The Dodd-Frank Wall Street Reform and Consumer Protection Act, which was enacted in 2010, included a host of corporate governance changes. Among other things, Dodd-Frank directed the Securities and Exchange Commission to adopt rules requiring public companies to make disclosures regarding the ability of their employees and directors to engage in hedging transactions relating to company securities. According to the SEC, the purpose of this requirement is to provide transparency to shareholders about whether a company’s employees or directors may engage in transactions that reduce or avoid the incentive alignment associated with equity ownership related to their employment or board service. For a variety of reasons, these hedging rules were delayed for years.
In the meantime, Institutional Shareholder Services and other investor groups expressed concerns with hedging transactions by company insiders and identified director and executive hedging as a “failure of risk oversight.” As a result, many public companies adopted policies that prohibit directors and executives from engaging in hedging activities involving company stock.
The SEC finally adopted its hedging rules in December 2018. For most public companies, the rules apply to proxy statements for annual meetings relating to fiscal years beginning on or after July 1, 2019. Smaller reporting companies and emerging growth companies will have an additional year to comply. Public company boards are encouraged to review their existing hedging policies and disclosures in light of these new requirements.
Overview of the New Disclosure Requirements. Under the new rules, which appear in Item 407(i) of Regulation S-K, a public company is required to describe any of its practices or policies regarding the ability of its employees or directors 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 that are:
• Granted to the employee or director by the company as part of the compensation of the employee or director, or
• Otherwise held, directly or indirectly, by the employee or director.
This description must provide a fair and accurate summary of the practices or policies that apply to hedging, including the categories of persons covered, and it must describe any categories of hedging transactions that are specifically permitted or specifically disallowed. In lieu of a summary, the company may disclose its practices or policies in full.
Considerations for Hedging Policies. When reviewing policies with these new disclosure requirements in mind, boards must ask themselves several important questions.
Does the company need a hedging policy? The new SEC rules do not specifically require public companies to maintain hedging policies. If a company does not have any practices or policies regarding hedging, it must disclose that fact or state that hedging transactions are generally permitted. Regardless of the technical legal requirements, hedging policies are widely considered best practices for corporate governance. In the SEC’s sampling of existing proxy statement disclosures, 97% of the selected S&P 500 companies and 71% of the selected S&P SmallCap 600 companies have disclosed hedging policies in prior years. Given the new rules, most public companies are expected to adopt policies if they have not already.
Who should be covered by the policy? Note that the new SEC rules address hedging policies relating to directors and all employees – not just executive officers. For smaller companies, broad coverage may make the most sense. However, if a large employee base would make enforcement of the policy impractical, it may make sense for larger companies to limit the policy to directors and key employees. Because the SEC rules cover securities held directly or indirectly by the person covered by the policy and their “designees,” policies should address activities by family members and controlled entities.
What activities should the policy cover? The SEC rules do not define the term “hedge,” but the SEC has indicated that it should be applied as a broad principle, covering instruments designed to hedge or offset any decrease in market value. While this position invites a sweeping consideration of potential hedging activities, it is important to remember that the rules only require the disclosure of the hedging policies the company actually adopts. For example, the SEC has indicated that a company would only need to describe portfolio diversification transactions or broad-based index transactions if the company’s hedging policy specifically addresses them. Policies certainly should address the financial instruments mentioned in the rule (prepaid variable forward contracts, equity swaps, collars and exchange funds) and any additional transactions of concern to the board, but otherwise general coverage may be the best course of action.
Where should the disclosure appear? The new SEC rules only require the hedging policy disclosure to be included in proxy statements or information statements that involve the election of directors, but public company disclosures regarding hedging policies are not new. The compensation discussion and analysis (CD&A) guidelines specifically identify company policies regarding hedging the economic risk of company stock ownership as an example of information that may be material to a company’s executive compensation program. However, CD&A disclosures are typically limited to compensation considerations for the named executive officers. The new SEC rules allow flexibility in the location of the disclosure in proxy statements, and compliance with CD&A requirements may be satisfied by including a cross-reference to the hedging policy disclosure appearing elsewhere in the proxy statement.
Given the prevalence of existing hedging policies, the new SEC rules may not require significant practical changes for many public companies. However, in an environment where investors are increasingly focused on corporate governance practices and plaintiffs’ lawyers pore over proxy statements for disclosure issues, public company boards are strongly encouraged to focus on hedging policies before next year’s proxy season begins.