Feb. 9, 2015
Today, the Commission proposed rules to implement the disclosures mandated by Section 955 of the Dodd-Frank Wall Street Reform and Consumer Protection Act. If adopted, these rules would require a registrant to disclose, in its proxy or information statement, whether employees (including officers) or members of the board of directors are permitted to engage in transactions to hedge or offset any decrease in the market value of equity securities granted to the employee or board member as compensation, or held directly or indirectly by the employee or board member.
While we ultimately voted to support the issuance of this proposal, our position should not be taken as unqualified support of the proposal in the form it was issued. Indeed, we remain quite concerned by several aspects of the proposal, and we hope to receive robust public comment on them.
First, the proposed rules do not exempt emerging growth companies (EGCs) or smaller reporting companies (SRCs). The release does solicit comment on whether such an exemption, or a delay in the effective date of the rule, could be appropriate for EGCs and SRCs. However, the release, based on little empirical data, ultimately concludes that the cost of the disclosure is likely to be minimal, and that investors in EGCs and SRCs may receive benefits from the rule. We question these conclusions and hope that, during the comment period, potentially-affected persons will submit data and information that can better inform the Commission at the adoption stage.
In particular, the direct costs of disclosure may fall disproportionately on EGCs and SRCs because they are less financially able to bear disclosure´s fixed costs. The indirect costs of disclosure may also disproportionately disfavor EGCs and SRCs. EGCs and SRCs appear less likely to have hedging policies already in place, and our new disclosure requirement could make them feel compelled to adopt policies prohibiting hedging. In addition to the costs of implementing such new policies, prohibiting hedging could misalign the incentives of EGCs´ and SRCs´ employees and directors with those of investors. Such misalignment may be more pronounced in EGCs and SRCs than that of larger companies, if the employees and directors of EGCs and SRCs have existing incentives that are different than those of larger companies. Moreover, the release does not analyze whether the incremental cost of this disclosure, when added to the already-substantial cumulative burdens of disclosure, may have negative effects on overall capital formation—or, put more simply, whether this could be the straw that broke the camel´s back. With respect to benefits, it is not clear that investors in these smaller companies, who may care more deeply about the company´s ideas or growth prospects, would experience the same benefits as investors in larger companies.
Where the Commission seeks to impose new burdens on EGCs and SRCs, it should proceed especially carefully, given the potential effects such actions may have on capital formation. Given these uncertainties, we cannot determine that the benefits of this regulation justify the costs with respect to EGCs and SRCs, and therefore the Commission should have proposed exempting them.
Second, the proposed rule would require certain investment companies (listed, closed-end funds) to make the disclosures contemplated by the rule. Given that investment companies are overwhelmingly externally managed, there is very little employee hedging that would be subject to the rule. Further, it is not clear how many fund directors have been awarded, or otherwise hold, shares of their listed closed-end funds—but staff believes it to be uncommon, and in some cases prohibited. Any mechanism by which directors could impact the discount at which shares of closed-end funds would trade is attenuated, given the limited control that directors have over the investment advisers that manage these funds day-to-day. Thus, the utility of a disclosure about the alignment of incentives between investors and directors based on whether hedging of shares is permitted is questionable, and yet it is the primary justification for subjecting over 600 listed closed-end funds to these disclosure requirements. We would not have included these funds within the scope of the rule.
Moreover, we are concerned that the release expressly seeks comment on whether to extend the disclosure requirement to all funds, including open-end funds. As the release makes clear, the characteristics of listed, closed-end funds that are cited as justification for including those funds within the scope of the disclosure regime are not present with respect to other types of funds. For example, these other types of funds are generally not required to hold annual shareholder meetings. It will therefore be important to receive comment from these other types of funds (e.g., mutual funds and ETFs) explaining what the impact of this rule would be on them.
Third, we believe the Commission should have exercised its statutorily-granted exemptive authority to exempt from the rule disclosures relating to employees that cannot affect the company´s share price. While the statute technically covers these employees, the legislative history and our own economic analysis seem to indicate that disclosures about whether these employees are permitted to hedge fall below the level of information that investors would find useful. When we are faced with a conflict of this nature, we can assume that Congress has given us exemptive authority for a reason, and that we should use it to tailor our legislative mandates in a way that produces only material information for investors. Failure to undertake this analysis risks harming investors through disclosure overload. Based on our own assessment, we believe it would have been appropriate to propose an exemption for this class; we hope to receive good input on the question on this topic that was included in the release.
Fourth, we are concerned that the release´s coverage of securities not just of the issuer, but also of the issuer´s affiliates—including subsidiaries, parents, and brother-sister companies—is overbroad. While the release does limit that population to companies that are themselves registered under Section 12, we remain concerned that the definition will require registrants to engage in a complex, facts-and-circumstances control analysis to determine who is covered by the proposed disclosure requirement. This in turn raises the costs of disclosure, particularly if registrants with preexisting hedging restrictions would now need to modify the scope of those policies so that those registrants may continue to state, for example, that hedging is generally prohibited.
Finally, we would be remiss if we did not note that the determination to move forward with this release reflects a prioritization of the Commission´s work that we do not share. If we are to focus on Dodd-Frank implementation, it should be on those rules actually germane to the financial crisis—e.g., credit ratings reference removal, or Title VII. But an eye single to Dodd-Frank also neglects other important priorities stemming from the rest of the federal securities laws. For example, it is not clear that prioritizing this release over the Division of Corporation Finance´s comprehensive disclosure review was the highest and best use of that Division´s expert staff.
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We look forward to receiving comments on all the questions raised by the release, but we particularly hope that the Commission will receive robust comment on these critical issues.