Share schemes and the Prospectus Directive

Not having to prepare a prospectus when offering awards to employees has undoubtedly contributed to the popularity of employee share schemes in the UK. But has the Prospectus Directive changed this?

The effect on employee share schemes

Offering shares to employees under employee share schemes has traditionally not involved any securities law issues in the UK, but the coming into effect of the EU Prospectus Directive (which for most purposes took effect here on 1 July 2005 through implementing legislation) has altered the underlying legal position.

In broad terms, the Directive requires the publication of a prospectus, and prescribes its contents, under two limbs:

• where there is an offer to the public of transferable securities, or
• where an application is made to admit transferable securities to trading on a regulated market (which includes the Official List but not AIM).

There are various exemptions, and offers to the public below a €2.5 million threshold, taking into account offers throughout the EU within the previous 12 months, fall outside the scope of the Directive completely.

Unlike the Public Offers of Securities Regulations 1995, which were repealed on 1 July 2005, neither the Directive nor the implementing legislation contains an automatic employee share scheme exemption. Offers to employees that are not within the €2.5 million threshold are therefore potentially public offers under the Directive, whether or not the securities are to be admitted to trading. If employers have to prepare a prospectus it is not hard to foresee that they might decide that the cost of operating employee share schemes outweighs the benefits, and stop operating them, or at least scale them back.

Lobbying

When the Directive was passing through its EU approval process, ifsProShare and others lobbied hard for a complete exemption for employee share schemes, arguing that this would be consistent with the EU’s aims of promoting employee share ownership. But against the background of Enron and other scandals and the large employee losses that resulted, legislators thought that this was the time for more, not less, regulation.

After a period of uncertainty, a common position is emerging. Some (but not all) of the issues first feared are now - at least in the UK – turning out to be unfounded, so that many companies are able to continue to operate employee share schemes as previously. Some of the uncertainty has stemmed from poor and inconsistent drafting in the Directive. It is perhaps surprising that, even though the Directive was adopted in November 2003, it has taken so long for the European Commission and the UK Listing Authority publicly to issue their views on many of the points - in most cases only after the Directive has come into force. Indeed, even now many of these views have not been publicly circulated.

Option schemes

Most employee share schemes are option schemes: employees are granted, free of charge, options that are non-transferable (except in the event of death) and have an exercise price set at the prevailing market price at the time of grant (or with a small discount, as with SAYE options).

The key question, as far as obligations under the Directive are concerned, is whether an offer of transferable securities occurs. Is it necessary to look through the option to the underlying shares? If so, the employer might need to determine whether the €2.5 million threshold would be reached. That would mean adding the exercise price of the options to the value of any other shares offered in the last 12 months – but does one count back from the grant of the option or the date of exercise? As a company normally cannot choose when an employee exercises his option, it might find itself having to produce a succession of prospectuses without warning.

There now seems to be a consensus (approved by the UKLA and the European Commission) that the Directive does not apply at all to options. The offer to consider here is the offer of options (which are not transferable securities within the meaning of the legislation), and there is no offer of the underlying securities either at the point of grant or the point of exercise. This means that the grant of options should not give rise to UK prospectus issues, whatever the size of the option award, or whether an EU listed or other company makes the offer.

Free share schemes

Most other commonly seen employee share scheme are free share schemes, under which free shares are transferred to employees either at the time of the award (in which case they may be forfeited if the employee leaves within a certain period or targets are not met) or are transferred to the employee at the end of a service period if performance targets are met. The schemes come under a variety of names but would include long-term incentive plans (LTIPs), performance share plans and also the free and matching share components of the Revenue-approved share incentive plan (SIP).

The relevant legislation defines an offer to the public as a communication setting out sufficient information about the securities and the terms on which they are offered to enable an investor to decide to buy or subscribe for them – in other words, by implication requiring that something must be paid for the securities. The regulatory authorities were initially reluctant to accept that free share schemes were by definition outside the scope of the Directive. It was argued, for example, that:

• the employees were providing services for these shares, and this could amount to consideration (however difficult to value)
• references to specific exemptions for bonus shares in the Directive implied that free shares were generally caught
• while the UK version of the Directive refers to consideration of under €2.5 million, versions of the Directive in other languages refer to share offers with a value of under €2.5 million, so that a free share award of shares worth, say, £350,000 would have a value of £350,000 even if there were no consideration.

But, although no formal guidance has confirmed this, the European Commission and the UKLA are now understood to accept that in the UK the test is whether the consideration for the securities, not their value, is less than €2.5 million. Therefore, free share awards are excluded from the prospectus requirement, whoever makes the award.

Share acquisition schemes

Following the introduction of share incentive plans in 2000, many companies introduced the partnership share element of the SIP. This allows employees to save up to £125 each month and acquire shares (either monthly or at the end of the year) with their savings, with the shares being held in trust for a period.

The position of these schemes under the Directive is more complicated. The partnership shares are clearly not free shares, but are they analogous to options? It helps, for example, that the employee can withdraw at any time (although this has more force when he is entitled to acquire shares at the end of the year rather than the end of the month). This argument has not found much support, however – which is hardly surprising. After all, any offer could be said to be an option or could be structured by way of an option.

There may be other ways of escape from the public offer prospectus requirement:

• A company already operating partnership SIPs as at 1 July 2005 might argue, for example, that, so long as it refrains from periodic general communications about the SIP with all employees, it would only ever make a SIP offer to new employees whom it specifically told about the SIP. Valuing the securities being offered to new employees would be difficult (as often the SIP continues indefinitely until the company or individual withdraws from it), but since the maximum amount that an employee could save in a year is set at £1,500 the new joiners would be unlikely to break through the €2.5 million annual threshold (although any other offers to the public in the last 12 months, whether or not they related to the SIP, would also have to be included). This route is unlikely, however, to be feasible for new SIPs.
• The SIP might use existing shares, bought to the employees’ order on the market, instead of newly-issued shares. On that basis, there would merely be an offer to buy shares on the employees’ behalf, not an offer setting out sufficient information about the shares and the terms on which they are offered to enable an investor to decide to buy shares from the company or subscribe for them, within the meaning of the legislation.
• There is an exemption where the offer is made to fewer than 100 persons in any one EU member state.

There is an exemption for EU listed companies (which does not include AIM companies), which can offer securities to their employees without producing a prospectus as long as a short document detailing basic information (and which might merely cross-refer to a website) is made available. According to one reading of the exemption, offers can be made where any company in the group has a listing of debt or shares, so a US listed company with a Luxembourg debt listing, for example, could take advantage of the exemption for share offers to its employees. However, the UKLA is known not to agree with this approach.

• It may be possible to argue that shares in private companies are not caught, on the grounds that they are not transferable securities within the meaning of the Directive. The definition (adopted from the Investment Services Directive) refers to securities that are “negotiable on the capital market”. The ordinary meaning of this appears to exclude British private companies, which are prohibited under the Companies Act from offering securities to the public. The European Commission, on the contrary, was understood to consider any security capable of being traded (whether or not on a public platform) to be within the definition. There may, however, be a middle way if appropriate restrictions on transfer are included in the company’s articles of association.

Admission to trading

Even if it is possible to avoid producing a prospectus under the public offer requirement, a prospectus may be required if the shares arising on exercise of an option or issued by the company are to be admitted to listing.

Exemptions may be available to EU listed companies: for example, the issue may represent an increase of less than 10% (in aggregate over the previous 12 months) of an existing class, or the company could take advantage of another exemption by giving the employees a short document with details of the shares (which in many cases could simply refer to the company’s website).

Outside the UK

Under the Directive, member states are free to impose national provisions even if the offer is outside the scope of the Directive or the offer is under €2.5 million. The UK has chosen not to regulate this area, but particular care must be taken in each non-UK jurisdiction, as it appears that various member states are imposing regimes for public offers below €2.5 million, or are taking positions on the Directive contrary to those described above taken by the UKLA or the European Commission.

This article first appeared in our Clearly Corporate Bulletin April 2006. To view this publication, please click here to open it as a pdf in a new window.