SEBI Regulation on Phantom Stock Options

[Dhruv Somayajula is a BA, LLB (Hons) student at NALSAR University of Law, Hyderabad]


To minimize attrition of employees that are indispensable to its operation, companies offer financial incentives such as stock options.  Stock appreciation rights (‘SARs’) are one such kind of stock options that create a right to the increment in value of the corporation’s stock over a specified period of time.[1] There is no payment of price for the shares by the employee, and the appreciation of a hypothetical share is calculated to determine the dividends from the stock option. Issuance of SARs is preferred by optionees who do not wish to bear the risk of share price volatility.

SARs calculate the increase in the value of a unit of the stock, and this cumulative value can be paid to the employee either through an equity-settled or a cash-settled basis. Payment of the value of appreciation through shares would be equity-settled SARs while payment through cash would be cash-settled SARs or ‘phantom stock options’. The latter option is convenient when the company wants to incentivize employees based on the share price, but do not wish to actually share any equity with them. This post will examine the approach of the Securities and Exchange Board of India (‘SEBI’) in regulating phantom stock options.

Regulatory Aspects of Stock Appreciation Rights

SEBI (SBEB) Regulations, 2014

In 2014, SEBI issued the SEBI (Share Based Employee Benefits) Regulations, 2014 (‘SBEB Regulations’), under which employee stock options of listed entities, including SARs are regulated. These regulations are applicable to listed entities which have a scheme:

(i) for direct or indirect benefit of employees;

(ii) involving dealing in or subscribing to or purchasing securities of the company, directly or indirectly;

(iii) ….[2]

Chapter III, Part C of the SBEB Regulations deals with the administration and implementation of the SARs scheme. The regulations confer a company with the freedom to implement either ‘cash settled or equity settled SARs scheme’.  However, as we shall see, SEBI has distinguished equity-settled SARs from cash-settled SARs, with the latter not being regulated by the SEBI (SBEB) Regulations, 2014.

Application of the SBEB Regulations to Phantom Options

In informal guidance sought by Mindtree Ltd and Saregama India Ltd, SEBI has adopted the view that SBEB Regulations are inapplicable to phantom stock options. The rationale behind this stance seems to be that cash settled SARs don’t involve “dealing in or subscribing to or purchasing securities of the company, directly or indirectly”. However, there seems to be a lack of clarity regarding the reasoning behind this approach. Cash-settled SARs also derive their benefits from the appreciation in the shares, as do equity-settled SARs.

The repetitive use of the term ‘indirect’ in the SBEB Regulation indicates its expansive scope. The SBEB Regulations state that “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.[3] Equity-settled SARs also derive benefits from appreciation in shares in the same way as cash-settled SARs and do not involve the subscription or purchase of securities directly. The distinction drawn by SEBI in their informal guidance can be traced back to the drafting of the guidelines themselves, which required a closer examination.

Background to SBEB Regulations

In 1999, SEBI issued the SEBI (Employee Stock Option Schemes) Guidelines (‘ESOS Guidelines’), 1999 to regulate companies offering employee stock options (ESOPs) and employee share purchases (ESPS) to their employees. These regulations were introduced to ensure that companies do not engage in unfair practices to manipulate share prices. Following the enforcement of these guidelines, it was found that several companies had issued stock plans which would not come within the ambit of the ESOS Guidelines.

In November 2013, SEBI released its review paper for the ESOS Guidelines, which contained the recommendations for the SBEB Regulations. The review paper recommended that “A separate section should be carved out under the proposed Regulations for Stock Appreciation Right (SAR) Scheme.” However, the review paper stated that the SBEB Regulations would not cover “Phantom options which do not involve purchase or sale of Shares.” (in page 6). Thus, the intent of the SBEB Regulations was clearly never to regulate cash-settled SARs. The rationale was that only those schemes which “deal in actual securities of the company” were to be regulated. Curiously, this rationale does not carry through to the text of the SBEB Regulations. This creates a scope for confusion over whether phantom stock options, which do not involve dealing in actual securities, are to be regulated by the SBEB Regulations. If a company fails to follow the prescribed norms of filing in relation to SARs as per SBEB regulations, does SEBI have the power to punish both companies offering equity-settled and cash-settled SARs equally? The informal guidance and the intention behind the SBEB regulations indicate otherwise, but the lack of a distinction in the definition and applicability of SARs creates a scope for confusion.


The above background helps in ascertaining SEBI’s reasons in both its informal guidance, and why the SBEB Regulations would not cover phantom stock options. However, this has the effect of introducing some level of ambiguity in respect of such options. There exist no other regulations which cover cash benefits arising out of share options granted to the employees of a company. SARs are regulated as long as the mode of pay-out is equity and not cash. This interpretation makes the words ‘indirectly dealing in’ securities redundant, since SEBI refuses to apply the SBEB Regulations where securities are not actually being dealt with. As of now, the market regarding phantom stock options is relatively new in India. Gaps between the text and interpretation of the SBEB Regulations will need to be covered at some point. SEBI could either amend the SBEB Regulations to exclude cash benefits arising out of securities or to allow for regulation of phantom stock options. Either way, a clarification on this ambiguity before any misuse of this loophole would be a proactive step in ensuring market confidence and shareholder safety.

Dhruv Somayajula

[1] Leo Herzel, Kenneth S. Perlman, Stock Appreciation Rights, The Business Lawyer, Vol. 33, No. 2 (January 1978), pp. 749-768.

[2] Regulation 1(4), SEBI (Share Based Employee Benefit) Regulations, 2014

[3] Rule 2(1)(ze), SEBI (Share Based Employee Benefit) Regulations, 2014.

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