This Perkins Coie LLP Update summarizes the impact of the Sarbanes-Oxley Act of 2002 on public company executive compensation and makes practical suggestions for complying with the Act. The following provisions of the Act affect executive compensation arrangements and benefits:
- Effective immediately, a company may not extend or arrange personal loans to executive officers and directors, or modify or renew personal loans already in effect before July 30, 2002 (this prohibition may include certain types of broker-assisted cashless exercises and split-dollar life insurance arrangements);
- Effective August 29, 2002, Form 4 reports must be filed within two business days following a change in stock ownership and, effective July 30, 2003, Form 4 reports must be filed electronically with the SEC and posted on the company's Web site; and
- Effective January 27, 2003, executive officers and directors may not trade during pension plan blackout periods.
Significant interpretive issues remain under these provisions of the Act. We are participating in requests to obtain further guidance from the pertinent regulatory agencies and congressional staff. In addition, the Act directs or permits the SEC to issue rules that may exempt some types of transactions or clarify the Act. We will keep you updated on regulatory developments and interpretive guidance as it becomes available.
In the meantime, we suggest that companies review their compensation and benefits policies in light of the new loan prohibition, and implement the following compliance measures to meet the new two-day Form 4 filing deadline:
- Amend the company's insider trading policy to require pre-clearance (or pre-notification) for company stock transactions by insiders;
- Obtain a power of attorney from each Section 16 reporting person that permits the company to file reports on the insider's behalf;
- Appoint an insider trading compliance coordinator;
- Require insiders to use designated brokerage firms for company stock transactions; and
- Begin electronic filing of Section 16 reports now.
Prohibition on New Personal Loans and on Modification and Renewal of Existing Loans
Section 402 of the Act amends the Securities Exchange Act of 1934 to prohibit any public company "directly or indirectly, including through any subsidiary, to extend or maintain credit, to arrange for the extension of credit, or to renew an extension of credit, in the form of a personal loan to or for any director or executive officer." Loans already outstanding as of July 30, 2002, are exempt from the Act, provided they are not materially modified or renewed after that date. Violation of Section 402 could subject a company to criminal penalties.
The Act does not define "executive officer," but Exchange Act Rule 3b-7 appears to provide the applicable definition until and unless the SEC indicates otherwise. Rule 3b-7 defines an "executive officer" of a registrant to include "its president, any vice president of the registrant in charge of a principal business unit, division or function (such as sales, administration or finance), any other officer who performs a policy making function, or any other person who performs similar policy making functions for the registrant. Executive officers of subsidiaries may be deemed executive officers of the registrant if they perform such policy making functions for the registrant." Rule 3b-7's definition of "executive officer" is substantially similar to the definition of "officer" for purposes of Section 16.
The Act does not cover:
- Personal loans to employees who are not executive officers or directors. It is not clear at this time, however, if the Act's loan prohibition will be applied to require repayment of loans made to individuals who subsequently become executive officers or directors of a public company.
- Loans outstanding as of July 30, 2002 if they are not materially modified or renewed after that date.
- For companies that regularly extend personal loans in the course of their business, specified types of consumer credit that are (a) made in the ordinary course of a company's consumer credit business, (b) of a type made available by the company to the public, and (c) made on market terms or on terms no more favorable than those offered to the general public.
- Loans for business purposes. Because the term "personal loan" is not defined in the Act, it is not entirely clear what constitutes a personal loan as opposed to a loan for business purposes. Arguably, advances for business travel and company-sponsored credit cards for business expenses are not personal loans, but rather bona fide business advances made in the ordinary course of business. Given the lack of definitive guidance on this issue, we recommend that companies implement clear policies restricting the use of advances and company-sponsored credit cards by executive officers and directors. For example, advances should be reasonable in amount in relation to the contemplated business activity, and company-sponsored credit cards should be strictly limited to business use and should not be used for personal expenses that require reimbursement to the company from the executive officers and directors.
The prohibition on loans immediately affects executive compensation and benefits arrangements in the following ways:
- Stock Option Exercises. The prohibition on loans may extend to certain types of broker-assisted cashless exercises of stock options that could be deemed a temporary extension of credit arranged by the company. Because of the uncertainty in this area, until further guidance is provided, we recommend that companies consider excluding executive officers and directors from their broker-assisted cashless exercise programs, and work with their brokers as regulatory clarification develops to structure cashless exercise programs that avoid the Act's loan prohibition. Also, executive officers and directors could exercise options by tendering already owned shares, if permitted by the company and its option plan.
At this time, most practitioners are not advising that existing Rule 10b5-1 trading plans with cashless exercise features be suspended or terminated, based on an analysis that such cashless exercise features may come within the exception for pre-existing loan arrangements.
- Split-Dollar Life Insurance. Under split-dollar life insurance policies, a company pays all or a portion of the premiums for a policy insuring the life of an officer. These premium payments are later repaid to the company using the policy's death benefit or cash surrender value. Because the prohibition on personal loans may extend to these types of arrangements, companies should not enter into new split-dollar arrangements until regulatory clarification is available. Although the Act's requirements are not clear, we believe split-dollar arrangements already in effect as of July 30, 2002 should be exempt if the company's obligation to advance additional premiums in the future is sufficiently fixed.
- 401(k) Plan Loans. While there is no definitive guidance on this topic, we do not believe the Act's prohibition on personal loans should prevent executive officers from obtaining loans from their 401(k) plan accounts. Such loans are issued by the 401(k) plan (not the sponsoring company) and the loan proceeds and collateral involve only vested amounts in an executive officer's 401(k) plan account. In other words, a sponsoring company does not have any legal interest in loans from its 401(k) plans. However, because the Act prohibits even "indirect" loans or arrangements to extend credit, we will continue to monitor developments closely.
- Other Personal Loans and Advances. Loans to executive officers and directors to cover home purchases, college tuition and other expenses are not permitted under the Act. Also, because the Section 402 prohibition applies to indirect as well as direct extensions of credit, and to extensions of credit "for" as well as "to" executive officers and directors, companies should avoid any extensions of credit that might be considered prohibited personal loans to family members or entities controlled by the executive officer or director.
Accelerated Form 4 Filing Requirement; Electronic Filing Requirement for Forms 4
- Accelerated Form 4 Deadline. Effective August 29, 2002, Section 403 of the Act amends Section 16(a) of the Exchange Act to require that any Form 4 be filed before the end of the second business day following a change in stock ownership. The Act gives the SEC authority to extend the filing period for certain transactions required to be reported on Form 4 for which it finds the two-day period is not feasible.
On August 6, 2002, the SEC issued an informational release (No. 34-46313) in which it announced its intention to amend the Section 16 rules to provide that all transactions between officers or directors and the issuer that are exempt from short-swing profit recovery under Rule 16b-3 of the Exchange Act, and that were eligible for deferred reporting on Form 5, must now be reported within two business days on Form 4.
The SEC also said in the release that it intended to adopt new rules that will provide exemptions from the Form 4 two-day filing requirement for narrowly defined specified transactions where the reporting person does not control (and often does not know) the timing of the transaction. The SEC has indicated that it may use this authority to exempt certain transactions under Rule 10b5-1 plans and certain transactions within employee benefit plans. Subject to these possible exemptions, all transactions executed on or after August 29, 2002 between a reporting person and an issuer (including grants, exercises, cancellations and regrants of stock options, including repricings) will have to be reported on a Form 4 within two business days, except where the rules under Section 16(a) provide otherwise.
- Effect on Form 5. We understand the SEC intends its current exemptive rules regarding Form 5 to otherwise remain in place. Accordingly, other exempt transactions that are reportable on Form 5, such as gifts, would remain reportable on Form 5. We expect the SEC to clarify this issue.
- Penalties. Under the SEC's current rules, which remain in effect, any late Form 4 filings must be disclosed in the proxy statement and a box must be checked on the cover page of the Form 10-K indicating that late Section 16 filings were made. The Act gives the SEC broad authority to seek any equitable relief it finds appropriate or necessary to benefit investors for any violations of the new two-day filing deadline.
- Electronic Filing Requirement. Beginning no later than one year following enactment of the Act, on July 30, 2003, each Form 4 must be filed electronically with the SEC, and a company must make the reports available on its Web site the first business day after filing with the SEC.
Practical Suggestions for Complying with the Two-Day Form 4 Filing Deadline
Companies should immediately review their insider trading and Section 16 compliance policies and procedures in light of the accelerated filing deadline, and should communicate revised requirements to their Section 16 reporting persons. To the extent they have not already done so, companies should consider the following:
- Implement Mandatory Pre-Clearance Procedures. Companies should revise their insider trading policies to require pre-clearance (or at least pre-notification) for all trades involving the company's stock by directors and executive officers (and others whose securities are attributable to the insider, such as trusts or other entities in which the insider has a reportable interest or immediate family members living in the insider's household). Under a mandatory pre-clearance procedure, the insider must notify and obtain clearance from a designated individual at the company prior to a transaction involving the company's stock (usually at least two business days prior notice is required). The company should also pre-clear all Rule 10b5-1 trading plans. Transactions pursuant to Rule 10b5-1 plans would not require further pre-clearance.
- Obtain Powers of Attorney. Timely filing of Section 16 reports is greatly facilitated by having each reporting person execute a power of attorney that grants a designated officer of the company authority to sign Forms 3, 4 and 5 on the insider's behalf. Such powers of attorney can help prevent late filings that might otherwise occur due to difficulties in obtaining the required original signatures in time for the filing (resulting from vacations, travel schedules, etc.).
- Require Use of Designated Brokerage Firms. Requiring all executive officers and directors to use one or two brokerage firms designated by the company to handle all their transactions in the company's stock can help ensure compliance with pre-clearance procedures, help meet the accelerated filing deadline, and help prevent inadvertent violations of Section 16, Rule 144 and Rule 10b5;5-1. The brokerage firms should be knowledgeable and skilled in handling transactions for public company executive officers and directors. The company should arrange procedures with the broker that would, among other things, prohibit the broker from entering any order (other than pursuant to a pre-cleared Rule 10b5-1 trading plan) without first verifying with the company's insider trading compliance coordinator that the company has pre-cleared the transaction and require the broker to immediately report to the company's compliance coordinator the details of all transactions involving the company's stock by Section 16 reporting persons.
Coordination with brokers will be especially important for executive officers who have entered into Rule 10b5-1 trading plans, unless the SEC uses its rulemaking authority under the Act to exempt such transactions from the two-day filing requirement. The company's compliance coordinator should be familiar with the terms of the plans, and the plans should require the broker to report transactions to the company's compliance coordinator immediately.
- Begin Electronic Filing Now. Although electronic filing is not required until July 30, 2003, we strongly recommend that companies help their insiders begin electronic filing now in order to meet the accelerated filing deadline. In its August 6 release, the SEC also recommends that insiders (and companies that file on behalf of their insiders) begin voluntary electronic filing of all Section 16 reports as soon as possible, and indicates that, on an interim basis, it will accept electronic filings that are not presented in the standard box format and that omit the horizontal and vertical lines separating information items as long as all the required information is presented in the proper order.
To file electronically under the SEC's current procedures, each reporting person must submit to the SEC an application to obtain an individual Edgar Access Code. However, to ensure that the company promptly receives the correct code for each reporting person, the SEC will permit the company or its outside counsel to collect all the Edgar Access Code applications and send them to the SEC under a single cover letter with a request that the codes be returned to the company or counsel by facsimile. The company can then forward the codes to the respective individuals. We would be happy to prepare these applications and file them with the SEC on your behalf. In addition, we can assist you in preparing or reviewing, Edgarizing and electronically filing the Section 16 reports. Of course, unless the reporting person has given a power of attorney authorizing a company officer to sign Section 16 reports, the company will still need to receive a signed copy of the report from the reporting person prior to filing of the report electronically.
We are currently using Section 16 compliance software to assist our public company clients with their Section 16 tracking and reporting. In view of the accelerated Form 4 filing deadline, we highly recommend that companies acquire a software package to administer their Section 16 reporting. The company's use of compliance software will also facilitate our assisting the company with reporting if its staffing needs so require during any given reporting window.
Prohibition on Insider Trading During Pension Plan Blackout Periods
- Effective 180 days following enactment of the Act, on January 27, 2003, Section 306 of the Act will prohibit executive officers and directors from purchasing, selling or transferring during any pension plan "blackout period" any company equity securities acquired in connection with their employment or services. A "blackout period" is any period of more than three consecutive business days during which 50% or more of the beneficiaries or participants in a pension plan are suspended from trading in the company's securities under the plan. A "blackout period" does not include, among other things, (a) a regularly scheduled period in which participants may not purchase, sell or acquire or transfer an interest in any equity of the issuer or (b) any suspension that is imposed solely because persons become participants or cease to be participants by reason of a corporate merger, acquisition or divestiture involving the plan or plan sponsor. The company must provide prior notice to executive officers, directors and the SEC of any imposed blackout period.
- Any profit realized from such a prohibited transaction may be recovered by the company or its shareholders, irrespective of the reasons for the transaction.
- Both the SEC and the Secretary of Labor are required to issue further rules under this provision. This rulemaking authority includes the ability to provide exceptions from the prohibition for purchases made pursuant to automatic dividend reinvestment programs and for purchases and sales made pursuant to advance elections. We understand that possible advance election exceptions may include purchases or sales pursuant to Rule 10b5-1 trading plans.
We look forward to working with you as we continue to monitor implementation of the Act. Please contact your client service lawyer or any of the lawyers listed at the end of this Update to discuss how the Act will apply to your specific circumstances.