Client Alerts


The Sarbanes-Oxley Act of 2002: Effect on Pension Plans and Other Employment Issues


The Sarbanes-Oxley Act of 2002 (Sarbanes-Oxley Act of 2002, H.R. Rep. No. 107-610 (2002)) was signed into law by President Bush on July 30, 2002. Created in part as a reaction to the corporate abuses uncovered at Enron, and aimed at restoring investor trust and confidence in the public markets, the Act regulates a wide range of corporate and individual actions, including a number in the employment, compensation and benefits areas.

This Alert first discusses several provisions of the Act that affect pension plans with individual accounts, such as a 401(k) plan. In direct response to the events at Enron, the Act prohibits executives from selling shares during a black-out period in such a plan and provides for advance notice of black-out periods. The Act also has dramatically increased the penalties associated with a violation of ERISA (the Employee Retirement Income Security Act of 1974) and also may require the company’s outside counsel to report any breaches of ERISA fiduciary duties with respect to a company benefit plan to the company’s general counsel and potentially to the Board of Directors.

This Alert next discusses some employment-related provisions of the Act, specifically the following: the forfeiture of bonuses and profits for certain executives who have made a profit on stock sales prior to an accounting restatement; additional protections for whistleblowers; the SEC’s ability to freeze extraordinary payments; and a prohibition on a company’s hiring of employees from its auditors.

Finally, this Alert provides a brief summary, and a link to another Alert providing a more detailed discussion, of the prohibition on loans to directors and executive officers of public companies. This is a provision of the Act that has received much public attention and, accordingly, merits a separate Alert.

Insider Trading During Individual Account Plan Blackout Periods

Effective January 26, 2003, the Act prohibits executive officers and directors from purchasing or selling any equity security of an issuer (other than an exempted security) during "black-out periods" applicable to the issuer’s individual account plans, if the securities were acquired in connection with the person’s service to the issuer. "Individual account plans" for this purpose include 401(k) plans and other defined contribution plans that provide an individual account for each participant. If an executive officer or director violates this prohibition on trading, any profit realized by the offender will inure to and be recoverable by the issuer, regardless of the executive officer’s or director’s intent. The issuer or its stockholders may bring an action for recovery of these profits. The SEC must issue guidance interpreting this portion of the Act prior to its effective date.

A blackout period generally is any period that exceeds three consecutive business days in length during which plan participants are suspended from trading the securities held in their individual accounts under the plan in the public markets. Blackout periods occur most commonly when there is a change in the record keeper for the plan, but other plan events may result in a blackout period. For these purposes, blackout periods generally do not include suspensions resulting from persons becoming or ceasing to be plan participants as a result of a merger, acquisition, divestiture or similar transaction involving the plan or the plan sponsor. Nor do blackout periods include suspension periods that are regularly scheduled, incorporated in the plan document and timely disclosed to participants.

Advance Notice of Blackout Periods to Be Provided to Individual Account Plan Participants

With respect to all individual account plans (not just those holding employer securities), the Act has amended ERISA effective January 26, 2003, to provide that plan administrators must give written notice to plan participants and beneficiaries at least 30 days prior to the commencement of a blackout period. This notice must be written in a manner calculated to be understood by the recipient and must include the reason for the blackout period, an identification of the investments affected by the blackout period, the expected beginning date and length of the blackout period, a statement that the participant or beneficiary should evaluate plan investments in light of the inability to direct or diversify investments during the blackout period, and such other information as may be required by regulation of the Department of Labor in the future. If the effective date or length of the blackout period changes for any reason, the plan administrator must provide a notice of the change as soon as reasonably practicable.

Exceptions to the 30-day notice requirement are provided in situations where deferral of the blackout period to meet the 30-day notice requirement would result in a plan fiduciary violating certain fiduciary duties under the plan or where the inability to provide the 30-day advance notice is due to events that were unforeseeable or to circumstances beyond the reasonable control of the plan administrator. In the case of each exception, the inability to comply with the 30-day advance notice requirement must be documented in writing. An additional exception is available for blackout periods applicable to participants and beneficiaries in connection with a merger, acquisition, divestiture, or similar transaction involving the plan or the plan sponsor and occurring solely in connection with becoming or ceasing to be a participant or beneficiary under the plan by reason of such transaction. The Department of Labor by regulation may provide additional relief from the 30-day advance notice requirement in the future.

The Department of Labor may assess a civil penalty against the plan administrator of up to $100 per participant per day from the date of the plan administrator’s failure or refusal to provide the 30-day advance notice, and also is required to publish a model notice on or before January 1, 2003.

Increased Criminal Penalties Under ERISA

Effective July 30, 2002, the Act has dramatically increased the criminal penalties imposed on persons who willfully violate the fiduciary responsibility provisions of ERISA. The maximum fine for individual offenders has been increased from $5,000 to $100,000 and the maximum prison term has been increased from one year to ten years. The maximum fine for corporate offenders has been increased from $100,000 to $500,000.

Professional Responsibility of Attorneys

Within 180 days following July 30, 2002, the SEC must issue rules for the minimum standards of professional conduct for attorneys appearing or practicing before the SEC. The rules must include a requirement that such counsel report breaches of fiduciary duty first to the General Counsel of the company (or if there is no General Counsel, then the Chief Executive Officer), and if the General Counsel or Chief Executive Officer does not properly address the issue, outside counsel is required to present the issue to the audit committee, to another committee consisting entirely of outside directors, or to the full Board of Directors. Until the issuance of SEC rules on this provision of the Act, it is

not clear whether these rules will apply to more than securities law matters. Fiduciary breaches can occur under ERISA with respect to a company’s role as a benefit plan sponsor. If the SEC writes its rules expansively, a company’s breach of ERISA fiduciary duties to its benefit plans and the participants in those plans may be required to be reported by the company’s outside counsel and by in-house attorneys to its General Counsel and potentially to its Board of Directors.

Whistleblower Protection

The Act contains several important new protections for corporate whistleblowers. First, the Act protects corporate whistleblowers by creating a new federal civil cause of action on behalf of any employee of a public company who is subject to retaliation for reporting corporate fraud. The Act provides further protection by imposing increased criminal penalties for retaliation against a whistleblower for providing any truthful information relating to the commission or possible commission of any federal offense—not just offenses relating to securities fraud. The Act provides similar protections for securities analysts by prohibiting brokers and dealers from retaliating against analysts for preparing unfavorable research reports.

New Civil Cause of Action. The Act’s new federal civil cause of action prohibits public companies from discriminating against an employee in retaliation for any lawful act done by the employee to:

  1. provide information or otherwise assist in an investigation regarding any conduct that the employee reasonably believes constitutes corporate fraud, when the information or assistance is provided to or the investigation is conducted by any federal regulatory or law enforcement agency, any member of Congress or Congressional committee, or any person with supervisory authority over the employee; or
  2. file, testify, participate in or otherwise assist in any proceeding relating to an alleged violation of corporate fraud laws or regulations.

An employee alleging discharge or other discrimination in violation of the Act may file a complaint with the Secretary of Labor ("Secretary") not later than 90 days after the date on which the violation occurred. The Secretary is authorized to investigate the complaint, notify the employer of the complaint, hold a hearing, and issue a decision on the complaint. Both the company and the complainant have the right to appeal the Secretary’s decision; if not appealed, it becomes final. However, if the Secretary does not issue a final decision within 180 days of the filing of the complaint, the complainant may bring a civil lawsuit in federal district court, without regard to the amount in controversy. In the civil lawsuit, the claimant can seek reinstatement, compensatory damages (including back pay with interest) and any special damages (including litigation costs and attorneys’ fees).

Enhanced Criminal Penalties. The civil whistleblower protections are augmented by enhanced criminal penalties for retaliation against whistleblowers. The Act imposes criminal liability on anyone who "knowingly, with the intent to retaliate, takes any action harmful to any person, including interference with the lawful employment or livelihood of any person, for providing to a law enforcement officer any truthful information relating to the commission or possible commission of any Federal offense." Penalties under the Act include a fine and/or imprisonment of up to ten years.

With respect to the new civil cause of action, employers are well served to take affirmative steps establishing clear procedures for employee complaints concerning possible corporate wrongdoing. First, employers should examine their written policies to ensure that they include information concerning the redress of complaints and to state that discrimination or harassment in retaliation against employees who raise concerns will not be tolerated. Second, employers should inform management employees of their responsibilities under the Act and train them to recognize protected employee activity. Third, employers may consider establishing in-house committees, a "Chief Complaint Officer" or some other clearinghouse for the receipt and resolution of employee complaints and concerns. This mechanism should provide for submission of anonymous employee complaints, because the Act specifically requires Audit Committees of Boards of Directors to establish procedures for employees to anonymously submit concerns regarding questionable accounting or auditing matters. Finally, employers need to become even more vigilant regarding the documentation and management of employee performance issues, and must ensure that any adverse action taken against possible whistleblowers is defensible and not related to or caused by the employee’s protected activity.

In addition, employers and their management employees should be aware that the enhanced criminal penalties contained in the Act apply broadly. The penalties can apply to individuals and, unlike many other of the Act’s provisions, privately-held companies. In addition, the underlying protected conduct by the whistleblower only needs to relate to "the commission or possible commission of any Federal offense"—it does not need to relate to securities violations or corporate fraud.

Forfeiture of Certain Bonuses and Profits

The Act requires Chief Executive Officers and Chief Financial Officers of public companies to reimburse their employers, under specified circumstances, for certain bonuses or equity-based compensation they received. In particular, if based on a public company’s misconduct, the company is required to prepare an accounting restatement because of material noncompliance with any financial reporting requirement under the securities laws, the CEO and CFO of the company must reimburse the company for: (1) any bonus or other incentive-based or equity-based compensation received from the company during the 12-month period following the first public issuance or filing with the SEC, whichever first occurs, of the financial report at issue; and (2) any profits realized from the sale of securities of the company during that same 12-month period. The SEC has the authority to exempt any person from application of this forfeiture requirement.

The Act does not define what "misconduct" will be required to trigger the reimbursement obligation of CEOs and CFOs. Moreover, the Act does not state that the CEO and CFO must have individual knowledge of or involvement in the underlying misconduct that caused the company’s material noncompliance with the financial reporting requirements. Thus, it appears that the forfeiture requirements apply regardless of any individual culpability of the CEO and CFO, and would even apply to a CEO or CFO hired after the relevant misconduct. However, because the SEC has the authority to grant exemptions to the forfeiture requirement, CEOs and CFOs who were not involved in the misconduct and were not neglectful in their duties relating to the financial reporting requirement at issue may be successful in petitioning the SEC for an exemption.

In addition, although the Act imposes an affirmative obligation on CEOs and CFOs to reimburse the company, the Act does not authorize or oblige the company to enforce the reimbursement requirement. Further, making deductions from employees’ pay, or failing to pay owed compensation, can violate state and federal law. Thus, employers are advised to move cautiously in this area and seek legal counsel prior to taking any actions against CEOs or CFOs who fail to make required reimbursements under the Act.

SEC Temporary Freeze Authority for Extraordinary Payments

Under the Act, the SEC also may seek a temporary order from a federal district court that requires a public company to place "extraordinary payments" (including those that would constitute compensation) that the company was planning to make to its directors, officers, partners, controlling persons, agents or employees in an interest-bearing escrow account, if the company or any potential recipients of the payments are the subject of investigation of possible violation of the Federal securities laws. The temporary order shall only be granted after advance notice and opportunity for a hearing are provided to the company, unless the court determines that so doing would be impracticable or contrary to the public interest. Unless limited or set aside by the court, the temporary order will remain in place for an initial 45 days, which can be extended to an additional 45 days upon a showing of good cause. If the company or any of the above-listed individuals are subsequently charged with a securities violation, the order will remain in place until the conclusion of the proceedings, at which time the company or other affected person has the right to petition the court for review of the order. If, however, no violation is charged prior to expiration of the order, the disputed payments (with accrued interest) will be returned to the company or other affected person.

The Act does not provide a definition of "extraordinary payments" other than noting that they may include compensation. The term "extraordinary" suggests that regular compensation payments, such as base salary, may not be subject to the SEC’s freeze authority. Written guidance from the SEC will be needed to clarify this point.

In addition, it is unclear whether the extraordinary payments may only be subject to court order if the person to whom the payment is to be made is personally being investigated or otherwise directly involved in the suspected underlying fraud. Because an employer may owe a legal obligation to the intended recipient to provide the payment, either by contract or other legal authority such as wage and hour laws, an employer may confront a situation where it is faced with conflicting legal obligations. As a result, legal counsel should be consulted immediately if a public company either receives notice of a filed petition for an order or an order itself.

Cooling Off Period for Hiring Employees of the Company’s Auditors

The Act also prohibits a registered public accounting firm from performing an audit of a public company if the CEO, CFO, Chief Accounting Officer, or controller of the issuer or any person serving in an "equivalent position" for the company was employed by the accounting firm and participated in any capacity in an audit of that company during the one-year period preceding the initiation of the audit.

Public companies must ensure that the individuals and bodies (such as the company’s Board of Directors) involved in hiring for such positions are aware of these requirements of the Act. The Act does not provide guidance as to which positions may be considered "equivalent" to the targeted positions. In general, companies should exercise caution when hiring a current or former employee of the company’s auditors for any senior financial or accounting position, and should recognize that the hire may result in the company not being able to use the affiliated accounting firm for audits for one year after the hire.

Executive and Director Loans

Effective July 30, 2002, the Act prohibits a public company from extending, maintaining, arranging or renewing credit in the form of personal loans to executive officers and members of the Board of Directors. The broad scope of this prohibition may have far-reaching effects on public companies. Besides its more straightforward targets, such as loans for the purchase of company stock and relocation loans, the prohibition on personal loans may, for example, prevent or severely restrict companies from allowing executive officers and directors to participate in company-sponsored, broker-assisted option exercises (commonly known as "cashless exercises") and from entering into split dollar life insurance arrangements with such persons. Please refer to the attached hyperlink for a Cooley Alert entitled, "The Sarbanes-Oxley Act of 2002: Prohibition on Personal Loans to Executives," devoted entirely to the subject of executive officer and director loans for a more detailed discussion of these significant aspects of the Act.


Please call members of the Compensation & Benefits Group or the Employment Group with any questions you may have regarding the issues discussed in this Alert.

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