ASIC is proposing to update its policy on employee incentive schemes.
As part of that process, ASIC released Consultation Paper 218: Employee Incentive Schemes (Consultation Paper), seeking feedback from stakeholders by 31 January 2014 on its proposed new relief and regulatory guidance. ASIC currently anticipates releasing a revised Regulatory Guide 49: Employee Incentive Schemes and class order in May 2014.
In this update, we discuss some of the key aspects of ASIC’s proposals and our submissions to ASIC on them.
For the most part, we consider that ASIC’s proposals are an appropriate response to market developments, particularly in recognising issues with trust structures, the offer of performance rights and the potential characterisation of incentives as derivatives.
However, we believe that a number of ASIC’s proposals still impose too high a regulatory burden, such as a proposed new condition of relief that requires the issuer to disclose the ‘key risks’ associated with the offer. Some of its other proposals do not adequately take into account taxation consequences or are otherwise commercially unattractive.
Background to Consultation Paper
ASIC has stated that it has revisited its employee incentive scheme policy in light of legislative change and market developments.
In essence, ASIC has previously provided class order relief under the existing CO 03/184 from various Corporations Act provisions (including the prospectus, financial services licensing, advertising and hawking provisions) for employee incentive schemes that meet specified criteria. The intention of the policy was to reduce the regulatory burdens which would otherwise prevent employers offering employees equity-based incentive arrangements, and was in addition to certain Corporations Act exceptions available for incentives to senior managers.
Schemes falling outside the policy or Corporations Act exemptions required applications to ASIC for case-by-case relief. The frequency of these relief applications and the policy that has developed in evaluating relief applications has informed the Consultation Paper.
Policy proposals include:
- expanding relief to prospective employees and certain contractors and casual employees
- expanding relief to non-executive directors (with specific restrictions, such as no performance conditions and no loans)
- expanding relief to offers of performance rights, specified depositary interests and options over stapled securities or depositary interests
- expanding relief to certain offers made through unallocated trusts (i.e. where shares are held in an unallocated pool on behalf of employees)
- inclusion of a key risks disclosure in offer documents
- an additional condition requiring a 12 month holding period before vesting of at least 25% of eligible products; and
- expanding relief for unlisted bodies, including exemptions for offers of ordinary shares valued up to $1000 per year or for offers of performance rights.
ASIC has released the draft updated Regulatory Guide 49 together with its Consultation Paper. ASIC has not released draft class orders at this time.
For a copy of the current Regulatory Guide 49 click here.
Overview of proposed policy changes
Set out below is a summary table of ASIC’s proposals, together with our comments and an overview of our submissions.
ASIC Proposals1 Our comments
Who can make offers
ASIC proposes to enable offers to be made by:
- bodies listed on ASX or an approved foreign market and their associated bodies corporate
- unlisted bodies and their wholly owned subsidiaries
- updates the names of approved foreign markets (no new markets are proposed to be added at this time)
- clarifies that offers may be made by associated bodies corporate of listed issuers (which includes related bodies corporate or where at least 20% voting power is held in the issuer or by the issuer)
- for unlisted bodies, limits relief to the issuer or its wholly owned subsidiaries
We submitted that the proposal for unlisted entities should at least extend to related bodies corporate where more than 50% of the issued share capital is held in or by the issuer. This means, for example, that joint ventures entered into by unlisted entities would be given the same treatment as those entered into by listed entities. This seems appropriate in our view, given that a control relationship would exist between the body corporate and issuer.
Who can receive offers
ASIC proposes to enable offers to be made to:
- full-time and part-time employees (including executive directors)
- certain contractors and casual employees
- prospective employees, as part of an offer of employment
- non-executive directors under specific, separate offers
ASIC proposes that the conditions for contractors require that:
· the offer is to the individual who performs the work or a company, all of whose members or all of whose directors are individuals who perform work under a contract for the issuer (or for listed issuers, an associated body corporate of the issuer, or for unlisted issuers, a wholly owned subsidiary of the issuer) the individual who performs the work under the contract:
- must have done so for the 12 months prior to the date of the offer; and
- during that time has worked the number of hours that are the pro-rata equivalent of 80% or more of a full- time position with the issuer (or for listed issuers, an associated body corporate of the issuer, or for unlisted issuers, a wholly owned subsidiary of the issuer)
· the employer has an ongoing intention to continue employing the contractor on an equivalent basis for at least the next 12 months
We submitted that contractor relief should:
- be extended to contractors where at least 50% of the directors or members are the individuals who perform the work under the contract (as this may capture more small business entities many of which are family controlled, while maintaining a significant level of connection or dependence between the issuer and the contractor)
- reduce the pro-rata equivalent for contractors to 40% of a full time position. This more closely equates with the proposed requirements for casual employees (we note there is no percentage requirement for part-time employees, who could potentially work less than 40% of a full time position)
- in relation to unlisted entities, not be restricted to offers made by their wholly owned subsidiaries. We submitted that for reasons set out above in our first submission, contractor relief should be extended to cover offers made by related bodies corporate of unlisted entities where more than 50% of the issued share capital is held in or by the issuer
- not include the ongoing intention of employment condition, given that its determination is unclear, it is not required in respect of employees and does not increase investor protection.
Non-executive directors (NEDs)
Under the new proposals, offers to NEDs may not be subject to a performance condition or involve loans i.e. directors must contribute their own funds to acquire products. ASIC states that its proposal to only provide limited conditional relief for such offers is consistent with recommended governance practice on the basis that each of the above matters may compromise the director’s independence (although ASIC does not point to empirical evidence that current incentive schemes have caused widespread governance problems).
Further, the proposed relief relates to quoted shares, depositary interests and stapled securities; in particular, it does not contemplate offers of options or performance rights to NEDs.
We note that Principle 8 of the ASX Corporate Governance Council Principles and Recommendations relates to remunerating fairly and responsibly. Box 8.2 of the guidelines provides that NEDs should not be offered options or bonuses, and should not “normally participate in schemes designed for the remuneration of executives”.
We have submitted that the “if not, why not” test – a fundamental principle underlying the ASX Corporate Governance Council’s recommendations – should be applied to offers made to NEDs.
In the alternative, we have submitted that if ASIC wishes to prescribe governance standards on this issue, the relief proposal should at least extend to options and performance
rights, and that companies should be able to apply discretion as to whether offers of options or performance rights are appropriate in the circumstances. We also noted that ASX provides a level of protection under the ASX Listing Rules, which require shareholder approval for certain issues of shares to directors (as opposed to the offer of issued shares for purchase).
Absent falling within the proposed ASIC relief, we note that other exemptions in the Corporations Act (such as the personal small-scale offerings disclosure exemption in section 708(1) or 1012E) may potentially be available to make offers to NEDs.
What financial products can be offered by listed bodies?
ASIC proposes to extend relief for listed bodies to include offers of:
- certain depositary interests
- stapled securities
- options over, and units in, any of these products
- performance rights
Performance rights typically require no monetary payment by the executive and automatically vest on satisfaction of conditions (such as performance or length of service). Some performance rights include the option of being partially or wholly cash settled.
Given issues with their taxation treatment and existing ASIC relief, some products called performance rights have had the legal structure of options yet may not be entitled to class order relief (e.g. where an option-style notice of exercise is required but the vested performance rights may be cash settled).
ASIC has recognised that the offer of performance rights has become increasingly popular in the market. While we are in favour of ASIC’s proposal to include the offer of performance rights in its class order relief, we submitted that a change should be made to the definition of ‘performance right’ so that the concept of automatic vesting is replaced with a concept of vesting for payment of no monetary consideration or no more than nominal monetary consideration.
We note that ASIC does not propose to offer relief for option or performance rights plans which involve more than nominal monetary consideration, a contribution plan or loan.
The definition of derivative in the Corporations Act is broad and may catch bonus schemes on the basis that the value or consideration is calculated by reference to something else, e.g. an underlying share2.
ASIC is considering a separate class order to clarify that cash bonuses as part of employment or employment-like remuneration will not be derivatives. However, cash bonuses will not be exempt if the amount of cash payable is determined by a measure referable to a financial product.
We note that the disclosure exemption under 1012E(1)(b) of the Corporations Act may potentially be available in respect of cash bonuses referable to financial products that are offered through trust structures, provided the small scale offerings requirements set out under this provision are met.
What structures can be used by listed bodies when making offers?
ASIC proposes revised and new class order conditions relating to:
- trusts, with products held on trust on an allocated or unallocated basis
- contribution plans (including salary sacrifice arrangements of future earnings and deductions from taxed salary amounts)
- loan arrangements
Use of trusts
Currently, relief is only available for offers of shares made through a trust where the shares which are held on trust are allocated to specific participants.
ASIC now proposes to extend relief to permit “underlying eligible products” (including shares, foreign shares, stapled securities and depository interests but excluding options and performance rights) to be held on trust in a pool for participants on an unallocated basis so as to permit the “warehousing” of underlying eligible products in a pool. This enables issuers to spread out the timing of acquisition of these products to avoid larger on-market trades, permits products to be purchased during open trading periods and permits averaging out the cost of purchasing such products.
The above proposal to extend relief to unallocated trusts is welcomed. However, we noted to ASIC that the problem remains that under offers using allocated trusts, beneficiaries must be given substantially the same rights as if they were the owners of the shares – a requirement which may be inconsistent with performance or vesting conditions often contained in employee share plans (and the associated transfer restrictions and forfeiture conditions).
The proposed requirements are that loans must be:
- without recourse or with recourse limited to the forfeiture of the eligible products that are the subject of the loan
- not repayable during the life of the loan
- interest free
The loan requirements noted are common in employee share scheme loan arrangements. However, due to the complexity of the applicable tax laws and the variety of employee share schemes, circumstances may arise where a better outcome might be obtained if one or more of those requirements do not apply.
For example, some exemptions from tax apply only to employee share schemes which are taxed under Division 83A of the Income Tax Assessment Act 1997. However, there are many employee share schemes which are not taxed under Division 83A. In such cases there may be issues in relation to the rules regarding loans made by companies which are classified as private companies for tax purposes. In other cases there may be concerns about the applicability of the ‘otherwise deductible rule’ or the occurrence of a debt waiver fringe benefit under the Fringe Benefits Assessment Act 1986.
For tax purposes a listed or public company may, in some circumstances, be a private company. In such cases it will often be the case that when a limited recourse loan is forgiven the employee will be deemed to have received an unfranked dividend equal to the amount forgiven.
Further, if a private company makes an interest free loan or a loan which is not repayable during the life of the loan to an employee who is already a shareholder, it will sometimes be the case that the employee is deemed to have received an unfranked dividend equal to the amount of the loan.
In some cases the above-mentioned requirements will restrict the range of schemes which may be offered to employees and in other cases cause employees to incur tax liabilities which might not otherwise arise.
We submitted that at the very least ASIC should be prepared to issue case-by-case relief if the result of the application of the above-mentioned requirements is to cause employees to have tax liabilities when there is no commensurate gain to them and a more beneficial scheme is available.
What general conditions apply?
ASIC proposes revised and new general conditions so that:
- the relevant quotation period is reduced to 3 months (from 12 months)
- the objective of the offer is not fundraising and includes a 5% share capital limit
- a significant portion of products must be held or not be received for a minimum of 12 months
- bodies must notify ASIC by lodgment of an ASIC form within 7 days of making the first offer under a scheme relying on the class order relief
- offer documents must be clear, concise and effective and include a disclosure of key risks
- ASIC may exclude a body from relying on the relief
The proposed form to notify ASIC of reliance on the class order relief would not appear on the public register. In addition:
- a further form may be required for substantial amendments to the scheme or the offering of a new plan under the scheme
- ASIC is proposing that the condition will include an obligation to provide ASIC on request with copies of the offer document and all accompanying documents given to participants in connection with the scheme
- we query the level of detail which ASIC will require for certain parts of the proposed notification (e.g. in relation to whether there are performance hurdles)
Our submission included the following comments:
- The 12 month holding period for at least 25% of the eligible products offered may hamper the offerings of schemes (e.g. where this may be inconsistent with the terms of an international scheme). Also, there are circumstances where entities grant equity-based remuneration with a shorter vesting period for the purpose of providing short term incentives.
- The requirement to provide a summary of key risks is, in our view, burdensome and inappropriate (despite ASIC’s statement that it does not expect the disclosure be of the level required in a disclosure document3). If an entity qualifies for this disclosure exemption, it seems contradictory to require a key risk disclosure (particularly in relation to listed entities).
What financial products can be offered by unlisted bodies and using what structures?
ASIC proposes to extend relief for unlisted bodies for offers of:
- Fully paid voting ordinary shares valued at up to
$1000 per employee per year, for no more than nominal monetary
- Options over or performance rights relating to ordinary shares, for no more than nominal monetary consideration, provided that, at the time of exercise or vesting:
- the body has been listed for at least 3 months; or
- a prospectus or offer information statement is given to the participant; or
- an independent expert report is provided on a 100% disposal of all ordinary shares in the body
We anticipate that a number of conditions of the proposal for unlisted entities will mean that it is unlikely that unlisted bodies will take advantage of the relief and would therefore need to seek case-by-case relief or identify other existing Corporations Act exemptions instead.
For example, the proposal conditions include that:
- the body can only issue one class of shares (ordinary shares)
- the offer cannot use a trust
- the $1000 value is determined based on audited accounts or expert valuation
- the 100% disposal alternative must occur in a single transaction
Valuations for the $1000 proposal
We submitted that an expert valuation may be an excessive cost, bearing in mind that many private companies do not audit their accounts. The benefit of an upper threshold at the level of $1,000 is that it will be available to entities which would be unwilling or unable to offer participation by employees due to costs. The proposed threshold is sufficiently low that this limits concerns regarding the potential unreliability of unaudited accounts.
We also noted that an entity should only be required to audit their accounts for the purpose of making such offers where there is also a general requirement for it to do so under the financial reporting provisions of the Corporations Act. In all other cases, it would be more appropriate for valuations to be based on annual accounts.
We believe this approach strikes the right balance given that valuations do not need to be precise in circumstances where employees are not required to pay for any shares under such offerings.
We added that an alternative approach may be to require expert valuation only where there are classes of share on issue which are not ordinary shares. This may alleviate concerns with accounts-based valuations, due to share classes having differing rights and therefore potentially differing values.
We submitted that:
- the threshold should be lower than 100% of the issued capital (e.g. if the sale is to a third party in respect of greater than 50% of ordinary shares);
- the relief should apply where shares other than ordinary shares are on issue; and
- the relief should extend to sale of substantially all of the business assets of the issuer.
A transaction in relation to more than 50% of the ordinary shares should establish pricing sufficiently to put an independent expert in a position to report. Further, valuations are often obtained for various classes of capital and an expert should be able to comment upon the relative value of share classes in the event that there are classes of shares on issue in addition to ordinary shares.
A percentage below 100% and the ability of the issuer to have more than one share class may also mean that the relief is utilised more frequently in private equity transactions, where there may be a sell down by a controlling investor in circumstances where management may continue as shareholders after the exit of the original controlling investor.
In relation to asset sales, we noted that there are often assets or liabilities retained within the entity which are not disposed of as part of the sale. An expert can address these issues in their report. To require that 100% of assets be included in the sale would mean that this relief is unlikely to be utilised in practice.
Use of trusts
We consider that the use of trusts is beneficial for unlisted entities. The ability to have a defined parcel set aside for participants (whether allocated or unallocated) provides security to participants, as well as flexibility in administration of the scheme (e.g. if the entitlement may be cash settled).
What other relief is available?
ASIC proposes to extend relief so that:
- Licensing, hawking and advertising relief is extended in line with the above proposals
- Disclosure and additional on-sale relief applies for issues to trustees in certain circumstances
ASIC proposes to extend its on-sale relief so that all securities and financial products offered to eligible participants under the new class order are also entitled to relief from ss 707(3) – (4) and 1012C(6) – (7) of the Corporations Act (on-sale relief) in respect of such securities and financial products.
Currently, CO 04/6714 provides on-sale relief so that only the purpose of the issuer is relevant. It is only available for the on-sale of securities and financial products issued under CO 03/184 (or any other individual instrument of relief in similar terms for an employee share) and on the exercise of options issued in reliance on such relief. As ASIC intends to broaden the type of products and the categories of participants that are eligible to be offered participation in the employee incentive scheme, the broadening of on-sale relief is also necessary.
ASIC also proposes to provide on-sale relief where it has provided disclosure relief for issues of underlying eligible products to trustees to hold on trust for employees as either allocated products or unallocated products.
As noted in ASIC’s Consultation Paper, when a trust structure is used the issuer’s purpose is to issue the eligible products to the trustee in anticipation of the trustee transferring the products to an employee in the future. Currently, CO 04/671 does not provide relief in this context because it does not remove the purpose of the issuer from the relevant tests under sections 707(3)(b)(i) and 1012C(6)(c)(i). Accordingly, ASIC’s proposal to include in its new class orders on-sale relief for issues of underlying eligible products to trustees of employee incentives schemes that have been granted disclosure relief will address this anomaly.