By James Bristol

Last week we addressed a few aspects of the Internal Revenue Code and Financial Accounting Standards that impact executive compensation at privately held companies.  In addition, there are federal and state securities laws that cannot be ignored for any company – of any size – that provides stock, stock options, restricted stock or other equity based compensation awards to employees, directors, independent contractors or other service providers. Compliance is often relatively simple if handled when compensation awards are made.

Rule 701 and other SEC regulations
Issuing stock, stock options, or other equity compensation in connection with employment is deemed a "sale" of a security. Federal securities laws apply to most stock incentive programs and, normally, the offering of company securities through a stock incentive plan must be registered with the SEC. For privately held companies, Rule 701 provides an exemption from registration that works for most employee programs. There are dollar limits on offerings and several disclosure requirements for employees who receive stock incentives. Federal anti-fraud rules and trading restrictions will also apply to privately held companies. Compliance requires developing a “plan” and written disclosures.

Blue Sky Law
This is a term that applies to state securities laws. Each state has laws that prohibit fraud in the sale of securities and require registration for offerings. Like Rule 701 on the federal level, most states have exemptions from registration that will cover employee stock incentive programs. But each state where there are option recipients must be evaluated. Some states, like Tennessee, require a filing with the state and a filing fee. California has the most elaborate exemption, requiring a variety of standards in the plan, such as a minimum vesting schedule.

Generally, companies that are publicly traded can rely on federal preemption of blue sky laws.

What Can Go Wrong
Compliance mistakes don’t always lead to federal or state investigations. However, employees and others have a right to enforce securities law violations in the form of a suit for securities fraud. We have seen many occasions when disgruntled former employees end up with significant rights because simple formalities of the law were over-looked. Again, we think every company needs to find a reasonable approach for managing the risks presented by these various considerations.  What real life encounters have you had with compliance, enforcement or claims from disgruntled employees?