SEC Adopts Rules Exempting Compensatory Employee Stock Options from Registration Under Section 12(g) of the Exchange Act
12/07/2007

The Securities and Exchange Commission (the “SEC”) has adopted two new exemptions from the registration requirements of Section 12(g) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), for compensatory employee stock options.

Section 12(g) of the Exchange Act requires a company with 500 or more holders of record of a class of equity security and assets in excess of $10 million at the end of its most recently ended fiscal year to register that class of equity security unless an exemption from registration is available. Stock options, including those issued to employees under stock option plans, are treated as a separate class of security for purposes of the Exchange Act. Although Exchange Act Rule 12h-1(a) provides an exemption from registration for interests in “stock bonus, stock purchase, profit-sharing, pension, retirement, incentive, thrift, savings or similar plans,” there was previously no exemption for compensatory employee stock options. Since the early 1990s, the SEC’s Division of Corporation Finance has provided no-action letter relief to private companies faced with registration under the Section 12(g) of the Exchange Act solely due to their compensatory employee stock options being held by 500 or more holders of record (and having more that $10 million in assets), subject to meeting certain criteria.

The new exemptions from Section 12(g) of the Exchange Act for compensatory employee stock options are available to private companies that are not required to file periodic reports under the Exchange Act and to public companies that are required to file those reports. The purpose of the new exemptions is to provide both public and private companies guidance and certainty in their compensation decisions and to prevent private, non-reporting companies from becoming subject to the registration and reporting requirements of the Exchange Act prior to the time they have public shareholders.

Exemption for Private, Non-reporting Companies

The new rules amend Exchange Act Rule 12h-1 to create a new exemption from the registration requirements of Section 12(g) of the Exchange Act for compensatory employee stock options issued by a private, non-reporting company that does not have a class of securities registered under Section 12 of the Exchange Act and is not subject to the reporting requirements of Section 15(d) of the Exchange Act. The new exemption requires:

• Compensatory employee stock options to be issued under a written stock option plan;
• Plan participants to be limited to employees, directors, consultants, and advisors of the issuer, its parents, or December 2007 Management Alert SEC Adopts Rules Exempting Compensatory Employee Stock Options from Registration Under Section 12(g) of the Exchange Act majority-owned, direct or indirect subsidiaries of the issuer or its parents;
• A prohibition on the transfer of the options and the shares received upon exercise of the options except for one transfer in the event of a family gift, domestic relations order, death or disability; and
• That the issuer provides, either by physical or electronic delivery or by available password-protected internet site, the risk and financial information required under Securities Act Rule 701, if securities sold in reliance on that rule in a 12-month period exceeded $5 million, and financial statements not more than 180 days old.

The exemption for private, non-reporting companies generally allows compensatory employee stock options to be held by those persons described in Securities Act Rule 701(c) or their permitted transferees, which includes employees, directors, general partners, trustees, officers, consultants and advisors only if such persons were employed by or providing services to the company at the time the securities were offered. For purposes of Rule 701, the term “employee” includes insurance agents who are exclusive agents of the company, its subsidiaries or parents, or derive more than 50% of their annual income from those entities. The new rules also permit option holders to receive compensation for their options from the company or arising from a change of control or other acquisition transaction after which the options no longer will be outstanding and the company no longer will be relying on the exemption. In order to ensure that a company will not fail to qualify for the exemption in the event of an impermissible transfer, the new rules permit a company to provide that in such event, the options will terminate automatically or that the company may repurchase the options. In order to qualify for the exemption, all of the foregoing limitations must be set forth in the compensatory plan pursuant to which options will be granted.

The exemption does not extend to any class of securities received or to be received on exercise of the stock option. Thus, a company will have to apply the registration requirements of Section 12 of the Exchange Act to the class of equity security underlying the compensatory employee stock options without regard to the exemption after those options are exercised. If a private, nonreporting company becomes subject to the reporting requirements of Section 15(d) of the Exchange Act, the exemption for compensatory employee stock options will terminate immediately. At such time as the exemption terminates or the company no longer satisfies the criteria of the exemption, the company would have 120 days under the new rules to register the options.

The exemption covers all compensatory employee stock options meeting the conditions of the exemption, even if the compensatory employee stock options are issued under separate written option plans. For the purpose of the exemption, the compensatory employee stock options will be considered to belong to the same class of equity security of the issuer if the same class of securities of the issuer will be issuable on exercise of the compensatory employee stock options.

Exemption for Reporting Companies

The new rules further amend Rule 12h-1 to create a second exemption from the registration requirements of Section 12(g) of the Exchange Act applicable to all companies that are subject to the reporting requirements of Sections 13 or 15(d) of the Exchange Act. This exemption requires:

• That the stock options be issued under a written compensatory plan; and
• That eligible plan participants be limited to employees, directors, consultants, and advisors of the issuer, its parents, or majority-owned, direct or indirect subsidiaries of the issuer or its parents.

While the exemption for reporting companies requires that eligible plan participants be limited to the persons listed above, the exemption allows compensatory employee stock options to be held by those persons described in general instruction A.1.(a) of Form S-8, which includes employees, directors, general partners, trustees (where the company is a business trust), officers, consultants, advisors, and agents who are exclusive agents of the company, its subsidiaries or parents, or derive more than 50% of their annual income from those entities. For purposes of Form S-8 and the exemption for reporting companies, the term “employees” includes former employees as well as executors, administrators or beneficiaries of the estates of deceased employees, guardians or members of a committee for incompetent former employees, or similar persons duly authorized by law to administer the estate or assets of former employees. In addition, securities issued to consultants or advisors will only be covered by the exemption for reporting companies if they are natural persons, they provide bona fide services, and the services are not in connection with the offering of securities, a capital raising transaction or market making activities.

In addition, the exemption for reporting companies will continue to be available even if there is an insignificant deviation from satisfying the eligibility conditions of the exemption, provided that the number of option holders that do not meet the eligibility condition are insignificant both as to the aggregate number of option holders and number of outstanding options. To be able to rely on the exemption, including the insignificant deviation provision, a company must have made a good faith and reasonable attempt to comply with the conditions of the exemption.

As with the exemption for private, non-reporting companies, the exemption for reporting companies does not extend to any class of securities received or to be received on exercise of the stock option. In addition, at such time as a reporting company no longer satisfies the criteria of the exemption, the company would have 60 days under the new rules to register the options.

Compliance

Both of the new exemptions are self-executing and are effective as of December 7, 2007.

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