NCEO s CEP Exam Preparation Course Fall 2017 Level 1 Core Topic: Corporate and Securities Law

Transcription

1 NCEO s CEP Exam Preparation Course Fall 2017 Level 1 Core Topic: Corporate and Securities Law Presented by Achaessa James, CEP, NCEO Moderated by Tim McCleskey, CEP Stock & Option Solutions 1

2 Achaessa James, CEP/PMC Achaessa James, is the product manager for equity compensation programs at the NCEO. She is responsible for the content of the NCEO s Prep Course for the CEP exams and is the NCEO s subject matter expert on equity compensation matters. She is a published author and regularly writes and presents on equity compensation topics. Her recent NCEO publications include the Private Company Equity Compensation Administration Toolkit and If I'd Only Known That!, a collection of humorous and painful examples of what happens when otherwise competent and responsible professionals don't know what they don't know and fail to get advice before taking actions that result in consequences that range from the merely awkward to the downright serious. Achaessa became a CEP in 2008 and has been doing equity compensation plan management and consulting since My name is Achaessa James. I am the Product Manager for equity compensation products here at the NCEO including the CEP Exam Prep Course - and I will be your presenter for today s session. Assisting me today is Tim McCleskey of Stock & Option Solutions. Tim and I are both CEPs and between the two of us we have about 35 years of experience in the equity compensation industry. Thank you, Tim, and welcome. 2

3 IMPORTANT REMINDER 3 Watch the Exam Tips recorded webinar if you have any questions about how to study using the CEPI binder materials The Reading List IS NOT a complete listing of the topics you need to study (it only goes down two outline levels) Refer frequently to the Exam Topics Outline (the Syllabus ) to see all topics (there are often three to four outline levels) So with our new boot camp format this year, we ve covered all of the general course review statistics in the Exam Tips webinar recorded on boot camp day 1. The only reminder I want to give here is that on the reading list appears to be straightforward, turns out to be more complex when you look at the Exam Topics Outline. Always remember, the Reading List only goes down two outline levels, but there are often 3 or 4 levels on the Exam Topics Outline. NEXT PAGE 3

4 Level 1 Securities Law Topics 4 Corporate Governance Corporate Law Federal Reserve Act Plan Provisions Sarbanes Oxley Act of 2002 Securities Act of 1933 Securities Exchange Act of 1934 Securities Law General Understanding MODERATOR: The Level 1 exam tests general knowledge of the basic rules and regulations for each core topic, so you won t need to acquire a deep knowledge of each of these areas but you will be responsible for knowing all of the assigned reading in depth So, jumping right in to the Level 1 Corporate and Securities Law topic, you ll remember from the Exam Tips webinar that 25% of the Level 1 questions are on this topic. Here is the basic checklist we ll use in this webinar to ensure that we ve covered all of the assigned topics. We won t be covering the topics in alphabetic order because when you look at all of the topics from an overall perspective you ll see how all of the topics and subtopics are all related in one way or another. It s useful to have the detailed reading list and the syllabus topic outline handy every time you re studying because as you re studying you ll see things start to connect and you ll be reading about one thing when you realize that it also applies to something else. So instead of going in the order set forth in the reading list, we may jump around a bit to have a better flow. 4

5 Let s start with a general understanding of corporate law and securities law since that s where the stock that we work with is created. 4

6 Level 1 Corporate Law & Securities Law 5 We re starting with the corporate law section because it covers some basic definitions. It s always best to start by comparing the syllabus to the reading list to make sure you understand the full depth of what you re assigned to learn. The Syllabus lists down to three levels of subtopics, but the Detailed Reading List only shows the first line topic and one level of subtopic. So as these two insets demonstrate there are three second level subtopics in the corporate law section and one in the Securities Law section. So always be sure to look at the Syllabus and not just the Detailed Reading List. In the Detailed Reading List, there aren t any changes in assigned reading from 2016 to I always look at Selected Issues first because its topics are more securities law related than the other textbooks. Sometimes we ll get lucky and find everything we need in Selected Issues. NEXT PAGE 5

7 6 Characteristics of Corporate Entities Definition of a Corporation Limited liability Centralized management Continuity of life Freely transferable interest stock, securities Actors in a Corporation Founders Owners stockholders / shareholders Directors Officers President, Treasurer, Secretary Executives CEO, CFO, COO, etc. 3)B) Corp Law > Board of Directors 3)C) Corp Law > Characteristics of Corp Entities Looking first at basic characteristics of corporate entities. A corporation is a legal entity that is separate from and independent of the people who formed, own, oversee, or manage the business and which has four specific attributes. For the purposes of your exam, and in actual practice, the people that form the business are called the Founders they are usually also the first shareholders in the company. The owners of a corporation are called stockholders or shareholders. The people who oversee the business are called directors, and the people who manage the business are called officers and executives. The first corporate attribute listed here limited liability is important to all of these groups of people because it means that the corporation, as an entity, is responsible for its own debts and taxes and that none of these people can be held responsible for the corporation s debt or taxes except under extraordinary circumstances. The second attribute listed here centralized management means that the owners of 6

8 the business (again, stockholders or shareholders) are not responsible for running the business. Those duties are delegated to the directors and officers. The directors are elected by the shareholders and are responsible for performing the functions and duties set out in the corporation s organizational documents, which generally include making business decisions for the corporation usually anything that has a financial or legal impact on the business, like where the company will bank, how much stock the company is authorized to issue, whether or not to take out a loan or get venture financing, how much the company s stock is worth and the granting of equity compensation awards. The board is charged with making these decisions as a group in order to maintain what s known as the corporate veil which is that legal separation between the entity of the corporation and the individual board members, so that the board members cannot be held personally responsible for any actions of the corporation. The officers are appointed by the board and are responsible for executing the board s decisions and managing the day-to-day operations of the corporation. A corporate officer is not the same as a corporate executive. The types of officers required are established by the state in which the company is incorporated and usually include a President, Vice President, Treasurer and Secretary. For practical purposes, an executive often has a working job title, like Chief Financial Officer and is also and appointed officer such as the Treasurer, or the CEO will also be the President. The third attribute continuity of life simply means that the corporation as an entity continues on even if the owners of the company die or leave the company, unlike partnerships or sole proprietorships. And the fourth attribute freely transferable interest means that the owners (the stockholders or shareholders) can transfer their stock in the company without affecting the company s status as a corporation. 6

9 7 Characteristics of Corporate Entities Reference: Selected Issues section Listed on national stock exchange Excludes foreign private issuers Can include a non listed company Limits modified by the JOBS Act of 2012 Textbook citation verified )C) Corp Law > Characteristics of Corp Entities 3)C)i) Corp Law > Characteristics of Corp Entities > Public v Private The most common distinction between a public company and a private company is where it s stock is sold a public company will sell its stock in a public market, like the New York Stock Exchange or NASDAQ, and private companies are limited to selling their stock in private offerings to qualified investors or through equity compensation grants to its employees and service providers. However, under Section 16 of the Securities Exchange Act of 1934 a private company can become subject to public company treatment under certain circumstances. The thresholds were changed by the JOBS Act of The new thresholds are highlighted in yellow on this slide and the JOBS Act, along with its creation of the Emerging Growth Company status is covered in more detail further along in this same section of Selected Issues. It is very likely that you will have a question on these limits in the exam. 7

10 8 Securities Law General Multiple Classes of Stock Common Preferred Rights and Privileges Voting or Nonvoting Dividends Liquidation preferences Stock Certificates Stock Dividends Stock Splits Par Value Textbook citation verified ) Securities Law 10)A) Securities Law > General Understanding 10)C) Securities Law > Par Value 10)D) Securities Law > Dividends 10)E) Securities Law > Stock Issuance 10)F) Securities Law > Stock Splits Stock and other securities convertible into stock is a distinguishing characteristic of a corporation. A corporation can basically authorize any type of stock that it wishes and call it whatever it wants but there are really only two basic categories of stock common and preferred. Common is the basic type of stock that is bought and sold on the open market and that is granted as equity compensation. Common stock is the underlying representation of the company s value as an enterprise and it is the common stock that is used as a reference when setting a value on equity compensation awards unless a plan specifically says otherwise. When a company has multiple classes of stock, such as preferred stock, or dual class common stock, there will usually be a base 8

11 common stock into which all other classes of stock convert, and the participation of all stock in such rights as voting and dividends is also usually calculated on an as-converted basis meaning that the convertible security will have the number of votes allocated to it based on the number of common shares it will convert into. As an administrator you may see purchases of Preferred stock reflected in the company s capitalization table, especially in privately held companies. It will usually be called something like Series A Preferred Stock, or Series B, etc. It is rare that preferred stock is used for equity compensation awards. It is called preferred because it has preferences attached to it. The owners of preferred stock have usually paid a higher price than the common stock and so receive preferential treatment for that higher price such as having different voting rights, having a designated director for a specific series of preferred stock, and having a proportionally higher liquidation value over common stock in the case of a corporate transaction. For example when a target company is being acquired the preferred stock may have a 2x liquidation preference which means that each share of preferred stock will be worth twice as much as a share of common stock. Another common liquidation preference is that the preferred stockholders will receive their portion of liquidation proceeds before the common stockholders receive anything. Stock certificates are issued when stock is purchased either through a sale/purchase transaction, a debt conversion transaction, or through the exercise of an equity compensation award or warrant. In Level 1 you are only interested in sale/purchase transactions and equity compensation award transactions. Certificates may be issued electronically or on paper and may be held in the owner s name or in street name by a brokerage firm. Street name means that the electronic certificates are held in the name of the broker and that the broker keeps track of who the shares actually belong to that person is called the shareholder or the beneficial owner. The important thing to know about shares held in street name is that the shares cannot be voted by proxy by the brokers unless the beneficial owner gives specific voting instructions to the broker. Stock dividends may be declared by the company at any time and those classes of stock eligible to receive the dividends will receive whatever the dividend is declared to be. An example would be if a company declared a twenty-five cent dividend then that means that each share of common stock would receive twenty-five cents. Stock splits can be either forward or reverse. A forward split is when one share of stock becomes numerous shares of stock. A reverse split is when numerous shares of stock become one share of stock. When a stock split occurs, the value of the stock is proportionally affected. For example, a single share of stock that has a value of $10 8

12 dollars and undergoes a 2 for 1 forward split will become two shares of stock each valued at $5 dollars. A reverse split will have a similarly proportionate result so that in a 1 for 5 reverse split five shares of stock each worth $5 dollars would result in one share of stock worth $25 dollars. The corporate charter documents usually have a provision that implements an automatic adjustment for all outstanding shares when a stock split is implemented. Par Value is a dollar amount assigned to shares of stock in the corporation s organizational documents. Par value has no relation to fair market value or stock price but, rather, is usually a nominal amount used to compute a minimum accounting value for the common stock on a company s balance sheet. Some states, like Delaware, require the assignment of a par value by the company, but some states do not. Many corporations issue no-par stock. As an administrator, and as a CEP candidate, the most important thing to understand about stock is that only the board can take any action regarding stock. Whether it is to create the initial capitalization, increase or decrease the capitalization, establish classes of stock, decide whether the stock will be issued using paper certificates or electronic notification, what rights and privileges a class of stock will have, whether dividends will be paid, whether an equity compensation plan will exist, to whom equity compensation awards will be issued, and with what terms anything to do with stock must be enacted by a board resolution and sometimes also requires shareholder approval. When administering the plan for your company, it s important to always confirm that the board resolutions match whatever is in your stock plan database because the board resolutions are the legally binding authorization of the company. Now that we ve covered stock basics, let s move into the 33 and 34 Act discussion and some of our Q&A review. 8

13 Characteristics of Corporate Entities 9 Voting Rights RSAs vs. RSUs Equity Alternatives, Table 3 1 Authorization to Grant Equity Awards Selected Issues section Board of Directors has final responsibility for all issuances Committee appointed by board, makes award recommendations Textbook citation verified )A) Corp Law > Authorization to Grant Awards 3)A)i) Corp Law > Authorization to Grant Awards > Board v Committee 3)C) Corp Law > Characteristics of Corp Entities 3)G) Corp Law > Voting Rights 3)G)i) Corp Law > Voting Rights > RSA v RSU The CEP wants you to understand the difference between voting rights for restricted stock awards and restricted stock units. The short answer is that there are no voting rights until the stock is actually issued. Thus, even though restricted stock awards may be unvested at grant, because the stock is actually issued at grant the shares will usually carry voting rights, whereas restricted stock units do not have any voting rights until the units are converted into stock and the stock is issued. You should tab out Table 3-1 in Equity Alternatives for a handy reference on the differences between Restricted Stock and Restricted Stock Units. The issuance of any corporate stock or securities must be first approved by the board of directors. Only the board of directors has the authority to authorize the sale and 9

14 issuance of stock or securities and designate what rights those securities have. Such authorizations will be memorialized in board minutes or a unanimous written consent of all of the directors. The board also has the right to delegate the administration of an equity compensation plan, including the grant of equity awards to a committee, typically the compensation committee. Usually, the committee will make recommendations which are then presented to the board for approval. Even where the board delegates the actual authority to authorize equity awards, such authorizations should be limited in scope, such as limits on the size of the awards and permissible award recipients, and the board is ultimately responsible for oversight of such committee decisions. 9

15 Level 1 Securities Law Topics 10 Corporate Governance Corporate Law Federal Reserve Act Plan Provisions Sarbanes Oxley Act of 2002 Securities Act of 1933 Securities Exchange Act of 1934 Securities Law General Understanding Next we ll move to the Securities Act of 1933 because in order for any stock to be sold in the United States it must conform with certain regulations that govern the offer and sale of securities. 10

16 Securities & Exchange Acts 11 Securities Act of Register Me Securities Exchange Act of Tell Me More 8) Securities Act of ) Securities Exchange Act of 1934 The basic premise of the 1933 Act is that in order to be bought or sold, securities must be registered or an exemption from registration must be available; the basic premise of the 1934 Act is that certain information must be disclosed. This memory aid 33 Register Me, 34 Tell Me More is a classic CEP tool because it s a great way to remember whether you re dealing with the 1933 Securities Act which sets forth registration requirements (and includes Rule 701 and Rule 144 which are registration exemptions) or the 1934 Securities Exchange Act which sets forth disclosure requirements (and includes Section 16 reporting and clawback requirements and Rule 10b5 trading restrictions). The biggest advantage to knowing the difference between the two off the top of your head may well be that you ll know which place to look in the book indexes when you re looking up these topics and that will definitely save some time. Both of these regulations were enacted during the Great Depression of the 1930 s that 11

17 was triggered by the first stock market crash in The 33 Act created the requirement for all publicly sold stock to be registered with the federal government before the 33 Act, regulation of securities was primarily governed by state laws. State registration laws are still in effect, they re called blue sky laws and you ll learn about them in the level 2 studies. The 34 Act established the Securities Exchange Commission and was originally intended to cover secondary sales of stock, meaning sales of stock not by the issuing company so, for example, transactions between stockholders and brokers and has evolved into a comprehensive legislation which also includes financial and disclosure reporting by the issuing company, insider trading, and transaction reporting requirements. We re going to start with the 33 Act because before you can sell the stock you have to register the stock. Or do you? 11

18 12 Reference: Equity Alternatives section 3.5 Restricted Stock in the legal context RS for securities law purposes refers to the registration status of the stock under the Securities Act of 1933 or the affiliate status of the stockholder under the Securities Exchange Act of 1934 Restricted Stock (RS) is not a class of stock, in the sense of multiple classes of stock RS can be any class of stock (common, preferred, etc.) Textbook citation verified )C)v) 33 Act > Rule 144 > Restricted Securities 10)A)i) Securities Law > General Understanding Multiple classes > awards If you haven t already realized it in your daily professional practice, the term Restricted Stock can be confusing because it has one meaning for administrative purposes (and we ll cover that tomorrow) and another meaning for securities law purposes. The important thing to remember about restricted stock is not a class of stock in the sense of multiple classes of stock but, instead, the term restricted can apply to any class of stock in either or both of two ways. In the administrative sense restricted stock refers to a type of equity compensation award which has vesting or resale restrictions. Use of the term Restricted Stock in the context of corporate and securities law is what we're studying today and is distinct from the administrative context. In the securities law context, Restricted Stock refers to the registration status of the stock or the affiliate status of the stockholder. 12

19 Section 3.5 of Equity Alternatives is a good 7 page overview directly focused on the securities law considerations of restricted stock, and the subchapters in section 3.5 correspond almost directly to the subtopics in the assigned reading list. Next we ll talk about those registration and affiliate status issues. 12

20 13 Reference: The Stock Options Book section 8.3 Securities Act of 1933 Rule 144 covers sales of stock by the stockholder Decision Tree Stock Options Book, section Restricted or unrestricted securities Affiliates or non affiliates Public sale or private sale Rule 701 covers sales of stock by issuing company Test Sheet Stock Options Book, Ex.8 1 (at end of section 8.3.3) Dollar cap test Assets test Outstanding stock test Textbook citation verified )C)i) 33 Act > Rule 144 > Affiliate 8)C)v) 33 Act > Rule 144 > Restricted Securities 8)D)ii) 33 Act > Rule 701 > General Understanding Even though the 33 Act requires a company to register any stock that it wants to sell, Rule 144 and Rule 701 are exemptions from that registration requirement. The Appendix 2 of The Stock Options Book includes the full text of each rule, but you ll notice that it is NOT on your assigned reading. It s really dense. For the extent of knowledge required by the level 1 exam, you don t need to get lost in Appendix 2. Chapter 8.3 of The Stock Options Book provides the most concise statement about these registration exemptions. Rule 144 covers sales of stock by stockholders and exam questions will focus on the status of the securities and the status of the stockholder. You ll learn about control securities and affiliate status. Rule 701 covers sales of stock by the issuing company and exam questions will focus on determining whether the company qualifies for the exemption. Let s start with a Rule 144 question. 13

21 Securities Act of The chief financial officer of a publicly traded company acquires stock through the exercise of an ISO that was registered under a Form S 8. What type of stock are the shares considered to be? a. Restricted stock b. Control stock c. Common stock d. Preferred stock Go to polling question #1 to answer MODERATOR READS THE QUESTION and instructs participants to enter their answers in the chat box 14

22 Securities Act of Reference: Selected Issues section Correct answer: b control stock Explanation: Issuer stock held by an affiliate is considered control stock regardless of the manner in which the stock was acquired and regardless of whether the stock has been registered. Rule 144 defines affiliates as persons in control of the issuer. All directors and certain key executive officers are deemed to be in control by the nature of their responsibilities within their companies. The stock is not considered to be restricted stock because it is a registered, public company stock. Textbook citation verified )C)ii) 33 Act > Rule 144 > Control Securities 8)C)v) 33 Act > Rule 144 > Restricted Securities This question is about control stock and the clue is that it mentions the S-8 registration statement so it s not just a simple ISO question. You should give section of Selected Issues a thorough reading to get a good grasp of control stock. It s called control stock because Rule 144 defines affiliates as persons in control of the issuer. Issuer stock held by an affiliate is considered control stock no matter how the stock was acquired and whether or not the stock has been registered. All directors and certain key executive officers are deemed to be in control by the nature of their responsibilities within their companies. There is a distinction between control stock discussed here and restricted stock - control stock is not considered to be restricted stock because it is registered. So let s talk about registered stock next. 15

23 Securities Act of Section 5 of the Securities Act of 1933 Says it s illegal to trade in securities for which no registration statement has been filed Rule 144 Covers sales of unregistered securities by nonaffiliates Covers sales of all securities by affiliates For its purposes, restricted stock is unregistered stock acquired from the issuer or an affiliate of the issuer in a transaction not involving a public offering Provides essentially the only way to sell restricted shares in the public market 8)C) 33 Act > Rule 144 8)C)i) 33 Act > Rule 144 > Affiliates 8)C)ii) 33 Act > Rule 144 > Control Securities 8)C)v) 33 Act > Rule 144 > Restricted Securities 8)C)vi) 33 Act > Rule 144 > Use and Limitations Section 5 of the Securities Act of 33 says it s illegal to trade in securities for which no registration statement has been filed. This is a big-time paraphrase of how this section of the law is written. The exemptions from this are laid out in a body of regulations that have arisen under the 33 Act and rely on the specific wording of the statute to explain when certain kinds of transactions don t fall under this explanation. Under U.S. securities laws, you must either register securities or establish an exemption from registration. Rule 144 is an exemption from registration. Often Rule 144 exam questions will involve unregistered stock because it covers sales of unregistered securities by non-affiliates, but it covers sales of all securities by affiliates. So a Rule 144 question that involves registered stock would by necessity have to apply the exemption because of the affiliate 16

24 status of the seller, not because of the registration status of the stock. Affiliates generally include: 10% owners; Section 16 reporting persons; and directors of the issuer. So effectively the same people covered by Section 16 which we ll look at shortly. Securities terminology generally refers to unregistered securities as restricted stock, or sometimes as restricted securities. In this context, that means stock that isn t registered and that can be resold only pursuant to an exemption under SEC rules. It s entirely separate from restricted stock as it s used to describe a type of equity award most commonly used by privately held companies. Rule 144 has requirements such as holding periods and methods of sale, but we ll wait until we get to the discussion of Rule 701 to give those elements some context. 16

25 Securities Act of Control stock Any issuer stock directly owned by an affiliate. Any issuer stock owned by a household relative of an affiliate. Any stock held by a corporation or trust in which the affiliate has a 10% ownership or beneficial interest. Control stock can be sold pursuant to Registration statement Private placement exemption Rule 144 8)C) 33 Act > Rule 144 8)C)i) 33 Act > Rule 144 > Affiliates 8)C)ii) 33 Act > Rule 144 > Control Securities Here we re diving a bit deeper into Control stock. For the purposes of determining what is control stock, it doesn t matter how the stock was acquired. It might have been purchased in the open market or received upon the exercise of registered or unregistered stock options. What matters is the level of control the owner of the stock has with regard to the issuing company. And remember, this pertains to publicly traded securities as well as unregistered securities. So, Any issuer stock directly owned by an affiliate. Any issuer stock owned by a household relative of an affiliate. Any stock held by a corporation or trust in which the affiliate has a 10% ownership or beneficial interest. All of these are considered control stock because the stockholders have a high level of control in the company. Control stock can be sold pursuant to Registration statement 17

26 Private placement exemption Rule 144 exemption We ve covered the Rule 144 exemption, so let s move on to the private placement exemption under Rule

27 Rule 701 General Understanding 18 Reference: Selected Issues in Equity Compensation, section Shares must be issued as a form of compensation. Recipient must be natural person. Issuer, parent or subsidiary company Issuer can t be reporting company under the 1934 Act, and can t be registered investment company. No SEC notice necessary. Issuance must be made under written plan. Recipients must receive a copy of the plan. Additional disclosures required if more than $5 million in securities sold in a 12 month period. Other exemptions may be claimed, too. Strictly federal. Textbook citation verified )D) 33 Act > Rule 701 8)D)ii) 33 Act > Rule 701 > General Understanding Rule 701 is another exemption from registration. While Rule 144 is an exemption for individuals, Rule 701 is an exemption from registration that non-reporting companies can use to offer unregistered stock to employees or service providers. Generally speaking, a company can issue or sell stock or equity even though the shares are unregistered as long as the company follows the requirements under 701. Under rule 701, any sale or grant of unregistered stock has to be in the form of compensation. The Value of securities issued must be made with reference to value of services exchanged for securities issued. The securities can t be valued at zero. So the recipients would be employees and other service providers. The equity recipient must be a natural person, so a service provider firm would not be eligible. The employment or service provider relationship can be with the issuing company or with a parent company or subsidiary company 18

28 No SEC notice is necessary when a company uses the Rule 701 exemption, but the securities must be issued under a written plan document and the award recipients must receive a copy of the document and if the securities that are being provided exceed five million dollars in a twelve month period, then there are additional disclosures that are required as a result. Rule 701 also carries value and quantity limitations that the company must meet each time it grants a batch of awards. Page 5 of the Quick Reference guide sets out those limitations. In the exam a question on Rule 701 could easily be something that says the company is planning on offering grants in x amount and is x beyond the limits that 701 allows. Rule 701 is a federal regulation and though most states accept Rule 701 as an exemption, not all do. And, finally, for federal exemption purposes, a company can rely on Rule 701 and still rely on other exemptions as well. 18

29 19 Reference: Selected Issues in Equity Compensation, section Rule 701 General Understanding Who can receive stock under Rule 701? Employees Directors and Officers General partners Trustees Consultants and advisors as long as they are people who provide bona fide services to the issuer, parent company, or majorityowned subsidiary Family members who get securities through gifts or domestic relations orders Who cannot? Anyone whose services are inherently capital raising or promotional, including brokers. Independent agents, franchisees, and salespeople who aren t employees. Service provider firms Textbook citation verified )D) 33 Act > Rule 701 8)D)ii) 33 Act > Rule 701 > General Understanding This slide 19 is a good list of who can receive stock under rule 701. I ll read it out loud for the folks listening to the mp3. So, employees, directors, general partners, trustees, officers, and consultants. Consultants have to be actual people known in the regulations as natural persons, so a Rule 701 award can t be given to a consulting firm. Recipients such as former employees, directors, et cetera, can participate only if they were actively employed or providing services on the grant date. And I like the last one: family members who get securities through gifts or domestic relations orders or divorce decree. Who else cannot receive securities under rule 701? Anyone whose services are related to raising capital so the promotion of raising capital, the actual raising of capital and that would include brokerage firms. Any independent agents, franchisees and sales people who don t have a direct employment relationship with the issuer are also excluded from the definition of consultant or advisor, and again we see service provider firms listed 19

30 because they are not natural persons. 19

31 Rule 701 Limitations and Resales 20 Size limitations: During any 12 month period, aggregate sales price or amount sold can t exceed the greatest of: $1 million 15% of issuer s total assets 15% of amount of outstanding class of securities being sold in reliance on Rule days after an IPO: Non affiliates can sell their Rule 701 stock without regard to Rule 144 Affiliates can sell shares pursuant to Rule 144, but without regard to Rule 144 holding period Textbook citation verified )D)i) 33 Act > Rule 701 > Application to post-ipo sales 8)D)ii) 33 Act > Rule 701 > General Understanding This slide #20 describes the three point test that an issuer must run on every grant date: The aggregate amount of current Rule 701 securities cannot exceed the greatest of $1 million dollars, 15% of the issuer s total assets measured as of most recent balance sheet, or 15% of the number of outstanding shares of the class of securities sold in reliance on Rule 701. If the grant date batch of shares passes one of these three tests then the awards are eligible for issuance under Rule 701. The test is based can be based on a rolling 12 month period or on an annual basis but once the issuer decides on the testing basis they have to stick with it. In the third test, the Outstanding class of securities includes currently exercisable or convertible options, warrants, rights and other securities. It doesn t include awards that are not currently exercisable or that are non-convertible. Separate classes of stock with identical rights can be counted as a single class of stock. 20

32 Speaking of those limits, it is likely that you will get an exam question that will basically tell you something about the fact that x number of shares equals maybe 20% or maybe 5% of the issuer s assets and 10% of what is outstanding, they are going to give you enough information to be able to figure out these three limits and whether the value being proposed exceeds the greater of those three limits. It may not be straightforward, but typically when I see questions in this regard, it is going to give you information about the company s total assets and usually when I see something about the company s assets then I know this might be a 701 question because they are giving you that information in order to calculate this size limitation. Rule 701 also has resale restrictions. Remember, Rule 701 is an exemption for the company to sell or award unregistered shares. But then in order to later sell the stock the person receiving the stock from the company must also either comply with registration requirements or conduct the sale in a manner that is exempt from registration. Since companies relying on Rule 701 must be non-reporting companies, that means that there is generally no market for the shares to be resold. When the company s stock becomes publicly traded, as in an initial public offering, stock issued under Rule 701 can be sold after 90 days. At this point nonaffiliates can freely sell shares by following the Rule 144 manner of sale conditions, meaning open market sales are okay, and affiliates must still sell them in reliance on Rule 144, but they don t have to abide by the Rule 144 holding period. 20

33 21 Securities Act of 1933 A company makes a round of stock option grants to its employees on February 2. On June 28, it conducts an IPO. After the IPO, can the company still rely upon Rule 701 to issue stock to its employees upon exercise of the February option grants? a. Yes, as long as the options were exercised under stock plan. b. Yes, as long as the options were granted under a written contract or stock plan. c. Yes, as long as the sales in reliance of Rule 701 in the preceding 12 months didn't exceed 20% of the company's total assets. d. No, the company can no longer rely on Rule 701 in this instance. Tim reads the slide and tells participants to enter their answers in the chat box. 21

34 22 Reference: The Stock Options Book, Appendix 2: SEC Rule 701 Securities Act of 1933 Correct answer: b Yes, as long as the options were granted under a written contract or stock plan. Explanation: Rule 701 provides a safe harbor exemption from registration for pre IPO issuers that grant restricted securities under an employee stock plan or compensatory contract. Textbook citation verified )D)i) 33 Act > Rule 701 > Application to post-ipo sales The correct answer is B, Yes, the company can rely on the Rule 701 exemption post-ipo as long as the options were already granted under a stock plan and met one of the Rule 701 tests at the time of grant. If you read that question too fast, it might have seemed if it were asking whether the company could continue using the Rule 701 exemption to grant shares after their IPO. Since Rule 701 is only available to non-public companies, once the company has held its IPO, it can no longer issue new awards and rely on Rule 701. In fact, as part of the IPO, companies usually adopt a new equity incentive plan and register it under a Form S-8 registration statement. But that s a Level 2 topic. 22

35 23 Level 1 Securities Law Topics Corporate Governance Corporate Law Federal Reserve Act Plan Provisions Sarbanes Oxley Act of 2002 Securities Act of 1933 { Securities Exchange Act of 1934 Securities Law General Understanding Next we ll look at the Exchange Act, remember 34, Tell Me More. The inset shows us that under this topic, there are 8 subtopics that we ll be looking at today, starting with a General Understanding of Insider Trading, but, again, not necessarily going in alphabetic order. You ll also notice that there is one brand new important sub of Post- Termination Reporting under the Section 16(a) Reporting subtopic. We ve always included this topic in the prep course so it looks like the CEPI has decided that it s important to call it out specifically which means you ll be likely to get an exam question about it. 23

36 34 Act Insider Trading 24 The vice president of sales of a publicly traded company intends to sell shares acquired pursuant to the company s ESPP. What is the safest time for this officer to engage in this transaction? a. Any time the officer is not in possession of material non public information. b. During the company's blackout period. c. During the company's window period when the officer is not in possession of material non public information. d. On the same day the company announces its quarterly earnings. And we ll start off with a question Tim reads the question and tells participants to enter their answers in the chat box. 24

37 25 Reference: Selected Issues in Equity Compensation section 2.4 under Insider Trading Policies 34 Act Insider Trading Correct answer: c During the company's window period when the officer is not in possession of material non public information. Explanation: Generally, companies establish trading windows during times when the company's earnings have not reached a point of material significance. Companies feel this is the safest time for an officer to transact in their company stock and usually make it part of their insider trading policies. If an officer trades during an open window when he or she is not in possession of material non public information, the officer is complying with company policy and abiding by the insider trading rules. Textbook citation verified )B) 34 Act > Genl Understanding Insider Trading 9)B)i) 34 Act > Genl Understanding Insider Trading > Windows/Blackouts So this is a question that requires you to weigh each answer against the other answers to determine which is safest. Most of the questions on the Level 1 exam test your knowledge, not the application of the knowledge, but there are still a few questions like this. So, here, C is the correct answer because the window is the safest because it is a company-designated trading period. The incorrect answers: a. Any time the officer is not in possession of material non-public information is not as safe as trading during a designated open window which coincides with the officer not in possession of material non-public information. b. During the company's blackout period a blackout period is a period during which he definitely cannot sell. Companies often impose blackouts on officers and directors beginning15 days before the end of the reporting period and ending two or three days after the reports have been issued. d. On the same day the company announces its quarterly earnings Like answer B, this is clearly a prohibited date for trading and in fact there should be some time for the 25

38 market to react to the announcement before trading. Once that time has passed is typically the safest to trade because it s when the insider is least likely to be in possession of material nonpublic information. Thus that two to three day lapse between the release of financial statements and the end of the blackout period and that s when the company is most likely to declare an open trading window. Now let s talk about insider information. 25

39 34 Act Insider Trading Rule 10b 5 26 Reference: Selected Issues sections 2.4 and Examples of inside information Actual or projected sales or earnings that have not yet been announced Major new products Changes in control or significant management changes Proposed mergers, acquisitions, or joint ventures Dividend increases or decreases Significant actions by regulatory bodies Basically any information that would create a substantial likelihood that a reasonable investor would think the information was important to investment decisions Textbook citation verified )C) 34 Act > Genl Understanding Insider Trading under 10b-5 Anyone who has material information before it s disclosed to other investors can get in trouble under Section 10(b) of the Exchange Act for buying or selling based on that information. It s OK to exercise while in possession of inside information that s not yet available to other investors that might affect their decisions about their investments in the company, but not to sell while in possession of it. Information is considered material if there s a substantial likelihood that a reasonable investor would think the information was important to investment decisions about the issuer s securities. It s meant to keep investors on a reasonably even footing. This slide shows a sampling of what kinds of inside information can be considered material. Examples of inside information Actual or projected sales or earnings that have not yet been announced Major new products or major changes to existing products Changes in control or significant management changes Proposed mergers, acquisitions, or joint ventures 26

40 Dividend increases or decreases Significant actions by regulatory bodies such as the awarding of patents or approval of a drug formula 26

41 27 Reference: Selected Issues section Act 10b5 1 Trading Plans Affirmative defense against trading while knowing inside information if: Binding contract entered into during a window period before the person became aware of the material nonpublic information Expressly provides a written formula for the amount, price, and date of the transaction Can demonstrate the transaction in question was pursuant to the plan 10b5 1 plans are also especially useful to exempt the vesting of restricted stock during blackout periods. Textbook citation verified )F) 34 Act > Rule10b5-1 9)F)i) 34 Act > Rule10b5-1 > Trading Plans One way to get around the problem of executives or others wanting to sell some of their stock, but often being in possession of material nonpublic information is to implement what s called a 10b5-1 trading plan, named for that section of the Exchange Act. A Rule 10b5-1 plan is a written plan under which those who are in a position to know material nonpublic information about a company can avoid insider trading liability by creating a written plan for the future timing of option exercises and stock sales. In most cases, these are used for insiders, but they can also be used for employees whose jobs mean they are in a position to know material information, for example, when a new product is coming out. Having a 10b5-1 plan in place is an affirmative defense against insider trading if: A Binding contract is entered into before the person became aware of the material nonpublic information. This includes entering a binding contract, giving instructions to another person, or entering into a written plan. 27

42 The plan must also expressly provide a written formula to determine the amount, price, and date of the transaction And contain irrevocable instructions to the broker or whoever will carry out the transaction on the insider s behalf. And the insider must be able to demonstrate that the transaction in question was completed pursuant to the written plan. Now let s look at what regulations apply to the actual buying and selling of stock. 27

43 28 34 Act Section 16 and Insider Trading Three components: Section 16 Defines insider trading and who is subject to insider trading laws Section 16(a) Sets forth reporting obligations of those persons Section 16(b) Sets forth the application of short swing matching and recapture of statutory profit 9)H) 34 Act > Section 16 9)J) 34 Act > Section 16(a) Reporting 9)K) 34 Act > Section 16(b) Short-Swing Profits Section 16 deals with insider trading. There are three components to Section 16. The definition of insiders in the main part of the regulation. Reporting obligations of insiders covered in Section 16(a) and Short-swing matching and statutory profit recapture covered in Section 16(b) Let s look at each of those components 28

44 29 34 Act Section 16 Officers President Principal financial officer Principal accounting officer (or if none, the controller) Any VP in charge of a principal business unit, division, or function Any other officer performing a significant policy making function Any other person performing a significant policy making function Officers of parent or subsidiary companies who are performing policy making functions for the company Board members, including outside directors Anyone with beneficial ownership of more than 10% of the company 9)H) 34 Act > Section 16 9)H)i) 34 Act > Section 16 > Persons subject to Section 16 applies to public companies, which you ll recall means not just companies listed on a stock exchange, but also U.S. corporations that meet certain ownership requirements as set forth in the JOBS Act. So a company whose stock isn t publicly traded could still fall under this rule if it s big enough and has enough shareholders. Section 16 of the 34 Act designates certain people as designated executive officers these are people who have to disclose their holdings and transactions in company stock and includes all of the people on this list. For the purposes of Section 16, these people are also considered to be insiders. In some of these cases, job function rather than title determines who is a Section 16 officer. The rules define an officer as a corporate employee performing important executive duties of such character that he would be likely, in discharging these duties, to obtain confidential information that would aid him if he engaged in personal market transactions. For example, the vice president of human resources may or may not be a Section 16 officer depending on how the company is structured. 29

45 34 Act Section Reporting person who loses insider status Termination, retirement, change of position Section 16(b) matching and Form 4 reporting obligations for six months after status change Transaction is opposite way, matchable, and not exempt from Section 16(b) Occurs less than six months after transaction that occurred before cessation of insider status Prior transaction is Within 6 months before change in status also not exempt from Section 16(b) opposite of new transaction (e.g. sale matches to purchase, acquisition to disposition, and vice versa) Certain other Form 5 reporting still required Reference: Selected Issues section and Appendix B Textbook citation verified )H) 34 Act > Section 16 9)H)i) 34 Act > Section 16 > Persons subject to 9)J)iv) 34 Act > Section 16(a) Reporting > Form 4 9)J)vi) 34 Act > Section 16(a) Reporting > Post-Termination Reporting You will want to print out this slide and put it in your binders. When a Section 16 reporting person is no longer a reporting person whether because of termination, retirement, or changing to a position that no longer carries the status of reporting person he or she is still required to report opposite-way matchable nonexempt transactions for six months after the last reportable transaction while still a Section 16 reporting person and any opposite-way nonexempt transactions made during those six months after losing reporting person status can also be matched for Section 16(b) short-swing profits calculation purposes which we ll cover in a couple of minutes. 30

46 31 Reference: Selected Issues section Act Section 16(a) Requires Section 16 reporting persons to file SEC reports of holdings in and any transaction in the issuer s securities Form 3 (I m a newbie!): Initial statement of beneficial ownership, within 10 days of becoming a reporting person Form 4 (I ve bought/sold more!): Periodic statements of changes in beneficial ownership, within 2 days of the non exempt transaction Form 5 (I m still alive!): Annual statements of changes in beneficial ownership, within 45 days of the end of the issuer s fiscal year Textbook citation verified )J)iv) 34 Act > Section 16(a) Reporting > Forms 3/4/5 9)J)v) 34 Act > Section 16(a) Reporting > General Reptg guidelines Section 16a requires Section 16 reporting persons to file SEC reports of holdings in and transactions in the issuer s securities. These filings all include direct and beneficial ownership. Beneficial ownership means that the insider is considered to own the shares held by any relative who shares the same household or a child living away from home while attending college. It also includes step- and in-law relationships. If the insider controls the purchases and sales of securities owned by the relative or if the relative is a minor, then the insider is considered to be a beneficial owner even if they don t share the same household. Form 3: Must be filed within 10 days of the person becoming an insider. When preparing for an IPO a Form 3 for each of the company s insiders must be filed on or before the date the company goes public. For these purposes filed means received by the SEC electronically through the EDGAR system. All SEC filings also have to be posted on the company s Web site. Form 4: Must be filed within two business days or 5 business days, depending upon the type of transaction. 31

47 Form 5: Is necessary only if the person needs to report a transaction that for some reason didn t have to be reported on a Form 4 for example a gift of stock to a family member or charity, a transfer of options to a family member, or a small acquisition that doesn t exceed $10,000 and isn t from the company or a benefit plan run by the company or it can be used for delinquent filings of things that should have been filed on a Form 4 but weren t. If no transactions fit this description, then no Form 5 is necessary. Also, an insider can choose to file transactions that must be reported on Form 5 on a voluntary Form 4 instead. The Form 5 deadline is 45 days after the end of the issuer s fiscal year. Filing a voluntary Form 4 is known as early reporting. Section of Selected Issues tells us that the voluntary Form 4 is due any time before the due date of the Form 5. To avoid confusion and the risk of late or non-filing, it is recommended that transactions which are reportable on the year-end Form 5 be nevertheless reported as soon as possible on a voluntary Form 4. Even filings past due should be reported on Form 4 as soon as discovered. In other words, do not wait to file on Form 5. No form is necessary when: Stock options expire or are canceled if the reporting person doesn t get any money for it When Equity awards vest When Beneficial ownership changes from direct to indirect When An equity award is transferred as part of a divorce agreement We ll take a look at some transactions that are required to be reported and some others that are not required to be reported but, in general, reporting persons should assume they have to report all transactions in issuer stock even if it s involuntary on their own part or if it results in no net change of ownership when combined with another transaction this is especially true given the two business day deadline for reporting, which leaves little time to correct errors. 31

48 32 Reference: Selected Issues section Act Section 16(a) Form 4 Required Reporting (partial) Grant or exercise of a stock option or SAR Grant of stock award such as restricted stock, RSU, or performance share or unit Delivery of stock to issuer to pay exercise price or taxes Material amendment of an option or SAR Withholding of stock by issuer to pay taxes required to be withheld on exercise of option or SAR, or upon vesting of a stock or performance share award Sale of stock acquired upon exercise into open market, including sale pursuant to cashless exercise Sale of stock received in connection with stock award or performance share award Textbook citation verified )J)iv) 34 Act > Section 16(a) Reporting > Forms 3/4/5 9)J)v) 34 Act > Section 16(a) Reporting > General Reptg guidelines Here are some examples of transactions that have to be reported on Form 4. This is not an exhaustive list and you should study Selected Issues section carefully. The presumption is that any transactions in the issuer s stock do have to be reported and the same transactions as must be reported by a reporting person must also be reported when they are transacted by the reporting person s spouse, household relatives, or any company in which the reporting person has a controlling interest. 32

49 33 34 Act Section 16(a) Reference: Selected Issues section Textbook citation verified )J)iv) 34 Act > Section 16(a) Reporting > Forms 3/4/5 9)J)v) 34 Act > Section 16(a) Reporting > General Reptg guidelines For Form 4 reporting, you will want to be familiar with the term deemed execution date. The deemed execution date is the earlier of the date on which the reporting person is notified of the transaction OR the third business day following the trade date. You ll also want to read the cited reference section to see the short list of transactions that have 5 business days to be reported on a Form 4. 33

50 34 Reference: Selected Issues section Act Section 16(a) Reporting NOT required (partial list) Expiration or cancellation of options where no consideration is received by the reporting person Vesting of an outstanding stock option, stock award, or stock appreciation right Non material amendment to an option, e.g. amendments which accelerate vesting, add a tax withholding or cashless exercise feature, or adding a transfer feature Transactions in tax conditioned plans, e.g. Employee Stock Purchase Plan purchases Transfers pursuant to a divorce decree or domestic relations order These transactions are not required to be reported individually but the aggregate net results must be included in the total ownership column at least once per year with a footnote explanation. Textbook citation verified )J)iv) 34 Act > Section 16(a) Reporting > Forms 3/4/5 9)J)v) 34 Act > Section 16(a) Reporting > General Reptg guidelines And here is a partial list of transactions which are not required to be reported individually, but the net effect of which must be reflected in the total ownership column of the Form 4 at least once per year with a footnote explaining the changes. I include this list because the first two items are specifically noted on the Section 16b-3 portion of the syllabus, so you might have a question on them. READ SLIDE 34

51 34 Act Section Which of the following stock ownership forms is NOT required under Section 16 of the Securities Exchange Act of 1934 or subsequent SEC rulings? a. Statement of beneficial ownership of issuer stock when person first becomes subject to Section 16. b. Statement by each reporting person listing all stock holdings. c. Statements of changes in beneficial ownership. d. Statements including transactions that are not exempt from Section 16(b). - Now let s take a question on Section 16 Tim reads the slide and tells participants to enter their answers in the chat box. 35

52 34 Act Section Reference: The Stock Options Book section Correct answer: b Statement by each reporting person listing all stock holdings. Explanation: People with Section 16 status need only divulge holdings in the specific companies in which they hold Section 16 status, not their entire investment portfolios. Textbook citation verified )J)iv) 34 Act > Section 16(a) Reporting > Forms 3/4/5 9)J)v) 34 Act > Section 16(a) Reporting > General Reptg guidelines The correct answer is B because Section 16 reporters only need to report their stock ownership in the companies in which they hold Section 16 status. 36

53 34 Act Section 16(b) Short swing Profits 37 Reference: Selected Issues section 2.3 Requires public companies to take back any statutory profits a Section 16 reporting person makes on nonexempt sales and purchases of company stock within six months of each other. Textbook citation verified )K) 34 Act > Section 16(b) > Forms 3/4/5 Section 16b is the short swing profits rule which requires public companies to take back any statutory profits on matchable opposite way nonexempt trades made by a Section 16 reporting person over any six-month period. Statutory profit is not the same as actual profit and the purchase and sale transactions that are matched are not even necessarily for the same shares. To calculate the statutory profit the company will compare the highest sale price to the lowest purchase price within the 6 month period and the difference is the statutory profit. That is the process whether there were only two matchable transactions or multiple matchable transactions during the measurement period 37

54 34 Act Section 16(b) 6 month Period 38 Transactions being matched must be: Within any period of less than six months Best practice recommends looking backward and forward six calendar months minus one day Based on existence of irrevocable commitment, not actual receipt of payment or delivery of stock Reference: Selected Issues section 2.3 Textbook citation verified )K) 34 Act > Section 16(b) > Forms 3/4/5 9)K)i) 34 Act > Section 16(b) > Forms 3/4/5 > Calculation of 6-mos and the measurement period is a rolling 6 month period so every time a new transaction is contemplated best practice recommends that you look both backward and forward to see what transactions match during that period. This diagram is a basic demonstration of the concept. I designed this diagram to demonstrate the matching process and the point when you would stop matching when the lowest purchase price exceeds the highest remaining sale price. You can see that each of the numbered items 1, 2, and 3, are matched in order lowest purchase price to highest sale price. You ll note that the April 1 purchase is not matched against the May 10 sale because the purchase price is higher than the sale price, so no statutory profit can be found against the April 1 st purchase and by the time a higher sale price occurs on June 10, there is also a lower purchase price on May 1 to match it against. You may be asked a question that requires you to do some matching, but it won t likely be this complicated. 38

55 39 Reference: Selected Issues sections 2.3 and The Stock Options Book section Act Section 16(a) General Reporting Guidelines Applies to Section 16 reporting persons Applies to any rolling 6 month period Nonexempt, discretionary transactions Matches reportable transactions, highest sale to lowest purchase for statutory profit Equity Award Expiration or Cancellation Not reportable Equity Grants Employee benefit plans are exempt Restricted Stock (RSA, RSU) Vest/Release Transactions between issuer and reporting person are exempt Textbook citation verified )J)ii) 34 Act > Section 16(a) > Equity Award Exp/Cancel 9)J)iii) 34 Act > Section 16(a) > Equity Grants 9)J)vi) 34 Act > Section 16(a) > Genl Reporting Guidelines 9)J)viii) 34 Act > Section 16(a) > RSA/RSU vest/release I ve taken these headers from the Level 1 Syllabus on Section 16(a) reporting, but as you can see most of these items were already covered above in the Section 16(b) subtopic. For Section 16(a) purposes expirations and cancellations are not reportable, and equity grants from an employee benefit plan and RSA/RSU vest or release events are exempt. and, even though the Section 16(b) exemptions aren t introduced until Level 2 these last two subtopics equity grants and restricted stock deal with the two most basic exemptions, so you should know that equity grants through an employee benefit plan are exempt and, as regards RSA and RSU vesting and release, transactions between the issuer and the reporting person are also exempt. 39

56 39

57 40 34 Act Section 16b 3 Additional Exemptions Reference: The Stock Options Book section 8.4 Textbook citation verified )J)iii) 34 Act > Section 16(a) > Equity Grants 9)J)viii) 34 Act > Section 16(a) > RSA/RSU vest/release And since we ve started talking about exemptions, this slide sets forth the general rule that if the award is approved by either the board, the shareholders, or a committee of non-employee directors it is exempt. It is also exempt if the option and the underlying shares are held for six months from the date of grant. And, finally, as long as the grant meets one of these exemptions, then the exercise of the grant is also exempt. Again, exemptions are officially part of the syllabus until Level 3, but because of the subtopics introduced in the Level 1 syllabus it s important for you to know these basic exemptions. 40

58 34 Act Regulation S K 41 Regulation S K Proxy Statement Disclosures Policies and Practices Compliance disclosures Compensation Committee disclosures Compensation disclosures, include Director Compensation Table Summary Compensation Table The 34 Act also covers reporting requirements for issuing companies. Under the SEC s integrated disclosure system, the basic disclosure requirements for all 33 Act and 34 Act documents are set forth in a series of SEC regulations. Regulation S-K sets forth the textual disclosures for the registration statement. Under Item 402 of Reg S-K the company must disclose information concerning the various forms of compensation paid to senior executives and directors, along with explanations of its compensation philosophy, policy, and specific decisions involving compensation to these individuals, particularly with regard to activities and policies that are reasonably likely to have a material adverse affect on the company. There are about 10 disclosure items, often grouped into soft and hard disclosures. The soft disclosures are usually subjective narrative such as the Compensation Discussion and Analysis (also called the CD&A), the Compensation Committee Report, the Insider Participation Report, and the narratives that accompany the tabular disclosures which are considered the hard disclosures, such as the Director Compensation Table and the Summary Compensation Table, along with the Beneficial Ownership Reporting Compliance section of the annual proxy statement which identifies any delinquent Section 16 filings by officers and directors. 41

59 34 Act Regulation S K 42 Named executive officers are: Everyone who has served as CEO or CFO during the last completed fiscal year. Three most highly compensated executive officers (other than CEO and CFO) serving in that capacity as of the end of the year and whose compensation totals at least $100,000. Up to two others who would have been on the list except that they weren t executives as of the end of the fiscal year. The Named Executive Officers are the folks whose compensation must be disclosed in the Summary Compensation Table and other disclosures. This group includes everyone who has served as CEO or CFO during the last completed fiscal year. Three most highly compensated executive officers (other than CEO and CFO) serving in that capacity as of the end of the year and whose compensation totals at least $100,000. To figure out who falls into this category, add up everything required on the Summary Compensation Table except for amounts that go into the columns labeled Change in Pension Value and Nonqualified Deferred Compensation Earnings, which are not counted. And then Up to two others who would have been on the list except that they weren t executives as of the end of the fiscal year. For example a CEO or CFO or any of the other three most highly compensated executive officers who retired or were demoted to a non-executive position during the year. 42

60 34 Act Regulation S K 43 Summary Compensation Table items reported Base salary earned Bonus earned Value of stock awards granted Value of non equity incentive plan compensation Change in present value of accumulated benefit under defined benefit and actuarial pension plans; above market or preferential earnings on nonqualified deferred compensation All other compensation not includable in another column Total compensation The items included in the Summary Compensation Table are measured based on the fiscal year covered in the proxy statement in which it appears. The items include: Base salary earned and bonus earned Stock awards granted. this item is based on the fair value established for accounting purposes under ASC 718. The full fair value of stock awards granted in the covered fiscal year must be reported. (This is a change from earlier rules that required reporting the compensation expense amount recognized during the fiscal year.) The value of Non-equity compensation awarded under an incentive plan, this includes performance-based awards payable in cash Pensions. Since it s not equity comp, you should know it s there but shouldn t need to know the details All other compensation includes Perqs, tax gross-ups, termination payments, preferential discounted stock purchases, value of dividends paid on stock or option awards if not factored into accounting value. And then Total compensation is the Sum of all columns 43

61 34 Act Regulation S K 44 A publicly held company grants options to its CEO. The options vest in equal installments over the next four years. The expense reported in the Summary Compensation table will be based on the options a. grant date intrinsic value. b. grant date fair market value. c. grant date fair value. d. exercise date intrinsic value. Go to polling question #2 to answer Here s a typical question on Reg S-K reporting Tim reads the question and instructs participants to enter their answers in the chat box 44

62 34 Act Regulation S K 45 Reference: Selected Issues section Correct answer: c grant date fair value Explanation: The dollar amount reported for stock and option awards is to be based on the full grant date fair value for financial reporting purposes in accordance with ASC 718 for awards made during the covered fiscal year. Textbook citation verified 2017 The correct answer is C. The dollar amount reported for stock and option awards is to be based on the full grant date fair value for financial reporting purposes in accordance with ASC 718 for awards made during the covered fiscal year. The Summary Compensation Table is among the executive compensation disclosures that public companies must make. It falls under Item 402 of Regulation S-K. It is the centerpiece of the rule s tabular disclosure requirements and is designed to give a comprehensive overview of company s executive pay practices in a single location. It includes amounts paid to each named executive officer over last three fiscal years (or for shorter period in which company has been reporting company but in any case no less than a year). It s really important that you make a thorough study of Selected Issues section to understand Executive Compensation Disclosures under Reg S-K 45

63 34 Act Terminology 46 Reference: Selected Issues glossary Annual and Special Meetings of Shareholders Meetings called to solicit shareholder votes Shareholders eligible to participate are established by Record Date Votes can be registered in person or by proxy Textbook citation verified )L) 34 Act > Terminology 9)L)i) 34 Act > Terminology > Shareholder Meetings (L2) 9)L)ii) 34 Act > Terminology > Record Date The last subtopic under the 34 Act is Terminology and it asks us to look at the term record date. Now I m not sure when the subtopic here of annual and special meetings of shareholders was moved to Level 2, but I don t see the logic of introducing Record Date, without the context of Shareholders, so we re going to talk about Shareholder meetings anyway. Shareholder meetings are held to solicit shareholder votes on corporate issues. They are generally held on an annual basis, but special meetings can be called at any time as long as certain requirements are met such as communicating with the shareholders to announce the meeting in a timely manner and providing specific types of information to the shareholders in advance of the meeting. Shareholder votes can be made in person or 46

64 by proxy, either by a mail in voting process (electronic or hardcopy) or, in certain circumstances, by a broker holding the shares who has been instructed how to vote by the shareholder. The record date is the cutoff date that the board establishes to determine stock ownership and eligibility to participate in shareholder activities such as receiving capitalization adjustments and dividends, and having the right to attend shareholder meetings and vote. 46

65 Level 1 Securities Law Topics 47 Corporate Governance Corporate Law Federal Reserve Act Plan Provisions Sarbanes Oxley Act of 2002 Securities Act of 1933 Securities Exchange Act of 1934 Securities Law General Understanding And that moves us on to the Sarbanes-Oxley Act of 2002 and the Federal Reserve Act because their subtopics overlap 47

66 Sarbanes Oxley Act of Financial reporting controls Accelerated Section 16 reporting deadlines Prohibits personal loans to executive officers and directors Insider Trading Compensation and stock sale profit clawbacks from CEO and CFO if financials are restated because of misconduct Auditor conflict of interest Corporate governance and director conflicts 7) Sarbanes-Oxley Act of )A) SOX > General Understanding In response to the major corporate and accounting scandals that took place at the turn of the century, the U.S. legislature passed the Sarbanes-Oxley Act of 2002 to strengthen existing standards and enact new standards affecting financial reporting, insider trading and executive compensation. The standards affect all U.S. public company boards, management and public accounting firms. The act contains 11 titles, or sections, ranging from additional corporate board responsibilities to criminal penalties, and requires the SEC to implement rulings on requirements to comply with the law. In response, the SEC has adopted dozens of rules to implement the Sarbanes Oxley Act, including creating a new, quasi-public agency, the Public Company Accounting Oversight Board, or PCAOB, charged with overseeing, regulating, inspecting and disciplining accounting firms in their roles as auditors of public companies. The act also covers issues such as auditor independence, corporate governance, internal control assessment, and enhanced financial disclosure. 48

67 Sarbanes Oxley Act of Reference: Selected Issues section 1.6 Section 404 Internal Controls, requires annual review by management & external auditors, including: Third party administrators (SSAE 16) IT controls for administration database, with matrix security Segregation of duties Approval process (board, shareholder, awards, transactions) and audit to database Communications with external partners and internal stakeholders Financial expense calculations SEC reporting 7) Sarbanes-Oxley Act of )A)i) SOX > General Understanding > Internal Controls Internal Controls is a brand new Level 1 topic in 2017, so let s look at that a bit closer. Section 404 of the Sarbanes-Oxley Act requires public company management and external auditors to review and report annually on the adequacy of internal controls over financial reporting. At a minimum the company should have essential processes and procedures in place that govern: How it works with third-party administrators and require those vendors to provide an SSAE 16 report on their own processes and procedures. It s own internal IT controls over databases and software conduits use for the transfer and update of plan data, with a focus on defining authorized personnel and the specific extent of each person s security access parameters. Segregation of duties to ensure that the people that initiate and approve transactions aren t the same people who record the transactions, and that there is an additional set of eyes reviewing the work of the person that does record the transactions. 49

68 They should have an end-to-end process in place that ensures every activity under the plan is fully documented, including board and shareholder approvals, with transactional documentation from authorization to issuance to purchase or cancellation, and that everything ties out to the tracking system. There should be comprehensive communications procedures for working with external partners like brokers and transfer agents along with audit procedures covering data sharing, transaction approval, and stock issuance authority. Likewise and with internal stakeholders to ensure that award recipients are fully informed and awards fully documented, as well as employee demographics kept current for financial reporting and regulatory compliance purposes. Financial expense calculations and preparation of financial reports should be fully documented. And, finally, the company should have procedures to ensure that before anything gets filed with the SEC, everything that goes into its financial statements is fully audited and everything ties back to the system of record, including award recipient demographics, cash accounting and receivables, tax withholding and deposits. 49

69 50 Sarbanes Oxley Act of 2002 On June 1, 2015, a publicly held company grants 5,000 NSOs to a member of the board of directors under its broad based stock incentive plan, under which shares are registered on a Form S 8. When the options vest, on June 1, 2017, the board member completes a notice of exercise and instructs his broker to use the sale proceeds to cover the exercise cost and the taxes due. Which of the following is true? a. The margin loan from the broker can be used to cover the exercise price but not the taxes. b. The broker can withhold taxes from the sale proceeds but can t extend a margin loan to cover the exercise price. c. The board member cannot legally execute a broker assisted same day sale. d. The broker may act upon the instructions. Tim reads the question and instructs participants to enter their answers in the chat box. 50

70 Sarbanes Oxley Act of Reference: The Stock Options Book sections 7.1, 7.1.1, and Correct answer: d The broker may act upon the instructions. Explanation: Under the Sarbanes Oxley Act of 2002, publicly traded companies are prohibited from extending loans to officers and directors. However, under Regulation T, a broker can extend a margin loan to an insider who is exercising options under an employee benefit plan that is registered on a Form S 8. The SEC has not yet ruled on this point, but such broker assisted cashless exercises, which do not involve an extension of credit from the company itself, have become common. Textbook citation verified ) Sarbanes-Oxley Act of )A) SOX > General Understanding The correct answer is D. Under the Sarbanes-Oxley Act of 2002, publicly traded companies are prohibited from extending loans to officers and directors, including accepting a promissory note. However, under Reg T, a broker can extend a margin loan to an insider who is exercising options under an employee benefit plan that is registered on a Form S-8. The SEC has not yet ruled on this point, but such broker-assisted cashless exercises, which do not involve an extension of credit from the company itself, have become common. For non-executives, payment of the exercise price with a promissory note can avoid securities, tax, and accounting problems by providing for adequate interest and appropriate collateral. If the options are ISOs, the plan document, board resolution, and grant agreement must specify that promissory notes are acceptable non-cash consideration. 51

71 With these notes or loans, the two key points are adequate interest and appropriate collateral. If the IRS deems a loan to be a below-market loan, meaning that the note holder wasn t charging enough interest, the option will be treated as having been offered at a discount and thus will be subject to Internal Revenue Code Section 409A, which means the optionee will have to pay a 20% tax plus penalties at vesting. If the option was an ISO, it will be disqualified. This won t be a problem if the interest rate is set at the Applicable Federal Rate set out in Internal Revenue Code Section What goes into determining this is a whole other level of discussion and one that you won t need for the Level 1 test. Just remember adequate interest and applicable federal rate and you ll have what you need. And then for appropriate collateral, for tax purposes, having the underlying stock at risk qualifies as appropriate collateral. But remember that if the stock is issued pursuant to Rule 144, that rule s holding period doesn t start until the shares are fully paid for. 51

72 52 Reference: The Stock Options Book sections 7.1, 7.1.1, and Federal Reserve Act Fundamentals of Regulation T regulates Broker Same Day Sale Transaction Funds may be advanced (as an extension of credit) to cover the exercise price and withholding taxes Optionee must deliver notice of exercise and irrevocable instructions to the broker Option plan must be registered on Form S 8 Includes employee optionees and non employee optionees Textbook citation verified ) Federal Reserve Act 5)A) Federal Reserve Act > Reg T 5)A)i) Federal Reserve Act > Reg T > Broker exercises/margin Rules As noted in the previous topic, even though the company is no longer allowed to extend loans to executive officers and directors, Regulation T allows securities brokers and dealers to advance funds to an optionee to cover the exercise price and related tax withholding under certain circumstances. The Optionee must deliver notice of exercise and irrevocable instructions to the broker The Option plan must be registered on Form S-8 This Includes employee optionees and non-employee optionees 52

73 Level 1 Securities Law Topics 53 Corporate Governance Corporate Law Federal Reserve Act Plan Provisions Sarbanes Oxley Act of 2002 Securities Act of 1933 Securities Exchange Act of 1934 Securities Law General Understanding Next we ll look at the corporate governance topic 53

74 Corporate Governance Stock Market Regulations 54 Reference: Selected Issues glossary, and The Stock Options Book section Textbook citation verified ) Corp Governance 2)D) Corp Governance > Stock Market Regs 2)D)i) Corp Governance > Stock market Regs > Streeet Name v Reg Owner In the Corporate Governance section of the syllabus, the focus is really limited, listing only Stock Market Regulations with the focus on shares held in street name and registered shareholders. You ll recall that stock certificates are issued when stock is purchased either through a sale/purchase transaction, a debt conversion transaction, or through the exercise of an equity compensation award or warrant. Certificates may be issued electronically or on paper and may be held in the owner s name or in street name by a brokerage firm. Street name means that the electronic certificates are held in the name of the broker and that the broker keeps track of who the shares actually belong to that person is called the shareholder or the beneficial owner. The important thing to know about shares held in street name is that the shares cannot be voted by proxy by the brokers unless the beneficial owner gives specific voting instructions to the broker. 54

75 The registered owner, or registered shareholder, is the beneficial owner, the one that is entitled to receive the benefits of owning the shares, such as dividends and appreciation in share price, that will suffer the risks of ownership, such as falling stock prices, and is also the one responsible for voting or directing the vote of the shares. 54

76 55 Corporate Governance Stock Market Regulations The Stock Options Book Selected Issues Textbook citation verified ) Corp Governance 2)D) Corp Governance > Stock Market Regs There is much more in the assigned reading on corporate governance than these limited issues, however, so I recommend that you take the time to do the reading. It looks long on the detailed reading list, but it s really only 6 pages in The Stock Options Book and 4 pages in Selected Issues. The main takeaway from this reading assignment is that even though there are circumstances for which federal or state securities laws don t require shareholder approval the stock market regulations often do require shareholder approval. And even when the Plan or regulations don t specifically say that shareholder approval is required it s still important to get shareholder approval because anytime that shareholder approval is not sought on a material issue involving stock, shareholders get very unhappy and there are many who will seek a legal remedy and no company wants a shareholder lawsuit. So be sure to give a thorough reading to Section 4.3 of the stock options book and section 6.2 of Selected Issues. 55

77 Level 1 Securities Law Topics 56 Corporate Governance Corporate Law Federal Reserve Act Plan Provisions Sarbanes Oxley Act of 2002 Securities Act of 1933 Securities Exchange Act of 1934 Securities Law General Understanding And now for the last topic in this webinar 56

78 57 Plan Provisions Plan Design Considerations The Stock Options Book (print out Exhibit 4 1 and put in your binder) Plan and Agreements are governed under contract law Omnibus is most flexible Plan type Plan amendments which diminish rights can be breach of contract Textbook citation verified ) Plan Provisions 6)A) Plan Provisions > Plan Design Considerations 6)A)ii) Plan Provisions > Plan Design Considerations > Basic corp governance Our last topic is Plan Design Considerations as it relates to securities law. This is a total of 7 pages in The Stock Options Book including Exhibit 4-1. It gives a good understanding of the contractual nature of grants made under the plan, that an omnibus plan is the most flexible type of plan that allows for a wide variety of award types to be issued, and that plan amendments which cause a diminishment of rights to the option holders can be legally problematic. Pay particular attention to The Stock Options Book Exhibit 4-1 (you may want to copy it and put it in your binder), to the section 4.1 discussion about grant acceptance and electronic acceptance issues 57

79 Level 1 Securities Law Topics 58 Corporate Governance Corporate Law Federal Reserve Act Plan Provisions Sarbanes Oxley Act of 2002 Securities Act of 1933 Securities Exchange Act of 1934 Securities Law General Understanding And that completes our coverage of all of the Corporate and Securities Law Topics for Level 1. 58

80 Questions? Achaessa James, CEP National Center for Employee Ownership 1629 Telegraph Ave., Suite 200 Oakland, CA