SEC Moves to Modernize Framework for Securities Offerings and Sales to Workers

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The SEC takes a highly anticipated first step toward updating Rule 701 and Form S-8

TAKEAWAYS

  • Amendments to Rule 701 would increase the cap on exempt offerings and ease disclosure burdens.
  • Revisions to Form S-8 would permit issuers to register multiple plans using a single Form S-8 and move registered securities between plans.
  • Temporary expansion of Rule 701 and Form S-8 would facilitate compensatory transactions with platform workers.

Rule 701, adopted pursuant to Section 3(b) of the Securities Act of 1933 (the Securities Act), provides an exemption from the registration requirements of the Securities Act for certain offers and sales of securities made pursuant to the terms of compensatory benefit plans or written contracts relating to compensation, by an issuer that is not subject to the reporting requirements of Section 13 or Section 15(d) of the Securities Exchange Act of 1934 (the Exchange Act), and is not an investment company. Rule 701 is the primary exemption used by non-reporting companies, including foreign issuers, to issue equity incentive awards, including stock options and restricted stock units (RSUs), without registering the offering pursuant to Section 5 of the Securities Act. Rule 701 provides unusual flexibility—Rule 701 offerings may be made to large numbers of employees, without the accreditation or qualification required by other exemptions, and do not impair simultaneous offerings under other exemptions by being integrated or aggregated with those offerings.

Form S-8 offers a simplified method for a company registered under Section 12 of the Exchange Act to register securities transactions involving an issuance to the issuer’s employees (which for purposes of Form S-8 includes consultants and advisors as long as they are natural persons and provide bona fide services to the registrant) in a compensatory or incentive context, and for noncapital-raising purposes.

At the end of November 2020, the Securities and Exchange Commission (the SEC) proposed two sets of amendments to Rule 701 and Form S-8.

  • The first proposal would make the Rule 701 exemption available to more issuers, for more purposes, would decrease disclosure burdens, and would align Form S-8 with Rule 701.
  • The second proposal creates a path that would permit exempt awards of equity under Rule 701 or pursuant to Form S-8 to so-called “platform workers” providing bona fide services to issuers through an internet-based platform. This proposal follows the SEC’s July 2018 concept release that solicited comment on extending both Rule 701 and Form S-8 to “gig economy” arrangements.

1. Proposed Changes to Rule 701

Increased Cap for Rule 701 Offerings: The SEC has proposed that the amount of securities that may be sold in reliance on Rule 701 in any 12-month period, currently the greatest of $1 million, 15% of total assets of the issuer, or 15% of the outstanding amount of the class of securities being offered, would be increased to the greatest of $2 million, 25% of total assets of the issuer, or 15% of the class of securities.

Former Employees: The Rule 701 exemption currently applies to offers of securities to employees and other eligible service providers who are employed by or otherwise provide services to the issuer at the time the offer is made (while permitting exercise of options or other rights after a recipient is no longer employed by or providing services to the issuer). The SEC proposes that former employees may be offered securities under Rule 701 so long as the offer relates to services provided by the employee within 12 months prior to the employee’s separation from the issuer. One important use of the revised rule will be to permit an acquiring company to offer securities to persons who had been employees of the acquired entity, but who are not employees of the acquiring company or the acquired entity at the time of the offer.

Entities as Consultants and Advisors: No question has caused more interpretive difficulty under Rule 701 than the terms “consultants and advisors,” which after the adoption of Rule 701 were given very expansive definitions, only to then be pared back to a substantial degree. Rule 701 currently permits offers to consultants and advisors only if they are natural persons who provide bona fide services to the issuer, its parents, its majority-owned subsidiaries or majority-owned subsidiaries of the issuer’s parent, which services are not related to capital-raising transactions, or to promoting or maintaining a market for the issuer’s securities. The SEC proposes to extend eligibility beyond natural persons to entities provided that (1) substantially all of the activities of the entity involve the performance of services and (2) substantially all the ownership interests in the entity are held directly by no more than 25 natural persons, of whom at least 50 percent perform services for the issuer through the entity, or persons or estates that have acquired such interests upon the death of such a natural person.

Ending the Retroactive Disclosure Trap: One of the most troubling traps for the unwary in Rule 701 has been the requirement that certain financial disclosures be provided to all persons participating in the offering if the aggregate sales in reliance on Rule 701 in any 12-month period exceed $10 million (increased in 2018 from $5 million). If this threshold is exceeded, all persons who receive offers to purchase must be given the requisite disclosure prior to making a purchase decision, including those who accepted offers to purchase before the $10 million limit was exceeded. Further, as Rule 701 counts sales pursuant to stock options based on the date of grant, option exercises in subsequent years can relate back to an earlier period, retroactively causing the disclosure to have been inadequate if the $10 million limit was exceeded in any 12-month period. As a result, a careful issuer could ensure compliance only by limiting the potential size of its Rule 701 sales to $10 million in any 12-month period or by providing enhanced disclosure to all offerees to guard against having made offers and sales that are retroactively deemed to have been based on inadequate disclosure if the limit is exceeded within 12 months.

The proposed revisions to Rule 701 would provide that the requirement to provide the additional disclosure would apply only to sales that occur after the $10 million limit has been exceeded. This simple change would permit issuers to escape the retroactive disclosure trap, as an issuer that wants to exceed $10 million in sales in a 12-month period, or that has prior-period options outstanding, could provide the required disclosure beginning with sales or option exercises that would actually cause the issuer to exceed the limit in any 12-month period.

Financial Statement Requirements Eased: If the $10 million Rule 701 threshold is exceeded in any 12-month period, Rule 701(e) requires that the issuer provide the purchaser with two years of consolidated balance sheets, income statements, cash flows, and changes in stockholders’ equity, and that such financial statements must be of a date that is no more than 180 days before the sale relying on the Rule 701 exemption. This effectively requires that issuers prepare quarterly financial statements within three months after the end of each quarter, which can be a burdensome frequency of disclosure for private companies. Further, a foreign issuer that does not prepare financial statements in accordance with U.S. GAAP must provide a reconciliation of its home country reports to GAAP, again within three months after the end of each quarter.

The proposed revisions would provide that financial statements must be available on at least a semi-annual basis and completed within three months after the end of the second and fourth quarters. Issuers would no longer be required to prepare financial statements quarterly in order for sales to be made continuously pursuant to Rule 701. In addition, the proposed amendment would provide that foreign private issuers may provide financial statements that are not reconciled to U.S. GAAP.

Financial Statements – 409A Alternative Valuation Information: Whereas enhanced disclosure under Rule 701 currently requires disclosure of the issuer’s financial statements to the purchaser, under the proposed revision, issuers (except foreign private issuers) may choose to provide alternative valuation information in lieu of financial statements, specifically an independent valuation report of the securities’ fair market value as determined by an independent appraisal consistent with the rules and regulations under Internal Revenue Code Section 409A. The proposed amendments would not permit reliance on other aspects of the Section 409A rules that permit determination of fair value for tax purposes by other means. To keep valuation information current, the Section 409A independent valuation report must be a date that is no more than six months before each sale of securities in reliance on the Rule 701 exemption. This updating schedule would be comparable to that for financial statements under Rule 701(e). Valuation disclosure provides an alternative to financial statement disclosure; however, this disclosure is not something that all issuers will find attractive as obtaining request valuations may be costly and may result in increased valuations for purposes of equity grants and exercise of options or settlement of RSUs.

Timing of Disclosure for Options vs. RSUs: Rule 701 currently provides that if a sale involves a stock option or another derivative security, the issuer must deliver the Rule 701(e) disclosure a reasonable period of time before the date of exercise or conversion. This rule was adopted in 1999 and contemplates options and other derivative securities where the sale involves an investment decision at the time of exercise or conversion. Since Rule 701(e) was initially adopted, compensatory programs that use derivative securities such as RSUs and performance stock units that do not require a decision to exercise or convert have become increasingly common. To address this development, the SEC has proposed that:

  • if the sale involves a stock option or another award that involves a decision to exercise or convert, the issuer would be required to deliver the disclosure a reasonable period of time before the date of exercise or conversion; and
  • if the sale involves an RSU or another award that does not involve a decision to exercise or convert, the issuer generally would be required to deliver disclosure a reasonable period of time before the date the RSU or similar derivative security is granted.

If adopted, this revision would finally resolve a troubling tendency by the SEC staff to find that the investment decision for an RSU should be considered to occur on the date of realization, rather than the date of grant. Practitioners had argued, alternatively, that the grant of an RSU did not involve a sale, or that if it did involve a sale, the investment decision occurred when the service provider accepted RSUs as a term of employment or engagement. The problem with the latter interpretation arose when companies did not want to provide sensitive financial information to a new hire before the prospect agreed to accept an employment package that included RSUs. To protect against the unwanted early distribution of the issuer’s financial information for RSUs and similar awards, under the revised rule, disclosure would be considered to have been delivered a reasonable period of time before the date of sale if it is provided no later than 14 calendar days after the date the person begins employment.

Merged Entities: The SEC has proposed that where two entities merge and the acquired entity’s outstanding equity awards are assumed by the acquiring issuer so that shares of the acquiring issuer will be issued upon the exercise or conversion of the awards, the exercise or conversion would be exempt from registration, subject to the acquiring issuer’s compliance, where applicable, with the enhanced disclosure requirements under Rule 701(e), provided that the acquired entity had complied with Rule 701 at the time it originally granted the awards. In determining whether the amount of securities the acquiring issuer sold during any consecutive 12-month period exceeds $10 million, the acquiring issuer would consider only the securities that the acquiring issuer sold in reliance on Rule 701 during that period and would not be required to include any securities sold by the acquired entity pursuant to the rule during the same 12-month period.

2. Proposed Changes to Form S-8

Addition of Plans and Securities to Form S-8: There has been limited guidance as to whether issuers must use a separate Form S-8 for separate employee benefit plans. If adopted, the SEC’s proposal would provide that issuers may register offers and sales of securities pursuant to multiple plans on a single Form S-8 and may add additional plans and securities to an existing Form S-8 by filing an automatically effective post-effective amendment to a previously filed Form S-8. Issuers would be permitted to create a pool of shares registered under the Form S-8 and would not be required to allocate registered securities among incentive plans. The initial registration statement would be required, instead, to list the types of securities covered by the registration statement and identify the plan or plans pursuant to which the issuer intended to issue securities as of that date.

Former Service Providers: Form S-8 may not be used to register securities offered to former service providers or to the former service providers of an entity acquired by the issuer. The SEC proposes to mirror the proposed changes to Rule 701 by amending Form S-8 to permit the offer and sale of securities to former service providers of the issuer or an acquired entity as compensation for services to the issuer or the acquired entity during a performance period ending within 12 months preceding the former service provider’s resignation, retirement or other termination.

Entities as Consultants and Advisors: Form S-8 may not be used to register securities issued to entities, other than personal services businesses that are wholly owned by and serve as corporate alter egos of natural persons who provide services to the issuer. The proposal would mirror the changes to Rule 701’s treatment of consultants and advisors, described above under “Entities as Consultants and Advisors”.

3. “Platform Worker” Programs

In recent years, the SEC has solicited comment on the question whether Rule 701 and Form S-8 should be revised to permit the offer or sale of securities to service providers who do not enter into traditional employment relationships with the issuer—those who participate in the so-called “gig economy.”

The “gig economy” reflects quickly developing workplace arrangements which often involve short-term or freelance arrangements, where the individual service provider—rather than the company—sets the work schedule. Often this relationship involves the individual’s use of a company’s internet “platform” for a fee to provide peer-to-peer services such as lodging, ride-sharing, food delivery, grocery shopping, household repairs, dog-sitting, tutoring or tech support. Other new work relationships may involve individuals using the platform to perform tasks or services for the platform provider itself. An individual who provides services or goods through these platforms may have similar relationships with multiple internet platforms, through which the individual may engage in the same or different business activities.

“Gig workers” participating in these arrangements may not be employees, consultants, advisors or de facto employees under Rule 701 and Form S-8, and therefore may not be eligible to receive securities in compensatory arrangements under them. However, the SEC has recognized that companies may have the same compensatory and incentive motivations to offer equity compensation to gig workers as they do to traditional employees, consultants and advisors.

Under the SEC’s second set of proposed amendments, Rule 701 and Form S-8 would be modified to permit exempt offers or registration of, equity interests offered pursuant to a written compensatory benefit plan or contract to workers who provide services available through the issuer’s internet-based marketplace platform or through another widespread, technology-based marketplace platform or system (“platform workers”) provided that certain new requirements are satisfied.

The proposed amendments to Rule 701 and Form S-8, however, would impose greater restrictions on grants to platform workers than are applied to traditional employees, consultants and advisers. For example, reliance on Rule 701 or Form S-8 for a platform worker program would (1) be conditioned on relatively restrictive limits on the amount of securities that may be offered pursuant to the program; and (2) require modest periodic disclosure to the SEC (a significant departure from current Rule 701 practice). Further, as proposed, the platform worker provisions of Rule 701 or Form S-8 generally would apply only to offers or sales of securities to platform workers that occur prior to the expiration of the five-year period beginning on the date the proposed amendments become effective, although offers commenced in compliance with such provisions prior to such expiration could be completed. SEC action would be required to extend the modifications beyond that five-year period.

Definition of Platform Worker and Control of the Platform: Under the proposal a “platform worker” is a natural person (or a qualifying entity, as described below) unaffiliated with the issuer who (1) bona fide services to the issuer, its parent company or a subsidiary of either of the issuer or its parent or to third-party end-users for the benefit of the issuer, (2) pursuant to a written contract or agreement (3) through an internet-based platform or other widespread, provides technology-based marketplace platform or system that the issuer operates and controls. The SEC stated in the proposing release that a platform worker could provide services “to end users, such as ride-sharing, food delivery, household repairs, dog-sitting, or tech support, or using the platform to sell goods or lease property to third parties.”

A platform worker may be an entity if substantially all of its activities involve the performance of bona fide services and the entity is wholly owned by the natural person performing the services. An issuer will be deemed to control the platform if it (1) provides access to the platform and establishes the principal terms of service for using the platform; (2) establishes the terms and conditions by which the platform worker receives payment for the services provided through the platform; and (3) can accept and remove the platform worker.

Limitations on the Value of Securities That Can Be Provided and Other Conditions: Unlike existing Rule 701 and Form S-8, the SEC’s proposed amendment includes restrictions on the offers and sales that may be made to platform workers. The amount and terms of securities issued to a platform worker may not be subject to individual bargaining or the worker’s ability to elect between payment in securities or cash. Under the platform worker program, no more than 15 percent of the value of compensation received by a platform worker from the issuer for services provided during a consecutive 12-month period, and no more than $75,000 of the value of compensation received by the platform worker from the issuer during a consecutive 36-month period, could consist of securities. The value would be determined in a manner consistent with Rule 701. As with the existing Rule 701, securities issued to platform workers under Rule 701 would be restricted securities.

Securities Provided to Platform Workers Included in Rule 701 Cap: The SEC’s proposed expansion of Rule 701 would not create a separate ceiling on the amount of securities that could be offered or sold in reliance on the Rule 701 exemption. The SEC clarified that platform workers would be an additional class of persons eligible to participate in the issuer’s Rule 701 offers and sales and would be subject to the same Rule 701(d) limitations on the total amount of securities that an issuer may sell. Accordingly, under the SEC’s proposed amendments, the amount of securities that may be sold in reliance on Rule 701 in any 12-month period, including sales to platform workers, would be greatest of $2 million, 25% of total assets of the issuer, or 15% of the class of securities.

Periodic Disclosure to the SEC: Rule 701 has not required periodic reporting to the SEC (or even a filing to take advantage of the exemption). The proposed revisions to Rule 701 provide for submission of certain limited information on a periodic basis, but the release makes clear that furnishing the identified information would not be a condition to reliance on Rule 701 or Form S-8. Issuers would be asked to furnish the following information to the SEC at six-month intervals commencing six months after the first issuance to a platform worker:

  • The criteria used to determine eligibility for securities awards to platform workers, whether they are the same as for other compensatory transactions and whether those criteria, including revisions to the criteria, are communicated to workers in advance as an incentive;
  • The types and terms of securities issued to platform workers during each six-month interval and whether they are the same as for other compensatory transactions by the issuer during that interval;
  • With regard to a Rule 701 offering, the steps taken to restrict the transfer of the securities sold;
  • The percentage of the issuer’s outstanding securities represented by the amount of securities issued cumulatively in reliance on these provisions;
  • During each six-month interval, information regarding the number of platform workers generally and the number participating pursuant to these provisions, plus (1) with regard to the Rule 701 exemption, the number of non-platform workers who received securities in accordance with Rule 701; and (2) with regard to Form S-8, the number of participating platform workers relative to the other persons eligible to receive securities pursuant to the Form S-8 registration statement; and
  • The number and dollar amount of securities issued to platform workers in each six-month interval, in absolute amounts and as a percentage of the issuer’s total sales in reliance on Rule 701 or pursuant to Form S-8, as applicable.

The type of information proposed to be required would permit the SEC to monitor the use of the rule during the initial five-year term of the proposed revisions, and to decide whether and how to modify the rule at that time.

CONCLUSION

The SEC has requested comments on the proposed amendments to Rule 701 and Form S-8. Comments on both proposals are due on February 9, 2021. We will continue to monitor the potential adoption and implementation of the SEC’s proposed amendments to Rule 701 and Form S-8 and provide an update as it becomes available. For further information about Rule 701 and Form S-8, please see our prior Client Alerts dated July 23, 2018 and June 21, 2018.

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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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