The SEC Publishes New NYSE and Nasdaq Rules Regarding Stockholder Approval of Equity Plans

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1 NUMBER 228 FROM THE LATHAM & WATKINS TAX DEPARTMENT BULLETIN NO. 228 OCTOBER 21, 2002 Subject to certain exceptions, the proposed rules contained in both the NYSE and Nasdaq Releases will require stockholders to approve all new equity-compensation plans and all material changes to existing equity-compensation plans. The SEC Publishes New NYSE and Nasdaq Rules Regarding Stockholder Approval of Equity Plans The Securities and Exchange Commission (SEC) recently issued two releases containing rule changes proposed by the New York Stock Exchange (NYSE), Release No ; File No. SR-NYSE (the NYSE Release) and the Nasdaq Stock Market, Inc. (Nasdaq), Release No ; File No. SR-NASD (Nasdaq Release) regarding stockholder approval of equity-compensation plans. Subject to certain specifically enumerated exceptions, the proposed rules contained in both the NYSE and Nasdaq Releases (Proposed Rules) will require stockholders to approve all new equity-compensation plans and all material changes to existing equity-compensation plans. The NYSE Release also contains revised rules governing the voting of proxies on equity-compensation plans. Although both the NYSE and the Nasdaq Releases contain similar substantive rules regarding stockholder approval, there are some differences and the Releases utilize somewhat different terminology. The following summarizes the substantive effects of each Release and, where appropriate, describes any substantive differences between the Releases. The SEC is currently soliciting comments regarding the Proposed Rules. All comments on the NYSE Release must be submitted by November 1, Comments on the Nasdaq Release must be submitted by November 7, The Proposed Rules remain subject to change upon the SEC s review of comments submitted with respect to the Proposed Rules. However, the SEC is expected to approve the Proposed Rules (perhaps with modifications to harmonize the rules) shortly following the end of the comment period. If you are interested in commenting on the Proposed Rules, please contact any of the attorneys listed at the end of this Client Alert. The Proposed Rules are not expected to apply to any plan adopted before the date the Proposed Rules become effective unless and until the occurrence of any subsequent material revision or amendment to the plan. The following is a brief summary of the Proposed Rules as described in the Releases.

2 Proposed Stockholder Approval Rules NYSE Release The NYSE Release provides that the following new rule will be added to the NYSE Listed Company Manual: To increase shareholder control over equity - compensation plans, shareholders must be given the opportunity to vote on all equity- compensation plans, except inducement awards, plans relating to mergers and acquisitions, and tax qualified and parallel nonqualified plans. 1 The NYSE Release contains commentary that explains, and expands upon, this new language. In particular, the commentary provides that as general rule the NYSE requires that all equity-compensation plans, and any material revisions to the terms of such plans, be subject to stockholder approval. (Emphasis added.) According to the commentary, examples of material revisions would include, but not be limited to, revisions that: materially increase the shares available for issuance under the plan (other than a change solely to reflect a change in capitalization); change the type of awards available under the plan; materially expand the class of persons eligible to receive awards under the plan; materially extend the term of the plan; materially change the method of determining the exercise price of options under the plan; and remove or limit a plan provision that prohibits option repricing. If a plan does not contain language that specifically permits option repricing, the plan will be deemed to prohibit repricing for purposes of this new rule, and any actual repricing of options will be deemed to be a material revision that requires stockholder approval. For these purposes, repricing is defined broadly and includes transactions that are not considered repricings under generally accepted accounting principles. 2 Nasdaq Release The Nasdaq Release amends NASD Rule Section 4350(i) to require shareholder approval prior to the issuance of designated securities: 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... (Emphasis added to indicate revised additional language.) The Nasdaq Release contains additional guidance which makes clear that Nasdaq will continue to provide guidance as to what constitutes a material amendment to a plan and indicates that it considers amendments which enhance the benefits, increase the number of shares or change the class of eligible participants under the plan to be material. However, unlike the NYSE Release, the Nasdaq Release does not contain any express provisions with respect to option repricings. The Nasdaq Release also makes conforming changes to NASD Rules 4310(c)(17)(A) and 4320(15)(A), which require 15 day notification prior to the adoption of a material amendment to a plan. Previously these rules required 15 day notification prior to the establishment of a plan. Exceptions to Stockholder Approval Requirements Both the NYSE Release and the Nasdaq Release provide that several types of plans and awards will be exempt from the general stockholder approval requirements. In circumstances in which equity-compensation plans (or amendments) are not subject to stockholder approval, the plan (or amendment) must be approved by the company s compensation committee or a majority of the company s independent directors. The following types of plans and awards are exempt from stockholder approval under the Proposed Rules: Inducement Grants. Grants of options or shares to an individual as an inducement to such individual s first becoming an employee of the issuer or any of its subsidiaries 3 will not be subject to the stockholder approval requirement. BULLETIN NO OCTOBER 21, 2002

3 Mergers and Acquisitions Conversion Awards. Stockholder approval will not be required to convert, replace or adjust outstanding options or other equity compensation awards to reflect a merger or acquisition transaction. Mergers and Acquisitions Assumed Plans. Shares issuable under certain stockholder approved plans assumed in connection with a merger or other corporate acquisition transaction may be used without additional stockholder approval. In particular, where the party that is not the listed company following the transaction has shares available for grant under a pre-existing plan that was previously approved by stockholders, the remaining shares available (as adjusted to reflect the transaction) may be utilized for post-transaction awards (either under the pre-existing plan or another plan) so long as (1) the time during which awards may be made with respect to such shares is not extended beyond the time during which awards could have been made under the pre-existing plan, absent the transaction; and (2) awards are not made to individuals who were employed by the granting company at the time the merger or acquisition was consummated. A plan adopted in contemplation of a merger or acquisition transaction will not be deemed to be pre-existing for purposes of this exception. Qualified Plans; Employee Stock Purchase Plans. Any plan intended to be tax-qualified under Section 401(a) of the Internal Revenue Code of 1986, as amended (Code), will be exempt from the stockholder approval requirement. For example, a taxqualified Employee Stock Ownership Plan (ESOP) will not be subject to the stockholder approval requirement. Similarly, any Employee Stock Purchase Plan intended to satisfy Section 423 of the Code (ESPP) will not be subject to the stockholder approval rules. (However, ESPPs must generally be approved by stockholders within 12 months before or after board approval under the existing tax rules governing ESPPs.) Parallel Nonqualified Plans. Any plan that is a parallel nonqualified plan will be exempt from the stockholder approval requirement. Both Releases define parallel nonqualified plan to mean any plan that is a pension plan within the meaning of the Employee Retirement Income Security Act of 1974, as amended (ERISA), that is designed to work in tandem with a plan that is intended to be tax-qualified under Section 401(a) of the Code and to provide benefits that exceed certain limitations set forth in the Code. 4 However, a plan will not be considered a parallel nonqualified plan unless it covers substantially all participants in the related tax-qualified plan whose compensation is in excess of the limit contained in Section 401(a)(17) of the Code (currently $200,000) and the plan s terms are substantially identical to the related tax-qualified plan (other than the elimination of the applicable limitations). Compliance with these additional requirements may be difficult, since the rules governing such plans under ERISA may not allow the plans to cover all such participants. Certain Additional Issues Interpreting the Proposed Rules. According to the NYSE Release, the NYSE s Proposed Rules are intended to articulate the NYSE s general philosophy with respect to corporate governance. Upon adoption, NYSE-listed companies will be expected to apply the NYSE s Proposed Rules in good faith. To the extent that the new rules contain any ambiguity, NYSE-listed companies will be expected to make reasonable interpretations and to disclose the interpretations that they make. 5 Foreign Private Issuers. The NYSE s Proposed Rules regarding stockholder approval do not apply to NYSE-listed companies that are foreign private issuers so long as the foreign private issuer complies with its applicable home country practice. 6 The Nasdaq Release does require non- Canadian foreign issuers only to provide notice of the establishment and or material amendment of plans. BULLETIN NO OCTOBER 21, 2002

4 Evergreen Plans. The footnotes to the NYSE Release specifically address the treatment of evergreen plans (i.e., plans that provide for an automatic increase in the number of shares available under the plan pursuant to a formula). Automatic increases in the number of available plan shares under an evergreen formula will not be considered a plan revision so long as the evergreen term does not exceed 10 years. 7 An evergreen plan adopted prior to the effective date of the Proposed NYSE Rules must be submitted for stockholder approval before the next increase in shares pursuant to the evergreen formula that occurs on or after the effective date of the [Proposed NYSE Rules], unless the plan (including the evergreen formula) was approved by shareholders before the effective date of the [Proposed NYSE Rules]. 8 The Nasdaq Release does not contain any express provisions regarding evergreen plans. NYSE Treasury Share Exception. According to the NYSE Release, the NYSE s traditional treasury stock exemption will no longer be available. Thus equity-compensation plans that utilize treasury shares will be required to obtain stockholder approval unless one of the abovementioned exceptions applies. Nasdaq De Minimus Exception. The Nasdaq Release specifically eliminates its prior de minimus exception, which allows for the grant of the lesser of 1% of the number of shares of common stock outstanding or 25,000 shares without shareholder approval. NYSE Proxy Voting Rules In addition to the stockholder approval rules described above, the NYSE Release (but not the Nasdaq Release) provides that NYSE Rule 452 will be revised to preclude [NYSE] member organizations from giving a proxy to vote on equity compensation plans unless the beneficial owner of the shares has given voting instructions. Thus brokers will not be permitted to vote uninstructed shares. NYSElisted companies will need to take this into account for purposes of achieving a quorum as well as for purposes of obtaining stockholder approval of equity-compensation plans. The Nasdaq Release does not contain a similar rule with respect to proxy voting. Endnotes 1 Proposed Section 303A(8) of the NYSE Listed Company Manual. See Section II(A)(1) of the NYSE Release. 2 For example, the definition of repricing includes 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, unless the cancellation and exchange occurs in connection with a merger, acquisition, spin-off or other similar corporate transaction. (Representatives of the NYSE have informally indicated that the foregoing reference to the strike price being equal to or less than the fair market value of the underlying stock is instead intended to refer to the strike price being equal to or greater than the fair market value of the underlying stock and that the language will be revised accordingly prior to adoption of final NYSE rules.) Such a cancellation and exchange will be considered a repricing regardless of whether the option, restricted stock, or other equity is delivered simultaneously with the cancellation, regardless of whether it is treated as a repricing under generally accepted accounting principles, and regardless of whether it is voluntary on the part of the option holder. See footnote 10 to the NYSE Release. 3 See the Commentary in Section II(A)(1) of the NYSE Release. The Nasdaq Release describes inducement grants as awards granted to an individual not previously an employee or director of the company as an inducement material to the individual s entering into employment with the company. 4 In particular, parallel nonqualified plan is defined as a plan intended to work in tandem with a tax-qualified plan and to provide benefits that exceed the limits set forth in [Code] Section 402(g) (the section that limits an employee s pre-tax contributions to a 401(k) plan), [Code] Section 401(a)(17) (the section that limits the amount of an employee s compensation that can be taken into account for plan purposes) and/or [Code] Section 415 (the section that limits the contributions and benefits under qualified plans). See footnote 13 to the NYSE Release or footnote 1 to IM , as contained in the Nasdaq Release. 5 See footnote 4 to the NYSE Release. 6 See footnote 5 to the NYSE Release. 7 See footnote 8 to the NYSE Release. 8 See footnote 15 to the NYSE Release. BULLETIN NO OCTOBER 21, 2002

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6 Client Alert is published by Latham & Watkins as a news reporting service to clients and other friends. The information contained in this publication should not be construed as legal advice. Should further analysis or explanation of the subject matter be required, please contact the attorneys listed to the right or the attorney whom you normally consult Latham & Watkins. All Rights Reserved. BOSTON BRUSSELS CHICAGO FRANKFURT HAMBURG HONG KONG LONDON LOS ANGELES MILAN MOSCOW NEW JERSEY NEW YORK NORTHERN VIRGINIA ORANGE COUNTY PARIS SAN DIEGO SAN FRANCISCO SILICON VALLEY SINGAPORE TOKYO WASHINGTON, D.C. If you have any questions about this Client Alert, please contact Bradd L. Williamson in our New York office, Robin L. Struve in our Chicago office, Joseph M. Yaffe in our Silicon Valley office, or any of the following attorneys. BRUSSELS John P. Lynch CHICAGO Robin L. Struve (312) FRANKFURT Joerg P. Soehring HAMBURG Holger Iversen Peter Markl HONG KONG Mitchell D. Stocks LONDON David Miles LOS ANGELES James D.C. Barrall (213) MOSCOW Anya Goldin NEW JERSEY James E. Tyrrell, Jr. (973) NEW YORK Jed W. Brickner Bradd L. Williamson (212) ORANGE COUNTY David W. Barby (714) PARIS Olivier Delattre SAN DIEGO Barry M. Clarkson (619) SAN FRANCISCO Gregory P. Lindstrom (415) SILICON VALLEY Robert A. Koenig Joseph M. Yaffe (650) SINGAPORE Mark A. Nelson TOKYO OFFICE Daivid L. Shapiro WASHINGTON, D.C. Erin M. Sweeney (202) BULLETIN NO OCTOBER 21, 2002