In somewhat of a surprise announcement, last week the SEC proposed rules to implement the requirement under the Dodd-Frank Act that companies disclose their policies with respect to hedging by employees and directors.

This Has Nothing to Do With Yard Work

Hedging is a means by which investors protect themselves against downside risk—think “hedging your bets.”  This is all well and good for the average investor, but when the investor in question is an officer or director of the company who has received compensatory awards of stock and/or options, hedging can be problematic. Companies grant equity awards to align their officers and directors with shareholders and to motivate them to increase the value of the company’s stock. If the officers and directors can use hedging instruments to protect themselves from downside risk, they might be less motivated by their equity awards.

Likewise, where a company has implemented ownership guidelines, if officers and directors can hedge against the stock they own to comply with the guidelines, then the guidelines aren’t terribly effective because officers and directors haven’t really assumed the risk of ownership.

More Controversial Than You Might Think

The proposal was issued via written consents of the Commissioners, rather than an open meeting, which is why it caught many of us by surprise. An open meeting would have been announced in advance and people that follow the SEC’s meeting schedule would have known it was happening.

I thought that this ought to be relatively simple—essentially, “disclose your hedging policy”—especially since companies are already doing this for their NEOs in the CD&A.  But I guess nothing that the SEC does is very simple; the proposing release is 103 pages long.  That is, however, shorter than the CEO pay ratio disclosure proposal, which clocked in at 162 pages.

Part of the complexity is that there are virtually an infinite number of possible types of arrangements and instruments that can be used to hedge a financial position.  Complicated strategies like equity swaps, variable prepaid forward contracts, and collars (in case you are wondering, I have no idea what any of these things are, except that I do know that an equity swap is not the same thing as a swap exercise) and more straightforward transactions such as a short sale (I know what that is: a short sale is selling stock you don’t own yet—you are hoping the stock price will decline before you have to buy the stock to close out your position).

The SEC requests comments on a number of matters related to the rules, including:

• Should the disclosure apply to all employees (the language included in Dodd-Frank) or just officers and directors (the individuals investors are probably most concerned about when it comes to hedging)?
• Should the rules be part of corp governance disclosures under Reg S-K Item 407 or part of the Say-on-Pay disclosures under Item 402?  The proposal includes them under Item 407, which means that shareholders technically aren’t voting on them as part of Say-on-Pay.
• Types of equity securities that should be subject to the disclosure.
• Should companies be required to disclose hedging activities that employees, officers, and directors have engaged in?
• Should smaller reporting companies or emerging growth companies be exempted from making the disclosure or subject to a delayed implementation schedule?

Comments should be submitted to the SEC by April 20, 2015.

Cooley’s blog has a nice summary of the proposal, if you don’t want to read all 103 pages.

– Barbara