Institutional Shareholder Services
November 6, 2002
Mr. Jonathan G. Katz
Dear Secretary Katz:
We appreciate the opportunity to submit our comments on the Nasdaq Stock Market's (Nasdaq) proposed rule change relating to shareholder approval of equity compensation plans. The statement represents the views of Institutional Shareholder Services (ISS) and not necessarily those of our clients.
ISS commends Nasdaq for proposing a set of rules to require that most equity compensation plans be submitted to shareholders for approval. Such actions will contribute to the process of restoring investor confidence in our capital markets. We must express some concern, however, that the Nasdaq proposal fails to match the New York Stock Exchange's (NYSE) pledge to provide shareholders with the right to approve all potentially costly amendments to stock plans.
Given the current fragile market environment, it is essential that U.S. securities markets lead a "race-to-the-top" via the use of uniform standards on key market protection mechanisms such as shareholder approval. Many institutional investors view shareholder ratification of stock option plans as an important ownership right. Yet growing numbers of companies-the lion's share of which populates the various Nasdaq markets-are allocating massive amounts of equity to their compensation plans without submitting these programs for shareholder approval. Adoption of the proposed rule will mark a critical step in restoring shareholders' confidence in the fairness of the market.
While we support the proposed set of rules on the whole, we would suggest the following improvements.
The NYSE has done a service to investors by making clear that option repricings-including the option exchange programs that have become popular in the wake of recent accounting changes-qualify as "material revisions" that require shareholder approval. In its filing to the SEC, the NYSE elaborates:
Unfortunately, Nasdaq does not propose a similar bright-line standard. Instead, Nasdaq promises to "continue to provide guidance as to what constitutes a material amendment to a plan." If allowed to stand, this weaker Nasdaq standard could undermine investor confidence by encouraging forum shopping (and market jumping) by NYSE-listed firms. To stop such a "race-to-the-bottom," Nasdaq should adopt the NYSE's proposed rule on this critical issue.
Beyond the issue of repricing, adoption of this rule as proposed will lead to numerous questions as to the definition of types of stock plan changes that qualify as material. In resolving these questions, it will be particularly important for the SEC and Nasdaq to maintain a high level of transparency. Therefore, we urge the Commission to require that the markets engage in an open process in implementing the rules. For example, we would suggest that the SEC require Nasdaq (and the NYSE) to publish all staff determinations, both positive and negative, on requests for exemptions from exchange rules (and listing standards) on its Web site in real time.
Nasdaq proposes requiring issuers to notify the market no later than 15 calendar days prior to taking actions on non-shareholder approved plans. Investors should receive advance notice of these actions as well. Such advance notice would allow shareholders to contact corporate boards to register their views before such actions are taken. It will also allow investors to monitor Nasdaq's process for issuing interpretations of its rules.
Exemption for Inducement Grants
The proposed exemption for inducement grants would encourage the use of such awards simply for the purpose of avoiding shareholder approval. Nasdaq proposes to check potential abuses by requiring board compensation panels or a majority of the independent directors to approve inducement grants. Involving directors in the process is a positive step, but it is far from failsafe. We recommend that Nasdaq consider other steps to limit the exemption. For example, the exemption could be restricted to individuals who fill critical management positions. An individual who replaces one of the "five highly compensated executives" named in the prior year's proxy statement could qualify for such an exemption. In addition, we recommend that Nasdaq set a minimum threshold for mandatory shareholder approval. Nasdaq, for example, could mandate a shareholder vote on any inducement grant involving one percent or more of the company's fully diluted shares.
As additional protection, we recommend that inducement grants be put to shareholder ratification at the next scheduled meeting. Furthermore, and as a minimum, the SEC and Nasdaq should require companies to disclose their use of this exemption in real time by means of a press release, an 8-K filing, or both.
The Nasdaq's proposal to waive approval for all shareholder-approved plans acquired via mergers and benefit-type compensation programs (Section 123 Plans and parallel nonqualified plans) could provide opportunities to circumvent the approval process. To avoid that possibility, we recommend that Nasdaq set a minimum threshold for mandatory shareholder approval. Nasdaq, for example, could mandate a shareholder vote on any otherwise exempt program (including inducement grants, as noted above) that reserves one percent or more of the company's fully diluted shares for compensation purposes.
Transparency, once again, will play a critical role. We recommend real-time disclosure of the adoption of any programs exempt from shareholder approval.
The Nasdaq proposal is an improvement over existing standards, and for that reason we urge its adoption. At the same time, we suggest that there is room for further improvement. We believe that our suggested amendments will strengthen Nasdaq's standards both substantively and procedurally.