Overview.Section 306 of the Sarbanes-Oxley Act of 2002 prohibits directors and executive officers of an issuer from purchasing or selling, during a pension plan blackout period, any equity security of the issuer if the security was acquired in connection with service or employment as a director or executive officer. The prohibition extends to transactions under plans not affected by a blackout, including stock option and nonqualified plans, and transactions in securities held outright by directors and executive officers.

Section 306 also requires each issuer to provide notice to its directors and executive officers of impending plan blackout periods. The rules now proposed by the SEC, including those under new Regulation BTR, would supplement those issued by the Department of Labor/Pension and Welfare Benefits Administration (DOL) for the advance notices of plan blackout periods, which are discussed in the October 2002 Legal Alert of our Employee Benefits Group.

Persons Covered. The insider trading prohibition during plan blackout periods would extend to all "directors and executive officers" of an issuer, including persons performing similar functions in an unincorporated entity. As proposed, the rules’ definition of "executive officers" employs the same definition of "officer" used in the Section 16 insider trading rules under the Securities Exchange Act - i.e., an issuer’s president, principal financial officer, principal accounting officer or controller, any vice president in charge of a principal business unit and any other person who performs a policy making function for the issuer. As a result, the same group of officers would be covered under both sets of provisions.

Securities Covered. Under the proposed rules, Section 16 officers and directors (covered insiders) would be prohibited from effecting transactions (purchases, sales and other acquisitions or transfers) in any "equity security" of the issuer "acquired in connection with service or employment as a director or executive officer.""Equity security" is defined broadly, and would include options, futures, phantom stock, convertible equity securities and warrants that relate to an equity security of the issuer.

Equity securities acquired "in connection with service or employment as a director or executive officer" (covered securities) would include those acquired directly or indirectly:

  • at a time when the person was a covered insider, under a compensatory plan, contract, authorization or arrangement (such as an option, bonus, profit sharing or deferred compensation plan);
  • at a time when the person was a covered insider, as a result of any transaction or business relationship required to be disclosed as a related party transaction or relationship in the issuer’s SEC filings;
  • as "director qualifying shares" or for the purpose of meeting the issuer’s minimum ownership requirements for directors orexecutive officers (including open market purchases for such purposes); and
  • at any time, if acquired as an inducement to service or employment with the issuer, or as a result of a merger, consolidation or other acquisition transaction involving the issuer (insider inducement securities).

Securities acquired outside of a person’s service as a covered insider -- such as shares acquired when the person was an employee but not a covered insider -- would not be covered by the prohibition, unless they were insider inducement securities, as described above. However, Regulation BTR would establish an irrebuttable presumption that the first equity securities sold during a plan blackout period by a covered insider who owns any covered securities would be deemed to be from the covered securities, regardless of the actual source of the specific securities sold. Accordingly, such covered insiders may effectively be prohibited from selling any equity securities of the issuer during a plan blackout period. For example, a covered insider who holds equity securities in a plan account could be prohibited from trading equity securities acquired on the open market before the person was a covered insider.

Exempt Transactions. Exempt transactions would include acquisitions under broad-based dividend or interest reinvestment plans (but not reinvested dividends in nonqualified plans); transactions under 10b5-1 trading plans (provided that the election was not made or modified during a blackout period or while the person was aware of an impending blackout); non-participant directed or elected transactions under certain tax-qualified plans; and stock splits, stock dividends and rights granted to all shareholders.

Plan Blackout Periods Covered. The proposed rules define a "blackout period" as any period of more than three consecutive business days during which the ability of at least 50% of the U.S. participants or beneficiaries under all individual account plans maintained by the issuer to conduct transactions in the issuer’s equity securities is temporarily suspended by the issuer or a plan fiduciary. Individual account plans include 401(k) plans, profit sharing and savings plans, stock bonus plans, money purchase pension plans and certain non-qualified deferred compensation arrangements.

Note that this definition covers plans in which participants hold or could hold equity securities of the issuer, whether or not the plan actually held equity securities of the issuer at the time of calculation. This definition would include plans that provide for employer matching contributions and those that include "open brokerage windows" that permit plan participants to invest in any public-traded security, including those of the issuer.

The SEC’s proposed rules would not include regularly scheduled suspension periods described in plan documents and disclosed to an employee before, or within 30 days after, enrolling in the plan. Also, suspensions imposed to permit employees of acquired or divested entities to become, or cease to be, plan participants following a corporate merger, acquisition, divestiture or similar transaction would not be considered plan blackout periods under the SEC proposals.

Note the difference from the exclusion provided by the DOL rules for regularly scheduled suspensions, which focus on descriptions in summary plan descriptions (SPDs). Because SPDs are not required to be distributed to participants within the time period prescribed by the SEC rules, SPDs may not be effective to establish the exclusion under the SEC rules unless they are distributed as contemplated.

Other important differences from the DOL rules are that (i) the SEC rules would cover certain non-qualified plans, which generally are not subject to the DOL rules; and (ii) the DOL rules are triggered by any blackout period in any individual account plan, whereas the SEC rules would be applicable only where 50% or more of U.S. participants in all plans are affected.

Required Notices. Under the SEC’s proposed rules, an issuer of equity securities must provide prior notice of a blackout period to each covered insider and to the SEC, containing information specified under the rules. The notice must be provided at least 15 calendar days before the start of the plan blackout period, with shorter notice permitted if the issuer reasonably determines and states in writing that unforeseeable circumstances do not allow for the full notice period.

Notices would be deemed provided as of the date of mailing, or electronic transmission, of the notice. Notice to the SEC would be provided by filing a Form 8-K within two business days of the earlier of receipt of notice of the plan blackout period from the plan administrator, or actual knowledge of the plan blackout period by the person overseeing the issuer’s plans.

The SEC notice rules, as proposed, would differ somewhat from those of the DOL. The DOL notice provisions for plan blackout periods apply to all individual account plans subject to the DOL’s reporting and disclosure rules, regardless of whether any such plan includes equity securities of the issuer or whether the issuer is a public company. Also, the DOL rules generally require that notices be provided 30 days (instead of 15 days) in advance of a plan blackout period. The SEC rules do not specify that DOL notices would suffice for SEC purposes. As a result, unless changes are made in the final rules, issuers could be required to provide separate notices in order to comply with SEC and DOL requirements.

Remedies. Under Section 306, any profit realized by a covered insider in violation of the trading prohibition would be recoverable by the issuer, regardless of the covered person’s motive or intent. The issuer would be permitted to file suit to recover such profits, and if the issuer did not do so within 60 days after request by a shareholder, the shareholder would be able to bring a derivative action. The SEC has not yet proposed rules on how to calculate those profits, but has solicited public comment and suggestions.

Violators also would be subject to action by the SEC, including civil injunctive actions, cease and desist proceedings, civil penalties and other remedies generally available to the SEC, including potential criminal actions.

Timing. The SEC has solicited comments on its proposed rules by mid-December. The provisions of Section 306 will be effective as of January 26, 2003. The notice requirement will apply to blackout periods beginning on or after that date. For blackout periods occurring between January 26, 2003 and February 10, 2003, however, the proposed rules would require that notices be provided as soon as reasonably possible.

Securities Legal Alert is a bulletin of new developments and is not intended as legal advice or as an opinion on specific facts. For more information on securities law issues, contact us through our Web site, www.KilpatrickStockton.com.