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Exemption from Securities Registration Under Rule 701

Under Rule 701 of the Securities Act of 1933, companies have been able to offer their own securities as part of written compensation agreements to employees, directors, general partners, trustees, officers, or certain consultants without having to comply with federal securities registration requirements. The original rule, created in 1988, limited outstanding offers in reliance on Rule 701 (plus the amount of securities offered or sold under Rule 701 in the past 12 months) to an aggregate amount not to exceed the greater of (1) $500,000 or (2) 15% of either the issuer’s total assets or 15% of the outstanding securities of the class of securities being offered. In no case, however, could the total amount offered or sold exceed $5 million during the preceding 12-month period.

Many private companies complained that the old rules were too limiting, and in 1996, Congress, as part of the National Securities Market Improvement Act, directed the SEC to amend the rule. Effective April 7, 1999, the SEC issued new regulations that accomplish this purpose. The new rule is especially attractive to closely held companies that offer broad-based stock option plans or who want to allow employees to purchase shares through 401(k) plans or employee stock purchase plans. While the new rule makes securities law compliance easier for these companies, it still requires some potentially costly disclosures. Moreover, the rule applies to federal law; most states will track these rules, but some will not.

Under the new rule, if total sales (not offerings) of stock during a twelve-month period do not exceed the greater of:

$1 million,
15% of the issuer’s total assets, or
15% of all the outstanding securities of that class,

then the offerings are exempt from registration requirements, even if the total amount exceeds the old limit of $5 million. The offerings must be discrete (not included in any other offer). As under the old rule, all optionees and shareholders must be provided with a copy of the benefit plan or contract under which the options or securities are granted. For total sales over $5 million during a twelve-month period to the specified class of people above, companies must disclose additional information, including risk factors, copies of the plans under which the offerings are made, and certain financial statements.

While these are the general outlines of the new rules, there are a number of specific wrinkles, as outlined below.

Measuring Sales

One of the most important changes the new rule makes is that the limit is now based on actual sales, not just offers. In measuring sales, all options granted during the period are considered part of the aggregate sales, with the option price defined as of the date of grant. This is a change from the prior rule, which looked at whether the options were vested. Repriced options are treated as new grants. For restricted stock or compensatory stock purchases, calculations will be made as of the date of sale. For deferred compensation equity plans, measurements will be based on the date on an irrevocable election to defer compensation. In calculating outstanding securities for the 15% rules, all currently exercisable or convertible options, warrants, rights, and other securities are treated as outstanding.

The rule also requires that if stock is provided in exchange for employee or consultant services, the value for the purposes of the exemption calculations is the price of the stock provided, not the amount of compensation foregone.

Treatment of Subsidiaries

The new rule allows companies to include employees of majority-owned subsidiaries, something they could not do before. Private wholly-owned subsidiaries of public companies can use their parents' assets in making the 15% of assets calculations if the parent fully guarantees the obligations of the subsidiary under the new rule (such as for deferred compensation).

Disclosure Rules

Except for providing a copy of the benefit plan or contract under which the options or securities are awarded, there are no specific disclosure requirements under Rule 701 for sales up to $5 million in a 12-month period. When sales exceed $5 million in a 12-month period, however, then companies must make disclosures to all shareholders prior to the sale, and must include at least:

a summary plan description if the plan is an ERISA plan or a summary of the material terms if it is not,
risk factors associated with the investment, and
financial statements required under Regulation A, Form 1-A (this is essentially a simplified registration form, similar to a prospectus, but less detailed and allowing for unaudited but GAAP-prepared financial statements)

Issuers who have audited financial statements must provide them. Financial statements must be not more than 180 days old. The disclosure for stock options must be delivered within a reasonable period before the date of exercise. If the $5 million threshold is exceeded and disclosures to optionees or shareholders receiving grants or awards earlier in the 12-month period is not deemed timely, then the Rule 701 exemption is lost for the entire amount of the options or stock granted, not just the amount exceeding $5 million.

Non-reporting (private) foreign companies must also comply with the disclosure requirements, using generally accepted accounting principles (GAAP) or a reconciliation to such principles for their financial statements, even if the foreign company is otherwise exempt from U.S. registration requirements because it is registered in its home market. The amendments expand coverage under Rule 701 to cover options transferable to certain family members and estate planning agencies through a gift or domestic relations order.

Who Is a Consultant?

The circumstances under which securities can be issued to consultants have been limited under Rule 701 consistent with the SEC’s efforts for public companies under Form S-8 to curb the abusive practices of disguising capital raising sales as compensatory awards. The new rule allows exemptions on a facts and circumstance basis for offers to consultants who have significant "employment characteristics," such as a bookkeeper, programmer, or former employee hired as a consultant, but does not allow exemptions for offers to securities promoters, franchisees, independent agents and similar individuals.

Caveats

The changes to Rule 701 are not retroactive. Offers and sales made in reliance on Rule 701 before its effective date will continue to be valid if they meet the requirements of the previous rule. Once an issuer exceeds 500 shareholders and $10 million in assets, it is generally required to register under the Securities and Exchange Act and provide full disclosure as a public company. The issuer may, however, continue to rely on Rule 701 to sell any securities previously offered. Securities issued under Rule 701 are restricted securities ands can only be resold through registration or compliance with an applicable exemption. Transactions exempt from registration under Rule 701 are not exempt from antifraud, civil liability, or other provisions of federal securities laws. Antifraud rules in particular may require substantial disclosure of information to securities purchasers.

This article can only summarize the detailed considerations that are involved in this issue. For a full discussion of the rule, go to www.sec.gov/rules/final/33-7645.htm, and, of course, consult securities laws experts before making any decisions.

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