The Securities and Exchange Commission (“SEC”) proposed hedging disclosure rules[i] recently that would implement Section 955 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”). The SEC proposal would require, primarily through an amendment to Item 407 of Regulation S-K, that public companies disclose, in their proxy statements and consent solicitations distributed in connection with an election of directors, whether directors, officers and employees of the company are permitted to engage in transactions to hedge the value of company stock. The proposed rules would not require that any company prohibit hedging transactions or adopt hedging policies.
There are current disclosure obligations with respect to hedging policies in Item 402(b) of Regulation S-K, but these obligations only apply to named executive officers. The CD&A requires disclosure of material information necessary to understand the company’s compensation policies and decisions regarding named executive officers. The rule lists, as an example of information to be disclosed, policies regarding hedging of economic risk of equity ownership, if material. The SEC has proposed that, if the company’s disclosures under new Item 407(i) would satisfy its CD&A disclosure requirement with respect to material hedging transactions, then that company’s CD&A may simply cross-reference to the Item 407(i) disclosure. This cross-reference would, however, subject the hedging disclosure to say-on-pay votes.
Officers and directors of public companies are also subject to disclosure obligations under Section 16(a) of the Exchange Act and must report hedging transactions involving one or more derivative securities within two business days on Form 4.
Under Dodd-Frank, covered transactions involve the purchase of financial instruments (including prepaid variable forward contracts, equity swaps, collars and exchange funds) that are designed to hedge or offset any decrease in the market value of equity securities. The SEC proposal expands the scope of Dodd-Frank to cover all transactions with economic consequences comparable to the purchase of the financial instruments specified in Dodd-Frank. A short sale, for example, would not be deemed a financial instrument but could effectively hedge a decrease in the market value of equity securities. The SEC favored the principles-based approach in its proposal as a means of offering shareholders more complete disclosure, to avoid encouraging directors and employees to favor transactions not covered by the disclosure obligations and to be consistent with the standard used in the CD&A.
While the scope of covered transactions is broader under the SEC proposed rule than under the Dodd-Frank language, the SEC suggests that company disclosure would not have to list each hedging transaction prohibited or permitted. As an example, if only a few transactions are prohibited, the disclosure could list the transactions prohibited and indicate that all other forms of hedging are permitted. Instruction 4 to proposed Item 407(i) somewhat inconsistently reads that “a registrant that permits hedging transactions shall disclose sufficient detail to explain the scope of such permitted transactions.” The SEC has requested comment on whether a company would need to specifically list both permitted and prohibited transactions to make an effective disclosure.
“Equity securities” as used in proposed Item 407(i) would mean equity securities (as defined in Exchange Act Section 3(a)(11) and Exchange Act Rule 3a11-1) issued by the company, any parent of the company, any subsidiary of the company or any subsidiary of any partner of the company that are registered under Section 12 of the Exchange Act. The SEC has requested comment on whether this disclosure requirement is effective or whether it should be limited.
The proposed rule would cover hedging against equity securities granted as compensation in addition to equity securities held, directly or indirectly, by the employee or member of the board of directors. Therefore, the disclosure obligation would cover transactions intended to hedge a decrease in the market value of securities purchased in the open market. The SEC elected to cover all equity securities held by the employee or director based on the premise that a shareholder should be aware if a director, officer or employee’s interests are not aligned with the shareholders, regardless of how those equity securities were acquired.
The proposed rule would cover transactions by employees (including officers as well as employees that generally would not be in a position to impact the share price) and directors and their respective designees. The proposed rule would require disclosure specifying whether certain directors, officers or employees are prohibited from engaging in hedging transactions while others are not. Disclosure of hedging policies under the proposed rule is broader than the current CD&A disclosure requirement, which is limited to hedging policies applicable to named executive officers.
The proposed rule would cover any company with securities registered pursuant to Section 12 of the Exchange Act of 1934, including emerging growth companies, smaller reporting companies and registered investment companies. By contrast, emerging growth companies, smaller reporting companies and registered investment companies are not required to provide CD&A disclosure required by Item 402(b). The SEC acknowledged that this would result in greater initial costs to these companies but did not expect the proposed rule to constitute a substantial, incremental burden. The SEC has requested comment on whether smaller reporting companies or emerging growth companies should be exempt or subject to a delayed implementation schedule.
The SEC released the proposed rules seriatim and raised a number of questions in its proposed rule that it has asked us to consider. Commissioners Gallagher and Piwowar issued a Joint Statement on the Commission’s Proposed Rule on Hedging Disclosures that also raised a number of questions for consideration and comment.[ii]
In addition to the issues raised above, other issues to consider include:
The comment period will expire on April 20, 2015.
While the SEC rules are not yet final, hedging policies are attracting attention.[iii] Companies may want to take this opportunity to adopt policies or review their existing policies in light of the issues addressed by the proposing release.
Emerging growth companies and smaller reporting companies, in particular, may want to begin evaluating whether to adopt a hedging policy, since the proposed rule did not exempt or permit delayed implementation by emerging growth companies and smaller reporting companies.
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