Control & Restricted Stock: More Flexible Than Ever?

Q. Do you own control stock? That depends on who you are. Q. Are you aware of your company's trading policies? Q. How can you sell, borrow against and otherwise monetize your shares? Q. How can you use your shares to transfer wealth? education released first quarter 2011 Control & Restricted Stock: More Flexible Than Ever? summary Yes, the world of control and restricted securities tends to get a bit technical, but it's not as hard as you think. Start out with this basic understanding: It is unlawful for a company (also known as the issuer ), or anyone acting on behalf of an issuer (also known as an underwriter ), to sell shares to the public without first registering the shares with the SEC or finding an exemption from registration. Now focus on the underwriter: Anyone who could be an underwriter risks underwriter s liability if he or she sells unregistered shares to the public, meaning that person could face fines, private lawsuits even jail. Who could be an underwriter? Unfortunately, anyone who acquires shares directly from an issuer or from another Most restricted and control stock is held by corporate executives who have a few other things to think about as well. underwriter of the issuer (called restricted shares ), and anyone who is in a position to control the issuer (also known as an affiliate ) holding control shares could be an underwriter. So, you can see that the key to being able to sell your restricted or control shares without fear of underwriter s liability is to be sure you can t ever be considered an underwriter in the first place. Rule 144 is the principal safe harbor for sales of control or restricted securities. As long as you comply with Rule 144 s provisions, the SEC assures that you will not be considered an underwriter. Of course, if you are not an underwriter, you can sell your shares without fear of underwriter s liability. With Rule 144 s protection, you can treat control and restricted shares almost as you would any other shares. You just have to make sure to follow the Rule. Most restricted and control stock is held by corporate executives who have a few other things to think about as well. Some corporate executives must report their stock transactions to the SEC, for example, those deemed Section 16 insiders. Company trading policies may further limit their ability to sell or otherwise deal with their company shares. If these additional issues apply to you, then you have to take them into account to manage your employer stock positions safely. Letting you manage your restricted, control and employer stock positions with flexibility and without fear of violating federal law or company policy is what Morgan Stanley Smith Barney s Executive Financial Services Department ( EFS ) is

question and answer all about. EFS and your Morgan Stanley Smith Barney Financial Advisor can help you navigate through these restrictions so that you can accomplish your financial goals. Q. Do you own control stock? That depends on who you are. A. Control stock is very different from restricted stock. Control stock is considered to be any stock of an issuer held by a control person (also known as an affiliate ) of the issuer, even if purchased on the open market. So, who s a control person? Anyone who directly or indirectly controls Q. Do you own restricted stock? That depends on how you acquired the securities. the actions of a corporation is a control person or affiliate of that issuer. While there is no hard and fast rule, directors, executive officers or others who own a high percentage of the company s outstanding shares typically fit the bill. The issuer s counsel usually makes the final determination as to who is a control person or affiliate of the issuer. Spouses and certain family members of affiliates are treated as affiliates as well. The key to understanding control stock is that unlike restricted stock, it doesn t matter how the affiliate acquired the stock. Again, even if an A. In general, any stock you acquired from an issuer or an affiliate of an issuer in a transaction that wasn t registered with the SEC is considered to be restricted stock. Shareholders typically get restricted stock through a private sale or as compensation for services. Stock certificates representing restricted stock will usually (but not always) have a legend stamped on them warning that the stock is not registered and may not be sold publicly unless it is registered under applicable federal and state securities laws, or is exempt from such requirements. affiliate buys his company s shares on the open market, those shares instantly become control shares just because the affiliate is a control person. Typically, affiliates end up with control stock as compensation for services rendered, or upon the exercise of stock options. Control stock can also be restricted stock. For example, if an affiliate acquired the stock from the company in an unregistered sale, it is both restricted and control stock. Don t forget restrictions based on company policies. Company trading policies are another factor to consider when managing company stock that you own. Many companies have restrictions on trading by key employees who may be neither affiliates nor Section 16 insiders, but may have access to information about the company that isn t public. (See definition of an insider on next page.) Some examples of key employees are high-ranking managers or the CEO s assistant. Their ability to sell shares may be monitored by the company. Your company may also have a policy against pledging company stock for a margin loan. If it does, then you can t do it even if the SEC is fine with it and even if Morgan Stanley Smith Barney were otherwise willing to make the loan. Also, if your company s insider trading policy allows you to sell shares only during open trading windows, then you can only sell during those periods regardless of other considerations. Q. So what can you do? A. You still have several alternatives for managing your restricted and control stock holdings and concentrated positions, including the possibility of generating cash from your stock, diversifying those holdings or transferring them to heirs and charities. And, 2

you can do these things without getting into trouble with regulators and your company. Here are some ideas: Selling, borrowing against and otherwise monetizing your shares. Sales under SEC Rule 144: Remember that you could be considered an underwriter if you sell restricted or control stock to the public, but that Rule 144 provides a safe harbor against being considered an underwriter. That makes Rule 144 the safest and most common way for holders of restricted and control shares to sell their shares. You get the Rule 144 protections simply by following the provisions of the Rule: If you are holding restricted stock, you must have held it for at least one year (or six months if the issuer is a reporting company that is current in its SEC filings). If you are also an affiliate, then: (i) you can only sell if the issuer has current public information available at the time of sale; (ii) you can only sell a maximum number of shares based upon the Rule s volume limitations; (iii) your sale must be made by your broker in a manner permitted by the Rule, and: (iv) you must file a Form 144 with the SEC if you exceed certain threshold amounts. Selling under SEC Rule 145: If you were an affiliate of a company that was a party to a registered (under an S-4 registration statement) merger, acquisition or business combination involving a shell company (other than one created just to facilitate the transaction), SEC Rule 145 may provide a safe harbor against underwriter liability for sales as early as 90 days after the issuer ceases to be a shell company. Rule 145 cannot be relied on by affiliates of the issuer at the time of sale; they should instead use Rule 144. Also, Rule 145 is not needed if the merger parties were both operating companies, or if you were not an Q. What about Section 16 Insiders? A. Affiliates are often confused with Section 16 Insiders. Section 16 Insiders are considered to be a company s directors or shareholders who own 10% or more of any class of a company s outstanding stock, or certain levels of corporate executive officers. These insiders must file reports with the SEC under Section 16 of the Securities Exchange Act of 1934, disclosing all transactions in the issuer s securities. Section 16 Insiders are usually also affiliates of the issuer, but they need not be. It depends on how the issuer s counsel views their ability to control the issuer. affiliate of either party at the time of the merger those shares are fully registered by the S-4 and can be sold without restrictions. Sales under SEC Rule 701: Companies that are not publicly traded are typically exempt from the SEC s financial reporting requirements. Often, these companies grant stock options to employees before they go public as part of the employees compensation. These options may be exercised and the shares sold 90 days after the company goes public, subject to some of the provisions of Rule 144. Sales under an S-3: One obvious way to avoid selling unregistered shares is to have the sales registered. Of course, this can only be done by the issuer and not the individual. But, the S-3 form registration (SB-2 for smaller companies), also known as a shelf registration, allows holders of restricted stock to sell registered shares without having to rely on an exemption to registration or the safe harbor of Rule 144. Sales Upon Exercise of Executive Stock Options: Stock options give executives the right to purchase company stock for a specified price (the exercise morgan stanley smith barney 2011 3

question and answer Covered Call Risks 1 2 3 An option writer may be assigned at any time during the life of the option, including the day written, regardless of the in- or out-ofthe-money status of the position. If the short call is assigned, the writer must deliver the underlying security. The writer of a covered call forgoes the opportunity to benefit from an increase in the value of the underlying security above the option strike price, but continues to bear the risk of a decline in the value of the underlying security. 4 5 6 Buying back a call to close an existing position and writing another call with a different strike price and/or expiration, also known as rolling, can have an adverse impact on the profitability of the account. Rolling may result in added, transaction costs, which can reduce returns or add to any losses. Note: It may not be prudent to continually roll positions at a loss. If a secondary market in options becomes unavailable and prevents a closing transaction, the options writer's obligation would remain until expiration or assignment. The sale of the stock through an option assignment or the closing/expiration of an option position may produce a tax consequence. Please consult with your Tax Advisor prior into entering any transactions. 4

price) during a specified period of time. Ideally, the market value of the stock will rise above the exercise price, allowing the executive to realize a profit (minus taxes and fees). You may be able to exercise options and sell the shares immediately, using the proceeds to cover the exercise price and applicable taxes without paying for them out-ofpocket. Shares issued under stock option plans are usually registered for sale under an S-8 registration statement. However, affiliates cannot sell their option shares under an S-8 registration statement, so they will generally still have to sell under the provisions of Rule 144 (except for the holding period requirement), to be safe from potential underwriter liability, and of course they must sell during an open trading window and otherwise be in compliance with company policies. Sales through 10b5-1 Trading Plans: These are plans adopted by corporate insiders, affiliates and key employees during open trading windows, when they are not in possession of inside information. The plans allow you to trade your company stock or exercise your stock options according to a pre-established trading schedule, which can extend into and through closed window periods. Trading plans provide you with an affirmative defense against allegations that you traded stock while in You may decide to establish an Irrevocable Trust, Limited Partnership or Limited Liability Company and fund it with your restricted stock as a wealth transfer mechanism. possession of material nonpublic information (i.e. inside information ). As long as you didn t have inside information when you adopted the Plan, it doesn t matter if you have inside information when sales are made pursuant to the trading schedule. Sales through Blind Trusts: Like 10b5-1 plans, blind trusts provide a defense against perceptions of selfdealing or insider trading. However, unlike a 10b5-1 plan, a blind trust is managed by an independent trustee, who is given discretion to buy and sell shares without your input or even knowledge. To preserve independence, the trustee will sell shares without providing any details of the sale, other than as may be necessary to file tax returns and comply with applicable securities laws. Hedging Transactions: Derivative transactions such as prepaid forward sales and equity collars combine features of sales or loans with various put and call options to give an investor liquidity or a regular cash flow from a restricted or concentrated stock position, while at the same time providing downside protection (but often limited upside potential), and sometimes a deferral of income taxes. Equity collars are not available to affiliates. 1 1 Option Disclosures: Options are not suitable for all investors. Investors should not enter into option transactions until they have read and understood the Option Disclose Document (ODD), titled Characteristics and Risks of Standardized Options. Before engaging in the purchase or sale of options, investors should understand the nature of and extent of their rights and obligations and be aware of the risks involved, including, without limitation, the risks pertaining to the business and financial condition of the issuer of the underlying security or instrument. Options investing, like other forms of investing, involves tax considerations, and transaction costs that can significantly affect the profit and loss of buying and writing options. The transaction costs of options investing primarily of commissions (which are imposed in the opening, closing, exercise and assignment transactions), but may also include exchange fees in particular transactions. Transaction costs are especially significant in option strategies calling for multiple purchase and sales of options, such as multiple leg strategies, including spreads (including rolling), straddles and collars. A copy of the Option Disclosure Document can be found at the following website: http://www.theocc.com/ about/publications/character-risks.jsp Borrowing Against Restricted or Control Stock Positions: Morgan Stanley Smith Barney is one of the leaders in lending against restricted and control stock and concentrated stock positions. These are generally structured as margin loans, and they can be either purpose or non-purpose loans. Non-purpose loans must not be used morgan stanley smith barney 2011 5

question and answer for purchasing securities. But, you can use purpose loans for buying securities as well as to pay taxes, finance a home, free up cash for investing in other assets, or merely to increase your liquidity and cash flow. 2 2 Margin can be very risky, and is not suitable for all investors. Before opening an account, you should fully understand the risks associated with margin. These risks include: You can lose more money than invested (deposited), you may have to deposit additional cash or marginable securities on short notice to cover market losses, you may be forced to sell some or all securities when there is a decline in account equity value, some or all of your securities may be sold without prior notice in order to maintain account equity at required maintenance levels, You are not entitled to choose which securities or other assets in your account(s) are liquidated or sold to meet margin call, The firm can increase its house maintenance margin requirements at any time and is, not required to provide you advance written notice, and you are not entitled to an extension of time on a margin call. Exchange Funds: An exchange fund offers diversification and taxsensitive management to executives with significant positions in a single company stock. Contributions of appreciated stock to a properly structured exchange fund are generally tax deferred, not avoided, under current federal tax law. Clients should discuss such strategies with their tax advisor before entering into such arrangement. Fund assumes investor s tax cost basis in contributed stock and investor s cost basis in fund shares equals basis of contributed stock. In a complete redemption of fund shares, basis in fund An exchange fund offers diversification and tax-sensitive management to executives with significant positions in a single company stock. shares is transferred to distributed stocks. Many lenders accept shares in exchange funds as loan collateral. Note that exchange funds provide no protection in a market decline, are illiquid and may involve high expenses. Using Your Shares To Transfer Wealth The gift tax rules allow you to transfer a certain amount each year to as many individuals as you wish free of gift tax (the annual exclusion ). This can help with tax planning and with your estate planning and philanthropic goals. Giving it to Family Members: Individuals are allowed to transfer a certain amount each year free of gift tax (the annual exclusion ). You may gift restricted stock to anyone you choose in an amount equal to this annual exclusion ($13,000 per person, per recipient in 2010). If the holding period has been met prior to the gift (generally 6 months or one year), the recipient, the recipient will not be considered an underwriter even without complying with Rule 144 (unless the recipient is himself an affiliate of the issuer). The gift may trigger reporting obligations under Section 16 if you re an affiliate of the company. Transfer Shares to an Irrevocable Trust, Family Limited Partnership or Limited Liability Company: You may decide to establish an Irrevocable Trust, Limited Partnership or Limited Liability Company and fund it with your restricted stock as a wealth 6

transfer mechanism. If you re an affiliate, you may have reporting requirements under Section 16 when you make the gift, and the Trust or Family Limited Partnership may use Rule 144 when it sells the shares to avoid underwriter s liability. Transfer Shares to a GRAT: The transfer of assets assumed to have potential for significant appreciation to a grantor retained annuity trust ( GRAT ) is a common wealth transfer technique. You, as the grantor, may transfer restricted or control stock to a GRAT and receive annual annuity payments for the term of the GRAT. Any stock remaining at the end of the GRAT s term is distributed to the beneficiary named in the GRAT free of gift tax. Giving Shares to a Private Family Foundation: Restricted or Control Stock may also be transferred to private family foundations set up to advance family philanthropic goals. Regardless of the donor s status, the foundation will not be considered an affiliate and will not be subject to Section 16 rules, but should sell under Rule 144 if the shares are restricted and the donor has not met the holding period set forth under Rule 144. Giving Shares to Charity: Many charities and other nonprofit organizations accept donations of restricted stock. A gift of restricted stock could qualify for an immediate charitable income tax deduction based on the fair market value of the stock on the date of the gift. And donating it would allow the donor to avoid paying capital gains on any appreciation in the shares. As with other donees, the charity will tack on to donor's holding period and can sell the stock once the holding period has been met. Giving Shares to a Charitable Trust: The transfer of control or restricted Many charities and other nonprofit organizations accept donations of restricted stock. A gift of restricted stock could qualify for an immediate charitable income tax deduction based on the fair market value of the stock on the date of the gift. And donating it would allow the donor to avoid paying capital gains on any appreciation in the shares. stock to a Charitable Remainder Trust ( CRT ) allows you, as the donor, to contribute assets to the CRT, receive an immediate income tax deduction, and receive annual payments for the term of the trust (generally your life or a number of years not to exceed 20). At the end of the trust s term, any remaining assets go to the charitable beneficiary named in the trust. If you are an affiliate, and are also the Trustee of the CRT, then the CRT will also be considered an affiliate. Similarly, the transfer of control or restricted stock to a Charitable Lead Trust ( CLTs ) allows you, as the donor, to gift assets to a CLT in which a charity or charities receive annual payments for the trust term and non-charitable beneficiaries named in the trust (generally your family members or trusts for their benefit) receive any assets remaining at the end of the trust term. Depending upon how the trust is structured you may or may not receive an income deduction for your contribution of stock to the CLT. At the end of the trust s term, any remaining assets go to the named noncharitable beneficiaries, generally the donor s family members or trusts for their benefit. Sales of Restricted Stock by Estates: Restricted stock may end up in a decedent s estate. The estate might be considered an affiliate in certain circumstances and if so, sales should comply with Rule 144. Otherwise, estates are generally free to sell their restricted shares. morgan stanley smith barney 2011 7

If you currently own control or restricted stock, Morgan Stanley Smith Barney s Executive Financial Services Department can work with you and your Financial Advisor to help determine how your stock can be used for liquidity, asset protection and wealth transfer, through loans, sales under Rule 144, 10b5-1 trading plans, hedging or gifting. Diversification does not guarantee a profit or protect against a loss. This material does not provide individually tailored investment advice. It has been prepared without regard to the individual financial circumstances and objectives of persons who receive it. The securities discussed in this material may not be suitable for all investors. Morgan Stanley Smith Barney recommends that investors independently evaluate particular investments and strategies, and encourages investors to seek the advice of a financial adviser. The appropriateness of a particular investment or strategy will depend on an investor s individual circumstances and objectives. Morgan Stanley Smith Barney LLC, its affiliates and Morgan Stanley Smith Barney Financial Advisors do not provide tax or legal advice. This material was not intended or written to be used for the purpose of avoiding tax penalties that may be imposed on the taxpayer. Clients should consult their tax advisor for matters involving taxation and tax planning and their attorney for matters involving trust and estate planning and other legal matters. 2011 Morgan Stanley Smith Barney LLC. Member SIPC. CCG6453538 6453538 02/11