United States: New SEC and Labor Department Rules Relating to Pension Plan "Blackout" Periods

Co-authored by Stanton Eigenbrodt and Michael J Collins

On January 22, 2003, the Securities and Exchange Commission (the "SEC") adopted final rules under Section 306(a) of the Sarbanes-Oxley Act of 2002 (the "S-O Act"). Section 306(a) prohibits any director or executive officer of an issuer of any equity security from purchasing, selling or otherwise acquiring or transferring certain equity securities of the issuer during a "blackout period" under a retirement plan that temporarily prevents plan participants from engaging in equity securities transactions through their plan accounts.

The most important provisions of Section 306(a) and the final SEC rules include the following:

• The rules prohibit directors and executive officers from effecting certain transactions with respect to certain issuer securities if at least 50% of all U.S. participants in the issuer's individual account plans (e.g., 401(k) plans) are restricted from trading issuer securities under the plans for at least three business days.
• The securities subject to the prohibition on sales and other dispositions generally includes any securities acquired from the issuer in connection with the individual's directorship or employment (but not other securities held by the affected individual). There is a rebuttable presumption that any securities that were acquired from the issuer in the directorship/employment context and hence are subject to the prohibition.
• Issuers must notify their directors and executive officers, as well as the SEC, of any impending blackout period.

In addition to the restrictions imposed under Section 306(a) of the S-O Act, Section 306(b) amended the Employee Retirement Income Security Act of 1974 ("ERISA") to require ERISA plan administrators to provide participants with advance notice of certain blackout periods. The Labor Department issued interim final regulations implementing the requirements of Section 306(b) last October.

Although the SEC and Labor Department rules both address retirement plan blackouts, there are a number of differences between the rules. Most importantly, the Labor Department rules define "blackout period" quite broadly to include most restrictions on the ability of plan participants to change investments or obtain plan distributions. As noted above, Section 306(a) and the SEC rules generally do not apply unless at least 50% of U.S. participants in all individual account plans of the issuer and its affiliates are subject to a blackout period that prevents buying or selling securities of the issuer. Thus, many blackout periods that will require notice to plan participants under the Labor Department rules will not implicate the SEC rules.

Basic Rules. The final rules prohibit directors and executive officers of issuers from directly or indirectly trading specified equity securities during blackout periods that affect individual account plans of the issuer and its affiliates. The rules apply to the directors and executive officers of domestic issuers, foreign private issuers, banks and savings associations, small business issuers and, in certain limited instances, registered investment companies.

Securities Subject to the Rules. The final rules define the term "equity security" to include both equity securities and derivative securities relating to an equity security, whether or not issued by the issuer. However, the prohibition does not apply to all equity securities of the issuer owned by the director or executive officer. Rather, it is limited to equity securities that the individual "acquires in connection with his or her service or employment as a director or executive officer." In this regard, any equity securities sold or otherwise transferred during a blackout period are automatically treated as "acquired in connection with service or employment as a director or executive officer" unless the individual establishes that the equity securities were acquired from another source and this identification is consistent with the treatment of the securities for tax purposes and all other disclosure and reporting requirements.

Blackout Periods Covered by the SEC Rules. With respect to a U.S. issuer, the Section 306(a) trading prohibition is triggered only if a blackout period (i) lasts more than three consecutive business days and (ii) temporarily suspends the ability of at least 50% of the U.S. participants or beneficiaries under all individual account plans maintained by the issuer and its affiliates (generally defined to include 80%-directly or indirectly related entities on either a parent-subsidiary or brother-sister basis), to purchase, sell or otherwise acquire or transfer an interest in equity securities of the issuer. There is an important exception for certain regularly-scheduled plan blackout periods if the period is reflected in the plan document and participants are notified. For example, if a 401(k) plan only permits participants to change investment elections at the end of each calendar quarter, this generally would not constitute a blackout period under the SEC rules. (It also would not constitute a blackout under the Labor Department rules addressed below.) Also, certain suspensions imposed in connection with a corporate merger, acquisition, divestiture or similar transaction are not subject to the SEC rules.

In addition, certain transactions are not covered by the trading prohibition if the transactions are made pursuant to an advance election or are otherwise outside the control of the director or executive officer. Some of these transactions include the following:

• acquisitions of equity securities under dividend or interest reinvestment plans;
• purchases or sales pursuant to a Rule 10b5-1(c) prearranged contract, instruction or plan;
• purchases or sales of equity securities, other than "discretionary transactions," pursuant to certain employee benefit plans (for this purpose, a "discretionary transaction" has the meaning set forth under Rule 16b-3(b)(1) and generally encompasses elections to reallocate balances into or out of an issuer equity fund);
• compensatory grants and awards of equity securities pursuant to programs under which grants and awards occur automatically; and
• acquisitions or dispositions of equity securities in connection with a merger, acquisition, divestiture or similar transaction occurring by operation of law.

Consequences of Violation. A violation of the Section 306(a) trading prohibition is a violation of the Securities Exchange Act of 1934 ("Exchange Act") and is subject to possible SEC enforcement action. In addition, similar to Section 16(b) under the Exchange Act, Section 306(a) provides that an issuer, or a securityholder on its behalf, may bring an action to recover the profits realized by a director or executive officer from a prohibited transaction during a blackout period.

Notice Requirements. In addition to the substantive prohibitions noted above, Section 306(a) requires that the SEC and affected directors and executive officers receive advance notice of blackout periods that implicate the rules. The final rules specify the content and timing of this notice.

The notice to directors and executive officers will be considered timely if an issuer provides it no later than five business days after the issuer receives the notice from the pension plan administrator required by the Labor Department rules (which generally is at least 30 days before the beginning of the blackout period, as described below). If the issuer does not receive such notice, the issuer must provide its notice to directors and executive officers at least 15 calendar days before the actual or expected beginning date of the blackout period. The SEC must be notified on Form 8-K at the same time that the directors and executive officers are required to receive notice of the blackout period. A draft form of notice to directors and executive officers is attached to this Memorandum.

Effective Date. Section 306(a) and the final rules discussed above generally take effect on January 26, 2003. We have attached a memo that issuers can use to briefly explain the new rules to their directors and executive officers.

The Labor Department issued its interim final rules on October 21, 2002. The rules implement the requirements of Section 306(b) of the S-O Act, which amended ERISA to require plan administrators to notify plan participants and beneficiaries of certain blackout periods.

Definition of Blackout Period. For purposes of Section 306(b), a blackout period is any period of more than 3 consecutive business days during which time the ability of any participants or beneficiaries under a plan to direct or diversify investments or to obtain loans or distributions is suspended, limited or restricted. The most common reason why a plan would have such a blackout period is a change in recordkeepers which requires time to transfer records and reconcile assets. Other events that may necessitate a blackout period include changes in investment alternatives, changes of trustees, and corporate transactions that affect plan coverage (e.g., spin-offs of plan assets into the acquiror's plans).

Comparison of Definition of Blackout Period with SEC Rules. The definition of blackout period under Section 306(b) and the Labor Department rules is much more expansive than under Section 306(a) and the SEC rules. In some cases, a plan blackout period will implicate both the Labor Department and SEC rules. For example, if an issuer and its affiliates maintain only one 401(k)-type plan that covers all U.S. employees, a blackout period with respect to that plan generally will trigger the application of both rules if the plan provides an employer stock investment option. However, if the issuer and its 80%-related affiliates sponsor multiple plans, a blackout period with respect to one such plan would require notice under the Labor Department rules but normally will not under the SEC rules unless the plan covers more than 50% of U.S. employees and includes an employer stock investment option.

Timing of Notice. Under the DOL rules, the notice of a blackout period must be provided to all affected participants and beneficiaries at least 30 days, but not more than 60 days, in advance of the last date on which such participants and beneficiaries can exercise the affected rights. There is an exception to the 30-day minimum (i) where it would be a violation of ERISA's fiduciary duties to wait 30 days to implement the blackout (e.g., the bankruptcy of the issuer), or (ii) in cases involving unforeseeable circumstances beyond the control of the plan administrator (e.g., a computer systems problem with the plan administrator that affects its ability to process loan applications). The 30-day advance notice requirement also does not apply to blackouts imposed in connection with participants becoming, or ceasing to be, participants solely in connection with a merger, acquisition, divestiture, or similar transaction involving the plan or the plan sponsor. In each instance where the 30-day advance notice is not required, the plan administrator still must provide the notice "as soon as reasonably possible under the circumstances."

Model Notice. The regulations contain a model notice for plan sponsors to use to satisfy their obligations under Section 306(b). The notice must include the reasons for the blackout period and the identification of the rights affected, the expected beginning date and length of the blackout period, and, if the ability to direct investments is suspended, a statement that the participants should evaluate their current investments in light of their ability to direct or diversify assets during the blackout period.

Effective Date. The Labor Department regulations become effective January 26, 2003 and apply to blackout periods commencing on or after that date. For blackout periods beginning January 26, 2003 through February 25, 2003, plan administrators are required to furnish the required notice as soon as reasonably possible.