On June 9, 2022, the staff (“Staff”) of the US Securities and Exchange Commission (“SEC”) added Question 101.01 to its Compliance and Disclosure Interpretations (“C&DI”), addressing forward contracts on restricted securities. The new CD&I clarifies that forward contracts on restricted securities would not be considered “intended to be physically settled” under certain circumstances as discussed below.

Typically, forward contracts benefit from an exclusion from the definition of “swap” and “security-based swap;” this is because the definitions of “swap” and “security-based swap” exclude “any sale of a nonfinancial commodity or security for deferred shipment or delivery, so long as the transaction is intended to be physically settled.” Forward contracts are typically “intended to be physically settled.”  To the extent forward contracts are excluded from the definition of “swap” and “security-based swap,” they are not subject to Title VII under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Dodd-Frank Act”).

CD&I Question 101.01 clarifies that while a determination of whether an instrument is a “swap” or a “security-based swap” is based on facts and circumstances, the SEC Staff would not consider a forward contract as “intended to be physically settled” if, at the time the parties enter into the contract, the underlying securities (i) cannot be legally transferred, or (ii) are subject to contractual restrictions on transfer. In order for the contract to be considered “intended to be physically settled,” the following conditions must both be met: (i) the offer and sale of the underlying securities must be registered in compliance with Section 5 of the Securities Act or otherwise exempt from registration; and (ii) any contractual restrictions on the transfer of the underlying securities must be satisfied or otherwise waived.

This means that employees and stockholders of private companies that are subject to employment or charter restrictions on transfers may be prevented from using forward contracts to obtain liquidity in the absence of the company’s express cooperation. Although some private companies sponsor liquidity programs for employees and stockholders, typically, these are sponsored through organized platforms and are structured as outright sales.   

If the contractual restrictions are not waived, the forward contract would not be considered “intended to be physically settled” and would be subject to regulation under Section 5 of the Securities Act of 1933 (the “Securities Act”), which was amended by the Dodd-Frank Act to make it unlawful for any person to offer to sell, offer to buy, or purchase or sell a security-based swap to any person or entity that is not an eligible contract participant (“ECP”) without first registering with the SEC. As a result, these transactions would no longer be practically viable.