New Israeli Court Ruling on Employee Stock Options: Implications for Employers

Employee Stock Options as a Strategic Remuneration Tool

The granting of stock options to employees is a prevalent remuneration mechanism, especially among high-tech companies and startups. Stock options are one of the tools companies use to incentivize employees’ long-term commitment, create a correlation between employee performance and the achievement of strategic objectives, and enable employees to share in the company’s successes. By issuing stock options, a company is undertaking to grant its employees the right to purchase its shares at a predefined price, subject to predefined suspending conditions. For the most part, employees may only exercise options according to a gradual vesting mechanism based, inter alia, on their period of employment and on the achievement of predefined targets.

The Statutory Framework in Israel

Section 102 of the Income Tax Ordinance offers unique tax advantages when granting stock options to employees, subject to compliance with regulatory requirements. To comply with the Ordinance’s requirements, the stock options must be granted through an orderly employee stock option plan (ESOP), which stipulates the allotment principles, vesting period, exercise conditions, and restrictions applying to each party. The company’s board of directors must approve the ESOP and the company must submit the ESOP to the Israel Tax Authority (ITA).

Employees’ personal employment agreements often include clauses undertaking to grant stock options. However, such an undertaking is usually considered a conditional undertaking rather than a vested right. This means that even if an employment agreement states that the employee will be “entitled” to stock options, the fulfillment of this promise is subject, in any case (as is usually stated in employment agreements), to the board of directors’ approval of the ESOP, to the signing of a stock option agreement, to the board of directors’ approval of the individual stock option grant to the employee, and to the employee’s fulfillment of the suspending conditions specified in the stock option agreement.

New Court Ruling: Careless Management of Undertakings to Grant Stock Options Could Result in Legal Exposure

The recently handed down ruling in the Kovach case clarifies how the court examines conditional undertakings to grant stock options within the framework of employment relations. The Kovach case involves an employee who signed an employment agreement that included an undertaking to grant the employee stock options, subject to the board of directors’ approval and subject to the employee’s continued employment at the company for a period exceeding  12 months. The employee was dismissed shortly before the vesting date of the first tranche of options pursuant to the agreement and with only two months left to complete the conditional period of employment.

The employee alleged her dismissal was intended to prevent her from completing the required employment and from exercising her vested options. The company, for its part, claimed the board of directors did not approve the stock option allotment as required and, therefore, it is invalid.

The court accepted the employee’s position and ruled that the employer dismissed her with mala fides and, through its acts and omissions, deliberately caused the nonfulfillment of the suspending conditions, in order to deprive the employee of the right to exercise the options. The court ruled that, pursuant to the provisions of section 28(a) of the Contract Law (General Part), when a party to a contract takes deliberate action to prevent the fulfillment of a suspending condition in a contract, it may not rely on that non-fulfillment to evade fulfilling its contractual obligations. Therefore, the court ruled that the employee is indeed entitled to the first tranche of options according to the vesting schedule defined in the agreement, even if the board of directors did not approve the allotment and even if the employee did not formally complete the conditional period of employment (Tel Aviv Regional Labor Court, Labor Dispute 7535-07-22 Tima Kovach v. Novo Central Ltd.).

Recommendations to Employers: How to Manage Undertakings of Stock Options to Employees

The court’s determinations in the Kovach ruling underscore how important it is for employers to carefully and wisely manage their undertakings to grant stock options to employees, especially in startup companies that use options as a key remuneration tool. Quite a few employers include general references in their employment agreements to a future entitlement to stock options, subject to the board of directors’ approval of an ESOP or of a particular stock option allotment, but fail to take practical measures to fulfill those undertakings. In such situations, procrastination or a lack of good faith could give rise to an employee’s legal right, even if the formal suspending conditions have not been fulfilled.

This ruling conveys to employers that careless conduct in their undertakings to grant stock options to employees could expose them to legal risks, as well as cause loss of employee trust in the credibility of the company’s undertakings to them. This is not to  suggest that employers should refrain from future undertakings to grant stock options, since they constitute a significant and essential remuneration tool, especially in a competitive market. However, when a company issues an undertaking, even if conditional, it must ensure that it backs up its undertaking with genuine, substantive intentions and concrete measures to implement it. For more guidance with regard to adopting an ESOP and granting stock options, click here.

By obtaining expert legal assistance, including meticulous planning, precise drafting of agreements, and ongoing legal support in properly managing the process, companies can avoid unnecessary risks and lawsuits.

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Adv. Ken Shaked, a partner in our firm’s Corporate Department, specializes in providing ongoing legal assistance to high-tech companies, entrepreneurs, and startups.

Adv. Daniel Adler is an associate in our firm’s Corporate Department.

Barnea Jaffa Lande’s Corporate Department provides end-to-end legal counsel to high-techs and startups companies during all stages of their local and international operations, including advice on private and public financing and fundraising, tender offers, corporate restructuring, commercial agreements, merger and acquisition transactions, collaborations, corporate takeovers and control struggles, corporate splits, asset acquisitions, and regulation.