(The following post originally appeared on ONSecurities, a top Minnesota legal blog founded by Martin Rosenbaum to address securities, governance and compensation issues facing public companies.)
Over the past few years, there has been an increasing focus on public company insider hedging and pledging activities. Institutional shareholders and proxy advisory firms have been pressuring public companies to disclose their policies on hedging and pledging. Under the Dodd Frank Act, enacted in 2010, Congress charged the SEC with adopting rules regarding disclosure of this activity in SEC filings. However, the SEC has not yet proposed or adopted rules implementing this mandate. The SEC has eliminated its expected rulemaking timetable for this and certain other Dodd-Frank provisions and, instead, the SEC’s website now indicates that the rulemaking is “pending action.”
Taking matters into its own hands, the shareholder advisory firm Institutional Shareholder Services (ISS) specifically addressed hedging and pledging activity its 2013 U.S. corporate governance policy updates, which were posted on November 16, 2012. Among other policy updates, ISS added a footnote to its policy on voting for director nominees in uncontested elections in circumstances where there are perceived governance failures. Currently, ISS will recommend that shareholders vote “against” or “withhold” votes from directors (individually, committee members, or the entire board) due to, among other things, “[m]aterial failures of governance, stewardship, risk oversight, or fiduciary responsibilities at the company”. The new footnote cites hedging and significant pledging of company stock as examples of activities that will be considered failures of risk oversight. Other cited examples of risk oversight failures include bribery; large or serial fines or sanctions from regulatory bodies, and significant adverse legal judgments or settlements.
By identifying the existence of hedging and significant pledging as a risk oversight and corporate failure, ISS will attempt to hold directors accountable for permitting that practice to exist. “Against” or “withhold” recommendations may not be limited solely to individuals that actually engage in hedging or pledging activity.
As rationale for this update, ISS states that director and executive stock ownership, whether resulting from equity compensation grants or open market purchases, should serve to align executives' or directors' interests with the interests of shareholders. ISS asserts that hedging severs the alignment of these interests and, therefore, any amount of hedging will be considered a problematic practice warranting a negative voting recommendation.
Pledging is treated differently. As noted by the Society of Corporate Secretaries & Governance Professionals in a comment letter on the proposals (PDF), ISS’ initial proposal was to consider pledging by executives as a problematic practice in all cases. In its comments, the Society argued that “an across the board policy was inappropriate, and that it could affect many smaller, founder-led companies where company stock constitutes the majority of an executive's (or other director's) net worth and such pledging has been used judiciously for an appropriate reason such as purchasing a home.” In response to these and other comments, ISS revised its policy to state that only “significant” pledging will be considered a problematic practice warranting a negative voting recommendation. What constitutes “significant” pledging will be determined on a case-by-case basis. In making voting recommendations for election of directors of companies who currently have executives or directors with pledged company stock, ISS will take the following factors (in additional to “other relevant factors”) into consideration:
- Whether the company has an anti-pledging policy that prohibits future pledging activity;
- The magnitude of aggregate pledged shares in relation to the total shares outstanding, market value or trading volume;
- The company’s progress or lack of progress in reducing the magnitude of aggregate pledged shares over time; and
- Whether shares subject to stock ownership and holding requirements include pledged company stock.
ISS’ 2013 policy updates will be in effect for shareholder meetings on or after February 1, 2013.
Comment. Companies who currently have executives or directors with pledged company stock will likely include disclosures regarding these matters in the proxy statements for their meetings even in the absence of SEC rules mandating such disclosure. I would also expect to see companies without insider hedging or pledging activity call that out in their filings. As Dave Lynn pointed out in his September 2012 InsideCounsel article, policies governing hedging and pledging activity are often included in a company’s insider trading policy, and companies will no doubt be reviewing their existing policies to assess the potential impact of ISS’ new policy recommendations.