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Taking stock of stock distributions

The recent surge in acquisition activity by public companies and the re-emergence of the IPO market have provided private equity funds with increased opportunities to hold publicly traded stock. Stephen Mears of Testa, Hurwitz & Thibeault discusses the factors determining whether a fund should sell this publicly traded stock or distribute this stock to its partners.

If the fund needs cash to finance its operations or investment activities, the fund will need to sell the stock. Even if the fund does not intend to retain the proceeds, a sale by the fund (followed by a cash distribution) may be attractive to fund managers and limited partners because there is less administration; limited partners do not need to (and often do not want to) determine when and how to sell the stock on their own; the return is realized immediately and equally for all partners; and the fund can manage the sale to minimize adverse effects on the stock price.

However, there are also advantages to stock distributions. The primary advantage is that the fund’s partners can make their own determinations regarding when to sell the stock, and partners that hold distributed stock can benefit from future increases in the stock price. In addition, if the fund is an "affiliate" of the portfolio company (e.g., because a fund manager serves as a director or because of a significant stock ownership position), the fund’s ability to sell the stock may be limited under the securities laws. Yet, in many circumstances, these same restrictions will not apply to limited partners following distribution of the stock.

Furthermore, a sale of stock by a fund may result in a tax liability for its taxable partners, whereas a stock distribution generally does not result in a tax liability until the stock is ultimately sold by the distributee. This gives the distributee greater control over the timing of the tax event.

Many private equity funds use stock distributions as a primary means of providing liquidity to their partners. Developing and following certain basic distribution policies and procedures can help to ensure that the advantages of stock distributions are realized and that stock distributions are viewed positively by both fund managers and limited partners.

Distribution Policies. There are three important goals in establishing distribution policies:

· Ensuring that partners have timely access to the stock for resale purposes. This is particularly important if the stock price does not remain stable in the post-distribution period.

· Ensuring an orderly market for the stock. Preventing a decline in the stock price is of particular concern in connection with large distributions or distributions of thinly traded stock.

· Minimizing administrative complexity. The less administrative complexity, the more positive the distribution experience will be for both fund managers and limited partners.

Establishing Distribution Procedures. The size of the distribution, number of limited partners, constraints of the fund’s governing documents and the securities law restrictions on resale of the stock will all dictate the proper procedures for a particular distribution. However, there are some general guidelines:

· Understanding Resale Restrictions. It is critical to understand the securities law restrictions applicable to the resale of the underlying shares by the fund’s partners following distribution of the stock. Resale restrictions will vary depending upon a number of factors, including the manner in which the fund acquired the stock and the length of time the fund has held the stock. The key is to make sure that limited partners will be able to freely sell the distributed stock following the distribution, and that limited partners are aware of any remaining conditions to the disposition of the stock (such as the need to file a Form 144 with the SEC). If the fund’s shares are registered for resale under a registration statement filed by the issuer (e.g., pursuant to registration rights granted to the fund), the fund will need to ensure that the issuer takes the necessary steps, both prior to filing the registration statement and at the time of the distribution, to permit limited partners to sell the distributed stock under the registration statement. In this case, the fund should also inform limited partners of the requirement to deliver a copy of the prospectus in connection with their sale of the distributed stock.

· Advance Planning. Preparation and organization are key components to successful distribution procedures. This includes monitoring the resale status of all publicly traded stock held by the fund, removing restrictive legends from stock certificates as soon as possible in advance of a sale or distribution, maintaining up-to-date information on the fund’s partners, obtaining any required approvals under the fund’s governing documents and consulting with counsel regarding securities law matters.

· Appointing a Designated Broker. Many investment banks and other firms provide specialized services designed to coordinate a fund’s distribution and the resale of distributed stock by the fund’s partners. An experienced broker can help to speed the resale process, reduce post-distribution volatility and ease the administrative burden on the fund.

Insider Trading Considerations. The fund’s managers will often be aware of material non-public information about the fund’s portfolio companies, and, as a result, the fund will be restricted from selling securities of those companies under insider trading rules. A distribution of securities is not viewed as a sale for purposes of the insider trading rules. However, a distribution of a company’s stock at a time when the fund is aware of material non-public information about the company may present a risk of allegations that the fund "tipped" its limited partners to sell the stock, which is a potential insider trading violation. In order to reduce this risk, funds should consider the following in connection with establishing their distribution policies and procedures:

· Avoid Distributions while in Possession of Material Inside Information. Even if securities law liability is avoided, limited partners that hold the stock following the distribution will bear the burden of any stock price decline when the bad news is announced, which creates a potential relationship problem.

· Avoid Continued Service on Public Company Boards. This significantly reduces the likelihood of the fund possessing inside information.

· Avoid Recommendations to Limited Partners. Funds should not make recommendations to limited partners regarding whether they should hold or sell the distributed stock (i.e., should not "tip"). Funds should also avoid providing research or analyst reports about the issuer in connection with a distribution, as these reports could be construed as tips to hold or sell the stock.

· Take Advantage of Rule 10b5-1. Rule 10b5-1 under the Securities Exchange Act provides certain affirmative defenses to insider trading prohibitions. In order to take advantage of Rule 10b5-1, a fund might consider excluding its representative on a public company’s board from the decision-making process with regard to selling or distributing stock of that company so that the decision is made only by fund managers who are not aware of material inside information. This should reduce the risk of liability for "tipping" limited partners in connection with a distribution. Rule 10b5-1 also provides an exception for sales made pursuant to pre-arranged trading plans established at a time when the seller was not aware of material inside information. Fund managers should consider taking advantage of Rule 10b5-1 for their personal sales of stock distributed to them by the fund.

Other Securities Law Matters. Funds making a stock distribution must consider whether the distribution requires an update to any filings under Sections 13 and 16 of the Securities Exchange Act by the fund or its managers. Fund managers must also be cognizant of these filing requirements, and the short-swing trading liability rules under Section 16, in connection with their personal sales of distributed stock.

Conclusion. A distribution of publicly traded stock may have a number of inherent advantages for a private equity fund and its partners. Funds can ensure that these advantages are realized by developing and adhering to effective distribution policies and procedures.

This article is reproduced with permission of Testa, Hurwitz & Thibeault, LLP. For more information about Testa, Hurwitz & Thibeault, LLP, please contact www.tht.com

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