The potential pitfalls of referring to employee share option plans in employment offers and contracts and how to do so safely

What are employee share option plans and why would you implement them?

Employee share options provide employees with rights to acquire shares in a company (usually the employing company or a member of the same group) at a pre-agreed fixed price (often called the exercise price or strike price) in the future. Normally, the exercise price is the market value of the shares at the time the option is granted.

For example, an employee could be granted an option to buy 100 shares at a price of £1.00 per share.

If structured correctly, tax will not be payable by the company or the employee at the time that the share option is granted, and if the company grows and increases in value during the period between the option being granted and the employee exercising the option, the employee’s shares will consequently be worth more than they paid for them at the time of grant (meaning that if the employee sells their shares post-exercise of the option and the share price rises above the exercise price, they could make a profit).

Employee share incentive plans are a helpful tool for a company to recruit new talent, retain valuable employees and motivate them by enabling them to acquire shares in the company in a tax efficient way. The purpose of implementing such schemes is to incentivise employees and to reward them for investing their time and skills in helping the company grow.

The most commonly adopted type of employee share option plan for UK-based employees is the Enterprise Management Incentive (“EMI”) option scheme. Under an EMI scheme, qualifying companies can grant options over shares to qualifying employees worth up to £250,000 (per employee) without attracting income tax or National Insurance Contributions charges on the grant date. EMI schemes allow qualifying employees to purchase shares in a company for a discounted value. For further information on EMI share option schemes, please consult our detailed blog post here.

Issues can arise when companies seek to include details of employee share plan entitlements in offer documents or in employment contracts, and caution must be exercised when companies wish to do this.

Ensuring that participation in employee share plans does not become a contractual right

Generally speaking, it is advisable not to refer to share plans in offers of employment and employment contracts, because there is a risk that if such references are made within such documents, entitlement to participate in a particular share plan could become a contractual right. Omitting to mention share plans within employment-related documentation therefore removes this risk.

The reasoning behind this includes that the company should (ideally) not bind itself to provide share plan benefits which it may not be able to deliver in the future (this is further explained below under the subheading ‘Avoiding binding commitments’).

Additionally, if employees have a contractual right to a particular share plan, they may need to consent to any changes the company wants to make to a plan, or to its withdrawal or replacement, because these circumstances may then amount to a variation of their contractual terms of employment. However, consent will not be required if either of the following apply:

• the terms in the employment contract are sufficiently wide to enable the company to take the necessary action, or contain a power to amend without consulting employees; or
• the company decides to make the change unilaterally, and relies on employees’ conduct (by not objecting to the change) to establish implied agreement to the change.

Also, if a business unit is sold and the Transfer of Undertakings (Protection of Employment) Regulations 2006 (“TUPE”) apply, the buyer will be required to provide similar arrangements after the transfer, which could potentially make the company a less appealing acquisition target (as the prospective buyer may not want to offer the employees a share scheme to the employees post-acquisition).

Regulation 4(2)(a) of TUPE provides as follows: “all the transferor’s…duties and liabilities under or in connection with any…contract [of employment] shall be transferred by virtue of this regulation to the transferee”. This raises the question whether the new employer is obligated to offer a replacement share scheme following the transfer.

Regulation 4(2)(a) of TUPE applies to duties and liabilities only where they arise under or in connection with a contract of employment. Therefore, it will not apply if the share scheme can be shown either to be non-contractual, or to arise under a separate contract that is not transferred.

This illustrates the importance of ensuring that participation in employee share plans does not become a contractual right, and highlights the significance of referring to share plans within employment-related documentation with care.

Generic company materials such as employee guides or handbooks, or materials accessible by all employees on a company intranet, often refer to share plans. Entitlement to participate in a particular plan will not be a contractual right as long as the communication of these materials is general, and not targeted at an individual employee, and if it is made sufficiently clear within these materials that an individual employee has no contractual right of participation in a particular plan.

Share plans being or becoming a contractual right

If an offer letter or employment contract states that employees will be invited to participate in a particular share plan, then entitlement to participate in that plan will be an express contractual right. For this reason, share plan rules often contain provisions stating that employees have no contractual right to participate in the plan. This is the case even for tax-advantaged all-employee plans (where the company must invite all eligible employees to participate), such as EMI share option schemes, because the company retains discretion as to whether to operate the plan at all.

Entitlement to participate in a particular share plan may be an implied contractual right where it has become customary for the company to operate it. However, employment case law provides that if the operation of an arrangement is in fact discretionary (as most share plans will be), simply because it has been regularly operated over a number of years will not always mean that it becomes an implied term.

Avoiding binding commitments

An important reason for not referencing share plans in offers of employment and employment contracts is to ensure that the company does not commit to providing a particular type of plan or award in the future. This is because, at the time the document is drafted, the company will not know whether it can in fact fulfil a commitment to provide a particular plan or award.

For example, if a company promises its employees that it will set up or maintain a tax-advantaged share plan such as an EMI share option plan, it could later transpire that it cannot meet the statutory requirements to set up or maintain such a plan.

Under the relevant UK legislation governing EMI share options, which is mostly contained within the Income Tax (Earnings and Pensions) Act 2003, in order to qualify to grant EMI options, a company must be an independent trading company with gross assets of no more than £30 million and fewer than the equivalent of 250 full-time employees (these are some of the statutory requirements that must be met in order for companies to set up or maintain an EMI share option plan). Additionally, certain trading activities will not qualify and there are detailed rules relating to the independence requirement, the trading requirement and the shares that can be used for EMI options.

Therefore, if a company refers to a share option plan within employment related documentation and consequently the employee’s participation in the plan becomes a binding commitment made by the company, at the time the employment offer / contract is drafted the company could (for example) have less than 250 full-time equivalent employees, but subsequently the company could grow to the point that it has more than this number of employees, meaning that it would no longer meet the statutory requirements for EMI option schemes.

In this case, the company will have made a binding contractual commitment to provide a particular type of arrangement and its employees will be entitled to bring a claim for breach of contract.

How to safely reference share plans in employment-related documentation

As above, the general rule is that companies should avoid making reference to a specific invitation or proposed award under a particular plan unless absolutely necessary, and should not do so in offers of employment or employment contracts.

However, if a company needs to make a specific promise regarding share plans, for example to secure the services of a particular employee, it should ensure that it will be able to do one of the following:

• carry out its obligation at any time; or
• alter the terms so that it can provide an alternative without requiring the employee’s consent.

If companies wish to refer to share plans in offer letters and employment contracts, those references must be sufficiently broad to ensure that employees will not acquire a contractual right to participate (for the reasons outlined above). Any reference(s) to share plans in such documents should:

• not be specific to a particular plan;
• state that the company may, from time to time, invite the employee to participate in share plans, subject to any eligibility requirements (such as a qualifying period) specified in the rules of those plans;
• state that the operation of any share plan by the company is discretionary and that the employee has no contractual right to participate;
• state that the participation in a share plan on one occasion will not entitle the employee to participate in future; and
• state that any entitlements under a share plan will not be pensionable.

This article is intended for general information only, applies to the law at the time of publication, is not specific to the facts of your case and is not intended to be a replacement for legal advice. It is recommended that specific professional advice is sought before relying on any of the information given. © Jonathan Lea Limited.