The death of the employee share option? And a new complexity regarding the on-sale of shares

Articles Written by Clare Brown (Partner), Marko Komadina (Partner), Scott Cummins (Special Counsel)

Sept 2022 (updated Oct 2022)

From 1 October, we expect to see significant changes in the way that companies offer equity to their Australian personnel. For many businesses, new rules in the Corporations Act significantly reduce the red tape associated with offering equity to staff. However, there are some traps which both listed and unlisted companies will need to navigate carefully.

With effect from 1 October 2022, the Corporations Act has been amended to replace the existing class order relief for employee incentive schemes under which most listed companies, and some unlisted companies, have long offered equity to their directors and employees.

When the legislation was passed a few months ago, we outlined the role of these new rules and some of the major changes compared to the class orders. The below provides additional insights about how those rules are likely to work in practice, drawn from our experience planning for and advising clients on these changes in advance of the 1 October transition:

  • Pathways to relief – the easy way & the hard ways: There are stark differences between the different pathways to relief under the new employee share scheme (ESS) rules. Where available, the easy ways are substantially simpler than under the existing class orders. Failing them, the hard way is substantially more cumbersome than under the existing class orders. The implications of these differences include that the humble market-priced option – perhaps the most common form of equity incentive for unlisted companies (and also used by many listed companies) – will be rendered impractical in many instances. For companies that have historically offered ESS interests outside of the class order regime, there are also some associated changes in relation to the design and distribution obligations.
  • On-sale, temporary extension of class orders and cleansing notices: There is a deficiency in the new rules relating to the ability of participants in listed company employee incentive schemes to on-sell their resulting shares within the first 12 months after acquiring them, for example, after vesting of performance rights or exercise of options). ASIC is consulting on a potential fix, but in the meantime, all listed companies will need a strategy to facilitate on-sales. One option (until the end of 2022) will be to continue to make offers under the class orders, but companies wishing to rely upon the new rules immediately may need to issue cleansing notices for shares issued under an employee incentive scheme.

Pathways to relief

Under the new rules, Parliament has created several pathways through which companies can offer equity under an ESS.

From 1 October, there is effectively a ‘hard way’ and three ‘easy ways’ to offer equity under an ESS. The differences between them are so stark that we expect that most companies will prefer one of the easy ways in the absence of significant countervailing factors, for example, tax or a desire for consistency in ESS structures across multiple countries.

The easy pathways

The three ‘easy pathways’ involve (among other requirements):

  1. No monetary consideration: Ensuring that no monetary consideration can be paid in connection with a grant of ESS interests – either on the initial grant, or upon exercise of any options or incentive rights. We therefore expect that performance rights (or RSUs), share appreciation rights (or phantom equity) and zero exercise-price options (or ZEPOs) will become even more popular following 1 October. But perhaps the most common form of equity incentive for unlisted companies (and many listed companies) – the share option exercisable for cash consideration (usually the market price of a share at the date of grant) – cannot be used under this pathway;
  2. Senior managers; professional/sophisticated investors: Limiting offers to senior managers, or others who are regarded for the purposes of the Corporations Act as professional or sophisticated investors; and
  3. Small scale offers: Making personal offers within the company’s ‘20-in-12’ capacity, which in summary allows companies to issue securities to up to 20 investors per rolling 12 months, provided the company raises no more than $2 million in that period by doing so.

The offer structures in points 2 and 3 above already exist as exceptions to the disclosure document obligations under Chapter 6D of the Corporations Act. However, structuring offers in those ways will not automatically ensure that a company satisfies other obligations that sometimes apply to employee share schemes, such as financial services licensing requirements and the design and distribution obligations. The role of the new ESS rules is equivalent to the role of the old class orders: by making offers in accordance with the new ESS rules, companies can avoid the need to consider, and if necessary comply with, those other obligations. As the conditions to the ‘easy pathways’ are relatively simple, companies will generally find it attractive to make offers under the new ESS rules rather than working through those other Corporations Act requirements. This includes some companies that did not previously need to rely upon the class orders, as the ESS exemption from the design and distribution obligations in the Corporations Act has now been narrowed[1]

Companies can rely upon a mix of the pathways. Companies could both offer equity for no monetary consideration to their general staff members, and offer equity for monetary consideration under a separate plan for senior managers.

Although the statutory requirements for the ‘easy pathways’ are generally fairly simple, there can be some nuances beyond the requirements outlined above. Companies should still take legal advice about how to offer equity after 1 October.

A particular subtlety arises for companies using trust structures in their ESSs, as the protection afforded by the new ESS rules falls away if there is any breach of the trust deed; even if the breach is immaterial and subsequently cured, and even if the trust is only used for ESS interests granted under small scale offers or offers for no monetary consideration. These companies may therefore need to assess whether certain changes to their trust deeds are desirable to reduce the possibility of such breaches.

The hard pathway

The nuances of the ‘easy pathways’ pale in comparison to the complexities and requirements associated with offers under the ‘hard pathway’, which applies if none of the ‘easy pathways’ are available. Many of the requirements under this pathway are significantly more onerous than those presently existing in the class order relief under which companies have offered equity to their directors and employees for many years. The new aspects include:

  • personal contractual liability of directors (and certain others) for misleading statements and omissions in connection with the offer;
  • retrospective revocation of relief under the new ESS rules for even innocent and immaterial breaches of the statutory requirements, with no cure periods available;
  • more detailed structuring and disclosure requirements. This is especially pronounced for unlisted companies, which will need to provide certain financial information, including some quite specific documentation going to the valuation of the company. And there is now a seemingly open-ended requirement to provide participants with an updated ESS offer document each time the document becomes out of date in any material respect; and
  • new limits on the monetary consideration, for unlisted companies, that an ESS participant may pay in any 12 month period. Under the class orders, the limit was on the value of securities offered. For some companies, particularly those with multiple incentive schemes (including historical option schemes), the new rules could be extremely difficult to apply in practice. To facilitate offers under the ‘hard pathway’, such companies may consider it necessary to prevent the exercise of options until certain liquidity events such as an IPO or a sale of the entire company.

Given the above, we expect companies going forward will generally prefer to rely upon one of the ‘easy pathways’. So apart from offers limited to senior managers or so-called professional or sophisticated investors, our expectation is that many companies will restructure their ESSs to ensure that no monetary consideration is paid on either grant or exercise, or favour traditional ‘no monetary consideration’ awards such as performance rights. The humble market-priced option will unfortunately be a casualty of the new rules, except where structured to only be exercisable on a cashless (or ‘net’) basis.

On-sale, temporary extension of class orders and cleansing notices

Historically, ESS participants in listed company schemes have been able to freely on-sell their ESS shares immediately after acquiring them in reliance on on-sale relief provided in the class orders. For offers made under the new rules (i.e. from 1 October) ESS participants will be prohibited from on-selling their shares within the first 12 months after acquiring them, other than to a narrow group of recipients such as other ESS participants, the senior managers of the company, and certain others who are regarded for the purposes of the Corporations Act as professional or sophisticated investors.

This will create a headache for listed companies as the ASX Listing Rules require that shares in a quoted class be freely tradeable once they are issued.

Unsurprisingly, many in the market have objected to this and just before the new rules went live, ASIC released a consultation paper regarding a potential modification to the Corporations Act (by way of a new legislative instrument) that, if implemented, would generally permit the unrestricted on-sale of shares where they are quoted on ASX (or certain overseas exchanges).

Although we expect ASIC’s proposal to receive widespread support, it is unlikely to take effect until late in 2022 or the beginning of 2023. Unless and until it takes effect, the on-sale issues described above continue to apply. Companies offering ESSs before the modification takes effect should therefore be comfortable that they can satisfy the ASX Listing Rules by other means, such as:

  • Temporary extension of class orders. ASIC will leave the old class orders in operation until 1 January 2023 (although offers made before that date can remain open for acceptance for up to 13 months). This means that companies can continue to rely upon the class orders and the associated on-sale relief until ASIC’s proposed modification to the new rules takes effect. But companies that do this will not be able to rely upon the ‘easy way’ pathways to make ESS offers under the new rules. In many cases, maintaining the status quo will be simpler than trying to structure around the hopefully-temporary on-sale issue associated with the new rules. But companies that wish to rely upon the new rules instead could consider one or a combination of the strategies below.
  • Cleansing notices: If eligible to do so, a listed company could issue a cleansing notice immediately after it issues the relevant shares. Although the cleansing notice will ensure the shares are immediately tradeable – important for many ESS participants – the use of a cleansing notice means the listed company must disclose all materially price-sensitive information it holds, even if the information would otherwise fit within the exception to its continuous disclosure obligations in ASX Listing Rule 3.1A. In many instances, this will not be problematic. However, that cannot be assured at the time of an ESS offer, which could cause difficulties if a participant later becomes entitled to be issued shares at a time when, for instance, the company is in the middle of planning a capital raising or is negotiating a material transaction.
  • Regulating when shares are issued: To ameliorate some of the disadvantages associated with the use of cleansing notices, companies can structure their ESSs in such a way as to limit when shares are issued. For instance:
    • performance rights can be structured using vesting conditions that are all satisfied (or not) by reference to a consistent measurement time, for example, the release of the audited year-end financials for a particular year. Similarly, all share appreciation rights granted in a particular tranche can be calculated by reference to the share appreciation until a consistent date. Options can be structured to only be capable of being exercised on say, the last day of a quarter; and
    • for securities convertible into shares, such as options, performance rights and share appreciation rights, boards could give themselves the discretion to delay the issue of resulting shares for up to a predetermined period after vesting or exercise or to align with the commencement of the next trading window under the company’s securities trading policy. This gives companies the ability to issue shares, and therefore cleansing notices, in batches where vesting/exercise dates are not aligned. The discretion also gives boards a degree of flexibility to avoid being forced to issue a cleansing notice at an inconvenient time, although it may not be a solution in all cases.
  • 12 month lockups: Companies could impose restrictions on the transfer of the resulting shares for 12 months, supported by a holding lock. This will require the agreement of the participant, although that can be achieved by the inclusion of appropriate language in the plan rules or invitation letter.

In summary

Whether listed or unlisted, any company offering equity incentives to its Australian personnel should, at a minimum, review its plan documentation and processes for compliance with the new ESS rules. In almost all cases, updates will be required – although the nature and complexity of the updates will depend on the structures being used.

The new ESS rules appear fairly straightforward at first blush, but there are a number of traps lurking in the detail. Our commentary above is a summary in nature, and we encourage our clients to seek specific legal advice before offering new equity to directors or employees after 1 October 2022. Please feel free to get in touch to discuss further.


[1]  With effect from 1 October, the ESS exception to the design & distribution obligations in the Corporations Act will only apply to offers made under the new ESS rules. Therefore, companies that have historically made offers outside the class orders (i.e. by satisfying, or meeting relevant exemptions from, the financial services licensing and other Corporations Act requirements) will now need to assess whether their ESSs are caught by the design & distribution obligations. If they are caught, these companies can either switch to making offers under the new ESS rules; or else will now need to comply with the design & distribution obligations, including by making, periodically reviewing, and complying with, ‘target market determinations’.

Important Disclaimer: The material contained in this article is comment of a general nature only and is not and nor is it intended to be advice on any specific professional matter. In that the effectiveness or accuracy of any professional advice depends upon the particular circumstances of each case, neither the firm nor any individual author accepts any responsibility whatsoever for any acts or omissions resulting from reliance upon the content of any articles. Before acting on the basis of any material contained in this publication, we recommend that you consult your professional adviser. Liability limited by a scheme approved under Professional Standards Legislation (Australia-wide except in Tasmania).

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