July 9, 2007
Changes in California Securities Regulations for Compensatory Option Plans

Effective July 9, 2007, the California Corporations Commissioner adopted amendments to the California Code of Regulations (the “Regulations”) which govern the offer or sale of securities pursuant to a compensatory stock option or purchase plan.  As a general matter, the California Securities Law of 1968 imposes various requirements on the sale of securities within the state of California. Most prominently, the rules and regulations prohibit the sale of securities unless such sale is qualified, an exemption from qualification is available, or the sale is not subject to qualification. 

Companies issuing securities in connection with stock option or stock purchase plans often rely on a registration exemption set forth in California Corporations Code Section 25102(o). The changes to the Regulations were meant to bring this exemption further in line with federal law, including Rule 701 (“Rule 701”) of the Securities Act of 1933, as amended (the “Securities Act”). In most respects, the amended Regulations significantly liberalize the rules governing the issuance of securities pursuant to company stock option or purchase plans. This memorandum summarizes both the scope of these changes and the practical effect the amended Regulations will have on issuing companies moving forward. 

Company Repurchase Rights/Restrictions on Transfer
The amended Regulations clarify the manner in which issuers may restrict, through the use of a right of first refusal, the transfer of securities issued pursuant to a compensatory option or purchase plan. As was the case prior to amendment, any transfer restriction must be reasonable and cannot result in an outright prohibition on transfer.  The amended Regulations add provisions under which a company’s repurchase right which is exercisable in the event of a termination from service will be presumptively reasonable provided certain requirements (relating to the repurchase price, the duration of the repurchase restriction, etc.) are satisfied.

Total Number of Securities Issueable under a Plan
In the past, the Regulations required that the total number of securities authorized for issuance under a plan be limited to a number which did not exceed thirty percent (30%) of the then outstanding securities of the issuer; the amended Regulations eliminate this restriction.  Under the amended Regulations, the number of securities available for issuance under a plan may be expressed as a specific number of securities or as a percentage of the issuer’s outstanding securities, as that number may change from time to time.

Eligible Grantees
Prior to the amendment, the Regulations limited the pool of permissible grantees eligible to receive stock options to employees, directors, managers or consultants. The amended Regulations expand this class to include officers, general partners, trustees (if a business trust is the issuer), and advisors, in addition to the grantees noted in the preceding sentence.  

Transfer to Revocable Trust
The revised Regulations liberalize the transferability of securities issued in reliance upon Section 25102(o) by permitting the transfer to a revocable trust in addition to permitting transfer in accordance with the laws of descent.   

Exercise Price
Formerly, compensatory options were required to have an exercise price which was not less than 85% (110% in the case of persons owning in excess of 10% of the issuer’s securities) of the fair value of the issuer’s securities at the date of grant. The amended Regulations eliminate this minimum exercise price requirement.

Issuers should note however, that while such minimum exercise price is no longer mandated under California corporate law, the tax and accounting consequences of issuing discounted options (including the need for an issuer to book an appropriate corresponding compensation expense) can be substantial, including, without limitation, the application of Section 409A of the Internal Revenue Code of 1986, as amended.  It is strongly urged that issuers confer with competent tax counsel before granting discounted options. 

Vesting Schedule; Voting Rights
The requirement that the right to exercise an option vest at a rate of at least 20% per year over the five years from the date of grant has been eliminated in the amended Regulations. This allows companies to select vesting schedules that are more in line with business objectives, such as performance based vesting, which therefore maximizes the retention element inherent in most compensation plans. 

Additionally, the amended Regulations do away with the requirement that shares granted under a compensatory program must contain voting rights commensurate with other classes of the issuer’s securities. 

Approval of Option Plan
The amended Regulations provide that the option plan must be approved by the shareholders holding the majority of the outstanding securities entitled to vote (i) within 12 months before or after the date the plan is adopted by the issuer’s Board of Directors, Managers or other governing body, or (ii) prior to or within 12 months of the date of grant of an option or issuance of any security under the plan or agreement in the state of California, whichever is later. This amendment is important to issuers in that the necessary shareholder approval requirement may now be obtained after a grant is made.  Additionally foreign private issuers (generally issuers organized under the laws of a country other than the United States) are not required to obtain shareholder approval provided that the number of persons granted options in California, under all option plans of the issuer, do not exceed thirty-five (35).  

Issuance of Securities
The amended Regulations provide that securities, other than options, issuable under a plan or agreement must be issued within 10 years after such plan is adopted or approved by the issuer’s security holders.   

Information to Security Holders
As amended, the Regulations provide that issuers no longer need to provide annual financial statements to security holders in connection with an option plan so long as the plan or agreement complies with all of the conditions of Rule 701 or to the extent that the issuance of securities is made exclusively to key persons whose duties provide them access to sufficient information.

CIRCULAR 230 DISCLOSURE
THE DISCUSSION OF TAX CONSIDERATIONS WAS NOT INTENDED OR WRITTEN TO BE USED, AND CANNOT BE USED BY ANY TAXPAYER, FOR THE PURPOSE OF AVOIDING TAX PENALTIES THAT MAY BE IMPOSED BY THE INTERNAL REVENUE SERVICE.  ANY TAX ADVICE CONTAINED HEREIN WAS WRITTEN TO SUPPORT THE PROMOTION OR MARKETING OF THE TRANSACTIONS OR MATTERS ADDRESSED BY THE WRITTEN ADVICE. EACH PARTY SHOULD SEEK ADVICE BASED ON THE PARTY’S PARTICULAR CIRCUMSTANCES FROM AN INDEPENDENT TAX ADVISOR.