The Sarbanes-Oxley Act of 2002 makes far-reaching changes in federal regulation applicable to public companies and their directors, executives, auditors and advisers. In addition to corporate governance, disclosure and accounting reforms, the Act includes several provisions impacting executive compensation arrangements. Directors, executives, compliance officers and benefit plan administrators of public companies should promptly consider the following provisions of the Act:
* Restrictions on company stock sales during retirement plan blackout periods
* Disgorging executive pay due to accounting restatements
* Freeze on extraordinary payments to directors and officers
This article briefly summarizes these provisions, identifies significant interpretative issues and suggests actions for public companies to consider with respect to executive compensation practices.
Prohibition on Personal Loans to Directors and Executive Officers
Section 402 of the Act prohibits reporting companies (those that file periodic reports with the Securities and Exchange Commission) from making or arranging an “extension of credit in the form of a personal loan” to or for the benefit of their directors and executive officers, subject to a grandfathering provision and some very narrow exceptions like extensions of credit provided by reporting companies that are in the consumer credit business and certain loans made by FDIC-insured banks and thrifts.
Section 402 exempts outstanding loans made before July 30, 2002, “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 July 30, 2002. Section 402 may be violated even if the change is minor and does not affect the overall financing arrangement. It is not clear what happens if a grandfathered loan is not repaid when due. A failure to attempt collection of a grandfathered loan could be viewed as a modification of the loan.
“Extensions of Credit” and “
Many types of transactions that might not ordinarily be viewed as loans may involve an “extension of credit” such as guarantees and installment sales. A public company might be viewed to “arrange for extension of credit” merely by helping establish a financing arrangement, such as selecting or recommending a lending institution. It is also unclear what types of arrangements and transactions will be considered to be an extension of credit “in the form of a personal loan.” The Act does not define the term “personal loan.”
Public companies should immediately identify all transactions potentially subject to Section 402. Common arrangements discussed in more detail below that may be viewed to involve an extension of credit are split-dollar life insurance and cashless stock option exercises. Other transactions with directors and executive officers that might be treated as an extension of credit include:
* Loans for geographic relocation
* Routine advances for business purposes (such as reimbursement accounts and travel expense allowances), particularly if repaid over long period of time
* Personal use of company credit cards
* Indemnification payments made under company bylaws or an employment agreement before a determination of entitlement to such payment
* Use of company funds to meet an executive’s payroll tax obligations for non-qualified deferred compensation benefits
* Signing bonuses subject to repayment on early termination of employment
Section 402 raises several important interpretative questions that ultimately will need to be resolved through regulatory guidance by the SEC or legislative clarification. While there will likely be many requests for interpretative rules, it appears that guidance under Section 402 will not be forthcoming for some time due to several other demands on the SEC under the Act. Until further regulatory guidance is available, public companies should not provide new or modified extensions of credits to executives and directors that may be viewed as personal in nature.
Split-Dollar Life Insurance
Many publicly held companies provide permanent life insurance protection to their executives in the form of split-dollar life insurance. A company that provides split-dollar life insurance to its executives will pay all or substantially all of the premiums on policies subject to the arrangement. The executive is then required to return the company’s premium payments to the company at some later point in time, which is usually the executive’s termination of employment or death. This type of split-dollar arrangement is often referred to as an “equity” split-dollar arrangement (Equity SDA), because the executive owns all policy cash surrender value (i.e., equity) in excess of the company’s recovery right.
Recently, the IRS proposed to treat premium payments made under Equity SDAs as loans when the executive owns the split-dollar policy and has rights to all cash surrender value in excess of premium payments. Other forms of split-dollar life insurance (including Equity SDAs when the employer owns the policy) in which the company receives repayment of its premium payments upon termination of the arrangement have not been considered by the IRS to involve loans. It is currently unclear whether the existence of an Equity SDA or payment of premiums under such an arrangement will be treated as a “personal loan” under Section 402. It appears that Congress chose to not fully consider how the personal loan prohibition might apply to split-dollar life insurance. Senator Sarbanes has publicly stated that split-dollar was “raised with us at the last minute and it’s a fairly complicated issue, and we weren’t able to address it.”
Cashless Stock Option Exercises
Another common executive compensation practice that has been impacted by Section 402 is the cashless exercise of stock options facilitated through a broker. In a cashless exercise, the option holder instructs a brokerage firm to sell a sufficient number of the shares being obtained by the option exercise to satisfy the option price and any withholding taxes applicable. The broker sells the shares and remits the exercise price and any taxes required to be withheld to the company with any balance remitted to the option holder. The company delivers the requisite number of shares to the broker and the balance to the option holder.
There are two common methods to execute a cashless exercise of a stock option. A broker may sell the shares on the date of receipt of exercise instructions and remit the exercise price and withholding taxes to the company a few days later, on the date of the settlement of the sale of those shares. Alternatively, a broker may sell the shares on the date of receipt of the instructions and remit the exercise price and withholding taxes immediately to the company, treating the amount as a margin loan to the option holder. Other variations on this practice also exist.
Any cashless exercise method involving an insurer may be viewed as resulting in an “extension of credit” under Section 402. A broker-assisted direct sale involves the company making stock or cash available to the option holder for the exercise, albeit only for a very short period of time. While a margin loan from a broker does not involve the use of the company funds, it may also be subject to Section 402 to the extent that the reporting company is viewed to “arrange” this financing by establishing the cashless exercise program with the brokerage firm. To date the SEC has not taken a formal position regarding whether Section 402 prohibits cashless exercise programs.
Note that Section 402 only applies with respect to extensions of credit by the reporting company (or a related party) or extensions of credit that have been arranged by the reporting company for a director or executive officer. A cashless exercise should not be prohibited if a director or executive officer arranges the cashless exercise without any involvement from the reporting company and the credit extension is from the broker or other third party and not the reporting company.
Restrictions on Company Stock Sales During Blackout Periods
Effective early next year, Section 306(a) of the Act will prohibit directors and executive officers of public companies from purchasing or selling an equity security of the reporting company that the director or officer “acquires in connection” with his or her service with the reporting company during any retirement plan “blackout period.” Any profits realized by a director or an executive officer in violation of Section 306(a) are recoverable by the company or by stockholders in a derivative action.
Subject to certain exceptions, a blackout period for purposes of this restriction is generally any period of more than three consecutive business days during which 50% or more of plan participants and beneficiaries under “individual account plans” (such as a 401(k) or profit sharing plan) are unable to buy and sell company stock.
It is unclear how the purchase and sale prohibitions under Section 306(a) will apply to transactions due to significant drafting irregularities in the statute. Perhaps recognizing the provision’s deficiencies, the Act expressly directs the SEC, in consultation with the U.S. Department of Labor, to issue rules “to clarify the application” of the purchase and sale restrictions.
Disgorging Executive Pay Due to Accounting Restatements
Section 304 of the Act requires that chief executive and financial officers forfeit certain bonuses and gains on stock sales in connection with the filing of an “accounting restatement due to material noncompliance of the issuer, as a result of misconduct, with any financial reporting requirement under the securities laws” during a specified recapture period. The “recapture period” is the 12-month period following “the first public issuance or filing with the SEC (whichever first occurs) of the financial document embodying such financial reporting requirement.”
Section 304 became effective on July 30, and absent interpretive relief applies retroactively to compensation paid or gains realized prior to that date. Section 304 does not define the types of actions (or omissions) that constitute “misconduct” triggering the forfeiture requirement. In addition, Section 304 does not identify whose misconduct is relevant. In the absence of guidance to the contrary, it appears that forfeiture may be triggered regardless of who engaged in the misconduct resulting in the accounting restatement.
If the forfeiture requirement is triggered under Section 304, the chief executive officer and chief financial officer must reimburse the reporting company for “any bonus or other incentive-based or equity-based compensation received by that person from the issuer” (targeted compensation) and “any profits realized from the sale of securities of the issuer,” during the recapture period after the filing of the “financial document embodying such financial reporting requirements.” As a result, only targeted compensation “received” and profits from securities sales “realized” during the recapture period are subject to forfeiture.
It is unclear how one determines when targeted compensation is “received” for purposes of Section 304. Consider how Section 304 might apply to common executive compensation arrangements. Is equity-based compensation “received” upon the grant of a stock option, the exercise of a stock option or both? Is restricted stock “received” upon grant or vesting? Are performance-based non-qualified deferred compensation benefits “received” in the year earned or in the year of actual receipt? Do constructive receipt principles similar to those under tax laws apply? These types of interpretative questions will require regulatory guidance or legislative clarification.
Freeze on Extraordinary Payments to Directors and Officers
Section 1103 of the Act allows the SEC, during an investigation of a reporting company or its directors, officers, partners, controlling persons or other employees, to seek a temporary court order the company to escrow “extraordinary payments” to such person for 45 to 90 days (or, if such person is charged with a violation of the securities laws, until conclusion of the proceedings). There is no definition of “extraordinary payments” other than to indicate that it includes compensation. “Extraordinary payments” might include bonuses, stock option exercises, payments under a non-qualified deferred compensation plan and severance pay.
What’s Next in Executive Compensation?
A new era in executive compensation has dawned. Perceived abusive executive compensation packages at numerous publicly held corporations have triggered intense scrutiny by stockholders, legislators and regulators. This intensity is likely to increase. The Act also required the SEC to adopt new rules (which it did effective Aug. 29) requiring nearly all stock and option transactions between public companies and their directors and executive officers to be publicly reported within two business days.
Further regulatory changes may also impact executive compensation practices. For example, pending legislative proposals could significantly affect deferred compensation arrangement for executives, and the IRS has proposed new rules concerning “golden parachute” severance packages and split-dollar life insurance arrangements.
Public companies and their executive officer and directors should act without delay in evaluating with the help of qualified objective advisors whether their executive compensation programs will hold up to critical examination in the new environment.
David A. Cifrino and Andrew C. Liazos are partners at the international law firm of McDermott, Will & Emery practicing in its Corporate Responsibility and Executive Compensation Practice Groups.