Article by Michael L Zuppone, Kirby D Behre and Rob Carlson
On July 30, 2002, President Bush signed into law the Sarbanes-Oxley Act of 2002 ("Act"), which he called "the most far-reaching reforms of American business since the time of Franklin Delano Roosevelt."
Although enacted with the primary purpose of reforming the oversight of public auditors, improving corporate governance and requiring greater executive responsibility and accountability, the Act also contains various provisions that directly impact companies’ relations with their employees.
Specifically, the Act:
- prohibits personal loans to directors and executive officers;
- enacts new protections for employee whistleblowers; and
- enacts new criminal penalties for acts of retaliation against employee whistleblowers.
I. Prohibition on Loans and Credit to Directors and Executives
Section 402 of the Act amends Section 13 of the Exchange Act (15 U. S.C. § 78m) so that "issuers" are now prohibited from extending or arranging for the extension of, maintaining, or renewing (either directly or indirectly) personal loans to their directors or executive officers or any "equivalent thereof."
Q: What companies are covered by Section 402?
A: Section 402 of the Act applies to "issuers," which the Act defines as companies with outstanding publicly-traded securities that file periodic reports and other information with the Securities and Exchange Commission ("SEC") and companies that, although not yet publicly traded and not yet subject to such reporting obligations, have already filed a registration statement seeking to become public.
Q: Who constitutes an executive officer or "equivalent thereof "?
A: The Act does not define "executive officer" or "equivalent thereof." However, Rule 3b-7, promulgated by the SEC under the Exchange Act, defines an executive officer as "the president, vice president in charge of a principal business unit, division or function, and other officers or persons who perform policy making functions." Executive officers of subsidiaries may be deemed executive officers of the issuer if they perform policy making functions for the issuer. It is reasonable to infer that Congress intended this definition to apply to Section 402 of the Act. Therefore, issuers should apply the prohibition on loans to those persons whom the issuer has treated as executive officers for purposes of that issuer’s compliance with the Exchange Act, at least until the SEC otherwise clarifies the category of persons subject to the prohibition through rule-making authority granted by Congress under Section 3(a) of the Act.
Q: When does this prohibition become effective?
A: The prohibition took immediate effect on July 30, 2002.
Q: Are there any exceptions to the prohibition?
A: There are a few limited exceptions. The prohibition does not cover the following credits and/or loans: (1) home improvement and manufactured home loans;(2) consumer credit or extensions of credit under an open end credit plan; (3) charge cards; and (4) margin loans by a registered broker or dealer permitted under the rules of the Federal Reserve, provided that: the issuer is in the business of extending credit to the public; and the credit and/or loan is made available in the ordinary course of business, of a type generally made available to the public, and on market terms or terms no more favorable than offered by the issuer to the general public.
Also excepted from the prohibition is any loan made or maintained by an insured depository institution to its employees,provided the loan already is regulated by the Federal Reserve. (Note that this exception does not apply to non-U. S. banks whose securities are listed in the United States.)
Q: What about preexisting loans?
A: Preexisting personal loans may remain in effect, provided that the loan is not renewed and the terms of the loan are not "materially" modified after July 30, 2002. Although the Act does not define what constitutes a "material" modification, it is likely that a "material" modification would include terms such as an extension of the due date, an interest rate change, or a modification that would result in a forfeiture of, or otherwise detrimentally affect, the issuer’s rights as creditor.
Q: What about loans extended to employees who are not executive officers at the time of the loan, but who become executive officers subsequent to the loan?
A: Because the Act forbids not only extending but also "maintaining" credit to persons covered by Section 402, it is possible that a loan that was permissible when extended (i.e., because the recipient was not a director, an executive officer or the equivalent thereof) would violate the Act if maintained after the recipient becomes a covered person. Thus, before an individual becomes a director or executive officer (or equivalent thereof) of an issuer, the issuer should consider whether any credit previously extended to that individual should be repaid before the promotion occurs in order to minimize the risk of a Section 402 violation.
Q: How does Section 402 affect executive compensation packages and other benefits?
A: In the aftermath of Section 402, issuers covered by the Act may need to reevaluate such common executive compensation package provisions as advances for salary, insurance premiums (e.g., split dollar life insurance), and travel and relocation expenses, home loan programs, and cashless option exercise programs. The prudent course of action would be to suspend these programs for directors and executive officers (and the equivalent thereof), at least until the SEC provides further clarification though rulemaking pursuant to authority granted by Congress under Section 3(a) of the Act.
II. Civil Protections for Employee "Whistleblowers"
Section 806 of the Act amends chapter 73 of title 18, United States Code (18 U.S.C. § 1514A) to provide a Federal retaliation claim for an employee who is discharged, demoted, suspended, threatened, harassed, or "in any other manner discriminate[d] against . . . in the terms and conditions of employment" because he or she engaged in "any lawful act," which is defined as follows:
(1) to provide information to or otherwise assist in an investigation by any Federal regulatory or law enforcement agency, member or committee of Congress, or company personnel with supervisory or investigative authority, where the employee reasonably believes the conduct he or she is reporting violated Federal securities or anti-fraud laws; or
(2) to file, testify, participate in, or otherwise assist in proceedings filed or about to be filed (with any knowledge of the employer) involving alleged violations of the securities laws or SEC regulations, or involving securities fraud.
Q: What companies are covered by the whistleblower protections?
A: Section 806 of the Act applies to the same category of companies that are subject to Section 402, with two exceptions. First, Section 806 is narrower than Section 402 in that it does not apply to companies that have filed a registration statement but do not yet have a class of securities registered under Section 12 of the Exchange Act or report under Section 15(d) of the Exchange Act. Second, Section 806 is broader in that it applies not only to the company but also to its officers, employees, contractors, sub-contractors, and agents.
Q: Is reporting alleged fraud to a Congressman protected conduct, even where there is no pending Congressional investigation?
A: It is unclear. The White House and certain members of the Senate have publicly disagreed on what constitutes protected activity in reporting alleged fraud to Congress. The President, in an interpretive statement made by the White House staff only hours after he signed the bill into law, indicated that employees reporting alleged fraud to Congress are only protected by Section 806 if they report fraud to Congress in the course of an investigation by Congress. The White House reasoned as follows:
Given that the legislative purpose of [Section 806] is to protect against company retaliation for unlawful cooperation with investigations and not to define the scope of investigative authority or to grant new investigative authority, the executive branch shall construe [Section 806 as it relates to Congress] as referring to investigations authorized by the rules of the Senate or the House of Representatives and conducted for a proper legislative purpose.
Senator Patrick Leahy, along with Senator Charles E. Grassley, disagreed with this interpretation in a letter to the President, arguing that the language of the Act does not limit protected activity either to ongoing investigations of Congress or to matters within the jurisdiction of any Congressional Committee. They argued that the plain language of Section 806 does not support the White House’s interpretation.
Q: When does this provision become effective?
A: The provision took immediate effect on July 30, 2002.
Q: What are the procedural requirements that an employee must follow to bring a claim under Section 806?
A: To bring a claim for retaliation under Section 806, the employee must first file a complaint with the Department of Labor ("DOL"). If the DOL does not issue a final decision within 180 days of the filing of the complaint, and the delay is not due to the employee’s bad faith, the employee may bring the retaliation claim in Federal district court for de novo review, without regard to the amount in controversy. Otherwise, the DOL’s decision is appealable by either party directly to the U. S. Circuit Court of Appeals in which the violation allegedly occurred or in which the claimant resided at the time of the alleged violation.
Q: What is the applicable statute of limitations?
A: The employee must file his or her complaint with the DOL no later than 90 days after the date on which the alleged violation occurred.
Q: What can a prevailing employee recover?
A: If an employee prevails in his Section 806 claim, he or she is "entitled to all relief necessary to make the employee whole." The statute expressly provides that such relief includes: (1) reinstatement with the same seniority status that the employee would have had but for the discrimination; (2) back pay, with interest; and (3) special damages sustained as a result of the discrimination, including litigation costs, expert witness fees, and reasonable attorney fees. Although the provision does not define "special damages" beyond the types of damages listed, it is probable that such damages would include emotional distress damages. On the other hand, they would probably not include punitive damages, which are not directed at "making an employee whole."
Q: Does Section 806 preempt state-law retaliation claims?
A: No. Section 806 expressly reserves the employee’s rights, privileges, and remedies available under any other Federal law, state law and/or collective bargaining agreement.
Q: Does the employee have to be correct that there is a violation of the Federal securities or anti-fraud laws?
A: No. The employee need only "reasonably believe" that there is a violation of the applicable law in order to receive whistleblower protection.
III. Criminal Penalties: Section 1107 Retaliation Against Informants
In addition, Section 1107 of the Act also amends 18 U.S.C. Section 1513 so that it is now a felony to retaliate against whistleblowers.
Q: Who is covered by Section 1107?
A: Section 1107 of the Act applies to any person, including individuals and corporate or other organizations.
Q: When does this provision become effective?
A: The provision took immediate effect on July 30, 2002.
Q: What constitutes retaliation under Section 1107?
A: Section 1107 describes retaliation as "knowingly, with the intent to retaliate, tak[ing] any action harmful to a person, including interference with the lawful employment or livelihood of " a whistleblower.
Q: What constitutes protected activity under Section 1107?
A: The whistleblower must have "provide[d] to a law enforcement officer any truthful information relating to the commission or possible commission of any Federal offense." Unlike Section 806, protective activity under Section 1107 is not limited to providing information regarding violations of securities laws, but instead covers information related to any possible commission of any Federal offense. On the other hand, the recipient of the whistleblower’s information under Section 1107 must be a law enforcement officer (unlike Section 806, which also covers information conveyed to any Federal regulatory agency, member or committee of Congress, or company personnel with supervisory or investigative authority).
Q: What are the penalties?
A: A violator can be subject to a fine (generally up to $250,000 for individuals and $500,000 for organizations) and/or imprisonment of up to 10 years.
IV. Extraterritorial Applicability of the Act
Q: Does the Act apply to foreign companies?
A: Yes. Unlike traditional SEC and national securities exchange rules, there exists no exemption for "foreign private issuers." On its face, Section 402 of the Act would prohibit foreign private issuers subject to SEC reporting obligations from extending or maintaining loans to executive officers and directors made outside the United States. While the whistleblower protections contained in Section 806 on their face apply to foreign private issuers subject to SEC reporting obligations, we believe it is reasonable to conclude that the protections would extend only to acts of retaliation made against employees resident in the U. S. (although it is possible that Federal authorities could assert jurisdiction over acts affecting U. S. residents working overseas). Similarly, with respect to the whistleblower retaliation felony provisions contained in Section 1107, while on their face they extend to foreign corporations and individuals, we believe that it is reasonable to conclude that the jurisdictional reach of the provision would extend only to acts of retaliation made in the U. S.
Client Alert is published solely for informational purposes and should in no way be relied upon or construed as legal advice. For specific information on recent developments or particular factual situations, the opinion of legal counsel should be sought.
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© 2002 Paul, Hastings, Janofsky & Walker LLP