TAKEAWAYS 

  • Recently enacted legislation rolling back Dodd-Frank directs the SEC to increase the Rule 701 enhanced disclosure threshold from $5 million to $10 million.
  • This change impacts privately held, high-growth companies, venture capital funds, and non-reporting companies, including foreign private issuers, and may help these issuers remain private longer and provide increased cash liquidity.
  • The SEC is expected to release transitional guidance, but until such guidance is provided, privately held companies that rely on Rule 701 for equity awards to US employees should continue to comply with the current rule.

On May 24, 2018, President Trump signed into law the Economic Growth, Regulatory Relief, and Consumer Protection Act which, among other things, directs the Securities and Exchange Commission (SEC) to adopt amendments to Rule 701 under the Securities Act of 1933 (Securities Act) and so-called “Regulation A+” that would increase the Rule 701 disclosure threshold from $5 million to $10 million, with subsequent increases every 5 years to account for inflation. This change gives private companies greater flexibility in their employee compensation structures and decreases compliance costs. However, these changes to Rule 701 are not self-executing and will be subject to the SEC’s lengthy rulemaking process.

Review of Rule 701

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 the Securities Act. Issuers that are not subject to the reporting requirements of Section 13 or Section 15(d) of the Exchange Act of 1934 and are not investment companies registered or required to be registered under the Investment Company Act of 1940 may rely on the Rule 701 exemption. Under this rule, non-reporting companies are allowed to issue “exempt” securities to employees and certain consultants so long as the securities are issued pursuant to a written compensatory benefit plan. Additionally, the aggregate amount of securities issued in reliance on Rule 701 within any 12 month period (either on a rolling or an annual basis) must not exceed the greatest of the following: (i) $1,000,000, (ii) 15 percent of total assets of the issuer, or (iii) 15 percent of all outstanding securities of the same class being offered. Sales of securities underlying options must be counted as “sales” on the date of the option grant rather than the date of vesting or exercise.

Rule 701 requires enhanced disclosure to be made to recipients of such securities when the total sales of such securities exceed $5 million within any 12-month period (either on a rolling or an annual basis). The issuer must disclose to all recipients of such securities within that 12-month period (i) a summary of the applicable equity incentive plan’s material terms, (ii) an explanation of the risk factors associated with investment in the securities, and (iii) financial statements of the issuer in accordance with generally accepted accounting principles in the United States (U.S. GAAP).

Non-reporting foreign private issuers are required to provide the same disclosure as non-reporting domestic issuers if sales under Rule 701 exceed $5 million within any 12-month period (either on a rolling or an annual basis). This reporting obligation can be particularly cumbersome for foreign private issuers if the issuer’s financial statements are not ordinarily prepared in accordance with U.S. GAAP because Rule 701 requires that the financials provided must be reconciled to U.S. GAAP unless they are prepared in accordance with IFRS as issued by the International Accounting Standards Board.

Rule 701 Threshold Increases to $10 million

The new law mandates that the SEC change the Rule 701 threshold from $5 million to $10 million within 60 days after the enactment of the law. For companies that issue securities in reliance on Rule 701, the threshold increase provides more flexibility on timing and reduces the costs of compliance.

Private companies, and in particular start-ups, can offer more equity awards (e.g., stock options) to employees without undergoing a costly disclosure process. Early stage companies are understandably hesitant to release information regarding their products or their financial statements and will usually elect to stay under the $5 million limit. The threshold increase will allow a company to offer more equity awards without disclosing information that may impact a company’s competitive advantage. For many companies, the requirement to provide this additional disclosure is a material part of their decision to go public, and this increase will allow companies to stay private for a longer period of time.

The ability to issue more equity awards may be beneficial for many reasons. Having the flexibility to offer equity awards with a greater value will help a private company relying on the Rule 701 exemption to compete with other companies in the talent market. Also, the opportunity to issue equity awards with a greater value in lieu of cash compensation will free up cash to be used elsewhere, which could potentially improve liquidity.

Timing of New Rule 701 Threshold

Although the new law requires the SEC to amend Rule 701 within 60 days, the SEC rulemaking process, which includes the release of proposed rules and a comment period, will likely require more than 60 days. In the interim, the SEC is likely to issue transition guidance upon which issuers may rely until a final rule is issued.

Transition Guidance is Needed

The legislative mandate directing the SEC to increase the disclosure threshold leaves private issuers on the verge of exceeding current $5 million threshold questioning whether they should continue to grant equity awards prior to receiving SEC guidance. For many high-growth tech companies, this question has real, immediate implications. For instance, what are the options for a company in the middle of a 12-month testing period that has already exceeded the $5 million threshold? Must the company provide the required disclosures or will the $10 million threshold apply to all sales during the current testing period? If the increased Rule 701 threshold will be applied only prospectively, would it apply to a current testing period that straddles the enactment of the new law, and if so how?

Consider the following questions, assuming that on July 23, 2018, the SEC adopts an amendment to Rule 701 by substituting $10 million for $5 million in Rule 701:

  1. Issuer uses the calendar year to measure sales under an employee share purchase plan. On June 23, 2018, it has “sales” of $4 million shares under Rule 701. Can Issuer sell $6 million additional shares prior to December 31, 2018 without providing the disclosure? Or only $1 million additional shares?
  2. Issuer uses the calendar year to measure sales under a stock option plan. As of June 1, 2018, it has granted stock options valued at $6 million which do not vest until December 31, 2018. Disclosure would not be required until a “reasonable period before the date of sale,” i.e., the exercise date. Will the new $10 million threshold apply to these stock options so that no disclosure is required? What if the exercise date was May 31, 2019?

The SEC’s final rule and any transition guidance will determine how these questions are resolved.

Until guidance regarding the new Rule 701 threshold is provided, issuers should continue to monitor their compliance based on the current $5 million threshold.