At the end of 2018, the SEC dredged up its 2015 rule proposal regarding hedging disclosure (required by Dodd-Frank) and voted to adopt final rule amendments. The amendments mandate disclosure about the ability of a company’s employees or directors to hedge or offset any decrease in the market value of equity securities granted as compensation to, or held directly or indirectly by, an employee or director. As described in the legislative history of the related Dodd-Frank provision, the purpose of the requirement was to “allow shareholders to know if executives are allowed to purchase financial instruments to effectively avoid compensation restrictions that they hold stock long-term, so that they will receive their compensation even in the case that their firm does not perform.” As required, companies have now begun to include the new hedging disclosure in their proxy statements. To see how companies were approaching their responses to the new rule, comp consultant F.W. Cook examined the first 40 proxies that contained the new disclosure (covering the period from August 23, 2019 to October 4, 2019) and provides us with a number of observations that may well be helpful as we head into the new proxy season.
What does the rule require? New Item 407(i) of Reg S-K requires companies to provide a “fair and accurate summary” of the company’s practices or policies (whether or not written) regarding the ability of employees, including officers, and directors (as well as any of their designees) to hedge transactions, including specifically the categories of persons covered and categories of hedging transactions permitted and disallowed. Alternatively, the company can disclose the practices and policies in full. This principles-based approach allows each company, within the broad outlines of Dodd-Frank and the related rule, to “continue to make its own judgments in determining what activities, if any, should be covered by a practice or policy.” As a result, the disclosure will simply reflect the policies or practices the company decides to adopt—or not. If there are no hedging practices or policies, the company must disclose that fact or state that hedging transactions are generally permitted. Notably, the SEC makes clear that nothing in the rule or in the adopting release was intended to suggest that companies must have “a practice or policy regarding hedging, or a particular type of practice or policy. These amendments relate only to disclosure of hedging practices or policies.” Nevertheless, even if disclosure-only, regulation by humiliation tends to work, as many companies will ultimately prefer not to disclose that they have no hedging policy.
The rule does not define the term “hedge,” and the scope of the new disclosure requirement is “not limited to any particular types of hedging transactions.” Instead, the rule applies to financial instruments identified in Dodd-Frank (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, and to other transactions with the same economic effects as the transactions specified by Dodd-Frank. Some examples of hedging transactions identified by the SEC are short sales, borrowing or other arrangements involving a non-recourse pledge of securities and selling a security future that establishes a position that increases in value as the value of the underlying equity security decreases. Although some commenters were concerned about potentially overbroad interpretations of the term—such as portfolio diversification transactions—the SEC concluded that the approach adopted mitigated those concerns: “In this regard, a company would only need to describe portfolio diversification transactions, broad-based index transactions, or other types of transactions, if its hedging practice or policy addresses them.” Disclosure is required regarding equity securities, whether compensatory or otherwise held, regardless of the source of the acquisition.
What amounts to a “practice”? Again, the term is not defined but, as an example, the SEC suggested that “a company that does not have a written hedging policy might have a practice of reviewing, and perhaps restricting, hedging transactions as part of its program for reviewing employee trading in company securities. Similarly, a company might have a practice of including anti-hedging provisions in employment agreements or equity award documentation.”
Notably, the CD&A rules also potentially call for disclosure regarding hedging policies. The CD&A rules, however, are more limited in their reach in that CD&A applies only to the Named Executives Officers. In addition, the CD&A rules require a discussion of hedging policies only to the extent material and do not apply to emerging growth companies or smaller reporting companies. Nevertheless, because there is some potential for duplication, in proxy or information statements with respect to the election of directors, if the information disclosed under new Item 407(i) would satisfy the CD&A obligation to disclose material policies on hedging by NEOs, the company may elect to simply cross-reference the new 407(i) disclosure in CD&A. That cross-reference would, however, make the 407(i) disclosure subject to say-on-pay votes, which would not otherwise be required.
Most companies will be required to comply with the new rule in proxy and information statements for the election of directors during fiscal years beginning on or after July 1, 2019. And, for EGCs and SRCs, the disclosure will be required in proxy and information statements for the election of directors during fiscal years beginning on or after July 1, 2020. (See this PubCo post and this Cooley Alert.)
It’s also worth noting that ISS and Glass Lewis generally view hedging as a problematic practice. Hedging constitutes, in ISS’ view, a type of governance failure in risk oversight that could lead to a recommendation “against” a director, committee or the full board, if material. Glass Lewis’ view is that hedging de-links the alignment of executives’ interests with that of shareholders, and the firm favors strict anti-hedging policies. However, Cook notes, these firms have historically focused on executives, and it’s not whether their views of best practice extends beyond executives.
Companies that want to adopt hedging policies will need to consider how broadly or narrowly to craft them.
Who should be subject to the policy? As the SEC noted, there is no requirement that companies have a hedging policy. But, no surprise here: all 40 companies reviewed by Cook did disclose that they had hedging policies in place. Of the 40 companies, 62% had hedging policies applicable to directors and all employees, 33% covered directors and executives only and 5% were undisclosed.
Cook suggests that companies may want to look at “which particular groups of employees have the ability to significantly affect overall company performance, as well as the financial ability of such employees to hold employer stock.” If these are not significant for an employee, “a company may consider whether it is appropriate to subject him or her to a company’s hedging policy. One may argue that subjecting such employees to a hedging policy is counterproductive. Some employees who might have otherwise purchased company stock or held shares received through equity incentive awards will choose not to do so if they cannot hedge the risk of loss.” Companies may also want to take into account which employees are more likely to hold employer stock, such as employees required to hold a substantial amount of stock as a result of stock ownership guidelines. Similarly, wide coverage may make sense for a smaller highly compensated employee population or where equity grants are widely dispersed throughout the employee base.
Another factor that Cook suggests companies look at is their ability to enforce the policy. If the persons covered are subject to stock ownership guidelines, there may already be a mechanism in place to monitor transactions. But enforcement of the policy prohibition for the entire employee population could be much trickier. Employees may require education about the types of transactions that are prohibited or may not be receptive to the imposition of policy restrictions. What’s more, the risk of noncompliance in a larger population would likely be greater, and, if not relying on an honor system, the company would need to determine how to monitor transactions among the broad employee base and how to address policy violations.
In addition, Cook suggests that, in determining the scope of a hedging policy, companies may also want to take into consideration the breadth of transactions covered. For example, if the policy covers only hedging and not other derivative transactions generally, it may make sense to apply coverage more narrowly: “if the policy only covered transactions that hedged the risk of stock ownership, a company might conclude that there is less reason to extend the policy to employees not subject to stock ownership guidelines.” In addition, Cook observes that certain types of derivative transactions, such as “puts” that have value only if the stock price drops—so that the purchase of the put is a bet against the company—may be so antagonistic to “company values” that the company may want to prohibit them across the entire employee population.
What types of transactions should be covered? Cook found that, of the 40 companies reviewed, 43% reported that their policies covered only hedging transactions in company stock and 58% disclosed that their policies prohibited both hedging transactions and derivative transactions generally, whether set forth in hedging policies or in prohibitions under the company’s insider trading policy. Cook suggests that companies may have elected to cover derivative transactions generally because they convey “the appearance of insider trading, reflect undesired speculative trading, increase the risk of a securities law violation, and/or possibly alter employees’ alignment with the company’s best interests (for example, by encouraging short-term thinking).” However, Cook found no significant correlation between the scope of personnel and the range of transactions covered.
What should be disclosed and where should we locate the disclosure? All companies reviewed by Cook included summaries of their policies as opposed to disclosing the entire policy, as permitted by the rule. As noted above, the SEC permits the disclosure regarding the policy to be included in CD&A, even if it also applies to non-executive employees. Cook observed that 60% of the companies reviewed included their disclosure only in CD&A, 15% located it outside of CD&A and 25% included the policy disclosure both in CD&A (presumably just the part related to NEOs) and elsewhere in the proxy.