May 7, 1998

Comments RE: Rule 701 Proposals

Mr. Jonathan G. Katz


U.S. Securities and Exchange Commission

Mail Stop 6-9

450 Fifth Street, N.W.

Washington, D.C. 20549

Dear Mr. Katz:

Please treat the comments in the attached March-April 1998 issue of
The Corporate Counsel at pages 2-4 as this writer's comments on the Commission's proposed amendments to Rule 701.

Please don't hesitate to call me to amplify on any of my comments.


Jesse M. Brill
(510) 548-3494

The Proposed Rule 701 Amendments

As our readers no doubt are aware, on February 27 the SEC issued its proposals to amend Rule 701 (see Release No. 33-7511) which, as our readers know, provides an exemption from 1933 Act registration for non-reporting issuers for securities offered and sold to employees as well as consultants and advisors. [The Rule is also used by non-reporting foreign issuers with U.S. employees, as well as for securities of privately held subsidiaries of public issuers, e.g., where deferred compensation involves a security and the §4(2) exemption is not available.] The comment period expires May 4, 1998.

The New Amount Limit

The main purpose of the new proposals is to remove the Rule 701 $5 million ceiling. The new limit would be the highest of (a) $1 million, (b) 15% of the issuer's total assets, and (c) 15% of the securities of that class. [The proposed rule changes illustrate the Commission's new 1933 Act general exemptive authority granted by NSMIA (see our November-December 1996 issue at pg 7), in that previously Rule 701 was circumscribed by the §3(b) $5 million maximum.]

Sales, Not Offers, Will Be Counted. Unlike the current limit which is based on offers (but see our September-October 1996 issue at pg 9), the new limit will be based on the actual sales in any 12-month period.

The New Disclosure Requirement

The proposals impose on companies a new disclosure requirement. (Previously, the only "disclosure" requirement was to deliver a copy of the plan or written agreement.) As proposed, the issuer must deliver within a reasonable time prior to sale (e.g., exercise of an option):

(1) A copy of the stock plan or contract, as applicable;

(2) A copy of the ERISA summary plan description if the plan is subject to ERISA, or

a summary of the material terms of the plan if the plan is not subject to ERISA;

(3) Risk factors associated with investment in the securities; and

(4) Financial statements in accordance with Form 1-A of Reg A as of a date no more than 180 days prior to the sale.

Re-institute Form 701?

It should not be overlooked that the Staff is also considering re-instituting Form 701, which was allowed to "sunset" in 1993. (See our May-June 1993 issue at pg 7.)


We note that, consistent with the recent S-8 proposals (and with prior Staff interpretations-see our September-October 1992 issue at pg 6), Rule 701 would also extend to immediate family donees and to transferees via a domestic relations order. This would mean that Rule 701 would apply to both transferred stock and exercises of transferred options. We note, however, that the Staff is not inclined to allow privately resold 701 stock to be covered under the Rule 701 resale provision (see our May-June 1993 issue at pg 6). [As our readers may recall, Rule 701 securities are "restricted securities" that "free up" (except for the brokers' transaction requirement) 90 days after the company becomes a 1934 Act reporting issuer.]

Our Comments

The Amount Limit. We generally like the proposed amount limit. Even the smallest companies will benefit from increasing the minimum amount limit from $500,000 to $1 million. We think that companies will welcome the new limits, especially basing the calculation on sales instead of offers. We fear, however, that there could be unforeseen problems with the unlimited offer approach unless companies implement (and disclose to participants) a mechanism for, e.g., limiting option exercises so as not to run afoul of the limits. Thus, if a company's limit is, say, 1,000,000 shares, then as long as not more than 1,000,000 shares are sold in a 12-month period the company could conceivably have outstanding an unlimited number of options. In most instances, this may not be a problem because optionees will wait until after an issuer has gone public to exercise their options (after which all the options could be exercised as Rule 701 options-or pursuant to an S-8, see pg 6 below). But, especially if options have a short term, there could be situations where, e.g., options are about to expire and must be exercised while an issuer is still a private company. While we think the "sale" approach should be adopted, we recognize that, unless companies implement safeguards, there will be a risk of exceeding the 701 limit.

The Disclosure Requirement. We have some reservations about the new disclosure requirements. Although we generally favor disclosure, we have long held the belief that, at least with respect to stock options, beyond informing optionees of the basic terms of the options (and making available the full plan), any other disclosure (including financial information) is superfluous and generally not read.

Moreover, we believe that many companies will find the financial statement requirement onerous, especially small start ups and companies concerned about their financial statements falling into competitors' hands. Our solution here would be to allow companies to elect not to deliver the financial statements but, instead, to be subject to an absolute right of rescission, i.e., for exercises, until financial statements are delivered (which might not be until the company becomes a 1934 Act reporting issuer). This provision should address the Commission's disclosure concern since the 1933 Act remedy for improper or inadequate disclosure would, in fact, be rescission. Although at first blush this may seem like a drastic solution, in fact, generally there will not be many pre-IPO exercises and usually the fair market value of the securities will be higher than the exercise price.

Status of Rule 504

As our readers may recall, the Staff has stated that it intends to revisit Rule 504 to address abuses (presumably to go back to a Rule 144/restricted securities framework). So far, no proposal has surfaced, but look for a proposal in June.

Interestingly, some practitioners have attempted to utilize Rule 504 as a supplement to Rule 701. Although Rule 701 is expressly not subject to integration with any other offers or sales (including Rule 504 offers and sales), the Rule 504 $1 million 12-month lookback includes any other §3(b) sales (which presumably still would include sales under the new, post-NSMIA, Rule 701). [In other words, while Rule 504 sales would not count against the Rule 701 12-month lookback, Rule 701 sales within 12 months prior to a Rule 504 sale would count against the 504 limit.]