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SEC adopts final rules on hedging disclosure—finally!

Wow, that took a while.

The Dodd-Frank Act required the SEC to adopt rules about disclosing a company’s practices and polices related to employees and directors hedging their positions in company equity securities. The purpose is to provide transparency to shareholders in the context of director elections regarding whether employees and directors are permitted to engage in transactions that mitigate the long-term incentive alignment associated with employee and director equity ownership.

The SEC proposed the hedging disclosure rules in February 2015. At long last, on December 18, 2018, the SEC adopted final rules adding new Item 407(i) to Regulation S-K requiring companies to describe any practices or policies they have adopted regarding the ability of their 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.

Companies can satisfy the hedging disclosure requirement by either disclosing the practices or policies in full or by providing a fair and accurate summary. If the company chooses to provide a summary, it must describe the categories of persons the practices or policies 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.

The Compensation Discussion and Analysis section of the proxy statement already requires disclosure of hedging policies that are material and necessary to an understanding of named executive officers compensation policies and decisions. To reduce duplicative disclosure, the amendments would also provide instructions that this aspect of the Compensation Discussion and Analysis section may be satisfied by cross-reference to its Item 407(i) disclosure.

The final rules only require disclosure in proxy or consent solicitation materials and information statements for fiscal years beginning on or after July 1, 2019 (for smaller reporting companies and emerging growth companies July 1, 2020) in connection with the election of directors. Requiring disclosures in such circumstances enables shareholders to consider the hedging policy disclosure at the same time they consider the company’s other corporate governance disclosures and vote for the election of directors.

Hedging Instruments – A Principles-Based Approach

The rule uses a principles-based approach to hedging policy disclosure, covering all transactions designed to hedge or offset any decrease in the market value of equity securities. It expressly covers prepaid variable forward contracts, equity swaps, collars, and exchange funds hedging transactions, but also covers other transactions with comparable economic consequences.

The final rule requires Item 407(i) disclosure for equity securities of the company, any parent, subsidiary, or subsidiary of any parent of the company that are registered under Section 12 of the Exchange Act.

Proxy Advisory Firm and Institutional Investor Considerations

Proxy advisory firms and many institutional investors consider anti-hedging policies an important compensation risk mitigation measure. ISS proxy voting policy flags any hedging by directors or executive officers as a material failure of risk oversight and may cause ISS to recommend negative votes for individual directors, members of the governance committee, or the whole board. ISS will also red flag a company’s lack of any anti-hedging policy. Glass Lewis’s proxy voting policy provides that hedging by executive employees severs the alignment of interest of the executive with shareholders and that companies should adopt strict anti-hedging policies.

Category: Boards of Directors, Capital Markets, Corporate Governance, Disclosure, Dodd Frank, Public Companies, Securities & Exchange Commission, Securities Law