Briefing
SEC Adopts New Hedging Disclosure Requirements for US Reporting Companies
The US Securities and Exchange Commission (the “SEC”) has adopted new rules which will require US reporting companies to describe any practices or policies that the company has adopted regarding the ability of its employees (including officers) or directors, or any of their designees, to purchase financial instruments or otherwise engage in transactions that hedge or offset, or that are designed to hedge or offset, any decrease in the market value of equity securities either granted to the employee or board member as compensation or held directly or indirectly by the employee or board member. The new disclosure is required in any proxy statement or information statement relating to an election of directors. The rules require disclosure, but do not prohibit hedging and do not require or endorse any particular policy regarding hedging.
The new rules – mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010 and first proposed by the SEC in February 2015 – are meant to provide transparency to shareholders about whether employees or directors are permitted to engage in transactions that mitigate or avoid the incentive alignment associated with long-term ownership of company equity securities. Under the SEC’s current rules, disclosure of company policies regarding hedging is identified as an example of disclosure that may be included in the Compensation Disclosure & Analysis (CD&A) but applies only with respect to named executive officers.
The new rules will not be applicable during the upcoming proxy season for companies with a typical December 31 year end. US reporting companies, other than emerging growth companies1 and smaller reporting companies,2 must comply with the new disclosure requirements for proxy and information statements with respect to the election of directors during fiscal years beginning on or after July 1, 2019. Companies that qualify as emerging growth companies or smaller reporting companies must comply with the new disclosure requirements for proxy and information statements with respect to the election of directors during fiscal years beginning on or after July 1, 2020.
The disclosure requirement
The new rules require a US reporting company to describe any practices or policies that it has adopted regarding the ability of its employees (including officers) or directors, 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 the company’s equity securities held by such employees and directors.
In particular:
- The description must 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.
- The description must also describe any categories of hedging transactions that are specifically permitted and any categories of such transactions specifically disallowed.
- If the company does not have any such practices or policies regarding hedging, the company must disclose that fact or state that hedging transactions are generally permitted. (For example, a company could disclose that “Our company does not have any practices or policies regarding hedging or offsetting any decrease in the market value of registrant equity securities.”)
The SEC has clarified that the disclosure requirement applies to any hedging policies and practices “whether written or not.” For example, the SEC’s adopting release states 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.”
The new rules do not define the term “hedge.” However, the SEC’s adopting release clarifies that “a short sale can hedge the economic risk of ownership, as can entering into a borrowing or other arrangement involving a non-recourse pledge of securities. Similarly, selling a security future that establishes a position that increases in value as the value of the underlying equity security decreases can provide the downside price protection that is the essence of the transactions contemplated” by the new disclosure requirement.
The new rules do not require that companies adopt policies or practices with respect to hedging, and for companies that have such policies the new rules do not mandate any particular kind of policy or practice. Also, while the new rules require disclosure of hedging policies, they do not require disclosure of actual hedging transactions engaged in by employees or directors (some hedging transactions will continue to be disclosed by officers and directors in accordance with Section 16 under the Exchange Act).
Equity securities subject to disclosure
The new rules require disclosure of whether employees and directors may hedge “equity securities” – defined to include any equity securities issued by the company, any parent of the company, any subsidiary of the company or any subsidiary of any parent of the company. The rule is not limited to equity securities registered under Section 12 of the Exchange Act.
In addition, the new rules cover equity securities granted pursuant to compensatory equity grants and other equity securities “held directly or indirectly” by an employee or director. The new rules do not define “held directly or indirectly” but the SEC adopting release states that “this terminology covers a broad variety of means by which equity securities can be held.” The SEC specifically declined to define “directly or indirectly” by reference to “beneficial ownership” as defined for purposes of Section 13 of the Exchange Act because “the voting power and investment power standards articulated [in the definition of ‘beneficial ownership’] do not necessarily correlate to whether a person has the risk of loss in an equity security that would be mitigated by a hedge.” Rather than providing a definition of “directly or indirectly” in the rules, the SEC concluded that companies will describe the scope of their hedging practices or policies, which may include whether and how they apply to securities that are “indirectly” held.
Employees and directors subject to the disclosure requirements
The new rules cover policies and practices regarding hedging transactions conducted by any employee, officer or director of the company or any of their designees.
The SEC declined to limit the requirement to only transactions conducted by directors and officers, to limit the requirement to only employees that participate in making or shaping key operating or strategic decisions that influence the company’s stock price or to add a materiality qualifier. The SEC also declined to specify that employees include consultants.
With respect to “designees” of employees or directors, because companies will determine who their policies and practices are meant to cover, the SEC declined to provide any further guidance defining who would be considered a “designee.” A number of commenters on the rule stated that it is not clear who the term “designee” is intended to cover – one commenter recommended defining “designee” as someone specifically appointed to make decisions that the authorizing person would reasonably believe could result in the hedging of equity securities the person beneficially owns; another commenter recommended defining “designee” to include immediate family members and family or affiliated investment vehicles. The SEC did not further address these comments in its adopting release for the new rule.
Location of disclosure
The new disclosure is required in any proxy statement or information statement relating to an election of directors, whether by vote of security holders at a meeting or an action authorized by written consent. However, it is not required in any registration statement pursuant to the Securities Act of 1933 (the “Securities Act”) or the Exchange Act, and is not required in any Form 10-K. The disclosure also will not be deemed to be incorporated by reference into any filing under the Securities Act or the Exchange Act except to the extent the company specifically incorporates it by reference.
Issuers subject to the rule
The new disclosure will apply to companies subject to the federal proxy rules, including emerging growth companies, smaller reporting companies and business development companies, but not registered investment companies (including other listed closed-end funds). Foreign private issuers are exempt from the new rules because they are not subject to the proxy statement requirements of Section 14 of the Exchange Act.
Relationship to CD&A
The SEC’s Compensation Discussion and Analysis (“CD&A”) rules currently provide that disclosure of a company’s security ownership requirements for named executive officers and any company policies regarding hedging the economic risk of such ownership is an example of the kind of information that should be provided in the CD&A if material. Unlike the SEC’s new rules, the CD&A requirement applies only with respect to named executive officers and is not applicable to smaller reporting companies or emerging growth companies. To reduce potentially duplicative disclosure in proxy and information statements, the SEC’s new rules clarify that a company may satisfy its CD&A obligation by cross referencing the information disclosed pursuant to the new disclosure requirement to the extent it satisfies the CD&A disclosure requirement.
Conclusion
The new rules require disclosure, but do not prohibit hedging and do not require or endorse any particular policy regarding hedging. In addition, the disclosure will be included within the corporate governance disclosures rather than the compensation disclosures and, as a result, will not be subject to shareholder say-on-pay votes to approve the compensation of named executive officers.
Many US reporting companies have already adopted anti-hedging policies, both due to the existing CD&A requirement and the position of Institutional Shareholder Services (“ISS”) opposing hedging by directors and officers. The new rules may have a greater impact on smaller companies, who have not previously been subject to the CD&A requirement.
Although the new rules will not be in effect for calendar year end companies during the upcoming proxy season, we believe that companies should take them into consideration when adopting or revising their hedging policies and when drafting proxy statement disclosure regarding their hedging policies.
1The term “emerging growth company” is a company with annual gross revenues of less than $1.07bn during its most recent fiscal year. A company retains emerging growth company status until the earliest of (1) the end of the fiscal year in which its annual revenues exceed $1.07bn, (2) the end of the fiscal year in which the fifth anniversary of its IPO occurred, (3) the date on which the company has, during the previous three-year period, issued more than $1bn in non-convertible debt or (4) the date on which the company qualifies as a large accelerated filer.
2The term “smaller reporting company” includes US reporting companies with a public float of less than $250m, as well as US reporting companies with annual revenues of less than $100m for the previous year and either no public float or a public float of less than $700m.
