California Department of Corporations Adopts Less Restrictive Stock Plan Rules

07.17.2007

The California Department of Corporations has adopted important and long-awaited amendments to state securities law regulations, easing the substantive restrictions on stock option and stock purchase plans operated in California.  These rules affect not only privately-held companies, but also publicly-traded companies whose stock is either not listed on a stock exchange or listed on certain smaller stock exchanges.  The amendments are effective July 9, 2007.

For many years, California has imposed substantive restrictions on the terms of employee stock and option plans operating in California, including minimum pricing and minimum vesting requirements, voting rights restrictions, and restrictions on company repurchases.  While these amendments have not removed all the substantive restrictions, many of the more onerous ones have been eliminated or liberalized, bringing California’s requirements in line with those of most other states.

Details on California Stock Plan Regulations

Many privately-held companies operating in California seek to use the exemption available under Section 25102(o) of the California Corporate Securities Law for grants of stock options or other securities under equity compensation plans.  In order to qualify for the exemption, the plan had to conform to a number of requirements set forth in the California Code of Regulations.  Public companies whose stock is either not listed on any stock exchange or listed on certain smaller stock exchanges, are subject to similar rules.  (Companies listed on the NYSE, the American Stock Exchange or Nasdaq are “covered securities” under Section 18 of the Securities Act of 1933, and therefore not subject to the California qualification rules).  The California regulations previously included a number of specific restrictions including minimum pricing and minimum vesting requirements, voting rights restrictions, and restrictions on company repurchases. 

Under the amended rules, many of the more onerous restrictions are now being eliminated.   Keep in mind, however, that plans seeking to use the Section 25102(o) exemption must still comply with the requirements of Rule 701 under the Securities Act (the primary Federal exemption for compensatory equity grants).  Rule 701 imposes certain limits on the number of shares that can be granted under the exemption, and also has specific disclosure requirements.  Grants of incentive stock options must comply with the ISO rules as well.

Going forward, a stock option plan may qualify for the Section 25102(o) exemption by conforming to the following rules affecting the substance and structure of the plan:

• The plan must comply with the requirements of Rule 701.
• Options may only be granted to natural person who are employees, officers, directors, consultants, or other service providers (as defined by Rule 701) of the company, the company’s majority-owned subsidiaries, or majority-owned subsidiaries of the company’s parent, as part of a compensatory benefit plan.
• Options must have an exercise period of not more than 120 months from the date each option is granted.
• Options may not be transferable, except by will, the laws of descent or distribution, to a revocable trust, or as permitted by Rule 701.
• The plan must contain a provision that options be proportionately adjusted in the event of a stock split, reverse stock split, recapitalization or similar transaction.
• Unless employment is terminated for cause, options must contain the right to exercise the option in the event of termination of employment, to the extent that the optionee is entitled to exercise on the date employment terminated, until at least 30 days from the date of termination (6 months from the date of termination if termination was caused by death or disability), or, if earlier, the stated expiration date of the option.
• Options must be granted within 10 years of the date the plan was adopted or the date the plan was approved by shareholders, whichever is earlier.
• The stock option plan must be approved by the shareholders within 12 months of the later of the date the plan was adopted or the first option grant was made under the plan.  Option granted after the plan approval date, but before the shareholder approval date, must be rescinded if shareholder approval is not obtained within the prescribed period.

Similar regulations apply to plans authorizing grants of restricted stock or other equity securities.    

The new rules eliminate the specific restrictions on repurchase rights, exercise price, minimum vesting requirements and voting rights in the prior rules for plans relying on the Section 25102(o) exemption. 

As noted above, public companies that are unlisted or that are not listed on a major exchange are also subject to the California rules.  Public companies required to comply with these rules are not eligible for the Section 25102(o) exemption, but must file a permit application with the California Department of Corporations under Section 25111 or 25113 of the California Corporate Securities Act.  In reviewing permit applications for stock plans, the California Department of Corporations will generally apply the same substantive standards as apply to plans exempted under Section 25102(o), with several important exceptions.  Plans not eligible for Section 25102(o) must still comply with certain repurchase restrictions (the period during which a company may repurchase stock following employment termination may not exceed 6 months, and repurchase rights on shares held by non-officer employees must lapse at the rate of least 20% per year over 5 years from the grant date).  In addition, the number of securities issuable under the plan may not exceed 30% of the then-outstanding number of shares, unless the right to exceed this limitation is approved by a 2/3 shareholder vote.  Plan participants must also receive financial statements of the company at least annually.

Foreign private issuers are exempt from the regulations, as long as there are no more than 35 California residents granted options or securities under a plan, whether or not the California recipients are accredited investors under the Federal securities laws.

The amended rules mean that companies with plans operating in California in reliance on Section 25102(o) may now have more flexibility with respect to the design of their plans. Specifically:

• Companies can now grant performance-vesting options to non-officers; previously, such grants were restricted by the minimum vesting rules.
• Companies may now make option grants to a 10% shareholder with an exercise price at fair market value; previously, such grants had to be made at 110% of fair market value.
• Companies eligible for the Section 25102(o) exemption can now use longer repurchase periods.
• Companies may now grant awards of non-voting stock; previously, the class with the most favorable voting rights had to be used.
• Companies may rely on Section 25102(o) with respect to grants of full-value restricted stock and stock unit awards; previously, these awards were problematic, because of the requirement in the old rules that employees purchase stock at a purchase price equal to at least 85% of fair market value on the grant date.

Companies who included restrictions in their plans to comply with the prior California regulations may now want to consider amending those plans to remove the restrictions.

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.

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