Personal loans get the legislative boot: what directors need to know about the personal loan prohibition contained in the Sarbanes-Oxley Act of 2002.

• Author: Hartman, Thomas E.
• Position: Executive Loans

THE SARBANES-OXLEY ACT of 2002 was enacted in response to the financial and corporate governance scandals that have surfaced in the last year. The Act is the most comprehensive federal statute in the field of securities regulation in more than 50 years and the most comprehensive federal law-making ever in the field of corporate governance--covering, among other things, corporate responsibility, financial disclosures, corporate fraud, a new public company accounting oversight board, and outside auditor independence. The excesses that the Act was meant to curb are well documented and have received much attention in the media. However, many of the details of the Act, such as those on the prohibition on personal loans to directors and executive officers, are only now starting to receive much attention.

As with most provisions of the Act, the prohibition on personal loans is widely perceived to be a reaction to specific abuses. Many commentators have attributed this prohibition to the loans made to Bernard Ebbers when he was CEO of WorldCom. Mr. Ebbers received more than $350 million in personal loans from WorldCom in 2000 to repay bank loans he had secured with shares of his WorldCom common stock. The banks had called the loans after the value of the WorldCom stock collateral plunged from more than $100 per share to around $25 per share. Rather than force him to sell millions of shares of WorldCom stock to repay the bank loans, which likely would have further depressed the stock price, the WorldCom board approved loans to him totaling $366 million, with his WorldCom stock pledged as collateral. WorldCom has since filed for bankruptcy, the collateral has only marginal value, and WorldCom has yet to be repaid by Mr. Ebbers.

Prohibition on personal loans

The personal loan prohibition in the Act is crafted as a general prohibition that is subject to limited exceptions. The general prohibition is that it is "unlawful for any issuer...directly or indirectly, including through any subsidiary, to arrange for the extension of credit, or to renew an extension of credit, in the form of a personal loan to or for any director or executive officer (or equivalent thereof) of that issuer."

In addition to prohibiting loans directly to directors and executive officers, the Act probably also prohibits a company guarantee of a loan from a third party to a director or executive officer, since that would likely be deemed to constitute arranging for the extension of credit.

Exceptions to the prohibition

Grandfather Provision. There is an exclusion, or "grandfather provision," for an "extension of credit maintained by the issuer on July 30, 2002, so long as there are no material modifications to the terms of, or any renewal of, the existing credit arrangements after that date. The Act does not provide guidance as to the breadth of the grandfather provision. For example, it is unclear how it applies to binding commitments to be performed after July 30, at the election of an insider or a third party, that would be...