Optional illusions

February 12, 2001 —

Stock options are the grease that keeps the wheels of our New Economy turning. In the high-stakes race to attract IT talent, many high-tech companies offer candidates attractive and potentially lucrative stock options as a part of compensation packages.

But what happens when promised stock options do not materialize, thanks to an employee dismissal or the IPO-unfriendly market? More and more, employees turn to the courts to get the value of worthless or withheld stock options.

Stock option stakes

"Stock options are potential damages," says Pat Lucas, chair of the litigation group for Fenwick & West, in Palo Alto, Calif. Several employee lawsuits worth millions -- based on claims of stock options owed -- have been filed or litigated recently. The defendants in these "disappointment suits" make up a who's who of dot-coms and high-technology players, including InfoSpace, Oracle, DoubleClick, and Qualcomm.

Courts, depending on the circumstances surrounding the lawsuit, have granted awards in some cases and have dismissed others. But experts agree the "disappointment suit" trend is growing.

According to the U.S. Bureau of Labor Statistics, during 1999 5.3 percent of employees at publicly traded companies received options as a part of a compensation package. Despite this small number, stock options hold great power: They have changed the dynamics of termination lawsuits, making them the key monetary issue and the driving force behind many of these suits.

"In about the last year or two years, wrongful termination suits in Northern California have been all about stock options," says John C. Fox, chairman of the employment and labor law group at Fenwick & West. "Every week $5 [million] to $10 million lawsuits cross my desk."

Employees believe they have been wrongfully fired and are suing to get the compensation they feel they deserve. Historically wrongful termination cases revolved around claims of discrimination. Awards were based on back pay, damages, and court costs.

Not today. Wrongful termination suits often center around an employee who left a company under conditions perceived as unfair. The "wronged" employee, who often worked long hours for less than market pay, later files suit to recoup the value of stock options he or she might have received if everything had worked out as planned -- and promised.

Still, many successful lawsuits never live uup to the stock option potential. "The settlement of the largest employment discrimination case is less than the value of any typical individual stock option case," Fox says. "The value of lost stock options can exceed $100 million." Awards and settlements are unlikely to reach that amount.

Vesting schedules up ante

Part of the stock option claims rest on vesting schedules. "Historically, four or five years were the vesting schedule -- one year to vest with annual vesting of 25 percent," Fox says. "About two years ago, historical vesting schedules changed."

A high-flying stock market and keen business competition led to fast-track stock option packages designed to lure potential employees. "Now you see one-year vesting periods with immediate 25 percent vesting. Monthly vesting follows after this one-year period," Fox says.

But with the downturn in the economy and the "cash is king" attitude of employees, Fox says that options packages are returning to their more stringent forms. "We're seeing the results of mistakes made when things were red hot," Lucas says. "We're seeing prudence and caution reasserting itself."

Any simply defined vesting schedule allows plaintiffs to easily suppose that large monetary awards are due. "The plaintiff can [define] damages very easily," Fox says. "You're looking at a $10 to $20 million potential upside."

But the potential for big money damages only applies when a stock is doing well. As long as a stock is high-flying, damages based on stock options are large. Should the value of a stock drop, however, the potential damages become worthless. "A number of claims fizzled when the stocks went underwater," Fox says. "Even if they could prove the case, the value of the unvested options is worthless. This prompted some settlements. The poor market has galvanized the settlement of several hot cases."

Lessons learned

IT executives need to understand how to protect their companies from an ugly employment lawsuit. In some cases, the IT manager may need to protect himself or herself. California, for example, allows for a manager to be named in a lawsuit based on his or her actions.

At hiring

Protecting your company and its executives starts on the day you hire a new employee. According to Fox, it's critical that companies use solidly crafted employment instruments at the time of hiring. These documents, from stock option agreements to employee handbooks to employment contracts, define the grounds for termination and how options are defined and handled.

"Be sure to check the stock option grant instruments; make sure it indicates the employee is 'at will,'" Fox says. When an employee is at will, it should be clear that the employer can fire the employee, with or without cause. Signed agreements, employee handbooks, and company memos should make these issues clear.

Putting together reasonable stock option packages, combined with careful hiring practices, may also reduce the litigation risk of "disappointment" suits. "Don't create fantastic packages to get employees in the door only to terminate them 8 to 10 weeks later," Lucas says.

During work

An IT executive may make personal or corporate trouble by making promises, in writing or during conversation, to staff members. "Make sure promises don't contradict contractual agreements," says Emily Durkee, an associate at the law firm of Gray Cary, in San Diego. A company needs to put in writing that contracts and employment agreements can't be changed by an offhand remark.

According to Durkee, employers who want to avoid later legal problems need to "have clear, written agreements." Additionally, employers would be well advised to train employees in understanding employment obligations and how stock option packages work. "Have a point person to contact," Durkee says, to answer employee questions about stock instruments.

At termination

Giving an employee a pink slip is often painful for all involved, but this is not the time to stop paying attention to the details. "Review carefully the reasons for termination; make sure there are sufficient grounds for termination of employee. Have an attorney bless the package," Fox says.

"Communicate at the beginning," Durkee says. "Also, at termination, have a conversation regarding the employee's status under the stock program, including, for example, the employee's number of vested shares and what the employee must do to exercise those shares following termination."

Bad stock option for a CTO

The following are sure steps on the path toward legal trouble.

Make overly broad promises

After you've completed a tough round of painful layoffs, reassure remaining employees that their jobs are safe. To boost morale, make overly broad promises about how no one else will get fired. Or casually mention to an employee how he or she will absolutely get rich from stock options, regardless of the company's fate.

Hire anybody you can

It's tough to find the right person, with the right skills, who'll fit into your company's culture. So look for someone close enough. Ignore the red flags popping up in your mind and hire a candidate who might not be able to handle the job. Don't conduct thorough background and references checks.

Don't have a lawyer look at termination paperwork

The dissolution of a company you've poured your life into is painful. About the last thing is bringing in the lawyers to make insure that all the Is are dotted and Ts are crossed on the paperwork and pink slips.

Don't put it in writing

At your startup, you're focused on one thing and one thing alone: Build a killer app and get it to market. Everything else is secondary including employment contracts and human resource practices. Who has time to write an employee manual? Not now -- perhaps after you hire some HR professionals -- but certainly not before you've filled key positions that entail lucrative and complex stock option packages..

Companies need to make sure employees understand that acceptance of any severance benefits requires a waiver of future claims. "Include a single sentence in the employee handbook that states you get severance pay only if settlement or release is signed," Fox says. "You tell this to executives and you can hear the palm slapping the forehead."

It's not easy to plan for employment disasters, but steps taken early may save considerable grief down the road. "At startups, no one can imagine they'll fail and that there will be a failing out. They don't tend to worry too much about the details. Focus is their great strength and great weakness," Fox says. "No one focuses on the unthinkable event of a falling out among friends"

With so much money at stake, there will always be those who are willing to roll the dice. But there are steps an organization can take to protect itself and its executives from future litigation. Employers who are conscientious and consistently follow the laws that cover termination will find themselves in a much better position to defend themselves against a potentially costly lawsuit.

"Ultimately, these cases boil down to whether termination was consistent with contractual, statutory, and common law rights," Fox says.

The contentious cases

Several lawsuits with stock option packages at the center of the claim have been filed against former employers. These cases illustrate important points.

* Liable

Awarded $1,614,710

Fleming vs. Parametric Technology

Damages awarded by trial court were upheld by the 9th U.S. Circuit Court of Appeals. The Court of Appeals stated, "Where an employee has earned a right to a benefit which is contingent upon his being employed at some later date, the employer cannot terminate him for the very purpose of depriving him of the benefit, even if he is expected to render services in the meantime."

The "take home" point is that employers cannot fire an employee to deny the fruit of past labor. Because of court maneuvering, this case has little precedent value.

* Liable

Awarded $2,700,000

Baratta vs. Oracle Corp.

Sandy Baratta, a former vicce president at Oracle, accused the company of terminating her because she blew the whistle on Oracle pirating trade secrets from rival SAP. Oracle claimed Baratta was let go because she browbeat underlings. In June of 2000, a jury sided with Baratta and awarded her $2.7 million, based mainly on her stock options and their potential worth at the time of her firing. Oracle is appealing the verdict.

* In court

Seeking up to $700,000

Erickson vs. Broadcom

Eric Erickson contends that Broadcom terminated him to avoid paying his stock options. This again raises the question, are stock options compensation for past services?

* In court

Seeking interpretive ruling

Oracle vs. Falotti

Can Oracle dismiss Pier Carlo Falotti, executive vice president of Oracle's European, Middle East, and African operations, while he was taking a sick day? According to Swiss law, no one can be dismissed during a sick day, which would mean Falotti is entitled to 125,000 shares of Oracle stock. Oracle filed suit in Northern California District Court contending that Falotti was actually working the day in question. Oracle is asking the court whether Swiss law or Oracle's contract governs the dispute.

* In court

Seeking unspecified damages and options

John E. Richards vs. InfoSpace

Filed in December under the Racketeer Influenced and Corrupt Organizations Act, Richards claims InfoSpace's policy was to avoid putting stock option agreements in writing to prevent making "other employees jealous" and that the company reneged on oral promises to give him more options than any other InfoSpace employee.

* In court

Seeking in excess of $500,000,000

Sprague vs. Qualcomm

When Qualcomm sold its infrastructure division to Ericsson, a group of employees cried foul and filed a class-action lawsuit. At issue is whether the division sale deprived employees of their option rights and what option rights employees have in a partial change of ownership in a company. At one point, the case went to arbitration.

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