A Small Question in the Big Statute: Does Section 402 of Sarbanes-oxley Prohibit Defense Advancements?

• Publication year: 2022

39 Creighton L. Rev. 357. A SMALL QUESTION IN THE BIG STATUTE: DOES SECTION 402 OF SARBANES-OXLEY PROHIBIT DEFENSE ADVANCEMENTS?

Creighton Law Review

Vol. 39

CYNTHIA BULAN(fn*)

I. INTRODUCTION

Prior to the passage of the Sarbanes-Oxley Act of 2002,(fn1) if an officer or director of a publicly traded corporation were sued as a result of his position as an officer or director of the corporation, he had several potential means of paying for his defense. The sued officer or director could, of course, pay for his own defense. Directors and Officer's Liability ("D&O") Insurance provided another possible source for defense costs. However, historically D&O policies have been indemnification policies, not liability policies which would require the insurer to assume the defendant officer's or director's defense.(fn2) Many state statutes, however, permit a corporation to advance defense costs to the defendant officer or director upon the condition that the officer or director execute an undertaking in which he agrees to repay any costs advanced if later it is found that the officer or director was not entitled to indemnification from the corporation. With the passage of Sarbanes-Oxley, this last option, sometimes referred to as "advancement rights," may no longer be legal.

Section 402 of Sarbanes-Oxley, which amends section 78m of the Securities Exchange Act of 1934,(fn3) prohibits a corporation from extending credit "in the form of a personal loan to or for any director or executive officer" of the corporation.(fn4) Specifically, section 402, in pertinent part, states:

(1) IN GENERAL. - It shall be unlawful for any issuer . . . , directly or indirectly, . . . to extend or maintain credit, 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.

(2) LIMITATION. - Paragraph (1) does not preclude any home improvement and manufactured home loans . . ., consumer credit . . ., or any extension of credit under an open end credit plan . . ., or a charge card . . ., or any extension of credit by a broker or dealer . . . .(fn5)

Subsection 3 of the statute further excludes specific types of loans from the statute's coverage,(fn6) none of which are relevant to advancement of defense costs. This Article considers whether defense advancements constitute a prohibited personal loan under section 402.

The applicability of section 402 to advancements is important because corporations and their officers and directors are sued on a regular basis in both state and federal courts.(fn7) As a result, officers and directors can incur substantial costs defending themselves. Because lawsuits of this sort can last for years, the outlay for defense costs and expenses can reach a sizable amount long before a determination is made that the defendant is entitled to indemnification from either the corporation or a D&O policy.(fn8) In fact, defense costs and expenses often constitute a defendant's biggest concern because of the knowledge that those costs usually must be paid on an ongoing basis during the course of a lawsuit, instead of after resolution of the suit and after a determination has been made that the officer or director is entitled to indemnification.(fn9) Additionally, defense costs usually must be paid whether or not the suit proceeds to final judgment.(fn10) Therefore, regardless of the outcome of the suit someone must bear the burden of paying defense costs.

Prior to the passage of Sarbanes-Oxley, advancement rights were governed entirely by state law.(fn11) State laws provided the source of a corporation's power to grant advancement rights.(fn12) State laws determined whether a corporation could advance costs and corporations could then amend their charters, by-laws, and contracts with individual officers and directors accordingly. Because most state statutes governing advancements are permissive, corporations could grant broad or narrow advancement rights and could make such rights permissive or mandatory.(fn13)

This Article will first give a summary of the pre-Sarbanes-Oxley framework that existed for advancement of defense costs. It will then look at the legislative history of section 402 of Sarbanes-Oxley. It will then analyze, based on pre-existing law, whether such defense advancements are now prohibited as personal loans under section 402. Finally, it will discuss how the doctrine of federal preemption may effect advancements with the passage of Sarbanes-Oxley.

II. THE PRE-SARBANES-OXLEY FRAMEWORK

In most jurisdictions, statutes permit the advancement of defense costs. However, in most jurisdictions the statute does not make such advancements mandatory. For example, the Delaware statute(fn14) states:

Expenses (including attorneys' fees) incurred by an officer or director in defending any civil, criminal, administrative or investigative action, suit or proceeding may be paid by the corporation in advance of the final disposition of such action, suit or proceeding upon receipt of an undertaking by or on behalf of such director or officer to repay such amount if it shall ultimately be determined that such person is not entitled to be indemnified by the corporation as authorized in this section.(fn15)

As the language of the Delaware statute indicates, advancement is permissive; however, in jurisdictions that permit advancements of defense costs the corporation may, by charter, by by-law, or by contract with individual officers or directors, make such advancements mandatory.(fn16) Under the Delaware statute, a person who receives an advancement of defense costs need not repay the advancement as long as it is ultimately determined that the officer or director is entitled to indemnification.(fn17) An officer or director is entitled to indemnification if he is a party to a suit "by reason of the fact that he is or was a director [or] officer . . . of the corporation" and he has acted in "good faith and in a manner the person reasonably believed to be in or not opposed to the best interests of the corporation."(fn18) This "good faith" determination is made by (1) a majority vote of the directors who are not parties to the action; (2) a committee of uninvolved directors that is designated by a majority vote of the uninvolved directors; (3) independent legal counsel in a written opinion, if there are no uninvolved directors or if the uninvolved directors so direct; or (4) the stockholders.(fn19) An officer or director is also entitled to indemnification "to the extent that [he] has been successful on the merits or otherwise in defense of any action."(fn20)

The right to indemnification is not the same as the right to the advancement of defense costs.(fn21) The right to indemnification gives a person the right to reimbursement of losses or expenses; it is not a right for payment at the time the loss is incurred. On the other hand, a right to advancement requires payment of the defense costs as the costs are incurred. Given that a lawsuit can drag on for many years and that counsel usually is paid on an ongoing basis, this is an important distinction that has very practical effects for an officer or director involved in a lawsuit.

The Delaware statute requires that in order to receive advancements of costs that the officer or director execute an undertaking.(fn22) Nothing in the language of the Delaware statute requires that the undertaking be anything more than an unsecured promise to repay any advances upon a later finding that the officer or director is not entitled to indemnification.(fn23) Not all corporations have chosen to make advancements mandatory; some leave advancements to the discretion of the board.(fn24) Others may set out in their charter or by-laws that such advancements require that the receiving officer or director put up some sort of security for the advancement.(fn25)

In addition to the framework created by state statute and corporate charters and by-laws, corporations have also started using separate individual indemnity contracts for officers and directors.(fn26) These individual contracts may also contain provisions regarding the advancement of defense costs.(fn27) Thus, prior to the passage of Sarbanes-Oxley, state statutes and contract law fully governed the area of advancement rights.

III. HISTORY OF SECTION 402

Sarbanes-Oxley was passed in the wake of growing corporate scandals begun by the revelation of massive accounting frauds at Enron Corp. and WorldCom, Inc., among others. As these frauds were coming to public attention, the public also learned that the companies involved had arranged for large loans for some of their high-level executives.(fn28) Because Congress acted relatively quickly in passing Sarbanes-Oxley, the legislative history of the Act, and section 402 in particular, is limited. However, the Act itself states that its purpose is to improve the accuracy and reliability of corporate disclosures required by securities laws.(fn29)

Following the public disclosure of these frauds, Congress began working on and debating a number of bills that would improve corporate accountability. On June 18, 2002, the Senate Banking Committee passed Senate Bill 2673, which required public companies to disclose any loans made to company officers or directors.(fn30) During the debate on Bill 2673, President...