Distribution compliance period: Meaning, Criticisms & Real-World Uses

What Is Distribution Compliance Period?

The distribution compliance period refers to a specific timeframe during which certain restrictions apply to the resale of securities initially offered outside the United States under Regulation S of the U.S. Securities Act of 1933. This period is a core component of securities regulation, designed to ensure that offshore offerings do not effectively become unregistered public offerings within the U.S. market. It mandates that during this time, participants in the offering refrain from selling the securities to U.S. persons or within the U.S. to prevent "flow-back" of unregistered securities. The distribution compliance period acts as a crucial safeguard, aligning the intent of offshore sales with the U.S. registration requirements. Securities subject to a distribution compliance period are typically considered restricted securities until the period expires.

History and Origin

The concept of a distribution compliance period originated with the adoption of Regulation S by the U.S. Securities and Exchange Commission (SEC) in 1990. Prior to Regulation S, the extraterritorial application of the registration requirements of the Securities Act of 1933 was less clear, leading to uncertainty regarding offshore offerings. Regulation S provided a safe harbor for offers and sales of securities made outside the United States, clarifying the conditions under which such transactions would not be subject to U.S. registration. The distribution compliance period was introduced as a key mechanism within Regulation S to prevent the indirect distribution of unregistered securities into the U.S. market, thereby upholding the principles of investor protection. Over time, the SEC has periodically reviewed and amended Regulation S, including adjustments to the length of the distribution compliance period for certain types of securities. For instance, in 2007, the SEC reduced the distribution compliance period for equity securities of U.S. reporting companies from one year to six months to align with changes made to Rule 144 holding periods⁶.

Key Takeaways

The distribution compliance period applies primarily to securities sold offshore under Regulation S.
It is a timeframe during which restrictions on resale into the U.S. market are in effect.
The primary goal is to prevent unregistered securities from flowing back into the U.S. market.
The length of the period varies depending on the type of issuer and the category of securities.
Compliance is crucial for both issuers and purchasers to avoid violating U.S. federal securities laws.

Interpreting the Distribution Compliance Period

The interpretation of the distribution compliance period is straightforward: it dictates when and how securities sold offshore can be resold into the U.S. market. For instance, Category 2 of Regulation S offerings, typically involving equity securities of reporting foreign issuers or debt securities of reporting issuers, generally has a distribution compliance period of 40 days. Category 3 offerings, which include equity securities of U.S. reporting issuers or securities of non-reporting issuers, traditionally had longer periods. These periods ensure that the securities have "come to rest" offshore before they can be considered freely tradable in the U.S. without registration. After the distribution compliance period, the securities may be resold in the U.S. under certain conditions, often relying on exemptions like Rule 144 for affiliates or non-affiliates, or if the securities are later registered. Adherence to these timeframes is critical to maintaining the integrity of the capital markets and avoiding enforcement actions from the SEC.

Hypothetical Example

Imagine "Global Tech Inc.," a U.S.-based public company, decides to issue new shares to investors in Europe through an offshore offering under Regulation S. As a U.S. reporting issuer, Global Tech Inc.'s equity securities would typically fall under Category 3 of Regulation S, which often entails a distribution compliance period of six months.

During this six-month distribution compliance period:

Initial Sale: Global Tech Inc. sells shares to European institutional investors. These investors acquire restricted securities.
Resale Restrictions: The European investors are prohibited from immediately reselling these shares to U.S. persons or within the U.S. securities markets. They can, however, resell them to other non-U.S. persons outside the U.S. within the period, provided certain conditions are met, such as using an offshore transaction.
Preventing Flow-back: This period ensures that the offering truly remains offshore and doesn't become a backdoor way to distribute unregistered shares in the U.S.
Period Expiration: After six months, assuming Global Tech Inc. has maintained its public information requirements, the shares held by non-affiliate investors who purchased in the offshore offering generally become freely tradable in the U.S., much like shares sold in a public offering. If an investor is an affiliate of Global Tech Inc., they would still need to comply with the volume and other limitations of Rule 144 even after the distribution compliance period expires.

This example illustrates how the distribution compliance period acts as a gatekeeper, regulating the flow of securities from offshore markets back into the U.S. system.

Practical Applications

The distribution compliance period has several critical practical applications in the realm of global finance and securities law:

International Offerings: It is fundamental to how U.S. companies raise capital from international investors and how foreign companies raise capital globally while navigating U.S. securities laws. By understanding and adhering to the distribution compliance period, issuers can tap into broader investor bases without triggering burdensome U.S. registration requirements.
Secondary Market Trading: The period directly impacts the secondary market liquidity of securities initially sold offshore. Investors holding these securities must wait for the period to expire, and sometimes satisfy additional conditions, before they can freely resell them in U.S. public markets. This influences investment strategies for qualified institutional buyers and other participants in private placements.
Regulatory Compliance: For legal and compliance teams within financial institutions and corporations, understanding the nuances of the distribution compliance period is vital to avoid violations of the Securities Act of 1933 and the Exchange Act. Non-compliance can lead to significant penalties, including rescission rights for purchasers and SEC enforcement actions⁵.
Investor Protection: From the perspective of investor protection, the distribution compliance period helps ensure that U.S. investors purchasing securities in the public market have access to the full disclosures provided through the SEC's registration process. It acts as a barrier against the immediate influx of unregistered securities that may lack adequate public information.

Limitations and Criticisms

While essential for regulatory compliance, the distribution compliance period, along with other restrictions, can impact market liquidity. Critics sometimes argue that the restrictions associated with these periods can reduce the attractiveness of certain offshore offerings to investors who desire immediate flexibility in reselling their holdings. This can result in a "liquidity discount" on unregistered securities compared to their freely tradable counterparts.

Furthermore, ensuring strict compliance with the distribution compliance period and associated rules can be complex. Determining whether a resale to a "U.S. person" has occurred or whether adequate current public information is available for resale under Rule 144 after the period can be challenging, particularly for non-reporting companies. While the SEC has made efforts to ease certain requirements, such as reducing the distribution compliance period in some instances⁴, the intricate nature of global securities transactions can still present compliance hurdles. Academic research, such as studies on the illiquidity premium in over-the-counter (OTC) markets, sometimes touches upon how restrictions similar to distribution compliance periods can affect asset pricing and trading behavior³.

Distribution Compliance Period vs. Holding Period

The terms "distribution compliance period" and "holding period" are both tied to restrictions on reselling securities, but they apply in different contexts under U.S. securities laws, particularly under the purview of the Securities and Exchange Commission (SEC).

A distribution compliance period specifically refers to the time frame imposed under Regulation S for securities initially sold in offshore transactions. Its primary purpose is to ensure that the sale is truly an offshore offering and that unregistered securities do not immediately flow back into the U.S. market. During this period, direct sales to U.S. persons or within the U.S. are generally prohibited.

In contrast, a holding period is a requirement under Rule 144, governing the resale of restricted securities and control securities in the U.S. market. This period dictates the minimum amount of time an investor must own the securities before they can be resold publicly in reliance on the Rule 144 safe harbor. For reporting companies, the holding period for restricted securities is typically six months, while for non-reporting companies, it is generally one year². The holding period focuses on the length of time an investor bears the investment risk of the securities.

While a distribution compliance period precedes the ability to resell into the U.S. under Regulation S, a holding period is a condition for reselling restricted or control securities within the U.S. under Rule 144, regardless of their initial acquisition method. Often, once the distribution compliance period for Regulation S securities expires, those securities may then be resold in the U.S. subject to the applicable holding periods and other conditions of Rule 144.

FAQs

What is the purpose of a distribution compliance period?

The main purpose is to prevent securities that are offered and sold outside the United States under Regulation S from effectively circumventing U.S. registration requirements by flowing back into the U.S. market too quickly. It maintains the distinction between U.S. registered offerings and offshore unregistered offerings.

How long does a distribution compliance period typically last?

The length varies depending on the type of issuer and the category of securities. For example, equity securities of U.S. reporting companies sold under Regulation S typically have a six-month distribution compliance period, while debt securities may have a 40-day period.

Does the distribution compliance period apply to all securities?

No, the distribution compliance period specifically applies to securities sold in offshore transactions under Regulation S. It does not apply to securities sold in registered public offerings in the U.S. or certain other exempt offerings.

Can securities be sold during the distribution compliance period?

Generally, yes, but only to non-U.S. persons and outside the United States in an offshore transaction. Resales into the U.S. or to U.S. persons are typically restricted during this period to prevent the "flow-back" of unregistered securities.

What happens after the distribution compliance period expires?

After the distribution compliance period expires, non-affiliates who hold the securities generally can resell them in the U.S. public market without restriction, provided the issuer is a reporting company and certain public information requirements are met. Affiliates, however, would still need to comply with the volume and other limitations of Rule 144 for any resales into the U.S.¹.