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The Employee Ownership Update

Corey Rosen

June 27, 2003

(Corey Rosen)

New Exchange Rules for Approval of Equity Plans

The SEC has approved new rules for the New York Stock Exchange and the NASDAQ for shareholder approval of equity plans. The rules are effective June 30, with very limited transition rules for some existing plans. For the NYSE, the new rules are Section 303A(8) of the Listed Company Manual. For the NASDAQ, the new rules are NASD Rules 4310(c)(17)(a) and 4320(e)(15)(A). The rules are very similar to each other. The most significant exception is that the NYSE rules prohibit broker voting on these issues; NADSAQ already does not allow broker voting on any issue. In effect, therefore, the two sets of rules are the same for broker voting as to shareholder approval of equity plans. Other inconsistencies are minor; probably the most significant is that the NYSE rules require the company to submit in writing to the SEC reasons why it is relying on one of the material modification exemptions; the NASDAQ is considering adding such a rule. A summary of the rules are as follows. Details can be found here on the SEC's site.
  1. Scope: All new equity compensation plans, and any material revisions to these plans, must be approved by shareholders, with certain narrow exceptions, as outlined below.
  2. Material modification: Material modifications of plans, with narrow exceptions, must be approved. This includes changes in terms, the number of shares, coverage, types of awards, and pricing or repricing unless specifically permitted by a plan. Changes that reduce employee rights and benefits do not require approval, however.
  3. Employment inducement awards: If the company's independent compensation committee approves them, inducement awards to new hires may be made without shareholder approval. Disclosure is required, however.
  4. Qualified plans and parallel excess plans for qualified plans: Employee Stock Ownership Plans, other Section 401 plans invested in company stock (401(k), profit sharing, and stock bonus plans), Section 423 Employee Stock Purchase Plans, and parallel plans that add benefits otherwise limited by contribution limits in these plans do not require approval.
  5. Broker voting: In what may be the most significant hurdle of the new rules, broker-held shares in NYSE-listed companies cannot be voted by proxy by the brokers unless the beneficial owner provides specific instructions. This new rule is effective 90 days after the effective date of the rules. NASDAQ already does not allow such voting on any issue.

IRS Issues Comprehensive Proposed Rewrite of Regulations for Incentive Stock Options and Employee Stock Purchase Plans

In proposed regulations published June 9, 2003 (26 CFR Parts 1 and 14a, Reg 122917-02, June 9, 2003), the Internal Revenue Service proposed an update, reorganization, and elaboration of existing rules governing incentive stock options and employee stock purchase plans (ESPPs). The proposed regulations did not add any dramatic new changes in the regulations of these plans, but did answer of number of technical uncertainties about certain plan specifics. Among the more notable of the changes are:

These regulations withdraw the 1984 proposed regulations under Code Sections 421, 422, 424, and 6039. The effective date of the new regulations is 180 days after the publication of the final regulations. The new regulations would apply to any option granted on or after that date; prior to this, companies can rely on the regulations as proposed for options granted June 9 or later. A more detailed description of the regulations is available on request to NCEO members.

Department of Labor Sues Enron Fiduciaries

The Department of Labor has sued the fiduciaries of Enron's 401(k) plan and ESOP for improperly encouraging employees to invest in Enron stock and for continuing to hold Enron shares in the plan when there were reasons to believe that was not prudent. Enron's 401(k) plan was primarily invested in Enron shares and the ESOP was essentially entirely invested in the stock. The two plans owned over 25 million shares in 2001. Charged as fiduciaries are the plans' Administrative Committees, Enron Corporation, Kenneth Lay and Jeffrey Skilling (the former CEO and CFO of the company), Enron's board, and the plans themselves. The suit alleges the Administrative Committees, despite numerous signs of problems, never monitored plan holdings of Enron shares, never question or slowed investment in these shares, never considered the prudence of concentrating assets in Enron shares, and never considered freezing or removing Enron shares as an investment option for employees. Two of the members of the Committee, the DOL alleges, had specific information that accounting and financial irregularities were about to cause serious problems. Enron, although not a named fiduciary, never sought to monitor the committee, remove its members, or correct misstatement by Kenneth Lay regarding Enron's financial condition. Lay and Skilling also never monitored the committee, never supplied them with adverse information they had about the company, and Lay misled participants about the company's financial condition, even encouraging them to buy shares when he knew that problems were forthcoming. The Board is accused of failing to appoint a trustee to manage the ESOP's holding of shares, and never performing that duty itself.

While the egregious facts in the Enron case set it apart form other ERISA cases, the case could provide guidelines on when ESOP and 401(k) plan trustees should act to diversify plan assets.

For a copy of the complaint, go here. For a detailed discussion of ESOP fiduciary obligations, see attorney David Ackerman's 99-page article on the topic, which appeared in the Winter 2001 issue of our Journal of Employee Ownership Law and Finance. [As of 2008, this article has now been expanded into a book we publish, Questions and Answers on the Duties of ESOP Fiduciaries.]

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