In this article, Porus Confectioner, pursuing Diploma in Entrepreneurship Administration and Business Laws from NUJS, Kolkata discusses the rules regarding issuance of stock option plans.

Introduction

Human Resources is a key talent that drives success in an increasingly knowledge-based corporate environment. The need to obtain, retain and reward talented people has become an important driver to get the best from Employees. ESOS (Employee Stock Option Schemes) is one such tool to make employees a part of the team that brings growth and profitability, by creating a sense of ownership, working towards a common aligned vision and purpose and rewarding persons who have thereby grown the company.

This note proposes to explain the key aspects of Stock Option plans and the legal position and procedures.

As per SEBI (Share Based Employee Benefits Regulations) 2014  the following kinds of share benefits briefly explained below are covered :

• Employee Stock Option Plans (ESOPs): contracts that give employees the right, but not the obligation, to purchase shares at a fixed price.  This is the most commonly used structure.
• Employee Stock Purchase Plans (ESPPs): these plans offer an employee the option to buy the shares at a discounted price.
• Stock Appreciation Plans (SARS): plans that offer an employee to receive cash or share to the extent of the excess of market price over the exercise price.
• General Employee Benefits
• Retirement Benefit Schemes

Our focus here would be to discuss the most popular option, Employee Stock Option Plans (ESOPS).

Employee Stock Option Plans ( ESOPS)

Definitions

ESOPS are contracts or schemes that give employees the right, but not obligation to purchase or subscribe to a specified number of shares of a company at a Fixed price (called Exercise price)  after a specified lock-in period. The exercise price remains constant, whilst the share price may move up or down.

The following laws cover the issuance and administration of ESOPS:

• Companies Act, 2013 and allied rules
• SEBI (Share Based Employee Benefits) Regulations 2014 and amendments
• Foreign Exchange Management Act, 1999
• Income Tax Act 1961
• Department of Public Enterprises Guidelines, where applicable
• ICDR Regulations 2009

Section 2 (37), Companies Act 2013,  defines Employee Stock Option thus :

“Employee Stock Option“ is the option given to directors, officers or employees of a company or it’s holding or subsidiary company or companies, if any, which gives directors, officers or employees, the benefit or right to purchase, or to subscribe for, the shares of the company at a future date at a predetermined price.“

As to who is an Employee is also spelt out in the 2(1)(f) of Share Based Employee Benefits Regulations, 2014 as well as Companies Act, 2017.  Both definitions are similar.

ESOP Procedure

The SEBI (Share Based Employee Regulation) 2014 and its amendments up to March 2017 is comprehensive and details all the requirements for setting up and administration of ESOP Plans, whether through the Direct or Trust route.

Ordinarily, though it can be, ESOPS are not given to all employees.  The first step would be to set up the ESOP and understand and identify the seniority level of employees would be offered ESOPS.

Eligibility for ESOPs

Guidelines under Companies (Share Capital and Debentures) Rules clarifies who is eligible for ESOPs:

1. Permanent employee of a company who has been working in or outside India
2. Directors of a company, whether whole time director or not, but excluding an independent director
3. An employee as defined in Clause a and b of above rules of a subsidiary, in India or outside company but does not include
   1. An employee who is a promoter or person belonging to a promoter group
   2. A director who either himself or through a relative or through any body corporates, directly or indirectly, owns more than ten per cent of the outstanding shares of the company.

Once a company has identified eligible employees the next steps would remain as follows:

• Prepare the ESOP Scheme
• Have the ESOP Scheme approved by the Remuneration and Compensation Committee at a Board Meeting. This is described in further details below.
• Convene Shareholders Meeting with details as specified in Rule 12, Companies (Share Capital and Debenture Rules) 2014. The details to be included are –
  • total number of stock options granted
  • identification of the class of employees eligible
  • appraisal process for determining the eligibility of the employee
  • details of vesting and vesting and lock in period
  • maximum no. of options that can be granted per employee

Directors Report

Once the Scheme is ready and enforceable, the company, in the Directors Report is required to furnish all details in the Year with the following details:

• Options granted, vested and exercised and total shares exercised,
• exercise price,
• options lapsed,
• any variations in terms of options,
• money realised, options in force, etc.

Where the option is not taken by an employee, it shall be renounced to the institution, since they are not transferable.

Also required to be mentioned are options granted to:

1. Key Managerial persons
2. Any other employee who has received more than 5 % of total allocated options
3. Employees who have been granted more than or equal to  1 per cent of the Issued capital

Register

The company shall maintain a register, at the registered office,  of Employee Stock Options and shall update the options immediately with regard to the particulars of the option granted. The entries in the register are to be authenticated by the Company Secretary or a person authorised by the Board.

Remuneration and Compensation Committee

The members of this Committee are constituted by the Board and as per Section 178 of the Companies Act 2013 and may act as the Compensation Committee for the purpose of approvals and implementation of the SEBI ESOP guidelines. The role of the Compensation Committee is to ensure that detailed terms and conditions of the plan are in accordance with all laws, including Compliance with Prohibition of Insider Trading Rules and Prohibition of  Fraudulent and Unfair Practices relating to Securities markets regulations. The role extends to ensuring adherence to guidelines by the delegation of powers to officers of the company as required.

Shareholders Approvals

The requirements of Shareholders approvals for the ESOP are enumerated in the SEBI rules and require shareholders approval by passing a Special Resolution.  The scheme approvals need to cover:

1. Description of schemes
2. Total number of options, shares, etc, to be granted
3. Identification of classes of employees eligible to be beneficiaries and appraisal process for identifying the employees in terms of performance parameters  
4. Requirements and period of vesting including the maximum period in which vesting must happen.
5. Exercise prices and formulae, periods, methods of valuation and maximum quantum of benefits per employee
6. Whether the scheme is to be administered directly or through trusts.
7. Guidelines to ensure Fair Value of shares/options and disclosure in Directors Report

In the following circumstances separate shareholder approvals are required :

1. Where the acquisition of stocks from the Secondary market is needed for implementation of the scheme. The Limits fixed for acquisition should be within the SEBI rules.
2. Similarly, where the secondary market acquisition is through a trust, to maintain the maximum 5 % cap as required by SEBI rules.
3. Where there is Grant of options to employees of subsidiary or holding company
4. Where Grant of options/Shares exceeds 1 % of the Issued Share Capital of the company during a particular financial year.

FEMA provisions for ESOPs

Many persons entitled to ESOPs work in foreign countries. The provisions of FEMA (transfer of issue of securities to a person resident outside India) Regulations, 2000, FDI regulations and Policy cover the relevant provisions in such cases.

The regulations permit Indian companies issuing shares to employees abroad or employees directors of holding/subsidiary companies abroad provided:

• The ESOP scheme is as per companies Act, SEBI rules, and Companies (Share and Debentures) Rules of the Central Government
• That all sectoral caps have been observed and adhered to
• Where Foreign Investment in a company is as per specific FIPB guidelines, the option/share has to be in accordance with FIPB approvals
• Prior approvals for any such options/shares for Bangladesh or Pakistan
• RBI may also require specific reports for options/shares to Non Residents at such frequency as set out by RBI in the specific form within set time limits of the issue of shares.

Income Tax Act 1961

Generally, ESOPS for employees are tax deductible in the books of the company being considered a legitimate expense for retention and promotion of employee performance. The discount or difference is wholly and exclusively chargeable as legitimate expenses, though care should be taken to ensure that differences or discounts ware reasonable and properly accounted, to stand scrutiny from income tax authorities. The SEBI (Share Based Benefit Regulation) 2014, gives the accounting requirements also to be set out for recognition of the Fair value of the shares. Here, the SEBI Guidance note for Accounting for SEBI share based employee benefits rules need to be followed.

With most Corporates having moved to IND-As accounting standards, these would mostly now be followed for accounting and tax purposes in India.  

Trusts

Before 1999 a number of ESOP offers Plans were set up as trusts since organisation felt the need to create a separate structure to monitor and control ESOP administration.

However, on noticing sharp practices which gave rise to fluctuation in share prices, using ESOPs shares and options for purposes other than strict rewarding of employees, including share manipulation, SEBI guidelines had prohibited trusts of listed companies from the purchase of secondary market shares in settlement of their employee options. This caused an inconvenience to listed companies who then were at unable to settle their employee plans

However, by subsequent amendments to the SEBI (Share Based Employee Regulations), listed companies were again permitted to purchase shares from registered stock exchanges in settlement of employee stock options.  However, the Trust based plans are far more onerous in terms of Compliance. There are rules, reporting standards, information to stock exchanges, monitoring and controls, limits on the number of shares that can be purchased from the secondary market in a particular year, disclosures with regard to voting rights if the shares are not exercised directly, disclosures by the trust, etc to ensure strict compliance with the purpose for which the shares were given as well rules to ringfence existing shareholder rights.

All such requirements are detailed in the SEBI rules for listed companies to follow.  To please take note of the fact that the trust structure is very onerous and is to some extent, difficult to administer, given the stringent rules.

Conclusion

The above set out the procedure and requirements for the offer of ESOPs to employees more on a direct route. The onerous requirements in case of a trust for the purpose have also been explained.

Companies, especially in the new growth knowledge sectors of Information Technology, Business Process Outsourcing, Pharmaceuticals and web-based service offerings have taken the benefit of the offer of ESOPs to retain and upgrade talent.  A number of listed companies also offer ESOPs for senior managerial staff. The ESOP rules are now set in place and rules are set in place for listed corporates to follow in practice.

However, the real benefits of ESOPs accrue to the relatively smaller unlisted companies who need to draw and retain experienced and knowledgeable talent. The options for unlisted companies are limited to share buy back or buy off from Venture Capital or PE Funds or await listing for employees to benefit. SEBI guidelines exist for unlisted companies too and even here the practice is more or less set in place.