Report of the Committee on

Sweat Equity, ESOP and Preferential Allotment

1 Terms of Reference and Approach

In August 2002, the Central Government set up a Committee to consider the issues relating to sweat equity shares, Employees Stock Option Scheme (ESOP) and preferential allotment for companies other than listed companies. The composition of the Committee is given in Annexure I. The Committee was asked to submit its report within a month.

The Committee held four meetings during the course of its deliberations. In addition, the members interacted extensively through the medium of email.

The Committee studied the existing regulatory framework for listed companies laid down by the Securities and Exchange Board of India (SEBI) and discussed the need to augment these in the light of recent corporate developments in India and in the United States. The Committee also had the benefit of the material made available to it by SEBI about the latter’s ongoing efforts to revise and strengthen its regulatory framework for listed companies. The Committee also deliberated on the differentiation that needs to be made between listed companies and unlisted companies as well as between unlisted public companies and private companies.

The Committee would like to place on record its appreciation of the support provided by the Member-Secretary, Mrs. Alka Kapoor. It would also like to thank Mr. Selvaraj of the Department of Company Affairs (DCA) and Ms. Rajrani Bhalla of SEBI for their valuable contribution in preparing drafts of the rules and regulations proposed by the Committee. Mr. Rajiv Mehrishi and Mr. R. Vasudevan of the DCA provided valuable inputs and support to the Committee. The Committee would also like to thank the Institute of Company Secretaries of India and the Securities and Exchange Board of India for their hospitality when the meetings of the Group were held in their premises.

2 Employee Stock Options

2.1 Existing Regulatory Framework for Listed Companies

The existing regulatory framework for listed companies is based on the twin principles of disclosure and shareholder approval. The stock option scheme has to be approved by the shareholders through a special resolution. Companies have full freedom on the price at which stock options can be issued. However, if the exercise price is below the market price at the date of grant, the difference between the two (the intrinsic value of the option) should be expensed in the profit and loss account as a part of employee compensation expense. There is no requirement to disclose or expense the Black-Scholes or similar fair value of the option. There is no ceiling on the quantum of stock options that can be issued either in the aggregate or on a per employee basis. However, large grants to specific employees must be individually voted on by the shareholders by special resolution. There is a minimum vesting period of one year before the options can be exercised, but there is no lock in period after the options are exercised. Options can be granted to the employees and directors of the company (whether in India or abroad) or to the employees of the subsidiary or the holding company. However, options cannot be granted to the promoters or large shareholders of the company.

2.2 SEBI’s Review of its ESOP Regulations

During the deliberations, the Committee was informed that SEBI has reviewed its regulatory framework and that the review committee has recommended mandatory disclosure of the fair value of the option (as measured by the Black-Scholes or similar model). However, actual expensing of this fair value would be optional.

2.3 Recent Corporate Developments

The Committee reviewed recent corporate failures in the United States where employee stock options could have played a role. The Committee noted the emerging view that stock option grants in some companies in the United States might have been excessive and that these grants might have created perverse incentives for the chief executives and senior managerial personnel. It noted however that stock option grants in the United States are not subject to shareholder approval. The Committee also noted recent reports that in some cases of well publicized corporate failures, the rights of option grantees as investors might not have been adequately safeguarded. The Committee also took into account the emerging demand for the expensing of Black-Scholes values of employee stock options.

2.4 Recommendations of the Committee

2.4.1 Market Price of the Share

In the case of unlisted companies, there is no readily available market price for the shares of the company. The accounting disclosures under the listed company regulations are based critically on the market price of the share. The Committee debated the possibility of using an independent valuation of the share as the basis for accounting disclosures. However, given the costs involved in obtaining such valuations and the uncertainties surrounding them, the Committee recommends that such valuation should be optional and that companies should instead be allowed to use the book value of the share as the fair value of the shares for the purpose of accounting for the stock options.

2.4.2 Black-Scholes Values

The Committee recognizes the advantages of disclosing fair value (as measured by Black-Scholes or similar models). However, it sees considerable difficulties in obtaining reliable estimates of the parameters of the Black-Scholes model. In the United States, FAS 123 allows unlisted companies to use a Black-Scholes model in which the volatility of the stock is set to zero. In this case, the Black-Scholes value reduces to the excess of the stock price over the discounted exercise price[1] and the only difference from the intrinsic value (excess of stock price over the exercise price) is the recognition of the interest cost arising from the fact that the exercise price is paid only on exercise of the option.

In this framework, there are four parameters to be estimated (apart from the exercise price which is a part of the option scheme itself)

1 The stock price: As already stated in 2.4.1 above this is approximated by the book value or an independent valuation if the company so desires.

2 The risk free interest rate for discounting: Where the exercise price is fixed in Indian rupees, the risk free rate should be the zero coupon rate estimated from traded government securities for a maturity corresponding to the expected life of the option. This estimate is put out daily on the web site of the National Stock Exchange (Wholesale Debt Market Segment). The Department of Company Affairs could also consider making this information available in a more user friendly manner at its web site. Similar basis should be applicable for issues in other currencies.

3 The expected life of the option: It is known from global experience that employees typically exercise their options well before their maturity. Thus the expected life is greater than the vesting period, but less than the maturity. Companies could estimate this based on their own experience or the experience of their peer group. To simplify this process, it could be provided that where no such data is available, the company may take the expected life as half of the maturity.

4 Expected future dividends: The standard Black-Scholes formula is based on the assumption of a non dividend paying stock. To account for dividends, the present value of expected future dividends is subtracted from the current stock price. Companies need to make an estimate of this also from their own past dividend policy or that of their peer group. Where no data is available, future dividends may be ignored (assumed to be zero).

The Committee discussed at length whether the fair values should be expensed or merely disclosed. While recommending that disclosure be mandatory and expensing be optional at present, the Committee recognized that there may be a view to move towards mandatory expensing.

2.4.3 Option Grants to Promoters

The Committee deliberated at length on whether promoters should be excluded from employee stock options even for unlisted companies. While noting that there was greater justification for granting stock options to promoters at the unlisted stage than after listing, the Committee nevertheless recommends that they be excluded even for unlisted companies. The principal rationale for this recommendation is that promoters have the avenues of sweat equity and preferential allotment available to them and it is not necessary to allow stock options also as an additional route.

The definition of promoter was debated upon at length. The SEBI definition of promoters is based upon disclosures in the offer document which has no relevance to an unlisted company. The Committee noted that there is no definition of promoter in the Companies Act. The Committee is however of the view that there is a need for a definition of promoter and recommends that promoters should be defined as those who are in control of the company or hold themselves out as promoters for any purpose. The Committee recognises that there may be a view to reconcile the definition with the provisions of Section 7 of the Companies Act.

2.4.4 Exemption for Private Limited Companies

The Committee is of the view that private limited companies can be exempted from some of the procedural and disclosure aspects of the regulatory framework. Specifically, private companies need not seek shareholder approval for stock option schemes and need not provide detailed disclosures about the scheme in the Directors’ Report. However, they would be required to expense the intrinsic value of the options and to make adequate disclosures to the option grantees including a disclosure of risks and a disclosure of financial information equivalent to that available to the shareholders.

2.4.5 Restriction on Quantum of Stock Options

The majority of the Committee is of the view that the cumulative stock option grants to employees by any company should not exceed 15% of the voting rights of the company (or rupees fifty million whichever is higher) except with the prior approval of the Central Government. The majority believes that excessive option grants in favour of employees may provide excessive incentives to employees including a tendency to deal with the financial and operating results in a manner so as to artificially impact the share prices in a particular direction.

Prof. Varma, however, disagrees strongly with this recommendation. His dissenting view is as follows:

“Given that employee stock option grants are approved by shareholders by a special resolution and that promoters are excluded from the purview of stock options, there is no justification whatsoever in setting a ceiling on option grants. The regulator should allow the balance between human capital and financial capital to be determined by the free and unimpeded play of market forces. It would be most unfortunate if it chooses to intervene on the side of financial capital which is perfectly capable of looking after its own interests. Considering the fact that the Committee envisages no limits on the quantum of preferential allotments, the recommendation for a ceiling on employee stock options veers very close to a bias against human capital in favour of financial capital.

As regards the suggestion that large option holding by employees would lead to an incentive to manipulate earnings, this argument carried to its logical conclusion would mean that promoters and others who hold more than 15% of the voting rights of a company should be debarred from becoming directors or holding senior managerial positions. It is difficult to understand how promoters would somehow be immune to a tendency that allegedly affects only ordinary employees”

2.4.6 Disclosures to Option Grantees

An option grant is in some sense a sale of a security for a non cash consideration (employee services). This would suggest that the option grantee be accorded some of the protection that is accorded to a buyer of securities. The Committee recommends the following:

(a) Initial disclosure requirement: Just as a sale of securities is accompanied by a prospectus or offer document, an option grant should be accompanied by a brief disclosure document provided to the employee. A suggested format is provided in the Schedule to the Draft Rules (Annexure II). The Committee debated whether the provisions of the amended Section 67 of the Companies Act read with section 2(12) and 2(45AA) of the Companies Act and section 2(h) of the Securities Contract Regulation Act would required a prospectus to be issued whenever a company issued stock options to 50 employees in a year. The Committee is of the view that on a harmonious construction of these definitions, a prospectus would not be necessary. However, a simplified disclosure document is called for that provides a disclosure of risks and a disclosure of financial information equivalent to that available to the shareholders.

(b) Continuing disclosure requirement: The Committee is of the view that an option grantee should receive copies of all documents that are sent to the members of the company. This would include the annual accounts of the company as well as notices of meetings and the accompanying explanatory statements.

(c) Option Administration: If the option administrator (whether the company itself or an outside securities firm appointed for this purpose) provides advisory services to the option grantees in connection with the exercise of options or sale of resulting shares, such advice must be accompanied by an appropriate disclosure of illiquidity, concentration and other risks. The option administrator should conform to the code of conduct appropriate for such fiduciary relationships.

2.4.7 Transition from Unlisted Company to Listed Company

The Committee deliberated upon the regulatory framework for the transition from an unlisted company to a listed company. The Committee was informed that the SEBI Committee that reviewed the regulatory framework for listed companies has recommended the following framework:

“ESOP shares issued by an unlisted company may be allowed to get listed after the IPO subject to fulfillment of following requirements:

a. Ratification of the resolution passed for issuance of ESOP

The notice shall include all the disclosures required in terms of SEBI (ESOP guidelines).

b. Disclosures in the offer document

· A disclosure about the intention of the ESOP holders to sell their ESOP shares within 3 months after the date of listing of shares in the said IPO (aggregate number of shares intended to be sold by all ESOP holders put together to be disclosed regardless of whether the shares arise out of options exercised before or after the IPO),

· Specific disclosures about the intention of sale of ESOP shares within 3 months after the date of listing, by directors, Senior Managerial personnel and also large option grantee i.e persons having ESOP shares amounting to more than 1 % of the issued capital (excluding outstanding warrants and conversions), which inter-alia shall include name, designation and quantum of ESOP shares and quantum they intend to sell within 3 months..

· A disclosure in line with the guideline 12 of ESOP guidelines, regarding all the ESOPs issued in last 3 years (separately for each year) and on a cumulative basis for all the ESOPs issued prior to that in the prospectus.

c. Lock-in requirements

· The existing provisions of Lock-in specified in SEBI (DIP) guidelines shall not be applicable on the ESOP shares held by employees other than promoters subject to the aforesaid disclosures in the offer document and ratification of the earlier resolution. However, no ESOP holder shall sell shares arising out of ESOPs within 3 months after the date of listing unless an intention to sell as these shares has been disclosed in the offer document. Where the ESOP holder belongs to the category of directors, Senior Managerial personnel and large option grantees, this disclosure should have been made by name in the offer document. In other cases, it should have been part of the aggregate intention to sell disclosed in the offer document.

· However, ESOP shares held by the promoters will be subject to lock-in as per relevant provisions of SEBI (DIP) Guidelines, 2000.”

The Committee therefore does not consider it necessary to recommend a transitioning framework. Mr. Vinod Jain, FCA, is however of the view that shares arising out of ESOP should be locked in for a period of six months or one year after listing.

2.4.8 Draft Rules for Employee Stock Options

The draft rules for Employee Stock Options are given in Annexure II.

3 Preferential Allotments

3.1 Regulatory Framework for Listed Companies

The regulatory framework for preferential allotments in the case of listed companies has several key elements:

(a) Adherence to market prices: The preferential allotment price cannot be less than the recent average market price.

(b) Shareholder approval: Shareholder approval through a special resolution is required under the provisions of the Companies Act. SEBI regulations provide that while seeking such approval, additional disclosures must be made about the proposed allottees and the changes in shareholding pattern and control arising from the allotment. It also requires the resolution to be acted upon within three months.

(d) Open offer: Under the Takeover Regulations as recently amended, if a preferential allotment triggers a change of control, the acquirer has to make an open offer to the minority shareholders to the extent of 20%.

3.2 Recommendations of the Committee

3.2.1 Market Price

The Committee debated at length whether the market price (or fair price) requirement should be extended to unlisted companies. It considered the possibility of using the book value or an independent valuation for this purpose. After considerable discussion, the Committee decided that neither of these two alternatives would be satisfactory when used as a constraint on the price. (In the case of employee stock options, these alternatives are used only for accounting purposes and there is no restriction on the price itself). For this reason, the Committee recommends that there should be no restriction on the price at which the preferential allotment is made.

3.2.2 Shareholder Approval

The Committee is of the view that the shareholder approval mandated by the Companies Act should be an informed decision. As such additional disclosures must be made about the class of proposed allottees, the price or price band, the changes in shareholding pattern and control arising from the allotment, and the time period during which the allotment is proposed to be made.

The Committee also recommends that preferential allotments be notified as one of the items for which a postal ballot is required.

The majority view of the Committee is that the shareholder resolution should have a maximum life of only twelve months. This is based on the fact that a general body meeting would be held at least once a year and the resolution could be renewed if needed. Mr. Vinod Jain, FCA, however disagrees with this recommendation. His dissenting view is that:

“There is no need to limit the life of the resolution as long as the time frame within which the allotment is proposed to be made is disclosed to the shareholders. A limitation on the life of the resolution would go beyond the legislative intent of Section 81(1A) of the Companies Act and would require a legislative amendment to have statutory force.”

3.2.3 Applicability

The Committee recommends that the Preferential Allotment Rules should apply only to public limited companies and not to private limited companies.

3.2.4 Draft Rules for Preferential Allotment

The draft rules for Preferential Allotment are given in Annexure III.

4 Sweat Equity

4.1 Regulatory Framework for Listed Companies

The Committee was informed that SEBI was in the process of formulating regulations for sweat equity on the basis of a committee report. The regulatory framework recommended by the SEBI committee is based on the twin principles of fair valuation and fair pricing:

(a) There must be a fair valuation (by an independent expert) of the know-how, intellectual property rights or value addition in consideration for which sweat equity is issued.

(b) The shares must be issued at a fair price (market price).

The proposed regulatory framework also requires that the shareholder approval be sought after providing full disclosure of the transaction including the expert’s report on the valuation of the consideration. Sweat equity may be issued to promoters also, but in this case, a majority of the shareholders other than promoters must approve the transaction. The accounting treatment of the transaction is based upon the relevant accounting standards. This means that the intellectual property rights can be capitalized only if it constitutes an intangible asset under AS 26. If it does not, then it has to be expensed. In this case, since the expense is in the nature of remuneration, it should be included in the ceiling on managerial remuneration.

4.2 Recommendations of the Committee

By and large, the Committee recommends that the regulatory framework proposed for listed companies should also be extended to unlisted companies. The majority of the Committee however recommends a restriction on the quantum of sweat equity issues by any company as discussed in 4.2.4 below.

While arriving at its recommendations, the Committee deliberated at length on the following aspects of sweat equity regulations.

4.2.1 Definition of Intangible Asset

The proposed regulatory framework for listed companies relies on AS 26 for the definition of intangible assets that can be capitalized when received as consideration for issue of sweat equity. The Committee discussed several alternatives designed to make the regulation more stringent. It discussed a proposal to invoke the provisions of AS 26 that apply to self generated intangible assets. It also considered a proposal to require that the enterprise has an unrestricted legal right to acquire, hold or transfer the asset. After considerable deliberation, the Committee is of the view that AS 26 which is modelled on the corresponding international accounting standards represents a fair and balanced view of intangible assets and that there is no need to go beyond this definition.

4.2.2 Fair Price of the Share

The Committee discussed the assessment of the fair price of the share for an unlisted company where there is no market price available. The Committee is of the view that since every sweat equity transaction is anyway supported by an independent expert valuation of the consideration, there is little additional difficulty in requiring that expert valuation to include a fair valuation of the share also.

4.2.3 Managerial Remuneration

The Committee agrees with the view adopted in the proposed listed company regulatory framework that issue of sweat equity for a consideration that does not constitute an asset is a form of remuneration. As such, where sweat equity is issued to the directors for consideration other than cash, it would be subject to the ceiling on managerial remuneration under section 198 of the Companies Act.

4.2.4 Restrictions on Quantum of Sweat Equity

The majority of the Committee is of the view that there should be a restriction on the quantum of sweat equity that a company can issue. The majority recommends that the cumulative issue of sweat equity by a company should not exceed 15% of the voting rights or rupees fifty million whichever is higher except with the prior approval of the Central Government. Prof. Varma disagrees with this recommendation for reasons similar to his dissent in 2.4.5 regarding a similar restriction on the quantum of employee stock options.

4.2.5 Draft Rules for Sweat Equity

The draft rules for Sweat Equity are given in Annexure IV.

5 Review of Recommendations

The majority of the Committee has recommended restrictions on the quantum of employee stock options and sweat equity. The restriction takes the form of a requirement for prior Central Government approval beyond a particular ceiling. The majority however wishes to emphasize that the primary rationale for this restriction is a concern about possible abuses and misuses in this area. As such, the intention is that the Central Government would take a sympathetic view of requests for approval of larger option grants or sweat equity issues in genuine cases. The majority is also of the view that the restrictions themselves should be reviewed after a period of two to three years on the basis of the experience gained during this period.

Prof. J. R. Varma (Chairman)	Vinod Jain	Nihal Kothari
Shailesh Haribhakti	Amarjit Chopra	R.M. Joshi
H.C. Jayal	I. Srinivas	Rajiv Mehrishi
R. Vasudevan	Alka Kapoor (Mrs.)

Annexure II

EMPLOYEE STOCK OPTION SCHEME AND

EMPLOYEE STOCK PURCHASE SCHEME RULES, 2002

GSR: (E)-In exercise of the powers conferred by Section 642(1)(b) of the Companies Act, 1956, the Central Government hereby make the following Rules namely:-

1. Short title and commencement;

(I) These Rules may be called Companies (Employee Stock Option Scheme and Employee Stock Purchase Scheme), Rules, 2002.

(II) They shall come into force on the date of their publication in the official gazette.

2. Applicability:

These Rules shall apply to any company which grants employees stock options either under a scheme or otherwise as defined in sub-section (15A) to Section 2 of the Companies Act, 1956.

3. Definitions:

(I) In these Guidelines, unless otherwise defined; -

(i) “employee” means

a) a permanent employee of the company working in India or out of India; or

b) a director of the company, employed as a whole time director or executive director of a company;

c) an employee (as defined in sub-clause (a) or (b) above) of a subsidiary of the company in India or out of India, or of a holding company of the company.

(ii) “employee stock option scheme (ESOS)” means a scheme under which a company grants option to employees to purchase shares and stocks.

(iii) “employee stock purchase scheme (ESPS)” means a scheme under which the company offers shares/stocks to employees.

(iv) “exercise” means making of an application by the employee to the company for issue of shares against option vested in him in pursuance of the ESOS.

(v) “exercise period” means the time period after vesting within which the employee should exercise his right to apply for shares against the option vested in him in pursuance of the ESOS.

(vi) “exercise price” means the price payable by the employee for exercising the option granted to him in pursuance of ESOS.

(vii)”grant” means issue of option to employees under ESOS.

(viii)”option” means a right but not an obligation granted to an employee in pursuance of ESOS to apply for securities of the company at a pre- determined price.

(ix) “promoter” means

(a) the person or persons who are in over-all control of the company; and

(b) the persons or persons who hold themselves out as promoters.

[Explanation: Where a promoter of a company is a body corporate, the promoters of that body corporate shall also be deemed to be promoters of the company.]

(x) “promoter group” includes spouse of the promoter, any parent, brother, sister or child of the promoter or of the spouse).

(xi) “Remuneration Committee” means a committee which consists of at least three non-executive independent directors including nominee director or nominee directors, if any.

(xii)”share” means securities as defined in section 2(45AA) of the Companies Act and shall include American Depository Receipts (ADRs), Global Depository Receipts (GDRs) or other depository receipts representing underlying equity shares or securities convertible into equity shares.

(xiii)”vesting” means the process by which the employee is given the right to apply for shares of the company against the option granted to him in pursuance of ESOS.

(xiv)”vesting period” means the period during which the vesting of the option granted to the employee in pursuance of ESOS.

(II) All other expressions unless defined herein shall have the same meaning as have been assigned to them under the Companies Act, 1956.

PART - A - ESOS

4. Eligibility to participate in ESOS

(a) An employee shall be eligible to participate in ESOS of the company provided that an employee who is a promoter or belongs to the promoter group shall not be eligible to participate in the ESOS.

(b) A director who either by himself or through his relative or through any body corporate, directly or indirectly holds more than 10% of voting rights in the company shall not be eligible to participate in the ESOS.

5. Terms and Conditions of ESOS

The Board or Remuneration Committee thereof shall, inter alia, formulate the detailed terms and conditions of the ESOS including;-

(a) the quantum of option to be granted under an ESOS per employee and in aggregate.

(b) the conditions under which option vested in employees may lapse in case of termination of employment for misconduct including gross negligence, breach of confidentiality or non-compete agreements;

(c) the exercise period within which the employee should exercise the option and that option would lapse on failure to exercise the option within the exercise period;

(d) the specified time period within which the employee shall exercise the vested options in the event of termination or resignation of an employee.

(e) the right of an employee to exercise all the options vested in him at one time or at various points of time within the exercise period;

(f) the procedure for making a fair and reasonable adjustment to the number of options and to the exercise price in case of rights issues, bonus issues and other corporate actions;

(g) the grant, vest and exercise of option in case of employees who are on long leave; and

(h) the formats for exercise of options including the procedure for cashless exercise of options.

6. Shareholder approval

(I) No public company shall offer ESOS to its employees unless the shareholders of the company approve ESOS by passing a special resolution in the general meeting.

(II) The explanatory statement to the notice and the resolution proposed to be passed in general meeting for ESOS shall, inter alia, contain the following information :

(a) the total number of options to be granted;

(b) identification of classes of employees entitled to participate in the ESOS;

(d) maximum period (subject to clause 9.1) within which the options shall be exercised;

(e) exercise price or pricing formula;

(f) the appraisal process for determining the eligibility of employees to the ESOS;

(g) maximum number of options to be issued per employee;

(III) Approval of shareholders by way of special resolution in the general meeting shall be obtained by the public company in case of ;

(a) grant of option to employees of subsidiary or holding company and,

(b) grant of option to identified employees, during any one year, equal to or exceeding 1% of the issued capital (excluding outstanding warrants and conversions) of the company at the time of grant of option.

(IV) The cumulative grant of options to employees by a company shall not exceed 15% of the issued capital of the company or 5 crores of rupees whichever is higher at any point of time except with the prior approval of the Central Government.

7. Variation of terms of ESOS

(I) The company shall not vary the terms of the ESOS in any manner which may be detrimental to the interest of the employees without the consent of 90% by value and 75% in number of the beneficiaries.

(II) Subject to I above, the company may by special resolution in a general meeting vary the terms of ESOS offered pursuant to an earlier resolution of a general body but not yet exercised by the employee.

(III) The provisions of clause 6 shall apply to such variation of terms as they do to the original grant of option.

(IV) The notice for passing special resolution for variation of terms of ESOS shall disclose full details of the variation, the rationale therefor, and the details of the employees who may be affected by such variation.

8. Pricing

(I) The companies granting option to its employees pursuant to ESOS will have the freedom to determine the exercise price and period.

9. Lock-in period and rights of the option-holder

(I) There shall be a minimum period of one calendar year between the grant of options and vesting of option.

(II) Subject to (III) below, the company shall have the freedom to specify the lock-in period for the shares issued pursuant to exercise of option.

(III)The company shall ensure that in the case of Directors, Chief Executive Officer, Chief Financial Officer and any employee to whom a cumulative option grant of 1% or more of the issued capital has been made, a minimum period of two years should elapse between the date of grant of option and the date of sale of shares arising out of the option.

(V) The employee shall not have right to receive any dividend or to vote or in any manner enjoy the benefits of a shareholder in respect of option granted to him, till shares are issued on exercise of option and registered in Members Register.

10. Consequence of failure to exercise option

(I) The amount payable by the employee, if any, at the time of grant of option may be;-

(a) forfeited by the company if the option is not exercised by the employee within the exercise period; or

(b) refunded to the employee if the option is not vested due to non-fulfillment of condition relating to vesting of option as per the ESOS.

11. Non transferability of option

(I) Option granted to an employee shall not be transferable in any manner.

(II) No person other than the employee to whom the option is granted shall be entitled to exercise the option.

(III) In the event of the death of employee while in employment, all the options granted to him till such date shall vest in the legal heirs or the nominees of the deceased employee.

(IV) In case of a private limited company the ESOS may provide that in the event of death or cessation of employment the options granted to the employee may be compulsorily extinguished at such fair value as may be determined in terms of the ESOS Scheme.

(V) In case the employee suffers a permanent incapacity while in employment, all the option granted to him as on the date of permanent incapacitation, shall vest in him on that day.

(VI) In the event of resignation or termination of the employee, all options not vested as on that day shall expire. However, the employee shall, subject to the provision of clause 5, be entitled to retain all the vested options.

12. Disclosure in the Directors’ Report

(I) The Board of Directors of a public company, shall, inter alia, disclose either in the Directors Report or in the annexure to the Director’s Report, the following details of the ESOS:

(a) options granted;

(b) the pricing formula;

(d) options exercised;

(e) the total number of shares arising as a result of exercise of option;

(f) options lapsed;

(g) variation of terms of options;

(h) money realised by exercise of options;

(i) total number of options in force and their weighted average maturity and exercise price;

(j) employee wise details of options granted to;-

(i) senior managerial personnel;

(ii) any other employee who receives a grant in any one year of option amounting to 5% or more of options granted during that year.

(iii) identified employees who were granted option, during any one year, equal to or exceeding 1% of the issued capital (excluding outstanding warrants and conversions) of the company at the time of grant;

(k) Diluted Earnings Per Share (EPS) pursuant to issue of shares on exercise of option calculated in accordance with Accounting Standard AS 20.

(l) Where the company has calculated the employee compensation cost using the intrinsic value of the stock options as defined in clause b(1) of Schedule I, the difference between the employee compensation cost so computed and the employee compensation cost that would have been recognized if it had used the fair value of the options as defined in clause b(3) of Schedule I. The impact of this difference on profits and on EPS shall also be disclosed.

(m) The weighted-average fair value of options granted during the year. If the exercise prices of some options differ from the market price of the stock on the grant date, weighted-average exercise prices and weighted-average fair values of options shall be disclosed separately for options whose exercise price (1) equals, (2) exceeds, or (3) is less than the market price of the stock on the grant date.

(n) A description of the method and significant assumptions used during the year to estimate the fair values of options, including the following weighted-average information: (1) risk-free interest rate, (2) expected life, (3) expected volatility, (4) expected dividends and (5) the fair value of the underlying share at the time of option grant.

(o) Where the employees of the company have been granted options in the parent company or subsidiary company, the following information shall be disclosed:

(i) The employee compensation cost recognized by the parent or the subsidiary in respect of these options. The company shall also disclose the impact that this cost would have on profits and on EPS had this been a cost of the company itself.

(ii) The information required under sub clause (l) above in respect of these options.

13. Accounting Policies

(I) Every company that has granted options or passed a resolution for an ESOS under clause 6.1 of these Rules shall comply with the accounting policies specified in Schedule I.

14. Certificate from Auditors

(I) In the case of every company that has passed a resolution for an ESOS under clause 6.1 of these Rules, the Board of Directors shall at each annual general meeting place before the shareholders a certificate from the auditors/practising company secretary of the company that the scheme has been implemented in accordance with these Rules and in accordance with the resolution of the company in the general meeting.

15. Disclosure to Option Grantees

(I) Every company that makes an option grant shall provide the option grantee with a simplified disclosure document in the format specified in Schedule III.

(II) Every company shall provide to all outstanding option grantees copies of all documents that are sent to the members of the company. This would include the annual accounts of the company as well as notices of meetings and the accompanying explanatory statements.

(III) If the option administrator (whether the company itself or an outside securities firm appointed for this purpose) provides advisory services to the option grantees in connection with the exercise of options or sale of resulting shares, such advice shall be accompanied by an appropriate disclosure of the illiquidity, concentration and other risks. The option administrator shall conform to the code of conduct appropriate for such fiduciary relationships.

PART-B- ESPS

16. Eligibility to participate in ESPS.

(I) An employee shall be eligible to participate in the ESPS.

(II) An employee who is a promoter or belongs to the promoter group shall not be eligible to participate in the ESPS.

(III) A director who either by himself or through his relatives or through any body corporate, directly or indirectly holds more than 10% of the voting rights in the company shall not be eligible to participate in the ESPS.

17. Shareholder Approval

(I) No public company shall offer ESPS to its employees unless the shareholders of the company approve ESPS by passing special resolution in the meeting of the general body of the shareholders.

(II) The explanatory statement to the notice shall specify :

(a) the price of the shares and also the number of shares to be offered to each employee.

(b) the appraisal process for determining the eligibility of employee for ESPS.

(III) The number of shares offered may be different for different categories of employees.

(IV) The special resolution shall state that the company shall conform to the accounting policies specified in clause 19.2.

18. Pricing and Lock-in

(I) The company shall have the freedom to determine price of shares to be issued under an ESPS, provided they conform to the provisions of clause 19.2.

(II) Subject to (III) below, the company shall have the freedom to specify the lock-in period for the shares issued pursuant to exercise of option.

(III)The company shall ensure that in the case of Directors, Chief Executive Officer, Chief Financial Officer and any employee to whom a cumulative ESPS issue of 1% or more of the issued capital has been made, a minimum period of two years should elapse between the date of issue of shares under ESPS and the date of sale of these shares.

19. Disclosure and Accounting Policies

(I) The Directors’ Report or Annexure thereto of a public company shall contain, inter alia, the following disclosures :-

(a) the details of the number of shares issued in ESPS;

(b) the price at which such shares are issued;

(i) senior managerial personnel;

(ii) any other employee who is issued shares in any one year amounting to 5% or more shares issued during that year;

(iii) identified employees who were issued shares during any one year equal to or exceeding 1% of the issued capital of the company at the time of issuance;

(d) diluted Earning Per Share (EPS) pursuant to issuance of shares under ESPS; and

(e) consideration received against the issuance of shares.

(II) Every company that has passed a resolution for an ESPS under clause 17.1 of these Rules shall comply with the accounting policies specified in Schedule II.

SCHEDULE I ( Clause 13.1 )

Accounting Policies for ESOS

(a) In respect of options granted during any accounting period, the accounting value of the options shall be treated as another form of employee compensation in the financial statements of the company.

(b) The accounting value of options shall be equal to the aggregate, over all employee stock options granted during the accounting period, of the intrinsic value of the option or, if the company so chooses, the fair value of the option.

For this purpose :

1. Intrinsic value means the excess of the fair value of the share at the date of grant of the option under ESOS over the exercise price of the option (including up-front payment, if any)

2. The fair value of the underlying share at the time of grant may be estimated as the book value per share or if the company so chooses the fair value may be estimated on the basis of an independent valuation report.

3. Fair value of an option means the price that would obtain for that option in an arm’s length transaction between a willing buyer and a willing seller.

(i) In the case of a listed company, the fair value shall be estimated using an option-pricing model (for example, the Black-Scholes or a binomial model) that takes into account as of the grant date the exercise price and expected life of the option, the current fair value of the underlying stock and its expected volatility, expected dividends on the stock, and the risk-free interest rate for the expected term of the option.

(ii) In the case of an unlisted company, the fair value shall be estimated using an option pricing model that assumes a volatility of zero for the underlying stock. In this case, the fair value of the option equals the current fair value of the underlying stock less the present value of the exercise price. If the company intends to pay dividends during the expected life of the option, the present value of these dividends shall also be deducted while arriving at the fair value of the option. The discounting of the exercise price as well as of the expected dividends shall be done at the risk-free interest rate for the expected life of the option. If the fair value as computed above is negative, the fair value shall be taken as zero.

4. The fair value of an option estimated at the grant date shall not be subsequently adjusted for changes in the price of the underlying stock or its volatility, the life of the option, dividends on the stock, or the risk-free interest rate.

5. Where the exercise price is specified in Indian rupees, the risk-free interest rate used shall be the interest rate applicable for a maturity equal to the expected life of the options based on the zero-coupon yield curve for Government of India securities.

6. The expected life of an award of stock options shall be estimated taking into account the average length of time similar grants have remained outstanding in the past. If the company does not have a sufficiently long history of stock option grants, the experience of an appropriately comparable peer group may be taken into consideration. In the absence of clear evidence to the contrary, the expected life of the option shall be assumed to be not less than half of the term of the option. In no case, however, shall the expected life of the option be less than the vesting period.

7. The estimated dividends of the company over the estimated life of the option may be estimated taking into account the company’s past dividend policy as well as the dividend policy of an appropriately comparable peer group. Where expected dividends are difficult to estimate, they may be taken as zero.

(c) Where the accounting value is accounted for as employee compensation in accordance with ‘b’, the amount shall be amortised on a straight-line basis over the vesting period.

(d) When an unvested option lapses by virtue of the employee not conforming to the vesting conditions after the accounting value of the option has already been accounted for as employee compensation, this accounting treatment shall be reversed by a credit to employee compensation expense equal to the amortized portion of the accounting value of the lapsed options and a credit to deferred employee compensation expense equal to the unamortized portion.

(e) When a vested option lapses on expiry of the exercise period, after the fair value of the option has already been accounted for as employee compensation, this accounting treatment shall be reversed by a credit to employee compensation expense.

(f) The accounting treatment specified above can be illustrated by the following numerical example:-

Suppose a company grants 500 options on 1/4/2002 at Rs 40 when the fair value of the shares is Rs 160, the vesting period is two and a half years, the maximum exercise period is one year. Also suppose that 150 unvested options lapse on 1/5/2004, 300 options are exercised on 30/6/2005 and 50 vested options lapse at the end of the exercise period. The accounting value of the option being:

500 x (160-40) = 500 x 120 = 60,000

The accounting entries would be as follows:

1/4/2002

Deferred Employee Compensation Expense Dr.

To Employee Stock Options Outstanding

(Grant of 500 options at a discount of

Rs 120 each)

60,000

31/3/2003

Employee Compensation Expense Dr.

To Deferred Employee Compensation Expense

(Amortisation of the deferred compensation over two and a half years on straight-line basis)

24,000

31/3/2004

Employee Compensation Expense Dr.

To Deferred Employee Compensation Expense

(Amortisation of the deferred compensation over two and a half years on straight-line basis)

24,000

1/5/2004

Employee Stock Options Outstanding Dr.

To Employee Compensation Expense

Deferred Employee Compensation Expense

(Reversal of compensation accounting on lapse of 150 unvested options)

18,000

14,400

3,600

31/3/2005

Employee Compensation Expense Dr.

To Deferred Employee Compensation Expense

(Amortisation of the deferred compensation over two and a half years on straight-line basis)

8,400

30/6/2005

Cash Dr.

Employee Stock Options Outstanding Dr.

To Paid Up Equity Capital

To Share Premium Account

(Exercise of 300 options at an exercise price of Rs 40 each and an accounting value of Rs 120 each)

12,000

36,000

3,000

45,000

1/10/2005

Employee Stock Options Outstanding Dr.

To Employee Compensation Expense

(Reversal of compensation accounting on lapse of 50 vested options at the end of exercise period)

6,000

The T-Accounts for Employee Stock Options Outstanding and Deferred Employee Compensation Expense would be as follows:

Employee Stock Options Outstanding Account

1/5/2004	Employee Compensation/ Deferred Compensation	18,000	1/4/2002	Deferred Compensation	60,000
30/6/2005	Paid Up Capital/ Share Premium	36,000
1/10/2005	Employee Compensation	6,000
		60,000			60,000

Deferred Employee Compensation Expense Account

1/4/2002	ESOS Outstanding	60,000	31/3/2003	Employee Compensation	24,000
			31/3/2004	Employee Compensation	24,000
			1/5/2004	ESOS Outstanding	3,600
			31/3/2005	Employee Compensation	8,400
		60,000			60,000

Employee Stock Options Outstanding will appear in the Balance Sheet as part of Net Worth or Shareholders’ Equity. Deferred Employee Compensation will appear in the Balance Sheet as a negative item as part of Net Worth or Shareholders’ Equity.

SCHEDULE II ( Clause 19.2 )

Accounting Policies for ESPS

(a) In respect of shares issued under an ESPS during any accounting period, the accounting value of the shares so issued shall be treated as another form of employee compensation in the financial statements of the company.

(b) The accounting value of shares issued under ESPS shall be equal to the aggregate of price discount over all shares issued under ESPS during any accounting period ;

For this purpose :

Price discount means the excess of the fair value of the shares at the date of issue over the price at which they are issued under the ESPS.

Fair value of the shares means the fair value as defined in clause b(2) of Schedule I.

Suppose a company issues 500 shares on 1/4/2002 under an ESPS at Rs 40 when the fair value is Rs 160. The accounting value of the shares being :

500 x (160-40) = 500 x 120 = 60,000

The accounting entry would be as follows :

1/4/2002

Cash Dr.

Employee Compensation Expense Dr.

To Paid Up Equity Capital

To Share Premium Account

(Issue of 500 shares under ESPS at a price of Rs 40 each when fair value is Rs 160)

20,000

60,000

5,000

75,000

SCHEDULE III

Simplified Disclosure Document for Employee Stock Option Grantees

Part A: Statement of Risks

All investments in shares or options on shares are subject to risk as the value of shares may go down or go up. In addition, employee stock options are subject to the following additional risks:

Concentration: The risk arising out of any fall in value of shares is aggravated if the employee’s holding is concentrated in the shares of a single company.
Leverage: Any change in the value of the share can lead to a significantly larger change in the value of the option as an option amounts to a levered position in the share.
Illiquidity: The options cannot be transferred to anybody, and therefore the employees cannot mitigate their risks by selling the whole or part of their options before they are exercised.
Exit[2]: Since the shares of the company are not listed on any stock exchange, there is no ready market for the shares that the employee would receive on exercise of the options. There can be no assurance that the company would make an IPO within any set period, and even if there is an IPO, there can be no assurance that a liquid market for the share would develop.
Vesting: The options will lapse if the employment is terminated prior to vesting. Even after the options are vested, the unexercised options may be forfeited if the employee is terminated for gross misconduct.

Part B: Information about the company[3]

Confidentiality[4]: This document contains information that is normally available only to the shareholders of the company. The employees are required to maintain strict confidentiality about the contents of this document.
Business of the company: A description of the business of the company on the lines of item V(a) of Part I of Schedule II of the Companies Act.
Abridged financial information: Abridged financial information for the last five years for which audited financial information is available in a format similar to that required under item B(1) of Part II of Schedule II of the Companies Act. The last audited accounts of the company should also be provided unless this has already been provided to the employee in connexion with a previous option grant or otherwise.
Risk Factors: Management perception of the risk factors of the company in accordance with item VIII of Part I of Schedule II of the Companies Act.

Part C: Salient Features of the Employee Stock Option Scheme

The Part would contain the salient features of the employee stock option scheme of the company including the conditions regarding vesting, exercise, adjustment for corporate actions, forfeiture of vested options. It shall not be necessary to include this Part if it has already been provided to the employee in connexion with a previous option grant, and no changes have taken place in the scheme since then.

Annexure IV

COMPANIES (ISSUE OF SWEAT EQUITY SHARES) RULES, 2002

G.S.R. (E) - In exercise of the powers conferred by Proviso to sub-section (1) of 79A of the Companies Act, 1956 (1 of 1956) read with sub-section (1) of section 642 of the said Act, the Central Government hereby issues the following Rules, namely :-

1. Short title and commencement

(I) These Rules may be called the Unlisted Companies (Issue of Sweat Equity Shares) Rules, 2002.

(II) They shall come into force on the date of their publication in the Official Gazette.

2. Definition

In these Rules, unless otherwise defined :-

(i) Asset means a resource controlled by the company and from which future economic benefits are expected to flow to the company.

(ii) Employee means :-

a) a permanent employee of the company working in India or out of India; or

b) a director of the company, employed as a whole time director or executive director of a company;

(iii) Intangible Asset means an identifiable non-monetary asset, without physical substance, held for use in the production or supply of goods or services, for rental to others, or for administrative purposes.

(iv) “Share Price” means price of a share on a given date arrived on the net worth basis.

(v) Value Addition means anticipated economic benefits derived by the enterprise from expert and/or professional for providing know-how or making available rights in the nature of intellectual property rights, by such person to whom sweat equity is issued for which the consideration is not paid or included in -

(a) the normal remuneration payable under the contract of employment, in the case of an employee and/or

(b) monetary consideration payable under any other contract, in the case of non-employee.

3. Applicability

These Rules shall be applicable to issue of sweat equity shares by all unlisted companies.

4. Special resolution

(I) For the purpose of passing a special resolution under clause (a) of sub-section (1) of section 79 of the Companies Act, 1956 (1 of 1956) the explanatory statement to be annexed to the notice for the general meeting pursuant to Section 173 of the said Act shall contain disclosures as specified below.

(i) the date of the meeting at which the proposal for issue of sweat equity shares was approved by the Board of Directors of the company;

(ii) the reasons/justification for the issue;

(iii) the number of shares, consideration for such shares and the class or classes of persons to whom such equity shares are to be issued;

(iv) the value of the sweat equity alongwith valuation report/ basis of valuation and the price at the which the sweat equity will be issued

(v) the names of the persons to whom the equity will be issued and the person’s relationship with the company;

(vi) ceiling on managerial remuneration, if any, which will be affected by issuance of such equity

(vii) a statement to the effect that the company shall conform to the accounting policies specified by the Central Government;

(viii) diluted Earning Per Share pursuant to the issue of securities to be calculated in accordance with the Accounting Standards specified by the Institute of Chartered Accountants of India.

(II) Approval of shareholders by way of separate resolution in the general meeting shall be obtained by the company in case of grant of shares to identified employees and promoters, during any one year, equal to or exceeding 1% of the issued capital (excluding outstanding warrants and conversion) of the company at the time of grant of the sweat equity shares.

5. Register of shares

The company shall maintain a Register of Sweat Equity Shares issued under Section 79A in the Form specified in Schedule I.

6. Obligations of the Company

The company shall not issue sweat equity shares for more than 15% of total paid up equity share capital in a year or shares of the value of 5 crores of rupees, whichever is higher except with the prior approval of the Central Government.

7. Disclosure in the Directors’ Report

The Board of Directors, shall, inter alia, disclose either in the Directors Report or in the annexure to the Director’s Report, the following details of issue of sweat equity :-

(a) Number of shares to be issued to the employees or the directors.

(b) Conditions for issue of sweat equity shares.

(d) The total number of shares arising as a result of issue of sweat equity shares.

(e) Money realised or benefit accrued to the company from the issue of sweat equity shares.

(f) Diluted Earnings Per Share (EPS) pursuant to issuance of sweat equity shares.

8. Pricing of Sweat Equity Shares

The price of sweat equity shares to be issued to employees and directors shall be at a fair price calculated by an independent valuer.

9. Issue of Sweat Equity Shares for consideration other than cash

Where a company proposes to issue sweat equity shares for consideration other than cash, it shall comply with following :-

(a) The valuation of the intellectual property or of the know-how provided or other value addition to consideration at which sweat equity capital is issued, shall be carried out by a valuer.

(b) The valuer shall consult such experts, as he may deem fit having regard to the nature of the industry and the nature of the property or the value addition.

(d) A copy of the valuation report of the valuer shall be sent to the shareholders with the notice of the general meeting.

(e) The company shall give justification for issue of sweat equity shares for consideration other than cash, which shall form part of the notice sent for the general meeting.

(f) The amount of Sweat Equity shares issued shall be treated as part of managerial remuneration for the purposes of sections 198, 309, 310, 311 and 387 of the Companies Act, 1956 if the following conditions are fulfilled:

(i) the Sweat Equity shares are issued to any director or manager; and,

(ii) they are issued for non-cash consideration, which does not take the form of an asset which can be carried to the balance sheet of the company in accordance with the relevant accounting standards.

10. Lock in of sweat equity shares

Sweat equity shares issued to employees or directors shall be locked in for a period of three years from the date of allotment.

11. Certificate from Auditors

In the case of every company that has allotted shares under these Rules, the Board of Directors shall at each annual general meeting place before the shareholders a certificate from the auditors of the company/ practising company secretary that sweat equity shares have been allotted in accordance with the resolution of the company in the general meeting and these Rules.

12. Accounting policies

(I) Where the sweat equity shares are issued for a non-cash consideration, such non-cash consideration shall be treated in the following manner in the books of account of the company:

(a) where the non-cash consideration takes the form of a depreciable or amortizable asset, it shall be carried to the balance sheet of the company in accordance with the relevant accounting standards; or

(b) where clause (a) is not applicable, it shall be expensed as provided in the relevant accounting standards.

(II) In respect of sweat equity shares issued during accounting period, the accounting value of sweat equity shares shall be treated as another form of compensation to the employee or the director in the financial statement of the company.

SCHEDULE I

REGISTER OF SWEAT EQUITY SHARES

(Pursuant to Rule 5)

The register of sweat equity shares issued by the company in the following format:

S.No.	Folio No. / certificate No.	Date of passing of resolution	Date of issue of sweat equity shares
1	2	3	4

Name of the allottee	Status of the allottee - whether director or employee	Reference to entry in register of members	Number of sweat equity shares issued
5	6	7	8

Face value of the share	Price at which shares issued	Total consideration paid by employee/director	Lock in period till which date
9	10	11	12

[1] In this model, the value of the option is zero if the discounted exercise price exceeds the stock price.

[3] It shall be sufficient for the company to update this document once a year when the audited accounts become available.

[4] To be deleted if the company is a public company.

Prof. J.R. Varma (Chairman)	Indian Institute of Management, Ahmedabad
Vinod Jain	Chartered Accountant - Institute of Chartered Accountants of India
Nihal Kothari	Head of Taxation - Hindustan Lever Ltd. (representing CII)
Shailesh Haribhakti	Managing Partner & CEO - Haribhakti Group (representing ASSOCHAM)
Amarjit Chopra	Chartered Accountant (representing ICAI)
R. M. Joshi	Executive Director - SEBI
H. C. Jayal	Director (Finance) - Ministry of Commerce & Industry
I. Srinivas	Director - Deptt. of Industrial Policy & Promotion
Rajiv Mehrishi	Joint Secretary - Department of Company Affairs
R. Vasudevan	DII - Department of Company Affairs
Alka Kapoor (Mrs.)	Deputy Director (Member Secretary) - The Institute of Company Secretaries of India