In Envirokare Tech, Inc. v. Pappas, 420 F. Supp. 2d 291 (S.D.N.Y. 2006), the Southern District of New York held that Section 402 of the Sarbanes-Oxley Act of 2002, which prohibits a publicly reporting company from making personal loans to its executive officers and directors, does not prohibit a company from advancing defense costs to its directors or officers as those costs are incurred even though the advances are repayable if indemnification were ultimately held to be unavailable. The case represents one of the first times that courts have interpreted this sometimes ambiguous section of the Sarbanes-Oxley Act.
The case involved a claim by Envirokare Tech, Inc., a Nevada corporation, against its former chief executive officer for a breach of fiduciary duty. As permitted by state law, the company’s bylaws entitled officers and directors to be reimbursed for expenses incurred in defending a civil or criminal action arising out of their service with the company, upon receipt by the company’s board of directors of a satisfactory undertaking to repay the company if a court ultimately decided that indemnification was not permitted. This provision is very common. State corporation statutes generally permit the advancement of expenses to defend indemnifiable claims. Delaware is typical in permitting companies to indemnify directors and officers. Section 145(e) of the Delaware General Corporation Law provides that “[e]xpenses (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 … 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.”
Under Section 402 of Sarbanes-Oxley, it is “unlawful” for a public company “directly or indirectly” … to extend or maintain credit … in the form of a personal loan to or for any director or executive officer (or equivalent thereof) of that [company].” Because its former chief executive officer would be required to repay any amounts that were advanced to him if a court decided he were not entitled to indemnification, Envirokare claimed that the advances amounted to an extension of credit, and that it was therefore prohibited from advancing his defense expenses as incurred.
Section 402 was effective immediately upon adoption of Sarbanes-Oxley and, in contrast to much of that statute, is not subject to SEC rulemaking. The Section 402 provisions are instead a part of the U.S. Criminal Code, and the SEC has declined to offer interpretive guidance in that area. From the earliest days of Sarbanes-Oxley, practitioners posed the question of whether the advancement of indemnification expenses would be prohibited under the statute. Courts had, until now, not addressed the question directly.
The Court in Envirokare did not attempt to define comprehensively what a “personal loan” under Section 402 means, but it held that the advancement of defense costs in this context do not fall within that term. The Court reasoned that nothing in the legislative history of Sarbanes-Oxley indicated that the advancement of indemnifiable defense costs under state law was one of the abuses Congress intended to address, observing instead some of the multimillion dollar personal loans to executives that received extensive press attention at the time. The Court stated that if Congress intended to prohibit a practice that is explicitly permitted by the laws of every state in the United States, it would have made its purpose more explicit.
In Envirokare, the officer who requested reimbursement for the expenses of his defense was no longer employed by the company. Section 402 of Sarbanes-Oxley does not prohibit loans to former executive officers or directors, and the Court could justifiably have relied on that reasoning alone (as at least one Delaware court had done before). In basing its decision on the determination that the advancement was not a “personal” loan, and in suggesting that the statute should be interpreted in light of the context in which it was enacted, the Court has perhaps offered a more useful precedent. The result in Envirokare is consistent with the conclusion of a group of 25 law firms that subscribed to a memorandum in October 2002 stating a consensus position, in the absence of official guidance, among practitioners on a number of the interpretive questions arising under Section 402.