Q&A on Corporate
Ethics Under the Sarbanes-Oxley Act
The information
contained in this article is intended for informational purposes only
and should not be construed as legal advice or a substitution for obtaining
legal advice from an attorney. Reading this article is not intended
to create an attorney-client relationship. For personal legal advice,
please consult an attorney of your choice. Because of the possible unanticipated
changes in industry regulations and applicable state and federal laws,
the authors and creators and any and all persons or entities involved
in any way in the preparation of this article disclaim all responsibility
for the legal effects or consequences of the interpretation of the information
provided.
1. Who cannot
receive personal loans from a company?
Executive officers
and directors - and their spouses, minor children, trusts, and similar
entities. An "executive officer" is not covered under the
Sarbanes-Oxley Act. Most practitioners believe the definition encompasses
the same persons identified in the Form 10-K as executive officers
- who typically also are Section 16 insiders. Since "indirect"
personal loans also are prohibited, loans to spouses, minor children,
trusts and similar arrangements are suspect and should not be made.
2. What is a
"personal loan"?
It is unclear
- as the Sarbanes-Oxley Act does not define the term and there is
no definition of the term in the Securities Exchange Act of 1934.
The new law prohibits the extension or maintenance of credit; arranging
of credit or renewal of credit. In the absence of guidance from the
SEC or other regulators, many practitioners have been conservative
in how to interpret this term - and there have been differences of
opinion among many practitioners. Some practitioners have noted that
this new law is novel and indicative of a greater attempt to federalize
state corporate law.
3. Can executive
officers or directors still use brokers to conduct cashless exercises
of stock options?
This is unclear
- and probably the most controversial aspect of this Sarbanes-Oxley
Act provision due to its potential widespread impact. Many companies
allow executive officers and directors to exercise their options through
"broker-assisted cashless exercises." This allows the officer
to exercise an option and sell the underlying shares at approximately
the same time - and use the proceeds from the sale to pay the exercise
price and any withholding taxes. These companies have made agreements
with brokers to provide this service for its officers and directors.
Depending on
the precise facts of the agreement between the company and the broker,
these cashless exercise agreements involve either a temporary financing
of the officer's exercises by the company - or an "arranging"
for credit by the company with the broker on behalf of the officers
or directors. Companies typically either advance shares to the broker
with a value equal to the exercise price (which the broker sells to
pay the exercise price) - or promise to deliver shares to the broker
after the broker uses its own shares to sell to pay the exercise price.
There are other
permutations of these types of arrangements in which the company arguably
extends - or "arranges" - credit to the officers and directors
for a short period of time (between the time of the option exercise
and the time of the underlying stock sale).
Since new Section
13(k) prohibits companies from "arranging" for the extension
of credit, the question is whether the company's involvement with
the broker is sufficient for these agreements to be considered "arranged"
credit that is prohibited under the new law.
Practitioners
differ widely in their opinions until further guidance is obtained
from regulators. Some believe that the Sarbanes-Oxley Act was never
intended to apply to cashless exercises as they are not susceptible
to the type of abuses that led to Congress acting - this view is growing
in popularity . Others recommend the suspension of cashless exercises
through these programs for executive officers and directors.
Some practitioners
point out that officers can make their own arrangements with brokers
to exercise their options and sell the underlying stock. These entail
the officer or director tendering their own shares to pay the exercise
price. Under these circumstances, the officer or director should not
recognize any gain for selling the underlying shares. However, these
arrangements could result in adverse accounting treatment for the
company.
Note that even
cash exercises can be problematic - as the company may be deemed to
be extending credit between the time of the exercise (and withholding
taxes are paid by the company) and the time that the officer receives
a paycheck reflecting the deduction for the withholding.
4. Can companies
still pay advances to executive officers for upcoming credit card obligations
or other expenses?
It is unclear.
Although Section 13(k)(2) provides exemptions from the prohibition
on personal loans for extension of credit under charge cards or under
an open end credit plan - these exemptions are qualified to require
that the credit be made in the "ordinary course" of the
company's consumer credit business.
Some practitioners
believe this qualification is confusing and casts the availability
to rely on the exemption into doubt - pending further guidance from
a regulator. On the other hand, some practitioners believe that bona
fide travel advances or use of company credit cards for business purposes
should not be considered "personal loans" - so long as they
are made in the ordinary course and promptly repaid.
If companies
decide to bear the risk and make advances, some practitioners advise
that there should be clear policies restricting the use of advances
and credit cards for business purposes.
5. Can companies
still guarantee loans to executive officers from a third-party?
No. Most practitioners
believe this would be an "indirect" extension of credit
from the company to an executive officer under most circumstances.
6. Can executive
officers obtain loans in 401(k) and other broad-based employee loan
programs?
It is uncertain.
The "market terms" requirement for loans that are exempt
from the prohibition on loans requires that the loans be no more favorable
than what is offered to the "general public." Since most
401(k) and other broad-based employee loan programs offer terms that
are more beneficial than that offered to the public, executive officers
may not be able to obtain loans under these plans.
On the other
hand, it should be noted that these loans are permissible from an
insured depository institution to its insiders under an exemption
under the Sarbanes-Oxley Act for these types of loans.
7. Can executive
officers obtain loans in connection with grants of restricted stock?
No. Some companies
grant restricted stock under terms that require the grantees to receive
a loan from the company for all - or a portion - of the purchase price
of the stock. After a certain threshold is met (either corporate performance
targets or employment until a certain date), the loan is partially
or completely forgiven.
8. Can companies
still use indemnification arrangements under which an executive officer's
or director's litigation expenses are paid in advance?
It is unclear
- for many of the reasons set forth above regarding advances for other
expenses. On the other hand, some practitioners note that the analysis
in making these arrangements does not involve any consideration of
whether the insider is creditworthy. Others provide more detailed
rationales for the inapplicability of Section 402 to indemnification
arrangements.
Laura Anthony
is the founding partner of Legal & Compliance, LLC, a corporate
and securities law firm specializing in securities & regulatory
matters, business transactions, commercial litigation and entity formation.
She is also a member the NASD Dispute Resolution Board of Arbitrators
and can be reached at 800-341-2684; by e-mail at LauraAnthonyPA@aol.com
or contacted through the company’s web sites http://www.LegalAndCompliance.com
and http://www.MyWebLawyer.com.
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