SEC Proposes Exemption from Exchange Act Registration for Compensatory Stock Options

07.17.2007

Section 12 of the Securities Exchange Act of 1934 requires companies with 500 or more holders of a class of equity securities to register that class under the Exchange Act.  Stock options have historically been regarded by the SEC as a separate “class” for Exchange Act registration purposes.  As a result of this interpretation, companies with more than 500 option holders became subject to the reporting requirements of the Exchange Act, unless the company sought and received a favorable “no-action” letter from the SEC.  The SEC is now proposing a rule that would provide an exemption from Exchange Act registration for compensatory stock options that conform to certain requirements, which would permit non-reporting companies to have more than 500 optionees to avoid Exchange Act registration.

Background – Exchange Act Registration Requirements

Under Section 12(g) of the Exchange Act, a company with 500 or more holders of a “class” of equity securities, and assets in excess of $10 million at the end of its most recent fiscal year, must register that class of equity security.  Stock options, including stock options issued for compensatory purposes, are a separate class of equity security for Exchange Act purposes.  This means that a privately-held company with 500 or more option holders might be forced to register under the Exchange Act even if the company was not yet ready to do an initial public offering of its common stock.

The Staff of the SEC’s Division of Corporation Finance has granted no-action relief to companies faced with Exchange Act registration based solely on their compensatory stock options.  The utility of the no-action position was limited, because the Staff had historically required that the company provide essentially the same level of information as would be provided to shareholders by a company actually registered under the Exchange Act.

The proposed revision to the Exchange Act rules would codify and liberalize the Staff’s no-action position.  Specifically, the information disclosure requirement would be conformed to the information requirement found in Rule 701 under the Securities Act of 1933, the exemption under which most private company compensatory equity awards are issued.  The revision would also extend the position to reporting companies that have 500 or more option holders.

Proposed Exemption for Non-Reporting Companies

The proposed revision to Exchange Act Rule 12h-1 would provide an exemption from Exchange Act registration for stock options.  The exemption would apply only to compensatory stock options (i.e., not options issues for capital raising purposes) issued under a written compensatory stock option plan, and only if the following conditions are present:

• Eligible option holders are limited to employees, directors, consultants and advisors of the company, its parents, or majority-owned, direct or indirect subsidiaries of the company or its parents.
• Options are non-transferable, except for transfers to family members (as defined in Rule 701) through gift or pursuant to domestic relations orders, or transfers upon death or disability of the option holder; options received by such permitted transferees may not be further transferred.
• No other pledges, gifts, hypothecations or other transfers of the stock options, or the shares issued upon exercise of the options, are permitted until the company becomes otherwise subject to the reporting requirements of the Exchange Act.
• The options, or the securities issued upon option exercise, or securities of the same class as those issued upon option exercise, may not be the subject of a short position, a “put equivalent position,” or a “call equivalent position,” as those terms are defined in Rule 16a-1 under the Exchange Act.
• There is no market or other process or methodology that would permit option holders, or holders of shares received on exercise of an option, to receive any consideration for their options or shares until the company becomes otherwise subject to the reporting requirements of the Exchange Act.
• The company has undertaken to provide option holders the information that would be required by Rule 701 if securities sold in reliance on that Rule exceeded $5 million, and to provide option holders access to the company’s books and records, including corporate governance documents, to the same extent they are available to other shareholders.

The transferability restrictions must be set forth in writing in either the stock plan, the stock option or other stock purchase agreement, or the company’s articles of incorporation or bylaws.  The information required could be delivered either physically or electronically.  The proposed exemption would not restrict exercises of the option by the recipient or permitted transferees.

The company may condition delivery of its financial and other information on the execution by the option holder of a confidentiality agreement.  However, if the option holder or shareholder refuses to sign such an agreement, the company must allow the holder to inspect the documents at the company’s offices.

Proposed Exemption for Reporting Companies

Companies already subject to the Exchange Act reporting requirements potentially face a similar registration issue if they have more than 500 stock option holders.  Few public companies in fact register the options as a separate class.  To clarify that such registration is not required, the proposed amendment to Rule 12h-1 would also extend the exemption to public reporting companies, provided that the company has already registered the class of securities for which the options may be exercised (generally, the common stock).

IRS Circular 230 Disclosure:  To ensure compliance with requirements imposed by the IRS, we inform you that any tax advice contained in this communication (including any attachments) was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding any tax penalty or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

Click here for a printable version