SOX Prohibition on Loans to Officers and Directors

Since the adoption of the Sarbanes-Oxley Act (SOX) in 2002, public companies and their advisers have been seeking guidance on Section 402 of the Act (codified as Section 13(k) of the Securities Exchange Act of 1934, as amended), which imposed a prohibition on public companies extending loans to their directors and executive officers.’

Under Section 402, public companies were no longer permitted “to extend or maintain credit, to arrange for the extension of credit, or to renew an extension of credit, in the form of a personal loan to or for any director or executive officer,” either directly or indirectly through a subsidiary or otherwise. The concerns addressed by this blanket prohibition were the use and abuse of public company funds to provide personal financing to insiders. However, many corporate practices among public companies and insiders that have the character of a “loan” or an “arrangement of credit” do not present the concerns that Section 402 was designed to address. For example, cashless exercises of stock options or the advancement of travel or relocation expenses could be deemed to fall within the term “personal loan.”

No-Action Letter

In the absence of guidance from the SEC, a consortium of 25 law firms published a memorandum in October 2002 detailing the consensus of the various practitioners on the application of Section 402. In the decade since the enactment of SOX, this memorandum has remained the only guidance on such issues, given the SEC’s stated position of not providing formal interpretive guidance with respect to the applicability of Section 402.

On March 4, 2013, the SEC issued a no-action letter in response to a request for interpretive guidance regarding the applicability of Section 402 to a program that would allow directors and executive officers to obtain credit utilizing equity grants made by a public company issuer. The SEC’s response indicated that a public company that permitted its directors and/or executive officers to participate in such a program would not be deemed to be extending or maintaining credit, arranging for the extension of credit, or renewing an extension of credit in violation of Section 402. Further, the SEC noted, this would not be deemed in violation of Section 402 if it undertook certain administrative activities as described in the request for interpretive guidance.

Background

The initial request for interpretive guidance came from RingsEnd Partners, LLC and related to the equity-based incentive compensation program (EBIC Program) RingsEnd had put together for the benefit of employers. RingsEnd created the program so that employees of public companies could avoid having to sell shares awarded as part of their incentive compensation in order to pay the taxes due and any required exercise price. RingsEnd took the position that the interests of a company’s executives and directors are better aligned with stockholders when they are able to retain grants of stock awards for a long period, as opposed to needing to sell portions of such awards in order to pay the taxes on the fair market value of the award upon vesting.

The EBIC Program was designed to encourage employee participants to retain such stock awards for as long as possible by providing a mechanism to allow participants to elect to pay taxes at the time of grant, and obtain funds to make such tax payments through a third-party loan secured by the shares issued as part of the stock award. However, RingsEnd encountered difficulty when trying to convince public companies to participate in an EBIC Program due to the lack of SEC guidance on the applicability of Section 402 of Sarbanes-Oxley to this sort of arrangement.

EBIC Program

Under the EBIC Program, restricted stock issued under a typical employer incentive compensation plan would serve as collateral for loans to employee participants. The EBIC Program would have the following features: