United States: SEC Proposes Equity Hedging Disclosure Rules Under Dodd-Frank - April 2015

On 9 February 2015, the SEC proposed long awaited equity hedging disclosure rules to implement Section 955 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the "Dodd-Frank Act"). The proposed rules adopt Item 407(i) of Regulation S-K, which would require issuers to disclose in any proxy or information statement relating to the election of directors whether any employee, officer or director (or the designee of any employee, officer or director) is permitted to purchase financial instruments (including prepaid forward variable contracts, equity swaps, collars and exchange funds) or otherwise engage in transactions that are designed to hedge or offset any decrease in the market value of equity securities (1) granted to the employee or director as compensation, or (2) held directly or indirectly by the employee or director. Foreign private issuers would not be subject to the disclosure requirements.

Statutory Purpose:

Based on its review of the legislative history, the SEC interpreted the statutory purpose of Section 14(j) of the Exchange Act, as being 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." The proposed rules provide for a "principles based" approach, rather than a "rules based" approach, to allow for more flexibility to fulfil this legislative purpose. The proposed rules would not require an issuer to prohibit hedging transactions or to otherwise adopt a policy addressing hedging. Moreover, the proposed rules do not require disclosure of actual hedging activity, although the SEC has requested comments as to whether it should so require. While there is no requirement to provide a detailed list of outstanding hedging activity, disclosure of many hedging instruments is currently required pursuant to Section 16(a) of the Exchange Act. Similarly, Item 403(b) of Regulation S-K requires the disclosure of hedging transactions that involve the pledging of issuer equity securities as collateral.

Relationship to Existing CD&A Obligations:

The SEC proposed to include the hedging disclosures in Item 407 of Regulation S-K, which focuses on corporate governance matters, as opposed to Item 402, which focuses on the compensation of directors and executive officers. Item 402(b) requires disclosure in the Compensation Discussion and Analysis (the "CD&A") of any issuer policies regarding hedging the economic risk of stock ownership, if material. To minimize duplicative disclosure, the SEC has proposed to amend Item 402(b) to permit an issuer to satisfy its CD&A disclosure obligations by cross-referencing to Item 407(i).

Covered Issuers:

Section 14(j) requires hedging disclosures by all "issuers." While the SEC has broad authority to exempt certain categories of issuers, it did not provide for many exemptions from Section 14(j). As proposed, Item 407(i) would apply to substantially all US issuers, including emerging growth companies ("EGCs"), smaller reporting companies ("SRCs") and listed closed-end investment companies. Foreign private issuers and unlisted investment companies (including exchange-traded funds and mutual funds) would not be subject to the disclosure requirements.

Covered Transactions:

Section 14(j) expressly refers only to the "purchase of financial instruments intended to offset decreases in the market value of equity securities (such as prepaid variable forward contracts, equity swaps, collars and exchange funds)." The proposed rules would also require disclosure of transactions with "economic consequences" comparable to the purchase of the specified financial instruments. Thus, all policies relating to transactions that establish downside protection—whether by purchasing or selling a security or derivative security or otherwise—must be disclosed.

The SEC requested comments on the scope of covered transactions. For instance, the SEC noted that there is a "meaningful distinction" between an index fund that includes a broad-range of equity securities, one component of which is the issuer's equity, and a financial instrument, even one nominally based on a broad index, designed to or having the effect of hedging the economic exposure to issuer equity. The SEC questioned whether an issuer that prohibited hedging generally, but permitted the purchase of broad-based indices should nonetheless be able to disclose that it prohibits hedging. A failure to exclude these types of indices from the definition of covered transactions would likely complicate both the administration of hedging policies and the required disclosures.

The proposed rules clarify that a pledge or loan of equity securities would not be considered a hedging transaction covered by the proposed rules, notwithstanding the fact that such transactions may be viewed as "offers or sales" for purposes of the Securities Act of 1933.

Covered Employees and Directors:

Section 14(j) requires disclosure with respect to any "employee or member of the board of directors of the issuer, or any designee of such employee or member." The proposed rules clarify that the term employee also includes officers.

Covered Equity Securities:

The proposed rules define "equity securities" to mean any equity securities (as defined in the Exchange Act) that are issued by the issuer, its parents and subsidiaries or subsidiaries of its parents (e.g., brother and sister companies) that are registered under Section 12 of the Exchange Act. The SEC is seeking specific comments on whether to include affiliate securities in the definition.

Section 14(j) provides that the disclosure rules would apply to equity securities that are (1) granted to the employee or director as compensation or (2) held directly or indirectly by the employee or director in any proxy or information statement relating to the election of directors. The proposed rules retained this language. The SEC is seeking comments on whether to define "held directly or indirectly" or "designee" or use the more common concept of "beneficial ownership" under the securities laws.

The SEC also requested comments as to whether the disclosures should be further expanded to cover debt securities.

Required Disclosures:

Given the broad definition of covered transactions, an issuer must disclose both the categories of transactions it prohibits, as well as which categories it permits. If an issuer discloses that it specifically prohibits certain categories of transactions, the issuer could then disclose that it permits all other types of transactions in lieu of providing a complete listing of specific permitted transactions, and vice versa. Similarly, if an issuer either prohibits or permits all types of hedging transactions, it would not be required to describe the permitted or prohibited transactions by category. The issuer would, however, need to provide sufficient detail to explain the scope of any permitted transactions. Finally, if the issuer's hedging policy covers some, but not all, of the categories of persons subject to the disclosure requirements, the issuer would need to disclose both the categories of those persons who are permitted to hedge and those who are not.

The SEC has requested comments on numerous provisions of the proposed rules. Comments are due on or before 20 April 2015.

The proposed rules can be found at:

http://www.sec.gov/rules/proposed/2015/33-9723.pdf.

Our client publication discussing the proposed equity hedging disclosure rules is available at:

http://www.shearman.com/en/newsinsights/publications/2015/02/sec-proposes-equity-hedging-disclosure-rules.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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