Securities Offerings to Employees of Private Companies
There seems to be a popular misconception among corporate executives of private companies that securities offerings made to employees are inherently exempt from the registration requirements of federal and state securities laws. To the contrary, any offering of securities, including an offering of stock options or other securities made to employees, must qualify for an exemption from these registration requirements. Just because a company has adopted an equity incentive plan that permits the issuance of a specified number of securities does not mean that the issuance of that amount of securities is permitted under the securities laws. With all of the recent attention that has been focused on stock option grant practices (see the accompanying article in this legal bulletin), now is an ideal time for companies to assess their securities law compliance procedures with respect to employee securities offerings.
Availability of the Rule 701 Exemption
Rule 701 of the Securities Act of 1933 provides an exemption from the registration requirements of the federal securities laws for securities issued in connection with written compensatory benefit plans and agreements established by the issuer (or certain of its affiliates) for the participation of its employees, officers, directors, and in certain specified instances, consultants and advisors, among others. Any purchase, savings, option, bonus, stock appreciation, profit sharing or other similar plan will constitute a compensatory benefit plan subject to the rule. The exemption is available only if (1) the issuer is not a public company and is not an investment company, (2) the recipients of the securities were employed by or providing services to the issuer at the time the securities were offered and (3) the securities are offered for compensatory purposes and not to raise capital for the issuer.
If an issuer meets the above requirements, the issuer may offer an unlimited amount of securities and, in any consecutive 12 month period, may sell securities equal to the greatest of the following:
1) $1,000,000 aggregate sales price;
2) securities with an aggregate sales price of 15% of the total assets of the issuer, measured at the issuer’s most recently prepared balance sheet, but, such balance sheet may be no older than the issuer’s last fiscal year end; or
3) 15% of the number of outstanding securities of the same class, as measured by the issuer’s most recent balance sheet date, but again, such balance sheet may be no older than the issuer’s last fiscal year end.
When determining the aggregate sales price of stock options, the granting of an option is treated as a “sale” of the underlying securities at the exercise price at the time of the grant, regardless of whether the option is currently vested or exercisable. With respect to other securities, the calculation of the sales price is made on the date of the sale or, in the case of deferred compensation or similar plans, on the date when the irrevocable election to defer is made.
In order to qualify for the Rule 701 exemption, various disclosure requirements must be satisfied. The issuer must always deliver investors a copy of the compensatory benefit plan pursuant to which the securities will be issued. Additional documents need to be delivered if the aggregate sales price or amount of securities sold in any consecutive 12-month period exceeds $5,000,000. If this limit is exceeded, the issuer must provide the following items:
1) A copy of the summary plan description required by the Employee Retirement Income Security Act of 1974 (“ERISA”) if the plan is subject to ERISA;
2) A summary of the material terms of the plan if it is not subject to ERISA;
3) Information about the risks associated with investment in the securities sold
pursuant to the plan or compensation contract; and
4) Copies of the issuer’s financial statements as of a date no more than 180 days before the sale of securities under Rule 701.
Offers and sales that are exempt under Rule 701 are not integrated with other offers and sales made by the same issuer. Accordingly, there are certain planning opportunities if an issuer needs to exceed the aggregate sales price limitations under Rule 701 and can utilize another exemption for sales. For example, it might be possible to make a few large sales to executive officers under another exemption, and then use Rule 701 for rank and file employees.
All securities issued pursuant to Rule 701 are deemed to be “restricted securities” and cannot be resold unless an exemption from registration is available.
State Securities Laws/Antifraud Rules
In addition to satisfying Rule 701, an issuer also must comply with all applicable state laws for an offering to employees. Some states have an exemption that mirrors the Rule 701 exemption, while other states have a completely different statutory framework for the offer and sale of securities under compensatory benefit plans. Each state in which the issuer offers securities under a compensatory benefit plan needs to be analyzed for compliance with applicable state securities laws.
As is the case with any securities offering, the satisfaction of Rule 701 and applicable state securities laws does not exempt any offering of securities from the antifraud provisions of the federal and state securities laws.
The Sherman & Howard Business Department is ready to assist clients on compliance with Rule 701 or applicable state securities laws. Please visit our website at www.shermanhoward.com for more information.