Managing Employee Share Plan Issues

The option backdating scandal continues to blight high-profile companies and individuals in the US, illustrating how employee share plans – and executive plans in particular – can damage companies disproportionate to the numbers involved.

The scandal has precipitated a long line of investigations affecting high profile chief executives and accounts restatements worth over $4bn. The CEO of Comverse recently settled actions for $3m. Even Steve Jobs, CEO of Apple, has been questioned and his company is now the subject of a suit by shareholders.

WHAT IS THE PROBLEM?

The backdating of options itself may not have been illegal at the time but it caused problems because:

• The reporting of the grants in financial statements did not reflect legal reality – the reporting, rather than the grant itself, was therefore in breach of US securities laws
• The tax and accounting treatment of options granted with exercise prices less than market value was, at the time, less favourable than that of options granted with an exercise which was equal to or more than market value
• Most plan rules under which the options were granted did not permit the grant of options at a discount

Many appear to involve the falsification of records of board meetings. This compounds the financial damage with serious reputational issues for the companies and the individuals involved – Apple's share price slid several points on the news that Steve Jobs was under investigation.

Backdating was common practice among US companies and although legal differences mean it is less likely to occur in Europe, without due care, there is no telling which bit of our current common practice might precipitate the next scandal on this side of the Atlantic.

TAX COMPLIANCE

UK tax authorities have been taking a great deal of interest in share plans over the last few years, imposing tax withholding on share plans, a new and complicated regime for the tax of restricted shares, an onerous reporting regime and obligation to shop yourself to the tax authorities if you are even thinking about a plan that might be too tax efficient. All this is requires care: a tax claim can be costly to settle or to fight and the damage to the company's reputation and relationship with the tax authorities can take years to heal.

A recent case is a good illustration: a major UK retailer has taken legal action against a former chief executive and other former directors to recover millions of pounds in tax on their share options, which they should have withheld when they exercised their options but did not. In the circumstances, it was an easy mistake to make but the matter is now in the public eye, having been reported in newspapers and trade journals.

This issue highlights the need for accurate global tax compliance, especially for multinationals operating their plans in their home country and all the other countries in which they have operations.

INSIDER TRADING

The dark side of employee share ownership is that shares fall into the hands which grip the levers controlling the company. Without proper protections, this can lead to abuses and, again, reputational damage to a company far beyond the direct financial implications.

A recent example is the investigation by the French authorities of the former chief executive of Airbus over allegations that he profited from a sale of shares in Airbus' parent, EADS (which he had acquired under an option plan) shortly before the announcement of problems at Airbus and announcements of sales of large stakes in the company.

Recent European laws have extended to the EU the rules which have served the UK well in the recent past, requiring:

• The disclosure by directors and senior executives of all transactions in shares in the company to the market
• Directors and senior executives to obtain consent from a designated officer before trading their shares

France has gone further, requiring that French executives must continue to hold a portion of their options (or the shares resulting from them) until they cease to hold office.

ACCOUNTING FOR SHARESAVE

The new rules on accounting for share plans have been with us for some time and companies are learning to live with the negative impact on their reported earnings. But a recent refinement on the rules announced by the UK and European accounting regulators could result in big charges to earnings for companies operating Sharesave schemes (Sharesave is an extremely popular kind of all-employee option plan which attracts favourable tax treatment in the UK. Similar issues may affect French PEE plans or US-style ESPPs.)

Effectively, the change causes a double charge to a company's earnings where participants in a Sharesave plan cancel their savings contracts and take out a new one. Employees often do this, particularly where the options they were granted in previous years are underwater.

The result is that employees may burden their employer with a greatly increased earnings charge. Without changes to the way plans are operated, employers can do little to control this cost. The resulting hit to earnings can accelerate the slide in the share price that caused employees to cancel their contracts in the first place. There are ways to mitigate this impact with careful planning.

Finance directors are increasingly reviewing the people and processes managing their share award programmes to make sure proper practices are in place to comply with global regulatory requirements and good corporate governance.