dealer.
All the legal pieces of the puzzle are in place: Ms. Sakaguri is allowed to sell her limited liability company interest under Rule 144; and it’s not hard to create an ATS where she can sell it. So why does everyone complain about the lack of liquidity in private securities?
The answer is that the legal pieces of the puzzle turn out not to be the most important. Ms. Sakaguri is allowed to sell her limited liability company interest, but finding someone who wants to buy it is another story. We can create all the legal mechanisms we want, but a secondary market needs lots of buyers and sellers, especially buyers.
Remember, Ms. Sakaguri is allowed to sell her limited liability company interest under Rule 144 without providing any information about NewCo. That’s great, except there aren’t a lot of people willing to buy that limited liability company interest without information about NewCo. Other characteristics of NewCo, if it’s a typical privately-owned company, also make it unattractive:
- It probably has a very limited business, possibly only one product or even one asset.
- It probably has limited access to capital.
- It probably lacks professional management.
- Sakaguri probably has limited or no voting rights.
- There are probably no independent directors.
- The insiders of NewCo are probably allowed to pay compensation to themselves more or less free of limits, and have probably protected themselves from just about every kind of legal claim that investors could bring.
When Franklin Roosevelt and Sam Rayburn created the American securities laws in the 1930s, what emerged from all the new regulation was the most efficient, most transparent, most vibrant public capital market in the world. Eighty-five years later, you might say Americans have become spoiled by the safety of buying publicly-traded companies on national exchanges. When Ms. Sakaguri asks them to buy her limited liability company interest in NewCo on an alternative trading system, she’s asking for a lot.
To create a more vibrant secondary market for private securities we need greater standardization, greater protections for investors, and greater transparency. Some of these things the industry can do by itself – for example, by using blockchain technology. Other things will probably require regulation.
To create a vibrant market in automobiles we didn’t adopt laws protecting auto manufacturers. We adopted laws protecting consumers, e.g., lemon laws. My guess is that to create a vibrant secondary market for private securities the law should focus on buyers, not sellers.
What About Tokens?
More companies than I can remember have said they want to convert their limited liability company interests or preferred stock to token form because “There’s a secondary market for tokens.”
From a legal point of view that’s not true. The laws governing secondary sales of securities apply equally to the most boring share of common stock, represented by a paper certificate stored in a battered aluminum filing cabinet, and the most interesting token treated as a security under the Howey test, residing only in the cloud on a public blockchain.
But it is true in two other senses:
- The rules I’ve talked about above apply only to tokens that are securities under the Howey test. A token that is a currency and not a security is not subject to those rules. I would also say that a true utility token isn’t subject to the rules, either, except a token being traded is probably a security under the Howey test, i.e., it probably isn’t a true utility token.
- The reason there isn’t a vibrant market in private securities isn’t the legal restrictions, but the risk inherent in private securities. The frenzy over anything called a token in the last 12 months has overridden investor fears of private securities. Whether that frenzy will continue is impossible to predict (it won’t).
The same people ask “What about all those crypto exchanges?” There are two answers to that question as well. One, many or all of them have become alternative trading systems controlled by broker-dealers, or are in the process of doing so. Two, many got in trouble. Some are being sued privately, some are being sanctioned by the SEC, and three of the really bad ones had to watch Fox News for a month.
Questions? Let me know.