Rule 701 Enforcement Action

It’s not often that Rule 701 makes the news, but it did earlier this year when the SEC brought an enforcement action over a private company’s failure to comply with the requirements of the rule.

A Fenwick & West memo notes: “This is the first enforcement action to result from a sweeping SEC investigation into the Rule 701 option-granting practices of late-stage private companies begun in July 2016.”

Background on Rule 701

Rule 701 allows private companies to issue securities (stock, stock options, and other awards) to their employees through compensatory arrangements without having to register the securities. It’s a handy exemption because the employees don’t have to be accredited investors and the limits on the amount of stock companies can issue are fairly high.

One drawback of relying on Rule 701, however, is that if the company issues more than $5 million worth of stock to employees within a 12-month period, the company must make certain disclosures to employees (including risk factors and financial statements).

Why the Rule 701 Enforcement Action?

The company involved, Credit Karma, issued almost $14 million worth of stock over a 12-month period—that’s nearly three times the amount at which the additional disclosures are required. Despite this, Credit Karma failed to make the required disclosures to employees, even though they were disclosing this same information to other investors.

What’s the Penalty for Violating Rule 701?

Typically, when a company fails to properly register or exempt an issuance of stock, the company must make a rescission offer to the buyers—meaning that the company must offer to buy their stock back from them. This remedy has not always proved to be a deterrent to ever-optimistic pre-IPO companies, who are often banking on employees being able to make a lot more money by selling their stock after a successful IPO.

Credit Karma agreed to pay a fine of $160,000 to the SEC. Of course, that’s less than the median employee at Facebook makes in a year, so I’m not sure how meaningful that fine is to a private company with a valuation of $4 billion.

Don’t Want to Loop Employees In? Pay Cash.

I often encounter private companies that are reluctant to disclose any information about the business to their employees; sometimes they don’t even want to disclose the stock valuation. But if you are paying employees in stock, they have a right to know the value of that compensation. And if you exceed the $5 million threshold under Rule 701, the SEC says they also have a right to financial information and risk factors. The SEC permits reasonable accommodations to be made to ensure that the information remains confidential, but you have to provide employees with access to it.

If management isn’t comfortable with that, I recommend that you pay employees in cash.

- Barbara