STOCK OPTIONS AND CASH BALANCE PENSION PLANS:
LIABILITY EXPOSURES FROM EMPLOYEE COST CONTAINMENT
As companies continually strain to maximize profits, opportunities to contain employee costs understandably are attractive to management. For many companies, such costs are one of the largest categories of operating expenses. Therefore, any program that can successfully reduce employee costs without jeopardizing the company's ability to attract and retain quality employees is frequently adopted with little resistance.
In the last several years, companies have adopted two such programs with increasing frequency: employee stock option programs and cash balance pension plans. Both of these types of programs can result in enormous cost savings for the company and can also be financially beneficial to at least some employees under some circumstances. However, both create potentially large D&O, employment practices and fiduciary liability exposures that are only now beginning to come into focus. The following discussion summarizes those exposures and possible insurance ramifications relating to those exposures.
A. Stock Options
By issuing stock options to employees as a form of compensation, companies can reduce their cash costs for employees and essentially force shareholders to pay such compensation directly through dilution of their shares of stock in the company. Not only does use of stock options reduce company costs, but stock options have also grown to become a powerful tool for attracting and retaining qualified workers in an economy that currently sees a shortage of qualified workers in almost every region of the country. A recent survey of a large variety of companies conducted by the National Council on Employee Ownership concluded, among other things:
- Over 80% of the companies surveyed provide ongoing stock option grants to non-managers, not just one-time grants.
- The average value of stock option grants to non-management employees (defined as the number of options granted times the share value on the date of grant) was between $37,000 and $41,000 for professional and technical employees and $12,500 for administrative employees.
- The average employee garners between 12-20% of annual pay in the form of exercisable stock options.
A stock option is a right to purchase stock of the company at a fixed price for a defined period of time. Companies can issue two types of stock options: qualified or incentive stock options ("ISOs"), and non-qualified stock options. Employees favor ISOs since they can defer federal income tax to the date they sell the stock underlying the options, the option spread is often taxed as a capital gain, and the spread is not subject to FICA. Likewise, employers favor ISOs because they do not have to pay FICA tax on them, and the options are not subject to ERISA participation, vesting or anti-discrimination rules. As a result, ISOs are by far the most popular method of granting options to employees.
Some of the principal terms of an ISO are as follows:
- Options may not be granted for an exercise price less than the fair market value of the underlying stock on the date of grant.
- The exercise period may not exceed ten years.
- Vested options must be exercised within 90 days following termination of the employee.
- Options are not transferable.
- Options may only be granted to employees.
Unlike ISOs, the terms of non-qualified options are not strictly regulated. There is more flexibility in determining option price and term. There is no limit on the number of options that can be granted or vested in a particular year, and there are no restrictions on the disposition of the acquired stock. A non-qualified option is taxed to the employee at the time of grant, but only if it has a readily ascertainable fair market value at that time, which is always the case for publicly-traded stock. If it does not have a readily ascertainable fair market value, the grant is taxed at the time of exercise. Most non-qualified options are granted to key employees who receive the right to purchase a certain number of shares at a predetermined price. That option may be exercisable immediately or after the passage of a certain amount of time or the occurrence of a certain event.
The use of stock options as a form of employee compensation can result in a variety of claims against the company and its D&Os. From an employment practices liability standpoint, employees may allege that they were promised but did not receive a certain number or certain type of stock options or that the company illegally discriminated against the employee when awarding stock options to employees. Most frequently, though, the issue will arise in a wrongful discharge claim, where the former employee may allege that as a result of the illegal discharge, he/she forfeited unvested stock options, was forced to exercise vested stock options prematurely, or failed to receive additional stock options which would have been granted in the future if the employee had remained an employee.
If a company's stock price significantly increases over time, the value of stock options similarly increases. It is not unusual in many companies for low-level employees to realize or at least expect huge profits from their stock options.
As a result, it is not unusual for claims based on stock options to allege huge damages.
A recent Tenth Circuit Federal Court of Appeals decision in Greene v. Safeway Stores, 2000 U.S. App. LEXIS 8488 (9th Cir. 2000), provides an excellent example of this type of claim. In Greene, the plaintiff brought an age discrimination claim against his employer alleging that his termination at age 52 denied him various stock option benefits that he otherwise would have realized if he remained employed until his planned retirement at age 55. Greene was required under the terms of the stock option plan to exercise his vested options within 95 days after termination, which he did. The plaintiff provided expert testimony at trial that: (a) had he exercised his vested options at age 55, he would have experienced an additional gain in excess of $3,000,000; and (b) had he retired at age 55, as planned, he would have received additional vested options worth over $1,000,000.
Based on this information, the jury awarded him $4,400,000 for the unrealized stock option values, in addition to $600,000 for loss of salary, bonuses and health benefits, and $1,700,000 for loss of retirement plan benefits. The Court of Appeals affirmed the jury's decision. Importantly, the Court rejected defendant's argument that a front pay award based on unrealized stock option value is too speculative.
From a D&O liability perspective, large awards of stock options to employees create several potentially troubling exposures. Employees with a significant number of stock options are obviously incentivized to enhance the share price, thereby increasing the value of their options. This incentive can be a positive motivator if properly channeled. However, it also increases the temptation for employees to engage in conduct which would artificially inflate the stock price. For example, employees in the sales department may be tempted to report as finalized sales various pending transactions that are still subject to material contingencies, thereby resulting in premature revenue recognition from the transactions. Similarly, employees involved with inventory levels, financial reporting, accounts payable and other financially material activities may be tempted to improperly report information or improperly allocate income or expense items to different reporting periods so that the company's performance for a reporting period appears stronger than it actually is. If employees can artificially inflate the company's stock price for some limited period of time while their stock options are exercisable, the employees can reap large personal gains from their manipulative conduct. This temptation is also acute when the number of stock options awarded to the employee is at least in part based on the results reported by the employee.
If such conduct is committed by low-level employees, it may be difficult for senior management to detect and correct the wrongdoing before the stock price is inflated, yet senior management will inevitably be the target of any securities claim that may be filed after the wrongdoing is disclosed. Therefore, the existence of stock option plans indirectly places much more importance on effective and reliable internal compliance programs, which ultimately are the responsibility of senior management and the Board.
In addition, if directors repeatedly approve the issuance of large amounts of stock options to employees, shareholders whose interest in the company is thereby diluted may assert claims against the directors for unreasonable and excessive dilution. Although such claims have to date been rarely brought, it seems likely that at some point directors will be challenged if they continue over long periods of time to shower enormous amounts of stock options on a large number of employees.
From an insurance standpoint, most EPL insurance policies today are not clear whether they cover that portion of a settlement or judgment that constitutes the value of stock options. The standard EPL policy form issued by many insurers may or may not afford coverage for that portion of a settlement or judgment attributable to claims arising out of stock options. A few policy forms expressly cover or expressly exclude coverage for the value of stock options. Most policies, though, are silent. For those policy forms that are silent, the primary policy provisions which may limit or eliminate coverage for the stock option value are as follows:
- Breach of contract exclusion;
- Compensation Earned exclusion, although this exclusion does not apply to any "back pay or front pay;"
- "Benefits" exclusion; and
- The exclusion in the definition of Loss for the cost to comply with any injunctive or other non-monetary relief or any agreement to provide any such relief.
One or more of these provisions may apply to an EPL claim related to stock options, depending upon the nature of the claim, the causes of action asserted by the claimant and the circumstances. To some extent, the existence of coverage under many EPL policy forms is dependent upon how claimant's counsel chooses to draft the complaint.
Because of the much greater exposure presented by stock option claims today and the greater sensitivity all parties have towards this exposure, it may be advantageous to all parties for the EPL policy to either affirmatively exclude coverage for this exposure (based upon the volatile and potentially catastrophic liability risk) or to expressly grant coverage for this exposure subject to appropriate limitations. Some of those limitations which insurers may seek to impose when affirmatively granting such coverage include:
- Sublimit;
- Coinsurance;
- Significantly higher retention so that only catastrophic coverage is granted;
- Limit the coverage only to the Insureds' monetary liability arising out of a stock option claim (i.e. do not cover the Insureds' obligation to grant additional options, issue stock, etc.);
- Exclude stock option liability arising out of a claim for wrongful termination if the termination occurred within a designated number of days (e.g. 30 or 60) before the stock options vested (i.e. adopt an irrebuttable presumption that if the termination occurred shortly before the stock options vested, the vesting likely played a role in the termination decision and therefore no coverage should exist);
- Add an "intent to injure" exclusion for purposes of this coverage only; and
- Utilize a supplemental Application which solicits information directly relevant to the stock option exposure.
A D&O claim related to stock options may raise several coverage issues under a typical D&O insurance policy, depending on the facts of the claim. If the claim arises out of the defendant D&O allegedly exercising his/her stock options at a market price which was artificially inflated by his/her wrongdoing, an issue may arise whether the personal profit exclusion is triggered. Whether that exclusion will apply depends in part on whether the exclusion's preamble is broad (e.g. "based upon, arising out of or in any way related to...") or narrow (e.g. "for"). Also, some forms of this exclusion apply only if there is a final adjudication of illegal personal profit, thus not applying to settlements. Many insurers, though, are reluctant to offer a "final adjudication" form of this exclusion because the insurers believe it is inappropriate for the policy to fund a settlement which allows the insured D&O to retain profits wrongfully obtained.
If the claim against the D&O seeks to recover from the D&O proceeds from the stock option exercise, a coverage issue may also arise as to whether the claim is against the D&O in his/her insured capacity as a director or officer, or is against the D&O in the uninsured capacity as an optionholder/shareholder.
B. Cash Benefit Pension Plans
A second method of employee cost reduction which has become increasingly popular in the last several years is converting a company's defined benefit plan to a "cash balance" pension plan. Under a traditional defined benefit plan, an employee's benefits are determined, among other things, based on the employee's years of service and the employee's average compensation in his/her final years of employment. Under a cash balance plan, an employee's benefits equal a defined percentage of the employee's actual compensation for each year of service plus interest thereon.
Because traditional defined benefit plans focus primarily on the level of compensation in the years just before retirement (which frequently is relatively high compared to prior levels of compensation for the employee), the retirement benefit grows much more rapidly in the later years, i.e. the rate of benefit growth is "back-loaded" as compared to a benefit under a cash balance plan. Consequently, when a defined benefit plan is converted to a cash balance plan, an older worker will often see a lower rate of benefit growth after the conversion and will also see a lower final retirement benefit than if the plan conversion had not taken place. Some critics say the pensions of workers in their 40's, 50's or 60's could be reduced between 20% to 50% as the result of a conversion to a cash balance plan. Corporations prefer the new cash balance plans for a number of reasons. On the one hand they are more attractive to younger and more mobile employees. On the other hand, because of the reduction in benefit growth for older workers, the conversion can result in an overall cost savings to the employer which can be quite significant.
The conversion from a defined benefit plan to a cash balance plan may subject companies and plan fiduciaries to potential exposure under several legal theories, including the Age Discrimination in Employment Act (ADEA) and the Employee Retirement Income Security Act (ERISA). An employer may face liability exposure under the ADEA if benefits to older workers are lower under the new plan than under the old plan. One federal circuit court has held that an inference of age bias can be inferred under the ADEA if a company's new cash balance plan provides lower benefits to older workers than the company's existing defined benefit plan. Goldman v. First National Bank of Boston, 985 F.2d 1113 (1st Cir. 1993).
Under ERISA, employees adversely affected by a conversion likely will allege that the company and other plan fiduciaries breached their fiduciary duty to the employees by reducing accrued benefits or by failing to accurately disclose the allegedly adverse impact the change would have on older workers. The mere act of converting to a cash balance plan, though, should not subject the company to exposure under the fiduciary duty provisions of ERISA since the act of amending a pension plan is a corporate act as an employer, not a fiduciary act for the benefit of plan participants. Employers are generally free to adopt, modify or terminate employee benefit plans for any reason at any time. However, ERISA liability may still exist if the conversion decreases vested accrued benefits or if disclosures relating to the conversion are inaccurate or misleading.
Although relatively few claims have arisen to date relating to a conversion to a cash benefit plan, it is likely more such claims will be made in the future as more companies make this conversion. Because older workers are likely be to harmed in most such conversions, it is relatively easy for a plaintiff to at least allege a persuasive and sympathetic claim for wrongdoing.
From an insurance standpoint, a claim arising out of a company's conversion to a cash balance plan can potentially implicate ERISA fiduciary coverage, employment practices coverage and D&O coverage, depending on the legal theories and defendants named in the claim. Because each of these coverages frequently have significantly different retentions, limits and exclusions, significantly different coverage exists depending on how the claimant chooses to structure the claim. For example, the fiduciary coverage contains a "benefits due" exclusion which may eliminate coverage for that portion of a settlement or judgment constituting benefits due under a plan, whereas the D&O coverage and perhaps the EPL coverage do not contain such an exclusion. In addition, a single "cash balance" claim may implicate several types of policies, thereby creating difficult allocation issues between policies and the potential for multiple retentions and multiple limits applying.