Overview
On December 18, the SEC adopted a final rule requiring companies to disclose in proxy or information statements for the election of directors any practices or policies regarding the ability of employees or directors to engage in certain hedging transactions with respect to company equity securities. This long-awaited rule implements the mandate imposed by Section 955 of the Dodd-Frank Act to provide investors with information on whether directors and employees are permitted to hedge any decrease in market value of their own company’s stock. Most companies must include this disclosure with respect to fiscal years beginning on or after July 1, 2019.
In Depth
On December 18, the US Securities and Exchange Commission (SEC) approved a final rule requiring companies to disclose in proxy or information statements for the election of directors any practices or policies regarding the ability of employees or directors to engage in certain hedging transactions with respect to company equity securities. This rule implements Section 14(j) of the Securities Exchange Act of 1934, which was enacted by Section 955 of the Dodd-Frank Wall Street Reform and Consumer Protection Act in April 2015.
As proposed, this rule would have required disclosure of the categories of transactions a company permitted. The commission moved away from this approach in the final rule by requiring companies to disclose a fair and accurate summary of the hedging practices or policies that apply, including the categories of persons covered and any categories of hedging transactions that are specifically disallowed. Alternatively, the company must disclose the practices or policies in full.
The final rule only regulates the disclosure of hedging practices and policies; it does not direct companies to have practices or policies regarding hedging nor does it dictate the content of any such practice or policy. If the company does not have any such practices or policies, it must disclose that fact or state that hedging is generally permitted.
The adopting release notes the following highlights of the new Item 407(i) of Regulation S-K:
- Item 407(i) of Regulation S-K will require a company to describe any practices or policies it has adopted regarding the ability of its employees (including officers) or directors to purchase securities or other financial instruments, or otherwise engage in transactions, that hedge or offset, or are designed to hedge or offset, any decrease in the market value of equity securities granted as compensation, or held directly or indirectly by the employee or director.
- The disclosure must either disclose the practices or policies in full or provide a fair and accurate summary of the practices or policies that apply, including the categories of persons they affect and any categories of hedging transactions that are specifically permitted or specifically disallowed.
- If the company does not have any such practices or policies, the company must disclose that fact or state that hedging transactions are generally permitted.
- Disclosure is required with respect to equity securities of the company, any parent of the company, any subsidiary of the company, or any subsidiary of any parent of the company.
Despite requests from McDermott, the American Bar Association and other commentators, the SEC declined to define what constitutes “hedging.” Instead, the final rule is framed as a principled based disclosure. The result is that the final rule arguably requires disclosure of certain types of permitted transactions as an allowed form of hedging. McDermott previously authored a comment letter to the SEC describing several types of common transactions that could be considered to be a form hedging that are not typically prohibited under existing hedging policies.
Disclosure required by the new rule can be provided within or outside of the Compensation Disclosure and Analysis (CD&A). Companies are already required to disclose, if material, policies on hedging by named executive officers (NEO[s]) in the CD&A pursuant to Item 402(b) of Regulation S-K. If a company provides the new disclosure outside of the CD&A, the final rule provides that the company can satisfy the existing requirement with a cross reference to the new disclosure.
Given this flexibility, a company can choose to:
- Include a new disclosure outside of the CD&A and provide the Item 402(b) NEO hedging disclosure as part of the CD&A without a cross-reference; or
- Incorporate the new disclosure into the CD&A, either by directly including the information or by providing the new information outside of the CD&A and adding a cross-reference within the CD&A.
As a practical matter, incorporating the new disclosure into the CD&A would mean it is covered by the advisory say-on-pay vote required by the Dodd-Frank Act.
Of note, the final rule is not limited in application to equity securities granted as compensation, but covers hedging policies with respect to all equity securities held by employees, officers and directors, whether directly or indirectly. For example, this would include any shares held by an executive officer or director for the purpose of satisfying a stock ownership commitment.
The new disclosure requirements is effective with respect to proxies and information statements with respect to fiscal years beginning on or after July 1, 2019. Smaller reporting companies and emerging growth companies have been given an additional year to comply with the final rule. Foreign private issuers and listed closed-end funds are exempt from this rule.
We recommend that covered companies review their existing practices and policies with respect to hedging in light of the final rule. Specifically, consideration should be given to clarifying what types of transactions are—and are not—prohibited under hedging policies. For example, a company could modify it hedging policies by stating that only financial instruments that are “derivative securities” with respect to an issuer’s equity securities for purposes of Section 16 of the Exchange Act are prohibited hedging transactions. This type of objective standard would simplify disclosure, make it easier to ensure compliance with the policy and avoid potential claims over misleading disclosures. The McDermott comment letter also includes other approaches that companies may want to consider for their hedging policies. Any changes to hedging policies should be considered in light of the views of proxy advisory firms, which generally view hedging by a company’s insiders as a poor pay practice, which, in certain instances, could result in a voting recommendation by ISS against one or more directors.
