SEC Proposes Rules to Implement Sarbanes-Oxley Act Reforms

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1 November 1, 2002 SEC Proposes Rules to Implement Sarbanes-Oxley Act Reforms On October 30, 2002, the Securities and Exchange Commission issued rule proposals implementing provisions of the Sarbanes-Oxley Act (the SOA ) and that would amend certain bank dealer exceptions in the Securities Exchange Act of I. Rule Proposals to Implement Provisions of the SOA The SEC proposed rules relating to the following matters in response to SOA directives: the use of non-gaap financial measures; proposed amendment to Form 8-K to require the filing of quarterly and annual earnings releases; MD&A disclosure about off-balance sheet arrangements, contractual obligations and contingent liabilities and commitments; and restrictions on insider trading during and notification of individual account plan blackout periods. New Regulation G and Use of Non-GAAP Financial Information The Commission proposed new Regulation G prohibiting material misstatements or omissions that would make the presentation of a material non-gaap financial measure, under the circumstances in which it is made, misleading, and would require quantitative reconciliation (by schedule or other clearly understandable method) of the differences between the non-gaap financial measure and the corresponding GAAP financial measure. Regulation G would apply whenever a company publicly discloses or releases material information that includes a non-gaap financial measure. A non-gaap financial measure would be defined as a numerical measure of a company s financial performance that either (1) excludes amounts, or is subject to adjustments that have the effect of excluding amounts, that are included in the comparable GAAP measure; or (2) includes amounts, or is subject to adjustments that have the effect of including amounts, that are excluded from the comparable GAAP measure. Regulation G would provide limited exceptions for foreign private issuers under certain circumstances. Changes would also be made to Item 10 of Regulation S-K, Item 10 of Regulation S-B and Form 20-F to address the use of non-gaap financial measures.

2 Form 8-K Filings for Earnings Releases The SEC also proposed to amend Form 8-K to require public companies to file with the SEC releases or announcements disclosing material non-public financial information about completed annual or quarterly fiscal periods. The SEC proposed that public disclosure of financial information for a completed fiscal period by means of oral, telephonic, webcast, broadcast or other similar means would not be required to be filed, if the presentation occurs within 48 hours of a related release or announcement filed on Form 8-K, the presentation is accessible to the public, and webcast information is posted on the company s website. MD&A Disclosure about Off-balance Sheet Arrangements, Contractual Obligations and Contingent Liabilities and Commitments The SEC proposed rules explicitly requiring MD&A disclosure in Forms 10-K and 10-Q and in Securities Act registration statements of all material off-balance sheet transactions, arrangements, obligations (including contingent obligations), and other relationships of the company with unconsolidated entities or other persons that may have a material current or future effect on financial condition, changes in financial condition, results of operations, liquidity, capital expenditures, capital resources or significant component of revenues or expenses. While current MD&A rules already require a certain degree of disclosure related to off-balance sheet arrangements, the proposed rules will more specifically address the types of disclosure that companies must provide. This proposal is consistent generally with the SEC s MD&A release from earlier this year. Taking things one step farther, however, the proposed rules would also lower the threshold that triggers disclosure from the current reasonably likely to the proposed more than remote chance that a transaction would have a material effect on the company. In addition, the proposal would require registrants other than small business issuers to provide an overview of aggregate contractual obligations in a tabular format and an overview of contingent liabilities in a tabular or textual format. Restriction of Insider Trading During Pension Fund Blackout Periods Section 306(a) of the SOA prohibits any director or executive officer of an issuer from, directly or indirectly, purchasing, selling or otherwise acquiring or transferring any equity security of the issuer during a blackout period for an individual account plan, such as a 401(k) plan, a profit sharing plan or a money purchase plan, that prevents plan participants and beneficiaries from engaging in transactions involving issuer equity securities held in their plan accounts, if the director or executive officer acquires the equity security in connection with his or her service or employment as a director or executive officer. Section 306(a) also requires an issuer to notify its directors and executive officers, as well as the SEC, of an impending blackout period on a timely basis. The SEC proposed rules under Section 306 of the SOA in response to the statutory directive that the SEC, in consultation with the Secretary of Labor, issue rules clarifying the application of the insider trading prohibitions. Covered Persons. The proposed rules would apply to directors and executive officers of all reporting companies, including foreign private issuers, banks and savings associations and small business issuers. The term director would have the same meaning as under the Exchange Act rules, and the term executive officer would have the same meaning as the term officer under the insider reporting requirements of Section 16(a) of the Exchange Act. - 2

3 Covered Securities. Under the proposed rules, any equity security of an issuer would be subject to the trading prohibitions. This would include both equity securities and derivative securities relating to an equity security, whether or not issued by the issuer. The term derivative security would have the same meaning as under the Section 16 rules. Covered Transactions. The Section 306(a) prohibitions only apply if an acquisition of equity securities by a director or executive officer is in connection with his or her service to or employment with an issuer. The proposed rules would apply to indirect as well as direct acquisitions and dispositions of equity securities where a director or executive officer had a pecuniary interest (as defined under Section 16) in the transaction. Thus, the proposed rule would deem acquisitions or dispositions of equity securities by family members, partnerships, corporations, LLCs and trusts to be acquisitions or dispositions by the director or executive officer if he or she had a pecuniary interest in the equity securities. The proposed rule would exempt: acquisitions of equity securities under dividend or interest reinvestment plans; purchases or sales of equity securities that satisfy the affirmative defense conditions of Rule 10b5-1(c); purchases or sales of equity securities pursuant to certain employee benefit plans, other than discretionary transactions; and increases or decreases in equity securities holdings resulting from a stock split, stock dividend or pro rata rights distribution. Blackout Period The proposed rule would clarify the nature and extent of a blackout period that will trigger Section 306(a) insider trading prohibitions and how statutorily mandated exceptions would operate. Remedies. In addition to an enforcement action by the SEC, Section 306(a) provides that an issuer, or a security holder on behalf of the issuer, may bring an action to recover the profits realized by a director or executive officer from a prohibited transaction during a blackout period. The proposed rules would clarify how profits would be computed for purposes of private action. Notice. The proposed rule would specify the content and timing of notice of a blackout period and also would require an issuer to notify the Commission of an impending blackout period by means of a Form 8-K filing. II. Proposed Rule Amending Bank Dealer Exceptions Under the Exchange Act The SEC also proposed rules that would (1) amend SEC rules granting an exemption to banks from dealer registration for certain de minimis riskless principal transactions, (2) amend SEC rules that define terms used in the bank exceptions to dealer registration, and (3) grant a new exemption to banks from broker and dealer registration for certain securities lending with qualified investors under the Exchange Act. - 3

4 De Minimis Exception The Exchange Act excepts a bank from the definition of broker if the bank effects no more than 500 securities transactions per calendar year (not including transactions that qualify for other statutory exemptions). Riskless principal transactions are dealer transactions under the securities laws. The SEC has allowed banks to use the de minimis transaction exception found in the broker exceptions for riskless principal transactions; however, where dealer banks act as intermediaries between two non-broker-dealer customers, the transaction counted as two trades (one with each customer) under the 500-transaction limit. The SEC now proposes to amend the rule so that in the case of a riskless principal transaction, even if it involves two separate counterparties, it would count as only one transaction against the annual 500- transaction limit. Definition of Terms Used in Asset Backed Transaction Exception to Dealer Registration The asset-backed dealer exception permits banks to issue and sell securities backed by obligations the bank and its affiliates originated, or other obligations that were originated by other banks and their affiliates in a syndicate. The proposed rule would Amend the definition of originated so that banks could use other distribution channels (e.g., automobile dealers, mortgage companies, other banks) even thought the bank does not make and fund the loan at exact time the loan is actually made. Retain the standard for predominantly originated at 85 %. Replace the definition of member of a syndicate of banks with a definition of member as it relates to syndicate of banks to clarify that the individual banks originate the obligations, not the syndicate. Retain the requirement that when a syndicate of banks issues asset-backed securities through a grantor trust or other separate entity, each bank selling the securities, and thus, acting as a dealer in the transaction, must have originated at least 10% of the value of the pool of obligations backing the securities. Securities Lending Transactions with Qualified Investors A non-custodial securities lending arrangement permits a customer to divide custody and securities lending management between two expert entities. The Exchange Act excepts from the definition of broker only custodian banks that engage in securities lending. This limited bank exception creates uncertainty for banks that may engage in securities lending or borrowing transactions without having custody of the underlying securities. It also creates uncertainty in situations where banks meet the Exchange Act definition of dealer. To provide legal certainty to banks engaging in securities lending transactions, the proposed rule would add an exemption from the definition of broker for banks engaging in non-custodial securities lending activities as well as an exemption from the definition of dealer for banks engaging in certain custodial and non-custodial securities lending activities. Importantly, the proposal would require that a bank deal with a qualified investor on both sides of the transaction as a condition of the exemption. In addition, the exemption would not extend to banks borrowing securities for, or lending from, their own accounts except as a conduit lender (a conduit lender - 4

5 is defined as a bank that borrows or loans securities, as principal, for its own account, and contemporaneously loans or borrows the same securities, as principal, for its own account). Finally, the current Commission exemption from the definition of dealer for banks, savings associations and savings banks expires on November 12, The Commission will extend the exemption from the definition of dealer until February 10, 2003 to permit time for public comment, analysis of comments, and adoption of final rules. If you have any questions or required further information regarding these or other matters, please call your regular Nixon Peabody contact or feel free to contact one of the attorneys listed below: in our Boston office, Al Jordan (617) in our New York City office, Dick Langan (212) in our Rochester office, Deborah McLean Quinn (585) in our San Francisco office, Steven Plevin (415) in our Washington, D.C. office, John Partigan (202) For a complete list of the securities law practice group members, please refer to the final page of this Securities Law Alert. The foregoing summary of SEC releases is provided by Nixon Peabody for education and informational purposes only. It is not a full analysis of the matter summarized and is not intended and should not be construed as legal advice. This publication may be considered advertising under applicable laws. - 5

6 Securities Law Practice Team Please feel free to call or any of the securities team members listed below. ATTORNEY NAME PHONE Grant Beckwith gbeckwith (202) Michael Barron mbarron (617) Roger Byrd rbyrd (585) Gale Chang gkchang (212) Jeffrey Cohen jcohen (202) Justin Doyle jdoyle (585) Brent Faye rfaye (415) Kimberly Fox kfox (212) Steven Fuller sfuller (617) Lori Green lgreen (585) Raymond Gustini rgustini (202) Joan Barkhorn Hass jhass (617) Alexander Jordan ajordan (617) William Lance wlance (617) William Lewandowski wlewandowski (585) Richard Langan rlangan (212) James Locke jlocke (585) Richard McGuirk rmcguirk (585) Brian McMillin bmcmillin (617) Christopher Mason cmason (212) Brian Mulford bmulford (202) Jay Mumford jmumford (585) Timothy Mungovan tmungovan (617) Carolyn Nussbaum cnussbaum (585) Julianne Oehlbeck joehlbeck (585) Scott O Connell soconnell (603) John Partigan jpartigan (202) Steven Plevin splevin (415) Deborah McLean Quinn dquinn (585) Joseph Reynolds jreynolds (202) John Riddle jriddle (415) Stephen Rider srider (617) Jeffrey Rosenbloom jrosenbloom (585) Bruce Rosenthal brosenthal (212) Peter Rothberg prothberg (212) Molly Stiles mstiles (212) Philip Taub ptaub (603) Deborah Thaxter dthaxter (617) Visit our website at ALBANY, NY Omni Plaza 30 South Pearl Street Albany, NY BOSTON, MA 101 Federal Street Boston, MA (617) Fax: (617) BUFFALO, NY 1600 Main Place Tower Buffalo, NY (716) Fax: (716) LONG ISLAND, NY 990 Stewart Avenue Garden City, NY (516) Fax: (516) MANCHESTER, NH 889 Elm Street Manchester, NH (603) Fax: (603) NEW YORK, NY 437 Madison Avenue New York, NY (212) Fax: (212) NORTHERN VIRGINIA Suite Greensboro Drive McLean, VA ORANGE COUNTY, CA Plaza Tower 600 Anton Blvd., Suite 1600 Costa Mesa, CA PROVIDENCE, RI One Citizens Plaza Providence, RI (401) Fax: (401) ROCHESTER, NY Clinton Square P.O. Box Rochester, NY (585) Fax: (585) SAN FRANCISCO, CA Two Embarcadero Center San Francisco, CA (415) Fax: (415) WASHINGTON, D.C. Suite th Street, N.W. Washington, D.C (202) Fax: (202)