Exemption from Securities Registration Under Rule 701
Under Rule 701 of the Securities Act of 1933, companies can 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. Under Rule 701, 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. The offerings must be discrete (not included in any other offer). 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 $10 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. (Formerly $5 million, this threshold was raised to $10 million in 2018 and will be indexed to inflation every five years in $1 million increments.)
While these are the general outlines of the rule, there are a number of specific wrinkles, as outlined below.
The limit is 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. Repriced options are treated as new grants. For restricted stock or compensatory stock purchases, calculations are made as of the date of sale. For deferred compensation equity plans, measurements are 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
Companies can include employees of majority-owned subsidiaries. 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 (such as for deferred compensation).
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 $10 million in a 12-month period. When sales exceed $10 million in a 12-month period, however, then companies must make disclosures to all shareholders before 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 $10 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 $10 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. Rule 701 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.
Once an issuer exceeds 2000 shareholders, 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 and can only be resold through registration or compliance with an applicable exemption. Transactions exempt from registration under Rule 701 are not exempt from anti-fraud, civil liability, or other provisions of federal securities laws. Anti-fraud 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 dating from when it was amended in 1999, go to this link on the SEC's Web site. Of course, you should consult securities laws experts before making any decisions.