THE PERILS, PITFALLS AND PROMISES OF

STOCK OPTION AGREEMENTS



I. The Promise(1)

A. Unilateral Contract. Stock option agreements are typically analyzed as unilateral contracts.

B. Contra Proferentum. Ambiguous plan language is construed against drafter.

C. Inconsistent documents. If the documents provided the employee are not consistent (which occurs with surprising frequency) a court may be inclined to give employee benefit of more liberal document.

D. Key Events. The key events in an stock option program are:

(1) Grant of Option. This is the date on which the employee is granted the stock option. Generally the grant will specify a purchase price for the stock, state the number of shares that the employee can purchase, when the employee can start making stock purchases, and will specify the time period over which the stock may be purchased. Generally this is not a taxable event.

Example: Effective 1/01/02 MLG, Inc. grants Mitchell the right to purchase 10,000 shares of MLG common stock at $1.00 per share. 5000 shares may be purchased starting on 1/1/03 and ending on 1/1/08, and 5000 shares may be purchased starting on 1/1/04 and ending on 1/1/09.

(2) Vesting Date. This is the date on which an employee can start to purchase stock at the option price. Typically, stock options agreements require that the individual be employed with the company on the vesting date.

(3) Exercise of Option. This is the purchase of stock by the employee pursuant to the option agreement. This is a taxable event.

(4) Option Termination Date. This is the date on which the right to purchase stock under an option agreement expires. Often the option terminates within a fixed period (for example 90 days) after an employee terminates employment with the company.

(5) Stock Sale Date. This is date on which the stock that is purchased is sold. It is generally a taxable event.

E.What Motivates Employers to Create Stock Option Programs. The reasons given for creating stock option plans typically include:

(1) Attract and retain good people. The theory is that good people will be attracted to and will produce more if they are given a chance to share in the growth of the company, both short and long term.

(2) Estate Planning. The use of stock options can be a tax efficient way to transfer wealth to younger generations.

(3) Maximize Cash. The exercise of a nonqualified stock option results in an income tax deduction equal to the value of the stock transferred less the amount paid for the options. IRC Section 83(h). Morever, cash reserves are augmented by the payments made to exercise the option.

Example: MLG, Inc. has income of $100,000. Its employees are granted and exercise stock options for stock worth $110,000 by paying $10,000 in cash. MLG corporation is entitled to an income tax deduction of $100,000 ($110,000-$10,000) and also obtains $10,000 from the employees who exercise the option. It therefore has on hand $110,000 to use for corporate purposes. Had MLG, Inc. paid the $100,000 out to employees as cash compensation it would have no cash.

F. Types of Options

(1) Nonqualified

Most stock options are non-qualified. Non-qualified stock options (often referred to as NQSOs) are a generic term for stock options which do not comply with the requirements of IRC 422A for incentive stock options (ISOs). They can also be options which initially constitute ISOs, but as to which a "disqualifying disposition," as referred to in IRC 421(b) is made.

(i) Advantages. Great flexibility in the pricing, permissible time of exercise, employment status, and other matters is possible with an NQSO. For example, an NQSO could be offered which would permit the grantee to purchase stock at a price of $20 per share even though the stock was worth $25 a share at the date of grant of the option. The option could be granted to a consultant who was not an employee, and the option could be exercisable for a period in excess of 10 years, or could be immediately exercisable. None of these terms would be possible with an ISO.

(ii) Tax Effect. If an NQSO is granted to an individual, there will be no tax effect at the time of grant, assuming the option does not have a readily ascertainable fair market value. IRC 83(e)(3) and see Treas.Reg. 1.83-7(b), defining readily fair market value. If the option has a readily ascertainable fair market value, the tax treatment will be governed by IRC 83.

Upon the exercise of the option (assuming no readily ascertainable value), the individual will recognize income to the extent of the difference between the fair market value of the stock and the consideration paid for the option. However, if the stock received upon exercise of the option is subject to a substantial risk of forfeiture and is not transferable, the income will not be taxable until one of those conditions lapses, at which time the amount of gain will be determined based upon the fair market value of the stock at the time of lapse. See, for example, Robinson v. Commissioner, 805 F.2d 38 (1st Cir.1986), in which the employer had one year following the exercise of a stock option in which to repurchase the stock at cost. The employee was not subject to taxation until expiration of the one year. IRC 83(a).

Under Treasury Regulation 1.83-1(c) if nonvested property is disposed of in a gratuitous transfer (e.g., charitable or to a family member), there is no taxation until the property is sold or the conditions lapse. Thus, for example, a stock option transferred to a charity was not taxed to the recipient until it was exercised; (PLRs 9737014, 9737015,and 9737016); and the gift transfer of a nonstatutory stock option to a family member did not trigger the recognition of income until the exercise of the option. PLR 9830036.

(2) Incentive Stock Options (ISO's)

If the requirements for an incentive stock option are met, a corporation may make available to employees, on a discriminatory basis, stock options which can be exercised at no immediate tax cost to the employee and which will qualify for capital gains treatment when the stock is eventually sold.

(i) Tax Consequences

Under an ISO no gain is recognized upon the grant of the stock option to an individual, nor is any income recognized on the exercise of the option. On disposition of the stock acquired through exercise of the option, long term capital gain will be recognized, assuming the stock has been held for the requisite period (i.e., that there has been no disqualifying disposition). The employer will not be entitled to any deduction. IRC 421(a)(2). The difference between the option price and the fair market value of the stock at the exercise date will be a tax preference item in the year of exercise. IRC 56(b)(3).

(ii) Requirements

Incentive stock option plans must meet specific statutory requirements. These are set forth in the attached Chapter 7 from Employee Fringe and Welfare Benefit Plans.

G. Phantom Stock. As an alternative to granting an employee an interest in stock or awarding stock options, an employer may establish a phantom or shadow stock plan. This is an agreement under which the employee is treated as if he or she had received a certain number of shares of the company stock. The amount which the employee will receive under such an arrangement is pegged to the price or value of the company's stock. Once the units have been credited to the employee, the equivalent of dividends are generally paid to the employee, allowed to be reinvested to purchase additional units, or deferred with interest. The plan normally provides for appropriate adjustment in the value of units if changes are made in the capitalization of the stock with respect to which the units are priced.

(1) Benefit Payments

Benefits are usually deferred for a specific period of time or an event such as death or retirement. Benefits are usually paid in cash, either in a lump sum or installments, but in some plans may be paid in stock.

(2) Advantages

Because a phantom stock plan does not require the actual issuance of shares of the employer's stock, it may enable the employer to offer much of the practical benefit of stock ownership without causing:

(i) a dilution of equity,

(ii) securities problems as to stock which would otherwise have been issued,

(iii) a risk of the loss of S corporation status. See GCM 39750 which approves the use of a shadow stock plan with an S corporation.

(3) Income Tax Consequences

The income received from a phantom stock plan will be ordinary, and will be equal to the amount of cash or stock received.

H. ERISA Coverage

(1) Significance. ERISA coverage is a significant issue because ERISA coverage gives the employer the option to obtain a deferential standard of review for decisions (if the plan is drafted properly) and a non-jury trial in federal court. On the other hand, ERISA coverage could create a cause of action under ERISA Section 510 for interference with benefits if an employee is terminated just prior to the vesting of his or her stock options.

(2) Case Law. One court has concluded that a stock grant plan was not covered by ERISA because it was neither an employee welfare benefit plan nor an employee pension plan. The court concluded the plan did not fit within the definition of an employee welfare benefit plan because providing stock options to certain employees as part of their compensation package was different then providing medical benefits, or benefits for sickness, accident, disability, death, or unemployment. The court also concluded the plan did not fit within the definition of an employee pension plan because the plan was not specifically designed to provide retirement income and did not systematically defer income past the termination of employment. Although the plan required a four year wait after the stock was granted for the restrictions to lift, the plan also required that the employee be employed with the company at the end of the four year period. Accordingly the court concluded that the plan was not a employee pension plan. Kaelin v.Tenneco, Inc., 28 F.Supp.2d 478 (N.D. Ill, 1998)



II. Pitfalls & Perils

A. Tax Losses. An individual can incur huge losses from nonqualified stock options if he or she exercises the options while the price of the underlying stock is high, is restricted from selling the stock, and the value of the stock plummets while the underlying stock is still restricted. Some of the restrictions that may apply are:

(1) SEC restrictions

(2) Corporate restrictions on sale of stock

The problem arises because the amount of income tax is based on the fair market value of the stock when the option is exercised while the amount obtained to pay taxes is based on the sale price of the stock.

This is not a problem for incentive stock option plans because the exercise of the option does not result in income tax.

B. Is the Stock Option Plan Effective ? If the perceived benefit is too small (for example, a stock option plan that requires the sale of stock back to the company at a price set by the company) the employee will not be enthused by the plan and may be insulted.

C. Termination of Employment

(1) Convert at Will to Employment for Term. The existence of a stock option does not alter an employees status as an at-will employee absent language that establishes an employment contract. Alexander v. America Online, Inc. 2000 WL 333321250 (M.D. Fla. 2000) (contract stated options were special incentive plan and not part of employee's compensation)) See also Harrison v. Jack Eckerd Corporation, 342 F.Supp. 348 (M.D. Fla.1972) ( no alteration of at-will status where stock option agreement expressly made dependent on continuation of employment and where no manifestation of intent to create definite term of employment)

(2) Terminations just prior to vesting. Terminating an at-will employee prior to the vesting of stock options is a not bad faith termination because in Florida an action for breach of an implied covenant of good faith cannot be maintained in the absence of a breach of an express contract provision. Alexander v. America Online, Inc. 2000 WL 333321250 (M.D. Fla. 2000)(no breach where stock option agreement expressly stated that (1) employer was not obligated to continue employment and (2) stock options are not considered part of the employee's compensation and where no express provision of contract could reasonably have been violated).

D. ERISA

(1) Background. Section 510 of ERISA makes it unlawful for any person to discharge, fine, suspend, expel, discipline, or for the purpose of interfering with the attainment discriminate against a plan participant (The protections of 510 also extend to potential participants who would have participated in the plan but for the unlawful action. See Saporito v. Combustion Engineering Inc., 843 F.2d 666 (3d Cir.1988)), or beneficiary for the purpose of interfering with or preventing the exercise of any right to which he or she is entitled or to which he or she may be become entitled to under the provisions of the plan, or Title I of ERISA. ERISA 510, 29 U.S.C.A. 1140.

Section 510 of ERISA can come into play in connection with a reduction in force. See, e.g. Gavalik v. Continental Can Co., 812 F.2d 834 (3d Cir. 1987). In Gavalik, the employer developed and implemented a system to identify Continental's unfunded pension liabilities so as to avoid triggering future vesting by placing employees who had not yet become eligible for break- in-service on layoff, and to retain those employees whose benefits had already vested. The court concluded that this was a violation of Section 510 of ERISA.

(2) Specific Intent. To prevail under ERISA 510 the plaintiff must demonstrate that the defendants had a specific intent to interfere with rights protected by that section. No cause of action exists under ERISA 510 for losses of benefits that are a mere consequence of a termination of employment (Gavalik v. Continental Can Co., 812 F.2d 834 (3d Cir.1987), cert. denied 484 U.S. 979, 108 S.Ct. 495, 98 L.Ed.2d 492 (1987)); the Ninth Circuit has held that such a claim may not be brought. Pacificare v. Martin, 34 F.3d 834 (9th Cir.1994). In other words, an employee who is terminated for insubordination does not have a cause of action under ERISA 510 merely because as a result of termination he or she ceases to accrue further pension benefits. However, such employee need not show that the discriminatory reason was the sole reason for terminating the employee, but only that it was a determinative factor. (Id).

Specific intent to interfere with rights protected by ERISA 510 may be shown by direct evidence such as eyewitness testimony or indirectly. Specific intent was not shown by terminated employee when employee merely established that plan was funded solely by the employer, that plan provided for 10 year vesting, that he was 11 months short of full vesting when terminated, and that employer was reducing costs. Hendricks v. Edgewater Steel Co., 898 F.2d 385 (3d Cir. 1990).

(3) Shifting Burdens of Proof. It has been held that the presumptions and shifting burdens of proof used in cases brought under Title VII to prove intent indirectly apply in actions brought under ERISA 510. Dister v. Continental Group, Inc., 859 F.2d 1108 (2d Cir. 1988). This analysis of indirect proof of intent has three stages. The plaintiff must prove by a preponderance of the evidence a prima facie case of discrimination. If the plaintiff proves a prima facie case, the defendant must articulate some legitimate, nondiscriminatory reason for the employee's rejection. The explanation must be clear and specific. Finally, should the defendant meet this burden, the plaintiff is given the chance to prove by a preponderance of the evidence that the legitimate reason offered by the defendant is pretextual. Kowalski v. L & F Products, 82 F.3d 1283 (3d Cir. 1996). The employer does not incur liability merely because it makes a poor business decision as to the employee's qualifications in terminating the plaintiff, the issue is whether the employer manufactured a putative business reason to avoid liability.

This analysis is illustrated by the Third Circuit's reasoning in Dister v. Continental Group, Inc. 859 F.2d 1108 (2d Cir. 1988). In Dister, the Third Circuit concluded that the plaintiff established a prima facie case by showing (1) he was in a protected group (i.e. he was an employee who had a chance to obtain rights in an ERISA covered benefit plan), (2) there was abundant evidence that he was qualified for his position, and (3) that his discharge occurred under circumstances creating an inference of prohibited discrimination (i.e. the discharge occurred four months before the plaintiff would have obtained increased benefits if he had remained employed and the employer saved about $550,000 by discharging the plaintiff early). But in Dister the Third Circuit concluded that the employer had articulated a legitimate nondiscriminatory reason for terminating the plaintiff, namely that the termination occurred because the employer changed its business priorities and wanted to cut costs. The Third Circuit also concluded that the plaintiff was unable to show by a preponderance of the evidence that the employer's reason was a pretext and concluded that the employer actually discharged the plaintiff for the nondiscriminatory reasons stated. The record showed that the plaintiff's duties had been reduced and that on many days he had nothing to do.

(4) Exhaustion of Plan Remedies. The courts are split on whether plan remedies must be exhausted before an action can be brought under ERISA 510.Compare Zipf v. American Telephone & Telegraph Co., 799 F.2d 889 (3d Cir.1986) with Kross v. Western Electric Co., 701 F.2d 1238 (7th Cir. 1983); and see Mason v. Continental Group, Inc., 763 F.2d 1219 (11th Cir. 1985). The Eleventh Circuit has held that plan remedies must be exhausted. The Third Circuit has concluded that although there is no liability under IRC 510 merely because an employer harbors a discriminatory intent, it is also not necessary that the discriminatory scheme be successful. It is enough if the employer takes some act to further the discriminatory scheme. Gavalik v. Continental Can Co., 812 F.2d 834 (3d Cir.1987). In such cases a court may award injunctive relief. Id. The Eleventh Circuit has held that punitive damages are not available for actions brought under ERISA 510 and ERISA 502(a)(3)(B)(i) (action for equitable relief for ERISA violations). Bishop v. Osborn Transportation, Inc., 838 F.2d 1173 (11th Cir.1988).

E. ADEA Damages. The Tenth Circuit has held that a successful ADEA plaintiff as part of his damages award was entitled to the difference between the net value from the exercise of stock options at the time he intended to retire and the net value he received from the exercise of stock options as result of termination. This difference was over $3 million. The Tenth Circuit also held that the plaintiff was entitled to the gain he would have received on the stock options he would have received had he remained employed until his intended retirement date. Finally the Tenth Circuit held that plaintiff was not entitled to have this damages award doubled under the liquidated damages provisions of the ADEA. Greene v. Safeway Stores, Inc. 210 F.3rd 1237 (10th Cir. 2000)

F. Structural Changes. These include such things as changes in control, mergers and acquisitions and leasing of employees. In all these circumstances an issue may arise as to whether a termination occurred. This leads to the following related questions:

(1) is the right to exercise options in the future accelerated

(2) is the right to exercise options in the future cut off

Often these questions are not addressed in the stock option agreement.

(1) what happens if division or subsidiary sold

(2) what if employee is leased to another employer



III. Responses

A. If establishing a stock option program.

(1) Be sure you are doing something that is perceived as valuable

(2) Cover all contingencies

(3) Consider whether want to create an ERISA plan

(4) If trouble consider plan amendment

(5) Consider phantom stock

B. If advising

(1) Check to see if illusory

(2) If represent terminated employee stock options could be an important element to damages.



1. For additional information on the securities and tax aspects of stock options see the attached Chapter 7 from Employee Fringe and Welfare Benefit Plans (West) This material is also online at Westlaw.