ASIC's employee incentive scheme class orders - new and improved

In brief

After much anticipation, ASIC has released new employee incentive scheme class order relief. Partner Greg Bosmans and Special Counsel Gadi Bloch, members of Allens' Head Office & Governance team, report on the implications for listed and unlisted companies.

Background

In November 2013, ASIC issued a consultation paper proposing various amendments to its employee incentive scheme class order ([CO 03/184]) (see our previous Client Update: Proposed new employee incentive scheme relief). ASIC has issued two new class orders to replace [CO 03/184], which apply to listed companies ([CO 14/1000]) and unlisted companies ([CO 14/1001]) respectively.

Listed companies

Financial products covered

From the perspective of listed companies, the key change is that the new class order expressly covers a broader range of financial products.

The old class order primarily applied to fully paid shares and options over them, as well as fully-paid stapled securities. In its consultation paper, ASIC expressed the view that many of the financial products commonly offered by companies under employee incentive schemes could not be characterised as options and therefore did not fall within the scope of the class order relief (while still being consistent with the policy rationale underlying that relief). These included a performance right, or other right to acquire a share, that had any of the following features:

• The right did not have an exercise mechanism and instead resulted in the automatic delivery of shares upon satisfaction or waiver of relevant conditions.
• It could be satisfied by way of a cash payment referable to the value of the underlying shares, rather than the delivery of those shares.
• It entitled the holder to cash payments referable to the dividends paid on the underlying shares pending vesting (or to the delivery of additional shares to an equivalent value).

Differing views could be taken as to whether a financial product would still constitute an option notwithstanding the existence of certain of these characteristics, with many regarding performance rights as generally constituting a nil exercise priced option.

However, if a company wished to offer or grant rights having any of the above characteristics it was, at least in ASIC's view, necessary to apply to ASIC for individual relief. Needless to say, this involved additional time and expense.

The new class order expressly covers financial products having any of the above characteristics, where the underlying security is a fully paid share or stapled security. It also covers:

• interests in a registered managed investment scheme;
• certain depositary interests, such as Australian CDIs and United States ADRs, with a fully paid share as the underlying security; and
• performance rights (referred to in the new class orders as 'incentive rights') and options in respect of each of the above.

In addition, the quotation period for the financial product being offered, or underlying the option or performance right being offered, has been reduced. The class order previously required the relevant financial product to have been quoted for a period of 12 months, without suspension during that period for more than two trading days. This has been reduced to a period of three months, without suspension during the 12-month period prior to the date of the offer (or such shorter period as the financial product has been quoted) for more than five trading days.

Despite the expansion of the financial products covered by the class order, debt securities and partly paid securities are still not covered, as ASIC does not consider these to be consistent with the policy rationale of the relief. On the other hand, ASIC has indicated potential flexibility in being prepared to consider individual relief for offers of products that fall outside the class order but that satisfy the policy objectives. In appropriate cases, ASIC may also relax the quotation period requirements, on grounds similar to that applied in other disclosure contexts (such as rights issues) where equivalent criteria apply.

The broader scope of the new class order is welcome. However, companies taking advantage of the greater flexibility should bear in mind that tax deferral – ie the deferral of the taxing point for the relevant award to a later time than grant – will not extend to all types of awards that the class order now allows.

Eligible participants

Under the amended class order, offers under an employee incentive scheme may be made to contractors and casual employees who have worked, or are expected to work, for the pro rata equivalent of 40 per cent or more of a full time position. This is an extension of the scope of the old class order, which focused on full-time and part-time employees (and directors).

Contractors for this purpose can include corporate contractors (such as a family-owned company) where the individual who performs the work is a director of the contractor, or the spouse of a director. However, it should be remembered that tax deferral would not be available to such participants.

In addition, under the new class order, prospective full-time, part-time and casual employees, and prospective contractors, may receive offers that are conditional on accepting the relevant position. Companies using this new flexibility will need to ensure that the offers are structured correctly to enable the prospective participants to benefit from Australian tax deferral, if that is being sought.

In each of the above cases, the relevant personnel may be employed or engaged by the listed company itself, or by an associated body corporate, being a body corporate in which the listed company has at least 20 per cent voting power, or which has at least 20 per cent voting power in the listed company. Associated bodies corporate were also covered by the old class order.

(However, it should be remembered that if share awards in a company are granted to employees who are not employed by that company, or a 'subsidiary' of that company (generally being a greater-than-50 per cent test), the employer will generally be required to pay fringe benefits tax (rather than the employees paying income tax) on the value of those awards.)

ASIC is now more prescriptive about which 'nominees' of scheme participants can receive awards under an incentive scheme in lieu of the participant, while still being eligible for the class order relief. Immediate family members, companies owned by the participant or immediate family members, and corporate trustees of self-managed superannuation funds of which the participant is a director are the only such nominees now permitted. While on its face this is a narrowing of the old class order, in practice it is unlikely to present an issue.

ASIC did not adopt the proposal in the consultation paper that, in order to be eligible to participate, contractors and casual employees must have been engaged for a period of at least 12 months before the date of the offer. We agree that there is no need to apply such a distinction compared to the position that applies to other personnel.

Nor did it adopt the additional conditions for offers to non-executive directors proposed in the consultation paper (namely, that such offers could not be subject to performance conditions and that a non-executive director should be required to contribute their own funds to acquire the products offered). While there may be other reasons to implement such constraints – such as from a governance perspective, consistent with the ASX Corporate Governance Council's Corporate Governance Principles and Recommendations regarding performance-based remuneration for such directors – they were not appropriate as potential conditions of ASIC's relief.

ASIC has foreshadowed, however, that extensions of the relief in individual cases to apply to personnel not covered by the class order will be rare.

Use of trusts

The old class order accommodated the use of trusts by companies operating employee incentive plans. The new class order continues to do so, but on the basis of some different conditions. For example, while the trustee is still required to maintain written records in respect of the administration of the trust (including of any products specifically allocated to scheme participants), these will no longer need to be audited annually, and are no longer required by the ASIC relief to be available for inspection. On the other hand, the activities of the trustee of the trust in that capacity are now specifically limited to employee incentive schemes of the relevant company. Accordingly, it would not be possible to use the same trust arrangement to acquire shares for other purposes such as a dividend reinvestment plan. This is consistent with the 'sole activities' requirement under Australian tax law for employee share trusts.

Where an internal trustee is used (ie the listed company or an associated body corporate is the trustee), shares held in the trust will not be able to be voted by the trustee at its own discretion. In addition, the number of shares held in the trust will be limited to five per cent of the voting shares in the listed company, to prevent distortion that could result from those shares being quarantined in this way.

Where a professional trustee is used, it will still need to hold an appropriate Australian Financial Services Licence, although ASIC has indicated that it may be prepared to provide individual relief to allow appropriately licensed foreign trustees to be used.

In most cases, the new conditions should reflect the manner in which relevant trusts are operated in practice. However, companies that currently utilise a trust structure may need to review the rules of their employee incentive schemes and the relevant trust deed, to ensure that the conditions are satisfied.

Contribution plans and loans

The new class order continues to permit the use of contribution plans in respect of offers of fully paid quoted shares, as well as now in respect of depositary interests, interests in registered managed investment schemes and stapled securities. However, a contribution plan cannot be used in connection with offers of options or performance rights.

The definition of contribution plan makes it clear that contributions may be made from pre-tax wages or salary or post-tax wages or salary or other .funds of the participant. It continues to be a general requirement for unused contributions to be held in a special purpose trust account with an Australian ADI, although that account can now be maintained outside Australia, which will assist foreign companies.

Similarly, the new class order continues to permit the use of loans in respect of offers of eligible financial products other than options and performance rights. However, new conditions have been introduced requiring any loan to be interest free and either non-recourse, or with recourse limited to forfeiture of the financial products to which the loan arrangement relates.

In our experience, most employee incentive schemes that involve loans already satisfy the second condition, with practice varying as to whether interest is charged on the loan. As a result, the impact of these new conditions is likely to be limited in practice.

The new class order also allows an employee incentive scheme to involve both a contribution plan and a loan, which was not previously the case.

The five per cent cap

To ensure that offers under employee incentive schemes that were relying on the old class order were not for fundraising purposes, the old class order imposed a cap on the amount of capital that could be issued in reliance on the relief. In essence, the number of shares that a company could issue in reliance on the class order or equivalent ASIC relief (or that would be issued as a result of the exercise of options) within a five-year period was capped at five per cent of the total number of issued shares in that class.

That cap is continued in the new class order, although relaxed to some degree in that now it is calculated over a shorter three-year period. Consistent with the broader scope of the new class order, it applies to each class of shares, depositary interests, interests in registered managed investment schemes or stapled securities that are issued, or that underlie options or performance rights that are issued, in reliance on the new class order or equivalent ASIC relief. As before, offers of financial products that do not rely on ASIC relief, such as offers outside Australia, or offers on the basis of a statutory exemption, or offers made under an Australian disclosure document such as a prospectus, are not counted towards the cap.

In its consultation paper, ASIC had proposed that the notional shares by reference to which any cash payment to be made under an employee incentive scheme is to be calculated should also be included for the purposes of the cap – the policy rationale being that offers under employee incentive schemes should not create a significant exposure that may materially prejudice creditors' interests. That rationale seemed curious, given that a company would not generally be constrained from making cash payments to employees (subject to certain qualifications). The proposal is fortunately not reflected in the new class order.

Offer document content and notification process

As foreshadowed, ASIC has introduced a condition that offer documents should be worded and presented in a clear, concise and effective manner. The condition also provides that the offer documents must include general information about the risks associated with the relevant financial product. At present, such disclosure is not commonly provided, and most companies will need to amend their pro forma offer documents in order to satisfy this condition.

ASIC has also reduced the administrative burden for companies relying on the new class order, by simplifying the regulatory notification requirements. Rather than the company being required to lodge offer documents with ASIC following each offer (or group of offers) under an employee incentive scheme, the company is only required to notify ASIC before, or within one month after, making the first such offer in reliance on the class order for a particular scheme. This notification would be undertaken using a standard ASIC form, which will require the company to provide some detail on the key elements of the scheme. The company would not be required to make any further notifications, unless a new plan is later offered in reliance on the class order (or, potentially, if the existing scheme is amended in such a way so that the key elements previously notified to ASIC are no longer correct – ASIC has not been clear on this point). However, if requested by ASIC, a company relying on the class order must make available to ASIC the offer documents and all other accompanying information given to eligible participants in connection with offers under the relevant scheme.

No holding period requirement

In the consultation paper, ASIC proposed imposing a new condition that each offer of eligible products under an employee incentive scheme should not result in the participant receiving 25 per cent or more of their entitlements under the offer as cash or shares (which were not subject to restrictions on disposal) until the expiry of a minimum 12-month period.

While the proposed condition was unobjectionable in principle, in our view it was not required to promote the stated objective of fostering interdependence between employers and participants. Further, the condition may have led to anomalous results in some circumstances (such as where vesting of options or performance rights was accelerated in a 'good leaver' scenario or upon a change of control), unless appropriate exceptions were provided for.

Perhaps in light of these matters, the new class order does not include any conditions imposing a holding period.

Other matters

Consistent with the generally facilitative theme of the new class order, ASIC has included some other welcome practical elements.
For example, companies with existing incentive schemes that have been operating in reliance on the old ASIC class order or equivalent individual relief will continue to be able to do so, and will not need to transition immediately to the new relief.

ASIC has also acknowledged in the class order that participants in employee incentive schemes should not be disadvantaged as a result of failure by their company to comply with the conditions of relief. Specifically, the 'on-sale' relief given by the new class order to participants – ensuring that they do not need to produce a prospectus if they wish to sell financial products received under an employee incentive scheme within 12 months after receiving them – will still be available, even if the class order relief does not technically apply. This could be the case, for example, because the company did not include a particular required disclosure, or because it provided ASIC with notification regarding the scheme too late. Provided that the participant has no reason to believe that the scheme is not covered by the class order, then they will be protected.

Unlisted companies

Financial products covered

The old class order previously provided disclosure relief for offers of options over fully paid shares in an unlisted body (ie a body not listed on ASX or any of the foreign securities exchanges approved by ASIC) under an employee incentive scheme. In a major advance, the new class order extends also to offers of fully paid shares themselves, as well as to performance rights in respect of such shares.

However, now the relevant shares that are offered, or that underlie the options or performance rights offered, must be voting ordinary shares, rather than any other class of shares. ASIC has justified this on the basis that other classes of shares are potentially more difficult to value, and are accompanied by less transparency, in an unlisted company context. Nevertheless, this could reduce the utility of the new class order for some unlisted companies, which may prefer to offer different classes of shares to different categories of owners. Of course, that would not mean that those companies could not proceed with those offers – rather, they would need to rely upon another means of doing so.

In addition, shares can only be offered for 'token or trivial' consideration, ie in essence only 'free' shares can be offered.

Options and performance rights, on the other hand, can still be offered on terms that require payment of more than such nominal consideration for them to become exercisable or to vest, but, in that case, they cannot become exercisable or vest unless one of two conditions is met. One of those conditions is that the quotation period described above for listed companies must first be met for fully paid voting ordinary shares of the relevant company at the time of exercise or vesting, ie in effect the unlisted company must have become a listed company for at least a three-month period before exercise or vesting.

The alternative condition is that the relevant participant must be provided with a 'valuation document' (not more than one month old) at least 14 days prior to exercise or vesting. A valuation document may take the form of:

• a disclosure document, such as a prospectus;
• an independent expert's report; or
• a copy of an executed agreement under which shares in the same class as shares to which the options or rights relate are to be acquired on arm’s length terms by a third party that is not an associate of the body and which specifies a value of a share in that class.

In each case, the purpose of the requirement is for the participant to have the benefit of appropriate information, as a substitute for a suitable period of market trading, to enable them to form a view on value in relation to their options or performance rights.

The last of these options, which was not provided for in the consultation paper, primarily caters for the situation in which minority shareholders are subject to a 'drag along', requiring them to sell their shares at the same time and price as exiting substantial shareholders. In such circumstances, there would be no real investment decision to be made by scheme participants that would be assisted by a disclosure document or independent expert's report. Companies seeking to rely on this option will need to ensure that offers can be timed appropriately with the exit mechanism.

Eligible participants

Offers under an employee incentive scheme may be made to full-time or part-time employees, directors (including non-executive directors), casual employees or contractors of an unlisted company, in the same way as for listed companies. However, for unlisted companies the relief does not extend to personnel who occupy those positions with any associated body corporate, but rather only with wholly-owned subsidiaries.

Like for listed companies, prospective personnel in the relevant categories are also covered.

$5000 cap

The old class order did not impose any limits on the value or number of options that could be offered in reliance on the relief. In the consultation paper, ASIC proposed that unlisted companies should be limited to granting no more than $1000 worth of shares (calculated by reference to the net tangible assets of the company as shown in the company's most recent financial report) to a participant in any 12-month period.

ASIC has increased this amount to $5000 in the new class order. However, the amount applies in respect of all financial products (ie including options and performance rights) offered to a participant in any 12-month period. In our view, this amount is far too low and will substantially restrict the ability of unlisted companies to utilise employee incentive schemes to attract and retain personnel.

The new class order does not prescribe the manner in which financial products are to be valued for the purposes of applying the $5000 cap, with the directors of the unlisted company having a general discretion to determine the value of the products being offered (within the constraints of the most recent 'directors' valuation resolution', discussed below). While this discretion is welcome, it does sit somewhat at odds with the idea that a company should refrain from providing anything but general and incidental financial product advice in connection with an offer under an incentive plan.

20 per cent cap

As with listed companies, the class order imposes a cap on the number of shares that may be issued pursuant to offers made in reliance on the class order (or equivalent ASIC relief). In recognition of the fact that unlisted companies may have a greater need to utilise employee incentive schemes to attract and retain personnel, and may have a smaller equity base, the cap is set at 20 per cent, rather than five per cent.

While the cap is measured on the same basis as for listed companies, the fact that it is assessed against the number of issued shares in the class of shares offered (rather than the company's issued capital as a whole) may have a greater impact on unlisted companies, which are more likely to have multiple classes of shares on issue, such as preference shares.

Offer document content

In addition to the content requirements that apply in respect of offer documents issued by listed companies, offer documents issued by unlisted companies also need to include, among other things, a so-called 'directors' valuation resolution'. This is a resolution of the directors of the unlisted company relating to a valuation of the company or its financial products, and that is used to value an offer to a participant under the scheme (at least in part to ensure that the $5000 cap discussed above is not breached). The resolution must be accompanied by an explanation of the methodology used or adopted by the directors for the purposes of the directors’ valuation resolution (and presumably the valuation itself).

The requirement for this valuation to be conducted could be burdensome for some unlisted companies. While the new class order is not prescriptive as to how the directors must carry out the valuation, and does not require a third party to provide it (which will reduce cost and inconvenience), there may be circumstances where the unlisted company would not otherwise undertake such a valuation for the purpose of implementing an employee incentive scheme. For example, this may be the case where the number of financial products being offered is determined based on a set percentage of the company's issued capital, or a formula that is not tied to value.

The offer documents must also include the most recent financial report of the company. For companies that are not required to prepare or lodge financial reports under the Corporations Act, a special purpose financial report (which need not be audited) will suffice. This should facilitate reliance on the class order by foreign companies that are not registered as such in Australia, and by Australian small proprietary companies.

Contribution plans and loans

Unlike listed companies, an unlisted company may not utilise a contribution plan or loan in connection with an employee incentive scheme.

Interaction with tax concessions

Australian companies should be able to utilise the existing $1000 tax exemption in respect of grants of shares under the new class order (assuming other relevant conditions are satisfied).

However, the class order may not accommodate offers that would attract the recently announced additional tax concessions for shares awarded by start-up companies (see our Focus: Back to a future for employee share scheme options). In particular, the class order relief only applies where shares are granted for no more than nominal monetary consideration, whereas it would seem that the tax concessions only apply where shares are granted at a small discount to their market value. It would be unfortunate if the ability to utilise the proposed tax concessions was hampered by unduly restrictive conditions to the class order relief.

ASIC has indicated that it will be involved in consultation with the ATO in relation to the ATO's forthcoming work on the tax concessions; however, it is not clear whether that will result in any relaxation of the new class order.