Employee stock options are frequently used as an employee incentivisation and retention tool, given the benefit accrued over time. An ESOP-wrapped compensation is attractive because the gains from the shares acquired on exercise of employee stock options are much higher than the exercise price paid for the options. While the maximum or minimum price payable on exercise of the options is not prescribed by the law – which only lays down the requirement for the price to be accounting-standard compliant – the price typically ranges from the face value of the share to the fair market value of the share.
Employees who are hesitant to shell out a hefty sum as the exercise price and tax payments, at times prefer cashless settlement through one of the two mechanisms:
(i) Sell to Cover Mechanism: where certain number of shares (to be acquired on exercise) are sold to cover the exercise price and the taxes, and remaining shares are transferred to the employee; and
(ii) Sell all Mechanism: wherein employee stock options are settled by way of net cash payment to the employee after options are exercised and all the acquired shares are sold on behalf of the employee.
These mechanisms were routinely utilised as the employees could get the net benefit with ease, without additional actions or payments.
The Companies Act, 2013, which regulates grant of options by private and unlisted public companies, does not contain any specific provision on companies undertaking cashless exercise. However, the Securities and Exchange Board of India (Share Based Employee Benefits and Sweat Equity) Regulations, 2021 (“2021 SBEB & SE Regulations”), which have replaced the erstwhile Securities and Exchange Board of India (Share Based Employee Benefits) Regulations, 2014 (“2014 SBEB Regulations”), provide for cashless exercise of options granted by listed entities.
Position prior to August 2021
The 2014 SBEB Regulations, while permitting cashless exercise of ESOPs, did not specify any other conditions, thereby permitting both Sell to Cover Mechanism and Sell All Mechanism of cashless exercise.
Current regime for cashless exercise for listed companies
Regulation 3 (15) of the 2021 SBEB & SE Regulations provides that the trust through which an employee stock option scheme is being implemented is permitted to sell shares in secondary market to enable the option holder to pay the exercise price, the amount necessary to meet the option holder’s tax obligations and other related expenses pursuant to exercise of the options, i.e. a Sell to Cover Mechanism only.
The key distinction in the provisions under the 2014 SBEB Regulations and the 2021 SBEB & SE Regulations are set out below:
| Regulation 3(15) of SEBI (Share Based Employee Benefits) Regulations, 2014 | Regulation 3(15) of 2021 SBEB & SE Regulations |
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The trust shall not become a mechanism for trading in shares and hence shall not sell the shares in secondary market except under the following circumstances: (a). cashless exercise of options under the scheme covered by Part A of Chapter III of these regulations; |
The trust shall not become a mechanism for trading in shares and hence shall not sell the shares in secondary market except under the following circumstances: (a). to enable the employee to fund the payment of the exercise price, the amount necessary to meet his/her tax obligations and other related expenses pursuant to exercise of options granted under the ESOS; (emphasis supplied) |
| Regulation 9(2) of SEBI (Share Based Employee Benefits) Regulations, 2014 | Regulation 9(2) of 2021 SBEB & SE Regulations |
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No person other than the employee to whom the option, SAR or other benefit is granted shall be entitled to the benefit arising out of such option, SAR, benefit etc.: Provided that in case of ESOS or SAR, under cashless exercise, the company may itself fund or permit the empanelled stock brokers to fund the payment of exercise price which shall be adjusted against the sale proceeds of some or all the shares, subject to the provisions of the applicable law or regulations. |
No person other than the employee to whom the option, SAR or other benefit is granted shall be entitled to the benefit arising out of such option, SAR, benefit etc.: Provided that in case of ESOS or SAR, subject to applicable laws, the company or the trustee may fund or permit the empanelled stock brokers to make suitable arrangements to fund the employee for payment of exercise price, the amount necessary to meet his/her tax obligations and other related expenses pursuant to exercise of options granted under the ESOS or SAR and such amount shall be adjusted against the sale proceeds of some or all the shares of such employee. (emphasis supplied) |
To summarise, under the 2014 SBEB Regulations (repealed by the 2021 SBEB & SE Regulations), a trust could trade in shares and sell the shares in secondary market for “cashless exercise of options under the scheme covered by Part A of Chapter III of these regulations;” without a mention of the permissible limit. The cashless exercises under a trust route now seems to permit Sell to Cover Mechanism only.
Sell All or Sell to Cover Mechanism: Clarification or Confusion
The report of the Expert Group on 2014 SBEB Regulations and the Securities and Exchange Board Of India (Issue of Sweat Equity) Regulations, 2002 dated June 18, 2021 (“SEBI Report”) (basis which the 2021 SBEB & SE Regulations was formulated) while contemplating the need to clarify the term ‘cashless exercise’, stated as follows:
“since the term ‘cashless exercise’ was not specifically defined under the SBEB Regulations, it would be helpful to include language to clarify the process pursuant to which cashless exercise may be undertaken under Regulations 3(15) and 9(2) of the SBEB Regulations.”
The SEBI Report consequently sets out the revised language for cashless exercise, providing that a trust can undertake cashless exercise of such number of shares as are required to pay the exercise price, and applicable tax obligations, etc. (i.e. Sell to Cover Mechanism), which now finds its place in Regulation 3(15) and 9(2) of the 2021 SBEB & SE Regulations, as detailed above.
Arguably, the 2021 SBEB & SE Regulations now permits only Sell to Cover Mechanism of cashless exercise, and seems to prohibit cashless exercise through Sell All Mechanism. However, since the apparent intent of the Expert Group was to only clarify the meaning of cashless exercise, listed companies are now faced with the predicament of legitimately engaging in Sell All Mechanism, and if going forward, such a mechanism would be permitted to implement cashless exercise of options.