Pre-IPO companies can have disclosure obligations, too.

A trap for the unwary…

A recent SEC enforcement action should serve as a potent reminder to pre-IPO and other private companies that SEC rules sometimes impose affirmative disclosure obligations on private companies that offer and sell securities to their employees.

Most well-advised start-ups and other emerging companies know that they need an exemption from the registration requirements of the Securities Act of 1933 in order to grant options or issue other equity awards to their employees. For these issuances, private companies generally rely on the exemption provided by Rule 701 — an exemption specifically designed for compensatory grants to employees, officers, directors and certain consultants.

Credit Karma, Inc., described by the SEC as “a pre-IPO internet-based financial technology company headquartered in San Francisco, California,” purported to rely on Rule 701 for grants of options to its employees. According to the SEC’s order, Credit Karma granted $13.8 million of options to its employees in the twelve months from October 2014 to September 2015. While Rule 701 does not necessarily impose any particular dollar limit on the grant of equity awards to employees, Rule 701(e) does require that, if a company grants more than $5.0 million of awards in reliance on Rule 701 in a twelve-month period, it must provide recipients with three principal disclosures: (a) two years of financial statements, (b) risk factors and (c) a summary of the material terms of the relevant equity plan. The disclosure must be provided a reasonable period of time before sale or, in the case of options, a reasonable period of time before exercise.

Various employees of Credit Karma subsequently exercised options, and Credit Karma failed to provide the required disclosures before exercise. The SEC fined Credit Karma $160,000 for the violations and issued a cease-and-desist order to prevent future violations.

In determining the amount of the fine, the SEC took into account Credit Karma’s cooperation with the SEC’s investigation and its prompt efforts to remediate the violations. The SEC notified Credit Karma of its investigation on July 6, 2016, and Credit Karma provided the disclosures required by Rule 701(e) to employees less than two weeks later. The SEC took note of the fact that, during the period when employees had been exercising options, Credit Karma had given institutional investors access to a virtual data room that contained both audited and unaudited financial statements and other disclosures designed to highlight potential investment risks. The fact that Credit Karma regarded this information as “highly confidential and proprietary” was not dispositive, in the SEC’s view.

Rule 701(e) is a “sleeper” requirement for many companies. Many new companies can issue options for years without ever approaching the $5.0 million threshold, so it is no surprise that some companies fail to recall or monitor compliance with the rule. Compliance issues often arise as a company approaches an IPO or other exit and is experiencing significant increases in valuation that raise the exercise price of stock options.

Companies that rely on equity compensation should be sure to monitor compliance with Rule 701 on an ongoing basis, particularly as their valuations increase. The SEC will not excuse disclosure violations based on confidentiality concerns, so these companies should either obtain confidentiality agreements from employees who receive equity awards or consider limiting the group of recipients to trusted employees who already have access to the company’s most sensitive information.

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