Employee share plans in the United States: regulatory overview

A Q&A guide to employee share plans law in the United States.

The Q&A gives a high level overview of the key practical issues including, whether share plans are common and can be offered by foreign parent companies, the structure and rules relating to the different types of share option plan, share purchase plan and phantom share plan, taxation, corporate governance guidelines, consultation duties, exchange control regulations, taxation of internationally mobile employees, prospectus requirements, and necessary regulatory consents and filings.

To compare answers across multiple jurisdictions, visit the Employee Share Plans: Country Q&A tool.

This Q&A is part of the global guide to employee share plans law. For a full list of jurisdictional Q&As visit www.practicallaw.com/employeeshareplans-guide.

Contents

Employee participation

1. Is it common for employees to be offered participation in an employee share plan?

It is common for employees in the US to be offered participation in an employee share plan. Share option grants are one of the more common methods of compensating employees.

 
2. Can employees be offered a share plan where the shares to be acquired are in a foreign parent company?

It is increasingly common for publicly traded multinational corporations to offer employee share plans to US employees. However, foreign issuers must consider US securities and tax laws (see Questions 29 and 30).

 

Share option plans

3. What types of share option plan are operated in your jurisdiction?

There are two basic types of US share options:

  • Incentive stock option (ISO). An ISO is a special type of stock option that meets the requirements of section 422 of the Internal Revenue Code (Code) and may receive preferential tax treatment.

  • Non-statutory stock option (NSO). An NSO is any stock option other than an ISO.

To qualify as an ISO, the following requirements must be met:

  • ISOs can only be granted to employees of the company (or any parent or subsidiary) (see Question 4, Incentive stock options: Discretionary/all-employee).

  • ISOs must be granted within ten years from the earlier of the date the plan is adopted or approved by shareholders.

  • ISOs cannot be exercisable for a period longer than ten years after the date of grant (or five years for ISOs granted to persons who own more than 10% of the voting power of the company (or any parent or subsidiary)).

  • ISOs must have an exercise price of no less than 100% of the fair market value (FMV) of the underlying stock on the grant date (or no less than 110% of the FMV for ISOs granted to persons who own more than 10% of the voting power of the company (or any parent or subsidiary)) (see Question 4, Incentive stock options: Market value).

  • ISOs must be granted pursuant to a written plan that:

    • sets forth the maximum number of shares that may be issued under the plan;

    • states the class of employees eligible to receive options;

    • is approved by a majority of the stockholders of the company within 12 months of its adoption by the board of directors.

Grant

4. What rules apply to the grant of employee share option plans?

Incentive stock options

Discretionary/all-employee. Incentive stock options (ISOs) can be granted on a discretionary basis only to employees of the company or its parents or subsidiaries on the grant date. The option must be exercised by the employee while employed or no later than three months after termination of employment (except in the case of disability, after which an ISO can be exercised for up to one year, or death, in which case an ISO can be exercised at any time until its expiration).

Non-employee participation. Non-employees cannot participate (see above, Discretionary/all-employee).

Maximum value of shares. The aggregate fair market value (FMV) of ISO stock (as measured on the grant date) that can be exercised for the first time in any calendar year cannot exceed US$100,000. To the extent this limitation is exceeded, the excess shares underlying the option are treated as non-statutory stock options (NSOs) (see below, Non-statutory stock options).

Market value. ISOs must have an exercise price of no less than 100% of the FMV of the underlying stock on the grant date (or no less than 110% of the FMV for ISOs granted to persons who own more than 10% of the voting power of the company (or any parent or subsidiary)) (see Question 3).

Non-statutory stock options

Discretionary/all-employee. NSOs can be granted on a discretionary basis to employees as well as independent contractors, non-employee directors, and others.

Non-employee participation. NSOs can be granted to non-employees (see above, Discretionary/all-employee).

Maximum value of shares. NSOs are not subject to any value or per share limitation.

Market value. The exercise price must be at least equal to the FMV of the underlying shares on the grant date to avoid having the NSO treated as a discount option subject to Code section 409A and suffering related adverse tax consequences (see Question 7, Incentive stock options and non-statutory stock options: Code section 409A).

 
5. What are the tax/social security implications of the grant of the option?

Incentive stock options and non-statutory stock options

There is no income or employment tax due on the grant of an incentive stock option or non-statutory stock option.

Vesting

6. Can the company specify that the options are only exercisable if certain performance- or time-based vesting conditions are met?

Incentive stock options and non-statutory stock options

The company can make the vesting of incentive stock options and non-statutory stock options subject to performance- or time-based vesting conditions.

 
7. What are the tax/social security implications when the performance- or time-based vesting conditions are met?

Incentive stock options and non-statutory stock options

Generally, there is no income tax due on vesting of an incentive stock option (ISO) or non-statutory stock option (NSO), with two exceptions:

  • Early exercise options. Tax is payable if an option has an early exercise feature, and the option is exercised early without making a Code section 83(b) election. In this case, the option holder will have an alternative minimum tax (AMT) adjustment (for ISOs) or will recognise ordinary income (for NSOs) on each future vesting date equal to the difference between the fair market value (FMV) of the shares that vest on each vesting date and the exercise price.

  • Code section 409A. Code section 409A applies if an option is granted with an exercise price less than the FMV of the underlying stock on the grant date (discount option). Code section 409A provides that an option holder with a discount option would generally result in early income recognition in the year the option vests (regardless of whether the option is exercised) equal to the difference between the FMV on 31 December of each year of the underlying shares that vest and the exercise price. In addition to paying the ordinary income tax on this spread amount, the employee would also likely be subject to an additional 20% penalty tax, plus possible late payment penalties and interest charges. Further, it is likely that during each subsequent tax year (until the discount option is exercised or terminates), any increase in the value of the underlying shares will be taxed as well. Finally, California (if the employee is a California taxpayer) also imposes a 5% state tax on the spread, plus possible late payment penalties and interest charges.

Exercise

8. What are the tax/social security implications of the exercise of the option?

Incentive stock options

There is no regular federal income tax due on exercise of an incentive stock option (ISO). However, the exercise of an ISO may subject the option holder to alternative minimum tax (AMT). In calculating AMT income, shares purchased on exercise of an ISO are treated as if they had been acquired by the option holder pursuant to a non-statutory stock option (NSO) (that is, the spread on exercise is an AMT adjustment item that is added to the option holder's AMT income for the year).

Non-statutory stock options

On exercise of an NSO, the option holder will recognise ordinary income equal to the difference between the fair market value (FMV) of the shares on the exercise date and the exercise price. If the option holder is an employee or former employee, the company must withhold applicable income and employment taxes.

Sale

9. What are the tax and social security implications when shares acquired on exercise of the option are sold?

Incentive stock options

Regular exercise. If the shares are held for more than one year after the incentive stock option (ISO) exercise date and more than two years after the ISO grant date, any gain or loss on a sale or other disposition will be long-term capital gain or loss. An earlier sale or other disposition (disqualifying disposition) will disqualify the ISO and result in ordinary income tax on the excess, if any, of the fair market value (FMV) of the shares on the date of exercise (or, if less, the amount realised on the sale of the shares) over the exercise price. Any further gain or loss will be taxed as short-term or long-term capital gain or loss, as the case may be. To the extent that the employee realises ordinary income in connection with a disqualifying disposition, the company may generally take a corresponding tax deduction.

Early exercise. As with a regular exercise of an ISO, if both of the above ISO holding periods are met, any gain or loss on a sale of the shares will be long-term capital gain or loss. However, if shares are acquired on the early exercise of an ISO and disposed of in a disqualifying disposition, generally the option holder will recognise ordinary income in the year of disposition in an amount equal to the excess (if any) of the FMV of the shares at vesting (or, if less, the amount realised on the sale of the shares) over the exercise price. In the event of an early exercise, followed by a disqualifying disposition, the 12-month clock for long-term capital gain treatment begins on the vesting date, as opposed to the date of early exercise. Since the vesting date is later than the date of early exercise, there is an increased likelihood that any capital gain on a disqualifying disposition will be short-term capital gain and taxed as ordinary income.

Non-statutory stock options

The subsequent sale of the shares underlying a non-statutory stock option will be treated as capital gain or loss and will be long-term or short-term depending on whether the shares are held for more than one year.

 

Share acquisition or purchase plans

10. What types of share acquisition or purchase plan are operated in your jurisdiction?

Share acquisition or purchase plans operated in the US can be structured a few different ways. The most common are the following:

  • Employee share purchase plans. An employee share purchase plan (ESPP) allows employees to purchase shares through payroll deductions at a discount over an "offering period" of up to 27 months. A longer offering period gives a greater potential opportunity for employees to purchase shares at a significant discount to the then fair market value (FMV). However, the longer the offering period, the higher the accounting compensation expense that the company must record from the ESPP. Some companies choose to have 24-month offering periods, divided into four six-month purchase periods, which allows employees to receive the benefit of a long offering period, but enables them to purchase shares as frequently as they would be able to with a short offering period. Other companies use instead a six-month offering period to minimise the financial accounting compensation expense. Companies usually set up ESPPs as tax-qualified "section 423" plans, but the ESPP can also be a non-qualified plan. ESPPs (particularly section 423 plans) are fairly common for public companies.

  • Restricted share plans. Restricted shares are shares of company common stock that are issued for no consideration or sold at a specified price to a recipient, but that vest in accordance with terms and conditions that the board of directors establishes at its discretion. Generally, restricted shares cannot be transferred and will be held by the company until all restrictions have lapsed (that is, the shares vest). On vesting, the recipient benefits by assuming full ownership of the shares. On termination of employment, the unvested shares will either be automatically forfeited or subject to a company repurchase option at the original purchase price paid by the recipient. Recipients holding restricted shares can usually exercise full voting rights with respect to the shares subject to the award and are entitled to receive all dividends and other distributions paid with respect to such shares.

Acquisition or purchase

11. What rules apply to the initial acquisition or purchase of shares?

Employee share purchase plans

Discretionary/all-employee. If the employee share purchase plan (ESPP) is a section 423 plan, it can only be offered to employees of the company (consultants and independent contractors do not qualify) and equal rights must be granted unconditionally to all participants. However, employees who own more than 5% of the voting stock of the company cannot participate in the ESPP.

Non-employee participation. If the ESPP is a section 423 plan, non-employees cannot participate. If the ESPP is a non-qualified plan, non-employees can participate.

Maximum value of shares. If the ESPP is a section 423 plan, no employee can purchase more than US$25,000 worth of stock in a calendar year. If the ESPP is a non-qualified plan, there is no similar value limit.

Payment for shares and price. The shares are generally paid for through after-tax payroll deductions and the price is typically set at 85% of the lower of the fair market value (FMV) of a share of the company's stock on either:

  • The first trading day of the offering period.

  • The purchase date.

Restricted share plan

Discretionary/all-employee. A plan can grant restricted shares on a discretionary basis and they do not have to be offered to all employees on the same terms.

Non-employee participation. A plan can grant restricted shares to non-employees.

Maximum value of shares. There is no legally mandated maximum value of shares that can be awarded under the plan.

Payment for shares and price. The plan can designate how the shares will be purchased and at what price, or alternatively, the plan can provide for the shares to be issued for services rendered without a purchase price.

 
12. What are the tax/social security implications of the acquisition or purchase of shares?

Employee share purchase plans

No tax or social security obligations arise on purchase of shares in a tax-qualified employee share purchase plan (ESPP).

For non-qualified ESPPs, the tax treatment is similar to non-statutory stock options, that is, the participant will recognise ordinary income on purchase of the shares equal to the difference between the fair market value (FMV) of the shares on the purchase date and the amount paid. If the participant is an employee or former employee, the company must withhold applicable income and employment taxes.

Restricted share plans

If any portion of the shares are vested at grant, then the recipient must include in income (and will be taxed on) the difference between the amount, if any, paid for the stock and its FMV on the grant date. The recipient can file an election under section 83(b) of the Code with the Internal Revenue Service and accelerate the measurement and payment of tax, if any, and the commencement of the capital gains holding period to the date on which the stock is received. If an 83(b) election is filed, the amount of income recognised will equal the difference between the amount, if any, paid for the stock and its FMV on the date of receipt.

Vesting

13. Can the company award the shares subject to restrictions that are only removed when performance or time-based vesting conditions are met?

Employee share purchase plans

The company can subject shares issued under an employee share purchase plan to vesting conditions, but this is uncommon.

Restricted share plans

Restricted share plans usually subject shares to either performance- or time-based vesting restrictions.

 
14. What are the tax and social security implications when the performance or time-based vesting conditions are met?

Employee share purchase plans

Not applicable (see Question 13, Employee share purchase plans).

Restricted share plans

On each vesting date (including any portion that is vested on grant), the recipient must include in income (and will be taxed on) the difference between the amount, if any, paid for the stock and its fair market value (FMV) on the date of vesting. Alternatively, the recipient can file an 83(b) election with the Internal Revenue Service and recognise ordinary income equal to the full FMV of the shares received upfront and thereby start his or her capital gains holding period.

Sale

15. What are the tax and social security implications when the shares are sold?

Employee share purchase plans

If the employee share purchase plan (ESPP) is a section 423 plan, the federal income tax liability will depend on whether the employee makes a qualifying or disqualifying disposition of his or her shares. A qualifying disposition is a sale or other disposition of shares that is both:

  • More than two years after the start of the particular offering period in which such shares were acquired.

  • More than one year after the actual purchase date (generally at the end of an offering period).

If the employee makes a qualifying disposition, he or she will recognise ordinary income in the year of the disposition equal to the lesser of either:

  • The amount by which the fair market value (FMV) of the shares on the date of the qualifying disposition exceeds the purchase price.

  • 15% of the FMV of the shares on the first day of the offering period in which those shares were acquired.

This amount of ordinary income will be added to the employee's basis in the shares and any additional gain recognised on the qualifying disposition will be long-term capital gain. If the FMV of the shares on the date of the qualifying disposition is less than the purchase price, there will be no ordinary income and any loss recognised will be a long-term capital loss.

A disqualifying disposition is any sale or other disposition that is made prior to the satisfaction of either of these minimum holding-period requirements. If the employee makes a disqualifying disposition, he or she will generally recognise ordinary income in the year of the disposition equal to the FMV of the purchased shares on the purchase date minus the purchase price. The amount of the ordinary income will be added to the employee's basis in the shares, and any resulting gain or loss recognised on the disposition will be a capital gain or loss. If the shares have been held for more than one year since the date of purchase, the gain or loss will be long term.

With non-qualified ESPPs, the employees do not receive the favourable tax treatment that comes from meeting the holding-period requirements of a section 423 plan. Instead, the federal income tax implications resemble that of the sale of non-statutory stock option (NSO) shares (see Question 9, Non-statutory stock options).

Restricted share plans

The subsequent sale or disposition of the shares will be treated as capital gain or loss and will be short- or long-term depending on whether the shares are held for more than one year. The holding period begins on the date of receipt of the shares if an 83(b) election is filed or on each vesting date if no 83(b) election is filed.

 

Phantom or cash-settled share plans

16. What types of phantom or cash-settled share plan are operated in your jurisdiction?

Restricted share unit plans

Restricted share unit (RSU) plans provide an opportunity for participants to receive company shares or the cash equivalent in the future. RSU plans are popular with both public and private companies for many reasons, including:

  • No required investment for participants.

  • No dilution of share ownership for the company.

  • Relative ease to implement and administer.

Share appreciation rights plans

Share appreciation rights (SARs) plans provide an opportunity for participants to benefit from increases in share price over a fixed exercise price without actually buying any shares. While public and private companies may offer SARs, SARs are generally less popular than other types of equity awards.

Grant

17. What rules apply to the grant of phantom or cash-settled awards?

Restricted share unit plans and share appreciation rights plans

Discretionary/all-employee. Restricted share units (RSUs) and share appreciation rights (SARs) can be granted on a discretionary basis.

Non-employee participation. RSUs and SARs can be offered to non-employee directors and consultants.

Maximum value of awards. There is no maximum award value that can be granted under an RSU plan or SAR plan.

 
18. What are the tax/social security implications when the award is made?

Restricted share unit plans

There are generally no tax/social security implications if the restricted share unit (RSU) has vesting conditions or is otherwise subject to a substantial risk of forfeiture.

Share appreciation rights plans

The same rules apply as for RSUs (see above, Restricted share unit plans). If a share appreciation right has an exercise price less than the fair market value on the grant date, it is taxable when it is no longer subject to a substantial risk of forfeiture and incurs an additional 20% tax unless otherwise exempt from or in compliance with Internal Revenue Code section 409A.

Vesting

19. Can phantom or cash-settled awards be made to vest only where performance or time-based vesting conditions are met?

Restricted share unit plans and share appreciation rights plans

Restricted share units and share appreciation rights can be structured to vest on satisfaction of performance and/or time-based vesting conditions.

 
20. What are the tax/social security implications when performance- or time-based vesting conditions are met?

Restricted share unit plans

On vesting, if the restricted share units (RSUs) are settled (in cash or shares), that value is recognised and taxed as ordinary income. The employer will generally receive an income tax deduction for the year in which the RSU-holder recognises income.

If settlement of the RSUs is deferred after the vesting date, no income tax is generally due on vesting. However, in all cases, employers and employees are subject to employment tax withholding (including social security and medicare) and employers are subject to Federal Unemployment Tax Act (FUTA) withholding on vesting (a federal employer tax used to fund state workforce agencies).

Share appreciation rights plans

Share appreciation rights (SARs) are generally taxed only on exercise. Unless exercised, vesting of an SAR does not generally result in taxation. Similar to RSUs, the employer will generally receive a compensation deduction for the year in which the grantee recognises income.

Payment

21. What are the tax and social security implications when the phantom or cash-settled award is paid out?

Restricted share unit plans

The value of the cash or share settlement is taxed as ordinary income. If settlement is not deferred on vesting, employers and employees are also subject to employment tax withholding (including social security and medicare) and employers are subject to Federal Unemployment Tax Act (FUTA) withholding (see Question 20, Restricted share unit plans). The employer will generally receive an income tax deduction for the year in which the grantee recognises income.

Share appreciation rights plans

On exercise, any amount paid or value received is taxed as ordinary income. For grants to employees, employers and employees are also subject to employment tax withholding (including social security and medicare) and employers are subject to FUTA withholding. The employer will generally receive an income tax deduction for the year in which the grantee recognises income.

 

Corporate governance guidelines, market or other guidelines

22. Are there any corporate governance guidelines, market rules or other guidelines that apply to any of the above plans?

Companies listed on a US securities exchange are subject to all applicable listing rules and regulations. Equity compensation plans which govern the issuance of restricted share units (RSU) and share appreciation rights (SAR) must be approved by shareholders under the NYSE and NASDAQ rules. Additionally, companies may have internal rules that govern the grant of an RSU or SAR, such as annual limits or plan budgets. Finally, firms offering shareholder advisory services (for example, ISS and Glass Lewis) and certain other groups usually have proxy voting guidelines which they employ when public companies propose a new equity plan or an amendment to an existing equity plan.

 

Employment law

23. Is consultation or agreement with, or notification to, employee representative bodies required before an employee share plan can be launched?

It is necessary to consult with and notify employee representatives before launching an employee share plan for those employees whose employment is subject to a collective bargaining agreement. At a practical level, it is reasonable to expect that the representatives would agree to the extension of coverage under the plan to such employees.

 
24. Do participants in employee share plans have rights to compensation for loss of options or awards on termination of employment?

Participants have no statutory rights to compensation for loss of awards on termination of employment, and have only such rights as are bestowed pursuant to the governing plan document or applicable share award agreement.

 

Exchange control

25. How do exchange control regulations affect employees sending money from your jurisdiction to another to purchase shares under an employee share plan?

The US does not generally impose exchange control restrictions relating to the transfer of money to enable or facilitate purchase or shares under an employee share plan.

 
26. Do exchange control regulations permit or require employees to repatriate proceeds derived from selling shares in another jurisdiction?

US law does not prohibit or require employees to repatriate proceeds derived from selling shares in another jurisdiction.

 

Internationally mobile employees

27. What is the tax position when an employee who is tax resident in your jurisdiction at the time of grant of a share option or award leaves your jurisdiction before any taxable event affecting the option or award takes place?

The tax position of an employee will depend on the employee's continuing tax status after he or she departs the US, and also on the period of service over which the option or award became vested.

An employee who is a US citizen will remain subject to US tax on his or her worldwide income at all times without regard to whether the income is considered to be from US or non-US sources. Therefore, the employee will be subject to US taxation on share options and awards without regard to the employee's location at the time of the taxable event.

Employees who are residents of the US (either because they meet the "substantial presence" residency test or are US permanent resident "green card" holders) are subject to taxation in the same manner as US citizens. If an employee retains his or her green card status after leaving the US, the departure should have no effect on the employee's tax position.

If the employee is a US resident based on "substantial presence" in the US and then ceases to be a resident, the tax position following departure from the US generally will be determined based on the employee's tax status during the applicable vesting period. In particular, an employee who is a non-resident alien for US tax purposes at the time of the taxable event will be subject to US tax on the portion of the gain on exercise of the share option or vesting of the share award that is treated as "US source" income. US tax regulations will treat as US source income a percentage of the gain based on the amount of time the employee spent working in the US between the date of grant and the date of vesting of the option or award.

 
28. What is the tax position when an employee becomes tax resident in your jurisdiction while holding share options or awards granted abroad and a taxable event occurs?

The tax position of the inbound employee is analysed under the general US tax rules in a similar way to the outbound employee (see Question 27). If the employee has come to the US and is a US citizen or US tax resident, the employee will be subject to US tax on the gain from the share options and awards without regard to when the options were granted or when the vesting period occurred.

In addition, for employees who come to the US but remain non-resident aliens for US tax purposes, on a taxable event the employee will be taxed based for the portion share option or award gain that is attributable to US source income.

For employees subject to US tax, it is important to confirm whether an option grant satisfies the requirements for exemption from section 409A of the US Internal Revenue Code. Failure to satisfy the requirements can result in accelerated US income taxation and penalties for the employees.

 

Securities laws

29. What are the requirements under securities laws or regulations for the offer of and participation in an employee share plan?

The main US securities laws applicable to an employee share plan are the following:

  • Securities Exchange Act of 1933 (Securities Act).

  • Securities Exchange Act of 1934 (Exchange Act).

  • "Blue sky" state securities laws.

Securities Act

Public companies. The Securities Act generally requires that US public companies register shares offered under an employee share plan. Typically, US public companies will register their shares by filing a Securities Exchange Commission (SEC) Form S-8, which is a short-form registration statement that can be filed electronically and is effective immediately. A Form S-8 is filed if a company adopts a new employee share plan and/or whenever additional shares are reserved for future issuance under the employee share plan.

One of the main components of a Form S-8 is a prospectus that must be delivered promptly to all participants in the employee share plan, but need not be filed with the SEC. The prospectus is a summary of the main terms of the employee share plan along with a summary of the various tax consequences (typically in an easy to read Q&A format) that allows participants to make an informed investment decision as to their equity award granted under the employee share plan.

Private companies. Private companies often rely on Rule 701 of the Securities Act (Rule 701) as an exemption from the requirement to register their securities with the SEC. There are also exemptions under Regulation D and Regulation S that both public and private companies may rely on to avoid registration with the SEC (see Question 30).

Exchange Act

Under the Exchange Act, generally only public companies whose stock is listed on a national US stock exchange (for example, NYSE or Nasdaq) are required to register their stock and file regular periodic reports with the SEC.

The Exchange Act contains ongoing public reporting requirements, such as:

  • Quarterly reports on a Form 10-Q.

  • Annual reports on a Form 10-K.

  • Current reports on a Form 8-K to report certain material events.

  • Proxy statements relating to a company's annual shareholder meeting.

Blue sky state securities laws

Similar to federal securities law, each state also has a requirement that shares offered under an employee share plan must either be registered or qualify for exemption from registration. However, public companies that are listed on a national US stock exchange are not subject to blue sky state securities laws (National Securities Markets Improvement Act of 1996 (NSMIA)).

Private companies, on the other hand, must register their shares with the applicable state in which an equity grant is made or find an exemption from registration. The most common exemptions from registration are:

  • Self-executing Rule 701 exemption: if the grant of the equity award qualifies for exemption under Rule 701, then it will also automatically qualify for exemption under that state's securities laws and no filing is required.

  • Equity grants made to a current service provider pursuant to a compensatory benefit plan, such as an employee share plan.

To claim an exemption from state registration, a limited number of states require a notice filing with the state along with the payment of a small fee.

Certain other states impose additional requirements, such as limitations on the number of recipients of equity awards or specific plan terms. For example, to claim an exemption from registration in California, an employee share plan must contain certain specific plan terms, most of which largely mirror the incentive stock option (ISO) regulations, but also include requirements regarding proportionate adjustments for certain specific corporate transactions and minimum post-termination exercise periods for options.

 
30. Are there any exemptions from securities laws or regulations for employee share plans? If so, what are the conditions for the exemption(s) to apply?

To avoid registration, private companies must rely on a securities exemption. The securities exemptions for employee share plans fall into one of the following categories:

  • Rule 701.

  • Section 4(a)(2).

  • Regulation D.

  • Regulation S.

  • Blue sky state securities exemptions.

Rule 701

Rule 701 is the main exemption from registration under the Securities Act for private companies. Equity awards granted under an employee share plan to employees, directors, consultants and other service providers for compensatory purposes are eligible for the Rule 701 exemption from registration. Rule 701 is only available for grants to service providers who are natural personals and not legal entities.

Overview. The number of securities a private company can sell under the Rule 701 exemption from registration is subject to two limitations:

  • Hard cap limit. The aggregate sales price or amount of securities that can be sold in reliance on Rule 701 during any consecutive 12-month period must not exceed the greatest of the following:

    • US$1 million;

    • 15% of the company's total assets (measured as of the company's most recent balance sheet date); or

    • 15% of the outstanding amount of the class of securities being offered and sold in reliance on Rule 701 (measured as of the company's most recent balance sheet date).

    The aggregate sale price is determined on the grant date of the option and valued based on the exercise price. Therefore, the entire value of the option (number of shares multiplied by the exercise price) is included as of the grant date for purposes of this calculation.

  • Soft cap limit. The company must provide certain detailed disclosure (see below) to each recipient if the aggregate sales price or amount of securities sold during any consecutive 12-month period in reliance on Rule 701 exceeds US$5 million. Again, the "sale" of an option is deemed to occur on the grant date of the option, and the option is valued based on its exercise price.

Information disclosures under Rule 701 soft cap limit. A company granting options in excess of the soft cap limit can rely on Rule 701 only if certain disclosures are made to all individuals who received securities in reliance on Rule 701. The required disclosures consist of:

  • A copy of the stock plan and award agreement.

  • A Q&A prospectus, including a summary of the material terms of the stock plan and a summary of risk factors associated with investing in the company's securities.

  • A copy of the company's balance sheet not more than 180 days old and statements of income, cash flows and other stockholders' equity for each of the two fiscal years preceding the date of the balance sheet and for any interim period between the end of the most recent fiscal year and the date of the balance sheet. Because financial statements must be no more than 180 days old, the financial disclosure should be updated on a quarterly basis.

The SEC has stated that companies must provide these disclosures to all individuals receiving equity awards if the company believes that it will exceed the US$5 million limit during any coming 12-month period.

The penalties for non-compliance with Rule 701 could result in rescission rights for each of the participants, which would require the company to offer to repurchase shares and unexercised options plus interest, which can be extremely costly for the company as it would require compliance with each applicable state's rescission laws. In addition, non-compliance with Rule 701 can deter potential investors and/or delay an IPO due to negotiations with the SEC over Rule 701 compliance. Many state blue sky laws also require compliance with Rule 701 so a violation could result in non-compliance with state securities laws as well.

Rule 701 strategy. To reduce the pressure on the Rule 701 limits, the following strategies can be taken:

  • Consider adopting a fixed 12-month period (for example, the calendar year or fiscal year) as opposed to a rolling 12-month period.

  • Identify grants to accredited investors and move such grants to another securities exemption (such as Regulation D (see below, Regulation D).

  • Do not count options that are cancelled or forfeited.

  • To the extent options will be granted to persons outside of the US, consider Regulation S safe harbour (see below, Regulation S).

Section 4(a)(2) private placement exemption

Section 4(a)(2) of the Securities Act exempts from registration "transactions by an issuer not involving any public offering". This is the most commonly used exemption for grants to entities and other non-Rule 701 issuances. To qualify for this exemption, the recipient must:

  • Either have enough knowledge and experience in finance and business matters to be "sophisticated investors" (for example able to evaluate the risks and merits of the investment), or be able to bear the investment's economic risk.

  • Have access to the type of information normally provided in a prospectus for a registered securities offering.

  • Agree not to resell or distribute the securities to the public.

This exemption is intended to be used for a limited number of one-off grants although there is no bright line rule. The advantage of this exemption is that no Form D is required to be filed with the Securities Exchange Commission (SEC) and individual states. However, if a company offers securities to even one person who does not meet the requirements for this exemption, the entire offering may be in violation of the Securities Act. Therefore, some companies may prefer to rely on the objective standards provided under Regulation D (see below).

Regulation D

Regulation D of the Securities Act offers three different exemptions from the registration requirements under Rules 504, 505 and 506, each of which contain a general prohibition on solicitation or advertising to market the securities (except for Rule 506(c) discussed below). The only filing requirement under each of these exemptions is the requirement to file a notice on Form D with the SEC. The notice must be filed within 15 days after the first sale of securities in the offering. Many blue sky state securities laws also require the filing of a Form D notice in a Regulation D offering. The three exemptions are as follows:

  • Rule 504 seed capital exemption. Rule 504 provides an exemption for private companies for the offer and sale of up to US$1 million of securities in a 12-month period to an unlimited number of recipients.

  • Rule 505. Rule 505 provides an exemption for the offer and sale of up to US$5 million of securities in a 12-month period to an unlimited number of "accredited investors" and up to 35 persons who are not accredited investors. Recipients must be granted the equity awards for investment purposes only, and not for the purpose of reselling the securities. Under Rule 505, if there are non-accredited investors, these recipients must receive a disclosure document that largely contains the same detailed financial statements, risk factors and other information included in a registration statement with the SEC. For these reasons, companies typically will only rely on a Rule 505 exemption with respect to accredited investors.

  • Rule 506. Rule 506 provides two different ways of issuing securities that are exempt from registration:

    • Rule 506(b). Rule 506(b) is a "safe harbour" for the non-public offering exemption in section 4(a)(2) of the Securities Act, which means it provides specific requirements that, if followed, establish that a securities issuance falls within the section 4(a)(2) exemption. Rule 506 does not limit the amount of money a company can raise or the number of accredited investors it can sell securities to; however to qualify for the safe harbour, a company is subject to the same disclosure requirements and restrictions as to the 35 non-accredited investors limit under Rule 505, except unlike Rule 505, all non-accredited investors must be "sophisticated investors";

    • Rule 506(c), which was added in 2013 to implement a statutory mandate under the JOBS Act. Rule 506(c) was enacted as part of the JOBS Act to eliminate the prohibition on using general solicitation or advertising under Rule 506 provided that all purchasers of the securities are accredited investors and the company takes reasonable steps to verify that the purchasers are accredited investors.

The common categories of "accredited investors" include:

  • A director or executive officer of the company selling the securities.

  • An individual with a net worth of at least US$1 million, excluding the value of his or her primary residence.

  • An individual with income exceeding US$200,000 in each of the two most recent calendar years or joint income with a spouse exceeding US$300,000 for those years and a reasonable expectation of the same income level in the current year. 

Regulation S

Regulation S of the Securities Act provides an exemption for certain grants made outside of the US to non-US recipients, provided that certain resale restrictions and holding periods are satisfied.

Blue sky state securities laws

Public companies that are listed on a national US stock exchange are not subject to blue sky state securities laws (see Question 29, Blue sky state securities laws). Most private companies will rely on either a self-executing Rule 701 exemption or the more general exemption for grants to service providers pursuant to a compensatory benefit plan. When granting equity awards, it is important to note the state in which the recipient resides to determine whether there may be a notice filing requirement and/or other specific employee share plan requirements. Notable states in which a notice filing may be required are California, Delaware, District of Columbia, Maryland, Minnesota, New York, Oregon, Tennessee and Wyoming.

 

Other regulatory consents or filings

31. Are there any other regulatory consents and filing requirements and/or other administrative obligations for an offer of and participation in an employee share plan?

Section 16 reporting

Section 16 of the Exchange Act imposes reporting requirements and trading restrictions on certain persons who are considered "insiders" (that is, directors, officers and 10% owners) of public companies. Specifically, section 16 requires insiders to:

  • File public reports with the Securities Exchange Commission under section 16(a) of transactions and holdings involving the company's equity securities, that is, Forms 3, 4 and 5.

  • Disgorge to the company under section 16(b) any profits realised on "short-swing transactions" (that is, any purchase and sale, or sale and purchase, of the company's equity securities within a period of less than six months).

  • Refrain under section 16(c) from engaging in short sales of the company's equity securities.

NYSE and Nasdaq rules

Subject to certain limited exceptions, NYSE and Nasdaq stock exchange rules require that shareholders approve employee share plans when they are first adopted and/or materially amended.

 
32. Are there any data protection requirements or obligations for an offer of and participation in an employee share plan?

Administrators of employee share plans must comply with the company's privacy and document retention policy as well as data privacy laws for each state or jurisdiction in which the recipient resides. Many states have privacy laws protecting an individual's social security number and other personal data and foreign countries generally have more stringent data privacy laws. As a result, award agreements generally should not require a participant to disclose his or her social security number and it is best practice to include a data privacy provision in the award agreement that authorises the use and disclosure of a participant's data for purposes of administering the award.

 

Formalities

33. What are the applicable legal formalities?

Translation requirements. It is customary for all plan documents to be translated into English and it is best practice for the award agreement to include a statement that the English version will be the authoritative version in the event of any discrepancy.

E-mail or online agreements. To deliver or accept documents electronically, a participant must be able to access documents electronically and consent to electronic delivery/acceptance. Participants also have a right to sign a paper copy and/or receive a paper copy of any such document free of charge.

Witnesses/notarisation requirements. Most employee share plans do not need a witness or to be notarised in order to be binding under US law. However, certain foreign countries may have witness or notary requirements as a condition to making an award agreement a legally binding contract.

Employee consent. Certain states require consent to deduct amounts from wages or salary for the purchase of shares or to satisfy tax withholding obligations. It is best practice to include in the enrolment form or award agreement a consent to deduct such amounts from wages or salary, although an additional consent may be required at the time such amounts are deducted from current wages.

 

Developments and reform

34. Are there any current trends, developments and reform proposals that have or will affect the operation of employee share plans?

The Dodd-Frank Act of 2010 (Dodd-Frank) ordered that the Securities Exchange Commission (SEC) issue new rules relating to US public companies' compensation arrangements and related proxy disclosures.

The following rules have been discussed:

  • Pay ratio rules. The SEC recently adopted its final rules, which are related to the pay-for-performance rules proposed in 2015 (see below). Commencing in early 2018, public companies will have to disclose the ratio of 'their CEO's total compensation to their median employee's compensation. Because of the delayed effective date of these rules, they have not sparked any emerging trends. Given the political pressure surrounding these rules and the 'delayed effective date, it is uncertain whether litigation or legislative responses will successfully challenge the enforcement of the new rules.

  • Compensation clawbacks. The SEC proposed new rules this year relating to compensation clawbacks. The Sarbanes-Oxley Act of 2002 (SOX) initially codified policies for corporate clawbacks, but the Dodd-Frank rules greatly expand those policies. In short, every public company will have to adopt, maintain, and disclose its policy for the recovery of incentive compensation from any current or former executive officer in the event of certain financial restatements. Even without the proposed rules, in the last few years, there has been a noticeable trend to adopt more expansive clawback policies. This trend was largely driven by proxy advisory firms demanding more rigorous clawbacks. It is unlikely that there will be a long delay between the proposed and final rules and, therefore, final rules could appear for the 2016 proxy season.

  • Hedging rules. These were proposed in 2015. They would basically require companies to disclose in their proxy whether any employee or director can hedge ownership of the company's equity securities. The proposed enhanced disclosure has not caused any developing trends, because most companies already have hedging policies in place. It is expected that these rules might be finalised as early as autumn 2015.

  • Pay-for-performance rules. These were proposed in 2015. They would require public companies to disclose the relationship between the compensation actually paid to certain executives and the company's financial performance, as measured by total shareholder return. There has been an increasing trend towards linking pay to performance since Dodd-Frank was enacted. Similar to the pay ratio rules, these rules only passed with a 3-2 vote, and they are subject to many of the same objections as the Pay Ratio Rules. Therefore, the timing for adopting the final rules is also uncertain.

 

Online resources

Internal Revenue Code

W www.law.cornell.edu/uscode/text/26

Description. This website provides the complete text of the Internal Revenue Code. It is maintained by Cornell University Law School. It is up to date as of August 2013.

Internal Revenue Service

W www.irs.gov/Tax-Professionals/Tax-Code,-Regulations-and-Official-Guidance#irc

Description. This website provides a variety of links to various tax code information. It is maintained by the Internal Revenue Service.

Securities Exchange Commission (SEC)

W www.sec.gov/about/laws.shtml

Description. This website provides a variety of links to various laws that govern the securities industry.



Contributor profiles

Mitchel Pahl, Senior Counsel

Orrick, Herrington & Sutcliffe LLP

T +1 212 506 5023
E mpahl@orrick.com
W www.orrick.com

Professional qualifications. New York, US, Bar Admission

Areas of practice. Executive compensation; employee benefits; tax and securities laws.

Publications

  • IRS Pulls Determination Letter Program, Puts Premium on Plan Assessments by Sponsors.

  • Missed Deferrals – New 401(k) Correction Procedures.

  • Deferred Compensation Client Alert: High Tax Rates Spur the Allure of Deferred Compensation.

Jeremy Erickson, Senior Associate

Orrick, Herrington & Sutcliffe LLP

T +1 415 773 5862
E jerickson@orrick.com
W www.orrick.com

Professional qualifications. California, US, Bar Admission

Areas of practice. Executive compensation; employee benefits; tax and securities laws.

Publications

  • SEC Pay Ratio Rules: A Recipe for Compliance and Model Disclosure.

  • Pay For Performance Table and Best Proxy Disclosure.

  • Institutional Shareholder Voting Guidelines.

  • Deferred Compensation Client Alert:High Tax Rates Spur the Allure of Deferred Compensation.

Michael Yang, Senior Associate

Orrick, Herrington & Sutcliffe LLP

T +1 650 614 7472
E myang@orrick.com
W www.orrick.com

Professional qualifications. California, US, Bar Admission

Areas of practice. Executive compensation; employee benefits; tax and securities laws.

Publications

  • Institutional Shareholder Voting Guidelines.
  • 2015 Annual ISO and ESPP Information Reporting Requirements.
  • Annual ISO and ESPP Information Reporting Requirements.

Keith Tidwell, Associate

Orrick, Herrington & Sutcliffe LLP

T +1 415 773 5592
E ktidwell@orrick.com
W www.orrick.com

Professional qualifications. California, US, Bar Admission; Kentucky, US, Bar Admission

Areas of practice. Executive compensation; employee benefits; tax and securities laws.

Publications

  • SEC Pay Ratio Rules: A Recipe for Compliance and Model Disclosure.
  • A Plain English Guide to the SEC's Compensation Clawback Rules.

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