Photo by Oblivious Dude
Photo by Oblivious Dude

The SEC’s Division of Corporation Finance recently issued new Compliance and Disclosure Interpretations (“C&DIs”) for Securities Act Rule 701 which clarify application of the Rule in the context of mergers. In a nutshell, Rule 701 provides an exemption from SEC registration requirements for private companies, private subsidiaries of public companies and foreign private issuers to offer their own securities, including stock options, restricted stock and stock purchase plan interests, as part of written compensation plans or agreements, to employees, directors, officers, general partners and certain consultants and advisors.

Under Rule 701, the aggregate sales price or amount of securities sold in reliance on Rule 701 during any consecutive 12-month period must not exceed the greatest of $1 million, 15% of the total assets of the issuer (measured as of the issuer’s most recent balance sheet date, if no older than its last fiscal year end), or 15% of the outstanding amount of the class of securities being offered and sold in reliance on Rule 701, (again, measured at the issuer’s most recent balance sheet date, if no older than its last fiscal year end). If the aggregate sales price or amount of securities sold during any consecutive 12-month period exceeds $5 million, the issuer must deliver specific written disclosures a reasonable period of time before the date of sale, including a copy of the summary plan description under ERISA or, if the plan is not subject to ERISA, a summary of the material terms of the plan, information about the risks associated with investment in the company’s securities, and financial statements meeting the requirements of the SEC’s Regulation A as of a date no more than 180 days before the date of the sale.

In the context of a merger transaction, the newly issued C&DIs provide the following guidance:

  • An acquirer in a merger transaction that assumed the target company’s derivative securities does not need an exemption if, at the time of the grant by the target, the compensatory benefit plan under which the securities were issued permitted the assumption without the consent of the holders of the derivative securities.
  • Securities underlying the derivative securities are considered to have been sold on the date of the grant of the derivative securities. As a result, so long as the target company complied with Rule 701 at the time the derivative securities assumed were originally granted, the exercise or conversion of the derivative securities would be exempt.
  • Post-merger, in determining the amount of securities that the acquirer may sell pursuant to Rule 701 in any consecutive 12-month period, the acquirer must include the aggregate sales price and amount of securities for which the target company claimed the exemption during the same 12-month period for which the acquirer is making the determination.
  • Post-merger, to calculate total assets or outstanding amounts of a class of securities offered, an acquirer may use either (1) a pro forma balance sheet as of its most recent balance sheet date that reflects the merger as if it had occurred on that date, or (2) a balance sheet date after the merger that will reflect the total assets and outstanding securities of the combined entity.
  • When aggregate sales in any 12-month period exceed $5 million, an issuer may elect to provide financial statements that follow the requirements of either Tier 1 or Tier 2 Regulation A offerings, without regard to whether the amount of sales that occurred pursuant to Rule 701 during the time period contemplated in Rule 701 would have required the issuer to follow the Tier 2 financial statement requirements in a Regulation A offering of the same amount.
  • For assumed derivative securities where the target company was required to provide disclosures under Rule 701 post-merger, the acquirer would assume the disclosure obligation and would satisfy it by providing information required under Rule 701.
  • Post-merger, in determining whether the amount of securities the acquirer sold during any consecutive 12-month period exceeds $5 million, the acquirer must include any securities that the target company sold during the same period. 

While the new C&DIs offer some clarity for purposes of how an issuer can comply with Rule 701 after consummation of a merger, issuers may nonetheless choose alternative routes for compensating their employees, directors, officers, general partners and certain consultants and advisors. Importantly, securities issued pursuant to Rule 701 are not “covered securities” under the National Securities Markets Improvement Act of 1996 (“NSMIA”), which means the issuer must either register, or qualify for an exemption from registration for, these securities in each state in which it offers the securities (although most states have a similar exemption). Additionally, the reach of Rule 701 as it relates to consultants is limited to natural persons who, among other things, have significant “employment characteristics,” a standard that the SEC has stated will depend on the facts and circumstances. Where significant blue sky issues can arise, or where an issuer desires to offer securities to a consultant and avoid any potential grey areas, the issuer may choose instead to proceed under the SEC’s private offering rules, i.e., Section 4(a)(2) of the Securities Act and Regulation D, where securities sold will be deemed “covered securities” under the NSMIA, and where the limitations on the persons to whom the securities may be offered are more definitive and a function generally of financial stability.

Issuers might also choose private offering exemptions, and specifically, those under Rule 506(b) or 506(c) of Regulation D, over Rule 701 where the intended size of the offering may exceed $5 million in any consecutive 12-month period. Here, and assuming the issuer intends to offer securities only to persons who are “accredited” as defined under Regulation D, the issuer could avoid the potentially-onerous disclosure requirements of Rule 701 for offerings in excess of $5 million, notwithstanding any anti-fraud concerns. (As a side note on this issue specifically, a few weeks ago the House Financial Services Committee passed a bill that, if passed, would increase Rule 701’s threshold for providing certain disclosures for compensatory stock programs to $20 million and adjust it for inflation every five years).