February 16, 2012 –
SEC’s No-Action Letter is good news for pre-IPO companies

On February 13, 2012, the Securities and Exchange Commission issued a No-Action Letter to the Fenwick & West LLP law firm. This No-Action Letter is good news for private companies that are approaching the statutory 500 shareholder limit (which would generally require them to register as public reporting companies under Section 12(g) of the Securities Exchange Act of 1934). Exceeding this limit can be very painful for a company, as it may be forced to register its class of shares under the Securities Exchange Act of 1934, which would require significant disclosures of information (the same as if it had undertaken an initial public offering) without realizing any of the benefits of public company status. The No-Action Letter will allow private companies to issue certain equity-based compensation to employees, directors and some consultants without triggering the reporting requirements of the 500 shareholder limit. Read Fenwick’s original request for the No-Action Letter (which describes the background of this situation).

Fenwick is the law firm that represents Facebook in its current initial public offering. Fenwick had previously sought and obtained similar relief specifically for Facebook in 2008. In this No-Action Letter, however, Fenwick obtained a much broader exemption from the SEC on this issue. Since the No-Action Letter was issued to the law firm rather than to a single company, the relief from these public reporting requirements should be very broad and should be applicable to any company whose situation is close enough to that described by Fenwick in its request for the No-Action Letter.

The situation that Fenwick used here involved “restricted stock units” (“RSUs”). RSU’s as described by Fenwick in the No Action Letter are equity compensation vehicles that generally entitle the holder to receive shares of a company’s common stock if certain future conditions are met before the RSUs expire. These RSUs are widely used by some companies, but there was a question regarding whether the issuance of an RSU caused the recipient to become a shareholder of the company, thus increasing the number of total shareholders and potentially causing the company to exceed the 500 shareholder limit.

The SEC granted an exemption in the No-Action Letter for the issuance of RSU’s to employees, directors and certain consultants. In addition to other existing strategies, this should provide good opportunities for larger private companies to provide equity-based compensation to these parties with RSU’s while avoiding the problems of premature public disclosure requirements.

Further relief in this area is likely to occur as Congress and securities regulators are closely examining proposals to raise the 500 shareholder limit. The SEC’s small business advisory group recently recommended that this limit be doubled. Many commentators and practitioners feel that this 500 shareholder limit is outdated and does not reflect the reality of many large, fast-growing companies like Facebook, Twitter and Zynga. All of these companies obtained relief similar to that granted in the No-Action Letter for their individual situations. Many commentators and practitioners also feel that this relatively low shareholder limit has substantially slowed the growth of these types of companies.

This is a highly technical area of compensation and securities law, and a misstep here could really hurt a company and its ability to do future securities offerings. This could be especially bad if a company is contemplating an IPO soon. Thus, companies must be careful in structuring an equity compensation plan that relies on the logic of the No-Action Letter. Be aware that the SEC carefully explained that the exemption granted in the No-Action Letter is based solely on Fenwick’s description of the specific RSU plan, and that any different facts or conclusions might not allow a company to be eligible for the exemption.

All private companies who are or anticipate approaching the 500 shareholder limit should take a careful look at the No-Action Letter, as it may present great opportunities to continue to issue equity compensation prior to an IPO without triggering premature public disclosure requirements.