Navigating the Sarbanes-Oxley Loan Prohibitions

Alice Murtos

Presentation Roadmap

Loan Prohibition Grandfathered Loans Directors and Executive Officers Arranging Loans Common Expense Advances Qualified Retirement Plans Cashless Exercise of Stock Options Split Dollar Life Insurance

Context of the Loan Dilemma

Key terms were not defined in the statute No significant legislative history on the intended

scope of the loan prohibitions Effect on many ordinary employment-related and

employee benefit transactions SEC guidance likely to be delayed given statutory

deadlines for issuing guidance under other sections of Sarbanes-Oxley

Context of the Loan Dilemma (cont’d)

Public commentary by Senators Schumer, Levin and Collins

Media coverage of insider loans Law firm “manifesto” presented to the SEC Civil and criminal sanctions

Analytical Framework

Identify existing and potential loan transactions

Analyze risk that transaction is prohibited and potential consequences

Consider alternative arrangements

Loan Prohibition

An issuer may not directly or indirectly: Extend or maintain credit Arrange for an extension of credit Renew an extension of credit

In the form of a personal loan

To directors or executive officers (or the equivalent)

Grandfathered Loans

An extension of credit Maintained on July 30, 2002 No material modification No renewal

Loan commitment precedes July 30, 2002, but funding occurs on or after July 30, 2002

Demand loans

Grandfathered Loans (cont’d)

Full and partial loan forgiveness as a material modification

Potential for modifications that work in favor of the issuer

Directors and Executive Officers(Or the Equivalent)

Resident and non-resident individuals are covered

Directors of the issuer but not of subsidiaries

Apply Exchange Act Rule 3b-7 to determine who is an Executive officer President Vice president in charge of a principal business unit Any other policy making officer, including officers of

subsidiaries who perform policy-making functions for the issuer

Directors and Executive Officers (cont’d)

Related parties (for example, spouse, children, trust, controlled business)

Treatment of existing personal loans upon becoming a director or executive officer

Arranging Loans

Arranging for favorable loan terms

Loan guarantees

Broad construction in other areas of the securities laws like the margin lending rules Introduction to a third-party lender Recommendation of a third-party lender

Stock option issues

Common Expense Advances

Legitimate business expense advances such as for travel, entertainment and relocation expenses Corporate policy Documentation of expenses Business purpose with incidental personal use Amount Timing

Common Expense Advances (cont’d)

Indemnification and litigation advances Business purpose of the payments No expectation when paid that amount will be

returned to the employer Prompt return of payment to employer if

contingency occurs Public policy considerations

Common Expense Advances (cont’d)

Employment tax advances upon option exercise, restricted stock vesting, bonus stock awards or payments or funding of deferred compensation

Qualified Retirement Plans

Participant borrowing from his own account

Beyond the scope of these conflict of interest provisions and existing ERISA requirements that individuals administering plan act in the interest of participants

Plan as an issuer when employer securities offered as an investment choice

Cashless Exercise of Stock Options

Potential problems arise when the timing of the delivery of the shares does not coincide with payment of the exercise price and related tax-withholding obligation

Additional complications when the issuer has some involvement in the selection or availability of the broker

If the company delivers the shares at settlement and is not involved in broker selection, there should not be a loan

Cashless Exercise of Stock Options (cont’d)

Potential Company Loan Scenario Participant exercises option Company delivers the shares to the broker Broker sells the shares for the participant and

pays proceeds to the company to satisfy the exercise price and the amount of any tax withholding

Time lag varies but is generally no more than a few days

Cashless Exercise of Stock Options (cont’d)

“Arranging” for a Loan Scenario Company identifies a broker to facilitate cashless exercise of stock options Broker provides temporary financing through the

use of existing shares, paying exercise price to the company before settlement or other means

Cashless Exercise of Stock Options (cont’d)

Cashless exercise generally does not implicate conflict of interest issues

Mechanism to simplify option exercise and settlement that is ancillary to efficient plan administration rather than in the nature of a personal loan

Company involvement is sufficiently remote to preclude a determination that the company arranged the credit

Cashless Exercise of Stock Options (cont’d)

Alternatives to Cashless Exercise Preclude directors and executive officers from

exercising options on a cashless basis Avoid facilitating the use of brokers identified by

the company Allow the use of “mature” shares to effect stock-

for-stock exercises to pay option price and tax withholding

Restructure arrangements to substitute stock appreciation rights for options

Split Dollar Life Insurance

Collateral Assignment Plan Company pays the premium on a whole life

insurance policy on the life of the employee Employee is the owner of the policy but policy

proceeds equal to the premiums will be paid to the company upon the employee’s death or earlier “roll out” of the arrangement

Recently proposed Treasury regulations expressly treat these arrangements as loans by the company to the employee for tax purposes

Split Dollar Life Insurance (cont’d)

Endorsement Plan Company pays the premiums on a whole life

insurance policy on the life of the employee Company is the owner of the policy, but policy

proceeds above the amount of the premiums will be paid to a beneficiary of the employee upon his death

In some cases, the employee is liable to make up any difference between premiums and cash value if the policy terminates before crossover

Split Dollar Life Insurance (cont’d)

Loan analysis and available options are very closely tied to the specific policy terms and the terms of the collateral assignment

Consideration of impact on the tax effects of the alternatives used to minimize Sarbanes-Oxley exposure

Alternatives Pending Guidance Some insurers are providing grace periods for paying

premiums Place policy on reduced paid-up status so that premiums

are no longer due

Split Dollar Life Insurance (cont’d)

Suspend the split dollar arrangement and have the employee pay the premiums

Suspend the split dollar arrangement and provide the employee with the amount necessary to pay the premiums, including the relevant gross-up for taxes

Consider reducing the face value of the policy in connection with the suspension mechanism to reduce the amount of the premiums

Split Dollar Life Insurance (cont’d)

Use dividends on the policy or an automatic premium loan to pay some or all of the premiums

Terminate the split dollar plan and “roll out” the policy if the cash value exceeds the premiums paid by the employer. The equity in the policy will not be taxable if this occurs before January 1, 2004 for arrangements entered into before January 28, 2002. The employee can take a loan against the policy to repay the premiums to the employer to keep policy.