companies tend to reward their directors, officers and employees with stock
options. In the US most do so through formal incentive stock option plans
which are structured as either incentive stock options (ISOs) or nonqualified
stock options for tax treatment purposes. Although tax issues are
important, securities laws should not be ignored when issuing stock
options. This article provides a general overview of Rule 701 which
private companies (domestic and foreign) may rely on when issuing stock to US
Stock options and the underlying stock are securities. Both the options
and the shares of stock subject to option must be registered under the
federal and applicable state securities laws unless an exemption from
registration can be found. Rule 701 under the Securities Act of 1933
(the “1933 Act”)
provides a federal exemption from registration for benefit plan securities
issued by private company issuers.
In order to rely on Rule 701 the following requirements must be met:
The company must not be a reporting issuer
pursuant to section 13 or 15(d) of the
Securities Exchange Act of 1934 (the “1934
The issuances must be made to qualifying individuals – generally,
employees, directors, general partners, trustees (where the issuer is a
business trust), officers, or qualifying consultants and advisors, and their
family members who acquire such securities from such persons through gifts
or domestic relations orders of the company or its subsidiaries.
Rule 701 does not exempt issuing shares
to companies, or to non-employees who help in fund raising or promotion of
The amount of securities issued is less than one of several limits, during
any 12-month period:
the aggregate sale price of shares granted cannot exceed $1,000,000; or
the number of shares granted cannot exceed 15% of the total assets of the
the number of shares granted cannot exceed 15% of the outstanding common
stock (including any preferred stock on an as-converted basis); and
Optionees must be provided with a copy of the plan or agreement to issue
the securities, which must be in writing (incentive, stock option, stock
appreciation or stock purchase plan, an individual incentive, option or
similar agreement, or an employment agreement). Additional disclosure
must be provided if the aggregate sales price in any 12-month period
(measured for this purpose as the sale dates rather than the grant dates)
exceeds $5,000,000. This additional disclosure material includes
a summary of the material terms of the plan, risks associated with
investment, and current financial statements.
sales pursuant to Rule 701 are not integrated with those under other
exemptions, so the 35 non-accredited investors allowed under Regulation D
will not be diminished by issuing options covered by Rule 701.
Issues to Keep in Mind
A company must also ensure that it complies with state regulations when
issuing stock options under Rule 701. Rule 701 offerings are
automatically exempt from state filing requirements in a number of, but not
all, states. You will need to rely on an available state exemption in
the state in which the recipient of the stock option resides. State
requirements can vary considerably. For instance, New York and New
Jersey require pre-issuance filings with their state regulators. California
regulators have substantive rules regarding the terms of options and grants
to employees and consultants, such as minimum vesting schedules and pricing
terms. (The rules in California are currently under review).
issuing options you should review the applicable state laws for compliance.
Limit Number of Shareholders.
A private company may inadvertently become a public reporting company if the
compensation benefit plan adopted increases the number of shareholders to 500
or above. Under the 1934 Act, any company with more than 500
shareholders is subject to public reporting requirements as well as the SEC's
proxy and insider-trading rules (no-action relief may be possible from the
500 shareholder limit).
Issuance of Public Debt Removes Eligibility to Rely on Rule 701.
Rule 701 offerings are available only for companies that are not subject to
public reporting obligations. If a company files an exchange offer
registration statement it becomes legally subject to reporting requirement to
at least until the end of its fiscal year. (Thereafter, the issuer typically
is required by its bond indenture to continue to file periodic reports, but
may not be legally subject to public reporting requirements). Rule 701 is not
available during the period in which a company is legally subject to
reporting obligations; however, offerings to employees registered on Form S-8
can be made.
Two types of stock options receive special treatment under the Internal
Revenue Service Code (“Code”):
incentive stock options (ISOs) and options under an employee stock purchase
plan (ESPP) that is qualified under section 423 of the Code. There is no
recognition of income on the option grant or on the exercise of the option
under either of these programs, provided that certain conditions under
sections 422 and 423 of the Code are satisfied. Additionally, if the stock is
disposed of after completion of the statutory holding period, any
appreciation will be taxed as capital gain. Non-ISO options and non-ESPP
options are taxed at the time of grant.
To qualify as an ISO, stock options must be issued only to an employee and
must have an exercise price not less than the fair market value on the date
they were granted. The company cannot grant the employee ISOs exercisable for
more than $100,000 in stock in any year.
Resale of Private Company Stock Options
Securities sold pursuant to Rule 701 are "restricted securities" and can be
resold only pursuant to an effective registration statement, unless an
exemption from the registration requirements is available.
Ninety days after the company becomes a reporting issuer under the
1934 Act, securities issued under
Rule 701 may be resold by persons who are not affiliates (as defined by Rule
144 of the 1933 Act), without
compliance with manner of sale provisions, notice requirements, current
public information requirements, or volume limitations of Rule 144, and by
affiliates without compliance with paragraph (d) of Rule 144.
In addition to Rule 701, private companies may rely on a number of other
exemptions from the registration requirements of the 1933 Act when
issuing stock options. These exemptions include:
Other sundry exemptions.
It is always wise to check with your legal counsel before implementing or
issuing any option plan. Looking for an available exemption from
registration after the fact can hold some nasty surprises.
Consequences of Securities Law Non-Compliance
Failure by a company to comply with federal and applicable state securities
laws will provide an optionee rescission rights to both the option and
underlying shares exercised. The company would be required to repay to the
optionee any amounts paid or incurred by the optionee in cnnection with the
acquisition of the securities. These amounts may be nominal or substantial
and depending on the fortunes of the company the cash demands could be
There is also the possibility of state or federal enforcement actions against
the company or those individuals responsible for the failure to comply.
An enforcement action is independent of the right to recission.
April 26, 2007
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