A registration rights agreement may be particularly useful, in the appropriate context, for a shareholder or shareholders holding stock in a public company. Generally, holders of shares in a public company do not need registration rights even though their shares have never been registered because they can sell so-called "restricted" shares under Securities Act Rule 144. However, the holder of a large block of shares, large enough to constitute the holder an "affiliate" of the issuer, faces a more difficult problem. Whether or not the shares have been registered, the holder as an affiliate must limit its unregistered sales to the leeway provisions of Rule 144, which allow, in effect, a dribbling out of restricted shares subject to the Rule in amounts not to exceed a test based on trading volume or percentage of outstanding shares. Thus, a major shareholder cannot get rid of its block with ease and facility, at least in any time period the shareholder would like, under the proscriptions of Rule 144; hence, that shareholder needs a registration statement (or an exchange offer).
To be sure, registering an affiliate's stock in an already public company is not ordinarily a controversial decision. If a large shareholder wants to dump its stock, usually the management of the company is sympathetic, particularly because the big shareholder's alternative (absent registration and sale) is to find a buyer for the entire block who, in turn, may very well be an unwelcome buyer for the entire company. However, when the fine points of the transaction are negotiated, the company is not without leverage since, as indicated before, the issuer and only the issuer may file a registration statement. Moreover, if there is to be any discipline in the process, the secondary offering will be underwritten; in fact, it will be very carefully orchestrated so as to avoid depressing the market by a huge influx of shares in a relatively short period of time. The underwriters usually sell to institutional purchasers, and these sales are arranged on the basis of a carefully planned presentation involving the company's management—so-called "road shows."
The underwriters in turn will seek indemnification from some "deep pocket" in the event they are sued on the theory that the registration statement contained material misstatements or omissions. Because the company is preparing the registration statement, the logical indemnitor is the company; the selling shareholders are asked to join in but the company in the final analysis should stand behind the statements made in its registration statement, statements which the company is in a peculiarly advantageous position to screen. However, absent a preexisting contract, the company may elect to shove the litigation risk entirely onto the selling shareholders, arguing that it is the selling shareholders who want the transaction to go forward. The company is cooperative, but in essence indifferent, contending there is no consideration to the company from the sale; therefore, while the company is willing to bear some incidental expense, the company is not getting paid to undertake the contingent and unlimited risk of a shareholder lawsuit. The company points out that, occasionally, the omission is accidental or one that even the finest legal and accounting minds could not have foreseen; nonetheless, some idiosyncratic jury may find the basis for substantial liability.
If there exists a registration rights agreement, on the other hand, this argument is usually mooted. The agreement, itself executed at the time the affiliate initially invests, requires the company to provide indemnification. The company thus avoids any accusation it is favoring an insider shareholder by assuming risks. Those risks have been allocated at a time when consideration was passing indubitably to the company. The agreement may also contain other handy provisions. For example, the company may be required to eschew primary sales for a period of time deemed necessary by the underwriters to allow the market to settle down after the secondary offering.
In short, registration rights agreements are often most useful in contexts in which they are least frequently negotiated—when a purchaser is accumulating a substantial block in a public company. Secondary sales of shares in theretofore private companies are rare; accordingly, registration rights agreements are not particularly useful in that context in a practical sense. They are, however, quite useful in organizing the rights and responsibilities of the parties at the time the secondary seller seeks to dispose of an inconvenient large block of shares in a public company.
Joseph W. Bartlett, Special Counsel, JBartlett@McCarter.com
McCarter & English, LLP
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