The US Securities and Exchange Commission’s new Rule 701 and concept release may ease a new generation of companies’ ability to offer and issue equity-based compensation, and question the appropriateness and continued utility of Form S-8 with respect to the changing “gig economy.”
On July 18, the US Securities and Exchange Commission (SEC) adopted final rules to amend Securities Act Rule 701 (Rule 701), which provides an exemption from the registration requirements of the Securities Act of 1933 (’33 Act) for securities issued as compensation by companies that are not subject to the reporting requirements of the Securities Exchange Act of 1934 (nonreporting companies).
Under the amendments, a nonreporting company may avail itself of the Rule 701 disclosure exemption for up to $10 million (an increase from $5 million) in aggregate sales or amount of securities sold during any consecutive 12-month period.
The SEC also has asked for public comment on how Rule 701, together with Form S-8, can be further modernized in light of the changing economy and evolving work arrangements.
Background of the Rule 701 Exemption
Offers and sales of securities in the United States must be either (1) registered under the ’33 Act or (2) made pursuant to an available exemption from registration.
Thirty years ago, the SEC adopted Rule 701 to allow nonreporting companies to sell securities to their employees without needing to register the offer and sale of such securities. The Rule 701 exemption allows nonreporting companies to sell, during any consecutive 12-month period, securities equal in aggregate value to the greatest of (1) $1 million, (2) 15% of the total assets of the company, or (3) 15% of the outstanding amount of the class of securities being offered and sold under the Rule 701 exemption.
Currently, companies relying on the Rule 701 exemption may avail themselves of limited disclosure requirements to employee-participants (i.e., only providing a copy of the compensatory benefit plan or relevant contractual agreement to the recipient) until the aggregate sales price of securities issued under the exemption in the prior 12-month period reaches $5 million. Under the amendments, the SEC has doubled this disclosure threshold to $10 million.
After surpassing the threshold, the nonreporting company must deliver a more fulsome disclosure package to all equity compensation recipients in the relevant 12-month period. The additional disclosure includes
- a copy of the summary plan description required by the Employee Retirement Income Security Act of 1974, as amended (ERISA), or a summary of the plan’s material terms if it is not subject to ERISA;
- a description of the risks associated with investments in the company’s securities; and
- the financial statements that otherwise would be required in an offering statement on Form 1-A under Regulation A.
Once the nonreporting company’s offers and sales exceed the threshold, for any subsequent offers or sales, delivery of such additional disclosure must occur within a reasonable period of time prior thereto. If not, the Rule 701 exemption becomes unavailable for prior offers and sales, even those issued before the nonreporting company exceeded the disclosure threshold.
Upon publication of the amendment to Rule 701(e) in the Federal Register, which likely will occur within the next two weeks, the disclosure delivery threshold will be raised to $10 million, both for subsequently initiated and currently ongoing offerings made in reliance on the Rule 701 exemption. This amendment to Rule 701(e) was required by Section 507 of the Economic Growth, Regulatory Relief, and Consumer Protection Act, which was signed into law on May 24, 2018.
Call for Public Comment
The SEC also issued a concept release on July 18, in which it requested public comment to further modernize Rule 701, together with Form S-8, in light of the evolution of the forms and types of equity compensation.
The SEC is seeking comment as to whether Rule 701 should be further revised, including
- whether the definition of the eligible recipients of securities offered and sold in Rule 701 transactions should be expanded in light of the growing “gig economy” and, if so, in what manner;
- whether Rule 701 should be revised so that the obligation to deliver additional disclosure, or the impact of failure to comply with this obligation, applies only subsequent to the offer and sale of securities conducted after the disclosure threshold is passed;
- whether Rule 701’s disclosure and delivery requirements should otherwise be softened, broadened, or clarified, and if the SEC should distinguish between the disclosure requirements for domestic and foreign nonreporting companies; and
- whether the maximum amount of securities that may be offered and sold under Rule 701 should be raised and, if so, how.
Questions posed regarding Form S-8 include
- if Rule 701 is revised to broaden the eligible recipients of securities under the rule, whether corresponding changes should be made to Form S-8;
- how Form S-8 may be simplified to reduce administrative burdens and costs, and whether Form S-8 should be revised such that a company could register, on a single form, the offers and sales pursuant to all employee benefit plans that a company sponsors;
- whether the registration requirements of Form S-8 itself should be simplified, including specifically with respect to the use of Form S-8 in connection with Section 401(k) plans;
- whether the SEC should implement a “pay-as-you-go” basis to Form S-8 (similar to what currently is available to well-known seasoned issuers conducting shelf registration statement takedowns); and
- whether, and in what capacity, Form S-8 remains relevant, and what the impacts would be of rescinding Form S-8.
The SEC will receive comments until 60 days after the publication of the concept release in the Federal Register. We anticipate that the concept release also will be published in the Federal Register within the next two weeks.
Failure to comply with the enhanced disclosure requirements of Rule 701 can lead to SEC penalties. In March 2018, the SEC imposed a $160,000 fine on Credit Karma, a late-stage nonreporting company, due to the company’s failure to provide adequate information and risk factor disclosures once it issued stock options in amounts that exceeded the disclosure threshold. Although the increased threshold provides an added cushion for nonreporting companies, the Credit Karma enforcement action serves as a reminder to track carefully Rule 701 offerings.