Exploring The Dimension of Unvested Stock Options During Involuntary Termination

[By Pallavi Mishra]

The author is a student at the Hidayatullah National Law University.

 

In recent years, the concept of Employees’ Benefit Schemes in the form of Stock Options has gained popularity for paying compensation to the employees, while also giving them incentives to contribute towards the betterment of the company. The history of discussion on employment schemes in India dates back to 1997, wherein the JR Verma Committee suggested that the guiding principles for the administration of employment schemes in India would be “complete disclosure and shareholder approval.” Presently, the Employee Stock Options for listed companies in India are governed under the Companies Act, 2013 and SEBI (Share Based Employee Benefits) Regulations, 2014 (“SEBI SBEB Regulations”). While briefly discussing the procedure of grant of options, the author in this article delves into examining the bargaining position of an employee who has been involuntarily terminated from service leading to forfeiture of unvested stock options. The article also contemplates amendments that may be brought about in the functioning of the Compensation Committee, required to be constituted for the administration of employees’ stock options in India.

Exercise, Grant and Vesting of Stock Options

Stock options are usually offered to the employees at a price lower than that prevalent in the market. In order to convert the options into shares and exercise the rights granted, the employees are under an obligation to render their services to the company during the “vesting period”. As per Regulation 18, there is a statutory requirement of a minimum of one year within which none of the stock options can be exercised by an employee in India. It is important to note that in addition to this, a company usually imposes other time-and-performance based stipulations before the employees gain the right to convert options into shares of the company. A combined reading of Regulations 2(j), 2(zi) and 2(zj) lead to the inference that only once the vesting period and conditions are fulfilled can the employee exercise the stock options and receive benefits associated with the grant of shares under the scheme. [i]

Unvested Stock Options and Involuntary Termination

In the above-mentioned scenario, there may arise an unfair situation wherein an employee has been rendering services to the company for a fairly long period of time but is terminated from the service under unforeseen circumstances. Alternatively, an employee may also be terminated from service in bad faith shortly before the vesting period to deter him from receiving the benefits of his stock options. This scenario assumes immense importance in the current times as many companies across India have been laying off employees and reducing workforce to overcome the losses incurred due to the COVID-19 pandemic.

As per Regulation 9, in case of voluntary or involuntary termination of an employee from the service, all unvested shares get forfeited while the employee retains the right to vested shares, which he may be forced to exercise prematurely under unfavorable market conditions. In light of this issue, it is necessary that fair and equitable caveat be introduced within the SEBI SBEB Regulations to improve the position of an employee who has worked hard under the expectation of gaining the right to ownership in the company.

Way Forward

It is suggested that mandatory provisions for pro-rata vesting be introduced as a proviso to Regulation 9(6) for situations wherein the employee is terminated unexpectedly and/or involuntarily. The theory of pro-rata vesting rests on the assumption that a stock option is a deferred form of compensation for the employee and every day the employee becomes entitled to some percentage of it. In cases of termination of an employee, the SEBI SBEB Regulations must also provide for review by the Compensation Committee (required to be appointed under Regulation 6 for the administration of employment benefit schemes) to assess whether the employee has completed “substantial performance” of the vesting conditions and the time period. The committee could take into consideration factors like whether the employee has performed his duties regularly, his contributions towards the growth of the company, and the time left for the unvested options to become vested.

While there is a dearth of jurisprudence in relation to this issue in India, a parallel could be drawn from section 12 of the Specific Relief Act which states that “Where a party to a contract is unable to perform the whole of his part of it, but the part which must be left unperformed by only a small proportion to the whole in value and admits of compensation in money, the court may, at the suit of either party, direct the specific performance of so much of the contract as can be performed, and award compensation in money for the deficiency.” In the case of AL Parthasarthi Mudaliar v. Venkatah Kondiar Chettiah, observations in relation to the performance of a contract were made, wherein it was stated that equity demands specific performance of a contract, where the portion left unperformed in small. Thus, it is a settled principle in law that justice requires the remaining part of the contract to be performed rather than a negation of the entire contract. Assuming that the grant of stock options is a contract between the company and the employee, wherein the employee has performed the contract substantially, there is sufficient ground for him to claim pro-rata vesting of the shares in case of unforeseen and involuntary termination from employment. Reliance is also placed on the Californian jurisdiction case of Division of Labour Law Enforcement v. Ryan Aeronautical Company in which similar observations were made with regard to breach of stock option contract between the employer and the employee, wherein the Court while granting damages to the employee held that substantial compliance could be said to meet the requirements of the vesting obligations under the contract.

It is also interesting to note that Rule 12 of the SEBI (Share Capital and Debentures) Rules, 2014 entails any company other than a listed company to comply with several conditions before it can offer stock options to its employees. These conditions are exhaustive in nature and include the requirement of a provision in the scheme to be made in case an employee is to be terminated from the service. Parallel to this, under the SEBI SBEB Regulations, the business-judgment rule has been given a wide application and there is considerable freedom upon the shareholders and the Compensation Committee to decide the terms of the scheme. The composition of the Compensation Committee under Regulation 5(1) is the same as the Nomination and Remuneration Committee constituted under section 178 of the Companies Act, 2013. Regulation 6(1) requires the approval of the scheme by shareholders by special resolution. In the end, it remains a question as to who is in a position to challenge the scheme devised by the Compensation Committee even when the terms of the scheme are unfair to the employees or if the scheme does not lay down provisions for the exercise of options in cases of unforeseen and involuntary termination. The legislative position does not provide for any safeguards to the employee to look out for his interests. Speaking of the foreign jurisdictions briefly, the courts in the USA and Australia either allow for compensation in the form of damages or direct the company to let the employee exercise his stock options by accelerated vesting. For determining the damages, the Courts have regarded the proportion of the vesting period to the date of termination.

The author is of the view that involuntary termination should not entail complete forfeiture of the past services. To this effect, guidance is drawn from the Supreme Court’s observations in the case of Sheelkumar Jain v. New India Assurance Company Limited. The case pertains to an employee’s right to pension benefits but is comparable to the employee stock options scheme as the underlying principle to receive both of these benefits rests on the employee’s years of service and other performance conditions. The Apex Court herein observed that “pension is not a charity or bounty nor is it a conditional payment solely dependent on the sweet will of the employer. It is earned for rendering a long and satisfactory service. It is in the nature of deferred payment for past service. It is a right attached to the office and cannot be arbitrarily denied.” In the case of stock options, the company enriches itself with the services and commitment of the employee by promising him ownership in the company. The forfeiture of all unvested options on account of involuntary termination is therefore arbitrary in nature.

Conclusion

Share Option Schemes under the SEBI SBEB Regulations should differentiate between cases wherein the employee is terminated due to misconduct and cases wherein he is terminated involuntarily, for no fault of his. A measure for protecting the employees’ right to benefits under the scheme in cases of involuntary termination should be legislative compliance under these Regulations. Provision for representation of employees before the Compensation Committee is also an effective way for allowing the employees to voice their concerns over their vested and unvested stock options. As suggested, a provision of pro-rata vesting will ensure an equitable method for both the employee and the company. This is because the company will only be required to grant a small portion of shares to employees who have worked for a short time period in the company as compared to those who were substantially close to all the shares being vested. These measures will enhance an employee’s motivation to work for the growth of the company, which essentially is the underlying objective of the employment benefit schemes under the SEBI SBEB Regulations.

Securities Regulation, Company Law, Covid-19

[i] Rahul Cherian and Lubna Kably, Stock Option Plans, Nishith Desai Associates and The Economic Times, p. 6, (May 13, 2021), https://www.nishithdesai.com/fileadmin/user_upload/pdfs/ESOPs_In_India.pdf

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