The Congressionally-mandated amendment aims to ease the disclosure burdens of private companies that grant compensatory stock to employees.

Grants of securities to employees, including stock options, restricted stock and RSUs, are subject to the federal securities laws, which require these issuances to be registered with the Securities and Exchange Commission (SEC) unless an exemption from registration applies. Private companies may rely on Rule 701 under the Securities Act of 1933, as amended to grant securities to employees for compensatory purposes. The SEC recently approved an amendment to Rule 701(e) to increase from $5 million to $10 million the aggregate sales price or amount of securities granted to employees within a 12-month period that would trigger expanded disclosure requirements. This change will spare some private companies from the regulatory burden associated with their equity compensation programs and may thereby encourage the expanded use of such programs to incentivize employees, facilitate recruitment and retention, and improve company performance.

Requirements of Rule 701

Although the amendment leaves the other aspects of Rule 701 unchanged, private companies that grant securities to employees, advisors or consultants should take the opportunity to review the rule’s requirements. Rule 701 typically is the most useful exemption for private companies that have, or are considering establishing, an equity compensation program. The requirements of Rule 701 are as follows:

• Only private companies, including foreign private issuers, may rely on Rule 701.
  • Publicly-traded companies and investment companies subject to the Investment Company Act of 1940 are not eligible to rely on Rule 701.
• The securities must be issued pursuant to a written compensatory benefit plan or written compensation contract that must be provided to employee participants.
• A “compensatory benefit plan” is defined as “any purchase, savings, option, bonus, stock appreciation, profit sharing, thrift, incentive, deferred compensation, pension or similar plan.”
• The securities must be issued to employees, officers, directors, partners, trustees, consultants or advisors who are employed or providing bona fide services to the company at the time the securities are granted.
• The securities may not be granted in connection with a capital raising transaction.
• The aggregate sales price or amount of securities sold in reliance on Rule 701 may not exceed the greatest of the following in any consecutive 12-month period:
  • $1,000,000;
  • 15% of the total assets of the company measured at the company’s most recent balance sheet date (if no older than its last fiscal year end); or
  • 15% of the outstanding amount of the class of securities being offered and sold in reliance on Rule 701, measured at the company’s most recent balance sheet date (if no older than its last fiscal year end).
• In addition, companies must provide financial and other disclosure to participants if the aggregate sales price or amount of securities sold pursuant to the exemption during any consecutive 12-month period exceeds $10 million, which represents an increase from the pre-amendment threshold of $5 million. In that case, the following information must be provided:
  • If the plan is subject to the Employee Retirement Income Security Act of 1974 (ERISA), a copy of the summary plan description.
  • If the plan is not subject to ERISA, a summary of the material terms of the plan.
  • Information regarding risk factors associated with an investment in the securities.
  • Financial statements as required in an offering statement under Regulation

Effective Date

Congress directed the SEC to raise the $5 million threshold to $10 million under the Economic Growth, Regulatory Relief, and Consumer Protection Act, which was signed into law on May 24, 2018. The change to Rule 701(e) took effect on July 23, 2018 and companies may begin relying on the increased threshold immediately for offerings commenced in the current 12-month period.

Practical Considerations

Losing sight of the Rule 701 requirements can cause headaches for growing companies. In connection with its IPO, Google and its general counsel agreed to a cease-and-desist order with the SEC due to Google’s failure to provide the additional disclosure to employees despite Google’s grants of securities well in excess of the then-$5 million threshold.

Compliance with Rule 701 requires companies to carefully track and anticipate aggregate sales prices or amounts of securities issued or to be issued to employees, consultants or advisors. If a company exceeds the new $10 million threshold in a 12-month period, the additional disclosure requirements apply to all sales made during that 12-month period, even those sales that occurred prior to the company exceeding the threshold. Failure to provide employees with the required disclosure a reasonable time prior to sale will cause a company to lose the Rule 701 exemption for the entire offering if no other exemption is available.

Companies relying on Rule 701 also should be mindful of the need to comply with state securities laws. Most states have exemptions from registration that track, or are similar to, Rule 701. However, some of these states may have additional filing fees or notice requirements.

Efforts to Modernize Rule 701

In conjunction with the rule amendment, the SEC also published a Concept Release to solicit comments on ways to update the requirements of Rule 701 in light of evolving practices in stock compensation and contractual relationships in the labor market since the Rule was last amended almost 20 years ago. Among other things, the SEC is seeking comment on whether and how Rule 701 should be expanded to permit workers in the “gig economy” who do not fit within traditional employment relationships to be eligible to receive company stock pursuant to the exemption. The SEC will accept comments on or before September 24, 2018. For more information regarding the SEC’s solicitation for comments, including how to submit comments, see the Concept Release File No. S7-18-18 at https://www.sec.gov/rules/concept/2018/33-10521.pdf.