Awards Pursuant to

Written Compensatory Benefit Plans –

Should Securities Act Rule 701 be Updated?

September 13, 2017
Securities Act Rule 701
What is Rule 701?

– Rule 701 exempts from the registration requirements of Section 5 of the 

Securities Act, offers and sales of securities issued to certain individuals 

pursuant to compensatory benefit plans or contracts established by the issuer, 

its parents, its majority-owned subsidiaries or the majority-owned subsidiaries 

of the issuer’s parent. 

Who can use Rule 701?

– Rule 701 may be used by any issuer that is not subject to the reporting 

requirements of Section 13 or 15(d) of the Securities Exchange Act (i.e., private 

companies) that is not an investment company required to be registered under 

the Investment Company Act of 1940.

Overview of Rule 701

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Who can Rule 701 be used for?

– Current employees, consultants, advisors, officers, directors, general partners 

and trustees (where the issuer is a business trust) of the issuer, its parents, its 

majority-owned subsidiaries or the majority-owned subsidiaries of the issuer’s 

parent (referred to herein as “Service Providers”).

– Former Service Providers if such persons were employed by, or providing 

services to, the issuer at the time the securities were offered.

– Family members of the above Service Providers who acquire securities from 

the Service Providers by gift or domestic relations orders.

Overview of Rule 701

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What is not permitted under Rule 701?

– Rule 701 is not available for resales.

– Rule 701 is not available for plans or schemes established to circumvent the 

compensatory purpose of Rule 701, such as to raise capital.

– Rule 701 is not available for any offer or sale that technically complies with Rule 

701 but is part of a plan or scheme to evade the registration requirements of 

the Securities Act.

Overview of Rule 701

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Limitations on Securities Sold in Reliance on Rule 701 – “Hard Cap Limit”

– In any consecutive 12-month period, the issuer may only sell an amount of 

securities in reliance on Rule 701 equal to the greater of:

– $1 million in value;

– 15% of the issuer’s total assets based on its most recent balance sheet 

dated no earlier than its most recent fiscal year end (or those of its parent if 

the parent guarantees the securities and the issuer is a wholly owned 

subsidiary); and

– 15% of the outstanding class of offered securities based on the issuer’s most 

recent balance sheet dated no earlier than its most recent fiscal year end.

– Rule 701 sales or offerings are not integrated with any other types of offerings 

made by the issuer (i.e., we only count against the limit, securities sold in reliance 

on Rule 701).

Overview of Rule 701

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Disclosure Required for All

– All recipients of securities under Rule 701 must receive a copy of the 

compensatory benefit plan or contract.

Additional Disclosure Required for Some – “Soft Cap Limit”

– If the issuer sells securities that is more than $5 million in value in reliance on 

Rule 701 in any consecutive 12-month period, the issuer must provide the 

following disclosure “a reasonable period of time” prior to sale:

– if the plan is subject to the Employee Retirement Income Security Act of 

1974 (“ERISA”), a copy of the summary plan description and, if not, a 

summary of the material terms of the plan;

– risk factors; and

– financial statements required to be furnished by Part F/S of Form 1/A 

(Regulation A Offering Statement), dated no earlier than 180 days before the 

sale.

Overview of Rule 701

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Proposed Changes to Rule 701
Compensating employees and consultants with equity has become an invaluable 

tool for private companies to hire service providers necessary for the growth and 

development of the company.

– At the earliest stages, equity compensation is often the only real form of 

compensation available to private companies to hire service providers necessary 

for the development of the company.

– We recognize that minimum cash compensation is required under Federal 

and state law, however, it is often a challenge to pay even this minimum 

compensation at the earliest stages.

– At later stages, equity compensation is critical to recruit talent necessary to 

continue the growth and development of a company. 

– Competition for talent is intense and equity compensation is generally a 

necessity.

The Role of Equity Compensation in 

Private Company Growth & Development

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Many private companies, particularly those at the earliest stages, do not have the 

internal resources or funds to support compliance with rules like Rule 701.

This lack of resources and available expertise can lead to inadvertent compliance 

issues where there is complexity or substantial cost required to comply with the 

rules.

Given the importance of equity compensation to the growth and development of 

private companies, it is critical that the rules related to the issuance of such 

equity compensation are rational and not unduly complicated and/or difficult to 

comply with.

Challenges with Compliance under the Current Framework

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Revise Definition of Consultants and Advisors to Remove Natural Person 

Requirement

– Rule 701 is available for consultants and advisors only if:

– They are “natural persons;”

– They provide bona fide services to the issuer, its parents, its majority-owned 

subsidiaries or majority owned subsidiaries of the issuer’s parent; and

– 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 for the issuer’s securities.

Proposed Change: Remove Requirement that Consultants 

be “Natural Persons”

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Background on Private Company use of Consultants and Advisors

– Private companies routinely hire consultants to perform services traditionally 

performed by employees. This is particularly true for early stage private 

companies who often cannot afford to engage certain types of service providers 

full time (e.g., controllers, chief financial officers, human resources support, etc.). 

– Most consultants, even individual consultants, will provide their services via an 

entity created for such purpose. This is often done for tax and liability purposes.

– Under the current rules, companies must jump through hoops in order to 

compensate these consultants with equity.

– Sometimes this involves engaging both the individual and the entity as 

consultants.

– Alternatively, securities may be sold directly to the entity pursuant to an 

accredited investor exemption, if available.

Proposed Change: Remove Requirement that Consultants 

be “Natural Persons”

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In the preamble to the 1988 release pursuant to which Rule 701 was first adopted, 

the Staff noted that there was concern that including consultants would lead to 

abuse and the use of the rule for non-compensatory purposes.

However, the staff agreed that this concern was not warranted and was 

adequately addressed by the rules.

“Although the Commission originally believed that broadening the rule to include

consultants could go beyond the compensatory purposes of the provision, commenters

have repeatedly stated that this limitation is unnecessary because securities issuances

to such parties also can be for compensatory and not capital raising purposes and thus

there is no meaningful basis for distinguishing between issuances to them and to

employees. The Commission has been persuaded by the commenters on this issue. In

addition, the concern expressed by the Commission in the July release about use of the

rule for non-compensatory purposes is addressed by new Preliminary Note 5 and the

conditions in the exemption requiring a written plan or contract. Consequently, the rules

has been modified to extend to consultants and advisors who provide bona fide services

to a company, its parent or majority-owned subsidiaries.” Release No. 33-6768 (April 14,

1988) [53FR 12918]

Proposed Change: Remove Requirement that Consultants 

be “Natural Persons”

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In the preamble to the 1999 release pursuant to which Rule 701 was amended, 

the Staff expressed concern that Rule 701 was being misused for noncompensatory purposes and, in an effort to curb this abuse, aligned the 

definition of consultant under Rule 701 with the rules set forth for Form S-8 

and, in the process, added a requirement that the consultant recipient be a 

“natural person.”

We recommend reverting to the original rule by deleting the requirement that 

consultants be “natural persons.”

• There was no clear rationale expressed for adding the requirement that eligible 

consultants be “natural persons” and this change does not address the stated 

concern.

• Enforcement of the rules that prohibit the use of Rule 701 for non-compensatory 

purposes and services related to capital raising and market-making would be a 

more appropriate response to curbing abuse of these rules than creating 

barriers to private companies that are properly using Rule 701 for compensatory 

purposes by restricting grants to “natural purposes” and increasing the cost and 

complexity associated with the administration of compensatory benefit plans.

Proposed Change: Remove Requirement that Consultants 

be “Natural Persons”

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History of “Hard Cap Limit”

– Rule 701 was first adopted pursuant to Section 3(b) of the Securities Act which 

granted the SEC authority to adopt special exemptions from the registration 

requirements of the Securities Act for issuances of securities in which the 

aggregate amount offered does not exceed $5 million. 

– In 1988, the SEC adopted Rule 701 pursuant to this authority 

– In October 1996, Congress enacted the National Securities Markets Improvement 

Act of 1996 ("NSMIA"), which gave the SEC authority to provide exemptive relief 

in excess of $5 million for transactions such as offers to employees.

– The legislative history of NSMIA stated specifically that the SEC should use 

this new authority to lift the $5 million ceiling on Rule 701.

– Rule 701 was amended to its current form in April 1999.

Proposed Change: Eliminate “Hard Cap Limit”

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In the preamble to the 1999 release pursuant to which Rule 701 was amended, 

the Staff stated that the increase in the “Hard Cap Limit” was being made to 

provide issuers with the flexibility they need, without creating opportunities for 

abuse.

We recommend eliminating the “Hard Cap Limit.”

• Compliance with the “Hard Cap Limit” requires ongoing analysis with no clear 

benefit.

• NSMIA removed the requirement to have any limit on compensatory sales made 

under Rule 701.

• “Hard Cap Limit” on compensatory sales do not address or otherwise curb 

abuse related to non-compensatory sales.

• Enforcement of the rules that prohibit the use of Rule 701 for non-compensatory 

purposes and services related to capital raising and market-making would be a 

more appropriate response to curbing abuse of these rules than creating 

barriers to, and additional work for, private companies that are properly using 

Rule 701 for compensatory purposes.

Proposed Change: Eliminate “Hard Cap Limit”

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Rule 701 does not address the implications of amendments of securities 

previously issued under Rule 701.

However, C&DI 271.10 requires issuers to count stock options that are repriced

as new grants/sales under Rule 701 as of the date of the repricing.

We recommend adopting a rule that clarifies that material amendments to any 

security previously issued under Rule 701 does not result in a new grant or 

sale for purposes of Rule 701.

• The “repricing rule” can cause companies to exceed the “Hard Cap Limit” and 

the “Soft Cap Limit” at a time when no additional securities are issued (there is 

simply a “re-setting” of the original arrangement to ensure the equity is meeting 

is compensatory objective.

• Clarification would be welcome that other material amendments that do not 

result in the issuance of additional securities would also not result in a new grant 

or sale for purposes of Rule 701.

Proposed Change: Adopt Rule Excluding Material 

Amendments from Calculation of Limit

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Rule 701 has no rules specifically addressing restricted stock units (RSUs).

• At the time Rule 701 was adopted, and at the time Rule 701 was later amended, 

private companies generally did not grant RSUs due to tax issues associated 

with doing so.

We recommend clarifying the rules as they relate to RSUs.

• Clarify that RSUs are considered “sales” on the date of grant, similar to options.

– RSUs are derivative securities, like options, where no shares are issued unless 

and until the RSUs settle (typically upon or after vesting).

• Clarify that RSUs should be valued for purposes of any Rule 701 limits based on 

the value of the underlying shares on the date of grant.

Proposed Change: Clarify Application of Rule 701 to 

Restricted Stock Units

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Expanded disclosure must be provided to any person who receives securities 

under Rule 701 during any 12 month period in which the company sells more 

than $5 million in value under Rule 701.

• Since the $5 million limit could be exceeded at the end of a 12 month period, 

but the rule requires disclosure to be provided for any sales under Rule 701 

during the 12 month period (or, for options, anyone who exercises options 

during this time), companies must generally “guess” as to whether the $5 million 

limit will be exceeded and begin providing disclosure before the disclosure 

threshold is exceeded in order to ensure compliance.

We recommend changing the rules to provide that expanded disclosure is only 

required to be provided for sales that occur after the threshold is exceeded.

• The current rule is impractical in its application, with no clear rationale for the 

structure of the rule.

• Consideration should be given to whether additional time should be given to 

enable companies to prepare and distribute the disclosure (i.e., a short, buffer 

period after the threshold is exceeded).

Proposed Change: Rationalize Timing of Expanded 

Disclosure Obligation and Measurement Period Applicable 

to “Soft Cap Limit”

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Rule 701 requires expanded disclosure to be delivered a “reasonable period of 

time prior to the sale” (or, for options and other derivative securities, exercise 

or conversion).

We recommend revising the rule to provide that any disclosure delivered at 

any time prior to sale such that the recipient has an opportunity to review the 

disclosure satisfies the obligation to deliver disclosure.

We recommend revising the rule to provide that making the disclosure 

available in a manner consistent with the SEC’s electronic disclosure rules 

(e.g., on an online data site that is accessible to the individual) satisfies the 

obligation to deliver disclosure and there is no requirement for the issuer to 

confirm actual receipt or review of such disclosure.

We recommend revising the rule to provide that making the disclosure 

available in a physical location accessible to the individual satisfies the 

obligation to provide disclosure.

Proposed Change: Clarify Timing and Delivery 

Requirements of Expanded Disclosure

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Rule 701 requires expanded disclosure to be delivered to option holders a 

reasonable period of time prior to exercise, and to holders of derivative 

securities, a reasonable period of time prior to conversion.

However, C&DI 271.24 requires expanded disclosure to be delivered to RSU 

recipients a reasonable period of time prior to grant.

• In adopting the above C&DI, the SEC distinguished between options and other 

derivative securities that are exercised or converted, and RSUs, which the SEC 

acknowledged are derivative securities, that are not exercised or converted.

We recommend adopting a rule that provides that expanded disclosure must 

only be provided to RSU recipients a reasonable period of time prior to 

settlement.

• RSUs are derivative securities and should be treated like other derivative 

securities.

• Although an RSU is not exercised or, technically, converted, it is settled. Prior 

to settlement, the holder of an RSU holds only a contractual right to receive 

shares in the future (for no purchase price paid).

Proposed Change: Conform Timing of Disclosure 

Obligation for Options and Restricted Stock Units

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The expanded disclosure required under Rule 701 includes financial 

statements required to be furnished by Part F/S of Form 1-A (i.e., Regulation A).

• Regulation A was recently revised creating a significant amount of complexity 

and confusion with regard to its application under Rule 701.

• Some of this complexity was relieved by C&DI 271.21 which allows issuers to 

choose to follow the requirements of Tier 1 or Tier 2 Regulation A offerings. 

However, substantial complexity remains.

We recommend simplifying the financial disclosure required under the 

expanded disclosure requirement by de-coupling it from Regulation A and 

requiring instead a current balance sheet and income statement.

• In the legislative history to the 1999 release, the SEC stated that Regulation A 

financial disclosure is something private companies “may be very familiar with” 

suggesting compliance would not be burdensome. This is generally not true, 

particularly for companies first subject to the expanded disclosure rules. These 

companies often struggle and incur significant expense complying with this rule.

• Although audited financials are not required, many companies feel that the 

equivalent of audited financials must be provided to comply with the rules.

• Consider clarifying whether, and the extent to which, footnotes are required.

Proposed Change: De-Couple Expanded Disclosure from 

Regulation A and Simplify Required Disclosure

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Rule 701 requires financial disclosure provided under the expanded disclosure 

rules to be dated as of a date no more than 180 days before the sale.

We believe the expectation of this rule was that financial disclosure would only 

need to be updated and provided every six months.

However, it takes time to prepare the financial disclosure that must be 

provided. As a result, financial disclosure must generally be updated and 

provided quarterly.

We recommend revising the rules to require financial disclosure to be updated 

and provided once a year unless a material event results in a material change

to the enterprise value of the company or the value of the securities to be 

issued.

• The current rule is unduly burdensome and costly for private companies.

• The proposed rule generally conforms to the IRS rule that requires companies 

to value private company stock for purposes of pricing stock option grants, 

which strikes a reasonable balance between ensuring disclosure is appropriate

and the cost and burden imposed on the company to prepare such disclosure.

Proposed Change: Change the Frequency in which 

Financial Disclosure must be Updated

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A violation of the “Hard Cap Limit” results in the loss of the Rule 701 

exemption only for securities sold in excess of the Hard Cap Limit.

A violation of the expanded disclosure obligation results in the loss of the Rule 

701 exemption for all securities sold in the applicable 12-month period.

We recommend conforming the consequence of violating the expanded 

disclosure obligation, with the consequence of violating the “Hard Cap Limit” 

such that only those sales pursuant to which expanded disclosure was not 

provided lose the Rule 701 exemption.

• Often times, a failure to provided expanded disclosure, is an inadvertent result 

of an administrative error.

• There is no clear rationale for the punitive result of the current rules. 

• Under the proposed rules, if there is a broad-based failure to provide expanded 

disclosure, there will be a broad-based loss of the Rule 701 exemption.

Proposed Change: Conform Consequence of Expanded 

Disclosure Violation to “Hard Cap Limit” Violation

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Many commentators have called for an increase to the $5 million “Soft Cap 

Limit.”

We recommend increasing the $5 million “Soft Cap Limit” to at least $10 

million.

• The current $5 million “Soft Cap” limit has been a surprise to many smaller 

companies that generally do not expect to be subject to a burdensome 

disclosure obligation in connection with the issuance of equity compensation to 

their employees and consultants.

• This “surprise,” combined with the look-back nature of the current rule and the 

“repricing rule,” has resulted in inadvertent compliance issues for some 

companies.

• The hire of a key employee can result in an equity grant that results in 

exceeding the $5 million “Soft Cap Limit” at a time when the “Soft Cap Limit” 

would not otherwise be exceeded.

– These grants can be 5-10% of the fully diluted outstanding shares of a 

company and represent a grant date value in excess of $5 million.

Proposed Change: Increase the “Soft Cap Limit”

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