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Editorial

EMPLOYEE SHARE OPTION AND INCENTIVE PLANS

May 2008 - Finance. Legal Developments by Al Tamimi & Company.

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By Marcus Wallman and Sonya Stewart  Our most productive investment remains our people. It is through the dedication, skill and initiative of our people that Visy Industries has prospered and will continue to move ahead” Richard Pratt, Chairman, Visy Industries

 

 Introduction 

We now receive an increasing number of enquiries about long term incentive plans.  These enquiries range from “what are they?” (which is a valid question given the broad range of alternatives available, as discussed below) to “how can we set up a scheme in our company?”. 

 

These schemes have become an established component of senior and mid-level executive remuneration offered in overseas markets, particularly in the context of listed companies.  With the significant economic growth being experienced within the UAE in recent years has come an increasing demand from local companies for world class executives.  These companies are finding that they need to offer remuneration comparable to that being offered around the world when competing for executive talent.  Employee share option and other long term incentive plans are important components of these packages.   

 

 What are employee share option and incentive plans? 

There are a number of acronyms and phrases that are bandied about in the context of what we generally call “employee share option and long term incentive plans”, including ESOPs, LTIPs, Phantom Plans and SARs.  Essentially, however, all these plans link part of employee remuneration to the financial performance of the company (or corporate group) for which the employee works and the employee’s length of service with the company.  Let’s look at alternatives in more detail:

 

Employee Stock Option Plan (ESOP) – An employee stock option plan is a plan under which employees are granted options to acquire shares at an exercise price determined at the time the option is granted.  The exercise of the option may be made conditional.  Conditions may include the passing of time (for example, an option granted in respect of, say, 100 shares may be exercisable in respect of 50 of those shares after 2 years and the remaining 50 of those shares after 3 years from the date of grant) and/or certain financial targets being met by a company or corporate group or which are referable to the participant himself (such as departmental performance).  There are any number of combinations of exercise conditions which can be applied to an option. 

 

Any plan relating to the grant of stock options will contain rules dealing with what happens to options where the employment ceases (these are often referred to as “good leaver/bad leaver” provisions).  For example, if an employee dies before he was entitled to exercise his options the rules may provide for the employee’s personal representatives to exercise all the options within, say, 6 months of the date of death notwithstanding that not all the exercise conditions may have been met (this is referred to as “accelerated vesting”).

 

Long Term Incentive Plans (LTIPs) – The term “long term incentive plan” is a very broad term which encompasses all forms of plans, whether they be ESOPs where shares are actually transferred upon the exercise of an option granted to a participant or whether they offer benefits (e.g. cash bonuses).  With regard to this latter category, essentially, these plans are contractual bonus arrangements under which the company agrees in advance to pay a bonus to the participant and the amount of the bonus is generally linked to the share price (or other financial indicator(s)) of the company and the length of service of the employee.  These plans can also incorporate good leaver/bad leaver provisions. 

 

Coming within the definition of LTIPs are what are commonly referred to as “phantom stock” plans.  These plans are simply a promise to pay cash bonuses measured by reference to the value of a company’s shares or the increase in such value over time.  Another form of LTIP arrangement are plans called “Stock Appreciation Rights” (SARs) which, again, is a form of bonus whereby the payment is made by reference to the increase in value of a company’s stock over a specified period of time.  However, with SARs, the bonus may be paid either in cash or by the transfer to the participant of such number of shares that have an equivalent value.

 

One of the advantages of LTIPs (i.e. other than ESOP’s) is the great flexibility offered by such plans as they are simply a contractual arrangement between the company and the employee which sets out the circumstances in which a payment may need to be made by the company to the employee.  However, because they can be designed in so many ways, many decisions need to be made at a business level about who get how much and the factors driving the size of any bonus payments.  Careful consideration needs to be given, from a cash flow perspective, to the potential amount and timing of actual cash payments.

 

Employee Share Ownership Plans (also referred to as ESOP’s to add to the confusion!) – Employee share ownership plans are essentially the same as employee share option plans.  They grant to employees the right to receive an ownership interest in shares in a company (often held by an “employee benefit trust” where employees own a beneficial interest in a proportion of the trust’s shareholding).  These schemes, which began in the US in the mid 70’s after the introduction of tax legislation made them attractive to both the companies and employees, often resulted in employees owning significant stakes (sometimes more than 50% of the total share capital of a company) and were seen as a form of retirement benefit plan for such employees.  In cases like Enron, the company became bankrupt and the employees were left with no savings.  We do not see these types of schemes being implemented in the UAE in the near future for various reasons including the restrictions on foreign ownership of shares in UAE entities (generally, foreign ownership is limited to 49%), the fact that there are no tax incentives to implement such schemes (as there is no income tax and, generally speaking, corporation tax, currently imposed in the UAE).  In the UAE there are statutory end of service gratuity rights which tend to take the place of other retirement benefit arrangements.  

 

Why implement LTIPs

 

There are two basic rationales behind the implementation of LTIPs.  The first is to align the interests of the employees with those of the employer.  Clearly, a common element among all LTIPs is the better the performance of the Company (as reflected by the increased share price or perhaps other financial performance indicators) then the more valuable the share options or other bonus awards made to the employee.  Secondly, LTIPs assist is the retention of employees as invariably the rules will link options or award payments to the length of time employees remain with the company.  The current trend is the UAE is to have vesting periods of between 3 and 5 years but it is not uncommon for these periods to extend to 10 years.

 Implementation of LTIPs in general and ESOPs in particular 

LTIPs - From a legal perspective, the implementation of LTIPs which do not involve the actual transfer of shares in a company is simply a matter of drafting an appropriate set of rules governing the plan and pursuant to which awards are made to employees.  These rules constitute a contract between the company making the award and the recipient of the award (usually a certificate evidencing the award is issued to the employee and the employee is asked to sign a form acknowledging receipt of the award and that the award is governed by the relevant set of plan rules).  Typically, the rules of such plans will deal with issues such as vesting periods (i.e. how long an employee has to be with a company before he is entitled to receive a payment), the basis of determining the amount of the payment to be made to the employee (for example, linking it to the share price of the company) and the good leaver/bad leaver provisions as mentioned above. 

 

ESOPs – There are a number of legal issues to be considered with regard to the establishment of an ESOP, which I will mention briefly in this article.  Of course, any particular plan must be considered on a case by case basis as there may be specific circumstances which require specific legal structures to be implemented.

 

Generally, ESOPs are only appropriate for listed entities as shares of listed entities are freely transferable (subject to foreign ownership restrictions imposed by the UAE Commercial Companies Law) and hence they are seen as liquid assets that the employee can easily convert to cash if desired after an option has been exercised. 

 

There are a number of legal difficulties in applying ESOPs to limited liability companies established in the UAE (LLCs), including:

 

Ø      the limit of 50 shareholders in an LLC;

Ø      all existing shareholders have pre-emption rights over the transfer and issue of any shares (so, technically, all shareholders’ need to agree to each separate transfer of shares upon the exercise of an option); and

Ø      the process of transferring shares in an LLC is a cumbersome process as it involves all shareholders’ signing a share transfer document and an amendment to the memorandum of association of the company in the presence of a notary public.  

 

Consequently, we recommend the use of other forms of LTIPs for plans adopted by LLC entities.  

 

With regard to structuring an ESOP for a listed company, we recommend that a separate special purpose vehicle (SPV) is established which is used to hold pool of shares which can be used to satisfy options as and when they are exercised by employees.  The UAE Commercial Companies Law does not allow for a company to hold its own shares (except in limited circumstances not relevant to an ESOP) and hence the company itself cannot issue any form of “treasury stock” to be used to satisfy options.  The UAE Commercial Companies Law also provides for pre-emption rights in respect of the issue of new shares by public joint stock companies (i.e. the type of corporate entity which can be listed on the local exchanges) which means that it would be impractical for a listed company to issue new shares every time an option is exercised as all shareholders’ would need to consent.

 

With regard to funding the acquisition of shares in a company by the SPV to be used in connection with an ESOP, there are alternative methods available.  For example, the company itself can either loan or gift monies to the SPV (in the case of a loan, such loan can be repaid from monies received by the participants in the plan when they pay the exercise price to the SPV in exchange for the SPV).  While there are no UAE laws which prohibit a company funding the acquisition of its own shares (there is such a restriction contained in the DIFC Companies Law covering DIFC entities), often such a restriction is contained in the memorandum of association of a company and, if this is the case, the memorandum must be amended.  We generally recommend not just removing such prohibition but also inserting specific articles authorizing ESOPs and other LTIPs generally.  Alternatively, third party funding can be obtained by the SPV.

 

With regard to regulatory considerations, the two regulatory authorities that need to be considered when implementing ESOPs in the context of entities listed on UAE exchanges are the Securities & Commodities Authority and the UAE Central Bank.  Depending on the circumstances, such authorities need to be notified of the ESOP or their approval sought for the implementation of the ESOP. 

 

Of course, implementing ESOPs in the context of companies listed or undertaking a listing on the Dubai International Financial Exchange requires specific consideration of the applicable laws and regulations of the Dubai International Financial Centre.  However, broadly speaking, the structural considerations are similar to those referred to above in the context of companies listed on the local markets.

 

Finally, we recommend that the auditors of a company that is considering implementing an ESOP are consulted on the proposed structure from an early stage as often the final structure chosen may impact on the balance sheet of the company implementing the structure.

 Plan Design and Administration 

It is worth pointing out that in addition to the role played by the lawyers in drafting scheme documentation and implementing scheme structures, clients often find it helpful engage the services of plan designers and administrators.  There are a number of consultancies who offer plan design services and who can advise on the commercial aspects of schemes in light of the specific needs of a client.  There are also administrators who can undertake the on-going administration of schemes.  Often such a task is seen as burdensome for a company’s HR department and many clients are happy to outsource such task to a specialist administrator, particularly in respect of schemes with a large number of participants.  Often such administration companies also provide trustee services which may be appropriate in the context of a particular scheme’s legal structure. 

 Conclusion ESOPs and other LTIPs have proven to be very valuable weapons in the battle to retain and incentivise staff.  In an increasingly competitive labour market, employers in the UAE are realizing the benefits of these schemes to both attract and retain employees.  No matter whether the company is a large listed company or a smaller private entity, schemes can be structured to suit any company’s particular needs.  In our view these schemes will play an increasingly important role in the UAE market.