NAVIGATING THE ENIGMA OF STOCK APPRECIATION RIGHTS FOR INDIAN UNLISTED COMPANIES AMIDST THE DARK WATERS OF STATUTORY HUSH

NAVIGATING THE ENIGMA OF STOCK APPRECIATION RIGHTS FOR INDIAN UNLISTED COMPANIES AMIDST THE DARK WATERS OF STATUTORY HUSH

Introduction

Stock Appreciation Rights (or “SARs”, as they are more popularly known) have found their way into the board rooms of many companies as a noteworthy model of incentivization. SARs, in layman language, are indicative of a right issued by a company which entitles the right holder to benefit from the appreciation in value of the company on maturity over a fixed period, if any, in cash or in shares or a combination of both. As is the case with any other investor in a company, the entitlement of a SAR beneficiary grows with the growth of the company and likewise, declines with the downward performance of the company.

At the threshold, SARs appear to be, and are indeed, a promising win-win model wherein the company can have substantial control over risk exposure and capitalization table while the beneficiary of SARs can get an exit in cash at the market value or corresponding shares of the issuer company or both, as applicable, all of which is relatively less onerous than the conventional routes of subscription and / or purchase of shares or ESOP (as defined hereinafter).

However, a deep dive into the legal, contractual, and regulatory nuances of SARs under Indian law, particularly with respect to the eligible beneficiaries of SARs issued by unlisted companies, indicates a faint but lingering possibility of regulatory invasion and arbitrage, as has been dealt with further in this article.

Overview of Applicable Law

The Companies Act, 2013 (the “Act”) is the key legislation that regulates all companies, whether listed or unlisted, in India. In addition to the Act, the Securities and Exchange Board of India (“SEBI”) regulates and governs Indian listed companies. Further and insofar as foreign investment in Indian companies is concerned, the central government of India and Reserve Bank of India (“RBI”) jointly administer the regulatory burden in this regard under the Foreign Exchange Management Act, 1999 and more particularly, the Foreign Exchange Management (Non-Debt Instruments) Rules, 2019 (“NDI Rules”).

Regulatory Conundrum

The Act is the key statute in India insofar as unlisted Indian companies are concerned and SEBI / RBI assume additional significance if the context so requires. It is in this regard that SARs occupy a unique place in the Indian regulatory framework for unlisted companies. The Act is silent on the validity and attendant compliance related to SARs. However, SEBI and RBI have defined and regulated “stock appreciation right” and “share based employee benefits”, as contextually relevant and applicable, under the SEBI (share-based employee benefits and sweat equity) regulations, 2021 (“SEBI Regulations”) and the NDI Rules. While the Act is silent as on date, the company law committee, in its report of March, 2022, has recommended that the Act should be suitably amended to expressly recognize and regulate SARs. The report generally describes SARs and the need to regulate SARs including the following key aspects:

1. it only refers to “employees” as beneficiaries of SARs; and
2. it recommends the passing of a special resolution in such cases where SAR schemes are proposed to be settled in shares of the issuing company.

The silence under the Act, permissibility under the SEBI regulations and NDI Rules in addition to the general freedom of parties to contract under the Indian Contract Act, 1872 (the “Contract Law”) makes SARs an attractive tool in the hands of unlisted companies. This is in view of the negligible cost of compliance, minimal regulatory oversight and interference, and possibility of extending the scope of SARs beyond such beneficiaries who are not otherwise eligible for ESOP (as defined hereinafter) under the Act and / or for SARs under the SEBI Regulations and the NDI Rules (the “Relevant Beneficiaries”).

Critical Analysis

As mentioned above, the Act does not prohibit unlisted companies from issuing SARs to any Relevant Beneficiaries. In view of the foregoing vast scope, SARs fundamentally assume the nature of a contract between the issuing unlisted company and the SAR beneficiary and thus, SARs need to satisfy the test of the Contract Law. At this juncture, it is pertinent to mention that the Contract Law read with the Act technically allows any company to issue SARs to any Relevant Beneficiary without the need for any specific eligibility criterion. However, the prevalent law and advisory in this regard (although not applicable to an unlisted Indian company) permits issuance of SARs only to such people who are in the employment of the issuer company or at a director / managerial level provided such persons meet certain specified criteria.

Further, although the Act does not regulate SARs, it does recognize and provide for employees’ stock options and schemes and plans related thereto (“ESOP”) which can be availed only by employees or by limited categories of key managerial personnel. In this background, the regulatory authority under the Act may have sound reason to approach an unlisted company issuing SARs to Relevant Beneficiaries asking if such unlisted company is trying to flout the ESOP route by issuing SARs to such Relevant Beneficiaries given that they would otherwise not qualify as beneficiaries under an ESOP.

Moreover, the permissibility of SAR issuance to only specified relationships by SEBI and RBI and the observations of the CLC in its report further indicate that the intention of the law is to ultimately permit such issuance to persons who meet the requirement of specified employment / managerial relationships with the issuer company.  Therefore, although there is no prohibition under law, an unlisted company may be better advised on the side of caution to refrain from issuing SARs to any Relevant Beneficiaries.

Having set out the critical aspects to be evaluated in terms of the major risk attributable to identification of the SAR beneficiary, it is now pertinent to evaluate the pros and cons of the structure as such, all of which are briefly set out as follows:

Particulars

PROS

CONS

Issuing Unlisted Company

• Ability to unilaterally control the capitalization table through the SAR policy
• No personal obligations on the promoters or key personnel of the company
• More control in the hands of the company to draft and implement the SAR policy
• Minimum regulatory interference and compliance burden

• Excessive cash outflow may be triggered
• Low clarity on regulatory compliance
• Less clarity on status of the SAR holder prior to maturity of SAR

Beneficiary

• Minimum documentation
• No onus of compliance on the beneficiary except for applicable taxation

• High Risk and Less Protection
• No guarantee of exit
• Validity of reason behind holding SAR may be questioned if a Relevant Beneficiary does not have appropriate relationship with the issuer company
• Beneficiary cannot enjoy the same rights as a shareholder (particularly information rights)

Concluding Comments

In a nutshell and in view of the above analysis, it is safe to opine that the benefits of SARs are best utilised by an unlisted company, if the beneficiary of the SARs is a person who qualifies as a beneficiary for ESOP or under the SEBI regulations, even though the foregoing are not expressly applicable in case of an unlisted company. Any over-stepping of the foregoing in terms of including Relevant Beneficiaries such as potential financial or strategic investors who do not qualify as beneficiaries otherwise, may trigger unnecessary attention and interest of the regulatory watchdogs despite the law as on date technically allowing any Relevant Beneficiary to benefit from SARs. Moreover, and in the interest of good governance as well as caution, it is advisable that unlisted companies should follow the procedure as established for ESOPs under the Act while adopting a SAR scheme for the issuance of SARs.

Endnote:

1) A “stock appreciation right or SAR” means 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. Explanation1—A SAR settled by way of shares of the company shall be referred to as equity settled SAR. Explanation   2 — For   the   purpose   of   these   regulations, any   reference   to   stock appreciation right or  SAR  shall  mean  equity  settled  SARs  and  does  not include  any scheme which does not, directly or indirectly, involve dealing in or subscribing to or purchasing, securities of the company. "SAR grantee” means an employee to whom a SAR is granted. “Employee” means an employee as 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 any of the foregoing in a group company of the company subject to certain additional restrictions.

2) "Share Based Employee Benefits" means issue of equity instruments to employees or directors or employees or directors of the holding company or joint venture or wholly owned overseas subsidiary or subsidiaries who are resident outside India, pursuant to Share Based Employee Benefits schemes formulated by an Indian Company.

3) Paragraphs 3.8 – 3.10, Restricted Stock Units (RSUs) and Stock Appreciation Rights (SARs), Chapter I on Changes Proposed to CA-13, Report of the Company Law Committee, Ministry of Corporate Affairs, Government of India, March 2022.