SEC Eases Small-Business Disclosures for Stock-Based Compensation

The agency doubled the dollar threshold for exemption from many requirements

Stephen Miller, CEBS By Stephen Miller, CEBS July 26, 2018
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SEC Eases Small-Business Disclosures for Stock-Based Compensation

The U.S. Securities and Exchange Commission (SEC) recently took actions making it easier for small companies—such as startups—to grant employees company stock options and other equity as compensation.

On July 24, the SEC published in the Federal Register a final rule to amend Securities Act Rule 701 by doubling the dollar amount (based on annual stock sales) under which securities issued as compensation to employees, directors or consultants are exempt from requirements to provide detailed disclosures to plan participants. The final rule took effect July 23.

The SEC also issued a concept release soliciting comments by Sept. 24 on how Rule 701, together with SEC Form S-8 (used by public companies to register securities) can be further modernized in light of the changing economy and evolving work arrangements.

"The rule as amended, and the concept release, are responsive to the fact that the American economy is rapidly evolving, including through the development of both new compensatory instruments and novel worker relationships—often referred to as the gig economy. We must do all we can to ensure our regulatory framework reflects changes in our marketplace, including our labor markets," said SEC Chairman Jay Clayton in a statement.

[SHRM members-only toolkit: Managing Pay Equity]

Disclosure Threshold Doubled

Companies relying on the Rule 701 exemption can take advantage of limited disclosure requirements to employees participating in equity compensation programs. The exemption threshold is based on the total sales of company stock during the previous 12 months. The amendment raises that threshold from $5 million to $10 million.

Under the exemption, disclosure requirements can be satisfied by providing participants with a copy of the stock equity plan or relevant contractual agreement, rather than more extensive disclosures required under SEC rules.

For instance, after surpassing the threshold, companies must deliver extensive disclosure packages to all equity compensation recipients in the relevant 12-month period. These additional disclosures include:

  • A copy of the summary plan description required by the Employee Retirement Income Security Act (ERISA), or a summary of the plan's material terms if it is not subject to ERISA.
  • A description of the risks associated with investments in the company's securities.
  • The financial statements that otherwise would be required in an offering statement.

The SEC's action was in response to the Economic Growth, Regulatory Relief, and Consumer Protection Act signed into law May 24 by President Donald Trump. The act, under a provision titled "Encouraging Employee Ownership," required the commission to double the dollar limit for the Rule 701 exemption and thereafter to increase the threshold amount for inflation every five years. The SEC was directed to act within 60 days of the law's enactment.

The rule change "makes it easier for private companies to grant an increased level of equity compensation without the concern of having to disclose confidential financial information to employees," said compensation attorney Howard Berkenblit, a partner at Sullivan and Worcester in Boston. He expects that the final rule "will lead to more grants—whether that means larger amounts to the same individuals or more grants to a broader base of employees remains to be seen—and gives companies more flexibility."

Only the requirement as to when detailed financial and other information must be delivered to grant recipients has changed, Berkenblit noted, and not the overall limit on how much a company may grant in any 12-month period, "although that's something the SEC will be looking at." Consequently, "there are still limits on how much private companies can use the exemption under Rule 701, regardless of whether or not they are willing to deliver information," he said.

The newly required inflation adjustment should make it easier for private companies whose equity isn't publicly traded "to offer share-based compensation to their employees without bumping up against the enhanced Rule 701 cap limits," said compensation attorney Daniel Janich, a partner in the Chicago office of Holifield Janich Rachal Ferrera. "The company issuing its shares to employees is required to satisfy either the exemption requirements [under Rule 701, as amended] or registration and disclosure requirements. If neither, it commits a serious violation of our securities laws," he pointed out.

An analysis by attorneys at law firm Morgan Lewis noted that failure to comply with Rule 701 disclosure requirements can lead to steep SEC penalties. In March 2018, for instance, the SEC imposed a $160,000 fine on Credit Karma, a company that tracks personal credit scores, for failing to provide adequate information and risk-factor disclosures to program participants once it issued stock options in amounts that exceeded the disclosure threshold then in place.

"Although the increased threshold provides an added cushion for nonreporting [private] companies," the attorneys wrote, "the Credit Karma action serves as a reminder to track carefully Rule 701 offerings."

A Startup's Equity Attracts New Hires

"As a small employer in biotech, we don't currently offer a match in our 401(k) but we offer an employee stock purchase plan where employees can save up to 15 percent" on the company's shares, said Stacy Solorio, senior director of HR operations at Atara Biotherapeutics, a startup in San Francisco that was founded in 2012 and went public in 2014. The organization also grants restricted stock units to employees at all levels in the organization, "not only when they join but annually with their performance review."

Find the value proposition for your organization "and sell that to job candidates," Solorio advised. "If you're in a position where you're rapidly growing, as we are, candidates will see the potential upside to [working at] the company and want to get in early with that extra equity."


Registration Requirements

The SEC also provides an exemption from registration for nonpublic companies that grant equity as compensation. Once a company exceeds 2,000 shareholders, however, it is generally required to register under the Securities and Exchange Act and provide full disclosure as a public company. 

"Recipients of securities under an employee benefit plan don’t count toward the 2,000 shareholder limit—this was a 2016 change under the JOBS Act to allow companies to make broader equity grants without triggering the need to go public," Berkenblit said, referring to the Jumpstart Our Business Startups (JOBS) Act.

Gig-Economy Workers

The SEC acknowledged in its concept release that since Rule 701 was last amended in 1999, new types of contractual relationships between companies and individuals have emerged involving high numbers of temporary and freelance workers, especially at startups where cash available for compensation may be limited. One issue the commission has requested feedback on is whether Rule 701 and Form S-8 should be extended to gig-economy workers.

Currently, the disclosure exemption for employees under Rule 701 covers traditional employees, directors and certain consultants and advisors but "does not clearly cover gig-economy workers, as they don't neatly fit within any of those categories," Berkenblit pointed out.

"A definitional change by the SEC could allow companies that use gig workers to broaden their use of equity compensation under the Rule 701 exemption for private companies," he said.

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Related SHRM Article:

Equity Compensation Plans Build Loyalty but Uncertainty Abounds, SHRM Online Compensation, February 2018


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