Performance securities are sometimes issued to directors, senior executives, employees or contractors, either as part of their remuneration package or under an employee incentive scheme, as a means of incentivising them to achieve a particular performance milestone.
One under-appreciated aspect to them (and indeed, other forms of equity incentives) is that without careful drafting they might extend beyond the employment period. And without an express provision, it may be difficult to convince a court that the implied construction of the terms of an equity incentive with a performance hurdle or milestone that are held by a director or senior manager (or their associated entity) require them to hold their particular office or employment at the time when the performance hurdle or milestone is met.
Such was the position in the recent case of Recce Pharmaceuticals Ltd v Ian David Brown [2022] WASCA 66. Although the case turns on its facts, disputes over these arrangements rarely get to court, and so it is instructive.
Performance shares and ASX Guidance
ASX Listing Rules Guidance Note 19 (GN19) refers to performance securities as securities that convert, or may convert, into a given number of ordinary shares with all the usual rights attached if and when a nominated performance milestone is achieved but otherwise have limited rights until then. The number of ordinary shares into which the performance security converts may be a fixed number or may be determined by reference to a particular formula.
For the number of performance securities into which the performance security will convert if the relevant milestone is achieved to be, in the opinion of ASX, appropriate and equitable for the purposes of ASX Listing Rule 6.1, that number must be:
- fixed or calculated by reference to a formula that delivers a fixed outcome so that investors and analysts can readily understand, and have reasonable certainty as to, the impact on the entity's capital structure if the milestone is achieved; and
- reasonably proportionate to the additional value the entity will derive if the milestone is achieved, compared to if the milestone is not achieved.
For a performance milestone attached to a performance security to be, in the opinion of ASX, appropriate and equitable for the purposes of ASX Listing Rule 6.1:
- there must be an appropriate and demonstratable nexus between the performance milestone and the transaction or purpose for which the performance security is being issued;
- the performance milestone must be clearly articulated by reference to objective criteria so that investors and analysts can readily understand, and have reasonable certainty as to, the circumstances in which the performance milestone will be taken to have been met; and
- the performance security must have an expiry date by which the relevant milestone is to be achieved and, if the milestone is not achieved by that date, either the performance security must be cancelled or bought back for no or nominal consideration only or else the total number of performance securities on issue must convert into a nominal number of ordinary shares.
ASX recommends that a security price hurdle attached to a performance security should be based on the volume average market price over a reasonable period of time (for example, over 20 consecutive trading days on which the entity's securities have actually traded) rather than the market price at a particular date or for a shorter period.
The milestone is met, but the directors and senior management are gone
In Recce Pharmaceuticals Ltd v Ian David Brown [2022] WASCA 66, the company had issued various classes of performance shares to certain directors and key management personnel. The performance shares were convertible into ordinary shares upon the achievement of performance milestones that the company's share price was not less than a specified price with a specified time after the date of issue of the performance shares.
The company asserted that the performance shares which achieved the performance milestone were not eligible for conversion because it was a requirement that the relevant director or key management personnel continue to be employed by the company at the time the milestone was achieved. The terms of the performance shares did not expressly require this.
The company unsuccessfully sought to argue before the Court of Appeal (WA) that:
- properly construed, the performance shares required “performance” by the holders up to or around the point in time when the performance milestone was reached; or
- alternatively, that the terms governing the performance shares contained an implied term to that effect.
What the court found
In accordance with usual contractual principles, the court determined that the proper approach to construing the terms and conditions attaching to the performance shares was what is the objective meaning to be attributed to the words the parties or party used to express what was agreed or provided for.
Applying that test, the court held that:
- the performance milestones (being the performance of the company's share price) referred to the performance of the company rather than of the directors or key management personnel;
- as matters unrelated to an entity's performance (such as macroeconomic factors and market sentiment) may affect share price (as recognised by GN19), the word “performance” in the phrase “performance shares” did not convey a requirement that there be a nexus between the incentive and milestone in terms of the carrying out of tasks by the directors or key management personnel;
- there was no identifiable textual basis for the imposition of the company's suggested condition in the terms and conditions of the performance shares; and
- there were conceptual difficulties with the company's suggested implied construction, including uncertainty as to whether a person had ceased to qualify as a key management person where the person's role changed before the achievement of the performance milestone, and because some of the holders were associated entities to the relevant director or key management personnel.
It was not to the point that it might be thought that the company's suggested implied construction better achieved giving effect to the purpose of the performance shares discerned by the court. To have preferred the company's suggested implied construction would have been to disregard the clear words of the terms and conditions of the performance shares and have amounted to a judicial re-writing of those terms and conditions.
Court findings
Applying usual contractual principles, the court held that the suggested implied term was:
- not reasonable and equitable – the suggested implied term would likely expose the parties to the potential of litigation to test the satisfaction of the condition; and
- not necessary to give business efficacy to the instrument – the terms and conditions were workable in a business sense without the addition of the suggested implied term. The express terms, properly construed, were not inconsistent with and gave effect to the purpose of the performance shares as revealed by the instrument and the surrounding circumstances.