America's Community Bankers
December 16, 2002
Jonathan G. Katz
Re: Insider Trades During Pension Fund Blackout Periods
Dear Mr. Katz:
America's Community Bankers ("ACB")1 is pleased to comment on the proposed rule issued by the Securities and Exchange Commission ("SEC") to clarify the application and prevent evasion of section 306(a) of the Sarbanes-Oxley Act of 2002 ("Sarbanes-Oxley").2 Section 306(a) prohibits directors and executive officers of an issuer from directly or indirectly purchasing, selling, or otherwise acquiring or transferring any equity security of the issuer (other than an exempted security) during any blackout period with respect to such equity security if the director or officer acquired the equity security in connection with his or her service or employment as a director or executive officer. This provision was adopted in response to reports of public company employees losing a great deal of money in company-sponsored retirement plans when they could not dispose of the company's securities while directors and executive officers were free to sell their stock.
The rule clarifies the statutory language by defining relevant terms, addressing the scope of coverage, and providing details about required notices.
ACB supports the principles behind the adoption of section 306(a) and believes that the proposed rule should adhere closely to the statutory language and intent. Section 306(a) specifically only covers directors and executive officers, while the SEC is proposing to cover a broader range of company officers. This broad coverage could impose a significant compliance burden. In addition, the securities covered by the statutory prohibition are those equity securities of an issuer acquired by an individual "in connection with his or her service or employment as a director or executive officer." The SEC proposal would cover equity securities acquired in arms-length, commercial transactions and may, under certain circumstances, cover securities held by family members or certain partnerships, corporations, limited liability companies or trusts. To avoid a compliance nightmare in trying to determine whether a transaction is permissible during a blackout period, most companies will advise directors and executive officers (and their family members and certain related businesses) not to engage in any transactions involving the company's equity securities during a blackout period. As a result, directors and executive officers will be less inclined to invest in the companies that they serve.
ACB also believes that the requirement to provide notice of a pending blackout period to directors and officers and the SEC should mirror, to the extent possible, the blackout period notice provisions recently adopted by the Pension and Welfare Benefits Administration ("PWBA") under section 306(b)(2) of Sarbanes-Oxley.3 Furthermore, directors and executive officers should not be subject to enforcement or private civil actions for trading during blackout periods when they do not receive adequate notice that the trading prohibition is in effect.
It is not clear why a Form 8-K filing would be required in the event of a pending blackout. While the information about a blackout period will be important to directors, executive officers and employees, it is hard to imagine that this information would be material to investors. At a minimum, the filing requirement should be triggered only when the company receives notice from the PWBA. Otherwise, the information required in the Form 8-K filing may not be available.
Definition of Executive Officers
The SEC is proposing to apply the prohibition on trading during blackout periods to all officers, as defined in section 16a-1(f) of the SEC's rules under the Securities Exchange Act of 1934 ("Exchange Act").4 The prohibition should apply only to executive officers, as defined in section 3b-7 of the Exchange Act rules.5 Congress chose to apply the prohibition specifically to executive officers knowing that this would be a smaller number of management officials than all officers in a company or all officers with policy-making functions. This was a conscious decision by Congress is evidenced by the fact that Congress specified in each Sarbanes-Oxley provision the management officials to be covered. For example, section 303, which prohibits the improper influence on the conduct of audits, applies broadly to all officers. On the other hand, section 402, which restricts loans to management, applies, like section 306(a), to executive officers. Other provisions, such as sections 302 (certification requirements) and 304 (forfeiture of certain bonuses and profits) apply to specific officers, such as the chief executive officer and chief financial officer. ACB believes that the SEC should follow the decision made by Congress to apply the pension fund blackout period trading prohibition only to directors and executive officers. This is especially the case because the proposed rule would cover a broad range of equity securities, as discussed below, and broader coverage would result in a significant compliance burden.
Definition of Equity Securities Acquired in Connection with Service or Employment
ACB is concerned that the broad definition of "acquired such equity security in connection with service or employment as a director or executive officer" will discourage directors and executive officers from investing in the companies that they serve and may result in the sale of securities currently held to avoid the restrictions during a blackout period. The definition would not only cover securities that are acquired under a compensatory plan, contract, authorization or arrangement that is clearly related to service or employment, but subparagraph (2) of the definition and coverage of the rule also would encompass securities acquired in arms-length, commercial transactions and securities in which a director or executive officer has an indirect interest. The SEC believes that such broad coverage is necessary to prevent evasion of the statutory trading prohibition. While we are sympathetic to that argument, the practical effect of such broad coverage will be to prohibit directors and executive officers from trading in any equity securities of the company during a blackout period, even though other company employees will be free to acquire and sell securities in the open market.
Directors or executive officers would be prevented from selling securities that they acquired with their own funds even in the event of financial need, so they may be more likely to sell the securities once they receive notice of a pending blackout period to avoid the restrictions. While it is helpful that transactions satisfying the 10b-5-1(c) affirmative defense conditions would be exempt, it is fairly burdensome to require directors and executive officers to comply with those conditions in order to be free to sell securities acquired in arms-length transactions. It also would remove discretionary control over the securities that the individual may want or need for financial planning purposes.
Subparagraph (4) of the definition is also troublesome. It would cover securities acquired prior to becoming a director or executive officer of the issuer if the equity securities were acquired as an inducement to service or employment with the issuer or a parent, subsidiary or affiliate, or as a result of a merger, consolidation or other acquisition transaction involving the issuer. Coverage should only apply to securities acquired prior to becoming a director or executive officer in these circumstances if the inducement is for service or employment as a director or executive officer with the issuer, parent, subsidiary or affiliate, or with an acquiring company as a result of the listed transactions. Otherwise, the definition would include securities acquired in connection with general employment, rather than employment as a director or executive officer as contemplated by Congress. This part of the definition seems to go beyond the intent of the statute and is not necessary to prevent evasions of the trading prohibition.
The irrebutable presumption that equity securities of the issuer sold during the blackout period are securities covered by the definition seems a bit harsh and unnecessary. We understand the SEC's interest in simplifying identification and eliminating the need to trace the source of equity securities, but directors and executive officers should be given the opportunity to provide that evidence. Although we think that most companies will ask their directors and executive officers to refrain from any transactions involving the company's equity securities during the blackout period to lessen the compliance burden, there may be situations of financial need when an individual has to engage in a transaction during this time. That individual should be permitted to show that the securities were acquired in an arms-length commercial transaction and are not covered by the prohibition. Many people are accustomed to maintaining records covering the purchases and sales of securities for tax purposes and directors and executive officers should be able to use similar information to demonstrate the source of the securities.
The SEC should broaden the transactions that are exempt from the trading prohibition, especially in light of the broad coverage of the rule. At least if there are enough appropriate exemptions, directors and executive officers may be less hesitant to invest in the company's securities. The exemptions in the proposed rule and several additional exemptions suggested by the SEC seem appropriate. For example, transfers such as bona fide gifts, transfers pursuant to involuntary events, such as death, and other transfers of stock for estate planning purposes should be permitted because it is unlikely that they would be undertaken to evade the trading prohibitions. There would be other, very legitimate motives for engaging in these transactions. Exemptions for the closing of derivative securities positions, the exercise of a put equivalent position, and other acquisitions and sales of equity securities pursuant to contractual agreements would seem necessary to avoid a default by the director or executive officer and any resulting penalties, especially when the arrangement is entered into without knowledge of a pending blackout period. The same can be said for transactions that are compelled by the laws or other requirements of an applicable jurisdiction. The director or executive officer would not be exercising discretion and could otherwise face penalties for violating a legal requirement. None of these situations would appear to involve the potential evasion of the trading prohibition and the exemption would prevent an unreasonably harsh result.
The SEC should not change the statutory definition of blackout period established by Congress by shortening the three consecutive business day requirement. It does not appear that the SEC was given authority to change the definition and a change would conflict with the rules of the PWBA. It is clear that Congress was most concerned about establishing a degree of fairness when pension plan participants and beneficiaries are subject to trading restrictions that last at least three consecutive days. There can be unforeseen and unplanned technological glitches or other emergencies that result in unscheduled pension plan trading restrictions lasting a day or two. It would be impossible for plan administrators to provide any advance notice to the company in these circumstances and, therefore, directors and executive officers would not be notified in advance to stop trading during the blackout period. Congress recognized that trading restrictions lasting one or two days do not impose a significant burden on pension plan participants and beneficiaries. Exposing directors and executive officers to possible forfeiture of profits for trading securities when the individual had no idea that restrictions were in place would be inappropriate and unfair. Accordingly, the rule should define a blackout period precisely the way Congress chose to define the term in the statute.
Calculation of Realized Profits
ACB recognizes that there are several possible ways to calculate realized profits and the issue can become quite complicated. One course of action would be to leave the calculation for courts to determine on a case-by-case basis. An alternative would be for the SEC to establish a specific formula for use in enforcement and private civil actions. In order to ensure that all directors and executive officers subject to actions for remedies under the rule are treated similarly, and to avoid the payment of unreasonable amounts in any action to recover profits, the SEC should, at a minimum, establish guidelines for all parties to follow when determining realized profits.
The notice requirements should mirror, to the extent possible, the notice requirements in the PWBA interim final rules. Any changes made to the PWBA rules as a result of public comments on that proposal should be made to the related provisions of this proposal. Companies should provide the notice to directors and executive officers within a day or two after receiving the notice required by the PWBA. Also, the requirement of the company to give notice should only be triggered when the company receives the notice from the plan administrator. Otherwise, a requirement would be imposed on the company that would be impossible to meet unless someone at the company discovers that a blackout period is pending.
If the company fails to give notice to directors and executive officers, either because of its own negligence or because no notice was received from a plan administrator, directors and executive officers should not be subject to enforcement or private civil actions for transactions conducted during a blackout period. It is unfair and unreasonable to penalize individuals when they had no idea that the trading prohibition was in effect. If they had the proper advance notice, they could either engage in transactions before the blackout period starts or after it terminates, or refrain from trading altogether. Profits should not have to be disgorged when the director or executive officer is not given this opportunity.
It is unclear why the SEC is requiring a Form 8-K filing when the matter would seem to have limited interest to investors, other than plaintiff's attorneys who may monitor this type of information. If a director or executive officer trades the company's equity securities during a blackout period, an investor would not have the information to know whether the securities are covered by the prohibition on trading. Investors could start contacting the company or the individual to try and get additional information, even when a trade is perfectly legitimate and permissive. This will open up the door to plaintiff's attorneys who will use partial information to draw incorrect conclusions about the legality of an activity. The SEC should not adopt the Form 8-K filing requirement.
If the SEC believes that a Form 8-K is the proper method of notifying the SEC about a blackout period, the rule should be revised so that the requirements can be met. The SEC is proposing to require the filing within two business days of the earlier of receipt of the notice from the plan administrator required by the PWBA rules or actual notice of the blackout period by the person designated to oversee the company's pension plans (or a human resources director or employee with similar responsibilities). Because the required notice to the SEC would have to include the same information that is required in the notice under the PWBA rules, the Form 8-K filing should only be triggered upon the receipt of the notice from the plan administrator. Otherwise, the appropriate person may have actual knowledge that a blackout period may be coming, but will not have all the details to satisfy the filing requirements.
ACB appreciates the opportunity to comment on this important matter. If you have any questions, please contact the undersigned at (202) 857-3121 or via e-mail at firstname.lastname@example.org, or Diane Koonjy at (202) 857-3144 or via e-mail at email@example.com.