Summary: This article examines how proxy advisory firms have meaningfully tightened their scrutiny of Employee Stock Option Plan (“ESOP”) proposals, evaluating them on regulatory compliance as well as on governance standards. It explores the key areas of concerns in relation to dilution, exercise price, Board discretion, extension of benefits to group companies, etc., and highlights the practical risks companies face when ESOP schemes are drafted without first engaging with the updated proxy advisory guidance.
Institutional shareholders often base their voting decisions on shareholder proposals, including ESOP resolutions, on proxy advisory firms’ recommendations. Where proxy advisory firms have recommended voting against a shareholder proposal, the alignment of institutional investors with such recommendation has, on numerous occasions, been sufficient to ensure the proposal’s defeat. This is not a coincidence. In new-age companies, where promoter shareholding is low or negligible, or there are no promoters, the entire burden of securing the requisite majority falls on a shareholder base dominated by institutional investors who take their cues from proxy advisory reports. Further, since many listed companies have at least one active ESOP scheme in place, an adverse proxy advisory recommendation carries consequences that Boards can no longer treat as peripheral.
The broad principles that govern their approach have not changed much, but the granularity of what is now expected from companies seeking shareholder approval for their ESOP schemes has undergone a major shift. Proxy advisory firms evaluate ESOP proposals on two distinct fronts — regulatory compliance and governance standards. The thresholds applied for governance purposes reflect what proxy advisory firms consider to be the standard for responsible corporate behaviour, over and above what the law requires. Hence, an “Against” recommendation is often given by proxy advisory firms on account of governance concerns.
Meeting the Letter of the Law, but Missing the Governance Mark
In recent months, a clear and consistent pattern in voting recommendations for ESOP proposals has emerged. The most cited reasons for negative recommendations include, wide discretion granted to the Board or the Nomination and Remuneration Committee (“NRC”) to determine or modify key terms of the scheme, non-disclosure of the exercise price or pricing formula, absence of compelling justification for extending benefits of the scheme to group companies, including holding, subsidiary or associate companies, excessive dilution, etc. Generally, almost none of these concerns involve a contravention of the SEBI (Share Based Employee Benefits and Sweat Equity) Regulations, 2021. They are all governance concerns and yet they have repeatedly resulted in resolutions being voted down. This is demonstrated by several recent cases in which proxy advisory firms have successfully opposed the passage of resolutions relating to ESOPs due to the aforementioned reasons.[1][2][3] In yet another instance, all four special resolutions pertaining to the ESOP scheme of a listed company were defeated on similar grounds, despite a clarificatory response being filed by the company in relation to the negative recommendation of the proxy advisory firm.[4] Hence, a resolution that is legally compliant can still attract an adverse recommendation if it falls short of prevailing governance standards.
Dilution and Pricing: The First Line of Scrutiny
Dilution is the starting point for any proxy advisor’s analysis of an ESOP proposal. Each of the firms apply a threshold ranging broadly from 2% to 10% of issued share capital, but the thresholds differ across advisors and so do the methodologies for reaching them. Some advisors are prepared to extend their standard threshold where schemes carry meaningful performance conditions and credible vesting periods, while others are not. For companies with multiple ESOP tranches currently outstanding, accurately mapping cumulative dilution is essential, as the overall impact may be more complex than it initially seems. Mapping it carefully before proposing any resolution is helpful. Exercise price is another area where expectations have sharpened considerably. Proxy advisors generally maintain the default position that the exercise price should be at least equal to the fair market value of the share as on the date of grant, to limit the financial impact of employee expenses on the company and in turn protect shareholder value. However, if the exercise price is not at a discount to the fair market value, the ESOP scheme loses its true objective of being an employee benefit and retention tool. Further, ESOP schemes that simply authorise the NRC to determine the exercise price at the time of grant, without any stated parameters, are increasingly being treated as non-transparent.
Other Considerations
Proxy advisors are no longer satisfied with a general statement that vesting will be linked to performance. They expect companies to identify the specific parameters that will govern vesting and, in some cases, to commit to disclosing actual performance against those targets in subsequent annual reports. Further, proposals to extend ESOP benefits to employees of subsidiaries, holding or associate entities, attract a distinct and layered set of considerations. Proxy advisors are not uniformly opposed to such extensions, but their support is conditional on the nature of the entity, the adequacy of cost reimbursement arrangements and the justification offered.
Conclusion
ESOP resolutions have always required diligence, but the bar has risen. Companies that approach the drafting process without first engaging with the updated proxy advisory guidance and without a clear view of how their specific scheme has been structured, may be risking the proposal being rejected. The questions that arise do not have one-size-fits-all answers. Companies with large institutional shareholding base should be mindful of the governance standards laid down by proxy advisory firms. Such companies are at greater risk of having their proposals rejected due to adverse proxy recommendations. This is primarily because an increasing number of institutional investors follow the guidance and detailed rationale provided by proxy firms, to whom they have delegated much of their decision-making authority.
For further information, please contact:
Bharath Reddy, Partner, Cyril Amarchand Mangaldas
bharath.reddy@cyrilshroff.com
[1] A proxy advisory firm issued “Against” recommendations on all three ESOP-related resolutions placed before the shareholders of a listed engineering and construction company. The recommendation proved decisive as all ESOP resolutions failed to secure the requisite majority, with approximately 28% of valid votes cast against each resolution which was sufficient to defeat these proposals.
[2] All three special resolutions pertaining to an ESOP plan of a listed apparel company were defeated, notwithstanding legal compliance, on account of proxy concerns regarding excessive dilution and the potential for disproportionate benefits accruing to a single employee.
[3] A special resolution to amend the restricted stock unit plan of a listed personal care company failed (following an adverse proxy recommendation citing the absence of a defined exercise price) with approximately 36.70% of valid votes cast against it, notwithstanding promoter support.
[4] All four special resolutions pertaining to the ESOP scheme of a listed steel tubes and pipes manufacturer were defeated. Further, it is important to note that notwithstanding the company filing a response to the proxy advisory firm’s report, there was no change in the recommendations made.
