Employee Share Option Schemes (ESOPs) are an
effective way of incentivising directors and employees. They
provide them with a sense of ownership in the business and allow
them an opportunity to share in the successes of the business.
The incentive will to a large extent be lost, however, if the
value of the underlying security (usually an ordinary share in the
issued capital of the employer, or its parent) is less than the
relevant exercise price. Such options are generally referred to as
"Underwater" or "Out of the money".
Many ASX listed employers are finding themselves caught in deep
water when it comes to their ESOPs following the volatility of the
Australian stock markets which has caused major stock indices to
fall by as much as 20% since January this year.
With the loss of this financial incentive, companies may be
concerned that key employees might be more inclined to consider
offers from other employers. To address this risk, directors have
been seeking advice on what can be done to increase the value of
employee options by, for example, amending the exercise price or
extending the option term (that is, the period during which the
option may be exercised).
Listing Rule restrictions
For unlisted companies, there may be scope to amend the ESOP
terms in this way. The original terms will often provide a
mechanism for variation.
However, for companies listed on the ASX, there is very little
scope to address underwater options. ASX Listing Rule 6.23.3
prohibits any change to a company's options which has the
reducing the exercise price;
increasing the period for exercise; or
increasing the number of securities received on
Unlike many restrictions placed on a company, this prohibition
applies regardless of whether the company has received
shareholder approval for the modification of the option terms.
Subject to the terms of the ESOP, a possible solution for listed
companies is to cancel their underwater options for
consideration. This will require the consent of the company's
shareholders and the relevant employee. The consideration for the
cancellation may take various forms (for example, a cash payment to
the employee). There is no requirement that the value of the
consideration equate with the options' economic value (which,
for underwater options, can be minimal or nil, depending on the
remaining term). If the consideration is to take the form of other
options (i.e. on more favourable terms), the ASX is likely to take
the view that the overall effect of the transaction constitutes a
change in the terms of the options and therefore a breach of ASX
Listing Rule 6.23.3. In any case, if there is any doubt, legal
advice should be sought before committing to any particular plan of
It is also possible for a company to simply grant new options to
employees without cancelling their existing underwater options. A
company must be aware though of the possibility that both old and
new options "come into the money" down the track, which
might give rise to an unintended windfall gain to the employee.
Alternatives to ESOPs
While companies listed on the ASX are greatly constrained in
their ability to amend ESOPs, alternatives remain for a company to
provide incentives to its employees through alternative equity
participation mechanisms. For example, a company could implement an
employee share purchase plan which involves either restricted or
unrestricted shares and would provide the company with greater
flexibility in terms of amending the terms of the plan.
"Phantom" share option plans are also becoming
increasingly popular and allow a company to gain similar results to
company share and option plans without issuing or transferring a
single share. These plans act like traditional stock market-based
schemes, where options are issued and exercised, and staff benefit
from upward movement in the shares' value. The only difference
is that no shares actually change hands. The plans are effectively
long-term cash bonus schemes.
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.
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Long experience representing many of Australia's leading employers has taught us that in employment litigation the identity of an employee's representative is a major factor in how employee litigation runs.
Australian employees receive certain entitlements (such as annual leave and superannuation) where contractors do not.
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