Regulatory: Revisiting hedging and pledging policies

The increasing level of disclosure, heightened investor scrutiny and consideration accorded by proxy advisory firms has caused many companies to adopt or alter policies

Over the past few years, there has been considerable focus on policies addressing the hedging and pledging of securities by public company employees, executives and directors. In particular, significant market volatility has brought to light some key issues arising from the pledging of company securities by employees, executives and directors of public companies, including concerns as to whether an individual’s interests remain aligned with shareholders through his pledging of equity awards or other shares owned to secure loans. Similar concerns exist with regard to hedging and monetization arrangements, where employees, executives or directors may seek to continue to own company securities obtained through the company’s benefit plans or otherwise, but without the full risks and rewards of ownership.

Background on hedging and pledging transactions

Hedging or monetization transactions can be accomplished through a number of possible mechanisms, including, but not limited to, through the use of financial instruments such as exchange funds, prepaid variable forwards, equity swaps, puts, calls, collars, forwards and other derivative instruments, or through the establishment of a short position in the company’s securities. In addition, individuals may seek to secure loans by pledging the company’s stock as collateral for the loan, including through the use of traditional margin accounts with a broker. Because securities held in a margin account as collateral for a margin loan may be sold by the broker without the customer’s consent if the customer fails to meet a margin call, and securities pledged (or hypothecated) as collateral for a loan may be sold in foreclosure if the borrower defaults on the loan, significant concerns exist when the margin sale or foreclosure sale may occur at a time when the pledger is aware of material nonpublic information or otherwise is not permitted to trade in the company’s securities. The company may also face potentially adverse public perceptions when employees, executives and directors engage in these types of transactions.

Regulatory developments

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 directed the Securities and Exchange Commission (SEC) to adopt rules requiring disclosure of whether any employee or director is permitted to purchase financial instruments that 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. While the SEC has not yet proposed or adopted rules implementing this directive, public companies have recently felt pressure from institutional investors and proxy advisory firms to disclose the company’s policies about hedging and monetization transactions. Meanwhile, the SEC first required disclosure of shares pledged by the highest-paid executive officers and the company’s directors beginning in 2006, focusing additional attention on these arrangements in the context of a company’s overall corporate governance and compensation policies and practices.

Adopting or revisiting policies

The increasing level of disclosure, the heightened investor scrutiny and the consideration accorded by proxy advisory firms has caused many public companies to adopt policies about hedging, monetization or pledging transactions, or revisit existing policies to consider whether the scope or coverage of such policies should be changed. The options that companies have pursued include:

  • prohibiting hedging, monetization and/or pledging transactions for executive officers and directors, or perhaps even for all employees and directors;
  • subjecting hedging, monetization and/or pledging transactions to a pre-approval process;
  • restricting the types of hedging, monetization and/or pledging transactions that may be undertaken; or
  • permitting hedging, monetization or pledging transactions without any specific policy on their use.

The variation in approaches reflects how situations differ substantially from company to company and from individual to individual. In some cases, hedging, monetization or pledging transactions may serve legitimate tax planning or other purposes, thereby making a complete prohibition on such transactions unworkable. For this reason, some companies have chosen to address the situation though a pre-clearance process, which provides compliance personnel within the organization the ability to carefully analyze a transaction before an individual proceeds with it. Other companies may choose to restrict only certain types of transactions, particularly ones in which it is perceived that the risks to the company and the participating individuals may be high.

Another key area of consideration is the extent of coverage for these policies. The Dodd-Frank Act disclosure requirement will seek disclosure with respect policies concerning all employees and directors, while in many cases companies have adopted policies that are specifically limited to the company’s executive officers and directors. Companies are concerned that adopting policies broadly applicable to all employees and directors may be difficult to communicate and enforce.

Some companies have also sought to extend prohibitions to other types of short-term or speculative transactions, such as trading in exchange traded puts and calls on the company’s securities, or short-term trading transactions (i.e., buying and selling the company’s securities within six months).

Location of policies

Very often, policies with regard to hedging, monetization or pledging are included in a company’s insider-trading policy. Some companies have adopted standalone policies addressing some or all of these topics, and others have incorporated these concepts into the company’s code of conduct, stock ownership guidelines and corporate governance guidelines.

Conclusion

With the advent of advisory votes on executive compensation and increased disclosure regarding a wide variety of hot-button issues for shareholders, we will continue to see public companies adopting or revisiting their policies concerning hedging, monetization and/or pledging transactions.

Contributing Author

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David Lynn

David M. Lynn is a co-chair of Morrison & Foerster LLP's Public Companies and Securities Practice. Mr. Lynn's practice is focused on advising a wide...

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