Control securities

What Is Control Securities?

Control securities are shares of a company's stock held by an affiliate or "control person" of that issuing entity. A control person is an individual or entity who possesses the power to directly or indirectly influence or direct the management and policies of a publicly traded company, whether through ownership of shares, by contract, or otherwise.²² This concept is fundamental to securities regulation, as it subjects the sale of such securities to specific rules designed to protect investors and maintain fair markets. The defining characteristic of control securities is not how they were acquired, but rather who holds them.

History and Origin

The regulatory framework for control securities originates primarily from the Securities Act of 1933, often referred to as the "truth in securities" law.²¹ This landmark legislation was enacted to require investors to receive financial and other significant information concerning securities offered for public sale and to prohibit deceit, misrepresentations, and other fraud in the sale of securities.²⁰

The concept of a "control person" emerged from the Act's broader aim to ensure adequate disclosure requirements and prevent market abuses, such as insider trading and market manipulation. Individuals with significant influence over a company have access to material nonpublic information, and their unrestricted ability to sell large blocks of stock could harm public investors. The Securities and Exchange Commission (SEC), established under the Securities Exchange Act of 1934, subsequently developed specific rules, most notably Rule 144, to provide a structured exemption for the public resale of these shares, balancing the need for liquidity for control persons with investor protection.

Key Takeaways

• Control securities are held by individuals or entities deemed to have significant influence over a company, known as "control persons" or "affiliates."
• Their sale in the public market is subject to specific regulations, primarily SEC Rule 144, to ensure fair disclosure and prevent market disruption.
• Control persons typically include executive officers, directors, and major shareholders.
• The primary objective of regulating control securities is to protect public investors from potential abuses arising from informational advantages.
• The sale of control securities often involves adherence to holding period requirements, volume limitations, and specific manners of sale.

Interpreting Control Securities

Interpreting the nature of control securities largely revolves around understanding the status of the holder and the implications for their resale. The term "control" is broadly defined as the power to direct or cause the direction of the management and policies of a person, whether through the ownership of voting securities, by contract, or otherwise.¹⁹ This can encompass officers, directors, and significant shareholders (often presumed at 10% or more of voting stock, though not a strict rule).¹⁸,¹⁷

Because control persons have the potential to influence corporate decisions and possess material nonpublic information, their sales of control securities are treated differently from those by ordinary investors. The resale of control securities in public markets must either be registered with the Securities and Exchange Commission (SEC) or qualify for an exemption from registration requirements, most commonly provided by SEC Rule 144.¹⁶ This rule sets forth conditions such as adequate current public information about the issuer, volume limits on sales, and specific manners of sale, all designed to ensure that these transactions occur transparently and do not negatively impact the company's stock price or mislead investors.¹⁵,¹⁴

Hypothetical Example

Consider Jane Doe, who is the Chief Financial Officer (CFO) of ABC Corp., a publicly traded software company. As a CFO, Jane is considered a control person because of her executive position and influence over the company's financial operations and strategic decisions. She owns 100,000 shares of ABC Corp. stock, which she acquired over several years through executive compensation plans. These 100,000 shares are considered control securities due to her status as an affiliate.

If Jane decides to sell 20,000 of her shares on the open market, she cannot simply instruct her broker-dealer to sell them like an ordinary investor would. Instead, her sale must comply with the conditions of SEC Rule 144. This means she would need to verify that ABC Corp. has up-to-date public information available, adhere to specific volume limitations (e.g., she can only sell a certain percentage of the outstanding shares or average weekly trading volume within a three-month period), and execute the sale through a routine broker's transaction without solicitation. She would also likely need to file a Form 144 with the SEC if the sale exceeds certain thresholds. These steps ensure her sale is transparent and does not unfairly disadvantage other investors.

Practical Applications

Control securities regulations play a vital role in capital markets by establishing a clear framework for the sale of shares by corporate insiders. These rules are crucial for:

• Regulatory Compliance: Companies and their affiliates must strictly adhere to the provisions of SEC Rule 144 when control securities are sold publicly. This includes ensuring proper disclosure requirements are met and, for larger sales, filing a Form 144 with the SEC.¹³
• Investor Protection: The regulations are designed to prevent control persons from exploiting their informational advantage. By imposing holding periods and volume limits, the rules reduce the likelihood of large, undisclosed sales that could disrupt the market or mislead public investors.
• Broker-Dealer Responsibilities: Broker-dealer firms have obligations to conduct due diligence before facilitating the sale of control securities. The Financial Industry Regulatory Authority (FINRA) reminds member firms to ensure compliance with federal securities laws and FINRA rules when participating in the unregistered resale of restricted and control securities, including undertaking appropriate inquiry into "red flags" that may indicate an illegal unregistered distribution.¹²
• Corporate Governance: The rules around control securities reinforce principles of good corporate governance by promoting transparency and accountability among those who hold significant influence over a company.

Limitations and Criticisms

While the regulation of control securities serves important investor protection goals, there are certain limitations and criticisms:

• Complexity of Determination: Ascertaining who qualifies as a "control person" can sometimes be complex and is often a fact-specific analysis. The definition of control involves the power to direct management or policies, which isn't always tied to a precise percentage of ownership.¹¹ While officers, directors, and major shareholders are generally presumed to be control persons, simply holding such a position or a certain ownership percentage isn't always determinative, leading to potential ambiguity.¹⁰
• Liquidity Constraints for Insiders: The volume limitations and specific manner-of-sale requirements under Rule 144 can limit a control person's ability to quickly liquidate large positions, potentially affecting their personal financial planning or the company's ability to attract and retain talent through equity compensation.
• Risk of Unregistered Sales: Despite regulations, there remains a risk of illegal, unregistered sales of control or restricted securities. Regulatory bodies like FINRA actively monitor for "red flags" that suggest firms may be facilitating such illegal distributions.⁹ Investors should always verify the registration of any investment professional and be wary of promises of high returns with little risk, as these can be indicators of fraud.⁸,⁷

Control Securities vs. Restricted Securities

Control securities and restricted securities are distinct but often confused categories of unregistered stock, both commonly regulated under SEC Rule 144.

The primary difference lies in their origin:

• Control Securities: These are defined by who owns them. If an individual is an affiliate or "control person" of the issuing company (e.g., an executive, director, or major shareholder), any shares they hold are considered control securities, regardless of how they were acquired (e.g., through the open market, an employee stock plan, or a private placement). Their status as a control person dictates the regulatory treatment of their shares.
• Restricted Securities: These are defined by how they were acquired. They are typically obtained in transactions that did not involve a public offering, such as a private placement from the issuer or an affiliate, or through an employee stock option plan. The securities themselves carry a "restriction" on resale, usually indicated by a legend on the stock certificate. Once these shares are held by a non-affiliate for a specified holding period, they generally become freely tradable.

While distinct, overlap exists: a control person who acquires shares in a private placement would hold both control and restricted securities. Conversely, a non-affiliate who purchases restricted securities would only hold restricted securities, not control securities. Both categories typically require adherence to SEC Rule 144 for public resale.

FAQs

What defines a "control person" for control securities?

A "control person" is an individual or entity with the power to direct or influence the management and policies of a company.⁶ This often includes executive officers, directors, and shareholders who own a significant percentage of the company's voting stock.⁵ There isn't a strict formula, and the determination can depend on specific facts and circumstances.⁴

How are control securities typically sold?

Control securities are typically sold in the public market under the provisions of SEC Rule 144. This rule provides a "safe harbor" or exemption from full SEC registration, provided certain conditions are met, such as adequate public information about the company, adherence to volume limitations, and sales through routine broker-dealer transactions.³

What are the main restrictions on selling control securities?

The main restrictions for control securities, under Rule 144, include limits on the amount of securities that can be sold within a specific three-month period (volume limitations), requirements that the sales occur through routine broker transactions (manner of sale), and the need for adequate current public information about the issuing company.² Unlike some restricted securities, control securities held by affiliates do not have a specific holding period requirement under Rule 144, but the other conditions still apply.¹

Why are control securities regulated differently from other stocks?

Control securities are regulated differently because the individuals holding them (control persons or affiliates) have access to nonpublic information and the power to influence the company. Special regulations are in place to prevent these individuals from using their position to engage in insider trading or to conduct large, undisclosed sales that could unfairly impact the stock price or mislead public investors. The intent is to ensure fair and transparent markets.