Lawyers are sometimes chided for dwelling on distinctions that strike the uninitiated as arcane. Accordingly, the distinction that a distribution of portfolio company stock from a venture fund to its limited partners in kind is just that – a “distribution” rather than a sale – probably will excite a venture fund’s counsel much more than its managers. However, this subtle distinction gives rise to legal and tax advantages that make distributions of securities attractive to venture funds and to their limited partners. In the case of thinly traded stock, however, certain precautions must be observed to preserve the tax and securities law advantages that distributions in kind afford.
Because a distribution is not a sale, it typically does not trigger recognition of gain for federal income tax purposes. The limited partners will not have to pay federal income tax as a result of the distribution. The limited partners inherit the fund’s tax basis in the stock and, by making an independent decision to sell the stock, can time the recognition of taxable gain to their individual advantages.
In addition, because a distribution is not a sale, a distributing fund is not constrained by Securities and Exchange Commission Rule 144 under the Securities Act of 1933, which restricts sales of stock held by venture funds for less than two years or when funds are “affiliates” of the company. Such resale restrictions are particularly problematic for funds holding thinly traded stocks, as they can prevent large block sales of the security when the timing is optimal for the fund. In contrast, as limited partners typically are not affiliates of the portfolio company, they can sell the stock under Rule 144 with fewer restrictions than would apply to the fund itself.
Finally, because a distribution is not a sale, a distributing fund technically is not exposed to the threat of litigation based on Section 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b-5. However, thanks to some enterprising arguments put forward of late by plaintiffs’ class action lawyers, this insulation from litigation is no longer secure. Moreover, in the wake of the Private Securities Litigation Reform Act of 1995, the SEC itself has announced an increased readiness to investigate alleged Section 10(b) and Rule 10b-5 violations. As a result, funds planning to distribute stock in kind must adopt sound strategies to insulate themselves, their managers and their limited partners as much as possible from potential lawsuits and SEC investigations.
This article outlines some of the rules and risks regarding distributions in kind and presents strategies for successfully managing them, with particular emphasis on thinly traded securities.
Favorable Tax Treatment
Under Section 731(c)(3)(A)(iii) of the Internal Revenue Code of 1986, limited partners typically will not realize gain on distributions of publicly traded stock from a venture fund. The limited partners succeed to the fund’s tax basis and will incur federal tax liabilities only when they actually sell the stock. The fund’s limited partners receive this favorable tax treatment as long as the limited partners are “eligible partners” and the fund is an “investment partnership,” as those terms are defined in Section 731.
Fortunately, both of the requirements of Section 731 are easy to satisfy. First, an “investment partnership” is defined as any partnership that has never been engaged in a trade or business and substantially all of whose assets are invested in investment-type assets, such as interests in other entities. Provided that a venture fund restricts its business activities to investing in other entities, it probably will not be engaged in a trade or business and substantially all of its assets will be investment assets. Most modern partnership agreements contain provisions requiring that the fund operates in a manner that ensures it will be an investment partnership for purposes of Section 731.
Second, an “eligible partner” is any partner who, before the date of the distribution, does not contribute any property to the partnership other than investment assets (i.e., capital contributions used for partnership investments and fees). This rule is designed to prevent some very specific tax chicanery: a limited partner attempting to exchange appreciated property for distributed stock and avoiding tax on the transaction. The net result is that limited partners need worry only about losing eligible partner status under Section 731 if they contribute assets other than cash. Venture funds risk losing investment partnership status only if their business strays from investment activities. As neither situation has been the norm, favorable tax treatment usually accompanies in-kind distributions of stock.
More Flexibility Under Rule 144 – Holding Periods and Trading Volume
Rule 144 permits holders of stock that is not registered under the Securities Act (known as “restricted stock”) to sell such stock without its first being registered with the SEC, provided such sales comply with Rule 144 limitations. Shares of restricted stock typically have a legend that alerts a company’s transfer agent that the stock cannot be sold without compliance with Rule 144. In addition, shares of restricted stock cannot be held in “street name” or sold by electronic transfer using a depository trust company.
Rule 144 also limits affiliates of a company when selling their stock, even when the stock has been registered under the Securities Act. There is no hard and fast rule as to who is an affiliate of a company. The determination focuses on whether a person directly or indirectly controls the company. Normally, it refers to all large shareholders, directors and officers. As venture funds often are large shareholders or have a board seat, they are often affiliates under Rule 144.
Under Rule 144, no holder of restricted stock can sell it for at least one year after its acquisition from the company or from an affiliate of the company, except in limited circumstances involving a merger or sale of the company’s assets.1 After this one-year period and until two years have elapsed, holders of restricted stock cannot sell in any three-month period more than the greater of 1% of the company’s outstanding stock or the average weekly trading volume over the four weeks prior to filing of the notice of the sale. Moreover, adequate public information must exist about the company, and the stock must be sold in unsolicited transactions. After two years, the aforementioned trading volume and other restrictions expire – unless the stockholder is an affiliate of the company. In this case, the trading volume and other restrictions continue as long as the stockholder remains an affiliate.
As venture funds typically hold stock for longer than one year, the one-year minimum holding period is not of primary concern. The trading volume limitations, however, can sharply curtail a fund’s plans to divest itself of a major stake in a company, especially if the company is thinly traded. The smaller the number of outstanding shares and the lower the average weekly trading volume, the fewer shares the venture fund can sell in any given three-month period. A fund in this position may have to “dribble out” shares over many quarters, leading to administrative complexity and possible loss of favorable market prices.
However, Rule 144 restrictions apply only to sales of stock, not to distributions. As a result, a venture fund can distribute stock in kind to its limited partners in situations where direct sales of stock would be disadvantageous as a result of Rule 144 restrictions. The fund can distribute the shares all at once, even if the stock is thinly traded and need not wait for the initial one-year holding period to expire.
On the other hand, the fund’s limited partners must realize that shares of restricted stock distributed to them remain restricted stock in their hands. The limited partners still must abide by Rule 144 when they wish to sell their stock, even though the distribution by the fund was made free of Rule 144 restrictions. The good news for the limited partners, however, is that Rule 144 restrictions typically are much less onerous to them than they are to the fund.
Although the limited partners must satisfy the one-year minimum holding period requirement, Rule 144 allows them to add together, or “tack,” the length of time they own the shares and the length of time the venture fund had owned the shares. For example, if a fund owned shares for 11 months before distribution, its limited partners could sell the shares one month after distribution, tacking their one-month period to the fund’s 11-month period to total one year.
The big advantage limited partners enjoy over venture funds regarding Rule 144 is that L.P.s typically are not affiliates of the company.2 As a result, the Rule 144 trading volume and other restrictions typically do not apply to them after the two-year holding period (including tacking). After this period, most limited partners can sell their shares virtually without restrictions. They also can instruct the company’s transfer agent to remove the Rule 144 restrictive legend from their stock certificates and subsequently hold the stock in street name and sell it by electronic transfer.
If stock is held for more than one year but less than two years (including tacking), limited partners still can sell it, but they must abide by the trading volume restrictions. In fact, the limited partners must aggregate their sales to determine whether trading volume restrictions have been exceeded. In other words, during this period the number of shares that all limited partners can sell as a group is capped. As a result, trading volume restrictions may prevent some limited partners from selling their shares when they wish if many partners seek to sell at the same time. Many funds chose not to distribute stock held less than two years as a result of this restriction, and some fund agreements prohibit in-kind distributions of such stock.
The process of selling restricted stock can take three to five business days. During this time, the selling broker typically obtains a legal opinion or clearance memorandum authorizing removal of the restrictive legend and, if less than two years have passed or the seller is an affiliate, files a Form 144 with the SEC. Under conventional circumstances, this three- to five-day delay should not prove more than a mild inconvenience. But such a delay can result in losses if a stock’s price has started to nose dive. As a result, limited partners who are holding restricted stock should instruct their brokers to have the restrictive legends removed as soon as possible. Once the legends are removed, which should also take three to five business days, limited partners can sell their stock instantly via electronic transfer and so react to changing market conditions.
Insulation from Litigation?
Don’t Count On It
Section 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b-5 prohibit making materially untrue or misleading statements, concealing information or engaging in any fraudulent or deceptive practices in connection with the sale of securities. Trading stock while in possession of material non-public information about the company, or “insider trading,” is just one type of practice that Section 10(b) and Rule 10b-5 prohibit. The rule here is “abstain or disclose” – abstain from trading or disclose the inside information to the other party before the transaction. Courts have determined that stockholders or former stockholders can sue alleged violators of Section 10(b) and Rule 10b-5 for civil damages. Such suits typically take the form of shareholder class actions in which some or all the members of the board of directors often are named as defendants.
To add fuel to the fire, since the passage in late 1995 of the Private Securities Litigation Reform Act, the SEC appears to have stepped up its own enforcement and oversight activities, particularly in the area of alleged insider trading. SEC insider trading investigations often are triggered by the filing of a class action suit, so defendants can face both civil litigation and an SEC investigation simultaneously. The SEC is empowered to seek large monetary penalties against those it believes have violated the securities laws, including three times the amount of profit earned or loss avoided.
Note that, again, Section 10(b) and Rule 10b-5 by definition apply only to sales of securities, not to distributions. As a result, distributions of securities in kind by a venture fund should not expose the distributing fund or its affiliates to civil liability or SEC sanctions based on Section 10(b) and Rule 10b-5. Nonetheless, the plaintiff’s bar recently has filed class action suits claiming distributions in kind triggered liability under Section 10(b) and Rule 10b-5, and the SEC has investigated fund managers who sat on a company’s board of directors at the time large distributions and sales of portfolio company securities were made by their funds.
Two recent cases for which Testa, Hurwitz & Thibeault served as defense counsel provide good examples. In each case, representatives of a venture fund remained on a company’s board of directors after the company went public. The funds distributed securities in kind during run-ups in the stock prices. The run-ups ended abruptly when bad news about the companies triggered precipitous drops in the stock prices. In the resulting lawsuits, plaintiffs alleged the representative directors knew of the bad news before it became public and conspired to conceal it while their venture funds distributed and sold the stocks at high valuations. In one of the cases, the plaintiffs’ counsel contended that fund managers “tipped” their limited partners when the distributions were made, signaling that the limited partners should sell immediately. Both suits also spawned SEC investigations.
In our judgment, both cases against the directors were totally without merit. However, because both cases settled, the theory that distributions in kind can give rise to liability under Section 10(b) and Rule 10b-5 has not yet been tested in court. Until this theory has been definitely rejected by the courts, venture funds and their representative directors may be targeted for suit or SEC investigation, or both, based on in-kind distributions of stock to their limited partners.
This is not to say that every future distribution in kind will be a magnet for litigation or investigation. However, risk-averse managers should consider erecting defenses against this possibility. The best defense to a securities class action lawsuit or an SEC investigation, by far, is to minimize one’s exposure as a potential target. Accordingly, venture fund representatives should:
* Consider resigning from the board of directors when its portfolio companies go public. Although resignation from the board does not completely prevent a fund or its managers from becoming targets, the potential for litigation or investigation is greatly reduced. Granted, there can be sound business reasons for wanting to retain representation on the board. If a venture fund’s representative will stay on the board, the fund and the director representative can still take steps to reduce exposure to potential litigation, although no one can guarantee any precautionary steps will prove ultimately effective.
* Consider avoiding involvement in day-to-day operations of the company. The more responsibilities a director takes on (such as membership on the audit or compensation committees), the harder it may be to get claims dismissed prior to trial or convince the SEC that the fund was not exposed to inside information.
* Consider not distributing securities of a portfolio company during its “blackout period,” during which trading in the company’s stock by insiders is prohibited. A typical blackout period includes the final several weeks of a fiscal quarter and lasts until 48 hours after earnings for that quarter are released.
* Consider establishing a written policy prohibiting distributions while the venture fund possesses material non-public information. Such a policy also should prohibit managers who own shares of a portfolio company from selling those shares without fund approval. Make sure the policy is distributed to all fund managers and employees and that the policy is enforced.
* Consider having fund managers other than the manager who serves as a board representative make the distribution decision. While this arrangement probably will not prevent frivolous class action claims from being filed, insulating the manager who serves as an outside director from the initial distribution decision might help to get claims against the manager or the fund thrown out prior to trial and convince the SEC that the fund had a formal system in place to prevent sales or distributions from being made on the basis of inside information.
* Consider a policy of regular distributions. While making distributions to limited partners on a regular basis might not always mesh well with the economics of running a fund, partial distributions of a substantial block of stock to limited partners at the same time each quarter until the position in the company is depleted will bolster the argument that the distribution had nothing to do with inside information about the company.
* Consider keeping any material non-public information a director does acquire segregated from the fund’s other managers. If the board member resigns from the board, make sure the company stops sending non-public information.
* Be cautious about keeping notes, memoranda or e-mail regarding why a stock was distributed. Any such documents that suggest a distribution decision was made because of concerns about the company’s future financial performance ultimately may be discovered by plaintiffs’ attorneys or the SEC.
Finally, when a venture fund distributes stock in kind, the fund must not make any recommendations to its limited partners regarding whether to hold or sell the stock, either orally or in writing. In the lexicon of insider trading, this could be attacked as “tipping,” and tipping is as potent an allegation for potential plaintiffs and the SEC as if the fund sold stock itself based on inside information. Even if a venture fund has no inside information to underlie a recommendation, plaintiffs could argue otherwise, as they have in litigation Testa, Hurwitz & Thibeault has defended. If a fund provides information about a distributed stock to its limited partners, the fund should provide only information that is publicly available, such as annual and quarterly reports to shareholders filed with the SEC.
Other Distribution Legal Issues
Section 16(b) of the Securities Exchange Act of 1934 prevents large shareholders, directors and executive officers of a company from reaping short-swing profits from sales of that company’s stock. Venture funds become subject to Section 16(b) when they hold more than 10% of the company’s stock or have a representative on the board of directors. If it is subject to Section 16(b), a venture fund cannot sell stock in the company for six months after its most recent purchase. If the fund does, any profits earned on the sale can be recovered by the company or its stockholders, usually by means of a shareholder derivative lawsuit.
Again, however, Section 16(b) applies only to sales, not to distributions. As a result, venture funds can distribute stock to limited partners within six months of their most recent purchases without forfeiting profits. Once distributed, limited partners can sell the stock free of Section 16(b) restrictions, provided the L.P.s are not independently subject to Section 16(b).
Finally, Section 13 of the Securities Exchange Act of 1934 dictates that a venture fund probably will have to file a Schedule 13G as a result of distributions of stock in kind. Stockholders who acquire more than 5% of a public company’s stock while it was still private typically must file a Schedule 13G to report changes in their percentage ownership (unless the stockholder is buying stock for the purpose of a takeover or to otherwise exert control over the company, then a Schedule 13D is required). A Schedule 13G must be filed within 45 days of the end of the fiscal year in which the distribution occurred.
A Final Word
The decision of whether to distribute thinly traded stocks in kind to limited partners is obviously a multi-faceted one. Business and investor relations issues probably will – and should – play the predominant role in the decision making. But from a purely legal point of view, distributions in kind offer several advantages. They delay recognition of taxable gain and obviate the need for the fund to comply with trading volume and other restrictions under Rule 144 (although the limited partners must remain conscious of Rule 144 requirements).
Unfortunately, distributions in kind will not immunize a fund and its managers from litigation or SEC investigations under Section 10(b) and Rule 10b-5, at least not without some positive precedent from the courts. However, a fund can take several effective steps to minimize its litigation exposure. Resigning from the boards of companies once they go public is typically our first piece of advice.
Finally, a fund always should get its legal counsel involved in the decision of whether to distribute thinly traded stocks in kind. This article gives only broad-brush treatment to legal issues that, in fact, can become quite complex. Each fund and each distribution will entail unique issues, which require unique advice and counsel.
This is the last of three articles focusing on the issue of distributing thinly traded stocks to limited partners. The first article, The Challenge of Distributing Thinly Traded Stocks by Standish Fleming of Forward Ventures (VCJ, February, page 48), examined the G.P. perspective on distributions; the second, The Mechanics of Effective Distributions (VCJ, April, page 43), presented the opinions of Jay Luby of the Strategic Trading Division of U.S. Trust Co. and David York of the venture services group of Hambrecht & Quist.
1 Under SEC Rule 145, any holder of Restricted Stock, including a venture fund, can sell it without restriction in a transaction involving a merger or asset sale. However, if the fund is an affiliate of the company that was merged or sold and receives securities as compensation, then the securities received will be Restricted Stock. Before selling the stock, the fund must either abide by all applicable Rule 144 restrictions or satisfy the holding period requirements set forth in Rule 145(d).
2 Note, however, that a holder of 10% or more of the beneficial interest of an affiliate may be deemed an affiliate pursuant under Rule 144(a)(2). As a result, if a fund is an affiliate, a limited partner holding a 10% or greater partnership interest in that fund may be deemed an affiliate as well and will continue to be subject to the Rule 144 restrictions as long as the fund is an affiliate.
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