Sarbanes-Oxley Act: Prohibition on Insider Trading During Pension Plan Blackout Periods

Time to Read: 6 minutes

Section 306(a) of the Sarbanes-Oxley Act of 2002 prohibits directors and executive officers of an “issuer” from engaging in specified transactions involving an equity security of the issuer during a pension plan “blackout period.” The prohibition applies only to equity securities acquired in connection with the individual’s service or employment as a director or executive officer. A violation of the prohibition may lead to civil and criminal penalties and to disgorgement by the director or executive officer of any profit realized from the transaction. Section 306(a) takes effect January 26, 2003.

Action Items
Companies should:

  • Update, and review with executive officers and directors, insider trading policies to ensure compliance with the new rules; and
  • Work with their HR departments to ensure that planned pension blackout periods are timely communicated to affected directors and executive officers, and to the SEC.

What Companies and Individuals are Subject to Section 306(a)?
The transaction prohibition of Section 306(a) affects directors and executive officers of public companies and other “issuers,” a term that includes foreign private issuers. In the case of a foreign private issuer, however, the proposed rules treat as a “director” only directors who are also top-level management employees.

What Securities are Subject to the Transaction Prohibition?
The transaction prohibition applies to any equity security of an issuer, including derivative securities.

What Transactions are Prohibited?
The transaction prohibition of Section 306(a) applies only to securities acquired in connection with the individual’s service or employment as a director or executive officer and only to transactions within a blackout period. Thus, for example, the prohibition would affect purchases from the issuer (e.g., option awards) during a blackout period, as well as sales during a blackout period of securities previously acquired from the issuer. If a director or officer holds any equity securities that were acquired in connection with his or her service or employment as a director or executive officer and engages in any sale or transfer of shares during a blackout period, the shares acquired in connection with such employment or service irrebuttably will be deemed tocome out first, without regard to the actual source of the securities disposed.

  • The service-nexus requirement. Inducement awards are covered by the prohibition, as are “qualifying shares” and other securities held to meet minimum stock ownership requirements. Securities acquired solely or primarily as a result of an individual’s status as a director or executive officer are also covered by the prohibition. This may reach equity securities that were, in fact, acquired in an arms-length commercial transaction.
  • Pre- “issuer” acquisitions. The prohibition applies to securities acquired in connection with director/executive officer service regardless of whether the acquisition and related service took place while the company was an “issuer” (i.e., in general, a public company). For example, stock acquired by an individual while CEO of a private company could be subject to restriction if, after the company goes public, the company has a plan blackout period affecting the stock. However, the rule does not apply to equity securities acquired before the individual becomes an executive officer or director, other than inducement awards.
  • Indirect transactions. An acquisition or disposition will be attributed to a director or executive officer who has a “pecuniary interest” in the transaction. For example, certain transactions made by family members, partnerships, corporations, limited liability companies and trusts would be covered.

Exempt Transactions
Some transactions are exempt from Section 306(a)’s transaction prohibition:

  • Acquisitions under broad-based, nondiscriminatory dividend (or interest) reinvestment plans.
  • “10b5-l plan” purchases and sales. However, for purposes of applying the affirmative defense requirements of Rule 10b5-l, awareness of an impending blackout period constitutes awareness of material, non-public information.
  • Certain purchases and sales under tax-qualified and other broad-based plans. This exemption generally tracks the Section 16(a) reporting exemption for purchases and sales (other than “discretionary transactions”) under “tax-conditioned” plans (qualified plans, excess benefit plans, and stock purchase plans, as defined). The Section 306(a). exemption is slightly more liberal than the Section 16(a) reporting rule, however, because it includes “discretionary transactions” that would qualify under the 10b5-1 plan exemption.
  • Stock Splits and Similar Transactions. Increases and decreases in the number of equity securities held as a result of most stock splits, stock dividends, or pro rata rights distributions are exempt.

Blackout Period
For purposes of Section 306(a), a blackout period is any period of more than three consecutive business days during which the ability of 50% or more of the participants or beneficiaries located in the U.S. under all individual account plans (including nonqualified plans) maintained by the issuer that permits participants or beneficiaries located in the U.S. to acquire or transfer an interest in any equity security of the issuer is “temporarily suspended.” (A narrow exception applies in the case of “one-participant retirement plans,” as defined.) The proposed rules apply a different test to foreign private issuers: for those issuers, a blackout period will occur only if the restrictions under the relevant plans affect both 50% or more of all U.S. individual account plan participants and more than 15% of all individual account plan participants worldwide. For these purposes, all individual account plans of the issuer and other “controlled group” members (generally, an 80% vote-or-value ownership test applies) are taken into account.

  • The blackout period definition includes situations in which a participant’s rights to acquire equity securities of the issuer are suspended even if the participant (or the plan as a whole) is not currently invested in those securities – for example, a suspension affecting an “open brokerage window.”
  • The blackout period definition excludes:
    • Regularly scheduled transaction suspensions that are incorporated into the plan and timely disclosed to participants. Although the statute requires that the disclosure must be made, in general, in advance of participation or as an amendment to the plan, the proposed rules allow a 30-day grace period after enrollment or after an amendment.
    • Certain suspensions incurred in connection with corporate merger, acquisitions and similar transactions.

Notice Requirements
Section 306(a) also requires an issuer to provide timely notice of a blackout period to its directors and executive officers, and to the SEC. The proposed rules describe the required content of the notice. Generally, the notice must be provided to directors and executive officers at least 15 calendar days prior to the beginning of the blackout period. The notice to the SEC generally must be made on Form 8-K. For blackout periods that commence on or after January 26, 2003 and on or before February 10, 2003, issuers should furnish the notice to directors and executive officers as soon as reasonably possible.

Note: The Section 306(a) notice requirement rules are distinct from the separate, ERISA-based notice requirements under Section 306(b) of the Act, as to which the Department of Labor has regulatory authority. The Section 306(b) “blackout” provisions apply to a much broader range of plan transactional suspensions than do the rules of Section 306(a).

A violation of Section 306(a) of the Act may lead to civil or criminal SEC enforcement action. There is also a private right of action to recover any “profit” realized similar to the right under Section 16(b). No suit may be brought more than two years after the date on which the recoverable profits were realized.

  • The SEC declined to propose a specific approach for calculating realized profits and instead has solicited comments on various possible approaches. For example, if an executive officer or director impermissibly exercises an option during a blackout period and later sells the stock, are profits to be determined by reference to the realized “spread” in the option at time of exercise or by taking into account any gain on a later sale?
  • There does not appear to be a limit on time between the prohibited insider trade and the realization of profits. For example, securities impermissibly purchased during a blackout period could be sold many years after the end of the blackout period. The two-year limit on actions to recover profits starts only when the profits are realized.

Contact Information
If you have any questions or would like to learn more about the proposed rules, please contact the lawyer who normally represents you.

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