A California tech firm recently settled with the Securities and Exchange Commission (SEC), paying $160,000 for violating Rule 701 of the Securities Act (Rule 701) because the firm failed to provide detailed financial statements and risk disclosures to employees who had been granted stock options. Absent a Rule 701 exemption, the non-public company could have been liable for selling unregistered securities. This settlement serves as a reminder to check stock and equity incentive plans and deferred compensation plans for compliance with Rule 701. If the $5 million threshold of Rule 701 has been exceeded, financial and risk disclosures must be provided to the offerees in addition to a copy of the plan document.
Rule 701 Exemption Summary
Rule 701 exempts a company from registration of its securities that are issued under a “compensatory benefit plan”, such as a stock or equity incentive plan, to employees, officers, directors, consultants and advisors. Under Rule 701, sales of securities in any 12-month period must not exceed the greatest of:
-
$1 million;
-
15% of total assets of the company; or
-
15% of the outstanding amount of the class of securities offered under the plan.
Subject to the maximum (above) that can be sold in any 12-month period, if the aggregate sales price of the securities sold in any 12-month period exceeds $5 million, then the company must deliver to the offerees:
-
A copy of the compensatory benefit plan;
-
A summary plan description or, if the plan is not subject to ERISA, a summary of the material terms of the plan;
-
Information about the risks of investment in the securities offered under the plan; and
-
Financial statements compliant with Reg A as of a date no more than 180 days before the sale under the plan.
Lessons Learned
The California company, Credit Karma, Inc., issued over $5 million in stock options to its employees starting in the fall of 2015. Credit Karma and its executives were aware of Rule 701 and its requirements, but failed to deliver complete financial information and disclosures, citing confidentiality concerns. Confidentiality of financial results is no defense to the disclosure requirements.
Credit Karma provided disclosure packets to the employees within 2 weeks of the SEC’s staff inquiry on its Rule 701 compliance. Because of this prompt compliance, the settlement order recites that the lowered civil penalty is based on the company’s cooperation in the SEC’s investigation. Penalties could have been greater if prompt cooperation with the SEC had not been provided.
Prior to any large grant of stock options or other equity awards, compliance with Rule 701 and its thresholds should be reviewed. A rolling 12-month period can aggregate plan sales in different fiscal years. As a result, relying on annual financials may not be sufficient.
The foregoing is a brief summary of Rule 701. Private companies with any compensatory benefit plan under which securities may be issued should review the entire rule and check with legal counsel to confirm compliance with Rule 701, as well as any applicable state securities laws.
