Aligning Incentives with Equity: Employee Stock Options and Rule 10b-5

Abstract

When the Internet boom was in full swing and the stock markets skyrocketed to new levels, companies new and old used stock options to attract and retain employees. Implicit in those options was the promise that employees could participate in the growth of a company's value. However, as the scandals involving WorldCom, Enron, and Global Crossing demonstrate, corporate managers were not always honest with employees or public investors about the company's true value. Public investors can seek civil remedies for securities fraud through a private action under the Securities and Exchange Commission's Rule 10b-5. The Rule's purchase or sale requirement, however, has been interpreted to exclude employees who receive their options through a group plan rather than through individual negotiation. Employees who individually negotiate for an employment package including options are deemed to have purchased their options; employees who receive their options through a group plan are deemed to not have purchased them. This formalistic disparity favors executives, managers, and other high-level employees who individually negotiate for their employment contracts; employees who receive their options en masse are left out in the cold.

This article argues that distinguishing between employees based on their method of obtaining stock options is wrong, both as a matter of doctrine and policy. The doctrinal distinction between negotiated options and groups plans is based on an outmoded theory about employment contracts - a theory that, in the past, deemed employer pension promises to be a mere gratuity. An employer's offer of stock options - just like health benefits - is a binding contract once the employee accepts that offer by working. On a policy level, employees who receive their options through a group plan are, in fact, more likely than their individual-negotiation counterparts to need the antifraud protections that Rule 10b-5 affords. Although employees may have certain informational advantages over outside investors, they are often just as susceptible to managerial fraud. The possibilities of employee strike suits or the chilling of option grants are not sufficiently important to warrant the elimination of antifraud security. And other legal avenues, such as contract law or ERISA, do not provide the same protections as Rule 10b-5. Ultimately, the article concludes that all employees should be able to pursue relief under Rule 10b-5 for fraud that materially affects the value of their options.

Keywords: employee stock options, Rule 10b-5, securities fraud, employment contract

JEL Classification: K12, K22, K31