Amendments to Rule 701 Increase Opportunities For Startups and Private Companies

The recently enacted U.S. Economic Growth, Regulatory Relief and Consumer Protection Act of 2018 includes a provision that requires the U.S. Securities and Exchange Commission (the “SEC”) to revise Rule 701, which provides an exemption from the registration requirement of the U.S. Securities Act of 1933 (the “Securities Act”) for securities issued to an issuer’s employees and certain other persons pursuant to written compensatory plans.

Under Rule 701, an offering is exempt from the registration requirement of the Securities Act if total sales of securities during a twelve-month period do not exceed the greatest of: (i) $1 million; (ii) 15% of the issuer’s total assets (measured at the most recent balance sheet date); and (iii) 15% of all the outstanding securities of the class (measured at the most recent balance sheet date). In addition, an issuer historically was permitted to grant only up to $5 million of equity awards (e.g., stock, stock options, restricted stock units, etc.) during any twelve-month period unless the issuer delivered certain disclosures to the employee and other service provider recipients.

The amendment to Rule 701 increases the $5 million cap to $10 million and directs the SEC to adjust that threshold for inflation every five years. Increasing the cap will benefit smaller private companies by sparing them the additional costs of focusing on calculations and providing additional disclosures.

The SEC had never instituted an enforcement action under Rule 701 until March of 2018, when the SEC charged Credit Karma, Inc., a personal finance company, with failing to provide detailed financial information and risk disclosure to its employees as required by Rule 701. The SEC contended that Credit Karma possessed the detailed financial information required to disclose to its employees, but Credit Karma failed to disclose such information because of its desire to keep certain information confidential. The SEC ultimately imposed a $160,000 penalty. It remains to be seen whether the SEC will take a more aggressive approach to enforcing the disclosure requirements with respect to larger companies whose offerings exceed the higher cap after the amendment.

Accordingly, private companies that wish to offer equity-based compensation to employees should be advised of the increased disclosure threshold and take this as an opportunity to review future equity compensatory plans to maximize the opportunities afforded by Rule 701. Attorneys in Taft’s Securities Group can help companies assess disclosure requirements and the sufficiency of such disclosures.

Finally, many commentators and practitioners have suggested other Rule 701 revisions and updates that would make such disclosures less burdensome for private companies, but whether the SEC will take up additional reforms of Rule 701 is uncertain. We will continue to monitor SEC actions that impact Rule 701.

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