MEMORANDUM
TO:
Annemarie Tierney
FROM:
Morgan, Lewis & Bockius LLP
DATE:
October 19, 2011
SUBJECT:
Summary Analysis of Certain Securities Law Issues
Introduction
You have asked us for a brief summary of certain securities law issues relevant to the
establishment of a liquidity program on the SecondMarket platform by a private company issuer
(sometimes referred to below as a “Liquidity Program Sponsor”) under which the issuer’s
shareholders, potentially including officers, directors and employees, may sell their shares. The
issues we address are: (i) the potential applicability to a Liquidity Program Sponsor of the
broker-dealer registration requirements under Section 15(a) of the Securities Exchange Act of
1934, as amended (the “Exchange Act”); (ii) the potential applicability to a Liquidity Program
Sponsor of Section 5 of the Securities Act of 1933, as amended (the “Securities Act”) and the
availability of exemptions therefrom; and (iii) the potential liability of a Liquidity Program
Sponsor under the antifraud provisions of the Exchange Act. This Memorandum does not
constitute a comprehensive legal analysis of the issues discussed herein, but is merely a brief
summary to be used exclusively for the internal purposes of SecondMarket; it is not intended as
legal advice to, and is not to be relied upon by, any person other than SecondMarket.
Broker-Dealer Registration
It is our understanding that SecondMarket provides significant flexibility to a Liquidity
Program Sponsor in structuring a liquidity program. For example, an issuer can determine the
shareholders who will be entitled to sell, the qualifications, identity and number of potential
purchasers, the amount that can be sold, the frequency of sales, and the pricing mechanism. This
level of involvement may raise questions regarding the applicability to the issuer of the brokerdealer registration requirements under Section 15(a) of the Exchange Act. Although the SEC has
not addressed this question in the context of issuer-sponsored liquidity programs run by an
independent broker-dealer such as SecondMarket, SEC guidance in other contexts has identified
the “badges” of broker-dealer status that could result in an obligation on the part of the issuer to
register as a broker-dealer.
In the context of issuer-sponsored direct participation plans, the SEC has stated that:
“When an issuer induces or attempts to induce the purchase or sale of its securities, receives
compensation based on securities transactions, or holds or maintains the funds, securities and
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accounts [of investors], it may be required to register as a broker-dealer under Section 15(a) of
the Exchange Act.”1 An issuer may avoid registration as a broker-dealer by limiting its
involvement to ministerial matters and ensuring that all solicitation activities and the transfer of
funds and securities are handled by a registered broker-dealer.
For example, in the context of issuer-sponsored internal markets, the SEC staff has issued
no-action letters permitting issuers to sponsor internal markets without registering under
Section 15(a), as long as the securities and cash transfers are handled by a registered brokerdealer.2 Also instructive are issuer-sponsored bulletin boards. The SEC staff has not required
that an issuer register as a broker-dealer when establishing a matching service to bring buyers
and sellers of its securities together, as long as the issuer does not handle funds or securities,
make a recommendation to buy or sell the security, participate in price negotiations, or receive
any compensation in connection with purchases and sales through the matching service.3
You have informed us that a Liquidity Program Sponsor would not handle funds or
securities, make recommendations to buy or sell the securities, or receive any compensation in
connection with purchases or sales. Consistent with the SEC staff interpretations, an issuer can
make employees and other holders aware of the liquidity program and can provide a link to the
SecondMarket website on the issuer’s website. Indeed, in StockPower Inc., avail. July 13, 1998,
the SEC staff agreed that an issuer could sponsor a direct stock purchase plan funded by either
open-market purchases or new issuances and provide investors access to software that would
direct the purchase and sale orders through a bank transfer agent who would cause the orders to
be executed by a registered broker-dealer.
A Liquidity Program Sponsor may be involved in establishing the prices for securities
sold on the SecondMarket platform. We understand that SecondMarket has designed its
platform so that all sales within a given marketing period are at the same price in order to avoid
the disruptive effect of some sellers getting better prices than others. The price can be set
through (i) independent valuation, which may involve using the issuer’s Section 409A valuation;
(ii) negotiations by the issuer directly with one or more buyers; or (iii) a modified Dutch auction
or other competitive pricing process, possibly with the issuer setting the reserve price. In certain
contexts where the issuer has interposed itself between buyers and sellers, the no-action letters
favor a fixed price system, usually at a price set by an independent valuation expert,4 but the
SEC has not imposed a fixed price requirement as a condition to granting no-action relief.
1
Exemption from Rule 10b-6 for Certain Dividend Reinvestment and Stock Purchase Plans, Securities Act
Release No 7114 (December 1, 1994), 1994 SEC LEXIS 3825, at Section VII.
2
Science Applications, Inc., avail. December 5, 1973, reaffirmed, July 11, 1977.
3
Flamemaster Corporation, avail. October 29, 1996; PerfectData Corporation, avail August 5, 1996; Real
Goods Trading Corp., avail. June 24, 1996; Spring Street Brewing Company, avail. March 22, 1996.
4
Professional Project Services, avail. June 22, 2006; TEOCO Corporation, avail. October 20, 2005; Marshalls
Finance LTD, avail. June 15, 1993.
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While issuer negotiation of a price at which trades may occur is a factor occasionally
mentioned in the no-action letters, in no letter has it been determinative.5 The involvement of
SecondMarket as a registered broker-dealer should mitigate any concern that the issuer must also
register as a broker-dealer merely because it is involved in setting the price at which holders can
sell, or otherwise interposes itself between buyers and sellers.
A separate broker registration issue arises with respect to the obligation of employees of
the Liquidity Program Sponsor who have direct contact with potential buyers on behalf of the
issuer. Rule 3a4-1 under the Exchange Act provides a safe harbor from broker registration to
employees and other persons associated with the issuer, provided they (i) are not otherwise
associated (and have not been associated in the last 12 months) with a broker-dealer; (ii) are not
compensated based on the sales of the issuer’s securities; (iii) provide substantial services to the
issuer that do not involve the offer and sale of its securities; and (iv) participate in such programs
only once a year. Failure to meet the conditions of the safe harbor does not give rise to a
presumption that the employee is acting as broker. However, if a Liquidity Program Sponsor
intends to conduct secondary markets more often than once every 12 months, it may wish to
consider limiting direct contact between its employees and potential buyers. An alternative
would be to use SecondMarket as an intermediary in negotiations with potential buyers.
Securities Act Registration and Exemptions
We understand that you have previously analyzed the Securities Act exemptions relevant
to the resale of unregistered securities on the SecondMarket platform. The summary below
therefore does not address resale exemptions available to sellers and buyers and instead focuses
on the potential applicability to a Liquidity Program Sponsor of the registration provisions of
Section 5 of the Securities Act.
In addition to prohibiting offers and sales, Section 5(c) of the Securities Act prohibits
solicitations of offers to buy any securities, unless a registration statement is in effect or an
exemption is available. The SEC has emphasized in a number of contexts that Section 5(c) may
be applicable to an issuer even if it is not directly selling its securities. Section 2(a)(3) defines an
“offer” as “every attempt or offer to dispose of, or solicitation of an offer to buy, a security …”
Thus, a Liquidity Program Sponsor may need to establish its own exemption from Section 5(c),
if it is deemed to be soliciting offers to buy its securities.
To our knowledge, the SEC has not addressed the question of what activities of the issuer
would amount to solicitation of offers to buy in the context of private secondary markets. The
SEC has provided guidance with respect to the level of issuer activity that triggers Section 5(c) in
the context of employee benefit and other stock purchase plans funded by open market
purchases. In this context, the SEC generally allows an issuer to engage in ministerial activities
such as conducting payroll deductions or including notice of the plan availability in shareholder
communications. Merely making the plan available to employees or shareholders is not enough
to trigger Section 5(c).
5
Note that in another context in which the issuer negotiates the price at which its securities are sold – that of a
friendly third party tender offer – the SEC has never raised a broker-dealer registration issue.
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Issuer activity that may constitute solicitation of offers could include being actively
engaged in identifying potential buyers or negotiating prices with them. It may be important for
a Liquidity Program Sponsor to have this level of involvement. In such instances, it would be
prudent for the Liquidity Program Sponsor to take steps to ensure compliance with the
requirements of the private offering exemption under Section 4(2) of the Securities Act. If the
Section 4(2) exemption would be available to the issuer if the issuer were the direct seller, then
an exemption should also be available to protect the issuer from liability for soliciting offers to
buy in the resale context.6
The steps that should be taken to secure a private offering exemption include: (i) the
issuer should avoid general solicitation; (ii) the issuer (and SecondMarket) should ensure that all
buyers are accredited investors; (iii) the number of prospective buyers should be limited;
(iv) buyers should sign an acknowledgement that resale is restricted under the securities laws;
(v) certificated shares should be legended; and (vi) the issuer should provide buyers with all
information that it considers material to a decision to purchase its securities.
Potential Liability Under the Antifraud Provisions of the Exchange Act
A Liquidity Program Sponsor may be concerned with potential liability under the
antifraud provisions of the federal securities laws in connection with secondary purchases and
sales of its securities.
Rule 10b-5 adopted by the SEC under Section 10(b) of the Exchange Act makes it
unlawful:
To make any untrue statement of a material fact or to omit to state
a material fact necessary in order to make the statements made, in
the light of the circumstances under which they were made, not
misleading … in connection with the purchase or sale of any
security.
Both an issuer and any person who trades the issuer’s securities on the basis of inside
information have potential liability under Section 10(b) and Rule 10b-5. Issuer liability for
disclosures is possible even if the issuer is not selling securities, as long as the information is
provided “in connection with” or “touches” a securities transaction. Issuer liability in the context
of a Liquidity Program could arise through: (i) failure to maintain adequate controls on insider
trading by employees and other insiders; or (ii) material misstatements, or omissions that make
other statements misleading, in information made available to buyers or sellers.
Section 20A of the Exchange Act creates a private right of action against persons who
buy or sell securities while in possession of material non-public information or illegally “tip”
such information. Section 20A specifically provides that an employer does not have liability
solely by virtue of employing a person who illegally trades, but also provides that a “controlling
person” may have liability under Section 20(a) of the Exchange Act.
6
Note that if the issuer were deemed to be soliciting offers to buy, buyers would be subject to a new one-year
holding period under Rule 144; this would also be the case if affiliates were sellers.
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Employers may have liability under Section 20(a) of the Exchange Act for any conduct
that could directly or indirectly “induce” a violation by an employee. Such “inducement” may
include failure to maintain adequate controls on insider trading by employees.7
One way to avoid potential liability under Section 20(a) is for an issuer to adopt and
enforce a private company insider trading policy. Such a policy would be similar to a typical
public company policy in certain respects, but with important differences. Public companies
have the obligation to release public information about their financial results and other matters.
Thus, most public companies have adopted insider trading policies that restrict trading by
designated insiders (typically including officers, directors and employees with regular access to
non-public material information) to specified “window periods”; other employees are not
restricted to such window periods, but are prohibited from trading while in possession of
material non-public information.
Private companies have no obligation under the securities laws to release information to
the public. However, many private companies do make financial and other material non-public
information available to all or most of their employees, and may have an obligation to do so
under Rule 701 in connection with their equity compensation programs. Thus, a private
company insider trading policy may restrict all employees (and may even attempt to restrict
former employees for a particular period of time post-employment) to specified “window
periods” during which the company may sponsor a liquidity program.
A Liquidity Program Sponsor may also seek to avoid potential liability under Rule 10b-5
and Section 20(a) by ensuring that buyer-participants in the program have the same information
that is available to employee-sellers. Thus, the Liquidity Program Sponsor may post on the
private SecondMarket website the same information it makes available to its employees under
Rule 701. If officers, directors and others with access to a greater level of information are also
sellers, the issuer may need to consider either posting additional information, or making sure that
the market is timed such that the insider-sellers do not possess material non-public information
other than Rule 701 information. We note that the potential for antifraud liability arises in
connection with direct private sales by an issuer of its securities no less than in connection with a
secondary market.
Private company issuers may conclude that the benefits of sponsoring a controlled
secondary market through SecondMarket outweigh any risks associated therewith. Such benefits
include the ability to provide a specified level of liquidity to employees while controlling the
timing of sales. In addition, the ability to approve the identity of purchasers may enable an
issuer to create or maintain relationships with supportive investors, and the ability to control the
number of purchasers may help an issuer avoid the “500 shareholder” trigger for registration
under Section 12(g) of the Exchange Act.
7
See also, In the Matter of Morgan Stanley & Co. Inc. and Morgan Stanley DW Inc., SEC Exchange Act
Release No. 54047 (June 27, 2006) (SEC cease and desist proceeding under Section 21C for causing
employee violation through failure to main effective insider trading policies and controls).
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