SEC to Act on NYSE and NASDAQ Proposed Rules Requiring Shareholder Approval of Equity Compensation Plans

11.04.2002

Updates

NYSE and Nasdaq recently filed with the SEC final proposed rules (which the SEC has published for a brief comment period) that will require shareholder approval of most equity compensation plans and eliminate discretionary broker voting of proxies on these plans. The rules will be effective immediately upon SEC approval, which is expected as soon as mid to late November 2002.

This Update summarizes the proposed shareholder approval rules and provides practical guidance and suggested action to be taken before the new rules become effective. We have divided the discussion into two sections to provide NYSE and Nasdaq listed companies ready access to a complete summary of the relevant proposals.

The basic shareholder approval requirements and exemptions are the same for both the NYSE and Nasdaq rules. The proposed rules generally call for shareholder approval for most new equity compensation plans or arrangements and for all material revisions or amendments to existing plans. The proposed rules eliminate the current exemptions for broadly based plans and de minimis grants, as well as the treasury share exemption. Retained in both rules are exemptions for inducement grants, awards made in connection with merger and acquisition transactions, tax-qualified plans and parallel nonqualified plans, and warrants and rights offerings made to all shareholders. Generally, existing plans are grandfathered provided there are no material revisions or modifications to the plan.

The NYSE and Nasdaq proposed rules diverge primarily in their description of what constitutes an equity compensation plan or a material revision or amendment to a plan. For example, the NYSE rules, unlike the Nasdaq rules, exclude from the definition of an equity compensation plan fair market value purchases of stock from or facilitated by the issuer. The NYSE rules also deem the repricing of stock options, unless expressly permitted by the plan, and the operation of "evergreen" share replenishment provisions, unless the plan is limited to a term of ten years, to be material revisions to plans requiring shareholder approval. The Nasdaq rules have a broader exemption from shareholder approval for inducement grants, applying the exemption to directors as well as employees; the NYSE rules limit the exemption to employees. These differences may be reconciled in the SEC comment and approval process.

Current NYSE Rules

Current NYSE Rule 312.03(a) requires shareholder approval for all stock option or purchase plans or other arrangements (plans) pursuant to which officers or directors may acquire stock. The current rules exempt broadly based plans in which at least a majority of the eligible participants are not officers or directors and at least a majority of the grants go to employees other than officers and directors. Also exempted are de minimis grants if made pursuant to a plan under which no single officer or director may acquire more than 1% of the common stock outstanding and which, together with all other shareholder approved plans, does not authorize more than 5% of the common stock outstanding. The current rules also exempt inducement grants material to new employees entering into employment contracts, warrants and rights issued generally to all security holders, and grants made from treasury shares. (There is no specific NYSE rule exemption for treasury share grants, but since the NYSE rules are listing requirements, they generally apply only to newly listed shares.)

Proposed NYSE Rules

Shareholder Approval Requirement

NYSE's proposed new Rule 302(A)8 requires shareholder approval for all equity compensation plans and for material revisions to the terms of existing plans. Equity compensation plans are not deemed to include plans available to shareholders generally, such as dividend reinvestment plans, or plans that merely provide a convenient way for employees, directors or other service providers to buy shares on the open market or from the issuer at fair market value, even if brokerage and other costs are subsidized. This definition may be sufficiently broad to permit nonshareholder approved arrangements where cash compensation, such as salary, bonus or retainers, is paid in stock or deferred into stock unit accounts that are paid in stock.

Grandfathering of Existing Plans

The proposed rules will be applicable to a plan adopted before the effective date of the rules only upon a material revision of the plan. Note the exemption for plans containing an evergreen feature, discussed below.

Exemptions From Shareholder Approval

The proposed rules eliminate the broadly based plan, de minimis grant and treasury share exemptions, but retain, clarify or expand three exemptions:

grants of options or other equity incentives made as a material inducement to a person's first becoming an employee of the issuer or any of its subsidiaries;
certain awards made in connection with merger and acquisition transactions; and
tax-qualified plans and parallel nonqualified plans.

Independent Director Approval

The proposed rules require approval of all nonshareholder-approved plans by a company's compensation committee or a majority of the company's independent directors. We expect that the same exemption for "controlled companies" contained in NYSE's comprehensive corporate governance proposals will apply to the proposed rules. A controlled company is a company of which more than 50% of the voting power is held by an individual, a group or another company.

Material Revision Defined

NYSE has defined a "material revision" as including, but not limited to, a revision that

materially increases the number of shares available under the plan, other than an increase solely to reflect stock splits and similar transactions;
changes the types of awards available under the plan;
materially expands the class of persons eligible to receive awards under or otherwise participate in the plan;
materially extends the term of the plan; or
materially changes the method of determining the strike price of options under the plan. (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 prices is given as an example of a change that will not be viewed as material.)

Evergreen Plan Alert

An automatic increase in the shares available under a plan pursuant to a formula set forth in the plan (evergreen formula) will not be considered a revision that requires shareholder approval, provided the plan has a fixed term that is not in excess of ten years.

Please note, however, that existing evergreen plans not previously approved by shareholders but adopted before the effective date of the proposed rules will need to be submitted for shareholder approval before the next increase in shares pursuant to the evergreen formula.

Existing shareholder approved evergreen plans are grandfathered, except that NYSE has informally advised that existing plans will be grandfathered only if they have a term not in excess of ten years.

Companies with shareholder approved evergreen plans without fixed terms should consider amending these plans before the effective date of the new rules to add fixed terms.
NYSE has advised informally that a company may make this amendment without shareholder approval, so long as the plan term is not in excess of ten years from the date the plan was last approved by shareholders.

Repricings Require Shareholder Approval

The NYSE proposed rules prohibit repricing of stock options without shareholder approval unless the plan "specifically" permits repricing. If a plan does not contain a provision that specifically permits option repricing, the NYSE rules will consider repricing prohibited, and any actual repricing will be considered a material revision of the plan requiring shareholder approval, even if the plan is not revised. If a plan contains a provision that prohibits option repricing, the NYSE rules will consider any revision that deletes or limits the scope of the provision to be a material revision requiring shareholder approval.

A "repricing" is defined as any of the following (or any other action that has the same effect):

amending the terms of an outstanding option to lower its strike price;
any other action that is treated as a repricing under generally accepted accounting principles (GAAP); and
canceling an option at a time when its strike price is equal to or less than the fair market value of the underlying stock, in exchange for another option, restricted stock or other equity, regardless of whether the exchanged security is delivered simultaneously with the cancellation, the exchange is treated as a repricing under GAAP, or the exchange is voluntary on the part of the option holder. An exception applies if the cancellation and exchange occur in connection with a merger, acquisition, spin-off or other similar corporate transaction.

Broadened Merger and Acquisition Exemption

The proposed NYSE rules contain two exemptions to the shareholder approval requirement in the case of corporate mergers and acquisitions. First, shareholder approval is not required to convert, replace or adjust outstanding options or other equity compensation awards to reflect a merger or acquisition transaction.

The second exemption is for shares available for grant under pre-existing acquired company plans. These shares may be used for post-transaction grants, after appropriate adjustment in the number of shares to reflect the transaction, under either the pre-existing plan or another plan, as long as three requirements are met:

the pre-existing plan was approved by acquired company shareholders;
the time during which grants can be made is not extended beyond the time during which they could have been made under the pre-existing plan; and
the grant recipients were not employed by the acquiring company at the time the merger or acquisition was consummated.

Note that any shares reserved for listing in connection with the merger or acquisition transaction will be counted in determining whether the transaction involved the issuance of 20% or more of the company's outstanding common stock and thus required shareholder approval under NYSE Rule 312.03(c). NYSE notes that plans adopted in contemplation of the merger or acquisition will not be viewed as pre-existing for purposes of this exemption.

It is significant that the proposed rules extend the exemption from shareholder approval to "replacement" or substituted awards, in addition to assumed awards, and to ungranted shares under a pre-existing acquired company plan.

Companies should consider amending their equity plans to permit replacement awards and pre-existing plan awards to be made under their shareholder approved plans without counting these grants against the number of shares authorized for issuance under the shareholder approved plans.
Please note that such additional shares will still have to be registered on an additional Form S-8.
Note also that if a company uses the ungranted shares from the pre-existing acquired company plan for future grants, it will have to include both the shares subject to outstanding options and the shares available for future grant under the pre-existing plans in the nonshareholder approved portion of the tabular portion of the SEC's new executive compensation plan disclosure (Item 201 of Regulation S-K). If the company just assumes options and does not use the ungranted shares from the acquired company plan, only footnote disclosure of the assumed options is required.

Tax-Qualified Plan Exemption

The proposed NYSE rules exempt from the shareholder approval requirement any plan intended to meet the requirements of Section 401(a) of the Internal Revenue Code (e.g., ESOPs), any parallel nonqualified plan, and any plan intended to meet the requirements of Code Section 423 (employee stock purchase plans, or ESPPs). Code Section 423 requires that ESPPs be approved by shareholders.

A "parallel nonqualified plan" is defined as a plan that is a "pension plan" within the meaning of ERISA and designed to work in parallel with a plan intended to be qualified under Code Section 401(a) to provide benefits that exceed the limits set forth in:

Code Section 402(g), which limits an employee's annual pre-tax contribution to a 401(k) plan;
Code Section 401(a)(17), which limits the amount of an employee's compensation that can be taken into account for plan purposes; and/or
Code Section 415, which limits contributions and benefits under qualified plans.

A parallel nonqualified plan must cover all or substantially all employees who are participants in the related qualified plan whose annual compensation is in excess of the Code limits, and it must have terms substantially the same as the qualified plan it parallels, except for the elimination of the limits described above.

Elimination of Discretionary Broker Voting

Under existing NYSE Rules 452.11(12) and 402.08(B)(12), a broker can vote without customer instruction if the broker has not received instruction from the beneficial owner by the date specified in the statement accompanying the proxy materials; provided the aggregate amount of shares under all plans being submitted for shareholder approval does not exceed 5% of the outstanding common stock. The proposed NYSE rules eliminate this exemption and preclude member organizations from giving a proxy to vote on any equity compensation plan or material revision to the terms of an existing equity compensation plan unless the beneficial owner of the shares has given voting instructions, even when shareholder approval of the plan is not required by NYSE rules.

Current Nasdaq Rules

Current Nasdaq Rule 4350(i)(1)(A) requires shareholder approval for all stock option or purchase plans or other arrangements (plans) in which officers or directors may participate. The current rules exempt broadly based plans in which at least a majority of the eligible participants are not officers or directors and at least a majority of the grants go to employees other than officers and directors. Also exempted are de minimis grants up to the lesser of 1% of the common stock outstanding and 25,000 shares. The current rules also exempt inducement grants essential to new employees entering into employment contracts, warrants and rights issued generally to all security holders, and grants made from treasury shares.

Proposed Nasdaq Rules

Shareholder Approval Requirement

Nasdaq's proposed amendments to Rule 4350(i)(1)(A) require shareholder approval when a stock option or purchase plan is to be established or materially amended or other arrangement made pursuant to which options or stock may be acquired by officers, directors, employees or consultants.

Nasdaq notes that a company will not be permitted to use repurchased shares to fund option plans or grants without prior shareholder approval.

Grandfathering of Existing Plans

Existing plans in place before the effective date of the new rules will be grandfathered, but any material modification of such plans will require shareholder approval.

Exemptions From Shareholder Approval

The proposed rules eliminate the broadly based plan, de minimis grant and treasury share exemptions, but retain, clarify or expand four exemptions:

grants of options or stock made as an inducement material to a person's first entering into employment with or becoming a director of the company, including grants to new employees in connection with a merger or acquisition;
certain awards made in connection with merger and acquisition transactions;
tax-qualified nondiscriminatory employee benefit plans and parallel nonqualified plans; and
warrants and rights issued generally to all shareholders.

Independent Director Approval

The proposed Nasdaq rules require approval by a company's compensation committee or a majority of the company's independent directors for inducement grants and tax-qualified and parallel nonqualified plans. We expect that the same exemption for "controlled companies" contained in Nasdaq's comprehensive corporate governance proposals will apply to this requirement. A controlled company is a company of which more than 50% of the voting power is held by an individual, a group or another company.

Guidance on Material Amendments

The Nasdaq rules do not define "material amendments" to a plan that will require shareholder approval, but state that Nasdaq will continue to provide guidance as to what constitutes a material amendment, and notes that it currently determines the existence of a material amendment consistent with the SEC's position under former Rule 16b-3 of the Securities Exchange Act of 1934. The SEC stopped providing guidance on material amendments to plans in 1996 when it amended Rule 16b-3 to eliminate that rule's requirement for shareholder approval of plans. In determining whether an amendment is material, Nasdaq will look to whether there is a material change to

the benefits to potential recipients under the plan;
the number of shares available under the plan; or
the class of eligible participants under the plan.

The proposed Nasdaq rules do not explicitly address repricing. Nasdaq has informally advised, however, that unlike the proposed NYSE rules described above, Nasdaq will not require a plan to have specific language permitting repricing before a company can reprice without shareholder approval. Nasdaq's position may change as the rules are finalized.

Broadened Merger and Acquisition Exemption

The proposed Nasdaq rules contain two exemptions to the shareholder approval requirement in the case of corporate mergers and acquisitions. First, shareholder approval is not required to convert, replace or adjust outstanding options or other equity compensation awards to reflect a merger or acquisition transaction.

the pre-existing plan was approved by acquired company shareholders;
the time during which grants can be made is not extended beyond the time during which they could have been made under the pre-existing plan; and
the grant recipients were not employed by the acquiring company at the time the merger or acquisition was consummated.

Note that any shares reserved for listing in connection with the merger or acquisition transaction will be counted in determining whether the transaction involved the issuance of 20% or more of the company's outstanding common stock and thus required shareholder approval under Nasdaq Rule 4350(i)(1)(D). Nasdaq notes that plans adopted in contemplation of the merger or acquisition will not be viewed as pre-existing for purposes of this exemption.

Companies should consider amending their equity plans to permit such replacement awards and pre-existing plan awards to be made under their shareholder approved plans without counting these grants against the number of shares authorized for issuance under the shareholder approved plans.
Please note that such additional shares will still have to be registered on an additional Form S-8.
Note also that if a company uses the ungranted shares from the pre-existing acquired company plan for future grants, it will have to include both the shares subject to outstanding options and the shares available for future grant under the pre-existing plans in the nonshareholder approved portion of the tabular portion of the SEC's new executive compensation plan disclosure (Item 201 of Regulation S-K). If the company just assumes options and does not use the ungranted shares from the acquired company plan, only footnote disclosure of the assumed options is required.

Tax-Qualified Plan Exemption

The proposed Nasdaq rules exempt from the shareholder approval requirement any tax-qualified, nondiscriminatory employee benefit plan (e.g., plans that meet the requirements of Code Section 401(a) (or parallel nonqualified plans) or Code Section 423. Code Section 423 requires that ESPPs be approved by shareholders.

Code Section 402(g), which limits an employee's annual pre-tax contribution to a 401(k) plan;
Code Section 401(a)(17), which limits the amount of an employee's compensation that can be taken into account for plan purposes; and/or
Code Section 415, which limits contributions and benefits under qualified plans.

Notification Requirements

The Nasdaq proposals also make conforming changes to Rule 4310(c)(17)(A) to require that companies notify Nasdaq on the appropriate form no later than 15 calendar days prior to establishing or materially amending a stock option or purchase plan or other arrangement pursuant to which stock may be acquired by officers, directors, employees or consultants without shareholder approval.

Elimination of Discretionary Broker Voting

Nasdaq rules permit reliance on NYSE rules governing discretionary broker voting. Under existing NYSE Rules 452.11(12) and 402.08(B)(12), a broker can vote without customer instruction if the broker has not received instruction from the beneficial owner by the date specified in the statement accompanying the proxy materials; provided the aggregate amount of shares under all plans being submitted for shareholder approval does not exceed 5% of the outstanding common stock. The proposed NYSE rules eliminate this exemption and preclude member organizations from giving a proxy to vote on any equity compensation plan or material revision to the terms of an existing equity compensation plan unless the beneficial owner of the shares has given voting instructions, even when shareholder approval of the plan is not required.

Text of the Rules

As this Update is intended only as a summary of the rules, you are encouraged to review the full text of the NYSE and Nasdaq proposed rules at http://www.sec.gov/rules/sro/34-46620.htm and http://www.sec.gov/rules/sro/34-46649.htm, respectively. You can find further discussion of other recent laws and regulations of interest to public companies on our website.

SEC to Act on NYSE and NASDAQ Proposed Rules Requiring Shareholder Approval of Equity Compensation Plans

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