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by Laura Anthony, Esq.

SEC Issues New C&DI On Rule 701

ABA Journal’s 10th Annual Blawg 100

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On June 23, 2016, the SEC issued seven new Compliance and Disclosure Interpretations (“C&DI”) related to Rule 701 of the Securities Act of 1933, as amended (“Securities Act”). On October 19, 2016, the SEC issued an additional three C&DI. The majority of the new C&DI focus on the effect on Rule 701 issuances following a merger or acquisition and clarify financial statement requirements under Rule 701. Two of the new C&DI address restricted stock awards including the disclosure requirements are triggered and when the holding period begins under Rule 144.

Rule 701 – Exemption for Offers and Sales to Employees of Non-Reporting Entities

Rule 701 of the Securities Act provides an exemption from the registration requirements for the issuance of securities under written compensatory benefit plans. Rule 701 is a specialized exemption for private or non-reporting entities and may not be relied upon by companies that are subject to the reporting requirements of the Securities Exchange Act of 1934, as amended (“Exchange Act”). The Rule 701 exemption is only available to the issuing company and may not be relied upon for the resale of securities, whether by an affiliate or non-affiliate.

Rule 701 exempts the offers and sales of securities under a written compensatory plan. The plan can provide for issuances to employees, directors, officers, general partners, trustees, or consultants and advisors. However, under the rule consultants and advisors may only receive securities under the exemption if: (i) they are a natural person (i.e., no entities); (ii) they provide bona fide services to the issuer, its parent or subsidiaries; and (iii) the services are not in connection with the offer or sale of securities in a capital-raising transaction, and do not directly or indirectly promote or maintain a market in the company’s securities.

Securities issued under Rule 701 are restricted securities for purposes of Rule 144; however, 90 days after a company becomes subject to the Exchange Act reporting requirements, securities issued under a 701 plan become available for resale. In addition, non-affiliates may sell Rule 701 securities after the 90-day period without regard to the current public information or holding period requirements of Rule 144.

The amount of securities sold in reliance on Rule 701 may not exceed, in any 12-month period, the greater of: (i) $1,000,000; (ii) 15% of the total assets of the issuer; or (iii) 15% of the outstanding amount of the class of securities being offered and sold in reliance on the exemption. Rule 701 issuances do not integrate with the offer and sales of any other securities under the Securities Act, whether registered or exempt.

Rule 701(e) contains specific disclosure obligations scaled to the amount of securities sold. In particular, for all issuances under Rule 701 a company must provide a copy of the plan itself to the share recipient. Where the aggregate sales price or amount of securities sold during any consecutive 12 month period exceeds $5 million, the company provide the following disclosures to investors a reasonable period of time before the date of the sale: (i) a copy of the plan itself (ii) risk factors; (iii) financial statement as required under Regulation A; (iv) if the award is an option or warrant, the company must deliver disclosure before exercise or conversion; and (v) for deferred compensation, the company must deliver the disclosure to investors a reasonable time before the date of the irrevocable election to defer is made.

As with all other Securities Act registration exemptions, the company is still subject to the antifraud, civil liability and other provisions of the federal securities laws. In addition, Rule 701 is not available for plans or schemes to circumvent the purpose of the Rule, which is for compensatory purposes, and not to raise capital. Moreover, Rule 701 is not available to exempt any transaction that is in technical compliance with this section but is part of a plan or scheme to evade the registration provisions of the Securities Act.

Rule 701 does not preempt state law and accordingly, in addition to complying with Rule 701, the company also must comply with any applicable state law relating to the issuance.

New C&DI

On June 23, 2016, the SEC issued seven new C&DI and on October 19, 2016 an additional three new C&DI all related to Rule 701. The majority of the new C&DI focus on merger and acquisition transactions, including reverse mergers. In addition, the new C&DI clarify financial statement requirements under Rule 701.  A summary of the new C&DI follows.

In a merger transaction where the acquirer assumes derivative securities of the target (such as options and warrants) and, as such, they become economically equivalent derivative securities of the acquirer, no exemption need be relied upon for the assumption and transfer of the obligation to the acquirer as long as the derivative securities (again, such as employee options and warrants) were properly issued under Rule 701 and the transfer to the acquirer does not require the consent of the holders of the derivative securities.

In other words, if a company issued options or warrants to its employees under a Rule 701 plan and that company is later acquired, such as through a reverse merger with a public shell company, the options or warrants could become obligations of the public company, without further registration or reliance on a registration exemption. As long as the options or warrants were properly issued under Rule 701 in the first place, the later exercise and conversion into other securities of the acquiring company, such as common stock, would also be exempt from registration. Moreover, where the acquiring company is subject to the Securities Exchange Act reporting requirements, the Exchange Act reports would satisfy any disclosure requirements under Rule 701(e)

Securities issued under Rule 701 would aggregate with securities issued under the same rule after a merger or acquisition. Rule 701 issuances by the target and acquirer aggregate for all purposes, including determining issuance limits under the rule and disclosure obligations to share recipients. Assuming the $1,000,000 limit, if the target company had issued Rule 701 securities up to $500,000, the combined post-merger entity would only be able to issue an additional $500,000 in that 12-month period. However, the combined companies could use a post-merger balance sheet in determining total assets for purposes of calculating allowable continued issuances under Rule 701. Likewise, the combined companies can use post-merger financial statements to satisfy the disclosure obligations required under Rule 701.

As a reminder from above, the amount of securities sold in reliance on Rule 701 may not exceed, in any 12-month period, the greater of: (i) $1,000,000; (ii) 15% of the total assets of the issuer; or (iii) 15% of the outstanding amount of the class of securities being offered and sold in reliance on the exemption.

The new C&DI clarifies when disclosure delivery requirements are triggered when aggregate sales of a restricted stock award (commonly referred to as a restrictive stock unit or RSU) in a 12 month period exceeds the $5 million threshold. When a company grants a restricted stock award, the date of sale is the date of grant of the award and thus the disclosure must be provided a reasonable time before the date of grant. Unlike an option or warrant, the employee does not need to take additional action to convert or exercise a restricted stock award, rather the award vests and the stock becomes irrevocably granted to the employee by the satisfaction of conditions (such as time of employment). Accordingly, Rule 7(e)(6) requiring disclosure be delivered prior to the exercise of an option or warrant would not apply.

Rule 701 requires that the same financial statements required in Regulation A be provided as disclosure to share recipients. Rule 701 was not amended or modified when the new Regulation A/A+ rules came into effect on June 19, 2015, leaving open the question as to which of the different Regulation A+ financial statement requirements need be used in a Rule 701 disclosure. The new SEC C&DI clarifies that a company can elect to provide the financial statements required under either Tier 1 or Tier 2 of Regulation A, regardless of the value of securities being offered or issued under Rule 701.

Finally the SEC clarifies when the Rule 144 holding period begins for restricted stock awards. In particular, the holding period begins “when the person who will receive the securities is deemed to have paid for the securities and thereby assumed the full risk of economic loss with respect to them.” For negotiated employment agreements the holding period begins on the date the investment risk passes to the employee, which generally is the date of the agreement. For restricted awards that vest over time and are conditioned solely on continued employment or satisfaction of other conditions not tied to the employees performance, the holding period begins on the date of the agreement. Like any other derivative security, if the employee is required to pay additional consideration for the securities (such as through exercise of a warrant or option) a new holding period would begin on the date of that payment (i.e. the date of the new investment decision).

Application of Exchange Act Section 12(g) to Employee Compensation Plans; Determining Holders of Record

On May 3, 2016, the SEC issued final amendments to revise the rules related to the thresholds for registrations, termination of registration, and suspension of reporting under Section 12(g) of the Securities Exchange Act of 1934. The amendments revise the Section 12(g) and 15(d) rules to reflect the new, higher shareholder thresholds for triggering registration requirements and for allowing the voluntary termination of registration or suspension of reporting obligations.

In particular, a company that is not a bank, bank holding company or savings and loan holding company is required to register under Section 12(g) of the Exchange Act if, as of the last day of its most recent fiscal year-end, it has more than $10 million in assets and securities that are held of record by more than 2,000 persons, or 500 persons that are not accredited. The same thresholds apply to termination of registration and suspension of reporting obligations.

The rules establish a non-exclusive safe harbor that companies may follow to exclude persons who received securities pursuant to employee compensation plans when calculating the shareholders of record for purposes of triggering the registration requirements under Section 12(g). Exchange Act Section 12(g)(5) provides that the definition of “held of record” shall not include securities held by persons who received them pursuant to an “employee compensation plan” in exempt transactions. By its express terms, this new statutory exclusion applies solely for purposes of determining whether an issuer is required to register a class of equity securities under the Exchange Act and does not apply to a determination of whether such registration may be terminated or suspended.

The rule establishes a statutory exclusion for security holders who received their stock in unregistered employee stock compensation plans, and provides a safe harbor for determining whether holders of their securities received them pursuant to an employee compensation plan in exempt transactions.

In its Section 12(g) rules, the SEC incorporates Rule 701(c) and the guidance under that rule for issuers to rely on in their Section 12(g) analysis. The proposed safe harbor allows an issuer to conclude that shares were issued pursuant to an employee compensation plan in an unregistered transaction as long as all the conditions of Rule 701(c) are met, even if other requirements of Rule 701, such as 701 (b) (volume limitations) or 701(d) (disclosure delivery requirements), are not met.

Under the definition of “held of record,” for purposes of Section 12(g), an issuer may exclude securities that are either:

held by persons who received the securities pursuant to an employee compensation plan in transactions exempt from, or not subject to, the registration requirements of Section 5 of the Securities Act or that did not involve a sale within the meaning of Section 2(a)(3) of the Securities Act; or

held by persons who received the securities in a transaction exempt from, or not subject to, the registration requirements of Section 5 from the issuer, a predecessor of the issuer or an acquired company, as long as the persons were eligible to receive securities pursuant to Rule 701(c) at the time the excludable securities were originally issued to them.

The SEC also excludes securities issued under the “no-sale” exemption to registration theory from the “held of record” definition, including shares issued as a dividend to employees. That is, the SEC is excluding securities that did not involve a sale within the meaning of Section 2(a)(3), as well as exempt securities issued under Section 3 of the Securities Act. Examples of securities issued under Section 3 include exchange securities under sections 3(a)(9) and 3(a)(10).

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The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
LAnthony@LegalAndCompliance.com

Securities attorney Laura Anthony and her experienced legal team provides ongoing corporate counsel to small and mid-size private companies, OTC and exchange traded issuers as well as private companies going public on the NASDAQ, NYSE MKT or over-the-counter market, such as the OTCQB and OTCQX. For nearly two decades Legal & Compliance, LLC has served clients providing fast, personalized, cutting-edge legal service. The firm’s reputation and relationships provide invaluable resources to clients including introductions to investment bankers, broker dealers, institutional investors and other strategic alliances. The firm’s focus includes, but is not limited to, compliance with the Securities Act of 1933 offer sale and registration requirements, including private placement transactions under Regulation D and Regulation S and PIPE Transactions as well as registration statements on Forms S-1, S-8 and S-4; compliance with the reporting requirements of the Securities Exchange Act of 1934, including registration on Form 10, reporting on Forms 10-Q, 10-K and 8-K, and 14C Information and 14A Proxy Statements; Regulation A/A+ offerings; all forms of going public transactions; mergers and acquisitions including both reverse mergers and forward mergers, ; applications to and compliance with the corporate governance requirements of securities exchanges including NASDAQ and NYSE MKT; crowdfunding; corporate; and general contract and business transactions. Moreover, Ms. Anthony and her firm represents both target and acquiring companies in reverse mergers and forward mergers, including the preparation of transaction documents such as merger agreements, share exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. Ms. Anthony’s legal team prepares the necessary documentation and assists in completing the requirements of federal and state securities laws and SROs such as FINRA and DTC for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile. Ms. Anthony is also the author of SecuritiesLawBlog.com, the OTC Market’s top source for industry news, and the producer and host of LawCast.com, the securities law network. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Las Vegas, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington, D.C., Denver, Tampa, Detroit and Dallas.

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