Common Sense Comes to SOX 402?

News Brief

By Cydney Posner

I guess that if Michael Oxley writes to Corp Fin to ask for an interpretation of a section of the law that bears his name (as in Sarbanes-Oxley), that just might elicit a response from the staff. Notwithstanding the staff's decade of forbearance, as previously noted in thecorporatecounsel.com blog, the staff have finally deigned to respond to a question on SOX 402 (prohibition on loans to executives and directors, now in Section 13(k) of the Exchange Act).

The letter, RingsEnd LLC, sought confirmation that a public company could allow its directors and executive officers to participate in an equity-based incentive compensation program without being deemed to be extending or maintaining credit, or arranging for the extension of credit, in the form of a personal loan in violation of SOX 402. The program is designed to mitigate any incentive employees may have to sell their shares early to pay taxes, "while aligning long-term employee and shareholder interests, thereby fostering long-term value and stability for the company and its shareholders." Under the program at issue, participating employees receive shares of employer stock as incentive compensation and transfer the shares to an independently managed Delaware statutory trust. The trust then obtains term loans, secured by the shares, under a loan facility provided by an independent banking institution. The trust then distributes the borrowed funds to the employees to pay taxes on the shares. When the loans mature, the trustee sells sufficient shares to pay off the loans and then distributes the remaining shares and any residual cash to the employees. The company will neither encourage nor discourage employee participation in the program nor will it, "directly or indirectly, or through any subsidiary or affiliate, make the loan, guarantee repayment of the loan, or support the loan. The issuer will not reimburse the …participant for income taxes payable by the participant on the value of shares received from the issuer. Nor will the issuer have any role in the administration of the [progam] or the trust." Fees to and administrative costs of the lender and RingsEnd will be paid by the employees through the trust, and the company will not pay money of any kind to the employees, RingsEnd, the lender, the trust or the trustee in connection with the offering of the program or the provision of loans to the trust. Likewise, neither RingsEnd nor the lender pay anything to the company in connection with the opportunity to offer the program to the employees.

However, the company will need to perform certain ministerial tasks necessary to allow employees to participate in the program, "such as delivering the share awards to the trust, as directed by participating employees; providing the trustee and the lending institution with information regarding the employee-participants and the stock awards; and delivering to the lending institution a prospectus and registration statement covering the shares under the plan."

RingsEnd argued that these loans were not "insider loans" of the type intended to be prohibited by SOX, but rather were loans made by an independent lending institution to the trust. The company "has no role in providing or supporting the funds for the loans and neither encourages nor discourages participation, which is entirely within the discretion of each employee. It would therefore defy the common meaning of the word to conclude that the issuer ‘arranged for' the loan that is provided by the lender to the trust. Further, construing the word ‘arrange' so broadly as to deem an issuer in violation of the personal loan prohibition of SOX 402 if it merely permits its employees to participate in the [program] would run counter to the legislative history of SOX 402." That legislative history shows that Section 402 was adopted in response to disclosure of a string of "abusive" insider loans and loan guarantees that served no legitimate business purpose, created conflicts of interest and impaired the interests of company shareholders, in some cases, helping to drive companies into bankruptcy. Congress sought to prohibit companies from using their own funds to make loans to insiders, and the legislative history shows no intent to inhibit employees from obtaining a loan from an independent bank: in debate, Senators argued that executives who had received $5 billion in loans from company funds could have just as easily gone to the "corner bank" to get a loan like everyone else, thereby avoiding any conflicts of interest.

RingsEnd also contended that "the legislative history shows no intent by Congress to have the phrase ‘arrange for the extension of credit' read as encompassing anything other than providing a loan guarantee or similar ‘arrangement.'" To support that point, RingsEnd analyzed the progression of grammatical revisions from the original language, which prohibited the issuer from providing a "loan guarantee or similar arrangement," to the final version of Section 402, a prohibition against companies "arrang[ing] for the extension of credit." That final version, RingsEnd contended, was just the product of a syntactical rearrangement of the sentence and should be read no more broadly than the original language. Nothing in the legislative history, RingsEnd concludes, suggests "that Congress intended to prohibit a company from engaging in ministerial activities to allow its senior officers to obtain a loan from an independent bank."

In further support of its contention that SOX 402 has a narrow purpose, RingsEnd cites a 2005 SEC administrative order, In re Peter Goodfellow and Stamatis Molaris. In that order, the SEC found that the respondents violated SOX 402 because they authorized interest-free loans to themselves from the company, "precisely the kind of conduct that Congress sought to prevent in enacting Section 13(k)." The SEC also stated in the order that SOX 402 "was designed to prevent executives of public companies from using company funds for personal purposes." In addition, RingsEnd cites a 2006 case from the SDNY, Envirokare Tech, Inc. v. Pappas, 420 F. Supp. 2d 291, in which the company had argued that SOX 402 precluded it from advancing defense costs to a former officer it had sued. In deciding in favor of the officer, the court stated that "SOX 402 should be read in light of both ‘common sense' and ‘the context in which the statute was enacted,'" and, accordingly, its scope should not be extended to preclude advancement of defense costs: "'Congress, had it intended such a radical step as prohibiting such advances, surely would have made its purpose evident in explicit terms.'"

In its response letter, the SEC staff concurred that the company, by permitting its directors or executive officers to participate in the program and by performing the described ministerial or administrative activities that enabled the participation, "would not be deemed, directly or indirectly, to be extending or maintaining credit, arranging for the extension of credit, or renewing an extension of credit, in the form of a personal loan to or for such individuals, for purposes of Section 13(k) of the Securities Exchange Act of 1934…."

Largely because of the lack of guidance under SOX 402, together with the large penalties that could be imposed for its violation, attorneys have usually interpreted SOX 402 very conservatively and have been reluctant to bless activities that, while not the primary target of the statute, could be viewed to be within its ambit. While the letter and result are obviously very fact specific, to the extent that the activity at tissue provides a clear benefit to the company and the company's conduct is of the same ministerial nature as that described in the letter, the staff's concurrence that the program passes muster under SOX 402 might help to alleviate some of the concerns that many have had in applying SOX 402. Whether the SEC will continue to issue letters to help flesh out the extent of the application of SOX 402 to just ordinary Michaels remains to be seen.

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