UK Listed companies are under continual pressure to issue their share capital effectively. It is not surprising therefore that there is gro...

UK Listed companies are under continual pressure to issue their share capital effectively. It is not surprising therefore that there is growing interest in a method under which a company can avoid issuing the full number of shares over which employee share options have been granted, yet can deliver the same value to the optionholders.

The Problem
The “inefficiency” of a company issuing the full number of shares to satisfy an option can be demonstrated as follows:

Assume a UK higher rate taxpayer was granted a non-Inland Revenue approved option over 100,000 shares with an exercise price of £1 per share. His total exercise price would be £100,000. If he exercises the option in full when the share price is £3 and does not use his own funds to cover the exercise price or the tax and NICs due, he will immediately have to sell 33,334 shares (33,334 x £3 = £100,002) of the issued 100,000 shares to pay his exercise price. He will also have to sell a further 27,334 shares (27,334 x £3 = £82,002) to pay 41 per cent tax and NICs (and may have to sell more shares to cover costs, unless commission-free dealing is available). After these sales, he will only be left with 39,332 shares. Put another way, only 39.3 per cent of the shares issued to the employee end up in his own hands! The “efficiency” ratio is even worse if the employee bears the employer’s NIC on the exercise of the option.

The Solution
The method described in this article is referred to as a stock or share appreciation right (or “SAR”) but other names are also used, including equity-settled incentives or “ESIs”. However, there are many types of SAR. This article does not consider cash-settled SARs (popularly known in the UK as phantom options). Nor does it specifically consider rights granted up-front as SARs without an option to acquire shares in the normal way. It only considers rights which have been granted up-front as options and which the company may choose at the time of exercise to be settled as a SAR.

SARs give the employee shares with a value equal to the profit in the option at the time of exercise. In the ideal case (although this may not be possible - see “UK Company Law” below), the optionholder pays no exercise price and so the shares are received free of any payment. Calculating the profit on a pre-tax basis, which is £200,000, only 66,666 shares would have to be issued to provide the employee with the same economic benefit - a 33 per cent saving compared with issuing 100,000 shares under the normal arrangements. With this arrangement, the employee is usually in exactly the same position as if he had exercised an option in the normal way; he would have to sell 27,333 shares in order to be able to settle his income tax and NICs liability, leaving him with 39,333 shares representing a net profit of £118,000. Going one stage further is to calculate the profit on a post-tax basis. In this case the company would pay relevant tax and NICs on behalf of the employee, and would only issue shares to the value of the post-tax profit (assuming a 41 per cent combined tax and NIC rate) of £118,000, meaning that only 39,333 shares would have to be issued. However, companies may not want to go this far as it would be a large cash cost for them to meet the tax and NICs out of their own resources.

The shares which the company has “saved” can then be used for making further awards or for purposes other than employee share schemes. Using fewer shares for employee share schemes means that a listed company uses up less of its headroom. Under Association of British Insurers (“ABI”)/National Association of Pension Funds (“NAPF”) guidelines, the number of newly issued shares which may be used in any ten-year period for employee share schemes is capped at 10 per cent of a company’s issued share capital (and 5 per cent for executive schemes for larger companies). Although the exact wording of scheme rules varies, dilution limits take into account only the number of shares issued or issuable, and are neutral as to price received or receivable by the company. So, a lower usage of shares means more shares can be issued without the company having to seek shareholder approval to increase the limits, use an employee trust to acquire shares on the market to satisfy awards or (worse still) stop making awards.

A number of issues do, however, need to be considered when settling options as SARs.

Scheme Rules
Many schemes will be drafted so as to require the optionholder to pay a specified exercise price in return for the issue of a specified number of shares. Is the removal of this requirement an impermissible amendment to the rules without prior optionholder and/or shareholder approval?

In most cases, depending on the specific scheme rules, companies will be unable to force optionholders to accept this form of option settlement, but optionholders (other than under Inland Revenue approved arrangements - see “Tax” below) are unlikely to have much reason to object. Nonetheless, optionholder consent should always be sought as a matter of course prior to settling options as SARs, as it could be to their detriment. For example, an optionholder may wish to pay the exercise price and/or tax and NICs himself and receive the larger number of shares that comes from a normal option arrangement as he may believe that those shares will rise in value or he might want to pay his subscription price out of his own resources and thereby retain a larger shareholding, and to deprive him of the opportunity would be prejudicial.

More problematic is whether the amendment to the scheme rules needs shareholder consent. Again, this depends upon the precise wording of the scheme rules. Most scheme rules now permit an amendment to be made provided that it is neither to shareholders’ disadvantage nor to the advantage of optionholders, although some are more restrictive. While SAR settlement is not directly to the advantage of the optionholder in relation to his option (as he is no better or worse off), it does enable more options to be granted to employees in the longer term (and possibly more shares to be issued, and so value given, to employees). A cautious view therefore is that this would need prior shareholder as well as optionholder approval, unless the company feels that its self-policing of the arrangements will lead to no actual shareholder disadvantage. On this note, it is interesting that P&O sought shareholder approval when it introduced SARs as an alternative method of settlement for its options in 2004. Another concern is that the company no longer raises any cash in the form of exercise price paid by the optionholder and so is considerably worse off in cash terms using SARs. Although companies do not generally use share option schemes as cash-raising exercises, it is a side benefit.

A further problem arises when interpreting the dilution limits, which include both issued and issuable shares. Once an option has been settled using a SAR, the number of shares issued is known. However, while an option remains unexercised, problems arise when considering the number of shares which will be issued if the company intends to settle the option using a SAR. Before settlement, the number of shares required to settle a SAR varies with the prevailing share price. Using the above example, if the share price at settlement were £4, a gain of £300,000 would require 75,000 shares; a share price of £1.50 would require 33,333 shares. Broadly, the higher the price, the more shares required to be issued. A company will therefore have to be careful in policing its scheme limits, as the number of shares issuable once under SARs in this way will vary day by day. Probably the only pragmatic view is to assume full issue under a normal option exercise until an option is settled using a SAR.

Tax
HM Revenue and Customs will not permit approved options (whether CSOP, SAYE or EMI) to be satisfied using SARs without the optionholder forfeiting his tax benefits and the company forfeiting any NIC savings. The stated reason for this is not so much an objection in principle as the view that relevant tax legislation requires full payment of exercise price. However, the corporation tax deduction for companies is the same whether a SAR or normal option exercise is used. The personal tax position is the same for ISOs and Section 423 ESPPs in the United States as for UK Revenue approved options - ie, use of SARs will result in loss of personal tax benefits. At one stage it appeared that SARs would be caught by the harsh tax deferral rules of the US Jobs Creation Act, but there is now a limited safe harbour for standard SARs. Whether the personal or corporate tax position would be affected in other overseas jurisdictions by the use of SARs will always have to be investigated carefully on a country-by-country basis. Problems can arise in some European jurisdictions (eg France and Italy).

Accounting
Under revised accounting rules introduced as IFRS 2 and FRS 20, the decision to satisfy an option using a SAR has no accounting impact. Equally, under revised accounting rules being introduced by the US from June 2005 the position is the same. Previously, a SAR could have negative UK and US accounting implications, as a SAR led to US variable accounting with mark-to-market requirements, and an expense was required to be shown in the UK, but in both countries option exercise had no P&L accounting impact.

UK Company Law
UK company law presents a number of obstacles, and a company’s articles of association also have to be reviewed carefully.

UK company law prevents companies issuing shares at less than their nominal value and requires that nominal value be paid up in money or money’s worth. However, provided a company’s articles of association so permit (and sufficient available reserves exist), it may be possible for an amount equal to the nominal value of the shares to be issued to be transferred from distributable reserves so as to enable the shares to be issued fully paid-up as to their nominal value. However, the articles of some PLCs permit reserves to be used in this way only where all shareholders are treated equally (although in such cases the articles could perhaps be amended - with shareholder approval), and not all companies have distributable reserves which can be used, particularly if they have never made a profit. A further relevant provision is that PLCs may not, other than in certain circumstances, issue shares for non-cash consideration without a prior auditor’s report and following certain other formalities; this could give rise to difficulty if SARs were to be used in return for the surrender of options. For this reason in particular, it is important that the ability of the company to settle potential option entitlements using SARs is established in such a way that the options are only exercisable if the company elects not to use SARs. Financial assistance provisions, which restrict a company’s ability to use its own funds in connection with the acquisition of its own shares, should not be an issue because of the employees’ share scheme exception.

Where reserves are unavailable or shares cannot be issued “free” for other reasons, it should be possible to issue shares on the basis that the optionholder subscribes their nominal value. This would still produce significant savings in terms of the number of shares issued, as the nominal value of a share is often extremely small compared to the market value. On the basis of the original example, assuming a nominal share value of 10p, 68,965 shares would have to be issued to give the optionholder a pre-tax gain of £200,000 (ie, £200,000 ¸ (£3 - 10p = £2.90)), leaving him with shares worth £200,000 after selling enough shares to pay the subscription price (although he would still have to sell shares to pay income tax and NICs). This is still a considerable saving compared with issuing 100,000 shares under normal option arrangements. A smaller number of shares could be issued if the company pays a bonus to meet the exercise price, and a smaller number still if the company meets tax and NICs out of its own resources but this may be too expensive for the company in cash terms.

Existing Shares
Of course, operating SARs using existing rather than new shares offers few problems, as those shares have already been issued and so there is no dilution saving. However, if an employee trust has to buy and transfer fewer shares, there will be associated commission and stamp duty savings. It may also be difficult to buy a large number of shares in the market to satisfy options; using SARs assists in this respect.

The Future and Action to be Taken
Many of the problems identified above in terms of seeking optionholder and shareholder approval can be removed if the relevant SAR terms are included in option plans when they are established. Consequently, there seems little reason not to insert these provisions in new plans as a matter of course and to include the relevant provisions in a company’s articles of association. Whether to amend existing plans (with or without shareholder approval), and/or make new grants under existing schemes on terms permitting settlement in SARs, or to amend existing articles of association, are more difficult decisions to make, but the savings can be considerable. Given the ten-year time-lag for operating the ABI 10 per cent limit, every share issued now will have an impact for 10 years, and so delay now may have consequences later on.

Moreover, in the longer term there may be further related changes.
· It may not be long before there arises a general trend to issue up-front SARs where there is no intention ever to issue the full number of shares under option arrangements.

· Finally, conventional wisdom has always been that, if a company wants to operate a free share scheme (using newly issued shares), it must set up an employee trust to subscribe for shares at nominal value using payments made by employing companies, and the trust then giving shares to employees. The route described in this article, which involves issuing free shares direct to employees, may bypass the use of the trust, thus saving trustee fees and leading to a simpler overall structure.