Corp Fin's New Rule 701 C&DI And California's Compensation Plan Exemption

Yesterday, Broc Romanek reported that Corp Fin has published a new C&DI addressing the permissibility of electronic delivery of disclosures under Rule 701(e).  Readers will recall that Rule 701 is an exemption from the registration requirements of the Securities Act for offer and sales of securities pursuant to compensatory benefit plans and contracts.  The rule is available only to issuers that are not subject to the Exchange Act's reporting requirements.  Thus, Rule 701(e) requires the issuer to "deliver" certain financial and other disclosures when the amount of securities sold during any consecutive 12-month period exceeds $5 million.  The C&DI issued on Monday expresses the staff's view on whether an issuer may implement safeguards with respect to these disclosures when they are made electronically:

We understand that some companies satisfying their Rule 701(e) delivery obligations electronically have concerns about the potential disclosure of sensitive company information. Standard electronic safeguards, such as user-specific login requirements and related measures, are permissible. The use of a particular electronic disclosure medium either alone or in combination with other safeguards, such as the use of dedicated physical disclosure rooms that house the medium used to convey the information required to be disclosed, should not be so burdensome that intended recipients cannot effectively access the required disclosures.  For example, we would expect that physical disclosure rooms would be accessible during ordinary business hours upon reasonable notice. Once access to the required information has been granted, however, the medium used to communicate the required disclosure should provide the opportunity to retain the information or have ongoing access substantially equivalent to personal retention.

While implicitly recognizing that non-reporting issuers have a legitimate interest in preventing the disclosure of sensitive financial information to third persons, the C&DI does not specifically address what limitations an issuer may place on the use of the disclosures.  For example, can these safeguards preclude disclosure of information in connection with an employee's resale of the security or are safeguards permissible only to protect against disclosure to competitors?

Companies relying on Rule 701 will need to identify a state level exemption for the offer and sale of securities pursuant to their compensation plans and agreements.  To state what should be obvious, the application of a state's securities laws does not depend upon the jurisdiction of incorporation or formation of the issuer.  Thus, a Delaware corporation offering and selling securities in California must be just as concerned with California's qualification requirement as a California corporation.

California has a statutory exemption from qualification for offers and sales of a security issued by a corporation or limited liability company that is exempt under Rule 701.  Cal. Corp. Code § 25102(o).  The terms of the purchase plan and agreement must also meet comply with the Commissioner of Business Oversight's standards for qualification for purchase plans (10 CCR §§ 260.140.42, .45 & 46) or option plans (10 CCR §§ 260.140.41, .45 & 46), as the case may be.  The statute further requires the filing of a notice with the Department of Business Oversight and the payment of a fee.

Rule 260.140.46 requires that the plan or agreement provide that security holders will receive financial statements at least annually.  This ongoing disclosure requirement is in contrast to Rule 701(e) which requires disclosure either before exercise (in the case of an option or other derivative security) or the irrevocable election to defer (in the case of a deferred compensation arrangement).  The California rule also parts company with Rule 701(e) by mandating that the disclosure requirement appear in the plan or agreement.  Issuers relying on Rule 701 will not need to concern themselves with these differences because the California rule does not apply when a plan or agreement complies fully with Rule 701.

This doesn't mean that California's Rule requiring disclosure is irrelevant.  Many issuers can not utilize Rule 701(e) and hence may not rely on Section 25102(0).  These issuers include companies that exceed the thresholds in Rule 701(d) and companies subject to the Exchange Act reporting requirements with no securities listed on a national securities exchange.  Generally, the Commissioner of Business Oversight will require these issuers to comply with Rule 260.140.46 in connection with qualification of the offer and sale of securities under their compensatory plans.