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Restricted security

What Is a Restricted Security?

A restricted security is a class of financial instruments, typically equity shares, that cannot be freely traded in the public market due to specific limitations imposed by securities regulation. These limitations are generally tied to the way the securities were acquired, most commonly through private offerings or compensatory benefit plans, rather than a public offering. The primary purpose of these restrictions, rooted in the Securities Act of 1933, is to ensure that investors receive adequate disclosure about the securities they purchase. Without such disclosure, the free resale of these securities could undermine investor protection laws designed for public markets. Holders of restricted securities must typically adhere to strict rules, such as those outlined in Rule 144 of the Securities and Exchange Commission (SEC), before they can sell their holdings to the broader investment public.

History and Origin

The concept of restricted securities emerged directly from the foundational principles of U.S. securities law, particularly the Securities Act of 1933. Enacted in the wake of the 1929 stock market crash and the ensuing Great Depression, this legislation aimed to restore investor confidence by mandating transparency in the sale of securities. Prior to this, securities sales were primarily governed by state laws, known as "blue sky laws." The 1933 Act introduced federal requirements, primarily focused on the registration of securities offered for public sale, ensuring that companies disclose all material information to potential investors via a prospectus.7

However, the Act also recognized certain exempt transactions from registration, such as private placements to sophisticated investors, under the premise that these investors did not require the same protections as the general public. Over time, the resales of securities acquired through these unregistered transactions posed a challenge, as they could inadvertently create a new public distribution without the necessary disclosures. To address this, the SEC developed rules, most notably Rule 144, to govern the resale of these securities, thereby creating the category of "restricted securities."

Key Takeaways

  • Restricted securities are acquired in unregistered transactions, such as private placements, rather than through public offerings.
  • They are subject to limitations on resale, typically requiring a specific holding period and compliance with SEC rules like Rule 144.
  • The restrictions aim to protect investors by ensuring adequate disclosure about the securities before they enter the public market.
  • Owners of restricted securities may include company insiders, employees, or accredited investors who participate in private funding rounds.
  • Removing the restrictions often involves meeting conditions related to time, public information availability, and trading volume limitations.

Formula and Calculation

There is no direct "formula" or "calculation" for a restricted security itself. The term defines the nature of the security based on its issuance method and the regulations governing its resale. However, its salability is subject to specific volume limitations under SEC Rule 144, which can be seen as a calculation constraint when an affiliate intends to sell.

For affiliates selling equity securities, Rule 144 imposes a volume limitation:
The amount of equity securities that may be sold during any three-month period cannot exceed the greater of:

  1. One percent (1%) of the outstanding shares of the class being sold; or
  2. The average weekly reported trading volume for that class of securities on all national securities exchanges and/or through the automated quotation system of a registered securities association during the four calendar weeks preceding the filing of the notice of sale on Form 144, if applicable.6

This calculation dictates the maximum number of shares that can be divested within a rolling three-month period once the holding period is satisfied and other conditions are met.

Interpreting the Restricted Security

Understanding a restricted security involves recognizing its illiquid nature and the regulatory hurdles to its sale. Unlike publicly traded shares that can be bought and sold freely, restricted securities come with a "restrictive legend" stamped on the certificate or noted electronically, indicating that they cannot be immediately resold in the open market. This legend serves as a warning about the lack of liquidity.

For an investor holding a restricted security, interpretation means assessing the impact of the holding period and resale rules (such as Rule 144) on their ability to realize value. A longer holding period, or complex requirements for public information about the issuer, can significantly affect the timing and ease with which the security's market value can be accessed. For companies, managing the issuance and tracking of restricted securities is crucial for compliance with federal securities laws.

Hypothetical Example

Imagine Company X, a fast-growing tech startup, decides to raise capital by conducting a private placement of its common stock to a group of venture capitalists and key employees. These investors are considered accredited investors, meaning they meet certain financial sophistication criteria as defined by the SEC.5

Sarah, an early employee, receives 10,000 shares of Company X stock as part of her compensation package. Since these shares were issued through an unregistered offering (the private placement), they are designated as restricted securities. The stock certificate she receives has a legend indicating these restrictions.

Under SEC Rule 144, Sarah's shares are subject to a holding period. If Company X is a reporting company (subject to SEC filing requirements), she would typically need to hold the shares for six months. If Company X is not a reporting company, the holding period would be one year. During this time, she cannot sell her shares in the public market.

Once the holding period is satisfied, and assuming Company X becomes a publicly traded company (perhaps through an initial public offering), Sarah, as an employee and potentially an affiliate of the company, would still need to comply with volume limitations and other conditions of Rule 144, such as selling through a broker-dealer in an ordinary brokerage transaction, before she can sell her shares.

Practical Applications

Restricted securities appear in various real-world financial contexts, primarily stemming from transactions exempt from the full registration requirements of the Securities Act of 1933.

  • Employee Stock Compensation: Many private companies, and sometimes public ones, award employees restricted stock or restricted stock units (RSUs) as part of their compensation. These shares are typically restricted from immediate sale and are often subject to vesting schedules, where ownership transfers over time.
  • Venture Capital and Private Equity Investments: When venture capital firms or private equity funds invest in a private company, they receive shares that are restricted. These shares can only be liquidated following a public offering or a private sale that satisfies an exemption.
  • Mergers and Acquisitions: Shares issued as consideration in certain mergers or acquisitions may also be restricted, particularly if the acquiring company is private or the transaction structure relies on registration exemptions.
  • Rule 144 Compliance: For any individual or entity holding restricted securities, understanding and complying with Rule 144 is a critical practical application. This rule provides the pathway for holders of restricted or control security to sell their shares into the public market without registration, provided specific conditions related to holding period, current public information about the issuer, trading volume limits, and manner of sale are met. The SEC provides an overview of how these sales can be made.4

Limitations and Criticisms

While restricted securities serve an important regulatory purpose, they come with significant limitations and can attract criticism, primarily due to their impact on the investor. The chief drawback is the inherent illiquidity. Holders cannot easily convert these shares into cash, especially if the company remains private or if market conditions are unfavorable when restrictions lapse. This limited ability to sell can expose investors to prolonged market risk, as they are unable to diversify their holdings or respond to changing personal financial needs.

Moreover, the process of removing restrictions and selling restricted stock, particularly for company insiders or large holders, can be complex and expensive, often requiring legal counsel to ensure compliance with Rule 144 and other regulations. Non-compliance can lead to severe penalties. Critics also point to the potential for significant concentration risk, where an individual's wealth is heavily tied to a single, illiquid asset, which can be particularly problematic for employees of private companies whose compensation heavily includes such shares.3 The disparity in access to investment opportunities, where only accredited investors can participate in many private offerings that result in restricted securities, has also been a subject of debate, though the SEC has expanded the definition of accredited investor over time.2

Restricted Security vs. Control Security

Restricted securities and control security are often discussed together because they both fall under the purview of SEC Rule 144 regarding public resale, but they originate from different circumstances.

  • Restricted Security: A restricted security is defined by how it was acquired. It typically refers to securities obtained in unregistered transactions, such as a private placement from the issuer or an affiliate of the issuer. The primary concern with restricted securities is the lack of public information or registration statement at the time of their initial distribution.
  • Control Security: A control security, on the other hand, refers to any security held by an affiliate of the issuing company. An affiliate is generally a person who, directly or indirectly, controls, is controlled by, or is under common control with the issuer. This typically includes executive officers, directors, and major shareholders. The restriction here is not on how the security was acquired, but on who holds it. Even if an affiliate acquires shares in the open market (which would not be restricted securities), those shares become control securities in their hands and are subject to Rule 144 volume limitations when they are sold publicly.

In essence, a security can be both restricted and a control security if it was acquired in a private transaction by an affiliate. However, a security can be restricted but not a control security (if held by a non-affiliate), or a control security but not restricted (if an affiliate bought registered shares on the open market). Both types require compliance with Rule 144 for public resale.

FAQs

How long do you have to hold a restricted security?

The holding period for a restricted security depends on whether the issuing company is a reporting company with the SEC (e.g., files quarterly and annual reports under the Securities Exchange Act of 1934) or a non-reporting company. For reporting companies, the holding period is typically six months. For non-reporting companies, it is generally one year. After this period, other conditions under Rule 144 must still be met for public resale.1

Can restricted stock be sold before vesting?

Generally, no. Restricted stock typically comes with both resale restrictions (due to its "restricted" nature under securities laws) and vesting requirements (from the employer). Vesting means the employee's ownership of the shares becomes absolute over time or upon meeting certain performance criteria. Until shares are vested, they are not fully owned by the employee and cannot be sold. Even after vesting, the underlying "restricted" nature of the shares still requires compliance with SEC resale rules before they can be sold in the public market.

What is a restrictive legend on a stock certificate?

A restrictive legend is a notation printed directly on a physical stock certificate or noted in the electronic records of a brokerage, indicating that the securities represented by the certificate cannot be resold without registration under the Securities Act of 1933 or unless an exemption from registration is available. This legend alerts potential purchasers that the shares are not freely tradable. To sell such securities publicly, the legend usually needs to be removed by a transfer agent after the conditions of an exemption, such as Rule 144, have been met.