Blog: SEC Advisory Committee Recommends Changes To Rule 701

by Cooley LLP

On Wednesday of last week, at the final meeting of the SEC Advisory Committee on Small and Emerging Companies (soon to morph into the Small Business Capital Formation Advisory Committee), the Committee heard a presentation on Rule 701, the exemption from registration typically relied on by private companies for equity compensation issued to employees, directors and consultants under compensatory benefit plans or contracts. At the conclusion of the presentation, the Committee resolved, as one of its final actions, to advise the SEC to adopt the presentation’s recommendations for changes to the Rule. (For more information about the meeting and its final recommendations to the SEC, see this PubCo post.)

First, the presenters (from an emerging private company and a law firm) observed that Rule 701 can be difficult to interpret and that simplification would be beneficial, particularly because many smaller companies that rely on it often do not have the resources to wrestle with the complexity of the Rule. The specific recommendations included the following:

  • Eliminate the requirement that consultants be natural persons. The original purpose of the limitation was concern that the Rule would be used to issue securities for capital raising and not solely for compensatory purposes. However, the presenters advocated that the requirement be eliminated because many private companies use consultants, often in lieu of full-time employees, but many consultants—even those that are often just individuals—run their businesses through an entity format for liability or tax purposes. The presenters contended that the limitation is not necessary and that the concern is otherwise addressed by other aspects of the Rule.
  • Remove the Rule 701 “hard cap” limit. Currently, companies cannot use the Rule to sell, in any consecutive 12-month period, an amount of securities with a value over the greater of $1 million in value, 15% of total assets or 15% of the outstanding stock. The presenters argued that compliance with the cap requires a lot of analysis and imposes an additional step in the hiring process without much benefit in terms of curbing abuses.
  • Increase the $5 million “soft cap” to at least $10 million. Under the so-called “soft cap,” companies are required to provide financial statement and other disclosure if, under Rule 701, the company sells, in any consecutive 12-month period, securities with a value in excess of $5 million.  The presenters contended that just the hiring of a key employee who receives a large equity grant can sometimes result in inadvertent compliance issues.


Bills entitled the ‘‘Encouraging Employee Ownership Act’’ have passed the House and, on September 12, the Senate and would now need a presidential signature to become law.  Both bills would require the SEC, within 60 days after enactment, to raise the soft cap of Rule 701 from $5 million to $10 million, and to index it for inflation every five years to reflect changes in the CPI.

  • Exclude “material amendments” from the calculation of the limits in the Rule. Currently, the CDIs require that companies count stock options that are repriced as new grants/sales for purposes of Rule 701, which can cause companies to exceed the hard cap (discussed above) or the soft cap.  However, the presenters contended that, in repricing, companies are really not issuing new options, but rather just resetting the prices to ensure that the options remained compensatory.  Under the current interpretation, the presenters argued, companies sometimes limit the repricing to executives just to avoid violating the limit.  The presenters also requested clarification that other material amendments do not similarly result in additional grants/sales for purposes of the Rule.
  • Clarify the application of the Rule to RSUs. Currently,  the presenters pointed out, Rule 701 does not specifically address restricted stock units. The presenters suggested that the Rule be clarified to treat RSUs like options, with “sales” occurring on the date of grant. (See, however, CDI 271.24.) The value for purposes of the Rule 701 caps, they maintained, should be based on the value of the underlying shares on the date of grant. The presenters also recommended conforming the timing of disclosure under the soft cap for RSUs to that of options, so that disclosure would be required to be delivered a reasonable time prior to settlement (and not prior to grant, as is currently the case for RSUs).


CDI 271.24 provides that, under Rule 701, RSUs that settle based on conditions related to company performance and/or length of service without payment of any additional consideration by the employee are deemed to be “sold” for purposes of Rule 701 on the date of grant. Under Rule 701(e), if the issuer triggers the information requirement (by selling an aggregate amount of securities (including the RSUs) during a consecutive 12-month period that exceeds $5 million), the issuer must deliver the specified information “a reasonable period of time before the date of the sale.” Accordingly, the issuer must provide the required information a reasonable time before the date that the RSU award is granted. According to Corp Fin, although RSUs are derivative securities (as their value is derived from value of the underlying common stock), they are not “exercised or converted,” and thus Rule 701(e)(6) relating to the exercise or conversion of derivative securities does not apply. (See this PubCo post.)

  • Require expanded disclosure under the soft cap only for sales that occur after the threshold is exceeded. Currently, expanded disclosure must be provided to any person who receives securities under Rule 701 during the 12-month period in which the company sells securities under Rule 701 with a value over $5 million. Although the $5 million limit would be exceeded at the end of a 12-month period, disclosure must be provided for any sales (including option exercises) under Rule 701 during the 12-month period.  This structure, the presenters contended, requires companies to attempt to predict when the cap will be exceeded and to provide disclosure beforehand to ensure compliance. This result, the presenters argued, is impractical. A change should be made to require disclosure only after the limit is exceeded, and should include some additional time to permit preparation of the required disclosure.
  • Clarify timing and delivery requirements for expanded disclosure.  Currently, the expanded disclosure must be “delivered” a “reasonable period of time prior to the sale” (or option exercise). The presenters recommended that delivery of the disclosure be permitted (i) at any time prior to sale so long as the recipient has an opportunity to review the disclosure and (ii) “in a manner consistent with the SEC’s electronic disclosure rules (e.g., on an online data site that is accessible to the individual)” or simply by making the disclosure available in a physical location accessible to the individual.  There should be no requirement to confirm actual receipt or review of the disclosure.

Other recommendations included simplifying the financial disclosure requirement by requiring only a current balance sheet and income statement (instead of financial statements as would be required under Reg A); requiring the financial statements to be updated and provided, in the absence of a material event or material change, only once a year (instead of at least 180 days prior to the sale); and conforming the consequences for violation of the soft cap (currently, loss of the Rule 701 exemption for all securities sold in the applicable 12-month period) to those applicable for violation of the hard cap, that is, loss of the Rule 701 exemption only for securities sold in excess of the limit.

[View source.]

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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