What Is the Legal Status of Employee Stock Options (ESOPs) in Bankruptcy?

Employee Stock Options (ESOPs) are a form of employee benefit where employees are granted the option to purchase shares in the company, often at a discounted price. In the context of bankruptcy or insolvency, the treatment of ESOPs becomes a matter of concern, as employees might face uncertainties regarding their rights to exercise these options and the value of the shares during the Corporate Insolvency Resolution Process (CIRP) or liquidation of the company.

Legal Status of Employee Stock Options (ESOPs) in Bankruptcy:

Treatment of ESOPs Under Corporate Insolvency Resolution Process (CIRP):

During CIRP, the primary objective is to resolve the insolvency and find a solution for the creditors. ESOPs granted to employees may be subject to the resolution plan, which could involve converting stock options to equity, modifying the terms of the options, or canceling them entirely, depending on the resolution process.

Employee claims arising out of stock options are generally treated as unsecured claims. Employees, like other creditors, may not have priority in the distribution of proceeds in the event of liquidation or under the resolution plan.

In some cases, if the resolution plan is successful, employees may continue to have the option to exercise their stock options if the company continues to operate after the resolution.

Impact on Unvested ESOPs:

Unvested ESOPs may be affected during bankruptcy proceedings. The treatment of unvested options will depend on the resolution plan or liquidation. If the company is liquidated, the unvested ESOPs are often canceled, and employees may not be entitled to any compensation for them.

In a successful resolution plan, unvested ESOPs may either be vested, modified, or canceled depending on the terms agreed upon by the creditors and the resolution applicants.

Impact on Vested ESOPs:

Vested ESOPs represent ownership rights in the company, and their treatment in insolvency proceedings can vary:

• If the company is restructured and continues operating, employees with vested options may still have the opportunity to exercise their options under the terms set in the resolution plan.
• In a liquidation scenario, the value of vested ESOPs may be significantly diminished, as the company’s assets are sold off to settle the creditors. Employees may not be able to exercise their options if there are no assets left to distribute.

Priority of Employee Claims:

In terms of priority during liquidation, employees are typically treated as unsecured creditors. Employee claims, including those for unpaid wages, bonuses, and claims under ESOPs, are settled after secured creditors and other preferential claims, which can result in employees receiving little to no compensation for their stock options if the company is liquidated.

Impact of Bankruptcy on Stock Price:

In bankruptcy or insolvency, the stock price of the company typically declines, and the value of stock options may decrease substantially. For employees holding ESOPs, this means that the options may become worthless or significantly less valuable.

Even if the company is restructured, the stock options may be worth much less, affecting the employees’ compensation that was originally tied to stock price growth.

Rights of Employees Under the IBC:

Under the Insolvency and Bankruptcy Code (IBC), employees are generally entitled to file claims for unpaid wages or dues, but the ESOP claims do not have the same priority as claims from secured creditors or other stakeholders.

Employees, like other creditors, may participate in the Committee of Creditors (CoC) if their ESOP-related claims are substantial, but the decision regarding their claims is primarily determined by the resolution plan and the treatment of equity.

Impact of ESOPs in Liquidation:

If the company enters liquidation (instead of a successful resolution plan), the assets of the company are sold to satisfy the debts. In this case, the value of the company’s stock may become negligible, and the ESOPs might become completely worthless if there is no remaining equity or the liquidation value does not cover the creditors’ claims.

Employees who have vested ESOPs may still exercise their options before the liquidation, but they may not receive any meaningful compensation due to the collapse of the company’s value.

Legal Framework Under the IBC:

Section 53 of the IBC (Ranking of Claims):

Section 53 of the IBC outlines the priority of claims in the event of liquidation. Employee claims, including unpaid salaries and ESOP-related claims, fall under the category of unsecured creditors, which means they are lower in priority compared to secured creditors.

Section 25(2)(f) of the IBC (Resolution Plan and Employees):

The resolution plan under Section 25(2)(f) can propose various treatments of employee stock options, including adjustments to vesting schedules or providing an alternative compensation structure if the company is to be restructured and continues operations.

Employee Claims as Unsecured Creditors:

Employees who hold vested stock options may file their claims as unsecured creditors during insolvency proceedings. However, their claims will be treated along with other unsecured claims and will have a lower priority in the distribution of assets.

Example:

Imagine a tech company that has granted stock options to its employees, and the company files for bankruptcy.

• Vested ESOPs: Employees with vested ESOPs may be able to exercise their options if the company continues to operate after a successful resolution plan. However, if the company is liquidated, these options may be worthless as the stock price drops drastically.
• Unvested ESOPs: These options are often canceled during the insolvency proceedings, and the employees will have no claim to them.
• Employees as Creditors: Employees may file claims for unpaid wages or dues under the IBC, but their claims related to ESOPs will be treated as part of unsecured creditors.