SEC Proposes Exemption of Compensatory Employee Stock Options from Registration under Section 12(g) of the Exchange Act

By Cydney Posner

The SEC has posted its proposal to exempt compensatory employee stock options from Exchange Act registration. The proposal includes an exemption from Exchange Act Section 12(g) registration for private, non-reporting issuers for compensatory employee stock options (but not the underlying stock) and a separate exemption for options of issuers that have registered the class of equity security underlying those options. The proposal results, at least in part, from the recommendations of the SEC's Advisory Committee on Smaller Public Companies, and builds on and modifies in important ways the requirements for relief from registration of employee options set forth in a series of SEC no-action letters.

Section 12(g) of the Exchange Act requires that an issuer with 500 or more holders of record of a class of equity security and assets in excess of $10 million at the end of its most recently completed fiscal year register that class of equity security, unless otherwise exempt. A class is defined to include "all securities of an issuer which are of substantially similar character and the holders of which enjoy substantially similar rights and privileges." As a result, stock options are considered by the SEC to be a separate class of equity security for purposes of the Exchange Act. The expanded use of stock options as compensation, driven in part by the availability of Rule 701, has led a number of issuers to, and sometimes beyond, the brink of (otherwise premature) registration under the Exchange Act. While the SEC has issued a series of no-action letters that provided relief from the requirement to register employee options under the Exchange Act, the requirements set forth in the letters are more onerous than those in the proposed exemptions, including, for example, requirements that the options terminate at the time employment terminated, that preclude exercise until after either the issuer’s IPO or the time at which the issuer was no longer relying on the relief, that issuers provide information, including audited financials, comparable to the information that would be provided had the issuer registered, and that limited transfers of options and underlying option stock as well as pledging of the securities.

Proposed Exemption for Issuers That Are Not Exchange Act Reporting Issuers

The first proposal is to amend Rule 12h-1 to provide an exemption from 12(g) registration for compensatory employee stock options issued under written compensatory stock option plans of an issuer that does not have a class of securities registered under Exchange Act Section 12 and is not subject to the reporting requirements of Exchange Act Section 15(d). The proposed exemption would terminate once the issuer became subject to the reporting requirements of the Exchange Act.

The exemption would be subject to compliance with a number of conditions that are intended to preclude trading in the options or option shares and thus to ensure that there are no public investors that need the full range of protections that Exchange Act registration would provide. These conditions include:

• Eligible optionees are limited to employees, directors, consultants and advisors of the issuer, its parents and majority-owned, direct or indirect subsidiaries of the issuer or its parents (persons described in Securities Act Rule 701( c));
• Restrictions on transfer are applicable to optionees and holders of shares received, or to be received, upon exercise of those options, as well as to their other shares of the same class as the underlying option shares; and
• Risk and financial information is provided to optionees and holders of option shares that is of the type that would be required under Rule 701 if securities sold in reliance on Rule 701 exceeded $5 million in a 12-month period.

The proposed exemption would apply only to the class of compensatory employee stock options and not to the class of securities underlying those options. In addition, the options must be granted under a written compensatory stock option plan that is limited to employees, directors, consultants and advisors and would apply only to employee stock options issued for compensatory purposes. All options granted under the issuer’s written plans would be considered to be of the same class so long as the underlying securities were of the same class, and the exemption would apply to all of the plans on a combined basis, with the proposed exemptive conditions applying to the options issued under each plan. SARs and other rights would not be eligible for the exemption.

Under the proposed exemption, there would be no restrictions applicable to the timing of exercise of the options.

Restrictions on Transfer. Generally, the exemption is designed to be unavailable if optionees and holders of option shares could enter into agreements or otherwise monetize the options, the shares to be received upon exercise of those options or shares of the same class of equity security as the underlying option shares. The restrictions on transfer are thus intended to prevent the development of a trading market that would permit the optionee to profit from the option until the issuer became subject to the Exchange Act reporting requirements.

More specifically, under the proposed exemption:

• The options and option shares received or to be received on exercise could not be transferred except:
• to family members (as defined in Rule 701) by gift or pursuant to domestic relations orders; or
• on death or disability of the optionee;
• Optionees or holders of option shares received through a permitted transfer from the original holder could not transfer those options or option shares
• Pledges, gifts, hypothecations or other transfers of the options, option shares or shares of the same class of equity security as the option shares by the optionee or holder of option shares would be prohibited, other than transfers back to the issuer (or to affiliates of the issuer if the issuer were unable to repurchase those options or option shares), until the issuer became subject to the reporting requirements of the Exchange Act;
• The options, option shares and other shares of the same class as the option shares could not be the subject of a short position, a "put equivalent position" or a "call equivalent position" (as defined in Rule 16a-1) by the optionee or holder of option shares until the issuer became subject to the reporting requirements of the Exchange Act; and
• There could be no market or available process or methodology that would permit optionees or holders of option shares to receive any consideration or compensation for the options, the option shares or shares of the same class, except from permitted transfers to the issuer or its affiliates as discussed above, until the issuer became subject to the reporting requirements of the Exchange Act. (Note, however, that these proposed restrictions are not intended to interfere with any means by which the issuer values its options for purposes of FAS 123R.)

If an express prohibition on transfer were not permitted under applicable state law, the proposed exemption would be available if the issuer retained the obligation, either directly or by assignment to an affiliate of the company, to repurchase the option or the option shares, which obligation would have to be contained in the stock option agreement pursuant to which the option is exercised, in a separate stockholders' agreement or in the issuer’s bylaws or certificate of incorporation.

Required Information. Under the exemption, issuers would need to provide the following information to optionees and holders of option shares:

• The same risk and financial information as would be required under Rule 701 for sales in excess of $5 million in a 12-month period, including a requirement to always provide financial statements that are not more than 180 days old; and
• Access to the issuer’s books and records, including corporate governance documents, to the same extent that they were available to other shareholders of the issuer.

The information (other than books and records) must be provided either by physical or electronic delivery (in compliance with SEC interpretations) or by availability on a password-protected Internet site, along with any password needed to access the information. Disclosure may be conditioned upon agreement by the optionee or holder of option shares to maintain the confidentiality of the information; if the holder elects not to agree to confidentiality, the issuer may choose not to provide the information so long as it allows inspection of the documents at a described issuer offices.

Issuer Obligation to Impose the Conditions to the Proposed Exemption. Because the exemption would be self-executing, the SEC would require that the necessary limitations and conditions be contained either in the written stock option plans or individual written option agreements. Similarly, the transferability restrictions on the option shares must be included in the issuer’s bylaws, certificate of incorporation or a stock purchase or stockholder agreement between the issuer and the exercising optionee or holder of option shares.

Proposed Exemption for Exchange Act Reporting Issuers

The second proposal is to amend Rule 12h-1 to provide an exemption for compensatory employee stock options of issuers that have registered under Exchange Act Section 12 the class of equity security underlying those options and, therefore, are already required to file reports under the Exchange Act. The proposed exemption would not be available to an issuer that is required to file Exchange Act reports solely pursuant to Exchange Act Section 15(d). As a result, neither of these proposed exemptions would be available for Section 15(d) reporting companies. The SEC notes that reporting issuers may not have recognized the need to comply with Section 12(g) registration for employee stock options and, consequently, in addition to providing a useful exemption, the proposed exemption will provide salutary guidance regarding the Exchange Act registration requirement for compensatory employee stock options.

This proposed exemption would require that the options be issued pursuant to a written compensatory stock option plan and that the class of persons eligible to receive the options be limited to Rule 701( c) persons. Because the issuer would already be required to file information with the SEC, there would be no additional information requirements. Fortunately, it is not necessary that the issuer be current in its SEC reporting to take advantage of the exemption. The protections of Exchange Act Sections 13(e) and 14(e) will continue to apply to offers for compensatory employee stock options, and Sections 13, 14 and 16 will continue to apply as appropriate (although the options are not viewed to be subject to Section 16 as a separate class of equity security).

Transition Provisions

Issuers that have received no-action letters could continue to rely on them or to rely instead on one of the proposed exemptions. The proposed exemptions would be self-executing. If the issuer became ineligible to rely on an exemption, the issuer would be permitted up to 60 calendar days from the date it became ineligible to file a registration statement under Section 12(g).

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