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Compliance : Sarbanes Oxley : Section 404

BakerHostetler Obtains Landmark Interpretive Guidance on SOX 402

By Michael Oxley
Michael Oxley
Of Counsel

The U.S. Securities and Exchange Commission’s Division of Corporation Finance has issued new guidance on how public companies can provide equity-based compensation to their employees in a program that involves loans, without violating the Sarbanes-Oxley Act of 2002.

The SEC staff’s new interpretive guidance addresses how corporate directors and officers may participate in a new compensation program using loans from a third-party source – and not run afoul of Section 402 of Sarbanes-Oxley.  Written to prohibit companies from making or arranging personal loans to executives in the wake of some egregious abuses of the 1990s, Section 402 contains particular language that public companies have not had any guidance on – until now.

The SEC staff’s guidance was issued in response to a formal request sent to the SEC’s staff by law firm BakerHostetler. The firm’s team was led by attorneys Michael Oxley, Thomas Gallagher and Andrew Reich. Mr. Oxley, former Ohio Congressman and Chairman of the House Financial Services Committee, is one of the co-authors of the historic Sarbanes-Oxley law. Mr. Oxley is now Of Counsel in BakerHostetler’s Washington, D.C. office. Messrs. Gallagher and Reich are both based in the firm’s New York office.

The new guidance on SOX 402 is noteworthy. SOX was enacted by Congress in response to corporate accounting scandals of the time – including Enron and Worldcom. Section 402 was included to combat a particular abuse in which senior officers used corporate funds to make outsized personal loans to themselves, usually on preferential terms. However, since passage of Section 402, the SEC staff has not provided interpretive guidance on it.

In BakerHostetler’s Feb. 28 letter to the SEC staff, Messrs. Oxley, Gallagher and Reich sought guidance on Section 402 with regard to an innovative equity-based incentive compensation (EBIC) program that their client, financial services firm RingsEnd Partners LLC, developed with global financial institution BNP Paribas. The EBIC program contemplates that participating employees will receive company stock as incentive compensation and thereafter transfer those shares to an independently managed Delaware statutory trust. The trust could then obtain term loans from an independent banking institution, using some or all of the shares transferred to the trust as collateral. The letter notes that, in the absence of interpretive guidance on SOX 402, public companies have been reluctant to permit directors and officers to participate in the proposed program.

BakerHostetler contended that an issuer allowing its employees to participate in the EBIC program would not be extending or maintaining credit, or arranging for the extension of credit, in the form of a personal loan to employees subject to SOX 402. The lawyers noted that although a company would “need to perform certain ministerial tasks in order to allow its employees to participate in the EBIC program,” the company would “neither encourage nor discourage employee participation,” nor would the company “directly or indirectly make or guarantee the loans, or provide any extension of credit or other financial support” to the trust, its trustee, or trust beneficiaries (the employees). BakerHostetler argued that the legislative history suggests that under the final version of SOX 402, the phrase prohibiting a company from “arrang{ing} for the extension of credit” should be read no more broadly than prohibiting the company from providing a “loan guarantee or similar arrangement,” language found in earlier versions of SOX 402.

In the new guidance issued by the SEC, the agency’s staff wrote that an issuer that permits its directors and officers to participate in the plan “would not be deemed thereby, directly or indirectly, to be extending or maintaining credit, in the form of a personal loan to or for such individuals for purposes of Section 13(k) of the Securities Exchange Act of 1934” {SOX Section 402}. The SEC also wrote that an issuer that undertakes certain ministerial or administrative activities to permit its directors and officers to participate in the EBIC Program would similarly not be deemed, directly or indirectly, to be extending … or arranging for the extension of credit in the form of a personal loan to or for such individuals” within the meaning of SOX 402.

Mr. Oxley commented, “The SEC staff had never issued guidance on Section 402, and until this week, it seemed highly unlikely that the Division of Corporation Finance would do so.  Without interpretive guidance, compliance officers and corporate counsel would be concerned that an innovative program such as EBIC could invite possible enforcement action from the SEC.

“However, as we reviewed, researched and vetted the EBIC program,” continued Mr. Oxley. “We concluded not only that nothing in EBIC violated SOX 402, but also that EBIC supported some of the same goals Congress meant to encourage, such as incentivizing company management to act in the long-term interests of shareholders.  We then requested the Division of Corporation Finance to consider our arguments. We believe that that our presentation on SOX 402’s background and legislative purpose was useful, and we thank the SEC staff for their receptivity.”

Mr. Oxley noted that BakerHostetler worked with client RingsEnd for about a year before the new guidance came out. “The EBIC program today is not the same program as a year ago – we needed to make changes to it to permit it to pass muster under SOX 402,” he said. “We worked with our client to make adjustments to the way the EBIC program was structured, to keep the program’s financial benefits and still gain regulatory approval.”

Mr. Gallagher added: “Since SOX went into effect, companies were concerned that the SEC would take the position that any type of loan extended to executives in which the company had any involvement whatsoever, no matter how ministerial in nature, would be prohibited under Section 402, which was designed to prevent executives from abusing their relationship to the company and from looting the company’s assets. We analyzed EBIC, concluded that this is the type of program the government should encourage, and worked with our client to modify the program to ensure that it clearly complied with SOX 402. We concluded that, interpreted as intended, Sox 402 should not be seen as prohibiting something like EBIC. We are glad on behalf of our client that we were able to obtain interpretive guidance supporting these views.”

He continued, “The EBIC program does a much better job than existing corporate programs in aligning the interests of the company’s shareholders with its senior management. If the company does well, executives and employees in the EBIC program will do well. The program also has favorable tax attributes for EBIC participants. In short, the EBIC program has significant public benefits-- it promotes long-term value and stability for the company and its shareholders, it aligns management interests with corporate shareholders and it encourages long-term holding of company shares by EBIC participants.”

Michael Oxley
Of Counsel

Michael Oxley, former Congressman and Chairman of the House Financial Services Committee, serves clients in the areas of corporate governance, investigations and government policy. In addition to his position with BakerHostetler, Mr. Oxley also is Senior Advisor to the Board of Directors of NASDAQ OMX Group, Inc.

After a 25-year career representing Ohio’s Fourth Congressional District, Mr. Oxley is best known for his co-authorship of the landmark Sarbanes-Oxley Act of 2002, which restored Americans’ confidence in the capital markets early in the decade and created a new accounting oversight board for publicly traded companies.

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