Common Stock Authorization

Discussion

State statutes and stock exchanges require shareholder approval for increases in the number of common shares a board is authorized to issue. Companies increase their supply of common stock for a variety of ordinary business purposes: raising new capital, funding stock compensation programs, business acquisitions, and implementation of stock splits or payment of stock dividends. When proposing an increase, companies will request a number of authorized shares that provides a cushion for unexpected financing needs or unanticipated opportunities. It would be impractical and costly for companies to continually seek shareholder approval of additional stock each time they needed to issue shares for ordinary business purposes. In most cases, shareholders should approve reasonable proposals to increase share authorization.

Governance Issues

However, certain governance issues arise from these proposals. First, issuing stock in connection with mergers, acquisitions, financings, or stock incentive programs dilutes the equity interests and voting power of existing shareholders. When evaluating a proposal to increase authorized common shares, shareholders should consider how the company has used its authorized stock in the past. Shareholders should scrutinize requests for additional authorized shares by companies that have used stock to fund lavish incentive compensation programs or to finance mergers that have not enhanced shareholder value.

Second, some states (notably Delaware) calculate annual franchise taxes for companies based on the number of authorized but un-issued shares. As a result, having a significant number of excess shares can be costly, especially for smaller companies.

In addition, an increased share authorization may provide shares that could be used to activate a company's poison pill. Some pills issue large numbers of shares at bargain prices in order to dilute a potential acquirer's position and make an acquisition prohibitively expensive. Shareholders should vote against proposals to increase authorized common shares in which the stated purpose is to reserve additional shares to implement a poison pill.

Another issue concerns targeted share placements. If a board has a sufficiently large authorization, it could issue a large number of common shares to a friendly third party in order to deter a takeover attempt and defeat a possibly worthwhile tender offer. The question of whether or not excess shares could be used as a takeover defense should be evaluated on a case-by-case basis. In practice, authorized common shares are rarely, if ever, actually issued to deter a threatened takeover because many companies have an arsenal of other anti-takeover defenses at their disposal.

Evaluating Authorization Increases

When faced with a request to increase authorized common shares, shareholders should examine the number of shares outstanding and reserved as a percentage of the total number of shares currently authorized for issuance. ISS recognizes that patterns of utilization of authorized common shares vary from industry to industry. However, a company with few shares available- because most of the current authorization is outstanding or reserved for issuance-is afforded a larger allowable increase. The allowable increase represents the maximum permitted number of shares that can be added to the current share authorization.

Shares reserved for legitimate business purposes include stock-based mergers, stock splits, stock dividends, conversion of securities, and shareholder-approved stock-based incentive plans. A larger allowable increase is given to companies with a significant number of shares reserved for legitimate business purposes. Excluded from this group are shares reserved for a shareholder rights plan, stock-based incentive plan, or re-pricing--unless they have been approved by shareholders.

Additionally, shareholders should examine company-specific performance. ISS has compiled data on common stock authorization proposals for companies comprising 98 percent of the investment U.S. equity market. Companies are classified into one of 11 peer groups, including a group designated for rapidly growing companies whose shares recently became publicly traded. Each company's performance is measured on the basis of three-year total shareholder returns. Companies that have posted superior total shareholder returns should be given more latitude with respect to capital stock increases than lesser-performing companies.

The allowable increase will be adjusted upward if a company has a history of using authorized common shares for stock splits within the past five years or to fund stock-based incentive programs with cost levels that are considered appropriate by ISS' binomial option pricing model. The allowable increase will not be adjusted downward if a company has not declared any stock splits or has stock option plans with costs that exceed ISS guidelines. The allowable increases for each peer group are updated semiannually and are intended to result in recommendations against only extreme proposals.

ISS recommends votes against proposals to increase the number of authorized common shares when the proposed increase exceeds the allowable increase. Proposals to increase authorized common shares are supported when the proposed increase falls within the allowable increase.

Shareholders should approve increases beyond the allowable increase when a company's shares are on the verge of being de-listed or if a company's ability to continue to operate as a going concern is uncertain.

In cases where a company has more than one class of common stock and the classes have different voting rights, shareholders should oppose proposals to increase the number of authorized shares of the class of stock that has superior voting rights. All classes of common stock should have one vote per share. Approving an increase in the number of authorized super-voting shares perpetuates the unequal voting rights structure.