The Securities and Exchange Commission (SEC) recently released proposed rules to implement Section 955 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank), which calls for disclosure of whether employees or members of boards of directors are permitted to purchase financial instruments that are designed to hedge or offset any decrease in the market value of company equity securities. Neither Dodd-Frank nor the proposed rules require that a company actually have a hedging policy or that a hedging policy contain any particular terms.
The proposed rules come on the heels of efforts by the major proxy advisory firms in recent years to have companies adopt hedging policies (by treating the absence of such a policy as a basis for recommending “against” votes for sitting directors). In response to these efforts, many companies have begun disclosing in their proxy statements that they have anti-hedging policies for executive officers. If the SEC’s proposed disclosure requirements are adopted in their present form, companies likely would need to reexamine the terms of their existing policies and assess whether changes or clarifications would be appropriate.
Expansive View of Covered Transactions
The proposed rules begin by adopting an expansive interpretation of transactions covered by Section 955 of Dodd-Frank. While that section concerns only the purchase of financial hedging instruments, the SEC has proposed a “principles-based” disclosure regime in which companies would be required to report any transactions under which employees or directors could effectively avoid compensation requirements that they hold stock long-term, thus enabling them to receive their compensation even in the case that their companies do not perform. Such transactions could include:
- the purchase of a financial instrument (including prepaid variable forward contracts, equity swaps, collars and exchange funds);
- short sales; or
- sales of security futures.
As a result of this broadly defined set of covered transactions, the proposed rules suggest companies will need to disclose the categories of permitted and prohibited transactions. The proposed rules recognize that, depending upon how a company defines its policies, there may be an infinite set of either permitted or prohibited transactions. Therefore, disclosures that list permitted transactions and state that all others are prohibited (and vice versa) are acceptable.
Covered Securities – May Include More than the Company’s and Equity Held Outright
The proposed rules define the equity securities covered by the disclosure requirements as any equity securities − as defined by Section 3(a)(11) of the Securities Exchange Act of 1934 (Exchange Act) and its accompanying Rule 3a11-1 − that are registered on a national securities exchange or under Section 12 of the Exchange Act that are issued by:
- the company;
- any parent of the company;
- any subsidiary of the company; or
- any subsidiary of any parent of the company.
For many companies, determining the equity securities covered by the proposed rules likely will be fairly straightforward. However, a company may be required to disclose its policies as a broader array of equity securities, as would be the case, for example, of a company that has undergone reorganization and has a publicly traded subsidiary.
In addition, the source from which an employee or director obtains the equity securities would be irrelevant under the proposed rules. Thus, both compensatory equity securities grants and other equity securities holdings would be covered by the disclosure regime.
Disclosure Required for All Employees and Directors
Following their approach to the transactions and types of equity securities covered, the proposed rules state that companies must report their hedging policies as to all employees, including officers, as well as directors. Such an approach would be an expansion beyond the disclosures companies are required to provide as to their named executive officers in proxy materials.
This aspect of the proposed rules likely will be the subject of comment. It is anticipated that commenters will suggest that hedging policies for employees other than executive officers are not material to shareholders, and thus should not be subject to disclosure.
Disclosure Required Whenever Directors Elected
The proposed rules contemplate companies providing these disclosures whenever action is to be taken as to the election of directors. As a result, companies would be required to include information regarding hedging policies in materials provided to shareholders at annual and special meetings, as well as in connection with an action authorized by written consent.
Interplay with CD&A – Cross References Allowed
As mentioned earlier and required by Item 402(b) of Regulation S-K, many companies already provide disclosures regarding hedging policies applicable to named executive officers as part of the compensation discussion and analysis (CD&A) found in their proxy statements. The proposed rules are intended to operate outside of the CD&A rules, by creating a new Item 407(j) to Regulation S-K. To avoid potentially duplicative disclosures, the proposed rules allow companies to satisfy their CD&A disclosure obligations by cross-referencing the new Item 407(j) disclosures if those disclosures otherwise satisfy the CD&A standards.
Small Reporters, Listed Investment Companies and Emerging Growth Companies Covered
The proposed rules conclude by indicating that they would apply to traditional, publicly traded companies and that there will be no relief for:
- closed-end investment companies that have shares listed and registered on a national securities exchange;
- smaller reporting companies; or
- emerging growth companies.
However, the proposed rules would exempt non-listed closed-end investment companies and foreign private issuers.