SEC takes a longer look at pre-IPO companies, Rule 701

For years, many people—especially legislators and regulators—have fretted over the downturn in the number of companies going public.

That trend, however, seems to be reversing itself as many of the tech world’s “unicorns” make the leap to public markets. Innovative companies that either have gone public or soon plan to go public amid great anticipation include Spotify, Snap Inc., Uber, Pinterest, Palantir Technologies, Vice Media, Dropbox, and Slack.

While the Securities and Exchange Commission is typically thought of in terms of policing public companies, its purview does, although more rarely, extend to pre-IPO entities.

As private companies stay private longer—and amass massive valuations before taking the IPO plunge—the SEC is taking a more stringent look at them. In particular, a recent focus has been on the Securities Act Rule 701, an exemption that many companies use to grant options and other equity-based compensation. 

On March 12, the SEC issued a rare enforcement action under Rule 701, as a San Francisco-based financial technology company, Credit Karma, agreed to settle charges it unlawfully offered securities to its employees and failed to provide them with timely financial statements and risk disclosures. It was the first such enforcement action since 2005.

Rule 701, which applies solely to private and pre-IPO companies, exempts certain sales of securities made to compensate employees, consultants, and advisers.

If a company sells more than $5 million in securities in a 12-month period, it is required to issue detailed financial statements and risk disclosures to the recipients of the securities issued “in a reasonable period of time before the date of the sale.” Securities issued under Rule 701 are “restricted securities” and may not be freely traded unless the securities are registered or the holders can rely on an exemption.

According to the SEC’s Order, Credit Karma issued nearly $14 million in stock options to employees over a one-year period, but were not given the required disclosure information.

The company had, however, provided potential institutional investors access to a virtual data room that contained audited and unaudited financial statements, as well as risk disclosure documents and information regarding intellectual property, securities issuances, and disputes and litigation. It did not, however, provide the same information to its own employees, because it viewed the financial information as highly confidential and proprietary.

Without admitting or denying the allegations, Credit Karma agreed to pay a $160,000 penalty.

The SEC’s renewed interest in Rule 701 falls in line with its “Silicon Valley Initiative.” The effort was announced in 2016 by former Chairman Mary Jo White during a speech at the Rock Center on Corporate Governance at Stanford University.

“As technology has evolved, so too have the financial markets that support it,” she said. “New models for how these companies are funded and how investors unlock their value are changing the landscape of private start-up financing and the IPO market.”

She cautioned: “Being a private company obviously does not mean that you can disregard the interests of investors.”

White said the Commission would ramp up efforts to oversee the accuracy of disclosures made by pre-IPO companies, rules defining accredited investors, secondary market trading, and potential risks tied to financial controls and corporate governance.

“Beyond the hype and the headlines, our collective challenge is to look past the eye-popping valuations and carefully examine the implications for investors, including employees of these companies, who are typically paid, in part, in stock and options,” she said.

“They came out pretty loudly in 2016 and said they had concerns that, as private companies grow ever-larger without going public, the SEC Enforcement Division ought to be paying more attention to those companies,” says Michael Dicke, co-chair of law firm Fenwick & West’s securities enforcement group, formally associate regional director for enforcement in the SEC’s San Francisco regional office. “Everybody needs to understand that just because you are not a public or publicly reporting company you cannot think that the securities laws don’t apply to you. It doesn’t mean that the SEC cannot investigate you.”

Recently the Enforcement Division conducted a “sweep” through its San Francisco office and sent Rule 701 information requests to large pre-IPO companies.

“Everybody needs to understand that just because you are not a public or publicly reporting company you cannot think that the securities laws don’t apply to you. It doesn’t mean that the SEC cannot investigate you.”
Michael Dicke, Co-chair of Securities Enforcement Group, Fenwick & West

“When they do a sweep, they are not targeting a particular company—and when they ask for information, they usually have a specific reason to ask for it,” Dicke explains.

As for why the SEC decided an enforcement sweep was called for, Dicke suspects there were complaints from employees saying that they hadn’t been given disclosure information with their equity awards, as required under rule 701.

“I also think the SEC was especially interested in looking at Rule 701 because it hasn’t been the subject of an enforcement action since 2005,” he says. The Commission is also “interested in a democratization of information flow within companies.”

“There is concern that at a lot of fast-growing pre-IPO companies, management and board members have a lot of good financial information and can evaluate prospects for the company. But more junior employees don’t have access to that information, so it is very hard for them to evaluate what their options are,” Dicke says. That is important, “especially in Silicon Valley where there is a great competition for talent, especially for engineers.”

“What is the HR department telling them to get them in the door? Things get said like, ‘This company is going to achieve $3 billion-dollar status, go IPO in two years, and you are going to become a millionaire.’ Well, is that true?” he asks.

Dicke points to another reason the SEC may have conducted its informational sweep: a growing call to amend changes to Rule 701.

Congress is considering the CHOICE Act, a sweeping set of financial regulation reforms that would raise the $5 million threshold for sales in a 12-month period to $20 million. The Employee Ownership Act, if passed, would bump up the point at which specified disclosure is required to $10 million to be adjusted in step with inflation. 

The SEC’s Advisory Committee on Small and Emerging Companies discussed updating the rule, last amended in 1999, at its September 2017 meeting.

“Compensating employees and consultants with equity has become an invaluable tool for many private companies in the United States and is really important and critical for companies to have this tool in order to hire the talent that they need to hire to support the growth and development of the company,” said Christine McCarthy, a partner at the law firm Orrick, in her recommendation for updating the rule. “At the earliest stages, some companies don’t have the cash resources to pay service providers in cash, and oftentimes they’ll look for ways to pay service providers either primarily or exclusively in equity.  At later stages, equity compensation is critical in order for those companies to hire the talent they need to support the development of the company.”

“Many private companies, particularly those at the earliest stages, don't have the resources to comply with rules that are complicated or overly burdensome or costly to administer,” she added. “The lack of resources available to private companies can create inadvertent compliance errors where there’s complexity or cost associated with complying with rules.”

It is “absolutely critical that the rules that are in place for these private companies are rational, not unduly complicated, and not too difficult to comply with,” she said.

Steve Miller, chief financial officer of eyeglass company Warby Parker, echoed those concerns. “Equity compensation has always been a meaningful tool that a start-up company can use to attract and retain talent,” he said. “One of the bigger issues that we’ve had as a fast-growing company is actually understanding how to interpret 701 and make sure that we’re in compliance with it.” 

Among the suggested changes, McCarthy said, is a proposal to remove restrictions on consultants, requiring that they be “natural persons” even though “many choose to organize themselves in the form of an entity, even if they are just one individual providing services.”

“It is very common for early-stage companies to hire consultants because they don’t have the resources to hire people full-time,” she said. “Having the rule structured so that it’s not permitted to grant equity under Rule 701 to someone who’s providing services as an entity is problematic,” she added. “It causes companies to have to jump through hoops in order to figure out ways to get these individuals that are providing services to the company equity.”

“We’ve worked with a range of consultants at my current company, and also at my previous companies, to help us get up-to-speed on a range of different items like supply chain analysis, general public relations, legal services, temporary CFO services, and the like,” Miller said.

The recommendation under consideration also incudes eliminating the rule’s “hard cap” limit on the total amount of securities that could be issued pursuant to Rule 701.

“We grant stock options on a regular basis throughout the year,” Miller explained. “Every time that we put forward a round of grants, we have to understand whether or not we’re going to bump up against the $5 million limit.  Previously, we did that using a spreadsheet and we were never quite sure if the numbers were accurate and we weren’t entirely sure how to understand the nuances of the law.”

Warby Parker recently implemented a tool, eShares, to automated the process of doing the 701 check. It has “made my life a lot easier; it’s made our legal team’s lives a lot easier and my controller’s life a lot easier,” Miller said.

“It’s still a challenge, though, because you want many things as a startup company, and one of the biggest things that you want is flexibility to make decisions, and hiring decisions are your most important,” he said. “Before we make a hiring decision, particularly of a senior executive, [we make sure] that we’re going to be in compliance with 701. It’s an added step in the decision chain that we didn’t used to have to go through, so it just adds complexity to the process from a few different aspects.”

Another amendment would exclude material amendments from the calculation of the Rule 701 limit. This would apply to repricing stock options, a move that is often a response to slower-than-expected growth or revenue setbacks. The change would make it clear that a repricing is not a new grant or sale under Rule 701.

Another alteration would clarify the application of Rule 701 to restricted stock units. Rule 701 currently has no rules that specifically discuss and apply to restricted stock units. At the time it was adopted, private companies as a general matter, were not granting restricted stock units, but it has become a form of equity compensation they have started to use.

Another change: changing the rule to provide that the expanded disclosure is not required until after the threshold is exceeded. The problem, McCarthy explained, is that a company may not discover it exceeded the $5 million limit until the end of the 12-month period.

Another potential change would allow disclosures in any manner consistent with the SEC’s electronic disclosure rules (for example, in an online data site) to satisfy the obligation to deliver disclosure and that there’s no requirement to confirm actual receipt or review of the disclosure.