The Sarbanes-Oxley Loan Ban - an Update on Benefits Issues

This Legal Alert provides an update on the prohibition on personal loans to public company directors and executive officers contained in Section 402 of the Sarbanes-Oxley Act (the "Act"), with a focus on three key issue areas – 401(k) plan loans, stock option cashless exercises, and split-dollar life insurance. We address these subjects without the benefit of interpretive guidance from the Securities and Exchange Commission ("SEC"). Based on other priorities facing the SEC in connection with the Act, guidance on Section 402 is unlikely in the near future. On the other hand, the annual meeting of the American Bar Association ("ABA") ended this week and, where applicable, we provide our view in this Alert of any consensus that emerged on these issues during the meeting.

Section 402 of the Act amends section 13 of the Securities Exchange Act of 1934 ("Exchange Act") to make it unlawful for an issuer of securities, directly or indirectly, 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 (or equivalent thereof) of that issuer. Any loan in existence on July 30, 2002, is exempted from the reach of this prohibition, so long as there is no material modification to any term of the loan or any renewal of such loan on or after that date. The Act provides an exemption for loans made by issuers in the ordinary course of the issuer’s business. We read this narrow exemption as covering only loans by financial institutions to their own employees.

Section 402 applies only to "personal loans." The Act does not define this term. The ABA consensus is that a 401(k) loan is a personal loan, a view we share, but there is no similar consensus regarding cashless exercises or split-dollar life insurance.

The Section 402 prohibition applies only to directors and "executive officers" and "any equivalent thereof." Our and the ABA consensus view is that the term "executive officer" has the meaning given to this term by Section 3(b)(7) of the Exchange Act, which does not include a company’s principal accounting officer. In other words, the definition of officer for purposes of Section 16 of the Exchange Act, which does include a company’s principal accounting officer, should not apply. In addition, we think the phrase "any equivalent thereof" is reasonably read as applying to issuers that are not corporations rather than to expand the definition for corporations.

A violation of the prohibition contained in Section 402 constitutes a violation of the Exchange Act. An individual who willfully violates the Exchange Act, or the rules thereunder, can be punished by fines of up to $5 million (increased from $1 million) or sentenced to up to 20 years in prison (increased from 10 years) or both. A corporation can be fined up to $25 million (increased from $2.5 million).

A 401(k) plan loan may violate the Act either as an indirect loan from an entity related to the issuer or as a loan that has been arranged by the issuer (because the issuer establishes the features of the plan). We expect that the SEC will ultimately exempt 401(k) loans from the reach of Section 402, and representatives of the SEC who appeared at the ABA meeting endorsed this view. However, in advance of SEC guidance, we believe the cautious approach is for a company to preclude new 401(k) plan loans to executive officers. For many companies it may be sufficient for management to advise its executive officers that, due to the uncertainty, the company asks that they not seek new 401(k) plan loans at this time. For other companies, additional precautions may be necessary, including plan amendments to formally eliminate plan loans for executive officers.

Under a typical cashless exercise program, the issuer arranges with one or more brokerage firms to handle cashless exercises on behalf of the issuer. A cashless exercise takes place when the executive notifies the broker of his or her desire to exercise a stock option and directs the broker to sell a number of the shares to be purchased in the option exercise that is sufficient to pay the exercise price. The actual procedure by which a cashless exercise is effected varies from company to company and from broker to broker. The company may transfer shares to the broker prior to receiving payment of the exercise price for such shares. In such a case, the company could be viewed as having made a personal loan directly to an executive officer in the form of the advanced shares. The broker may advance the exercise price to the company on behalf of an executive officer prior to the settlement date and then recoup this advance from the sales proceeds on the settlement date. In this case, the broker’s advance may be viewed as a personal loan to the executive officer and the company may be viewed as having "arranged" for this loan by its involvement in setting up the cashless exercise program with the broker.

The SEC staff continue to say that they have not taken a position on cashless exercises. At the same time, exercises have occurred since the July 30, 2002 effective date of the Act. For example, after analyzing their programs, some issuers have allowed exercises through a broker selected solely by the executive. In addition, some procedures arguably do not involve any personal loan. While views on Section 402’s application to cashless exercise vary, and each case must be judged separately, nonetheless, a de facto consensus developed at the ABA meeting for a cautious approach of generally suspending cashless exercises pending SEC guidance. The emergence of this consensus, by itself, puts additional pressure on employers considering going forward with cashless exercises, even where such exercises are arguably defensible.

Under recent guidance on the taxation of split-dollar life insurance, the IRS took the position that collateral assignment split-dollar arrangements involve loans for federal tax purposes but that endorsement split-dollar arrangements do not. Unfortunately, SEC staff have stated informally that the SEC has not yet determined whether it agrees with the IRS view that endorsement split-dollar arrangements do not involve company loans. The view of the IRS will be given some weight, but the failed attempt to exempt split-dollar legislatively from Section 402 may be an impediment to the SEC’s providing prompt relief for split-dollar arrangements. As a result, we believe it would be risky for a company to enter into new split-dollar arrangements at this time for its executive officers and directors. This includes split-dollar arrangements with new executive officers under existing split-dollar programs. The Act’s grandfather provision would exempt any split-dollar arrangements that were fully in place prior to July 30, 2002, so long as those arrangements are not materially modified on or after July 30, 2002. While there is reason to think this will permit the continuation of premium payments if the terms of the arrangement are sufficiently fixed, still it is advisable to delay, to the extent possible, additional premium payments until clarifying guidance is issued.

Employee Benefits Legal Alert is a bulletin of new developments and is not intended as legal advice or as an opinion on specific facts. For more information on the subject of this Alert, please call any of the attorneys in the Employee Benefits Group or contact us through our website www.kilpatrickstockton.com.