Private Company Fined for Failure to Comply with Rule 701 in Option Exercises

Published Date
May 2, 2018
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On March 12, 2018, the United States Securities & Exchange Commission (the “SEC”) fined a late-stage private company $160,000 as a result of its failure to comply with the enhanced disclosure requirements of Rule 701 in connection with exercises of options to purchase its stock. The fine was instituted pursuant to an Order Instituting Cease-and-Desist Proceedings (the “Order”), in which the SEC accepted a proposed offer of settlement from the company.

This enforcement action emerged from the SEC’s investigation into Rule 701 compliance launched in July 2016 in connection with its commitment to close scrutiny of certain late-stage private companies, known as the “Silicon Valley Initiative.” The penalized company, Credit Karma, Inc., failed to comply with Rule 701(e)’s requirement to provide detailed financial statements and risk factor disclosure to those exercising options when the aggregate exercise price of the options it had issued during a consecutive twelve-month period exceeded $5 million.

The SEC’s demonstrated interest in pursuing enforcement actions relating to Rule 701 compliance emphasizes the need for private companies to carefully track the aggregate amount of their compensatory equity awards, and to be mindful of the limits and conditions required for the Rule 701 exemption to apply. The following is a brief overview of Rule 701 as it relates to compensatory equity awards customarily granted by private companies, and focuses on certain conditions relevant to those companies and the Order. This memorandum is not and is not intended to be a comprehensive discussion of Rule 701 and its other requirements for a valid exemption from registration.

General Prohibition on Offers or Sales of Securities

Generally, the federal securities laws prohibit the offer or sale of any securities, which includes the granting of compensatory securities, without first either registering those securities under the Securities Act of 1933, as amended (the “Securities Act”), or complying with the requirements of a valid exemption from such registration requirements. Many privately held companies rely on the exemption provided by Rule 701 of the Securities Act to issue compensatory securities to help them attract and retain talented employees.

Rule 701 Exemption for Compensatory Benefit Plans

Broadly speaking, Rule 701 provides an exemption from the registration requirements of the Securities Act for the issuance of securities to its employees, directors, consultants and advisors under a compensatory benefit plan. There are a number of conditions that must be met for a valid Rule 701 exemption, including those relating to which entity may issue the securities, who may receive the securities, limits on the aggregate issuance amounts, disclosure requirements and restrictions on resale.

Limits on Aggregate Issuance Amounts

Rule 701(d) provides that the upper limit on the aggregate sales price of the securities that may be sold under Rule 701 during a consecutive twelve-month period is the greatest of (i) $1,000,000; (ii) 15% percent of the assets of the issuer (or its parent under certain circumstances); or (iii) 15% of the outstanding amount of the class of securities being offered.

In the case of a stock option, for purposes of calculating compliance with the limits set forth in Rule 701(d), the aggregate sales price is deemed to be the exercise price of the option, and is determined on the date the option is granted, rather than the date it is exercised. With respect to other securities, the calculation is made on the date of sale. With respect to deferred compensation or similar plans, the calculation is made when an irrevocable election to defer is made.

$5 Million Threshold Triggers Additional Disclosure Requirements

Rule 701(e) requires that an issuer provide the grantee of a compensatory equity award a copy of the compensatory benefit plan under which such award was issued a reasonable time prior to the date of sale. If such award is a stock option, the issuer must provide a copy of such compensatory benefit plan a reasonable time prior to the exercise of such option. This requirement is satisfied, and it is customary practice, to deliver a copy of the plan at the time the compensatory equity award is granted. However, if an issuer issues compensatory equity awards with an aggregate value in excess of $5 million in a consecutive twelve-month period, the issuer must also comply with additional disclosure requirements, which include the delivery of detailed financial statements and a set of risk factors describing the risks of an investment in an issuer’s stock.

Credit Karma Enforcement Action

During the period beginning October 1, 2014 and ending September 30, 2015, Credit Karma issued stock options with an aggregate exercise price of approximately $13.8 million. As this amount exceeded Rule 701(e)’s $5 million threshold for aggregate issuances, Credit Karma was required to provide detailed financial statements and risk factors, among other deliverables, to those grantees who exercised their options. However, although Credit Karma periodically provided limited financial data to those exercising options, it did not provide information and risk factors sufficient to satisfy Rule 701(e).

The Order states that by August of 2015, Credit Karma’s senior executives were aware of and had discussed Rule 701, as references to the Rule were included in a presentation to the Board in that month. The SEC notes that Credit Karma had the required disclosure information available in a virtual data room made available to institutional investors, but did not provide it to employees because the company viewed the information as highly confidential and proprietary. Upon receiving the SEC’s inquiry, Credit Karma took prompt remedial action, and continued to cooperate during the inquiry. The SEC noted that both these factors were favorably considered in the acceptance of the settlement offer.

Practical Considerations

Issuers relying on Rule 701 should be diligent about tracking the aggregate securities issued in any consecutive twelve-month period in order to determine compliance with the offering limitations in Rule 701(d), as well as to determine if the enhanced disclosure requirements of Rule 701(e) have been triggered. Before exceeding the $5 million limitation, an issuer should carefully consider proactively providing a detailed set of financial statements and fulsome risk factor disclosure available to those who receive securities in relevance on Rule 701.

Finally, if an issuer finds itself in violation of Rule 701, prompt remedial action may reduce associated fines and penalties imposed for failure to comply with the exemption.

The foregoing is a brief overview of certain provisions of Rule 701 as they relate to compensatory securities. Rule 701 contains other requirements in addition to those discussed above, and if an issuer intends to rely on Rule 701 to exempt its issuance of securities from the registration requirements of the Securities Act, it should consult a qualified attorney knowledgeable in Rule 701’s application. If you have any questions, please feel free to contact Alan Bickerstaff, Christopher Forrester, Doreen Lilienfeld, or your regular Shearman & Sterling contact.


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This content was originally published by Shearman & Sterling before the A&O Shearman merger

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Christopher Forrester

Christopher Forrester


Silicon Valley

Christopher is Head of West Coast US Capital Markets and US Emerging Company/Venture Capital and Technology Sector Lead.