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Sarbanes-Oxley Act: What You Need to Know Now

The U.S. law known as the Sarbanes-Oxley Act made sweeping reforms to corporate governance law that go far beyond just financial issues. This article takes a look at how the law has changed the rules of business, and how it affects your organization

On July 30, 2002, President George W. Bush signed the "Sarbanes-Oxley Act" (the Act) as a legislative response to the accounting and financial scandals of Enron and WorldCom. The Act is the most sweeping legislation affecting corporate governance, disclosure requirements and accounting and auditing since the establishment of the securities laws in the 1930s.  The implications for public companies, their directors, officers and stockholders, and the legal and accounting professions are extremely significant.  

The objective of the Act is to restore the confidence of the investing public in the markets by adding new disclosure requirements, revising the current governance standards, creating an auditor oversight board, increasing criminal penalties for securities laws violations and creating new crimes relating to fraud.  Obviously, the Enron case reduced investors' confidence in financial statements, the integrity of corporate managers and their accountants.   

The requirements of Sarbanes-Oxley may be divided into three categories: certification, auditors and disclosure.  Perhaps the best-known provisions concern top management: the Chief Executive Officers (CEOs) and Chief Financial Officers (CFOs) of publicly traded companies must certify financial statements, and those who knowingly certify falsely are liable for criminal and civil penalties.  This so-called C-level certification is the boss's personal guarantee that processes are established to ensure the proper flow of information.  The second mandate, auditory, requires companies to develop and publish internal processes such that outsiders can attest to the existence of appropriate controls.  Finally, under the act's disclosure mandates, companies must report financial results and material changes in corporate financial condition or operations "on a rapid and current basis."

Hybrid financial instruments under the Act

The prohibition against making loans to executive officers and directors under the recently enacted the Act raises difficult interpretive questions for many public companies.  One such question is whether this prohibition against public companies loans to executive officers and directors applies to company sponsored programs providing for cashless exercise of stock options.  This following structure may be a solution to that problem.

As we mentioned, one of the provisions of the Act prohibits U.S. public companies, some non-public U.S. companies and non-U.S. companies whose shares are traded in the U.S. from extending credit to an "Insider" (in the context of the Act, an Insider is a director or executive officer).  This provision may affect split-dollar life insurance, retirement plan loans, and cashless exercise of options.   Moreover, the Act also requires that if a company restates its financial statement due to "material non-compliance," then the CEOs and CFOs must reimburse the company for any bonus or incentive based compensation, including any equity-based compensation, received during the 12 month period after the original filing date of the financial statement. 

Under the loan prohibition provisions of the Act, issuers are precluded from extending, maintaining, arranging or renewing personal loans to Insiders, including through a subsidiary.  Extensions of credit outstanding on July 30, 2002, are exempted from this prohibition, provided that no renewals of such arrangements are made after such date.  Therefore, any loans to Insiders related to the acquisition of stock violate the Act.   As a consequence, it is important for issuers to immediately review their options plan, stock options agreements and any other grant documentation and restrict any loan provisions contained therein to employees who are not Insiders.  Any loans to Insiders made before July 30, 2002, should not be modified or renewed.  Similarly, loans to enable employees to meet their tax obligations associated with stock options, restricted stock, and other equity compensation plans should be reviewed.

The loan prohibition provisions may preclude the cashless exercise of stock options by Insiders.  In the typical cashless exercise of a stock option, the holder of the option contacts a broker designated by the issuer and instructs the broker of his or her wish to exercise the option and sell all (or some) of the shares.  The broker sells the stock and uses the sales proceeds to pay the option price to the issuer and any required tax.  The holder of the option receives any remaining proceeds from the sale of shares.  

This would allow the Insiders to benefit from hybrid financial instruments (such as a stock option) via a tax efficient way in which interest expenses should preferably be tax deductible, whereas accrual or recognition of interest income should preferably take place at a later time.   Combining Luxembourg's accounting and tax rules, a debt instrument can be created that may work in connection with an a US resident lender to a Luxembourg company.   The beneficial owner of the Luxembourg entity will be an Insider through a nominee scheme.  

Preferred Equity Certificates (PECs)

A Luxembourg company borrows funds from a U.S. group company in the form of Preferred Equity Certificates ("PECs"). PECs generally have a very long term from 50 up to 98 years, they are subordinate to all other debt instruments issued by the company but not to share capital and they can be converted into ordinary or preference shares at the option of the creditor and/or the debtor.

For Luxembourg accounting purposes, a debt, even with a certain extent of equity features, can still be treated as a debt. As the Luxembourg tax balance sheet is similar to the commercial balance sheet, except in limited number of cases, enumerated by income tax law, PECs will receive debt treatment for Luxembourg tax purposes allowing for interest deduction and exemption from Luxembourg withholding tax.

On the U.S. side, certain forms of debt are re-characterised as equity investments for tax purposes. As no interest accrues on equity, the income from PECs for U.S. tax purposes is treated as dividends. However, taxable dividends do not occur until they are duly declared.  

• PECs provide that no taxable income is recognised in the books of the U.S. creditor.

• PECs allow for immediate interest deduction in Luxembourg.

• PEC interest deduction can be used to offset Luxembourg taxable income.

• PEC interest is not subject to Luxembourg withholding tax.

• PECs do not attract Luxembourg net worth tax.

• PECs can be used to purchase subsidiaries, real estate, loans and other assets.

Interest accrues only if the Luxembourg debtor has sufficient retained earnings and is only due and payable if and to the extent declared by the board of directors of the debtor. However, even if sufficient retained earnings are available, the interest does not need to be declared due and payable in order to avoid recognition of income in the U.S. As long as interest has been accrued (due) it can be deducted for Luxembourg income tax purposes. Moreover, it does not need to be payable or effectively paid.

This article was contributed by Amicorp Group, which specializes in rendering management, administration, fiduciary, consulting, and corporate structuring services to local and international corporates as well as individuals. For more information, members can contact Sytske Kimman at S.Kimman@amicorp.com