SEC Amends Rule 701 And Issues A Concept Release On Rule 701 And Form S-8 – Part II
Posted by Securities Attorney Laura Anthony | September 4, 2018 Tags:

On May 24, 2018, President Trump signed the Economic Growth, Regulatory Relief and Consumer Protection Act (the “Act”) into law. Section 507 of the Act directed the SEC to increase the threshold under Rule 701 of the Securities Act, for providing additional disclosures to employees from aggregate sales of $5,000,000 during any 12-month period to $10,000,000. In addition, the threshold is to be inflation-adjusted every five years. The Act required that the amendment be completed within 60 days and on July 18, 2018, the SEC complied and published the amendments. The amendments were effective immediately upon publication in the federal register.

On the same day, the SEC issued a concept release on potential further amendments to both Rule 701 and SEC Form S-8. The SEC is seeking public comment on ways to modernize the rules related to compensatory plans acknowledging the significant changes in both types of compensatory offerings and workforce composition in the past few decades.

Part I of this blog series discussed the Rule Change and Rule 701 in general. This Part 2 discusses the Concept Release.

Concept Release on Rule 701 and Form S-8

As the SEC notes in its press release announcing the rule change and concept release, equity compensation can be an important component of the employment relationship. In addition to preserving cash for the company’s operations, equity compensation aligns the interests of the employer with the employee and helps facilitate recruitment and retention.

Where Rule 701 allows non-reporting companies to sell securities to their employees, Securities Act Form S-8 provides a simplified registration form for reporting companies to use to issue and register securities pursuant to employee stock option or purchase agreements.  Since Rule 701 and Form S-8 were last amended, forms of equity compensation have continued to evolve, and new types of contractual relationships between companies and the individuals who work for them have emerged.

The Concept Release focuses on soliciting comments related to:

  • “Gig economy” relationships, in light of issuers using Internet platforms to provide workers the opportunity to sell goods and services, to better understand how they work and determine what attributes of these relationships potentially may provide a basis for extending eligibility for the Rule 701 exemption;
  • Whether the SEC should further revise the disclosure content and timing requirements of Rule 701(e); and
  • Whether the use of Form S-8 to register the offering of securities pursuant to employee benefit plans should be further streamlined.

Rule 701 Eligibility

As mentioned in my summary above, Rule 701 allows for issuances to employees, directors, officers, general partners, trustees, or consultants and advisors under written compensatory plans. Furthermore, 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.

However, with the rise in technology and the Internet, there has been the concurrent increase in new and different types of employment relationships including short-term, part-time or freelance arrangements. Huge companies have developed using this “gig economy” structure including in areas of ride sharing, lodging, food delivery, household repairs, dog sitting, marketing, web development, logo design, and tech support as just a few examples.

Individuals can have relationships with multiple companies and careers based on a particular service as opposed to a particular employer. These individuals may not fit within the parameters of an “employee” or consultant or advisor for purposes of Rule 701 eligibility. However, despite the non-traditional relationship, the company would have the same motivations to provide equity compensation including cash preservation, aligning company and workforce interests and facilitating recruitment and retention.

The SEC Concept Release solicits comment regarding these “gig economy” relationships to better understand how they work and determine what attributes of these relationships potentially may provide a basis for extending eligibility for the Rule 701 exemption. The concept release drills down on the issue with 21 questions on this subject alone.

In addition to the high-level questions related to how employees, consultants and advisors should be defined and the impact on investors and going public transactions of a larger eligibility pool, the SEC seeks input on the working of the gig economy in general such as whether an individual actually performs services for a company, or just customers and end users with the company just being a platform to obtain these customers and end users. Thought must be given to the level of control a company has over the individual and level of participation of the individual with the company in determining if such individuals should be included in an expanded eligibility regulation.

Rule 701(e) Disclosure Requirements

Although the SEC has amended Rule 701(e) to increase the threshold for providing additional disclosures to employees from aggregate sales of $5,000,000 during any 12-month period to $10,000,000, it has not amended how the rule operates. In particular, the rule requires that all investors, including prior investors, receive disclosures as soon as the aggregate amount of sales reaches the $10,000,000 mark or the exemption is lost. Disclosures must be delivered within a reasonable period of time before the date of sale. The rule does not specify the manner of delivery of the disclosure. Accordingly, a company must carefully monitor issuances and ensure that disclosure goes out to all recipients of Rule 701 securities prior to actually reaching the threshold.

The SEC seeks comment on whether the rule should continue to operate such that prior investors must receive disclosure before the threshold amount is exceeded. Moreover, the SEC questions whether the consequence of failing to do so should continue to be the loss of the exemption for the entire offering. As an alternative, the SEC could create a mechanism for a company to post information made available to all investors concurrently.

Rule 701 requires that the disclosure match the financial statement requirements in Regulation A. Under Regulation A, financial statements go stale after 180 days; accordingly, once the threshold is reached, disclosures must be updated to remain current. The SEC seeks comment on this aspect of the rule as well.

Additionally, the SEC seeks comment on the timing and manner of delivery of disclosures, including issues of confidentiality of the disclosure materials.

Rule 701 Issuance Caps

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 SEC seeks comment on the current caps including whether the $1,000,000 figure should be increased, including eliminating the cap altogether and whether the 15% figure should have an annual cap in dollar amount.

Form S-8

Form S-8 was originally adopted in 1953 as a simplified form for the registration of securities to be issued pursuant to employee stock purchase plans. Form S-8 requires certain disclosures that can be incorporated by reference to Securities Act and Securities Exchange Act periodic reports and registration statements. A Form S-8 is effective immediately upon filing, though like any filing with the SEC, may be subject to review and comment.

A Form S-8 may only be used to register securities issued or to be issued to natural persons who are employees, consultants or advisors to a company, pursuant to a written plan. The definition of a “consultant” is consistent with Rule 701. The types of written plans vary and can include different types of employee benefit plans, Internal Revenue Code 401(k) plans, other retirement saving plans, employee stock option plans, nonqualified deferred compensation plans, incentive plans, restricted stock plans, and direct contracts for services with individual employees, consultants or advisors. The form can register new issuances or the resale of restricted securities.

The form may not be used for capital-raising purposes. In particular, no securities may be issued through a Form S-8 to consultants either (i) as compensation for any service that directly or indirectly promotes or maintains a market for the registrant’s securities, or (ii) as conduits for a distribution to the general public.

To be eligible to use Form S-8, a company must be subject to the periodic reporting requirements of Section 13 or 15(d) of the Exchange Act and must have filed all reports required to be filed in the preceding 12 months. A shell company cannot use Form S-8; however, a company is eligible 60 days after ceasing to be a shell company and the filing of Form 10 information related to operations.

The filing fee for a Form S-8 is calculated the same way as filing fees for at-the-market offering registration statements.

Request for Comment

The questions in the concept release focus on how to reduce costs and further streamline the form.

The SEC asks for input on whether the definition of a consultant under Rule 701 and Form S-8 should remain the same, including if the scope of eligible securities recipients under Rule 701 is expanded to include individuals participating in the “gig economy.”

The SEC asks several questions related to the administrative burdens associated with Form S-8 and how the form and its processing could be further simplified, such as by, for example, allowing the registration of all shares under compensatory plans as opposed to a specific number of shares.

Finally, the SEC requests comment on general matters related to Form S-8 including whether it should be eliminated and Rule 701 expanded to reporting companies. My personal view is that would not work as Form S-8 shares are registered and thus freely tradeable and Rule 701 shares are restricted.

Commissioner Kara M. Stein’s Public Statement on the Rule Change and Concept Release

Commissioner Stein issued a statement related to the Rule 701 amendments and Concept Release in which she expressed her mild pessimism about the SEC actions. Ms. Stein notes that compensatory securities issuances are not always beneficial and that the SEC should be considering whether more companies should be able to use Rule 701 and S-8 as a gating question rather than just thinking about how to expand their use. As such, she is very interested in the responses to the Concept Release.

Although she voted in favor of the rule change, she notes that “[W]hile I am still uncertain of all of the costs and benefits of such an increase, Congress did not give us discretion. Accordingly, I will support this recommendation.”

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
330 Clematis Street, Suite 217
West Palm Beach, FL 33401
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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, the OTC Market’s top source for industry news, and the producer and host of, 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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