Company Name: American Bar Association (ABA)
Public Availability Date: December 7, 2000

[LETTER OF INQUIRY]

May 2, 2000

Richard K. Wulff, Esquire
ChiefOffice of Small Business Policy
Division of Corporation Finance
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549

Re: Request for Interpretive Letter on Rule 701

Dear Mr. Wulff:

When members of the Securities and Exchange Commission Staff met with representatives of the American Bar Association's Joint Committee on Employee Benefits in May 1999, the Staff was asked several questions by representatives of the Joint Committee regarding the manner in which the aggregate sales limits under Rule 701 would be applied. We are writing to request that the Staff confirm that the "assets limit" and the "outstanding securities limit" may be measured as of the balance sheet dates described below.

This letter has been prepared by members of the Committee on Federal Regulation of Securities of the Business Law Section of the American Bar Association and has been reviewed with members of the Federal Regulation of Securities Subcommittee of the Employee Benefits Committee of the ABA Tax Section. It does not represent an official ABA position.

Background

The Commission amended Rule 701 on February 25, 1999 to make Rule 701 more useful and eliminate unnecessary restrictions. Release No. 33-7645 (File No. S7-5-98) (the "Release"). Rule 701 exempts offers and sales of securities under a written compensatory benefit plan established by the issuer, its parent, its majority-owned subsidiaries or majority-owned subsidiaries of the issuer's parent, for the participation of their employees, directors, general partners, trustees, officers or consultants and advisors.

Rule 701(d)(2) provides that the aggregate sales price or the amount of securities sold in reliance on Rule 701 in any twelve-month period must not exceed the greatest of an amount determined under clauses (d)(2)(i), (d)(2)(ii) or (d)(2)(iii) as follows:

(i) $1,000,000;

(ii) 15% of the total assets of the issuer (or of the issuer's parent if the issuer is a wholly-owned subsidiary and the securities represent obligations that the parent fully and unconditionally guarantees), measured at the issuer's most recent balance sheet date (if no older than its last fiscal year-end) (the "assets limit"); or

(iii) 15% of the outstanding amount of the class of securities being offered and sold in reliance on the rule, measured at the issuer's most recent balance sheet date (if no older than its last fiscal year-end) (the "outstanding securities limit").

In addition, issuers must provide purchasers with specified information if aggregate awards in such twelve month period exceed $5,000,000.

1. Balance Sheet Date Determinations.

Rule 701 provides that stock issued during any twelve-month period must be valued based on the applicable sales price and that options granted during any twelve-month period must be valued based on the applicable exercise price. While the Release states that the assets limit and the outstanding securities limit are based on a twelve-month measurement period, there is no specific indication in the Release of the date as of which the value of assets or the amount of outstanding securities must be determined. However, Rule 701(d)(2)(ii) and Rule 701(d)(2)(iii) each respectively provide that the assets limit and the outstanding securities limit must be measured as of the issuer's "most recent balance sheet date (if no older than its last fiscal year end)." By contrast, Rule 701 prior to its amendment ("Old Rule 701") required in predecessor limits (contained in Old Rules 701(d)(5)(i)) and 701(d)(5)(ii)) that such limits were to be calculated as of the most recently completed fiscal year. Even under Old Rule 701, the Staff has previously stated that, where during any twelve-month period the "outstanding securities formula" provided a more advantageous calculation than the "assets formula" used at the beginning of such twelve-month period, the issuer could avail itself of the more advantageous "outstanding securities formula." Jackson, Tufts, Cole & Black (May 25, 1988).

We believe that the proper interpretation of Rule 701, as amended, is to permit an issuer to use its last fiscal year-end balance sheet for purposes of the assets limit and the outstanding securities limit or to select its most recent balance sheet (so long as it is no older than its last fiscal year-end). We believe that this interpretation is consistent with both the language and policy of Rule 701. Rule 701 by its terms recognizes the last fiscal year-end balance sheet as the baseline for measurement and the ability of an issuer to use its most recent balance sheet (if no older than its last fiscal year-end). This approach permits an issuer to have the benefit of certainty, consistent with Old Rule 701, by using the last fiscal year-end balance sheet and the flexibility of using a later balance sheet if that is advantageous to do so. This flexibility is necessary to allow issuers to use an increase in their assets or outstanding securities from additional rounds of financing as the measure for additional awards under Rule 701.

There has been a significant increase in the use of broad-based equity compensation arrangements for employees of high technology issuers prior to their becoming eligible to use a Form S-8. Moreover, with the time period between the formation of these issuers and their going public decreasing as companies ramp-up operations and hire new employees at increasing rates, and the valuations of their securities increasing, such issuers are finding themselves potentially exceeding the assets limit and outstanding securities limit. Absent an ability to increase the asset limit or the outstanding securities limit during any applicable twelve-month period, such issuers would find themselves in the position of being unable to issue equity-based compensation to employees pursuant to Rule 701.

To illustrate what we believe to be the proper interpretation of the assets limit and the outstanding securities limit, assume an issuer had assets as of December 31 (its fiscal year-end) of $10 million. If the issuer had no compensatory sales or option grants under Rule 701 in the preceding twelve-month period, the issuer initially could issue $1,500,000 million worth of equity based compensation based on such assets limit for the twelve-month period beginning after that date and prior to its next fiscal year-end. If on its balance sheet on the following April 30 the issuer had assets of $20 million (for example, as a result of a round of additional equity financing), the issuer's assets limit based on that balance sheet would be $3 million for the applicable twelve-month period beginning after that date. Using the same example, if the issuer had 20 million shares issued and outstanding as of December 31 and had 30 million shares issued and outstanding on the following April 30 (for example, because it issued 10 million shares in a financing), the outstanding securities limit under Rule 701 would increase from 3 million shares for the twelve month period based on the December 31 balance sheet to 4.5 million shares for the twelve-month look-back period should the issuer elect to use the April 30 balance sheet.

We believe that the issuer in the foregoing example should be able to use the increased assets limit or the increased outstanding securities limit reflected on the April 30 balance sheet for the twelve-month measurement period. Without such increase, the issuer would be limited to the December 31 balance sheet date even though the issuer may have had additional equity financings or noncompensatory stock issuances since the year-end balance sheet date. We believe that this result is consistent with the policy underlying Rule 701 to facilitate the issuance of shares of non-public companies to employees under plans that are fundamentally compensatory in nature.

Any other result would be harmful to fast growing private companies without increasing the protection of investors. This is especially true in the case of new high technology companies that are issuing significant option grants to attract employees prior to an initial public offering and/or increasing the price of their common stock (and similarly the stock purchase prices and option exercise prices of compensatory stock awards) to anticipate accounting comments by the Staff at the time of their initial public offerings. Without the ability to increase the Rule 701 limits based on their most recent balance sheet, many high technology companies would have no ability to grant equity-based compensation awards to their employees under an applicable securities law exemption in a timely manner.

Alternatively, an issuer should be able to continue to use its last fiscal year-end balance sheet (or a later balance sheet that it elected to use) should it so elect rather than having to establish a new measurement amount each time it has a new balance sheet. This would afford issuers certainty and make the rule easier to apply.

2. Gap Period Determinations.

As noted above, both the assets limit and the outstanding securities limit may be measured at the issuer's most recent balance sheet date (if no older than its last fiscal year-end). The problem arises when an issuer wants to make awards after the close of its fiscal year but before its year-end balance sheet is available. If Rule 701 is read literally, such issuer would be unable to use Rule 701 solely because it does not have a fiscal year-end balance sheet available yet. For example, many calendar year companies do not have a fiscal year-end balance sheet available until well into March. For foreign issuers, it may be even longer. In order to avoid a blackout period during which an issuer would not be able to make equity awards to employees using Rule 701, the limitation on using a balance sheet date "no older than its last fiscal year-end" should be interpreted to mean "its last fiscal year-end for which a balance sheet is available." This interpretation would facilitate use of Rule 701 and would be consistent with its policy.

Conclusion

For the foregoing reasons, we believe the Staff should confirm that the assets limit and the outstanding securities limit of Rule 701 may be measured as described above.

We appreciate your consideration of these issues. If you have any questions or wish to discuss this further, please contact any of the undersigned.

Very truly yours,

Keith F. Higgins
John J. Huber
Stanley Keller
Gloria W. Nusbacher
Anne G. Plimpton
Louis Rorimer
Susan P. Serota
Scott P. Spector
Ann Yvonne Walker

[STAFF REPLY LETTER]

December 7, 2000

RESPONSE OF THE OFFICE OF SMALL BUSINESS
DIVISION OF CORPORATION FINANCE

Re: American Bar Association

Incoming letter dated May 2, 2000

For purposes of making the calculations in Rule 701(d)(2)(ii) or (d)(2)(iii), an issuer may elect to use its last fiscal year-end balance sheet or a more recent balance sheet. This selection may be done even after calculations have been made using an earlier-dated balance sheet. We understand that this position permits an issuer to choose the financial statements that will provide the more favorable calculation under the formulas. The position does not mandate the usage of a later balance sheet.

You also have asked about the determination under the formulas in the period immediately following the close of a fiscal year, when a balance sheet for the most recent fiscal year is not yet available. We would raise no objection during the 90 days following the end of a fiscal year if the issuer uses a balance sheet for a different period until the balance sheet for the most recent fiscal year becomes available. This position assumes that the following two conditions are met:

• the balance sheet the issuer uses is as of a date no more than 3 months before the end of the most recent fiscal year; and

• the issuer prepares and uses a balance sheet for the most recent fiscal year end no later than 90 days following the end of that fiscal year.

Because this position is based upon representations made in your letter, any different facts or conditions might require a different conclusion.

Sincerely,

Richard K. Wulff, Chief

Office of Small Business