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SEC Interpretive Letter to Bank of America Merrill Lynch expands the Scope of Derivative Transactions under the Rule 144 Safe HarborDecember 5, 2011
On December 1, 2011, the Securities and Exchange Commission’s Division of Corporation Finance issued an interpretive letter to Bank of America, N.A. and Merrill Lynch, Pierce, Fenner & Smith Inc. clarifying the application of Rule 144 under the Securities Act of 1933 to the sale of securities as part of forward or option-based contracts entered into between a broker-dealer and an affiliate of the issuer (also known as a holder of “control securities”) or a holder of “restricted securities.” The Division’s letter to Bank of America Merrill Lynch, which we refer to herein as the BAML Letter, is available here. The BAML Letter provides substantial benefits to affiliates and broker-dealers by:
- Expanding the ability of affiliates to hedge and/or monetize their securities positions through forward and option-based contracts; and
- Confirming a broker-dealer’s ability to dynamically adjust or hedge its risk under the contract without registering its hedging sales under the Securities Act.
Availability of Rule 144 Safe Harbor for Forward/Option-based Derivatives
The BAML Letter makes clear that affiliates and holders of restricted securities may enter into a forward or option-based derivative contract with a broker-dealer without having to register the transaction or the dealer’s initial hedge under the Securities Act; the parties may instead rely on the Rule 144 safe harbor to effect the transaction and the dealer’s initial hedge without registration. To take advantage of the new interpretive position, the transaction must comply with each of the following conditions:
- At the time the parties enter into the forward or option-based contract, the affiliate or holder of restricted securities must be able to sell outright in reliance on Rule 144 the restricted or control securities in an amount equal to the maximum number of shares deliverable on settlement;
- The affiliate or holder of restricted securities must file a notice on Form 144 with the SEC; and
- After entry into the contract, the broker-dealer must promptly introduce into the public market a quantity of securities of the same class equal to the maximum number of shares deliverable on settlement of the contract in transactions conforming to the manner-of-sale conditions described in Rule 144(f) and (g).
Under these circumstances, the Division agreed that:
- Restricted or control securities that are the subject of the pledge to the broker-dealer may be treated as securities that are neither restricted nor control securities in transactions for the broker-dealer’s own account; and
- Securities returned to the affiliate or holder of restricted securities on settlement of the contract will not be restricted securities within the meaning of Rule 144(a)(3).
In addition, under the above circumstances, the Division agreed that, as long as the initial sale by the broker-dealer of the maximum number of shares deliverable under the contract is accomplished in a manner consistent with Rule 144, the existence of the forward or option-based contract will not disturb an exemption -- such as the exemption provided under Section 4(3) of the Securities Act -- otherwise available to the broker-dealer for ongoing purchases and sales. This assures broker-dealers that they may buy and sell the same class of securities for their own account as part of their dynamic hedging of the risk assumed under the contract. The Division’s position regarding dynamic hedging is limited to circumstances in which the terms of the contract are not based on the price at which any dynamic hedging sales or purchases occur and the counterparty under the contract has no economic interest in such sales or purchases. The dynamic hedging position is not limited by the size (or delta) of the initial hedge.
The BAML Letter builds upon two prior Division letters. In 1999, the Division agreed that, under certain circumstances an affiliate or holder of restricted securities could sell securities underlying a pre-paid variable share forward contract entered into between the affiliate or holder of restricted securities and a broker-dealer in reliance upon the safe harbor provided by Rule 144. In 2003, the Division addressed the Securities Act implications of a forward or option-based contract between a broker-dealer and an issuer of equity securities and the broker-dealer’s related public offer and sale of the maximum number of shares deliverable by the issuer under the contract in a transaction registered under Section 5 of the Securities Act. Under the circumstances described in that letter, the Division agreed that the existence of the contract would not affect an exemption otherwise available to the broker-dealer from registering offers and sales of the same class of equity securities exceeding the maximum number of shares deliverable under the contract in connection with its dynamic hedging activities related to the contract.
Practical Legal Considerations
The BAML Letter reaffirms, confirms, and expands a number of aspects of the Rule 144 safe harbor. Some of the most important practical benefits of the BAML Letter include:
- Reaffirming that, under certain circumstances, restricted or control securities that are the subject of a pledge to a broker-dealer may be freely resold in transactions for the broker-dealer’s own account;
- Reaffirming that, under certain circumstances, securities returned to the affiliate or holder of restricted securities on settlement of the contract will not be restricted securities within the meaning of Rule 144(a)(3);
- Confirming that the existence of a related forward or option-based contract between a broker-dealer and an affiliate or holder of restricted securities will not disturb an exemption (such as the exemption provided under Section 4(3) of the Securities Act) otherwise available for a broker-dealer’s dynamic hedging activities;
- Expanding the Division’s previously issued guidance under Rule 144 to include public resales by affiliates or holders of restricted securities of securities underlying any forward or option-based derivative contract; and
- Providing clarity with respect to the regulatory requirements for derivative contracts in which the contemplated public resale is accomplished either under the Rule 144 safe harbor or under an effective Securities Act registration statement.
Understanding the scope of the BAML Letter is an important step in structuring any type of derivative transaction with a public sale component. However, the Securities Act implications for any derivative transaction are to some extent unique and, therefore, require a careful examination and complete understanding of the transaction’s particular facts and circumstances. Generally, such an understanding requires the parties to review each contemplated transaction’s basic structure and to answer the following questions:
- What class or classes of securities are implicated by the derivative transaction?
- What class or classes of securities are being offered or sold (including any solicitation of an offer to buy) in connection with the derivative transaction?
- How, when, and by whom are such securities being offered or sold?
- Is an exemption from registration under the Securities Act available for each offer and sale of securities?
- If an exemption from registration is not available, what Securities Act registration requirements relate to the transaction, and what public disclosure and prospectus delivery obligations result from such registration requirements?
The BAML Letter contemplates a wide variety of derivative transactions, and is not limited by the size (or delta) of the broker-dealer’s desired initial hedge or the minimum number of shares deliverable. Therefore, the BAML Letter provides broad flexibility to the broker-dealer to structure a customized derivative transaction that meets the individual objectives of a holder of restricted or control securities (referred to herein as a “Rule 144 shareholder”).
As with the 1999 Letter, many types of forward transactions are contemplated by the BAML Letter. The broker-dealer purchaser may pay the purchase price at initiation of the transaction (a pre-paid forward) or on one or more pre-determined or subsequently determined dates during the term of the transaction (a post-paid forward). The purchase price and/or the number of shares deliverable under a forward transaction might be fixed or based on a formula (a variable-price forward or a variable-share forward, respectively).
More complex forwards also are contemplated by the BAML Letter, for example, knock-out forwards. These contracts enable the Rule 144 shareholder to sell a defined number of shares at regular intervals at a price above current market levels, provided that on pre-scheduled benchmark dates the stock price remains above a pre-specified barrier. For example, if the stock price is at $100 on the trade date, the contract could provide that 10 shares will be delivered in respect of each “testing date” in return for $110 per share provided that the stock price on such testing date is at least $90. The testing dates start in the future and may be any dates agreed between the parties (e.g., daily, weekly, monthly, etc.). The total number of shares delivered pursuant to the contract will depend on the stock prices on each testing date. This strategy does not provide full downside protection since it “knocks out” if the barrier price is hit (resulting in no shares being delivered or money payable with respect to that testing date), but is advantageous if the Rule 144 shareholder thinks that the stock will trade in a range between the barrier price and the sale price during the term of the contract. As with other forward transactions, the Rule 144 shareholder often will be required to post the underlying shares as collateral to “cover” the potential delivery obligation, with excess collateral returned to the Rule 144 shareholder if a “knock out” occurs.
Option-based transactions covered by the BAML Letter include both simple put options purchased by the Rule 144 shareholder or call options written by the Rule 144 shareholder, as well as more complicated transactions that involve one or more combinations of options. The BAML Letter does not constrain the terms of the option-based transaction, including the relationship of the strike price of the option to the current market price of the shares, the duration of the option, the exercise style of the option, whether the number of shares deliverable under the option is fixed or based on a formula, or whether the option is contingent. Two examples are a covered call and a collar:
Covered Calls: A Rule 144 shareholder may sell a call option in reliance on the BAML Letter. In return for receiving an upfront premium, the Rule 144 shareholder would be obligated, at the broker-dealer’s election, to sell the shares underlying the call option to the broker-dealer at the strike price. The strike price is usually set above the current market price so that the stock must appreciate for it to be likely that the option will be exercised. For example, if the stock price is at $100 on the trade date, the Rule 144 shareholder could sell a call option struck at $130 that expires one year later. In return, the broker-dealer might pay a $5 premium. This option premium allows the Rule 144 shareholder to increase the yield on owning the shares (as the Rule 144 shareholder receives this amount plus any dividends paid on the underlying shares) and also serves as a partial hedge to protect against the stock price falling (the loss in the value of the shares owned is offset up to the amount of the premium received, $5 in the above example). The Rule 144 shareholder will often be required to post the underlying shares as collateral to “cover” this potential delivery obligation.
Collar: A Rule 144 shareholder may want downside protection but also may want to retain the shares if the stock price does not increase above an agreed level. In such cases, the Rule 144 shareholder could enter into a freestanding collar rather than a variable-share forward. Under the collar, the Rule 144 shareholder would buy a put option and sell a call option, with the result that the Rule 144 shareholder would deliver shares against payment of the relevant option strike price if the stock price fell below an agreed level or increased above a higher agreed level. For example, if the stock price is at $100 on the trade date, the Rule 144 shareholder could buy a put option struck at $100 and sell a call option struck at $120. Both options might expire after one year and the strike prices might be set so that the premium payable by the Rule 144 shareholder for the put offsets the premium payable by the broker-dealer for the call (known as a “costless collar”). If the stock price is between $100 and $120, both options would expire worthless and no shares would be delivered under the collar. Again the Rule 144 shareholder will often be required to post the underlying shares as collateral to “cover” this potential delivery obligation.
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If you have any questions regarding the BAML Letter, any other letters or issues discussed in this alert, or how to structure derivative transactions consistent with relevant precedent, please contact the authors of this alert or your OMM advisor. In addition, the authors of this alert wish to thank Glen A. Rae, Robert J. Dilworth and Eric P. Hambleton of Bank of America Merrill Lynch, who assisted with the submission of the interpretive request to the Division and were instrumental in assessing relevant legal issues and current market practice.
 Goldman, Sachs & Co. (avail. Dec. 20, 1999).
 Goldman, Sachs & Co. (avail. Oct. 9, 2003).
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