January 31, 2020 | By Patrick T. McCloskey
Startups and early-stage companies frequently compensate their employees with equity securities. Like any other securities offering, these issuances need to comply with federal and state securities laws and regulations. This means that, unless the so-called “no sale” theory applies,1 such issuances need to be registered or exempt from registration at both the federal and state level.
The most common federal exemption relied upon by early-stage issuers for compensatory equity is Rule 701. This exemption is attractive because it covers issuances to both accredited and non-accredited investors and, unless the value of the securities issued upon reliance on Rule 701 exceeds $10.0 million within a 12-month period, there are no extensive disclosure obligations, just a requirement to deliver a copy of the compensatory benefit plan or contract. In addition, Rule 701 doesn’t require any filing with, or clearance from, the SEC.2 The major drawback to Rule 701 is that, unlike the Rule 506 exemption, it does not preempt state securities or “blue sky laws.” This means issuers relying on Rule 701 need to make sure there is an exemption from registration under applicable state securities laws. While some states have an exemption that essentially mirrors Rule 701, New York does not.
Section 359-f(2)(e) of the New York General Business Law (the “GBL”) provides that the attorney general may, upon written application, grant an exemption for “securities issued in connection with an employees’ stock purchase, savings, pension, profit-sharing or similar plan.” In other words, Section 359-f(2)(e) of the GBL requires that the issuer submit a written application with the NYAG’s Investor Protection Bureau in advance and await confirmation of grant of the exemption before offering the compensatory equity. The application is comprised of an affidavit or petition from a principal officer of the issuer and it must be accompanied with a copy of the compensatory plan and the payment of a $300 fee. The issuer must also file a Further State Notice with the New York Department of State, Miscellaneous Records Bureau (with the $75 fee) and, if a foreign issuer, a Form U-2 Consent to Service of Process Form with the New York Department of State, Division of Corporations.3
To the extent the issuer has an effective Form 99 or Form M-11 on file with the Investor Protection Bureau,4 the issuer could file a Further State Notice, but it is not clear whether this general filing would cover a compensatory equity issuance where Rule 701 is relied upon for a federal exemption.
Startups and early-stage companies should be cautious about the technical requirements of Section 359-f(2)(e) of the GBL when Rule 701 is relied upon as a federal exemption for compensatory equity issued to New York employees or service providers. If a company is adopting an equity incentive plan with participants in New York, the safest course of action would be to apply for the exemption at inception to avoid delays at the time of each issuance or grant.
It is also important to note that if an issuer relies on another federal exemption for a compensatory equity issuance (such as Rule 506 or Section 4(a)(2)), the analysis would be different and the issuer would need to approach the situation as it would for a Rule 506 or Rule 4(a)(2) offering in New York (more on that in another blog post).
1 The rationale behind the no sale theory is that no exemption is required where no investment decision is being made by the recipient of the compensatory equity. The SEC takes the position that this situation only applies to broad-based grants under stock bonus plans where there is no direct cost to the employees. Conversely, the SEC takes the position that compensatory equity granted or acquired pursuant to an individual employment arrangement needs to be registered or exempt because such arrangements involve separately bargained for consideration. See SEC Release No. 33-10521, Footnote 2 (July 18, 2018) (citing SEC Release No. 33-6188 (January 15, 1981)).
2 There is an outside limit on the amount of securities a company can issue under Rule 701 during any 12 month period (the greatest of (1) $1.0 million; (2) 15% of the total assets of the issuer; and (3) 15% of the outstanding amount of the class of securities being offered). In addition, Rule 701 is not available to public companies or investment companies.
3 See NYAG Investor Protection Bureau Broker-Dealer and Securities Registration Information Sheet.
4 While the breadth of New York’s blue sky laws are beyond the scope of this blog post, the Martin Act is unique in that it generally requires issuers to register as dealers in their own securities, and this registration is effectuated by the filing of a Form 99 or a Form M-11 (the applicable form depends upon the federal exemption relied upon by the issuer, but both forms are effective for a period of four years).