What are Stock Appreciation Rights?
Stock appreciation rights (“SARs”) are a form of incentive or deferred compensation tied to the employing company’s stock performance.[1]According to the glossary aggregated by Nasdaq,[2] under a SAR, the employee gets the increase in the stock price from the date of the grant to the date of exercise. However, a SAR does not have any dilutive effect on the share capital of the issuing company.
A SAR has been defined under the Securities and Exchange Board of India (Share Based Employee Benefits and Sweat Equity) Regulations, 2021 to mean “a right given to a SAR grantee entitling him to receive appreciation for a specified number of shares of the company where the settlement of such appreciation may be made by way of cash payment or shares of the company.”[3]
In the general parlance, SARs are rights provided to an individual which are associated with the valuation of the issuing company. For example, an employee holds 1,000 SARs corresponding to the value of equity shares in the company. If the price per equity share of the company was INR 1,000 at the time of granting the SARs, and the price of the same equity share increased to INR 1,500 at the time of exercise of such SARs, the employee shall be entitled to INR 5,00,000 (1000*500) at the time of exercising the SARs.
Highlights of SARs
Allocating ownership to the employees has now become a conventional method for remunerating the employees for their performance and to actuate the employees to work towards multiplying the valuation of the issuing company. Employee stock options have been the most relied upon instrument for the objective driven allocation of the ownership in the company. However, by the virtue of such allocation, the issuing company ends up diluting the shareholding of the existing shareholders, including investors. To overcome the dilution effected by the employee stock options, the issuing companies have extended reliance on SARs.
Upon the issuance of employee stock options, new shares are typically issued by the company, which results in the dilution of the existing shareholders’ ownership. Unlike employee stock options, SARs do not create dilution since no actual shares are reserved or issued against the issuance of SARs. However, the valuation of SARs is corresponding to the valuation of the shares in the issuing company, and such SARs are settled in cash or shares, in some instances.
SARs provide possibilities to the issuing company to settle the appreciation value either in cash or by way of issuance of shares. On the other hand, upon the exercise of employee stock options, the company has to issue the shares of the company to the holder of such stock option.
Further, unlike employee stock options, SARs do not require employees to invest their own funds to exercise and acquire shares. Employees receive the appreciation value without having to purchase the stock, thereby reducing their financial risk. If the stock price does not appreciate during the SARs’ vesting period, employees do not lose any money since they do not need to exercise the rights.
In many ways, including the abovementioned, the companies have found a reliable alternative to employee stock options in SARs, whereby, a performance linked incentive is being provided to the employees while retaining control over the dilution of the existing shareholding in the issuing company.
SARs by listed companies in India:
The issuance of SARs by listed companies in India is recognized and regulated by the Securities and Exchange Board of India under the SEBI (Share Based Employee Benefits and Sweat Equity) Regulations, 2021 (“SEBI Employee Benefit Regulations”).
Key provisions in relation to SARs under the SEBI Employee Benefit Regulations:
- SARs Grantee: The SEBI Employee Benefit Regulations explicitly provide that SARs can only be issued to the employees of the issuing company[4]. Further, ‘employee’[5] has been defined under the SEBI Employee Benefit Regulations to mean:
- an employee designated by the company, who is exclusively working in India or outside India; or
- a director of the company, whether a whole time director or not, including a non-executive director who is not a promoter or member of the promoter group, but excluding an independent director; or
- an employee as defined in sub-clause (i) or (ii), of a group company including subsidiary or its associate company, in India or outside India, or of a holding company of the company, but does not include- (a) an employee who is a promoter or a person belonging to the promoter group; or (b) a director who, either himself or through his relative or through any body-corporate, directly or indirectly, holds more than ten per cent of the outstanding equity shares of the company.
- Process for issuing SARs: The SEBI Employee Benefit Regulations provide for extensive procedure for the issuance of SARs. The listed companies are required to constitute a compensation committee[6] for the administration and superintendence of the SARs scheme. Further, the regulations require the company to obtain a special resolution from the shareholders in a general meeting for offering the scheme of SARs.[7]
- Transferability of SARs: The SEBI Employee Benefit Regulations prohibits the transferability of SARs to any other person other than the grantee.[8] Further, the SARs granted to an employee are restricted from being pledged, hypothecated, mortgaged or otherwise alienated in any other manner.
- Administration of SARs Scheme: The regulations provide a list of information required to be disclosed in the SARs scheme including vesting requirements, SAR price or pricing formula, maximum term of SARs, method of settlement etc.[9] Further, the regulations provide that the issuing company is at a freedom to settle the appreciation amount of SARs in cash or equity shares.[10]
- Vesting Period: The SEBI Employee Benefits Regulations provide that the minimum vesting period for SARs shall be 1 (one) year.[11]
- Rights of the SAR holder: It has been provided under the regulations that the SAR holders shall not be having any rights, including the dividend and voting rights, available to the shareholders in respect of a SAR granted.[12]
SARs by unlisted companies in India:
SARs by unlisted companies are not specifically regulated in India. While the Companies Act, 2013 provides for regulations and guidelines governing employee stock options and sweat equity allocation by the unlisted companies, there is no specific regulatory framework provided for SARs under the same. Considering the lack of regulatory framework, SARs issued by unlisted companies in India are primarily governed through the contractual arrangement between the issuing company and the grantee.
Grey areas in relation to SARs by unlisted companies:
While the SEBI Employee Benefit Regulations provide that SARs can only be issued to the ‘employees’ of the issuing company, there is no corresponding regulatory framework for SARs issued by unlisted companies. Due to the lack of instructions, SARs are currently being issued and allocated to third-parties who are not employees of the issuing company. If and when regulated, the purpose of issuance of SARs, which is to incentivize the employees, may be fortified through the intention of law.
Since there is no framework around the issuance of SARs by unlisted companies, there are pragmatic problems faced regarding the process to be adopted for the issuance of SARs by unlisted companies. The lack of guidelines raises queries around the nature of resolution passed, the requirement to obtain valuation report for determining the fair market value, and the constituents of SARs scheme, for the issuance of SARs by unlisted companies. Although the guidelines provided under the SEBI Employee Benefit Regulations in relation to the issuance and administration of SARs may be followed by the unlisted companies, there is a need felt to have a clearly set out process note for the unlisted companies issuing SARs.
The Company Law Committee constituted by the Ministry of Corporate Affairs in their report dated March, 2022 have opined for the recognition of SARs under the Companies Act, 2013 along with the enabling provisions.[13] The committee further recommended process for the issuance of SARs under the Companies Act, 2013 including the requirement of passing a shareholders’ resolution in the event the scheme requires the issue of further securities. Despite the fact that the Company Law Committee has recognized and recommended to affirmatively regulate SARs issued by unlisted companies, there is a compelling need felt to codify the same.
[1] Paragraph 3.8 of the Report dated March, 2022 by the Company Law Committee constituted by the Ministry of Corporate Affairs. (Click here)
[2] https://www.nasdaq.com/glossary/s/stock-appreciation-rights
[3] Regulation 2 (qq) of the SEBI (Share Based Benefits and Sweat Equity) Regulations, 2021.
[4] Regulation 2(jj) of the SEBI (Share Based Benefits and Sweat Equity) Regulations, 2021.
[5] Regulation 2(i) of the SEBI (Share Based Benefits and Sweat Equity) Regulations, 2021.
[6] Regulation 5 of the SEBI (Share Based Benefits and Sweat Equity) Regulations, 2021.
[7] Regulation 6 of the SEBI (Share Based Benefits and Sweat Equity) Regulations, 2021.
[8] Regulation 9(1) of the SEBI (Share Based Benefits and Sweat Equity) Regulations, 2021.
[9] Schedule E of the SEBI (Share Based Benefits and Sweat Equity) Regulations, 2021.
[10] Regulation 23(2) of the SEBI (Share Based Benefits and Sweat Equity) Regulations, 2021.
[11] Regulation 24 of the SEBI (Share Based Benefits and Sweat Equity) Regulations, 2021.
[12] Regulation 25 of the SEBI (Share Based Benefits and Sweat Equity) Regulations, 2021.
[13] Paragraph 3.10 of the Report dated March, 2022 by the Company Law Committee constituted by the Ministry of Corporate Affairs. (Click here)