Thinking about offering equity compensation to your employees or independent contractors? Here is some of the information you need to know about securities laws in Oregon and Washington.
Companies sometimes opt to provide profit interests, stock options, or other alternative compensatory benefits in exchange for services in addition to or in lieu of paying monetary compensation to employees and contractors. This approach can help cash-strapped startup companies attract talent or help create a sense of loyalty in established companies. There are a lot of factors to consider when setting up an alternative compensatory benefit scheme, such as vesting schedules, company buy-backs, tax implications, as well as securities compliance. This article will provide an introduction to the securities laws that a company should be aware of when electing to use alternative compensation plans.
What is a security and who regulates them?
Before getting into the nuts and bolts, it is important to have a basic understanding of securities and the laws that regulate them. Generally speaking, securities are investment instruments. Federal law broadly defines the term to not only include instruments typically identified as securities, such as stocks and bonds, but also ‘investment contracts.’ An investment contract includes transactions where one person invests his or her money in a common enterprise and is led to expect profits from the efforts of a third party. (See Section 2(a)(1) of the Securities Act of 1933, as amended, for types of securities listed under federal law).
At the federal level, the Securities and Exchange Commission (SEC) is responsible for regulating securities. If you or your company issues securities, then you must either register the securities with the SEC (a very expensive process) or find an exemption that exempts you from registration. These exemptions often require the issuer to follow certain procedures and submit certain filings.
State level securities laws, often referred to as “blue sky laws,” vary from state to state. Sometimes federal law preempts state securities laws, but otherwise the securities will need to be registered separately with the state or qualify for a state-level exemption as well (and even where preemption exists, an issuer may still be required to complete a notice filing under state law).
Are profits interests, stock options, and other alternative compensatory benefits, securities?
Generally speaking, yes. However, whether or not an instrument is a security can only be determined on a case-by-case basis(see footnote 1). Both the states and the federal government regulate equity compensation plans under securities laws and failure to comply can lead to potential fines, other compliance actions, and inhibit the company’s ability to offer securities in the future.
How do I comply with federal securities law?
Securities issued pursuant to compensatory benefit plans or compensation contracts typically fall under the SEC’s Rule 701 exemption, descriptively titled “Exemption for offers and sales of securities pursuant to certain compensatory benefit plans and contracts relating to compensation.” Under Rule 701, issuers are exempt from federal registration provided they meet the Rule’s conditions. Here is an overview of the Rule’s conditions:
- Not available to public or investment companies. Rule 701 is not available to public companies that are subject to reporting requirements under the Securities Exchange Act of 1934 or are investment companies required to be registered under the Investment Company Act of 1940.
- Mathematical Cap. To be eligible to use Rule 701, an issuer can only issue in a 12-month period the greater of (i) $1,000,000 worth of securities, (ii) 15% of the issuer’s total assets, or (iii) 15% of the class of securities being offered. When valuing the sale price or amount of the securities offered, note that the reference cannot be an invoice from the contractor or the employee’s salary. Rather, the value is determined by the value of the actual securities issued. For example, if an employee provides services to you worth $10,000, and rather than paying the employee normal compensation you provide her with $15,000 worth of stock, then the $15,000 is the reference value.
- Type of investor. Securities issued in reliance of Rule 701 can only be offered and sold to the issuer’s “employees, directors, general partners, trustees (where the issuer is a business trust), officers, or consultants and advisors.” Note that the definition of a “consultant or adviser” is narrow. The consultant or adviser must be a natural person who provides genuine services to the issuer not in connection with the offer or sale of securities in a capital-raising transaction. In addition, the SEC narrowly interprets the terms consultant or adviser to only include persons in a de-facto employment relationship with the issuer or persons who otherwise display significant characteristics of employment.
- Written Compensatory Plan or Contract. The securities must be offered pursuant to a written plan or contract and the employee or contractor needs to be given a copy of the plan or contract. In addition, if the total sales price or amount of securities sold in a 12-month period exceeds $5 million, then additional disclosures are required.
- Anti-Fraud Law. As with the offer or sale of any type of security, securities anti-fraud provisions apply. This includes the prohibition of making “any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading…” (see footnote 2)
In addition to federal law, you need to ensure your profits interests, stock options, or other alternative compensatory benefits comply with state law.
How do I comply with Oregon securities law?
With the adoption of OAR 441-035-0300, as of February 1, 2017 issuers are not required to register Rule 701 exempted securities in Oregon if certain conditions are met. Among other criteria, the new rule requires the issuer to submit a notice of the offering to the Oregon Division of Financial Regulation and pay a fee.
How do I comply with Washington State’s securities law?
Compensatory securities to employees and certain contractors are exempted in Washington under RCW 21.20.310(10). This exemption provides that profit sharing, stock bonuses, stock options, and other compensatory plans are exempt from registration if the plan meets the requirements of Section 401, 422, or 423 of the Internal Revenue Code (IRC). Provided the plan meets the IRC requirements, no further action with Washington is required, making this a self-executing exemption. If the plan doesn’t meet the IRC requirements, then the issuer must notify the Washington Division of Securities 30 days prior to any offering or sale of securities under the plan.
- Definition of a Security, Section 2(a)(1) of the Securities Act of 1933 (the “1933 Act”), 15 USC §77b(a)(1). Available here.
- Investment Contracts – the Howey Test, S.E.C. v. Howey Co., 328 US 293 (1946). Available here.
- SEC Rule 701. Available here.
- SEC Rule 701 Final Release. Available here.
- Oregon Exemption for Certain Compensatory Benefit Plans, OAR 441-035-0300. Available here.
- Washington Securities exempt from registration, RCW 21.20.310(10). Available here.
- Washington Securities Act Interpretive Statement-06. Available here.
Footnote 1: Teamsters v. Daniel, 439 US 551, 99 S Ct 790, 58 L Ed2d 808 (1979) and Peyton v. Morrow Electronics, Inc., 587 F2d 413, 414 (9th Cir 1978)
Footnote 2: SEC Rule 10b-5
Co-Authors: Jake Shwartz and Erik Swanson
About the Author: Erik Swanson
Email: firstname.lastname@example.org | Direct: (503) 802-5549
Prior to joining Immix, Erik ran a successful consumer goods wholesale company and spearheaded a rapid growth transition into the retail sector. As a bilingual business attorney, Erik serves clients with day-to-day business and legal needs in English and Spanish.