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Avoiding Lawsuits in Your Stock Option Plan

It's inevitable. As more people get stock options, there are going to be more lawsuits over how these plans are run. While far from a comprehensive list, there are some common issues that come up in these suits that careful plan design can help avoid.

Careful Plan Design

First, back up to that last phrase in the paragraph above—"careful plan design." Far too many stock option plans are drafted by amateurs. It is very tempting for any corporate attorney to claim to be able to set up a stock option plan even if they have only limited experience with the issues. This is even more true of a broad-based plan. An attorney might have set up a plan for executives and assume that the same structures can be used for a plan for all employees. Unfortunately, it is easy to overlook any number of specific issues that should be covered in a plan. Just ask the executives at Computer Associates who will be repaying hundreds of millions of dollars from their stock option exercises because their plan did not specify that when the shares split the options split too.

To find an attorney who actually has experience with these plans, you can use the Service Provider Directory in the members-only part of this site (assuming that you're one of our members). Whether you choose one of these people or someone else, however, make sure you get a client list of companies for whom they have set up comparable plans. Also ask if they belong to the various organizations covering stock options, such as the NCEO, the National Association of Stock Plan Professionals, or the Global Equity Organization, and whether they have written articles, spoken on the subject, or otherwise have specific experience in the area.

Plan for Acquisition

Many companies write their plans with the assumption that they will not be acquired. In fact, many of them will, whether they are publicly traded or not. One of the most common, and costly, areas of options lawsuits is what happens when there is an acquisition. Will options immediately vest and become fully exercisable (employees will like that but these provisions can make your company less attractive to a suitor)? If options do not vest on acquisition, what happens to the unvested options? Can they be translated into options in the acquiring company's stock? For options that are vested, are they immediately exercisable or will the employee receive options or shares in the acquirer instead? If options are exchanged, how will the exchange value be set?

Some plans will outline specifically what will happen on each of these issues. That, of course, limits the company's flexibility in the face of a negotiation. If more discretion is desired, then the plan needs to lay out the procedures about who will make the decisions and on what basis. One approach to help build more employee confidence in this discretionary plan is to require that someone other than senior management make the decision, such as a committee of outside directors or an independent fiduciary appointed by the company. The fairness of any option exchange could be reviewed by an independent source, such as a qualified valuation or CPA firm. However these issues are handled, the more ambiguous or silent the plan is on what happens, the more likely employees are to sue.

Clarify Termination Rules

Another common area for suits is termination, whether for cause or not. Most plans state that unvested shares are forfeited when an employee terminates employment, but this is not universally the case nor universally spelled out. Employees still might argue that their termination was inappropriate and perhaps even that they were terminated so that the company would not have to deal with all their options. Making sure the plan and the contract with employee specifies the employee's rights for unvested options if terminated can help avoid lawsuits, although sufficiently aggrieved employees might sue anyway.

Some plans also state that unexercised but vested options are canceled if an employee is terminated for cause. This creates much stickier issues. Employees with substantial option value may well contend that their termination was to reduce costs to the employer. If your plan has such a provision, you need to review it very carefully with an attorney specializing in the employment laws of your state.

Finally, some plans state that options will be canceled if an employee goes to work for a competitor. Obviously, companies are not enthused about employees taking a large option award and starting a competing enterprise or going to work for one. The problem with the non-compete agreements is that they are often very difficult to enforce, and are illegal in some states. Employment law is a complex area that is almost entirely based on state, not federal, rules, so before creating a non-compete clause, get a careful legal review.

Transferring Options

Rules for the transferability of options are less quarrelsome, but options that have been transferred to a spouse who then gets divorced before the options vest can be another source for lawsuits (each spouse will claim the unvested options as theirs, for instance). Spelling out in advance who has a right to unvested and/or unexercised options can help make these lawsuits less likely.

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