O n April 5, 1999, the Securities and that their securities could - - PDF document

Corporate Finance Alert

May 1999

New SEC Rules: The SEC Giveth and the SEC Taketh Away

By: Peter H. Ehrenberg, Esq. and John D. Hogoboom, Esq.

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n April 5, 1999, the Securities and Exchange Commission announced the promulgation of a number of final rules with broad-based effect on both public and private

• companies. Many of the rule amendments are

targeted at curbing specific abusive practices identified by the SEC in the micro-cap market. In addition, the rule changes expand the exemptions available for the sale of securities by private companies under employee benefit plans and allow for simplified registration of securities issuable to certain holders of transferable options.

Restrictions on Limited Offerings

Previously, Rule 504 (which is a part of Regulation D -- the SEC’s principal private placement exemption) allowed small private issuers to offer and sell up to $1 million in securities to an unlimited number of persons without regard to their sophistication or experience and without delivery of any specified disclosure in a public

• ffering in which general advertising and general

solicitation were permitted. In adopting Rule 504, the SEC intended to rely primarily upon state blue sky bureaus to regulate 504 exempt offerings. As a result, subject to state law requirements, under Rule 504 issuers had the ability to sell a limited amount of securities to a broad-base

• f potential investors and to assure those investors

that their securities could be immediately transferable, avoiding the discounts typically associated with the sale of “restricted securities”. Unfortunately, Rule 504 has resulted in certain abuses in the micro-cap market. Responding to those abuses, the SEC has now modified Rule 504 to make it more difficult for a public market to develop in Rule 504 securities. Under amended Rule 504, private offerings (i.e.,

• fferings subject to prohibitions on general

solicitation and general advertising) may be made in amounts of up to $1,000,000. Under the Rule as revised, such securities will be deemed to be “restricted securities” and thus generally will not be transferable for a period of one year after the

• sale. Public offerings under Rule 504 of up to

$1,000,000 in unrestricted securities can now be made only if either (a) the issuer registers the

• ffering under a state law that requires public filing
• f a disclosure document and delivery of a

...the SEC announced the promulgation of a number of final rules with broad-based effect

• n both public and private companies.

CFOs & Analysts Roundtable: “Managing the Information TUG-OF-WAR”

On June 10th, our M&A and Corporate Finance Group will host a breakfast roundtable focusing on the dialog between analysts and CFOs. The roundtable, consisting primarily of CFOs and analysts, will be chaired by Peter Ehrenberg. Chief Financial Officers from public companies are invited to participate. The event will be held from 8:00 a.m.-10:00 a.m. at our offices in Roseland, New Jersey. For more information, or to register, please call Cheryl Derites at 973.597.2500 ext. 2886 or email her at cderites@lowenstein.com.

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This document is published by Lowenstein Sandler PC to keep clients and friends informed about current issues. It is intended to provide general information only. 65 Livingston Avenue www.lowenstein.com

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Roseland, New Jersey 07068-1791 Telephone 973.597.2500 Fax 973.597.2400

disclosure document to investors prior to sale or (b) the offering is made under state law exemptions that permit general solicitation and general advertising, provided that such offerings are made only to accredited investors. For New Jersey offerings, the two primary private placement exemptions set forth in the state’s Uniform Securities Law (N.J.S.A. 49:3-50(b)(9) and (12)) prohibit general solicitation and general advertising. Since state registration is often extremely cumbersome and since state laws are likely (as in New Jersey) to prohibit general solicitation and general advertising for unregistered offerings, it is likely that the modifications of Rule 504 will lead most issuers relying upon Rule 504 to utilize Rule 504 only for private offerings that treat the offered securities as “restricted securities”. Accordingly, private offerings under Rule 504 will not be significantly different than other Regulation D

• fferings, although greater disclosure obligations

will continue to exist under the other provisions of Regulation D.

Additional Flexibility under Rule 701

The SEC’s Rule 701 provides an exemption from registration for securities issued by non-reporting companies pursuant to compensatory arrangements. The Rule previously limited the aggregate offering price of securities that could be sold in any twelve-month period to the greatest of (a) $500,000, (b) 15% of the issuer’s total assets or (c) 15% of the outstanding securities

• f the class being offered, provided that in no event

could more than $5,000,000 in securities be

• ffered.

The revised rule adds flexibility in three important respects.

First, the $5,000,000 cap has been

eliminated.

Second, the minimum ceiling of

$500,000 has been increased to $1,000,000. Thus, regardless of the size

• f an issuer, at least $1,000,000 of

securities may be

• ffered

in compensatory arrangements during a given year in conforming with Rule 701.

Third, these dollar limits will now be

based on the amount of securities actually sold, thereby providing clearer limits and more certainty to issuers seeking to rely on the exemption. The elimination of the $5,000,000 cap will especially benefit relatively large private

• companies. Issuers that exceed the $5,000,000

annual amount will, however, be subject to a new regulatory restriction. If the $5,000,000 threshold is exceeded, issuers will be required to provide specific disclosures to all investors before sales are

• made. The disclosures consist primarily of a copy
• f the compensatory benefit plan or contract

together with a summary thereof, a description of risk factors associated with the investment and certain financial statements. Since issuers remain subject to the anti-fraud provisions of federal and state securities law, the imposition of this disclosure obligation may not, in practice, add substantially to an issuer’s disclosure burden. For issuers providing New Jersey residents with compensatory benefits, the added flexibility permitted by the revisions to Rule 701 should be read in conjunction with enhanced flexibility afforded to issuers under the New Jersey Uniform Securities Law. In 1997, that law was amended to exempt from registration all securities issued pursuant to employee benefit plans. Prior to that date, cumbersome prerequisites made it far more difficult for stock compensation to be afforded to employees by private issuers. Private issuers wishing to use Rule 701 to

• ffer securities to their employees also should be

mindful of the requirements of the Securities Exchange Act of 1934, which subjects issuers with more than 500 shareholders and $10 million or

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more in assets to the reporting requirements of that Act.

Modifications in the Use of Form S-8 Registration Statements

Form S-8 registration statements are utilized by public companies to register shares of stock issuable pursuant to compensatory

• arrangements. Over the years, the SEC has

concluded that such registration statements do not present a significant risk to the Nation’s capital markets and has dramatically reduced its regulation of such registration statements. This reduction has been effected over the years in two primary initiatives. First, the SEC concluded that, unlike other registration statements, S-8s as a class should not be reviewed prior to their effectiveness. Accordingly, all registration statements on form S-8 become automatically effective as soon as they are filed with the SEC. Second, several years ago the SEC revised its prospectus rules with respect to S-8s. Recognizing that most public companies prepare explanatory documents for their employees that describe in significant detail the key elements of stock compensatory programs, the SEC determined that it would no longer be necessary for formal prospectuses to be included in S-8s. Instead, issuers have been encouraged to utilize “employee friendly” communications in order to provide employees with material information regarding stock compensatory arrangements. While such “employee friendly” documents are treated as prospectuses when delivered in connection with an S-8 registration statement, such documents need not be filed with the SEC unless the SEC expressly requests that an issuer submit such employee-friendly documents to the SEC for its review. Unfortunately, the SEC’s initiatives to liberalize the use of S-8s have led to certain

• abuses. Principal among these abuses is the use of

S-8 registration statements to deliver compensatory stock benefits to consultants. As a logical matter, there is no reason to treat consultants differently than employees if consultants are providing bona fide services to an

• issuer. The SEC recognized this similarity when it

determined, several years ago, that issuers should be permitted to offer and sell shares to consultants pursuant to S-8 registration statements. However, in recent years, certain issuers have relied upon the “consulting” title to issue shares pursuant to the simplified S-8 registration procedures to agents retained by the issuer to assist in capital formation projects and to issue shares to “middle men” who, in turn, sell such shares to investors having no prior relationship with the issuer. Over the years, the SEC has commented negatively on the manner in which companies have utilized S-8 registration statements for purposes that do not approach employment-like

• functions. In revising Form S-8, the SEC has acted
• n its concerns by allowing only securities received

by consultants that are (i) natural persons and (ii) providing bona fide services (other than in connection with capital raising or maintaining a market for the registrant’s securities) to be included in an S-8. While curbing abusive behavior is a laudable goal, the SEC may have gone too far in restricting S-8 availability for consultants. Requiring consultants to be natural persons is highly arbitrary. Further limiting the availability of the form to individuals will not necessarily curb the abuses that presently concern the SEC. Under transitional rules adopted by the SEC, any securities issued on or after May 10, 1999 under any currently effective Form S-8 must comply with these requirements. Accordingly, consultants previously holding freely transferable securities may suddenly become subject to significant restrictions on their ability to resell those securities.

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Transferable options can be an important estate planning device. Public issuers that have refrained from allowing option transfers to family members because of the unavailability of Form S-8 may want to reconsider this policy now that the SEC has authorized the use of S-8 registration statements for transferable options. Transferability features will be required to be disclosed in annual meeting proxy statements. Although the SEC refrained from mandating specific disclosures except in the summary descriptions of stock option plans, the adopting release provides useful guidance regarding appropriate disclosure of transferable option grants. For more information on this Alert, or any other corporate finance matter, please contact Peter H. Ehrenberg, John D. Hogoboom or any other member

• f the Corporate Finance Group at 973.597.2500.

It is difficult to assess at this juncture whether the SEC’s arbitrary line-drawing will result in practical difficulties for issuers. At a minimum, it will be imperative for issuers desiring to grant stock options to consultants to make sure that their options fit within the constructs of the SEC’s new S-8 requirements. On the positive side, the SEC also amended Form S-8 to allow issuers to sell shares under an S-8 registration statement to “family members” of optionees who have obtained the right to purchase such shares upon the transfer of

• ptions from optionees to their family members.

This step follows the 1996 modification of the SEC’s 16b rules, which had previously limited Section 16b exemptions to non-transferable

• ptions. The adoption of the new rule eliminates

the need for public companies to file separate registration statements applicable only to transferable options.

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