Final NYSE and Nasdaq Rules Relating to Shareholder Approval of Equity Compensation Plans

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1 T O O U R F R I E N D S A N D C L I E N T S June 30, 2003 Final NYSE and Nasdaq Rules Relating to Shareholder Approval of Equity In October 2002, the New York Stock Exchange and The Nasdaq Stock Market each filed with the Securities and Exchange Commission proposed changes to their rules relating to shareholder approval of equity compensation plans. 1 On June 20 and June 23, 2003, respectively, the NYSE and Nasdaq filed final rules with the SEC reflecting discussions with the SEC and public comment letters that each had received. Both the NYSE and Nasdaq proposals were approved by order of the SEC dated June 30, 2003 and became effective today. 2 The final rules require companies to obtain shareholder approval of equity compensation plans, subject only to limited exemptions. In general, the new shareholder approval requirements will only apply to plans adopted or materially revised after June 30, The final rules eliminate exceptions for broadly based plans and plans issuing de minimis share amounts, as these exceptions were perceived to permit abuse of the shareholder approval requirements. The final rules also explicitly eliminate treasury stock exceptions, which were traditionally understood to permit the issuance of repurchased or treasury shares under equity compensation plans without shareholder approval. Companies should review their existing and contemplated plans and arrangements pursuant to which shares may be issued to determine whether shareholder approval of these plans and arrangements may be required under the final rules. For example, excess benefit plans and deferred compensation plans, many of which had typically been exempt from shareholder approval under the prior rules 1 2 These proposals were summarized in our October 18, 2002 memorandum. This memorandum is available at on the Fried Frank website. Release No , Self-Regulatory Organizations; New York Stock Exchange, Inc. and National Association of Securities Dealers, Inc.; Order Approving NYSE and Nasdaq Proposed Rule Changes and Nasdaq Amendment No. 1 and Notice of Filing and Order Granting Accelerated Approval to NYSE Amendments No. 1 and 2 and Nasdaq Amendments No. 2 and 3 Thereto Relating to Equity (June 30, 2003). The Release may be found at A Partnership Including Professional Corporations New York One New York Plaza New York, NY Washington, DC 1001 Pennsylvania Avenue, NW Washington, DC Los Angeles 350 South Grand Avenue Los Angeles, CA London 99 City Road London EC1Y 1AX United Kingdom Paris 5, boulevard de la Tour Maubourg Paris France Copyright June 30, 2003 Fried, Frank, Harris, Shriver & Jacobson

2 of the NYSE and Nasdaq, may no longer qualify for exemption. In addition, companies should update their compliance procedures to reflect the requirements for press releases and notices imposed by the final rules, as described below. 3 The Final NYSE Rule The final NYSE rule is included in the NYSE Listed Company Manual as Section 303A(8). 4 It provides that all equity compensation plans and any material revisions to the terms of these plans must be approved by shareholders, with limited exemptions as set forth in the rule. It provides exemptions for inducement awards, certain actions taken with respect to equity compensation plans in the context of merger and acquisition transactions, and taxqualified and parallel excess plans. Definitions of Equity Compensation Plan and Material Revision Equity compensation plan. The final NYSE rule defines the term equity compensation plan to mean 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. This definition includes individual compensatory grants that are not made under a plan. However, the definition does not include any plan or arrangement that does not provide for the delivery of equity securities of the issuer (for example, phantom stock units payable solely in cash). The final NYSE rule provides that neither of the following arrangements will be considered equity compensation plans for purposes of the rule (even if brokerage or other costs of the plan are borne by the listed company): Any plan that is made available to shareholders generally (for example, a typical dividend reinvestment plan). 3 4 The context of the promulgation, adoption and effectiveness of the final rules would lead one to expect that each will be interpreted in a manner similar to the other, and companies and their advisors will likely look to both rules for interpretive guidance. Nevertheless, the final rules, while similar, are not identical. It will be an interpretive question in each particular case as to whether differences between the final NYSE rule and the final Nasdaq rule are intended to have a substantive effect on their scope and meaning. The current NYSE pilot shareholder approval rule, included in the Listed Company Manual as Section (a), has expired. Fried, Frank, Harris, Shriver & Jacobson 2 June 30, 2003

3 Any plan that merely provides for the purchase of shares on the open market or from the listed company for their fair market value. These plans are not considered equity compensation plans even if they provide for the delivery of shares on a deferred basis or provide for payments through payroll deductions or other foregone compensation. A plan that permits the purchase of shares for less than their fair market value (for example, a typical employee stock purchase plan) is considered an equity compensation plan. Material revision. The final NYSE rule provides that material revisions to an equity compensation plan include 5 any of the following: (iv) (v) A material increase in the number of shares available under the plan (other than an increase solely to reflect a reorganization, stock split, merger, spinoff or similar transaction). 6 An expansion (whether or not material) of the types of awards available under the plan. A material expansion of the class of persons eligible to participate in the plan. A material extension of the term of the plan. A material change to the method of determining the strike price of options under the plan The final NYSE rule provides that its list of material revisions is not exhaustive, presumably leaving listed companies and their advisors with the task of determining whether other plan changes not explicitly covered by the final NYSE rules constitute material revisions. The final NYSE rule does note that the curtailment of a plan (as compared with its expansion) will not be considered a material revision. The final NYSE rule provides that, if a plan contains a formula for automatic increases in the shares available (an evergreen provision) or for automatic grants pursuant to a formula set forth in the plan, each such increase or grant will be considered a material revision unless the term of the plan is not more than 10 years. The final NYSE rule refers to both of these types of plans as formula plans. The final NYSE rule also provides that, if a plan (referred to as a discretionary plan ) contains no limit on the number of shares available for grant and it is not a formula plan, then each grant under the plan will require separate shareholder approval even if the term of the plan is limited to 10 years or less. The final NYSE rule makes clear that a requirement that grants be made out of treasury or repurchased shares will not, in itself, prevent a plan from being considered a discretionary plan. The transition rules relating to formula plans and discretionary plan are discussed in this memorandum below. Fried, Frank, Harris, Shriver & Jacobson 3 June 30, 2003

4 (vi) The deletion or limitation of any provision prohibiting repricing of options. 8 The final NYSE rule provides that any plan that does not explicitly permit repricing of options will be considered to prohibit repricing, and therefore any actual repricing will be considered a material revision even if the plan is not revised. Exemptions from the Shareholder Approval Requirement As noted above, the final NYSE rule exempts all of the following from the shareholder approval requirement: Inducement awards. Plans relating to mergers and acquisitions. Tax-qualified plans and parallel excess plans. The final NYSE rule provides that, if a grant, plan or amendment would have been subject to the shareholder approval requirement in the absence of one of these exemptions, then that grant, plan or amendment must be approved by the listed company s independent compensation committee or a majority of the listed company s independent directors. In addition, the final NYSE rule adds the requirement that a listed company notify the NYSE in writing if it takes action in reliance on one of these exemptions. Inducement awards. An inducement award is an award granted as a material inducement to a person who becomes an employee of the listed company or any of its subsidiaries or to a person rehired following a bona fide period of interruption of employment. The final NYSE rule makes clear that exempt inducement awards may be granted to new employees in connection with a 7 8 The final NYSE rule provides, as an example, that changing the method of determining fair market value under a plan from the closing price on the date of grant to the average of the high and low price on the date of grant is not a material revision. The final NYSE rule defines a repricing to mean any of the following or any other action that has the same effect: lowering the strike price of an option after it is granted; any other action that is treated as a repricing under GAAP; and canceling an option at a time when its strike price exceeds the fair market value of the underlying stock, in exchange for another option, restricted stock, or other equity award, unless the cancellation and exchange occurs in connection with a merger, acquisition, spin-off or other similar corporate transaction. The final NYSE rule does not apply to repricings through an exchange offer that commenced before June 30, Fried, Frank, Harris, Shriver & Jacobson 4 June 30, 2003

5 merger or acquisition. It also adds the requirement that the listed company disclose in a press release the material terms of any award (including the name of the recipient and the number of shares involved) promptly following a grant in reliance on this exemption. Plans relating to mergers and acquisitions. The final NYSE rule provides that shareholder approval is not required to convert, replace or adjust outstanding awards (including those of the target company) to reflect merger or acquisition transactions. In addition, the final NYSE rule provides that shares reserved for issuance under the target company s plans may be used for post-acquisition grants, so long as the target company s plans had previously been approved by that company s shareholders. (A plan adopted and approved in contemplation of the transaction would not be considered pre-existing for this purpose.) These shares may be used either for grants under the target company s plan or another plan so long as (1) the number of shares available for grants is appropriately adjusted to reflect the transaction, (2) the time during which the shares are available for grants is not extended beyond the period that would have been available, absent the transaction, under the pre-existing plan and (3) the awards are not granted to the employees of the acquiror and its pre-transaction subsidiaries. 9 Tax-qualified and parallel excess plans. The final NYSE rule provides that the following types of plans (and material revisions thereof) are exempt from the shareholder approval requirement: Plans intended to meet the requirements of Section 401(a) of the Internal Revenue Code (for example, 401(k) plans and ESOPs) or Section 423 of the Internal Revenue Code (employee stock purchase plans). 10 Parallel excess plans (referred to as parallel nonqualified plans under the proposed rule). The definition of a parallel excess plan under the final NYSE rule is narrower than the definition of parallel nonqualified plan under the proposed rule. The final NYSE rule provides that a parallel excess plan is a pension plan designed to work in conjunction with a plan qualified under Section 401(a) of the Internal 9 10 The final NYSE rule also provides that shares reserved for listing on the NYSE in connection with merger and acquisition transactions in reliance on this exemption must be counted in determining whether a transaction involves the issuance of 20% or more of the acquirer s outstanding common stock, thereby triggering the requirement that the transaction be approved by the acquiror s shareholders under Rule (c) of the Listed Company Manual. An employee stock purchase plan intended to receive the tax treatment under Section 423 of the Internal Revenue Code must in any event be approved by the listed company s shareholders pursuant to the Internal Revenue Code. Fried, Frank, Harris, Shriver & Jacobson 5 June 30, 2003

6 Revenue Code, but that is not restricted by the limitations on the maximum amount of contributions and/or level of benefits imposed upon tax-qualified plans by the Internal Revenue Code. In addition, the final NYSE rule requires that a parallel excess plan cover all or substantially all employees of an employer who are participants in the related qualified plan and whose annual compensation is in excess of the limit set forth in Section 401(a)(17) of the Internal Revenue Code and have substantially the same terms as the qualified plan that it parallels except for the elimination of the limitations described above. However, the final NYSE rule adds the requirement that no participant under a parallel excess plan may receive employer equity contributions under the plan in excess of 25% of the participant s cash compensation. 11 Transition Rules Regarding Pre-Effective Date Discretionary and Formula Plans Special rules apply to discretionary plans and formula plans (as described in footnote 6, above) that are in effect before June 30, Discretionary plans. Perhaps not surprisingly, discretionary plans, which contain no share limits, are looked upon with disfavor under the final NYSE rule. Listed companies may make grants after June 30, 2003 under discretionary plans in effect before that date without obtaining further shareholder approval of the plan or grants only until the first to occur of the following: The listed company s next annual meeting at which directors are elected that occurs after December 27, June 30, The expiration of the plan. Any grants made during this transition period must be consistent with past practice. If a plan can be separated into a discretionary portion and a nondiscretionary portion, the non-discretionary portion of the plan will be deemed to be a separate plan and may continue to be used separately (subject to any applicable transition rules). Formula plans. The final NYSE rule provides that grants under formula plans in effect before June 30, 2003 may be made after June 30, 2003 without further shareholder approval for only the limited transition period applicable to discretionary plans or, if later, until the shares that were available immediately before June 30, 2003 (that is, without giving regard to any increase thereafter) have been used. However, a formula plan which has been approved by 11 The final NYSE rule makes clear that the exemption for tax-qualified and parallel excess plans will apply to plans that fail to qualify for the exemption solely because they contain provisions necessary to comply with non-u.s. tax laws applicable to non-u.s. employees covered by them. Fried, Frank, Harris, Shriver & Jacobson 6 June 30, 2003

7 shareholders before June 30, 2003 may continue to be used beyond the transition period if the plan has a term of 10 years or less. If the plan does not have a term of 10 years or less, it may be amended (either before or after June 30, 2003) to provide for such a term, and the amendment will not be considered a material revision of the plan. The term must run from the date of original adoption or the date of the plan s most recent shareholder approval, whichever is later. Broker Voting on Equity The final NYSE rule amends NYSE Rule 452 to preclude brokers from voting on equity compensation plans presented to shareholders unless they receive instructions from the beneficial owners of the shares being voted. The final NYSE rule provides that amended Rule 452 will be effective for any meeting of shareholders that occurs on or after September 28, The Final Nasdaq Rule Like the final NYSE rule, the final Nasdaq rule requires shareholder approval prior to the issuance of securities in connection with the establishment or material amendment of a stock option plan, purchase plan or other equity compensation arrangement pursuant to which options or stock awards may be acquired by officers, directors, employees or consultants. Like the final NYSE rule, the final Nasdaq rule provides exceptions for all of the following: Warrants or rights issued generally to all security holders of the listed company or stock purchase plans available on equal terms to all security holders of the listed company (such as a typical dividend reinvestment plan). Tax-qualified, non-discriminatory employee benefit plans (for example, plans that satisfy Section 401(a) or Section 423 of the Internal Revenue Code) or parallel nonqualified plans, 12 if approved by the issuer s compensation committee or a majority of the issuer s independent directors. 12 Like the final NYSE rule, the exception under the final Nasdaq rule related to parallel nonqualified plans is more limited than the exception under the initial Nasdaq proposal (which was substantially identical to the definition of such term under the proposed NYSE rule), in that it excludes from the definition of a parallel nonqualified plan any plan under which a participant receives employer equity contributions under the plan in excess of 25% of such participant s cash compensation. Fried, Frank, Harris, Shriver & Jacobson 7 June 30, 2003

8 (iv) (v) Plans that merely provide a convenient way to purchase shares on the open market or from the issuer at fair market value (this exception was not included in the initial Nasdaq proposal). Certain plans or arrangements relating to an acquisition or merger. This exception is substantially the same as the exemption under the final NYSE rule related to mergers and acquisitions, as described above, except that it appears that plans and arrangements exempt from shareholder approval may also be used following the transaction (the final NYSE rule requires that the plan or arrangement have been approved by shareholders). 13 Inducement grants to a person not previously an employee or director of the listed company (including grants made to new employees in connection with a merger or acquisition), or following a bona fide period of non-employment, as an inducement to the individual entering into employment with the listed company, if approved by the issuer s compensation committee (comprised of a majority of independent directors) or a majority of the issuer s independent directors. The final Nasdaq rule, unlike the initial Nasdaq proposal, includes a nonexhaustive list of revisions that Nasdaq considers material. This list is similar to the list included in the final NYSE rule and includes all of the following: Any material increase in the number of shares available under the plan (other than an increase solely to reflect a reorganization, stock split, merger, spinoff or similar transaction). 14 Any material increase in benefits to participants, including any material change to (1) permit a repricing (or decrease in exercise price) of outstanding options, (2) reduce the price at which shares or options to purchase shares may be offered or (3) extend the Like the final NYSE rule, the final Nasdaq rule states that shares available for issuance under a target s plan by reason of a merger or acquisition will be counted in determining whether the transaction involves the issuance of 20% or more of an acquiror s outstanding common stock, thereby triggering the requirement that the transaction be approved by the acquiror s shareholders. The final Nasdaq rule states that if a plan provides for automatic increases in the number of shares subject to a plan or automatic grants of options under a plan pursuant to a formula, then the plan cannot have a term in excess of 10 years unless shareholder approval is obtained every 10 years. In addition, like the final NYSE rule, the final Nasdaq rule provides that if a plan contains no limit on the number of shares available for grant, then each grant under the plan will require separate shareholder approval even if the term of the plan is not greater than 10 years. The final Nasdaq rule, like the final NYSE rule, makes clear that a requirement that grants be made out of treasury or repurchased shares will not exempt a plan from these additional shareholder approval requirements. Fried, Frank, Harris, Shriver & Jacobson 8 June 30, 2003

9 duration of a plan. Unlike the final NYSE rule, the final Nasdaq rule does not contain a presumption that a plan that is silent as to repricing prohibits repricing. (iv) Any material expansion of the class of participants eligible to participate in the plan. Any expansion in the types of options or awards provided under the plan. The final Nasdaq rule does not contain any explicit transition rules, other than a general statement that existing plans are grandfathered until they are materially modified. * * * If you would like to discuss these final rules or related matters, please do not hesitate to contact any of the individuals listed below. New York Howard B. Adler Donald P. Carleen Michael A. Levitt Jonathan F. Lewis Laraine S. Rothenberg Rebecca Ditsch Sean Feller Washington Lawrence R. Bard Fried, Frank, Harris, Shriver & Jacobson 9 June 30, 2003