The Securities and Exchange Commission (SEC) approved final rules requiring U.S. public companies to disclose in proxy or information statements for the election of directors any practices or policies regarding the ability of employees (including officers) or directors to engage in hedging transactions with respect to company equity securities.1 The purpose of the requirement is to provide transparency to shareholders at the time they are asked to elect directors, about whether a company’s employees or directors may engage in transactions that could reduce the extent to which their equity compensation and equity holdings are aligned with shareholder interests. The rules do not require a company to prohibit hedging transactions or implement hedging policies or practices or dictate their content.
Highlights of the rules
- New Item 407(i) of Regulation S-K requires a company to describe any practices or policies it has adopted regarding the ability of its employees (including officers), directors or their designees to purchase financial instruments, or otherwise engage in transactions, that hedge or offset, or are designed to hedge or offset, any decrease in the market value of company equity securities.
- A company can satisfy this requirement by either providing a fair and accurate summary of the practices or policies that apply, including the categories of persons they affect and any categories of hedging transactions that are specifically permitted or disallowed, or alternatively, by disclosing the practices or policies in full.
- If a company does not have hedging practices or policies, the rules require the company to disclose that fact or state that hedging transactions are generally permitted.
- The equity securities for which disclosure is required are equity securities of the company, any parent of the company, any subsidiary of the company, or any subsidiary of any parent of the company.
- The new disclosure is required in proxy or information statements relating to the election of directors.
What types of hedging transactions do the rules cover?
The term “hedge” is not defined in the rules and the scope of the new disclosure requirement is not limited to any particular type of hedging transaction. In the SEC’s view, downside protection is the “essence” of the transactions contemplated by Section 14(j) of the Exchange Act. The rules take a principle-based approach and cover disclosure of not only the use of financial instruments (including prepaid variable forward contracts, equity swaps, collars and exchange funds), but also require disclosure of transactions designed to have the same economic effect as these types of financial instruments.
What is a company required to disclose?
A company is required to describe any practices or policies that it has adopted regarding the ability of its employees (including officers) or directors, or any of their designees, to purchase financial instruments or otherwise engage in transactions that hedge or offset, or are designed to hedge or offset, any decrease in the market value of registrant equity securities. The description must provide a "fair and accurate" summary of the practices or polices that apply, including the categories of persons covered, or disclose the practices or policies in full. For example, if a company prohibits hedging by executive officers and directors but does not prohibit other employees from engaging in hedging transactions, the company is required to disclose both categories of persons. If a company specifically permits certain categories of hedging transactions or disallows specific categories of hedging transactions, the disclosure must describe each of those categories. There is no obligation to disclose any particular hedging transaction that an employee or director may have engaged in with respect to the company’s equity securities because this type of information would be duplicative of the disclosures required by Section 16 reports for executive officers and directors and was deemed too burdensome by the SEC for companies to report with respect to other employees.
What if a company does not have hedging practices or policies?
If a company has not adopted hedging policies or does not have hedging practices, it is required to disclose that fact or to state that hedging transactions are generally permitted.2 Hedging policies do not necessarily need to be written to trigger disclosure. For example, if a company does not have a written policy but has a practice of reviewing and restricting hedging transactions as part of its insider trading monitoring, those practices would need to be disclosed. Also, if a company has a practice of including hedging prohibitions in employment contracts or equity award agreements, disclosure under Item 407(i) could be triggered.
Who does the rule cover?
The rules require disclosure of practices or policies that apply broadly to anyone employed by the company, including officers, and all members of the board of directors. The rules also apply to “designees” of employees and directors, but the SEC did not provide any guidance on who should be considered a designee. Because companies with hedging practices or policies will ultimately determine who is covered by the scope of their practice or policy, the SEC elected not to define the term “designee” and to instead defer to companies to make this determination.3 The rules do not specifically cover consultants.
What is a “registrant equity security”?
Although Section 14(j) of the Exchange Act refers to “equity securities,” which could be interpreted to cover any equity security that an employee or director holds, the rules make clear that the scope is limited to those equity securities defined in Section 3(a)(11) of the Exchange Act that are issued by the company or by any parent of the company, any subsidiary of the company or any subsidiary of any parent of the company. Whether the equity securities are covered under the rules does not depend on whether they are registered under Section 12 of the Exchange Act. Instead, the company’s practices or policies will determine which classes of securities are covered. For example, to the extent a company has different policies or practices for different classes of equity securities, the company’s disclosure should reflect that fact. The rules cover equity securities that a company grants to an employee or director as part of her or his compensation or that are otherwise directly or indirectly held by the employee or director no matter how acquired. The rules do not define the term “held, directly or indirectly” and instead defer to companies to describe the scope of their hedging practices or policies, which may include whether and how they apply to securities that are indirectly held.
What SEC filings are required to contain the new hedging disclosure?
The only SEC disclosure documents that are required to contain hedging disclosure under Item 407(i) of Regulation S-K are proxy statements filed on Schedule 14A and consent solicitation and information statements filed on Schedule 14C, in each case, when action is to be taken to elect directors. Item 407(i) information is not required in Form 10-K Part III disclosure even if that disclosure is incorporated by reference from the company’s definitive proxy or information statement or in registration statements.
How does Item 407(i) relate to existing compensation discussion and analysis (CD&A) obligations?
Current Item 402(b) of Regulation S-K calls for disclosure in the CD&A of company policies regarding hedging the economic risk of company securities ownership by named executive officers, to the extent material. The new rules do not affect this existing requirement. However, Item 402(b) of Regulation S-K is being amended to add an instruction providing the company with the option to satisfy its CD&A obligation to disclose material polices on hedging by named executive officers by cross referencing to the information disclosed pursuant to Item 407(i) to the extent that the Item 407(i) disclosure satisfies the CD&A disclosure requirement. While the rules give a company flexibility in how to present the new disclosure, the SEC noted that if the Item 407(i) disclosure is included in the CD&A or the CD&A contains a cross-reference to the Item 407(i) disclosure, such disclosure will be subject to the company’s shareholder advisory say-on-pay vote.4
Which companies are subject to the new hedging disclosure rules?
The rules apply to U.S. public companies, including emerging growth companies (EGCs) and smaller reporting companies (SRCs), although compliance is delayed by one year for EGCs and SRCs. The rules also apply to business development companies. The rules are not applicable to foreign private issuers because they are not subject to the proxy statement requirements of Section 14 of the Exchange Act. Investment companies registered under the Investment Company Act of 1940 and listed closed-end funds are also excluded from the new hedging disclosure requirements.
Is the information disclosed under the rules incorporated by reference into other SEC filings?
No, the instructions to the rules state that the information required by Item 407(i) will not be deemed to be incorporated by reference in any filing under the Securities Act or the Exchange Act, except to the extent that the registrant specifically incorporates it by reference.
When do companies need to begin complying with the rules?
Companies that are not EGCs or SRCs must comply with the disclosure requirements in proxy and information statements for the election of directors during fiscal years beginning on or after July 1, 2019. Compliance for companies that qualify as EGCs or SRCs is delayed by one year, and those companies must comply with the disclosure requirements in proxy and information statements for the election of directors during fiscal years beginning on or after July 1, 2020.