Last week the Securities and Exchange Commission (SEC) proposed amendments to its rules and forms, as required by the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank), that would require SEC reporting companies to disclose whether they permit their directors, officers and other employees to engage in hedging transactions with respect to company (and related entities) securities. According to the SEC Release proposing the amendments, available here [PDF], the SEC believes, based on a report issued by the Senate Committee on Banking, Housing, and Urban Affairs, that the purpose of the Dodd-Frank requirement that the amendments address is “to provide transparency to shareholders, if action is to be taken with respect to the election of directors, about whether employees or directors are permitted to engage in transactions that mitigate or avoid the incentive alignment associated with equity ownership.”

In that regard, the SEC proposes to add a new paragraph (i) to Item 407 of Regulation S-K, which would require that SEC reporting companies:

In proxy or information statements with respect to the election of directors, disclose whether the [company] permits any employees (including officers) or directors of the [company], or any of their designees, to purchase financial instruments (including prepaid variable forward contracts, equity swaps, collars, and exchange funds) 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—

  1. Granted to the employee or director by the [company] as part of the compensation of the employee or director; or
  2. Held, directly or indirectly, by the employee or director.

An instruction to proposed Item 407(i) provides that “equity securities” means only those equity securities issued by the company or any parent or subsidiary of the company or any subsidiary of any parent of the company, but only to the extent such securities are registered under Section 12 of the Securities Exchange Act of 1934. As noted above, the disclosure would apply to the allowance for hedging transactions not just of securities granted as compensation but securities otherwise held by the company’s directors and employees. Four other instructions provide additional clarification as to the specifics of the disclosure that would be required, including (i) the categories of hedging transactions a company permits and those it prohibits or, alternatively, disclosing that it either allows or prohibits all hedging transactions, (ii) the scope of any permitted hedging transactions, and (iii) the categories of persons who are permitted to hedge and those who are not, if the company allows some persons covered by the amendment to engage in such transactions and prohibits others from doing so.

The proposed disclosure requirement is broader than the Dodd-Frank Act provision, which referred only to the purchase of financial instruments designed to hedge or offset decreases in the market value of a company’s securities; as noted above, the proposed amendment applies to all hedging transactions, not just the purchase of financial instruments, “that establish downside price protection – whether by purchasing or selling a security or derivative security or otherwise.” This would include, for example, a short sale or the sale of a security future.

The proposed amendments do not require SEC reporting companies to prohibit hedging transactions or adopt a policy to address hedging transactions, but solely require disclosure if such hedging is permitted. Allowing directors and employees (particularly officers) to engage in transactions that hedge against the risk of a decrease in value in the company securities they hold, however, is not looked upon favorably by shareholders and investor advocates, and we expect that the vast majority of SEC reporting companies will, rather than choose to disclose that they permit such hedging, in fact adopt policies prohibiting hedging. Many SEC reporting companies have already adopted such policies since the passage of Dodd-Frank even in the absence of an SEC proposal in this regard (although some of this may have been in response to the Compensation Discussion and Analysis requirement to discuss company policies regarding hedging with respect to named executive officers, if material, but this requirement does not apply to smaller reporting companies and emerging growth companies as the amendments will), and we expect more to follow in the wake of the proposal. Although the final amendments may differ from the proposal, particularly in light of the large number of matters the SEC has requested comment on, we don’t believe the crux of the proposed disclosure will change substantially, and believe the proposal provides enough guidance for those SEC reporting companies that want to adopt an anti-hedging policy prior to the SEC’s adoption of final amendments. On the other hand, with comments on the proposed amendment not due until at least mid-April, the amendments will not be effective for the 2015 proxy season, giving companies plenty of time to adopt a policy to address hedging prior to the required disclosure becoming effective, should they desire to do so.