An important question for derivatives practitioners is whether an act that prohibits direct or indirect "personal loans" by public companies to their executive officers and directors outlaws an investment bank that has managed a public offering or offered other banking service, such as M&A advisory, from entering into total return swaps, collars or similar derivatives transactions with the executive officers and directors of the issuer. The act in question is section 402 of the Sarbanes-Oxley Act of 2002.
To minimize the potential legal risk, institutions should strictly monitor all monetizing transactions entered into with executive officers and directors of existing investment banking clients and ensure the transactions are executed at market rates and on market terms.
Tyco International, ceo Dennis Kozlowski's USD15,000 umbrella stand and USD2,200 wastebasket may be the enduring icons to emerge from the corporate scandals of 2001 and 2002, but the passage of Section 402 was probably motivated by more prosaic matters, like the USD19 million interest-free loan Kozlowski received from Tyco, which Tyco subsequently forgave, and the approximately USD400 million in personal loans WorldCom made to its then ceo, Bernard Ebbers, to cover margin calls that otherwise would have required him to sell WorldCom stock. The section was intended to put an end to that sort of corporate abuse, but has been among the more controversial provisions of the act because its reach is potentially so broad.
Historically, derivatives transactions have been utilized to help "insiders" hedge and monetize restricted securities of the issuer. In the case of an initial public offering or merger and acquisition transaction, an investment banker employed by the underwriter or financial advisor might introduce the executive or director to a salesperson on the equity derivatives desk. This salesperson, in turn, may propose a transaction that would enable the executive to hedge or monetize their position in the issuer's securities. These transactions typically take the form of an option, a zero-cost collar, or a total-return swap.
Transactions that serve only to hedge against a decline in the value of the issuer's security should not be characterized as "loans" within the meaning of Section 402. The thornier issue under Section 402 arises when executive officers or directors seek to "monetize" the value of their shares of the issuer's security. In many cases, a sale may be impracticable because the shares are restricted or undesirable because the sale would be subject to short-term capital gains treatment. In order to achieve the economic equivalent of a sale without these problems, executive officers or directors sometimes enter into "monetizing" transactions in which an investment bank makes an upfront payment to them in an amount based on the current value of their position in the issuer's security.
The concern is that the upfront payment from the investment bank might be characterized as a "personal loan" for purposes of Section 402 and that the issuer, by introducing the executive or director to the bank, might be viewed under Section 402 as having "arranged" for that loan. The theory would be that the bank, but for its relationship with the issuer, would not have entered into the loan (i.e., made the upfront payment) with the executive officer or director. The situation is even more problematic if the executive or director receives favorable pricing or the issuer bears the cost of, or subsidizes, the insider's monetization trade.
Though strong arguments can be made that most monetization transactions differ markedly from the types of financing transactions Section 402 was intended to address, the Securities and Exchange Commission has yet to publish any guidance on Section 402, so the question of whether an issuer has impermissibly "arranged" a "personal loan" will be decided based upon the particular facts of each case. Consequently, institutions would be well advised to assess whether their policies and procedures enable them to monitor transactions effectively.
This week's Regulatory Focus was written by Anna Pinedo, partner, and Sherri Venokur, special counsel, in the commodities and derivatives practice group at Stroock & Stroock & Lavan in New York.
