SEC Hands Credit Karma Some Instant Karma

• Posted on: Jun 1 2018

San Francisco-based Credit Karma, Inc. (“Credit Karma” or the “Company”), the rapidly growing financial services tech company, has been penalized by the Securities and Exchange Commission (“SEC”) for regulatory violations related to its Employee Stock Ownership Plan (“ESOP”). The SEC alleged that the Company unlawfully offered securities to its employees and failed to provide them with timely financial statements and risk disclosures. 

A copy of the press release announcing the settlement can be found here.

The Credit Karma Penalty

In the tech sector, stock options are used as a perk to attract and retain highly-skilled workers. Between October 1, 2014, and September 30, 2015, the company issued about $13.8 million in employee stock options, above the regulatory threshold of $5 million. 

In the SEC’s Order instituting cease-and-desist proceedings (here), the SEC found that Credit Karma did not register its offer of stock options.  Instead, the Company sought to rely on Securities Act Rule 701, which allows privately-held companies to compensate their employees with securities without incurring the obligations of public registration and reporting as long as, once the company issues $5 million worth of securities, it provides essential information about the investment to employees.

The SEC found that even though financial statements and risk disclosures were available and confidentially provided to potential institutional investors, Credit Karma failed to provide this information to its own employees.

“Registration requirements exist to ensure that all investors have access to important information before deciding to invest,” Jina Choi, director of the SEC’s office in San Francisco, said in a prepared statement. “This is equally true for employees who are investors in the companies where they work.”

The alleged wrongdoing occurred while Credit Karma was rapidly growing and hiring employees at a dramatic pace. “Between 2014 and 2016, Credit Karma headcount increased by a factor of five to support an additional 20 million new members,” Credit Karma stated in comments emailed to news organizations.  In early 2014, for example, the Company had about 100 employees. By the end of 2016, the number spiked to about 500. Credit Karma presently employs about 750 people, most of whom are located in San Francisco.

The SEC also found that Credit Karma executives were aware of the disclosure requirements regarding the stock options as early as April 2015.  Notwithstanding, “[f]or the next eleven months after August 2015, Credit Karma continued to grant employees stock options and allowed them to exercise their vested stock options granted in the unregistered offering.” The SEC concluded that “[a]lthough Credit Karma periodically provided certain limited financial information to its employees, it failed to deliver to the employees the complete financial information and disclosures required by Rule 701.”  Credit Karma also allowed employees to exercise vested stock options, but failed to deliver complete financial information and other required disclosures to employees. 

After the Company received an inquiry from the SEC regarding its Rule 701 disclosures in July 2016, Credit Karma began providing disclosure packets to its employees. According to Credit Karma, the violations have ceased. “We have been in full compliance since mid-2016,” the company stated.

The SEC concluded that Credit Karma violated the registration requirements of the Securities Act of 1933 because it offered to sell and sold its securities to employees without a valid Rule 701 exemption. As a result, without admitting or denying the allegations in the Order, Credit Karma consented to the civil penalty and the SEC ordered Credit Karma to cease and desist from any further registration violations.

The Takeaway

The Credit Karma action is the first enforcement proceeding to arise out of the SEC’s investigation into Rule 701 option-granting practices.  The settlement reinforces the SEC’s concern that private companies are not providing to employees the disclosures mandated under Rule 701.

The Credit Karma action teaches the importance of Rule 701 compliance. Private companies should, therefore, examine their procedures and controls for ensuring that Rule 701 disclosures are made in a reasonable amount of time before options are exercised if the $5 million threshold is met, or if the company anticipates that the threshold will be met. The Credit Karma action also teaches that companies should carefully consider the methods by which Rule 701 disclosures are made to ensure that they permit effective and ongoing access to the disclosure information. Finally, private companies should keep in mind that until the SEC states otherwise, Rule 701 disclosures must be made prior to the grant of the stock options.