United States: SEC Proposes Dodd-Frank Disclosure Rule Regarding Hedging Policies

The Securities and Exchange Commission (SEC) recently proposed adding new Item 407(i) to Regulation S-K (Item 407( i)) to implement the hedging disclosure requirements of Section 955 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank).1 The proposed rule would require most public companies to disclose in their proxy statements and information statements relating to an election of directors whether their employees (including their officers) or directors are permitted to engage in hedging transactions relating to equity securities of the issuer or certain related parties registered under Section 12 of the Securities Exchange Act of 1934 (Exchange Act). The proposed rule would not require issuers to (1) prohibit hedging transactions, (2) adopt policies or procedures addressing hedging by any category of individuals, securities, hedging instruments or hedging strategies or (3) disclose specific hedging transactions.2 

The SEC did not propose an effective date for the proposed rule, but comments on the rule are due by April 20, 2015. Consequently, the proposed rule will not impact the 2015 proxy season. However, issuers should review the proposed rule and reconsider their existing hedging policies and practices in anticipation of the SEC's adoption of the final rule.

Proposed Hedging Disclosure Rule

Covered SEC documents. The hedging disclosure would only be required in proxy statements or information statements relating to an election of directors, whether such election occurs at an annual or special meeting or is handled by written consent. The disclosure would not be required in Form 10-Ks or registration statements filed under the Exchange Act or Securities Act of 1933 (Securities Act). 

Covered issuers. The proposed rule would apply to all issuers subject to the SEC's proxy rules, including smaller reporting companies (SRCs), emerging growth companies (EGCs), business development companies and registered closed-end investment companies with shares listed and registered on a national securities exchange (Listed Closed-End Funds). MLPs would not be required to provide the disclosure unless they elect directors at unitholder meetings or the final rules provide otherwise.

Foreign private issuers would not be required to provide disclosure under Item 407(i) because they are not subject to the SEC's proxy statement requirements. In addition, the SEC has proposed to amend Schedule 14A in a manner that would not require registered investment companies, other than Listed Closed-End Funds, to provide Item 407(i) disclosure.

Covered transactions. An issuer would be required to disclose whether it permits its employees (including officers) or directors or any of their designees4 to purchase financial instruments, including prepaid variable forward contracts, equity swaps, collars and exchange funds,5 or otherwise engage in transactions designed to or having the effect of hedging or offsetting any decrease in the market value of the equity securities of the issuer or any of its parents or any subsidiary of the issuer or any of its parents (such parents or subsidiaries, Related Issuers) registered under Exchange Act Section 12 (Covered Equities), which Covered Equities are granted to the employee or director by the issuer as part of the employee's or director's compensation or which are held, directly or indirectly, by the employee or director.

The proposed rule does not appear to limit the required Item 407(i) disclosure only to disclosure of whether an issuer has a policy permitting the issuer's officers, directors and employees to hedge Covered Equities. Rather, the proposed rule's language is broad enough to require issuers having policies prohibiting hedging of Covered Equities to disclose any instance in which they permit one of their officers, directors or employees to maintain in place a hedge transaction regarding a Covered Equity even though the original execution of that transaction violated the policy. Moreover, the proposed rule's language can be read to require that issuers having anti-hedging policies disclose if they have issued any waiver of their policies to permit an officer, director or employee to enter a hedge transaction regarding Covered Equities without considering that action a violation of the anti-hedging policy.

Importantly, the proposed rule expands on Dodd-Frank Section 955 by adding a principles-based requirement to disclose whether its officers, directors or employees are permitted to enter into transactions with economic consequences comparable to the purchase of the specified financial instruments (for example, short sales or selling a security future). As a result, the scope of the proposed rule is not limited to any particular types of hedging transactions and would cover all transactions that establish downside price protection.

The proposed rule does not define the term "hedge," as the SEC believes the meaning of "hedge" is generally understood and should be applied as a broad principle. However, the SEC did note that a pledge or loan of equity securities not involving a prepaid variable forward or similar transaction would not be considered a hedging transaction covered by the rule. Moreover, the SEC is seeking comment on whether the proposed rule should explicitly distinguish between instruments that provide exposure to a broad range of issuers or securities and those that are designed to hedge particular securities or have that effect.

Covered equity securities. As noted above, Item 407(i) disclosure would be required only as to equity securities of the issuer or any of its Related Issuers that are registered under Exchange Act Section 12, that is, that are listed for trading on a national securities exchange and, as a result, are registered under Exchange Act Section 12(b) or the class of which equity securities is registered under Exchange Act Section 12(g). Item 407(i) disclosure would also be required only as to any Covered Equities held, directly or indirectly, by an officer, director or employee, however acquired, including Covered Equities received by the officer, director or employee pursuant to compensation grants by the issuer.

Unfortunately, neither the proposed rule's text nor the preamble in the Release gives any guidance of how indirect ownership of Covered Equities will be determined for purposes of Item 407(i), including how attenuated the interest of the officer, director or employee in Covered Equities must be before the Covered Equities will not be considered to be held indirectly by the officer, director or employee. Consider, for instance, a case in which a director has a pecuniary interest in Covered Equities held through a trust of which the director is a beneficiary, but the director neither is a trustee of the trust nor has any control over the trustee's actions with respect to the Covered Equities. Will the director be deemed to hold those Covered Equities indirectly for purposes of Item 407(i) even though he cannot compel the trustee not to enter into any hedging transactions regarding those Covered Equities? But for Exchange Act Rule 16a-8, the director would be considered the beneficial owner of those shares for purposes of reporting under Exchange Act Section 16(a), although he would not be so for purposes of Exchange Act Section 13(d) and the rules thereunder. The SEC should clarify when an officer, director or employee holds Covered Securities in the final rule.

Although the proposal ensures that Item 407(i) disclosure must be made as to whether an issuer permits hedging by its officers, directors and employees with respect to a more narrow set of equity securities than Dodd-Frank Section 955 could be interpreted to mandate for the hedging disclosure rule,6 issuers should consider whether their hedging policies apply to equity securities of their Related Issuers. As the SEC is seeking comment on whether the term "equity securities" should be so limited, perhaps the SEC will narrow even more the type of equity securities as to which the disclosure must be made and in the final rule limit the term "equity securities" to only the issuer's equity securities.

Hedging disclosure requirements. As noted above, in accordance with proposed Item 407(i), an issuer would be required to disclose whether it permits its employees (including officers) or directors to engage in hedging transactions of the type described above regarding its Covered Equities granted by the issuer to the employee or director as compensation or held, directly or indirectly, by the employee or director. An issuer would also be required to disclose the categories of hedging transactions it permits and those it prohibits, unless it states, if true, that it does not permit any hedging transactions or permits all hedging transactions. An issuer would be permitted, if true, to disclose that it prohibits or permits particular categories of hedging transactions and permits or prohibits, respectively, all other hedging transactions. For example, an issuer could disclose that it prohibits its officers, directors and employees from entering into prepaid variable forward contracts with respect to its Covered Equities, but permits all other hedging transactions regarding its Covered Equities, or that it permits exchange fund transactions, but prohibits all other hedging transactions.

If an issuer permits any hedging transactions, the proposed rule would require the issuer to provide sufficient detail to explain the scope of the permitted transactions. For example, an issuer permitting hedging of Covered Equities held for a specified time would need to disclose the specific time for which the Covered Equities must have been held prior to hedging them and any limitations imposed on the type of hedging transaction that could be entered into after that holding period elapses. 

An issuer that permits hedging transactions by some, but not all, of the categories of covered persons would be required to disclose the categories of covered persons who are permitted to engage in hedging transactions and those who are not. For example, an issuer could disclose that it prohibits all hedging transactions by its executive officers and directors, but does not restrict hedging transactions by employees who are neither executive officers nor directors.

Item 407(i) disclosure would be required solely as to the issuer's policies for its employees (including officers) and directors and not as to any other persons. As a result, as the rule is currently written no Item 407(i) disclosure would be required as to an issuer's or its subsidiaries' policies for employees or directors of its controlled subsidiaries (including operating subsidiaries of an issuer that is primarily a holding company), who could also receive equity securities of the issuer as compensation.

Incorporation by reference. The hedging disclosure will not be deemed to be incorporated by reference into any filing under the Securities Act, the Exchange Act or the Investment Company Act of 1940, unless the issuer specifically incorporates it by reference in such a filing. Moreover, the disclosure would not be subject to forward incorporation by reference under Item 12(b) of Form S-3.

Interaction with CD&A Hedging Disclosure

The Compensation Discussion and Analysis (CD&A) disclosure requirements in Regulation S-K Item 402(b)(2) include, as a non-exclusive example of the kind of information that should be provided if material, an issuer's equity or other security ownership requirements or guidelines and any issuer policies regarding hedging the economic risk of such ownership. This CD&A disclosure requirement, which does not apply to SRCs, EGCs, registered investment companies or foreign private issuers, is narrower than the proposed hedging disclosure rule as it only relates to hedging by the issuer's named executive officers. 

To reduce potentially duplicative hedging disclosure, the SEC has proposed an amendment to Regulation S-K Item 402(b) that would allow an issuer to cross-reference its Item 407(i) disclosure if that Item 407(i) disclosure satisfies the CD&A hedging disclosure requirement.

Practical Considerations

Since the SEC is seeking specific comment on all aspects of the proposed rule, it is difficult to predict how closely the final hedging disclosure rule will resemble the proposed rule, especially in light of the concerns with the proposed rule that two SEC Commissioners publicly expressed after they voted in favor of the rule's proposal.7 However, although the final hedging disclosure rule may differ from the proposed rule, we discuss below some practical considerations that we believe issuers should consider in response to the proposed rule. 

  • Review hedging policies. Although the proposed hedging disclosure rule does not require an issuer to adopt hedging policies or practices or prohibit hedging, issuers should take this opportunity to review any existing policies and practices (for example, codes of conduct or insider trading policies) to determine whether they adequately address the issuer's policies on hedging transactions and cover the matters addressed by the proposed rule. Issuers without written hedging policies should consider whether to adopt such policies. Issuers addressing hedging transactions by their officers, directors and employees on an ad hoc basis should consider their practices for addressing those transactions and whether they should adopt a hedging policy to govern such transactions.
  • Consider proxy advisor service guidelines. Issuers should conduct such review or consider adopting policies not only in response to the proposed hedging disclosure rule, but also in response to how ISS and Glass Lewis address hedging of issuer stock by executive officers and directors in their proxy voting guidelines. Hedging by directors or executive officers of issuer stock will negatively impact an issuer's ISS QuickScore and is deemed to be a problematic practice that will warrant ISS recommending an against or withhold vote for individual directors or the entire board in extraordinary circumstances. Glass Lewis believes that issuers should adopt strict policies to prohibit executives from hedging issuer stock.
  • Carefully consider whether to use the CD&A cross-reference. Before choosing to satisfy any hedging disclosure obligation in a CD&A by cross-referencing to Item 407(i) disclosure appearing elsewhere in a proxy or information statement, issuers should consider whether they want to draw that hedging disclosure to the attention of a shareholder reviewing the CD&A when determining how to cast a say-on-pay advisory vote. Issuers should be mindful, however, that even if the Item 407(i) disclosure is not cross-referenced in a CD&A, shareholders may well consider the Item 407(i) disclosure when determining how to vote on a say-on-pay proposal.
  • Update disclosure controls and procedures. Determine whether existing disclosure controls and procedures will need to be modified in order to record, process, summarize and report the information required to be included in Item 407(i) disclosure and, if so, how to modify those disclosure controls and procedures, the timeline for implementing the modifications and which persons within the issuer will be responsible for implementing the new aspects of the modified disclosure controls and procedures.
  • Consider commenting on the proposed rule. As the SEC appears open to comments on all aspects of the proposed rule as well as other questions addressed in the Release, issuers may wish to consider commenting on those aspects of the proposed rule as to which they can expect the SEC to have some basis for changing the proposed rule in issuers' favor. For example, limiting the Covered Equities to only those of the issuer and not its Related Issuers, or exempting, or delaying the rule's effective date for, SRCs and EGCs.

Stay Tuned! 

The final rule could be different in some ways from the proposed rule depending on the SEC's response to submitted comments and other considerations. However, the SEC has limited ability to make the proposed rule more issuer friendly in view of the specific requirements of Dodd-Frank Section 955 and Exchange Act Section 14(j) and the probability that the proponents of the adoption of Dodd-Frank Section 955 will be closely monitoring any attempt by the SEC to make the final rule less faithful to those proponents' vision for the final rule.

Finally, the long-awaited proposal of the hedging disclosure rule could portend a slew of upcoming rulemaking as the SEC seeks to complete its outstanding Dodd-Frank executive compensation-related rulemaking.

Footnotes

1. See Disclosure of Hedging by Employees, Officers and Directors, Securities Act Release No. 33-9723; Exchange Act Release No. 34-74232 (Feb. 9, 2015), 80 Fed. Reg. 8486 (Feb. 17, 2015), available at http://www.gpo.gov/fdsys/pkg/FR-2015-02-17/pdf/2015-02948.pdf (Release).

2. Although not required by the proposed rule, existing SEC rules may require disclosure of specific hedging transactions. For example, some hedging transactions (including prepaid variable forward contracts) may involve pledges of the underlying issuer equity securities as collateral, and the amount of shares pledged as security by directors, director nominees and named executive officers must be disclosed pursuant to Regulation S-K Item 403(b). Moreover, for issuers with a class of equity securities registered pursuant to Exchange Act Section 12, hedging transactions by officers and directors in transactions involving one or more derivative securities are subject to reporting under Exchange Act Section 16(a). For purpose of such reporting, derivative securities include options, warrants, convertible securities, security futures products, equity swaps, stock appreciation rights and other securities that have an exercise or conversion price related to an issuer equity security or derive their value from any of the issuer's equity securities.

3. The proposed rule goes beyond what was required of the SEC by Dodd-Frank Section 955, which required disclosure relating to whether issuers permitted hedging only in proxy statements or consent solicitations relating to an annual meeting of shareholders. See Exchange Act Section 14(j), which mandates the adoption of the hedging disclosure rule and was added to the Exchange Act by Dodd-Frank Section 955.

4. Although the SEC is seeking comment on whether it should define the term "designee" in the final rule, the Release does indicate that whether someone constitutes a "designee" would be a facts and circumstances determination. The SEC would likely consider a person with a hedging position in an issuer's equity securities that passes through the benefits of that hedge to an officer, director or employee of the issuer to be a "designee" for purposes of Item 407(i).

5 The SEC has the proposed rule cover "exchange funds" because the SEC believes that Exchange Act Section 14(j) can be interpreted to cover transactions involving dispositions or sales of securities and an employee, officer or director can acquire an interest in an exchange fund only in exchange for a disposition to the exchange fund of equity securities held by the employee, officer or director. Whether the disposition of Covered Equities to an exchange fund is a hedging transaction will depend on the terms of the fund.

6. After reviewing Dodd-Frank Section 955 shortly after Dodd-Frank's enactment, numerous observers expressed concerns that new Exchange Act Section 14(j) would result in the SEC's adoption of a rule that would require issuers to disclose whether they permitted their officers, directors and employees to hedge the equity securities of any issuer of securities, not just equity securities of the filing issuer. It remains to be seen whether the activists who were the promoters of Section 955 and the other corporate governance-related provisions of Dodd-Frank challenge how the SEC has currently proposed to implement Section 955 through the proposed rule.

7. See SEC Commissioners Daniel M. Gallagher and Michael S. Piwowar, Joint Statement on the Commission's Proposed Rule on Hedging Disclosures (Feb. 9, 2015), available at http://www.sec.gov/news/statement/020912ps-cdmg-cmsp.html#.VOJK6ebF-y4. SEC Commissioner Aguilar issued a statement in support of the proposal. See SEC Commissioner Luis A. Aguilar, Aligning the Interests of Company Executives and Directors with Shareholders (Feb. 9, 2015), available at http://www.sec.gov/news/statement/020915-ps-claa.html#.VOJLCubF-y4.

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