United States: Rule 701 Enhanced Disclosure Threshold To Increase

On May 24, 2018, President Trump signed into law the Economic Growth, Regulatory Relief, and Consumer Protection Act (Reform Act).1 Although largely focused on regulatory exemptions for smaller financial institutions, the Reform Act also amended a number of securities law provisions focused on capital formation. For a detailed summary and analysis of the Reform Act, including the capital formation related provisions, see our client memorandum " First Major Dodd-Frank Reform Bill Signed into Law." 

One important provision tucked into the securities law-focused amendments was a direction to the Securities and Exchange Commission (SEC) to increase, from $5 million to $10 million, the amount of securities that a company can issue to employees and other service providers in reliance on Rule 701 in any consecutive 12-month period without triggering enhanced disclosure obligations.


Rule 701 provides an exemption from the registration requirements of the Securities Act for the issuance of stock, options or other securities by private companies to their employees, directors, consultants and advisors under a compensatory benefit plan. Many private companies rely on Rule 701 as an important tool to efficiently issue stock and options to recruit and retain talent. There are a number of conditions that must be met to rely on Rule 701, including those relating to which entity may issue the securities, who may receive the securities, limits on the aggregate amounts that can be sold during any 12-month period, disclosure requirements and restrictions on resale. The Reform Act requires the SEC to increase the threshold triggering enhanced disclosure obligations for reliance on the exemption.

Increasing the Enhanced Disclosure Trigger

Although all companies seeking to rely on Rule 701 must provide investors with a copy of the compensatory benefit plan or contract under which the stock, options or other equity securities are being granted, Rule 701 currently requires enhanced disclosures if the aggregate amount of securities sold during any consecutive 12-month period is in excess of $5 million. The Reform Act requires the SEC to increase this threshold to $10 million within 60 days of enactment of the Reform Act and further provides that the $10 million threshold will be indexed to inflation every five years. 

A company that sells securities in excess of the threshold is required to provide investors with the following enhanced disclosures "a reasonable period of time before the date of the sale":

  • If the plan is subject to ERISA, a copy of the summary plan description required by ERISA;
  • If the plan is not subject to ERISA, a summary of the material terms of the plan;
  • Information about the risks associated with an investment in the securities; and
  • Financial statements as of a date no more than 180 days before the sale of the securities.2

We note that the enhanced disclosure must be provided to any person who receives securities under Rule 701 during the 12-month period.3 Therefore, even if the threshold has yet to be exceeded, companies should provide the enhanced disclosure if there is reason to believe it will ultimately be exceeded within the 12-month period. It is important that companies be diligent about tracking the aggregate securities sold in any consecutive 12-month period in order to determine compliance with the offering limitations in Rule 701, as well as to determine if the enhanced disclosure obligation will be triggered. The change to the enhanced disclosure threshold mandated by the Reform Act is not effective today. The SEC is required to adopt implementing rules.

Our Take

Interestingly, the mandate to the SEC to revise the Rule 701 enhanced disclosure obligation threshold comes on the heels of a widely-publicized SEC enforcement action against Credit Karma for its failure to provide the Rule 701-required enhanced disclosures in connection with the issuance of stock options, which were well in excess of $5 million over a 12-month period. This SEC enforcement action was the first of its kind. For a summary of the Credit Karma enforcement action, see our client memorandum " Private Company Fined for Failure to Comply with Rule 701 in Option Exercises." 

Rule 701 has largely sat unchanged since 1999. Although there has been SEC Staff interpretative guidance around the application of the rule, the key thresholds for the use of the exemption—the aggregate issuance cap4 and the enhanced disclosure obligation threshold—have remained the same even as companies have stayed private longer and grown larger and larger during this period. So, an increase to the enhanced disclosure obligation threshold will be a meaningful improvement to how Rule 701 functions as a tool for companies to compensate their employees, but there are other conditions of the rule that have frustrated private companies.

In September 2017, the SEC's Advisory Committee on Small and Emerging Companies issued recommendations to the SEC detailing a number of reforms to Rule 701.5 These recommendations included eliminating the aggregate issuance cap, increasing the enhanced obligation threshold to $10 million and addressing a number of other areas that have long made Rule 701 a cumbersome process.

With the Congressional action on Rule 701, the prospect of further Congressional action related to Rule 701 seems very unlikely. Additionally, although SEC Chairman Jay Clayton has made capital formation a key priority for the agency, Rule 701 reform has not been listed among his specific priorities or identified on the SEC's rulemaking agenda, so it does not seem likely that the SEC will pick up the Rule 701 baton from Congress. The only hope for additional reform in this area is that, as part of the rulemaking to implement the amendments mandated by the Reform Act, the SEC sees an opportunity for a deeper look at Rule 701.


1   The Reform Act can be found at: https://www.congress.gov/bill/115th-congress/senate-bill/2155/text?r=4#toc-HCA5FAF0C5DFF4F53AE97BCCC48768FD7

2  Foreign private issuers as defined in Rule 405 must provide reconciliation to U.S. GAAP if their financial statements are not prepared in accordance with U.S. GAAP or provide financial statements prepared in accordance with International Financial Reporting Standards as issued by the International Accounting Standards Board.

3  SEC Compliance and Disclosure Interpretation 271.12, available at: https://www.sec.gov/divisions/corpfin/guidance/securitiesactrules-interps.htm.

4  Under Rule 701, companies are limited to an aggregate issuance cap equal to the greater of (1) $1 million, (2) 15% of the issuer's total assets and (3) 15% of the outstanding class of offered securities.

5  For the recommendations of the SEC's Advisory Committee on Small and Emerging Companies, see https://www.sec.gov/info/smallbus/acsec/acsec-rule-701-recommendation-2017-09-21.pdf

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