Shareholders take a swipe at Sun

Shareholder activists are calling for Sun to do away with its "poison pill" takeover defence and realign its executives' stock option plan to be more performance-based, according to a Sun proxy filed on Tuesday.

The move comes after Sun issued a salary hike and a cash bonus to its chief executive, Scott McNealy. McNealy received a base salary of $121,789, up 21 per cent on the previous year, as well as a $1.1m cash bonus, even though he missed performance targets identified in Sun's regular bonus plan, according to the proxy.

Sun, whose stock under-performed those of competitors such as Dell and key indexes such as the S&P 500, has been struggling to turn its business around and push its lackluster share price beyond the $3 to $4 range, where it has traded for most of the past couple years. The company also restated its financial performance for fiscal years 2003 and 2004, and updated its 2005 results because of tax-accounting errors.

McNealy's total compensation for fiscal 2005, including the $11.8m in options he exercised, reached approximately $13m. McNealy also received an additional 1.25 million options in fiscal 2005.

Sun's shareholders, meanwhile, have expressed concern about the terms under which Sun's board has awarded stock options to top-level executives, and one group is calling for a shareholder vote to remedy the issue during the company's annual meeting on 27 October.

The Service Employees International Union (SEIU) is asking investors to approve its proposal, which would tie the exercising of options to performance-based metrics. The proposal calls for options to be priced based on an industry index and above the current market price at the time they are granted. The proposal also states options could vest only when a performance target is met. Many companies have options vest on a regular, yearly schedule over a certain period of time.

SEIU states in its proposal: "From 2001 through 2004, Sun Microsystems CEO Scott McNealy was awarded options to buy (7.5 million) shares of Sun Microsystems stock. Such grants can result in substantial compensation for only modest gains in share price. If Sun Microsystems' stock price increases by only $1 per share, Mr McNealy could reap over $7.5m, even if Sun... under-performed its competitors during that period."

Sun's board, however, said a large portion of its executive compensation is already performance-based.

Sun's board advised shareholders to vote against the SEIU proposal, stating in the filing: "Executive compensation practices are influenced by a wide range of complex factors, including changes in strategic goals, regulatory developments and the competitive compensation practices of other companies. As a result, it is important that the [compensation] committee retain the flexibility to select incentives that balance these influences."

Sun will also face another shareholder proposal at the meeting that calls for the company to do away with its shareholder rights plan, otherwise known as a "poison pill".

Poison pills flood the market with additional shares of the target company, should an undesirable buyer attempt to take over the company. As a result, such plans can make unwanted takeover attempts prohibitively costly to pursue.

William Steiner, a Sun shareholder, stated in his proposal in the proxy filing: "Poison pills... prevent shareholders, and the overall market, from exercising their right to discipline management by turning it out. They entrench the current management, even when it's doing a poor job."

Sun's board, however, advises shareholders to vote against Steiner's proposal and notes that shareholder rights plans enhance shareholder value in the event of a friendly or hostile takeover attempt.

Shareholder initiatives calling for the removal of "poison pills" and a tighter relationship between pay for performance is nothing new, though Sun's shareholders have remained largely quiet over the last few years, putting forth few shareholder proposals.

McNealy's compensation has remained rather stagnant over the last couple years. He has received no new pay increases and no bonuses since 2003. While he has received in excess of one million shares annually over the past few years, that is below the industry norm of those awarded to other CEOs, when considering the total number issued to employees, said Jon Holman, who runs executive recruiting firm The Holman Group.

Nonetheless, investors at the annual shareholders meeting may still take issue with McNealy's special bonus of $1.1m, given that he, along with other top Sun executives, failed to meet the goals established under the company's bonus plan.

Sun's proxy states: "While the company met its free cash-flow goal and improved its performance with respect to operating income in comparison to... 2004, the company did not achieve its operating income goal. Additionally, the company did not meet the earnings-per-share requirement. As a result, none of Sun's executive officers received a bonus under the bonus plan for... 2005."

The company generated $369m in positive cash flow from operations. Based on contributions made throughout the fiscal year, according to the proxy, the board awarded discretionary bonuses to McNealy and other top executives in part to help retain top talent at the company.

In addition, Sun said in a regulatory filing on Tuesday that Lynn Turner, managing director of research at Glass Lewis, will leave Sun's board on 27 October. Turner, who had been a professor at Colorado State University's Center for Corporate Financial Reporting when he joined Sun's board in 2002, now works for a company that advises institutional shareholders on how to vote on proxy matters.

Turner will effectively be replaced by Pat Mitchell, the chief executive of the Public Broadcasting Service, who joined Sun's board earlier this month.

CNET News.com's Stephen Shankland contributed to this report

Dawn Kawamoto writes for CNET News.com