United States: SEC Broadens Relief From Public Company Reporting Triggered By Option Grants

Originally published in: an upcoming issue of World Securities Laws Report Summer 2001

Over the last several years, the trend for emerging companies has been to issue stock options to virtually all employees, from the top down. Many companies now also include consultants under their option plans. Even without publicly traded equity, as a result of its option grants, an emerging company can become subject to the same reporting obligations under the Securities Exchange Act as a public company with thousands of shareholders; in other words, 10-Qs, 10-Ks and 8-Ks must be filed. Fortunately for emerging companies, the SEC has within the last several weeks expanded the relief that it offers from Exchange Act reporting triggered by option grants. The expanded criteria is set out in an update to the SEC’s Current Issues and Rulemaking Projects Outline.

For companies that do not have publicly traded securities, public company reporting obligations can arise under Section 12(g) of the Exchange Act. Section 12(g) provides that – absent an available exemption – an issuer with 500 holders of record of a class of equity securities and more than $10 million in assets at the end of its most recent fiscal year must register the class of equity under the Exchange Act. Thereafter, the issuer is required to comply with ongoing Exchange Act periodic reporting requirements.

For purposes of Section 12(g), equity securities include rights to subscribe for or purchase stock. Thus, options are a class of Section 12(g) equity securities.

Since 1991, the SEC has granted relief from Exchange Act reporting when the reporting obligation has been triggered by option grants; relief is obtained by filing a "no-action" request with the SEC. Some of the better known emerging issuers that have obtained no-action relief have included Kinkos and Starbucks. However, until the criteria for relief recently were expanded, an issuer could not obtain relief from Exchange Act reporting if the options were exercisable during the relief period, if they survived the termination of employment or if they were granted to consultants. Other conditions for relief included restrictions on transferability and an undertaking to provide option holders with material information regarding the issuer. Certain other requirements, which have not changed and are therefore not discussed in this article, also must be satisfied.

In light of current market conditions – a number of issuers with postponed IPOs have made option grants to 500 or more holders under a plan not previously eligible for relief – the SEC has broadened the relief criteria. Relief now can be obtained if options are immediately exercisable. The option holder is not required to wait for the issuer to go public.

Under the new criteria, issuers also may allow employees that are terminated to preserve some residual equity upside. This will in some cases be attractive where employees are let go in a downsizing. Former employees can continue to hold vested options. The SEC's new relief criteria do not, however, change the tax code, which requires vested incentive stock options to be exercised within 90 days after the termination of employment for ISO treatment.

In most cases, options still will not be transferable. However, they can be transferred in the event of the employee’s death or disability. If an employee exercises his or her options before the issuer goes public, the underlying stock may not be transferable before the issuer becomes a public company, except back to the issuer or upon the death or disability of the employee.

A significant broadening of the relief criteria is that options now also may be granted to consultants, so long as the consultant is eligible to participate in the option plan under Rule 701. This will be of benefit to emerging companies, since, especially at the earlier stages, they in many cases outsource some functions to consultants who receive options. Rule 701 requires that the consultant be a natural person, that the consultant provide bona fide services to the issuer or certain specified affiliates and that the services are not in connection with the offer and sale of securities in a capital raising transaction and do not promote or maintain a market for the issuer's securities.

To qualify for relief under the new criteria, option holders must receive essentially the same Exchange Act registration statement and annual and quarterly report information that they would have received had the issuer been a public company. The disclosure provided to option holders must include GAAP financials, including audited annual financial statements. Based on public statements by some SEC personnel, the accompanying narrative disclosure at a minimum will require a "Management's Discussion and Analysis" and a description of the issuer's business.

In contrast, under many of the requests for no-action relief under the old criteria, issuers undertook to provide option holders 1) a reasonable period of time prior to the termination of employment, relevant information material to the employee's decision whether to terminate his or her employment and forfeit options, subject to the employee agreeing to sign a confidentiality agreement, 2) annual audited GAAP financials, unaudited quarterly financials in a format consistent with the issuer’s general accounting and financial reporting practices and other information generally provided to the issuer’s stockholders and 3) to the same extent required to be provided to stockholders, access to the issuer’s books and records, also subject to the employee signing a confidentiality agreement.