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The Effect of § 402(a) of the Sarbanes-Oxley Act on a Company’s Ability to Advance Defense Costs to Its Directors and Officers

By Dan A. Bailey

This paper discusses the potential effect of Section 402(a) of the Sarbanes-Oxley Act (codified at 15 U.S.C. § 78m(k)) on the ability of a corporation to advance defense costs to its directors and officers. Section 402(a) adds a provision to the Securities Exchange Act of 1934 which generally prohibits corporations from making personal loans to directors and officers, and a few commentators have questioned whether this new section could conceivably affect defense cost advancement. However, for the reasons summarized below, 402(a) should not prohibit such defense cost advancement.

Section 402(a)(1) of the Sarbanes-Oxley Act provides, in relevant part:

It shall be unlawful for any issuer (as defined in section 2 of the Sarbanes Oxley Act of 2002), directly or indirectly, including through any subsidiary, to extend or maintain credit, to arrange for the extension of credit, or to renew an extension of credit, in the form of a personal loan to or for any director or executive officer (or equivalent thereof) of that issuer….

Section 402(b) provides a limited exception for certain home and consumer credit loans made by companies in the consumer credit business if the loans are on the same terms as available to the general public.

The plain language of § 402(a) clearly contemplates that its prohibition is not intended to reach all extensions of credit by a company to its directors and officers, but only those credit extensions that are “personal loans”. However, the term “personal loan” is not defined anywhere in the Act. Furthermore, the SEC has not yet issued any interpretative Release or other guidance on how § 402(a) is to be interpreted. For this reason, it is helpful to consider the legislative history of this provision, as well as prior SEC pronouncements related to this matter to determine whether defense cost advancement will likely be affected by § 402(a).

Legislative History

The title of § 402 is “Enhanced Conflict of Interest Provisions,” which suggests that the intent in adopting the ban on personal loans was to eliminate the conflicts of interest that arise from such loans. There is also some legislative history to be gleaned from the Congressional Report. When the Sarbanes-Oxley Act came out of the Senate Banking Committee, it required the SEC to adopt rules mandating the disclosure of any loan or guaranty of an obligation made by a company to a director or officer. S. 2673 § 402. Senators Schumer and Feinstein sponsored the amendment that was ultimately adopted which replaced the disclosure requirement with a prohibition on personal loans. The only recorded comments on the provision were made by Senator Schumer at the amendment’s introduction:

It is a very simple amendment. It basically says that with certain narrow exceptions, CEOs and CFOs of companies will not be able to get loans from those companies.

In his speech before Wall Street yesterday, President Bush forcefully stated: “…I challenge compensation committees to put an end to all company loans to corporate officers.”

I couldn’t agree more….These same kinds of transactions were used [in the 80’s S&L crisis] to “cook the books” and our Nation’s economy and financial institutions paid the price for it. Once again, history repeats itself.

My amendment is very simple: it makes it unlawful for any publicly traded company to make loans to its executive officers. Let me give a few examples as to why we should do this.

Executives of major corporations, including Enron, WorldCom, and Adelphia, collectively received more than $5 billion in company funds in the form of personal loans….

The question is: Why can’t these super rich corporate executives go to the corner bank, the Suntrust’s or Bank of America’s, like everyone else to take loans?

In the case of WorldCom, Ebbers had funded his personal stock market activities by borrowing on margin. When the value of those investments plunged, Ebbers had to pay up. How did he do it? He borrowed money from his board of directors to pay for the stock he had bought that was now being called in.

This is just wrong, and it must be stopped.

148 Cong. Rec. S. 6687, 6690. These comments mirror the section’s title by suggesting that § 402(a) was intended to prevent conflicts of interest and to avoid the problems that arise when companies that are not engaged in the consumer credit business make personal loans to their officers for non-company business (i.e., loans that would more properly be handled by normal banks).

Considered as a whole, this legislative history indicates that § 402(a) was intended to address the specific conflicts of interest raised by a corporation’s personal loans to directors and officers by banning that type of loan completely. It does not appear that Congress intended to ban those extensions of credit which are made for the benefit of the company. The language of the statute limits the ban to “personal loans,” which suggests that extensions of credit directly relating to the company business would fall outside the scope of § 402(a).

Advancement of defense costs to a director and officer for claims against them does not appear to implicate the conflicts of interest that were the impetus behind the adoption of this provision. Defense cost advancement serves a legitimate corporate purpose by encouraging individuals to serve as directors, and is primarily a business-related advancement, not a personal loan. Advancement is allowed under virtually every state indemnification statute. The legislative history of § 402(a) contains no suggestion that these state laws were intended to be abrogated. Also, defense cost advancement pursuant to state law is not the type of transaction that creates the conflicts of interest or encourages the abusive behavior sought to be curtailed by the Act. For all of these reasons, the limited legislative history of § 402(a) suggests that it would not bar companies from advancing defense costs to D&Os.

Prior SEC Interpretations of Related Provisions

The SEC has released two statements of staff positions relating to investment companies which suggest that the SEC, if and when it releases guidance on the meaning of § 402(a), will not find that § 402(a) bars the advancement of defense costs.

In a 1980 SEC Release, the SEC stated that an indemnification provision does not violate Sections 17(h) or 17(i) of the Investment Company Act (“ICA”)1 merely because it permits the company to advance attorneys’ fees or other expenses incurred by the directors and officers. The indemnification provision examined by the SEC in that Release conditioned the defense costs advancement on (i) the D&Os providing security for any repayment obligation; (ii) the company being insured for such defense cost advancement; or (3) there being reasonable assurance that the D&Os would not be found liable for prohibited conduct. Investment Company Act of 1940, Release No. 11330 (Sep. 4, 1980), 1980 SEC LEXIS 778. Most importantly, the Release went on to find that the staff would not recommend any SEC action under section 17(a)(3) or section 21 of the ICA, which prohibit directors and officers from borrowing money or other property from the investment company,2 if defense costs are advanced under a state law indemnification provision. A later Release in 1999 provided further guidance on indemnification under the ICA and noted that advancement is important because “[t]he risk of potential liability could…deter some independent directors from making controversial decisions that may benefit the fund and discourage qualified individuals from serving as independent directors.” SEC Release No. IC-24083, 17 CFR Part 271, 1999 SEC LEXIS 2196.

These SEC Releases further suggest that § 402(a) will not be interpreted to prohibit the advancement of defense costs to D&Os. The 1980 Release specifically endorsed the practice under the ICA notwithstanding a prohibition in the ICA against D&O’s borrowing money from the Company. The 1999 Release expressly confirmed that defense cost advancement serves a legitimate corporate function and should be allowed to further the company’s best interests. This indicates that defense cost advancement should not be viewed as a “personal” loan to D&Os and thus not prohibited by § 402(a). Although one commentator suggested that the language in the 1980 Release “may more represent the staff’s prosecutorial intentions than its legal analysis,” both the 1980 and 1999 Releases together suggest that the SEC would not adopt a definition of “personal loans” under § 402(a) which would bar companies from advancing defense costs.

White Paper Drafted by Corporate Law Firms

A recent memorandum drafted by 25 large corporate law firms concludes that advancement of defense costs would not implicate § 402(a). In “Interpretive Issues Under § 402 - Prohibition of Certain Insider Loan” (found on the Leboeuf, Lamb, Green & MacRae website), the authors list three reasons for their conclusion. First, they cite to the “well-developed and longstanding state policy interest in providing indemnification advances (unrelated to insider conflicts of interest)”, and suggest that Congress would not have barred indemnification advances given these state interests and the corresponding corporate benefits. Second, they suggest that advancement is not “in the form of a … loan” because the indemnified D&O would only be required to repay the company in certain contingencies, which “makes the likelihood of such repayment reasonably uncertain.” Finally, the authors proffer that defense cost advancement would not be seen as “personal’ because expenses are incurred in connection with services to the issuer that constitute a business purpose regardless of whether ultimately these amounts need to be repaid.”

Conclusion

In conclusion, it appears that § 402(a) should not be interpreted to prohibit a company from advancing defense costs to its D&Os. Although the language of § 402(a) is not entirely clear on the issue, the legislative history of § 402, several prior SEC rulings, and the purposes for both the “personal loan” prohibition and state law advancement authorization all strongly indicate that such advancements should be permissible notwithstanding § 402(a). 

Notes
1 Together these provisions prohibit an investment company from protecting a D&O from liability for willful misfeasance, bad faith, gross negligence, or reckless disregard.
2 The prohibition in section 17(a)(3) of the ICA is even broader than the “personal loan” prohibition of § 402(a) in that the ICA prohibits all borrowing of money and property, not just “personal” loans.

ABOUT THE AUTHOR

Dan A. Bailey is a member of the Columbus, Ohio, law firm of Arter & Hadden, LLP. Mr. Bailey specializes in D&O liability insurance, corporate and securities law. He is a frequent lecturer and has authored and co-authored several books dealing with D&O liability isuses.

riskVue | The webzine for risk management profesionals
August 2003