This article is reprinted with permission from the
August 30, 2002
edition of
New York Law Journal.
2002 NLP IP Company.

Part 1: Sarbanes-Oxley's Impact on Executive Compensation, Loans

By Joseph E. Bachelder

ON JULY 30, 2002, President George W. Bush signed into law Public Law No. 107-204, the Sarbanes-Oxley Act of 2002 (act), containing new accounting and corporate governance rules for corporations whose stock is publicly traded.1 Several provisions in the act affecting executive compensation and loans will be discussed in the column:

1. Prohibitions on personal loans and other extensions of credit to 'executive officers' and directors.

2. Disgorgement of certain types of compensation received and disgorgement of profits realized on the sale of employer securities by CEOs and CFOs of companies where there have been financial misstatements due to misconduct.

3. Disgorgement of profits realized by 'executive officers' and directors from purchases or sales (and certain other transactions) involving equity securities of the employer during certain pension fund 'blackout periods,' if those securities were acquired in connection with employment by, or services to, the issuer.

4. Accelerated filing for insider transactions.

5. Enhanced criminal penalties under 32(a) of the Securities Exchange Act of 1934 (the Exchange Act).

Part I of the column, appearing in today's issue of The New York Law Journal, will discuss prohibitions on personal loans and other extensions of credit to 'executive officers' and directors. Part II of the column, which will appear in a future issue of NYLJ, will discuss the other provisions of the act noted above.

Personal Loans

A. Personal Loans to Certain Officers and Directors Prohibited. Section 402(a) of the act (adding a new 13(k) to the Exchange Act) provides:

It shall be unlawful for any issuer ... 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 (or equivalent thereof) of that issuer.

Employers that are 'issuers' within the meaning of the act2 will be subject to civil and possibly criminal sanctions, if they make or maintain personal loans, or otherwise extend or arrange credit in the form of personal loans, to their 'executive officers' and directors on or after July 30, 2002.3

The types of loans typically made by public corporations to their executives to which this new rule applies include loans to purchase a new home, to purchase employer stock (whether by exercise of an option or otherwise) or to pay taxes (e.g., in connection with the vesting of restricted stock). Likewise, a guarantee by the issuer of third-party loans for the same purposes would be prohibited by 402(a) (that is, they would have been 'arranged' by the issuer's guarantee).

Subject to clarification by the Securities and Exchange Commission (SEC), credit transactions to which this new rule appears to apply include:

1. Certain 'cashless exercises' of stock options, including broker- assisted option exercises. Such transactions sometimes involve an extension of credit by the employer and sometimes by the broker (if the latter, presumably the extension of credit is made based on the employer's assurance of delivery of the stock). Often this arrangement has been worked out by the employer with the broker in advance.

It has been suggested that, to avoid the employer being involved in either extending or 'arranging' credit, the executive might directly contact a broker not connected with the employer. The executive would deliver to the broker and the broker in turn would deliver to the employer the option exercise form. The broker would pay the exercise price to the employer (assuming for this purpose there is a requirement, as typically is the case, that payment accompany exercise). In ordinary course, three business days will pass before delivery is required on the third-party sale of the option shares by the broker who will have received the shares in question from the employer. On the third business day after executing the third-party sale, the broker will deliver the shares to the purchaser.4 The net from a 'loan' standpoint is that the broker has provided the executive a three-business-day loan. If the employer does nothing other than (i) give assurance that the executive is entitled to acquire the shares involved upon exercise of the option and (ii) deliver the stock on payment of the exercise price, has the employer participated to the extent that it will be deemed to have 'arranged' a third-party loan to the executive?

Another suggestion that has been discussed to avoid an extension of credit is for the employer to modify the option or the option plan to delay the date when payment of the exercise price is due to the day the broker receives payment on its own sale (that is, the three-business-day delivery period normally associated with the sale of shares in the public market). In this case, the exercise of the option and the payment by the broker to the employer of the proceeds of the sale would occur on the same day and no loan would be necessary.

The foregoing suggestions should not be relied on without a careful examination of the mechanics and perhaps would best be deferred until specific rules have been adopted in this regard by the SEC.

Use of Corporate Planes and Cars

2. Personal use of corporate planes and cars, which use is then charged to the executive at regular intervals, such as quarterly, or at the end of each year. Does this constitute an extension, or arrangement, of credit by the employer to, or for, the executive? Does it make a difference if the planes or cars are owned by a third-party provider and the employer pays the charges and then collects from the executive the amounts charged to it?

3. Split-dollar life insurance arrangements. Will the amount paid into the policy by the employer be treated under the act as a loan to the executive? In proposed regulations, the Internal Revenue Service (IRS) has taken the position that employer-paid premiums under certain split-dollar life insurance arrangements are to be treated as loans to the executive or other 'service provider,' including a director.5

4. Corporate credit cards (that is, cards issued to employers by third- party credit card companies) that are used by executives who reimburse the employer for their personal charges. Does the carrying of personal charges by the employer represent a personal loan?

Other Credit Transactions

5. Other types of credit transactions as to which applicability of the new rule is unclear (although a strong argument can be made that they are not, in fact, loans (and generally, are not treated as loans for tax purposes)) are: (a) advancements of expenses under indemnification agreements that are subject to repayment if it ultimately is determined that the executive or director is not entitled to advancements; (b) excise tax gross-up payments that must be paid back to the employer in whole or in part (sometimes with interest) if it is determined the excise taxes are less than estimated at the time of payment of the gross-up amount; and (c) sign-on bonuses that are subject to repayment under certain conditions.

Unlikely to violate Section 402 - but still warranting note - is a borrowing from a 401(k) plan. If the employer itself is not involved, there should be no problem under 402.

Pending issuance of rules by the SEC under the act, if there is doubt about a particular transaction, consideration should be given to deferring or suspending it until rules in this regard are issued by the SEC. For example, an issuer might suspend, as to any executive officer or director, any premium payment under a split-dollar insurance arrangement pending clarification by the new rules. Another example would be a suspension of participation by any executive officer or director in any cashless exercise program pending clarification under the new rules. (See discussion above for suggestions that have been made to avoid having a cashless exercise of a stock option subject to the new rules. Even in such a case, suspension of the arrangement may be advisable pending issuance of the new rule.)

Grandfathered Transactions

Certain Transactions Grandfathered. Section 402(a) grandfathers certain credit transactions as follows:

An extension of credit maintained by the issuer on the date of enactment of this subsection shall not be subject to the provisions of this subsection, provided that there is no material modification to any term of any such extension of credit or any renewal of any such extension of credit on or after the date of enactment.

Obviously, a personal loan to an executive officer that is materially modified on or after July 30, 2002 will cease to be grandfathered under 402(a). But there are a number of circumstances that are not so clear.

1. Is forgiveness of a grandfathered loan a material modification of the loan if the loan documentation does not provide for such forgiveness? Does providing for forgiveness of a grandfathered loan in an employment agreement entered into prior to July 30, 2002 but not in the promissory note itself result in a future modification of such loan when forgiveness occurs? Does it make a difference whether the forgiveness is partial (thus the loan continues, modified in amount) or complete (the loan is extinguished)? What if the employer, in lieu of loan forgiveness, pays the executive a bonus equal to the loan amount coming due?

2. Are premium payments made by the employer on or after July 30, 2002 under pre-existing split-dollar insurance arrangements grandfathered or do they constitute new loans or modifications of existing loans for this purpose? This question is related to a broader question: Is a contractual commitment entered into prior to July 30, 2002 sufficient to grandfather a loan even if payments to the executive are made after July 30, 2002? Subject to issuance of rules by the SEC, the language of 402(a) indicates that payment of premiums under split-dollar life insurance arrangements after July 30, 2002 would not be grandfathered simply because the commitment to pay such premiums was entered into prior to July 30, 2002.

3. Is an extension of credit arranged by an employer, prior to July 30, 2002, such as a guarantee of a loan by an unaffiliated third party to an executive officer or director, not subject to 402 because it was entered into prior to July 30?

Section 402 prohibits an issuer as of July 30, 2002 from 'maintaining' personal loans made prior to July 30, 2002. It provides, however, a limited grandfather provision permitting an issuer to maintain such loans if there are no material modifications or renewals on or after July 30, 2002. The grandfather provision is silent with respect to the issuer's arrangement of pre-existing loans, presumably because an issuer who has arranged a loan - either through a guarantee or otherwise - is not itself maintaining that loan on July 30, 2002 and, thus, the act of arranging the loan prior to July 30, 2002 is not subject to 402(a). However, if the third party requests the issuer to make payment on the guarantee on or after July 30, 2002, can the issuer make payment under the guarantee without being deemed to have extended a personal loan to the executive officer or director?

4. If an employer that is not an 'issuer on the date of enactment' subsequently becomes an issuer, does it fail to qualify for the grandfathering clause of 402(a) as to loans and other extensions of credit made prior to July 30, 2002? Presumably, if such an employer makes a loan or an extension of credit on or after July 30, 2002 and then becomes an 'issuer,' such loans would not be grandfathered and would have to be paid off prior to the employer's becoming an issuer under the act.

If there are grandfathered loans or other extensions of credit maintained on July 30, 2002, issuers should avoid, if they can, any modification of such arrangements pending issuance of rules in this regard by the SEC.

Who's Covered?

What Officers and Directors Are Covered? Section 402(a) of the act, as quoted above, applies to 'any director or executive officer (or equivalent thereof)' of an issuer. Since 402(a) is an amendment to the Exchange Act, the meaning of executive officer should be the same as intended in the Exchange Act and defined in Rule 3b-7 thereunder. Rule 3b-7 provides as follows:

The term 'executive officer,' when used with reference to a registrant, means 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.

What is the 'equivalent' of an executive officer within the meaning of 402(a)? Is it meant to expand the group of executive officers that are treated as 'officers' by the issuer for purposes of 16(a) of the Exchange Act?6 Does 'equivalent' also refer back to 'director'? If so, would it include an ex- officio member of the board of directors of an issuer? A director emeritus?

Certain Issuers Exempted

Section 402(a) of the act exempts credit transactions if the issuer is itself in the consumer credit business and

(a) the credit transaction involving the executive is in the ordinary course of the issuer's business;

(b) the transaction is of a type generally made available by the issuer to the public; and

(c) the terms to the executive are on market terms or on terms no more favorable than the issuer offers to the general public.

There also is an exception for loans by banks and other lending institutions that are insured by the Federal Deposit Insurance Corp. if the loans are subject to restrictions on insider lending under the Federal Reserve Act. This would mean any loan made to an executive officer or a director of a bank or the bank's affiliates, if made in compliance with the Federal Reserve Act and Federal Reserve Regulation O, would be exempt.

An extension of credit (e.g., a margin loan) by a registered broker or dealer to purchase its own stock is not exempted.


1For the legislative history of the Sarbanes-Oxley Act of 2002, Pub. L. No. 107-204, (the 'act') see H.R. Conf. Rep. No. 107-610 (2002), S. Rep. No. 107-205 (2002) (accompanying S. 2673) and H.R. Rep. No. 107-414 (accompanying H.R. 3763). The current version of the Conference Committee Report includes only the text of the act. A Conference Committee Report discussing the background and purposes of the different provisions of the act is expected later this year.

2 The term 'issuer' as used in the act generally includes U.S. and foreign companies with publicly traded securities in the United States. Specifically, 2(a)(7) of the act defines 'issuer' as: an issuer (as defined in 3 of the Securities Exchange Act of 1934 (15 USC 78c)), the securities of which are registered under 12 of that act (15 USC 78l), or that is required to file reports under 15(d) (15 USC 78o(d)), or that files or has filed a registration statement that has not yet become effective under the Securities Act of 1933 (15 USC 77a et seq.), and that it has not withdrawn.

3 Criminal penalties for certain violations of the Securities Exchange Act of 1934 (the Exchange Act) are set forth in 32 of the Exchange Act. Section E of the column notes enhancements in the criminal penalties under 32(a) of the Exchange Act as introduced by the act.

4 The discussion of a 'cashless exercise' in the text of the column does not examine the mechanics of the arrangement once the broker receives the option shares from the employer and sells them. It is understood that typical practice is for the broker to sell all the shares subject to the option and remit the proceeds (less any charges) to the employer. The employer then applies the proceeds (a) to the exercise price and (b) to the amount needed to pay withholding taxes and then, ordinarily, delivers to the executive shares equal in value to the amount remaining after applying the net sales proceeds to (a) and (b).

5 Prop. Treas. Reg. 1.7872-15. The proposed regulation provides that a payment pursuant to a split-dollar arrangement will be treated as a loan if (1) the payment (including premium payments made to an insurance company) is made either directly or indirectly by the non-owner (e.g., the employer) to the owner (e.g., the executive or other 'service provider' including a director); (2) the payment is a loan under general principles of federal tax law or a reasonable person would expect the payment to be repaid in full to the nonowner; and (3) repayment is either secured by, or to be made from, the policy's cash surrender value or death benefit proceeds. Prop. Treas. Reg. 1.7872-15(a)(2)(i). Collateral assignment split-dollar arrangements, in which the employee owns the policy and the employer has a security interest for the repayment of its premiums, come within this definition.

6 Compare the definition of 'executive officer' in Rule 3b-7 with the definition of 'officer' for purposes of 16(a) of the Exchange Act as set forth in Rule 16a-1(f).