I have posted on the SEC’s new hedging disclosure rules a couple of times before (see, SEC Adopts Final Rules on Hedging Policies (Dodd-Frank Section Act 955)). However, there are at least three more issues to cover, including what constitutes hedging, who should the hedging policy cover, what about pledging, and more, which I will do in a series of blogs. Today, we’ll talk about what constitutes hedging under the SEC’s new disclosure rules.
The rules make it clear that the SEC intends the disclosure requirement to apply very broadly. “Establishing downside price protection is the essence of the transactions contemplated by Section 14(j).” The SEC declined even to state that the purchase and sale of mutual funds, index funds, and other diversified investment vehicles were excluded from the definition of hedging.
Item 407(i) as adopted does not define the term “hedge” because we believe the language of Section 14(j), which refers to financial instruments “that are designed to hedge or offset any decrease in the market value” is clear and indicates that “hedge” should be applied as a broad principle.
However, the SEC resisted all requests to provide a definition of hedging, instead placing that burden entirely on the company (and counsel). The SEC declined even to state that the purchase and sale of mutual funds, index funds, and other diversified investment vehicles were excluded from the definition of hedging. By focusing on the company’s practices or policies, the SEC intends to avoid adopting a definition that could prove either over- or under- inclusive, and allows for flexibility to address new downside price protection techniques as they develop. The first reporter to call us after the SEC’s release of the final rules asked: “Do you think companies should just ban these practices?” I replied, “Ah, but that’s the rub, without any definition of ‘hedging,’ who can tell what is banned?”
So what is a company to do? Should the company attempt to define hedging or provide examples of what sorts of transactions are prohibited? Questions already have arisen as to whether the activities of private equity or other investment firm in which a director is a partner, employee, or principal be considered hedging.
Our current thinking is that companies should not provide examples of what types of transactions are expressly permitted or prohibited. However, we believe that some companies provide limited examples of what sorts of transactions are permitted or prohibited. For example, a policy could state that covered employees may purchase/invest in mutual funds such as an S&P 500 index fund. But broad permission to invest in index funds may not be appropriate for some companies where industry-specific mutual funds are available.
Despite its disinclination to provide a definition of “hedging,” the language of the SEC release provides some specific references to transactions that it regards as hedging, including the following:
- financial instruments (including prepaid variable forward contracts, equity swaps, collars, and exchange funds)
- a short sale that hedges the economic risk of ownership
- entering into a borrowing or other arrangement involving a non-recourse pledge of securities
- selling a security future that establishes a position that increases in value as the value of the underlying equity security decreases
- some transactions that involve pledges of the underlying company equity securities as collateral
The SEC’s focus on the company’s practices or policies, rather than a specific definition that could prove either over- or under- inclusive, leads us to conclude that the policies adopted by a company should avoid too high a degree of specificity. As the SEC release itself states, for example, 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.
Finally, I want to draw your attention to an upcoming conference organized by our friend and long-time member Bruce Brumberg and myStockOptions.com, for financial, legal, and advisors working with or aspiring to counsel executives, directors, and high-net-worth employees at public and pre-IPO companies. The Financial Planning for Public Company Executives & Directors conference will be in San Francisco on June 18, 2019.