Section 402 of the Sarbanes-Oxley Act of 2002 prohibits publicly traded companies from providing, or arranging for, personal loans to their officers and directors. As enacted, Section 402 contains many ambiguities. Neither Congress nor the SEC has provided any official guidance, and the SEC staff has repeatedly stated that interpretation of Section 402 will, until further notice, be left to the private bar. In response, on October 15, 2002, a group of 25 leading U.S. law firms issued a 13-page memorandum (the "402 Memo") setting forth their consensus views on various interpretative questions under Section 402. A copy of the 402 Memo is attached.
The 402 Memo discusses 17 different "personal loan" and "arrangement" issues, including "cashless" exercise of stock options and 401(k) plan loans. The 402 Memo considers a number of different "cashless" exercise structures and concludes that "the apparent policy of Section 402 should permit the conclusion that 'cashless' exercise in general does not involve the type of personal loan intended to be prohibited by Section 402." The 402 Memo reaches a similar conclusion with respect to loans to executive officer-participants under an issuer's 401(k) plan.
Until such time (if ever) as the SEC publishes its views on Section 402 or the federal courts begin to interpret the provision, we believe the 402 Memo will be the leading source of interpretative guidance on the issues it covers. Therefore, subject to the qualifications concerning lack of official guidance contained in the 402 Memo itself, we believe that issuers choosing to follow the advice contained in the 402 Memo should be deemed to be acting in good faith compliance with Section 402. Issuers should only make the decision to follow the consensus interpretations in the 402 Memo after appropriate consultation with counsel concerning the facts and circumstances of the specific Section 402 situation at issue.
Two points in the 402 Memo merit further comment. First, we have previously alerted our clients that a "cashless" exercise program involving an obligation to pay the exercise price to the issuer on the date of exercise ("T") in which the issuer has contracted with a third-party broker to administer all such exercises created the most significant risk of violation of Section 402 of all traditional "cashless" exercise structures. The 402 Memo concludes that such a program "should be permissible" (as opposed to other forms of "cashless" exercises, which the 402 Memo concludes are "permissible"). In light of the 402 Memo's position, while we continue to believe that such a program is not without risk, issuers now have a greater foundation for choosing to reinstate or create such third-party administered broker programs, even with plans requiring payment of the exercise price on date T.
Second, the 402 Memo states that the requirement to pay withholding taxes upon exercise of an option is the issuer's, and not the optionee's, obligation. We believe that, under Sections 83 and 3402 of the Internal Revenue Code (and related regulations), this is the obligation of the optionee, not the issuer (which only acts as a conduit for payment). Therefore, the payment of withholding taxes by the issuer on date T may increase the risk of creating an "extension of credit" to the executive. Issuers should consult with tax counsel to consider ways in which to minimize this risk.
If you wish to discuss any specific items raised in this memorandum or the 402 Memo, please consult the Dorsey & Whitney corporate lawyer with whom you are in regular contact.