When dealing with the requirements of the Securities Exchange Act of 1933, it’s vital to understand the definition of an affiliate. We’ll look at what an affiliate is, as provided by the SEC under this act, and cover what you need to know.
Specifically, in this article, we will consider what an affiliate is within the Securities Exchange Act, specifically within SEC Rule 144 and Regulation D. The concept of an affiliate is present in all forms and regulations that pertain to these acts and frameworks. The Securities Act includes a specific statutory definition of an affiliate, as it forms the cornerstone for analyzing the facts and circumstances within a company.
What is an affiliate for the SEC?
As per SEC Rule 405, an affiliate refers to a person or insider, such as a corporate officer, board member, or a shareholder owning 10% or more of the stock, who holds a controlling relationship with the company issuing the securities. The term “control” here signifies the power to direct the company’s management and policies, either through the ownership of voting securities, contractual arrangements, or other means.
What does “control” mean within the affiliate definition?
This complex issue has been the topic of judicial decisions, SEC letters, practitioner discussions, and industry debate. The SEC has constantly maintained its position that the status of ‘control’ is dependent upon the circumstances and facts of each case, and has not definitively stated the circumstances in which an individual will be a “control person” of an issuer.
Navigating complexity
Without this clear-cut definition or checklist of examples, organizations need to work hard to establish their own situation. The simplest example would be where a group or individual owns a majority of voting shares within a company.
Case study: U.S. v. Wolfson
U.S. v. Wolfson is a federal court case that involves the determination of the term “affiliate” and the interpretation of control securities under the United States securities law.
The protagonist, Gregory W. Gray Jr., president and principal of various related entities in the investment industry, was the subject of investigations by the Securities and Exchange Commission (SEC) as well as the Federal Bureau of Investigation (FBI). He was found guilty of securities fraud and pled guilty to investment advisor fraud following an investigation into his businesses and investment practices.
Gray’s fraudulent schemes involved a web of complex transactions with multiple companies and individuals. One significant allegation was his relationship with Jason Sugarman and Robert Wolfson, where he misrepresented his relationship with Sugarman to his investors. Gray claimed that Sugarman was an “affiliate” (a term used to indicate a person in control of an issuer) of the company SQL Sentry, LLC, when in reality, the “affiliate” was Robert Wolfson. Gray funded a portion of Wolfson’s acquisition of SQL Sentry, LLC, using investor funds without proper disclosure.
The case illustrates the importance of understanding the correct interpretation of “affiliate” and “control securities” under U.S. securities laws. Misrepresenting such relationships can lead to severe legal consequences such as securities fraud charges. In this instance, Gray was sentenced to prison and had to pay substantial fines and penalties.
This case serves as a cautionary tale, emphasizing the need for transparency in investment operations and highlighting the severity of the legal response towards fraudulent activities in the securities market.
The 10% rule of thumb
In recent years, an accepted rule of thumb has become 10% ownership as an indicator of possible control. This can be useful, because a 10%+ share of any company fix is already monitored under Section 16 of the Exchange Act, and subject to its rules and reporting.
However, once again, the individual circumstances of the case must be considered.
There have been instances where courts have found that people owning more than 10% of a company’s stock were not in fact exercising control, based on involvement in the company, and because other groups owned a higher proportion of the stocks.
What about directors and executive officers?
Companies usually list directors and executive officers as affiliates because of their clear spans of organizational control. However, the law doesn’t actually require this. A number of cases have found that holding these roles can be a contributing factor to control within the SEC definition, but in itself, it isn’t a defining factor.
In an American Standard No-Action Letter, the SEC itself has said that an individual’s status as a director, officer, or 10%+ stock owner isn’t necessarily enough to determine whether or not they are a controller or part of a controlling group. The SEC has said that these facts must be considered, but only alongside other relevant facts as laid out under the Act (Rule 405).
The topic of control gets even trickier when other, more informal relationships are considered. These can be based on affiliated businesses, certain relatives, spouses, or even family living in the same home. Again though, the SEC and courts have maintained a consistent approach that any individual within a group that can affect company policies or management (either directly or indirectly) is also defined as a control person for reporting purposes.
Case Study: Pennaluna & Co. v. SEC
Pennaluna & Co. v. SEC is a crucial case related to securities regulation in the United States, and it further defined the concept of an affiliate within the context of securities law.
In this case, Pennaluna & Co., an Idaho-based brokerage firm, was involved in purchasing shares of a company for its own account from controlling shareholders of the company. Then, they re-sold these shares to their clients without complying with the registration requirements of Section 5 of the Securities Act.
The Securities and Exchange Commission (SEC) decided that Pennaluna was in violation of the Securities Act of 1933 because the shares should have been registered before they were sold to the public.
Upon appeal, the Ninth Circuit Court of Appeals affirmed the SEC’s decision. Essential in the court’s ruling was the interpretation of the term “affiliate” under Rule 144 of the Securities Act. The court ruled that the controlling shareholders were, indeed, affiliates of the company from which Pennaluna & Co. purchased the shares, as they had the power to directly or indirectly control the company or its policies due to their ownership of a significant amount of the company’s voting securities.
This case expanded the definition of the term “affiliate” to include not just executive officers and directors, but also controlling shareholders who have significant influence over the company. This helped to provide a broader interpretation of the regulation of control securities, emphasizing that even brokers could be in violation of securities laws if they engage in the sale of unregistered securities that they purchased from affiliates.
Factors to evaluate when determining an Affiliate or Control Person
These are essential factors to review when assessing affiliate status:
- Directors and officers within the company, and any other individuals with similar roles
- 10% of share ownership or more, including the effect of new issuances, re-sales, or access to convertible securities (which could result in more ownership from any one individual.)
- Voting control, with the ability to influence the votes of others, either alone or as a group (this could include quorums, in absentia votes and proxies.)
- Key relationships within the company. For example, if one company is almost entirely responsible for another’s revenues.
- Family relationships within key shareholders, directors, and officer networks.
- Creditor and debtor relationships, particularly where major creditors can foreclose assets.
- Shareholder intent (evidenced by Schedule 13G for passive investors) or 13D.
- Where individuals make efforts to assert control over a company (depending on the results of that control.)
About Rule 144 of the Securities Exchange Act
SEC Rule 144 defines the conditions for affiliates and non-affiliates. The rule ensures that public information about a company and its transactions is always transparent. Affiliate sales are subject to limitations on volumes sold (drip rules), and are required to be made through a broker selling-transaction, accompanying a Form 144 filing. Non-affiliate sales are still recorded but in a far more limited way. Ultimately, the determination of who is an affiliate (and for what time period) affects how Rule 144 is employed.
Conclusion
Under the terms of the Securities and Exchange Act, every security issued to an affiliate should have the appropriate Restricted and Control Legends placed on the securities (book-entry statements or physical stock certificates) through a stock transfer agent, like Colonial Stock Transfer.
*Please consult with your legal counsel if you have any questions.