The U.S. Securities and Exchange Commission (SEC) on November 6, 2017, clarified the requirements for delivering financial and other disclosures to employees and other service providers receiving options and other equity awards under Rule 701 of the Securities Act of 1933, as amended (Securities Act), in the form of a new Compliance and Disclosure Interpretation (C&DI) 271.25. We look at what the latest guidance means and steps companies can take to ensure their delivery methods permit effective access to and retention of the disclosure information.
Rule 701 Overview
U.S. federal securities laws require that securities must be registered under the Securities Act unless an exemption from registration is available. Rule 701 provides such an exemption for private companies making offers and sales of securities to certain employees and other service providers under written compensatory benefit plans (such as option and equity incentive plans). In addition to limitations on the sales price or number of shares that can be offered pursuant to Rule 701, an issuer is currently permitted to grant only up to $5 million of equity awards (e.g., stock, stock options, restricted stock units) during any 12-month period unless certain disclosures are delivered to the award recipients. (Legislation is awaiting the President’s signature that would increase the $5 million limit to $10 million.) These disclosures contain potentially sensitive information of the issuing company, including financial statements.
New C&DI 271.25
The new C&DI 271.25 acknowledges that companies may have concerns about the unauthorized release of sensitive company information that is delivered to satisfy its Rule 701 disclosure obligations and that safeguards may be used to help protect against such release. For example, companies choosing to deliver their Rule 701 disclosures electronically may use standard electronic safeguards, such as user-specific login requirements and related measures.
The SEC specified that any such safeguards (alone or in combination with other safeguards) should not be so burdensome that intended recipients cannot effectively access the disclosures. The SEC also stated that, once access to the information has been granted, the medium used to communicate the information should provide an opportunity to retain the information or have ongoing access that is substantially equivalent to retention.
The SEC also indicated that companies may use physical disclosure rooms to convey the disclosure information. Consistent with the requirement that safeguards not be overly burdensome, the SEC expects that physical disclosure rooms would be accessible during ordinary business hours upon reasonable notice to each eligible recipient and would provide for ongoing access.
Although the new C&DI 271.25 indicates that a physical room may be used to deliver Rule 701 disclosures, it is unclear what safeguards may be put in place to help avoid unauthorized release of the disclosure information while at the same time providing retention of or ongoing access to such information (if not otherwise available by, e.g., electronic means). For instance, we presume a company could prohibit an employee from bringing a device with a camera (such as a mobile phone) into the physical disclosure room. However, it is unclear whether a service provider could be prohibited from bringing a personal adviser into the physical disclosure room to assist him or her with understanding the disclosure information.
Although not specified in the new C&DI, we expect that the SEC would require that physical disclosure rooms be available in every jurisdiction in which the company has service providers entitled to Rule 701 disclosures, or an alternative means of effective access for service providers who do not have reasonable access to physical disclosure rooms in such jurisdictions.
Private companies should carefully analyze their delivery method(s) of Rule 701 disclosures to ensure that those methods permit effective access to the disclosure information and allow retention (or its equivalent) of such information.