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Amendments to Form S-8, Rule 701 and Rule 504

The Securities and Exchange Commission (the "SEC") has recently adopted or proposed several rule changes as part of the SEC's ongoing efforts to deter microcap fraud. The SEC's proposals and rule changes are as follows, each of which is summarized below:

  • amendments to Rule 504 of Regulation D under the Securities Act of 1933 (the "Securities Act") effective April 7, 1999 (Release No. 33-7644);
  • amendments to Rule 701 under the Securities Act effective April 7, 1999 (Release No. 33-7645);
  • amendments to Form S-8 under the Securities Act effective April 7, 1999 (Release No. 33-7646) (including related changes to Rule 401(g) and Item 402 of Reg. S-K) and proposed further amendments to Form S-8 (Release No. 33-7647); and
  • reproposed amendments to Rule 15c2-11 under the Securities Exchange Act of 1934 (the "Exchange Act") (Release No. 34-4110).
Amendments to Rule 504 of Reg. D

Rule 504 of Regulation D provides an exemption from the registration requirements of the Securities Act for securities offerings of non-reporting issuers that do not exceed an aggregate annual amount of $1 million. (Certain other offerings must be aggregated with the offering under Rule 504 in order to determine the available sales amount.) Unless the offering is exempt under state law, the transaction must be registered in each state in which the securities are offered. Prior to the recent amendments to Rule 504, the exemption allowed private companies to sell securities to an unlimited number of persons without regard to the investors' sophistication or experience and without specified disclosure obligations. General solicitation and advertising were permitted, and securities could be resold freely by non-affiliates of the issuer, who were not otherwise acting as underwriters.

Pursuant to the recent amendments, Rule 504 now treats exempted securities as "restricted securities" and prohibits general solicitation and advertising. An issuer will only be able to issue unrestricted or freely tradeable securities in a Rule 504 offering and engage in general solicitation and advertising under one of two circumstances:

  • the transaction is registered under a state law that requires the public filing and delivery of a substantive disclosure document to investors prior to sale (Where the sales are to occur in a state without such provisions, the transaction must be registered in a state with such requirements, and the disclosure document must be delivered to all potential purchasers in both states prior to sale.); or

  • for sales solely to accredited investors, the transaction is completed pursuant to a state law exemption permitting general solicitation and advertising.

Offerings under Rule 504 that began on or after April 7, 1999 must comply with these restrictions. In order to issue freely tradeable shares in Rule 504 offerings already in process as of April 7, 1999, the issuer must discontinue the offering and register under a state law requiring delivery of a disclosure document before sale.

As amended, Rule 504 still permits "private" offerings that do not exceed $1 million in a 12-month period. However, issuers may not engage in general solicitation and advertising in connection with such offerings and any securities issued will be restricted.

Amendments to Rule 701

Rule 701 under the Securities Act exempts from the Act's registration requirements offers and sales of securities by private companies to their employees under certain compensatory benefit plans or written compensatory agreements. The scope of the exemption covers securities offered or sold under a plan by a private company to the company's employees, officers, directors, partners, trustees, consultants and advisors. Prior to the recent amendments, the amount of securities subject to outstanding offers, in addition to the amount of securities offered or sold within the preceding 12 months, could not exceed the greatest of $5 million or an amount determined under one of two formulas: (a) 15% of the issuer's total assets measured at the end of the issuer's fiscal year; or (b) 15% of the outstanding securities of the class being offered. Regardless of the formula used, Rule 701 restricted the aggregate offering price of the securities subject to outstanding offers and the amount sold in the last 12 months to no more than $5 million.

Under the amendments, the SEC has removed the $5 million aggregate offering price cap. The maximum aggregate sales price or amount of securities that may be sold in one year under Rule 701 is now the amount equal to the greatest of:

  • $1 million;
  • 15% of the company's total assets (measured at the date of the company's most recent balance sheet if not older than the company's last fiscal year end); or
  • 15% of the outstanding securities of the class of securities being offered (measured at the date of the company's most recent balance sheet if not older than the company's last fiscal year end).

Offers, as opposed to sales, are no longer counted in determining the available exempted amounts. In calculating the 15% of assets test, a wholly-owned subsidiary may include its parent's assets, if the parent fully and unconditionally guarantees the obligations of the subsidiary (and the guarantee does not exceed 15% of the parent's assets).

Under Rule 704, the issuer must provide a copy of the compensatory benefit plan or contract to all offerees. Pursuant to the recent amendments, the issuer must now provide additional specific disclosure to each purchaser if more than $5 million worth of securities are to be sold. The required disclosure is the following:

  • a summary of the plan's material terms, or, if the plan is subject to ERISA, a copy of the summary plan description required by ERISA;
  • risk factors relating to an investment in the securities through the plan; and
  • financial statements that would be required in a Form 1-A offering statement under Regulation A.

If aggregate sales during a 12-month period exceed the $5 million threshold and the issuer has not provided the required disclosure to all offerees prior to sale, the issuer will lose the Rule 701 exemption for the entire offering.

Offerings by foreign private issuers are not subject to the aggregate offering price cap. However, if a foreign issuer exceeds the $5 million amount in a 12-month period, that issuer must provide the same disclosure as a domestic issuer, including financial statements as required by Regulation A. If U.S. generally accepted accounting principles ("GAAP") financials are unavailable, the issuer must provide financials that are reconciled to U.S. GAAP.

The amendments also modified the persons eligible to receive securities under Rule 701. Consultants and advisors traditionally have been among the classes of persons eligible to receive securities under the Rule. Pursuant to the amendments, the scope of eligible consultants and advisors has been made identical to the scope of consultants and advisors eligible for coverage by a Form S-8, as those rules have been amended. (Previously, the coverage of Rule 701 was broader than that of Form S-8). In addition, the SEC expanded Rule 701 to cover sales to employees of majority-owned subsidiaries of the issuer's parent (i.e., brother-sister subsidiaries). Further, the SEC has clarified that sales to former employees may be completed under Rule 701 provided the persons were employees when they were initially offered the securities.

Finally, as amended, Rule 701 also permits sales by immediate family members who acquire the securities through a gift or domestic relations order. The term "family member" has been defined to include: "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."

Amendments to and Proposals Regarding Form S-8

Form S-8 is the short-form registration statement for offers and sales of securities by an issuer to its employees. Form S-8 may also be used for offers and sales to consultants or advisors, under the definition of "employee", who provide legitimate services to the issuer that do not involve the offering of securities in a capital-raising transaction. Among other changes to Form S-8, the recent amendments have modified or, in some cases, clarified, the requirements with respect to sales to consultants.

Prior to the amendments, for a sale of securities to a consultant to be eligible for registration on Form S-8, three requirements had to be met: (1) the consultant or advisor had to be a natural person, (2) the consulting contract had to be between the issuer and the natural person, and (3) the issuer had to issue the securities directly to this natural person. Under the amended rules, shares may still only be issued to a natural person (subject to the limited exception where a consultant or advisor performs services through a wholly-owned corporate "alter ego"). However, the SEC has eliminated the requirement that the consulting contract itself be between the issuer and a natural person.

Moreover, the SEC has clarified when consultants and advisors are considered to be "employees" for purposes of Form S-8 and the Rule 405 definition of "employee benefit plan". Pursuant to the amendments, consultants and advisors are considered to be "employees" for purposes of Form S-8 and Rule 405 only where:

  • they are natural persons;
  • they provide bona fide services to the issuer; and
  • such services are not in connection with the offer or sale of securities in capital-raising transactions and do not promote or maintain, directly or indirectly, the market for the issuer's stock (i.e., are not services reasonably expected to raise or maintain the market price of the stock).

The SEC has offered interpretive guidance on the eligibility of employees and consultants for purposes of Form S-8. According to the SEC, Form S-8 is not available in the following situations: (1) either the issuer or a promoter controls or directs the public resale of the securities or (2) the issuer or an affiliate directly or indirectly receives the economic benefit from a portion of the proceeds from such resales. Otherwise, Form S-8 will remain available for securities issued to traditional employees as compensation, irrespective of the specific type of service provided by the employees. However, in the case of consultants and advisors, the type of services provided will determine whether or not Form S-8 is available.

The following chart provides examples of various services which the SEC has indicated would or would not be within the scope of Form S-8:

Investor/Shareholder Related Services

  • Consultants providing investor relations or shareholder communications services
  • Brokers, dealers and persons who find investors
  • Persons who arrange or effect mergers to take private companies public
Public Relations/Publicity

  • Consultants publishing legitimate scientific/medical research in periodicals generally circulating only within the scientific or medical community
  • Consultants circulating scientific or medical research to a broader audience in a manner reasonably likely to influence the market for a company's stock
  • Consultants providing (traditional) product or corporate image advertising (as long as the activities do not have the purpose or effect of influencing the market)
  • Consultants "hyping" the stock in a newsletter, over the Internet or otherwise publishing information that could be reasonably expected to influence the market for the company's stock
Business/Financial Advisors

  • Consultants advising on business strategies or compensation policies
  • Consultants performing traditional management functions primarily of a capital-raising or promotional nature
  • Attorneys and other consultants assisting a company in identifying acquisition targets or structuring acquisitions (including those in which securities are issued as consideration) unless the deal takes a private entity public
  • Accountants (effectively prohibited from receiving securities under the independence standards)
  • Business development consultants assisting in identifying potential parties for joint technology development, research and development arrangements, etc.
  • ==> Consultants arranging financings through bank credit lines
  • ==> Consultants arranging financings involving any securities issuances (debt or equity)
  • ==> Attorneys representing an issuer in matters not related to securities (litigation, IP work, etc.) or preparing Exchange Act filings
  • ==> Attorneys serving as counsel in a securities offering (whether company or underwriter's counsel)

In addition, the amendments specifically provide that insurance brokers who derive more than 50% of their annual income from the company are eligible under Form S-8 standards regardless of whether the agency relation is exclusive.

The amendments make Form S-8 available for the exercise of employee benefit plan stock options by an employee's family member who acquires the options from the employee through a gift or a domestic relations order. Under the amendments, a "family member" for this purpose is the same as for purposes of Rule 701. A subsequent transferee who is a family member may also exercise the option, so long as he or she received the option by gift or through a domestic relations order from another family member of the employee. However, Form S-8 cannot be used to cover shares acquired upon the exercise of employee benefit options transferred for value. The adopting release provides interpretative guidance on the prospectus delivery requirements of the issuer and the transferor in the case of transfer of options or shares issued pursuant to a Form S-8.

Also, under the prior rules, Form S-8 was only available to former employees for non-transferable stock options and the subsequent sales of the underlying securities. The SEC has now eliminated the "non-transferability" requirement. As amended, Form S-8 is available to former employees (and their families) for the exercise of transferable, as well as non-transferable, options.

The amendments to Form S-8 and Rule 405 with respect to eligible consultants will apply to all Form S-8 registration statements filed on or after April 7, 1999. Currently effective Form S-8 registration statements will be required to comply with the provisions as of May 10, 1999. The amendments to Form S-8 that allow the Form to be used by employees' family members for options transferred by gift or through a domestic relations order will apply automatically as of April 7, 1999 even if the Form S-8 covering the securities became effective prior to such date. It is not necessary to post-effectively amend the Form for this provision to apply.

In connection with the amendments to Form S-8, the SEC has amended Rule 401(g) which provides that any registration statement or amendment is deemed filed on the proper form unless the SEC objects to its use before the effective date of the registration statement or amendment. Effective April 7, 1999, registration statements and post-effective amendments that automatically become effective upon filing are excluded from Rule 401(g) and will no longer be presumed to be filed on the proper form. Therefore, an issuer bears the risk that an automatically effective registration statement (e.g., a Form S-8) is filed on the proper form. If a form available for a specified purpose is used for a different type of transaction, the registration may not be valid. Also, if a form available for sales to a specified class of persons is used for sales to persons other than in that class, the offering may be in violation of Section 5 of the Securities Act.

Also in connection with the amendments to Form S-8, the SEC has modified the disclosure requirements of Item 402 of Reg. S-K. The summary compensation table (in column (g)) must include the sum of the number of securities underlying options transferred by the named executive officer. In addition, reload options issued directly to transferees should be reported as new grants, both in the summary compensation table and in the option/SAR grants table. The option/SAR grants table disclosure requirements apply to all options and SARs granted during the year, including those that subsequently were transferred by the named executive officer. The amendments to Item 402 apply to all Securities Act and Exchange Act documents filed initially on or after April 7, 1999. Amendments to documents previously filed need not include the newly required disclosure.

The SEC has also proposed additional amendments to Form S-8 for which comments will be accepted until May 7, 1999. The SEC is proposing adding the Form S-2 or Form S-3 "timeliness standard" to the current Form S-8 eligibility standards. Under the proposal, in order to be eligible to use Form S-8, an issuer must have timely filed its Exchange Act reports during the one-year period and any portion of a month immediately preceding the filing of the Form S-8 (or any shorter period during which the issuer was required to file reports under the Exchange Act).

In addition, the SEC has proposed a waiting period before a company formed by the merger of a private company into a Exchange Act reporting company with only nominal assets at the time of merger would be eligible to use Form S-8. Under the proposal, the resultant company would not be eligible to use Form S-8 until it has filed an annual report on Form 10-K or Form 10-KSB containing audited financial statements reflecting the merger.

While not proposing any specific amendments, the SEC is seeking comments on means to deter abuses of Form S-8, particularly in the area of issuances of shares to consultants. Among the possible proposals being considered are the requirement of a certification from the issuer or the consultant that the consultant is not engaged in capital raising transactions for the issuer, a limitation on the percentage of shares which may be issued to consultants under Form S-8, or mandated disclosure in an issuer's periodic reports of issuances of shares to consultants under Form S-8's.

Reproposed Amendments to Rule 15c2-11

Rule 15c2-11 of the Exchange Act requires that broker-dealers review basic information concerning an issuer prior to publishing quotations for that issuer's securities. This information includes reporting companies, non-reporting companies, and issuers that file periodic reports with other government agencies. The broker-dealers must have a reasonable basis for believing that such information is accurate and has been obtained from reliable sources. Under the Rule, after one broker-dealer publishes quotations for a security for at least 30 days, other broker-dealers may publish quotations for that security without reviewing information about the issuer. Broker-dealers thereafter may quote indefinitely without reviewing any issuer information.

Under the reproposed amendments, the SEC would require that the first broker-dealer involved in the transaction review the specified issuer information before initiating a priced or unpriced quotation for an unlisted over-the-counter security. Thereafter, any other broker-dealer publishing a priced quotation for the security for the first time would have to review current information about the issuer. The broker-dealer publishing priced quotations would also have to review the issuer information annually. Broker-dealers would have to document their Rule 15c2-11 review and make a record of any significant relationships they have with the issuer or others, including the receipt of any compensation to make a market. They would have to provide all information to customers and other broker-dealers upon request, as well as to any information repository.

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