On February 9, 2015, the Securities and Exchange Commission (“SEC”) made progress in its Dodd-Frank rulemaking by proposing regulations (the “Proposed Rules”) that Commissioner Aguilar described as being necessary because --
- “hedging transactions could permit individuals to receive incentive compensation, even where the company fails to perform and the stock value drops”; and
- “[j]ust as problematic, hedging transactions can be structured so that executives or directors monetize their shareholdings while they still technically own the stock, which makes the fact that the hedging took place less transparent to investors.”[i]
Interestingly, the SEC did not confine its Proposed Rules to executive officers and directors. Nor does the proposal relate only to transactions that hedge against equity-based awards. In addition to directors and officers, the Proposed Rules extend to all employees, whom may own very small portions of the company. The Proposed Rules also include any hedging transaction that affects these individuals’ stock awards or direct stock ownership of the company’s securities (or those of any parent or subsidiaries of theirs).
The SEC’s emphasis on governance reflects the views of influential proxy advisor ISS, which since 2013 has considered any hedging or significant pledging of company stock to be “failures of risk oversight” that warrant negative voting recommendations against those directors who are responsible.[ii] Similarly, Glass Lewis has stated in its guidelines for the 2015 proxy season that –
“the hedging of shares by executives in the shares of the companies where they are employed severs the alignment of interests of the executive with shareholders. We believe companies should adopt strict policies to prohibit executives from hedging the economic risk associated with their share ownership in the company.”
With respect to pledging, Glass Lewis’s 2015 guidelines articulate general preference for stock ownership by executives, but (like ISS) articulates a multi-factor facts and circumstances approach.
Since 2006, the SEC has required proxy statement disclosure of executive pledges of stock as collateral.[iii] Nonetheless, it has been reported that an ISS survey in 2012 found that –
- at least one executive or director pledged shares as collateral in fifteen percent (15%) of the Russell 3000 Index companies,
- $57,000,000 was the average amount of company stock pledged and with the median being just over 5,000,000; and
- executive and director pledging of company shares occurred at approximately sixteen percent (15.8%) of S&P500 companies.
The breadth of usage and dollars shown in these results may explain why the SEC made the Proposed Rules applicable to all companies subject to the ’34 Act, including smaller reporting companies, emerging growth companies, business development companies, and registered closed-end investment companies with shares listed and registered on a national securities exchange. Further, the Proposed Rules apply a principles-based disclosure approach. They require any proxy or information statement for the election of directors to disclose whether the company permits any employee, executive, or director to “purchase 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 company equity securities” (Dodd-Frank Act §955).
Overall, because the hedging and pledging of company stock are widely considered to reflect poor corporate governance practices, the boards of public companies should take thoughtful action in 2015. In so doing, they should carefully analyze and update their insider trading policies. ISS recently reported that the policies of approximately fifty-four percent (54.3%) of Russell 3000 Companies and eighty-four percent (84%) of large capital S&P500 companies prohibit employees from hedging company shares. Outright prohibitions are worth considering, as well as other diversification strategies, such as programs that are carefully designed – with an eye to Code §409A -- to allow the conversion of equity awards into deferred compensation that has a self-directed rate of return.
If the boards of public companies take healthy steps in 2015, they will be well positioned to signal good governance when the SEC’s final hedging disclosure rules take effect (likely for, or before, the 2016 proxy season).