THE ECONOMICS OF THE PRIVATE MARKET
Appendix A. Definition of Private Placement, Resales of Private Placements, and Additional Information about Rule 144A
A private placement is a security that is issued in the United States but is exempt from registration with the Securities and Exchange Commission as a result of being issued in transactions not involving any public offering. This definition is based upon legal criteria and not upon the economic characteristics of the financial instrument. For example, in an economic sense, commercial loans to businesses and private placements of debt are similar, but in a legal sense a loan is not a security and thus is not a private placement. 162 Similarly, bank deposits are not private placements even though some are called notes and are distributed by dealers. 163
The legal status of a financial instrument can be economically important, however, because securities fall under the jurisdiction of securities law whereas other instruments are covered by commercial law. A significant practical difference between the two codes is that the Securities Act of 1933 (sections 12(2) and 17) provides for civil liabilities and criminal sanctions for fraud in the sale of a security. As a consequence, buyers of securities have greater protection and recourse in the event of fraud than those who make loans.
Exemptions from Registration for Private Placement Issuance
The Securities Act of 1933 requires that all offers and sales of securities be made through a registration statement filed with the Securities and Exchange Commission (SEC) unless an exemption from registration is available. Section 3 of the act exempts from registration certain types of securities, such as U.S. Treasury securities and commercial paper, and section 4 exempts certain securities transactions, such as the issuance of private placements and resales of registered securities. More specifically, section 4(2) of the act exempts ''transactions by an issuer not involving any public offering.'' 164 This exemption is based on the premise that sophisticated buyers of securities do not need the protection afforded by registration as they should be capable of obtaining information about the issuer on their own.
Initially issuers based exemptions under section 4(2) on interpretations by the SEC and case law. 165 Between 1974 and 1980, the SEC adopted three rules to clarify the conditions for exemptions for offerings. In 1982, the SEC issued Regulation D, which provides a different formal basis for a private placement exemption by combining and expanding these rules. Regulation D is a nonexclusive safe harbor, however, and most issuers have continued to rely on section 4(2), although their offerings satisfy most conditions of Rule 506 of Regulation D. 166
Rule 506 offers and sales may be for any amount and to any number of accredited investors, but the issuer or its agent may not engage in any general solicitation or advertising, the investors must purchase securities for their own accounts and not for distribution to the public, and no more than thirty-five unaccredited investors may purchase the securities. Accredited investors are mainly institutional investors, but the category also includes individuals with sufficient net worth or income. 167 The issuer must reasonably believe that unaccredited investors are capable of evaluating the investment. The rule does not require public disclosure of information about the issuer if only accredited investors are involved. However, the issuer must disclose to investors that the securities have not been registered with the SEC and that they cannot be resold unless they have been registered or the resale transaction is exempt. Finally, the issuer must file a notice with the SEC within fifteen days of the first sale. 168 Issuers relying on section 4(2) for an exemption generally attempt to conform to these conditions, except that they do not file a notice with the SEC. 169
Some private placements are issued under exemptions other than those offered by Regulation D and section 4(2). For example, section 4(6) of the 1933 act exempts issues totaling less than $5 million at one time (instead of over a twelvemonth period) under some circumstances, and section 3(a)(11) exempts securities that are issued by a resident of a state who is in business in that state and that are sold only to residents of the state. The relative volumes of placements issued under the several possible exemptions are not known, but remarks by market participants indicate that most of total volume relies for exemption on section 4(2).
Exemptions from Registration for Resales of Private Placements
Sections 4(2) and Regulation D provide exemptions from registration only for issuers of private placements. Those wishing to resell registered securities can rely on section 4(1) of the Securities Act, which exempts transactions by parties other than issuers, underwriters, and dealers. This exemption is not directly available to investors in private placements, however, because such investors are technically regarded as underwriters; if they were not, private placements could be indirectly distributed to the public through resales by investors, thereby circumventing the registration requirements of the Securities Act (Davis, Polk, and Wardwell, 1990).
Exemptions for resales of private placements are provided by the informal guidelines of the so-called section 4(11/2) exemption and by SEC Rules 144 and 144A. The section 4(11/2) exemption combines sections 4(1) and 4(2) of the Securities Act, neither of which by itself is sufficient to support an exemption. This exemption, based upon SEC no-action letters and market practice, assumes that resales of private placements are permissible without registration so long as they generally satisfy the conditions necessary for an issuer to justify an exemption under section 4(2). 170 That is, if buyers are of the same class of investors eligible to purchase private placements from an issuer and if they indicate their intention to hold the securities for investment purposes, then the seller in the transaction can be viewed as not being an underwriter and thus can rely on section 4(1) for an exemption (Carlson, Raymond, and Keen, 1992). Resales based on section 4(1/2) are somewhat cumbersome in that they involve letters of intent (to hold for investment purposes) from buyers to sellers.
Rule 144 permits investors to resell private placements after two years from the date of the securities' issuance, subject to certain limitations, and to sell without limitation after three years. 171
Rule 144A, adopted by the SEC in April 1990, provides an exemption from registration for secondary market transactions in private placements in which the buyer is a sophisticated financial institution, defined in the rule as a qualified institutional buyer (QIB). The rule applies only minimal restrictions to qualifying transactions. 172 QIBs are a subset of accredited investors; but, in any case, most private placements are purchased by QIBs, and thus the rule makes underwriting of new issues and active secondary trading feasible.
As defined by Rule 144A, QIBs are financial institutions, corporations, and partnerships that own and invest on a discretionary basis at least $100 million of securities. 173 The scope of this definition is broad enough to include the major investors in private placements, such as life insurance companies, pension funds, investment companies, foreign and domestic banks, savings and loan associations, and master and collective trusts. Besides meeting the securities requirement, banks and savings and loan associations must have net worth of at least $25 million. In contrast to other institutional investors, broker-dealers must own only $10 million of securities to qualify as a QIB. Moreover, if acting solely as an agent or a riskless principal, a broker-dealer does not have to be a QIB to place the securities.
The legal underpinning that the SEC used for Rule 144A is from the legislative history of the Securities Act. 174 The SEC concluded that the Congress never considered sophisticated institutional investors to need the protection offered by the registration of securities. Rather, the purpose of registration was to protect unsophisticated, individual investors. Thus, transactions in private placements involving only institutional investors may be legally separated from those involving individual investors. The implication of this argument, as embodied in Rule 144A, is that by establishing a class of private placement transactions confined solely to a well-defined class of sophisticated institutional investors, such transactions would be exempt from registration because they do not constitute an offering to the public. In essence, QIBs are not considered part of the public; therefore, sales to them involve no public offering, and sellers are not considered to be underwriters. QIBs can thus rely on section 4(1) of the Securities Act, which exempts secondary transactions not involving a dealer, underwriter, or issuer, and dealers can rely on section 4(3), which exempts transactions conducted as a part of dealer marketmaking (SEC, 1988).
Underwriting of Private Placements
The dealer exemption indirectly carries with it the authority to underwrite new issues of private placements. Generally speaking, an underwriting occurs when an investment bank purchases securities from the issuer with a view to reselling or distributing those securities to other parties. Under Rule 144A, as long as the resales are to QIBs, the activity is interpreted not as an underwriting or distribution but rather as a secondary market transaction. Consequently, an issuer may sell the securities to an ''underwriter'' using section 4(2) or Regulation D for an exemption from registration, and the underwriter may then resell the securities to eligible institutional investors relying on Rule 144A. 175
When a Rule 144A exemption is available, the buyer does not need to provide a letter stating that the purchase of the securities is for investment purposes, as it does with a traditional private placement. Rather, the buyer supplies information confirming its eligibility to purchase the securities under Rule 144A. The buyer also must agree not to resell the securities without having an exemption (Weigley, 1991).
SEC's Reasons for Adopting Rule 144A
The SEC adopted Rule 144A for three reasons (SEC, 1988). One was to formalize market practice regarding resales of private placements by eliminating the uncertainty surrounding the use of the section 4(11/2) exemption. A second was to increase the liquidity of private placements. Although a significant volume of trading that relied upon the section 4(11/2) exemption and Rule 144 had ocurred during the 1980s, most market participants felt that the conditions of those exemptions resulted in reduced liquidity in the primary and secondary markets.
Finally, the SEC hoped that Rule 144A would make the private placement market more attractive to foreign corporations. The SEC was motivated in part by the growing desire of many U.S. investors to purchase foreign securities in the United States without incurring the costs of obtaining them in foreign markets. Even though U.S. markets offered many advantages to foreign issuers-including a broad investor base, the opportunity to diversify funding sources, virtually the only source of long-term, fixed-rate funds, and financing for non-investment-grade companies-foreign corporations had not been a significant presence in U.S. markets, and thus their securities were not readily available to domestic investors.
Foreign corporations are reluctant to issue in the public and private markets for several reasons. In the public market, they are discouraged by the expense and the time involved in registering the securities with the SEC and in satisfying the continuing requirements for reporting. Particularly burdensome in this regard is the requirement that financial statements conform to U.S. generally accepted accounting principles. Some potential issuers are also loathe to disclose more information about their operations than that required in their home countries. Finally, the potential for litigation, brought by either the SEC or investors, that accompanies registration is a significant deterrent for many foreign corporations (Engros, 1992; Gurwitz, 1990).
Despite appearances, the burden of registration and disclosure requirements may not be as great as perceived by many potential foreign issuers. For example, relative to domestic issuers, the SEC requires much less disclosure for foreign corporations with limited business interests in the United States or limited ownership by U.S. residents, although the financial statements must, in part, still be reconciled with U.S. generally accepted accounting principles. Also, if shares of a foreign corporation are not listed on a U.S. stock exchange or quoted on the NASDAQ system, the SEC requires under Rule 12g3-2(b) only that the corporation provide information made public in its home country. 176 Nevertheless, outsiders have held the view that the disclosure requirements associated with public offerings in the United States are burdensome.
Although privately placed securities are a means for foreign corporations to avoid registration and public disclosure altogether, prior to adoption of Rule 144A foreign corporations had not issued extensively in the private market either. This was partly the result of the higher yields of traditional private placements. In addition, the greater frequency of restrictive covenants in private placements than found in securities issued in foreign markets and the negotiation of terms caused many potential issuers to shy away from the private market.
In adopting Rule 144A, the SEC hoped to lower one of the barriers to foreign issuance caused by the illiquidity of private placements. Also, by adopting Regulation S at the same time as Rule 144A, the SEC facilitated sales of overseas offerings by foreign and U.S. issuers in the private placement market. Regulation S stipulates conditions under which offshore offerings and resales of securities, whether issued by U.S. corporations or by foreign entities, are not required to be registered with the SEC. Generally, as long as securities transactions take place outside the United States and no effort is directed toward selling to persons within the United States, offshore transactions are exempt from registration with the SEC. 177 Under Regulation S, selling activities involved in the distribution of private placements and in resales pursuant to Rule 144A are not considered to be directed selling efforts. Thus, in contemporaneous offerings of securities inside and outside the United States, for which the securities sold in the United States are privately placed, the exemption from registration provided by Regulation S is preserved. Moreover, in strictly offshore offerings, Regulation S generally allows securities to be sold in the United States to QIBs without registration (SEC, 1990b; Morison, 1990). Taken together, Rule 144A and Regulation S have thus eased the way for foreign corporations engaged in offshore offerings to enter the 144A market.