Monitoring SEC Compliance with Equity Issuances to Employees

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A recent SEC order serves as a reminder to private equity sponsors to ensure that their portfolio companies monitor compliance with Rule 701 of the Securities Act of 1933 in connection with the issuance of incentive equity to employees, directors and officers. The SEC charged a privately-owned company, Credit Karma Inc., with violating Rule 7011 for failure to provide financial statements and risk disclosures to employee shareholders a reasonable period of time before the employees paid to exercise the stock options they had been granted by the company. Credit Karma issued approximately $13.8 million in stock options to its employees from October 1, 2014, through September 30, 2015 exceeding the $5 million threshold allowed during a twelve-month offering period without providing any disclosure to employees.

Under Rule 701, an issuance of securities to directors, officers, employees and consultants by a private company is exempt from compliance with the registration requirements of the Securities Act so long as the company complies with the requirements of the rule. One of the key requirements is that if the issuer issues securities with an aggregate value in excess of $5 million during a 12-month period, then the issuer must provide the following information to recipients of the securities a reasonable period of time prior to issuance: (i) a copy of the compensatory benefit plan or contract under which the securities are issued, (ii) a copy of the summary plan description required by ERISA or, if the plan is not subject to ERISA, a summary of the plan’s material terms, (iii) the risk factors associated with an investment in the securities and (iv) the financial statements required in an offering statement on Form 1-A under Regulation A. As a result of these requirements, particularly the financial statements requirement, many issuers try to stay under the $5 million threshold. In this regard, please note that securities issued to “accredited investors” can be structured to comply with another exemption from the registration requirements of the Securities Act and would not count against the $5 million threshold.

Sponsors should confirm that their portfolio companies have procedures in place to comply with Rule 701 and make a conscious decision as to whether they are willing to comply with the information requirements of Rule 701. If they do decide to comply with those requirements, then sponsors will need to ensure that the grant documentation for any equity incentives works in a way that will allow their portfolio companies to comply with the rule and that management monitors compliance with the rule and delivers the required information to recipients of those securities on a timely basis.

Endnotes    (↵ returns to text)

  1. Exchange Act Administrative Proceeding File No. 3-18398