One form of compensation gaining increasing favour in executive and high-tech compensation packages is that of the stock option or stock purchase plan. However, if the employment relationship is terminated by the employer, this initially appealing way of attracting talent to your company can lead to complications. Before setting up these plans, it pays to consider your potential liability if the employment relationship sours.
“TERMINATION ACCORDING TO LAW”
The wording of a stock option plan is crucial to defining the parameters of the parties’ rights and obligations. This is the message sent by the Ontario Court of Appeal in Veer v. Dover Corp. (May 19, 1999), an appeal from a decision reported in the April 1998 issue of FOCUS (see “Overreaction to single act of insubordination costs employer 24 months’ notice” on our Publications page).
At trial, Veer had been awarded 24 months’ notice for wrongful dismissal, along with damages of over $437,000 for unexercised but vested stock options. In awarding the stock option damages, the trial judge had rejected Dover’s argument that the language of the option agreement terminated all Veer’s rights as of his termination. That agreement provided that:
The trial judge and the Court of Appeal both held that, whether voluntary or involuntary, termination that extinguishes the right to exercise stock options must be “termination according to law”. This means that, when the employee has been wrongfully dismissed, the option survives until the end of the notice period determined by the court.
THE BROCK EXCEPTION
In support of its position that even an unlawful termination served to cancel Veer’s option rights, Dover pointed to the case of Brock v. Matheson Group Ltd., a 1991 Ontario Court of Appeal decision. In the Brock case, the option agreement specified that the employee’s rights would terminate “in the event of the Employee ceasing to be an employee provided that where the Employee is dismissed by the Corporation, the Employee shall have 15 days from the date notice of dismissal is given” to exercise the option.
The trial judge in Brock concluded, as did the courts in Veer, that “dismissal” and “ceasing to be an employee” refer only to lawful terminations. However, the Court of Appeal disagreed, stating that the relevant event in this option agreement was the date on which one “ceased being an employee”.
The Court of Appeal in Veer stated that the language of the agreement in Brock meant that the unlawfulness of termination was not a factor in interpreting the employee’s rights under that option agreement:
By contrast, the trial judge in Veer distinguished Brock not on the basis of the words “ceasing to be an employee”, but rather the specification in the plan of a 15-day period following dismissal for exercising option rights. However one interprets the reasoning behind the exception in Brock, this is the only language that has been judicially approved for cancelling option rights during the period of reasonable notice.
Brock had, in fact, exercised his option to purchase shares within the 15-day period specified in the stock option plan, so the Court’s conclusion that the option terminated with the end of his employment affected only the number of shares he was entitled to purchase, not his entitlement as such. This touches on the issue of when the option vests. Even where it is held that the option subsists for the entire notice period, if the language of the agreement vests the right to purchase shares after the end of the notice period, no damages will be payable in respect of those shares. In this connection, it may be advisable to include a provision in the plan to the effect that the terminated employee forfeits any unvested options.
CALCULATION OF DAMAGES
Once the initial entitlement and its scope are ascertained, it is necessary to calculate the employee’s damages for the lost opportunity of disposing of the shares at a profit. This will depend on the wording of the plan, but the cases point to some general principles. For stock option plans, damages will be the difference between the option price of the shares to which the employee is entitled and their market value on the date that the court determines the employee would be likely to sell the shares on the market. The issue for the court is not only one of timing, but also of the character and circumstances of the employee.
A recent Ontario decision, Poplack v. Intermetco Ltd. (March 2, 1999), illustrates the damage assessment exercise. The court found that Poplack had been wrongly prevented from purchasing 18,000 shares, 12,000 of which could have been bought upon his dismissal and the remaining 6,000 six months later. The court then made these findings: Intermetco was a closely-held company, whose shares were thinly traded; therefore, insertion into the market of a large number of shares would depress the price; over the relevant two-year period, the shares had traded at around $7.50; and Poplack was a conservative investor.
Based on these findings, the judge held that Poplack would have sold the first 12,000 shares within a year, “as quickly as possible after his dismissal but slowly enough to ensure the share price would not be adversely affected” at $7.50 per share. With respect to the remaining 6,000 shares, it was reasonable to assume that Poplack would have held off selling these, as he was still gradually selling the previous batch and waited another seven months until a takeover bid drove the share price up to $16.75.
It should be noted also that there have been cases where the court disallowed any damages for lost opportunity where it was established that the employee had never shown any inclination to participate in the plan. The important thing to remember is that it is not only the terms of the plan itself that affect the award of damages, but all the factual circumstances of the case.
Generally, employers will want to argue that employees should have mitigated their losses by purchasing their own shares. Of course, whether an employer wants to take this position depends on the market fluctuations and how this will affect the employee’s losses. In one case, the court rejected an employee’s position that promptly embarking on litigation was an acceptable substitute for making a substantial personal investment in shares. The employee should have purchased shares within three months of his resignation, the court ruled, and the company could not be responsible for replacing lost profits incurred as a result of this failure.
By contrast, the Court of Appeal in Veer rejected Dover’s argument that Veer ought to have mitigated his damages at the end of the notice period by investing approximately $300,000 U.S. in the shares to which he was entitled under the option agreement. The Court noted that no evidence had been led to show this would have been a reasonable course of action and that, given the sums involved, the opposite appeared to be the case.
Further, in Brock, the employee had taken a new job shortly after his termination. The trial judge held that, while Brock’s notice damages would be reduced by his earnings from his new job, the date of his new employment should not be used as a cut-off to reduce the number and value of shares to which Brock would have been entitled. This would penalize him for having mitigated his damages.
In Our View
The Court of Appeal in Veer gives some indication that there is a way of cutting off entitlement to stock options at the point of a wrongful dismissal: explicit language, as in Brock, to this effect in the contract of employment or the option plan agreement. However, language stating that even wrongful dismissal ends entitlement may undermine the very purpose of setting up a stock option plan in the first place, which is to attract highly qualified employees to a company.
Clearly, drafting such agreements involves striking a balance between setting out terms sufficiently attractive to prospective recruits, and limiting employer liability for damages if an employee is wrongfully dismissed. Our lawyers are available to assist you in making these determinations and finding the right solutions for your business.
For further information, please contact Lynn Harnden at (613) 563-7660, Extension 226.