In a move that will primarily benefit privately held companies, the SEC has adopted final rules providing new, self-executing exemptions from registration under the Exchange Act for companies that have granted stock options to 500 or more persons. In crafting the new exemptions, the SEC has relied heavily on existing concepts contained in Rule 701 under the Securities Act, the exemption pursuant to which non-reporting companies grant compensatory stock options and issue the shares underlying them, and Form S-8, the registration statement used by reporting companies to register such securities under the Securities Act. The new rules became effective on December 7, 2007.
Previously, otherwise non-reporting, privately held companies were subject to costly and burdensome periodic reporting and other obligations under the Exchange Act if they had 500 or more optionholders at the end of a fiscal year. Companies were able to seek relief from such requirements by submitting a no-action letter to the SEC, but the conditions for such relief were relatively onerous. The new exemption for non-reporting companies eliminates the need to seek relief from the SEC and removes a trap for unwary companies that sometimes resulted in an inadvertent failure to seek such relief or comply with Exchange Act obligations.
The exemption for non-reporting companies is available subject to the following conditions:
- (i) The options are granted under a written compensatory stock option plan;
- (ii) Optionholders are limited to the persons permitted under Rule 701 (i.e., employees, directors, consultants and advisors of the issuer, its parents, its majority-owned subsidiaries or majority-owned subsidiaries of the issuer's parent);
- (iii) The company must include in the stock option plan, in an agreement with the optionholder or in the company's organizational documents, restrictions on the transferability of options (and, prior to exercise, the underlying shares), including through hedging transactions; and
- (iv) The company must include in the stock option plan or in an agreement with the optionholder an undertaking to provide risk and updated financial information based on the requirements of Rule 701 every six months, and the company must provide such information.
The new exemption for reporting companies does not provide significant practical benefits to public companies given that it does not exempt those companies from complying with their existing Exchange Act obligations. However, the exception does mean that an issuer of high yield or other debt securities that is required to file periodic reports pursuant to Section 15(d) of the Exchange Act and that has 500 or more optionholders is not required to register that class of options under the Exchange Act. It also brings certainty to the Exchange Act registration obligations of other reporting companies that have 500 or more optionholders where there was previously doubt as to whether they were required to register the outstanding options as a separate class of security under the Exchange Act. The exemption for reporting companies requires compliance only with the conditions of clauses (i) and (ii) above.
It should be noted that the new exemptions only apply to stock options and do not address any other form of equity compensation. As a result, Exchange Act registration requirements with respect to restricted stock, stock appreciation rights (SARs) or restricted stock units (RSUs), must be analyzed under existing principles.
A detailed explanation of the two exemptions is set forth below, followed by practical tips to take advantage of the exemptions.
Background of the New Exemptions
Unless an exemption from registration is available, Section 12(g) of the Exchange Act requires a company with 500 or more holders of record of a class of equity security, including stock options, and assets in excess of $10 million at the end of its most recently completed fiscal year, to register that class of equity security under the Exchange Act. Registration under the Exchange Act subjects the company to reporting obligations under the Exchange Act, including preparation and filing of annual reports on Form 10-K, quarterly reports on Form 10-Q and periodic reports on Form 8-K. It also subjects the company to obligations under the Sarbanes-Oxley Act, including implementation of the SEC's requirements under Section 404 regarding internal control over financial reporting. These obligations often have a significant cost and impact on company resources.
Before the new exemptions, the SEC had articulated a set of relatively onerous requirements for granting no-action relief to companies with 500 or more optionholders. In addition, privately held companies sometimes passed the 500 optionholder mark inadvertently and failed to seek relief. Although these companies would frequently attempt to continue to rely upon the exemption under Rule 701, Rule 701 is not available to a company that is required to be a reporting company under the Exchange Act. Accordingly, the options granted, and underlying shares issued, by these companies were frequently granted in violation of Section 5 of the Securities Act, thereby giving their holders rescission rights.
For public companies, as described above, a question existed as to whether such companies were required to register outstanding options as a separate class of security under the Exchange Act when they had 500 or more optionholders.
As a result of these issues, the SEC adopted the new exemptions.
New Exemption for Non-Reporting Companies
The SEC has adopted new Rule 12h-1(f) under the Exchange Act to provide an exemption from registration under the Exchange Act for compensatory employee stock options under the following conditions:
- The company must not be required to file reports under the Exchange Act. The following companies are reporting companies under the Exchange Act and thus ineligible for the exemption:
- A company with a class of equity or debt securities listed on a national securities exchange. Such companies are required to register that class of securities under Section 12(b) of the Exchange Act.
- A company with 500 or more holders of record of a class of equity security and assets in excess of $10 million at the end of its most recently completed fiscal year. Such companies are required to register that class of equity security under Section 12(g) of the Exchange Act, unless there is an available exemption from registration.
- A company that filed a registration statement with the SEC that became effective. Such companies are required to comply with the reporting requirements of the Exchange Act pursuant to Section 15(d) thereof. The reporting requirements under Section 15(d) are automatically suspended as to any fiscal year, other than the fiscal year within which such registration statement became effective, if, at the beginning of such fiscal year, the securities of each class to which the registration statement relates are held of record by less than 300 persons.
A company that files reports voluntarily under the Exchange Act, such as many issuers of high yield and other debt, may use the exemption because such a company is not required to file reports.
- The options must have been issued under a written compensatory stock option plan. This requirement does not impose a new obligation because it is already a condition to the exemption from registration under Rule 701 of the Securities Act, which is relied upon by most non-reporting companies for the grant of stock options and the issuance of the underlying shares.
- Optionholders can only be employees, directors, consultants and advisors of the issuer, its parents, its majority-owned subsidiaries or majority-owned subsidiaries of the company's parent. The list of permitted optionholders under the new exemption is identical to the list under Rule 701.
- Transferability of options (and, prior to exercise, the underlying shares) is restricted, including through hedging transactions. Restrictions on transferability, which include restrictions on hedging, are intended to prevent optionholders from receiving consideration for their options or the underlying shares prior to exercise. While the SEC did not require that there be any restrictions on transferability of shares issued upon exercise of the options, it noted that non-reporting companies generally include provisions in their stock option plans limiting the transferability of such shares and that shares issued pursuant to Rule 701 are, in any event, "restricted securities" under Rule 144 of the Securities Act.
The pre-exercise restrictions on transfer are as follows:
- The stock options (and, prior to exercise, the shares underlying the options) may not be transferred except: (i) to family members (as defined in Rule 701(c) under the Securities Act) by gift or pursuant to domestic relations orders; or (ii) to an executor or guardian upon death or disability of the optionholder or holder of the underlying shares.
- The stock options and the shares issuable upon exercise of those options may not be pledged, hypothecated or otherwise transferred, and may not be subject to a short position, a "put equivalent position" or a "call equivalent position" by the optionholder (as such terms are defined in the rules under Section 16 of the Exchange Act).
It should be noted that the foregoing transfer restrictions:
- Do not apply to shares that are actually issued upon exercise of an option;
- Do not apply to: (i) transfers back to the issuer, or (ii) transfers in connection with a change in control or other acquisition transaction involving an issuer where the options will no longer be outstanding after the transaction and the issuer will no longer be relying on the exemption;
- May terminate when the issuer becomes subject to the reporting requirements of the Exchange Act or ceases to rely on the exemption; and
- Must be set forth in either (i) a written compensatory stock option plan, individual stock option agreement, or other agreement to which the issuer and the optionholder are a signatory or party, or (ii) in the issuer's by-laws or certificate of incorporation.
- Risk and financial information is provided to optionholders. The issuer must agree in a written compensatory stock option plan or other enforceable agreement to provide to optionholders the same information required by Rule 701(e) pertaining to unregistered sales of securities in excess of $5 million in any 12-month period. For so long as the exception is being relied upon, such information must be provided every six months irrespective of the value of securities sold during that period. The information consists of: (i) information about the risks associated with an investment in the shares underlying the options and (ii) financial statements that are not more than 180 days old. The issuer is only required to provide the above-referenced information if the optionholder or holder of shares issued or issuable upon exercise of those options agrees to keep it confidential.
If a non-reporting company using this exemption ceases to satisfy the above conditions, it must file a registration statement to register its stock options under Section 12(g) of the Exchange Act within 120 days.
New Exemption for Reporting Companies
The SEC has also adopted new Rule 12h-1(g) under the Exchange Act, which provides an exemption from registration under the Exchange Act for compensatory stock options of a company that has issued stock options to 500 or more persons and already files reports under the Exchange Act. This new rule eliminates uncertainty regarding a company's obligation to register under the Exchange Act stock options themselves, as a separate class of security, where a company has already registered the common stock issuable upon exercise of the stock options. The exemption also means that an issuer of high yield or other debt securities that is required to file periodic reports pursuant to Section 15(d) of the Exchange Act and that has 500 or more optionholders will not be required to register that class of options under the Exchange Act.
The requirements for this exemption are as follows:
- The options must have been issued under a written compensatory stock option plan. This requirement is identical to the requirement described above for non-reporting companies and mirrors the requirement of Rule 701 and Form S-8.
- Optionholders can only be employees, directors, consultants and advisors of the issuer, its parents, its majority-owned subsidiaries or majority-owned subsidiaries of the issuer's parent. This requirement is substantially identical to the requirement applicable to non-reporting companies but has two differences. First, reporting companies' permitted optionholders include those allowed under both Rule 701 and Form S-8. Reporting companies are not permitted to use Rule 701 and must register equity-based compensation grants on Form S-8; however, the SEC recognized that before becoming a reporting company, an issuer may have granted options to the slightly broader category of persons permitted under Rule 701. Second, the exemption for reporting companies will still be available if the type of permitted optionholder does not comply precisely with the requirements of Rule 701 or Form S-8, provided the deviation is insignificant and the company has made a good faith and reasonable attempt to comply with the permitted optionholder requirements after December 7, 2007. The significance of a deviation is measured both in terms of the total number of options outstanding and the total number of optionholders.
If a reporting company using this exemption ceases to satisfy the above conditions, it must file a registration statement to register its stock options under Section 12(g) of the Exchange Act within 60 days.
Practical Tips for Implementation
Confirm Availability of Exemption
- All issuers — reporting and non-reporting — should consider whether they foresee having 500 or more optionholders. If so, they should determine as soon as possible whether they are or can be in compliance with the requirements for the exemption in case they need to rely upon it in the future.
- Any issuer that already has 500 or more optionholders should determine whether one of the new exemptions is available to it and, if so, what steps are necessary to comply with it. A non-reporting issuer, or an issuer that files reports pursuant to Section 15(d) of the Exchange Act or voluntarily as a result of a contractual undertaking (e.g., debt issuers that report pursuant to indenture provisions), will benefit from the exemption and should review its availability. A reporting issuer with a class of equity securities registered under the Exchange Act may conclude that the exemption is of little benefit to it and decide, if it has not already done so, to register the class of options under the Exchange Act.
Confirm All Existing Optionholders Are "Permitted" and Implement Steps to Ensure Future Optionholders Are Permitted
- Non-reporting companies. If the aggregate number of optionholders of a non-reporting company equals or exceeds 500 at the end of the issuer's fiscal year and there are non-permitted optionholders, the exemption from registration under Rule 12h-1(f) will not be available and the issuer will need to register the entire class under Section 12 of the Exchange Act. (This contrasts with the grant of an option to a non-permitted person under Rule 701, which can generally be cancelled prior to exercise and, even if exercised, an alternate Securities Act exemption may be available.) As a result, it is imperative that non-reporting companies seeking to use the exemption confirm that they have granted options only to the categories of persons permitted under Rule 701. One of the most common types of non-permitted optionholder is a corporate entity — Rule 701 only permits option grantsto individuals subject to very limited exceptions. There is no "insignificant deviation" provision for non-reporting companies. Therefore, it is advisable to identify any issues early so that they can be addressed.
- Reporting companies. Reporting companies that wish to use the exemption should also confirm that they have granted options only to the categories of persons permitted under Rule 701 or Form S-8. In the event that there are any non-permitted holders, a reporting company that expects to remain so should consider whether the provision permitting an "insignificant deviation" from the categories of permitted optionholders is applicable.
Assess Need to Amend Stock Option Plans of Non-Reporting Companies or Reporting Companies that May Become Non-Reporting Companies
- Companies may need to amend their stock option plans to include the required transfer restrictions and to add provisions regarding provision of risk and financial information to optionholders. Although stock option plans of both reporting and non-reporting issuers usually contain restrictions on the transferability of stock options, these restrictions are unlikely to meet all of the new exemption's requirements. In particular, most existing plans probably do not contain the hedging restrictions required by the new exemption and most related award agreements probably do not include an affirmative undertaking to provide information required by Rule 701(c) if the number of optionholders is 500 or more. Including transfer restrictions and an information undertaking in option agreements on a going-forward basis is insufficient because these provisions must apply to all currently outstanding options. Therefore, non-reporting companies, or reporting companies that may become non-reporting companies, need to review their plans to determine what amendments are required. Addition of an information undertaking is unlikely to require optionholder approval; however, whether optionholder approval is necessary to add a restriction on hedging depends on if such a change is viewed as a clarification to existing transfer restrictions or as a substantive amendment.