Started working at a start-up and were promised shares? They aren’t really yours

The Haifa Economic Court determined in a precedential ruling that employees who receive shares from a company in a track that enables them to postpone receiving a tax benefit until exercising them – do not have rights as shareholders, as long as the shares are in the hands of the company’s trustee ■ The trustee’s commitments are first and foremost to ensure that tax is paid

09.02.20 | Efrat Neuman

The Haifa District Court’s Economic Department recently ruled on an interesting question that is relevant to many employees.  What happens during the period in which shares that the employee received are held by a trustee?  In order for the employee to be able to postpone payment of reduced taxes for them, because it is a taxable benefit, they are held by a trustee for a black-out period.  Only when the employee chooses to transfer the shares to himself – generally in a private company, in cases of the sale or IPO of the company – does he pay tax.

This situation raises several questions:  To whom do the shares belong during the period that the shares are held by the trustee?  Does the employee have any standing in the company while the shares are held for him?  And does this standing offer him rights as a shareholder in the company?  According to Judge Ron Sokol, as long as the employee has not exercised the shares, sold them or transferred them to his possession, and has not paid taxes for them – they do not belong to him officially in a manner that offer him rights as a shareholder.

The Employee asked for Information

In many start-ups, the employees participate in risk and reward and receive rights as options and company shares.  Consequently, they are incentivized to invest in their work at the company and become partners in its success, if such is forthcoming.

The allocation of the options or the shares constitute a benefit for the employee; and therefore, it is also taxable.  In order to allow for deferment of the payment of taxes, paragraph 102 of the Income Tax Order established a special arrangement regarding shares.  On the one hand, the employee is allowed a reduced tax rate – as capital gains and not according to the marginal tax – when exercising the shares, when he ‘encounters’ the shares or the money (transferring the shares from the trustee to the employee or at the time of the sale of the shares, the earlier of the two).  On the other hand, the company is not allowed to deduct the expense involved in the allocation for the purpose of reducing the company’s tax liability.

Sokol’s ruling referred to the case of an employee at Sol Chip, established in 2010, that is engaged in the development of solar energy-based chips.  The plaintiff, Ofer Navon, began working at the company since its inception, together with its two founders, in the position of development manager, and without being offered shares at that time.  Over the years of his employment, he was allocated options to purchase shares that were later converted into shares.

If the company adopts a compensation plan, by virtue of which it is possible to allocate 102 options in a capital gains track, it must be approved by the tax authority and a trustee must be appointed who will hold the options and shares after they are exercised.  The terms for the benefit in this track is that the shares are held by the trustee for at least 24 months.

In 2011, Navon exercised the share options and paid the price set for exercising the options.  From that date, the trustee has held his shares and they are also registered in the shareholders registry in the name of the trustee.

Navon did not stay at the company for long; and at the end of 2012, he left his job.  In 2015, he filed a monetary suit against the company at the Regional Labor Court of Haifa, in which he declared that he had accrued a debt and that he was entitled to convert the debt sum into shares.  A few months ago, the parties filed summaries in the case.

However, this was not the only suit filed in the matter of his employment at the company.  In March of 2018, he filed a suit with the Haifa District Court against the company in which he asked to declare that he was a shareholder; and consequently, he was eligible for all the rights granted to shareholders, including the right to participate in and vote at shareholder meetings and the right to receive information and the option of reviewing the minutes of the company’s general  meetings, the articles of association and financial reports.  Additionally, he noted that he was asking to exercise his right to transfer the rights from the trustee to himself; and for this purpose, he required all information regarding the company, because the transfer of the shares from the trustee to himself involved payment of tax derived from the Company’s valuation.

On the other hand, the company claimed that since the shares are held by the trustee and registered in his name, all the rights stemming from the possession of the shares, including the right to receive information are granted solely to the trustee.  He emphasized that according to the allocation agreement, the voting rights of the employees who receive shares, are granted only to the board of directors’ representative until the shares are issued to the public.  This is in order to ensure that the rights of the investors in the company who agreed to allocate the shares only on condition that the voting rights be reserved for the board of directors.

The right to information is at the mercy of the trustee

Last December, Judge Sokol noted in his ruling that in the income tax order and regulations, there is no explicit reference to the essence of the rights granted to the trustee who holds the shares in accordance with the allocation plan, and there is no reference to the employee’s rights as related to the shares during the black-out period.

According to Sokol, when the obligations of the trustee are examined, it appears that they are there, first and foremost, to ensure payment of the tax; and consequently, the duty of the trusteeship is primarily toward the tax authorities.  Additionally, he has a fiduciary duty to the company – he must ensure that the exercising of the rights to shares will not be detrimental to the company; and to the employee – he must hold the shares for him, in order that when the time comes, he will be able to exercise his rights and receive the shares, subject to the payment of tax.  “With a more general outlook, it is possible to say that the trustee’s duties are to ensure the exercising of the allocation plan and all of its components,” states the ruling.

According to Sokol, the position taken by the plaintiff in essence states that the allocation plan according to paragraph 102 of the order only negates the right to trade the shares – and to transfer them to his name or to sell them to a third party – and he is reserved the remainder of the rights granted to the shareholders.   According to Sokol, “This approach should not be accepted.  As long as the employee has not exercised his rights, either by transferring the shares to his name or by selling them to a third party, while paying tax, the employee has no rights to the shares.  He is only eligible to the rights with regard to the trustee, including the right to request of the trustee to fulfill his trusteeship duties.  This is what is stated in the regulations and the trusteeship agreement.”

He summarized the ruling saying that the plaintiff does not hold the company shares and does not have the right to receive information and to participate in shareholders’ meetings.  “If the Plaintiff is interested in transferring the shares to his name, he must carry all the required tax liabilities.  If for the sake of valuation, the plaintiff requires information of any kind, he must contact the trustee who is holding the shares, in order for him to begin the proper proceeding to receive the information.”  

The Plaintiff was represented by Adv. Gitai Barlel and the company was represented by Adv. Eliyahu Meir.  Adv. Achai Gomeh, partner at the Hamburger, Evron & Co. law firm (who was not involved in the case) said that, in its ruling, the court relied upon the explicit language of the Companies Law, in the matter of the status of the trustee as shareholder.  Moreover, he indicated the purpose of the special tax arrangement that paragraph 102 is designated to uphold, which will be thwarted if the Court grants every employee all the share-related rights, before he has paid the tax.  He stated that ‘it appears that the Court was concerned that the arrangement in paragraph 102 would become a sanctuary from paying taxes.”

He added that the Court decided not to rule on the question of the validity of the power of attorney signed by the employee – that authorized the chairman of the board of directors to participate in the company’s meetings and to vote in the name of the allocated shareholder – as long as the employee paid the taxes and received the shares.

Although the court ruling was granted in the case of a private company, it is also relevant to an employee who receives shares from a public company without exercising them (transferring them to his ownership or selling them) – either because they are in a black-out period that was set in paragraph 102 or if he is still not interesting in selling them due to economic considerations.  However, in public companies, employees who have exercised their options for shares are entitled to participate in general meetings and vote in them; with the cooperation of the trustee who is holding their shares.  One may wonder whether it is right for there to be one law for public companies and another for private companies.

Adv. Ziv Preis, partner at Lipa Meir & Co. related to the court ruling and noted that “the court set the trustee’s duties toward the tax authorities as his first duty; and in so doing, tipped the full balance in favor of the company, while limiting the employee’s rights to purely economic rights.  This is not necessarily a proper balance.  Currently, the right to information regarding the company is subject to the mercies of the trustee, who if he agrees will ask the company for the information and share it with the employee, subject to confidentiality requirements.  It is doubtful that the trustee will wish to get involved in this matter.  Theoretically, the employees can ask for rights to basic information as part of the granting of options or shares, but it’s doubtful it will be received, in light of the limited power of the employees vis-à-vis the company when receiving options or shares.”