A SMALL QUESTION IN THE BIG STATUTE: DOES SECTION 402 OF SARBANES-OXLEY PROHIBIT DEFENSE ADVANCEMENTS?

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1 A SMALL QUESTION IN THE BIG STATUTE: DOES SECTION 402 OF SARBANES-OXLEY PROHIBIT DEFENSE ADVANCEMENTS? I. INTRODUCTION CYNTHIA BuLANt Prior to the passage of the Sarbanes-Oxley Act of 2002,1 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. 2 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, 3 prohibits a corporation from extending credit "in the form of a personal loan to or for any director or executive officer" of the corporation. 4 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. t I would like to thank my research assistant Michael Kugler for his help in researching this paper. I would also like to thank Phyllis Coleman for her help and guidance throughout the entire process of writing this paper. 1. Sarbanes-Oxley Act of 2002, Pub. L. No , 116 Stat. 745 (2002). 2. JOHN F. OLSON ET AL., DIRECTOR & OFFICER LIABILITY: INDEMNIFICATION AND INSURANCE 10.07[3] (2001) U.S.C. 78m (2000) U.S.C. 78m(k)(1) (Supp. 2002).

2 358 CREIGHTON LAW REVIEW [Vol. 39 (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... 5 Subsection 3 of the statute further excludes specific types of loans from the statute's coverage, 6 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. 7 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. 8 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. 9 Additionally, defense costs usually must be paid whether or not the suit proceeds to final judgment. 10 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." State laws provided the source of a U.S.C. 78m(k)(1), (2) U.S.C. 78m(k)(3). Subsection 3 states: Paragraph (1) does not apply to any loan made or maintained by an insured depository institution (as defined in section 1813 of Title 12 of the Federal Deposit Insurance Act (12 U.S.C. 1813)), if the loan is subject to the insider lending restrictions of section 375b of Title U.S.C. 78m(k)(3). 7. In 2001 there were 487 federal securities-fraud class-action lawsuits filed. Christopher Oster, Accounting for Enron: Rates to Insure Against Wrongs by Officers Soar, WALL ST. J., Jan. 18, 2002, at C According to one commentator defense expenses in class action suits alleging securities fraud often can amount to well over $1 million. Joseph P. Monteleone, Directors' and Officers' Liability Insurance: The Sarbanes-Oxley Act of 2002 and Other Topical Issues, SH077 A.L.I.-A.B.A. 313, 315 (2002). 9. OLSON ET AL., supra note 2, OLSON ET AL., supra note 2, See, e.g., DEL. CODE ANN. tit. 8, 145(e) (2001); CAL. CORP. CODE 5238(f) (West Supp. 2005); N.Y. Bus. CORP. LAw 723(c) (McKinney 2003); Fla. Stat (6) (2004).

3 2006] A SMALL QUESTION IN THE BIG STATUTE 359 corporation's power to grant advancement rights. 12 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. 13 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 14 states: 12. Gregory V. Varallo, Funding Directors' Litigation Costs, 36 S & P's The Rev. of Sec. & Commodities Reg. 22 (Jan. 29, 2003). The Model Business Corporation Act also contains a section that allows advancement of defense costs. MODEL Bus. CORP. ACT 8.53 (2002). 13. Permissive advancement rights allow for advancements but do not require that a corporation make advancements in any given situation. Permissive advancement is not an entitlement. A corporation may choose to deny an advancement request under a permissive scheme. A corporation that has adopted a mandatory advancement provision must make the advancement, regardless of the facts and circumstances, as long as the requesting party has met the requirements of the corporation's advancement provision, often the tendering of an undertaking to repay. 14. This Article will focus on the Delaware statute because of the high number of public companies incorporated in Delaware and other states have similar statutory provisions. States with similar statutory language include California, CAL. CORP. CODE 5238(f) (West Supp. 2005) ("Expenses incurred in defending any proceeding may be advanced by the corporation prior to the final disposition of such proceeding upon receipt of an undertaking by or on behalf of the agent to repay such amount unless it shall be determined ultimately that the agent is entitled to be indemnified as authorized in this section...."); Florida, FLA. STAT. ANN (6) (West 2004) ("Expenses incurred by an officer or director in defending a civil or criminal proceeding may be paid by the corporation in advance of the final disposition of such proceeding upon receipt of an undertaking by or on behalf of such director or officer to repay such amount if he or she is ultimately found not to be entitled to indemnification by the corporation pursuant to this section...."); New York, N.Y. Bus. CORP. LAw 723(c) (McKinney 2003) ("Expenses incurred in defending a civil or criminal action or proceeding may be paid by the corporation in advance of the final disposition of such action or proceeding upon receipt of an undertaking by or on behalf of such director or officer to repay such amount as...."); Texas, TEX. Bus. CORP. ACT ANN K (Vernon 2003) ("Reasonable expenses incurred by a present director who was, is, or is threatened to be made a named defendant or respondent in a proceeding may be paid or reimbursed by the corporation,

4 CREIGHTON LAW REVIEW [Vol. 39 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. 15 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.1 6 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. 17 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." 8 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. 1 9 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." 20 The right to indemnification is not the same as the right to the advancement of defense costs. 2 1 The right to indemnification gives a person the right to reimbursement of losses or expenses; it is not a in advance of the final disposition of the proceeding.., after the corporation receives a written affirmation by the director of his good faith belief that he has met the standard of conduct necessary for indemnification under this article and a written undertaking by or on behalf of the director to repay the amount paid or reimbursed if it is ultimately determined that he has not met that standard or if it is ultimately determined that indemnification of the director against expenses incurred by him in connection with that proceeding is prohibited by Section E of this article DEL. CODE ANN. tit. 8, 145(e). 16. JOHN F. OLSON ET AL., DIRECTOR & OFFICER LIABILITY: INDEMNIFICATION AND INSURANCE 7.11 (2001). 17. DEL. CODE ANN. tit. 8, (a) (d) (c). 21. OLSON ET AL., supra note 16, 5.03[2].

5 2006] A SMALL QUESTION IN THE BIG STATUTE 361 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. 22 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. 23 Not all corporations have chosen to make advancements mandatory; some leave advancements to the discretion of the board. 24 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. 2 5 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. 26 These individual contracts may also contain provisions regarding the advancement of defense costs. 2 7 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. 28 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 (e). 23. OLSON ET AL., supra note 16, Id. 25. Id. 26. Id Id For example, the founding family of Adelphia Communications had received $3 billion in loans from the corporation. 148 CONG. REC. S6328 (daily ed. July 8, 2002) (statement of Sen. Sarbanes). Also, the CEO of WorldCom, Inc. had received a $366 million loan from the corporation. 148 CONG. REC. S6533 (daily ed. July 10, 2002) (statement of Sen. Sarbanes).

6 CREIGHTON LAW REVIEW [Vol. 39 to improve the accuracy and reliability of corporate disclosures required by securities laws. 2 9 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. 3 0 During the debate on Bill 2673, President George W. Bush specially requested that any legislation bar loans 3 1 and specifically challenged "compensation committees to put an end to all company loans to corporate officers." 3 2 As a result, Senator Schumer suggested that the bill be amended to prohibit loans, instead of just requiring the reporting of the loans. 33 The resulting debates on the floors of both houses of Congress indicate that the main concern about loans arose from the seemingly unlimited personal loans that corporations gave to insiders. 3 4 The loans were not only large but were also given on favorable terms. 35 As one senator put it, after the passage of section 402, "CEOs will have to go to the bank, just like everyone else, to acquire a loan." 3 6 Senator Schumer remarked that a prohibition on personal loans would help eliminate the possibility of an executive using company funds for personal reasons. 3 7 The Senate also expressed concern that such loans could create conflicts of interest. 3 s One senator noted that a ban on such loans would help eliminate "hidden" compensation to executives or officers that corporations often did not fully disclose to sharehold Stat. 745 (2002). 30. Public Company Accounting Reform and Investor Protection Act of 2002, S. 2673, 107th Cong. 402 (2002) CONG. REC. S6533 (daily ed. July 10, 2002) (statement of Sen. Gramm) CONG. REC. S6608 (daily ed. July 11, 2002) (statement of Sen. Byrd) (quoting a Washington Post article by Mike Allen dated July 11, 2002, and reprinted in the Congressional Record) CONG. REC. S6690 (daily ed. July 12, 2002) (statement of Sen. Schumer). Senator Feinstein co-sponsored the amendment. 148 CONG. REC. S6760 (daily ed. July 15, 2002) (statement of Sen. Feinstein). 34. For example, Senator Sarbanes cited, among others, the concealment by Adelphia Communications of personal loans to members of the founding family in the amount of $3 billion. 148 CONG. REC. S6328 (daily ed. July 8, 2002) (statement of Sen. Sarbanes). Senator Schumer cited to the more than $300,000 in loans made by WorldCom to its CEO. 148 CONG. REC. S7361 (daily ed. July 25, 2002) (statement of Sen. Schumer) CONG. REC (daily ed. July 15, 2002) (statement of Sen. Feinstein) CONG. REC. S7361 (daily ed. July 25, 2002) (statement of Sen. Schumer). 37. Id CONG. REC. S6760 (daily ed. July 15, 2002) (statement of Sen. Feinstein).

7 20061 A SMALL QUESTION IN THE BIG STATUTE 363 ers. 3 9 Ultimately, Congress agreed to prohibit all loans and the current version of section 402 became part of the bill. The legislative history does not address the issue of advancement of defense costs. Thus, Congress does not seem to have considered whether the advancement of defense costs would fall within the scope of section 402. The predominate reason given for section 402 appears to have been a desire to end the use of the corporate treasury as the personal bank of corporate executives and directors. However, after passage of the Act, several senators made comments indicting that their intent was to have section 402 read broadly. 40 IV. DEFINING ADVANCEMENTS IN LIGHT OF SECTION 402 There are several scenarios which could arise that would force a court to interpret the meaning of section 402, specifically whether section 402 has any bearing on advancement rights. An officer or director who is being sued could seek advancement from the corporation pursuant to the controlling state statute or the corporation's by-laws or charter. If the corporation refuses to advance the officer's or director's costs, citing section 402 as its reason for denial, the officer or director may sue the corporation directly to enforce his rights under the state statute or corporation's by-laws or charter and thereby force the court to interpret section 402. If, on the other hand, the corporation advances the costs to the officer or director, the corporation may be subject to claims that the corporation violated section No matter how the issue arises, it is quite likely that a court will have to address this issue in the not too distant future. 4 2 The definition section of Sarbanes-Oxley does not contain definitions for the key terms used in section "personal loan" and "extension of credit." Nor are these terms defined in the Securities CONG. REC. S6762 (daily ed. July 15, 2002) (statement of Sen. Feinstein). Low interest loans to executives became more popular as a form of compensation in the mid-1990s as a result of a change in the tax law regarding salaries to executives in excess of $1 million. 148 CONG. REC. S6769 (daily ed. July 15, 2002) (statement of Sen. Gramm). 40. James D.C. Barrall & Emma Cheung, Section 402: The Prohibition on Extensions of Credit to Executive Officers & Directors, in 1 THE PRACTITIONER's GUIDE TO THE SARBANES-OXLEY ACT (John J. Huber et al. eds., 2004) (citing comments made by Sens. Schumer, Levin & Collins). 41. These claims could take several forms, including shareholder derivative suits and administrative claims by the Securities Exchange Commission. The corporation could even be subject to criminal charges for a willful violation of the Securities Exchange Act of 1934, which section 402 amended. 42. In Tafeen v. Homestore, Inc., No. CIVA. 023-N, 2004 WL , at *1, *9-10 (Del. Ch. Mar. 22, 2004), the Delaware Court of Chancery recognized that section 402 may bar advancements to current officers or directors but declined to decide the issue because the case before the court involved former officers and directors.

8 CREIGHTON LAW REVIEW [Vol. 39 Exchange Act of 1934, 43 which section 402 of Sarbanes-Oxley amends. Adding to the uncertainty, the Securities Exchange Commission ("SEC") has stated that it does not intend to issue any clarification of section 402 in the near future. 4 4 With no guidance from the SEC, courts will be left to interpret the meaning of section 402 on their own. In order to fall within the prohibition of section 402, advancements must be "an extension of credit... in the form of a personal loan." 4 5 Therefore, an advancement must be an extension of credit, a loan, and personal. Otherwise, an advancement would not fall within the purview of section 402 of Sarbanes-Oxley. While the Securities Exchange Act of 1934 does not define any of these terms, it does use the term "extension of credit" in two other sections: sections 78g 4 6 and 78k(d). 4 7 Additionally, the term "extension of credit" is used in federal regulations that implement parts of the Securities Exchange Act of However, the regulations also do not define the term. Therefore, without much, if any guidance, from Congress, courts will have to figure out how to define the key terminology of section "an extension of credit... in the form of a personal loan." Then courts will have to determine whether advancements fall within the definition. A. ARE ADVANCEMENTS AN "EXTENSION OF CREDIT?" As previously stated, the term "extension of credit" is not defined in the Act. Given the speed with which Sarbanes-Oxley was passed and its large scope, it is highly likely that little thought was given to the potential interpretations of section 402 and the potential for section 402 to have an extremely broad sweep. In addition to prohibiting defense advancements, a broad interpretation of the term "extension of credit" could prohibit transactions, that like advancements, had not been considered problematic prior to the passage of Sarbanes-Oxley, 4 9 such as the use of company credit cards. In order to interpret the term "extension of credit," courts and practitioners have several different sources available for guidance. The Securities Exchange Act uses the term elsewhere. Therefore, the 43. See 15 U.S.C. 78c (2000). This is the definition section of the Securities Exchange Act of Gregory V. Varallo, Funding Directors' Litigation Costs, 36 S & P's The Rev. of Sec. & Commodities Reg. 22 n.2 (Jan. 29, 2003) U.S.C. 78m(k)(1) (2000) g k(d). 48. Regulations T, 12 C.F.R. pt. 220 (2005), and U, 12 C.F.R. pt. 221 (2005), use the term "extension of credit." 49. Larry Cata Backer, The Sarbanes-Oxley Act: Federalizing Norms for Officer, Lawyer and Accountant Behavior, 76 ST. JOHN'S L. REV. 897, 916 (2002).

9 20061 A SMALL QUESTION IN THE BIG STATUTE 365 definition given to the term in other sections of the statute may provide guidance, as may the enacting regulations for those other sections. Additionally, the term has been used in other acts and the associated regulations. Further, the language of section 402 itself may provide courts with guidance. As noted supra, the Securities Exchange Act of 1934 does use the term "extension of credit" elsewhere. While rules of statutory interpretation normally require that terms used in one part of a statute should be given the same meaning when used in another part of the same statute, rules of statutory interpretation permit for different definitions if the terms are used in a different context, if the terms involve different subjects, or if different policies are behind the different sections. 50 Section 78g of the Securities Exchange Act is entitled "Margin requirements." 5 1 Section 78k(d) is entitled "Prohibition on extension of credit by broker-dealer" 5 2 and is part of the larger section 78k, entitled "Trading by members of exchanges, brokers, and dealers." 53 The implementing regulations, T 54 and U, 55 also deal with extensions of credit. Regulation T, entitled "Credit By Brokers and Dealers," 5 6 addresses margin accounts as does Regulation U, entitled "Credit By Banks and Persons Other Than Brokers or Dealers for the Purpose of Purchasing or Carrying Margin Stock." 5 7 Thus, it could be argued that the term need not be interpreted the same way for section 402 of Sarbanes-Oxley as it is for sections 78g and 78k(d) of the Securities Exchange Act and Regulations T and U because clearly those sections use the term "extension of credit" in a different context and involve a very different subject than section 402. Furthermore, the policy behind these sections is substantially different than the policy behind section 402. Section 78g explicitly states that its purpose is to prevent over-leveraging in the purchase of securities. 5s The purpose behind section 78k(d) is to prevent broker-dealers from pushing shares on customers. 5 9 Clearly, section 402 has no relation to these other sections. The purpose behind section 402 appears to be significantly different based on the legislative history of the sec- 50. At. Cleaners & Dyers, Inc. v. United States, 286 U.S. 427, 433 (1932); U.S. West Communications, Inc. v. FCC, 177 F.3d 1057, 1060 (D.C. Cir. 1999) U.S.C. 78g U.S.C. 78k(d) k C.F.R. pt. 220 (2004) C.F.R. pt. 221 (2004) C.F.R. pt C.F.R. pt U.S.C. 78g(a). 59. See 15 U.S.C. 78k(d); See also Sarbanes-Oxley Act, Interpretive Issues Under Prohibition of Certain Insider Loans, at pdfs/loanl002.pdf, 1369 PLI/Corp. 623 (Feb. 2003) (also on file with the author).

10 CREIGHTON LAW REVIEW [Vol. 39 tion 60 and the title of the section, "Enhanced Conflict of Interest Provisions." Thus, the rules of statutory interpretation do not require that the term "extension of credit" have the same meaning throughout the Securities Exchange Act. Two commentators have suggested that the definition given to the term "extension of credit" in section 22(h) of the Federal Reserve Act may provide useful guidance. 6 1 According to the commentators, the legislative history of section 22(h) indicates that lawmakers had similar concerns when they passed section 22(h) and section 402: the avoidance of self-dealing and conflicts of interest. 62 Based on the similar policies behind the two sections, the commentators suggest that section 22(h) and Regulation 0, which implements section 22(h), may provide a useful guide for interpreting section 402 of Sarbanes- Oxley. 63 Section 22(h) of the Federal Reserve Act states, "A member bank extends credit by making or renewing any loan, granting a line of credit, or entering into any similar transaction as a result of which a person becomes obligated (directly or indirectly, or by any means whatsoever) to pay money or its equivalent to the bank." 64 Regulation O expands on section 22(h) by, among other things, listing transactions that would qualify as an extension of credit, including an "advance by means of an overdraft, cash item, or otherwise" 6 5 and "an acquisition.., of any note, draft, bill of exchange, or other evidence of indebtedness upon which an insider may be liable as maker, drawer, endorser, guarantor, or surety." 66 Applying this definition would result in a fairly broad definition of "extension of credit." Such a broad definition would likely encompass advancements because advancements are clearly an "advance" and an undertaking would be "evidence of indebtedness upon which an insider may be liable." Another commentator has suggested that section 402 itself provides guidance in how to interpret the term "extension of credit." The commentator argues that section 402 could easily be read to limit the meaning of the term "credit" to the type of credit extensions set out in subsection 2, specifically credit in forms that are usually available 60. See supra notes and accompanying text (discussing legislative history of section 402). 61. James D.C. Barrall & Emma Cheung, Section 402: The Prohibition on Extensions of Credit to Executive Officers & Directors, in 1 THE PRACTIONER'S GUIDE TO THE SARBANES-OXLEY ACT (John J. Huber et al. eds., 2004). 62. Id. 63. Id U.S.C. 375b(9)(D)(i) (2000) C.F.R (a)(2) (2005). 66. Id (a)(4).

11 2006] A SMALL QUESTION IN THE BIG STATUTE 367 from third party lenders. 6 7 Subsection 2 specifically mentions home improvement loans, manufactured home loans, consumer credit, charge cards, and extensions of credit by brokers and dealers. 68 The commentator argues that such an interpretation of the meaning of "credit" in subsection 1 would produce a "symmetrical" interpretation of subsections 1 and 2.69 He argues that this narrow interpretation of the term "credit" in subsection 1 is supported by the legislative history of the section and points to comments by Congresswoman Mink and Senators Enzi and Feinstein about section 402 targeting "sweetheart" loans of the type involved in the Adelphia Communications Corp. and Tyco International Ltd. cases. 70 However, as noted supra, comments made by some Senators after the passage of the Act indicate that at least some members of Congress intended section 402 be read broadly. The same commentator also argues that a broader interpretation of the term "credit" would also work. 7 1 Nothing in the statute, the legislative history, or the rules of statutory interpretation requires that subsections 1 and 2 be read in a symmetrical manner. 7 2 The commentator argues that a broader reading of the term "credit" might better serve the overall remedial purpose of the Act. 7 3 Additionally, some of the comments made during congressional debate indicate a broad intent to prohibit all types of loans, not just those mentioned in subsection Although Congress provided little guidance in how to interpret the terms of section 402, a broader interpretation appears more appropriate given the legislative history. Furthermore, the rules of statutory interpretation would also support a broader interpretation of the term "extension of credit." When a term is not defined in a statute, the rules of statutory construction dictate that, in most circumstances, the word should be given its ordinary or natural meaning. 7 5 Thus, a broader reading of the term would be required under this rule. A broader reading of the term "extension of credit" likely would encompass advancements. 67. Backer, supra note 49, at U.S.C. 78m(k)(2). 69. Backer, supra note 49, at Id. (citing 148 CONG. REC. H5474 (daily ed. July 25, 2002) (statement of Rep. Mink); 148 CONG. REC. S7355 (daily ed. July 25, 2002) (statement of Sen. Enzi); 148 CONG. REc. S6762 (daily ed. July 15, 2002 ) (statement of Sen. Feinstein)). 71. Backer, supra note 49, at Id. 73. Id. 74. Id. (quoting Sens. Feinstein and Sarbanes). 75. United States v. Alvarez-Sanchez, 511 U.S. 350, 357 (1994); Fed. Deposit Ins. Corp. v. Meyer, 510 U.S. 471, 476 (1994).

12 CREIGHTON LAW REVIEW [Vol. 39 State law may provide another potential source for determining whether section 402 covers advancements. Prior to the passage of Sarbanes-Oxley, several Delaware courts had concluded that advancements were an "extension of credit." One Delaware court has stated that "the advancement decision is essentially simply a decision to advance credit." 76 The court reasoned that an extension of advancement rights would not lead to any net liability on the part of the corporation, 7 7 which is true in all credit situations. Either the officer or director will ultimately be entitled to indemnification, in which case the corporation would have to indemnify the officer or director and such indemnification would include defense costs, or the officer or director will not be entitled to indemnification and the corporation will be entitled to repayment of the advanced costs from the officer or director. 78 Therefore, regardless of whether the corporation advances defense costs, it should ultimately end up having to pay out the same sum of money to the officer or director and the amount paid by the corporation would be dependent upon the indemnification, not the advancement, decision. The same court also noted that a decision to advance defense costs, when such an advancement is not mandatory, involves "important credit aspects." 79 In order to liken an advancement to a credit decision, the court had to believe either that the conditional nature of repayment was sufficient to make advancements a credit transaction or that under any scenario the corporation would be entitled to repayment of the advance costs. The latter view would find that advancements always get paid back, either by the officer or director pursuant to the undertaking or by the corporation through the indemnification of the officer or director. In the context of permissive advancement, another Delaware court has noted that a decision to advance costs is governed by the business judgment rule. 8 0 In its decision the court implied that board members making the decision of whether to advance costs should consider the ability of the director executing the undertaking to meet that undertaking should it ultimately be found that the director receiving the advance is not entitled to indemnity. 8 1 Thus, the court found that a board must make a decision on the creditworthiness of the director seeking advancement. In fact, the court specifically found that a 76. Advanced Mining Sys., Inc. v. Fricke, 623 A.2d 82, 84 (Del. Ch. 1992). 77. Advanced Mining, 623 A.2d at Id. at Id. 80. Havens v. Attar, C.A. No , 1997 WL 55957, at *1, *13 (Del. Ch. Jan. 30, 1997). 81. Havens, 1997 WL at *13.

13 2006] A SMALL QUESTION IN THE BIG STATUTE 369 board's failure to consider the ability of a director receiving advancements to repay the advancements was a sufficient showing that the board had breached its fiduciary duties and justified the court's decision to grant a preliminary injunction. 8 2 Clearly, a strong implication of this decision is that such an advancement is an extension of credit. If the court did not consider an advancement either an extension of credit or a loan of some sort, the court would have had no reason to find that the board may have breached its fiduciary duties. Thus, the courts that have considered the underlying nature of permissive advancements appear to look at them as some sort of extension of credit that should involve an appropriate credit analysis by a board before making an advancement. However, this analysis changes when advancement becomes mandatory under the corporation's charter or by-laws or by reason of a contract with an individual officer or director. As one court stated, when advancement is mandatory a board cannot "condition [] that advancement upon a showing of financial responsibility." 8 3 Another court has noted that a mandatory advancement provision "deprives the board of an opportunity to evaluate the important credit aspects of a decision with respect to advancing expenses." 8 4 Thus, one could argue that when a corporation chooses to adopt mandatory advancement provisions it also chooses to forego its right and obligation to assess an individual's creditworthiness before deciding whether to make advancements. In other words, the corporation has knowingly removed any credit determinations and turned advancement into a right regardless of a person's ability to repay the advancement. On the other hand, one could argue that mandatory advancements are an extension of credit, similar to permissive advancements. The difference is in the timing. Under a permissive advancement scheme, a board makes a credit decision at the time the advancement is sought. While under a mandatory advancement scheme, the board makes the credit decision at the time the board adopts the mandatory provision. If the mandatory provision pre-dates the officer or director seeking advancement, it could be argued that the board or the shareholders made the credit decision at the time the officer or director obtained his or her position. Mandatory advancement provisions may create an additional interpretation problem under section 402. Assuming that mandatory advancements constitute an extension of credit, the question arises under mandatory provisions at what point in time the credit was ex- 82. Id. at * Id. at * Advanced Mining, 623 A.2d at 84.

14 CREIGHTON LAW REVIEW [Vol. 39 tended. This issue is relevant because section 402 has a grandfather clause that excludes from its prohibition any "extension(s) of credit maintained by the issuer" on the date Sarbanes-Oxley was enacted. 8 5 If the extension of credit or loan occurs at the time of the actual advancement then the grandfather clause would not apply. However, if the right to advancement itself constitutes an extension of credit then such advancement rights would be grandfathered in under section 402, assuming that the right existed prior to the passage of the Act. Consequently, if mandatory advancements are an extension of credit, then it must be determined at what point in time the extension of credit is made in order to determine if the grandfather clause applies. There are several possible approaches to this timing issue: the credit is extended at the time the corporation must fulfill its obligation and make the advancement, the credit is extended at the time the mandatory provision was passed, or the credit is extended at the time the officer or director became an officer or director at a corporation that has a pre-existing mandatory provision. If credit is not extended until the corporation actually makes the advancement, then mandatory advancements should be treated the same as permissive advancements under Sarbanes-Oxley. However, if the credit is extended at an earlier point in time, then mandatory advancements may be permissible under the grandfather clause of section 402, assuming that the mandatory provision or the appointment of the officer or director pre-dates the passage of Sarbanes-Oxley. This would be true regardless of whether advancements, of any type, are now prohibited by section 402. As set out above, any credit decision under a mandatory scheme must have been made at a point prior to the officer or director seeking an advancement. However, for purposes of the grandfather clause of section 402, the issue is not when the decision was made but when the credit was extended. Although the decision may have been made at an earlier point in time, using the ordinary meaning of the term "extension of credit" would lead to the conclusion that the credit is not actually extended until the time that an advancement is actually made. Similar to pre-approval of a loan obtained by an ordinary borrower, the decision to give credit is made prior to the actual giving of, or extension of, credit. It appears that case law supports the conclusion that advancements are an extension of credit. Certainly, Delaware case law clearly supports the conclusion that permissive advancements are an exten U.S.C. 78m(k)(1). Under this section, the exemption only will apply if the issuer does not materially modify the terms of the extension of credit after the effective date of Sarbanes-Oxley.

15 20061 A SMALL QUESTION IN THE BIG STATUTE 371 sion of credit and arguments can be made that even mandatory advancements are an extension of credit. However, section 402 does not bar "extensions of credit," it bars extensions of credit "in the form of a personal loan." 8 6 B. ARE ADVANCEMENTS A "LOAN?" If advancements are an extension of credit, section 402 would only prohibit them if they were "in the form of a... loan." 8 7 Section 402 does not define the term "loan," nor does Sarbanes-Oxley in its definition section. 8 8 The Securities Exchange Act also does not define the term. 8 9 Only a few courts have defined the term "loan" in any context. A couple of Delaware courts have defined "loan" using basic dictionary definitions: "something lent or furnished on condition of being returned, esp[ecially] a sum of money lent at interest" 90 or "a borrowing of money or other personal property by a person who promises to return it."91 However, these basic definitions become difficult to apply to circumstances in which there is a promise of return only upon the meeting of certain conditions or the happening of a particular event. In the context of advancements, definitional problems arise because the money only has to be returned, or repaid, under certain circumstances and those circumstances cannot be determined until after the money has been advanced. Only after a board has determined that the officer or director is not entitled to indemnification, which usually occurs after resolution of the lawsuit, would the obligation to repay arise. Because of the conditional nature of repayment of an advancement and the timing of the indemnification decision, at the time of the advancement neither party knows whether the money will have to be repaid. However, given that the officer or director must execute an undertaking, it appears that the parties intend for the advancement to be repaid if it is ultimately determined that it should be repaid. Consequently, the parties' intentions of repayment must be conditional at the time of its making. The conditional nature of repay m(k)(1). 87. Id. 88. See 15 U.S.C See 15 U.S.C. 78c. This is the definition section of the Securities Exchange Act of Technicorp Int'l II, Inc. v. Johnston, No. Civ.A. 5084, 1997 WL , at *1, *21 (Del. Ch. Aug. 25, 1997) (emphasis in original removed) (quoting THE RANDOM HOUSE COLLEGE DICTIONARY 785 (1975)). 91. Feldberg v. Gilkey, Civ. A. No. 93C CV, 1995 WL , at *1, *1 (Del. Super Ct. May 24, 1995) (quoting the definition of "loan" found in BLACi's LAw DICTIONARY 936 (6th ed. 1990)). Courts outside of Delaware have also relied upon basic dictionary definitions for defining the term "loan." See Commonwealth v. Thompson, 780 N.E.2d 96, 98 (Mass. App. Ct. 2002) (quoting definitions of the term "loan" found in Webster's Third New Intern'l Dictionary and Black's Law Dictionary).

16 CREIGHTON LAW REVIEW [Vol. 39 ment of advancements makes it difficult to apply these basic dictionary definitions and reach a clear conclusion. Several commentators have argued, with limited legal support, that advancements are not a loan. 9 2 One commentator has argued that given the rarity of instances in which repayment of advancements is actually sought, one could argue that there is no intention at the time of the advancement to actually repay it. 93 The same commentator further argues that because advancement is a statutory creation, the obligation to repay arises as a matter of law and thus differs from a "personal loan." 9 4 This analysis is based in part upon the holding in Reddy v. Electronic Data Systems Corp. 95 In Reddy the court held that regardless of whether a recipient of an advancement executes an undertaking, if the recipient ultimately is not entitled to indemnification the recipient must repay the advancement. 96 The commentator argues that this amounts to liability as a matter of law and therefore cannot constitute a "personal loan." 9 7 However, the Reddy court based its conclusion on the fact that all contracts for advancement in Delaware include an implied reasonableness term. 98 The court reasoned that interpreting the language of the corporate by-law at issue in Reddy, in light of the implied reasonableness term, led to the conclusion that a person's acceptance of something termed an "advancement" necessarily means that the recipient agrees to repay the advancement if ultimately the recipient is not entitled to indemnification. 99 Simply because the repayment term is an implied term does not mean that the advancement is no longer a loan. Once it is known that receipt of an advancement requires the recipient to repay the advancement under certain conditions, the recipient impliedly agrees to such terms by accepting the advancement. Nothing obligates the potential recipient to become an actual recipient. Therefore, if the potential recipient does not like the terms of acceptance, i.e. the conditional repayment obligation, he or she need not accept the advancement. The same commentator has also argued that the implications of the Delaware statutory scheme lead to a conclusion that advance- 92. See, e.g., John T. Bostelman, The Sarbanes-Oxley Deskbook, 13:2.5[A] (2005); Varallo, supra note Varallo, supra note Varallo, supra note No. Civ.A , 2002 WL , at *1 (Del. Ch. June 18, 2002). 96. Reddy v. Elec. Data Sys. Corp., No. Civ.A , 2002 WL , at *1, *5 (Del. Ch. June 18, 2002). 97. Varallo, supra note Reddy, 2002 WL , at *5 (citing Citadel Holding Corp. v. Roven, 603 A.2d 818, 823 (Del. 1992)). 99. Id. at *5.

17 2006] A SMALL QUESTION IN THE BIG STATUTE 373 ments are not a loan because of the different treatment of advancements and loans under Delaware statutes A separate section of the Delaware statutes, section 143 of the General Corporate Law, addresses loans to officers and directors. 10 ' The commentator argues that the considerations for lending money under section 143 differ from those required under the advancement provisions of section While Delaware courts have held that permissive advancement under section 145 is governed by the business judgment rule, 10 3 section 143 permits loans "whenever, in the judgment of the directors, such loan, guaranty or assistance may reasonably be expected to benefit the corporation.' Sections 143 and 145 were passed at different 0 4 times.' 0 5 Therefore, the argument continues, the legislature must not have viewed advancements as the same as a "loan" because, if it had, then the later enacted section 145 would have been superfluous.' 0 6 Further, when the legislature added section 145(e), it could have, instead, amended section 143 to include the requirement of an undertaking.' 0 7 Thus, the commentator argues that the Delaware legislature intended loans and advancements as two distinct things. 0 8 However, advancements do benefit the corporation. Numerous courts have noted that benefit to the corporation, encouraging qualified individuals to serve on corporate boards, is one of the main policies behind permitting advancements Thus, clearly the corporation benefits from advancements. Consequently, the requirements of section 143 governing loans to corporate officers and directors have been met when a corporation advances costs under section 145. Furthermore, although the legislature could have amended section 143 to require an undertaking as suggested, section 145(e) was passed as part of a larger section dealing with indemnification of cor Varallo, supra note DEL. CODE ANN. tit. 8, Varallo, supra note Havens v. Attar, C.A. No , 1997 WL 55957, at *1, *13 (Del Ch. Jan. 30, 1997) DEL. CODE ANN. tit. 8, Section 143 of the Delaware General Corporation Law originally was passed in Section 145(e) was enacted in Varallo, supra note Id Id See, e.g., In re Cent. Banking Sys., Inc., No. C.A , 1993 WL , at *1, *3 (Del. Ch. May 11, 1993) (stating that advancements serve the beneficial purpose of encouraging qualified persons to become directors of Delaware corporations); VonFeldt v. Stifel Fin. Corp., 714 A.2d 79, 84 (Del. 1998) (noting that "[slection 145 serves the dual policies of: (a) allowing corporate officials to resist unjustified lawsuits... and (b) encouraging capable women and men to serve as corporate directors and officers, secure in the knowledge that the corporation will... defend their honesty and integrity").

18 CREIGHTON LAW REVIEW [Vol. 39 porate officers and directors. Because of the circumstances under which advancements are made and the circumstances under which they must be repaid, placing the advancement provisions in the code section dealing with indemnification makes as much sense, if not more, as putting the advancement provisions in the code section dealing with loans. Additionally, the legislature may have felt that the circumstances surrounding an advancement were such that additional loan requirements, e.g. execution of an undertaking, were necessary under those specific circumstances but not under other circumstances. Therefore, reliance on the fact that the Delaware legislature has passed two separate sections of the corporate law, one for loans and one for advancements, does not necessarily indicate that the legislature viewed loans and advancements as two completely different things; the legislature could just as easily have viewed advancements as a subset of loans. Other commentators have also addressed whether advancements are in the form of a loan. Specifically, a group of twenty-five large law firms published a memorandum discussing various interpretive issues arising under section 402 of Sarbanes-Oxley The memorandum argued that while advancements might constitute an extension of credit, they are not "in the form of a personal loan.""' The memorandum argues that advancements are not a loan because at the time the advancement occurs any repayment obligation is contingent and, therefore, reasonably uncertain. 112 However, the signatory firms to the memorandum have a vested interest in ensuring that advancements remain viable under section 402. Such firms often represent corporations, as well as their officers and directors, in litigation. Thus, the firms are often the ultimate recipients of advancements. In other contexts, a handful of courts have addressed the definition of "loan." Beyond the basic dictionary definitions, set out above, many courts that have defined the term have looked at the specific intentions of the parties at the time the money, or other item, was given. More specifically, many courts look at whether the parties have an absolute intention to repay the money at the time it is given." 13 Using this type of definition, several courts that have considered situ Sarbanes-Oxley Act, Interpretive Issues Under Prohibition of Certain Insider Loans, at PLIICorp. 623 (Feb. 2003) (also on file with the author) Id Id See, e.g., Hardware Wholesalers, Inc. v. Indiana Dep't of State Revenue, 597 N.E.2d 1339, 1342 (Ind. Tax 1992) (holding that a loan involves an obligation to repay absolutely), vacated on other grounds, Indiana Dept. of State Revenue v. Hardware Wholesalers, Inc., 622 N.E.2d 930 (Ind. 1993); In re Bellanca Aircraft Corp., 850 F.2d 1275, 1277 (8th Cir. 1988).

19 2006] A SMALL QUESTION IN THE BIG STATUTE 375 ations in which repayment was contingent have held that the contingent nature of repayment made the money given something other than a loan For example, the Eighth Circuit in In re Bellanca Aircraft Corp.,1 15 after noting that the "hallmark of a loan [is] an absolute right to repayment of funds advanced," held that funds that were to be repaid only upon the happening of a particular event did not constitute a loan. 116 However, in Bellanca Aircraft this was not the sole basis for the court's decision. The court also reasoned that the transaction in question constituted a sale, not a loan, because title to the goods involved in the transaction had passed between the parties. 1 7 Thus, it is difficult to determine whether the Bellanca Aircraft court would have decided the same way regarding the loan if title had not passed between the parties. Cases involving the Internal Revenue Service and the Internal Revenue Code have also defined the term "loan." 118 In most of those cases the courts also considered whether there was an obligation to repay and the intent of the parties at the time of the alleged loan For purposes of the Internal Revenue Code, courts consider something a loan if the parties have a mutual understanding that the borrower has an obligation to-repay the borrowed money and the borrower has a bona fide intent to repay the borrowed funds. 120 Courts also consid See In re Bellanca Aircraft Corp., 850 F.2d 1275, 1277 (8th Cir. 1988); United States v. Two Hundred Eighty Thousand Five Hundred and Five Dollars, 655 F. Supp. 1487, 1495 (S.D. Fla. 1986) (holding money given with the understanding it would be paid back only if the giver needed it was not a loan because when money is loaned there is "normally a clear understanding that the money will be paid back") In re Bellanca Aircraft Corp., 850 F.2d 1275, 1277 (8th Cir. 1988) Bellanca Aircraft, 850 F.2d at In Bellanca Aircraft, the trustee sought to recover funds as a preferential transfer. Id. Prior to the bankruptcy filing, the debtor transferred planes to another party in return for funds. Id. The trustee argued that the transfer was a floor plan financing arrangement, i.e. the funds constituted a loan with the planes as collateral. Id. Under the agreement between the debtor and the other party, the debtor only had to repay the funds if the planes were bought by a third party. Id. Consequently, the court held that the hallmark of a loan, an absolute right to repayment, was not present, and thus, the transaction did not constitute a loan. Id Id. at The holdings in most of those cases are limited to the definition of "loan" for purposes of the Internal Revenue Code See, e.g., Welch v. Comm'r, 204 F.3d 1228, 1230 (9th Cir. 2000); Collins v. Comm'r, 3 F.3d 625, 631 (2d Cir. 1993) Collins v. Comm'r, 3 F.3d 625, 631 (2d Cir. 1993). See also Welch v. Comm'r, 204 F.3d 1228, 1230 (9th Cir. 2000) (stating "[t]he conventional test is to ask whether, when the funds were advanced, the parties actually intended repayment"); Estate of Taschler v. United States, 440 F.2d 72, 75 (3d Cir. 1971) (holding a transaction cannot be a loan if, at the time of the transaction, the parties do not intend to repay the money); Northeastern Consol. Co. v. United States, 279 F. Supp. 592, 595 (N.D. Ill. 1967) (holding a loan requires an unconditional obligation to repay).

20 CREIGHTON LAW REVIEW [Vol. 39 ered whether the lender intended for the money to be repaid.' 2 ' The intent to repay, of both parties, must arise at the time the alleged loan is made. i2 2 In addition to intent, courts have also looked at a number of other factors to determine whether a transaction constitutes a loan: (1) whether the promise to repay is evidenced by a note or instrument, (2) whether interest was charged, (3) whether a schedule for repayment was set up, (4) whether collateral was given as security, (5) whether repayments were made, (6) whether the borrower had a reasonable prospect of repaying the loan and whether the lender had sufficient funds to advance the loan, and (7) whether the parties conducted themselves as if the transaction were a loan.' 2 3 These factors, however, are merely indicia of a loan.' 24 None are considered dispositive and no one factor must be present in order to find that a transaction constitutes a loan. i 25 In the case of defense advancements, some of these factors can be met. Because no one factor is dispositive, applying these factors to circumstances surrounding a defense advancement does not lead to a clear conclusion. In the case of defense advancements arguments can be made that several of these factors have been met. The required undertaking satisfies the first factor, a written instrument evidencing the transaction. It is likely that the sixth factor has also been met, at least in the case of permissive advancements. In almost all circumstances the corporation will have the means to advance the money. In a permissive advancement situation, if the board has exercised its business judgment before granting the advancement,' 26 it is likely that the officer or director borrower will have some means to repay the funds if necessary. To some extent the seventh factor may also be met in the case of advancements. The Delaware statute requires an executed undertaking promising repayment under certain conditions. Thus, the parties recognize at the time of the transaction that repayment is a possibility. This recognition may be enough to consider the seventh factor, whether the parties considered the transaction a loan, met See Welch, 204 F.3d at 1230; See also Crowley v. Comm'r, 962 F.2d 1077, 1079 (lst Cir. 1992) (stating that a shareholder distribution is a loan if at the time of the disbursement the parties intended it to be repaid) Welch, 204 F.3d at 1230; Crowley, 962 F.2d at Welch, 204 F.3d at 1230 (citing Crowley, 962 F.2d at 1079; Frierdich v. Comm'r, 925 F.2d 180, 182 (7th Cir. 1991); Piedmont Minerals Co. v. United States, 429 F.2d 560, 563 (4th Cir. 1970)). See In re AutoStyle Plastics, Inc., 238 B.R. 346, (Bankr. W.D. Mich. 1999) (listing similar factors used for determining whether a transaction is a loan or a capital contribution) Welch, 204 F.3d at Id. at See supra notes and accompanying text (discussing whether advancements are an extension of credit).

21 20061 A SMALL QUESTION IN THE BIG STATUTE 377 Defense advancements would not, however, satisfy the remaining factors. The fifth factor, whether repayments were made, would be inapplicable to a determination because for purposes of a section 402 analysis the determination of whether the transaction constitutes a loan must be made at the time of the transaction, not later. Repayment clearly does not come into play until after the transaction has been completed. Therefore, for a section 402 analysis, the fifth factor would be irrelevant. It is unlikely that factors two, three, and four, whether interest was charged, a repayment schedule was set up, and collateral was given, respectively, would be met in the case of most defense advancements. Most boards do not require these things as part of advancements. However, although advancement statutes do not require any of these things, a corporation's by-laws or charter could require the payment of interest or the posting of collateral. Therefore, two of these factors might be met under certain circumstances. Therefore, applying the factors sometimes used by courts in determining whether a transaction was actually a loan, it really is not clear whether advancements would fall inside or outside of the loan definition. Considering the intent of the parties at the time of the transaction does not help tip the balance in either direction because of the conditional nature of the parties' intentions at the time of the transaction. However, using the definition that a loan involves an unconditional agreement of repayment leads to a conclusion that advancements are not a loan. A few courts have found that under certain circumstances a conditional right of repayment does not necessarily make an advancement of money something other than a loan. However, for the most part, those cases have involved significantly different circumstances than those in a defense advancement situation, such as interpreting the Uniform Consumer Credit Code, which actually contains a definition of the term "loan." 12 7 Another instance when a conditional right of repayment did not prevent a court from finding that a transaction con See, e.g., State ex rel. Salazar v. The Cash Now Store, Inc., 31 P.3d 161 (Colo. 2001). In Salazar, the Colorado Supreme Court found under Colorado's version of the Uniform Consumer Credit Code monetary advances did constitute loans despite the absence of an unconditional obligation to repay the advances. Id. at 163. The "loans" in question were monetary advances given by the defendant in return for assignments of an individual's rights to receive federal or state tax refunds. Id. Under the agreements between the defendant and the individuals if the amount of the anticipated tax refund was lower than the parties anticipated, the individuals would be required to pay defendant the deficiency. Id. In other words, the individuals who received the cash advances would owe money to the defendant only if the amount of their tax refunds were less than anticipated. Of course, the court based its decision on the language of the statute. However, the definition section the court relied upon did not address the issue of repayment at all, let alone conditional repayment.

22 CREIGHTON LAW REVIEW [Vol. 39 stituted a loan and not something else involved insurance company loans to the insured. 128 In Dixey v. Federal Compress & Warehouse Co., the court held that payments by an insurance company to its insured constituted a loan even though the payments only had to be repaid under certain circumstances, specifically if the insured ultimately collected for the same damages from another source. 129 Thus, it appears that the large majority of courts, both federal and state, that have considered the issue have held that an advancement of funds that comes with only a conditional obligation to repay would not constitute a "loan." Most courts appear to consider an intent to repay at the inception of the transaction a hallmark of a "loan." Under most circumstances, a conditional intent to repay at the inception of the transaction would not meet the definition of a "loan." If the majority of courts continue to use this definition of "loan," defense advancements would not qualify as a loan because at the time they are made any repayment obligation is contingent. C. ARE ADVANCEMENTS "PERSONAL?" If advancements do not constitute a loan, whether they are personal becomes a moot point. However, if advancements are an extension of credit in the form of a loan, whether they constitute a "personal loan" must also be determined. It could easily be argued that advancements are not "personal" because they arise in connection with the officer's or director's service to the corporation, which makes their purpose business rather than personal. 130 There is no question that an advancement is only available to an officer or director when he or she is sued in that capacity. However, if it is ultimately determined that the officer or director is not entitled to indemnification because he or she was not acting in the interest of the corporation but in his or her own interest, the officer or director would have to repay the advancement pursuant to the undertaking he or she signed. At that point, does it become "personal"? In other words, if a board ultimately 128. See Dixey v. Fed. Compress & Warehouse Co., 132 F.2d 275, 277 (8th Cir. 1942); Williams v. Union Pac. R.R, 94 F. Supp. 174, 176 (D. Neb. 1950) Dixey v. Fed. Compress & Warehouse Co., 132 F.2d at 277. In Dixey, the plaintiffs cotton was destroyed by a warehouse fire. Id. at 276. Plaintiffs own insurance company loaned plaintiff the value of the cotton that had been destroyed. Id. at 277. The loan was repayable, without interest, only if plaintiff recovered money from another source. Id. at 277. The court held this was a loan and not payment under the policy. Id. at 278. Additionally, after payment by plaintiffs insurance company, plaintiff retained the right to pursue the warehouse owner for plaintiffs loss. Id. at See Bostelman, supra note 92, 13:2.5[A]; Sarbanes-Oxley Act, Interpretive Issues Under Prohibition of Certain Insider Loans, at lawyer.com/pdfs/loanl002.pdf, 1369 PLI/Corp. 623 (Feb. 2003) (also on file with the author).

23 2006] A SMALL QUESTION IN THE BIG STATUTE 379 determines that an officer or director is not entitled to indemnification, were the previously made advancements made for personal reasons? The first place to look for a definition of "personal" would be the statute itself. Nothing in section 402 defines "personal" or explains how a personal loan differs from any other type of loan. However, subsection 2 may help define what constitutes something "personal." Subsection 2 of the statute explicitly excludes certain types of loans from the prohibition set out in subsection 1. The excluded loans are home improvement and manufactured home loans, consumer credit, any extension of credit under an open end credit plan, a charge card, or any extension of credit by a broker or dealer. 131 Because the drafters specifically chose to exclude these loans, the drafters must have felt that these types of loans fell within the types of loans prohibited by the language of subsection 1. In other words, the types of loans listed in subsection 2 are all "an extension of credit, in the form of a personal loan." 13 2 Thus, based on the types of loans set out in subsection 2, one may be able to infer what types of loans are personal. Clearly, the types of loans listed in subsection 2 are loans for use in the borrower's personal life. The types of loans listed have no relation to an officer's or director's position with a company. They are loans that all people may have a need for at one time or another. They are the type of loans that all people can seek through credit granting institutions, such as banks. Advancements would not seem to fall within this definition because the need for advancements arises because of an officer's or director's position with a company. However, nothing in the statute indicates that these are the only types of loans that are "personal." One commentator has suggested that the language of the statute could be interpreted in a completely different manner. The commentator has suggested that "personal" might not mean "non-business," but personal in that the recipient will be personally responsible for repayment. 133 Given this definition, an advancement would be personal, especially if the recipient had signed an undertaking promising to repay if he were not entitled to indemnification. However, this does not seem like the most probable interpretation of the term "personal." Such a definition almost makes the phrase "personal loan" redundant because most people would assume that the recipient of a loan would be responsible for repayment. Such a definition would also appear to be redundant with the term "an extension of credit...to or for any U.S.C. 78m(k)(2) U.S.C. 78m(k)(1) Varallo, supra note 44.

24 CREIGHTON LAW REVIEW [Vol. 39 director or executive officer." If the recipient were not personally responsible for repayment, then it would not be an extension of credit to that person. Other potential sources for interpreting the meaning of "personal" are the state indemnification statutes. Essentially, one could argue that whenever an officer or director is entitled to indemnification under the statute, the purposes of the advancement were not personal. For example, the Delaware statute allows corporations to indemnify officers and directors if they are parties to a suit "by reason of the fact that [he] is or was a director [or] officer." 1 34 Therefore, if an officer or director is entitled to indemnification under the Delaware statute then it would seem that an argument easily could be made that the purpose of any advance was not personal. However, an officer or director is only entitled to indemnification if "[he] acted in good faith and in a manner [he] reasonably believed to be in or not opposed to the best interests of the corporation, and, with respect to any criminal action or proceeding, had no reasonable cause to believe [his] conduct 3 5 was unlawful.' Thus, the officer or director is not always entitled to indemnification. The statute does not permit indemnification essentially when an officer or director has breached his duties to the corporation or has acted criminally. It is exactly these types of situations, when indemnification is not permissible under the statute, that arguably would create a situation in which an advancement became personal because the officer or director was not serving the interests of the corporation. Delaware courts have read the indemnification statute fairly broadly, especially in circumstances when the officer or director has successfully defended himself against a lawsuit or criminal charge. Focusing on the phrase "by reason of," Delaware courts permit indemnification after a successful defense if there is a "causal connection or nexus between" the claim or charge and the "corporate function or 'official [corporate] capacity.'"' 136 Under this test, the motivation of the officer or director is not a factor, even if the motivation was personal gain. 137 However, the indemnification decision is made after the fact and may be dependent on the outcome of the suit, on the findings of fact, or 134. DEL. CODE ANN. tit. 8, 145(a) (a) Perconti v. Thornton Oil Corp., No. Civ. A NC, 2002 WL , at *1, *4 (Del. Ch. May 3, 2002). See also Tafeen v. Homestore, Inc., No. Civ. A. 023-N, 2004 WL , at *1, *4 (Del. Ch. Mar. 22, 2004) (quoting Perconti, 2002 WL , at *4 (Del. Ch. May 3, 2002)); Westphal v. U.S. Eagle Corp., No. Civ. A NC, 2002 WL , at *1, *2 (Del. Ch. Nov. 27, 2002) (same) Tafeen v. Homestore, Inc., No. Civ. A. 023-N, 2004 WL , at *1, *4-5 (Del. Ch. Mar. 22, 2004).

25 20061 A SMALL QUESTION IN THE BIG STATUTE 381 on the terms of a settlement agreement. This would create a timing issue for a decision about advancements because advancements are made at the beginning of and throughout the litigation, not after the case has been resolved. To make the decision about whether advancements were "personal" before the litigation was resolved would require a board of directors to examine the claims made in the suit and to make findings of fact based on the limited allegations in the complaint and other pleadings on file at the time the officer or director seeks the advancements. This would put an unworkable burden on the board and require them to act as a court. Clearly, that is not a position into which anyone would want to put a board of directors. Therefore, because of the timing issues the state indemnification statutes do not seem to provide helpful guidance in interpreting the term "personal." Another area of the law that may provide some guidance is case law interpreting portions of the Internal Revenue Code. Although unrelated to section 402, the Internal Revenue Code makes an important distinction between personal and business. Under the Internal Revenue Code a person may deduct trade or business expenses, 138 but not personal expenses. In the tax context, courts have often addressed the issue of whether attorneys' fees and litigation expenses qualify as a business expense or a personal expense. When faced with such a case, courts use an "origin and character of the claim" test, set out by the Supreme Court in United States v. Gilmore. 139 The test considers the source of the claim, not the consequences of the claim. 140 In other words, a court will consider whether the claim arose from, or proximately resulted from, a person's business A court will not consider whether the outcome of the claim will affect the person's business. 142 Based on this sort of test, advancements would not qualify as "personal" because advancements are only made to an officer or director when he is sued in his capacity as such U.S.C. 162(a) (2000). Section 162(a), in pertinent part, states "(a) In general. There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business United States v. Gilmore, 372 U.S. 39, 49 (1963) Gilmore, 372 U.S. at Id. at Id. at 48. For example, in Gilmore, the Court would not allow a husband to deduct legal fees incurred in his divorce while successfully protecting his interests in several businesses. Id. at 41. These business interests were the primary source of the husband's income. Id. at 42. After successfully protecting his interests during the divorce, the husband sought to deduct his legal fees as a business expense. Id. at 40. The Court found, although the outcome of the divorce proceedings might affect the husband's income earning abilities, the wife's claims arose entirely from the marital relationship, not from the husband's business interests. Id. at

26 CREIGHTON LAW REVIEW [Vol. 39 Using the same approach to differentiate between personal and business for purposes of advancements potentially could result in a narrower definition of what is personal than would result from reliance on the indemnity statutes. For example, a tax court has found that the defense of claims of malfeasance by an officer or director does constitute a business expense A finding of malfeasance would likely prohibit indemnification under the Delaware statute, which requires that the officer or director act in good faith. In the tax context, even when the taxpayer has been accused of criminal activity, courts have allowed a business expense deduction if the criminal activity arose in connection with the taxpayer's business.' 4 4 Using the definition that has evolved from tax law would lead to the conclusion that advancements are never personal in nature because the right to advancement or the right to seek advancement only arises when an officer or director is sued in his capacity as an officer or director. Consequently, an argument can be made that advancements are not "personal" in nature and would not be prohibited by section 402. V. SECTION 402 AND FEDERAL PREEMPTION The issue of preemption arises in several ways under section 402. First, if section 402 does prohibit the advancement of litigation costs and expenses, then state laws permitting such advancements clearly conflict with Sarbanes-Oxley which would make it impossible for a corporation to comply with both state and federal law. Second, if Congress intended Sarbanes-Oxley to occupy the field exclusively, then, whether or not section 402 actually prohibits advancements, it would preempt state laws permitting advancements. If Congress intended to preempt state laws permitting advancements, then it would seem more likely that Congress intended to include advancements in the prohibition of personal loans. Even if Congress, did not intend to include advancements in the prohibition, federal preemption of state advancement laws would leave corporations without a statutory basis for making advancements. Generally, federal statutes will preempt state legislation if (1) Congress explicitly states in the legislation that it intends to preempt state laws, (2) state laws conflict with the federal statute, (3) state laws would frustrate the federal scheme, or (4) from the totality of the 143. Hochschild v. Comm'r, 161 F.2d 817, (2d Cir. 1947) O'Malley v. Comm'r, 91 T.C. 352, 364 (1988) (finding the payment of legal fees for the defense of charges of bribery and fraud were deductible business expenses because the criminal charges stemmed from the taxpayer's attempt to influence a law maker regarding the taxpayer's industry).

27 2006] A SMALL QUESTION IN THE BIG STATUTE 383 circumstances it is clear that Congress intended to occupy the field to the exclusion of the states When a field traditionally has been occupied by the states, courts "start with the assumption that the historic police powers of the states were not to be superseded by the Federal Act unless that was the clear and manifest purpose of Congress." 146 However, when it is clear that Congress has intended to occupy a field, either explicitly through the language of the legislation or implicitly through the structure and purpose of its legislation, then state laws regulating that aspect of commerce are preempted Congress seldom includes explicit preemptive language. 148 Consequently, when explicit preemptive language does not appear in the congressional legislation, courts must consider the implicit preemptive intent of Congress Congress's implicit intent can be discerned from a statutory scheme that leaves "no room for the States to supplement it;" 150 from the existence of an "irreconcilable conflict" with state law; 15 ' when it is a "physical impossibility" to comply with both state and federal law; 15 2 or when the state law creates "an obstacle to the accomplishment and execution of the full purposes and objectives of Congress." 15 3 Furthermore, if federal legislation does not exclude all state legislation in a field, it will preempt any state legislation with which the federal legislation conflicts Nothing in the language of Sarbanes-Oxley explicitly indicates that Congress intended to preempt state legislation dealing with defense advancements to corporate officers and directors. The introductory language to Sarbanes-Oxley states that it is "[a]n Act to protect investors by improving the accuracy and reliability of corporate disclosures made pursuant to the securities laws, and for other purposes."' Section 402 is entitled "Enhanced Conflict of Interest 55 Provisions" and the subsection by which 402 amends section 13 of the Securities and Exchange Act of 1934 is entitled "Prohibition on Personal Loans to Executives." 156 The Act does not contain a preemption 145. Malone v. White Motor Corp., 435 U.S. 497, 504 (1978) Jones v. Rath Packing Co., 430 U.S. 519, 525 (1977) (quoting Rice v. Santa Fe Elevator Corp., 331 U.S. 218, 230 (1947)) Jones, 430 U.S. at Barnett Bank of Marion County, N.A. v. Nelson, 517 U.S. 25, 31 (1996) Nelson, 517 U.S. at Id. at 31 (quoting Rice v. Santa Fe Elevator Corp., 331 U.S. 218, 230 (1947)) Id. (quoting Rice v. Norman Williams Co., 458 U.S. 654, 659 (1982)) Id. (quoting Florida Lime & Avocado Growers, Inc. v. Paul, 373 U.S. 132, (1963)) Id. (quoting Hines v. Davidowitz, 312 U.S. 52, 67 (1941)) Jones, 430 U.S. at Stat. 745 (2002) Public Company Accounting Reform and Investor Protection Act of 2002, S. 2673, 107th Cong. 402 (2002); 116 Stat. 745, 787.

28 CREIGHTON LAW REVIEW [Vol. 39 or overall purpose section. Consequently, if Congress intended to preempt state advancement legislation, its intention must be implicit in the legislation. Obviously, if section 402 does prohibit advancements there would be an "irreconcilable conflict" with state law. Under that situation, section 402 would preempt any state legislation permitting advancements. However, based on the above analysis section 402 does not seem to prohibit advancements. The questions then become whether Congress intended to preempt state laws by creating a scheme of federal regulation "so pervasive as to make reasonable the inference that Congress left no room for the States to supplement it," or whether the Act "touches on a field in which the federal interest is so dominant that the federal system will be assumed to preclude enforcement of state laws on the same subject," or whether the goals "sought to be obtained" and the "obligations imposed" establish a Congressional purpose to preclude state authority The answer to all of these questions, in relation to advancements appears to be "no." Although Sarbanes-Oxley establishes a fairly detailed scheme of corporate disclosure, advancements have little or nothing to do with disclosure. Traditionally, advancements have been part of state statutory schemes that deal with indemnification of corporate officers and directors, not part of statutory schemes that deal with corporate disclosure. 158 Further, historically advancements have been regulated by state law Thus, it does not seem a reasonable inference can be drawn that Congress intended to leave no room for the states in the area of advancements. Nothing in the Act or the legislative history indicates that, at the time of passage, Congress even recognized that section 402 could have an impact on state legislation dealing with advancements. Additionally, there is nothing in the Act to establish Congress felt that the federal interest in advancements was so dominant that it should preclude all state laws on the subject. Finally, nothing in the language of the Act indicates a purpose to preclude state laws regarding advancements. Given that nothing in Sarbanes- Oxley other than section 402 could possibly be construed as dealing with advancement rights, it is difficult to support an argument that Congress intended to occupy the field of advancement rights. However, if Congress did intend to occupy the field, serious problems may arise because state statutes permitting advancements would be invalid. Even if section 402 did not prohibit advancements, if section Wisconsin Pub. Intervenor v. Mortier, 501 U.S. 597, 605 (1991) (quoting Rice, 331 U.S. at 230) See, e.g., DEL, CODE ANN. tit. 8, 145 and surrounding sections John Bostelman, The Sarbanes-Oxley Deskbook, 13:2.5[A] (2005).

29 2006] A SMALL QUESTION IN THE BIG STATUTE 385 preempts state statutes, corporations will be left with no statutory basis for permitting advancements. VI. CONCLUSION Although existing law would support a conclusion that advancements are an "extension of credit," strong arguments can be made that advancements are neither in the form of a "loan" nor are they "personal" in nature. Thus, indemnification advancements would not fall within the prohibition of section 402. Additionally, the legislative history would indicate that lawmakers did not have advancements in mind when they passed section 402. Furthermore, Congress does not seem to have even considered the effect that section 402 may have on advancements. Until this issue is clearly decided by a court or the Securities and Exchange Commission, corporations may want to look more closely at their D&O insurance policies. While most D&O policies do not include advancement rights, some do. Advancements made under a D&O policy would not be prohibited by section 402 because section 402 only limits loans made by "issuers...to or for any director or executive officer (or equivalent thereof) of that issuer.' 60 Because an insured officer or director would not be an officer or director of the company issuing the D&O policy, advancements made under the policy would not fall within the prohibition of section 402. Thus, until this issue is directly addressed, D&O policies that provide for advancements may be the safest way for a corporation to proceed Otherwise, the corporation risks exposure to additional suits regarding the legality of advancements U.S.C. 78m(k)(1) (2000) (emphasis added). 161, D&O policies that provide for advancements are not without drawbacks. Most policies require that costs be reasonable and some policies may require the insurer to consent to the party's choice of counsel. See JOHN F. OLSON ET AL., DIRECTOR AND OF- FICER LIABILITY: INDEMNIFICATION AND INSURANCE 10.07[2] (2001). Further, such policies may even give the insurer some say in decisions regarding litigation tactics. Id. Therefore, there is often some loss of control by the insured to the insurer when advancement claims are made on a D&O policy that allows for them.