• Sarbanes-Oxley Act: Effect on Executive Compensation and Employee Benefits
  • August 14, 2003 | Authors: Constance M. Hiatt; Marcus W. Wu
  • Law Firm: Hanson Bridgett LLP - San Francisco Office
  • On July 30, 2002, President Bush signed into law the Sarbanes-Oxley Act of 2002 (the "Act"). The Act implements sweeping reforms aimed at accounting firms and publicly held corporations. As part of its reforms, the Act changes the rules governing executive and equity compensation and blackout periods for defined contribution plans. This legislation applies to publicly traded companies and to companies that have filed registration statements that have not yet become effective. Below we highlight the significant executive compensation and benefits-related aspects of the Act.

    Prohibitions on Loans to Executives
    The Act prohibits companies from extending, directly or indirectly, credit in the form of personal loans to its directors and executive officers. Existing loans (as of July 30, 2002) are grandfathered as long as the terms of such loans are not modified. This prohibition affects common practices such as advances, cashless exercises of stock options and loans to assist with home purchases, and may affect certain split dollar arrangements and 401(k) plan loans.

    Blackout Restrictions
    1. Notice Requirements

    The Act amends the Employee Retirement Income Security Act of 1974 ("ERISA") to require that plan administrators of defined contribution plans provide advance notice to plan participants of an impending "blackout period." For this purpose, a blackout period is defined as a period of three (3) or more consecutive business days during which participants' ability to direct or diversify assets in their accounts, or to obtain loans or to distributions from a plan, is limited or restricted. A blackout period does not include any suspensions, limitations or restrictions that (1) occur by reason of application of the securities laws, (2) apply to only one participant, or (3) are changes to the plan that provide for a regularly scheduled suspension, limitation or restriction, provided such changes are disclosed to participants. Plan participants generally must receive notice of the blackout period at least 30 days before the commencement of the blackout period. The notice must provide:

    • the reasons for the blackout period;
    • the affected investments;
    • the length of the blackout period;
    • a statement that participants and beneficiaries should evaluate the appropriateness of their current investments in light of the restrictions imposed during the blackout period; and
    • any other items required under regulations.

    Under the Act, the Department of Labor is authorized to collect a civil penalty of up to $100 a day per participant for failure to provide the notice. In addition, the Department is directed to issue a model notice no later than January 1, 2003, and to issue interim rules on the notice requirement no later than October 13, 2002.

    Any amendments to the plan that are required to reflect the new notice requirement need not be adopted before the first plan year beginning on or after January 26, 2003. But this is true only if the plan is operated in good faith compliance with the Act, and the plan amendment, when adopted, is applied retroactively to the effective date required by the Act.

    2. Prohibition on Insider Trading
    Under the Act, during a blackout period a director or officer is prohibited from trading in any company equity securities that the director or officer acquired "in connection with his or her employment as a director or officer." The company must notify the SEC and affected directors or officers of the blackout period. For these purposes, a "blackout period" means any period of more than three (3) or more consecutive business days during which at least 50 percent of the participants or beneficiaries in all of the company's defined contribution plans are restricted from trading in company equity securities in the plan. In addition, a blackout period for this rule does not include (1) any regularly scheduled restricted period that is provided for under the terms of the plan and that is previously disclosed to employees on a timely basis, and (2) any suspension in trading in which individuals become or cease to be participants due to a corporate merger, acquisition or similar transaction involving the company or the plan.

    Because the definition of a "blackout period" is more expansive for purposes of the notice requirements described above, in some circumstances a restricted period can trigger the notice requirement, but not necessarily the prohibition on insider trading. Also, the applicability of the insider trading prohibition is determined by looking at all defined contribution plans maintained by a company, not merely at individual plans. Consequently, even if one or more of a company's defined contribution plans are subject to restriction period, the insider trading prohibition would not apply unless the number of affected participants and beneficiaries -- taking into account all of the employer's defined contribution plans -- is sufficiently large.

    Criminal Penalties
    The Act substantially increases penalties under ERISA for willful criminal violations. The monetary penalty imposed on individuals for such violations is increased from $5,000 to $100,000. The maximum imprisonment term is increased from one to ten years. Corporate penalties for such violations increase from $100,000 to $500,000.

    In addition, the Act increases the criminal penalties for willful violations of the Securities and Exchange Act of 1934. Specifically, the maximum sentence is changed from a $1,000,000 or a 10-year prison sentence, to $5,000,000 or a 20-year prison sentence. For corporations, the maximum fine for such violations is increased from $2,500,000 to $25,000,000.

    Reimbursement of Equity or Bonus Compensation
    If a company is required to restate its financial statements due to material non-compliance, as a result of misconduct, the company's CEO and CFO must disgorge incentive or equity-based compensation and trading profits received by him/her at any time during the year following the initial issuance or filing of the flawed financial statements.

    Company's Auditor Prohibited from Performing Non-Auditing Services
    The Act generally prohibits public accounting firms from providing non-audit services to their audit clients. The prohibited non-audit services include (1) bookkeeping or other services related to accounting records or financial statements, (2) financial information system consulting, (3) appraisal or valuation services, (4) actuarial services, (5) internal auditing, (6) management or human resource functions, (7) broker or dealer, or investment services, (8) legal services or expert services unrelated to audit, and (9) any other services determined by regulation to be impermissible.

    Attorney Disclosure Obligations
    Any attorney advising a company subject to the Act will be required to report evidence of a material violation of securities law or breach of fiduciary duty (or similar violation) to the CEO or general counsel. If that person does not respond appropriately, the attorney is then required to report the evidence to the audit committee or board of directors.

    Companies subject to the Act should start working with their executive compensation and benefits advisors now to ensure that their benefit programs comply with the new rules. For example: a company's defined contribution plan(s) may need amending to reflect the new blackout rules; plan administrators may want to establish new procedures to reflect the blackout rules; or a company may need to communicate the new restrictions on executive compensation programs to executives.