No Option to Buy

Originally published in The Moscow Times on March 5, 2001

The popularity of employee stock options plans is growing at an amazing speed worldwide. The right of a company's employees to buy shares at a reduced price or before a specified date, also called "option to purchase," has proved a valuable way of creating incentives that boost employee loyalty and productivity.

In the United States especially, such plans are reputed for turning managers into millionaires, as their companies' shares soar on the stock market.

Michael Eisner, chairman and chief executive of The Walt Disney Co., exercised in December 1997 options worth more than the total annual salaries of the top 500 chief executives in Britain.

Chief executives in the 500 largest British companies in aggregate made ?330 million ($540 million) in 1997, or ?660,000 each, including ?74 million from exercising options. Disney's Eisner exercised options worth ?348 million in December 1997, according to a report by Martin Conyon and Kevin Murphy in the Economic Journal, November 2000. Fortune magazine estimated in September 1999 that exercising accumulated stock options gave Eisner pre-tax gains of over $500 million since 1992.

The practice is increasingly applied in the United States as stock options are emerging as leading providers of compensation and incentives. According to a paper by Brian Hall of Harvard Business School and Kevin Murphy of the University of Southern California, in the 1998 fiscal year, 97 percent of the companies in the Standard & Poor's 500 index granted options to their top executives, up from 82 percent in 1992.

The paper estimated that the grant-date value of stock options accounted for 40 percent of total pay for S&P 500 CEOs in 1998, up from only 25 percent of total pay in 1992.

Stock options are also becoming increasingly important for rank-and-file workers. Forty-five percent of U.S. companies awarded options to their salaried employees in 1998, while 12 percent and 10 percent awarded options to their salary and hourly employees respectively, according to the paper.

Russian Restrictions

In Russia, however, it's illegal for Russian citizens to own shares in a foreign company without a license, due to restrictions under the currency, banking and securities laws. Sections Four and Seven of the October 1992 Currency Control Law, for instance, deny the right to own foreign property, such as securities in foreign currency.

"These [stock options] plans are available worldwide at certain multinational companies," said Mathieu Fabre Magnan, a lawyer with international law firm Salan's Moscow office.

But in Russia, Fabre Magnan said there are three main issues preventing Russian executives from enjoying this Western approach to compensation:

First, there are issues related to currency control. Under the Foreign Currency Regulation and Control Law adopted by parliament in 1992, Russian citizens cannot own stock or other forms of investment outside Russia, unless they have obtained a hard-to-get, hard-to-keep license from the Central Bank.

These restrictions are not unusual and Russia is not especially "late" in dropping them when compared to other countries, said Tim Carty, a senior manager and the director of Human Capital Services with Arthur Andersen.

"The whole purpose of the exchange laws is to encourage people to invest inside Russia. It's a natural reaction of the Central Bank to say 'no,'" Carty said. "However discredited, these are not alien concepts. The U.K. had currency control until 1979, and exchange control is common in many countries. Poland removed it last year and Hungary still has it."

The second hurdle is that applying for the license is a convoluted, painstaking process. Applications should be sent to the Central Bank's currency control department. If granted, the license will be issued within one to two months. The final decision rests entirely with the Central Bank, whose main criteria are the benefits to the development of domestic business and the applicant's compliance with the law.

The third barrier is that the issuance is subject to periodical reporting to the Central Bank.

"It's extremely impractical and very hard to monitor," Fabre Magan said of the licensing procedure, citing the bi-yearly, post-issuance letters that the Central Bank requires.

Despite the difficulties, companies do apply for licenses to create subsidiaries abroad. Fabre Magnan said oil and gas and construction companies, as well as the national airline Aeroflot, are the most likely applicants.

"At the end of the day, they usually give the license," he said. "But I've never seen a license given to an individual, and I've never seen an individual applying for one either."

But Steve Henderson, deputy director of Tax and Legal Services for Deloitte & Touche for the Commonwealth of Independent States, said licenses are not generally available even to companies. "My understanding is that very few Russian and foreign companies receive a license to own foreign stock," he said.

Carty of Arthur Andersen, who took part last fall in a companies' presentation of stock options programs at the American Chamber of Commerce, echoed this skepticism. "I am unaware of any organization that has been granted permission to run a stock options plan in full in Russia," he said.

"The Central Bank looks at that [stock options] as capital export. So just as it must give permission for opening a bank account abroad, it must give permission for this, too," said Boris Mozdukhov, deputy head of staff at the State Duma Committee on Credit Organizations and Financial Markets. "But, in fact, that section of the Law on Foreign Currency Regulation and Control is not working."

As proof of its impracticability, a Central Bank statement issued two years ago said that only about 10 people per year applied to the Central Bank for licenses for capital export operations, Mozdukhov said. This refers to all types of operations involving overseas assets — from opening bank accounts to registering companies abroad — not just stock options plans.

Winning approval from the Central Bank hinges on a bit more than someone's application, said Mozdukhov.

"You can't really call it a license, it's more a permission. It's not legal for ordinary citizens and individuals and for the rank and file workers, but if you are working in the financial sphere, via one's acquaintances and circles it's possible to get permission," he said.

The maximum penalty for breaking currency laws is the confiscation of the assets or a fine equivalent to the value of the assets, Carty said.

Creative Alternatives

There are legal ways of getting around Russian currency controls, such as when a company gives an employee a bonus that is equal to the difference between the stock option price and the market price. Fabre Magnan said the employee can buy a share at $1 and sell it at the market price of $15.

"This way you are not in violation of the law, and it's economically efficient. Under the Labor Code, you can give bonuses and you are free to calculate them the way you want. But it's a very complicated area of the law," he said.

Securities and corporate legislation complicate the process further by imposing a one-year limitation on the period between a company's decision to issue shares and the actual issuance.

"They cannot create a stock option excisable after one year — it adds complications and costs," Fabre Magnan said. "You need to make it excisable for a longer period. In the West, there is more flexibility — these stock options plans would be excisable within two years.

"These laws are very restrictive, but there are legal ways around them. Russians are very creative," he added.

Russian citizens cannot own stock abroad without a hard-to-get, hard-to-keep license.

Carty of Arthur Andersen pinpointed two such alternatives at a recent breakfast meeting organized by the European Business Club's human resources committee.

In addition to getting a license from the Central Bank, employees of representative offices and subsidiaries of foreign multinational companies can alternatively use a trust or a phantom stock plan, he said in his presentation.

These two variants, he said in an interview, grant some of the rewards of stock options plans as enjoyed by employees in other countries. The options are delivered in Russia in cash and therefore, do not amount to real stock options.

The phantom stock plan is considered less attractive because it is financed by cash instead of shares, which is often perceived as more expensive. Also, it does not put an end to currency control issues, unless structured carefully.

The second method grants shares and options to a discretionary trust instead of a person. The trust is then exercised, or held until the expiry date, and the resultant stock disposed of within the trust. That, too, has a drawback. "The assets are managed entirely at the discretion of the trustees. The beneficiaries of this trust have no rights or ownership at all, which is why it works," Carty said.

Microsoft is a well-known fan of such discretionary trusts for its Russia-based operations. The company's Russian executives enjoy the benefits of a stock option plan, even though they do not legally own the stock. In April of last year, the software giant granted about 70 million new stock options to all of its 34,000 full-time employees to compensate for the dive in the high-tech sector.

Legal Gap

The situation is exacerbated by the lack of legislation specific for stock options, whereas in Western countries separate laws exist. In Russia, such a compensation practice is swallowed up in the Securities Law, namely in the sea of normative acts that make up the Decree of the Federal Commission for Securities.

Deloitte & Touche's Henderson said the new chapter on personal income tax of Part II of the new Tax Code, which took effect Jan. 1, is the only piece of legislation bringing relief to the stock options legal void.

"There is no specific law regulating stock options plans in Russia, except for this new law," Henderson said. "It now does provide for taking into account the value of a stock option that has been taxed for selling the stock option.

"If you have a stock options plan and you may buy that stock option at $1, if you decide to exercise it, at that time it will be worth $2. You will receive $1 and that's taxable. Before, you were taxed twice: as employment income, and when you sell the stock for $2. You would be taxed for $2 instead of $1," he said.

Outside of the Jan. 1 law, the dos and don'ts of stock options are anyone's guess, according to Alexander Leonov, deputy chairman of the Duma's State Committee on Labor and Social Policy.

"Under the Russian law there is no prohibition on this [stock options plans]," Leonov said. "Russian law doesn't restrict the property rights of workers. But there is also very little practice of this. It's not widespread. For instance, nobody has approached us with inquiries about this."

Options for All

Maybe they will not have to wait for long. Last summer, Western consultant PricewaterhouseCoopers sent proposals to the Central Bank, calling for stock options to be legally part of Russians' salary packages.

At that time PwC was working on the project with the Landwell CIS law firm, now incorporated as PwC CIS Law Offices. The proposals were made on behalf of two multinational companies, whose names PwC declined to reveal.

Svetlana Orlova, a lawyer with PwC's Moscow office, said PwC has been holding negotiations with the Central Bank since sending the proposals, and that the Central Bank's last action was to send a letter of recommendation in mid fall to the Tax Ministry. The next decision…

Read the full text at The Moscow Times.