GT Alert

Executive Compensation Considerations for the Upcoming 2004 Proxy Season

February 2004
By Steven B. Lapidus and Mindy B. Leathe, Greenberg Traurig, Miami Office

  View or download the PDF version of this Alert here.

This Alert will highlight some of the executive compensation considerations for publicly held companies in the upcoming 2004 proxy season.

"In light of this trend, companies with plans under which only stock options may be granted should consider amending their plans, or adopting new plans, to provide greater flexibility with regard to the types of equity awards that may be granted."

As discussed below, the Financial Accounting Standards Board (“FASB”) soon is expected to announce new proposed rules for the expensing of stock options, and we already have seen an increased trend among public companies in the offering of restricted stock and other types of equity awards to executives driven in part by the anticipated financial accounting changes. In light of this trend, companies with plans under which only stock options may be granted should consider amending their plans, or adopting new plans, to provide greater flexibility with regard to the types of equity awards that may be granted. Companies also should review their compensation plans to make sure they specify the maximum aggregate number of shares with respect to which incentive stock options (“ISO’s”) and other equity awards may be awarded under the plan, as required by regulations recently proposed by the IRS, and to ensure that both cash and equity compensation awarded pursuant to its plans satisfy the shareholder approval requirements to qualify as “performance based compensation” for purposes of Section 162(m) of the Internal Revenue Code of 1986, as amended (the “Code”).

Material changes to equity compensation plans, such as those discussed above, generally require shareholder approval under new rules adopted by the NYSE, NASDAQ and AMEX during 2003 and companies therefore may wish to include proposals to modify their existing plans, or adopt new plans, to address these issues in this year’s proxy. In addition, shareholder approval is now required under those rules for shares to be issued pursuant to certain non-qualified deferred compensation plans adopted or materially revised after June 30, 2003, as well as shares issued under certain other plans after the expiration of a “limited transition period” for the new rules that are discussed in this Alert. Further, shareholder approval of the repricing of outstanding stock options may be required under the new exchange rules, unless the plan pursuant to which the options are granted contains certain language that previously was approved by shareholders.

In light of the foregoing, we highly recommend that clients review the following discussion carefully to determine whether any modifications should be made to their incentive compensation plans and/or whether any plans or changes should be submitted for shareholder approval this proxy season. A summary of recommended actions appears at the end of that discussion.

1. Potential Financial Accounting Changes

During the first quarter of this year, FASB is expected to announce proposed changes to the financial accounting rules for equity compensation awards that will include requiring companies to recognize a financial accounting charge for compensation expense equal to the fair value of stock options measured at the time of grant. FASB has indicated that it intends to issue a final standard with regard to these matters in the fourth quarter of 2004, and that the changes will be effective January 1, 2005.

Accounting for stock options is a highly controversial and political issue. There currently are a number of Bills pending in Congress, some of which are for and some of which are against the expensing of stock options. One Bill, for example, would require expensing only of options granted to a company’s chief executive officer and next four highest compensated executives.

In light of the foregoing, it is far from certain at this time when, whether or in what form the proposed accounting changes will become effective. Nevertheless, in part because of these anticipated changes in the financial accounting rules, and in part as a result of a shift in thinking as to what are the most appropriate and effective ways to provide equity incentives, there has been an increased trend towards the issuance of restricted stock and other types of equity awards to executives and directors of publicly traded companies. Generally, since restricted stock awards have value even if the price of a company’s shares does not increase or in fact diminishes, those awards frequently are perceived by recipients as having greater value than stock options, and thus a company generally will need to issue a fewer number of restricted shares than it normally would issue pursuant to options. This results in less shareholder dilution, and if the financial accounting rules change, may result in a smaller financial accounting expense if the value of the fewer number of shares of restricted stock is less than the value of the options they replace.

In light of these trends, companies may wish to amend their plans this year to expand the types of equity awards that may be granted thereunder.

2. Tax Considerations

a. Incentive Stock Options

During 2003, the Treasury Department issued new proposed regulations governing incentive stock options (“ISOs”). These proposed regulations will be effective with respect to any ISO granted on or after the 180th day after which the finalized regulations are published in the Federal Register. Taxpayers, however, may rely on the proposed regulations for the treatment of an ISO granted on or after June 9, 2003.

Under the new proposed regulations, a stock option cannot qualify as an ISO unless the option is granted pursuant to a plan that specifies the maximum aggregate number of shares that may be issued through ISOs and other stock options and stock-based awards. This maximum amount may be expressed as a percentage of the issued and outstanding shares as of the effective date of the plan, and may even increase annually based upon a certain percentage of the issued and outstanding shares as of the effective date of the plan. The new proposed regulations state, however, that a plan that merely provides that the number of shares available for grant may not exceed a stated percentage of the shares issued and outstanding at the time of each grant (or some other future event) does not satisfy this requirement unless there is an overall maximum amount stated in all events. Most plans currently satisfy this new requirement. Others will need to be amended. For example, a plan with an evergreen provision that provides for automatic increases in the number of shares with respect to which awards may be granted and a cap on the aggregate number of ISOs that may be granted generally was thought to have satisfied prior law but would not satisfy the requirements of the new proposed regulation unless the cap was revised to limit the number of shares that could be issued with respect to all awards (including ISOs).

Although the proposed regulations are not yet effective, companies making other revisions to their plans also may wish to amend their plans at the same time to comply with this requirement in anticipation of the finalization of these new regulations.

b. Section 162(m) Limitation on Compensation Deductions

(i) General Rules

Section 162(m) of the Code generally provides that a publicly-held corporation may not deduct compensation with respect to its CEO and the next 4 most highly-compensated officers (each a “covered employee”) to the extent that the amount of the compensation payable to that covered employee for the taxable year exceeds $1,000,000. Compensation that qualifies as “performance-based compensation,” however, is disregarded in applying the $1,000,000 limitation. In order to qualify as performance-based compensation, the compensation must be paid solely on account of the attainment of one or more pre-established, objective performance goals, where the goals are established by a committee composed solely of two or more outside directors, and are disclosed to and approved by the company’s shareholders. In addition, prior to the payment of the compensation, the committee must certify in writing that the performance goals have been satisfied.

Treasury Regulations generally provide that compensation attributable to a stock option or a stock appreciation right (“SAR”) is deemed to qualify as performance based compensation if the grant or award is made by the committee, the plan under which the option or right is granted states the maximum number of shares with respect to which options or rights may be granted during a specified period to any employee, and the exercise price of the option (or base value for measuring the value of the SAR) is not less than the fair market value of a share on the date the award is granted. Restricted stock and other equity awards that do not qualify for this special rule (e.g. discounted stock options) will not qualify as performance based compensation unless the general requirements under Section 162(m) summarized above are met.

(ii) Need for Shareholders to Reapprove Certain Plans

Once the material terms of a performance goal are disclosed to and approved by shareholders, no additional disclosure or approval generally is required unless the material terms of the performance goals are changed. However, Section 162(m) requires that if the committee has the ability to change the specific targets under a performance goal, then the material terms of that performance goal must be disclosed and re-approved by shareholders by no later than the first shareholder meeting that occurs in the fifth year following the year in which prior shareholder approval was obtained.

To provide flexibility for committees in structuring effective incentive compensation arrangements for executives, most incentive compensation plans merely set forth the types of business criteria that compensation committees may use in developing bonus formulas each year (rather than including a specific bonus formula in the plan). If a company has taken this more flexible approach in its plan, and that plan was approved by shareholders five or more years ago, then the company should consider resubmitting its plan for approval by shareholders this year.

(iii) Companies that Recently Became Publicly Held Corporations

Section 162(m) also contains some transitional exceptions for corporations that become publicly held, and that may be expiring for plans of some companies.

A. Reliance Period for Corporations that Become Publicly Held Corporations

Section 162(m) generally does not apply during a “reliance period” to compensation paid pursuant to a plan or agreement that existed during the period in which a corporation was not publicly held. The reliance period ends on the earliest of (i) the expiration of the plan or agreement; (ii) the material modification of the plan or agreement; (iii) the issuance of all employer stock and other compensation that has been allocated under the plan; and (iv) the first meeting of shareholders at which directors are to be elected that occurs after the close of the third calendar year following the calendar year in which the initial public offering (“IPO”) occurs or, in the case of a corporation that becomes publicly held without an IPO, the first calendar year following the calendar year in which the corporation becomes publicly held.

B. Transition Period for Subsidiaries that Become Separate Publicly Held Corporation

Similarly, if a subsidiary of a publicly held corporation becomes a separate publicly held corporation (whether by spin off or otherwise), any compensation paid to covered employees of the subsidiary will be deemed to satisfy the exception for performance based compensation during a “transition period” if certain requirements are met. The “transition period” ends no later than the first regularly scheduled meeting of the shareholders of the subsidiary that occurs more than 12 months after the date the subsidiary becomes a separate publicly held corporation.

Companies that recently became publicly held corporations and former subsidiaries of publicly held corporations that recently have become separate publicly held corporations should review their executive compensation plans to determine whether the “reliance period” or “transition period” afforded under the regulations has expired or is about to expire, and determine whether it would be advisable to submit those plans for shareholder approval during this proxy season.

3. Changes in Stock Exchange Rules for Shareholder Approval of Plans and Material Revisions

During 2003, the NYSE, NASDAQ, and AMEX each adopted new rules regarding the requirements for shareholder approval of equity compensation plans or arrangements1.

a. Equity Compensation Plan or Arrangement Defined

(i) NYSE Rule

The NYSE rule requires shareholder approval of all “equity compensation plans” and “material revisions” thereto. For this purpose, an “equity compensation plan” is defined 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.” The term includes the compensatory grant of options or other equity awards that are not made pursuant to a plan. The rule states, however, that plans that are made available to shareholders generally (e.g., a dividend reinvestment plan) or 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, do not constitute equity-compensation plans.

(ii) NASDAQ Rules

The NASDAQ rules provides that the shareholder approval requirements apply prior to the issuance of securities “when a stock option or purchase plan is to be established or materially amended or other equity compensation arrangement made or materially amended, pursuant to which stock may be acquired by officers, directors, employees, or consultants.”

(iii) AMEX Rule

The AMEX rule requires approval of shareholders “with respect to the establishment of (or material amendment to) a stock option or purchase plan or other equity compensation arrangement pursuant to which options or stock may be acquired by officers, directors, employees, or consultants, regardless of whether or not such authorization is required by law or the company’s charter.”

b. Exemptions for Plans Requiring Shareholder Approval

The new rules for each of the stock exchanges provide certain exceptions from the shareholder approval requirements.

(i) Shares Acquired Pursuant to Plans Qualified Under Section 401(a), Employee Stock Purchase Plans Under Section 423 and Certain Nonqualified “Parallel Plans“

The rules of all of the exchanges contain exemptions from the new shareholder approval requirements for shares acquired pursuant to plans that are qualified under Section 401(a) of the Code (e.g. 401(k) plans and ESOPs) or employee stock purchase plans that satisfy the requirements of Section 423 of the Code.

All of the rules also provide exemptions for certain parallel non-qualified deferred compensation plans (a “Parallel Plan”). A Parallel Plan is generally defined in the rules of each of the exchanges to mean a pension plan within the meaning of ERISA that is designed to work in parallel with a plan intended to be qualified under Section 401(a) of the Code to provide benefits that exceed certain limitations on contributions and compensation applicable to qualified plans. The rules provide that a plan will not be considered a Parallel Plan unless “(1) it covers all or substantially all employees of an employer who are participants in the related qualified plan whose annual compensation is in excess of the limit of Section 401(a)(17) of the Code (or any successor or similar limits that may hereafter be enacted); (2) its terms are substantially the same as the qualified plan that it parallels except for the elimination of the limits described in the preceding sentence and the limitations described in clause (3); and (3) no participant receives employer equity contributions under the plan in excess of twenty-five percent (25%) of the participant’s cash compensation.”

All of the rules state that an equity compensation plan that provides non U.S. employees with substantially the same benefits as a comparable Section 401(a) plan, Section 423 plan, or Parallel Plan that the listed company provides to its U.S. employees, but for features necessary to comply with applicable foreign law, are also exempt from the shareholder approval requirement of the rule.

Most non-qualified deferred compensation plans will not satisfy the foregoing requirements and thus shareholder approval generally would be required if stock of the employer is to be issued pursuant to those plans.

(ii) Mergers and Acquisitions

The rules also provide an exemption for certain shares issued pursuant to corporate acquisitions and mergers. Under one exemption, shareholder approval is not required to convert, replace or adjust outstanding options or other equity compensation awards to reflect the transaction. Under the second exception, shares available under certain plans acquired in corporate acquisitions and mergers may be used for certain post transaction grants without further shareholder approval. The acquiring company may use these shares for post transaction grants of options and other equity awards provided that the company not listed following the transaction has shares available for grant under a plan in effect prior to the transaction (and not adopted in contemplation of the transaction) that was previously approved by shareholders of the non listed company. The rules generally provide, however, that shares available under such a pre existing plan may be used for post transaction grants of options or other awards, either under the pre existing plan or in another plan, only if (A) the number of shares available for grants is appropriately adjusted to reflect the transaction (this requirement only appears in the NYSE rule), (B) 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, absent the transaction, and (C) the options and other awards are not granted to individuals who were employed, immediately before the transaction, by the post transaction listed company or any entities that were its subsidiaries immediately before the transaction.

(iii) Inducement Grants

The rules under each of the exchanges also provide that the shareholder approval requirements do not apply to grants of options or other equity based awards as a material inducement to a person being hired or rehired following a bona fide period of interruption of employment, including in connection with a merger or acquisition. To qualify for this exception, however, the listed company must disclose in a press release the material terms of the award, including the recipients of the awards and the number of shares involved.

(iv) Additional Requirements for Exemptions

The rules for each of the exchanges state that the foregoing exemptions for inducement grants, grants under plans that qualify under Sections 401(a) and 423, and Parallel Plans (and in the case of the NYSE rule the exemption for mergers and acquisitions as well) only may be made with the approval of the issuer’s independent compensation committee or the approval of the majority of the issuer’s independent directors, and that issuers must notify the exchange in writing when they use one of these exemptions. The rules also state that a listed company is not permitted to use repurchased shares to fund option plans or grants without prior shareholder approval.

c. Definition of Material Amendments

The new rules for each of the exchanges provide non exhaustive lists of plan amendments that are considered “material” and to thus generally require shareholder approval, which include the following:

(i) any material increase in the number of shares available under the plan (other than to reflect a reorganization, stock split, merger, spin off or similar transaction);

(ii) any expansion in the types of options or awards available under the plan;

(iii) any material expansion of the class of eligible participants;

(iv) a material increase in benefits to the participants, including, to extend the term of the plan;

(v) under the NASDAQ and AMEX rules, any material change to permit a repricing (or decrease in the exercise price) of outstanding options, or reduce the price at which shares or options to purchase shares may be offered; and

(vi) under the NYSE rule, any deletion of or limitation on any provision prohibiting repricing of options.

d. Increases in Available Shares Pursuant to “Evergreen” Provisions and other “Formula” Awards

The new rules for each of the exchanges provide that automatic increases in the shares available under the plan (sometimes called an “evergreen formula”) or provisions for automatic grants pursuant to some other formula (e.g. annual grants to directors of restricted stock having a certain dollar value or matching contributions based upon the amount of compensation the participant elects to defer under the plan) will be considered amendments to the plan requiring shareholder approval unless the plan has a term of not more than 10 years. These types of plans are referred to in the NYSE rules as “formula plans.” If a plan contains no limit on the number of shares available and is not a formula plan, then each grant under the plan will require separate shareholder approval regardless of whether the plan has a term of not more than 10 years. These plans are referred to in the NYSE rules as “discretionary plans.”

e. Repricing of Stock Options as Material Amendments

(i) NYSE Rule:

The new NYSE rules state that a plan that does not contain a provision that specifically permits repricing of options will be considered for purposes of the rules as prohibiting repricing, and as a result any actual repricing of options under such a plan will be considered a material revision of the plan requiring shareholder approval even if the plan itself is not revised. The term “repricing” is defined to mean any of the following, or any other action that has the same effect:

• Lowering the stock price of an option after it is granted;
• Any other action that is treated as a repricing under generally accepted accounting principles;
• Canceling an option at a time when its stock price exceeds the fair market value of the underlying stock, 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.

(ii) NASDAQ and AMEX Rules

Neither the NASDAQ nor the AMEX rules state that a plan is considered to prohibit repricing unless it expressly authorizes them. The rules for both state that although the general authority to amend a plan would not obviate the need for shareholder approval, if a plan permits a specific action without further shareholder approval, then no such approval would generally be required. The NASDAQ and AMEX rules both also state that when preparing plans and presenting them for shareholder approval, issuers should strive to make plan terms easy to understand, and both rules “recommend” that plans meant to permit repricing (which is not defined in either sets of rules) use explicit terminology to make this clear. In light of the foregoing, it does not appear that a repricing under a plan that does not expressly authorize repricing would require shareholder approval under the NASDAQ or AMEX rules if the language of the plan as previously approved by shareholders can be read to permit the “specific action” of repricing without shareholder approval. It is not clear, however, under either the NASDAQ or AMEX rules, whether general language authorizing the amendment of options (as opposed to general authority to amend the plan, which clearly would not be sufficient) would be sufficient to satisfy this requirement.

Companies that anticipate repricing options now or in the future should review their existing plans to determine whether any changes should be made to their plans to comply with the foregoing repricing requirements.

f. Effective Dates and Transition Rules

(i) NYSE Rules

The NYSE rule states that a plan adopted before June 30, 2003, which is the date of the SEC order approving the new NYSE rules, generally will not be subject to the new shareholder approval requirements unless and until it is materially revised. In the case of a “discretionary plan” (i.e., one under which there is no formula for grants nor any cap on the total number of shares with respect to which grants may be made), however, whether or not previously approved by shareholders, additional grants may be made after June 30, 2003 without further shareholder approval only for a “limited transition period” and then only in a manner consistent with past practice. Similarly, in the case of a “formula plan” (e.g. a plan with an evergreen formula or that provides a fixed formula for determining grants) that either (i) has not previously been approved by shareholders, or (ii) does not have a term of 10 years or less, additional grants may be made after June 30, 2003 without further shareholder approval only for a “limited transition period”.

The “limited transition period” is defined in the NYSE rule to end upon the first to occur of: (i) the listed company’s next annual meeting at which directors are elected that occurs more than 180 days after June 30, 2003; (ii) June 30, 2004; and (iii) the expiration of the plan.

A shareholder-approved “formula plan” may continue to be used after the end of this “limited transition period” if it is amended to provide for a term of 10 years or less from the date of its original adoption or, if later, the date of its most recent shareholders’ approval. Such an amendment may be made before or after June 30, 2003 and would not itself be considered a “material revision” requiring shareholder approval. In addition, a “formula plan” may continue to be used, without shareholder approval, if the grants after June 30, 2003 are made only from the shares available immediately before June 30, 2003 and thus, based only on formula increases that occur prior to June 30, 2003.

(ii) NASDAQ and AMEX Rules

Neither the NASDAQ nor the AMEX rules contain transition rules similar to those contained in the NYSE rule. In proposing its revision to the NASD rule, however, NASDAQ indicated that plans in effect on June 30, 2003 would be grandfathered, but that any material modification to plans in place or adopted after June 30, 2003 would require shareholder approval.

Recommended Actions

In light of the foregoing, companies should review their equity and non equity executive compensation plans to determine whether they should be amended and/or submitted for approval by shareholders this proxy season for any of the following reasons:

1. To expand the types of awards that may be awarded to plan participants under equity compensation plans.
2. To comply at this time (if they do not already do so) with the requirement in the proposed Treasury regulations (which are not yet effective) that the plan state the maximum aggregate number of shares with respect to which incentive stock options and other equity awards may be granted under the plan. Since the new rule is only proposed, we would not recommend amending plans to satisfy this requirement unless other amendments are being made to plan.
3. In the case of an equity compensation plan that has an evergreen formula for determining the number of shares with respect to which awards may be granted or otherwise provides for “formula” grants without any cap on the total number of shares with respect to which awards may be made, to limit the term of the plan to 10 years if appropriate.
4. To obtain shareholder approval to comply with Section 162(m) of the Code of:
   1. the performance criteria that the compensation committee may use in developing bonus formulas, if those criteria have not been approved by the company’s shareholders within the last 5 years.
   2. plans of companies that recently became publicly held corporations, or subsidiaries that recently became separate publicly held corporations, and have been relying upon exceptions to the shareholder approval requirements for their plans based upon “transition” or “reliance” periods that may soon be expiring.
5. To obtain shareholder approval with respect to the issuance of shares under any non qualified deferred compensation plan adopted or materially amended by the company after June 30, 2003, under which benefits may be distributed in the form of shares if the plan does not qualify as a Parallel Plan.
6. To amend the plan to expressly permit repricings (if the NYSE rule is applicable) or to permit “specific actions” that would include repricings (if the NASDAQ or AMEX rules are applicable). It should be noted, however, that amendments to permit repricings may meet shareholder resistance. This may be especially true with regard to institutional investors.

Footnotes

1 See NYSE Listed Company Manual Section 303A(8), NASD Rule 4350(i) and Interpretative Material 4350-5, adopted by NASDAQ and AMEX Company Guide Section 711 and related commentary. References herein to the rules of the exchanges include all of the foregoing.

© 2004 Greenberg Traurig

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