The U.S. Securities and Exchange Commission has issued Release No. 33-10891 proposing amendments to Securities Act Rule 701, which provides an exemption from registration for the issuance of compensatory securities by private companies, and Form S-8, the Securities Act registration statement for compensatory offerings by public companies. Additionally, in companion Release No. 33-10892, the SEC proposed rules to permit, on a temporary basis and subject to certain conditions, an issuer to provide equity compensation to certain "platform workers" who provide services available through the issuer's technology-based marketplace platform.
Issued on November 24, the proposed amendments and temporary rule are designed to modernize the framework for compensatory securities offerings in light of the substantial changes in both the type and form of compensatory equity offerings generally and the workforce since the SEC last substantively amended these rules, thereby facilitating the receipt by employees and other workers of equity compensation from their employer or service recipient while maintaining important investor protections.
The SEC is seeking comments regarding these amendments described in both Release No. 33-10891 and Release No. 33-10892. The proposal will be subject to a 60-day public comment period. Accordingly, the effective date of final amendments or final temporary rule is unknown.
In July 2018, the SEC published a "Concept Release" to solicit comment on whether and how best to modernize the exemption under Rule 701 and to update Form S-8, and the relationship between these two regulations, consistent with investor protections.
At the suggestion of many commenters who provided feedback on the Concept Release, including the American Bar Association Business Law Section, the SEC has proposed amendments to Rule 701 and Form S-8, which are each outlined in the following alert.
Additionally, the SEC has proposed a much-anticipated temporary rule to address novel work relationships between companies and individuals that have emerged in the so-called "gig economy."
Proposed Amendments to Modernize Rule 701
The SEC has proposed revising the financial disclosure requirements for Rule 701 exempt transactions exceeding $10 million, including how the disclosure threshold applies, the type of disclosure required, when the disclosure is triggered and the frequency with which it must be updated.
Rule 701 Financial Statement Disclosures Required Only for Prospective Issuances After Exceeding $10 Million Threshold
Under the current rule, issuers must (among other things) provide financial statements meeting certain requirements as set forth in the rule if the aggregate sales price or amount of securities sold during any consecutive 12-month period exceeds $10 million, and these financial statements must be provided to employee/service provider investors a reasonable period of time before the date of sale. An issuer would lose the exemption for all sales during the 12-month period leading up to the date on¬¬ which the issuer exceeds the $10 million threshold if the issuer had not provided the financial disclosure to all such investors during that 12-month period. This requires an issuer to be able to accurately anticipate when it will hit the $10 million threshold with significant risk for any miscalculation.
The proposed rules would require that the Rule 701 financial
statements be delivered only to employee/service provider
investors with respect to sales after the $10 million threshold is
Age of Financial Statements Extended to Six Months
Under the current rule, the Rule 701 financial statements must be as of a date no more than 180 days before the sale of securities, requiring an issuer to prepare quarterly financial statements.
The proposed rules would require that the Rule 701 financial
disclosures be available on at least a semi-annual basis and
completed within three months of the end of the second and fourth
quarters. The proposed rules include similar amendments for foreign
private issuers as well.
409A Reports Permitted in Lieu of Rule 701 Financial
Under the proposed rules, an issuer would be permitted to satisfy Rule 701 by providing a valuation report of the securities' fair market value as determined by an independent third-party appraisal consistent with the rules and regulations under Internal Revenue Code Section 409A (409A Report), in lieu of its financial statements. In order to provide the employee/service provider investor with meaningful and current information, the issuer would have to provide the 409A Report in its entirety, and such 409A Report would have to be dated within six months of the issuance of securities under Rule 701.
In the proposing release, the SEC noted that the proposed rules
would provide a practical, less costly alternative to issuers, as
many such issuers already prepare 409A Reports for the purpose of
complying with Internal Revenue Code Section 409A. Moreover, this
proposed amendment would increase use of the exemption provided in
Rule 701 as certain issuers may be more willing to disclose
valuation information other than U.S. Generally Accepted Accounting
Principles (GAAP) financial statements to avoid potential
unauthorized release of sensitive financial information. At this
point, the proposed rules are still unclear as to whether an issuer
would need to provide an updated 409A Report more frequently than
every six months to satisfy its Rule 701 disclosure requirements if
the 409A Report required updating for tax purposes (e.g., in the
event of a meaningful financing transaction or acquisition). The
proposed rules include similar amendments for foreign private
issuers as well.
Rule 701 Financial Disclosure May be Provided to RSU Recipients Within 14 Days Following Commencement of Employment
Under the current rule, financial and other disclosures required under Rule 701 must be provided a reasonable time before an investment decision is made in order to allow for an employee/service provider investor to make an informed investment decision. For stock options, the date of sale of securities and the individual's investment decision occurs upon exercise. By contrast for restricted stock units (RSUs), the SEC has consistently stated that the financial and other disclosures required under Rule 701 must be provided a reasonable time before the date of sale of securities and that the sale and the individual's investment decision is deemed to occur at grant rather than at settlement.
In response to the Concept Release, many commenters argued that
the date of sale does not occur until an RSU vests and is settled
and that effectively there is no investment decision. In the
proposed rule, the SEC did not agree with these comments and
restated its position that the issuer must provide the Rule 701
disclosures a reasonable period of time before the date of grant.
However, in order to facilitate this compliance, the proposed rules
would permit an issuer to provide the Rule 701 financial and other
disclosures within 14 calendar days following commencement of
employment of a newly hired employee. This is a small concession,
but an important one. We expect that comments will at a minimum
request the 14 calendar days to be applied to all grants of RSUs,
although the ability to distribute the 409A Reports in lieu of
financial statements may make delayed disclosure for all other
recipients less problematic.
Rule 701 Disclosure Requirements Following Business Combination
To clarify Rule 701's application to business combinations, the proposed rules provide that if an acquired entity complied with Rule 701 at the time it granted compensatory derivative securities, the exercise or conversion of those securities will be exempt from registration so long as the acquiring entity provides Rule 701 disclosure with respect to the acquiring entity prior to the exercise or conversion of such securities into shares of the acquiring entity. Separately, the proposed rules provide that the acquiring entity does not need to include any securities sold by the acquired entity in its calculation of the $10 million threshold during the same 12-month period.
Rule 701 Caps and Application to Subsidiaries
The SEC has also proposed raising two of the three alternative regulatory ceilings that cap the overall amount of securities that a non-reporting issuer may sell pursuant to the Rule 701 exemption during any consecutive 12-month period. The proposed amendments also make the Rule 701 exemption available for offers and sales of securities under a written compensatory benefit plan (or written compensation contract) established by the issuer's subsidiaries, whether or not majority owned.
Proposed Amendments to Streamline Form S-8
The SEC proposed amendments to streamline Form S-8 as follows:
- Clarify the ability to add multiple plans to a single Form S-8 and the ability to allocate securities among multiple incentive plans on a single Form S-8.
- Permit the addition of securities or classes of securities by automatically effective post-effective amendment and require the registration of an aggregate offering amount of securities for defined contribution plans.
- Implement a new fee payment method for registration of offers and sales pursuant to defined contribution plans and revise Form S-8 to eliminate the requirement to describe the tax effects of plan participation on the issuer (but not the employee/service provider).
Proposed Amendments to Modernize and Provide Consistency in Both Rule 701 and Form S-8
The proposed amendments to both Rule 701 and Form S-8 would extend consultant and advisor eligibility to entities meeting specific ownership criteria designed to link securities to the performance of services. They would also expand coverage of former employees and previously issued securities.
Extend Eligibility to Certain Controlled Entities
Under the current rule, a company may rely on Rule 701 or Form
S-8 for issuances to consultants and advisors only if they are
natural persons, they provide bona fide services to the issuer and
their services are not in connection with capital raising. The
proposed rules permit issuances in reliance on Rule 701 and Form
S-8 to "corporate alter egos" if they meet conditions
that are meant to provide flexibility for service providers to
obtain the legal benefits of organizing as entities while ensuring
that compensatory securities are issued only to entities through
which the services are provided that are owned by those service
providers and preventing Rule 701 and Form S-8 from being used to
facilitate passive investment vehicles. Among other things, the
conditions require that (i) substantially all of the activities of
the entity involve the performance of services and (ii)
substantially all of the ownership interests in the entity are held
directly by no more than 25 natural persons, of whom at least 50
percent perform such services for the issuer through the entity and
by the estates and heirs of those natural persons.
Extend Eligibility to Certain Former Employees and Service Providers
The proposed rules expand Rule 701 and Form S-8 to cover former employees and qualified service providers whose employment or service ended within the prior 12 months. They also expand Rule 701 and Form S-8 to cover securities issued by an acquiring entity in substitution or exchange for securities issued by an acquired entity to its former employees.
Proposed Temporary Rules Applicable to Certain "Platform Workers" Under Rule 701 and Form S-8
The proposed temporary rules would expand the definition of "employee" for purposes of Rule 701 (for private companies) and Form S-8 (for public companies). The proposed temporary rules recognize that the company-worker relationship has changed dramatically over the almost 20 years since the SEC first defined employee under its existing rules. In response to comments on the Concept Release, the SEC focused on novel work relationships between companies and individuals that have emerged in the so-called "gig economy."
These new types of work relationships typically involve an individual's use of an internet "platform" provided by a company (the "platform provider") to find a particular type of work, or "gig," such as a task or specific job. The work could involve the individual providing bona-fide services to end users, such as ride-sharing, food delivery, household repairs, dog-sitting or tech support, or using the platform to lease property to third parties. Other novel work relationships, while not fully annunciated, may involve individuals using the platform to perform tasks or services for the platform provider itself. The proposed expansion would not initially cover the use of a platform for the sale or transfer of permanent ownership of discrete, tangible goods.
Description of the Proposed Temporary Rule
The proposed temporary rule both (i) acknowledges the value of equity compensation to attract, motivate and retain all individuals that contribute to the success of an issuer, including "platform workers" and (ii) provides issuers with the ability to offer fair equity compensation to "platform workers" who are valuable contributors to those issuers that utilize a gig-economy workforce. The SEC acknowledged that existing rules do not recognize that gig-workers commonly work on a part-time or freelance basis, and, in some cases, for multiple competing businesses, and do not qualify as an "employee, consultant, advisor or de-facto employee" for purposes of Rule 701 or Form S-8. The proposed temporary rules would enable the SEC to assess appropriateness of the Rule 701 exemption for this new and evolving worker relationship over a five-year period.
The SEC acknowledged that the "gig economy is a fluid, developing market in which participating workers may be organized in various ways" for a variety of reasons, such as tax planning and personal liability protection, and that some commenters recommended that "platform workers" should not be subject to a natural person requirement to participate in Rule 701 offerings. To accommodate such workers and provide additional flexibility, the proposed temporary rule provides that a "platform worker" may be an entity as long as substantially all of its activities involve the performance of bona fide services that meet the requirements of proposed Rule 701(h), and the ownership interest of the entity is wholly and directly held by the natural person performing the services pursuant to the proposed temporary rule. This proposed approach would be similar to the proposed rules discussed above that would allow corporate alter egos to participate in Form S-8 offerings under existing employee, consultant, and advisor categories, but only where such businesses are generally wholly-owned by the natural person who provides services to the issuer.
As noted above, the proposed expansion would not cover the use of a platform for the sale or transfer of permanent ownership of tangible goods, with the result, that at least in the proposed temporary rules, businesses that provide such sales services via the company's platform or system, including the permanent sale of real estate, would not qualify under such proposed temporary rules.
Additional Requirements for Issuances to "Platform Workers" Under Rule 701 and Form S-8
In the proposed amendments, the SEC also recognized that the part-time and sometimes informal relationship between a company and "platform worker" may increase the risk of misuse of the securities exemption provided under Rule 701. The SEC has therefore included additional conditions and limitations to the use of this expanded plan participant rule.
Under the proposed definition of "platform worker," eligible workers would be those persons unaffiliated with the issuer who meet several conditions:
- First, the worker must provide bona fide services through or by means of the issuer's internet-based or other widespread, technology-based marketplace platform or system. Workers providing services to third-party end-users would qualify, as long as the issuer benefits from such services (e.g., by receiving a fee for the worker's use of the platform or a percentage of the compensation received from the end-user for the worker's services). Parents, subsidiaries or subsidiaries of the issuer's parent, would also qualify.
- Second, the services must be provided pursuant to a written contract or agreement between the issuer and the "platform worker" and must be provided through a platform-based marketplace (or other widespread, technology-based marketplace platform or system) that the issuer operates and controls.
- Third, the amount and terms of any securities issued to a "platform worker" may not be subject to individual bargaining. Similarly, as proposed, "platform workers" would not be permitted to elect between payment in securities or cash. These proposed requirements would reduce any incentive for "platform workers" to use the exemption as a means of realizing speculative investment opportunities rather than receiving the securities as a compensatory grant.
- Fourth, there is a proposed percentage limitation of no more than 15% of annual compensation via the platform or system during a twelve-month period and a dollar limitation of no more than $75,000 during a three-year period (valued as of the grant date of such securities). This proposed cap on the amount of compensation that a "platform worker" may receive as securities from the issuer is designed to limit an issuer's incentive and ability to use the new exemptive rule as a conduit for a public distribution of its securities, contrary to the compensatory purpose of Rule 701.
- Fifth, the issuance of securities must not be for services that are in connection with the offer or sale of securities in a capital raising transaction, or services that directly or indirectly promote or maintain a market for the issuer's securities.
- Sixth, for purposes of Rule 701 only, the SEC is proposing a condition that would require the issuer to take reasonable steps to prohibit the transferability of securities issued to "platform workers" pursuant to the exemption except for transfers to the issuer or by operation of law.
The proposed temporary rules also would permit a reporting issuer to register the offer and sale of its securities to its "platform workers" using Form S-8. The same conditions proposed for Rule 701 issuances would apply to issuances to "platform workers" that are registered on Form S-8, except for the proposed transferability restriction. Like its impact on Rule 701, the proposed Form S-8 rule would be temporary and would expire, absent further SEC action, on the same date as the proposed Rule 701 rule.
To help the SEC assess the usefulness of the proposed changes, a company that takes advantage of this expanded application of Rule 701 or Form S-8 for its "platform workers" will need to report certain information to the SEC on six-month intervals, including:
- Criteria used for granting awards to "platform workers;"
- Type and terms of the securities issued;
- Steps taken to prevent transfer of securities issued pursuant to Rule 701;
- Percentage of overall outstanding securities utilized for "platform workers;"
- Number of "platform workers" and other workers, including to what extent each received securities; and
- Number and value of equity issued to "platform workers."
The proposed amendments would expire, absent further action by the SEC, five years from the date of their effectiveness.
As mentioned above, while the SEC seeks comments regarding the proposals described in both releases during the 60-day public comment period, the effective date of the final amendments or final temporary rule is unknown.
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