SOX Prohibition on Loans to Officers and Directors

In the absence of guidance from the SEC, a consortium of 25 law firms published a memorandum in October 2002 detailing the consensus of the various practitioners on the application of Section 402. In the decade since the enactment of SOX, this memorandum has remained the only guidance on such issues, given the SEC's stated position of not providing formal interpretive guidance with respect to the applicability of Section 402.

On March 4, 2013, the SEC issued a no-action letter in response to a request for interpretive guidance regarding the applicability of Section 402 to a program that would allow directors and executive officers to obtain credit utilizing equity grants made by a public company issuer. The SEC's response indicated that a public company that permitted its directors and/or executive officers to participate in such a program would not be deemed to be extending or maintaining credit, arranging for the extension of credit, or renewing an extension of credit in violation of Section 402. Further, the SEC noted, this would not be deemed in violation of Section 402 if it undertook certain administrative activities as described in the request for interpretive guidance.

Background

The initial request for interpretive guidance came from RingsEnd Partners, LLC and related to the equity-based incentive compensation program (EBIC Program) RingsEnd had put together for the benefit of employers. RingsEnd created the program so that employees of public companies could avoid having to sell shares awarded as part of their incentive compensation in order to pay the taxes due and any required exercise price. RingsEnd took the position that the interests of a company's executives and directors are better aligned with stockholders when they are able to retain grants of stock awards for a long period, as opposed to needing to sell portions of such awards in order to pay the taxes on the fair market value of the award upon vesting.

The EBIC Program was designed to encourage employee participants to retain such stock awards for as long as possible by providing a mechanism to allow participants to elect to pay taxes at the time of grant, and obtain funds to make such tax payments through a third-party loan secured by the shares issued as part of the stock award. However, RingsEnd encountered difficulty when trying to convince public companies to participate in an EBIC Program due to the lack of SEC guidance on the applicability of Section 402 of Sarbanes-Oxley to this sort of arrangement.

EBIC Program

Under the EBIC Program, restricted stock issued under a typical employer incentive compensation plan would serve as collateral for loans to employee participants. The EBIC Program would have the following features:

• Employee participants would report the value of the stock award as taxable income on the award grant date, rather than on the date of vesting;
• Employee participants would transfer their stock awards to a Delaware statutory trust administered by an independent trustee (employee participants would have no control over the trustee, the trust, the trust assets or the trust obligations);
• The trustee would borrow funds via non-recourse term loans from an independent banking institution, using some or all of the transferred stock as collateral;
• The trustee would use the loan proceeds to make a distribution to the employee participants in an amount approximately equal to the tax incurred as a result of the stock award;
• The trustee, at loan maturity, would sell sufficient shares to pay off the loan, and distribute the remaining shares of stock and any residual cash to the employee participants; and
• Increases in the value of the stock awarded would not be taxable upon vesting or distribution to the employee participants, but would be taxed only upon future sales of shares.

In the request for guidance, RingsEnd took the position that the EBIC Program would not violate the prohibition on the extension of personal loans or credit by public companies to executive officers or directors because the loan to the trust would be provided by an independent banking institution, rather than by the public company. Under the RingsEnd request, the loan would not be viewed as having been “arranged” by the public company because the public company's role in the EBIC Program would be limited to certain administrative actions in order to allow employees to participate. The public company would not negotiate with the lender, provide a guaranty of the loan extended to the trust or encourage, or discourage employee participation. In light of this, the SEC agreed that participating in the EBIC Program would not violate Section 402 of the Sarbanes-Oxley Act.

What Public Companies Should Do

In light of the SEC's no-action letter, public companies that wish to allow their employees to participate in an EBIC Program must present the opportunity to their employees as completely voluntary, and neither encourage nor discourage participation. Employers should not provide any inducement to employees to participate, and the terms of the EBIC Program should be fully disclosed to the public company's board of directors. Additionally, the public company must have no role in administering the EBIC Program or the trust, or in obtaining the term loan, either directly or indirectly ' i.e., the company cannot make the loan, provide a loan guaranty, or otherwise support the loan.

An employer's participation in the EBIC Program should be limited solely to the administrative acts necessary to allow employees to participate in the EBIC Program, such as delivery of stock awards to the trust as directed by employee participants, providing information regarding the employee participants and their stock awards and delivering the lender a prospectus, and registration statement covering the shares of stock held by the trust. The employer cannot pay any fees, expenses, compensation or reimbursement to employee participants, the EBIC Program's sponsor, the lender, the trust or the trustee. All compensation, including fees and expenses associated with the creation and administration of the trust, to be received by the EBIC sponsor, the lender or the trustee must be paid by the trust, with such amounts being funded by the employee participants. Additionally, the EBIC Program sponsor must not compensate the public company for agreeing to allow its employees to participate in the program.

Conclusion

Keep in mind that no-action letters are provided by the SEC in response to the specific representations provided by the party requesting the guidance. SEC no-action guidance is given on a case-by-case basis, so any public companies that wanted to rely on this guidance without submitting a no-action request to the SEC must comply with the representations set forth in the original request letter, which are outlined above. Public companies interested in participating in a program similar to the EBIC Program described in the no-action request and discussed in this article, should take care to review such a program to make sure that it complies with the representations made by RingsEnd in the original no-action request.

Laura P. Washburn is a partner in the Corporate and Securities Practice Group at Bradley Arant Boult Cummings LLP (Birmingham, AL). She can be reached at [email protected]%20or 205-521-8370.

”

Since the adoption of the Sarbanes-Oxley Act (SOX) in 2002, public companies and their advisers have been seeking guidance on Section 402 of the Act (codified as Section 13(k) of the Securities Exchange Act of 1934, as amended), which imposed a prohibition on public companies extending loans to their directors and executive officers.'

Under Section 402, public companies were no longer permitted “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,” either directly or indirectly through a subsidiary or otherwise. The concerns addressed by this blanket prohibition were the use and abuse of public company funds to provide personal financing to insiders. However, many corporate practices among public companies and insiders that have the character of a “loan” or an “arrangement of credit” do not present the concerns that Section 402 was designed to address. For example, cashless exercises of stock options or the advancement of travel or relocation expenses could be deemed to fall within the term “personal loan.”

No-Action Letter

In the absence of guidance from the SEC, a consortium of 25 law firms published a memorandum in October 2002 detailing the consensus of the various practitioners on the application of Section 402. In the decade since the enactment of SOX, this memorandum has remained the only guidance on such issues, given the SEC's stated position of not providing formal interpretive guidance with respect to the applicability of Section 402.

On March 4, 2013, the SEC issued a no-action letter in response to a request for interpretive guidance regarding the applicability of Section 402 to a program that would allow directors and executive officers to obtain credit utilizing equity grants made by a public company issuer. The SEC's response indicated that a public company that permitted its directors and/or executive officers to participate in such a program would not be deemed to be extending or maintaining credit, arranging for the extension of credit, or renewing an extension of credit in violation of Section 402. Further, the SEC noted, this would not be deemed in violation of Section 402 if it undertook certain administrative activities as described in the request for interpretive guidance.

Background

The initial request for interpretive guidance came from RingsEnd Partners, LLC and related to the equity-based incentive compensation program (EBIC Program) RingsEnd had put together for the benefit of employers. RingsEnd created the program so that employees of public companies could avoid having to sell shares awarded as part of their incentive compensation in order to pay the taxes due and any required exercise price. RingsEnd took the position that the interests of a company's executives and directors are better aligned with stockholders when they are able to retain grants of stock awards for a long period, as opposed to needing to sell portions of such awards in order to pay the taxes on the fair market value of the award upon vesting.

The EBIC Program was designed to encourage employee participants to retain such stock awards for as long as possible by providing a mechanism to allow participants to elect to pay taxes at the time of grant, and obtain funds to make such tax payments through a third-party loan secured by the shares issued as part of the stock award. However, RingsEnd encountered difficulty when trying to convince public companies to participate in an EBIC Program due to the lack of SEC guidance on the applicability of Section 402 of Sarbanes-Oxley to this sort of arrangement.

EBIC Program

Under the EBIC Program, restricted stock issued under a typical employer incentive compensation plan would serve as collateral for loans to employee participants. The EBIC Program would have the following features:

• Employee participants would report the value of the stock award as taxable income on the award grant date, rather than on the date of vesting;
• Employee participants would transfer their stock awards to a Delaware statutory trust administered by an independent trustee (employee participants would have no control over the trustee, the trust, the trust assets or the trust obligations);
• The trustee would borrow funds via non-recourse term loans from an independent banking institution, using some or all of the transferred stock as collateral;
• The trustee would use the loan proceeds to make a distribution to the employee participants in an amount approximately equal to the tax incurred as a result of the stock award;
• The trustee, at loan maturity, would sell sufficient shares to pay off the loan, and distribute the remaining shares of stock and any residual cash to the employee participants; and
• Increases in the value of the stock awarded would not be taxable upon vesting or distribution to the employee participants, but would be taxed only upon future sales of shares.

In the request for guidance, RingsEnd took the position that the EBIC Program would not violate the prohibition on the extension of personal loans or credit by public companies to executive officers or directors because the loan to the trust would be provided by an independent banking institution, rather than by the public company. Under the RingsEnd request, the loan would not be viewed as having been “arranged” by the public company because the public company's role in the EBIC Program would be limited to certain administrative actions in order to allow employees to participate. The public company would not negotiate with the lender, provide a guaranty of the loan extended to the trust or encourage, or discourage employee participation. In light of this, the SEC agreed that participating in the EBIC Program would not violate Section 402 of the Sarbanes-Oxley Act.

What Public Companies Should Do

In light of the SEC's no-action letter, public companies that wish to allow their employees to participate in an EBIC Program must present the opportunity to their employees as completely voluntary, and neither encourage nor discourage participation. Employers should not provide any inducement to employees to participate, and the terms of the EBIC Program should be fully disclosed to the public company's board of directors. Additionally, the public company must have no role in administering the EBIC Program or the trust, or in obtaining the term loan, either directly or indirectly ' i.e., the company cannot make the loan, provide a loan guaranty, or otherwise support the loan.

An employer's participation in the EBIC Program should be limited solely to the administrative acts necessary to allow employees to participate in the EBIC Program, such as delivery of stock awards to the trust as directed by employee participants, providing information regarding the employee participants and their stock awards and delivering the lender a prospectus, and registration statement covering the shares of stock held by the trust. The employer cannot pay any fees, expenses, compensation or reimbursement to employee participants, the EBIC Program's sponsor, the lender, the trust or the trustee. All compensation, including fees and expenses associated with the creation and administration of the trust, to be received by the EBIC sponsor, the lender or the trustee must be paid by the trust, with such amounts being funded by the employee participants. Additionally, the EBIC Program sponsor must not compensate the public company for agreeing to allow its employees to participate in the program.

Conclusion

Keep in mind that no-action letters are provided by the SEC in response to the specific representations provided by the party requesting the guidance. SEC no-action guidance is given on a case-by-case basis, so any public companies that wanted to rely on this guidance without submitting a no-action request to the SEC must comply with the representations set forth in the original request letter, which are outlined above. Public companies interested in participating in a program similar to the EBIC Program described in the no-action request and discussed in this article, should take care to review such a program to make sure that it complies with the representations made by RingsEnd in the original no-action request.

Laura P. Washburn is a partner in the Corporate and Securities Practice Group at Bradley Arant Boult Cummings LLP (Birmingham, AL). She can be reached at [email protected]%20or 205-521-8370.

”