Briefing

The SEC has proposed new rules which would require US reporting companies to disclose whether their employees are permitted to purchase financial instruments or otherwise engage in transactions designed to or have the effect of hedging.

Introduction

The US Securities and Exchange Commission has proposed new rules which would require US reporting companies to disclose whether their employees (including officers) or directors, or any of their designees, are permitted to purchase 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 either granted to the employee or board member as compensation or held directly or indirectly by the employee or board member. The proposed disclosure would be required in any proxy statement or information statement relating to an election of directors, whether by vote of security holders at a meeting or an action authorized by written consent.

The proposed rules – mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010 – are meant to provide transparency to shareholders about whether employees or directors are permitted to engage in transactions that mitigate or avoid the incentive alignment associated with long-term ownership of company equity securities. Under the SEC’s current rules, disclosure of company policies regarding hedging is identified as an example of disclosure that may be included in the Compensation Disclosure & Analysis (CD&A) but applies only with respect to named executive officers. Comments are due on the proposed rules within 60 days of the proposal’s publication in the Federal Register; consequently, the rules will not yet be in effect for the 2015 proxy season.

Transactions subject to disclosure

The proposed rules would require disclosure in accordance with the following guidelines:

  • a company should disclose which categories of hedging transactions it permits or prohibits;
  • if certain hedging transactions are prohibited, the company must specifically disclose the categories of transactions it specifically prohibits, and may, if true, disclose that it permits all other hedging transactions in lieu of listing all permitted categories (e.g., “we prohibit prepaid variable forward contracts but permit all other hedging transactions”);
  • conversely, where a company specifies only the hedging transactions that it permits, in addition to disclosing the particular categories of transactions permitted, it may, if true, disclose that it prohibits all other hedging transactions in lieu of listing all of the prohibited categories (e.g., “we permit exchange fund transactions but prohibit all other hedging transactions”);
  • if a company does not permit any hedging transactions or permits all hedging transactions, it must state so and would not need to describe them by category;
  • if a company permits hedging transactions by some, but not all, of the categories of persons covered by the proposed rules, the company would disclose both the categories of persons who are permitted to hedge and those who are not (e.g., “we prohibit all hedging transactions by executive officers and directors, but do not restrict hedging transactions by other employees”); and
  • a company that permits hedging transactions must disclose sufficient detail to explain the scope of such permitted transactions (e.g., if a company permits hedging of equity securities that have been held for a specified period of time, the company must disclose the period of time the securities must have been held).  

Equity securities subject to disclosure

The proposed rules require disclosure of whether employees and directors may hedge “equity securities” – defined to include any equity securities issued by the company, any parent of the company, any subsidiary of the company or any subsidiary of any parent of the company that are registered under Section 12 of the Securities Exchange Act of 1934 (the “Exchange Act”). The proposed rules would only apply to such equity securities that are registered on a national securities exchange or registered under Exchange Act Section 12(g) and would cover equity securities granted pursuant to compensatory equity grants and other equity securities held by an employee or director.

Employees and directors subject to the disclosure requirements

The proposed rules would cover hedging transactions conducted by any employee, officer or director of the company or any of their designees. With respect to “designees” of employees or directors, the proposed rules state that a “designee” would be determined by a company based on the particular facts and circumstances. The SEC’s proposing release solicits comment on whether the definition of “employee” should be limited to employees that participate in making or shaping key operating or strategic decisions that influence the company’s stock price. The release also solicits comment on whether to add an express materiality condition to the definition to permit each issuer to determine whether disclosure about all of its employees would be material information for investors.

Location of disclosure

The proposed disclosure would be required in any proxy statement or information statement relating to an election of directors, whether by vote of security holders at a meeting or an action authorized by written consent. However, it would not be required in any registration statement pursuant to the Securities Act of 1933 (the “Securities Act”) or the Exchange Act, and would not be required in any Form 10-K. The disclosure also would not be deemed to be incorporated by reference into any filing under the Securities Act, the Exchange Act or the Investment Company Act of 1940.

Issuers subject to the rule

The proposed disclosure would apply to companies subject to the federal proxy rules, 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. Funds, other than listed closed-end funds, would not be required to provide the proposed disclosure. Foreign private issuers also would be exempt since they are not subject to the proxy statement requirements of Section 14 of the Exchange Act.

Relationship to CD&A

The SEC’s Compensation Discussion and Analysis (“CD&A”) rules currently provide that disclosure of a company’s security ownership requirements for named executive officers and any company policies regarding hedging the economic risk of such ownership is an example of the kind of information that should be provided in the CD&A if material. Unlike the SEC’s new proposal, the CD&A requirement applies only with respect to named executive officers and is not applicable to smaller reporting companies, emerging growth companies, registered investment companies or foreign private issuers. To reduce potentially duplicative disclosure in proxy and information statements, the SEC’s new proposal states that a company may satisfy its CD&A obligation by cross referencing the information disclosed pursuant to the new disclosure requirement to the extent it satisfies the CD&A disclosure requirement.

Conclusion

The proposed new rules require disclosure, but do not prohibit hedging and do not require or endorse any particular policy regarding hedging. In addition, the disclosure is proposed to be included within the corporate governance disclosures rather than the compensation disclosures and, as a result, would not be subject to shareholder say-on-pay votes to approve the compensation of named executive officers. Although the proposed new rules will not be in effect for the upcoming proxy season, we believe that companies should take them into consideration when adopting or revising their hedging policies and when drafting proxy statement disclosure regarding their hedging policies.