The US Securities and Exchange Commission recently instituted a cease-and-desist proceeding (found here) against Credit Karma, Inc., a San Francisco-based financial technology company, for failing to provide adequate disclosure to its stock option holders pursuant to SEC Rule 701 (Rule 701) because Credit Karma did not comply with relevant disclosure requirements for offerings in excess of $5 million.
As a result, Credit Karma agreed to a settlement with the SEC and paid a civil penalty of $160,000 – well above what the disclosures would have cost. In the settlement, Credit Karma accepted the SEC's findings that there was no valid securities exemption due to a Rule 701 disclosure failure, and therefore that Credit Karma had violated the registration requirements of the Securities Act of 1933.
Background on Rule 701
Rule 701 is a safe harbor exemption that excuses certain employee benefit plans, including stock incentive plans, from registering equity offerings and sales under the Securities Act.
For private companies, Rule 701 is a very important tool to avoid burdensome SEC registration requirements. Rule 701 specifically applies to companies that are not subject to reporting pursuant to sections 13 or 15(d) of the Securities Exchange Act of 1934. To qualify under the exemption, the company must issue securities pursuant to a written compensatory benefit plan only to employees, directors, consultants and advisors. Consultants and advisors must be natural persons whose services are not for capital-raising purposes.
Rule 701 has a ceiling on the number of securities that may be sold in any consecutive 12-month period. The total aggregate sales price or amount of securities that may be sold during any consecutive 12-month period is the greatest of:
- $1 million
- 15 percent of the total assets of the company or
- 15 percent of the outstanding amount of the class of securities being offered and sold.
Disclosure requirements under Rule 701
If the total aggregate sales price or amount of securities sold during any consecutive 12-month period is equal to or less than $5 million, the company is generally only required to deliver a copy of the plan (and award agreement, if applicable) to the purchaser.
However, if a company expects that the total aggregate sales price or amount of securities that may be sold during any consecutive 12-month period will exceed $5 million, then Rule 701 requires the company to provide each of the following to the purchasers:
- A summary of the material terms of the employee benefit plan
- The risks associated with the investment and
- GAAP compliant financial statements, including the latest balance sheet and the statements of income, cash flows, and capitalization for the preceding two fiscal years generally, dated not more than 180 days prior to the date of the sale of the securities.
These disclosures must be delivered a reasonable period of time before the date of sale, which means the date of exercise in the case of stock options and the date of grant in the case of restricted stock.
What did Credit Karma do wrong?
The SEC found that Credit Karma issued $13.8 million in stock options to service providers from October 1, 2014, through September 30, 2015. These grants exceeded the $5 million disclosure threshold, but Credit Karma failed to comply with the enhanced disclosure requirement.
The SEC stated that the failure to provide enhanced disclosure triggered the violation by Credit Karma and resulted in the entire offering failing to rely on Rule 701. In other words, the violation was not limited to the individuals who exercised stock options without enhanced disclosure.
Other state law issues
Offerings and sales under Rule 701 must still comply with any applicable state blue sky laws, many of which incorporate Rule 701 as a basis for compliance with state securities laws.
Private companies granting equity awards in the US should contact their US corporate, securities, and/or employee benefits and executive compensation counsel to ensure there are systems in place for tracking and monitoring of equity award grants under any compensatory benefit plan for compliance with Rule 701 and related state blue sky laws. This is an area of enhanced enforcement, and potential penalties greatly outweigh the cost of compliance.