Definition of Restricted Stock

Restricted Stock (the term also includes securities sold privately under the Rule 144A exemption to a "Qualified Institutional Buyer") are sometimes referred to as "investment stock," "letter stock," and "legend stock."

Rule 144 defines the term "restricted securities" to mean securities acquired directly or indirectly from an Issuer or from an affiliate of the issuer, in a transaction or chain of transactions not involving any "public offering."

The key phrase to keep in mind is ... "public offering." The law defines an underwriter as any person who has purchased from an Issuer with a view to, or offers or sells for an Issuer in connection with, the distribution of any security.

Individual investors may be underwriters if they act as links in a chain of transactions through which securities move from an Issuer to the public. Take the case of a lawyer who receives shares of stock in a corporation for services rendered. His stock was never registered for public sale and was acquired privately in a transaction that did not involve a public offering. Hence, it's public sale is restricted. Further, let's assume our lawyer gives the stock to his favorite non-profit organization, the local hospital foundation. The foundation in turn sells the stock on the open market, thus becoming the final link in a chain of transactions moving the stock from the original issuing company to the public. The foundation has become something else as well - an underwriter and a violator of the 1933 Act prohibition against publicly selling unregistered securities. (As a consequence, it may be subject to a civil action for damages or rescission by the purchasers. Alternatively, the SEC may institute an enforcement proceeding.)

The holder of restricted securities may have acquired them in any number of ways, including:

Corporate Reorganizations

Frequently an acquiring company will issue securities to the owners of a target company. These securities may be restricted.

Venture Capitalists

"Seed money" may be exchanged for restricted securities.

Exchange of Professional Services for restricted securities.

See the example of our lawyer mentioned above.

Private Placements

Institutions such as insurance companies may purchase securities directly from the Issuer in a private transaction exempted from 1933 Act registration statement requirements by Section 4(2) of the 1933 Act and Rule 506 of the SEC.

Direct Purchase

In a private transaction from a "locked-in" shareholder, such as an affiliate or a holder of restricted stock. This would be under the so-called "Section 4(1 and 2) exemption."

In a Rule 144A transaction by one qualified institutional buyer from another.

The problem of legally achieving liquidity is obviously more than academic. For holders of restricted stock one exemption option previously mentioned is Rule 144, which removes underwriter status and lifts the registration requirement. As in the case of stock held by an affiliate, pledgees and donees of restricted stock step into the shoes of the pledgor and donor, respectively, and must, generally, utilize Rule 144 in selling the pledged or donated securities.

A holder of restricted securities may, under certain conditions, make a further private placement of the securities. That is "Section 4(1 and 2) private placement." In such a case, provided that the seller is not an affiliate of the Issuer, the buyer can "tack" his holding period to that of the seller.

After a combined one-year holding period, the purchaser may sell the securities pursuant to Rule 144, assuming that all of the other conditions of Rule 144 are met at the time of the proposed sale.

Furthermore, after a combined two year holding period, if the purchaser is not at that time (and had not in the prior three months been) an affiliate of the Issuer, he or she would have freely saleable stock under Rule 144(k).

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