One of the advantages of private ownership by a private equity firm is relief from Sarbanes-Oxley and from reporting and other obligations applicable to public companies. However, following the transaction, management and other employees need to be provided with meaningful equity incentives that motivate strong company performance.
A private company that grants equity incentives deeply into its organization can inadvertently find itself subject to the very requirements it intends to be free of. This is so under the “500-person” rule of Section 12(g) of the Securities Exchange Act of 1934, which causes an unlisted issuer to be subject to Sarbanes-Oxley and public company disclosure and other requirements if more than 500 holders own a class of equity security, including compensatory stock options.
A new rule adopted by the SEC addresses this issue and grants helpful relief (subject to conditions) to these issuers.
Background
Private companies are generally not subject to public-company registration and disclosure requirements and compliance with Sarbanes-Oxley. As a result, they generally benefit from the following:
• No ongoing disclosure obligations. Unless • they have agreed to do so voluntarily (typically in connection with issuance of high yield debt), private companies are not required to report financial information on Forms 10-K and 10-Q and other issuer developments on Form 8-K under the Exchange Act. Private companies are also exempt from the onerous proxy and tender offer rules and from restrictions on selective disclosure.
• No Sarbanes-Oxley compliance. A private company is not subject to Sarbanes-Oxley’s independence requirements for audit committees and outside auditors. A private company is also not subject to Sarbanes-Oxley’s (1) restrictions of extensions of credit to officers and directors (which, in the private company context, are often used in connection with share purchases), (2) “up the ladder” reporting by legal advisors or (3) bonus disgorgement rules in the case of financial misstatements.
• No short-swing profit disgorgement. Under Section 16 of the Exchange Act, directors, officers and 10 percent owners of a public company are required to report their transactions in issuer securities and to disgorge “short-swing” profits (i.e., profits from purchases and sales of issuer equity securities and derivative securities within a six month period). Private companies avoid these reporting requirements and the risk of profit disgorgement.
However, if the private company has more than 500 investors holding a class of equity security and more than $10 million in assets at the end of any fiscal year, these obligations kick in. Because stock options are considered a separate class of equity security for purposes of the Exchange Act, an issuer with more than 500 option holders and sufficient assets would have to register its options under the Exchange Act and would become subject to the foregoing obligations.
In some going-private transactions, relief from the public company disclosure requirements may be a lesser concern because the issuer may be required to file Exchange Act reports on a “voluntary” basis as a result of covenants in its high-yield debt. A voluntary filer will, however, generally be subject to some but not all of the audit function requirements (in particular, a voluntary filer will be subject to the outside auditor independence rules but will not be subject to the audit committee independence rules) and will not be subject to the proxy and short-swing profit rules or the prohibition on extension of credit to officers and directors.
Prior to 2007, the SEC’s primary response to this issue had been through no-action relief exempting companies with more than 500 option holders from Exchange Act registration. The no-action process was lengthy and costly, and companies requesting relief were typically required to agree to numerous conditions, including limitations on the terms of the options, continuous disclosure obligations to option holders and a commitment to eventually register the underlying shares. In December 2007, the SEC adopted a rule that crafts an exemption from the registration requirements specifically for non-reporting issuers. This new rule, Rule 12h-1(f ), eliminates the need to seek future no-action relief on a case-by-case basis. The rule is significant because it further liberalizes the prior exemptive relief and eliminates the delay and expense associated with the noaction letter process. Presumably, the SEC also saw the writing on the wall – that, as going-private transactions become larger and larger, the requests for individualized no-action relief would likely become more numerous and more of a drain on SEC resources, in particular in times like the present, when the IPO market has slowed.
The exemption
In adopting Rule 12h-1(f ), the SEC’s expressed intention was to clarify and make routine the basis for an exemption to facilitate a company’s use of compensatory stock options, while at the same time assuring appropriate investor protections for option holders.
There are three principal components of the rule: first, it defines the group of individuals who may receive options; second, it imposes transferability restrictions; and third, it imposes information requirements.
Eligible option holders
The eligible option plan participants are the same as those permitted under Securities Act Rule 701(c). To wit, the exemption is available only for compensatory stock options issued under written compensatory stock option plans. Those plans must be limited to employees, directors, and individual consultants and advisors of the issuer, its parents, and majority-owned subsidiaries of the issuer or its parents. The options may also be held by the eligible option holders’ family members who acquire the securities through gifts or domestic relations orders.
Transferability restrictions
The stock options and, prior to exercise, the shares to be received, generally cannot be transferred directly or indirectly (including by pledging, hypothecating, or otherwise transferring the options or underlying shares, or establishing a short position or through establishment of a put or a call right). The purpose of these restrictions is to inhibit the development of a trading market for the options and the underlying shares while the issuer is relying on the exemption.
These restrictions no longer apply when the issuer becomes subject to Exchange Act reporting requirements or ceases to rely on the exception, or when the options are exercised. Limited exceptions to this restriction exist for transfers to family members by gift or pursuant to domestic relations orders, or on death or disability.
Transfers back to the issuer are also permitted as are transfers in connection with a change of control or other acquisition transaction involving the issuer.
Fortunately, these transfer and repurchase restrictions do not apply to the shares received on exercise of the options. Accordingly, normal contractual call and put features contained in stockholders’ agreements are not affected by the rule.
Required information
Every six months, the issuer must provide option holders with risk factors and financial information similar to the requirements under Securities Act Rule 701. The financial statements supplied must be no more than 180 days old. Provision of the required disclosures may be conditioned on the option holder agreeing to maintain the confidentiality of the information. This is a significant difference from the general rules applicable for offerings below the 500-person threshold, which require this information to be provided to an option holder only within a reasonable period of time prior to the exercise of the option. However, this is also a significant liberalisation of the prior no-action relief, which imposed full public companylike disclosure requirements. After the stock options are exercised, the issuer no longer has to provide any information to shareholders under the new rule.
Documentation matters
The rule requires that these limitations and conditions be included in one or more enforceable written agreements, such as the written stock option plans or the individual written option agreements, or in the issuer’s by-laws or certificate of incorporation. It is not sufficient for the rule to be satisfied in practice.
Transition matters
If an issuer with $10 million in assets but fewer than 500 option holders passes the 500-person threshold, it will have to be in compliance with the new rule by the end of its fiscal year to be eligible for the exemption. This means that if its existing employee stock option plans do not already contain the restrictions and information provisions required by the rule, they must be amended to comply. Ideally, issuers who anticipate having more than 500 option holders should design and implement compensation programs and employee stock option plans with the rule’s requirements in mind. Advance planning will avoid the additional costs associated with later amending plans to meet requirements for exemption eligibility. The exemption applies to options only
The 500-person rule applies separately to the underlying shares received on exercise of the options, and there is no exemption from Section 12(g) for having more than 500 shareholders. If sufficient numbers of employees exercise their options, the issuer will become subject to the Exchange Act.
Final points
Since the exemption is limited to issuers that are not subject to Exchange Act reporting requirements, the exemption expires once the issuer becomes a reporting company (a separate exemption from Exchange Act registration is available for options granted by public companies). Additionally, as long as the securities underlying the stock options are all of the same class of securities, the exemption applies on a combined basis to all compensatory stock options meeting the conditions of the plan. This rule applies even if the options are issued under different plans and have different strike prices, grant dates, vesting schedules and other terms. The exemption, however, does not extend to other rights issued in connection with the compensatory stock options, such as stock appreciation rights or phantom stock units.
Overall, the new rule is good news for large, private companies that award stock options to their employees. Issuers no longer have to obtain individual no-action relief and can instead rely on the final rule in deciding how deeply to grant equity into their ranks.
Elizabeth Pagel Serebransky also contributed to this article
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