STOCK APPRECIATION RIGHTS: A CORPORATE TOOL FOR MARKET MANIPULATION AND VALUE DISTORTION

The authors are Anushree Srivastava and Shravasti Yadav, 4th year students at Gujarat National Law University.

India's startup ecosystem has witnessed a surge in financial engineering strategies to optimize capital raising while navigating regulatory constraints. These listed and unlisted companies are continuously innovating in this ever-changing private fundraising landscape, finding ways to circumvent the security law ambit along with raising capital for their business. As traditional equity crowdfunding remains limited under Section 42(7) of the Companies Act 2013, Employee Stock Options (“ESOPs”) are fast emerging as a preferred way of raising funds. ESOP, defined under Section 2(37), is a compensation strategy that grants employees the right to purchase a specified number of shares in the company at a predetermined price. Stock appreciation rights (“SARs”), an addition to the ESOPs, seem to be an incentive mechanism for the employees. SAR as defined under Regulation 2(1)(qq) of the SEBI (Share Based Employee Benefits and Sweat Equity) Regulations, 2021, (“SBEB Regulations”) which grants employees the right to receive the increase in the value of a specified number of shares over a predetermined period, allowing them to benefit from stock price appreciation without having to purchase the shares unlike ESOPs where employees must pay an exercise price to acquire shares. These can be issued to directors or independent contractors.[1] However, recent trends indicate that private companies are repurposing SARs as a vehicle for capital raising, smartly side-stepping regulatory roadblocks that prohibit direct share issuance to retail investors.

Comparing SAR frameworks globally—such as Phantom Stock Plans under SEC rules in the US—sheds light on how Indian firms leverage SARs to access liquidity while avoiding direct equity dilution. The matters of Planify Capital Limited, Mayasheel Retail India Limited and Septanove Technologies Private Limited, indicate that companies cannot use web-based crowdfunding platforms to directly raise equity capital. Thus, instead of issuing shares, companies offer SARs, which provide similar financial upside without violating share transfer restrictions under Section 42. This circumvention is because the SBEB Regulations under regulation 23 defines SAR as equity-based compensation and could be settled through cash or stock. However, the SEBI has distinguished under Explanation 2 to Regulation 2(qq) that the two, with the latter not being regulated by the SBEB Regulations. Further, in an informal guidance note by the SEBI for Saregama India Limited it declared that SARs do not involve dealing in, subscribing to, or purchasing securities of the company directly or indirectly. Thus, companies were able to legally distribute SARs to investors without triggering the limits under Section 42.

This option is considered viable for the company as the SAR holders do not become shareholders, and by virtue of the settlement of SARs in cash, dilution of the shareholder’s stake in the company can be reduced or eliminated. However, apart from this circumvention, there exist other concerns with regard to the issuance of SARs, leading to price manipulation and value distortion.

The shared challenges of P-notes and SARs

Participatory notes (“P-notes”) are financial instruments required by investors or hedge funds to invest in Indian securities without having to register with the Securities and Exchange Board of India (“SEBI”). The main criticism of P-notes is associated with the lack of regulatory scrutiny, making it easier to engage in illicit activities, such as “pump and dump”. In response to these concerns, the SEBI implemented stricter regulations, including requirements for issuers to disclose details about underlying securities and the nationality of ultimate beneficial owners. Further, SEBI restricted their usage to direct FPI investment. P-notes and SARs appear to be two different financial instruments, however, they share a fundamental regulatory concern: bypassing traditional securities laws while enabling financial participation in equity-linked returns. SAR, operating in a regulatory vacuum without mandatory disclosure requirements or oversight frameworks, have emerged as potential instruments for market manipulation - drawing parallels to P-notes, which were historically flagged for similar concerns. Given their significant impact on market dynamics and share valuations, there is a pressing need to establish comprehensive regulatory compliance requirements for SARs to ensure market integrity and protect investor interests.

The erosion of fiduciary responsibilities by SARs.

Unlike ESOPs, SARs can be issued to partners, promoters, etc. who have substantial control over the company affairs. This would lead to a perilous incentive structure for such SAR grantees to prioritize short-term stock price appreciation over substantial long-term gains. Since the SARs become more profitable with the increase in stock price, it can lead these executive personnel to engage in practices aimed at quick capital gains rather than focusing on fundamental value creation. This aim of stock price appreciation would then be pursued by these executives through aggressive financial reporting, strategic timing of corporate announcements, etc. The resulting focus on immediate gains can lead to volatile stock performance and destructive stock performance.

The lack of regulatory oversight in SAR issuance can lead to various governance issues, including reduced transparency in corporate operation and potential compliance risks. SARs are typically classified as liability instruments linked to equity. Firstly, the valuation of these SARs is determined internally by the issuing companies, which raises significant concerns about transparency. Further, the Indian Accounting Standards, provide management of a company to exercise discretion in how they estimate and adjust these liabilities, potentially affecting financial statements and investor perceptions. These improper accounting practices would further violate Section 166 of the Companies Act, 2013,, which requires the directors of a company to act in good faith. Furthermore, companies can backdate SARs by selecting historically low stock values to maximize payouts, and there is no mechanism to validate when such SARs were issued in the absence of the regulatory filing system since they do not fall into “securities” unless it is settled in shares.

Further, the pre-IPO period presents a particularly vulnerable window for the manipulation of SAR, where companies can artificially inflate stock prices. When these SARs are exercised at the appreciated prices, the unlisted company retains the shares and then uses these SARs prices to build an artificially profitable portfolio of the company shares. Subsequently, the company launches its IPO at these elevated prices, which were a result of employees pursuing short-term capital gains for personal profit and questionable accounting practices. Thus, such practices undermine market integrity and pose significant risks to potential investors.

Conclusion

While SARs were originally intended as an employee incentive tool, their repurposing for quasi-equity fundraising raises critical concerns about regulatory arbitrage, market transparency, and investor protection. If left unchecked, such practices could blur the lines between compensation structures and securities instruments, challenging existing legal frameworks under the Companies Act, SEBI Regulations, and Income Tax Act. Regulators must address these gaps by clarifying the treatment of SARs in private markets, ensuring investor safeguards, and preventing their misuse as an alternative to traditional securities issuance.

[1] Soundarrajan Parthasarathy v. Deputy Commissioner of Income Tax, [2016] 70 Taxmann 27.