Federal Securities Aspects of a Stock Option Grant (Federal Securities Exemptions)
The grant of an option, exercise of the option, and purchase of the stock by an employee will constitute the sale of a security. Both the Federal Securities Act of 1933 and the Texas Securities Act make it unlawful for anyone to sell a security unless that security has been registered or there is an available exemption. Under both securities acts, a “security” includes stock and the right to subscribe to or purchase stock. This means the sale of the stock pursuant to the option must comply with both federal and state requirements covering the sale of securities.
Federal Exemption for Stock Option Plans
Rule 701 promulgated under the Securities Act of 1933 (Act) creates an exemption for offers and sales of securities pursuant to certain compensatory benefit plans and contracts relating to compensation. It exempts qualifying offers and sales from the registration requirements of the Act. This exemption is generally available to any corporation that is not subject to the reporting requirements of the Securities Exchange Act of 1934 (Exchange Act) and that is not an investment company registered or required to be registered under the Investment Company Act of 1940.
Rule 701 exempts offers and sales of securities under a written compensatory benefit plan or contract established by a corporation, its parents, its majority-owned subsidiaries, for their employees, directors, general partners, officers, or consultants and advisors, and their family members who acquire such securities from such persons through gifts or domestic relations orders. This rule also exempts offers and sales to former employees, directors, general partners, trustees, officers, consultants and advisors if they were employed by or providing services to the issuer at the time the securities were offered. For this rule to be available to consultants and advisors, they must be natural persons and provide actual services to the issuer, its parents, or its majority- owned subsidiaries. Additionally, these services cannot be in connection with the offer or sale of securities in a capital-raising transaction, and cannot directly or indirectly promote or maintain a market for the issuer’s securities.
For purposes of this rule, a compensatory benefit plan is any purchase, savings, option, bonus, stock appreciation, profit sharing, thrift, incentive, deferred compensation, pension or similar plan. The term “family member” includes any child, stepchild, grandchild, parent, stepparent, grandparent, spouse, former spouse, sibling, niece, nephew, mother-in-law, father-in-law, son-in-law, daughter-in-law, brother-in-law, or sister-in-law, including adoptive relationships, any person sharing the employee’s household (other than a tenant or employee), a trust in which these persons have more than fifty percent of the beneficial interest, a foundation in which these persons (or the employee) control the management of assets, and any other entity in which these persons (or the employee) own more than fifty percent of the voting interests.
The rule limits the amounts that may be sold, with the sales of securities underlying options being counted as sales on the date the option is granted. The aggregate sales price or amount of securities sold in reliance on this rule during any consecutive 12-month period must not exceed the greatest of:
2. 15% of the total assets of the issuer (or of the issuer’s parent if the issuer is a wholly-owned subsidiary and the securities represent obligations that the parent fully and unconditionally guarantees), measured at the issuer’s most recent annual balance sheet date (if no older than its last fiscal year end); or
3. 15% of the outstanding amount of the class of securities being offered and sold in reliance on this section, measured at the issuer’s most recent annual balance sheet date (if no older than its last fiscal year end).
“Aggregate sales price” means the sum of all cash, property, notes, cancellation of debt or other consideration received or to be received by the issuer for the sale of the securities. Non-cash consideration must be valued by reference to bona fide sales of that consideration made within a reasonable time or, in the absence of such sales, on the fair value as determined by an accepted standard. The value of services exchanged for securities issued must be measured by reference to the value of the securities issued. Options must be valued based on the exercise price of the option.
The aggregate sales price for options to purchase securities is determined when an option grant is made (without regard to when the option becomes exercisable). With respect to other securities, the calculation is made on the date of sale. With respect to deferred compensation or similar plans, the calculation is made when the irrevocable election to defer is made.
In calculating 15% of the outstanding amount of the class of securities, the securities underlying all currently exercisable or convertible options, warrants, rights or other securities, other than those issued under Rule 701, are treated as outstanding. In calculating the amount of securities sold for determining the aggregate sales price or amount of securities sold, the corporation must count the amount of securities that would be acquired upon exercise or conversion in connection with sales of options, warrants, rights or other exercisable or convertible securities, including those to be issued under Rule 701.
The amounts of securities sold in reliance on Rule 701 do not affect “aggregate offering prices” in other exemptions, and amounts of securities sold in reliance on other exemptions do not affect the amount that may be sold in reliance on Rule 701.
The issuer must deliver to those receiving the securities a copy of the compensatory benefit plan or the contract, as applicable. In addition, if the aggregate sales price or amount of securities sold during any consecutive 12-month period exceeds $5 million, the issuer must deliver the following a reasonable period of time before the date of sale:
a. If the plan is subject to the Employee Retirement Income Security Act of 1974 (“ERISA”), a copy of the summary plan description required by ERISA;
b. If the plan is not subject to ERISA, a summary of the material terms of the plan;
c. Information about the risks associated with investment in the securities sold pursuant to the compensatory benefit plan or compensation contract; and
d. Financial statements required to be furnished by Part F/S of Form 1-A (Regulation A Offering Statement) under Regulation A. These financial statements must be as of a date no more than 180 days before the sale of securities in reliance on Rule 701.
e. If the issuer is using its parent’s total assets to determine the amount of securities that may be sold, the parent’s financial statements must be delivered. If the parent is subject to the reporting requirements of section 13 or 15(d) of the Exchange Act, the financial statements of the parent required by Rule 10-01 of Regulation S-X and Item 310 of Regulation S-B, as applicable, must be delivered.
f. If the sale involves a stock option or other derivative security, the issuer must deliver the above a reasonable period of time before the date of exercise or conversion. For deferred compensation or similar plans, the issuer must deliver the above a reasonable period of time before the date the irrevocable election to defer is made.
Offers and sales exempt under Rule 701 are deemed to be a part of a single, discrete offering and are not subject to integration with any other offers or sales, whether registered under the Act or otherwise exempt from the registration requirements of the Act. Securities issued under Rule 701 are deemed to be “restricted securities” as defined in Rule 144, and resales of securities issued pursuant to Rule 701 must be in compliance with the registration requirements of the Act or an exemption from those requirements.
If Rule 701 is not available, then there are other federal exemptions that may apply. Also, it will be necessary to satisfy the Texas Securities Laws.
For additional information, please see the accompanying articles: Employee Stock Option Plans, Tax Aspects of a Stock Option Plan , Option Plan Decisions , Stock-based Compensation, Stock Appreciation Rights, Phantom Stock, Performance Units, Non-Qualified Deferred Compensation Plans.
This informational memorandum from the law offices of Thomas D. Solomon, P.C. is provided as a courtesy to our friends and clients to provide them with items of interest in the stock option plans area. It is not and is not intended to be an exhaustive treatment of its subject matter, but rather an overview of some of the pertinent elements of such subject. It is not intended to be legal advice or a legal opinion and should not be relied on in making legal or business decisions. If you have any questions, please contact us at 713-984-9400 or use the contact form.