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Proposal Seeks Disclosures of Hedging of Company Stock, Options

The SEC issued a proposed rule that would require public companies to disclose in proxy statements whether directors and employees use hedges to offset a decrease in company shares granted as compensation. The requirement from the Dodd-Frank Act will have to appear in proxy statements and require companies to disclose transactions that could distort an executive’s incentives by giving them a reason to want the stock price to drop when most investors want the shares to rise.

The SEC issued a proposal in Release No. 33-9723, Disclosure of Hedging by Employees, Officers and Directors, on February 9, 2015.

The market regulator wants comments within 60 days after the rule is published in the Federal Register, which can take up to a few weeks following a rule’s publication on the SEC’s website.

Issued to carry out a Dodd-Frank provision, the proposal, if finalized, will require companies to disclose in their proxy statements whether directors, officers, and other employees are allowed to hedge or offset a decrease in the market value of stocks granted as compensation or held by employees or directors.

“The proposed rules would provide investors with additional information about the governance practices of the companies in which they invest,” said SEC Chair Mary Jo White in a statement. “Increasing transparency into hedging policies will help investors better understand the alignment of the interests of employees and directors with their own.”

The rule will apply to proxies for the election of directors, including smaller public companies, emerging growth companies, business development companies, and registered closed-end investment companies whose stocks are publicly listed.

Dodd-Frank amended Section 14 of the Securities Exchange Act of 1934, and the proposal is essentially carrying out a requirement that’s already established in law. If it’s finalized, the rule will require companies to disclose whether employees or directors can buy derivatives, such as forward contracts or stock swaps to hedge or offset any drop in the stock price. The proposal offers amendments to the executive compensation provisions of Item 402 and the corporate governance provisions in Item 407 of Regulation S-K.

The proposal would also require companies to disclose other transactions that could distort an executive’s incentives by giving them a reason to want the stock price to drop when most investors want the shares to rise.

“A Senate report indicated that Section 14(j) was added so that shareholders would know whether executive officers are able ‘to effectively avoid compensation restrictions that they hold stock long-term, so that they will receive their compensation even in the case that their firm does not perform,'” the SEC said in Release No. 33-9723.

The SEC said a short-sale hedge can protect an executive or director against a drop in the stock price. Similarly, selling a stock future increases the value of the executive’s position as the stock drops and protects the executive, which is what the Dodd-Frank Act sought to discourage with the hedging disclosure. Starting in the 1980s and 1990s, activist investors often encouraged companies to adopt stock-compensation programs because they seemed to align executives’ financial interests with those of public shareholders. In the years leading up to the 2008 crisis, the growing prevalence of hedging instruments made many investors suspect the common interests had eroded.

“In the absence of this proposed disclosure, shareholders may not be aware of the executive officers’ and directors’ true economic exposure to the company’s equity,” said SEC Commissioner Luis Aguilar in a statement he issued shortly after the proposal was published.

“We are concerned that if the proposed disclosure requirement is not sufficiently principles-based, the result would be incomplete disclosure as to the scope of hedging transactions that an issuer permits,” the SEC said in the rule proposal. “If, for example, a company discloses that it prohibits the purchase of the types of financial instruments specifically listed in the statute, and does not otherwise disclose whether it permits other types of hedging transactions that may have the same economic effects as the purchase of the listed financial instruments, a shareholder might assume that the company does not permit any hedging transactions at all, even though that may not be the case.”

The five commissioners unanimously approved issuing the proposal without meeting publicly, which is an usual step for the agency but also understandable, given that the proposal essentially carries out a legally mandated provision from Dodd-Frank.

The SEC still needs to act on other Dodd-Frank disclosure rules related to executive compensation, including finalizing a disclosure requirement for the ratio of the CEO’s compensation to the median wages for employees and proposing disclosures of the connection between executive pay and the company’s financial performance and a company’s policies for recovering executive compensation after a company is forced to restate its earnings because of accounting fraud, or what is often called the clawback provision. All three rules are on the SEC’s 2015 agenda.

Of the remaining executive compensation disclosure rules, the hedging requirement may be the easiest to complete. The rule is “relatively straightforward,” said Keith Higgins, director of the SEC’s Division of Corporation Finance, in December at the AICPA’s Conference on Current SEC and PCAOB Developments in Washington.

Republicans Daniel Gallagher and Michael Piwowar issued a joint statement that said they were concerned by some aspects of the proposal in Release No. 33-9723 and asked that the final regulation exempt emerging growth companies and other small companies because the compliance costs may fall disproportionately on them. The 2012 JOBS Act established emerging growth companies as a special class for the purposes of securities regulation and granted them some important exemptions from SEC reporting rules until they’ve been public for five years, reached $1 billion in revenues, issued $1 billion in debt, or climbed to a stock market value of $750 million.

Gallagher and Piwowar complained that certain investment companies would be subject to the rule because they’re externally managed and have little employee hedging.

They said the proposal should have included an exemption related to employees who can’t affect a company’s share price even if the Dodd-Frank provision technically includes them. They’re also concerned that the release covers stocks of not only the company but also the companies’ affiliates, making the coverage “overbroad.”

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