(Article from Registered Funds Alert, May 2015)
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On February 9, 2015, the SEC announced proposed amendments to Items 402 and 407 of Regulation S-K and Schedule 14A, which govern the requirements that an issuer disclose its employees’ and directors’ ability to hedge any decrease in the market value of the issuer’s equity securities in proxy statements. The proposed amendments implement provisions of the Dodd-Frank Act that expand the hedging disclosure requirements. It is notable that the proposed amendments would not prohibit hedging by officers or directors, or impose any requirement that policies or procedures be adopted regarding hedging.
Current regulations do not apply the hedging disclosure requirements to directors or require funds registered under the 1940 Act (open-end or closed-end) to disclose such hedging, but do require all listed and non-listed business development companies (BDCs) to make the required hedging disclosures regarding certain executive officers. The SEC’s proposed amendments would expand the scope of the hedging disclosure requirements to cover officers and directors of exchange-listed closed-end funds.
With respect to disclosure of hedging by directors, Congress forced the SEC’s hand by explicitly adding directors to the scope of the hedging disclosure requirements in the Dodd-Frank Act. In expanding the requirements to include listed closed-end funds, however, the SEC seems to have acted of its own volition. This expansion is viewed by many as controversial and unnecessary, as closed-end funds are significantly different from traditional operating companies historically covered by the disclosure requirements. While all five SEC commissioners voted to approve the rule proposals, Commissioners Gallagher[1] and Piwowar, both Republicans, released a joint statement voicing some concerns about the proposed rules, including their skepticism of the need to impose the hedging disclosure requirements on closed-end funds.
Comments on the proposed amendments were due on April 20, 2015. Among the 20 comment letters that the SEC received on this proposal, letters by the Investment Company Institute (ICI) and Mutual Fund Directors Forum (MFDF) addressed the question of closed-end funds.
The SEC’s proposing release includes three reasons for expanding the requirements to listed closed-end funds, but not open-end funds. First, the SEC notes that, unlike open-end funds, closed-end fund shares trade at a price different from their NAV and are not redeemable from the fund. Second, the SEC stated that market participants have been found to engage in short sales of closed-end fund shares, which is unlikely (if not impossible) for open-end fund shares. Third, the SEC cites the fact that listed closed-end funds are required to hold annual shareholder meetings, while open-end funds are not. It is not clear why the first and third cited reasons, at least, explain why listed closed-end funds should therefore be subject to the hedging disclosure requirements.
Additionally, the proposing release does not address how closed-end funds fit within the stated intent of the Dodd-Frank Act amendments, which is to “allow shareholders to know if executives are allowed to purchase financial instruments to effectively avoid compensation restrictions that they hold stock long-term, so that they will receive their compensation even in the case that their firm does not perform.” The SEC stated its belief that the Dodd-Frank Act amendments relate to “the alignment of shareholders’ interests with those of employees’ and directors’.” Curiously, neither of these goals seems applicable to closed-end funds because of the way such funds are structured. As noted in the letters from the ICI and MFDF, closed-end funds have more characteristics in common with open-end funds than they do differences. The vast majority of funds are externally managed, meaning that they do not have employees, and appointed officers are often compensated by the fund’s adviser, instead of the fund. With respect to fund directors, interested directors do not receive compensation from the fund and independent director compensation has no relationship to fund performance and fund shares are not usually issued as compensation. These structural characteristics appear to mitigate the concerns raised by Congress and the SEC. As closed-end funds seem to raise minimal concerns in this area, the ICI’s comment letter also argues that the costs of implementing the necessary policies and procedures to ensure compliance with the hedging requirements would outweigh the any potential benefits to closed-end fund shareholders.
There have been no further developments since the comment deadline.
[1] As this Alert was going to press, various press reports indicated that Commissioner Gallagher intended to resign as a Commissioner but that he would remain until a successor is confirmed.