Sutherland, Asbill & Brennan LLP
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SUSAN S. KRAWCZYK
DIRECT LINE: (202) 383-0197
May 14, 1998
Filed Electronically: firstname.lastname@example.org
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549
Attention: Mr. Jonathan G. Katz
Re: Proposal to Amend Rule 701
File No. 57-5-98
This letter responds to the request of the Securities and Exchange Commission (the "Commission") in Release No. 33-7511 (March 5, 1998) (the "Release") for comments on proposals to modify Rule 701 (the "Proposed Amendments") under the Securities Act of 1933 (the "1933 Act") presented in the Release. Our comments are focused on the utility of the Rule 701 exemption for non-qualified deferred compensation plans sponsored by privately-held employers for their "top hat" employees 1 and, in the case of insurance company employers, also for their insurance agents. Our comments are based on our practical experience in advising employers, particularly insurers, on the various legal and regulatory implications of deferred compensation plans.
We commend the Commission in publishing the Proposed Amendments. The Proposed Amendments go a long way to making Rule 701 a viable exemption for non-reporting companies offering deferred compensation plans. In particular, the proposal to eliminate an absolute dollar limit on the amount of securities that can be issued in reliance on Rule 701, and the proposal to apply limits only to the amount of securities sold, rather than the amount offered, are commendable changes. These changes, if adopted, will make the exemption available to a greater number of employers, and also strike an appropriate balance between the various interests involved. However, there are several aspects of the Proposed Amendments that we believe deserve further consideration in the context of non-qualified deferred compensation plans. As discussed more fully below, our comments pertain to the use of Rule 701, as proposed to be amended by the Release, as an exemption from 1933 Act registration for non-qualified deferred compensation plans. We are not commenting on other types of plans, such as employee stock purchase plans, that may qualify for the Rule 701 exemption.
I. Financial Information Disclosure Requirements
The Proposed Amendments would require the provision of certain financial and other information to participants within a reasonable time period prior to the sale of securities made in reliance on Rule 701. The required information would consist of three core disclosures, one of which pertains to financial statements for the issuer. In particular, the Proposed Amendments would require that the financial statements be dated no more than 180 days prior to the sale of the securities and would require that the statements be prepared in accordance with generally accepted accounting principles ("GAAP"). We generally support the proposal to require the provision of relevant financial information to eligible participants in most circumstances. However, for the reasons discussed below, we recommend that these requirements be modified in certain respects.
A. Age of Financial Information. The Proposed Amendments require that participants be provided with financial statements that are dated no more than 180 days prior to the sale of the securities. We believe that the conditions regarding the age of the financial statements are unnecessarily restrictive when applied to offerings by deferred compensation plans utilizing measures that are based on measures other than the employers stock or financial performance. For example, such plans may measure a participants interest based on a pre-selected rate or other measure, such as an index of government securities, selected corporate stocks or a designated mutual fund. We believe that plans utilizing such measures present less compelling employer-related disclosure issues under the securities laws, and accordingly, should be accorded relief from the 180-day requirement for financial statements proposed in the Release.
In virtually all cases, deferred compensation plans operate on a year by year basis; the predominant, though not universal, practice among employers is to follow the calendar year since participants themselves generally are on a calendar year tax basis. Moreover, the common practice is to give eligible participants the opportunity during a limited period of time shortly before the beginning of a plan year to elect the amount of compensation to be deferred during the upcoming plan year. For example, participants eligible to participate in a plan for the 1999 compensation year ordinarily would be given the opportunity to make an election during a period in late 1998. Thus, in the case of most of the deferred compensation plans that we are familiar with, the election period occurs during October or November of each year. In our experience, this appears to be the most suitable time for participants to make irrevocable decisions regarding their compensation arrangements for the upcoming year. Participants are well-positioned at that time to evaluate compensation options for the coming year.
An employer holding an election period during October or November thus would be required under the Proposed Amendments to provide financial statements dated no later than March or April, respectively, of the same year. 2 However, in our general experience, many of the employers that as non-reporting companies would qualify for Rule 701 observe a fiscal year based on the calendar year. The 180-day requirement of the Proposed Amendments would effectively require these employers to produce interim financial statements solely for the election period held during the last few months of a calendar year. Requiring interim financial statements -- the effective consequence of the 180-day rule for many employers -- offers no worthwhile benefit to the participants that justifies the effort and expense entailed in producing these financial statements.
A participants decision to participate in a non-qualified deferred compensation plan is inherently a long-term decision. Generally under deferred compensation plans, deferrals, once elected, are irrevocable, and deferred amounts are not payable to a participant until termination of employment or some future date or event, such as retirement, which is likely to occur some years into the future. Furthermore, under most plans, a participant may not assign or transfer his or her rights under the plan except in connection with the laws of descent and distribution. Financial information for the short, interim period that may have elapsed since the date of the prior years financial statements, is simply not relevant to the long-term decision inherent in a deferral election. We submit that the most recent year-end financial information should be sufficient for participants to make an election under a deferred compensation plan since in this context financial statements will be used only to assess historical financial stability.
It is important to keep in mind that the deferred compensation plans being addressed by this comment, unlike other employee plans that may qualify for Rule 701, are purposely structured to offer long-term compensatory arrangements based on a specified measure that is not tied to the financial performance of the employer or its stock. Admittedly, interim financial information is of importance to a participant when the plan under consideration bases benefits directly on the employers ongoing financial performance or current value of its stock price. However, interim financial information for the employer has no relevance to a participant when the plan under consideration utilizes measures for calculating benefits that are based on other measures, such as a specified rate, index or mutual fund.
There are several significant examples in which the Commission has been flexible regarding the updating of financial statements in certain circumstances. Rule 13(a)-13(c) under the Securities Exchange Act of 1934, for example, exempts mutual life insurance companies from the requirement to provide quarterly financial information. Indeed, in the case of insurers, the 1933 Act registration statement for variable annuities, Form N-4, generally does not require an insurer to provide financial statements more current than the statements prepared as of its last fiscal year end, regardless of when the registration statement becomes effective. 3 Recently, the Commission proposed the adoption of a new registration statement form for variable life insurance policies, which would provide a similar exemption from the requirement to update financial statements. 4 We submit that, if annual financial statements are adequate for registered variable annuities or variable life insurance policies offered by insurers, annual financial statements should be as adequate for deferred compensation plans sponsored by insurers and offered in reliance on an exemption from registration under the 1933 Act.
It is our strong belief that, if no relief is forthcoming in this regard, employers seeking to qualify for the Rule 701 exemption will simply schedule the election period early enough in their fiscal year to avoid interim financial statement requirements. Eligibility to participate would close earlier in the year than is commonly the case, and would force participants to make irrevocable decisions months in advance of having all relevant compensation information for the plan year in question. Obviously, such an approach would not be in the best interest of participants and would require participants to make decisions based on less information rather than more. We strongly urge that the Commission consider making an exception from the 180-day rule for deferred compensation plans utilizing a measure not based on the employers financial performance or its stock performance.
B. Presentation of Financial Statements. The Proposed Amendments would require that financial statements be prepared in accordance with generally accepted accounting principles ("GAAP"). We believe that employers should have flexibility regarding the accounting principles followed for the presentation of financial information provided to participants in reliance on Rule 701. More particularly, we believe that the financial statements to be delivered to plan participants should not be required to be prepared in accordance with GAAP if the employer is required to prepare financial statements in accordance with another set of accounting principles.
For example, an insurance company should be able to provide financial statements on the relevant "statutory basis." Insurance companies, under the insurance laws of all states, are required to prepare financial statements on a "statutory basis" ("STAT"). STAT financial statements show a company on a liquidation basis. This presentation may even be more appropriate in the context of deferred compensation plans than financial statements showing a company as a "going concern" under GAAP. 5 After all, the primary risk under deferred compensation plans is that, because the employers promise to pay is not guaranteed, any compensation deferred into the plan may be reached by the employers creditors in the event of an employers insolvency. The liquidation basis of STAT financial statements is illustrative of what creditors could reach in the event of an insurers insolvency. A GAAP presentation would not provide any more meaningful information to participants. Moreover, preparation of GAAP financial statements entails considerable expense and effort for an insurer that has no other reason to produce GAAP financial statements.
In light of these considerations, we recommend that the general principle for financial statements provided in the context of deferred compensation plans should be that whatever financial statements the employer may otherwise be required to prepare for a regulatory authority would be presumed to be sufficient.
II. Comments in Response to Other Matters
A. Applicability to Consultants and Minimum Business Standards. The Release requests comment on whether consultants and advisors should continue to qualify as eligible participants, whether the definition of these terms should be narrowed, and whether eligibility standards should apply to them, such as minimum income from the issuer. We believe that consultants and advisers, such as insurance agents (whether or not exclusive), should qualify as eligible participants in offerings relying on Rule 701. In the case of insurers, deferred compensation plans represent a significant piece of the compensation package for their agents. In most cases, these agents are not employees of an insurer and are not even "captive" to a single insurer. Few insurance carriers are able to make a full product line of insurance products available to their agents. Most agents desiring to provide "full services" to their clients must represent more than one carrier in order to provide a full product line and may offer other non-insurance services, such as financial advice or securities brokerage, in compliance with applicable law. It is critical that insurance agents be permitted to participate in deferred compensation plans sponsored by insurers whose products they sell. Most agents do business on an independent contractor basis and are not eligible to participate in qualified retirement plans. Non-qualified deferred compensation plans offer agents the only program sponsored by an employer organization that they can participate in.
It is equally critical that agents ability to participate not be dependent upon some arbitrary minimum percentage of income from an employer organization. While insurers may impose minimum production levels for eligibility in their plans, no insurers are in a position to monitor the business activities of their agents to ascertain whether agents derive a certain minimum percentage of income from the insurer in relation to other sources of income. Imposing such a standard would require insurers to request information from agents concerning income from their overall business activities -- information that in our experience is not ordinarily made available by insurance agents to insurers. In view of the information gathering burden that such a standard would impose, we strongly urge the Commission to discontinue consideration of a minimum business requirement.
Finally, the Release requests comment on whether the definition of consultant and advisor should be narrowed to the definition used with Form S-8. As noted in the Release, narrowing the definition of consultant and advisor would reverse the staffs long-held position under no-action letters with regard to Rule 701. Moreover, as a practical matter it would disqualify almost all insurance agent deferred compensation plans because, as discussed above, very few agents are truly "captive" or "exclusive" to a single insurer. The abuses found under Form S-8 have not been found to be present under Rule 701. Such abuses should be addressed by ensuring that such consultants or advisors render bona fide services that are not in connection with capital raising transactions -- not by excluding an entire class of eligible participants. We recommend that the Commission codify its no-action position allowing consultants and advisors to participate in plans that may be exempt under Rule 701 regardless of whether or not their arrangements with an employer are exclusive.
B. Exemption from Specific Disclosure Requirements for Small Offerings. The Release requests comment on whether, if specific disclosure requirements are adopted, they should apply only to those offerings exceeding some specified floor, such as $1 million. We believe that it would be appropriate -- and we urge the Commission -- to exempt very small offerings, such as those under $1 million, from specific disclosure requirements. In our experience, non-qualified deferred compensation plans under that amount are most likely to be offered by very small businesses, such as medical practices and other "mom and pop" organizations. It would be fair and appropriate to assume that participants in such plans would be well-positioned to have access to relevant information on an informal basis, and need not be subjected to or burdened with specific disclosure requirements.
C. Notice Requirements. The Release requests comment on whether a notice should be required to be filed with the Commission by any issuer relying on the rule, and if so whether it should be required to be filed electronically. We believe that, in the case of non-qualified deferred compensation plans, a notice requirement would be unduly burdensome, particularly for small businesses, especially if the requirement could be satisfied only by electronic means. Many of the small businesses for which the Rule was designed do not routinely use electronic methods of communication and should not be required to use such methods solely because of compensation arrangements for employees.
III. General Comments
A. Preliminary Note. The Commissions staff has indicated that it "is not prepared to disregard the argument that the debt owing to plan participants ((under a deferred compensation plan)) is analogous to investment notes . . . (The Division of Corporation Finance) is currently leaving that question for counsels analysis of" the facts and circumstances. 6 In the absence of specific guidance or precedent, many employers may seek to structure the offering of their plans to satisfy the conditions of the Rule 701 exemption not because they believe that their plans entail the issuance of a security, but because they do not want to assume the risks of a violation of the federal securities laws. Compliance with the conditions of Rule 701 should not be viewed as an admission by an employer that its plan entails the issuance of securities. Accordingly, we urge the Commission to add a preliminary note to the Rule to recognize that an employers compliance with the Rules conditions would not be deemed an admission by the employer that its plan entails the issuance of a securities.
B. Coordination with State Securities Commissions. We strongly urge the Commission and its staff to work closely with state securities regulators and the North American Securities Administrators Association to develop parallel exemptions and approaches under state securities laws for Rule 701 offerings. While the Proposed Amendments would greatly streamline and rationalize compliance with federal securities laws, employers would still need to satisfy applicable state securities laws when offering securities in reliance on the Rule 701 exemption. There is no uniformity -- or even much similarity -- among the states with regard to plans that could qualify for the Rule 701 exemption. Indeed, recent Commission staff indications that the "family resemblance" test presented in Reves 7 may offer the more appropriate analytical framework for non-qualified deferred compensation plans may call into question whether the fairly common state exemption for employee plans is available since this exemption is predicated on the issuance of an "investment contract" in connection with an employee plan. 8 Clearly, when amending the federal securities laws in 1996, Congress intended to simplify and rationalize the dual regulatory scheme for securities. 9 Non-qualified deferred compensation plans, which are compensatory by nature and not a capital-raising venture, deserve also to be treated on a similar basis that simplifies and rationalizes securities compliance requirements.
We applaud the Commission for proposing the changes to Rule 701 presented in the Release. We believe that the proposed changes on the whole reflect a fair balancing of the burdens and benefits of securities regulation for the employers and participants involved. Nonetheless, we strongly urge the Commission to give full consideration to the comments discussed above.
* * *
If you have any questions or comments concerning our comments, please do not hesitate to contact the undersigned at 202-383-0197 or George Bostick at 202-383-0127.
/s/ Susan S. Krawczyk
Susan S. Krawczyk
cc: George Bostick, Esquire
-- / A "top hat" employee is generally a reference to employees covered under an unfunded plan "maintained by an employer primarily for the purpose of providing deferred compensation for a select group of management or highly compensated employees" within the meaning of Sections 201(2), 301(a)(3) and 401(a)(1) of the Employee Retirement Income Security Act of 1974, as amended ("ERISA").
-- / We have assumed that a "sale" would be deemed to occur at the time an election was made during the election period.
-- / See Item 24(b) of Form N-4, first adopted in 1985. See "Registration Forms for Insurance Company Separate Accounts That Offer Variable Annuity Contracts," Release No. 33-6588 (June 14, 1985).
-- / See Item 24 of Form N-6, proposed in "Registration Form for Insurance Company Separate Accounts Registered as Unit Investment Trusts that Offer Variable Life Insurance Policies," Release No. 33-7514 (March 2, 1998) ("Release No. 33-7514"). See also comment 20 in Dear Registrant (Oct. 23, 1992), concerning the circumstances in which interim financial statements for an insurer could be excluded from a registration statement for variable life insurance policies. Among other things, the comment requires the inclusion of the following statement in the prospectus for the policies: The most current financial statements of the company (depositor) are those as of the end of the most recent fiscal year. The company does not prepare financial statements more often than annually and believes that any incremental benefit to prospective policy holders that may result from preparing and delivering more current financial statements, though unaudited, does not justify the additional cost that would be incurred. In addition, the company represents that there have been no adverse changes in the financial condition or operations of the company between the end of the most current fiscal year and the date of this prospectus.
-- / In fact, in a different context the Commission has adopted a flexible approach with regard to the presentation of financial information for insurers in the proposed Form N-6. See Release No. 33-7514, notes 60 and 61. Furthermore, Regulation S-X permits financial statements for mutual life insurance companies and wholly-owned stock insurance company subsidiaries of mutual life insurance companies to be prepared in accordance with STAT, except when the applicable registration forms specifically provide otherwise. 17 C.F.R. 210.1-01(a); 17 C.F.R. 210.7-02(b).
-- / See Current Issues and Rulemaking Projects at the Commission’s website, http://www.sec.gov.
-- / Reves v. Ernst & Young , 494 U.S. 56 (1990).
-- / See, e.g., Section 402(a)(11) of the Uniform Securities Act which exempts "any investment contract issued in connection with an employees’ stock purchase, savings, pension, profit-sharing, or similar benefit plan. . . ."
-- / See the National Securities Markets Improvements Act of 1996, particularly Section 102 thereof, codified as Section 18 of the 1933 Act.