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By Peter Rasmussen and Yelena Dunaevsky
The SEC has less than two months to lift up the hood on Securities Act Rule 701 to comply with a congressional mandate. Congress passed the Economic Growth, Regulatory Relief, and Consumer Protection Act and the president signed it into law on May 24, 2018. Under §507 of the statute, the SEC has 60 days to revise Rule 701(e) to increase the threshold amount of securities that can be sold under the exemption without triggering an obligation to deliver additional disclosures to investors from $5 million to $10 million. The Commission must also review and adjust the threshold level for inflation every five years.
The legislative provision raises questions about how far-reaching the doubling of the information threshold for compensatory stock sales will be in practice. In addition, market participants, including the SEC’s Investor Advisory Committee, have urged the Commission to make other changes to the rule beyond the disclosure threshold to make the exemption more user-friendly. It remains to be seen whether the SEC will act on the committee’s advice and incorporate additional changes into a rule that has not been substantially revised since 1999.
Securities Act Rule 701 exempts certain offers and sales of securities made by private companies to compensate their employees, consultants, and advisors. The private companies must make the offers and sales under a written compensatory benefit plan or written compensation contract. Under Rule 701, all eligible companies, regardless of size, may sell or grant at least $1 million of securities in a 12-month period. A company may sell or grant more securities during that period if it meets certain thresholds based on its assets or on the number of its outstanding securities (the limits apply only to actual sales, there is no limit on the amount of securities that may be offered for sale). Practitioners refer to the maximum amount of securities that issuers may sell as a “hard cap.”
The rule also includes a so-called “soft cap.” Currently, if a company sells more than $5 million in securities in a 12-month period, it must provide substantial financial information and other disclosures to the persons that received securities in that period. The bill signed by the president directs the SEC to raise this amount from its current $5 million to $10 million.
The Rule 701 exemption applies only to securities sold by the issuer. It does not apply to sales by affiliates of the issuer, or to resales by purchasers of securities sold under the rule. Securities issued under Rule 701 are “restricted securities” and may not be freely traded unless the securities are registered or the holders can rely on an exemption.
All sales under Rule 701 are subject to the antifraud provisions of the securities laws. The SEC stated in adopting substantial revisions to the rule in 1999 that “compliance with the minimum disclosure standards for Rule 701 may not necessarily meet the antifraud standards of the securities law,” and that “the disclosure required will depend upon the facts and circumstances” of the particular offering. The rule also indicates that state securities laws will apply to these transactions, but many states provide a statutory or regulatory exemption for securities offered or sold pursuant to compensation plans.
Rule 701 is a non-exclusive exemption. The failure of an issuer to comply with all the terms of the rule does not preclude the use of another available exemption.
Under Rule 701, the issuer must provide a copy of the compensatory benefit plan, or the written contract that covers the offering, to all investors, regardless of the number of securities sold or granted. If the aggregate sales exceed the 12-month disclosure threshold (currently $5 million), then the issuer must provide the following additional information to all purchasers during that 12-month period:
An issuer could elect to provide financial statements that follow the requirements of either Tier 1 or Tier 2 Regulation A offerings, without regard to whether the amount of sales that occurred pursuant to Rule 701 during the time period contemplated in Rule 701(e) would have required the issuer to follow the Tier 2 financial statement requirements in a Regulation A offering of the same amount.
Despite the CD&I, the question of the proper financial statement requirement remains confusing in the absence of rulemaking. The Advisory Committee noted that issuers are often unsure whether footnotes are required, and whether the equivalent of audited financials must be provided to comply with the rules. According to the committee, the uncoupling of the requirement from the Regulation A language could reduce this confusion.
Foreign private issuers must provide a reconciliation to U.S. GAAP if their financial statements are not prepared in accordance with either U.S. GAAP or International Financial Reporting Standards. The required financial statements may be dated no more than 180 days before the sale of securities made in reliance on the rule. If the sale involves an option or other derivative security, the issuer must deliver disclosure by a “reasonable” period of time before the date of exercise or conversion. For deferred compensation or similar plans, the issuer must deliver disclosure to investors a reasonable period of time before the date the irrevocable election to defer is made.
Mr. Shriram Bhashyam, a securities and capital markets attorney and Founder and Head of Business Development at EquityZen, believes that the mood in Silicon Valley is optimistic. Fintech companies like EquityZen, according to Mr. Bhashyam, are interpreting the SEC’s recent actions and pronouncements as “signals that point towards a greater emphasis on capital formation and a lesser emphasis on enforcement under Chairman Clayton’s SEC than under prior Chair White.” The data has supported this view, as fiscal year 2017 saw a significant drop in enforcement cases from the previous year.
With the exception of the recent actions and investigations relating to ICO fraud, the new SEC commissioners seem to have indeed been focused more on capital formation and less on enforcement. The SEC is focused on capital formation for various reasons, one of them being a steep decline in the number of IPOs and registered public companies over the last few years. The Enforcement Division also appears to have moved away from the “broken windows” philosophy espoused by former Chair Mary Jo White. Lingering uncertainty over the future of the SEC’s administrative enforcement program before the U.S. Supreme Court has also slowed the number of cases prosecuted by the Commission.
The trend away from IPOs and more companies remaining longer in the private markets has resulted in renewed interest in Rule 701 and requires an enhanced awareness of its possible pitfalls. When the SEC adopted the rule, companies that could have approached $5 million in annual compensatory offerings would have likely gone public or been acquired before bumping up against the threshold. Now, for a select group of issuers, that possibility has become much more real.
Companies, like EquityZen, are capitalizing on the decreased appetite of private companies to go public. In recent years, more and more companies are choosing to rely on private inflow of capital and manage to stay private for 10 to 15 years, as opposed to three to six years, the norm in years past, before going through an IPO process. As such companies are staying private longer, they grow to larger and larger sizes, with larger and larger employee bases. To compensate their larger employee pools, companies often issue stock awards in reliance on Rule 701. But because the companies are putting off liquidity events, this increasing pool of employees does not have a ready market for their shares. With the changes to Rule 701 due in the near future, more employee stockholders are likely to be seeking to dispose of their privately issued shares.
The question of disposal could be a difficult one, however. The shares are private and restricted and cannot be easily sold or traded on a securities exchange. Consequently, many of the employees sitting on large stock piles of private company shares end up selling these shares to or through companies like EquityZen and SharePost. These companies present a solution by finding investors for shares held by employees and consultants of private companies, investors who do not mind holding on to these restricted shares for longer periods of time. These investors are seeking higher potential returns than they can get in the public market and typically bet on the idea that if they get in on the “ground floor” they will be able to realize higher returns once the private company goes through a liquidity event somewhere down the road. Because the shares in the hands of employees and consultants are restricted, prospective purchasers must qualify for an exemption, such as under Regulation D or “Section 4(a) 1 ½.”
Mr. Bhashyam welcomes the upcoming changes to Rule 701, but believes that they are “only marginally helpful” and will not have a significant impact on the market. His thoughts are that the raising of the additional disclosure limit from $5 million to $10 million will effect only a “smallish universe” of companies—companies that have sufficient assets or stock outstanding to be eligible to offer and sell between $5 million and $10 million worth of securities to their employees in a 12-month period, and that are not yet public.
On the other end of the spectrum, for companies in the early stages of development, the rule’s terms may unnecessarily complicate the issuance of stock to certain service providers at a time when cash may be scarce. As the SEC’s Investor Advisory Committee pointed out, these companies often hire consultants to perform services that are generally performed by employees, such as back office support and human resources management. The committee stated that “at the earliest stages, equity compensation is often the only real form of compensation available to private companies to hire service providers necessary for the development of the company.”
A problem arises, however, with a provision of the rule that restricts eligible consultants to “natural persons.” Due to tax and liability concerns, many service providers, such as attorneys and financial professionals, operate as limited liability companies or similar alternative entities. As the Advisory Committee noted, the natural person requirement, designed to prevent abuse of the compensatory purpose of the exemption, requires companies to perform administrative gymnastics to compensate their consultants with equity under the exemption. Companies may engage both the individual and the entity as consultants or sell securities to the consulting entity under Regulation D or another available exemption.
According to the Advisory Committee and a panel focusing on the upcoming changes to Rule 701 at PLI’s recent Private Placements and Hybrid Securities Offerings program, the natural person requirement causes unnecessary problems and does little to curb the potential for abuse. As stated by the Committee, “enforcement of the rules that prohibit the use of Rule 701 for non-compensatory purposes and services related to capital raising and market-making would be a more appropriate response to curbing abuse of these rules than creating barriers to private companies that are properly using Rule 701 for compensatory purposes.”
Another remaining issue with Rule 701 is the treatment of restricted stock units (RSUs). Currently, Rule 701 contains no provisions directly dealing with RSUs. At the time of the rule’s adoption, and its 1999 amendment, few private companies used these instruments due to their potential adverse tax considerations. RSUs have become more popular due to changes in the tax law, but the rule language remains unchanged.
The Advisory Committee urged the SEC to clarify the rules as they relate to RSUs to state that these units are considered “sales” on the date of grant. RSUs would therefore be considered to be derivative securities where no shares are issued unless and until the RSUs settle. The RSUs should also be valued for purposes of any Rule 701 limits based on the value of the underlying shares on the date of grant, in the committee’s view, so that settlement, rather than the time of grant, would be the proper time for delivery of the required expanded disclosure. While a 2016 CD&I advised that the date of sale of an RSU is the date the unit is granted, the Advisory Committee is of the opinion that the problems with the treatment of RSUs would best be resolved by rulemaking.
It is possible that the SEC, given that it has to issue a rulemaking release on Rule 701 to comply with the statutory mandate, may examine the entire rule with a critical eye. The majority of the commissioners are likely to be amenable to some tweaking to increase the usefulness of the exemption for the growing number of private companies. Rule changes such as eliminating the natural person requirement and the addition of provisions concerning RSUs do not appear to raise significant investor protection issues.
The devil, as usual, is in the details, and in DERA—the SEC’s Division of Economic and Risk Analysis. The first question is whether the staff could even cobble together a proposal that covers areas beyond the statutory mandate within the narrow 60-day window. Another issue is the requirement that the agency engage in a robust economic analysis of the proposals. Once the proposal is out, the congressional clock stops running, and the SEC may have time for DERA to do its work, but the time pressure remains. The next question is whether, in the midst of a rather limited rulemaking agenda, as seen from the agency’s most recent “Reg Flex” release, the SEC wants to undertake the non-trivial task of reshaping an exemption.
In the absence of another available exemption, sales of securities that do not comply with Rule 701 would likely result in a Section 5 violation, and could well run afoul of various state securities laws. In March 2018, the SEC settled with Credit Karma, a private “unicorn” valued at more than $3 billion, based on claims that the company issued almost $14 million in stock options to employees over a one-year period. Even though financial statements and risk disclosures were available and confidentially provided to potential institutional investors, stated the SEC, Credit Karma failed to provide this information to its own employees. Despite the fact that Credit Karma exceeded the disclosure threshold by nearly $9 million, the company agreed to pay only a $160,000 penalty.
The fact that the SEC brought charges and imposed a penalty, however minor, indicates that these transactions are on the Enforcement Division’s radar. While the days of former Chair Mary Jo White’s “Silicon Valley Initiative” may be gone, private issuers must be aware of the limitations imposed by Rule 701 and adjust their compensation practices accordingly.
N. Peter Rasmussen is a senior legal editor with Bloomberg Law, concentrating on corporate transactions and federal securities law. He holds a B.A. from DePauw University, a master’s degree in history from the University of Illinois at Chicago, and a J.D. from the University of Illinois College of Law.
Yelena Dunaevsky is the assistant managing editor in Bloomberg Law’s Corporate & Transactional unit, with over 15 years of experience in capital markets and securities law. Yelena oversees Bloomberg Law’s reference content covering securities offerings, corporate finance transactions, and other topics relevant to corporate practitioners. Yelena holds a B.S. in Economics from Cornell University and a J.D. from Fordham University School of Law.
Copyright © 2018 The Bureau of National Affairs, Inc. All Rights Reserved.
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