Trouble Ahead, Trouble Behind, and You Know Rule 701 Just Crossed My Mind

/in ,

By Benjamin Gibbons

This week we’re changing the station on the Benefits Dial to remind private companies who are granting securities to their employees of the importance of complying with Rule 701.  Rule 701 of the Securities Act of 1933 provides a federal securities registration exemption for privately-held companies who are granting securities (including stock options) through written compensatory benefit plans (such as omnibus equity incentive plans) to their employees and contractors (natural persons only).  Absent Rule 701, such securities would generally need to be registered with the Securities and Exchange Commission (SEC).

Among other requirements, Rule 701 provides that:

  • The aggregate sales price or amount of securities sold during any 12-month period cannot exceed the greater of the following “offering limits”:
    • $1,000,000;
    • 15% of a company’s total assets measured at the end of the most recently completed fiscal year; or
    • 15% of the outstanding securities of the class being offered.
  • Certain supplemental disclosures be provided to recipients with respect to offerings over a 12-month period that exceed $10 million ($5 million prior to July 24, 2018), which consist of:
    • a copy of the plan;
    • a summary of the material terms of the plan;
    • risk factors associated with investing in the securities; and
    • company GAAP financial statements prepared not more than 180 days before the sale/award of securities. 

Failure to comply with Rule 701 can result in substantial penalties.  In a 2018 settlement proceeding, the SEC levied a $160,000 fine on Credit Karma (a private company) for failing to provide all of the required supplemental disclosures to employees in connection with equity grants totaling more than $13 million over a 12-month period. In addition, failure to comply with Rule 701 could result in rescission rights for employees, which would require a company to offer to repurchase the securities from the employees.  While the SEC didn’t pursue rescission in Credit Karma’s case, the settlement serves as a reminder that the SEC is interested in ensuring Rule 701 compliance.

This post provides only a high-level refresher of Rule 701.  Be aware there are other nuances not discussed here, such as who equity grants can be made to and whether or not grants under Rule 701 satisfy state security registration exemption (blue sky) requirements.  We recommend carefully tracking offerings under Rule 701 to ensure that all requirements are met.