Institutional Investors Red-Flag India Inc.’s ESOP Schemes

It’s been building for a while. First it was companies such as Sterling and Wilson Solar, VST Industries and Intellect Design Arena. Then came others like , Khadim India, Jubilant Ingrevia, Mindtree. Now even blue-chip companies are being put on notice.

Asian Paints.

At its June-end annual general meeting, India’s largest paintmaker struggled to get public shareholder approval for its employee stock option plan. 56% of the public institutional votes cast and 76% of the public non-institutional votes cast were against the proposal. It passed largely due to promoter support.

How and why did it come to this?

Because often corporate ESOP schemes lack transparency or are missing key features of ‘pay-at-risk’ compensation — a mutual fund manager, corporate lawyer and proxy governance head told BloombergQuint.

Asian Paints’ ESOP scheme provides for an exercise price at a 50% discount to market price. Proxy advisory firm IiAS recommended that shareholders vote against the scheme because of the significant discount to market price.

Managing Director Amit Tandon explained that earlier he looked at dilution, cost to company and pricing. In fact, most institutional investors’ voting policies also explicitly reject “excessive dilution”. And often such investors have vetoed an ESOP proposal on account of cost. But pricing has become a more pervasive problem, according to Tandon.

Some discount is acceptable, he said. “What we are okay with is up to 20% discount to market price.”

The 20% threshold was arrived at via a poll of institutional clients, though different funds may have different comfort levels. Globally ESOP pricing is at market price, said Tandon. “Any variation from that is unacceptable.”

In India though, the present ESOP rules for unlisted and listed companies give boards complete freedom to decide the exercise price. Many have kept the exercise price at the face value of shares or at a significant discount to the market price of the shares, said Bharat Vasani, partner at law firm Cyril Amarchand Mangaldas, while describing the scale of the problem.

For instance, last year SBI Mutual Fund, the country’s largest, voted against the Greenply Employee Stock Option Plan 2020 once because no exercise price was disclosed and again later because the company board had retained flexibility to price the scheme at the face value of one rupee versus the prevailing market price of Rs 114.

It also objected to the cost of the scheme — “Further, we estimate the annualised cost of the scheme at Rs. 15.29 crore, which is high at 25.2% of FY20 profit before tax,” SBI MF explained in its voting disclosure.

UTI Mutual Fund supports ESOP programmes because they bring about alignment of incentives for management teams with the shareholders, Vetri Subramaniam, head of equity at UTI MF, said.

But the fund does not look favourably at issuances which are at a deep discount to the current price — as they have a higher cost and are not in keeping with the goal of appreciation linked incentives. Inadequate disclosures or ESOP plans with high cost implications will also be voted against, he said.

There’s one more avatar of the pricing problem — repricing. In September, HDFC Mutual Fund voted against Time Technoplast’s proposal to reprice its 2017 ESOP scheme at a lower price. It “will set a wrong precedent” the fund said in its voting disclosure.

Such practices make ESOPs less a performance incentive and more a remuneration tool, agree all three.

It’s worse when a bulk of the ESOP issue is being granted to a select few members of top management. According to one estimate Tandon cites, 70% of any ESOP scheme is going to the senior management.

“In most cases, ESOPs are used as a tool to by-pass the monetary limits of managerial remuneration prescribed under Section 197 of the Companies Act,” said Vasani.

Tandon agrees — If it is at a discount then why pretend it’s anything else and if it is an incentive, then let it be at the market price.

Subramanium said, “Ideally, we would like ESOP programmes to include a wider coverage, but the focus must be on the key employees and the principle must be aligned with those who are incentivised by a ‘pay at risk’ structure.”

Is The ESOP Performance Linked?

Often the discomfort with pricing is accentuated by the lack of upfront disclosures on who stands to benefit and performance parameters.

At the end of the day, what are you rewarding the person for, asked Tandon. “Is it performance linked, is it linked for showing up? I can imagine for junior employees it’s linked for showing up at work or to tenure in the company. But for senior management that cannot be the case. You need to have some well-defined parameters on which these are granted to employees.”

The current disclosure requirements are limited, Vasani pointed out.

The shareholder resolution only needs to disclose the generic classes of employees that are eligible for the scheme. Names are disclosed at the end of the year in the directors’ report. Some companies, but not all, specify performance metrics.

Vasani recommended the Ministry of Corporate Affairs and Securities and Exchange Board of India should strengthen disclosures at the time of voting;

  • to disclose names if only a select group are getting ESOPs.

  • mandate more objective performance-based criteria linked to Ebitda or net profit.

  • prescribe objective parameters for fixing the exercise price of ESOPs.

Sometimes such disclosures can offset the discount pricing aversion.

Newgen Software got a break last year when SBI MF voted in favour of its restricted stock units scheme despite the deep discount because, according to the fund, the company “clearly articulated the performance parameters for vesting”.

“We have voted in favour for ESOPs at a discount where the ESOP scheme was designed to attract talent at key senior levels and vesting was performance and milestone linked,” UTI MF’s Subramanium said.

Of course, not all investors may show such flexibility. Definitely not foreign investors advised by the two main foreign proxy advisory firms — Glass Lewis, which opposes a discount of more than 20% to market price, and ISS that opposes any discount altogether.

Remember, half of Asian Paint’s institutional shareholding is foreign-owned.

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