Rule 701 Enhanced Disclosure Threshold to Increase

On May 24, 2018, President Trump signed into law the Economic Growth, Regulatory Relief, and Consumer Protection Act (Reform Act), which, among other things, amended securities law provisions focused on capital formation. One amendment directs the SEC to increase, from $5 to $10 million, the amount of securities that a company can issue to employees, directors, consultants and advisors in reliance on Rule 701 in any 12-month period without triggering enhanced (more onerous) disclosure obligations.

Rule 701 provides an exemption from the registration requirements of the Securities Act for the issuance of stock, options or other securities by private companies to their individual service providers under a compensatory benefit plan. Rule 701 reliance requires a number of conditions to be met, including relating to which entity may issue the securities, who may receive the securities, limits on the aggregate amounts that can be sold, disclosure requirements and restrictions on resale. Many private companies rely on Rule 701 as a tool to efficiently issue equity awards to recruit and retain talent.

Although all companies seeking to rely on Rule 701 must provide participants with a copy of the compensatory benefit plan under which the securities are being granted, Rule 701 requires enhanced disclosure of  company risks and updated financial statements if the aggregate amount of securities sold during any consecutive 12-month period is above a threshold, currently $5 million.

This reform comes on the heels of a widely-publicized SEC enforcement action against Credit Karma for its failure to provide the Rule 701-required enhanced disclosures in connection with the issuance of stock options in excess of $5 million over a 12-month period. For a summary of the enforcement action, see our client memorandum ‘Private Company Fined for Failure to Comply with Rule 701 in Option Exercises’.

Rule 701 has largely sat unchanged since 1999. Although there has been SEC Staff interpretative guidance around the application of the rule, the key thresholds for the use of the exemption—the aggregate issuance cap and the enhanced disclosure obligation threshold—have remained the same even as companies have stayed private longer and grown larger during this period. An increase to the enhanced disclosure obligation threshold will be a meaningful improvement to how Rule 701 functions as a tool for companies to compensate their employees.

Other amendments, however, have been recommended that have long made Rule 701 a cumbersome process. With the Congressional action on Rule 701, the prospect of further Congressional action related to Rule 701 seems very unlikely. That being said, additional reform could come in this area as part of the rulemaking to implement the amendments mandated by the Reform Act if the SEC sees this as an opportunity for a deeper look at Rule 701.

For further information on this Rule 701 amendment, see our client memorandum ‘Rule 701 enhanced disclosure threshold to increase’.

For a detailed summary and analysis of the full Reform Act, including the capital formation related provisions, see our client memorandum ‘First Major Dodd-Frank Reform Bill Signed into Law’.

This post comes to us from Shearman & Sterling.