Repricing of ESOPs on account of market price crash

Abhishek Kumar Namdev, Assistant Manager | corplaw@finserv.com

Background

The basic intent of any company to bring out an ESOP Scheme is to incentivize its employees. Such incentives are basically in the nature of appreciation in the prices of shares. To explain this by way of an illustration, the following may be considered:

Grant price/ Exercise Price at the time of grant – INR 200 per share

Vesting – 1 year from date of grant

Market price at the time of exercise = INR 280 per share

Incentive / gain – INR (280 – 200) = INR 80 per share

This simply means that the usual expectation of any company is that the profits will increase because of which the share prices will also shoot up. In such a scenario, if instead of an increase in the share prices, the same falls so sharply that it even falls below the exercise price, there is no motivation or reason for any employee to exercise their vested options as it has no relevance from being economically beneficial. Those employees holding “underwater options” find no incentive to exercise the same.

Therefore, the next logical question is: Can the exercise price be decreased? Such adjustment is generally termed as repricing of ESOPs. In this write up, we have discussed the legal permissibility of repricing the options and the different scenarios in which the same can be given effect to.

Does Indian law permit repricing?

The answer is yes, and it finds regulatory support under the SEBI (Share Based Employee Benefits and Sweat Equity) Regulations, 2021 (“SBEB Regulations”).

Regulation 7(5) of the SBEB Regulations states that the price of options that have not been exercised may be changed irrespective of whether they have been vested or unvested if the option is rendered unattractive due to a fall in the price of shares in the market. Having said that, such repricing should not be detrimental to the interest of employees and will be subject to shareholder approval.The trigger is specific, a fall in market price rendering the option unattractive.

Also, the conditions are clear, such repricing should not be prejudicial to the interest of employees, and secondly, shareholders must approve it by way of a special resolution. Given the scenario where the market price has fallen, the repricing will be done downward so as to make the options attractive again.

For pricing of the ESOPs, following provisions become particularly relevant:

Indian law prescribes specific guidelines for the determination and disclosure of the exercise price. The relevant provisions are discussed below.

Determination of Pricing of ESOPs: The SBEB Regulations provide the responsibility for determining exercise price solely to the compensation committee (NRC), with the sole condition that the committee shall follow the relevant accounting policies. Moreover, Regulation 17 does not mandate any minimum floor or prescribe any formula for setting the exercise price.

However, SBEB Regulations do provide a benchmark for listed companies to follow while determining the exercise price. More specifically, regulation 2(1)(x) read with regulation 2(1)(hh)(i) indicate that for listed entities, the benchmark for the purpose of determining exercise price would be the latest closing price at a recognized stock exchange, where the higher trading volume in the shares of the Company is recorded, on the date prior to the date on which the compensation committee considers granting of ESOP.

What practices do listed entities typically adopt in structuring their ESOP schemes?

While most ESOP schemes provide that the exercise price shall be determined by the compensation committee at the time of grant, the manner in which such discretion is exercised varies across entities. In practice, a few broad approaches were observed which have been discussed below.

The most common approach, particularly among listed companies, is to set the exercise price at exactly the market price as defined under Regulation 2(1)(x), that is to say, the closing price on the exchange with higher trading volume on the day preceding the grant date, with no discount applied. An example of this approach is set out in one of a company’s grant disclosures.

The second approach is where the ESOPs are granted at a discount to market price, with the discount range varying widely. An example of such an approach is reflected in an ESOP scheme that permits pricing at a discount of up to 50% to the closing market price on the stock exchange with higher trading volume.

The third approach is setting the exercise price at face value. While uncommon among established listed companies, has been adopted by several new-age, recently-listed companies. This practice is largely a carry-forward of pre-IPO ESOP structures where options were originally granted before listing, at a time when face value was the only viable pricing anchor.

A Company, in its Scheme, fixed the exercise price at Rs. 1 per option, equal to the face value of its equity share. Similarly, another Company, across itsseveral Schemes, consistently grants options at an exercise price of Rs. 1 per share which is equal to face value even as the market price at the time of grant has ranged about Rs. 230 per share, making the spread between exercise price and market price substantial.

Another practice found is to obtain prior shareholder approval for granting options within a specified discount range, for instance at 20–25% on the last closing price before the day of grant and granting the authority to fix the actual discount to either the Board / Committee within the approved range.

Section 62(1)(b) read with Rule 12 of the Companies (Share Capital and Debentures) Rules, 2014 requires every company to make certain disclosures in the explanatory statement annexed to the notice for passing the special resolution, including disclosure with respect to the exercise price or the formula for determining the same.

Why not just cancel and regrant?

Can some companies prefer the option of cancelling the existing options and issue fresh ones at the current market price? This looks cleaner apparently but technically two problems.

First, under Ind AS 102, cancellation during the vesting period other than on account of cancellation due to forfeiture for non fulfilment of vesting conditions, is treated as accelerated vesting. As a result, all unrecognised compensation cost gets recognised immediately, hitting the P&L upfront. Second, a fresh grant resets the vesting clock, meaning the minimum one-year vesting period under Regulation 18 of the SBEB Regulations starts afresh. Employees may end up waiting longer than they originally required.

Global scenarios

In US, listed companies are required to follow ‘The Nasdaq Stock Market LLC Rules’¹, which requires every company to take the shareholders’ approval unless the original plan expressly permits repricing. The SEC treats exchange programmes where employees voluntarily swap underwater options for new ones as the company gives a tender offer, triggering Schedule to filing requirements. The market-accepted approach has evolved toward “value-for-value” exchanges, where employees receive fewer new options calibrated to the fair value of the surrendered ones, limiting dilution and accounting impact.

The Singapore Mainboard Rules mandate that the scheme itself provide for adjustments to the subscription or option price. Consequently, adjustments implemented strictly in accordance with the scheme may not necessitate separate shareholder approval. That being said, such adjustments are subject to an important safeguard, namely, that participants must be placed in a position economically equivalent to that of shareholders, thereby preventing any undue advantage. However, where the adjustment pertains to the option price, the manner in which such adjustments can ensure economic equivalence with shareholders remains a question.

The Toronto Stock Exchange (‘TSX’) through its Policy on Security Based Compensation requires a shareholder approval of any repricing of options if the participant is an Insider of the issuer, regardless of the terms of the plan. If a company’s option plan contains amendment provisions approved by shareholders that permit repricing of outstanding options held by non-insiders, then the TSX will not require shareholder approval for the repricing of such options.

The common principle across jurisdictions is shareholder primacy & full transparency.

Need for Shareholder’s approval for repricing

One of the major tasks before the Company is to approach the shareholders for repricing the options. However, the first question that comes to mind is can there be a situation where repricing can be done without the approval of the shareholders. Ordinarily, repricing requires the nod from the members, but such cases would be where the members fixed the grant price under the scheme. Where the authority to fix the grant price has been bestowed upon the NRC / Board, then any changes in the same should also be ideally decided by them. For example, the Scheme defines that the exercise price shall be at a discount of up to 25% or Rs. 20 (discount in terms of the percentage or absolute number) on the closing market price prior to the date of grant, in this case the NRC / Board should be having the power to determine the exercise price without have a recourse to shareholders as long as the fixation as well as repricing conditions align with the legislation as well as shareholders approval originally granted. Alternatively, the Scheme may provide that the exercise price shall be such price as may be determined by the NRC at the time of each grant, in accordance with the applicable provisions of the SBEB Regulations, 2021. Governance concern

The governance concern with repricing is straightforward. Shareholders who bought shares at the market price have no mechanism to reprice their investment when prices fall. Extending a repricing benefit to employees, particularly those in senior management, without strong justification may create an asymmetry that institutional investors and proxy advisors may become reluctant to accept. However, on the other hand, it is important to accept that it is these very employees that put in their efforts to push up the performance as well as share prices. It might also be imperative to note that where the market prices decline on account of external factors or global factors, repricing becomes all the more significant.

Among listed companies, there have been a few companies which sought shareholder’s approval for repricing There is no SEBI informal guidance on repricing, a gap that itself reflects how underexplored this area remains.

Conclusion

Where the shareholders have not accorded the power to the NRC /Board to reprice the ESOPs, it is legally required for the companies to take the approval route under the SBEB Regulations but comes with clear conditions, which include:

NRC rationale on record;
shareholder approval by special resolution;
no dip below face value;
accounting impact; and
Corresponding disclosures where the exercise price was earlier disclosed.

See our other resources on ESOPs

Rule 5635(c) of the Nasdaq Stock Market LLC Rules ↩︎

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