SEC Proposes Amendments to Securities Act Rule 701. Potential Opportunities for Service Businesses and Alternative Structures for M&A Transactions.

On November 24, 2020, the SEC proposed amendments to Rule 701 (Compensatory Offerings and Sales of Securities to Employees and Consultants) to modernize the framework for issuers in compensation transactions. This will likely have a beneficial impact for non-reporting companies and their ownership group.   

At a high level, the proposals would:

• Extend consultant and advisor eligibility to entities meeting specified ownership criteria* designed to link the securities to the performance of services. For example, currently, if a company desires to issue equity in lieu of cash for services rendered from a third party, the issued equity securities need to be issued to natural persons rather than an entity because currently Rule 701 only allows for grants to “natural persons”.
• Expand eligibility for former employees to specified post-termination grants and former employees of acquired entities. This change to the Rule would allow for individuals who are smaller shareholders of a company who are not accredited investors to participate in equity “rollover” transactions in the event that their company is sold**. This would also allow companies to grant stock rather than cash in severance agreements.
• Make the exemption available for offers and sales of securities under a written compensation benefit plan established by the issuer’s subsidiaries, whether or not majority-owned. For example, this exemption could expand eligibility of subsidiaries consolidated by the company as variable interest entities, such as physicians employed by medical practices controlled by the company.
• Raise two of the three alternative regulatory ceilings that cap the overall amount of securities that a non-reporting issuer may sell pursuant to the exemption during any consecutive 12-month period.

*A Specified Ownership Criteria as proposed would be:

1. Substantially all of the activities of the entity involve the performance of services; and
2. Substantially all of the ownership interest in the entity are held directly by:
   1. No more than 25 natural persons, of whom at least 50 percent perform such services for the issuer through the entity;
   2. The estate of a natural person specified above; and
   3. Any natural person who acquired the ownership interest in the entity by the reason of the death of the natural person specified above.

**Acquiring companies can complete this rollover transaction if the sale is structured to qualify for the federal “safe harbor” exemption provided by Rule 506. However, while Rule 506 allows for grants to up to 35 non-accredited investors, there are additional significant and burdensome disclosure requirements which makes this route unattractive for acquiring companies. 

The SEC also issued a proposal to permit equity compensation grants to certain “platform workers” (e.g. gig economy workers). 

These are just proposals, and are subject to comment from practitioners for 60 days from the date of publication in the Federal Register.   However, given the fact that these proposals are informed by public comments received in response to the SEC’s July 2018 Concept Release on the subject, it is likely that some form of these proposals will be adopted at some point in 2021.  Please contact either Aaron Monk or Mark Zummo at Kohnen & Patton LLP, if you would like to discuss the proposed amendments and what they may mean for you.