VideoNewspapers were shocked — shocked — to learn that former WorldCom CEO Bernie Ebbers had borrowed $408 million, ostensibly to purchase company stock. That discovery, coupled with the disclosure that former Tyco International CEO Dennis Kozlowski allegedly "borrowed" $242 million from Tyco for yachts, fine art, and luxury apartments, served to make the ban on corporate loans one of the most popular elements of the Sarbanes-Oxley Act of 2002.
But the ban on corporate loans (Section 402) is so broadly stated, and guidance from the beleaguered Securities and Exchange Commission so hard to come by, that no one knows exactly how to interpret it. There's no question that the ban would apply to loans of the type issued to Ebbers and Kozlowski. But it may also prohibit legitimate and productive uses of corporate loans. "The substance of Section 402 is simple — no loans to executives," says Joe Martin, executive vice president and CFO of South Portland, Maine-based Fairchild Semiconductor Corp. "But [the term] loans hasn't been defined, so there's a lot of confusion about whom and what it affects."
Indeed, even the act's sponsors, Sen. Paul Sarbanes (D-Md.) and Rep. Michael Oxley (R-Ohio), have expressed concern that the statute could hit unintended targets. Many of the benefits used to attract and retain executives (and lower-ranking employees as well) involve loans or credit extensions. Regardless of the intent of Congress, the broad language of Section 402 may apply to a wide range of compensation practices, including relocation loans, expense-account advances, company-financed insurance coverage, stock-option exercise programs, even loans from 401(k) plans.
Until the SEC offers guidance (indeed, the agency hasn't even said whether it will take up the issue), companies that use such arrangements will either have to scrap them or risk a challenge from regulators or prosecutors down the road. Not surprisingly, compensation consultants are unhappy. "Congress has performed brain surgery with a machete," complains Paul Dorf, managing director of Compensation Resources Inc.
Suggestions, Please
But while the SEC remains silent, corporate lawyers have stepped in with second opinions. On October 15, 26 corporate law firms circulated a white paper on Section 402 issues, with interpretations of its impact on a variety of corporate practices. "Congress intended the law to be broad — it's a question of how broad," says Dixie Johnson, a partner with Fried Frank Harris, one of the law firms that signed the white paper. "People would welcome more articulation on the statute, but at this point, they have to figure out the law themselves."
One thing is clear: sweetheart loans from public companies to executives will soon be a thing of the past. This category includes relocation and mortgage loans, and any other lending for the personal benefit of a senior executive. While existing loans are likely to be tolerated under a "grandfather" clause, from now on public companies will have to abandon some of the perks they have used to recruit talent. "This has put handcuffs on corporate compensation planners," says Dorf.
He argues that loans, even those intended to be forgiven if performance or tenure targets are met, can be legitimate compensation tools. Instead, companies are likely to switch to compensation packages weighted toward cash and restricted stock. Overall, compensation packages will shrink, as will executive share ownership financed by corporations. WorldCom and a number of other companies — most notably Conseco, where seven former executives and directors owe shareholders some $550 million — took a good idea to disastrous extremes. Now companies that still want their managers to have a significant stake in the company must rely on stock awards or mandate holding periods after options are exercised.
The legal white paper argues that Congress did not mean for Section 402 to apply to credit extensions. "The transaction must take the form of a loan, not merely be an extension of credit," the paper suggests. The term loan is commonly understood to be narrower than extension of credit. So, for example, it's expected that companies may continue to make advances for travel or reimbursable relocation expenses. Employees can still use the company car or credit card for personal reasons, as long as they reimburse the amounts in a reasonable amount of time.
Goodbye, Cashless Exercise?
Somewhat less straightforward is the issue of whether loans that facilitate the exercise of stock options were intended to fall under the statute. The National Center for Employee Ownership estimates that virtually all public companies offer cashless option-exercise programs for their employees. Typically, a company lends the money to exercise the options and is then quickly repaid when the employee sells some or all of the stock. "They are loans, but they're outstanding for a nanosecond," says Fairchild's Martin. What's more, the programs are usually available to all employees exercising options. "I don't think it was Congress's intent to isolate executive officers and directors and let everyone else use the facility," he suggests. Nevertheless, Fairchild has for the time being halted such loans to senior officers, and will not resume the practice without clearance from regulators.
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