Although just shy of its second birthday, the impact of the Sarbanes-Oxley Act ("Sarbox") has been so significant that many experts now believe that it is the single most important piece of legislation affecting corporate governance and financial reporting since the Securities and Exchange Act was enacted in the 1930s. Officially referred to as the "Public Company Accounting Reform and Investor Protection Act," Sarbox mandates that companies make new disclosures on such far-reaching corporate governance issues as internal controls, ethics codes and the makeup of certain audit committees.

Section 404 of Sarbox has recently received the most attention in the financial press, and requires companies to perform a self-assessment of the risks for business processes that affect its financial reporting. Public companies with a market capitalization of $75 million or more must comply with Section 404 for their fiscal year ending on or after June 15, 2004. With June deadline fast approaching, publicly traded companies are scurrying to implement expensive software systems and controls that will hopefully put them in compliance.

Those in the executive suite and boardroom had a much more personal taste of just how potent Sarbox can be, and the reason is something called "split dollar" life insurance.

Split dollar isn’t a kind of life insurance policy; rather, it is a term used to describe the way in which the company and the participant split the costs and benefits of a permanent life insurance policy. The company typically pays 100% of the premiums, but those premiums are returned to the company out of the life insurance proceeds at the executive’s death or out of the policy’s cash value if the plan is terminated before the executive dies.

Split dollar plans were traditionally established in two ways. The first is the so-called "endorsement" method where the policy is corporate-owned and the employee is allowed to name a personal beneficiary of the proceeds in excess of the corporation’s premiums via a policy "endorsement." The second is the "collateral assignment" method where the policy is owned by the insured or a trust, and the corporation and the beneficiary split the proceeds according to collateral assignment.

Starting in the mid-1980s, it was not all that uncommon to have company-paid life insurance programs such as split dollar included as part of the traditional benefit package provided to executives and directors. In some cases, life insurance was individually negotiated as part of an executive’s employment contract. In other cases, a company-wide fringe benefit program would provide split dollar life insurance to executives once they attained a certain level in the organization.

With confiscatory estate tax brackets, split dollar life insurance programs became a very popular way for executives and directors to pre-fund their future estate settlement costs. By having a life insurance policy owned by an insurance trust, and by having those life insurance premiums paid for by the company using split dollar, a very efficient process was created that allowed for the executive’s estate to pass 100% intact to the next generation, with the corporation recovering 100% its premium outlays.

A quick proxy search on EDGAR, the Securities and Exchange Commission’s online database, gives an indication of just how widespread split dollar life insurance programs became over the past 15 years. Many of the nation’s most prominent executives and directors, as well as those with less marquee names, found split dollar to be an attractive and very efficient fringe benefit. Then came Sarbox and its "personal loan" prohibitions.

Under Section 402 of Sarbox, an issuer is prohibited from extending credit in the form of a "personal loan" to executives and directors. When Sarbox was enacted in mid-2002, Section 402 had a chilling effect on all existing split dollar arrangements. Many tax experts and corporate compensation advisors interpreted Section 402 as prohibiting the payment of split dollar premiums. The concern was that split dollar policies were really interest-free loans from the corporation, and therefore prohibited "personal loans" for Section 402 purposes.

When Sarbox first hit, executives and directors in public companies with existing split dollar plans were forced to scramble to find a solution for their executives and directors. The fact that policies had premiums coming due that needed to be paid only added to the confusion. Some companies took the easy way out and simply bonused the executives the necessary premiums. The picture was even less clear for newly hired executives who might have become eligible to participate under their company’s existing "master" split dollar program.

Sarbox put the advisor community in a state of confusion. Many law firms issued "marketing" opinions which outlined their beliefs about the issues, but these marketing opinions are well short of the "more likely than not" standard that most clients require before they would consider moving forward with a transaction. As a result, many long-standing split dollar programs are "frozen" right now.

In a recent development, one of the nation’s largest law firms authored an opinion letter which takes the position that an endorsement split dollar arrangement should not be treated as the extension of credit for Sar-Box purposes. Many states require opinion letters to describe the likeliness of success. While some opinion letters contain a "more likely than not" standard, the letter authored by this firm is a "should" opinion letter, which is a much higher standard.

Under the terms of the particular endorsement split dollar agreement discussed in the letter, the corporation was entitled to receive the greater of its premiums paid or the policy’s cash surrender value. Furthermore, the executive assigned all of his interest in the endorsement agreement to a life insurance trust. This appears to be a classic case of an executive with a significant estate tax exposure deciding to use split dollar to "pre-fund" that liability. Ensuring that estate taxes are paid would seem to be something the government would want to encourage, not discourage!

In this regard, the letter reviewed the law and found that neither the Federal Reserve Board nor the SEC ever considered split dollar plans personal loans. In fact, three "supervisory letters" issued by the Federal Reserve determined that split dollar plans did not involve the extension of credit, and the Federal Deposit Insurance Corporation, Office of Thrift Supervision and Office of the Comptroller of the Currency each issued official guidance that defined split dollar plans as being compensation-based and not personal loans.

The significance of this development cannot be overstated. This is the first reported instance of a large, national law firm opining that Sarbox does not bar the payment of split dollar premiums on behalf of an executive in a publicly traded corporation. HR representatives, benefits consultants, and all those charged with administering split dollar plans for executives and directors should consider whether their past practices were in fact correct.