Earlier this month, the Securities and Exchange Commission Advisory Committee on Small Businesses heard a presentation on Rule 701 and whether it should be updated. Following the presentation, the committee resolved to advise the SEC to adopt the recommendations for changes to the rule.
Securities Act Rule 701 is a federal exemption from registration requirements for equity compensation that is issued to employees, consultants and directors under compensatory benefits plans or compensation agreements. Rule 701 is only available to private companies; public companies cannot participate. And there are limits on the amount of securities a company can sell in reliance on Rule 701.
Warby Parker, a prescription eyeglass company, and the law firm Orrick Herrington & Sutcliffe LLP, made the presentation at the committee’s Sept. 13 meeting. To begin, they said it was critical that the rules not be overly complicated or difficult to comply with. Specifically, they recommended:
Remove the requirement that consultants and advisors be natural persons. The presenters noted most consultants provide their services through an entity for liability or tax purposes. Under the current rules, companies must jump through various hoops to compensate these consultants with equity. The presenters suggested the limitation wasn’t necessary.
Eliminate the Hard Cap Limit. Under the current format, companies can in a 12-month period only use the rule to sell the greater of $1 million in value; 15 percent of total assets; or 15 percent of the outstanding stock. The presenters said that compliance with this limitation requires ongoing analysis with no clear benefit.
Increase the Soft Cap. Under the soft cap, companies are required to provide financial statements and other disclosures if securities with a value of more than $5 million are sold under Rule 701 within any consecutive 12-month period. There have been various calls for an increase to the $5 million limit. The presenters suggested raising it to $10 million.
Require Expanded Disclosure Be Provided For Sales that Occur After the Soft Cap Threshold is Exceeded. Currently, expanded disclosure must be provided to any person who receives securities under Rule 701 during any 12 month period in which the company sells more than $5 million in value. The presenters contended this requires companies to guess as to whether the limit will be exceeded and begin providing disclosures before the threshold is exceeded to ensure compliance. They called this impractical and said there was no clear rationale for the structure.
Clarify Timing and Delivery Requirements of Expanded Disclosure. Rule 701 requires expanded disclosure to be delivered a “reasonable period of time prior to sale.” It was recommended that delivery of the disclosure be allowed at any time before sale so long as the recipient has a chance to review the disclosure. And that it be able to be provided in a “manner consistent with the SEC’s electronic disclosure rules (eg. on an online data site that is accessible to the individual)” or by making it available in a physical location accessible to the individual.
Exclude “Material Amendments” from Calculation of Limit. Currently, issuers are required to count stock options that are repriced as new grants/sales under Rule 701 as of the date of the repricing. This can cause companies to exceed the Hard Cap and Soft Cap Limit. The presenters contended that in these situations there are no additional securities being issued, but instead a “re-setting” of the original arrangement to ensure the options remained compensatory. It was recommended a rule be adopted that clarifies that material amendments to any security previously issued under Rule 701 does not result in a new grant or sale for purposes of the rule.
Clarify Application of Rule 701 to Restricted Stock Units. The presenters pointed out that Rule 701 has no rules specifically addressing RSUs, which private companies generally did not grant when the rule was adopted. They recommended clarifying that RSUs are considered sales on the date of grant, similar to options. It was also suggested that it be clarified that RSUs should be valued for the purposes of any Rule 701 limits based on the value of the underlying shares on the date of grant.
Other recommendations included simplifying the financial disclosure requirement by de-coupling it from Regulation A and requiring instead a current balance sheet and income statement; requiring a financial disclosure be provided just once a year unless there is a material change to the value of the company or the value of the securities; and conforming the consequences for violating the Soft Cap (loss of Rule 701 exemption for all securities sold in the 12-month period) with the consequence for violating the Hard Cap Limit (only securities sold in excess of the limit).