Latham & Watkins Employee Benefits and Compensation Practice

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1 Number October 2005 Client Alert Latham & Watkins Employee Benefits and Compensation Practice Employee Compensation: A Cautionary Note for Employers with Stock Option Plans... an employee may also be able to claim for loss of stock options: this loss could include loss of opportunity to participate in the scheme, loss arising from the lapse of unvested options or of vested options before they can be exercised, loss of opportunity to receive additional share-related benefits and loss of opportunity to take advantage of increases in share value. Introduction On the unfair termination of an employee s employment, the potential losses for the employee that automatically spring to mind are those of salary and bonus. However, an employee may also be able to claim for loss of stock options: this loss could include loss of opportunity to participate in the scheme, loss arising from the lapse of unvested options or of vested options before they can be exercised, loss of opportunity to receive additional share-related benefits and loss of opportunity to take advantage of increases in share value. It is worth noting that an employee may also have a contractual claim for loss of stock options, but this is a separate issue that is not discussed below. United Kingdom When an employee is dismissed for a reason that is considered at law to be unfair, that employee can bring a claim for unfair dismissal, even if there has been no breach of the employee s contract. An award for damages for unfair dismissal consists of a basic award based on age, length of service and salary per week (subject to a statutory cap) and a compensatory element. Whilst a tribunal can order re-instatement or re-engagement of the employee as a remedy for unfair dismissal, this is rare in the UK. The purpose of the compensatory award is to attempt to put the employee, so far as possible, in the position that he or she would have been in but for the unfair dismissal. The principal element of compensation will be loss of earnings, both current (between the dismissal and the date of the hearing) and future (according to the tribunal s estimate of how long the loss might continue). An employee has a duty to minimise any loss he or she has suffered (by seeking another job, for example) and any award will be decreased accordingly. As well as compensating the employee for loss of basic salary, the award will also include loss of any benefits which the employee might reasonably have expected to receive had he or she not been dismissed unfairly. Losses Under a Share Option Scheme Such benefits will often include share option schemes, which are becoming increasingly popular as part of an employee s remuneration package. It has been established (Leonard v Strathclude Buses Limited [1998] IRLR 693 CS) that compensation for loss of share-related benefits is available Latham & Watkins operates as a limited liability partnership worldwide with an affiliate in the United Kingdom and Italy, where the practice is conducted through an affiliated multinational partnership. Copyright 2005 Latham & Watkins. All Rights Reserved.

2 to employees where the loss is attributable to some action taken by the employer. In theory, the implications of compensating for such losses could be extremely wide. However, in the UK this worry for employers is tempered by a number factors. Limits on Liability It is usually possible to make the dismissal fair, provided that the employer has a good reason for the dismissal and is prepared to spend the time to follow the correct procedures to ensure that the dismissal is brought about fairly, including giving the requisite notice period and paying salary during this period or making a payment in lieu of notice (provided that there has not been gross misconduct justifying summary dismissal). Except in limited circumstances, compensation for unfair dismissal is capped at a mere 65,200 (including the basic award). In addition, the compensatory award may be reduced if a payment under a contractual claim for wrongful dismissal has been made where the two awards are in respect of the same loss. This cap is removed if the dismissal was as a result of discriminatory treatment by the employer. Another way in which the potential risk in the UK is reduced is the treatment by the courts of the issue. The case of Selective Beauty UK Ltd v Hayes (EAT 5 April 2005) establishes that, when awarding compensation for loss of a future opportunity (such as the opportunity to exercise share options and consequent loss of profit to be made from selling those shares), the tribunal will assess the damages in percentage terms based on the likelihood of the event giving rise to an actual loss materialising (i.e. the likelihood that the employee would have remained in employment long enough for options to vest) and the consequent value of the loss. The court should not approach the assessment on the balance of probabilities that the event would occur and therefore award the full damages. Finally, the regular use of compromise or severance agreements in the UK, whereby employees are paid a sum of money in return for entering a general waiver of claims agreement, also severely restricts the circumstances in which an employer might become liable to pay for loss of stock options. The UK position should therefore offer employers comfort as to their potential liability. The position in both Germany and France is quite different and it is interesting to make a brief comparison. Germany In Germany, an employee who has been unfairly dismissed will be entitled to continue to work for the employer as if he or she had never been dismissed because an unfair dismissal is an ineffective one. Any salary not paid from the dismissal up until the time of reinstatement has to be paid to the employee retrospectively. In addition, stock options that would have vested during this time will be treated as having vested and the employee will be entitled to exercise the options and receive the shares. If it is not possible for the employee to receive the shares him or herself then the employee will have a claim for damages. However, in assessing the damages, it is difficult to determine when the employee would have exercised the options and/or sold the shares. There is no precedent for this as yet and it is therefore uncertain precisely how the amount would be calculated. It seems likely that it will be based on the difference between the exercise price of the option and the current market value, on the one hand, and the market value on the proposed sale date, on the other. This could result in a considerable award and the amount of damages that an employee can receive is not capped. 2 Number October 2005

3 Fair Dismissals In Germany, dismissals can be fair if they are done for a fair reason which must be one of misconduct, personal reasons (such as poor performance or extended illness) or redundancy, and with the required notice period. However, there are further complications if a works council exists. If a court decides that a dismissal was fair, then the employment relationship will terminate and the employee will not be entitled to receive either shares or damages, provided that the stock option plan does not provide for extended vesting/execution rights. Settlement In practice, court proceedings often take a year or more, and it may be that the employee does not wish to be reinstated. In this case, a severance package may be negotiated either in court or by way of out of court settlement. The payment of stock options may be a significant issue in the negotiation of a severance payment or settlement offer as, again, damages are not capped at all. The amount payable will usually depend, to a certain extent, upon the likelihood of the employee winning or losing a claim for unfair dismissal in court. Employees may waive claims arising out of their former employment by entering into a mutual termination agreement with their former employer as part of the severance package. Thus, compensating employees for loss of stock options on an unfair dismissal can be a major concern for employers in Germany, despite the fact that the primary remedy is one of reinstatement. France When an employee is dismissed, he or she can bring a claim for unfair dismissal before the Labour Court. If the dismissal is held to be unfair by the judge, an award for damages for unfair dismissal will be made to the employee. The amount of the award is based on age, length of service and salary. The court will also review, upon the employee s request, the loss of any benefits which the employee might reasonably have expected to receive had he or she not been dismissed unfairly. As a matter of law, where the employee has at least two years continuous employment and the employer has at least 11 employees, the employee is entitled to receive a minimum of six months remuneration by way of damages if unfair dismissal is established. Whilst a court can suggest reinstatement of the employee as a remedy for unfair dismissal, the outcome of court action is more commonly an award of damages awarded to the unfairly dismissed employee. Losses Under a Share Option Scheme In France, share options have become increasingly popular since the 1990s. Most share option plans provide that option holders must still be employees of the company (or the group) in order to exercise their rights relating to share options. Therefore, employees would lose these rights once their employment agreements terminated, whatever the circumstances of such termination. Fair Dismissal The French Supreme Court initially recognized the validity of share option plans requiring option holders still to be on the payroll of the company in order for options to be exercised (Cour de cassation, 9 May 2001, no ). Less than a year later, the Supreme Court reinforced that such provisions restricting the possibility to exercise the options, could only be enforced if the employees had received prior, formal notification of these provisions. Should the employer be unable to provide evidence that he had properly informed the option holders of these conditions under the plan (i.e.: need to be on the payroll) by supplying each beneficiary with a comprehensive information 3 Number October 2005

4 memorandum and/or a copy of the plan (if required, translated into French, such condition would not be enforceable; the beneficiary would thus be entitled to damages in respect of his loss of options (Cour de cassation, 15 January 2002, no ). Even if an employee has been duly informed of the relevant conditions in the share option plan which stated that he or she was not entitled to exercise his or her share options following his or her dismissal, the employee would be entitled to compensation for the financial damage caused, if his dismissal was found by the labour court to be unfair (e.g.: Cour de cassation, 29 September 2004, n ). Therefore, where the Labour Court holds a dismissal to be unfair, the employee is entitled to damages in respect of his loss of options. Assessment of Damages Assuming the dismissal is deemed by a court to be unfair, the amount of damages payable can be difficult to assess. If the employee had not been entitled to exercise his or her option under the rules of the plan at the date of dismissal, the issue is to determine when he or she would have exercised the options and/or sold the shares, and what the market value of the shares would have been at that time. If the employee had been entitled to exercise his or her rights at the date of his or her dismissal within to the deadlines specified in the plan, so that he or she would have benefited from an immediate profit, damages can be more easily assessed, as they should be, to a large extent, based on the difference between the option price and the share s value at that date. However, this assumes that the employee would sell immediately when in reality, taxation reasons might have influenced the employee not to have resold the share immediately and therefore the complications of determining what a shares value might be at some point in the future can not be avoided. It is worth noting that damages for the loss of share options rights are not capped under French law and therefore could be extremely high. It will almost always involve the appointment of a judicial expert by the judge, which will lead to a lengthy, complicated and costly procedure. In view of the difficulty of such prospective and technical calculations, it is advisable to request the appointment of an expert to make an assessment based on all the necessary factors. Avoiding the Risk Under French law it is possible to dismiss fairly, so long as the employer has justification, abides by the relevant dismissal procedure and gives the required notice period. However, courts take a very strict approach on the justification for dismissals and it can be difficult to avoid a claim for unfair dismissal. Compromise agreements are used as an effective way of avoiding payment including of damages for loss of stock options, but these must be entered into by the parties only after the dismissal has taken place and it is advisable to refer specifically to stock options in the agreement itself to be sure of avoiding a future claim. Conclusion Whilst compensation for loss of share options can be an issue in the UK, the scope of any potential liability is quite restricted. This is in contrast to the position in Germany and France where the risk for employers is much greater, primarily because there is no cap on the damages that can be awarded to an employee. In all cases, employers should be aware of the risks that may be involved in a European context on the termination of employees contracts of employment when considering implementing a company-wide share option plan. 4 Number October 2005

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6 Office locations: Boston Brussels Chicago Frankfurt Hamburg Hong Kong London Los Angeles Milan Moscow New Jersey New York Northern Virginia Orange County Paris San Diego San Francisco Shanghai Silicon Valley Singapore Tokyo Washington, D.C. Client Alert is published by Latham & Watkins as a news reporting service to clients and other friends. The information contained in this publication should not be construed as legal advice. Should further analysis or explanation of the subject matter be required, please contact the attorneys listed below or the attorney whom you normally consult. A complete list of our Client Alerts can be found on our Web site at If you wish to update your contact details or customize the information you receive from Latham & Watkins, please visit to subscribe to our global client mailings program. If you have any questions about this Client Alert, please contact Emma Scarratt in our London office, Stephane Henry, Matthias Rubner or Deborah Sankowicz from our Paris office, Norma Studt from our Hamburg office, or any of the following attorneys. Boston David A. Gordon Brussels Marc Hansen +32 (0) Chicago John P. Lynch Kevin A. Russell Kenneth G. Schuler Frankfurt Volker Schäfer Hamburg Stefan Lunk Hong Kong Mitchell D. Stocks London Stephen Brown Christopher Hitchins Los Angeles G. Andrew Lundberg Joel E. Krischer Milan Michael S. Immordino Moscow Anya Goldin New Jersey James E. Tyrrell New York Christopher Harris Catherine E. Palmer John D. Shyer Orange County Perry J. Viscounty Paris John P. Lynch Deborah Sankowicz +33 (0) San Diego Michael J. Weaver San Francisco Linda M. Inscoe Peter A. Wald Shanghai Rowland Cheng Silicon Valley Patrick E. Gibbs Matthew B. Lehr Singapore Mark A. Nelson Tokyo David L. Shapiro Washington, D.C. Richard P. Bress Kip C. Johnson, Jr Number October 2005