The Securities and Exchange Commission (SEC) recently released long-awaited proposed rules, as mandated by Section 955 of the Dodd-Frank Act, that would require a public company to disclose whether the company permits its employees, officers or directors to purchase financial instruments or otherwise engage in transactions that “hedge” their exposure to risk related to the company’s equity securities that they hold. The proposed disclosure would help investors evaluate whether the interests of a company’s directors and employees are aligned with the interests of shareholders. Comments on the proposed rules are due by April 20, 2015. The proposed rules do not include a proposed date for when the disclosure would first be required.
This update summarizes key highlights from the proposed rules and offers practical guidance.
Summary of the Proposed Rules
The proposed rules would add new paragraph (i) to the existing corporate disclosure requirements in Item 407 of Regulation S-K. As proposed, Item 407(i) would require companies to disclose in any proxy or information statement relating to the election of directors whether the company permits any employee, officer or director of the company (or his or her designee) to purchase any financial instruments or otherwise engage in transactions that are designed to or have the effect of hedging or offsetting any decrease in the market value of equity securities that the employees, officers or directors receive from the company as compensation or that they otherwise hold, directly or indirectly.
New Disclosure Required for All Domestic Public Companies. The new disclosure requirement would apply to all companies with securities registered under Section 12 of the Exchange Act, including smaller reporting companies, emerging growth companies and exchange-listed closed-end funds, but would exclude foreign private issuers, non-listed closed-end funds and unit investment trusts.
Broad Definitions for Employee and Designee and Types of Arrangements Covered. The term “employee” is broadly defined to include everyone employed by an issuer, including its officers. Whether someone is a “designee” of an employee or director would be determined by the company based on the facts and circumstances. The new disclosure requirements would apply to a wide range of derivatives and financial transactions, including collars, equity swaps, exchange funds, prepaid forwards, short sales and the sale of a single stock futures contract on the company’s stock.
Specific Disclosure Required. A covered company would be required to:
disclose which categories of hedging transactions it permits and which categories of hedging transactions it prohibits;
describe the scope of any permitted hedging transactions, including whether preapproval is required and whether a holding period or stock ownership guidelines apply before hedging will be permitted; and
specify whether any permissions or prohibitions apply to some (but not all) of its employees or directors.
No Specific Policy Required. The proposed rules are aimed at disclosure and providing transparency to shareholders about whether “employees or directors are permitted to engage in transactions that mitigate or avoid the incentive alignment associated with equity ownership.” Neither the provisions of the Dodd-Frank Act nor the proposed rules require companies to have a policy on hedging or to prohibit hedging. However, Institutional Shareholder Services (ISS) has stated that it views any amount of hedging of company stock by directors or officers as a “failure of risk oversight” that may lead to voting recommendations against individual directors, individual committee members or the full board of directors. Glass Lewis also has indicated that it will object to the absence of a policy that prohibits hedging by insiders.
How Does This Relate to Existing Hedging Disclosure Requirements? Item 402(b) of Regulation S-K currently requires companies to disclose in their Compensation Disclosure and Analysis (CD&A) their hedging policies related to named executive officers if this information is material to understanding their executive compensation arrangements. Emerging growth companies, smaller reporting companies and registered investment companies are not required to provide any CD&A disclosure. The disclosure requirements under the proposed rules would be substantially broader and more specific and would apply to a wider range of public companies than the existing disclosure required under Item 402(b).
SEC Staff Concerns With the Current Form of Proposed Rules
Although the SEC has approved the issuance of the proposed rules, Commissioners Daniel M. Gallagher and Michael S. Piwowar issued a joint statement that identified concerns with respect to several aspects of the proposal, including:
the application of the disclosure requirements to hedging policies applicable to lower-level employees who are unable to affect the company’s share price;
the failure of the proposed rules to exempt emerging growth companies or smaller reporting companies;
the application of the proposed rules to listed closed-end funds and a related request for comment on whether the disclosure requirements should apply to open-end mutual funds; and
the application of the disclosure obligation not only to securities of the issuer but also to equity securities of any subsidiaries, parent companies and brother-sister companies of the issuer that that are registered under Section 12 of the Exchange Act.
In addition, the SEC is soliciting public comment on a large number of questions that could affect the classes of companies to which the final rules would apply as well as the employees and securities that would be subject to disclosure under the final rules.
Companies Should Take a Wait-and-See Approach. Companies should review their existing policies on hedging with an eye toward the proposed rules. However, given the current questions surrounding the scope and substance of the proposed rules, companies should generally wait for the SEC to adopt the final rules before amending existing anti-hedging policies or considering whether to adopt anti-hedging policies in response to the new disclosure requirements. Companies should also evaluate whether existing disclosure controls and procedures may require updating for the new disclosure requirements and should consider the timing and logistics for collecting the information that would be required to be disclosed under the proposed rules.
You can find a copy of the full text of the proposed rules here.