a stock certificate with hazard tape covering it showing some common restrictions placed on restricted stock certificates.

Beware of Restricted Stock Certificates

If you own stock in your company, have you read the back of your stock certificate?  If the certificate restricts how you can sell or transfer your shares, you need to be aware of what these restrictions mean.  You want to know whether your shares are worthwhile or worthless.

At Gardner employment law, we have advised hourly workers to C-Suite executives to understand their shareholders’ rights. We can help you make an informed decision when you receive a restricted stock certificate.

What is a Restricted Stock Certificate?

A restricted stock certificate is any stock which carries restrictions on your ownership rights.  The certificate is evidence that you own shares of stock.  Any restrictions on your ownership rights must be in writing, usually on the back of the stock certificate.  The restrictions could include a date in the future when the restrictions will be lifted and you will have unencumbered rights of ownership, whether the shares can be sold or transferred, how the shares can be sold, whether you must first offer the shares back to your company to repurchase, and other restrictions which limit your rights in the stock. Restrictions on the certificate are called a “legend” which provides notice of the restrictions on your stock.

Employees frequently obtain restricted stock certificates through a stock option program or other stock compensation program from the employer.  We discussed some of the restrictions on stock options in our blog entitled “Are There Hidden Restrictions in Your Stock Options?”.  Stock options and stock certificates are not the same thing.  Stock options give the employee the opportunity or the choice to buy stock  in a corporation based on the terms stated in the option.  A stock certificate is the piece of paper that evidences the ownership of an intangible interest in a corporation.  Yet, your ownership rights in shares of stock can be so severely restricted that you own essentially nothing.

I handled a case a few years ago involving worthless stock certificates.  A client came to me after leaving the company where he had worked and asked how he could sell the shares of stock that he owned in the company.  The client had been recruited and hired as the CEO of the company, which was a startup.  The product that the company marketed and sold did sound rather amazing.  In the beginning, the client believed that his employer would become wildly successful.  So, he believed that he would eventually recover hundreds of thousands of dollars based on the value of his stock.  When I reviewed the back of the his stock certificate, it referred to a particular agreement by name.  The client brought me a copy of that agreement.  Then, deep within its many pages, that agreement referenced four other agreements, contracts that applied to his stock.  All of these agreements were very difficult reading.  When I analyzed the complicated wording of all these documents, the contracts required the client to offer the stock to the company over and over that literally would have put him in an endless loop.  Bottom line: his stock was worthless because he could never sell it and the company would never buy it.

What Does Vesting Mean regarding Stock Certificates?

Vesting occurs when an employee fulfills one or more conditions set by the company, usually a waiting period before the employee becomes the unencumbered owner of the stock.  Most commonly, companies require an employee to remain employed for a specific period of time before lifting the restrictions on any transfer of the stock.  That period of time is called the “vesting period.” After the employee works for the required amount of time, then the stock “vests” or, in other words, actually becomes the employee’s property free and clear. Vesting periods can be incremental over a period of time (graded vesting) or all at once (cliff vesting).  Often companies divide the stock award into subparts called “tranches,” with a percentage of the stock vesting after the various fractions of the total time period.

For example, say you have been granted 100 shares of stock in Company A who is your employer.   In scenario #1, twenty percent of the 100 shares will vest at the end of each over a period of five years (graded vesting).   The stock grant (or gift) is evidenced by a restricted stock certificate showing that you have 100 shares of Company A, but you must remain employed by the company for five years before all 100 shares vest and become yours.  If you remain with the company 3 years, you have a vested right in 60 shares, but the remaining 40 shares are “unvested.”  You cannot transfer or sell the unvested shares, and they are worthless to you.   In scenario #2, Company A might require that you remain employed for the entire five years before all 100 shares vest (cliff vesting).  In that instance, if you leave the company at any time during those 5 years, the 100 shares are unvested and you lose your rights to sell or transfer the stock.  The 100 shares will not become yours free and clear until after the fifth year.  During those 5 years while you are hard at work with your unvested stock, anything could happen.  You, not your employer, are taking the risk that the stock grant will pay off, while you slave away contributing to the company’s profitability.  This is the proverbial “chrome carrot” that companies use to retain hard-working employees to enhance the company’s bottom line.

Situations like this are common. Companies typically require a vesting period to ensure that the employee remains with the company long-term, rather than leaving with the stock certificates in hand once they are hired. While you may be restricted from selling or transferring  your stock during the vesting period, you may have other rights, such as the right to vote (depending on what type of stock you have and how your company is structured).  Also, you may receive dividends that the company elects to pay on those stocks.

Understanding vesting periods is only one piece of the puzzle.  Some restrictions on your shares of stock may apply even after your stock vests.  A company can place a myriad of restrictions on its stock. One of the most common restrictions is the “right of first refusal.”   This means the stockholder must offer his or her shares to the company or other shareholders before offering it to outsiders.   The right of first refusal protects the company and its shareholders by preventing the company’s shares from being sold too soon or to unwanted strangers, which might harm the company.  Small companies benefit from this restriction.

It is important to consult with an experienced attorney to understand the restrictions that are found in your legend statement and how they can impact your ownership rights in the stock.  You don’t want to learn the hard way, as my CEO client did.  Find out the value and any restrictions on the stock that you are offered before readily accepting the offer.

What is a Restricted Stock Unit?

An RSU (Restricted Stock Unit) is similar to a restricted stock certificate, but has a few notable differences. As Forbes states, RSU’s are essentially bookkeeping entries since no actual stock is granted until vesting.  A grant of RSU’s does not convey any stock, unlike a restricted stock certificate. Since RSU’s do not grant any stock until vesting, they are treated differently when dealing with voting rights and dividends. When you receive a restricted stock certificate, you are granted ownership of shares that restrict your rights, as explained above. When you receive RSU’s, the company is making a promise to grant shares of stock in the future.  It is similar to giving you an IOU which will grant you stock after the vesting period ends. RSU’s and restricted stock certificates may have similar restrictions,  but the differences in how and why the company makes the grants and the rights associated with RSU’s and stock certificates carry important distinctions.

What is a Restricted Security?

A security is any financial asset that can be traded to raise capital.  If the security is “restricted,” there is some limitation on your rights, one of more conditions that you must fulfill.   Shares of stocks in a corporation are just one type of security.  There are many other types of securities – debts, derivatives, etc.  A stock is a security, but every security is not a stock.  Thus, a “restricted security” is any financial asset that carries one or more limitations on the holder’s rights with regard to that security.

All forms of securities that are publicly traded are subject to regulation by the SEC (Securities and Exchange Commission).  Some securities may be financial instruments to raise capital for a closely held corporation, a private company that is not traded on the stock exchange.  Still, transactions that occur within private companies which are used to entice persons or entities to invest in that private company are subject to regulation under other various securities laws, both state and federal.  Texas has statutes regulating all types of securities, both public and private entities.

Similar to the explanation above about restrictions on shares of stock, restricted securities may be subject to holding periods which prevent the holder of the security to be traded unless certain conditions have been met.  A restricted security must bear a legend giving notice of the restrictions.  That legend which must be removed after the restrictions are lifted.  A security with a legend cannot be transferred or sold and must be removed before any transaction.

There is extensive documentation associated with any restricted security that is beyond the scope of this article.  Suffice it to say, you must consult an experienced securities attorney before attempting to sell restricted securities or else you run the risk of possible regulatory violations.  This could mean losing your stocks, steep fines, and sometimes even jail time.

When to Consult an Attorney

The moment you receive any stock which you did not purchase on the public market, you should consult an attorney to understand what exactly you have received. If you are negotiating a new position and part of the company’s offer is restricted stock, get a legal opinion before you make a decision. While these restrictions may appear in the legend on the back of the stock certificate or explained by the company trying to hire you, the legend can reference other documents which are binding on the holder of the security, just like the case of my CEO client.

Gardner Employment Law handles issues within this field of law. We have helped countless clients navigate the ins and outs of their restricted stock certificates, and we can do the same for you.

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