Sarbanes-Oxley Update: SEC Issues Final Rules on Insider Trading During Pension Fund Blackouts

On January 26, 2003, the prohibition on insider trading during pension fund blackout periods contained in Section 306(a) of the Sarbanes-Oxley Act of 2002 became effective. Section 306(a) generally prohibits directors and executive officers of SEC reporting companies (including foreign private issuers) from buying or selling their company's equity securities at times when plan participants are precluded from doing so under certain company pension plans, including 401(k) plans, profit-sharing plans, stock bonus plans and money purchase pension plans.

Effective the same date, the SEC adopted final rules under Section 306(a). Regulation BTR (for"Blackout Trading Restriction") clarifies the scope and operation of the Section 306(a) trading prohibition, establishes exceptions, delineates remedies for violations (including a specific calculation method for determining the amount of profits that may be recovered in a private action) and details the application of Regulation BTR to foreign private issuers. Regulation BTR also specifies the content and delivery requirements for the notice that a company must provide its directors and executive officers and to the SEC on Form 8-K in advance of any blackout period. (See SEC Release No. 34-47225, accessible at http://www.sec.gov/rules/final/34-47225.htm). The notice requirements have been modified to coordinate with related Department of Labor (DOL) regulations under Section 306(b) of Sarbanes-Oxley which also became effective on January 26.

U.S. reporting companies. Under Regulation BTR, a "blackout period" for a U.S. reporting company occurs when at least 50% of the participants located in the United States in all of the company's "individual account plans" are subject to a temporary suspension imposed by the company or a fiduciary for more than three consecutive business days that prevents such participants from purchasing or selling the company's equity securities held in a plan. An "individual account plan" means a plan in which participants hold or could hold equity securities of the company that meets the definition of "individual account plan" under Section 3(34) of ERISA, as well as any non-qualified deferred compensation plan that reflects the elements of Section 3(34). This includes 401(k) plans, profit-sharing and savings plans, stock bonus plans, money purchase pension plans and non-qualified deferred compensation plans that have a company stock fund, that provide for an open brokerage window through which participants may purchase any public company stock or that match contributions in company stock.

Foreign private issuers. Regulation BTR defines a "blackout period" for foreign private issuers to occur when (1) at least 50% of the participants located in the United States are subject to the trading suspension and (2) U.S. plan participants either total 50,000 or account for 15% of all participants worldwide.

Exclusions from definition. A "blackout period" does not include:

• regularly scheduled suspensions that are described in the plan documents and disclosed to an employee before, or within 30 days after, enrolling in the plan; and

• suspensions for the principal purpose of enabling employees of an acquired or divested business to become or cease to be plan participants following the acquisition or divestiture.

The DOL definition of a blackout period for pension plans is significantly broader than the defined term in Regulation BTR. The DOL regulations define blackout periods without regard to the percentage of participants affected and are not limited to plans that permit participants to acquire or hold employer securities. As a result, some plan blackouts will require notice to participants under DOL regulations but will not require directors and executive officers to refrain from trading under Regulation BTR.

The Section 306(a) trading prohibition applies only to an equity security acquired in connection with service or employment as an executive director. Equity securities, for purposes of the prohibition, include options and other derivative securities as defined in SEC rules under Section 16 of the Securities Exchange Act of 1934 and, with respect to foreign private issuers, depository shares evidenced by American Depository Receipts.

Regulation BTR defines equity securities "acquired in connection with service or employment as a director or executive officer" to include those acquired:

• under a compensatory plan or arrangement (whether or not set forth in any formal plan document) of the reporting company or one of its affiliates, at a time when the individual was a director or executive officer;

• as a result of certain transactions or business relationships between the individual and the company;

• as director's qualifying shares or to satisfy a company's minimum securities ownership guidelines for directors or executive officers, at a time when the individual is a director or executive officer; or

• as a direct or indirect inducement to service or employment as a director or executive officer with the company or one of its affiliates.

As originally proposed, Regulation BTR treated all equity securities as fungible by creating an irrebuttable presumption that equity securities sold by a director or executive officer during a blackout would be subject to the prohibition, regardless of the actual source of the securities disposed, if the director or officer owned any "acquired in connection" securities at the time of the transaction. Addressing concerns that this would act as an absolute bar on any dispositions during a blackout period, Regulation BTR permits directors and executive officers to establish an affirmative defense that the securities were not "acquired in connection" by tracing the origin of the actual securities transferred and demonstrating that this origin is consistent for all purposes related to the transaction (such as tax reporting and applicable disclosure and reporting requirements).

The final rules also apply to direct and indirect acquisitions and dispositions of equity securities where a director or executive officer had a pecuniary interest in the transaction. The term "pecuniary interest" has the same meaning as under the Section 16 rules, such that acquisitions and dispositions made by family members and related entities are attributed to the director or executive officer.

Section 306(a) permits the SEC to exempt certain transactions from the trading prohibition. Regulation BTR expands the list of exemptions contained in the original proposal and exempts:

• acquisitions under broad-based and non-discriminatory dividend or interest reinvestment plans;

• purchases or sales under Rule 10b5-1(c) trading plans (as long as the plan was not made or modified during the blackout period or at the time the director or executive officer was aware of the actual or approximate beginning or ending dates of the impending blackout);

• purchases or sales of equity securities pursuant to certain tax-qualified employee benefit plans (including those of foreign private issuers), such as a qualified employee stock purchase plan, other than discretionary transactions (as defined in the Section 16 rules);

• stock splits, stock dividends or pro rata rights distributions;

• compensatory grants and awards of equity securities pursuant to a plan that, by its terms, permits directors or executive officers to receive grants or awards, provides for grants or awards to occur automatically, and specifies the terms and conditions of the grants or awards;

• exercises, conversions or terminations of derivative securities that were not written or acquired by a director or executive officer during the blackout or while aware of the actual or approximate beginning or ending dates of the blackout period (subject to certain conditions);

• acquisitions or dispositions of equity securities involving a bona fide gift or a transfer by will or the laws of descent and distribution;

• acquisitions or dispositions of equity securities pursuant to a domestic relations order;

• sales or other dispositions of equity securities compelled by the laws or other requirements of an applicable jurisdiction; and

• acquisitions or dispositions of equity securities in connection with a merger, acquisition, divestiture or similar transaction occurring by operation of law.

Under Section 306(a) and Regulation BTR, a company, or a securityholder on behalf of the company, may bring an action (within two years of the violation) for disgorgement of profits realized by a director or executive officer in violation of the trading prohibition. Where a transaction involves a transfer of an equity security registered under the Exchange Act and traded on a national securities exchange or NASDAQ, profit is to be measured by comparing the difference between the amount paid or received for the security on the date of the transaction during the blackout and the average market price of the equity security calculated over the first three trading days after the blackout ends. In all other cases (for derivative securities or securities of an issuer that has filed a registration statement for an initial public offering that is not yet effective, for example), profit is to be measured in a manner that is "consistent with the objective of identifying the amount of any gain realized or loss avoided as a result of the transaction taking place during the blackout period" rather than outside of the blackout.

In addition, individuals violating the trading prohibition are subject to action by the SEC, including civil injunctive actions, penalties and cease and desist proceedings, as well as possible criminal liability.

Notice to directors and executive officers. Companies are required to provide notice to directors and executive officers no later than five business days after the company receives from the pension plan administrator the notice required by the DOL rules adopted under Section 306(b) of Sarbanes-Oxley. The company's notice must describe: (1) the reasons for the blackout; (2) the plan transactions to be suspended or affected; (3) the class of equity securities subject to the blackout; (4) the beginning and ending dates of the blackout period; and (5) contact information for the person designated to respond to related inquiries.

Notice to the SEC. Regulation BTR requires companies to notify the SEC by means of a newly created Form 8-K filing obligation, with the same content required in the notice to directors and executive officers. The 8-K must be filed on the same day the notice is transmitted to directors and executive officers. Foreign private issuers must file as an exhibit to their annual reports on Form 20-F or 40-F a copy of each notice provided to directors and executive officers during the most recently completed fiscal year, unless the notice was already provided to the SEC in a report on Form 6-K.

Notice to plan participants. DOL regulations require plan administrators to notify plan participants in writing at least 30 but not more than 60 calendar days before the last date rights may be exercised by a plan participant immediately before commencement of the blackout period. The required content is similar to the notice to directors and executive officers, except that if investments are affected by the blackout, the notice must also advise participants to evaluate whether their investments are appropriate in light of their inability to direct or diversify assets during the blackout period.

SEC reporting companies should identify plans covered by Regulation BTR, coordinate with plan administrators and develop communications and compliance strategies to avoid violations during future blackout periods that fall within the scope of the Section 306(a) prohibition as defined in Regulation BTR.

January 30, 2003