Following the big fall in the stock market this year, many employees find themselves holding options under employee option plans that are well out-of-the-money. Employee option plans play an important role in retaining and motivating staff and driving long-term business performance. Employers considering ways to reinstate the value of these option plans will need to negotiate their way through their option plan rules, the Corporations Act, the ASX Listing Rules (in the case of listed companies) and the income tax legislation to avoid adverse tax consequences for their employees.
To assess the impact of the crash on employee option plans, Deacons recently undertook a survey to examine the role of options and other share-based plans in executive remuneration and the extent to which options issued under those plans are out-of-the-money. For S&P/ASX 50 companies, we found that:
- 42% have options on issue under either current or expired employee option plans.
- While the options issued under those plans since 2003 are on average only 4% out-of-the-money (that is, the share price is an average of 4% below the exercise price), this result is somewhat skewed by strong performances by a couple of companies with 73% of the option tranches issued since 2003 being out-of-the-money.
- 84% have performance rights plans.
- Only 2 have employee options plans but do not have a performance rights plan.
However, our findings were quite different when we examined a sample of 50 of the 200 companies from the S&P/ASX Small Ordinaries. We found that:
- 64% have options on issue under either current or expired employee option plans.
- The options issued under those plans since 2003 are on average 48% out-of-the-money and 88% of the option tranches issued since 2003 are out-of-the-money.
- Only 30% have performance rights plans (14% have only performance rights plans and 16% have both employee option plans and performance rights plans).
It appears that the S&P/ASX 50 companies learnt a lesson from the dot-com crash and moved to performance rights schemes rather than employee option schemes to ensure that their incentive schemes continued to motivate their employees during downturns in the market. If our sample of Small Ordinaries companies is representative, it appears that the same cannot be said for many companies outside of the S&P/ASX 100 and this could have an adverse impact on their ability to retain and motivate their key employees. This is particularly the case given that comparatively larger falls in the share prices of the companies in the S&P/ASX Small Ordinaries index have led to their option plans being well out-of-the-money.
A more detailed outline of this survey is available from our website information on the methodology and limitations of the survey.
Options vs Performance Rights
Options granted under employee option plans typically have an exercise price which is at or around the market price of the share at the date of grant of the option. There is then a period after the grant (usually between 2 and 4 years) before the options vest in the employees (that is, before the employees become entitled to exercise the options). Vesting of the options is commonly subject to conditions and/or performance hurdles. Following the vesting of the options, the employee then has a period of time (typically a few years) in which to exercise the options.
In contrast, performance rights have a nil exercise price and are contractual rights to receive shares in the future. As with options, there is a period of time before these rights vest and vesting is dependant on certain conditions and/or performance hurdles being met. Following vesting, there is a period of time (typically a few years) during which the employee can exercise the rights. For the purposes of our analysis, we classified zero exercise price options (ZEPOs) as performance rights as they have a similar economic effect.
Performance hurdles generally involve comparing a company's total shareholder return against a comparator group of similar companies. Accordingly, provided that the company matches or outperforms its peers, these rights can vest even in a falling market.
The important difference between options and performance rights is that vested performance rights still have value to an employee even where the company's share price has dropped well below the share price at the time those rights were granted. For example, if the number of performance rights to be granted to an employee was determined based on a fair value of $20 and the employee was issued 1,000 performance rights (i.e. they have a notional value of $20,000), even if the company's share price has dropped to $10 at the time at which the rights vest the employee will still be entitled to be issued with 1,000 shares with a value of $10,000 after vesting without having to make any payment (as there is no exercise price).
However, if, in the same scenario, the employee had been granted options instead of performance rights with an exercise price of $20, the share price would need to recover to $20.01 before those options had any value to the employee.
Taxation of employee option schemes
Where a taxpayer acquires options under an employee option scheme, Division 13A of Part III of the Income Tax Assessment Act 1936 includes any "discount" (compared to market value) given in relation to the options in the taxpayer's assessable income.
Generally, employee option plans are structured to provide employees with the ability to take advantage of a concession known as the "deferred tax method". Under this concession, the employee may generally defer the taxing time until the option is disposed of or exercised. This contrasts with the ordinary rules that require tax to be paid in the year in which the options are acquired (known as the "up-front tax method").
Dealing with out-of-the-money options
There are a number of different methods that are often considered when dealing with out-of-the-money options. In each case, actions taken need to be consistent with the option plan rules. Where actions that need to be taken are inconsistent with the option plan rules, those rules need to be amended or employees otherwise need to agree to the necessary actions.
Amend to reduce option exercise price to better reflect current share price?
Where the option exercise price is reduced, there are unlikely to be any adverse tax implications for employees.
However, for listed companies, an amendment that has the effect of reducing the exercise price, increasing the period of exercise or increasing the number of shares received on exercise, will constitute a breach of Listing Rule 6.23 which expressly prohibits such amendments, .
Cancel existing options for new options?
The tax implications for employees of the cancellation of options in circumstances where new options are issued are not entirely clear but cancellation may potentially result in double taxation for employees. Further, there is a real risk that ASX could determine that these transactions are, in fact, part of the same transaction having the effect of reducing the exercise price on the options and therefore prohibited under Listing Rule 6.23.
Issue new options without cancellation of existing options?
Where new options are issued without the cancellation of the existing options, there are unlikely to be any adverse tax implications for employees. Employees who have paid tax under the up-front method should be entitled to a refund of tax when their existing options lapse. Employees will then be taxed on their new options under Division 13A applying either the up-front tax method or the deferred tax method.
Although there is still a risk for listed companies of ASX aggregating the two option issues as a single transaction, in our view, the issue of new options without the cancellation of existing options should not breach Listing Rule 6.23.
However, care should be taken to ensure that the new options will not take the company above the 5% limit under ASIC Class Order 03/184. If the 5% limit will be breached, a disclosure document for the new options will need to be prepared and lodged with ASIC unless a specific exemption is sought and obtained from ASIC.
Perhaps, the more significant risk with this approach is that the existing options (currently out-of-the-money) regain their value as the company's share price increases, leading to a double benefit for the employee.
Implement a performance rights plan
While a performance rights plan cannot replace options that will expire in the near future, it may provide a better mechanism for motivating employees in the future. Performance rights plans arguably promote better alignment between the interests of employees and shareholders and operate more effectively in a downturn.
Performance rights plans are taxed in a similar way to employee option plans.
For listed companies, a new performance rights plan will require shareholder approval or all securities issued under the plan will need to be counted toward the 15% cap in Listing Rule 7.1.
Further approval will be required if shares are to be issued to a director under the plan.
What does this mean for you?
Employers considering ways to reinstate the value of their employee option plans should be aware that there are a number of different methods that can be used which have varying implications under the Corporations Act, ASX Listing Rules and income tax legislation. For employers that decide not to do anything, it may be worthwhile to remind employees that have paid tax under the up-front method that they should be entitled to a refund of tax if their options are still out-of-the-money at the end of the exercise window.
It is also worth reviewing whether employee option plans are still the best mechanism for motivating employees and considering whether your company should adopt a performance rights plan.
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.