[Aayushi Choudhary is a 5th year student of Gujarat National Law University, Gandhinagar]
In recent years, companies have increasingly sought innovative ways to incentivize and retain not only their employees but also non-employee stakeholders such as consultants, contractors, and business partners. This trend has given rise to complex financial instruments that blur the lines between traditional securities and compensation packages. A pressing question has emerged in the Indian financial landscape: can instruments issued to non-employees be considered securities under section 2(h) of the Securities Contracts (Regulation) Act, 1956 (SCRA) and, consequently, fall within the regulatory purview of the Securities and Exchange Board of India (SEBI)?
This post delves into the nuances of this question, focusing on two prominent examples of such instruments: stock appreciation rights (SARs) and phantom stocks. These financial tools, while similar in some respects to traditional employee stock options, present unique challenges in terms of regulatory classification and oversight.
As companies like Zomato, Swiggy and Uber explore the possibility of issuing equity-linked instruments to non-traditional stakeholders such as delivery partners, the need for clarity in this area becomes increasingly urgent. The regulatory framework governing these instruments operates in a grey area, with implications for corporate governance, market integrity, and investor protection. This post aims to shed light on the complex interplay between corporate innovation and securities regulation in India.
Understanding SARs
SARs are a type of equity compensation that is becoming increasingly popular among businesses that seek to incentivize their employees without reducing their ownership stake. SARs establish a right to the holders to enjoy the increase in the stock price of the company over a predetermined time period. In contrast to conventional stock options, the receiver does not have to pay the entire price for the shares. Rather, the dividends from the stock option are computed as the appreciation of a fictional share. It offers flexibility in the structure, as the instrument can be settled either through an equity transfer or a payment of cash. This allows companies to reward their employees, partners, or workers for their contributions to the company’s growth without the need for actual share issuance. For optionees, SARs are particularly attractive as they do not have to bear the risk of share price volatility associated with owning actual shares.
Regulatory Framework in India
The regulatory landscape governing SARs and similar instruments in India has evolved over time, reflecting the changing nature of equity compensation. The SCRA provides the foundational definition of securities under section 2(h), which serves as a reference point for determining whether instruments like SARs fall under regulatory purview.
In 2014, the SEBI (Share Based Employee Benefits) Regulations were issued, which aimed to regulate schemes involving dealing in or subscribing to or purchasing securities of a company, directly or indirectly. These regulations primarily focused on employee benefit schemes, leaving some uncertainty regarding instruments issued to non-employees. There was ambiguity as to whether or not it applied to cash-settled SAR. Later in an informal guidance issued in relation to JSW Steel Limited and SAREGAMA India Limited, SEBI clarified that cash-settled schemes do not fall under the SEBI regulations. In 2021, the SEBI (Share Based Employee Benefits and Sweat Equity) Regulations came into effect and they explicitly defined “stock appreciation rights” and clarified that only equity-settled SARs fall under SEBI’s regulatory ambit leaving cash-settled SARs out of its regulatory purview. It excludes schemes that do not directly or indirectly involve dealing in, subscribing to, or purchasing company securities.
Phantom Stocks: A Grey Area
Phantom stocks, also known as “shadow stocks”, represent another innovative approach to employee compensation that exists in a regulatory grey area in India. These financial instruments are essentially contractual agreements between a company and its employees, promising a cash payout equivalent to the value of company shares at a future date, without actually transferring any equity.
Phantom stocks come in two varieties: “appreciation only” and “full value”. In the appreciation only method, employees receive the difference between the grant price and the current market value of the stock. The full value method entitles the employee to the entire current value of the stock at the time of payout. This flexibility allows companies to tailor their incentive structures to specific needs and circumstances.
One of the key advantages of phantom stocks is that they do not dilute the company’s share capital, as no shares are in fact issued. This makes them an attractive option for companies wishing to reward employees without altering their ownership structure. Additionally, phantom stocks generally do not require shareholder approval, simplifying their implementation.
However, the regulatory status of phantom stocks in India remains ambiguous. Neither the Companies Act, 2013, nor the SEBI (Share Based Employee Benefits and Sweat Equity) Regulations, 2021 provide specific guidelines for phantom stocks. This lack of clear regulatory framework leaves the governance of these instruments largely to the terms of the agreement between the company and the employee.
The ambiguity surrounding phantom stocks was highlighted in a 2015 case involving Mindtree Limited. The company sought clarification from SEBI regarding the applicability of SEBI regulations to their phantom stock scheme. In an informal guidance letter, SEBI suggested that the regulations not apply to Mindtree’s phantom stocks, as they did not involve actual purchase or sale of equity shares.
This regulatory uncertainty extends to the question of whether phantom stocks can be considered securities or derivatives under Indian law. While they derive their value from the company’s stock price, they do not involve the issuance or transfer of actual securities. This places them in a grey area between traditional securities and purely contractual obligations. The Ministry of Corporate Affairs in Companies Law Committee Report, 2022 suggested that SARs should be recognised under the Companies Act through enabling provisions.
The Derivative Question
The classification of instruments like SARs and phantom stocks as derivatives is a crucial point of contention in determining their regulatory status. This question directly impacts whether these instruments can be considered securities under section 2(h) of the SCRA and, consequently, whether they fall under SEBI’s regulatory purview.
Section 2(ac) of the SCRA defines a “derivative as:
(A) a security derived from a debt instrument, share, loan, whether secured or unsecured, risk instrument or contract for differences or any other form of security;
(B) a contract which derives its value from the prices, or index of prices, of underlying securities”
This definition raises several important considerations for instruments like SARs and phantom stocks:
- Value Derivation: The Madras High Court has explained that the underlying assets for a derivative can be “financial assets such as shares, bonds, and foreign currencies”. Phantom shares clearly derive their value from the price of underlying company shares, which aligns with part (B) of the derivative definition.
- Contractual Nature: Both SARs and phantom stocks are essentially contracts between the company and the recipient, potentially fitting the description in part (B) of the definition.
- Absence of Actual Securities: Unlike traditional derivatives, these instruments do not involve the actual purchase, sale, or ownership of securities, which complicates their classification.
The debate over whether these instruments qualify as derivatives has not been addressed in the legal contexts. In cases such as SEBI v. Rakhi Trading Pvt. Ltd and Percept Finserve Pvt Limited v. Edelweiss Financial Services Limited, arguments were made that cash settled options on preference shares (CSOPs) should not be considered as derivatives because they do not derive their value from an underlying variable like share price or stock index. However, in Solargridx Ventures Pvt Ltd, the Registrar of Companies held that CSOPs do derive their value from equity securities at various stages – inception, capital restructuring, and payout. Similarly, phantom shares also derive their value from equity shares. The classification of these instruments as derivatives would automatically qualify them as securities under section 2(h) of the SCRA. This would bring them under SEBI’s regulatory ambit, potentially affecting how companies’ structure and offer these incentives.
Conclusion
The question of whether instruments issued to non-employees can be considered securities under section 2(h) of SCRA or fall under SEBI’s regulatory purview remains complex and unresolved. The current regulatory framework, while evolving, has not kept pace with the rapid innovations in corporate incentive structures.
SARs and phantom stocks represent just two examples of the innovative financial instruments that challenge the traditional definitions of securities. Their unique characteristics – deriving value from company shares without involving actual share ownership place them in a regulatory grey area that demands attention.
Moving forward, there is a clear need for SEBI and other regulatory bodies to provide more comprehensive guidance on these issues. This could involve expanding the definition of securities to explicitly include cash-settled equity-linked instruments, or creating a new regulatory framework specifically for these types of financial innovations.
Ultimately, the goal should be to create a regulatory environment that fosters innovation while ensuring adequate protection for all stakeholders. As the financial landscape continues to evolve, so too must the regulatory approach, striking a balance between flexibility and oversight. Only then can Indian companies fully leverage these financial instruments to drive growth, attract talent, and compete effectively on the global stage.
– Aayushi Choudhary
