Sarbanes-Oxley Should Not Preclude All Broker-Assisted Cashless Option Exercises by Insiders

Although some law firms have advised public issuers to suspend broker-assisted cashless stock option exercises for executive officers and directors in light of Section 402 of the Sarbanes-Oxley Act, we believe, subject to certain limitations, that such suspension is not necessary.

The Statute Section 402 of the Sarbanes-Oxley Act of 2002 ("SO") amends Section 13 of the Securities Exchange Act of 1934 ("Exchange Act") by adding a new subsection (k). This subsection, which became effective immediately upon SO's enactment on July 30, 2002, imposes the following prohibition:

Section 2(a)(7) of SO defines "Issuer" as follows:

"Executive Officer" is defined in Rule 3b-7 under the Exchange Act as follows:

"Director" is defined in '3(a)(7) of the Exchange Act as:

The new statute, then, prohibits issuers subject to its coverage from directly or indirectly (including through a subsidiary):

The terms "extend," "maintain," "credit," "arrange," and "personal loan" are used in the statute but are not defined. And, unlike many other provisions of SO, this section does not contemplate any clarifying or implementing regulations by the SEC or other regulatory agencies. SEC representatives have informally indicated that no regulatory action is likely under this section in the near term. So the bare statutory text is likely to be all the guidance which is available for the foreseeable future.

Mechanics of Broker-Assisted Cashless Option Exercises

Broker-assisted cashless option exercises are customarily conducted with the assistance of a brokerage firm, in one of the following fashions:

• At the time of exercise of the option, the broker receives from the optionee a copy of the optionee's irrevocable notice to the issuer of exercise of the option, together with a copy of the optionee's irrevocable instructions to the issuer to deliver the option stock to the broker against the broker's simultaneous payment to the issuer of the option exercise price. On the date of receipt of such documentation, prior to the actual issuance by the company of the subject shares, the broker will sell for the optionee's account the number of shares of company stock necessary to satisfy the exercise price and applicable tax withholding obligations. When the broker receives the cash proceeds from such sale (typically three trading days after the sale), the broker will forward such proceeds to the issuer against simultaneous delivery by the issuer of the subject stock to the broker; or

• The broker makes a loan to the insider of the proceeds necessary to exercise the option, and delivers payment to the company on the same day as the exercise upon the broker's receipt of the exercise notice with irrevocable instructions to the issuer to deliver the option stock. Although the shares necessary to satisfy the option holder's payment obligation are almost always sold contemporaneously with the exercise, the broker will generally be paid interest on the funds advanced.

We believe that Section 402 would prohibit these procedures only if, first, they are viewed as an extension of credit by the broker to the optionee executive officer/director, and second, the extension of credit was viewed as having been arranged by the company.² The legislative history of this provision of SO contains no indication of Congressional intent as to whether cashless option exercises were intended to be within or without SO's prohibition. ³

Extension of Credit by Broker

The above-described broker-assisted cashless exercise procedures involve the sale or advance of funds by the broker relating to shares the optionee has not yet received, against assurance of delivery of such shares a short time later from the company. If for some reason the shares were not forthcoming by the company, the broker would be required to honor its settlement obligation for the shares from some other source, either from shares it owned itself or shares it purchased from others. In this sense, the procedure could be characterized as a loan by the broker of shares to the optionee for sale for his account, to be repaid by the issuance of shares by the company. ⁴

These broker-assisted cashless exercise procedures are specifically considered to be outside the coverage of Regulation T, which generally imposes limitations upon extensions of credit by brokers. ⁵

Section 220.3(e)(4) of Regulation T provides:

Reference to the regulatory restrictions upon extensions of credit by brokers under Regulation T provides less than clear guidance for Section 402 purposes. The above provision could suggest that since these types of arrangements are not prohibited by the Regulation T restrictions on broker extensions of credit, they should not be considered to constitute extensions of credit for purposes of Section 402. On the other hand, the provision could be read to suggest that although these activities will not be subject to the constraints imposed by Regulation T, they in fact do constitute "financing."

More generally, caution is in order in using Regulation T as a reference point for interpreting Section 402. Despite its use of similar terms ("extension of credit," "maintaining," "arranging") and its specific focus here on the precise type of transaction for which 402's applicability is being analyzed (cashless option exercises), Regulation T has a completely different policy basis than Section 402. ⁶

Ultimately, reference to Regulation T, as with the legislative history of Section 402, does not provide a solid basis for reaching a conclusion on whether the activity of brokerage firms in effecting cashless option exercises constitutes an "extension of credit" in the form of a "personal loan" to the optionee, as such terms are used in Section 402.

Arranging Extension of Credit by Issuer

If broker facilitation of cashless exercises as described above is considered to constitute an "extension of credit" to executives, Section 402 would prohibit the company from "arranging" such extension.

The concept of "arranging" extensions of credit has been the subject of extended Federal Reserve Board and SEC interpretation under Regulation T, which restricts the ability of brokers to arrange such extensions from other parties. The general tenor of such interpretation is that the concept of "arranging" under Regulation T context has been given a very broad meaning. The introduction of a customer to a lender has been interpreted to constitute "arranging" of the lender's extension of credit under Regulation T. The recommendation of a specific lender has been held to constitute such arranging. Even the simple delivery of securities to a lender against receipt of the proceeds of a loan has been held to constitute an arranging of the loan under Regulation T. ⁷

If such a broad conception of "arranging" was applied in interpreting Section 402, certain activities of an issuer in connection with a cashless exercise program might be considered to fall within the category of "arranging" the broker's extension of credit and thus be proscribed. Customarily, a company will agree to provide an acknowledgment to the broker that it has received the notice of exercise and instructions to deliver shares to the broker and (sometimes) that the notice of option exercise complies with the terms of the option plan and option agreement. Universally, the issuer will agree, pursuant to the optionee's instructions, to deliver the shares to the broker against the broker's simultaneous payment. Often companies will recommend brokerage firms to employees for cash option exercises. Frequently the company will reserve the right to approve the brokerage firm selected by the optionee for such purposes. Sometimes the issuer will designate one or more brokerage firms which optionees will be required to use for these purposes.

However, the differences in the policy bases behind Regulation T and Section 402 argue strongly that the term "arranging" under 402 should be interpreted more in accordance with the term's natural meaning than in the way followed under Regulation T.

Regulation T's primary purpose is to regulate the amount of credit directed into securities speculation and away from other sources. It is also intended to protect the securities markets from undue fluctuations and disruptions caused by excessive credit, and to protect investors against excessive securities credit. The protection of broker-dealers against excessive credit exposure to customers was not an original purpose behind the margin regulations.⁸ In later years, the regulatory agencies have made reference to the desirability of protecting brokers from excessive credit extension; however, this is not the primary thrust of the margin regulations.

A regulatory purpose geared to a control of the overall supply of credit into the marketplace naturally lends itself to a broad prohibition on "arranging" such credit. The harm is deemed to be done by the unregulated supply of credit, even where its source is only tenuously connected with a directly regulated broker dealer.

The purpose of the Section 402 loan prohibition, on the other hand, is focused on the protection of investors in the corporation. The Report of the Senate Committee on S.2673⁹ made reference to multimillion dollar loans to executives of Enron, WorldCom, Qwest, Global Crossing and AES Corp. and multibillion dollar loans to the founder of Adelphia. Several of these loans were later forgiven by the corporation. The Committee noted that it was "aware that investors are concerned about loans to insiders." Inherent in corporate loan transactions to related parties is the risk to the corporation's shareholders posed by the fact that adequate credit analysis may not be conducted and even that loans may simply later be forgiven, in each case to the detriment of shareholders.

Section 402's prohibition on a corporation's "arranging" loans to executives should be analyzed consistent with this purpose. The concern here is not in protecting a trading marketplace against an increased credit supply through loans to executives. Neither is the concern to protect the executive against the consequences of excessive borrowing. The focus is upon the potential of harm to the corporation and its shareholders.

Where the nature of the company's involvement in the making of the loan imposes risk to the company's shareholders, the prohibition on "arranging" should apply. For example, if by stated or unstated understanding, the company will favor a lending broker with some type of business relationship with the company as an exchange for the broker facilitating cashless exercises, this should be viewed as an "arranging" by the company. To avoid a claim of "arranging" on this basis, we believe it would be preferable for a company not to recommend or require that executives use brokerage firms with whom the company has an investment banking relationship, or whose investment analysts report on the company, or with which the company has some other business relationship. It may be prudent for a company to suggest to executives that they use brokerage firms other than those with whom the company has a relationship, or even to require the use of firms other than these, without designating particular firms to use.

Within these constraints, we believe a cashless exercise program should not constitute an unlawful "arranging" under Section 402 if the company's involvement is limited to: (i) recommending one or more brokerage firms for executive to use for cashless option exercises; (ii) reserving the right to approve the chosen firm based on standards of administrative competence in handling cashless exercises; (iii) agreeing to forward to the broker an acknowledgment of receipt of exercise form and the optionees instructions to deliver shares to the broker; (iv) informing the broker that the exercise form complies with the applicable plan requirements; and (v) agreeing to forward the option stock to the broker against the broker's simultaneous payment of the option exercise price and necessary tax withholding.

Such an interpretation is consistent with the statute's purpose, and also, we believe, involves a less strained reading of the term "arranging." Under this approach, the term "to arrange" would require more than a tenuous connection between the issuer's actions and the broker's extension of credit. "Arranging" by the issuer would mean active involvement in bringing into effect the extension of credit in question, and would be equivalent to "devising," "engineering" or "formulating" a procedure for broker extensions of credit. ¹¹

We do recommend, except as specified below, that issuers refrain from requiring that a single specified broker be used by all executives for cashless option exercises. Even where it could be demonstrated that this poses no risk to the company or its shareholders, this level of involvement is significant enough that it could be deemed to constitute an "arranging," under the plain meaning of the term. Notwithstanding this, if the issuer can demonstrate that it is imposing the requirement of use of a single brokerage firm for cashless exercises as part of an overall program requiring all executive officers and directors to use a single broker for all of their transactions in company stock, and can demonstrate that the purpose of imposing the requirement is to facilitate compliance with the accelerated reporting requirements for such transactions imposed by Section 403 of SO, we believe this should not be deemed to constitute an unlawful "arranging." ¹²

Timing Issues

Section 402, effective July 30, 2002, prohibits an issuer from "arranging for the extension of credit" to an executive officer or director. By its terms, if an issuer engaged in activity prior to July 30 resulting in an extension of credit prior to July 30, this would be beyond the statute's prohibition. Engaging in activity after July 30 in arranging credit extended after July 30 is prohibited.

Less clear is the application to issuer "arranging" activity occurring prior to July 30, 2002 which results in an extension of credit by another party after July 30, 2002. Section 402 exempts from its coverage "extensions of credit maintained by the issuer" after July 30 so long as they are not modified or renewed. Consistent with this provision, advances by an issuer after July 30 made pursuant to a contractual obligation entered into prior to July 30 should not be covered by the statute.

The statute contains no comparable provision relating to the timing of arranging activity. With regard to cashless exercise programs, however, if the participation by an issuer is such as to be deemed to constitute an arranging of broker extensions of credit, we believe the statute should be construed as excluding from its coverage such arranging activity insofar as it relates to broker actions after the effective date taken pursuant to contractual obligations entered into by the broker prior to the effective date. This could be the case, for example, in Rule 10b5-1 plans adopted prior to the effective date of the statute under which the broker is committed to facilitate cashless exercises under the terms of the plan.

Need for Interpretative Guidance

The loan prohibition of Section 402 has been interpreted by many practitioners to reach far beyond the scope of the abusive personal loans to insiders at which it appears to have been directed. Although interpretive guidance is clearly needed, it is unclear when and from whom interpretive guidance will come.

Until interpretive guidance is received, we believe that issuers are left with no choice but to consult with counsel and apply reasonable judgment to the interpretation of this difficult issue. While some issuers may decide to suspend all broker-assisted cashless exercises for executive officers/directors, we believe it is important for issuers to be aware that an alternative interpretation of Section 402 exists.

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Reed Smith, a leading global law firm with more than 700 lawyers located in 11 U.S. and two U.K. cities, represents Fortune 100 as well as mid-market and emerging companies. Clients include technology companies and entrepreneurs, financial services firms, health care providers and insurers, communications companies, manufacturers, universities, non-profit organizations, real estate developers, and municipalities throughout the United States and in 40 countries. For more information, please visit reedsmith.com. If you would like to receive future client bulletins via e-mail, please sign up on our Web site at http://www.reedsmith.com/admin/contact.asp.

If you have questions or would like additional information on the material covered in this Bulletin, please contact one of the authors:

.or the Reed Smith attorney with whom you regularly work.

¹ Executive officers are required to be identified in Item 10 of the issuer's Form 10-K.

² We believe that it is difficult to construct an argument that this procedure involves an extension of credit directly by the company, where the stock is not issued by the company until the company receives payment for it. Often, stock option plans contain provisions stating that the date of exercise of the stock option is deemed to be the date the company receives the notice of exercise from the optionee. These are included for the purposes of fixing the optionee's tax liability on such date. If the actual procedures followed in the issuance of stock do not involve the issuance prior to payment, these types of provisions, standing alone, should not cause the cashless option exercise to be considered an extension of credit by the company.

³ There is no mention of stock option exercises in the legislative history of the loan prohibition. However, the absence of such mention probably cannot be relied upon as an indication of an affirmative legislative intent that cashless option exercises be excluded from the prohibition's coverage. The use of the broad term "extension of credit in the form of a personal loan" was probably intended to cover more types of arrangements than those Congress specifically considered in the rapid deliberation of the statute.

⁴ The fact that the source of repayment is a source designated by the optionee rather than the optionee itself probably does not provide support for the conclusion that there is no loan to the optionee. Many loan arrangements are structured contemplating repayment by a designee of the obligor rather than the obligor itself.

⁵ Regulation T was adopted pursuant to the Section 7 of the Securities Exchange Act of 1934, which makes it unlawful for any broker or dealer to directly or indirectly "extend or maintain credit" in violation of rules promulgated by the Federal Reserve Board.

⁶ See discussion of the policy basis of Regulation T and Section 402 in connection with the term "arranging" below.

⁷ See generally cases cited in Rechlin, Securities Credit Regulation (West Group 2002), '7:2 ("Arranging of credit"); '7:6 ("Introduction of customer to lender"); '7:9 ("Delivery of collateral and receipt of funds from lender").

⁸ The House Report accompanying the Exchange Act stated:

¹⁰ The AES loan was made to executives to prevent them from being forced to sell company shares due to margin calls.

¹¹ The Oxford English Dictionary (2d edition) defines "arrange" (entry 8) as:

¹² This assumes no other business relationships with the broker as discussed above.