• New Nasdaq and NYSE Rules Require Shareholder Approval of All Equity-Based Compensation Plans
  • November 19, 2003
  • Law Firm: Pepper Hamilton LLP - Washington Office
  • The SEC recently approved changes to Nasdaq and New York Stock Exchange listing standards that will require shareholder approval for almost all equity-based compensation plans, material revisions to plans (including repricings) and individual non-plan grants. These new rules were put into effect on an accelerated basis on June 30, 2003, so listed companies considering adopting new plans, making new non-plan grants, or changing existing plans or the terms of existing grants need to take the new rules into account now.

    In a related development, the SEC also approved a change to NYSE rules which eliminates the ability of brokers to vote shares held in "street name" on equity compensation matters unless the broker receives specific voting instructions regarding the plan proposal from the beneficial owner. This rule will be effective for shareholder meetings that occur on and after September 28, 2003 and will apply to all listed companies, whether listed on the NYSE or Nasdaq. The rule is expected to make it more difficult for public companies to obtain the requisite shareholder approval of these matters. Nasdaq rules did not need to be changed for this purpose, as current NASD rules prohibit broker discretionary voting absent specific instructions from the beneficial owner.

    Most plans that were in place as of June 30, 2003 are grandfathered -- if they did not require shareholder approval under the prior rules, no shareholder approval is required under the new rules unless those existing plans are materially amended. Certain limitations on the grandfathering may apply to existing plans that contain "evergreen" provisions or automatic formula grants or those that provide for an unlimited number of shares available for grant. Companies should review their plans and these new rules now to ensure that additional grants under these types of plan do not trigger the new shareholder approval requirements.

    New Nasdaq Rule

    Revised Marketplace Rule 4350(i)(1)(A) requires Nasdaq-listed companies to obtain shareholder approval for stock option plans or other equity-based compensation plans or arrangements, including grants and awards made outside of plans, subject to limited exceptions. The most significant changes from prior Nasdaq rules include:

    • elimination of the shareholder approval exception for so-called "broadly based" plans and "de minimis" issuances (which allowed grants of lesser of 1 percent of the outstanding common stock or 25,000 shares);
    • guidance regarding the types of amendments to plans that will trigger the "material amendment" shareholder approval requirement (provided through "Interpretative Material" attached by Nasdaq to its new rule);
    • limitations on the life of "evergreen" plans and formula-based grants (shareholder approval will be required every 10 years if the term of the plan extends beyond 10 years, even if the plan was in place as of June 30, 2003);
    • elimination of the ability to use repurchased shares to fund options or other awards without shareholder approval; and
    • new requirement that the compensation committee or a majority of independent directors approve equity-based plans and awards not subject to the shareholder approval rule.

    As noted above, the revised rule does exempt some types of plans, awards and situations from the shareholder approval requirement. Some of these are holdovers from the prior rule or variations on those prior exceptions. In particular, the following do not require shareholder approval under the new rule:

    • "inducement grants" to new employees (and prior employees returning to employment after a bona fide period of non-employment), including grants to employees of the target in a merger or acquisition;
    • warrants or rights offered generally to all shareholders;
    • DRIPs and other types of stock purchase plans available on equal terms to all security holders;
    • plans that merely provide a convenient way to purchase shares at fair market value directly from the issuer or on the open market;
    • tax qualified, non-discriminatory benefit plans (such as ESOPs and Section 423 ESPPs) and parallel non-qualified plans;
    • conversions, adjustments or replacements of outstanding options or other equity awards to reflect the completion of an M&A transaction; and
    • certain post-transaction grants and awards made from available shares remaining under the plan of the acquired company in a completed M&A transaction (if the plan was approved previously by the acquired company's shareholders).

    In its "Interpretative Material," Nasdaq provides a non-exclusive list of plan amendments that will be deemed to be material and require shareholder approval. Nasdaq also provides guidance regarding techniques that may be used to avoid the shareholder approval requirements by including plan provisions permitting specific future amendments without shareholder approval. The list of plan changes that are deemed to be material include:

    • a material increase in the number of shares to be issued under the plan (other than to reflect a reorganization, stock split, merger, spin-off or similar transaction);
    • a material expansion of the class of participants eligible to participate in the plan;
    • an expansion of the types of options or awards under the plan; and
    • a material increase in benefits to participants, including any material change to:

      • permit repricing or decreasing the exercise price of outstanding options;
      • reduce the price at which shares or options to purchase shares may be offered (for example, to remove a requirement that issuances be at fair market value); or
      • extend the plan's duration.

    Plan provisions granting general authority to amend the plan to the Board, Compensation Committee or plan administrator will not obviate the need for shareholder approval. However, plans may include specific authority to amend the plan in the future without further approval of shareholders. It is possible, therefore, to include in the plan an authorization for the Board or Compensation Committee to act to reprice options without obtaining shareholder approval.

    In addition, Nasdaq has closed the possibility of avoiding the shareholder approval requirements for increasing the number of shares available under a plan by allowing the plan to issue an unlimited number of shares. While a plan that contains an evergreen formula for automatic increases in the shares available or provides for automatic grants under a dollar-based formula (subject to the 10-year limitation described earlier) would not require shareholder approval, a plan that simply imposes no limit on the number of shares available for grant will trigger a shareholder approval requirement for each and every grant out of that plan.

    Nasdaq also is considering whether Nasdaq-listed companies must notify it when they rely on exceptions from the shareholder approval requirement.

    New NYSE Rule

    New Section 303A(8) of the Listed Company Manual requires NYSE-listed companies to obtain shareholder approval for all "equity compensation plans" and material revisions to such plans, subject to limited exceptions. Under the new rule, an "equity compensation plan" includes any plan or other arrangement that provides for the delivery of equity securities of the listed company (whether newly-issued shares or treasury shares) to any employee, director or other service provider as compensation for services, including compensatory grants not made under a plan.

    Certain exceptions from the shareholder approval requirements of Section 303A(8) are outlined in the exclusions from the equity compensation plan definition. These include:

    • plans that do not actually deliver equity securities, but settle all awards only in cash (for example, cash-settled SARs and certain types of phantom stock plans);
    • DRIPs and other types of plans available to security holders generally; and
    • plans that merely allow employees, directors or service providers to purchase shares at fair market value directly from the issuer or on the open market (regardless of whether the shares are delivered immediately or on a deferred basis or whether the payments for the shares are made directly or by relinquishing compensation otherwise due).

    Additional exemptions from the shareholder approval requirements are set forth in other parts of the rule. Reliance on any of these exemptions is conditioned upon (i) the grant, plan or arrangement or amendment receiving the approval of the company's independent Compensation Committee and (ii) the company notifying the NYSE in writing that it has relied on one or more of the exemptions. These exemptions include:

    • "inducement grants" to new employees (and prior employees returning to employment after a bona fide period of non-employment), including grants to employees of the target in connection with a merger or acquisition;
    • tax qualified, non-discriminatory benefit plans (such as ESOPs and Section 423 ESPPs) and parallel non-qualified plans;
    • conversions, adjustments or replacements of outstanding options or other equity awards to reflect the completion of an M&A transaction; and
    • certain post-transaction grants and awards made from available shares remaining under the plan of the acquired company in a completed M&A transaction (if the plan was approved previously by the acquired company's shareholders).

    Material revisions to existing equity compensation plans also will require shareholder approval under the new NYSE rule. The rule provides a non-exclusive list of the types of amendments that will be deemed "material" including:

    • a material increase in the number of shares available to be issued under the plan (other than to reflect a reorganization, stock split, merger, spin off or similar transaction);
    • a material expansion of the class of employees, directors or service providers eligible to participate in the plan;
    • an expansion of the types of options or awards under the plan;
    • a material extension of the term of the plan;
    • a material change to the method of determining the strike price of options issued under the plan; and
    • a deletion or limitation of any provision prohibiting repricing of options (with "repricings" also including the cancellation of an out-of-the-money option in exchange for another option, restricted stock or other equity or any other action that would be treated as a repricing under GAAP).

    The NYSE's position on repricing is particularly important to take into account. In the NYSE's view, plans that do not include provisions that specifically permit repricing will be deemed by the NYSE to prohibit repricing. The effect of this position is that any repricing that occurs under a plan that does not specifically permit it will be deemed to be a material revision to the plan that requires shareholder approval.

    As noted earlier, most equity compensation plans adopted before June 30, 2003 are grandfathered and will not require shareholder approval unless and until they are materially amended. However, the grandfathering does not apply to certain types of "formula" plans and all "discretionary" plans . Under the NYSE rule, formula plans are those that contain a formula for automatic increases in the shares available under the plan (e.g., evergreen provisions) or for automatic grants under a specified formula. Discretionary plans are those that contain no limit on the number of shares available for issuance under the plan (and do not fall within the formula plan definition). These plans must be amended and/or approved by shareholders before the end of a designated transition period in order for the listed company to avoid potentially negative consequences.

    Formula plans may or may not be used after the transition period without further shareholder approval based upon the following factors:

    • plans that have a term of 10 years or less and were approved previously by shareholders may continue to be used without further approval; and
    • plans that do not have a term of 10 years or less but were approved previously by shareholders may be used only for the transition period, unless the plan is amended to provide that its term will be no longer than ten years from the later of the plan's original adoption or most recent shareholder approval (such amendments themselves do not require shareholder approval).

    The transition period ends on the earliest to occur of (i) the company's next annual shareholder meeting after December 27, 2003 at which directors are elected, (ii) June 30, 2004 or (iii) the expiration of the plan. After that time, each increase or grant pursuant to the formula will be considered a material revision requiring shareholder approval. Also note that grants may continue under a formula plan approved previously by shareholders (even if the term of the plan is greater than ten years) to the extent that shares were available for grant pursuant to the formula prior to June 30, 2003.

    Discretionary plans are subject to additional restrictions. Additional grants may be made after June 30, 2003 only in a manner consistent with past practice and, unless shareholder approval is obtained, only until the end of the transition period described above. This is the case whether or not the plan was approved by shareholders before June 30, 2003. Any grants made after the applicable transition date will be regarded as material revisions to that plan which cannot be made without shareholder approval. In addition, if it is possible to separate a plan into discretionary and non-discretionary portions, then the non-discretionary portion may continue to be used separately.

    The SEC's June 30, 2003 Release (No. 34-48108), which contains the SEC's summary and analysis, and the text of the final Nasdaq and NYSE rules, is on the SEC's Web site at www.sec.gov/rules/sro/34-48108.htm