United States: SEC Adopts Final Hedging Disclosure Rules

Last Updated: January 3 2019
Article by Cydney Posner

On Tuesday, the SEC finally dredged up the 2015 proposal to implement section 955 of Dodd-Frank regarding hedging disclosure in proxy statements and, without an open meeting, voted—yes finally—to adopt it. Section 955 mandated disclosure about the ability of a company's employees or directors to hedge or offset any decrease in the market value of equity securities granted as compensation to, or held directly or indirectly by, an employee or director.  According to the legislative history, the purpose was 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." The final rules were adopted "along the lines proposed," but with some modifications.

Most companies will be required to comply with the new disclosure requirements in proxy and information statements for the election of directors during fiscal years beginning on or after July 1, 2019. As a result, for calendar year companies, the new requirement will not apply to this upcoming proxy season. And, emerging growth companies and smaller reporting companies will have an extra year to comply: the disclosure will be required in proxy and information statements for the election of directors during fiscal years beginning on or after July 1, 2020.


You might remember that, when the hedging disclosure rules were initially proposed in 2015, although the proposal may have struck many as rather bland and non-controversial, the two Republican Commissioners at the time (former Commissioners Gallagher and Piwowar) voted to release the proposal but added some fireworks by issuing a joint statement expressing their concerns about it. First among the former Commissioners' complaints in their joint statement was that the proposal did not exempt EGCs or SRCs, even though they may be disproportionately affected by the direct or indirect costs of compliance (e.g., they may feel compelled to adopt hedging policies). As a result, the two Commissioners questioned whether the benefits of the proposal outweighed the costs. Under the final rules, EGCs and SRCs will be subject to the new disclosure requirement, but will have an additional year to comply with the new rule.  The former Commissioners also objected to the application of the proposed rules to listed, closed-end funds, and the final rules do exclude closed-end funds. In addition, they contended that, although the statute specifies that employee hedging should be covered, the SEC should have exercised its exemptive authority to exclude from the rule disclosures relating to employees on the basis that it is not the type of information about which investors have concerns.  Similarly, they questioned as "overbroad" the proposal's application to securities of the issuer's affiliates—including subsidiaries, parents, and brother-sister companies.  Finally, they objected generally to the "prioritization" given the proposal and maintained that priority should instead be given to those rules "germane to the financial crisis." While the final rules do not exempt employee hedging or the specified affiliates, with adoption of the final rules put off for almost four years, these two former Commissioners should take heart that their concerns about prioritization were certainly heard.

Final Amendments. The final amendments add new paragraph (i) to Item 407, Corporate Governance, of Reg S-K:

"(i) Employee, officer and director hedging.  In proxy or information statements with respect to the election of directors:

(1) Describe any practices or policies that the registrant has adopted regarding the ability of employees (including officers) or directors of the registrant, 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 hedge or offset, or are designed to hedge or offset, any decrease in the market value of registrant equity securities—

(i) Granted to the employee or director by the registrant as part of the compensation of the employee or director; or

(ii) Held, directly or indirectly, by the employee or director.

(2) A description provided pursuant to paragraph (1) shall provide a fair and accurate summary of the practices or policies that apply, including the categories of persons covered, or disclose the practices or policies in full.

(3) A description provided pursuant to paragraph (1) shall also describe any categories of hedging transactions that are specifically permitted and any categories of such transactions specifically disallowed.

(4) If the registrant does not have any such practices or policies regarding hedging, the registrant shall disclose that fact or state that the transactions described in paragraph (1) above are generally permitted."

The SEC viewed the final amendments to relate primarily to the alignment of shareholders' interests with those of employees and directors, as opposed to executive compensation and, therefore, as proposed, have included the amendment as part of the corporate governance disclosure rules.   As a result, the disclosure will not be subject to say-on-pay votes, even though there is an executive comp component to the new disclosure to the extent it relates to existing CD&A obligations.  Notably, the SEC makes clear that neither the final amendments nor the release are intended to suggest that companies must have "a practice or policy regarding hedging, or a particular type of practice or policy. These amendments relate only to disclosure of hedging practices or policies."

Scope of the Disclosure Requirement.  Instead of requiring, as proposed, disclosure of whether the company "permits" hedging transactions by employees (including officers) or directors, to avoid potential confusion about the term, the final amendments require a description of the company's practices or policies (whether written or not) regarding the ability of covered persons to hedge transactions. What amounts to a "practice"? As an example, the SEC suggests that "a company that does not have a written hedging policy might have a practice of reviewing, and perhaps restricting, hedging transactions as part of its program for reviewing employee trading in company securities. Similarly, a company might have a practice of including anti-hedging provisions in employment agreements or equity award documentation."  If there are no hedging practices or policies, the company must disclose that fact or state that hedging transactions are generally permitted. here is an example from the SEC of suggested language: "Our company does not have any practices or policies regarding hedging or offsetting any decrease in the market value of registrant equity securities."

As proposed, the final amendments do not define the term "hedge," but opt instead for a broad principles-based approach, applying to "transactions with the same economic effects—to hedge or offset any decrease in the market value of company equity securities—as the transactions specified by [Dodd-Frank]." That is, the scope of the new disclosure requirement is "not limited to any particular types of hedging transactions," and each company will "continue to make its own judgments in determining what activities, if any, should be covered by a practice or policy." Some examples of hedging transactions identified by the SEC are short sales, borrowing or other arrangements involving a non-recourse pledge of securities and selling a security future that establishes a position that increases in value as the value of the underlying equity security decreases.   Although some commenters were concerned about overbroad interpretations of the term—such as portfolio diversification transactions—the SEC concluded that the approach adopted mitigated those concerns: "In this regard, a company would only need to describe portfolio diversification transactions, broad-based index transactions, or other types of transactions, if its hedging practice or policy addresses them."

The final amendments apply to hedging of securities "held, directly or indirectly," by employees (including officers) or directors. The quoted phrase is not defined, but again, the SEC believes that, under the approach adopted, a definition is not necessary; the company will describe the scope of its policies, which may discuss the application, if any, to securities indirectly held. There is no requirement under the final amendments for disclosure about hedging transactions that have occurred; the information for executives would likely be required under Section 16, and obtaining that information for all employees could be very burdensome.  Interestingly, the SEC notes that the final rules do not refer to "beneficial ownership" in this context, as some commenters had suggested, "because the voting power and investment power standards articulated in that rule do not necessarily correlate to whether a person has the risk of loss in an equity security that would be mitigated by a hedge."

Equity Securities Covered. Under the final amendments, "registrant equity securities" include equity securities (as defined in Exchange Act section 3(a)(11)) issued by the company, any parent of the company, any subsidiary of the company or any subsidiary of any parent of the company; however, contrary to the proposal, the requirement is not limited to classes of securities that are registered under Section 12 of the Exchange Act. Instead, company policy will determine which classes of securities are subject to the policy. Why cover parents and subsidiaries? Because employees and directors may have interests in affiliated companies, for example, where companies grant equity securities of affiliated companies to their employees or directors that are intended to achieve incentive alignment that is similar to grants in the company's own equity securities (such as where a company creates a publicly traded subsidiary). Disclosure is required regarding equity securities, whether compensatory or otherwise held, regardless of the source of the acquisition.

Categories of Persons.  Under the final amendments, companies will need to disclose their practices or policies that apply to employees, including officers, and directors, as well as any of their designees. Whether someone is a "designee" will depend on the facts and circumstances; however,  because of the approach taken under the final amendments, each company will ultimately determine the categories of persons to which the company's policies apply, and the disclosure will reflect those policy choices. In addition, if a company discloses a policy that covers only a subset of employees or directors, it would not be required to disclose that it did not have a policy with regard to the company's other employees or directors.

Where Disclosure Required.  The disclosure would be required in proxy or information statements for meetings (or consents) at which directors will be elected, whether or not they are annual meetings. As a result, the disclosure would be required in the same instances as other Item 407 corporate governance disclosures. The final amendments do not require Item 407(i) disclosure in registration statements or in Annual Reports on Form 10-K, even if, as is typically the case, the Part III disclosure is incorporated by reference from the company's definitive proxy or information statement.  An instruction would provide that 407(i) information will not be deemed to be incorporated into any Securities Act or Exchange Act filing, except to the extent specifically incorporated by reference. The disclosure also is not subject to forward incorporation by reference under Item 12(b) of Form S-3 or under Item 12 of Form S-1.

Relationship to CD&A. The release notes that the CD&A rules identify hedging policies as potentially material to disclose, but  CD&A applies only to the named executives.  In addition, CD&A does not apply to SECs or EGCs. Nevertheless, there is potential for duplication. To reduce potentially duplicative disclosure in proxy and information statements, the final rules add an instruction to the CD&A rules (Item 402(b) of Reg S-K) providing that, in proxy or information statements with respect to the election of directors, if the information disclosed under new Item 407(i) would satisfy the CD&A obligation to disclose material policies on hedging by NEOs, the company may elect to simply cross-reference the new 407(i) disclosure in CD&A. That cross-reference would, however, make the disclosure subject to say-on-pay votes. (Note that it's also possible that the CD&A disclosure could be broader than the new 407(i) disclosure, for example, if the company's hedging policy also applied to debt securities.) The SEC noted that, to avoid making the Item 407(i) disclosure part of CD&A, companies could include that disclosure directly in their Item 402 disclosures and not cross-reference.

Issuers Covered.   As proposed, the final rules will apply to EGCs or SRCs.  The SEC believes that shareholders of EGCs and SRCs have the same interest as shareholders of other companies in obtaining information about potential alignment of shareholder interests with those of employees and directors. In addition, the change in the disclosure requirement to focus on a company's existing practices or policies should alleviate the compliance burden on these companies. The SEC also contended that governance disclosure requirements for EGCs and SRCs are less frequently scaled than are compensation disclosure requirements. Although EGCs and SRCs may face higher initial compliance costs because they are not subject to the CD&A requirements and, therefore, may not yet have addressed hedging policies, the SEC did not view the burden as significant, emphasizing that the rules do not require companies to adopt hedging practices or policies or dictate their content. However, to provide an opportunity for EGCs and SRCs to observe how other larger and more established companies implement Item 407(i), particularly because EGCs and SRCs may not already have hedging policies in place, the SEC adopted a delayed compliance date for EGCs and SRCs.

Neither foreign private issuers nor, in a change from the proposal, closed-end funds will  be required to provide Item 407(i) disclosure.  The final rules will apply, however, to BDCs.

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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