Private Companies: All SEC Inquiries are Cause for Alert (and What You Should Know About Rule 701)

On July 5, 2016, the SEC sent a slew of letters to late-stage, high-value private companies, including unicorn companies. These letters made “informal inquiries” about the securities-granting practices of the company.

To many, these requests may have felt benign—after all, the SEC just wanted to find out which employees got what kind of securities.

But it wasn't that long ago (March 2016) that SEC Chair Mary Jo White confirmed that private companies were not beyond the reach of securities regulations or the “official curiosity” of SEC investigators.

It seems this latest wave of informal inquiries could be their curiosity, piqued.

It’s useful to remember that most SEC investigations start informally and privately. From the SEC website:

All SEC investigations are conducted privately. Facts are developed to the fullest extent possible through informal inquiry, interviewing witnesses, examining brokerage records, reviewing trading data, and other methods.

The Letters and Rule 701

It’s notable that the SEC letters sent in July were very specific in asking for information about the company’s compliance with Rule 701.

Rule 701 regarding the “exemption for offers and sales of securities pursuant to certain compensatory benefit plans and contracts relating to compensation” is an exemption that private companies use in order to grant securities to employees without first registering those securities with the SEC.

Why Rule 701 is Tricky

The part of the rule that concerns everyone has to do with disclosure. The rule states that if, within any 12-month period, a company issues securities that are valued at more than $5 million, the company must give investors (here, its employees) certain disclosures, including financial statements and risk factors.

From the rule:

The issuer must deliver to investors a copy of the compensatory benefit plan or the contract, as applicable. In addition, if the aggregate sales price or amount of securities sold during any consecutive 12-month period exceeds $5 million, the issuer must deliver the following disclosure to investors a reasonable period of time before the date of sale ... Information about the risks associated with investment in the securities sold pursuant to the compensatory benefit plan or compensation contract; and … Financial statements required to be furnished by Part F/S of Form 1-A (Regulation A Offering Statement) (§ 239.90 of this chapter) under Regulation A (§§ 230.251 through 230.263) . . . .

The financial statements required by this section must be as of a date no more than 180 days before the sale of securities in reliance on this exemption …

Why is this tricky? First, some fast-growing private companies—companies whose valuations are often changing rapidly—may not have the kind of internal control mechanisms that would help them realize in a timely way that they may be on the verge of violating Rule 701.

In addition, a lot of high-flying private companies consider their financial information to be incredibly confidential and are not in the habit of sharing it with anybody, much less hundreds of employees.

Why It’s Serious

First, any company that receives an informal inquiry from the SEC needs to take it very seriously. There’s no such thing as a casual inquiry from the SEC.

All inquiries are a form of investigation, and informal investigations can turn into settlements without ever being escalated to another stage, as the SEC points out on its website: “In many cases, the Commission and the party charged decide to settle a matter without trial.”

Secondly, with Rule 701, there are consequences to violating the parameters of the exemption, which could be especially problematic if the company is on the verge of trying to file for its IPO.

Corrective action may have to be taken, and individuals responsible for a company’s compliance with federal securities law may find themselves the subject of a cease-and-desist order —or worse. Moreover, the SEC is unlikely to allow any company to finalize its registration statement and complete an IPO until all pre-IPO securities law issues have been addressed.

What To Do

First and foremost, if you haven’t received one of these SEC letters, now is the time to talk to your outside counsel and take steps to ensure that you are not at risk of violating Rule 701.

If you have received one of these SEC letters, immediately talk to your outside counsel. You’ll want your lawyers’ help in preparing all responses to the SEC.

If you have violated Rule 701, working with outside counsel to determine the best next steps to take is key. “Hoping this will go away” or that no one will notice is probably not a great strategy.

Next, call your D&O liability insurance broker. The issues with insurance can be profound. One of them is that, as we have discussed in the past, investigations are generally not covered for corporate entities.

Coverage Issues

In an informal inquiry, your company is technically cooperating with the SEC. This is a good move given that the SEC values early cooperation. Early cooperation can cause the SEC to lessen things like penalties down the road.

But from a D&O insurance perspective, cooperation can be problematic. If your company is voluntarily cooperating with the SEC, you are not responding to an adverse third-party action, which is what the policy is actually designed to cover. In addition, private company D&O policies (like public company D&O policies) often exclude coverage for SEC investigations of a corporate entity. However, if an individual is required to give testimony as part of a private company’s response to the SEC, in some cases there may be pre-claim inquiry coverage that helps to pay for the attorney who will represent this individual. (This type of coverage is much more common in public company D&O policies.)

One of the dangers here is the situation where a company receives an SEC informal inquiry in one policy period but doesn’t inform the company’s D&O insurance carriers in a timely way.

Consider what may happen if, during a future policy period, the SEC gets more aggressive and there’s a real claim, for example some sort of formal enforcement action against an individual officer. In this scenario there’s a risk that an insurance carrier might deny coverage because the company knew of the circumstance earlier and did not disclose it. Companies are typically obligated to inform their insurance carriers of a material change in risk before their policies renew.

You can talk to your insurance broker about whether you should notice the claim to your current insurance carrier; most policies also allow you to notice a circumstance, which is the act of letting a carrier know that something happened that could reasonably give rise to a claim.

These decisions can be tricky. The worst thing you can do is to leave the issues unaddressed.

Informal Doesn’t Mean Casual

Scenarios like this are exactly the reason why high-profile private companies need to work with brokers used to dealing with companies that are growing at a very fast pace.

Unless you are working with an insurance brokerage that has a dedicated team to handle D&O claims, things can get ugly.

Pattern recognition is important when it comes to handling the D&O claims of fast-growing companies. For example, in the case of the Rule 701 letters, a broker who doesn’t handle many claims would be less likely to see the potential danger to the corporation and its Ds and Os.

It’s not a straight line from a Rule 701 inquiry letter to a Department of Justice action against an individual for violating securities laws, including SEC Rule 10b-5’s prohibition against fraud.

An experienced broker will see the potential connection and work to ensure that limits will be available to protect individuals if push comes to shove.

The stakes are high in informal investigations: foot faults here can lead to a situation in which there is a serious claim against a company, its directors and its officers—but no insurance coverage.