A recently adopted Securities and Exchange Commission (SEC) rule requires companies to disclose in their annual proxy whether employees and directors may hedge against drops in value of company securities.
The final disclosure rule implements Section 955 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, which requires a company’s annual proxy to disclose whether employees or board members are permitted to purchase financial instruments designed to hedge or offset any decrease in the market value of a company’s equity securities.
Companies must comply with this requirement for proxy and information statements for the election of directors during fiscal years beginning on or after July 1, 2019. Those that qualify as “smaller reporting companies” or “emerging growth companies” must comply beginning on or after July 1, 2020.
The final rule goes further than the statute by requiring disclosure of other transactions that could have the same economic effects as the purchase of financial instruments that would hedging against any market value decline of company stock (e.g., prepaid variable forward contracts, equity swaps, collars and exchange funds). According to Willis Towers Watson research, 94% of S&P 500 companies already disclose policies in place that prohibit executives from hedging company stock, and a further 2% disclose policies that prohibit or discourage hedging “without prior approval”.
The adopted rule will, in addition to the existing hedging disclosure required under Item 402 in the Compensation Discussion and Analysis (CD&A), require a new disclosure under Item 407 in the corporate governance section of the proxy. Since the Item 402 disclosure requirement remains intact, the final rule permits companies to cross-reference from the CD&A to the new Item 407 hedging policy disclosure. This means the hedging policy will remain a subject of the company’s say-on-pay vote.
As the Dodd-Frank requirement is a disclosure rule, the SEC maintains that public companies need not have in place any particular hedging policy. Instead, they must simply disclose the existence of any policy, its terms and who is covered. Companies should review existing policies to make sure they are broad enough to cover all potential hedging transactions intended by the rule, and perhaps encompass a broader population that includes more employees and directors.
Existing Item 402 disclosure
Existing disclosures are required under the following rules:
- CD&A: Disclosures of company hedging policies related to named executive officers (NEOs) are not required in the CD&A unless a company determines that doing so provides material information necessary to an understanding of a company’s compensation policies and decisions regarding only the NEOs. Nonetheless, many companies take this opportunity to disclose a broader policy that covers directors and other employees. This disclosure requirement does not apply to smaller reporting companies, emerging growth companies, registered investment companies or foreign private issuers.
- Form 4 disclosure: Under Section 16(a) of the Exchange Act, hedging transactions by officers and directors involving derivative securities (e.g., options, warrants, convertible securities, security futures products, equity swaps and stock appreciation rights) require reporting within two business days on Form 4.
- Prepaid variable forward contracts: Where these contracts involve pledges of company equity as collateral, this must be noted in beneficial ownership disclosures for directors and NEOs on proxies, 10-Ks and Form 10s.
Final SEC disclosure rule
The final Dodd-Frank disclosure requirement largely follows the proposed rule and requires a description of practices or policies (written or not) that would permit employees or directors to hedge directly or indirectly against any decrease in the market value of equity securities granted by the company as compensation. The final rule does not require a disclosure of the policy itself, but instead requires “a fair and accurate summary of the practices or policies that apply,” which would include the categories of persons covered and any categories of hedging transactions that are specifically permitted and any categories that are specifically disallowed [emphasis added].
Alternatively, a company could decide to disclose the practices or policies in full. By broadening the rule to permit compliance by listing actions that are disallowed, the SEC acknowledged that following the statute’s mandate to list permitted transactions would be cumbersome for companies, since most policies specify prohibited actions.
The final regulation clarifies that a company is required only to disclose the categories of persons its hedging policy covers, not categories of employees not covered.
The SEC determined this information should be in the proxy so shareholders can consider it along with the company’s other corporate governance disclosures, (including practices or policies affecting the alignment of incentives) when voting for directors. Because it is a governance requirement, the rule provides no exceptions for smaller reporting companies, emerging growth companies or business development companies, although some of these companies will have a delayed compliance date. Foreign private issuers, investment companies registered under the Investment Company Act and listed closed-end investment companies are exempt from this disclosure requirement.
“Hedge” not defined
The final rule does not define “hedge” because the SEC finds the statutory language that refers to financial instruments “that are designed to hedge or offset any decrease in the market value” to be clear. Moreover, the SEC indicates that “hedge” should be applied broadly and apply to transactions with the same economic effects of hedging or that offset any decrease in the market value of company equity securities. The SEC consciously determined not to list specific transactions to avoid a rule that could become obsolete as new downside price protection techniques develop. It also acknowledged that this principles-based approach could lead to less comparability in the required disclosures across companies.
The final rule removes many of the proposed rule instructions that specify details of any “hedging” policies that are mandated to be disclosed — companies are now left on their own to determine what information must be disclosed under the “fair and accurate summary” rule or by disclosing the policy itself. This means companies must evaluate whether different portfolio diversification transactions, broad-based index transactions, or other similar transactions, are considered “hedges.” Once determined, companies will need to decide on how to disclose this information, if at all.
The final rule clarifies that covered equity securities are compensatory equity grants as distinguished from other equity held directly or indirectly by an employee or director. Equity securities are only those issued by the company, its parent, subsidiaries or any other subsidiary of the parent.
Steve Seelig is a senior director specializing in executive compensation in Willis Towers Watson’s Research and Innovation Center, and is based in Arlington. Email firstname.lastname@example.org or email@example.com.