by Cydney Posner
This morning, the SEC posted proposed amendments to rules to implement Section 955 of Dodd-Frank, which requires, in proxy statements for annual meetings, disclosure of whether employees or directors are permitted to hedge equity securities of the company. (Apparently, the SEC voted to issue the proposal without the standard fare of an open meeting.) The focus here is on transparency; the provision does not prohibit hedging. The Senate Committee report on this Section indicated that the purpose of the provision 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.”
Many companies already disclose their policies on hedging by executives because the CD&A rules identify the company’s hedging policy as an example of the type of information that should be provided in CD&A, if material. The proposed rule would expand somewhat the nature of that disclosure as well as the types of companies required to provide it.
That seems to be one of the many reasons that Commissioners Gallagher and Piwowar, while voting to approve release of the proposal, issued a joint statement expressing their concerns about it. First among them is that the proposal does not exempt emerging growth companies (EGCs) or smaller reporting companies (SRCs), nor, they state, does it request comment on whether those companies should be exempted, 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).
[Sidebar: Actually the release does request comment “on the need for either an exemption for smaller reporting companies or emerging growth companies or a delayed implementation schedule for these companies.”]
As a result, the two Commissioners question whether the benefits of the proposal outweigh the costs. They also object to the application of the proposed rules to listed, closed-end funds and the inquiry in the proposal as to whether all funds, including open-end funds, should be subject to the disclosure rule. In addition, they contend 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 question as “overbroad” the proposal’s application to securities of the issuer’s affiliates—including subsidiaries, parents, and brother-sister companies—even though it applies only to those securities registered under Section 12. Finally, they objected generally to the “prioritization” given this proposal and maintain that priority should instead be given to those rules “germane to the financial crisis.”
In response, Commissioner Aguilar issued a statement characterizing the proposal as a “positive step in the direction of providing more information to shareholders as to whether the interests of corporate insiders are truly aligned with their own.” In light of the increasing use of equity-based compensation, he views it as important to inform shareholders if corporate insiders are allowed
“to protect themselves from stock declines while retaining the opportunity to benefit from stock price appreciation, hedging transactions could permit individuals to receive incentive compensation, even where the company fails to perform and the stock value drops.Just as problematic, hedging transactions can be structured so that executives or directors monetize their shareholdings while they still technically own the stock, which makes the fact that the hedging took place less transparent to investors. Indeed, in the absence of this proposed disclosure, shareholders may not be aware of the executive officers’ and directors’ true economic exposure to the company’s equity. Accordingly, the proposed hedging rules are intended specifically to address this lack of transparency, and attempt to provide greater clarity to investors regarding employees’ and directors’ actual incentives to create shareholder wealth. In addition, better information about equity incentives could be useful for investors’ evaluation of companies, enabling investors to make more informed investment and voting decisions.”
The proposal would 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, disclose whether the registrant permits any 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 are designed to or have the effect of hedging or offsetting any decrease in the market value of equity securities—
(1) Granted to the employee or director by the registrant as part of the compensation of the employee or director; or
(2) Held, directly or indirectly, by the employee or director.”
The SEC viewed the proposed rule amendment to relate primarily to the alignment of shareholders’ interests with those of employees’ and directors’, as opposed to executive compensation and, therefore, proposed the amendment to the corporate governance disclosure rules. As a result, the disclosure would not be subject to say-on-pay votes.
Transactions Covered. Using a principles-based approach, the proposal expands on the Dodd-Frank mandate by requiring disclosure of whether the issuer permits — in addition to financial instruments designed to hedge or offset any decrease in the market value of equity securities — other transactions with comparable economic consequences, such as short sales or sales of futures. As a result, the proposal is not limited to any particular types of hedging transactions and would “cover all transactions that establish downside price protection – whether by purchasing or selling a security or derivative security or otherwise, consistent with the statutory purpose….” To convey a complete understanding of the scope of hedging at the company, a proposed instruction requires the company to disclose which categories of transactions it permits and which it prohibits. However, where the company only prohibits specified hedging transactions, it would disclose the categories of prohibited transactions and could, if true, disclose that it permits all other hedging transactions (instead of listing all of the specific categories that are permitted, which could be limitless). The same concept would apply if the company only permitted certain categories of hedging transactions. If all are permitted or all are prohibited, identifying categories would not be required.
Permitted hedging transactions must be described in sufficient detail “to explain the scope of such permitted transactions” (e.g., only if pre-approved or only after the company’s stock ownership guidelines have been met). The release indicates that the SEC is “of the view that there is a meaningful distinction between an index that includes a broad range of equity securities, one component of which is company equity securities, and a financial instrument, even one nominally based on a broad index, designed to or having the effect of hedging the economic exposure to company equity securities,” and requests comment on whether the rule should “explicitly distinguish” between those two types of instruments. Presumably, then, companies that prohibit hedging, but permit the purchase of broad-based indices could still state that they prohibit hedging.
Categories of Persons. If hedging is permitted for only some of the categories of persons, companies will need to disclose which categories of persons are permitted to hedge and which are not. The proposal clarifies that the term “employees” includes “officers.” The release does, however, request comment on whether each issuer should be permitted to determine whether disclosure about all of its employees would be material information for its investors. The disclosure also would apply to any “designees,” a determination that would be made by a company based on the particular facts and circumstances.
Equity Securities Covered. Equity securities covered by the proposed rule would include those issued by the company, any parent of the company, any subsidiary of the company or any subsidiary of any parent of the company that are registered under Section 12 of the Exchange Act. A ”parent” is defined under the Exchange Act as “an affiliate controlling such person directly, or indirectly through one or more intermediaries,” and likewise, a “subsidiary” is defined as “an affiliate controlled by such person directly, or indirectly through one or more intermediaries,” definitions that could conceivably be cumbersome under some circumstances.
As required by statute, disclosure is required regarding hedging of equity securities whether granted as compensation or otherwise held, directly or indirectly, regardless of the source. The application to subsidiaries is intended to cover situations where employees or directors may receive those securities as incentives, for example, where a company reorganizes to create a publicly traded subsidiary.
Where Disclosure Required. In an expansion of the statute, 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, this disclosure would be required in the same instances as other Item 407 corporate governance disclosures. The proposal would 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, Exchange Act or Investment Company Act filing, except to the extent specifically incorporated by reference.
To reduce potentially duplicative disclosure in proxy and information statements, the proposal would add an instruction to the CD&A rules (Item 402(b) of Reg S-K) providing that, to the extent that the information disclosed under new Item 407(i) satisfies 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.)
Issuers Covered. As noted above, the proposal would not exempt EGCs or SRCs from the new disclosure requirement. The release notes that the SEC is “not aware of any reason why information about whether a company has policies affecting the alignment of shareholder interests with those of employees and directors would be less relevant to shareholders of an emerging growth company or a smaller reporting company than to shareholders of any other company. In this regard, we believe it is consistent with the statutory purpose of Section 14(j) to require these companies to provide disclosure about their hedging policies. Moreover, given its narrow focus, the proposed disclosure is not expected to impose a significant compliance burden on companies.” The SEC also contends 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 views the burden as minimal.
Foreign private issuers would not be required to provide Item 407(i) disclosure. However, the requirements would apply to investment companies that are “listed closed-end funds,” which are funds that do hold annual meetings to elect directors and trade at negotiated market prices on exchanges and are not redeemable from the funds.