Stock Options: How to Keep Your Stake in the Company?

Stock Options: How to Keep Your Stake in the Company?

Option programs are frequently used to motivate key employees to give their best for modest compensation, or to help investors gain control over a company. Today I'll walk you through what to do if the person who granted you an option sold their stake prematurely, leaving you unable to claim it.

The Economic Logic of Options

You already know that options come as "puts" and "calls."

A put option lets you sell your share in a company at any time, regardless of the buyer's consent. In this structure the seller essentially says, "I'll sell if I want to, and the buyer cannot refuse."

A call option lets you buy a share in a company at any time, regardless of the seller's consent. Here the buyer essentially says, "I'll buy if I want to, and the seller cannot refuse."

It is generally understood that in a put option the buyer is obligated to purchase the share if the seller decides to sell, while in a call option the seller is obligated to sell if the buyer decides to purchase.

In practice, call options are far more common, and they can be structured in various ways:

• A founder grants key employees the right to buy a stake in the company at a nominal price after X years, provided they hit certain KPIs.
• A founder receives funding from an investor and grants them an option to purchase a stake in the business. Initially the investor may not be interested in joining as a participant, but if the company grows, they can exercise the option to buy the stake at a fixed price.
• A founder agrees with an investor that the latter will provide monthly development funding. If the investor breaches their obligations, the founder gains the right to buy back the investor's stake at a nominal price.
• A founder takes a loan from an investor, but the investor doesn't want to take control of the company. Instead, the founder grants the investor an option that converts into equity if the founder defaults on the loan (essentially a convertible loan).

Put options are less common in practice, but they work something like this: an investor and a founder initially receive stakes in an operating company, and the founder undertakes to buy out the investor's stake if certain targets are not met. The business doesn't grow, the investor sells the stake back to the founder, who is obligated to buy it. So the business fails to take off, and the founder is still left with debt…

How Are Share Options Formalized Under Russian Law?

In 2015 the Russian Civil Code introduced a dedicated provision for options — Article 429.2, which states:

Under an agreement granting an option to conclude a contract (an option to conclude a contract), one party, by means of an irrevocable offer, grants the other party the right to conclude one or several contracts on the terms stipulated in the option.

An option to conclude a contract is granted for consideration or other counter-performance, unless otherwise provided by the agreement, including one concluded between commercial organizations.

The other party has the right to conclude the contract by accepting such an offer in the manner, within the time limits, and on the terms stipulated in the option.

Every contract consists of two elements: an offer (a proposal to conclude a contract) and an acceptance (agreeing to that proposal on the terms set out in the offer). If you want to sell something you no longer need, you send an offer to a prospective buyer, and while they're thinking it over, you can still withdraw it.

But with an option that doesn't work: you can make the offer, but you cannot revoke it. Feeling uncomfortable? You should.

You cannot grant an irrevocable offer (or an option) over a share orally — you must go to a notary. The notary will draft the document for you, but it's better to double-check it. An option should ideally include:

• A reference to Article 429.2 of the Russian Civil Code, so the court can easily understand what you've structured.
• The subject matter of the contract. State clearly who grants whom the right under the option.
• Whether the option is for consideration or gratuitous. Sometimes the burden of waiting is paid for, but more often options on company shares are granted free of charge.
• The option's term. Nothing lasts forever, options included. If the parties do not specify a term for accepting the option, the default rule sets it at one year.
• The terms of the underlying transaction. An option is merely a proposal to conclude a contract, so it must contain the terms of that contract. Otherwise it's unclear what the offeror is proposing and what the offeree can accept.
• Liability. Liquidated damages, losses — an option can cover it all.

How to Force "Execution of the Option" or Recover Part of Your Losses?

You receive an option and walk around happy, already planning to buy a country house with part of your future stake. Day X arrives, all the KPIs are met, you go to the notary, accept the option, the notary submits the application to the Federal Tax Service (FTS) — and the response comes back:

Sorry, we cannot register the offeree as the owner of the share in the Unified State Register of Legal Entities (EGRUL), because on the date the option was accepted the share is registered not to the seller but to his grandson.

It turns out that if you don't monitor the EGRUL, a cunning offeror can sell the share to a third party, making it impossible to exercise the option. Nothing to do but go to court — but which legal remedy should you choose?

Compelling the Conclusion of the Underlying Contract

If a bad-faith offeror moved the asset away before the option was accepted, the first thing that comes to mind is to force them to conclude the underlying contract and let them figure out where to find the share.

Moreover, such a possibility is provided for in Article 429(5) of the Civil Code, even if it operates in the context of preliminary agreements.

In reality this is a serious mistake, because a preliminary agreement differs greatly from an option.

In a preliminary agreement the parties undertake to submit, in the future, an offer and an acceptance to conclude a contract — meaning that concluding the main contract requires active steps from both parties.

In an option, however, one party makes an offer it cannot withdraw, and concluding the main contract only requires the other party's acceptance — the offeror need do nothing.

It follows that you cannot compel the offeror to conclude the main contract — the contract is already deemed concluded the moment the offer is accepted.

I'm not alone in this view. In the Ruling of the Ninth Arbitration Court of Appeal dated October 4, 2023, in Case No. A40-20263/23, the court endorsed the following position:

An option is a contract whose performance depends on one of the parties — the option holder, who receives an unconditional right to "activate" the option within the time limits, in the manner, and on the terms stipulated in the option. The option holder may either exercise this right or decline to.

The subject matter of a preliminary agreement is the obligation to conclude a main contract in the future — that is, one concluded contract must be followed by another, final one. There, both parties undertake to conclude the main contract within a certain period, and the will of both parties is required to do so.

Therefore, compelling the conclusion of the main contract does not apply to options.

Compelling the New Shareholder to Transfer the Share

Can you compel the buyer of the share, to whom it was transferred in circumvention of the option, to perform the share purchase agreement that arose from the option's acceptance?

It seems logical that from the moment the option is granted, the share is encumbered by the offeree's right to purchase it, no matter who owns it.

This is only partially true. For example, if the offeror dies, their obligations under the option pass to their heirs — this is called "universal succession." The heir effectively steps into the offeror's shoes for all obligations binding the offeror (except those closely tied to their person). The same mechanism applies to an assignment of claims or a transfer of debt under an option.

But if the offeror sells the share, the obligations connected with the option remain with them. That is, if the offeror sells the share before the option is triggered, the obligated party under the share purchase agreement is still the offeror. The option obligations do not pass to the new shareholder.

It follows that the new shareholder owes you nothing, and you cannot force them to transfer the share.

Declaring the Share-Transfer Transaction Invalid

Neither you nor I like it when an offeror first promises a share to an offeree and then sells it to a third party in circumvention of the option. Right?

As an alternative, you could try to have the share-transfer transaction declared invalid.

This requires one of the grounds set out in the Civil Code (Articles 168 to 179). At first glance none seems to apply, but Article 168(2) of the Civil Code provides:

A transaction that violates the requirements of a law or other legal act and at the same time encroaches upon public interests or the rights and legally protected interests of third parties is void, unless it follows from the law that such a transaction is voidable or that other consequences of the violation not related to invalidity should apply.

The problem is that this ground for invalidity is not self-standing — you also need a specific rule that the share-transfer transaction violates.

Article 10(1) of the Civil Code comes to the rescue:

The exercise of civil rights solely with the intent to cause harm to another person, actions circumventing the law with an unlawful purpose, and any other knowingly bad-faith exercise of civil rights (abuse of right) are not permitted.

Armed with this secret knowledge of the combination of Articles 10 and 168 of the Civil Code, you can go to court to punish the negligent partner. But difficulties arise next, because in court you must prove that the seller and the buyer of the share colluded with the aim of harming the interests of the other participant.

Sometimes you can pull this trick off, but the collusion must be obvious to the court. A corporate conflict between the offeror and the offeree, a nominee director of the company controlled by the offeror, or correspondence between the participants in the scheme can help here. The latter can be requested in court — if the opponents fail to produce the correspondence or produce it incompletely, the court will require them to prove the absence of collusion (this is known as shifting the burden of proof).

An example of a successful case challenging the transfer of a share to a third party can be found in the Ruling of the Seventeenth Arbitration Court of Appeal dated October 19, 2023, in Case No. A60-53969/2022, where the court did find grounds to apply Articles 10 and 168 of the Civil Code:

Acting in concert, Arkhipova A.M. and Denisenko I.Yu., by concluding a purchase agreement for a share in the authorized capital of OOO Ekoarkhitektura in circumvention of the existing Agreement dated February 13, 2020, on granting an option to conclude a purchase agreement for a share in the authorized capital of OOO Ekoarkhitektura, and without notifying Pakalin G.E., caused damage to the property rights and interests of OOO Vebmaster, since they effectively reduced the value of OOO Vebmaster's asset — a 100% share in the authorized capital of OOO EVA.

But where there are no obvious signs of collusion, courts refuse to declare a transaction circumventing an option invalid. For example, in the Ruling of the Ninth Arbitration Court of Appeal dated January 26, 2022, in Case No. A40-110686/2021, the court endorsed the following argument:

In issuing the challenged judicial act, the court noted that the relationship between the plaintiff and Khabarov V.V. is of an obligational nature; consequently, the plaintiff has only an obligational claim against Khabarov V.V., based on the [Option] Agreement.

Declaring a transaction circumventing an option invalid is therefore quite difficult and, as a general rule, it is better to look for other options (including obligational claims).

Recognition of the Right to a Share in the Authorized Capital

An interesting way to protect rights arising from an option was proposed by the Moscow Arbitration Court in its Decision dated June 2, 2023, in Case No. A40-149995/2022. The facts of the case are straightforward: the company had a single participant, Kovylin V.A., who granted Kupchina I.S. an option to purchase a 100% share. Later, Kupchina I.S. accepted the option, but the share did not pass to her, because two months earlier Kovylin V.A. had sold it to OOO Invest-Proekt. The registering authority, however, refused to add OOO Invest-Proekt to the company's participants.

Everyone fell out, and both Kupchina I.S. and OOO Invest-Proekt asked the court to recognize their right to the share. Since they were both claiming the very same asset, the hearing resembled a "battle royale" — there could be only one winner.

Reviewing the case, the court relied on Article 398 of the Civil Code, under which:

In the event of non-performance of an obligation to transfer an individually determined thing into ownership, economic management, operational management, or compensated use to the creditor, the latter has the right to demand that the thing be taken from the debtor and transferred to the creditor on the terms provided by the obligation.

This right lapses if the thing has already been transferred to a third party holding the right of ownership, economic management, or operational management.

Because the transfer of the share under the purchase agreement circumventing the option had not been registered with the FTS, the court was able to recognize the offeree's right to the share. The court's logic is interesting: the right of first acceptance was recognized in favor of the person to whom the offer had been granted (the offeree under the option), even though it was accepted later than the purchase agreement was concluded.

However, this ruling will not work if the share has already passed to the buyer, because a right to a share cannot be set up against a claim to have it transferred, even if the latter arose earlier.

Recovering Damages and Liquidated Penalties, and Compensating Losses

Let's move on to the realistic options — the very obligational claims that courts persistently recommend bringing in such cases.

There are three main approaches:

• Recovering a liquidated penalty (Article 330 of the Civil Code).
• Recovering damages (Article 15 of the Civil Code).
• Compensating losses (Article 406.1 of the Civil Code).

Recovering a Liquidated Penalty

Penalties are fairly simple: since the option states the terms of the main contract, just include something like "in the event the seller fails to perform the obligation to transfer the share, the seller undertakes to pay a penalty of X rubles."

But penalties have their problems: you cannot rule out the risk that the court will reduce the penalty under Article 333 of the Civil Code, and, unlike a share in a company, a claim for a penalty is not as reliable — it's unclear whether the offeror will pay it or simply file for bankruptcy.

Recovering Damages

Paragraphs 1 and 2 of Article 15 of the Civil Code provide:

1. A person whose right has been violated may demand full compensation for the losses caused to them, unless the law or the contract provides for compensation of a lesser amount.

2. Losses are understood to mean the expenses that the person whose right has been violated has incurred or will have to incur to restore the violated right, the loss of or damage to their property (actual damage), as well as the income not received that this person would have received under ordinary conditions of civil commerce had their right not been violated (lost profit).

Clearly, the offeror knows about the option they granted, and by concluding a purchase agreement in circumvention of it, they thereby violate the offeree's rights.

Accordingly, the only contentious issue in proving damages is the method of calculating them.

I haven't found cases where courts awarded damages for circumventing an option, but potentially the amount could be calculated using one of the following models:

• Damages equal to the actual value of the company share the offeree was unable to obtain.
• Damages equal to the market value of the company share the offeree was unable to obtain.

The actual value of a share differs from its market value in that the former is determined from the company's net asset value (a balance-sheet line in the financial statements), while in determining the latter you can also account for other factors (for example, the company's expected profit).

Damages carry the same risk as a penalty: the offeror may simply have no money to pay. They can sell the share in circumvention of the option at a nominal price, thereby concealing their gain. For instance, the offeror may retain actual control over the company because they can give instructions to the buyer.

But here bankruptcy options open up: we pin the damages on the offeror, start bankruptcy proceedings against them, and go on to challenge the transaction circumventing the option on the grounds provided by the Bankruptcy Law. That will definitely be easier than challenging the transaction under Articles 10 and 168 of the Civil Code — but that's a story for another time.

Compensating Losses

Article 406.1 of the Civil Code provides:

Parties to an obligation, acting in the course of their entrepreneurial activities, may by their agreement provide for an obligation of one party to compensate the property losses of the other party arising upon the occurrence of circumstances defined in such agreement and not connected with a breach of the obligation by its party (losses caused by the impossibility of performing the obligation, by claims brought by third parties or state authorities against a party or against a third party named in the agreement, and the like).

The parties' agreement must specify the amount of compensation for such losses or the procedure for determining it.

For this provision to work, the option should include a "Representations as to Circumstances" section.

That section should contain a provision along these lines:

The seller represents that, as of the date the option is granted and as of the date it is accepted by the offeree, the seller is the owner of a share in the Company equal to or exceeding X (the size of the share to be transferred under the option).

In the event the above representation is inaccurate, the seller undertakes to compensate the buyer's losses in the amount of X (the desired sum) on the basis of Article 406.1 of the Civil Code.

If, by the date the option is accepted, the offeror has already transferred the share to a third party, an obligation arises for them to compensate the offeree for the losses incurred.