A. Introduction:

Share-based incentives are a popular tool used by companies to combat attrition and encourage performance. While employee stock option plans (“ESOPs”) and general employee benefits schemes have traditionally been in vogue, stock appreciation rights (“SARs”) which lend itself to a greater degree of customization, are slowly gaining momentum.
Phantom stock options (“PSO/s”) are a form of SARs which entitles the holder to receive cash payments instead of equity shares at the end of the vesting period or upon fulfilment of specific conditions. The value of the cash settlement, depending on the terms of the PSO could be either (i) a “full value” plan (i.e. the entire value of the stock on the date of settlement; or (ii) an “appreciation only” plan that yields to the beneficiary, in cash terms, the appreciation in the value of the stock during the measurement period/until the settlement date.
The defining feature of PSOs (and that distinguishes it from ESOPs and employee benefit schemes) is that in PSOs, the employee-beneficiary’s ‘ownership’ of the underlying stock is, typically, synthetic or notional. In other words, while PSOs will grant the employee a cash upside, the employee will not ever get to ‘own’ the underlying stock.

B. Advantages and Drawbacks:

From the company/management’s perspective, the most apparent advantage of a PSO is stock preservation and protection from early dilution in the equity of the promoters. The terms of the PSOs instrument will, however, need to be worded carefully. If the scheme provides for a minimum defined pay out to employees in the future (based on a floor valuation of the stock) the balance sheet implications of the PSOs will need to be thought through carefully.
From an employee/senior management’s perspective, one drawback of PSOs is that because there is no physical share transfer, PSOs are without any shareholders rights to the employee. Secondly, unlike stock options where once vested/exercised, the holder can thereafter time his exit for capital gain, in PSOs the cash benefit is ‘defined’ without room for further upside.
On the other hand, one advantage of PSOs is that (unlike an ESOP or share scheme) the employee is not required to pay anything upfront. Hence, PSOs are less expensive for the employees as compared to traditional ESOP.

C. Legal Background:

ESOPs are largely governed by the Companies Act, 2013 (“Act”) (including the rules thereunder) and for listed companies, also the Securities Exchange Board of India (Share Based Employee Benefits) Regulations, 2014 (“SBEB Regulations”). However, the Act does not expressly set out anything that is applicable to PSOs. We may therefore conclude that in the absence of further legislation or clarifications from the Ministry of Corporate Affairs, unlisted companies are free to formulate their own schemes/structures for PSOs, subject to the valuation being justifiable. The SBEB Regulations apply to SARs which are defined in an inclusive manner to cover both equity and cash settled SARs.
However, in the year 2015, Mindtree Limited had sought clarifications from Securities Exchange Board of India (“SEBI”) on whether their ‘SARs Scheme’ (which was in the nature of a PSO) was subject to the SBEB Regulations. SEBI clarified that the SBEB Regulations would not be applicable to PSOs, as it does not involve “dealing in or subscribing to or purchasing securities of the company directly or indirectly”. SEBI reiterated this when responding to a similar clarification requested by Saregama India Limited.
Although the informal guidance by SEBI provided that the SBEB Regulations do not apply to the PSOs in those cases, on plain reading, the definition of SARs under Regulation 2(1)ze of the SBEB Regulations seems to specifically include cash settled SARs. Therefore, in the absence of an amendment to the SBEB Regulations specifically exempting PSOs from its applicability, as a matter of abundant caution it is advisable for listed companies to seek clarification from SEBI at the time of formulating its PSO plan.
With respect to the question of non-resident beneficiaries of PSOs, PSOs do not fall within the definition of the term ‘equity instruments’ under the exchange control regulations. Further, PSOs are not covered in the definition of ‘capital’ under the Consolidated FDI Policy, 2017 either.
In light of the exclusion of PSOs, under the above definitions, arguably, PSOs are not subject to the pricing guidelines that applies to equity instruments under Indian law. This may offer some flexibility in structuring transactions involving PSOs offered to non-residents. Further, any cash pay-out to be made to a non-resident may also be structured as a permitted current account transaction under the Foreign Exchange Management Act, 1999 (and the rules thereunder).

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vide its Informal Guidance, dated July 27, 2015.
vide its Informal Guidance, dated July 24, 2015.
which means and include equity shares, convertible (fully and mandatorily convertible) debentures, preference shares and share warrants issued by an Indian company.
issued by Department of Industrial Policy and Promotion, Ministry of Commerce and Industry, Government of India.

D. Conclusion:

For companies (and particularly so in the universe of start-ups, angel investing and venture capital), the absence of a prescriptive legal or regulatory framework governing PSOs affords great flexibility to structure employee benefits or incentive schemes. PSOs give companies headroom where there are otherwise limits on equity dilution, plus a hassle-free option to incentivise employees without giving up equity. PSOs are also less complicated as the company’s obligation vanishes upon the employees exit since PSOs do not entitle the employee to hold actual shares in the company. PSOs also carry a much lower compliance burden than ESOPs.
Despite its many advantages, we are yet to witness widespread adoption of PSOs amongst corporates. This may in part be due to the lack of legal or regulatory structure resulting in a need to stick to the “tried and tested” or may even be because of an ownership mindset in employees (especially in senior management) who prefer direct equity over the lure of a potential cash bonus in the future.
Often, companies may issue PSOs as part of a larger bouquet of incentive schemes which may also include ESOPs. In the current Covid-19 pandemic and its associated uncertainties in equity and valuation, PSOs offer a useful and viable alternative to companies looking to snap up top talent, without risk of equity dilution in the near future.
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The material contained in this alert is for informational purposes only. The views expressed are not those of K Law and do not constitute legal advice. K Law disclaims all liability to any person or entity for any loss or damage caused by errors or omissions in this alert. This article was authorized by Rukmini Roychowdhury (Partner), Dhairal Shah (Associate Partner), Ashwin Gowda (Associate) and Siddhant Bhargava (Associate).

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