Shareholder Approval Requirements for Equity Compensation Plans; Brokers Ability to Vote on Those Plans

By Edward S. Best, Michael T. Blair, James B. Carlson, Robert E. Curley, Scott J. Davis, Jeffrey I. Gordon, Robert A. Helman, Michael L. Hermsen, Debra B. Hoffman, James J. Junewicz, Wayne R. Luepker, Philip J. Niehoff, Elizabeth A. Raymond, Laura D. Richman, David A. Schuette, Frederick B. Thomas, Mark R. Uhrynuk and James R. Walther

On June 30, 2003, the Securities and Exchange Commission adopted proposals by The New York Stock Exchange, Inc. and The Nasdaq Stock Market, Inc. to revise their respective listing standards to require shareholder approval of most equity compensation plans and of material amendments to equity compensation plans. In addition, brokers will no longer be permitted to use discretionary authority when voting stock held in street name on equity compensation proposals that have been submitted for shareholder approval. The new listing standards became effective on June 30, 2003, the date of adoption, and the new broker voting requirements will apply to all shareholder meetings that occur on or after September 28, 2003. See Release No. 34-48108. Unless otherwise noted below, the rules for the NYSE and the Nasdaq are similar.

The NYSE has amended Rule 303A(8) of its Listed Company Manual (the Corporate Governance Standards) and Nasdaq has amended Rule 4350(i) of the NASD Manual (the Shareholder Approval Standards of its Qualitative Listing Requirements) to require that shareholders be given the opportunity, with limited exceptions, to vote on all equity compensation plans and material revisions to such plans. The new rules require shareholder approval and do not distinguish between whether the shares are newly-issued or treasury shares. The new rules replace in their entirety the previous NYSE and Nasdaq rules with respect to shareholder approval of equity compensation plans. The new rules do not apply to compensation plans where the compensation is paid in the form of cash or non-equity securities.

The NYSE defines an equity compensation plan as a plan or other arrangement that provides for the delivery of equity securities (either newly issued or treasury shares) of the listed company to any employee, director or other service provider as compensation for services. Accordingly, a single grant of options to an executive officer, even if not pursuant to a broader plan, would be subject to the new requirements. However, two types of plans are not considered equity compensation plans. The first type is plans that are made available to shareholders generally, such as dividend reinvestment plans. The second type is plans that merely allow employees, directors or other service providers to elect to buy shares on the open market or from the listed company for their current fair market value, regardless of whether the shares are delivered immediately or on a deferred basis, or the payments for the shares are made directly or by giving up compensation that is otherwise due (such as through payroll deductions). However, stock purchase plans that allow employees to purchase shares at a discount would be considered equity compensation plans.

Nasdaq defines an equity compensation arrangement as a stock option, stock purchase plan or other equity compensation arrangement pursuant to which options or stock may be acquired by officers, directors, employees or consultants. Nasdaq excepts from its definition warrants or rights issued generally to all security holders of the company and stock purchase plans that are available on equal terms to all security holders of the company, such as dividend reinvestment plans.

A material revision of an equity compensation plan includes, but is not limited to:

• a material increase in the number of shares available under the plan, other than an increase solely to reflect a reorganization, stock split, merger, spin off or similar transaction;

• an expansion of the types of awards available under the plan;

• a material expansion of the class of employees, directors or other service providers eligible to participate in the plan;

• a material extension of the term of the plan; and

• a revision to permit a repricing of options.

Under the NYSE rules, a material change to the method of determining the strike price of options under the plan—other than a change in the method of determining fair market value from the closing price on the date of grant to the average of the high and low price on the date of grant—would also be considered a material revision requiring shareholder approval. The Nasdaq rules would also include within the definition of a material revision a material increase in benefits to participants, including any material change to reduce the price at which shares or options to purchase shares may be offered.

If a plan contains a formula that provides for automatic increases in the shares available for issuance under the plan, referred to in the new rules as "evergreen" plans, or for automatic grants pursuant to a formula, referred to in the new rules as "formula" plans, each such increase or grant will be considered a material revision requiring shareholder approval unless the plan has a term of not more than 10 years. Accordingly, listed companies with evergreen plans or formula plans that do not contain a maximum terms should amend their plans before the next increase or grant to provide for a maximum term. The term can be no longer than 10 years from the date of original adoption or, if later, the date of its most recent shareholder approval. The failure to make such an amendment will mean that the increase or grant must receive shareholder approval before it can be effective. If the plan is not a formula plan and contains no limit on the number of shares available for issuance, referred to by the NYSE as "discretionary" plans, then every grant must receive shareholder approval before it is effective. Accordingly, listed companies with plans that are not formula plans and that contain no limit on the number of shares available should amend their plans before the next grant to provide for a limit on the number of shares available for issuance.

Under the NYSE rules, an equity compensation plan that does not contain a provision that specifically permits repricing of options will be deemed to prohibit repricing of options. Accordingly, any repricing of options that occurs will be considered a material revision that would require shareholder approval even if the plan is not actually revised. For this purpose, a repricing includes:

• lowering the strike price of an option after it is granted;

• any action that is treated as a repricing under generally accepted accounting principles; and

• canceling an option at a time when its strike price exceeds the fair market value of the underlying security, in exchange for another option, restricted stock or other equity, unless the cancellation and exchange occurs in connection with a merger, acquisition, spin-off or other similar corporate transaction.

In contrast to the NYSE approach on option repricing, the Nasdaq rules simply admonish issuers that plans that are intended to permit repricing should use explicit terminology to make this clear.

Under the NYSE rules, any amendment that curtails, rather than expands, the scope of the plan is not considered a material revision. Under the Nasdaq rules, if a plan permits a specific action without further shareholder approval, then no shareholder approval would be required if such an amendment is made to the plan. The SEC cautioned, however, that the plan must be clear and specific enough to provide meaningful shareholder approval of those provisions.

Except as set forth above, neither the NYSE nor Nasdaq has defined more specifically what it means to constitute a material revision. Accordingly, other changes should be examined closely to determine whether it would be a material revision requiring shareholder approval, and discussed with a representative at the NYSE or Nasdaq, as applicable.

Shareholder approval is not required for inducement awards, certain grants, plans and amendments in the context of mergers and acquisitions, and certain tax-qualified types of plans. In each case, the NYSE rules require that grants, plans or amendments may be made only with the approval of the company’s compensation committee or a majority of the company’s independent directors while the Nasdaq rules require that grants, plans or amendments pursuant to inducement awards or tax-qualified plans may be made only with the approval of the company’s compensation committee or a majority of the company’s independent directors. Companies must also notify the NYSE or Nasdaq, as appropriate, when they use one of these exemptions.

Both the NYSE and Nasdaq rules provide that shareholder approval is not required for an award of options or other equity-based compensation used as a material inducement to a person or persons being hired by the listed company or any of its subsidiaries, or being rehired following a bona fide period of interruption of employment. Under the NYSE rules, following the grant of an inducement award in reliance on this exemption, the listed company must issue a press release disclosing the material terms of the award, including the name(s) of the recipients and the number of shares involved. The SEC has urged Nasdaq to adopt a similar disclosure requirement.

Shareholder approval is not required to convert, replace or adjust outstanding options or other equity compensation awards to reflect a merger or acquisition. Shareholder approval is also not required where a party that is not a listed company following a merger or acquisition has shares available for grant under pre-existing plans that were previously approved by shareholders. Aplan adopted in contemplation of a merger or acquisition would not be considered pre-existing. Shares available under a pre-existing plan may be used for post-transaction grants of options and other equity compensation awards, either under the pre-existing plan or another plan, so long as:

• the number of shares available for grants is appropriately adjusted to reflect the merger or acquisition;

• the time during which those shares are available is not extended beyond the period when they would have been available under the pre-existing plan; and

• the options or other awards are not granted to individuals who were employed, immediately before the transaction, by the post-transaction listed company or entities that were its subsidiaries immediately before the transaction.

However, these shares reserved for issuance would be counted in determining whether the merger or acquisition transaction involves the issuance of 20% or more of the listed company’s outstanding common stock and, therefore, whether shareholder approval is otherwise required for the transaction.

Shareholder approval is not required under the new rules for plans intended to meet the requirements of Section 401(a) of the Internal Revenue Code (such as employee stock ownership plans), plans intended to meet the requirements of Section 423 (employee stock purchase plans) of the Internal Revenue Code (although shareholder approval of such plans is required under the Internal Revenue Code) and parallel excess plans (pension plans that are designed to work in parallel with plans that meet the requirements of Section 401(a) of the Internal Revenue Code, to provide benefits that exceed specified statutory amounts). In order to qualify as a parallel excess plan, the plan must:

• cover all or substantially all employees of an employer who are participants in the related qualified plan whose compensation exceeds the statutory limits;

• have terms that are substantially the same as the qualified plan that it parallels except for the elimination of the statutory compensation limits; and

• result in no participant receiving employer equity contributions under the plan in excess of 25% of the participant’s cash compensation.

The NYSE rules also provide that an equity compensation plan that provides non-U.S. employees with substantially the same benefits as one of the three types of plans described in this section that the listed company provides to its U.S. employees, other than features necessary to comply with applicable foreign law, are also exempt from the shareholder approval requirements.

In general, a plan that was adopted before June 30, 2003 is not subject to the new shareholder approval requirements until it is materially revised.

Under the NYSE rules, grants under a discretionary plan can continue to be made without shareholder approval, consistent with past practice, until the earliest to occur of:

• the listed company’s next annual meeting at which directors are elected that occurs after December 27, 2003;

• June 30, 2004; and

• the expiration of the plan.

A similar transition rule applies to formula plans that have not previously been approved by shareholders or do not have a term of 10 years or less. Finally, a formula plan may continue to be used, without the necessary shareholder approval, if the grants after June 30, 2003 are made only from the shares available for issuance before that date.

Nasdaq has not adopted similar transition rules.

The new rules do not apply to foreign private issuers. Foreign private issuers can continue to comply with their home country requirements and provide, in their public reports, the necessary disclosures concerning the differences between the home country and NYSE or Nasdaq requirements and the effects of such differences on shareholders.

The new rules will apply to companies that are going public and listing on either the NYSE or Nasdaq. Accordingly, an issuer contemplating an IPO will be required to have its equity compensation plans approved by shareholders prior to the time its shares are approved for listing unless the plans were adopted prior to June 30, 2003. In addition, an issuer that intends to list on the NYSE should be able to take advantage of the transition rules described earlier.

Under NYSE Rule 452, brokers will now be prohibited from giving a proxy to vote on equity compensation plans unless the beneficial owner of the shares has given voting instructions to the broker. This is a change from the existing rule whereby brokers can vote shares it holds in street name whether or not the broker receives an instruction from the beneficial owner. This means that listed companies may need to exert more efforts to ensure that sufficient votes are received to approve equity compensation plans submitted for shareholder approval.

Every issuer should review each of its compensation plans to determine:

• whether it is an equity compensation plan;

• whether it has a fixed number of authorized shares and a fixed term;

• how much equity remains available for issuance under the plan;

• when amendments to the plan will be required to increase the number of authorized shares available for issuance under the plan so that sufficient time can be built into the planning schedule for that year’s annual meeting in light of the fact that the changes to the broker voting requirements will make shareholder approval harder to obtain; and

• what action should be taken now to protect issuances under existing plans without requiring additional shareholder approval.

Copyright © 2007, Mayer, Brown, Rowe & Maw LLP. and/or Mayer Brown International LLP. This Mayer Brown article provides information and comments on legal issues and developments of interest. The foregoing is not a comprehensive treatment of the subject matter covered and is not intended to provide legal advice. Readers should seek specific legal advice before taking any action with respect to the matters discussed herein.

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