The Sarbanes-Oxley Act of 2002 Loans and Blackout Periods. Post Date: 9/13/02

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1 The Sarbanes-Oxley Act of 2002 Loans and Blackout Periods Post Date: 9/13/02 contributed by Ed Burmeister, Baker & McKenzie

2 AB Sarbanes-Oxley Act of 2002 Loans & Blackout Periods Client Alert September 9, 2002 FOR MORE INFORMATION PLEASE CONTACT: Ed Burmeister Baker & McKenzie Two Embarcadero Center Twenty Fourth Floor San Francisco, CA (415) rnet.com Bonnie Levitt Baker & McKenzie Two Embarcadero Center Twenty Fourth Floor San Francisco, CA (415) om Janel Brynda Baker & McKenzie Two Embarcadero Center Twenty Fourth Floor San Francisco, CA (415) m THE SARBANES-OXLEY ACT OF 2002 Loans & Blackout Periods On July 30, 2002, President Bush signed into law H.R. 3763, known as the Sarbanes-Oxley Act of 2002 (the Act ). While the primary focus of the Act is to redress accounting and financial reporting abuses in light of the recent Enron and WorldCom scandals, three provisions of the Act directly affect the operation of certain benefit programs. This article seeks to alert administrators of executive benefit and compensation programs, including stock option, stock purchase or other equity-based programs and defined contribution retirement plans operating both inside and outside the U.S., of those planning and compliance issues raised by the Act. Two provisions of the Act relating to executive compensation were effective July 30, The first provision prohibits U.S. public companies, some non-public U.S. companies and non-u.s. companies whose shares are traded in the U.S. from extending credit to an Insider. 1 Until further guidance to the contrary is issued, it is likely this prohibition will affect split-dollar life insurance, retirement plan loans, and cashless exercise of options. Additionally, other types of benefit arrangements commonly awarded to Insiders may also fall within this prohibition. The second provision requires that if a company restates its financial statement due to material non-compliance, then the Chief Executive Officer ( CEO ) and Chief Financial Officer ( CFO ) must reimburse the company for any bonus or incentivebased compensation, including any equity-based compensation, received during the 12-month period after the original filing date of the financial statement. 1 For purposes of this article the term Insider means a director or executive officer as described more fully below (see Question 3 in the section Prohibited Loans). With regard to prohibited loans, the term Insider also includes any individual who is the equivalent thereof. Copyright Baker & McKenzie, 2002 This document is protected by U.S. copyright laws and international copyright treaties. Except for fair use, 17 USC 107 or other applicable local mandatory legal exceptions, no part of this document may be copied without the prior written permission of Baker & McKenzie. Unauthorized copying will be prosecuted to the maximum extent permitted under applicable laws. No copyright is claimed in the text of statutes, regulations or court opinions quoted in this document.

3 The third provision is not currently effective. However, on January 26, 2003, a new insider trading prohibition (also affecting option grants and exercises) will be linked to trading blackouts under defined contribution retirement plans which hold employer equity securities. Additionally, the Act requires that new blackout notices be provided to plan participants and beneficiaries even when Insiders are not restricted from trading and even though the plan holds no employer securities. The Act requires coordination between stock plan administrators and retirement plan administrators to assess the impact of the Act on current programs and practices, and develop an effective strategy to implement changes and educate Insiders, plan administrators, brokers, record keepers and other third parties. 1. What companies are affected by the Act? The Act applies to all companies that are required to file periodic reports with the Securities and Exchange Commission (the SEC ). This includes public U.S. companies, private U.S. companies that must register their securities with the SEC and non-u.s. companies whose shares are listed on an exchange in the United States. 2. Who should read this Alert? If you have administrative responsibility for stock plans, 401(k) and other defined contribution plan programs which contain employer stock, executive compensation programs, or insider trading compliance, this Alert will help you appreciate the impact of the immediate effect of the Act s loan prohibitions, and begin planning for new blackout requirements which impose Insider trading restrictions and notice requirements that are scheduled to go live January 26, Please feel free to share this Alert with your colleagues. This Alert is divided into three broad sections: Prohibited Loans Forfeiture of Certain Bonuses and Profits Blackout Periods for Retirement Programs PROHIBITED LOANS: 1. What does the loan prohibition generally provide? Under the loan prohibition provisions of the Act, issuers are precluded from extending, maintaining, arranging or renewing personal loans to Insiders (as described in Question 3 below) either directly or indirectly, including through a subsidiary. Extensions of credit outstanding on July 30, 2002 are exempted from this prohibition, provided that no 2

4 material modifications or renewals of such arrangements are made after such date. It is difficult to determine the full scope of the loan prohibition provisions of the Act, as many of the terms are undefined and subject to interpretation. For example, it is unclear what activities will be deemed to constitute arranging loans by the issuer or how broadly the concept of indirectly will be applied. Limited types of personal loans are excluded from the loan prohibition: loans made in the ordinary course of the consumer credit business of the issuer on market terms and that are generally made available to the public by the issuer; and, loans by insured deposit institutions that are subject to the Federal Reserve s restrictions on Insider lending. 2. When did the loan prohibition become effective? The loan prohibition became effective July 30, Which Insiders are affected by the current loan prohibitions? Directors and executive officers (or the equivalent thereof) of the issuer are affected by the loan prohibitions. While the term director is defined under the Securities Exchange Act of 1934 (the Exchange Act ), the term executive officer is not defined. However, the SEC has defined the term executive officer under the Exchange Act Rules and Regulations to mean an issuer s president, any vice-president of the issuer in charge of a principal business unit, division or function (such as sales, administration or finance), any other officer who performs a policy-making function or any other person who performs similar policy-making functions. 2 Officers of the issuer s parent or subsidiaries (including foreign subsidiaries) may also be deemed executive officers if they perform policy-making functions for the issuer. We will have to wait for guidance from the SEC to confirm whether a similar definition of executive officer will apply under the Act, as well as which individuals are included in the phrase or the equivalent thereof. Further, we note that the definition of an executive officer is narrower than the definition of an officer used for Section 16 reporting. 4. Are loans used to acquire stock or to pay the exercise price of options prohibited? Any loans to Insiders related to the acquisition of stock violate the Act. Therefore, it is important for issuers to immediately review their option plans, stock option agreements and any other grant documentation and restrict any loan provisions contained therein to employees who are not 2 Rule 3b-7 of the Exchange Act Rules and Regulations. 3

5 Insiders. Any loans to Insiders made before July 30, 2002, should not be modified or renewed. Similarly, loans to enable employees to meet their tax obligations associated with stock options, restricted stock, and other equity compensation plans should be reviewed. 5. Are cashless exercise programs for Insiders dead on arrival under the loan prohibition? The loan prohibition provisions may preclude the cashless exercise of stock options by Insiders. In the typical cashless exercise of a stock option, the optionee contacts a broker designated by the issuer and instructs the broker of his or her intent to exercise the option and sell all (or some) of the shares. The broker sells the stock and uses the sales proceeds to pay the option price to the issuer and any required federal, state and local taxes (including foreign taxes). The optionee receives any remaining proceeds from the sale of shares. The question is whether a cashless exercise is characterized as an extension of credit from the issuer or, if not, as an arrangement by the issuer for the extension of credit by the broker. Cashless exercises have become extremely popular and the exercise method of choice. These exercises were made popular by amendments to Regulation T of the Federal Reserve Board adopted in It is instructive to revisit the specific language of Regulation T in this regard: To temporarily finance a customer s receipt of securities pursuant to an employee benefit plan registered on SEC Form S-8 or the withholding taxes for an employee stock award plan, a creditor [Reg. T lingo for the broker] may accept, in lieu of the securities, a properly executed exercise notice, where applicable, and instructions to the issuer to deliver the stock to the creditor. Prior to acceptance, the creditor must verify that the issuer will deliver the securities promptly and the customer must designate the account into which the securities are to be deposited. It is arguable that in this transaction, credit is being extended to the option holder by the broker in that the securities to be sold do not have to be delivered prior to the settlement date (T+3), 3 based on the issuer s involvement in verifying prompt delivery of the shares. Otherwise, a short sale subject to margin requirements would result. Whether this represents arranging of a loan by the issuer is a debatable point. But, because of the uncertainty, it is advisable that companies give serious consideration to 3 Unless expressly agreed to in the contract, a broker-dealer may not enter into a contract for the purchase or sale of a security that provides for payment of funds and delivery of securities later than the third business day after the date of the contract (T+3). The SEC is contemplating the issuance of proposed rules requiring a next-day settlement (T+1). 4

6 limiting cashless exercise to non-insiders to avoid a violation of the Act. A violation of the loan provision of the Act will be treated as a violation of Section 13 of the Exchange Act. 6. What are the international legal considerations with regard to the loan prohibitions? a. Cashless Exercise. For option grants outside the U.S., issuers typically mandate cashless exercise to avoid adverse or problematic tax, exchange control or securities issues (e.g., Brazil, China, India, Indonesia, the Netherlands and Switzerland). This practice may be problematic if individuals residing overseas in those locations are directors or certain officers of the issuer. Moreover, some countries outside of the U.S. may consider cashless exercise a loan and use loan language in relation to cashless exercise. For approved options in the U.K., for example, the Inland Revenue often requires that any cashless exercise procedure specify that the employee is being loaned the exercise price to exercise the option and that the loan will be repaid immediately following the sale. This requirement would seemingly violate the Act if there are Insiders in the U.K. participating in an approved option plan. Thus, if an issuer has approved options in the U.K. with such a cashless structure, the cashless exercise should not be made available to Insiders of the subsidiary. We note that there is no guidance from the SEC concerning cashless exercise as it relates to the loan prohibition, and there is reason to believe that the SEC will not address this issue head-on in the near future. Thus, there is a risk in continuing these programs, and issuers may wish to suspend cashless exercise programs for Insiders until further guidance is received from the SEC. b. Loans for the exercise price or taxes. In Belgium, options are taxed at the time they are offered to the employee, thereby creating a tax liability in advance of vesting. To ease the tax burden, some Belgian banking institutions have devised loan programs through which the issuer may obtain a bank loan from the bank and then, in turn, grant a loan to the employee. This scheme may be a violation of the Act if the loan is made to an Insider of the issuer at the Belgian subsidiary. In the U.K., the issuer or its local subsidiary must recover the tax due on exercised non-inland Revenue approved options within 30 days after the date of exercise; otherwise, the local subsidiary will be deemed to have provided a taxable benefit to the employee equal to the amount of the tax. 5

7 To avoid this harsh result, it is not uncommon for the local subsidiary and the employee to enter into a formal loan agreement in an amount equal to the tax paid by the subsidiary. Again, such a loan arrangement between an Insider of the issuer working for the U.K. subsidiary may be prohibited under the Act. Therefore, issuers are advised to evaluate carefully the grant structure for Insiders in its non-u.s. subsidiaries. 7. Are 401(k) plan loan programs at risk? The Act may preclude Insiders from taking loans, a fairly common feature in 401(k) savings plans, against their qualified retirement plan accounts. Although on its face a loan between a 401(k) plan and the participant would not appear to be a direct extension of credit by the issuer, if the issuer acts as the plan administrator or facilitates loan repayments through payroll withholding, the issuer could be construed as arranging for the extension of credit to the Insider. If the Act s prohibition against loans is interpreted to include retirement plan loans, there is a dilemma. If the plan is modified to prohibit loans to Insiders, then the 401(k) plan would arguably violate Section 4975(d)(1) of the Internal Revenue Code (the Code ) and Section 408(b)(1)(A) of the Employee Retirement Income Security Act ( ERISA ), which require that plan loans be available to all participants and beneficiaries on a reasonably equivalent basis. If the plan in question is amended to exclude loans to Insiders, the 401(k) plan may be in compliance with the Act, but in violation of the Code and ERISA. Failure to comply with Code Section 4975(d)(1) or ERISA Section 408(b)(1) may make the loan a prohibited transaction which would subject the 401(k) plan to excise tax. Until guidance is issued, issuers may want to discuss with counsel whether their 401(k) plan loan provisions would be covered by the Act, to assess the potential risks of continuing to provide 401(k) plan loans to Insiders, and to analyze plan amendment options. 8. Are split-dollar life insurance programs prohibited loans? Under proposed regulations governing split-dollar life insurance arrangements recently released by the Internal Revenue Service ( IRS ), an employer is required to choose between (a) measuring the economic benefit of the insurance policy (and imputing income based on tables of value of life insurance benefit), or (b) treating the premium payments as loans to the executive and imputing income under IRS rules applicable to compensatory loans. If an issuer elects to treat the imputed value of the split-dollar life insurance policy as a loan for tax purposes, then providing split-dollar life insurance to Insiders would appear to be an impermissible loan under the Act. 6

8 9. Will the Act affect payroll tax practices? The loan prohibition may affect the common practice of depositing payroll tax withholdings with respect to non-cash compensation for fringe benefits (such as car and airplane travel) before checks to cover income and FICA tax withholding have been received from the Insider. These early deposits of payroll taxes, which are made to avoid any IRS penalties for late deposits of payroll taxes, or for an inadequate filing of quarterly payroll tax returns, are not currently regarded as loans under IRS rules; however, issuers should re-examine this practice in conjunction with counsel, in light of the loan prohibition in the Act. 10. Will this loan prohibition affect recruiting and relocating top management? The Act could be read to prohibit bridge loans, 4 advances and other routine financial practices connected to executive recruiting and transfer practices. Therefore, it is important to review the common recruiting and relocation packages offered to Insiders. Another common executive benefit involves issuance of credit cards for both business and personal use; this practice may be prohibited because any delayed repayment for prior personal expenses charged to the company credit card may, as a technical matter, be a loan. Since the Act prohibits only personal loans, presumably advances for business expenses, such as travel and entertainment expenses, will be permitted. 11. How will the Act affect expatriates? If the expatriate is an Insider, benefits provided by the issuer may violate the loan provisions of the Act. If Insiders relocate outside the U.S., the benefit package must be examined to determine whether any of its components including, but not limited to, tax equalization benefits may fall under the loan prohibitions of the Act. 12. What about loans in effect before July 30, 2002? The extension of credit to an Insider by the issuer prior to the enactment date of the Act is exempt from the loan prohibition (so long as there is no material modification or renewal of the credit on or after July 30, 2002). However, this grandfathered protection does not address loans provided to an employee who later becomes an Insider, nor does it address binding commitments entered into prior to July 30, 2002 for loan arrangements to provide for future draw-downs. Therefore, issuers should review all employment agreements and offer letters with Insiders to confirm 4 A bridge loan allows employees to borrow on equity in their old home to pay for a new home. Companies often guarantee such loans on behalf of employees who must relocate to accept a new position or a transfer. 7

9 that the Act s loan prohibition does not require modification of the terms of employment, including, for example, commitments for relocation loans. 13. What about new loans that are covered under binding contracts before July 30, 2002? Although the Act does not require immediate repayment of loans in existence on July 30, 2002, there does not appear to be a carve-out from the Act s prohibitions for loans to be issued after that date pursuant to binding contracts entered into prior to the Act s effective date, a common approach to similar legislative prohibition. Although the SEC may clarify this and expand the grandfather provisions of the Act by rule, for now a company having issued an offer letter, for example to a key executive which promises a relocation loan, will face a potential violation if it honors its commitment. 14. What can be done to minimize exposure under the loan provisions of the Act? In light of the loan provisions in the Act, we recommend human resources administrators, stock plan administrators and retirement plan administrators take the following actions: a. Identify any existing loan programs under employment agreements, stock option programs, stock equity programs (stock bonus and restricted stock awards), retirement plans, credit card and travel reimbursement policies, relocation benefits and split-dollar life insurance arrangements. b. Identify all the individuals who are directors, executive officers and their equivalents for purposes of the new loan prohibition. Keep in mind that the phrase or the equivalent of may mean this group of Insiders is larger than the group for purposes of Section 16 reporting and for the new trading blackout rules. c. Develop a communication piece to distribute to Insiders advising them of possible loan violations, the unavailability of loans, and provide a designated representative of the issuer as the contact person for information about what may now be questionable extensions of credit. d. Liaise with brokers who facilitate cashless exercise programs to bar such programs for Insiders. e. Suggest a training session for those involved with executive recruitment to avoid inadvertent extensions of credit. 8

10 f. Consider amending existing employment contracts, as well as option and other agreements, with Insiders to eliminate any future transactions in violation of the Act. g. Evaluate the effect of these rules outside the U.S. U.S. multi-based multinational organizations which conduct foreign operations through branches that are part of the same legal entity operating in the U.S. are far more likely to have non-u.s. executive officers. However, even employees of non-u.s. subsidiaries with sufficient decision-making authority may be Insiders with respect to the issuer. Special arrangements for loans and mandated cashless exercise must be evaluated immediately if Insiders participate. FORFEITURE OF CERTAIN BONUSES AND PROFITS: 1. What is the bonus forfeiture provision? Under the Act, if an issuer is required to file restated financials and the issuer s noncompliance is as a result of misconduct, then the CEO and CFO 5 must repay to the issuer all bonuses and equity-based compensation plus any profits realized from the sale of securities during the 12-month period following the filing of the materially noncompliant financial statements. 2. When did the bonus forfeiture provision become effective? This repayment obligation was effective upon adoption of the Act, July 30, 3. Who is affected by the bonus provision? The CEO and CFO of the issuer are subject to the bonus repayment provisions of the Act. Until further guidance is issued, it remains uncertain whether a successor CEO and/or CFO who was involved in the misconduct while serving the issuer in another capacity will be subject to the forfeiture provisions if he or she receives a bonus payment or realizes profits from sales of issuer securities. 4. What payments are subject to the bonus forfeiture provision? From a compensation perspective, Congress provided little guidance as to what types of compensation will be deemed to be a bonus or other equity-based compensation. For example, it is unclear if severance pay is considered equitybased compensation if the amount is based on the performance of the company s stock price as compared to the stock value of its peers. The answer may differ if the severance pay at issue is materially larger than severance packages offered to 5 The SEC may exempt any person from the application of Section 304 of the Act. 9

11 other company employees and was paid as an incentive to terminate services. It is unclear if equity-based compensation granted prior to a forfeiture period, but which vests during the period, will be deemed to have been received during the forfeiture period. Similarly, we await guidance from the SEC and IRS on whether payments deferred until after the 12-month period are exempted from this provision, or whether the test for receipt of compensation will be based upon when the payment was earned, or when it could have been received (had payment not been deferred). 5. What happens if the repayment of the forfeited amounts is not made? The CEO/CFO bonus forfeiture provision does not expressly permit shareholder actions to recover overpaid compensation, but issuers may have a private right of action to enforce the provision and, consequently, the provision may stimulate derivative litigation. In any event, it is not clear how the SEC will approach enforcement of this provision and whether it will use its exemptive authority to eliminate various categories of payments from the reach of the forfeiture provision. (Compare the private right of action in Blackout Periods for Retirement Programs at Question 10g below.) BLACKOUT PERIODS FOR RETIREMENT PROGRAMS: 1. When do blackout rules become effective? The blackout provisions of the act will go into effect on January 26, What are the blackout provisions generally? Congress crafted two similar, but not identical, blackout related provisions in the Act; one amends ERISA to require advance notice to participants and beneficiaries of a plan blackout; the other prohibits Insider trading in company stock during a blackout period. It is not clear if these provisions are intended to apply only to U.S. retirement plans or if they are also intended to apply to non-u.s. retirement plans maintained within the corporate group. We expect the SEC and the Department of Labor ( DOL ) to issue guidance prior to the effective date of January 26, 2003, but plan sponsors and plan administrators will need to develop a coordinated approach to ensure that blackout periods are identified well in advance, that participants and beneficiaries are provided notice of the blackout, and that Insiders receive notice of any trading restrictions. 10

12 3. Is there any difference in how a blackout is defined in the notice and Insider trading provisions? Yes. The definition of blackout for notice purposes is quite different from the definition of blackout for purposes of Insider trading. For purposes of the notice requirement, the Act defines a blackout as any period of more than three consecutive business days during which the ability of a participant or beneficiary to direct or diversify assets or to obtain loans or other distributions from the plan is temporarily suspended, limited or restricted. For a blackout to occur, the retirement plan does not need to contain company stock. For purposes of the prohibition against Insider trading, a blackout period is a period of more than three consecutive business days during which at least half of the participants and beneficiaries in all defined contribution retirement plans of the issuer and its controlled group members are unable to purchase, sell or otherwise acquire or transfer an interest in the equity of the issuer held in such a defined contribution plan due to a temporary suspension by the issuer or a fiduciary. The Act also authorizes the SEC, in connection with the DOL, to issue guidance regarding the application of the controlled group rules 6 with regard to when the 50% participant and beneficiary threshold is met. Unlike the prohibition against Insider trading, the notice requirement is not premised on a minimum number of participants or beneficiaries being affected by the blackout. The blackout notice requirement also examines each plan individually, rather than looking at a composite of all plans of the issuer and its controlled group members. This means there is a lower threshold for a blackout under the notice requirement than under the prohibition against Insider trading. The chart below compares the requirements. 6 The existence of a controlled group depends on common ownership of the entities comprising the group and normally treat all members of a controlled group as being employed by a single employer. For purposes of Code Section 414, a foreign corporation can be a member of a controlled group. 11

13 Blackout Period Insider Trading Restrictions Notice Requirements Timing More than 3 consecutive business days. More than 3 consecutive business days. Restriction Who imposes the restriction Plans Suspends ability to purchase, sell, acquire or transfer. Issuer or fiduciary. All individual-account retirement plans of the controlled group are considered. Suspends, limits or restricts ability to obtain loans, distributions or direct or diversify assets. Any person (e.g., trustee, administrator, record keeper). Any individual-account retirement plan. Securities Company stock. Any assets credited to an account. Number of Participants and Beneficiaries that must be affected Excludes More than 50%. Any regularly scheduled period of suspension set forth in the plan document and disclosed to employees before they become participants or as soon as is reasonable after an amendment to the plan and certain suspensions imposed on newly eligible participants in connection with mergers and acquisitions More than one. Any restriction that results from a qualified domestic relations order ( QDRO ) application of the securities laws, other plan limitations which have been previously disclosed to participants and beneficiaries, and certain limitations or restrictions arising in connection with a merger or acquisition. 4. What retirement plans are affected by the blackout rules? Both the notice requirements and the Insider trading prohibition apply to defined contribution retirement plans such as 401(k) plans, money purchase plans, profit sharing plans, stock bonus plans and employee stock ownership plans ( ESOP ). We note that while an ESOP does not generally allow participants to direct the investment of assets, under the Act any restriction which would affect those participants eligible to diversify out of employer securities (e.g., age 55 and 10 or more years in the Plan) would require a notice be distributed. The Act excludes certain one-person retirement plans. 12

14 5. What are the blackout notice requirements? a. Timing Under the Act, plan administrators are required to provide all affected participants and beneficiaries with at least 30-days advance notice of a blackout. b. What information needs to be included in the blackout notice? i the reason for the blackout period; ii an identification of the investments and/or other rights affected; iii the expected beginning date and duration of the blackout; iv a statement describing affected investments which will allow the v participant/beneficiary to evaluate current investment choices in light of the upcoming blackout; and vi any other matter as the Secretary of Labor may require by regulations. (The DOL is expected to issue guidance later this year and will provide a model notice no later than January.) Additionally, the notice must be written in such as way as to be understood by the average plan participant. c. What delivery process is required for the blackout notice? The notice must be in writing, however, electronic or other form is acceptable if it is reasonably accessible to the recipient. Until the DOL issues further guidance it is uncertain what other forms of delivery will be acceptable. 6. Are there any restrictions or circumstances that are exempt from the notice requirement? Yes. The Act specifically exempts from the definition of a blackout any restriction that results from a QDRO, application of the securities laws, or other plan limitations, which have been previously disclosed to participants and beneficiaries. Further, the Act excludes certain limitations or restrictions arising in connection with a merger or acquisition. Additionally, a limited exemption to the 30-day notice requirement is available if a fiduciary for the plan determines, in writing, either that doing so is impossible due to circumstances beyond the reasonable control of the plan administrator, or that postponing the blackout would constitute a violation of the Employee Retirement Income Security Act ( ERISA ). 13

15 In either of these circumstances the plan administrator is required to notify the participants and beneficiaries of the blackout as soon as reasonably possible (unless distributing a notice prior to the end of the blackout period is impracticable). 7. Does the plan administrator ever have to send out an amended notice? Yes. If there is a change in the anticipated length of the blackout period, the plan administrator is required to notify the participants and beneficiaries of the change, as soon as reasonably possible, by distributing an amended notice. 8. Must the plan administrator notify the issuer of a blackout period? Yes. In addition to sending out the notice to participants and beneficiaries, the plan administrator is required to provide timely notification to the issuer of any employer securities subject to a blackout period. The Act does not establish a time frame for providing notice to the issuer, but, presumably, it will be less than 30 days to allow the issuer sufficient time to notify Insiders of any prohibitions on trading. 9. What are the penalties for failure to comply with the notice requirement? In order to enforce the notice provisions, the Act amends ERISA to allow the imposition of a civil penalty against the plan administrator of up to $100 per day (per affected participant or beneficiary) from the date of the plan administrator s failure or refusal to provide the notice. Although the Act does not set a maximum penalty that may be assessed against the plan administrator for failure to provide a blackout notice, it is anticipated that the SEC and DOL will address this issue. 10. What are the Insider trading prohibitions? a. What types of trades are prohibited? Under the Act, it is unlawful for any Insider of an issuer of any equity security (other than an exempted security) to directly or indirectly purchase, sell, or otherwise acquire or transfer any equity security acquired in connection with services or employment as a director or an executive officer of the issuer during a blackout period (as defined for purposes of the new Insider trading restriction). It seems clear that Congress intended this broad language to include grants under stock option and restricted stock plans. However, the language may also encompass any plan involving employment-related securities, such as phantom stock plans and employee stock purchase plans ( ESPPs ). 14

16 b. What is an equity security? The Act does not define equity security; however, it is likely the SEC will use the same definition as it uses in administering Section 16 of the Exchange Act. This definition includes, but is not limited to, stock, certificates of profit-sharing, any security future, any right to purchase a security and options. c. How will the prohibition against Insider trading during a blackout period affect the operation of equity compensation plans? It is clear that during any blackout period, stock option grants and exercises, Insider purchases of stock under ESPPs, restricted stock grants, stock bonus grants and other similar transactions will be prohibited. Additionally, the grant and exercise of restricted stock units, stock appreciation rights and other types of compensation awards whose value is derived from the market value of the issuer s stock would be prohibited during blackout periods. The prohibition does not appear to cover equity securities acquired prior to becoming an Insider or after ceasing to be an Insider, as discussed in paragraph e below. The Act excludes securities acquired by the Insider other than in connection with performing services for the issuer. d. What is the effect on DRIPs, ESPPs and 10b-5 Trading Programs? Congress has given the SEC the authority, in consultation with the Secretary of Labor, to issue rules providing exceptions to this Insider trading restriction provision, possibly including purchases pursuant to an automatic dividend reinvestment program or purchases or sales made pursuant to an advance election. These exemptions would likely include purchases and sales made under a 10b-5 plan. We are less certain about purchases made pursuant to an ESPP because most of these plans permit employees to revoke the purchase election up to a short period prior to purchase. The status of these exemptions prior to the SEC issuing implementation regulations is unclear. Presumably, some guidance will be available prior to the effective date of the restrictions. e. What about equity securities obtained by an Insider during a period when the Insider was not a director or executive officer? During a blackout period, the Act bars Insiders from trading in equity securities of the issuer acquired in connection with his or her employment as an Insider. The prohibition does not appear to cover 15

17 securities obtained outside the employment relationship, or during employment but prior to becoming an Insider. Further guidance is necessary to determine whether, if an Insider has equity securities consisting both of prohibited equity securities acquired in his or her service as an Insider and non-prohibited equity securities (i.e., acquired prior to becoming an Insider), there will be a presumption that equity securities are prohibited equity securities until otherwise established. Alternatively, some sort of first-in first-out rule or specific earmarking or identification rule may apply. This issue is further complicated for new Insiders who may, at the time they attain Insider status, have outstanding option grants which have not fully vested, are in the middle of an ESPP purchase period, or are eligible for profit sharing which is credited at a later date. Additional guidance from the SEC presumably will clarify these issues, but it is possible that new tracking rules for equity securities will be required. f. What are the issuer s obligations under the Insider trading prohibition? The Act imposes new duties upon the issuer. The issuer is required to notify any Insider and the SEC in a timely manner of any blackout period. While the Act does not provide guidance as to timeliness, it is likely to be less than the 30-day notice requirement to participants and beneficiaries. This is because Insiders, as participants in a plan, would receive the 30-day notice distributed to all participants and beneficiaries. It is uncertain whether the future SEC guidance provided by the SEC will impose additional obligations on the issuer to monitor or ensure each Insider s compliance. g. What are the penalties if an Insider trades during a blackout? If the Insider trading provision of the Act is violated, any profit realized by an Insider inures to, and is recoverable by, the issuer, irrespective of any intent by the Insider to violate the Act. If the issuer fails or refuses to bring an action to recover profits earned by an Insider within 60 days of a request to do so, or if the issuer fails to diligently prosecute such act, the owner of any security of the issuer may bring a derivative action to recover the funds in on behalf of the issuer. h. Are there any exceptions to the Insider trading prohibition? Yes. Insiders are not prohibited from trading during (i) any regularly scheduled period of suspension set forth in the plan document and disclosed to employees (presumably in the prospectus) before they become participants or as soon as is reasonable after an amendment to the plan which imposes a regular trading suspension, or (ii) certain suspensions 16

18 imposed on newly eligible participants in connection with mergers and acquisitions. WHAT YOU SHOULD DO TO DEAL WITH BENEFIT ISSUES UNDER ACT: 1. What can stock plan administrators and defined contribution retirement plan administrators do to minimize a potential violation under the employee benefit provisions of the Act? a. Determine who is an Insider. While the Act does not define the terms director or executive officer, we suggest that issuers reexamine their lists of Section 16 insiders to determine whether any individuals should be added to or taken off that listing. This exercise is especially important in light of the prohibition against loans which is already in effect. b. Communicate with Insiders. i ii If you have not already done so, assign a contact person for Insiders and assign such person the obligation to notify Insiders and the SEC of any retirement plan blackouts during which Insider trading is prohibited. Distribute a notice to Insiders informing them of the new prohibition against loans, and alert them to potential Insider trading restrictions during a retirement plan blackout period. Address the immediate prohibition of cashless exercises of options and receipt of a retirement plan loan. Be sure to advise Insiders that temporary restrictions may be in place until further guidance is issued. c. Develop Coordination between Retirement Plan and Insider Trading. The new loan and blackout provisions of the Act require communication between the administrators of defined contribution plans and equity compensation plans. The blackout provisions explicitly require that the retirement plan administrator inform the issuer whenever there is a restriction placed on trading issuer securities within any defined contribution plan. Additionally, each retirement plan document should be reviewed to identify the plan administrator who has the new notice obligation. This will require an analysis of each affected retirement plan of all members of an issuer s controlled group. 17

19 d. Establish Monitoring Procedures. The blackout Insider trading prohibition requires that an issuer determine when 50% of the participants in all of the issuer s defined contribution plans are restricted in their ability to purchase, sell or otherwise acquire or transfer an interest in the issuer s equity securities. This means companies with more than one defined contribution plan need to develop a method of determining and aggregating the total number of participants and beneficiaries who would be restricted. This task is complicated by the controlled group aggregation rules and the possibility that participants may be enrolled in more than one defined contribution plan. e. Consider How to Track Insiders Equity. The new Insider trading restrictions apply to stock obtained during employment as an Insider. Therefore, unless a blanket prohibition for Insider trading on all employer securities during a blackout is implemented, a method to track equity securities acquired only during employment as an Insider must be developed. At this time, there is no guidance as to whether the restriction would apply to stock or options that are granted before Insider status is attained but vest after the individual is an Insider. f. Use Extreme Caution With Blackout Periods. Document the decision-making process leading up to a plan blackout period, including discussions regarding appropriate plan objectives and the best interests of the participants. Make sure that all plan administrators (including stock plan administrators) and the issuer are notified well in advance of the blackout. Negotiate the shortest possible blackout period. Confirm that no new announcements about financial information are scheduled for release during the blackout period. 2. Where can I get help? Please feel free to contact the Global Equity Services group at Baker & Mckenzie with any questions or concerns you have regarding the application of the Act to your benefit programs. We will continue to monitor developments, including SEC and DOL guidance, and will provide further updates as appropriate. 18