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workspan, January 2003, Volume 46, Number 1
Blackout Rules and DC Plans: Shedding Light on Sarbanes-Oxley
By Bonnie K. Levitt, Baker & McKenzie
While the primary focus of Sarbanes-Oxley is to redress accounting and financial reporting abuses, read about how several provisions directly affect the operation of defined contribution retirement plans.
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On July 30, 2002, President George W. Bush signed into law H.R. 3763, the Sarbanes-Oxley Act of 2002 (the Act). While its primary focus is to redress accounting and financial reporting abuse in light of the recent scandals involving Enron and WorldCom, among others, several provisions directly affect the operation of defined contribution (DC) programs and executive compensation, and directly link insider trading prohibitions to temporary blackout periods affecting plan participants. (The term "insider" means a director or executive officer, as described in the section in this article titled "Which Insiders Are Affected by the Blackout Rules.")
While benefits in the executive suite and boardroom are affected by the Act's prohibition on loans or extensions of credit to insiders, and the forfeiture of certain bonuses and profits by the CEO and CFO, this article focuses on the new blackout notice rules that affect broad-based rank-and-file retirement plans, and the effect on insider trading prohibitions.
On Jan. 26, 2003, a new insider trading prohibition will be linked to trading blackouts under defined contribution (DC) retirement plans that hold employer equity securities. Additionally, the Act requires that the new blackout notices be provided to plan participants and beneficiaries even when insiders are not restricted from trading and the plan holds no employer securities. The Act requires coordination between the issuer's retirement plan administrators, executive compensation managers and the legal department to develop an effective strategy to implement changes and educate insiders, plan administrators, brokers, record keepers and other third parties.
Which Companies Are Affected?
The Act applies to all companies that are required to file periodic reports with the Securities and Exchange Commission (SEC). This includes:
In October, SEC Chairman Harvey L. Pitt reiterated that the Act applies to all companies, whether U.S. or foreign, that seek access to the U.S. capital markets.1 Thus, U.S. subsidiaries of foreign multinationals with DC plans must comply with the Act's blackout notice rules and the foreign multinationals must comply with the insider trading restrictions.
Which Operational Areas Are Affected?
If you have administrative responsibility for 401(k) and other DC plan programs (regardless of whether they contain employer stock), executive compensation programs or insider trading compliance, this article will help in understanding and planning for new blackout requirements that impose insider-trading restrictions and participant notice requirements that are scheduled to go live Jan. 26, 2003.
What Are the Blackout Provisions, in General?
Congress crafted two similar, but not identical, blackout-related provisions in the Act; one amends the Employee Retirement Income Security Act of 1974 (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. On Nov. 7, 2002, the SEC released additional guidance in the form of proposed rules (the SEC Rules) implementing the insider trading restrictions. As of this writing, the rules had not been finalized and the SEC accepted comments through early December.
The Department of Labor (DOL) published interim final rules (the DOL Rules) relating to the blackout notice and civil penalties on Oct. 21, 2002.2 Regardless of any changes in the SEC Rules or DOL Rules, however, plan sponsors and administrators need to develop a coordinated approach to ensure that:
Is There a 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.
Notice Purposes
Both the Act and the DOL Rules define a blackout as any period of more than three consecutive business days when a participant or beneficiary's ability to direct or diversify assets or obtain loans or other distributions has been suspended, limited or restricted. For a "blackout" to occur, the retirement plan does not need to contain company stock.
Prohibition Against Insider Trading
A blackout period is a period of more than three consecutive business days3 during which at least half of the participants and beneficiaries in all DC retirement plans of the issuer and its controlled group members are unable to buy, sell or otherwise acquire or transfer an interest in the equity of the issuer held in such a DC 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 rules4 with regard to when the 50-percent participation and beneficiary threshold is met.
The SEC Rules clarify that, before determining what percentage of U.S. participants and beneficiaries are affected by the blackout, the issuer must first determine the "relevant individual account plans." Under the SEC Rules, an individual account plan is relevant for purposes of the 50 percent test only if it is an individual account plan offered by a member of the issuer's controlled group in which the participants and beneficiaries may hold equity securities.5
After determining the relevant individual account plans, the 50 percent test is applied by comparing the number of affected participants and beneficiaries in the United States and its territories who will be restricted from trading to the total number of participants and beneficiaries in the issuer's relevant U.S. individual account plans. If the percentage is at least 50 percent, the prohibition on trading would apply to the insiders of a domestic issuer. For the restriction on insider trading to apply to a foreign issuer, an additional calculation must be made to confirm that at least 15 percent of participants and beneficiaries in the issuer's relevant individual account plans worldwide are affected by the blackout. 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. Figure 1 compares the requirements.
Which Retirement Plans Are Affected by the Blackout Rules?
Both the notice requirements and the insider trading prohibition apply to DC retirement plans, such as 401(k) plans, money purchase plans, profit sharing plans, stock bonus plans and employee stock ownership plans (ESOPs). However, the notice requirement applies regardless of whether employer securities are held by the plan. Note that, while an ESOP does not generally allow participants to direct the investment of assets, under the Act any restriction that would affect those participants eligible to diversify out of employer securities (i.e., participants age 55 and 10 or more years in the ESOP) would require a notice. The Act excludes certain one-person retirement plans.
What Are the Blackout Notice Requirements?
Timing
Under the Act, plan administrators are required to provide all affected participants and beneficiaries with notice of a blackout at least 30 calendar days in advance of the blackout. The DOL Rules require plan administrators to provide notice as soon as possible for the period beginning Jan. 26, 2003, through Feb. 25, 2003. Moreover, under the DOL Rules, the notice must be provided at least 30 calendar days, but not more than 60 calendar days, before the last date that the participant could exercise the affected rights before the blackout.
For example, suppose a plan permits participants to direct investment only during the first 15 days of a month. If a blackout were imposed from May 1 to May 15 to effect a change in record keepers, then notice on April 1 (30 days before the May 1 blackout) would be too late because participants would only have 15 days in April to consider the blackout and take action. Therefore, because April 15 is the last date on which participants could take action before the blackout, the 30-day notice must be provided no later than March 16. Notice cannot be given more than 60 days in advance, but nothing in the DOL Rules prohibits earlier notices if supplemental notices also are provided.
What Information Needs to Be Included in the Blackout Notice?
DOL Rules require:
The explanation of a late notice and the requirement to identify a contact person are additions imposed by the DOL Rules. Also, the notice must be written in such a way as to be understood by the average plan participant. The DOL has published a sample notice that includes all of these requirements.
What Delivery Process Is Required for the Blackout Notice?
The notice must be in writing; however, electronic or other delivery methods are acceptable. Notices are considered furnished on the date of mailing via first class mail, or the date of an electronic transmission if sent electronically.
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:
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 a signed and dated writing, either that doing so is impossible due to unforeseeable events, circumstances beyond the reasonable control of the plan administrator (e.g., a major computer failure occurs and plan loans and distributions cannot be made for a period of 10 days), or that postponing the blackout would constitute a violation of the prudence and exclusive benefit obligations of ERISA.
The preamble to the DOL Rules provides an example in which the plan sponsor of a 401(k) plan with the sponsor's common stock as an investment option announces it is filing for bankruptcy. If the 401(k) plan administrator determines that it would be imprudent to invest in the sponsor's stock fund effective immediately, then the 30-day advance notice is not required. In 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).
Does the Plan Administrator Ever Have to Send 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.
Must the Plan Administrator Notify the Issuer of a Blackout?
Yes, if the issuer's securities are affected by the blackout. In addition to sending the notice to participants and beneficiaries, the plan administrator is required to provide the same notice to the issuer of any employer securities subject to a blackout period. The DOL Rules require sending the notice to the issuer at the same time the notice is sent to participants. Notice is required to be sent to the issuer's agent for service of legal process unless the issuer designates someone else.
What Are the Penalties for Failing to Comply with the Notice Requirement?
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, the DOL has addressed this issue.6 Under a recently issued guidance, the DOL Penalty Rules, a penalty accrues only until the end of the blackout period. Additionally, the DOL Penalty Rules provide procedures to assess the penalty and to waive all or part of the penalty.
Which Insiders Are Affected by the Blackout Rules?
The blackout provisions affect the issuer's directors and executive officers (or the equivalent thereof). While the term "director" is defined under the Securities Exchange Act of 1934, the term "executive officer" is not defined. However, the SEC has indicated the term "executive officer" shall have the same meaning as the term "officer" 7 under the insider reporting requirements of Section 16(a) of the Exchange Act.
Under Rule 16a-1(f) of the Exchange Act, an officer is defined as an issuer's:
Officers of the issuer's parent or subsidiaries (including foreign subsidiaries) also may be deemed executive officers if they perform policy-making functions for the issuer.
What Are the Insider Trading Prohibitions?
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 buy, 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 also may encompass any plan involving employment-related securities, such as phantom stock plans and certain employee stock purchase plans (ESPPs).
What Is an Equity Security?
The Act does not define equity security; however, the SEC has indicated it will define the term to include both equity securities and derivative securities (as interpreted under Rule 16 of the Exchange Act) regardless of whether they are issued by the issuer. This definition includes but is not limited to, stock, phantom stock, certificates of profit-sharing, any security future, any right to purchase a security and options.
How Will the Prohibition Against Insider Trading during a Blackout Period Affect the Operation of Equity Compensation Plans?
Stock option grants and exercises, insider purchases of stock under restricted stock grants, stock bonus grants and other similar transactions clearly are prohibited during any blackout period. Additionally, the grant and exercise of restricted stock units, stock appreciation rights (SARs) 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 prohibitions does not appear to cover equity securities acquired after ceasing to be an insider; however, it may cover certain equity securities acquired prior to becoming an insider, as discussed in the section in this article titled, "What about Equity Securities Obtained by an Insider during a Period when the Insider Was Not a Director or Executive Officer?" Both the Act and the SEC Rules exclude securities acquired by the Insider other than in connection with performing services for the issuer.
What Is the Effect on DRIPs, ESPPs and 10b5 Trading Programs?
Congress has given authority to the SEC, 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. The SEC Rules include exemptions for purchases and sales made under a 10b5-1(c) plan, acquisitions under a dividend or interest reinvestment plan and increases or decreases in securities holdings resulting from a stock split, stock dividend or pro rata rights distribution. Additionally, the SEC has stated that certain non-discretionary transactions under certain "tax conditioned plans" (e.g., qualified plans, excess benefits plans and ESPPs) will be exempt. It is uncertain whether this last exemption is broad enough to include all ESPPs or if it will exclude "discretionary" ESPPs that permit employees to revoke the purchase election prior to the purchase date.
What about Equity Securities Acquired by an Insider's Family or Entities Controlled by an Insider?
The SEC Rules provide further guidance on both direct and indirect acquisitions and dispositions of equity securities where an insider has a "pecuniary interest" (as interpreted under Section 16 of the Exchange Act) in the transaction. This means that acquisitions or dispositions of equity securities by the insider's family members and partnerships, corporations or limited liability companies controlled by the insider would be deemed acquisitions or dispositions by the insider if he or she had a pecuniary interest in the equity security.
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 SEC Rules clarify that the prohibition does not include equity securities obtained by the insider outside the employment relationship. However, under the SEC Rules, certain equity securities that are obtained before becoming an insider may be covered by the prohibition if they clearly are related to the employee's service or employment (e.g., an award made to induce an individual to become an employee). The SEC Rules also establish an irrebuttable presumption that any equity securities sold or otherwise transferred during a blackout period were acquired in connection with the insider's service or employment as an insider. This rule is complicated for new insiders who may, at the time they attain insider status, have outstanding option grants that 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.
The new SEC Rule eliminates the need to trace the source of equity securities traded during a blackout period; however, it does not eliminate the need to monitor the total number of equity securities acquired by an insider in connection with his or her service or employment. This is because equity securities held by an insider that are acquired in connection with service or employment only count against a single disposition transaction during a blackout period.
For example, if an executive officer owned 300,000 shares of the issuer's common stock, 100,000 shares of which were acquired as the result of the exercise of employee stock options, a sale of 100,000 shares of common stock during a blackout trading period would be presumed to be a sale of the option shares and, therefore, subject to the trading prohibition. However, a subsequent sale of 50,000 shares of common stock during the same blackout period would not trigger the trading prohibition because the option shares would have been deemed sold in the initial transaction.
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 SEC9 in a timely manner of any blackout period. While the Act does not provide guidance with regard to timelines, the SEC Rules clarify that the insider must receive notice 15 calendar days in advance of the blackout trading period. Like the DOL Blackout Notice, a shorter delivery period is permissible if the blackout was unforeseeable or due to circumstances beyond the issuer's reasonable control.
Additionally, the insider notice must be in writing; however, electronic or other delivery methods are available. For blackout periods occurring between Jan. 26, 2003, and Feb. 10, 2003, issuers are expected to furnish notice of a blackout trading period as soon as is reasonably possible.
What Information Needs to Be Included in the Insider Trading Blackout Notice?
Similar to the DOL Rules, the SEC Rules require:
What Are the Penalties if an Insider Trades during a Blackout?
Under the SEC Rules, an insider who violates the trading prohibition may be subject to possible civil injunction action, civil penalties or, in some circumstances, criminal liability. Also, if the Act's insider trading provision 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 on behalf of the issuer.
Are there Any Exceptions to the Insider Trading Prohibition?
Yes. Insiders are not prohibited from trading during:
What Can DC Retirement Plan Administrators and Issuers Do to Minimize a Potential Violation under the Blackout Provisions of the Act?
Suggestion One: Determine Who Is an Insider
While the Act does not define the terms "director" or "executive officer," the SEC Rules clarify that, for purposes of the prohibition against insider trading, the Act applies to directors and officer as defined under Section 16 of the Exchange Act. Issuers should re-examine their lists of Section 16 insiders in light of the Act to determine whether any individuals should be added or removed from the list. This exercise is especially important in light of the prohibition against loans that already is in effect.
Suggestion Two: Communicate with Insiders
Suggestion Three: Coordinate between Retirement Plan and Insider Trading
The Act's new blackout provisions require communication between DC plan administrators and the issuer. The blackout provisions explicitly require that the retirement plan administrator inform the issuer when there is a restriction placed on trading issuer securities within any DC 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.
Suggestion Four: Establish Monitoring Procedures
The blackout insider trading prohibition requires that an issuer determine when 50 percent of the participants in all of the issuer's U.S. DC plans that may or do hold equity securities are restricted in their ability to buy, sell or otherwise acquire or transfer an interest in the issuer's equity securities. This means companies with more than one DC 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 DC plan. Neither the DOL nor SEC Rules specifically address this issue. Foreign issuers also will have to consider tracking their worldwide participant census to determine if the plan restrictions affect 15 percent of all participants.
Suggestion Five: Consider How to Track Insiders' Equity
The new insider trading restrictions apply to stock obtained during employment as an insider. Therefore, unless a blackout prohibition for insider trading on all employer securities during a blackout is implemented, a method to track the number of equity securities acquired during employment as an insider must be developed. This is because, under the SEC Rule, until an insider has disposed of all of his or her equity securities obtained while employed as an insider, the insider will be deemed to have used "prohibited equity securities" in any transaction that occurs during a blackout.
Suggestion Six: Use Extreme Caution with Blackout Periods
Compliance with DOL Rules for blackout notices does not address a fiduciary's compliance with its duties under ERISA regarding the timing and administration of blackout periods. Therefore, 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. Ensure 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.
1 Remarks by
Chairman Harvey L. Pitt at the Financial Times' conference on Regulation and
Integration of the International Capital Markets in London, U.K. (October 8,
2002).
2 67 Fed. Reg. 203, pp. 64765-64774 (October 21, 2002).
3 In Section II,B,5 of the preamble to the SEC Rules, the SEC is
requesting comments on whether the statutorily defined timeframe of a "blackout"
-- three consecutive business days -- should be shortened.
4 The existence of a controlled group depends on common ownership
of the entities comprising the group and normally treats 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.
5 SEC Rules, preamble, Section II, B, 4, (b). Offering a self-directed
brokerage window in which stock of publicly traded companies (including the
issuer) may be acquired will be a relevant individual account plan, even if
there is no separate issuer stock fund available under the plan.
6 See 67 Fed. Reg. 203, pp. 64774-64786 (October 21, 2002) for the
DOL Penalty Rules.
7 Under the SEC Rules a separate definition of "director"
and "executive officer" applies for foreign private issuers.
8 Rule 16a-1(f) of the Exchange Act Rules and Regulations.
9 The SEC has indicated U.S. issuers will be required to notify the
SEC of an impending blackout period by filing a Form 8-K, and foreign issuers
must notify the SEC on Form 20a.
About
the Author
Bonnie K. Levitt is a partner with Baker & McKenzie. She can be reached
at bonnie.k.levitt@bakernet.com
or 415/984-3833. The author wishes to acknowledge the assistance of Janel M.
Brynda, an associate attorney in the Global Equity Services Group of Baker &
McKenzie in its San Francisco office.
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