Sarbanes-Oxley Act Restricts Insider Trading and Requires Advance Notice of Blackout Periods

By Erin E. Raccah, Susan P. Serota and Peter J. Hunt

The Sarbanes-Oxley Act of 2002 (Act), which was signed into law on July 30, 2002, prohibits insiders from trading in employer securities during certain "blackout periods" and requires plan administrators to provide 30-day advance notice to participants and beneficiaries of any "blackout period" under an individual account plan (such as a 401(k) plan). A blackout period (also referred to as a "freeze," a "lockdown" or a "transaction suspension period") usually occurs when an employer changes the record keeper for its retirement plan. During the blackout, it is typical for plan transactions to be suspended in order to give the old record keeper time to perform a final reconciliation of participant records and plan assets and to provide the participant records to the new record keeper. The blackout also gives the new record keeper time to build participant accounts on its system and to verify their accuracy.

These new rules will become effective January 26, 2003; however, plan administrators and insiders should consider complying with the new law even before the required date.

Under Section 306(a) of the Act, beginning January 26, 2003, executive officers and directors of a public company will be prohibited from directly or indirectly trading, acquiring or otherwise transferring during a "blackout period" equity securities issued by that company in connection with the insider’s service or employment. Securities acquired outside of the insider’s service or employment as a director or executive officer, such as securities acquired in the open market, are not subject to the ban.

The definition of "blackout period" for the insider trading prohibition is not identical to the definition used for the participant notice requirements, discussed below. For purposes of the insider trading prohibition, a "blackout period" is limited to a situation where the issuer or a plan fiduciary temporarily suspends, for at least three consecutive business days, the ability of 50 percent or more of the participants or beneficiaries under all individual account plans maintained by the issuer to purchase, sell or otherwise acquire or transfer an interest in any equity securities of the issuer held by the plan. An "individual account plan" is a retirement plan which provides for an individual account for each participant and which provides benefits based solely upon the amounts contributed to the account and any earnings and losses. Individual account plans include 401(k) plans, profit sharing plans, stock bonus plans and money purchase pension plans. Future rules will clarify how to apply the 50 percent benchmark to groups of entities affiliated with the issuer, and will also provide exceptions for suspensions connected with corporate transactions and regularly scheduled suspension periods incorporated into the plan.

Any issuer of securities registered under Section 12 of the 1934 Act (including securities listed on a national securities exchange in the United States), or that is required to file reports under Section 15(d) of the 1934 Act, is subject to the insider trading restriction. In addition, the restriction applies to any company that has filed a registration statement that has not yet become effective under the Securities Act of 1933 (1933 Act), unless and until that registration statement is withdrawn. The Act does not define "executive officer" and, although Section 306 does not amend the Securities Exchange Act of 1934 (1934 Act), we believe it is likely that the definition of "executive officer" contained in Rule 3B- 7 under the 1934 Act will also be deemed to apply to Section 306.

In the event an insider is subject to trading restrictions during a blackout period, the issuer of the securities must timely notify the insider as well as the Securities and Exchange Commission (SEC) of the blackout period. Future rules may provide an exception to the trading ban for purchases pursuant to an automatic divided reinvestment program or purchases and sales made pursuant to an advance election.

The penalty for trading or transferring employer securities during a blackout period is disgorgement to the issuer of any profits realized by the executive officer or director. As with the disgorgement of short-swing profits under Section 16(b) of the 1934 Act, an action to recover these profits can be brought by the issuer or, if the issuer fails or refuses to bring such action within 60 days after the date of the request, or fails diligently to pursue the action thereafter, the action may be brought by the owner of any security of the issuer in the name and on behalf of the issuer. Unlike Section 16(b), however, there is no clear definition in Section 306 of how to calculate profits realized, and calculating whether any profits were realized from a trade or transfer during a blackout period when there is no matching sale or purchase within a relatively close period of time may prove challenging.

As an investor and employee relations matter, issuers should seriously consider prohibiting directors and executive officers from trading during blackout periods that occur prior to the January 26, 2003, effective date. Moreover, in applying such a prohibition, issuers may wish to adopt a definition of "blackout period" that is broader than the definition prescribed by Section 306(a) of the Act. For example, an issuer could ban trading during blackout periods of 3 days or less, and could ban trading when fewer than 50 percent of participants and beneficiaries in the issuer’s individual account plans are affected by the blackout.

Section 306(b) of the Act, which amends Section 101 of the Employee Retirement Income Security Act of 1974 (ERISA), requires plan administrators of "individual account plans," as defined above, to provide at least 30-day advance notice to affected participants and beneficiaries of any "blackout period" under the plan. In addition, the plan administrator must give timely notice of such blackout period to the issuer of any employer securities subject to this blackout period.

The notice requirement applies to all individual account plans subject to ERISA, not only plans maintained by publicly held companies. For purposes of the notice requirement, a "blackout period" is defined as any period of more than 3 consecutive business days during which time the ability of participants and beneficiaries under the plan to direct or diversify investments or to obtain loans or distributions is suspended, limited or restricted. It applies to restrictions on making changes to any investment alternatives under an individual account plan (e.g., a mutual fund) and not just restrictions on changes to investments in employer securities.

For purposes of this notice requirement, a "blackout period" does not include a suspension, limitation or restriction that:

• occurs by reason of application of securities laws;
• is a change to the plan that provides for a regularly scheduled blackout period that was disclosed to participants in a summary of material modifications or in materials describing the specific investment alternatives; or
• applies to an individual pursuant to a qualified domestic relations order.

Further, the 30-day advance notice of a blackout period is not required if a plan fiduciary reasonably determines, in writing, that deferring the blackout period would violate the exclusive benefit or prudence rule of ERISA (thereby resulting in a breach of fiduciary duty under ERISA) or if the notice cannot be provided because of unforeseeable events or circumstances beyond the reasonable control of the plan administrator. In such cases, the notice must be furnished as soon as reasonably possible under the circumstances unless providing a notice in advance of the termination of the blackout period is impracticable. Fiduciaries should keep written records of the circumstances surrounding their determinations that an exemption from the 30-day advance notice requirement is available.

The Department of Labor (DOL) is required under the Act to provide further guidance and to issue model notices by January 1, 2003. The DOL is required to issue interim final rules to implement the new law by October 13, 2002. The Act does provide some guidance to plan administrators who would like to comply with the notice requirement before rules are issued. Notices must be in writing, but may be provided in an electronic or other form that is reasonably accessible to the recipient. In general, notices must -

• be written in a manner that will be understood by the average plan participant;
• include the reasons for the blackout period;
• identify the investments that will be affected, and include a statement that the participant or beneficiary should evaluate the appropriateness of his or her current investment decisions in light of the restrictions on directing investments or diversifying assets of his or her account during the blackout period;
• identify other rights that will be affected, such as obtaining loans or distributions;
• specify the expected beginning date and length of the blackout period; and
• include any other information that may be required by forthcoming regulations.

In the event the beginning or ending date of a blackout period changes after sending a notice to participants, the plan administrator must send a revised notice that meets the above requirements as soon as reasonably practicable.

The penalty for failing to provide the required notice is a fine of up to $100 per day for each failure, which may be separately applied for each recipient who did not receive the required notice. The Act increases the maximum criminal penalties for violations of ERISA’s reporting and disclosure obligations. The maximum criminal fine against an individual has been increased from $5,000 to $100,000 and the maximum prison term against an individual has been increased from one year to ten years. The maximum criminal fine against a corporation, partnership or other non-individual has been increased from $100,000 to $500,000. The increased penalties became effective on July 30, 2002.

Any plan amendment required to implement the new rules need not be made until the first plan year beginning on or after January 26, 2003, provided that the amendment is retroactive to the effective date and the plan is operated in good faith compliance with the rules.

Notwithstanding the new notice requirements, plan administrators may assume that they have a fiduciary duty under ERISA to implement blackouts in a prudent manner by giving appropriate consideration to all relevant facts and circumstances and by acting in the best interest of participants and beneficiaries of the plan. Especially in view of the volatility of the stock market, plan administrators would be well-advised to operate in good faith compliance with the new rules as soon as possible. Even though the Act is not effective until January 26, 2003, it is possible that a plan blackout period occurring shortly after January 26, 2003, or beginning prior to January 26, 2003, but continuing through that date, would require notice even before January 26, 2003.

Plan administrators may wish to negotiate with their service providers for the shortest blackout period possible in the event of a change in record keepers or in other situations where plan transactions may be restricted. In the event that the blackout period lasts longer than scheduled, plan administrators may wish to have agreements in place with their service providers that address who is responsible for notifying participants of the delay, and for covering losses, if any, incurred as a result of the delay.

Our overview of the Sarbanes-Oxley Act of 2002 can be found at www.pillsburywinthrop.com.

Questions relating to Section 306 of the Act or other executive compensation and employee benefits matters can be directed to any attorney in the Pillsbury Winthrop executive compensation and benefits practice team