SEC Proposes New Rule Requiring Disclosure of Equity Hedging Policies

By Heyward Armstrong, Amy Batten and Gerald Roach

On February 9, 2015, the U.S. Securities and Exchange Commission (SEC) proposed a long-awaited rule under the Dodd-Frank Wall Street Reform and Consumer Protection Act that would require public companies to disclose certain information regarding whether their employees and directors are permitted to hedge or offset any decrease in the value of the company’s securities. This disclosure would be required in proxy and information statements relating to an election of directors.

The proposed rule is subject to a 60-day public comment period after publication in the Federal Register; therefore, the comment period will likely run until mid-April 2015. In the proposing release, the SEC requested comment on a number of aspects of the rule, including whether it should apply to smaller reporting and emerging growth companies (the proposed rule currently would apply to them); and whether it should apply to policies with respect to all employees, or just employees whose roles may influence the company’s stock price (the proposed rule currently applies to all employees, as well as directors).

These requirements of the proposed rule, among others, caused SEC Commissioners Daniel M. Gallagher and Michael S. Piwowar to make a joint statement regarding their concerns with the proposed rule, which may impact the comments received and the SEC’s ultimate determinations regarding the scope and application of the proposed rule. 

Disclosure Requirements

Current Disclosure Requirements: Regulation S-K Item 402, the SEC rule that governs executive compensation disclosure, includes a list of nonexclusive examples of disclosures that may be (but are not necessarily) material to an understanding of the compensation paid to a public company’s named executive officers and thus may be required to be included in the company’s compensation discussion and analysis (CD&A). Included in this list is disclosure of any company policies regarding hedging the risk of equity ownership. Since the existing disclosure requirements for hedging policies are part of CD&A disclosure, they do not apply to companies classified as “smaller reporting companies” or “emerging growth companies” under SEC regulations. 

Proposed Disclosure Requirements: The proposed rule is broader in both applicability and scope. The proposed rule would

• apply to all public companies filing a proxy or information statement relating to the election of directors, including smaller reporting companies and emerging growth companies (though notably it would not apply to disclosure in any registration statements or Form 10-K filings); and
• cover hedging policies with respect to the company’s directors and employees (including but not limited to executive officers), whereas the existing rule only applies to hedging policies with respect to named executive officers.

Since the proposed rule is founded on corporate governance concerns and not on executive compensation, the proposed rule will be contained in Regulation S-K Item 407 (as Item 407(j)), which addresses corporate governance requirements, instead of Regulation S-K Item 402, and would therefore apply to emerging growth companies and smaller reporting companies.

While existing hedging disclosure under the compensation rules is often focused on conduct that is prohibited, the proposed rule would require public companies to identify activities that are permitted. Specifically, the proposed rule would require public companies to disclose whether an employee, officer or director, or any of their designees, is permitted to

• purchase financial instruments (including prepaid variable forward contracts, equity swaps, collars and exchange funds); or
• otherwise engage in transactions that are designed to have the effect of hedging or offsetting any decrease in the market value of the public company’s equity securities that were either granted to the employee or director by the company as part of his or her compensation or are directly or indirectly held by the employee or director.

Proposed instructions would clarify that the public company must include in the disclosure the categories of transactions it permits and prohibits and the categories of persons who are permitted to hedge. Where a company only prohibits certain transactions, the rules would allow the company to disclose the prohibited categories of transactions and that it permitted all other hedging transactions. “Equity securities” would include not only the securities of the public company itself, but also to any parent or subsidiary that is registered under Section 12 of the Securities Exchange Act of 1934, as amended, such that securities issued to employees or directors in connection with a company reorganization to create a publicly traded subsidiary would be included.    

To avoid potentially a duplicative disclosure, Regulation S-K Item 402 would be revised to include an instruction clarifying that any disclosure required, thereunder, could be satisfied by cross-reference to disclosure elsewhere in the proxy statement. Cross-referencing the disclosure, however, would render the more fulsome disclosure subject to say-on-pay votes on executive compensation. 

Practical Considerations

Many public companies already have formal or informal anti-hedging policies that apply to directors, executive officers and other employees. These policies, which are often included as part of insider trading policies or codes of ethics, take various forms, including absolute prohibitions on hedging transactions, requiring preclearance for hedging transactions or restricting the types of permissible hedging transactions. In light of the continued focus by proxy advisory firms and investors on hedging and in light of the proposed new disclosure requirements, companies may want to consider adopting, or revisiting their previously adopted, policies concerning hedging activities with respect to their equity securities, including considering the scope and applicability of such policies. An important part of this process will be considering what disclosure might look like under the proposed rule. In addition, companies covered by Institutional Shareholder Services (ISS) and Glass Lewis may want to take into account the views of these proxy advisory firms on hedging. Both ISS and Glass Lewis have indicated that companies should prohibit hedging, and ISS has further stated that any amount of hedging will be considered a problematic practice warranting a negative voting recommendation.

In summary, therefore, a hedging policy that makes sense for one company may not make sense for another. Companies should therefore carefully consider their individual facts and circumstances before adopting or revising a hedging policy, and should not make changes simply in response to the perceived expectations of investors and proxy advisory firms. 

If you have any questions about the proposed rule or adopting or revising hedging policies or if you would like to learn more about the issues covered in this alert, please contact your Smith Anderson Securities lawyer.

Special thanks to Amanda Keister, contributing writer.