In April 2015, the comment period expired for rules proposed by the U.S. Securities and Exchange Commission (the SEC) to implement Section 955 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act).¹ These proposed rules (the Proposed Rules)² would require disclosure of whether directors, officers and other employees are permitted to hedge or engage in any transactions that mitigate the incentive alignment associated with equity ownership.

Section 955 of the Dodd-Frank Act added Section 14(j) to the Securities Exchange Act of 1934 (the Exchange Act). Under Section 14(j), the SEC is instructed to require each issuer to disclose in any proxy or consent solicitation material for an annual meeting of the shareholders of the issuer whether any employee or member of the board of directors of the issuer, or any designee of such employee or director, is allowed to purchase financial instruments that are intended to hedge or offset any decrease in the market value of equity securities either (1) granted to the employee or director by the issuer as part of the compensation of the employee or director; or (2) held, directly or indirectly, by the employee or director.

While the SEC reviews comments submitted with regard to the Proposed Rules, this Legal Alert provides an overview of the changes to the disclosure requirements suggested by the Proposed Rules under Section 14(j) of the Exchange Act.

Requirements of the Proposed Rules

The Proposed Rules generally require disclosure of whether issuers allow employees,³ directors or officers, or any of their designees, to purchase financial instruments (including prepaid variable forward contracts, equity swaps, collars and exchange funds) and to engage in transactions that are intended to or have the effect of hedging or offsetting any decrease in the market value of equity securities that are granted as compensation, or are held directly or indirectly.

If an issuer permits some, but not all, of its employees and directors to hedge, the issuer would be required to disclose which categories of persons are permitted to hedge and which categories of persons are not. Likewise, if an issuer permits some types of hedging transactions, but not others, the issuer would be required to disclose which transactions it permits (including sufficient detail to explain the scope of the permitted transactions) and which it prohibits. In disclosing these categories, an issuer may, if true, disclose that it permits particular categories and prohibits all other hedging transactions.

If an issuer permits all hedging transactions or, alternatively, does not permit any hedging transactions, then the disclosure of such policy shall be sufficient without the need to describe each transaction by category.

Issuers Subject to the Proposed Rules
 
In general, the Proposed Rules apply to issuers with a class of equity securities registered under Section 12 of the Exchange Act, including:

• Smaller reporting companies;
• Emerging growth companies;
• Registered closed-end funds that have shares that are listed and registered on a national securities exchange; and
• Business development companies (BDCs), including both those listed and unlisted.

The following entities are excluded from the scope of the Proposed Rules:

• Foreign private issuers; and
• Investment companies registered under the Investment Company Act of 1940 that are not listed closed-end funds, including:
  • Non-listed registered closed-end funds;
  • Mutual funds whose shares do not trade on an exchange; and
  • Exchange-traded funds.

“Equity Securities” Defined

As proposed, “equity securities” would include any equity securities, as defined in Exchange Section 3(a)(11)⁴ and Exchange Act Rule 3a11-1,⁵ issued by the issuer and its parents, subsidiaries or subsidiaries of the issuer’s parents that are registered on a national securities exchange or registered under Exchange Act Section 12(g).

Implementation of the Proposed Rules

The Proposed Rules effectuate Section 14(j) by amending the following:

• Item 407 of Regulation S-K
  • The Proposed Rules add paragraph (i) to Item 407 of Regulation S-K, which requires companies to disclose whether they allow employees, officers or directors, or any of their designees, to engage in transactions that are intended to, or have the effect of, hedging or offsetting any decrease in the market value of equity securities.
• Item 402(b) of Regulation S-K
  • The Proposed Rules revise paragraph (b) to add Instruction 6, which stipulates that an issuer may satisfy its Compensation Discussion and Analysis (CD&A) requirement to disclose material policies on hedging by named executive officers by cross-referencing the information disclosed pursuant to proposed Item 407(i) to the extent that such information fulfills the CD&A disclosure requirement.
• Schedule 14A
  • The Proposed Rules revise Items 7 and 22 of Schedule 14A to require proposed Item 407(i) information to be provided if action is to be taken regarding the election of directors.

¹ Dodd-Frank Act, 124 Stat. 1904 (2010).
 
² Release No. 33-9723 (February 9, 2015).
 
³ The SEC has requested comment on whether the scope of “employees” subject to the Proposed Rules should be limited to those who participate in integral decision-making that affects the issuer’s stock price or, alternatively, if a materiality clause should be added to the definition, to allow each issuer to determine if disclosure regarding all of its employees’ hedging transactions would be material information for investors.
 
⁴ Exchange Act Section 3(a)(11) defines “equity security” as any stock or similar security; or any security future on any such security; or any security convertible, with or without consideration, into such a security, or carrying any warrant or right to subscribe to or purchase such a security; or any such warrant or right; or any other security which the SEC shall deem to be of similar nature and consider necessary or appropriate, by such rules and regulations as it may prescribe in the public interest or for the protection of investors, to treat as an equity security.

⁵ Exchange Act Rule 3a11-1 defines “equity security” to include any stock or similar security, certificate of interest or participation in any profit sharing agreement, preorganization certificate or subscription, transferable share, voting trust certificate or certificate of deposit for an equity security, limited partnership interest, interest in a joint venture, or certificate of interest in a business trust; any security future on any such security; or any security convertible, with or without consideration into such a security, or carrying any warrant or right to subscribe to or purchase such a security; or any such warrant or right; or any put, call, straddle, or other option or privilege of buying such a security from or selling such a security to another without being bound to do so.