At nearly all U.S. companies, senior executives are paid using a mix of cash compensation, including salary and bonus; equity compensation, which can encompass stock options,[fn1] restricted stock[fn2] and, less commonly, stock appreciation rights[fn3] or phantom stock;[fn4] and benefits such as pensions and insurance.[fn5] Some components of this package, like salary and (occasionally) a bonus, are fixed, while other elements are pegged to various financial and non-financial performance measures.

Activist shareholders have focused their attention on issues ranging from the rigor of the process by which compensation is awarded to the equity issues raised by large compensation disparities within companies. Shareholders have a special interest in stock-based compensation, however. When companies issue more stock in order to fund executive compensation plans, the corporate "pie" — its earning power — is divided into more slices, so the slices held by existing shareholders shrink. In addition, the voting right attached to each share becomes relatively less powerful, since there are more shares voting. These phenomena are referred to as "dilution." It is thus critical that the pie itself grow, which should happen if the executives are creating value for the company in exchange for the compensation.

Although shareholders may influence a company's stock-based compensation policies through their votes on management proposals to approve incentive compensation plans, all such plans need not be approved by shareholders. Some shareholders also register disapproval by withholding votes from directors serving on the compensation committee. However, neither voting against management plans nor withholding votes allows shareholders to identify specific problems or suggest alternative approaches. Accordingly, some shareholders have turned to the shareholder proposal process to shape the debate over stock-based compensation.

[fn1] A stock option gives the holder the right to purchase shares of a company's stock at a particular price (the "exercise price") for a specified period of time. John Downes & Jordan Elliot Goodman, Dictionary of Finance and Investment Terms 600 (1998).

[fn2] Restricted stock is "company stock that is given to, or sold at a deep discount to, a corporate executive subject to the limitation that it cannot be sold during a fixed period of time." Randall S. Thomas & Kenneth J. Martin, "The Effect of Shareholder Proposals on Executive Compensation," 67 U. Cin. L. Rev. 1021, 1029 (1999).

[fn3] Stock appreciation rights or SARs are "the right to receive the increase in the value of a specified number of shares of common stock over a defined period of time." Id. at 1030 n. 37.

[fn4] Phantom stock entitles the executive to receive the increase associated with common stock prices and any dividend payments that are declared and paid on the common stock, but does not constitute a claim for ownership of the company. Id. at 1030 n. 36.

[fn5] Report of the NACD Blue Ribbon Commission on Executive Compensation: Guidelines for Corporate Directors 7 (1993) (hereinafter, "NACD Executive Compensation Report").

§ 29.02 Limiting the Amount of Executive Pay

Some shareholder proposals seek, directly or indirectly, to limit the amount senior executives may be paid. A variety of mechanisms are employed to this end; the most common are imposing a cap on CEO pay based on the ratio between the highest- and lowest-paid employee and freezing senior executive pay following downsizing.

§ 29.02[A] Corporate Governance Guidelines

The Report of the NACD Blue Ribbon Commission on Executive Compensation is critical of the use of pay multiples, including the multiple of the CEO's pay to the pay of the lowest-paid worker. The Report states,

Pay-multiple analyses may be misleading. Such analyses are strongly impacted by company size, industry, the role and location of the company's lowest-paid worker, and the method used to value CEO long-term incentive compensation. . . . However, given the media's recent attention to this topic, it is wise for the committee to have an understanding of where the company stands on each ratio, and some understanding of how these ratios relate to those at other companies.[fn6]

The NACD Report portrays efforts to limit the amount of executive compensation as misguided and uninformed:

Executive compensation arrangements will sometimes result in very high levels of compensation following periods of superior performance. The general public may underestimate the role management plays in creating wealth for shareholders and society, and overestimate the relative cost of rewarding management for that role. Boards must resist the temptation to renege on existing compensation plans that reward superior performance with "politically incorrect" amounts.[fn7]

TIAA-CREF's Policy Statement on Corporate Governance provides that cash pay should "[s]tand the test of reasonableness and fairness by prevailing industry standards and under the critical scrutiny of investors, employees throughout the company, and the public at large" and should "[p]rovide compensation levels that are understandable relative to scale, complexity, and performance."[fn8] The fund counsels that companies should consider "reasonableness, scale, linkage to performance, and fairness to shareholders and all employees."[fn9]

More specifically, TIAA-CREF advocates that cash incentive plans should lead to "total cash compensation for the chief executive officer and other senior executives that is understandable and reasonable in view of performance compared with that of executives in similar positions in comparable companies; and compared with all pay levels within the organization."[fn10]

[fn6] Id., at 13.

[fn7] Id., at 21.

[fn8] TIAA-CREF Policy Statement on Corporate Governance, Five Fundamental Principles of Compensation Governance, Principle No. 2 (undated and unpaginated) (hereinafter, "TIAA-CREF Policy Statement") (available at www.tiaa-cref.org/libra/governance).

[fn9] Id., Principle No. 3.

[fn10] Id., Executive Compensation Program Guidelines.

§ 29.02[B] Typical Proposals

§ 29.02[B][1] Ratio or Cap

THEREFORE, BE IT RESOLVED, that shareholders urge the Board of Directors to address the issue of runaway remuneration of CEOs and the widening gap between highest and lowest paid workers by:

Establishing a cap on total CEO compensation expressed as a multiple of pay of the lowest paid worker at Citigroup;
Preparing a report for shareholders explaining the factors used to determine the appropriate cap.[fn11]

[fn11] Definitive Proxy Statement of Citigroup, Inc. filed on Mar. 8, 1999 (hereinafter, "1999 Citigroup Proxy Statement").

§ 29.02[B][2] Freeze Pay During Downsizing

RESOLVED, shareholders request that the Board build upon its previous commitment to a spirit of shared sacrifices and rewards by adopting an executive compensation policy that freezes the pay of corporate officers during periods of significant downsizing (layoffs involving the lesser of 5% of the company's workforce or 2,000 employees). This pay freeze shall continue for a period of one year following the layoffs.[fn12]

[fn12] Definitive Proxy Statement of AT&T Corp. filed on Mar. 27, 2000.

§ 29.02[C] The Debate Over Limiting the Amount of Executive Pay

Proposals to limit executive compensation, either through a cap or a temporary freeze, are based on the assumption that large pay disparities and other inequities harm employee morale and undermine corporate performance. As stated in one proposal seeking a pay freeze following downsizing, "[W]e believe that asking employees to sacrifice while at the same time rewarding executives sends a mixed message to employees, suppliers and shareholders. . . . If decisions to cut costs are in the long-term best interest of the company, executives should be willing to defer their rewards until positive results are demonstrated."[fn13]

Supporters of proposals to cap senior executive pay contend that large pay disparities impair productivity.[fn14] That proposition is bolstered by studies on the effect on productivity of pay inequity — the perception that one's level of compensation is not similar to others who make similar contributions to the organization. For example, a 1992 study found that interclass (lower-level/top management) pay equity was positively correlated with product quality.[fn15] Another study found that inequity between the CEO's pay and that of lower level managers was associated with higher turnover among the managers.[fn16]

Proposals seeking to limit executive compensation also implicitly argue that conflicts of interest are created when executives are rewarded for cost-cutting measures that may damage the company's long-term prospects. This contention is based on studies showing that downsizing, at least under certain circumstances, may reduce productivity and make companies less profitable. For example, proposals cite a 1992 American Management Association study that found that fewer than half of the companies that laid off workers in the previous six years had seen an improvement in operating profits.[fn17]

Companies opposing such proposals focus on the need to compete in the marketplace for executive talent. For example, one company stated, "Your Directors believe that executive compensation levels should not be fixed by pre-determined policies, but instead should reflect the competitive dynamics of the marketplace. It would not be in shareholders' best interest to constrain the Company's ability to attract and retain executive talent when other firms competing for executive talent do not adhere to such constraints."[fn18] Companies also urge that capping or freezing pay would weaken the pay-for-performance link.[fn19]

[fn13] Definitive Proxy Statement of Huffy Corp. filed on Apr. 17, 2000.

[fn14] See, e.g., 1999 Citigroup Proxy Statement, supra note 11.

[fn15] Douglas M. Cowherd & David I. Levine, "Product Quality and Pay Equity Between Lower-Level Employees and Top Management: an Investigation of Distributive Justice Theory," 37 Admin. S. Quarterly 302 (1992).

[fn16] Charles A. O'Reilly et al., "Overpaid CEOs and Underpaid Managers: Equity and Executive Compensation," Stanford Working Paper No. 1410 (1996).

[fn17] See Steve Lohr, "Big Companies Cloud Recovery by Cutting Jobs," The New York Times, Dec. 17, 1992, at A1 (reporting on study).

[fn18] Definitive Proxy Statement of Huffy Corporation filed on Mar. 8, 2000.

[fn19] See, e.g., 1999 Citigroup Proxy Statement, supra note 11; Definitive Proxy Statement of Raytheon Co. filed on Mar. 27, 2000.

§ 29.03 Performance Criteria

Activist shareholders criticize the performance criteria applied to determine senior executive pay on the ground that the standards do not reward the creation of long-term value, are easily manipulated or create perverse incentives. Shareholder proposals generally ask the company to adopt new performance criteria — often linked to a corporate responsibility issue — and sometimes require a report to shareholders.

§ 29.03[A] Corporate Governance Guidelines

TIAA-CREF recommends that companies should "explain the rationale for the salary levels, incentive payments, and stock option grants of top executive officers."[fn20] Stock-based compensation plans should "[h]ave measurable and predictable outcomes that are directly linked to the company's performance."[fn21] Specifically, the fund believes that cash incentive plans should ensure that payments are "objectively linked to appropriate parameters of company performance: earnings, return on capital, or other relevant financial or operational measures" and that measures of individual performance "can be controlled or materially influenced by the executives who will receive the incentive pay."[fn22]

The Report of the NACD Blue Ribbon Commission on Executive Compensation states, "Although there are many potential measures of performance, most relevant measures fall into one of two classes: measures based on the company's stock price performance, and measures based on the company's accounting and other internally generated measures of performance. . . . Each has value for certain situations."[fn23] The Report outlines the advantages and disadvantages of each type of measure.[fn24]

[fn20] TIAA-CREF Policy Statement, supra note 8, Principle No. 1.

[fn21] Id., Principle No. 3.

[fn22] Id., Appendix: Executive Compensation Program Guidelines.

[fn23] NACD Executive Compensation Report, supra note 5, at 16.

[fn24] Id. at 16-17.

§ 29.03[B] Typical Proposals

§ 29.03[B][1] General Criteria

RESOLVED, that the shareholders of Nordstrom, Inc. (the "Company") hereby request that the Company's Board of Directors take the necessary steps to establish a performance-based senior executive compensation system that focuses the five most highly-paid members of management on advancing the long-term success of the Company. To demonstrate that such steps have been taken, we request that the Compensation Committee Report included in the Company's annual report to shareholders identify specific performance criteria and explain why they have been selected; the specific target level that must be achieved to satisfy that performance criterion; and rank each performance factor in order of importance, as well as identify the weight attached to each factor.[fn25]

[fn25] Definitive Proxy Statement of Nordstrom, Inc. filed on Apr. 11, 2001 (hereinafter, "2001 Nordstrom Proxy Statement").

§ 29.03[B][2] Financial Criteria

RESOLUTION: The stockholders of Verizon request the Board to adopt and announce a policy that determines future awards of performance-based compensation for executive officers using a measure of earnings per share that does not include nonrecurring accounting rule income, particularly "pension credits" resulting from increases in the employee pension fund surplus.[fn26]

[fn26] Definitive Proxy Statement of Verizon Communications filed on Mar. 12, 2001.

§ 29.03[B][3] Linking Compensation to Employee-Related Measures

RESOLVED, that the stockholders of Delta Air Lines, Inc. ("Delta" or the "Company") request that the Personnel and Compensation Committee of the Board of Directors, in establishing and administering standards for use in awarding performance-based compensation for senior executives (specifically, the Chief Executive Officer, President, Chief Operating Officer, and all Executive Vice Presidents of the Company) formally incorporate specific measures of employee satisfaction, participation, and training, in addition to the traditional financial measures of Company performance.[fn27]

[fn27] Definitive Proxy Statement of Delta Air Lines, Inc. filed on Mar. 6, 2001 (hereinafter, "2001 Delta Proxy Statement").

§ 29.03[B][4] Linking Compensation to Achievement of Specific Goal

RESOLVED, the Board shall conduct a special executive compensation review to study ways of linking a portion of executive compensation to successfully addressing predatory lending practices. Among the factors considered in this review might be: implementation of policies to prevent predatory lending; constructive meetings with concerned community groups; and reductions in the levels of predatory lending complaints filed with government bodies. A summary of this review will be published in the Compensation Committee's report to stockholders.[fn28]

[fn28] Definitive Proxy Statement of Household International filed on Apr. 9, 2002.

§ 29.03[B][5] Linking Executive Compensation to Corporate Social Responsibility Performance

RESOLVED, shareholders request the Board to conduct a special executive compensation review to study the relationship between corporate social responsibility performance and company financial performance and to recommend that the social responsibility performance of the corporation be incorporated as one of the variables in establishing the compensation packages of senior officers of the corporation.[fn29]

[fn29] Definitive Proxy Statement of Citigroup, Inc. filed on Mar. 2, 2001 (hereinafter, "2001 Citigroup Proxy Statement").

§ 29.03[C] The Debate Over Performance Criteria

Shareholders have begun scrutinizing performance criteria more closely. Special attention is focused on the relationship between shareholders' fortunes and CEO compensation, since a primary purpose for using stock-based compensation is to align the interests of managers and shareholders. Shareholders complain that in 2000, when the S&P 500 index fell 10%, CEOs at 251 of those companies received compensation packages averaging $36.5 million, up 62% from 1999.[fn30] The group Responsible Wealth, whose members sponsor shareholder proposals to limit executive pay, announced in April 2001 the results of a study showing that of the 70 companies whose CEOs were most highly-compensated from 1993 through 1999, half underperformed the S&P 500, with nearly 40% underperforming by more than 15%.[fn31] On an anecdotal level, commentators have noted that some CEOs, such as those at CMGI and Adaptive Broadband, enjoyed large compensation increases as their companies performed more poorly.[fn32]

Some proposals suggest specific changes to financial criteria used to judge performance. For example, one proposal sought to require that certain financial measures rise from one year to the next in order to justify paying a bonus to the CEO. The proponent argued, "Management should be fairly compensated and awarded bonus compensation only when it produces results which equal or exceed the prior year's performance."[fn33] Similarly, another set of proposals requested that companies, in setting performance-based executive compensation, exclude contributions to income resulting from pension fund surpluses, on the ground that legal restrictions render such income unavailable to the company and that the amount of such surplus bears no relationship to management's skill in managing the company's business.[fn34]

Other proposals criticize the current criteria, but do not dictate particular changes. A proposal submitted in the 2001 proxy season by several shareholders asked companies to explain specifically the reasons they chose their particular criteria, the level of performance expected for each criterion, and the relative weight of each criterion in the pay-setting process. Proponents of these proposals contended that current performance criteria were insufficiently challenging and were not tied to a strategic plan to advance the companies' long-term success.[fn35] Companies responded that their compensation packages already are structured around appropriate objective financial criteria,[fn36] that the company complies with SEC disclosure requirements regarding performance criteria, and that disclosure of specific target levels would harm the company's competitiveness.[fn37]

The largest group of proposals asks companies to consider a wide range of non-financial criteria in evaluating executives and setting their pay. Some simply requested that the company consider adding social performance to the current criteria.[fn38] Others asked that pay be linked to a specific non-financial metric, most often one or more employee-related measures such as employee satisfaction, training or turnover.[fn39] One proposal urged that senior executives be evaluated in part based on the company's compliance with its own code of conduct.[fn40]

For the most part, proponents argue generally that linking executive compensation to corporate responsibility metrics is appropriate in order to motivate executives to improve performance in this area, which proponents claim is particularly important at companies where high-profile problems have impaired profitability or damaged corporate reputations. For example, proponents of a proposal at Citigroup pointed to liabilities stemming from predatory lending practices and sexual harassment litigation, and reputational damage from Citigroup's involvement in funding the Three Gorges Dam in China, as evidence that greater emphasis on corporate responsibility is necessary.[fn41]

Proponents of employee-related proposals point to studies regarding the relationship between certain workplace practices and company performance. For example, one proponent cited a study by human resources consulting firm Watson Wyatt Worldwide showing a correlation between superior human capital practices and shareholder returns.[fn42] Similarly, another proponent pointed to a Department of Labor study that found a positive relationship between "high performance workplace practices" and long-term financial performance.[fn43]

Most companies opposing proposals to link pay and nonfinancial metrics argue that they already take such measures into account but need more flexibility than the proposals allow. Delta Air Lines, for example, asserted, "The Board understands and appreciates the key role of Delta employees in providing our customers with a distinctive travel experience, and achieving Delta's long-term business goals. However, no single factor, including employee satisfaction, can be used to establish executive compensation without considering other relevant factors and overall competitive pay levels."[fn44] Likewise, Citigroup asserted that it uses "adherence to corporate values," among other factors, in evaluating executives.[fn45]

[fn30] See Gary Strauss, "CEO Paychecks: Fair or Foul? Compensation Deals Haven't Been Called Out as Market Slides," USA Today, Apr. 6, 2001, at B1; see also David Leonhardt, "For the Boss, Happy Days are Still Here," The New York Times, Apr. 1, 2001, at section 3, page 1 (contrasting decline of Wilshire 5000 index with rise in CEO pay).

[fn31] Strauss, supra note 30, at B1 (reporting on study).

[fn32] Louis Lavelle, "The Gravy Train is Slowing," Business Week, Apr. 2, 2001, at 44.

[fn33] Definitive Proxy Statement of Luby's, Inc. filed on Nov. 14, 2000.

[fn34] Definitive Proxy Statement of Qwest Communications International filed on Mar. 16, 2001; Definitive Proxy Statement of Verizon Communications filed on Mar. 12, 2001.

[fn35] See, e.g., Definitive Proxy Statement of Minnesota Mining and Manufacturing Company filed on Apr. 2, 2001; 2001 Nordstrom Proxy Statement, supra note 25.

[fn36] See, e.g., 2001 Nordstrom Proxy Statement, supra note 25.

[fn37] See, e.g., Definitive Proxy Statement of Halliburton Co. filed on Apr. 2, 2001.

[fn38] See, e.g., 2001 Citigroup Proxy Statement, supra note 29; Definitive Proxy Statement of American International Group filed on Apr. 6, 2001.

[fn39] See, e.g., Definitive Proxy Statement of Delta Air Lines, Inc. filed on Mar. 6, 2001 (link pay to employee satisfaction, participation and training); Definitive Proxy Statement of Raytheon Co. filed on Feb. 15, 2001 (link pay to employee training, morale and safety).

[fn40] Definitive Proxy Statement of Unocal Corp. filed on Apr. 9, 2001.

[fn41] 2001 Citigroup Proxy Statement, supra note 29.

[fn42] See 2001 Delta Proxy Statement, supra note 27; see also update of study at www.watsonwyatt.com.

[fn43] See Definitive Proxy Statement of AT&T Corp. filed on Mar. 27, 2000 (citing U.S. Department of Labor, High Performance Work Practices and Firm Performance (1993)).

[fn44] 2001 Delta Proxy Statement, supra note 27; see also Definitive Proxy Statement of Raytheon Co. filed on Feb. 15, 2001; Definitive Proxy Statement of AT&T Corp. filed on Mar. 27, 2000.

[fn45] 2001 Citigroup Proxy Statement, supra note 29.

§ 29.04 Stock Options

Institutional investors were among the earliest supporters of stock-based compensation as a tool to align the interests of managers and shareholders. In recent years, however, as the bull market made stock options extremely valuable to executives and costly to companies, some investors began to question the incentive effects and fairness of current practices.

Specifically, shareholders have asked companies to use "performance-based" stock options — indexed, premium-priced or contingent-vesting options. The practice of repricing stock options — lowering the exercise price or cancelling options and granting replacement options at a lower exercise price — has been criticized in proposals. Finally, two proposals tied executive stock options to the rest of the workforce, one by limiting the concentration of stock options that can be awarded to senior executives and the other by prohibiting stock option exercises for a year after significant layoffs have occurred.

§ 29.04[A] Corporate Governance Guidelines

The Council of Institutional Investors' Core Policies recommend that stock options not be repriced without shareholder approval.[fn46] CII also states that executive pay "should be indexed to peer or market groups, absent unusual and specified reasons for not doing so."[fn47]

TIAA-CREF advocates the use of "reasonable" grants of fixed-price options, but notes that "[I]n certain circumstances, it may be desirable for a company to explore alternatives that may more closely link pay to performance, such as performance-based options, which set performance hurdles to achieve vesting; premium (out of the money) options, with vesting dependent on attainment of a predetermined appreciation of stock; and indexed options — i.e., those with a strike price tied to an index." According to TIAA-CREF, stock plans "should specifically prohibit or severely restrict `megagrants,' which are grants of stock or stock options of a value at the time of grant greater than a reasonable and explainable multiple of the recipient's total cash compensation."[fn48]

The Report of the NACD Blue Ribbon Commission on Executive Compensation describes premium priced stock options as one method of eliminating expected stock market appreciation from the cost of granting stock options. The Report suggests other methods to accomplish this goal, including "increas[ing] exercise prices by the company's cost of capital" or "set[ting] an original exercise price that reflects the expected appreciation," which "make it possible to make much larger option grants without increasing the cost to share-holders." The Report asserts that indexed stock options "provide similar incentives to those provided by traditional stock options, but at a much lower cost to shareholders" and that indexing "protects shareholders from paying CEOs based on factors not controlled or affected by the CEO."[fn49]

The Report also recommends that "compensation committees should take steps to prevent or discourage option repricing." Specifically, the Report states:

In embryonic corporate settings where options form a major element of competitive base compensation, companies are sometimes forced to reprice options to retain valuable employees. These situations aside, it is rarely, if ever, justifiable to reprice options following firm-specific price declines (that is, declines relative to the firm, its market, or its industry). Repricing of options following general market declines is justifiable, but only if a symmetrical repricing occurs during general market advances. Option indexing, discussed above, can accomplish this. Managers will resist such an adjustment. It is in managers' immediate interests to argue for repricing when their firm's stock price goes down — and against repricing when stock goes up — regardless of the cause of these stock movements.

Anticipating such natural resistance, compensation committees and boards might consider amending the company's bylaws to require shareholder approval of option repricing.[fn50]

[fn46] Council of Institutional Investors, Corporate Governance Policies, General Principle D5 (undated) (available at www.cii.org) (hereinafter, "CII Policies").

[fn47] Id., Position D1.

[fn48] TIAA-CREF Policy Statement, supra note 8, Executive Compensation Program Guidelines.

[fn49] NACD Executive Compensation Report, supra note 5, at 18-19.

[fn50] Id. at 20.

§ 29.04[B] Typical Proposals

§ 29.04[B][1] Performance-Based Stock Options

RESOLVED: The shareholders of Bank of America (the "Company") urge the Board of Directors to adopt a policy that some portion of future stock option grants to senior executives shall be performance-based. "Performance-based" stock options are defined as 1) indexed options, whose exercise price is linked to an industry index; 2) premium-priced stock options, whose exercise price is above the market price on the date of grant; or 3) performance-vesting options, which vest when the market price of the stock exceeds a specific target."[fn51]

[fn51] Definitive Proxy Statement of Bank of America filed on Mar. 19, 2001.

§ 29.04[B][2] Repricing

RESOLVED: That the shareholders of Sprint Corporation ("Sprint") urge the Board of Directors of Sprint to adopt a policy that Sprint shall not reprice (or terminate and regrant) to a lower exercise price any stock option already granted to any employee or director of Sprint, without the prior approval of the holders of a majority of Sprint's issued and outstanding shares of common stock.[fn52]

[fn52] Definitive Proxy Statement of Sprint Corporation filed on Mar. 15, 2001.

§ 29.04[B][3] Limit Concentration of Stock Options

RESOLVED, that the Board limit the stock options received: 1) by any executive officer to no more than 5% of the total options granted in a single year, and 2) by the group of executive officers to no more than 10% of the total options granted in a single year.[fn53]

[fn53] Definitive Proxy Statement of Walt Disney filed on Jan. 12, 2001.

§ 29.04[B][4] Restrictions on Exercise

RESOLVED: That Coca-Cola Company stockholders urge the Board of Directors take the necessary steps to adopt a policy that no executives may cash in on stock options within one year of the announcement of a significant workforce (more than 1% of total workforce) reduction.[fn54]

[fn54] Definitive Proxy Statement of Coca-Cola Company filed on Mar. 2, 2001.

§ 29.04[C] The Debate Over Stock Options

In response to claims that the interests of executives were insufficiently aligned with those of shareholders, companies began in the 1990s to rely increasingly on stock options to compensate executives. In 2000, the average CEO received options to buy 715,000 shares of his company's stock, up from 476,000 shares the year before. The theory was that stock options tied pay to performance because the stock price had to rise before it made sense to exercise the option.

Recently, however, some shareholders have become more critical of stock options. One element of the debate involves the extent to which standard stock options, in which the exercise price is equal to the market price of the stock on the date of grant, inappropriately reward executives for increases in the stock price over which they have no control. Advocates of "performance-based" stock options — indexed, premium-priced or contingent-vesting options[fn55] — argue that standard stock options inappropriately allow executives to benefit from overall stock market rises and factors that cause the price of all stocks in a particular industry to rise.[fn56] Proponents quote Warren Buffett, who stated that standard stock options are "really a royalty on the passage of time."[fn57] Finally, sponsors of these proposals contend that standard stock options are significantly more costly to shareholders than performance-based options, citing a study by two Georgetown University professors.[fn58]

Companies defend their use of standard stock options on the ground that "Company executives realize no gain on the stock options without an increase in the price of the Company's common stock that benefits all shareholders."[fn59] Companies also point to the adverse accounting treatment accorded indexed stock options — companies must record a charge to earnings equal to the difference between the market value of the stock and the exercise price on the unexercised option — as a reason not to use them.[fn60] Finally, companies argue that the use of performance-based options will disadvantage them in competing for executive talent.[fn61]

The practice of repricing stock options — lowering the exercise price or cancelling options and granting replacement options with a lower exercise price — has also been attacked by shareholders on the ground that it severs the pay-for-performance link and is unfair to shareholders. According to one proponent seeking to impose a shareholder approval requirement, "Repricing essentially rewards poor performance and divides the interests of option holders from those of shareholders who cannot reprice their stock."[fn62] Companies claim that repricing is sometimes necessary in order to retain valuable employees whose options have become worthless.

A recent study by three researchers at Indiana University's business school undermines the contention that repricing helps retain employees. The researchers, who examined more than 100 repricings in 1997 and 1998, found that CEO and top management turnover was much higher at companies that repriced options than at similar companies that did not reprice.[fn63]

Shareholders have also sought to limit the percentage of stock options granted to senior executives, pointing to studies showing a positive correlation between broad-based stock ownership and corporate performance. Walt Disney, where this proposal came to a vote in the 2001 proxy season, responded that its employee stock purchase plan and 401(k) plan enable all Disney employees to acquire company stock. Disney also argued that the formula proposed by the shareholder, which prohibited an individual officer from receiving more than 5% of the total options granted in a year and limited executive officers as a group to 10% or less, could hurt Disney's ability to compete for talent.[fn64]

Finally, proposals have asked that executives be prohibited from exercising stock options within a year of the announcement of a significant workforce reduction. Like proposals imposing a pay freeze following downsizing, proposals to prohibit option exercises contend that downsizing does not improve long-term performance and that executives should thus not be rewarded for eliminating jobs, even if doing so leads to a short-term stock price increase.[fn65]

Companies reply that they do not reduce their workforces in order to boost the price of the company's stock, and that their incentive pay programs adequately focus executives on the long-term success of the company.[fn66]

[fn55] Indexed options are options whose exercise price is tied to the performance of a market or peer group index. A premium-priced option's exercise price is higher than the market price of the stock on the date of grant. A contingent-vesting option does not vest (become exercisable) until the market price of the stock reaches a predetermined threshold. See Definitive Proxy Statement of Bank of America filed on Mar. 19, 2001.

[fn56] See, e.g., Definitive Proxy Statement of Pulte Homes filed on Mar. 30, 2001.

[fn57] E.g., Definitive Proxy Statement of Bank of America filed on Mar. 19, 2001.

[fn58] 2001 Delta Proxy Statement, supra note 27.

[fn59] Definitive Proxy Statement of Pulte Homes filed on Mar. 30, 2001.

[fn60] See, e.g., Definitive Proxy Statement of Chubb Corporation filed on Mar. 24, 1999.

[fn61] See, e.g., Definitive Proxy Statement of Office Depot filed on Mar. 28, 2001.

[fn62] Definitive Proxy Statement of Sprint Corporation filed on Mar. 15, 2001.

[fn63] Gretchen Morgenson, "Dispelling the Myth that Options Help Shareholders," N.Y. Times, July 29, 2001, at sec. 3, p. 1.

[fn64] Definitive Proxy Statement of Walt Disney filed on Jan. 12, 2001.

[fn65] See, e.g., Definitive Proxy Statement of Coca-Cola Company filed on Mar. 2, 2001.

[fn66] See, e.g., Definitive Proxy Statement of Anheuser-Busch filed on Mar. 10, 2001.

§ 29.05 Dilution

According to compensation consultant Pearl Meyer & Partners, the 200 largest industrial and service companies had allocated a record 15.23% of their shares outstanding to management and employee equity compensation plans in 2000. The average resulting negative percent change in pro forma net income for these companies was — 5.15%.[fn67]

As dilution has increased, shareholders have begun voting against management pay plans in greater numbers and withholding votes from directors who authorize executive compensation packages that shareholders feel are excessive. However, some shareholders address the dilution issue directly through the shareholder proposal process, asking for more information about dilution or requesting that the company commit itself to not exceeding the industry dilution average.

[fn67] Pearl Meyer, "General Use of Stock Options," presentation at TIAA-CREF Institute Corporate Governance Forum, Apr. 5, 2001.

§ 29.05[A] Corporate Governance Guidelines

TIAA-CREF characterizes as a "red flag" total potential dilution from existing and proposed plans of more than 15% over the life of the plans or over 2% in any one year. However, the fund permits companies in "human-capital-intensive" industries to maintain total dilution of up to 25%, provided coverage under the plan(s) extends through at least middle management. Companies in the lower range of market capitalizations may have up to 20% dilution. TIAA-CREF also disfavors "run rates" — based on actual grants — of over 2% per year, except in human-capital-intensive industries where up to 3% is permitted.[fn68]

The Council of Institutional Investors Corporate Governance Policies recommend that shareholder approval be obtained for any plan if total potential dilution would be 5% or more.[fn69]

[fn68] TIAA-CREF Policy Statement, supra note 8.

[fn69] CII Policies, supra note 46, General Principle A6.

§ 29.05[B] Typical Proposals

§ 29.05[B][1] Disclosure Regarding Dilution

RESOLVED, that the shareholders of Lockheed Martin Corp. ("Lockheed" or the "Company") urge the Board of Directors (the "Board") to prepare and make available to shareholders a report on the dilutive effect of certain options to purchase the Company's stock, including:

The level of dilution (the relative reduction in voting power) that would result from the exercise of options held by senior executives of the company; and

Any target or maximum dilution level established by the Board or Company management.[fn70]

[fn70] Definitive Proxy Statement of Lockheed Martin Corp. filed on Mar. 20, 2001.

§ 29.05[B][2] Limitations on Dilution

RESOLVED: Limit Stock Dilution. Boeing shareholders recommend that the company not present any stock option proposal to shareholders that could make Boeing['s] total stock option dilution greater than Boeing's industry peer group. Being's peer group is based on standard industrial code groups.[fn71]

[fn71] Definitive Proxy Statement of Boeing Company filed on Mar. 23, 2001.

§ 29.05[C] The Debate Over Dilution

In the 2001 proxy season, two proposals dealing with dilution — those set forth above — were submitted by shareholders. The proponent of the proposal seeking disclosure on dilution, which was filed at Lockheed Martin, argued that current disclosure requirements do not give shareholders enough information on potential dilution from senior executive stock options and that excessive dilution threatens shareholders' economic interests and voting rights. The Lockheed Martin proposal also asked the company to disclose whether it had set any upper limit on dilution. The company responded that its periodic reports provided ample information on its stock option plans and awards, and that any maximum threshold would be disclosed in the compensation committee's report in the proxy statement.[fn72]

The Boeing proposal's sponsor urged that Boeing not seek shareholder approval for any stock option plan that would cause Boeing's dilution to exceed the industry average, claiming that dilution was already excessive and that executives had received enough stock-based compensation. According to Boeing, the proposal was too rigid and could impede its recruiting efforts.[fn73]

An ongoing empirical study by compensation consultant Watson Wyatt Worldwide supports the notion that heavy use of stock options, as measured by overhang — the number of stock options granted plus those remaining to be granted as a percentage of shares outstanding — is correlated with higher stock price volatility. Large stock option holdings, Watson Wyatt hypothesizes, provide an incentive for executives to undertake riskier business strategies.[fn74]

[fn72] Definitive Proxy Statement of Lockheed Martin Corp. filed on Mar. 20, 2001.

[fn73] Definitive Proxy Statement of Boeing Company filed on Mar. 23, 2001.

[fn74] See Watson Wyatt Worldwide, "Stock Option Overhang — Shareholder Boon or Shareholder Burden?" (2000) (available at www.watsonwyatt.com/homepage/us/res/overhang2000).

§ 29.06 Severance Arrangements/Golden Parachutes

Many senior executives enter into employment agreements, which define the circumstances under which they and their employers can terminate the employment relationship and provide for severance pay and other arrangements. (A useful catalog of CEO employment contracts from the Fortune 500 appears on The Corporate Library's Web site, www.thecorporatelibrary.com.) Severance provisions that are conditioned on the occurrence of a change of control of the company are referred to as "golden parachutes," although some activists use that term to refer to all severance arrangements.

Sometimes, a company and executive renegotiate the employment agreement in connection with the executive's termination, with the executive ending up with a more generous package than he or she originally negotiated. For example, Jill Barad, ex-CEO of Mattel, recently received $37 million, more than she was originally entitled to under her employment agreement.[fn75]

Shareholders have reacted by sponsoring proposals regarding severance agreements. A few proposals seek to eliminate such arrangements altogether. More commonly, however, proposals require that shareholders approve severance arrangements whose value exceeds a numeric threshold or a multiple such as two or three times the executive's base salary plus bonus.

[fn75] See Jim Drury, "It Pays to FAIL?", Chief Executive, Feb. 1, 2001, at 41.

§ 29.06[A] Corporate Governance Guidelines

The Council of Institutional Investors' Core Policies state, "Change-in-control provisions in compensation plans and compensation agreements should be `double-triggered,' stipulating that compensation is payable only (1) after a control change actually takes place and (2) if a covered executive's job is terminated as a result of the control change."[fn76]

The Report of the NACD Blue Ribbon Commission on Executive Compensation states:

Any special termination compensation (for example, golden parachutes, or post-employment or consulting retainer arrangements) requires close examination by the compensation committee. In this Commission's view, golden parachutes are desirable only to the extent that they increase management's willingness to consider value-increasing mergers; in any case such provisions should not extend below the highest managerial ranks, and should rarely, if ever, be adopted as a defensive response to an unwanted takeover attempt.

Severance payments may be in some cases the most costeffective way to replace a poorly performing CEO, but should not be systematically used as a "face-saving" substitute for outright dismissals.[fn77]

[fn76] CII Policies, supra note 46, General Principle D6.

[fn77] NACD Executive Compensation Report, supra note 5, at 20.

§ 29.06[B] Typical Proposal

RESOLVED: That the shareholders of Bank of America ("Bank of America" or the "Company") urge the Board of Directors to seek shareholder approval for future severance agreements with senior executives that provide benefits in an amount exceeding two times the sum of the executive's base salary plus bonus. "Future severance agreements" include agreements renewing, modifying or extending existing severance agreements or employment agreements containing severance provisions.[fn78]

[fn78] Definitive Proxy Statement of Bank of America Corporation filed on Mar. 25, 2002. This proposal was supported by a majority of shares voted, a first for a severance proposal at a large corporation.

§ 29.06[C] The Debate Over Severance Arrangements and Golden Parachutes

Sponsors of proposals regarding severance arrangements contend that paying excessive severance benefits, whether or not contingent on a change of control, can reward mismanagement and reduce shareholder value. For example, one proponent argued, "A change of control scenario is more likely to occur if executives have managed the company in ways that do not maximize shareholder value, and the existence of golden parachutes can allow covered executives to walk away with millions of dollars even if shareholder value has suffered during their tenure."[fn79] A proposal submitted to Sprint emphasized that the severance arrangement there, which included vesting of unvested stock options, did not even require that the Sprint/MCI WorldCom merger close, which it did not.[fn80]

Companies defend golden parachutes on the ground that they allow executives, unencumbered by concerns over their own job security, to evaluate takeover overtures objectively. Companies also contend that requiring shareholder approval of severance arrangements would place them at a competitive disadvantage in recruiting executives.[fn81]

[fn79] Definitive Proxy Statement of CSX Corporation filed on Mar. 26, 2001.

[fn80] Definitive Proxy Statement of Sprint Corporation filed on Mar. 15, 2001.

[fn81] See, e.g., id.; Definitive Proxy Statement of CSX Corporation filed on Mar. 26, 2001; Definitive Proxy Statement of PepsiCo filed on Mar. 23, 2001.

§ 29.07 Compensation Committee Functioning

Nearly all large publicly owned companies delegate to board committees responsibility for particular functional areas, including compensation.[fn82] The compensation committee evaluates and compensates members of senior management, administers compensation plans, and, at some companies, oversees the succession planning process and fixes director compensation.[fn83] Issues relating to the independence of members of the compensation committee are dealt with in § 28.03[B].

Shareholders have submitted proposals addressing one or more elements of the compensation committee's functioning. Specifically, shareholders have urged that compensation committees be permitted to hire independent professionals, such as compensation consultants and attorneys, to assist them in carrying out their responsibilities, and that the committee should formulate a mission statement for inclusion in a committee charter, which describes the committee's composition, goals and responsibilities.

[fn82] The Business Roundtable, Statement on Corporate Governance 14 (1997) (hereinafter, "BRT Report"); Thomas & Martin, supra note 2, at 1026.

[fn83] See BRT Report, supra note 82, at 16; NACD Executive Compensation Report, supra note 5, at 2-4.

§ 29.07[A] Corporate Governance Guidelines

The Report of the NACD Blue Ribbon Commission on Executive Compensation states that "the compensation committee should put in writing a statement of its responsibilities and goals. This statement should become part of the company's official documents relating to the charters and functions of its board committees."[fn84] The Report also recommends that the compensation committee "have access, at its discretion, to professional help, and should have authority to select the firms providing it."[fn85]

TIAA-CREF's Policy Statement on Corporate Governance emphasizes the importance of the compensation committee. It recommends that the compensation committee "develop and publish in the proxy a statement of its `charter,' a description of the criteria used to evaluate the performance of the chief executive officer and the rationale for his or her compensation."[fn86]

CalPERS' Corporate Governance Principles and Guidelines state that the independent directors should have access to independent compensation advisers to assist in evaluating the CEO's compensation.[fn87]

[fn84] NACD Executive Compensation Report, supra note 5, at 3.

[fn85] Id. at 2.

[fn86] TIAA-CREF Policy Statement, supra note 8, Executive Compensation Program Guidelines.

[fn87] California Public Employees' Retirement System, Corporate Governance Core Principles and Guidelines, Core Principle B4 (1998) (available at www.calpersgovernance.org).

§ 29.07[B] Typical

Proposal RESOLVED, that the shareholders of BankAmerica (the "Company") urge the Board of Directors of the Company to adopt a written charter governing the Compensation Committee that includes (but is not limited to) the following principles:

A primary function of the Compensation Committee (the "Committee") is to assist the Board of Directors (the "Board") in fulfilling its responsibility to establish and maintain compensation packages for the Company's senior executives that reward superior performance against transparent and appropriately challenging objectives, tie such persons' interests to those of the Company's shareholders and reduce compensation in the event of underperformance.

The Committee shall be composed of independent directors. A director is independent if his or her only non-trivial professional, familial or financial relationship with the Company or any senior executive of the Company is his or her directorship.

To fulfill its responsibilities and duties, the Committee shall:

Without the participation of any senior executive of the Company, have sole authority to select, evaluate and where appropriate terminate the services of any compensation consultant retained to provide advice regarding the compensation of senior executives of the Company.

Ensure that any compensation consultant retained by the Committee, or any affiliate of any such consultant, has not performed in the last five years any non-compensation-related services for the Company or any of its senior executives.[fn88]

[fn88] Definitive Proxy Statement of Bank of America filed on Mar. 20, 2000.

§ 29.07[C] The Debate Over Compensation Committee Functioning

The shareholder that submitted the compensation committee charter proposal set forth above to Bank of America argued that the company's compensation committee is insufficiently independent, that the committee should be able to retain its own compensation consultant and that neither the company nor the committee shoud be permitted to retain compensation consultants that have conflicts of interest due to their provision of other, non-compensation services to the company. Implicit in the proponent's argument is the proposition that consultants may temper their recommendations regarding the CEO's pay when they are at risk of losing other business if the CEO is displeased with the pay recommendation.

Bank of America responded that it had already enacted a compensation committee charter requiring that the committee be composed of independent directors and allowing the committee to retain consultants, but criticized the proposal's definition as too vague. The company declined to amend the charter to require that compensation consultants be independent.[fn89]

[fn89] Definitive Proxy Statement of Bank of America filed on Mar. 20, 2000.

§ 29.08 Additional Disclosure Regarding Compensation

Some shareholders have asked companies to disclose additional information about executive compensation not required under the SEC's rules.[fn90] These proposals generally aim to expand the scope of compensation disclosure beyond the five most highly compensated executives whose compensation is disclosed in the proxy statement.

[fn90] The SEC's executive compensation disclosure rules are contained in Item 402 of Regulation S-K, 17 C.F.R. § 229.402 (2001).

§ 29.08[A] Corporate Governance Guidelines

The Report of the NACD Blue Ribbon Committee on Executive Compensation recommends, "It may be wise for some companies to go beyond SEC-mandated disclosure rules, which address the informational needs of shareholders, to provide information of interest to other groups. For example, some companies may wish to reveal how well they are performing in the product/service quality and customer satisfaction areas."[fn91]

[fn91] NACD Executive Compensation Report, supra note 5, at 29.

§ 29.08[B] Typical Proposal

RESOLVED: "That the stockholders recommend that the Board take the necessary steps that IBM specifically identify by name and corporate title in all future proxy statements those executive officers, not otherwise so identified, who are contractually entitled to receive in excess of $250,000 annually as a base salary, together with whatever other additional compensation bonuses and other cash payments were due them."[fn92]

[fn92] Definitive Proxy Statement of International Business Machines Corporation filed on Mar. 13, 2000.

§ 29.08[C] The Debate Over Additional Disclosure

The proponent of proposals to require additional compensation disclosure argues that "shareholders will . . . be provided an opportunity to better evaluate the soundness and efficacy of the overall management."[fn93] The companies respond that they comply with the SEC's disclosure rules and that the current disclosure "furnishes an informed basis for . . . stockholders to evaluate the Company's use of compensation to motivate and retain its key personnel."[fn94]

[fn93] Definitive Proxy Statement of Consolidated Edison filed on Apr. 10, 2001.

[fn94] Definitive Proxy Statement of International Business Machines Corporation filed on Mar. 13, 2000; Definitive Proxy Statement of Consolidated Edison filed on Apr. 10, 2001.

§ 29.09 Executive Compensation Proposals - Most Common Bases for Exclusion

A proposal that seeks to amend (or which would result in an amendment to) an existing contractual arrangement relating to compensation — such as a stock option agreement or severance agreement — may be excludable under Rule 14a-8(i)(2) (requiring the company to violate the law) or Rule 14a-8(i)(6) (beyond the company's power to effectuate) to the extent that the proposal would require the company to amend the contract unilaterally and thus breach a contract with an executive.
A company will likely attack a proposal that focuses on nonsenior-executive compensation or benefits as relating to the company's ordinary business operations and thus excludable under Rule 14a-8(i)(7), and will succeed unless the proponent can show, by pointing to media attention, legislative and/or regulatory initiatives and other indicia of public concern, that the issue has transcended ordinary business and implicates significant policy concerns. However, proposals focusing on equity-based compensation, even if that compensation is paid to non-senior-executive employees, are not excludable to the extent they hinge on material dilution of shareholder interests.
Proposals seeking additional disclosure in a company's periodic reports, like the Form 10-K or proxy statement, are vulnerable to exclusion under Rule 14a-8(i)(7), on the ground that disclosure beyond that required by the SEC relates to a company's ordinary business operations.
Binding shareholder bylaw proposals regarding executive compensation may, depending on the law of the company's jurisdiction of organization and the company's governance documents, be excludable pursuant to Rule 14a-8(i)(1) as involving an improper subject for shareholder action.

Disclaimer |