Key aspects of legal regime for employee stock options

By Rashmi Pradeep, Cyril Amarchand Mangaldas

The grant of employee stock options has become a common tool used by employers around the world to retain talent. Under employee stock options schemes (ESOS), employees are granted options that give them a right to acquire shares in a company on fulfilling certain criteria, such as completing a predefined period of employment and/or performance parameters. After fulfilling the criteria, the stock option vests with the employee, entitling them to exercise the option and be awarded company shares at a discount.

Rashmi Pradeep
Rashmi Pradeep

In addition to traditional ESOS, other schemes such as employee stock purchase schemes (ESPS), stock appreciation rights schemes (SARS), general employee benefits schemes (GEBS) and retirement benefit schemes (RBS) are increasingly being adopted to attract and retain talent.

The legal regime regulating these schemes in India has undergone a change in the past few years, with the Companies Act, 2013, and the Securities and Exchange Board of India (Share Based Employee Benefits) Regulations, 2014 (SBEB Regulations), introducing substantial changes to the regulation of the schemes.

Until the adoption of section 62(1)(b) of the Companies Act, 2013, and rule 12 of the Companies (Share Capital and Debenture) Rules, 2014, no law expressly governed ESOS by unlisted companies. The Securities and Exchange Board of India (SEBI) regulated ESOS and ESPS solely through the ESOP guidelines issued in 1999, which have been superseded by the SBEB Regulations.

With the notification of the SBEB Regulations in October 2014, listed companies are required to comply with these regulations for all schemes which involve any allotment or transfer of the company’s shares. The Companies Act, 2013, governs ESOS for unlisted companies and the SBEB Regulations prescribe norms for ESOS, ESPS, SARS, GEBS and RBS for listed companies. Key aspects of the new regime are highlighted below.

Eligibility redefined: Previously, it was common for promoters or promoter groups to be granted stock options. Under the Companies Act, 2013, promoters and promoter groups are expressly barred from being granted stock options, bringing the definition of “employee” in line with that mandated by SEBI. Independent directors and directors who hold (directly or indirectly) more than 10% of the share capital of the company also are ineligible to receive stock options.

Trust structure: In January 2013 SEBI prohibited the secondary acquisition of shares by trusts for implementing stock option schemes. The SBEB Regulations revoked this prohibition and prescribed detailed norms on the settlement, management and operations of trusts.

A single irrevocable trust now is permitted to implement several schemes, provided that different books of accounts are maintained; management of the trust and the company are different; minimum prescribed clauses are included in the trust deed; detailed disclosures of the books of account are made; and the trust cannot vote on the shares. Further, the trust’s shareholding has been categorized as “non-promoter and non-public”.

The SBEB Regulations mandate that schemes involving secondary acquisition and/or gifts must adopt the trust structure. Trusts are also required to hold the shares for a minimum of six months and are restricted from trading in such shares.

Limitation on regulation: SEBI issued informal guidance in July 2015 clarifying that the SBEB Regulations apply only to schemes that involve the allotment or transfer of shares to employees. Therefore, schemes which provide cash benefits only, even though linked to the trading price of the shares, are not regulated by the SBEB Regulations. As a consequence SARS which are settled in cash only are not regulated by the SBEB Regulations.

Additional disclosures: Under the new regime, companies must provide additional disclosures in the explanatory statement to the notice to the shareholders and in the annual report of the board of directors. Listed companies have to provide detailed disclosures to the stock exchanges and also publish such information on their website.

The Companies Act, 2013, borrowed substantially from the earlier ESOP guidelines (which SEBI has further refined in the SBEB Regulations), to regulate ESOS for unlisted companies. As a result unlisted and listed companies are put on the same footing. Under the current regime, an unlisted company opting for an initial public listing of its shares will find it easier to comply with the SBEB Regulations.

The new definition of “employee” will ensure that shareholders/promoters do not use ESOPS as a ruse to acquire shares at a discount instead of creating true employee ownership. The new disclosure requirements lay the ground for a more transparent mechanism in which share-based incentives will be adopted and distributed to their intended recipients – the employees of the company.

Cyril Amarchand Mangaldas is India’s largest full-service law firm. Rashmi Pradeep is a partner at the firm.


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