The U.S. Securities and Exchange Commission (SEC) approved an amendment to Rule 701(e) under the Securities Act of 1933 on July 18, 2018, increasing from $5 million to $10 million the threshold in excess of which a private company is required to deliver additional disclosures, such as financial statements, to employees in a compensatory securities offering. The change became effective July 23, 2018.
The SEC also approved the issuance of a concept release soliciting public comment on possible ways to update the requirements of Rule 701 and Securities Act Form S-8, which provides a simplified registration form for compensatory offerings by public companies. In so doing, the SEC has signaled its willingness to consider possible ways to modernize its regulation of compensatory securities offerings and sales.
Rule 701(e) Amendment Mandated by Congress
Subject to certain requirements, Rule 701 provides a federal exemption for a nonreporting company from the registration requirements of the Securities Act for offers and sales of securities under compensatory employee benefit plans or written agreements for the company’s employees, officers, directors, partners, trustees, and, under certain circumstances, its consultants and advisors. Rule 701(e) requires the company to deliver to all such offerees, within a reasonable period of time before the date of sale, financial statements and certain other information if the aggregate sales price or amount of securities sold during any consecutive 12-month period exceeds $5 million ($10 million following the effectiveness of the amendment). In the adopting Release, the SEC clarified that companies that have commenced an offering in the current 12-month period will be able to apply the new $10 million disclosure threshold immediately upon effectiveness of the amendment.
The SEC’s action to amend Rule 701(e) came as no surprise. It was directed to do so by Congress within 60 days after the Economic Growth, Regulatory Relief, and Consumer Protection Act was signed into law on May 24, 2018. The law also requires that every five years the SEC index for inflation the disclosure threshold amount to reflect the change in the Consumer Price Index for All Urban Consumers. In publishing the final Rule 701(e) amendment without engaging in a cost-benefit analysis or seeking public comment, the SEC made clear that Congress itself had undertaken the requisite analysis and that the agency exercised no discretion. By raising the existing $5 million threshold, the SEC explained, Congress intended to address two key concerns: “that additional disclosure makes it more expensive for [private] companies to compensate their employees with . . . stock and that this disclosure puts [these] companies at risk of disclosing confidential financial information.”
Concept Release Signals Future Changes to Rule 701 and Form S-8
Both the Concept Release and remarks made by the commissioners and the staff during the SEC open meeting recognize that since Rule 701 and Form S-8 were last amended, new forms of equity compensation have evolved along with new types of contractual relationships between companies and individuals involving alternative work arrangements. A key question has emerged: what does the term “employee” really mean in the emerging “gig” economy? In light of these developments, as well as the congressionally-mandated change to Rule 701(e), the SEC believes that “this is an appropriate time to revisit the Commission’s regulatory regime for compensatory transactions.”
During the open meeting, several of the commissioners emphasized that compensatory offers and sales of securities to employee-investors present different issues for private companies than capital-raising offerings aimed at other prospective investors. As noted in the Concept Release, “using equity for compensation can align the incentives of employees with the success of the enterprise, facilitate recruitment and retention, and preserve cash for the company’s operations.” It was this important distinction that prompted the SEC many years ago to adopt Rule 701 and a streamlined Form S-8.
The Concept Release poses 56 questions in total (with almost 75 percent of the questions focused on Rule 701) for public comment—many stemming from the new types of contractual relationships arising between companies and individuals due to the Internet, including short-term, part-time, or freelance arrangements. Individuals participating in these arrangements do not enter into traditional employment relationships and therefore may not be “employees” eligible to receive securities under Rule 701(c). Yet, companies may have the same incentive-related motivations to offer equity compensation to these individuals.
Several of the comment requests focus on what activities an individual should need to engage in, in order to be eligible to participate in exempt compensatory offerings, or put another way, who should be considered an “employee” in the current gig economy. The Concept Release also solicits comments on further revising the disclosure content and timing requirements of Rule 701(e), including, among other things, asking whether the rule should continue to require more disclosure for a period that precedes the new $10 million threshold amount being exceeded, clarify what it means to deliver disclosure “a reasonable period of time before the date of sale,” and specify the manner or medium in which disclosure should be delivered.
The SEC is also soliciting comments on Form S-8. For the “continued harmonization” of Form S-8 and Rule 701, the SEC is asking to the extent the scope of eligible individuals, including “consultants and advisors,” is changed under Rule 701, whether the same changes should be reflected in amendments to Form S-8. Among other questions, the SEC asks whether it should adopt a “pay-as-you go” fee structure, where companies pay filing fees on Form S-8 on an as-needed basis rather than when the form is originally filed.
Howard Dicker and Aabha Sharma