Securities Law Liabilities In Employee Stock Options

As stock market prices soar, corporations rely increasingly upon stock options to serve as a form of currency to attract and retain sought-after employees. This practice is particularly important to development stage companies, such as Internet companies, with limited cash flow available, but the hope of an escalating stock market price, to serve as an incentive to attract qualified employees. This practice is further fueled by employees who have become more and more willing to forgo higher salaries for the potentially enormous opportunity for wealth that options to purchase securities issued by their employer may represent.

Stock options are only as valuable as the stock underlying those options. What happens if the stock price of a company suffers a significant diminution in value due to an unexpected drop in earnings, an announcement of a restatement of earnings or accounting irregularities, a criminal investigation, or some other bad news? Do employee option-holders have federal securities law claims against their employer akin to the claims possessed by the company's public stock holders? This article will explore the guidance issued by the Securities and Exchange Commission ("SEC") and recent case law that has addressed these issues.

Employee Stock Option Plans

Most option awards to employees are effected by means of an employee stock option plan that is implemented by the company, usually by its board of directors or a committee thereof. These plans authorize the company to award options to employees as part of their annual compensation or as a performance-based bonus. The terms of the options (including their price, vesting schedule and duration) are governed by the terms of the plan.

The Securities Act of 1933 (the "Securities Act") and the Securities Exchange Act of 1934 (the "Exchange Act"), as enacted, did not contain any reference to employee pension or profit sharing plans such as option plans. Indeed, the application of the federal securities laws to such employee benefits plans was quite unclear until the Supreme Court decided the case, International Bhd. of Teamsters, Chauffeurs, Warehousemen & Helpers of Am. v. Daniel.1 Daniel addressed the question of whether an employer who creates an employee benefit plan has "sold" a "security." This question is a crucial starting point in addressing employee stock option grants because if such a grant constitutes a "sale" of "securities" then: (1) the securities must be registered pursuant to the dictates of the Securities Act (absent an exemption); and (2) civil liability may arise for failure to comply with the registration and disclosure provisions of the Securities Acts or from false statements or omissions to state material facts in connection with such sales.

In Daniel, the United States Supreme Court held that the receipt of securities in noncontributory pension plans does not involve a "sale" of securities under the Securities Act and the Exchange Act. In a "noncontributory" benefit plan, employees have no choice as to participation and make no direct contributions to the plan. Instead, an employer determines the amount to be contributed, and pays that amount directly to the plan on behalf of the employee. In this situation, the Court held that an employee benefit plan was not an investment contract because there was no investment of money by the employee. Instead, "it seems clear that an employee is selling his labor primarily to obtain a livelihood, [and is] not making an investment."2 In reaching its conclusion, the Court focused on the extensive regulation of pension plans, including disclosure requirements, set forth in the Employee Retirement Income Security Act ("ERISA"). Thus, the court concluded that the extension of the Securities Acts to cover pension plans would serve "no general purpose."3

The "No-Sale" Doctrine

Since Daniel, the SEC has clarified its position with respect to securities law regulation of employee benefit plans through a principle referred to as the "no-sale" doctrine. Specifically, the SEC has made clear that the grant of securities to an employee pursuant to a noncontributory benefit plan is not a "purchase" or "sale." As explained by the SEC, "[t]he basis for this position generally has been that there is no 'sale' in the 1933 Act sense to employees, since such persons do not individually bargain to contribute cash or other tangible or definable consideration to such plans. It also is justified by the fact that registration would serve little purpose in the context of a bonus plan, since employees in almost all instances would decide to participate if given the opportunity."4

In contrast to involuntary, noncontributory employee benefit plans, such as discussed in Daniel, where a plan does involve a "separable" investment of money as well as an expectation of profits, the SEC has reached a different conclusion - determining that employee's voluntary contributions to such a plan would qualify as a "purchase" of "securities" governed by the federal securities laws. In this situation, "the amount set aside for investment purposes can be readily identified by examining the contributions made by each individual participant."5 In identifying which types of plans would be deemed "voluntary and contributory" the SEC focused on plans that "permit employees to make a determination . . . whether they will invest their own money."6

The Impact Of Daniel And The "No-Sale" Doctrine On Securities Law Liability

To possess standing to sue under Sections 11 and 12 of the Securities Act, a plaintiff must have "acquired" a security issued pursuant to a misleading registration statement, or received an offer to purchase and actually purchased a security pursuant to a misleading or improper prospectus. Similarly, to state a cause of action under Section 10(b) of the Exchange Act or Rule 10b-5 promulgated thereunder, plaintiffs must (among other things) demonstrate that the defendant made misstatements or omissions of material fact in connection with plaintiff's purchase or sale of securities.7 In essence, this "purchase" or "sale" requirement mandates that to possess standing to assert a claim pursuant to Section 10(b), a security-holder must make an affirmative investment decision which is effected by the allegedly misleading disclosures.

The SEC's "no-sale" doctrine as well as Daniel and its progeny have been cited by parties defending claims by employee stock option-holders arising in three scenarios under the federal securities laws. Specifically, this authority has been cited in response to lawsuits commenced by plaintiffs (i) who were granted options pursuant to an employee benefits plan, (ii) who individually negotiated an employment agreement, which includes stock options, and (iii) whose options are modified by the corporation.

Application Of The "No-Sale" Doctrine To Holders Of Employee Stock Options

Although there does not exist a large body of case law, the opinions that do exist have consistently held that mere participation in a noncontributory benefits plan does not satisfy the "purchase" or "sale" requirement for a federal securities law claim. Thus, the holding by employees of options granted pursuant to a non-contributory benefits plan - whether or not the options have vested - has been determined not to satisfy the "purchase" or "sale" requirement. This case law is consistent with the general principle that "holders" of securities (as opposed to purchasers or sellers) do not have standing to assert a Section 10(b) Exchange Act claim.8

The most recent case to address this issue arises from the April 15, 1998 announcement by Cendant Corporation ("Cendant"), disclosing its discovery of certain accounting irregularities. On the day following this announcement, Cendant's stock price declined from approximately $35 to approximately $19. Predictably, numerous lawsuits were filed by security holders, including claims by former employees who had been granted options pursuant to Cendant's stock option plan. In McLaughlin v. Cendant Corp.,9 the plaintiff was a former employee of Cendant and its predecessor, CUC International, Inc. ("CUC"). The plaintiff received her options pursuant to CUC's employee benefit plan, and alleged that she was induced to accept the options on the basis of materially false and misleading financial statements. The defendants argued that the plaintiff's acquisition of options was subject to the "no-sale" doctrine and, consequently, that the plaintiff lacked standing to assert a Section 10(b) claim. The Court agreed. In dismissing the Section 10(b) claim, the court explained that Plaintiff did not receive her options as part of a bargained-for exchange that required her to make an affirmative investment decision. . . . Though the plan stated that it was created to provide an incentive for employees to remain with Cendant, that language does not change the actual structure of the plan. . . . [P]laintiff's participation in the plan "was an incident of employment and [her] only choice would have been to forego the receipt of benefits entirely."10

Stock Options Exchanged For Employment

In contrast to those cases commenced by an employee who is merely a participant in a benefit plan, some decisions have held that the receipt of employee stock options may satisfy the "purchase" or "sale" requirement for a Section 10(b) claim where an individual negotiates an employment package that includes a grant of stock options. For example, in Yoder v. Orthomolecular Nutrition Inst., Inc.,11 pursuant to an oral agreement, the plaintiff accepted employment with an issuer of securities in return for an annual salary of $40,000 plus options to purchase up to 30,000 shares of the issuer's stock. In addressing a motion to dismiss the plaintiffs' Section 10(b) claim, the court focused on the definition of the term "sale" or "sell" in the Securities Act to include "every contract of sale or disposition of a security," as well as the definitions of those terms in the Exchange Act to include "any contract to sell or otherwise dispose of" securities. The court then concluded that the complaint alleged the existence of a contract for the sale of up to 30,000 shares of stock, falling "within the letter of these statutes . . . ."12 Judge Friendly then went on to explain that:

we perceive no reason why . . . Congress should have wished the courts to exclude from the benefits of facially applicable language a person who parts with his or her established way of life in return for a contract to issue stock. As the Supreme Court has noted in a similar context, "[t]he economic considerations and realities present . . . are similar in important in respect[s] to the risk an investor undertakes when purchasing shares. Both are relying on the value of the securities themselves, and both must be able to depend on the representations made by the transfer of the securities . . . ."13

Thus, in Yoder and similar cases, the courts have focused on the affirmative decision by the prospective employee to accept a compensation package that includes stock options as consideration for the individual's agreement to accept employment at the company. As a result, the court concluded that there existed bargained for consideration for the options - the agreement to accept employment and therefore a "purchase."

Modification Of Options

A further issue arises where employee stock options are modified by the issuer. In cases arising in this situation, plaintiffs argue that the option-holder's "acceptance" of the terms of the modified option constitute a "purchase" of securities. A second case arising from Cendant's disclosure of accounting irregularities is illustrative. Specifically, in Wyatt v. Cendant Corp.,14 plaintiffs sought to represent a class of former employees of CUC. In that case, at the behest of the Federal Trade Commission, CUC decided to divest its Interval Holdings, Inc. subsidiary in connection with its merger with HFS Incorporated. According to the complaint, prior to the divestiture, Interval's management negotiated with CUC to obtain incentives to encourage the continued services of its employees. Among other things, the terms of plaintiffs' options as to vesting and the time in which holders could exercise the options were modified in connection with the divestiture.

Plaintiffs first argued that they satisfied the "purchase" or "sale" requirement, because they were induced to stay at Interval based upon the expectation of receiving modified options. In rejecting this argument, the court explained that, following the divestiture, "plaintiffs remained as at-will Interval employees with the same responsibilities and compensation they had pre-divestiture . . . . Consequently, plaintiffs do not plead the existence of any 'specific consideration' or added value that they each provided in the pre-divestiture period traceable to the option modifications."15 Plaintiffs next argued that the option modifications were voluntary and they had made an "investment decision" because a letter from Interval purportedly gave them the ability to accept or reject the modification of the terms of the options. The court also rejected this argument, explaining that:

when a group of employees is offered options (or option modifications), an eligible employee does not make an individual affirmative "investment decision" if he or she chooses either to participate in the plan or to reject it . . . . Such is the case here. The only alternatives available were pre-ordained by CUC. Plaintiffs did not make any "individual affirmative decision[s]" to trade "particular consideration in return for a financial interest" merely because they plead that they could have accepted a different form of modification.16

A similar result was reached by a New Jersey State Court in Hecht v. Papermaster.17 In that case, B.S.G. Corporation, the employer of plaintiffs, was acquired by Medaphis Corporation. The plaintiff employees were given the ability to exchange their options in the acquired company for those of the acquiring company. Plaintiffs brought claims, inter alia, for alleged violations of Section 11 and 12 of the Securities Act based on modifications made to their options in connection with the merger. The court concluded that plaintiffs did not allege the existence of a "purchase" or "sale" subject to the registration requirements of the Securities Act. As the court explained, "while plaintiff's B.S.G. stock options were exchanged for Medaphis stock options . . ., this Court simply cannot conclude that plaintiff gave up valuable consideration in exchange for the Medaphis options . . . ."18 The court went on to explain that "because the conversion of the options at issue did not allow for any choice by the optionholder, that is the options were converted automatically with no opportunity for the optionholders to withdraw funds and decide whether to reinvest," no purchase or sale had occurred supporting a federal securities claim.19

Conclusion

In the context of the federal securities laws, there exists only limited authority relating to the liability of issuers and their directors to individual employees granted stock options. However, recent case law provides certain guidance as to the availability to option-holders of a private cause of action against issuers under the federal securities laws. Three general principles may be extracted from those cases:

Employees granted stock options pursuant to a noncontributory employee stock option plan do not satisfy the "purchase" or "sale" requirement necessary to assert a claim pursuant to the federal securities laws based solely on their status as holders of options.

Employees who obtain options as a material part of a compensation package included in an employment agreement, particularly where such package induces the employee to join a company, may have a claim.

In connection with a modification to the terms of employee options, the court will consider whether the option-holders were required to make an affirmative investment decision and to provide consideration for the modification to determine whether the "purchase" or "sale" requirement is satisfied.

In light of the extensive use of employee stock options, particularly by corporations in the development stages, an increase in claims by holders should be anticipated, which will further clarify these principles.


1. 439 U.S. 551 (1979).
2. Id. at 560.
3. Id. at 569. The responsibilities of a corporation and its directors to participants in a pension or defined contribution plan under the ERISA laws falls beyond the scope of this article.
4. 19 SEC Docket at 465, at *5, 1980 WL 29482, at *15 (Feb. 1, 1980). See also Compass Group PLC, SEC No-Action Letter, 1999 WL 311797 (May 13, 1999) ("when an employee does not give anything of value for stock other than the continuation of employment nor independently bargains for such stock, such as a stock bonus program that involves the award of stock to employees at no direct cost," the "no-sale" doctrine applies).
5. See Release No. 33-6188, 19 SEC Docket at 465, 1980 WL 29482, at *9.
6. Release No. 33-6281, 21 SEC Docket at 1372, 1981 WL 36298, at *2.
7. Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723 (1975); see also In re International Bus. Machs. Corp. Sec. Litig., 163 F.3d 102, 106 (2d Cir. 1998).
8. See, e.g., Krim v. BancTexas Group, Inc., 989 F.2d 1435, 1443 n.7 (5th Cir. 1993) (noting "well established" principle that "mere retention of securities in reliance on material misrepresentation or omissions does not form the basis for a Section 10(b) or Rule 10b-5 claim"); Gambella v. Guardian Investor Servs. Inc., 75 F. Supp. 2d 297, 299 (S.D.N.Y. 1999) ("Rule 10b-5 only protects defrauded purchasers or sellers. Both the [Second Circuit] rule and the Supreme Court's decision in Blue Chip Stamps have been subsequently interpreted to limit suits by individuals who allege that they were induced to retain securities by a defendant's fraudulent conduct.").
9. 76 F. Supp. 2d 539 (D.N.J. 1999). See also Childers v. Northwest Airlines, Inc., 688 F. Supp. 1357, 1363 (D. Minn. 1988) (dismissing a Section 10(b) claim on behalf of participants in an ESOP; "plaintiffs' participation in the ESOPs cannot be characterized as a 'purchase' of a security since participating employees did not furnish value"); Bauman v. Bish, 571 F. Supp. 1054 (N.D. W. Va. 1983) (holding that "no offer, sale, or purchase occurs with the operation of an ESOP as contemplated by the securities laws.").

10. 76 F. Supp. 2d at 545 (citations omitted) (quoting Childers, 688 F. Supp. at 1363). But see Feret v. CoreStates Fin. Group, No. Civ. A. 97-6759, 1998 WL 42650, at *14 (E.D. Pa. July 27, 1998) (holding in a two paragraph discussion of the issue that options granted to participants in a long-term incentive plan satisfied the "purchase" or "sale" requirement).
11. 751 F.2d 555 (2d Cir. 1985).
12. Id. at 559.
13. Id. at 560. See also Rudinger v. Insurance Data Processing, Inc., 778 F. Supp. 1334, 1338-39, (E.D. Pa. 1991) ("An agreement exchanging a plaintiff's services for a defendant corporation's stock constitutes a 'sale' under the terms of the Securities Exchange Act"); Campbell v. National Media Corp., No. 94-4590, 1994 WL 612807 (E.D. Pa. Nov. 3, 1994) (finding that grant of options to Chief Executive Officer to purchase 50,000 shares pursuant to an employment agreement was a purchase of securities).
14. 81 F. Supp. 2d 550 (D.N.J. 2000).
15. Id., at 556-57 (citations omitted).
16. Id., at 558 (quoting Childers, 668 F. Supp. at 1363).

17. Transcript opinion, Docket No. L-12961-96 (N.J. Super. Ct. Law Division May 12, 1998).
18. May 12, 1998 tr. at 80-81.
19. Id. at 81.
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