We have published an update on the recent disclosure proposals under Section 14(j) of the Securities Exchange Act of 1934 (the “Exchange Act”).  The update can be accessed here.

In summary, the Securities and Exchange Commission (SEC) recently released long-awaited proposed rules, as mandated by Section 955 of the Dodd-Frank Act, that would require a public company to disclose whether the company permits its employees, officers or directors to purchase financial instruments or otherwise engage in transactions that “hedge” their exposure to risk related to the company’s equity securities that they hold.

This posting augments our update by providing an overview of the different types of hedging transactions referenced in Section 14(j) of the Exchange Act, as well as the SEC’s rule proposal and related preamble, proposed rule and related preamble, Disclosure of Hedging by Employees, Officers and Directors; Proposed Rule, 17 Fed. Reg. 8486 (February 17, 2015) (the “Proposing Release”).  The Proposing Release is available here.

The Use of Financial Instruments for Hedging Purposes

In theory, disclosures along the lines of what are required by Section 14(j) are intended to allow the public and investors to better assess whether the interests of a company’s key decision makers are aligned with the long-term interests of the company. In an effort to align the interests of management and the company’s shareholders, public companies will issue stock to employees and directors as part of the company’s compensation program. However, it is not uncommon for some employees or directors to use derivatives or other financial instruments to protect themselves against a decline in the value of the company’s stock and, in the case of some arrangements, to monetize their holdings of company stock. From the perspective of an individual employee or director, such protection and monetization benefits of these arrangements may be particularly important if the company’s stock represents a significant portion of that individual’s personal wealth.

The following are descriptions of the specific types of arrangements included by reference in Section 14(j) of the Exchange Act that can be utilized by employees or directors for hedging purposes. (We refer solely to employee in these summaries, although it should be understood that directors may enter into these arrangements.)

  • Prepaid Variable Forward Contract – An employee could use this type of a contract as protection against a decline in the price of stock in exchange for a limit on the employee’s ability to appreciate in an increase in the value of the company’s stock. The contract would obligate the employee to sell, and a broker-dealer or other financial counterparty to purchase, a variable number of shares of the company’s stock at a specified future maturity date.[1] On that date, the number of shares deliverable by the employee will depend on the market price per share of company’s stock determined as of a date close to the maturity date. The contract will specify the maximum and minimum numbers of shares that the employee will be required to deliver at maturity. During the contract’s term, the employee will pledge the maximum number of shares required to be delivered at maturity.
  • Collar – The effect of a collar is similar to a prepaid forward contract, in so far as it provides the employee stockholder with downside protection in exchange for a limit on the employee’s ability to participate in an increase in the value of the company’s stock. However, the mechanics of a collar differ from a prepaid forward. In short, the employee simultaneously buys a put option and sells a call option. The put option provides downside protection, since it entitles the employee to sell the stock at a specified strike price (which the employee would do, if the market price of the stock trades below that level). The employee pays a premium to the seller of the put option (e., typically a broker-dealer or bank) in exchange for this right. The call option entitles the employee to receive a premium payment from the counterparty, but obligates the employee to sell the stock to the counterparty at a specified strike price, if the option is exercised by the counterparty. The counterparty will exercise this right, if market price per share of the stock exceeds that strike price. An employee will often use the premium received from the sale of the call option to pay some or all of the premium owed on the purchase of the put option.
  • Exchange Fund Exchange funds are also called “swap funds” and are privately offered investment vehicles. An employee contributes the company stock to the fund in exchange for an ownership interest in that fund. The value of the ownership interest will be determined by reference to the value of the company stock contributed by the employee. The fund invests in a diversified portfolio of securities, which affords the employee with the opportunity to become less concentrated in terms of the employee’s exposure to the company’s stock (i.e., the company stock is “swapped” or exchanged for an interest in a diversified basket of companies). Typically, the employee will receive an in-kind distribution of shares of the securities owned by the fund, although such distribution is likely to be several years later. Exchange funds are usually offered and managed by a broker-dealer, investment management firm, or other type of financial institution.
  • Equity Swaps – An equity swap is a type of derivative contract entered into between an employee and another counterparty that is usually a bank or broker-dealer. In the most straightforward type of equity swap, the employee enters into a contract that requires the employee to make payments to the counterparty over the life of the contract, in exchange for a promise by the counterparty to make payments to the employee if the value of the company’s stock goes down. The employee would participate in some or all of the appreciation in the value of the stock and may also receive a payment that is equivalent to the dividends on the company stock. In other types of equity swaps, the counterparty would take on the economic exposure to the company’s stock in exchange for a promise to provide the employee with payments that relate to the investment returns of a stock index or a diversified basket of stocks. This latter type of equity swap is conceptually similar to an exchange fund, in that both arrangements allow the employee to exchange concentrated exposure to the company’s stock for exposure to a more diversified investment portfolio.

The SEC’s proposed rule to implement the disclosure mandate in Section 14(j) of the Exchange Act would require disclosures in respect of the purchase of any of these financial instruments, as well as any transaction that would have economic consequences comparable to the purchase of these financial instruments. The Proposing Release cited two specific examples of economically comparable transactions: 1) a short sale of the company’s stock by an employee; and 2) the sale of a security futures contract on the company’s stock (also called a single stock future).[2] Both of these representative transactions would allow the employee to receive a payment if the value of the company’s stock decreased.

Good day.  Good background for your comment drafting process, or at least we hope.  DR2


[1] See description of prepaid variable forward contract in Proposing Release at footnote15, page 8487.

[2] Proposing Release at 8488.