Stock Compensation Meets

Securities Laws: Keeping Executives

and Employees Out of Jail

Bruce Brumberg, Editor

myStockOptions.com
Bruce@myStockOptions.com

Sue Morgan, Perkins Coie LLP

smorgan@perkinscoie.com

WorldatWork 48th Annual

Conference
May 12, 2003 San Diego
 2
All the financial scandals involve securities law
violations and sales of stock by insiders. The
stock sold, either from options or restricted
share grants, or founders stock, was often part
of equity compensation.
Topics to Keep Your Execs 3

and Employees Out of

Trouble
 Insider Trading
 Rule 10b5-1 Plans
 Section 16
 Sarbanes-Oxley Act:
 CEO/CFO Certifications of SEC Filings;
Executive Loans; Pension Plan
Blackouts; Non-Audit Services
 Other Current Issues
 4

The investigations,
stories and
accusations continue.
 5

Will ads for insider trading lawyers crowd

out ads for personal injury and medical
malpractice lawyers?
 6

Insider Trading
What is insider trading?
 You know material confidential information about a public
company (whether your company or another company).

 You trade on that information or tip others about it before

the information is released publicly.
 7

Insider Trading
 Civil Penalties: any profit made or loss avoided and
penalty of up to three times this amount. Bar for
serving as D&O of public company.
 Individuals face up to 25 years in prison for
securities fraud and fines of up to $1 million. Mail
and wire fraud, tax evasion and obstruction of
justice. Corporations face penalties.
 Controlling person’s liability for managers
 New disgorgement penalty for restatements
 8

Insider Trading
Material information: news that can
affect a company’s stock price,
for better or worse
This includes knowledge of:
• takeover
• accounting problems
• dividend change
• blockbuster product
• earnings better or worse than
expected
 9

Insider Trading
MYTHs
Only a company’s insiders or employees can commit insider
trading. Need to trade and be caught in the act.
 
TRUTHs
 The law applies to anyone who knows material nonpublic
information at the time of the trade or tip
 Applies to trades of stock in customers, suppliers, clients
 Tipping, even without the tipper trading, is illegal
 Most cases based on circumstantial evidence
 These rules are separate from the Section 16 rules for senior
executives and directors
10
 11

Insider Trading
The ImClone case

 What is the material nonpublic information and

when does it become public?

 Senior executives sell; CEO’s family members sell

 Martha Stewart: What did she know? When did

she know it? Who gave her information?

 What constituted obstruction of justice and false

statements to government investigators?

 Can brokers use information that senior

executives are buying or selling? Check your plan
provider’s rules.
 12

Insider Trading
How does insider trading
apply to stock options?
 
 Grant or exercise of stock options is not a
trade
 Cashless exercise/same-day sale raises
questions of insider trading
 Rules apply during post-termination exercise
period
 Rules also apply to company stock in 401(k)
 13

Insider Trading
Insider trading harms the goals of
employee ownership
 
 Employee ownership culture encourages information-sharing
and boasting about company.

 Even well-intentioned actions can be illegal.

 Destroys the financial link between employees and

shareholders. Damages reputation of equity compensation.

 Investors interpret insider trading investigation as sign that

company has undisclosed financial or accounting troubles.
 
 14

Insider Trading
Prevention Procedures
 Blackout Periods vs. Quarterly Trading
Windows
 Pre-clearance for Senior Executives and
Directors. Rule 10b5-1 plans as defense.
 Ongoing Education: Seminars, Videos (e.g.,
“Think Twice”), Reminders, Press Clippings
 Substantive prevention efforts, internal
investigations and cooperation with SEC
and DOJ can reduce corporate liability
 15

For more
details and
questions on
insider trading,
see Articles
and FAQs on
myStockOption
s
 16

10b5-1 Plans
 What are Rule 10b5-1 trading
plans?
 How they help
 How they work
 FAQs
 How you can help implement
 17

10b5-1 Plans
 How 10b5-1 plans help
 Permit advance planning for orderly
disposition
or to meet special needs
 Sales can take place even when insiders are
aware of material nonpublic information
 Companies can manage public perception of
insiders’ sales
 18

10b5-1 Plans
 How 10b5-1 plans work
 Provide an affirmative defense against insider trading
claims if
 When not aware of the inside information, the insider
must
 Enter into a contract to sell (or purchase),

 Instruct another person to sell for the insider’s

account, or
 Adopt a written plan for trading securities
 19

10b5-1 Plans
 The written trading plan must
 Specify amount, price and date of sales,

 Provide formula, algorithm or computer

program for determining amounts, prices and

dates, or
 Not permit the insider to exercise any

subsequent influence over how, when or

whether to effect the sales
 20

10b5-1 Plans
 Whose plan is it?
 Agreement between insider and

broker
 Brokers usually supply form

 Company should review


To avoid controlling person liability
 21

10b5-1 Plans
 When should the plan be signed?
 Generally, during a window period

 When should sales start?

 Hiatus before trading starts: two

weeks,
30 days, three months, after next
earnings release
 22

10b5-1 Plans
 What if your insider is always aware of inside
information?
 SEC advice equivocal

 Rule says “before becoming aware of the

information”
 Alternative: insider must not be aware of inside

information when plan commences

 Mechanisms: long hiatus before sales start (six

months); other officer signs off when trading can

begin
 23

10b5-1 Plans
 Should the plan be in writing?
 Two of three affirmative defenses do not

require
 Best practice is to have written plan

 Certainty of terms

 Use as evidence in judicial proceedings

 Summary judgment phase

 24

10b5-1 Plans
 Should the plan have a fixed term?
 Not required

 Best practice is to have fixed term

 Typically six months or one year

 Two years at outside

 25

10b5-1 Plans
 What factors influence trading
instructions?
 Impact on market

 Size of transactions
 Multiple insiders
 Two-day Section 16 reporting
 Frequent sales, barrage of Forms 4
 Ease of implementation
 Keep it simple
 Cashless option exercise issues
 26

10b5-1 Plans
 What should cause the plan to automatically
suspend or terminate?
 Insider’s death, bankruptcy, termination of insider

status, expiration of stock options subject to plan

 Announcement of merger, tender offer

 Withdrawal of company’s lack of objection to plan

 27

10b5-1 Plans
 When can insider terminate the plan?
 Can be when aware of inside information

 Does not violate Rule 10b5-1 because it is not

illegal not to trade (SEC informal advice)

 Issue of good faith if pattern or practice

 Should be hiatus before start new plan

 28

10b5-1 Plans
 When can insider modify the plan?
 Only when not aware of inside information;

must wait for open window

 Can trades be made outside a plan?
 Called “parallel trading”

 Would not invalidate trading plan (SEC informal

advice)
 On its own, trade must not violate

Rule 10b-5
 29

10b5-1 Plans
 Should the company make a public
announcement of the 10b5-1 plan
or program?
 Press release

 Form 8-K (SEC may require)

 Form 10-Q

 Company Web site

 30

10b5-1 Plans
 What should be disclosed?
 Existence of program (selling or buying)

 Names of insiders

 Number of shares

 Percentage of holdings (vested and unvested)

 Duration, other terms

 Whether insiders will trade outside plan

 31

10b5-1 Plans
 Sample disclosure
Four of the company’s executive officers currently have in effect Rule 10b5-1 sales
plans for shares of the company’s common stock. In accordance with the
requirements of Rule 10b5-1, the plans were established at times when the officers
were not aware of material nonpublic information. The plans specify the trading
periods, which range from six months to one year, the numbers of shares to be
sold and the prices at which shares may be sold. If all conditions of the plans are
met, the aggregate number of shares that may be sold under the plans would be
________, which would equal approximately __% of the aggregate number of
shares, including restricted shares and vested and unvested option shares, held
by the officers as of _______, 2002. The officers may amend the trading plans and
may sell additional shares of common stock outside of the trading plans, provided
they are not aware of material nonpublic information at such time.
 32

10b5-1 Plans
 What other laws impact plans?
 Controlling person liability

 Rule 144

 Timing of filings
 Attestation
 Exclusive broker?
 Section 16
 Section 13(d)
 State law
 33

10b5-1 Plans
 How you can help implement plans
 Designate 10b5-1 committee or

compliance officer
 Establish guidelines all plans must meet

 Establish procedures for review and

approval
 Vet plans of one or more brokers
 34

10b5-1 Plans
 Process for approval
 Committee reviews plan for compliance with company's

guidelines
 Dialogue takes place between committee, broker and

insider
 Committee makes any requests for changes and

approves or rejects plan

 Committee works with broker

to generate required paperwork (e.g., stock option

exercise forms)
 35

10b5-1 Plans
 Reporting transactions
 Broker files Form 144

 Pre-signed forms placed with broker

 Broker reports transaction details to compliance officer--
same day by phone, then confirmed by same-day fax or
email
 Compliance officer prepares Form 4 for insider's
signature--two-day filing unless exact date not specified
 36

10b5-1 Plans
 Sample guidelines
 General plan requirements

 Discretionary plans will not be permitted

 Modification/voluntary termination of plan can only take
place during an open window
 Company has discretion to terminate plan for certain events
 Automatic termination/suspension events
 Plan intended to comply with Rule 10b5-1
 Purpose, e.g., to permit orderly disposition or acquisition
 37

10b5-1 Plans
 Insider representations that
 Insider is not aware of material nonpublic information
 Insider is entering into plan in good faith, and not as part
of a scheme to evade the purpose of the rule
 Insider will not hedge against the trading plan
 Insider will comply with Rule 144 and Sections 16 and
13(d)
 Insider will exercise no control over broker’s actions
 38

10b5-1 Plans
 Broker representations that
 It will not seek instructions or advice from insider
 It will not deviate from the plan
 It will not execute if aware of material nonpublic
information
 Company representations that
 It has reviewed (or approved) trading plan
 It has no objections to the plan
 The plan does not violate the company’s insider
trading policy
 39

Section 16
 Provisions under securities laws
and SEC rules that require SEC
filings by senior executives and
directors for their company stock
transactions, and also matching of
trades within six-month period
 Forms 3, 4 & 5
 Short-swing profit liability
 40

Section 16
Form 4
 Filed two days after company stock transactions
 Previously reported on Form 5: Option grants,
transactions with the company, including option
issuances, cancellations and repricings
 Company procedures in place for assisting insiders
with filings
 Interacting with outside stock plan service
providers and brokers
 Coming soon: Filings must be made on EDGAR and
simultaneously posted on your company's Web site
 41

Section 16
Issues Raised
 Late filings reported in proxy statement: New meaning
about corporate governance and compliance

 Re-examine which officers are Section 16 officers: No

longer prestigious. SEC definition includes president, CFO,
chief accounting officers, VPs of principal business units
and any person with significant “policymaking function.”

 Changes in compensation design: Deferred comp; M&A

 42

Section 16
Short-Swing Profit Rules
 Senior officer and director who realize any profit from the
purchase and sale, or sale and purchase, of any company
shares within any period less than six months must return
this profit to the company
 Extends to transactions made by your spouse and other
family members and to trusts set up for their benefit
 Section 16(b) plaintiff's lawyers actively monitor securities
trades for these violations because they share in any
profits paid back to your company
 43

Section 16
Danger: The six-month danger period runs both
backward and forward from the date of a
transaction. Best match applies!

Down market example:

 Sold stock on January 1 at $15. Stock executive
purchased two years ago. Stock drops to $5 over
next four months. Buys stock on May 1 to show
market that confident in company future.
 We have a match! $10 per share “profit” on the
May 1 purchase paid back to company. Window
period and blackout rules no defense.
 44

Section 16
Option and Restricted Stock Grants
 Grants of shares and stock options under
employee benefit plans will normally be exempt,
assuming that the necessary shareholder or
board approvals are given in advance.

 Any sale of shares is still matchable against any

open market purchase of shares within the six-
month zone. Watch out for cashless exercise.
 45

Section 16
Example With Options

If you exercise a stock option and sell the

stock on January 1 when market price is $15,
your exercise is exempt from Section 16(b)
matching. The sale of the stock is not. Thus,
any gains resulting from a match with a
purchase six months before this date or six
months after will be a short-swing profits
violation. Purchase of stock in November at
$12 is matched for $3 per share.
 46

Sarbanes-Oxley Act of
2002
 CEO and CFO certifications
 Ban on personal loans
 Prohibition on trades during pension
plan blackout periods
 Prior audit committee approval of non-
audit services
 47

CEO/CFO Certifications
 Sarbanes Section 302: CEO/CFO of public
company required to submit a statement with
certain filings certifying that
 Has reviewed the report
 Based on CEO/CFO’s knowledge, the report does not
contain any untrue statement of a material fact or
omit to state a material fact necessary to make the
statements made, in light of the circumstances
under which such statements were made, not
misleading with respect to the period covered by the
report
 48

CEO/CFO Certifications
 Along with other certifying officers
 Are responsible for establishing and maintaining disclosure
controls and procedures
 Have designed such disclosure controls and procedures to
ensure that material information is made known to them,
particularly during the period in which the periodic report
is being prepared
 Have evaluated the effectiveness of the disclosure controls
and procedures as of a date within 90 days prior to the
filing date of the report
 Have presented in the report their conclusions about the
effectiveness of the disclosure controls and procedures
based on the required evaluation as of that date
 49

CEO/CFO Certifications
 Sarbanes Section 906: Requires CEO/CFO of
public company to submit a statement with
certain filings certifying that the filing “fully
complies” with the Exchange Act reporting
requirements and “fairly presents” in all
material respects the company’s financial
condition and results of operations.
 50

CEO/CFO Certifications
 What does this have to do with me?
 Flow-down certification
 Recent survey of large U.S. multinational companies
 Two-thirds require subcertifications
 Average of 18.6 additional executives
 Including heads of HR and Compensation
 Participation in disclosure practices committee
 Criminal penalties for CEO/CFO
 HealthSouth first criminal certification case
 51

CEO/CFO Certifications
 CEO/CFO not just certifying financial information
 Most of proxy statement is incorporated by reference
into Part III of the Form 10-K
 Executive compensation tables
 Beneficial ownership table
 Certain relationships and related transactions
 Section 16 compliance
 Item 201(d) executive compensation plan information table

 Also financial statement equity compensation note

 52

CEO/CFO Certifications
 Sample subcertification of proxy statement
1. I understand that the Chief Executive Officer and Chief Financial Officer of ABC Corp. will rely
on this certificate, along with other review procedures, in providing to the Securities and
Exchange Commission pursuant to 18 U.S.C. § 1350, as adopted pursuant to
§§ 906 and 302 of the Sarbanes-Oxley Act of 2002, a certification
in connection with ABC Corp.’s annual report on Form 10-K, which incorporates by reference
certain sections of ABC Corp.’s proxy statement for its 2003 annual meeting.
2. I have reviewed the proxy statement.
3. Based on my knowledge, the proxy statement does not contain any untrue statement of a
material fact or omit to state a material fact necessary to make the statements made, in light
of the circumstances under which such statements were made, not misleading as of the date
on which the proxy statement was filed.
 53

Ban on Personal Loans

 Section 402: Bans personal loans to directors
and executive officers
 Broker-assisted cashless exercises
 Probably okay if
 Regular T+3 settlement
 Choice among approved brokers
 Relocation
 Residential loans probably not okay; alternatives:
 Company buys and sells old residence, or
 Company buys new house and rents to executive
 54

Ban on Personal Loans

 Loan forgiveness
 Partial loan forgiveness not okay if modification of a
grandfathered arrangement
 Total loan forgiveness may not be okay--depends on
status of arrangement before forgiveness
 Bonuses okay if not tied to repayment and otherwise
justifiable compensation as sign-on or retention bonuses
 401(k) plan loans
 Probably okay but inadvisable
 DOL guidance: restrictions on pension plan loans to
officers of the plan sponsor do not violate ERISA loan
rules (Field Assistance Bulletin 2003-1)
 55

Pension Plan Blackouts

 New SEC Regulation BTR (Blackout Trading Restriction)
 Prohibits directors and executive officers from trading during pension
plan blackout periods
 What is a blackout?
 When at least 50% of participants in all individual account plans
cannot trade securities held in individual accounts for more than
three consecutive business days
 Exceptions for regularly scheduled blackout periods incorporated

into plan documents and disclosed to employees and for merger

transactions
 Exemptions for DRIPs, certain 10b5-1 plan transactions, tax-qualified
plan transactions other than discretionary transactions, formula
grants, gifts
 56

Pension Plan Blackouts

 How does BTR affect insiders?
 Restricts trading only of securities insiders acquired in connection with
their employment or service
 Includes trades by family members
 Insiders cannot acquire or dispose of securities acquired in connection with
employment or service as an insider
 Includes receiving discretionary equity awards
 Any profit realized by a director from a prohibited transaction is
recoverable by the company
 If company fails to act, shareholders can bring derivative action
 Insiders also subject to civil injunctions, penalties and cease and desist
proceedings, as well as possible criminal liability
 57

Pension Plan Blackouts

 What do you have to do to implement
BTR?
 Include notification of regularly scheduled trading
suspensions in plan documents
 Notify plan participants at least 30 days in advance
of blackouts (per DOL regulations)
 Applies to all individual account plans, regardless

of whether hold company stock

 58

Pension Plan Blackouts

 What do you have to do . . .
 Notify insiders of blackouts at least five business days after
company receives notice from plan administrator
 If no notice from plan administrator, notify insiders at least

15 calendar days before start of blackout period

 Limited relief possible

 File notice with SEC on Form 8-K no later than date by which
notice must be given to insiders
 Requirements differ for foreign issuers
 Further information:
 http://www.perkinscoie.com/resource/business/blackout.htm
 59

Non-Audit Services
 Be aware when establishing perquisites for executives that the
audit committee must
pre-approve, or establish policies and procedures
for pre-approval of, non-audit services by the company’s
auditing firm
 Includes provision of personal financial services to
executives by company’s auditors
 Sprint is a cautionary tale:
 Two top executives were fired after their participation in
a tax shelter for option exercise gains set up by the company’s
auditors left the executives with millions in potential tax liability and
a potential conflict with the auditors
 60

The new accounting board is

expected to issue more guidance
and limits on consulting and tax
advice for audit clients.
 61

Other Current Issues

 NYSE/Nasdaq proposed rules will affect your
relationship with the compensation committee
 NYSE: compensation committee of

independent directors must

 Approve CEO compensation

 Have sole authority to hire, fire and

set fees of compensation consultants

 Have written charter specifying

purpose, duties and responsibilities

 62

Other Current Issues

 Nasdaq: committee of independent

directors or majority of the independent
directors must approve CEO and
executive officer compensation
 63

Other Current Issues

 NYSE/Nasdaq proposed rules will affect
availability of equity and plan design
 Shareholders must approve all equity
compensation plans

Also material amendments to plans
 Discretionary broker voting on equity plans
is eliminated
 64

Other Current Issues

 Other things to watch out for:
 S-8 registrations must be effective before restricted stock is granted
 Expect new SEC guidance on Item 201(d) executive compensation
plan information table
 906 certifications may be required for 11-Ks
 Changes in accounting for equity compensation require heightened
awareness
 New world of SFAS 123 accounting.

 Impact on your Sarbanes-Oxley subcertifications for valuation

model used and its assumptions

 Interpretations in state of flux

 Liquidity accounting is variable

 65

References and Further

Reading
Sarbanes-Oxley Act
http://news.findlaw.com/hdocs/docs/gwbush/sarbanesoxley072302.pdf
Securities and Exchange Commission—Regulatory Actions
http://www.sec.gov/spotlight/sarbanes-oxley.htm
NYSE Corporate Governance Proposals
http://www.nyse.com/abouthome.html?query=/about/report.html
NASDAQ Corporate Governance Proposals
http://www.nasdaq.com/about/ProposedRuleChanges.stm
Perkins Coie LLP—Client Updates
http://www.perkinscoie.com/new.htm
myStockOptions.com--Insider trading, Section 16, Rule 144, 10b5-1
content for executives and employees, along with tools and content on
options, restricted stock and ESPPs
http://www.mystockoptions.com