Stock Compensation Meets Securities Laws: Keeping Executives and Employees Out of Jail

Bruce Brumberg, Editor myStockOptions.com Bruce@myStockOptions.com Sue Morgan, Perkins Coie LLP smorgan@perkinscoie.com WorldatWork 48th Annual Conference May 12, 2003 San Diego

All the financial scandals involve securities law violations and sales of stock by insiders. The stock sold, either from options or restricted share grants, or founders stock, was often part of equity compensation.

Topics to Keep Your Execs and Employees Out of Trouble

   

Insider Trading Rule 10b5-1 Plans Section 16 Sarbanes-Oxley Act:



CEO/CFO Certifications of SEC Filings; Executive Loans; Pension Plan Blackouts; Non-Audit Services

Other Current Issues

The investigations, stories and accusations continue.

Will ads for insider trading lawyers crowd out ads for personal injury and medical malpractice lawyers?

Insider Trading
What is insider trading?


You know material confidential information about a public company (whether your company or another company). You trade on that information or tip others about it before the information is released publicly.

Insider Trading


 

Civil Penalties: any profit made or loss avoided and penalty of up to three times this amount. Bar for serving as D&O of public company. Individuals face up to 25 years in prison for securities fraud and fines of up to $1 million. Mail and wire fraud, tax evasion and obstruction of justice. Corporations face penalties. Controlling persons liability for managers New disgorgement penalty for restatements

Insider Trading
Material information: news that can affect a company s stock price, for better or worse This includes knowledge of:
takeover accounting problems dividend change blockbuster product earnings better or worse than expected

Insider Trading
MYTHs
Only a company s insiders or employees can commit insider trading. Need to trade and be caught in the act.

TRUTHs


   

The law applies to anyone who knows material nonpublic information at the time of the trade or tip Applies to trades of stock in customers, suppliers, clients Tipping, even without the tipper trading, is illegal Most cases based on circumstantial evidence These rules are separate from the Section 16 rules for senior executives and directors

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Insider Trading
The ImClone case


What is the material nonpublic information and when does it become public? Senior executives sell; CEO s family members sell Martha Stewart: What did she know? When did she know it? Who gave her information? What constituted obstruction of justice and false statements to government investigators? Can brokers use information that senior executives are buying or selling? Check your plan provider s rules.

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Insider Trading
How does insider trading apply to stock options?


Grant or exercise of stock options is not a trade Cashless exercise/same-day sale raises questions of insider trading Rules apply during post-termination exercise period Rules also apply to company stock in 401(k)

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Insider Trading
Insider trading harms the goals of employee ownership


Employee ownership culture encourages information-sharing and boasting about company. Even well-intentioned actions can be illegal. Destroys the financial link between employees and shareholders. Damages reputation of equity compensation. Investors interpret insider trading investigation as sign that company has undisclosed financial or accounting troubles.

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Insider Trading


Prevention Procedures Blackout Periods vs. Quarterly Trading Windows Pre-clearance for Senior Executives and Directors. Rule 10b5-1 plans as defense. Ongoing Education: Seminars, Videos (e.g., Think Twice ), Reminders, Press Clippings Substantive prevention efforts, internal investigations and cooperation with SEC and DOJ can reduce corporate liability

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For more details and questions on insider trading, see Articles and FAQs on myStockOptions

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10b5-1 Plans


What are Rule 10b5-1 trading plans?

   

How they help How they work FAQs How you can help implement

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10b5-1 Plans


How 10b5-1 plans help



Permit advance planning for orderly disposition or to meet special needs Sales can take place even when insiders are aware of material nonpublic information Companies can manage public perception of insiders sales

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10b5-1 Plans


How 10b5-1 plans work



Provide an affirmative defense against insider trading claims if When not aware of the inside information, the insider must  Enter into a contract to sell (or purchase),  Instruct another person to sell for the insider s account, or  Adopt a written plan for trading securities

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10b5-1 Plans


The written trading plan must  Specify amount, price and date of sales,  Provide formula, algorithm or computer program for determining amounts, prices and dates, or  Not permit the insider to exercise any subsequent influence over how, when or whether to effect the sales

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10b5-1 Plans


Whose plan is it?  Agreement between insider and broker  Brokers usually supply form  Company should review


To avoid controlling person liability

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10b5-1 Plans


When should the plan be signed?  Generally, during a window period When should sales start?  Hiatus before trading starts: two weeks, 30 days, three months, after next earnings release

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10b5-1 Plans


What if your insider is always aware of inside information?  SEC advice equivocal  Rule says before becoming aware of the information  Alternative: insider must not be aware of inside information when plan commences  Mechanisms: long hiatus before sales start (six months); other officer signs off when trading can begin

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10b5-1 Plans


Should the plan be in writing?  Two of three affirmative defenses do not require  Best practice is to have written plan  Certainty of terms  Use as evidence in judicial proceedings


Summary judgment phase

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10b5-1 Plans


Should the plan have a fixed term?  Not required  Best practice is to have fixed term  Typically six months or one year  Two years at outside

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10b5-1 Plans


What factors influence trading instructions?  Impact on market

 

Size of transactions Multiple insiders Frequent sales, barrage of Forms 4 Keep it simple

Two-day Section 16 reporting



Ease of implementation


Cashless option exercise issues

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10b5-1 Plans


What should cause the plan to automatically suspend or terminate?  Insider s death, bankruptcy, termination of insider status, expiration of stock options subject to plan  Announcement of merger, tender offer  Withdrawal of company s lack of objection to plan

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10b5-1 Plans


When can insider terminate the plan?  Can be when aware of inside information  Does not violate Rule 10b5-1 because it is not illegal not to trade (SEC informal advice)  Issue of good faith if pattern or practice  Should be hiatus before start new plan

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10b5-1 Plans


When can insider modify the plan?  Only when not aware of inside information; must wait for open window Can trades be made outside a plan?  Called parallel trading  Would not invalidate trading plan (SEC informal advice)  On its own, trade must not violate Rule 10b-5

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10b5-1 Plans


Should the company make a public announcement of the 10b5-1 plan or program?  Press release  Form 8-K (SEC may require)  Form 10-Q  Company Web site

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10b5-1 Plans


What should be disclosed?  Existence of program (selling or buying)  Names of insiders  Number of shares  Percentage of holdings (vested and unvested)  Duration, other terms  Whether insiders will trade outside plan

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10b5-1 Plans


Sample disclosure
Four of the companys executive officers currently have in effect Rule 10b5-1 sales plans for shares of the companys common stock. In accordance with the requirements of Rule 10b5-1, the plans were established at times when the officers were not aware of material nonpublic information. The plans specify the trading periods, which range from six months to one year, the numbers of shares to be sold and the prices at which shares may be sold. If all conditions of the plans are met, the aggregate number of shares that may be sold under the plans would be ________, which would equal approximately __% of the aggregate number of shares, including restricted shares and vested and unvested option shares, held by the officers as of _______, 2002. The officers may amend the trading plans and may sell additional shares of common stock outside of the trading plans, provided they are not aware of material nonpublic information at such time.

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10b5-1 Plans


What other laws impact plans?  Controlling person liability  Rule 144
  

Timing of filings Attestation Exclusive broker?

  

Section 16 Section 13(d) State law

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10b5-1 Plans


How you can help implement plans  Designate 10b5-1 committee or compliance officer  Establish guidelines all plans must meet  Establish procedures for review and approval  Vet plans of one or more brokers

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10b5-1 Plans


Process for approval  Committee reviews plan for compliance with company's guidelines  Dialogue takes place between committee, broker and insider  Committee makes any requests for changes and approves or rejects plan  Committee works with broker to generate required paperwork (e.g., stock option exercise forms)

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10b5-1 Plans


Reporting transactions  Broker files Form 144



Pre-signed forms placed with broker

Broker reports transaction details to compliance officer--same day by phone, then confirmed by same-day fax or email Compliance officer prepares Form 4 for insider's signature--two-day filing unless exact date not specified

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10b5-1 Plans


Sample guidelines  General plan requirements

 

  

Discretionary plans will not be permitted Modification/voluntary termination of plan can only take place during an open window Company has discretion to terminate plan for certain events Automatic termination/suspension events Plan intended to comply with Rule 10b5-1 Purpose, e.g., to permit orderly disposition or acquisition

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10b5-1 Plans


Insider representations that



 

Insider is not aware of material nonpublic information Insider is entering into plan in good faith, and not as part of a scheme to evade the purpose of the rule Insider will not hedge against the trading plan Insider will comply with Rule 144 and Sections 16 and 13(d) Insider will exercise no control over broker s actions

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10b5-1 Plans


Broker representations that



 

It will not seek instructions or advice from insider It will not deviate from the plan It will not execute if aware of material nonpublic information It has reviewed (or approved) trading plan It has no objections to the plan The plan does not violate the company s insider trading policy

Company representations that

  

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Section 16


 

Provisions under securities laws and SEC rules that require SEC filings by senior executives and directors for their company stock transactions, and also matching of trades within six-month period Forms 3, 4 & 5 Short-swing profit liability

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Section 16
Form 4
 

Filed two days after company stock transactions Previously reported on Form 5: Option grants, transactions with the company, including option issuances, cancellations and repricings Company procedures in place for assisting insiders with filings Interacting with outside stock plan service providers and brokers Coming soon: Filings must be made on EDGAR and simultaneously posted on your company's Web site

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Section 16
Issues Raised


Late filings reported in proxy statement: New meaning about corporate governance and compliance Re-examine which officers are Section 16 officers: No longer prestigious. SEC definition includes president, CFO, chief accounting officers, VPs of principal business units and any person with significant policymaking function. Changes in compensation design: Deferred comp; M&A

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Section 16
Short-Swing Profit Rules


Senior officer and director who realize any profit from the purchase and sale, or sale and purchase, of any company shares within any period less than six months must return this profit to the company Extends to transactions made by your spouse and other family members and to trusts set up for their benefit Section 16(b) plaintiff's lawyers actively monitor securities trades for these violations because they share in any profits paid back to your company

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Section 16
Danger: The six-month danger period runs both backward and forward from the date of a transaction. Best match applies!

Down market example:



Sold stock on January 1 at $15. Stock executive purchased two years ago. Stock drops to $5 over next four months. Buys stock on May 1 to show market that confident in company future. We have a match! $10 per share profit on the May 1 purchase paid back to company. Window period and blackout rules no defense.

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Section 16
Option and Restricted Stock Grants


Grants of shares and stock options under employee benefit plans will normally be exempt, assuming that the necessary shareholder or board approvals are given in advance. Any sale of shares is still matchable against any open market purchase of shares within the six-month zone. Watch out for cashless exercise.

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Section 16
Example With Options
If you exercise a stock option and sell the stock on January 1 when market price is $15, your exercise is exempt from Section 16(b) matching. The sale of the stock is not. Thus, any gains resulting from a match with a purchase six months before this date or six months after will be a short-swing profits violation. Purchase of stock in November at $12 is matched for $3 per share.

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Sarbanes-Oxley Act of 2002

  

CEO and CFO certifications Ban on personal loans Prohibition on trades during pension plan blackout periods Prior audit committee approval of non-audit services

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CEO/CFO Certifications


Sarbanes Section 302: CEO/CFO of public company required to submit a statement with certain filings certifying that
 

Has reviewed the report Based on CEO/CFO s knowledge, the report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by the report

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CEO/CFO Certifications


Along with other certifying officers



Are responsible for establishing and maintaining disclosure controls and procedures Have designed such disclosure controls and procedures to ensure that material information is made known to them, particularly during the period in which the periodic report is being prepared Have evaluated the effectiveness of the disclosure controls and procedures as of a date within 90 days prior to the filing date of the report Have presented in the report their conclusions about the effectiveness of the disclosure controls and procedures based on the required evaluation as of that date

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CEO/CFO Certifications


Sarbanes Section 906: Requires CEO/CFO of public company to submit a statement with certain filings certifying that the filing fully complies with the Exchange Act reporting requirements and fairly presents in all material respects the company s financial condition and results of operations.

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CEO/CFO Certifications


What does this have to do with me?



Flow-down certification


Recent survey of large U.S. multinational companies Two-thirds require subcertifications Average of 18.6 additional executives Including heads of HR and Compensation

 

Participation in disclosure practices committee Criminal penalties for CEO/CFO



HealthSouth first criminal certification case

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CEO/CFO Certifications
 

CEO/CFO not just certifying financial information Most of proxy statement is incorporated by reference into Part III of the Form 10-K


Executive compensation tables Beneficial ownership table Certain relationships and related transactions Section 16 compliance Item 201(d) executive compensation plan information table

Also financial statement equity compensation note

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CEO/CFO Certifications


Sample subcertification of proxy statement

1. I understand that the Chief Executive Officer and Chief Financial Officer of ABC Corp. will rely on this certificate, along with other review procedures, in providing to the Securities and Exchange Commission pursuant to 18 U.S.C. 1350, as adopted pursuant to 906 and 302 of the Sarbanes-Oxley Act of 2002, a certification in connection with ABC Corp.s annual report on Form 10-K, which incorporates by reference certain sections of ABC Corp.s proxy statement for its 2003 annual meeting. 2. I have reviewed the proxy statement. 3. Based on my knowledge, the proxy statement does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading as of the date on which the proxy statement was filed.

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Ban on Personal Loans



Section 402: Bans personal loans to directors and executive officers



Broker-assisted cashless exercises



Probably okay if
 

Regular T+3 settlement Choice among approved brokers

Relocation


Residential loans probably not okay; alternatives:

 

Company buys and sells old residence, or Company buys new house and rents to executive

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Ban on Personal Loans



Loan forgiveness


Partial loan forgiveness not okay if modification of a grandfathered arrangement Total loan forgiveness may not be okay--depends on status of arrangement before forgiveness Bonuses okay if not tied to repayment and otherwise justifiable compensation as sign-on or retention bonuses

401(k) plan loans

 

Probably okay but inadvisable DOL guidance: restrictions on pension plan loans to officers of the plan sponsor do not violate ERISA loan rules (Field Assistance Bulletin 2003-1)

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Pension Plan Blackouts



New SEC Regulation BTR (Blackout Trading

Restriction)  Prohibits directors and executive officers from trading during pension plan blackout periods

What is a blackout?


When at least 50% of participants in all individual account plans cannot trade securities held in individual accounts for more than three consecutive business days  Exceptions for regularly scheduled blackout periods incorporated into plan documents and disclosed to employees and for merger transactions Exemptions for DRIPs, certain 10b5-1 plan transactions, taxqualified plan transactions other than discretionary transactions, formula grants, gifts

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Pension Plan Blackouts



How does BTR affect insiders?



Restricts trading only of securities insiders acquired in connection with their employment or service


Includes trades by family members

Insiders cannot acquire or dispose of securities acquired in connection with employment or service as an insider


Includes receiving discretionary equity awards

Any profit realized by a director from a prohibited transaction is recoverable by the company


If company fails to act, shareholders can bring derivative action

Insiders also subject to civil injunctions, penalties and cease and desist proceedings, as well as possible criminal liability

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Pension Plan Blackouts



What do you have to do to implement BTR?



Include notification of regularly scheduled trading suspensions in plan documents Notify plan participants at least 30 days in advance of blackouts (per DOL regulations)  Applies to all individual account plans, regardless of whether hold company stock

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Pension Plan Blackouts



What do you have to do . . .



 

Notify insiders of blackouts at least five business days after company receives notice from plan administrator  If no notice from plan administrator, notify insiders at least 15 calendar days before start of blackout period  Limited relief possible File notice with SEC on Form 8-K no later than date by which notice must be given to insiders Requirements differ for foreign issuers Further information:


http://www.perkinscoie.com/resource/business/blackout.htm

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Non-Audit Services


Be aware when establishing perquisites for executives that the audit committee must pre-approve, or establish policies and procedures for pre-approval of, non-audit services by the company s auditing firm


Includes provision of personal financial services to executives by company s auditors Sprint is a cautionary tale:


Two top executives were fired after their participation in a tax shelter for option exercise gains set up by the company s auditors left the executives with millions in potential tax liability and a potential conflict with the auditors

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The new accounting board is expected to issue more guidance and limits on consulting and tax advice for audit clients.

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Other Current Issues



NYSE/Nasdaq proposed rules will affect your relationship with the compensation committee  NYSE: compensation committee of independent directors must  Approve CEO compensation  Have sole authority to hire, fire and set fees of compensation consultants  Have written charter specifying purpose, duties and responsibilities

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Other Current Issues



Nasdaq: committee of independent directors or majority of the independent directors must approve CEO and executive officer compensation

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Other Current Issues



NYSE/Nasdaq proposed rules will affect availability of equity and plan design


Shareholders must approve all equity compensation plans  Also material amendments to plans Discretionary broker voting on equity plans is eliminated

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Other Current Issues



Other things to watch out for:






S-8 registrations must be effective before restricted stock is granted Expect new SEC guidance on Item 201(d) executive compensation plan information table 906 certifications may be required for 11-Ks Changes in accounting for equity compensation require heightened awareness  New world of SFAS 123 accounting.  Impact on your Sarbanes-Oxley subcertifications for valuation model used and its assumptions  Interpretations in state of flux  Liquidity accounting is variable

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References and Further Reading

Sarbanes-Oxley Act
http://news.findlaw.com/hdocs/docs/gwbush/sarbanesoxley072302.pdf

Securities and Exchange Commission Regulatory Actions

http://www.sec.gov/spotlight/sarbanes-oxley.htm

NYSE Corporate Governance Proposals

http://www.nyse.com/abouthome.html?query=/about/report.html

NASDAQ Corporate Governance Proposals

http://www.nasdaq.com/about/ProposedRuleChanges.stm

Perkins Coie LLP Client Updates

http://www.perkinscoie.com/new.htm

myStockOptions.com--Insider trading, Section 16, Rule 144, 10b5-1 content for executives and employees, along with tools and content on options, restricted stock and ESPPs
http://www.mystockoptions.com