SEC posts final rules

By Cydney Posner

The SEC has posted its final rules relating to the new exemptions from section 12 registration under the Exchange Act for employee compensatory stock options. The exemptions are set forth in amendments to Rule 12h-1.

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 exemptions adopted, including, for example, requirements that the options terminate at the time employment terminates, 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.

The first exemption, expanding upon a line of no-action letters issued by the staff of Corp Fin, applies to issuers that are not required to file reports under the Exchange Act, provided certain conditions are met. The second exemption is available to issuers that are required to file periodic reports under the Exchange Act because they have registered under Section 12 or are required to file reports under Section 15(d). The key modifications from the proposal include:

• for private, non-reporting issuers, elimination of transferability and ownership restrictions on holders of shares issued upon exercise of options, and elimination of requirements to provide information to holders of shares received upon exercise of options; and
• for public reporting issuers, expansion of the category of issuers eligible to rely on the exemption to include any issuer required to file periodic reports under Exchange Act Sections 13 or 15(d).

Exemption for Issuers That Are Not Exchange Act Reporting Issuers

The first exemption is applicable to options granted by issuers that do not have a class of securities registered under Section 12 and are not subject to the reporting requirements of Section 15(d). The exemption terminates once the issuer becomes subject to the reporting requirements or no longer satisfies the conditions to the exemption. The exemption will not be available if the issuer was required, but failed, to register another class of equity security under the Exchange Act.

The exemption would be subject to compliance with a number of conditions that are intended to preclude trading in the options and thus to ensure that there are no public investors that need the full range of protections that Exchange Act registration would provide. As a condition to the exemption, issuers must include the necessary limitations and conditions in the written stock option plans, within the terms of the individual written option agreements or in another enforceable written agreement (i.e., the condition must be enforceable by the optionholder and the issuer must have written evidence that it satisfies this condition).

Eligible Securities

• Limited to compensatory employee stock options (not, e.g., to SARs or other forms of equity comp) that are issued under a written compensatory stock option plan limited to eligible participants (see below);
• Applies to all compensatory employee stock options issued under all written compensatory stock option plans on a combined basis so long as the underlying securities are of the same class, with the exemptive conditions applying to the compensatory employee stock options issued under each option plan (note that the separate class analysis under Section 12(g)(5) is not affected for other purposes); and
• Not extended to any class of securities received or to be received upon exercise of the options.

Eligible Participants

The plans must limit the class of eligible persons to employees, directors, consultants and advisors of the issuer, its parents or majority-owned, direct or indirect, subsidiaries of the issuer or its parents-- the same group of participants (including permitted transferees) as allowed under Rule 701. The exemption will apply only to options issued for compensatory purposes.

Option Terms

The exemption would impose a number of restrictions on the terms of options outstanding at the time that the issuer is relying on the exemption.:

• The option and, prior to exercise, the shares to be received upon exercise, cannot be transferred except, as permitted by the exemption, to family members (as defined in Rule 701) by gift or pursuant to domestic relations orders, and upon death or disability of the optionholder;
• Other pledges, gifts, hypothecations or other transfers of the options or underlying shares (prior to exercise) are not permitted until the issuer becomes subject to the reporting requirements of the Exchange Act or is no longer relying on the exemption, except for transfers back to the issuer or transfers in connection with a change of control or other acquisition transactions involving the issuer if, following the transaction, the options no longer will be outstanding and the issuer no longer relying on the exemption; and
• The options or underlying securities cannot be the subject of a short position, a "put equivalent position" or a "call equivalent position" (as defined under Section 16) by the optionholder, prior to exercise, until the issuer becomes subject to the reporting requirements of the Exchange Act or is no longer relying on the exemption; however, the options may be subject to repurchase rights of the issuer, or the optionholder may participate in a change of control or other acquisition transaction involving the issuer.

The restrictions on transfer are intended to prevent the development of a trading market as well as profit-taking by the optionholder while the issuer is relying on the exemption. The conditions permit the issuer to provide that it may repurchase the options or that the options terminate in the event of an impermissible transfer. As adopted, in an important change from the proposal, the amendment does not restrict holders of shares following option exercise. The SEC took into account existing impediments to creation of a public market, including the facts that, under Rule 701, the shares would be "restricted securities," that optionholders typically do not exercise prior to their termination or a liquidity event and that most private companies take steps to restrict transferability of shares received upon exercise. The exemption does not impose any limitations on the ability of current or former employees, directors, consultants or advisors of an issuer to retain or exercise their options. The exemption does not impose any restriction on the timing of option exercise by the optionholder (regardless of whether the optionholder continues to be an employee, director, consultant or advisor of the issuer), in the event of the death or disability of the optionholder, by the estate or guardian of the optionholder or by a family member (as defined in Rule 701) who acquired the options through a gift or domestic relations order.

Required Information

To maintain the exemption, issuers must periodically provide to optionholders the same risk and financial information that would be required to be provided under Rule 701 if securities sold in reliance on Rule 701 in a 12-month period exceeded $5 million (as such provision may be modified). (Note, however, that the release cautions that compliance with the minimum disclosure standards for Rule 701 may not necessarily satisfy the antifraud standards of the securities laws.) Once an issuer has 500 or more optionholders, the required information, including financial statements that are not more than 180 days old, must be provided every six months. The required information will have to be provided once an issuer is relying on the exemption, regardless of whether the issuer would otherwise be required to provide the information under Rule 701.

The issuer will be permitted to provide the required information either by physical or electronic delivery (in compliance with the SEC interps on this topic) or by notice to the optionholders of the availability of the information on an internet site that may be password-protected (along with any password needed to access the information). A password-protected closed-system intranet site accessible to employees would also be permitted. To permit issuers to safeguard proprietary or confidential information that may be contained in the information to be provided, the exemption will permit provision of the disclosure to be conditioned upon the optionholder's agreeing to maintain the confidentiality of the information. The SEC did not adopt a proposed requirement to provide information to holders of shares received upon exercise of options or to provide optionholders access to the issuer's books and records.

Exemption for Exchange Act Reporting Issuers

The second exemption is available for options granted by issuers required to file periodic reports pursuant to Exchange Act Sections 13 or 15(d).

Because these issuers file Exchange Act reports, information will already be available to optionholders, and no further information requirement is imposed as a condition to the exemption, not even a requirement to be current in reporting. With regard to issuers reporting under Section 13, d any class of equity securities may be registered, not just the class underlying the options, as originally proposed. For issuers reporting under Section 15(d), the exemption will no longer be available once their obligations to file reports under Section 15(d) are suspended. In that case, to maintain the exemption, an issuer would have to register a class of security under Section 12. The SEC anticipates that issuers with 500 or more optionholders are likely to also have 500 or more holders of the class of underlying shares and therefore required to register that class under Section 12. In addition, if the issuer becomes a private, non-reporting issuer due to the suspension or termination of its reporting obligations, it may rely on the exemption for compensatory employee stock options of private, non-reporting issuers if the conditions to that exemption are satisfied.

The options must be issued pursuant to a written compensatory stock option plan. The class of persons eligible to receive or hold compensatory employee stock options under the stock option plans includes those participants permitted to be granted options under an issuer’s Form S-8, as well as those participants permitted under Rule 701. For reporting companies only, the exemption will continue to be available even if there is an insignificant deviation (similar to the type of deviation allowed under Reg D) from the eligibility conditions, that is, if the number of optionholders that does not meet the eligibility condition is insignificant both as to the aggregate number of optionholders and number of outstanding options. Following the effective date, the exemption is conditioned upon the issuer's having made a good faith and reasonable attempt to comply with the conditions.

Registering When No Longer Eligible for Exemption

A private, non-reporting issuer that becomes ineligible to rely on the exemption will have up to 120 calendar days from the date it became ineligible to file a registration statement under Section 12(g) for the class of compensatory employee stock options. A reporting issuer that becomes ineligible to rely on the exemption will have up to 60 calendar days from the date it became ineligible to file a registration statement under Section 12(g) for the class of compensatory employee stock options or a class of securities.

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