SEC Adopts New Hedging Disclosure Rules
By: Jamie Wang
On December 18, 2018, the Securities and Exchange Commission (SEC) announced that it had approved and adopted final rules requiring public companies to disclose, in proxy or information statements for election of directors, any of their policies and practices regarding the ability of the company’s employees, officers and directors to engage in certain hedging transactions with respect to the company’s equity securities. The final rules implement provisions of Section 14(j) of the Securities Exchange Act of 1934, which was added pursuant to the Dodd-Frank Wall Street Reform and Consumer Protection Act. The effective date of the new rules is 30 days after publication in the federal register. As noted in the release of the final rules, the new requirements are intended to provide shareholders with information, at the time that they are asked to elect directors, about whether employees, officers or directors may engage in transactions that could reduce the extent to which their equity holdings and equity compensation are aligned with shareholders’ interests.
New Disclosure Requirement
Pursuant to the new rules, a new Item 407(i) was added to Regulation S-K which will require a company to describe any practices or policies (whether written or not) that it has adopted regarding the ability of its employees, officers or directors to purchase any securities or other 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 equity securities granted as compensation or held directly or indirectly by the employee, officer or director. The equity securities for which disclosure is required are equity securities of the company, any parent or subsidiary of the company or any subsidiary of any parent of the company. This new disclosure is required in companies’ proxy or information statement relating to the election of directors.
U.S. public companies are generally subject to the new disclosure requirement, including smaller reporting companies and emerging growth companies. Foreign private issuers and listed closed-end funds will not be subject to such requirement. U.S. public companies that are not smaller reporting companies or emerging growth companies must comply with the new disclosure requirement when filing proxy or information statements relating to the election of directors during fiscal years beginning on or after July 1, 2019. Smaller reporting companies and emerging growth companies must be in compliance when filing proxy or information statements for the election of directors during fiscal years beginning on or after July 1, 2020.
A company could satisfy the new disclosure requirement by describing the practices or policies in full. Alternatively, a company could provide 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 specifically disallowed. If the company does not have any such practices or policies, the rule requires the company to disclose that fact or state that hedging transactions are generally permitted.
Relationship to Existing CD&A Obligations
Prior to the new rules, some public companies already make disclosures of their hedging policies and practices in the Compensation Discussion and Analysis (CD&A) contained in their proxy or information statements. Item 402(b) of Regulation S-K requires that the CD&A disclose material information necessary to understand a company’s compensation policies and decisions regarding certain executive officers. An example of this kind of required information, if material, includes any company policies regarding hedging the economic risk of the company’s equity security ownership.
The new rules generally extend beyond the CD&A requirement. The new rules require disclosure of hedging policies with respect to all employees, officers and directors. This CD&A disclosure item requirement, however, by its terms addresses hedging only by certain executive officers. In addition, the new disclosure is required whether or not material to compensation of the company’s employees, officers and directors, while the CD&A disclosure regarding hedging policies is only required to the extent material to understand compensation of certain executive officers. Furthermore, the new rules apply to smaller reporting companies and emerging growth companies, while a CD&A is not required for these companies. The SEC instructed that if disclosure provided under Item 407(i) satisfies the CD&A requirement with respect to hedging, instead of repeating the disclosure, the CD&A may make reference to the Item 407(i) disclosure.
The Senate Committee on Banking, Housing, and Urban Affairs stated in its report on the Dodd-Frank Act that the new Section 14(j) is intended 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.” Consistent with the mandate in Section 14(j), the SEC noted that the new rules are intended to provide transparency to shareholders at the time of the annual meeting as to the permissibility of any transactions that might reduce or avoid the intended incentive alignment associated with employee and director equity compensation arrangements. Proxy advisory firms also generally view hedging by a company’s insiders as a problematic practice and support policies that prohibit executives from hedging a company’s stock.
As discussed above, a company without hedging practices or policies must disclose that fact or state that hedging transactions are generally permitted. As such, although the SEC clarified that the rule does not direct companies to adopt a practice or policy regarding hedging, or a particular type of practice or policy, companies without a hedging practice or policy should carefully evaluate the market’s perception of a “no hedging policy” or “hedging permitted” statement, and, then, seriously consider the need to adopt a suitable hedging practice or policy.
Note that the rules do not define “hedge” or “hedging transactions” and the rules are not limited to any particular hedging transactions. The release does discuss the use of various type of financial instruments such as equity swaps and collars, but also covers any financial instruments or transactions designed to have the same economic effect as these types of instruments. Therefore, in formulating a hedging practice or policy, companies should carefully examine and consider the types of arrangements that are or are not permitted.
On a different note, because “practices or policies” is a broad term, disclosure may be required for information that does not instinctively fall under the new rules. In this regard, companies should consider whether any provisions of any employment or other agreements with any persons covered by the rule could be considered to fall within the scope of the rule – for example, if an employment agreement or equity award grant agreement prohibited transactions that might fall within the broad concept of hedging transactions covered by the new rules.