Yesterday the Securities and Exchange Commission announced the adoption of proposed rules to implement Section 955 of the Dodd-Frank Wall Street Reform and Consumer Protection Act which addresses disclosure of company policies related to employee and director hedging transactions.
The proposed rules would add a new subparagraph (i) to Item 407 (corporate governance) of Regulation S-K which would require disclosure in any proxy or consent solicitation materials or information statement relating to director elections regarding whether an issuer’s employees (including officers) and directors, or any of their designees, are permitted to purchase financial instruments or otherwise engage in transactions designed to hedge or offset any decrease in the market value of equity securities granted as compensation or otherwise directly or indirectly held from whatever source acquired.
The term “equity securities” would mean the equity securities (as defined in Section 3(a)(11) of the Securities Exchange Act of 1934 and Exchange Act Rule 3a11-1) of the issuer, as well as any subsidiary, parent company or subsidiary of a parent company of the issuer, that are registered under Section 12 of the Exchange Act.
The proposed rules would apply to emerging growth companies, smaller reporting companies, business development companies and registered closed-end investment companies listed and registered on a national securities exchange, but not other investment companies, such as ETFs or mutual funds, or to foreign private issuers.
The text of the proposed rules are set forth below.
Of course not much that the Commission does these days is without a bit of controversy, so accompanying the proposed rules we have a statement from Commissioner Aguilar and a joint statement from Commissioners Gallagher and Piwowar.
Highlights from Commissioner Aguilar’s statement:
By allowing corporate insiders to protect themselves from stock declines while retaining the opportunity to benefit from stock price appreciation, hedging transactions could permit individuals to receive incentive compensation, even where the company fails to perform and the stock value drops.
Just as problematic, hedging transactions can be structured so that executives or directors monetize their shareholdings while they still technically own the stock, which makes the fact that the hedging took place less transparent to investors. … Accordingly, the proposed hedging rules are intended specifically to address this lack of transparency, and attempt to provide greater clarity to investors regarding employees’ and directors’ actual incentives to create shareholder wealth. … [B]etter information about equity incentives could be useful for investors’ evaluation of companies, enabling investors to make more informed investment and voting decisions.
It is important to note what the proposed rules do not do: they do not prohibit hedging transactions by employees or directors of public companies.
And, from Commissioners Gallagher and Piwowar’s statement:
While we ultimately voted to support the issuance of this proposal, our position should not be taken as unqualified support … [i]ndeed, we remain quite concerned by several aspects of the proposal … .
First, the proposed rules do not exempt emerging growth companies (EGCs) or smaller reporting companies (SRCs). …
[T]he direct costs of disclosure may fall disproportionately on EGCs and SRCs because they are less financially able to bear disclosure’s fixed costs. The indirect costs of disclosure may also disproportionately disfavor EGCs and SRCs … [as they] appear less likely to have hedging policies already in place, and our new disclosure requirement could make them feel compelled to adopt policies prohibiting hedging. … [P]rohibiting hedging could misalign the incentives of EGCs’ and SRCs’ employees and directors with those of investors. … [T]he release does not analyze whether the incremental cost of this disclosure … may have negative effects on overall capital formation … .
Second, the proposed rule would require certain investment companies (listed, closed-end funds) to make the disclosures contemplated by the rule. … [T]he utility of a disclosure about the alignment of incentives between investors and directors based on whether hedging of shares is permitted is questionable … . We would not have included these funds within the scope of the rule.
Third, we believe the Commission should have exercised its statutorily-granted exemptive authority to exempt from the rule disclosures relating to employees that cannot affect the company’s share price. …
Fourth, we are concerned that the release’s coverage of securities not just of the issuer, but also of the issuer’s affiliates–including subsidiaries, parents, and brother-sister companies–is overbroad. …
Finally, we would be remiss if we did not note that the determination to move forward with this release reflects a prioritization of the Commission’s work that we do not share. …
One thing everyone did seem to be in agreement on is the desire to receive public comment.
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