Jonathan G. Katz, Secretary
The Securities and Exchange Commission
Office of Investor Education and Assistance
450 Fifth Street, NW
Washington, D.C. 20549
Re: File No. S7-5-98; Release No. 33-7511; Proposed Changes to Rule 701 dated February 27, 1998 (the "Rule 701 Release")
Dear Mr. Katz:
We welcome the Commission's efforts to clarify and revise Rule 701 as proposed in the above-referenced Release and appreciate the opportunity to submit our comments to certain proposed changes, which are set forth below.
(1) Amend Rule 701 to Comport With Current and More Flexible Interpretations.
We agree with the Commission’s general policy announced in the Rule 701 adopting release where the Commission stated it had been persuaded by commenters that issuances to consultants and advisors also can be for compensatory and not capital raising purposes and thus there is no meaningful basis for distinguishing between issuances to them and to employees. See Release No. 33-6768 (May 20, 1988). We further agree with the Staff's interpretations since the adoption of Rule 701 broadening the scope of non-employees eligible to receive issuances to include sales representatives, distributors, franchisees and physicians participating in managed care arrangements. See citations set forth in the Rule 701 Release at Note 26. With a ten year history behind it, Rule 701 continues to be a valuable tool to compensate a company’s employees and non-employee consultants and advisors while aligning the interests of such persons with the interests of the company’s stockholders. Moreover, because the securities issued under Rule 701 are restricted, the Commission has apparently not encountered the same type of abuses that are associated with Form S-8, with issuers selling securities to consultants and advisors, who are in effect underwriters in reselling the securities to the public. The restricted nature of securities issued under Rule 701, coupled with the requirement that issuances be for compensatory and not capital raising purposes, should be sufficient to prevent abuse and negate any need to distinguish between employees and non-employees.
The Commission recently proposed restrictions on issuances to consultants and advisors registered on Form S-8 in Release No. 33-7506, dated February 17,1998 (the "Form S-8 Release"). In the Rule 701 Release, the Commission requested comments on whether some or all of these restrictions should apply to Rule 701. With one possible exception discussed below, we do not believe any such restrictions should apply to Rule 701. Consultants and advisors should not only be retained as eligible participants under Rule 701, but the Staff’s interpretations broadening the scope of eligible non-employees should be codified to include within the definition of such persons those who sell, market and/or distribute the issuer’s products or services (hereinafter the term "consultants and advisors" shall be considered to include such persons). In addition, the Commission’s suggestion that Rule 701 eligibility of a consultant or advisor be based on the percentage of income they derive from sales of the issuer’s products should not be adopted because it would be too cumbersome in practice and of limited utility, and it artificially draws a line that may have no bearing on the true value or importance of the consultant or advisor to the issuer. Current Rule 701 implicitly requires such percentage to be significant enough to qualify the issuance as compensatory, and that should be sufficient. The extent of a non-employee’s relationship with the issuer is more properly addressed in connection with the level of disclosure such person receives (see disclosure discussion below). One proposed rule change in the S-8 Release that may provide additional protection in the Rule 701 context without unduly burdening the rule is prohibiting participation by consultants or advisors that directly or indirectly promote the issuer’s securities.
Although generally eschewing the Form S-8 Release restrictions on the eligibility of consultants and advisors in the Rule 701 Release, the Commission, without explanation, proposes to adopt one such restriction, which we believe would be particularly problematic in the Rule 701 context. Part III.D of the Rule 701 Release proposes a revision to make it clear that Rule 701 is available to plans and agreements encompassing consultants and advisors without regard to exclusivity of representation of the issuer, as long as they render bona fide services that are not in connection with capital raising. However, imbedded in this proposed clarification is a new requirement that consultants and advisors be natural persons. This change appears to be a codification of the Commission’s policy in the context of registration on Form S-8. See Image Entertainment, Incorporated (March 6, 1992) and Aaron Spelling Productions, Inc. (July 1, 1987), cited and discussed in the Form S-8 Release at page 10. However, the Commission has not previously indicated that this position carried over to Rule 701, and it is inconsistent with the above-described Staff interpretations broadening the scope of non-employees eligible for issuances under Rule 701, as well as the literal language of the Rule. Through discussions with the Commission prior to submitting this comment letter, we understand that the natural person requirement in the Rule 701 Release was not intended to imply a codification of prior policy in the Rule 701 context.
Even if additional protection is warranted to prevent abuses under Form S-8, this rationale should not be carried over into Rule 701 where there is already protection in place. As discussed above, securities issued under Rule 701 are restricted, and this distinction, coupled with the requirement that issuances be for compensatory and not capital raising purposes, has been sufficient to prevent abuse of Rule 701 for the past 10 years. Moreover, in our experience, primarily because of widespread concerns about liability and litigation in our increasingly litigious society, the vast majority of consultants and advisors, regardless of the service being rendered, do so through entities. Therefore, requiring consultants and advisors to be natural persons will severely limit the intended utility of the rule without any significant corresponding benefit. For this reason, although technically beyond the scope of our response to the Rule 701 Release, we ask that the Commission also reconsider its position requiring consultants and advisors to be natural persons in the Form S-8 context. Historically, the restriction seems to have been aimed at preventing unbridled expansion of the scope of consultants and advisors by requiring them to look like employees. However, as in the Rule 701 context, there seems to be no purpose in prohibiting participation of consultants and advisors under Form S-8 merely because they perform services through an entity organized for the purpose of limiting their liability. The requirement that issuances to consultants and advisors be compensatory, together with other restrictions discussed in the Form S-8 Release, are more clearly targeted at limiting abuse and should be sufficient to achieve that purpose.
The Form S-8 Release proposes to adopt the natural person restriction by adding it to the definition of an "employee benefit plan" set forth in Rule 405 and General Instruction A.1(a)(1)(iii) to Form S-8. Rule 701 does not refer to the Rule 405 definition, but instead inserts the restriction in proposed Rule 701(c)(1). In the event the Commission determines to adopt the restriction for Form S-8 purposes, but not for Rule 701 purposes, it should consider moving the restriction out of Rule 405. Its presence in Rule 405 appears unnecessarily duplicative, and the Rule 405 definition of an "employee benefit plan" is incorporated into exemptions from registration under certain blue sky laws relied upon by Rule 701 issuers. See e.g., Washington Interpretive Statement No. 6 (January 1, 1991, as amended on January 1, 1996). There may also be other cross-reference problems under state and federal securities laws if the restriction remains imbedded in Rule 405.
If the Commission determines that it must provide further restrictions in the Rule 701 context to prevent abuse, one alternative that would be more effective and less counterproductive than requiring consultants and advisors to be natural persons is to require that one or more of the following transfer restrictions apply to non-employee issuances: (1) options must be nontransferable, except under the laws of descent and distribution (General Instruction A.1(a) to Form S-8 provides a substantially similar restriction), (2) shares of stock must be subject to a right of first refusal in the company and/or the remaining stockholders prior to any transfer to third parties, and (3) shares of stock must be subject to a right of repurchase in the company and/or the remaining stockholders on termination of the non-employee’s contractual relationship. If any such transfer restrictions are adopted, there should be exceptions for intra-family transfers, like those described in proposed Rule 701(c).
2. Disclosure to Persons Covered by Rule 701.
We generally agree with the concept of setting forth certain standard disclosure obligations in Rule 701. However, because securities issued under Rule 701 are restricted and such issuances are for compensatory and not capital raising purposes, comparisons to disclosure regimes under Form S-8 or Regulations A and D are not particularly useful. It is clear that disclosure is required to inform participants in a Rule 701 offering of the terms and conditions of the securities being issued to them. This is generally achieved by distributing to the participant a copy of the plan or agreement describing such terms. Whether additional disclosure is warranted, and the extent of such disclosure, should be determined by first looking at the level of investment being made by the participant and then evaluating the participant’s level of familiarity with the business of the issuer (i.e., affinity) and/or the level of the participant’s sophistication with regard to investments.
In our general experience, most Rule 701 issuances fall into one of three categories: (1) stock grants, with or without forfeiture conditions, (2) stock option grants, statutory or non-qualified, and (3) stock purchases. Where Category (1) grants are made for incentive purposes, and not as consideration for past or future services, no disclosure should be required because the participant is making no investment. It is analogous to a stock bonus plan, which the Staff has generally not required to be registered based on the position that there is no sale under the Securities Act. See Release No. 33-6188 (February 1, 1980). In almost all instances, eligible persons will decide to participate if given the opportunity.
Where Category (2) grants are made for incentive purposes and not as consideration for past or future services, no disclosure should be required at the time of grant because the participant has not yet made any investment. As indicated in Note 17 of the Rule 701 Release, disclosure is only required in the context of stock option grants at the time of exercise, which in our experience frequently does not occur until after the issuer’s stock becomes publicly traded, or in the event of a sale of the issuer’s business. Absent such an extraordinary triggering event, disclosure should be deemed sufficient if the participant receives recent financial statements of the company prior to exercise. The use of unaudited financial statements should be permitted. If financial statements dated within the first 180 days are unavailable, distribution of financial statements dated within the last 12 months, accompanied by a representation by an officer that there has been no material adverse change since the date of the statements, should be permitted. Federal and state antifraud provisions should be sufficient to dictate additional disclosure prior to exercise of options in the event of an extraordinary triggering event.
Where Category (1) and (2) grants are made as consideration for past or future services, or where Category (3) purchases are made, the level of disclosure should be dictated by the participant's affinity with the issuer and/or the financial sophistication of the participant. Where the participant is a director, executive officer or key employee with similar access to information regarding the issuer, there should be no required disclosure. Where the person is an accredited or sophisticated investor, an employee, or a consultant or advisor with more than a certain percentage of its income derived from its relationship with the issuer, recent financial statements should be provided. Where the person is a consultant or advisor with less than such percentage of its income derived from its relationship with the issuer, and such person is not an accredited or sophisticated investor, additional disclosure could be required.
Thank you for the opportunity to express our comments. We would be pleased to further discuss these matters at the Commission's convenience. The undersigned can be reached at the address and telephone numbers provided below.
Very truly yours,
Thomas H. Curzon, Esq.
Osborn Maledon, P.A.
2929 N. Central Avenue, 21st Floor
Phoenix, AZ 85012
602- 640-9308
thcurzon@omlaw.com
Christopher S. Stachowiak, Esq.
Osborn Maledon, P.A.
2929 N. Central Avenue, 21st Floor
Phoenix, AZ 85012
602-640-9353
csstachowiak@omlaw.com