Executive credit crunch: the federal ban on corporate loans leaves companies scratching their heads – Compensation
NEWSPAPERS WERE SHOCKED–SHOCKED–TO learn that former WorldCom CEO Bernie Ebbers had borrowed $408 million, ostensibly to purchase company stock. That discovery, coupled with the disclosure that former Tyco International CEO Dennis Kozlowski allegedly “borrowed” $242 million from Tyco for yachts, fine art, and luxury apartments, served to make the ban on corporate loans one of the most popular elements of the Sarbanes-Oxley Act of 2002.
But the ban on corporate loans (Section 402) is so broadly stated, and guidance from the beleaguered Securities and Exchange Commission so hard to come by, that no one knows exactly how to interpret it. There’s no question that the ban would apply to loans of the type issued to Ebbers and Kozlowski. But it may also prohibit legitimate and productive uses of corporate loans. “The substance of Section 402 is simple–no loans to xecutives,” says Joe Martin, executive vice president and CFO of South Portland, Maine-based Fairchild Semiconductor Corp. “But [the term] loans hasn’t been defined, so there’s a lot of confusion about whom and what it affects.”
Indeed, even the act’s sponsors, Sen. Paul Sarbanes (D-Md.) and Rep. Michael Oxley (R-Ohio), have expressed concern that the statute could hit unintended targets. Many of the benefits used to attract and retain executives (and lower-ranking employees as well) involve loans or credit extensions. Regardless of the intent of Congress, the broad language of Section 402 may apply to a wide range of compensation practices, including relocation loans, expense-account advances, company-financed insurance coverage (see sidebar, page 80), stock-option exercise programs, even loans from 401(k) plans.
Until the SEC offers guidance (indeed, the agency hasn’t even said whether it will take up the issue), companies that use such arrangements will either have to scrap them or risk a challenge from regulators or prosecutors down the road. Not surprisingly, compensation consultants are unhappy “Congress has performed brain surgery with a machete,” complains Paul Doff, managing director of Compensation Resources Inc.
SUGGESTIONS, PLEASE But while the SEC remains silent, corporate lawyers have stepped in with second opinions. On October 15, 26 corporate law firms circulated a white paper on Section 402 issues, with interpretations of its impact on a variety of corporate practices. “Congress intended the law to be broad–it’s a question of how broad,” says Dixie Johnson, a partner with Fried Frank Harris, one of the law firms that signed the white paper. “People would welcome more articulation on the statute, but at this point, they have to figure out the law themselves.”
One thing is clear: sweetheart loans from public companies to executives will soon be a thing of the past. This category includes relocation and mortgage loans, and any other lending for the personal benefit of a senior executive. While existing loans are likely to be tolerated under a “grandfather” clause, from now on public companies will have to abandon some of the perks they have used to recruit talent. “This has put handcuffs on corporate compensation planners,” says Doff.
He argues that loans, even those intended to be forgiven if performance or tenure targets are met, can be legitimate compensation tools. Instead, companies are likely to switch to compensation packages weighted toward cash and restricted stock. Overall, compensation packages will shrink, as will executive share ownership financed by corporations. WorldCom and a number of other companies–most notably Conseco, where seven former executives and directors owe shareholders some $550 million–took a good idea to disastrous extremes. Now companies that still want their managers to have a significant stake in the company must rely on stock awards or mandate holding periods after options are exercised.
The legal white paper argues that Congress did not mean for Section 402 to apply to credit extensions. “The transaction must take the form of a loan, not merely be an extension of credit,” the paper suggests. The term loan is commonly understood to be narrower than extension of credit. So, for example, it’s expected that companies may continue to make advances for travel or reimbursable relocation expenses. Employees can still use the company car or credit card for personal reasons, as long as they reimburse the amounts in a reasonable amount of time.
GOODBYE, CASHLESS EXERCISE?
Somewhat less straightforward is the issue of whether loans that facilitate the exercise of stock options were intended to fall under the statute. The National Center for Employee Ownership estimates that virtually all public companies offer cashless option-exercise programs for their employees. Typically, a company lends the money to exercise the options and is then quickly repaid when the employee sells some or all of the stock. “They are loans, but they’re outstanding for a nanosecond,” says Fairchild’s Martin. What’s more, the programs are usually available to all employees exercising options. “I don’t think it was Congress’s intent to isolate executive officers and directors and let everyone else use the facility,” he suggests. Nevertheless, Fairchild has for the time being halted such loans to senior officers, and will not resume the practice without clearance from regulators.
Like Fairchild, many other companies are in a holding pattern on a variety of issues, waiting for interpretations from Congress or the SEC. Many have suspended the payment of premiums on company-financed life insurance policies for executives, because doing so might be interpreted as extending credit. “We’re advising clients not to make the payments until they get clarification,” says Tom Bates, a principal in The Todd Organization, a Greensboro, North Carolina-based consulting firm. In fact, many of the insurance companies that sell so-called split-dollar policies are working with customers to delay their payments without the policy lapsing until the issue is resolved.
When–or even whether–SEC guidance will be forthcoming, however, is uncertain. To say the least, the agency has its hands foil for the time being. In the meantime, corporate executives and human-re-source departments will have to reevaluate their inventory of executive benefits.
But given the extent of abuse at some companies, even finance chiefs like Martin concede that the federally induced reckoning is necessary. “What they’re doing is painful,” he says, “but it’s the right thing to do.”
RELATED ARTICLE: Death of Split Dollar?
One of the more far-reaching issues involving Section 402 of the Sarbanes-Oxley Act of 2002 concerns “split-dollar” life-insurance policies. The Association of Advanced Life Underwriting estimates that as many as 1,600 public companies have invested in such policies for their employees. They are called split dollar because the death benefit and the cash-value appreciation of the policy are split between company and employee.
The company pays the premium and is ultimately repaid when the employee dies or the policy is cashed out. Many of these plans benefit up to several hundred people, says Tom Bates, a principal in The Todd Organization, a consulting firm. “Clients are rethinking their policies. They don’t want any specter of loans outstanding to executives or directors.” Indeed, Bates is recommending they suspend premium payments until Congress or the Securities and Exchange Commission addresses the issue.
The SEC isn’t the only regulator eyeing split-dollar policies. In July, the Internal Revenue Service proposed regulations that would deem premium payments to be loans to executives. It has also been pursuing abusive arrangements, in which companies manipulate policy valuations to shelter income and reduce their taxes. “Anything called split dollar is tainted even if 99 percent of the policies are plain vanilla,” says Bates. “The outer-edge transactions have turned the term into a dirty word.”
ANDREW OSTERLAND Is A SENIOR EDITOR AT CFO.
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