February 07, 2001 >Concern about Potential Dilution

WASHINGTON--The widespread use of stock-based incentive plans for company employees, executives and directors has led to growing levels of potential dilution - and growing levels of investor concern - according to a study by the Investor Responsibility Research Center, a leading shareholder research and advisory service.

At S&P 1500 companies, average potential dilution reached 14.6 percent in 2000, compared with 13.4 percent in 1999. At S&P 500 companies, the study found an even more marked upward trend, with average potential dilution jumping significantly to 13.1 percent last year, from 11.4 percent in 1999 and just 9.2 percent in 1995.

"The use of stock and option incentives has traditionally been viewed positively by investors because it ties compensation to company performance," said Carol M. Bowie, the IRRC's Director of Corporate Governance Services. "But every time you issue more stock, you dilute the voting power, as well as the earnings and assets per share, of the current shareholders. You slice the pie into thinner pieces, and that's bound to cause concern among those sitting at the table."

SEC and stock exchanges looking into more shareholder approval
The issue of potential dilution is receiving increased scrutiny from the Securities and Exchange Commission, the New York Stock Exchange and the NASDAQ. Generally, current regulations exempt stock-based incentive plans from having to receive shareholder approval if they are sufficiently "broad-based" (i.e., a majority of participants are non-officer employees). A new regulation proposed by the NYSE and under consideration by the SEC, however, would essentially require shareholder approval of all plans that exceed certain dilution thresholds. The NASDAQ is currently soliciting comments on the same proposals.

Techs and small-caps leading the charge
The highest average potential dilution levels are found in the technology sector - 24.2 percent - whose companies often have less cash with which to attract and retain top-level employees. Indeed, the spectacular wealth created through stock-based compensation at certain high-profile technology companies during the late 1990s was a key factor in the spread of such compensation plans. Within the technology sector, companies in the computer software/services industry had the highest average potential dilution, at 33.5 percent. Across all industries, eleven companies in this year's study have potential dilution of greater than 50 percent.

Similarly, S&P SmallCap companies, have higher average potential dilution levels (16.8 percent), than S&P MidCap companies (13.9 percent) or the largest companies, those of the S&P 500 (13.1 percent).

The IRRC Potential Dilution: 2000 study calculates average potential dilution by dividing the total number of shares and options reserved by the company for use in equity-based incentive and compensation plans by the total voting power of shares currently outstanding (which in most cases equals the number of outstanding common shares). The study, which was authored by IRRC Senior Analyst Annick Siegl, examined dilution at 1,157 S&P 1500 companies that held shareholder meetings between January 1 and July 31, 2000.

Evergreen plans
One particular concern is that of "creeping dilution" at companies with evergreen plans. Evergreen plans are those in which a certain percentage of stock - typically 2 to 3 percent - is automatically reserved every year, indefinitely, for use in incentive plans. This year's study found 34 companies had such plans, with 100 more having quasi-evergreen plans, which continue annually until a set end date. While proponents of these plans say they broaden the company's ability to use equity as incentive, opponents hold that shareholders should have the right to approve the issuance of additional shares.

Indeed, shareholders are focusing greater scrutiny on the dilution caused by equity-based incentive plans. "Total potential dilution levels above 10 to 15 percent tend to trigger investor concern - and opposition at shareholder meetings," said Bowie. The IRRC study found 337 such plans put forth last year for shareholder approval for which voting results were available. While all but one of those proposals passed, shareholder opposition averaged a sizable 20.7 percent, with 25 proposals receiving "no" votes of 40 percent or more. In previous years these proposals have received less opposition, with an average of only 17.4 percent voting "no" in 1997.

The Investor Responsibility Research Center's web site is located at www.irrc.com.