EMPLOYEE STOCK OWNERSHIP – HOW MANY IS GOOD?

The trend for key employees to hold a certain number of shares through ESOP mechanisms in public joint-stock companies has recently become popular in the Vietnamese market. It contributes to the balance between the benefits and responsibilities of companies and their employees in production and business activities. However, when employees own a certain percentage of shares, they will have a considerable impact on the company.

ESOP mechanism and its impacts on companies

An ESOP (Employee Stock Ownership Plan) refer to a plan that issues shares under an option program for employees. It can be understood that a company will select employees who have made significant contributions to the company and offer them the company’s shares instead of cash in order to reward, encourage and motivate employees to commit and contribute to the company continuously. ESOP shares are usually issued at a preferential price with many conditions, such as (i) having an employee share ownership plan approved by the General Meeting of Shareholders (GMS), (ii) the total number of shares issued under the plan in every 12 months must not exceed 5% of the outstanding shares of the company, (iii) having criteria and list of employees eligible for ESOP, rules for determination of the quantity of ESOP shares and execution time that are approved by the GMS (or the Board of Directors if authorized by the GMS), and several other conditions according to Articles 60.4 and 64 of Decree 155/2020/ND-CP dated December 31, 2020, on detailing and guiding the implementation of a number of articles of the Law on Securities.

On acquiring ESOP shares, such employees will also become shareholders of the company. In most cases, companies want to create an alignment between their business results and the interests of employees through ESOP. In theory, owning more shares in the company can create a greater incentive for employees to improve the business results of the enterprises and will help control their self-interest behaviors since any action of theirs that devalues the company can cause corresponding damage to the employee’s benefits. In addition, ESOP is beneficial to both employees and enterprises when they ensure employee benefits while issuing new shares through their mechanisms under Article 123 of the Enterprise Law 2020 to supplement charter capital for the company.

However, besides the above advantages, the fact that key employees hold shares at a tremendously high rate can be a loophole that enables undesirable behaviors such as manipulating stock prices or affecting accounting records. For example, there was a case that near the time when an employee planned to sell his ESOP shares, that employee colluded with others and together they set up securities accounts for trading in order to create fake supply and demand, which resulted in an acceleration of the stock price, and then they sold them on the market to make a profit. Another case is that an employee, who was then a director of an enterprise, took advantage of his influence to “beautify” the accounting books and reports, changed from loss to profit so that he was eligible to receive a share bonus through ESOP. In such cases, there were conflicts of interest between the employees holding ESOP shares and the remaining shareholders, which are contrary to the original governance goal of encouraging employees to hold a certain number of shares of the company.

An overseas survey

The question is how many shares in a company that an employee can hold will optimize the benefits and limit undesirable effects for the company. A well-known experiment with 371 US companies conducted by Morck, Shleifer & Vishny (1988) provides a level of recommendation when comparing the correlation between the rate of shares owned by key employees and the companies’ performance. Accordingly, the study divides the ownership ratio into three levels as follows: (i) At a low level (<5%), the experimental result shows that when employees own a share rate of less than 5%, they can have beneficial effects on the activities of companies; (ii) The ownership level is higher (from 5% to 25%), the experimental model suggests that employees can take advantage of their management and management rights to make a profit and cause damage to shareholders; (iii) However, at ownership level higher than 25%, the model results manifest a positive impact on the companies but at a much lower performance compared with the low level (<5%) group . Therefore, Morck, Shleifer & Vishny (1988) suggest that having key employees hold less than 5% of the company’s shares is the best option for the company’s business activities.

It should be noted that the study was carried out decades ago and many social and economic factors have changed since then, but in our opinion, some of the experimental results concluded from it still have a high value of reference.

In Hong Kong, ESOP shares in each issue that an individual may receive may not exceed 1% of the number of shares of the same class outstanding, in exceptional cases (over 1%) must be approved by resolutions of the general meeting of shareholders.

Preventive measures for enterprises to counter the negative impacts of ESOPs

In Vietnam, the current law does not set any recommendations or limits regarding the share ownership ratio of employees in the company to ensure companies’ governance goals and limit unexpected behavior of key personnel. From our perspective, we believe such conflicts of interest can be minimized by keeping a share ownership ratio of employees lower than that of “major shareholders”, because (i) while their number of shares owned is still low, the possibility of conflicts of interest between them and the company will be less likely to arise, and (ii) the right of deep access to the company’s information and book can be waived, such rights could be:

“a) Access, extract the minutes of meetings, resolutions and decisions of the Board of Directors, mid-year and annual financial statements, reports of the Board of Controllers, contracts and transactions subject to approval by the Board of Directors and other documents except those that involve the company’s business secrets;

c) Request the Board of Controllers to investigate into specific matters relevant to the company’s administration where necessary. (…)”.

According to current regulations, a major shareholder in a public company is a shareholder owning 5% or more of the voting shares of an issuer. Although Law on Enterprises 2020 provides no definition of “major shareholders”, shareholders, based on their rights and obligations, can be divided into two groups: Group 1 - shareholders, group of shareholders owning from 5% of the total number of ordinary shares or more/another smaller percentage according to the charter; and Group 2 - shareholders, group of shareholders owning 10% or more of the total number of ordinary shares/another smaller percentage as stipulated in the charter. In fact, because the price of ESOP shares when issued is always lower than the market price, immediately after receiving the shares, the employees might benefit from the sell-off of those shares in the market, which leads to adverse influences on the company’s stock price and the stock market.

In order to prevent such transactions, from the legal perspective, the law has focused on the restriction when only allowing ESOP shares to be transferred for at least 01 (one) year from the end of the issuance (blackout period). In practice, companies often set the conditions for issuing ESOPs to limit the aforementioned adverse effects: (i) increasing the time limit for transferring ESOP shares. Recently, DIC Corp (ticker symbol: DIG) has approved a plan in which 15 million ESOP were issued at the price of 15,000 VND/share for its employees. According to the plan, the transfer of shares is expectedly restricted for 3 years from the end of the issuance of such shares; (ii) dividing into several issuances. This option will reduce the number of shares employees receive in an issuance, avoiding the case that some employees acquire the company shares at a low price; (iii) controlling the standards of employees selected to participate in the plan. Some criteria on conditions that employees are required to meet to receive ESOP should be adopted in the companies’ regulations to control their self-interest behaviors; and (iv) restricting the percentage of ownership that each individual can obtain in each issue. This ensures that an employee can hardly become a “major shareholder” as analyzed above, thereby reducing the risk of conflicts of interest between employees and the company.

In general, employees’ ownership of a certain percentage of the company’s shares can bring great benefits. However, companies still need measures to ensure that their values maximization is achieved to promote and develop enterprises and to avoid the risk of conflicts with their employees.

ADK & CO Vietnam Lawyers

https://scholar.harvard.edu/files/shleifer/files/mgt-own-mkt-val.pdf;
https://www.uel.edu.vn/phan-bien-xa-hoi/thieu-co-che-kiem-soat-co-phieu-esop-co-the-bi-lam-dung;
Điều 115.2 Luật doanh nghiệp 2020.
Điều 4.18 Luật chứng khoán 2019.
https://cafef.vn/dic-corp-dig-chuan-bi-phat-hanh-15-trieu-co-phieu-esop-voi-gia-bang-nua-thi-gia-20210810105520226.ch

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EMPLOYEE STOCK OWNERSHIP – HOW MANY IS GOOD?

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The trend for key employees to hold a certain number of shares through ESOP mechanisms in public joint-stock companies has recently become popular in the Vietnamese market.