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Section 306(a) of the Sarbanes-Oxley Act of 2002 (the "Act") prohibits the directors and executive officers of an "issuer" (as defined in the Securities Exchange Act of 1934, as amended (the "Exchange Act")) from engaging in certain types of transactions in the company's securities during pension fund blackout periods. The Act bars a director or an executive officer from purchasing and selling equity securities of the company during a blackout period in which plan participants are prohibited from engaging in transactions in the company's equity securities under the plan, if the equity security to be bought or sold by the insider was acquired in connection with his or her service or employment as a director or executive officer. By restricting the ability of directors and executive officers to trade in an issuer's equity securities when plan participants are unable to do so, Section 306(a) seeks to mitigate the differential treatment between plan participants and an issuer's directors and executive officers.

On January 22, 2003, the Securities and Exchange Commission (the "SEC") issued final rules (the "Final Rules"), including new Regulation Blackout Trading Restriction ("BTR") and amendments to SEC Forms 8-K, 20-F and 40-K, to clarify the application and help prevent evasion of Section 306(a).[fn1] In addition, the Final Rules specify the content and timing of the notice that issuers must provide under Section 306(b) of the Act to their directors and executive officers and to the SEC about a blackout period. The required notice is designed to help ensure that directors and executive officers have all relevant information about an impending blackout period. In addition, requiring delivery of notice to the SEC will help ensure that an issuer's securityholders are aware of an impending blackout period. The Final Rules also establish the means to calculate damages in a private right of action brought under Section 306(a) arising from a violation of the trading prohibition.

Section 306(a) and Regulation BTR became effective on January 26, 2003. However, the provisions of Regulation BTR regarding the requirement to file a Form 8-K with the SEC[fn2] will become effective on March 31, 2003.

We note that the "blackout periods" covered by Section 306(a) are only those that arise under certain types of pension and similar plans.[fn3] In contrast, regularly scheduled "blackout periods" adopted by many publicly-traded companies as a safeguard against violations of the prohibition of "insider trading" before their quarterly financial results are released do not trigger Section 306(a) and the Final Rules. In addition, the Section 306(a) insider trading prohibitions do not apply to pension plans that do not invest in equity securities of the relevant company. As a result, unlike some provisions of the Act, not all publicly-traded companies will be directly impacted by Section 306. In the Final Release, the SEC cited a Department of Labor ("DOL") estimate that approximately 30% of publicly-traded companies have plans that would be impacted.[fn4]

Issuers and Plans Subject to Regulation BTR

Issuers Subject. Regulation BTR applies to both domestic and foreign issuers (including "small business issuers"), banks and savings associations and, in rare instances, registered investment companies.[fn5] It also applies to companies that have filed a registration statement relating to an IPO which has not yet become effective. It will not apply to issuers of asset-backed securities. As to foreign private issuers, the statutory trading prohibition of Section 306(a) will apply to equity security transactions by directors and executive officers of a foreign private issuer when 50% or more of the participants or beneficiaries in pension plans maintained by the issuer who are located in the U.S. are subject to a blackout period, and the affected employees represent a significant number or portion of the issuer's plan participants.[fn6] It will not apply if a blackout period affected only plan participants or beneficiaries located outside the United States.

Plans Covered. Section 306(a) of the Act defines "individual account plan" according to the U.S. Employee Retirement Income Security Act of 1974 ("ERISA"). This definition, as adopted by Regulation BTR, includes defined-contribution pension plans providing individual accounts for each participant, in which the gains, losses and forfeitures of one participant's account may be allocated to another. Regulation BTR provides that so-called "one-participant retirement plans" under ERISA are excluded from the definition. Regulation BTR also excludes pension plans that are limited to directors of the issuer, since these plans do not create the same potential for unfairness.

Persons and Securities Subject to the Trading Prohibition

Persons Subject. The trading prohibition will apply to directors (as defined in Section 3(a)(7) of the Exchange Act) and executive officers of issuers. Regulation BTR provides that the executive officers covered by these restrictions will be the same group of individuals as are subject to the reporting rules for insiders under Section 16 of the Exchange Act.[fn7] The trading prohibition will not apply to an individual who ceases to be a director or executive officer of an issuer.

Securities Subject. In order to effect the purpose of Section 306(a) and to prevent its evasion, Regulation BTR covers any equity security or derivative security (such as options or warrants) relating to an issuer, whether or not issued by that issuer. As a result, consistent with the approach under Section 16 of the Exchange Act, Regulation BTR applies to any equity security that relates to an equity security of the director or executive officer's company, even if the security is issued by a third party.[fn8] In the case of foreign issuers, this definition will include American Depositary Receipts ("ADRs"). The Final Rules apply to transactions in these securities occurring inside or outside the U.S. Regulation BTR includes an exemption for "exempt securities," as such term is defined in Section 3(a)(12) of the Exchange Act.[fn9]

Transition Rules. Equity securities will be subject to the prohibition if they are clearly related to an individual's service as an executive officer or director, such as a grant to induce him or her to join the board. However, equity securities acquired before an individual became a director or executive officer are not subject to the prohibition, even if the acquisition took place while the individual was a company employee.

Equity securities acquired by an individual in connection with service or employment as a director or executive officer before the company was publicly-traded are subject to the prohibition. Similarly, equity securities acquired in connection with an individual's service or employment as a director or executive officer before the effective date of the Act are subject to the prohibition.

Transactions Subject to the Trading Prohibition

Section 306(a) of the Act prohibits transactions by a director or executive officer during a pension plan blackout period if the equity security was acquired "in connection with his or her service or employment as a director or executive officer." Regulation BTR is designed to cast a wide net, and applies the provisions of Section 306(a) to equity securities acquired by a director or executive officer:

• at a time when he or she was a director or executive officer of the issuer, under a contract with, or a compensation plan of, the issuer or an affiliate of the issuer;
• at a time when he or she was a director or executive officer of the issuer, as a result of one of several types of related-party transactions that must be disclosed in the issuer's proxy statement and/or annual report (without regard to the dollar value of those transactions), if he or she has a pecuniary interest[fn10] in the securities;
• at a time when he or she was a director or executive officer of the issuer, as "director's qualifying shares" or other securities that he or she must hold to satisfy an issuer's minimum ownership requirements for management[fn11];
• as an inducement to his or her service or employment with the issuer or an affiliate as a director or an executive officer (whether acquired before or after taking such position); or
• as a result of an acquisition transaction involving the issuer, if the securities received are received in respect of equity securities of an entity involved in the acquisition transaction that the individual had previously acquired through service as a director or executive officer of that entity.

Please note that these provisions include a broader range of securities than those that are covered by typical compensation plans, and cover any plan or arrangement that results in the acquisition of the issuer's equity securities in exchange for the performance of services for, or employment with, the issuer. In creating this definition, the SEC sought to ensure that issuers do not shift the form of their equity-based compensation programs to enable directors and executive officers to evade the application of Section 306(a).

Regulation BTR provides that any equity securities sold or transferred during a blackout period by a director or executive officer will be considered to have been acquired in connection with service or employment as a director or executive officer, if the director or executive officer owned such securities at the time of the transaction. However, under Section 101(b) of the Regulation BTR, he or she may demonstrate that these securities were not so acquired, by specifically identifying that the relevant securities had a different origin, and demonstrating that this identification of the securities is consistent for all purposes related to the transaction (such as tax reporting and any applicable disclosure and reporting requirements).[fn12] In contrast, the Proposed Rules had established an irrebutable presumption that any equity securities sold or transferred during a blackout period were acquired in connection with service or employment as a director or executive officer, to the extent that such individual held such securities. The Final Release points out that, in order to obtain the benefit of these provisions of the Final Rules, it may be helpful for the relevant director or executive officer to add a note to his or her Form 4 relating to the transaction describing the date and nature of the transaction in which the securities were acquired.

Exempt Transactions

As set forth in the Proposed Rules, the Final Rules set forth several types of transactions which will be exempt from the trading prohibition:

• Acquisitions of equity securities under broad-based, non-discriminatory dividend or interest reinvestment plans;
• Purchases or sales under "10b5-1 plans," if the plan was not adopted, and the instruction under the plan to purchase or sell the securities in question 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 and ending dates of the impending blackout period;[fn13]
• Purchases or sales of equity securities under certain "tax-conditioned plans,"[fn14] subject to certain limitations;[fn15] and
• Ownership changes resulting from stock splits, stock dividends and pro rata rights distributions.

The Final Rules provide exemptions for additional types of transactions that were not included in the Proposed Rules, but are also outside of the control of the director or executive officer in question:

• awards of equity securities under compensation plans that automatically enable directors or executive officers to receive grants or awards;
• exercises, conversions and terminations of derivative securities that were not written or acquired during the relevant blackout period or while the director or executive officer was aware of the actual or approximate beginning or ending dates of the blackout period, under certain circumstances where the director or executive officer does not have the discretion to choose the time of exercise, conversion or termination;
• transactions involving a bona fide gift or a transfer by will or inheritance laws;
• transactions under a domestic relations order;
• transactions required by law; and
• transactions in connection with a merger, acquisition, divestiture or similar transaction occurring by operation of law.

Definition of Blackout Period

The Act defines the term "blackout period" to mean any period of more than three consecutive business days during which the ability of at least 50% of the participants under all of an issuer's "individual account plans" to effect transactions in an equity security of such issuer in such a plan is temporarily suspended by the issuer or a plan fiduciary.

Applying the 50% Test. Regulation BTR provides that, to make this 50% calculation, the relevant individual account plans include only individual account plans in which participants or beneficiaries located in the U.S.[fn16] held or could hold equity securities of the issuer, whether or not the account plan actually contained equity securities of the issuer at the time of the calculation. As a result, the definition includes individual account plans that:

• permit participants or beneficiaries to invest their plan contributions in the issuer's equity securities;
• include an "open brokerage window" that permits participants or beneficiaries to invest in the equity securities of the issuer or any other publicly-traded company;
• match employee contributions with the issuer's equity securities; or
• reallocate forfeitures that included the issuer's equity securities to the remaining plan participants.

To determine which individual account plans are "maintained by the issuer," Regulation BTR applies the "single employer" rules under the Internal Revenue Code.[fn17] Regulation BTR applies these rules to determine the individual account plans of an issuer and its parent, subsidiary and affiliated entities that should be aggregated to determine whether the 50% test has been satisfied.

Location of Participants and Beneficiaries. Under Regulation BTR, the 50% test is applied by comparing (a) the number of participants or beneficiaries located in the U.S. under all of an issuer's individual account plans that will be subject to the suspension to (b) the total number of the issuer's participants or beneficiaries located in the U.S. under all of its individual account plans.[fn18] If this percentage is at least 50%, the trading prohibition will apply to the directors and executive officers of a domestic issuer.

In the case of a foreign private issuer, a second calculation will compare the number of participants or beneficiaries located in the U.S. under all of the issuer's individual account plans subject to the suspension to the total number of participants or beneficiaries under all of the issuer's individual account plans worldwide. If this percentage is greater than 15%, and the 50% test is also satisfied, the trading prohibition will apply to the foreign private issuer's directors and executive officers. Unlike the Proposed Rules, the Final Rules also provide that if this percentage is less than 15%, but there are more than 50,000 affected participants in the U.S. (and the initial 50% test is also satisfied), the trading prohibition will apply.[fn19]

Exceptions to Definition of Blackout Period

The Act excludes from the definition of "blackout period":

• a regularly scheduled suspension of trading in the issuer's equity securities, if that suspension is incorporated into the individual account plan, and timely disclosed to employees before they become plan participants or as an amendment to the plan; and
• a suspension described in the general definition of "blackout period" imposed solely to allow persons to become, or to cease to be, participants or beneficiaries in a plan because of a corporate merger, acquisition, divestiture or similar transaction involving the plan or plan sponsor.[fn20]

Under Regulation BTR, in order for a blackout period to qualify as "regularly scheduled," the plan must include a description of the prohibited transactions, and the frequency and duration of the period. A blackout period is also considered regularly scheduled if the employee was provided notice of this information before enrolling, or within 30 days after enrolling, in the plan, or within 30 days after the adoption of an amendment to the plan.[fn21]

In the case of a blackout imposed to consolidate plans following a merger or similar transaction, a blackout period does not trigger the trading prohibition if its main purpose is to enable individuals to participate in the plan, or to terminate participation in the plan. This exception is only available if the new participants are not permitted to participate in the same class of equity securities after the relevant transaction as they were before the transaction.

Remedies for Violations

Section 306(a) of the Act contains two distinct remedies. First, a violation of the insider trading prohibition is subject to SEC enforcement action, both civil and criminal.

In addition, where a director or executive officer realizes a profit from a prohibited transaction during a blackout period, an issuer, or a security holder of the issuer on its behalf, may bring an action to recover the profit.[fn22] This profit is recoverable irrespective of the director's or executive officer's intention. Plan participants and beneficiaries will also have standing to bring such an action against the insider. Unlike the short-swing trading liability provisions of Section 16(b) of the Exchange Act, a private right of action could be initiated against directors and executive officers of foreign private issuers with respect to these provisions, and the SEC could bring an enforcement action with respect to any violation by these individuals.

Regulation BTR establishes a profit recovery measure that focuses on the difference between the amount that a director or executive officer actually paid or received in the prohibited transaction and the amount that he or she would have paid or received had the transaction been conducted after the blackout period. For exchange listed securities and securities traded on Nasdaq, profit will be measured by comparing the difference between the amount paid or received for the equity security during the blackout period and the average market price of the equity security over the first three trading days[fn23] after the end of the blackout period.[fn24] For transactions that do not lend themselves to a simple calculation (such as transactions in derivative securities and transactions involving an issuer that has filed a registration statement for an IPO that is not yet effective), Regulation BTR does not provide a specific method of calculation; instead, it provides that damages may be determined in a manner that will identify the amount of any gain realized (or loss avoided) as a result of the prohibited transaction. In either case, Regulation BTR may lead to different results than the calculation that would be effected in an action brought under Section 16(b) of the Exchange Act.

Notice Requirements

Section 306(a)(6) of the Act requires an issuer to provide notice to its directors and executive officers and to the SEC of the blackout period.

Under the Final Rules, the required notice must include the following information:

• the reasons for the blackout period;
• the types of transactions and equity securities impacted by the blackout period;
• the length of the blackout period[fn25]; and
• contact information for the person designated by the issuer to respond to questions about the blackout period, or, if no such designation is made, the issuer's human resources director or a similar person.[fn26]

The notice may be in any graphic form that is reasonably accessible to the recipient. Notice will generally be considered provided as of the date of mailing or electronic transmission, as applicable.

The Final Rules provide that this notice must be provided by the issuer no later than five business days after it receives the notice from the pension plan administrator required by ERISA, which is generally 30 to 60 days prior to the blackout. If the issuer does not receive such notice, it must provide the notice to directors and executive officers at least 15 calendar days before the actual or expected beginning date of the blackout period. However, Regulation BTR provides that such advance notice is not required in any case where an unforeseeable event or circumstances beyond the issuer's reasonable control prevent it from doing so. In such cases, the issuer must give the notice, and a copy of its written determination that advance notice was not possible, to all directors and executive officers as soon as reasonably feasible. The issuer must also notify these individuals as soon as reasonably practicable prior to any changes as to the beginning or ending dates of the blackout period.

The issuer's failure to properly notify the director or executive officer will not be a defense to an SEC enforcement action or a private right of action under Regulation BTR. In addition, if the notice is not properly given, an issuer could be subject to SEC enforcement action for contributing to the director's or executive officer's violation.

The Final Rules also mandate that the notice to be given to the SEC must be provided on Form 8-K on the same day that notice is transmitted to directors and officers. The report on Form 8-K will have the same contents as the notice to the directors and executive officers.

The Final Rules also contain revisions to Forms 20-F and 40-F that require a foreign private issuer to file, as an exhibit to the report (when filed as an annual report), copies of all notices provided to directors and executive officers under Section 306(b) of the Act and the Final Rules during the previous fiscal year, unless the notices previously have been provided to the SEC on a Form 6-K. The SEC encourages (but does not require) foreign private issuers to make the required disclosure under cover of Form 6-K.

Section 306 of the Act became effective on January 26, 2003. Under Regulation BTR, the notice requirement for directors and executive officers would apply to blackout periods commencing on or after January 26, 2003. For blackout periods occurring between January 26, 2003 and February 25, 2003 (the date 30 days after the effectiveness of Section 306), issuers should furnish notice as soon as reasonably practicable. This approach is intended to ensure that notices that are fully compliant with Regulation BTR will be provided for blackout periods that commence before February 26, 2003.[fn27]

Possible Impact of the Act and the Final Rules

Companies subject to the trading prohibition will need to consider updating their "insider trading" policies in order to ensure compliance with Section 306 and the Final Rules. Private companies that have filed an IPO registration statement will also need to be sensitive to Regulation BTR's requirements. Plan documents will also need to be reviewed to determine whether they have provisions regarding regularly-scheduled blackout periods that comply with Regulation BTR and the DOL's regulations. Companies with plans covered by these rules will also need to create mechanisms for the plan administrator or the person designated to oversee these plans, or the issuer's human resources director, to notify management as to any impending blackout periods, and filing the required reports with the SEC.

Individual officers and directors who own securities subject to Regulation BTR will want to take measures to ensure their compliance. In particular, if an officer or director seeks to effect a transfer of any securities subject to the Final Rules during a blackout period, he or she should determine whether such securities will qualify for the exemption set forth in Section 101(b) of the Final Rules, and whether he or she has maintained appropriate tax and other documentation that is consistent with this treatment.

Finally, it is possible that Section 306(a) and the Final Rules will further encourage plaintiffs' law firms to monitor issuers' filings, and the Section 16 filings of their directors and officers, for possible violations of the trading prohibition. It is possible that a director or an executive officer will engage in one or more transactions that do not violate Section 16 and the related SEC's rules but are actionable under the trading prohibition of Section 306(a).[fn28] As a result, the Act and the Final Rules could increase the number of lawsuits filed against corporate insiders if they fail to properly comply with the new trading prohibition, or if they are not properly notified of blackout periods.

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Footnotes

1: See Release Nos. 34-47225; IC-25909; File No. S7-44-02 (the "Final Release"). The Final Rules revise in some respects the proposed rules (the "Proposed Rules") that were issued by the SEC in November 2002 in Release Nos. 34-46778; IC-25795; S7-44-02 (the "Initial Release")

2: See "Notice Requirements" below.

3: See "Definition of Blackout Period" below.

4: Section 306(b) of the Act required the U.S. Secretary of Labor to implement a 30-day notice period for ERISA plan participants generally as to impending blackout periods. On January 24, 2003, the DOL issued its final regulations with regard to notice to participants. See 68 Fed. Reg. 3716 (January 24, 2003); 68 Fed. Reg. 3729 (January 24, 2003). Unlike Regulation BTR, these new regulations apply to ERISA plans regardless of whether they invest in the securities of the issuer. For a description of these final regulations, please see our update, DOL Issues Final Rules Regarding Written Notice to Pension Fund Participants Prior to Blackout Periods, February 2003.

5: The Initial Release acknowledged that investment companies typically do not have employees because they are externally managed, with investment advisory and other services provided by other entities under contracts with the investment company.

6: See "Definition of Blackout Period-Location of Participants and Beneficiaries" below.

7: The definition includes an individual who holds a policy-making role for an issuer, whether or not he or she has a title that is customary for such a role. Because foreign private issuers are not subject to Section 16 of the Exchange Act, but would be subject to Section 306(a) of the Act, Regulation BTR sets forth definitions for the directors and executive officers of foreign private issuers that would be covered: the term "director" means a director who is a management employee and the term "executive officer" means the principal executive officer or officers, the principal financial officer or officers and the principal accounting officer or officers.

8: Examples provided by the SEC include a security-based swap agreement, a standardized option, a security future on an equity security and a security future on a narrow-based security index. In addition, an interest that may be settled only in cash, but is valued based upon an equity security, such as phantom stock, will be considered a derivative security under the Final Rules, unless it qualifies as an exempt transaction.

9: The term "exempted security" generally includes government securities, municipal securities and several other types of investments that are not issued by corporate registrants.

10: The Final Rules focus on indirect interests and direct interests in securities, and utilize the term "pecuniary interest" as provided under Section 16 of the Exchange Act. As a result, directors and executive officers will need to consider the treatment of some transactions by a family member sharing the same household, a partnership, corporation, limited liability company or trust, which could be attributable to him or her if he or she has an indirect pecuniary interest in the relevant equity securities.

11: In the Proposed Rules, such securities would have been covered by the prohibition even if they were acquired before the individual became a director or an executive officer.

12: In the SEC's example, if an executive officer owned 1,000 shares of an issuer's common stock, 250 shares of which were acquired as the result of the exercise of an employee stock option, a sale of 250 shares of common stock during a blackout period will be treated as a sale of the option shares that is subject to the trading prohibition, unless the executive officer establishes a different source of the shares sold and this identification is consistent for all related purposes.

13: The Final Release clarifies that the mere awareness of the potential for a blackout period will not render this exemption unavailable.

14: These plans must satisfy specified provisions of the U.S. Internal Revenue Code that are designed to ensure non-discriminatory treatment of plan participants and generally involve automatic, periodic acquisitions of equity securities made pursuant to advance elections. Accordingly, they do not trigger the same level of concern from the SEC's perspective. The Final Rules also recognize an exception under certain types of employee benefit plans of foreign private issuers that have been approved by a foreign taxing authority, or that are eligible for preferential treatment under foreign tax laws, as eligible for this exemption.

15: For example, so-called discretionary transactions, such as an intra-plan transfer involving an issuer equity securities fund or a cash distribution funded by a voluntary disposition of an issuer equity security, if it occurs during a blackout period, may not qualify for the exemption.

16: Regulation BTR excludes from this calculation individual account plans maintained outside of the U.S. primarily for the benefit of non-resident aliens.

17: The "single employer" rules are designed to aggregate the employees of an affiliated group of businesses to ensure compliance with the limitations on the benefits that can be provided to individual employees or groups of employees under tax-qualified employee benefit programs, such as discrimination in favor of highly-compensated employees.

18: In order to address the fact that the number of participants in a plan is likely to fluctuate, Regulation BTR permits an issuer to use plan data as of any date within the 12-month period prior to the suspension to determine the number of participants or beneficiaries. If there has been a significant change in participation in a plan since the selected date, the issuer must use plan data as of the most recent practicable date that reflects the change. Regulation BTR also permits an issuer to aggregate participants under different individual account plans without regard to overlapping plan participation.

19: This additional provision is only likely to affect foreign private issuers with a substantial number of U.S. employees.

20: The DOL regulations exclude additional periods relating to qualified domestic relations orders and account restrictions triggered by the actions of individual participants. See 68 Fed. Reg. 3716 (January 24, 2003).

21: The SEC will consider an issuer to have satisfied the new advance notice requirements with respect to an individual account plan that includes a regularly scheduled trading suspension maintained on January 26, 2003 (the effective date of Section 306(a) of the Act), if the issuer previously provided the information described in the rule in the documents required by ERISA to be provided to plan participants within the required time period.

22: This form of remedy (but not necessarily the means to calculate the damages) is similar to the form of remedy available for violations of the short-swing profits rules of Section 16 of the Exchange Act.

23: The three-day trading provision is designed to address broad fluctuations that may take place after a blackout period, and to deter attempts to manipulate the stock price.

24: For example, if a prohibited purchase of 1,000 shares is made at $10.00 per share, and the average trading price of the issuer's shares is $12.00 after the blackout period ends, the relevant individual will be deemed to have realized a profit of $2,000.

25: In contrast, the Proposed Rules would have required the notice to specify the actual or expected beginning and ending dates of the blackout period, which in practice, might be difficult to determine. As a result, the Final Rules provide some flexibility as to how the duration is specified, provided that information as to whether the blackout period has begun or ended is readily available without charge to affected directors and executive officers.

26: The DOL regulations require that the notice to participants provide a contact responsible for answering questions about the blackout period. See 68 Fed. Reg. 3716 (January 24, 2003).

27: Notice is not required for a blackout period that commenced before January 26, 2003 and remained effective on that date.

28: In cases alleging violations of both Section 16 of the Exchange Act and Regulation BTR, calculating damages may become more complicated, as the two provisions contemplate different measures of recovery. In some cases, it may provide plaintiffs with the opportunity to recover greater amounts under one claim than the other.