Restricted Securities

Restricted securities are unregistered securities that a company issues to its employees that must be held for a specified period. Like stocks sold on public exchanges, restricted securities offer partial ownership of a company. Unlike normal stocks, these stocks have no value until the issuing company “vests.” That vesting schedule is up to the company and may depend on the company reaching a particular financial milestone. This milestone may serve as an incentive for employees to ensure the company reaches its goal.

Companies often issue restricted securities to their employees as a form of additional compensation. Restricted stocks rose in popularity as companies’ enthusiasm for stock options lessened. Bank of America, for instance, recently doled out $800 million to employees in the form of restricted stock, in an effort to retain employees without increasing the company’s spending. Startups may offer restricted securities to their angel investors in exchange for funding.

Restricted securities can be difficult to sell. In order to sell them and have their restrictive legend removed, you may need the help of a securities attorney.  

Can Restricted Securities Be Sold on a Public Stock Exchange?

During their restricted period, restricted stocks can only be sold through private transactions, including risky private placements. Restricted stocks may also be sold through Regulation D offerings. To sell restricted securities on the public exchange, investors must go through a complex process to have the restricted stock’s legend removed.

What is a Private Placement?

Private placements are stocks issued by companies that do not want to register with the Securities and Exchange Commission (SEC). Registering a security requires companies to disclose information concerning the business, financial statements, and management.

Offerors generally only sell private placements to accredited investors, meaning especially wealthy investors or large, institutional investors such as pension funds. The SEC has determined that these investments are not suitable for ordinary investors because of their high degree of risk.

Are Restricted Securities the Same as Restricted Assets?

No, according to the “restricted stock” definition, these investments are not to be confused with “restricted assets.” Restricted assets are unrelated – they are donations made to non-profits that are to be set aside for a specific use.

What Does an Investor Have to Do Before Selling Their Restricted Securities?

If an investor acquires a restricted stock, they must hold it for at least 6 months before selling. These holding requirements are meant to ensure that the person who purchased the securities had the intent of investing and did not simply intend to resell the investments on behalf of the issuer. Restricted securities are only eligible for re-sale if the issuing company makes sufficient information about its business and financial statements available to the public.

Rule 144 requires investors who want to sell to a restricted security to register the sale with the SEC unless there is an applicable exemption. Section 4(1) of the Securities Act describes an acceptable exemption as a transaction performed by a person who is not an issuer, underwriter, or dealer.

Restricted Securities Legend Removal

Before selling a restricted security, the investor must have its legend removed by a transfer agent. Transfer agents will only remove the legend once they have received permission from the issuer. That permission typically comes in the form of a letter from an attorney for the issuing company. Investors may need to hire an attorney to navigate this process.

Restricted or Control Stocks?

When companies issue unregistered stocks to their affiliates, they are called “control stocks.” Affiliates are any officers, directors, or shareholders that own 10% or more of a company’s stock. Like restricted securities, control stocks are typically offered as a form of extra compensation. They are called “control” stocks because of the control that an affiliate exerts over a company.  

Restricted Securities: Rule 144

Because these are non-public securities, they cannot be sold on the public exchange. To prevent the sale of restricted securities, these investments come with a legend that cannot be removed unless the security meets the requirements of Rule 144.

Rule 144 is meant to prevent money laundering. To meet Rule 144 restricted stock requirements, restricted security offerors must disclose essential information so a purchaser can evaluate the security.

Insider Trading

This rule also addresses control securities, which are vulnerable to fraud since their owners are company insiders. Illegal insider trading occurs when individuals like executives execute securities transactions based on non-public information. This type of trading offers an unfair advantage to the insider. There have been cases of insider trading where affiliates use an outside party to remove the legends from their restricted shares, deposit them with a brokerage firm, and then sell them when the company’s stock price rises.

Rule 144: Restricted Stocks and Affiliates

The SEC requirements for selling restricted stocks are stricter for affiliates of the issuer. Affiliates must meet the requirements set forth by Rule 144 before they can sell their securities. These rules do not apply to people who are not affiliates and have not been affiliates for the past three months.

No Solicitation

Neither brokers nor sellers may solicit orders from investors to purchase restricted securities. If a broker solicited you to purchase a private placement that turned out to be a restricted stock, you may have a case for a securities attorney.

Holding Period

Restricted stock owners must own these securities for a specified period of time. Companies impose holding periods to prevent stock owners from selling their shares all at once. If an investor purchases restricted securities from the public market, they are not subject to the holding period requirement.

Current Public Information

The issuing company must have published adequate public information before an affiliate can sell restricted securities. Public issuing companies, for instance, must comply with the period reporting requirements set for by the Securities Exchange Act of 1934. Non-reporting companies must have publicly available information detailing the nature of their business, its officers and directors, and financial statements.

Volume Limitations

Affiliates are subject to Rule 144 volume limitations. These limitations are meant to stop affiliates from selling so much stock that the price is adversely affected. Rule 144 states, “The number of equity securities an affiliate can sell in a 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.”

Notice Filed with the SEC

If you are an affiliate, the SEC requires you to file a notice with the SEC if the sale involves “more than 5,000 shares or the aggregate amount is greater than $50,000 in any three-month period.”

Other Safe Harbor Rules

There are other rules that detail special circumstances that may allow for the sale of restricted securities.

Rule 145

Rule 145 allows businesses to sell restricted securities that were acquired as the result of a merger, acquisition, or reclassification.

Rule 701

Rule 701 applies to stocks that were issued as part of a stock option plan that is part of an employee’s compensation. Under Rule 701, stockholders who are not affiliates only have to comply with the “No Solicitation” provision of Rule 144. Affiliates must comply with every Rule 144 requirement except the Holding Period requirement.

Regulatory Action Involving Restricted Stocks

The Financial Industry Regulatory Authority (FINRA) has fined brokerage firms for failing to adequately supervise the resale of their restricted shares. These regulatory actions frequently also mention a failure to comply with anti-money laundering laws. Brokerage firms are supposed to rigorously review any sales of previously restricted securities, even if they have had their legends removed.

WestPark Broker Fined $10,000

For instance, on July 14, 2023, a former brokerage firm Compliance Officer entered into an Acceptance, Waiver, and Consent agreement in which they consented to the findings that they failed to establish supervisory systems for the sale of restricted securities when they worked for WestPark Capital. AWCs allow brokers to consent to findings without admitting or denying the allegations.

According to the AWC, the firm’s written procedures failed to specify what information and documents should be collected and reviewed to determine whether the transactions were eligible for a Rule 144 safe harbor.

When customers deposited restricted securities that had been listed on a national securities exchange and from which a restrictive legend had been removed, the broker did not review information concerning the customer’s acquisition of the shares, the holding period, or their affiliate status. The broker accepted that a transfer agent had removed the legend and determined the securities were therefore eligible for resale.

FINRA alleged that a WestPark Capital Compliance Officer liquidated restricted securities without reasonable inquiry. In 2019, WestPark Capital allegedly opened new accounts for two China-based customers that Issuer A had referred to the firm. The depositors had acquired large blocks of Issuer A shares in unregistered private sales by Issuer A. Following Issuer A’s 2019 IPO, the depositors removed the restrictive legends from their shares and transferred almost 2 million restricted securities to WestPark Capital.

According to FINRA, the Compliance Officer did not inquire about the nature of the relationship between Issuer A and the Depositor. They allegedly also did not confirm that these shares met the holding period requirement. In 2020, one of the depositors allegedly began liquidating their shares during a price spike. This suspicious trading activity should have raised red flags and prompted the Compliance Officer to investigate further.  

As part of the terms of the AWC, the broker consented to a fine of $10,000, a 12-month suspension, and a requirement to requalify as a general securities principal before working in that capacity again.

What Can I Do If I Did Not Want a Restricted Security?

Brokers may recommend restricted securities in violation of Rule 144, which prohibits brokers from soliciting investors for purchases of restricted securities. Investors may discover too late that they purchased a restricted stock, meaning that they cannot simply sell it on a stock exchange as they would with any other security.

If your broker recommended an investment that meets the restricted security definition, you may be able to recover money by filing a complaint with the Financial Industry Regulatory Authority (FINRA). According to FINRA Rule 2111, brokers should consider their investor’s liquidity needs, as well as the overall risk of investment. Registered securities – or any private placements – are often too complex to fit the financial needs of most investors. This is just one of many examples of investment fraud — our team of attorneys can review your case and determine what securities law violations may apply to your case. 

Contact a securities attorney if you have concerns about your broker’s recommendations. Call (877) 600-0098 or email info@kurtalawfirm.com.