Richard Garriott Sues NCSoft for $24 Million

    According to Kotaku Richard Garriott filed suit against NCSoft yesterday in the Western District of Texas (U.S. District Court) as a result of his stock option agreement with the company. This presents an interesting opportunity to introduce the concept of stock options in employment contracts. It also presents an ideal case study of why paying attention to your boilerplate (the "miscellaneous" provisions of a contract, like jurisdiction, choice of law and force majeure) is extremely important.

    Stock Options

    A stock option is a contract between an employer and an employee that grants the employee the right, but not the obligation, to purchase a designated number of shares (usually a set number of common shares) of a company at a designated price. This is typically the market price at the time the agreement is made. Simply put, a stock option agreement "freezes" the stock price for employees and allows employees to purchase shares at that same rate when the company's stock increases. The employee can purchase those stocks or any percentage thereof at that price and at any time during the exercise period, provided the stock option in those shares (the right to purchase) has vested. The stock option can vest all at once (for instance, five years after employment begins) or over a period of time (e.g., 25% after the first year, 50% after the second and so on).

    Stock options can be incentive based (ISO) or non-qualified (NSO). The ISO offers more favorable tax treatment—there is no income tax on the stocks; if the stocks are held after the exercise for a period of one year or more any profit made from a future sale is treated as a long term capital gain. The only tax that the employee may have to pay on the stocks is an Alternative Minimum Tax. In an NSO the difference in price between the market value at the time of exercise and the stock option price are treated as taxable income. In most cases you want your stock options to be treated as ISO—otherwise you're liable for a potentially exorbitant income tax every time you exercise your option.     

Note: There are a variety of compensation packages involving stocks and stock options that you may believe are stock option agreements but do not require to pay for the stock in order to exercise your rights under the agreement. This isn't the case, and for tax purposes it's good to know what kind of compensation you're getting. If you would like to know what you actually have, look through the list here.

    Garriott's Stock Option Agreement

    Garriott was entitled to receive 120,000 shares of NCSoft common stock at 126,200 Korean won (approximately $99 U.S.). Under the terms of the Agreement the stock options could be cancelled under a few different circumstances:

     1) termination of employment during the vesting period (which ended in 2003);

    2) voluntary departure after the vesting period if the options aren't exercised with 90 days after departure;

     3) gross negligence caused by Garriott that damages the company, 4) breach of the stock option agreement by Garriott; or

     5) the company's bankruptcy or dissolution.

    Garriott's stock option agreement satisfied all of the requirements to be treated as an ISO. He was an employee at NCSoft, the exercise period was within 10 years after the grant date, and the exercise price was the market price at the time the agreement was made. However, there are other requirements for ISO tax treatment— the employee must retain the stock for one year after exercising or two years after the grant date, and the options must be exercised during employment or within three months after employment terminates.

    Garriott's Complaint

    Garriott's complaint raises four causes of action: Breach of Contract, Fraud, and alternative cause of action for Fraud (that the firing itself was fraudulent) and Negligent Misrepresentation. There are a few problems with Garriott's complaint. I'll start with the substantive issues first.

        Substantive Problems

    The facts asserted in the complaint allege that Garriott was fired by NCSoft and his termination was involuntary. He also claims that NCSoft produced "false documentation" to support the claim that the termination was voluntary. The complaint alleges that NCSoft wrote the Open Letter from General British that appears on the Tabula Rasa website. It also concedes that at the time Garriott found nothing wrong with the letter. This is a bit a departure from the rest of the complaint, because the open letter certainly makes it sound like he made the choice to leave:

    "Many of you probably wonder what my plans are, now that I have achieved the lifelong dream of going to space. Well, that unforgettable experience has sparked some new interests that I would like to devote my time and resources to. As such, I am leaving NCsoft to pursue those interests."

    The language of the open letter places the impetus of the departure on Garriott. The fact that the complaint openly admits that he had no problem with it may hurt his case. Perhaps acting like it was voluntary and letting people believe it was voluntary, in his mind, didn't actually make it voluntary. However, it certainly won't help him if the case reaches discovery.

    Garriott's complaint alleges that because his termination was treated as "voluntary" by the company he was forced to exercise his stock option at a time when the market price was suffering due to the economic downturn. He contends that as a result of his termination he lost the benefit of the bargain of his agreement, and that if his termination had been treated as "involuntary" he would have retained his stock options until 2011. He also alleges that the forced exercise of the stock options, "worth tens of millions of dollars" (pro tip: you don't need to capitalize and bold the same statement multiple times in your complaint. Ever), caused him to lose millions of dollars in value (see?) and forced him to sell tens of millions of dollars of NCSoft shares in the current economic climate. 

    The complaint also raises an interesting tax problem—it alleges that apart from the direct financial loss sustained as a result of the involuntary termination, Garriott was forced to suffer hundreds of thousands of dollars in costs (see how annoying it gets?) How is not addressed and the claim itself is a bit misleading. The taxable income for an NSO is the difference between the stock option price and the market price. If the market price was trading at less than the stock option price, there is presumably no income tax liability. If the options were treated as an ISO, the options wouldn't be subject to an income tax at all. Furthermore, under the US Tax Code Garriott would have been forced to exercise those options within three months after termination whether the dismissal was voluntary or involuntary. Failing to do that and holding onto the stock options for two more years while the stock increased would expose Garriott to some serious tax liability at the time of exercise, because the options would be treated as NSOs. If he exercised via cashless exercise the tax liability is even more confounding– the amount earned (and the taxable income) from a cashless exercise is the difference between the fair market value at the time of sale and the exercise price — in this case, the cashless exercise would have sold the stock at a loss, which should typically have a positive effect on your taxes.

    Procedural Problems

    This is why reading your boilerplate is incredibly important. There are a few relevant procedural issues in this case. Choice of law, jurisdiction, and attorneys' fees are the most obvious.

    The contract is governed by Korean law. None the less, the complaint relies on a Texas statute to support a claim for attorneys' fees. This doesn't really work because choice of law provisions govern the entire contract, and the statute in question only allows attorneys' fees for contract disputes—the fraud and misrepresentation claims aren't within the purview of that particular statute. Jurisdiction is also an issue—the provision in this case is a bit more ambiguous because the Seoul District Court has "non-exclusive" jurisdiction. The lack of exclusivity may have been negotiated, and it could create a problem by allowing the case to be heard anywhere with personal jurisdiction over the defendant. However, forum non conveniens
allows a court to refuse to hear a case that would be better handled in the hands of another court. The fact that an appropriate court is stated in the contract and the contract is governed by Korean Law may tempt a Texas jurist to refuse to hear a matter that should be brought in a Korean court.

    It should prove to be an interesting (albeit short lived) case, if it goes anywhere.

    

Update: NCSoft's corporate site provides Stock Information. If you're curious. Apparently NCSoft's stock began to fall a while back and is only now beginning to steadily ramp up– their stock is on the rise for the first time since 2002. It's been steadily increasing since February and is currently trading at about $112 a share. At the date around when Garriott's stock options would have been cancelled were they not exercised, it was trading at about 66,000 won, or around $52. Another interesting factoid– when Garriott's stock options were 50% vested the stock price was near its highest. 

Comments (9)

  1. Dan

    I’m hoping more details as to the Tabula Rasa shutdown are revealed from all of this.

  2. Mona Ibrahim

    Dunno what else there is to know– even with a “dedicated player base” a game can fail commercially if you aren’t generating new players or there’s a high churn. Active development just suggests that they were continuing to throw good money after bad.

  3. David Caron

    I’ve always felt Garriott was a little bit insane, and often inept. Not only in regards to this lawsuit, but also his developmental execution and grasp of video game industry trends. Don’t get me wrong, he’s a great idea man and has very broad vision. But he lacks coherence in application of his ideas, and piss poor business sense.
    In short, he’s a great script writer, but an awful director. Coupled with his near legendary ego, it becomes a recipe for failure.

  4. xxxx

    http://legalplay.typepad.com/Garriott%20stock%20option%20agreemen.pdf
    3.3 suggests that the company can choose whether or not to give the recipient shares or the difference between the Exercise price and the market price in cash (settlement method). If the company does so, then it is possible that Garriott either loses a lot of money if he chooses to exercise when the market price is lower than the exercise price (which would be stupid and you probably wouldn’t do that anyway), or if the market price is higher than the exercise price, Garriott would potentially lose out on any further increase in the market price if he would have chosen to keep the stock for a longer period of time. Either way, it strikes me that it isn’t really a good idea to let the contract state that the company can make that decision, if I was the recipient, that would be a decision I would want to make, depending on how cash strapped I was and whether or not I believed the companies stock would be higher in the future. Is this common practice?

  5. Nicholas Knight

    You’ve never been the recipient of a stock option grant, have you?
    When exercising stock options, if you’re not immediately selling the resulting stock, you actually have to put up the money to purchase them.
    If he did not have the cash available to tie up in NCSoft stock long-term, and was forced to exercise the options immediately, he would have had no choice but to sell immediately.

  6. leftie

    On Ten ton hammer it says Richards brother Robert wasa board director of NcSoft when Richard quit. And if you look at NcSoft.net corporate board, it also says Robert owns a big share of stock. Maybe stock options? Anyway, wonder if Roberts going to sue, too.

  7. Mona Ibrahim

    Nicholas: you mean a cashless exercise sale? If you’re not going to get any compensation out of it why exercise at all, unless you plan to report it as a loss for income tax purposes? In which case where is the hundreds of thousands of dollars in tax liability coming from?

  8. Conley

    Here’s a story more from the Korean’s perspective than Garriott’s PR flack, which has driven the narrative of most of the news stories. http://www.koreatimes.co.kr/www/news/biz/2009/05/123_44665.html

  9. Moneo

    “Furthermore, under the US Tax Code Garriott would have been forced to exercise those options within three months after termination whether the dismissal was voluntary or involuntary. Failing to do that and holding onto the stock options for two more years while the stock increased would expose Garriott to some serious tax liability at the time of exercise, because the options would be treated as NSOs.”
    Correct me if I’m wrong, but paying taxes on a profit Garriott could have made is still better than making zero profit and paying zero taxes?
    Going by today’s stock prices, excersizing the options would net about a million dollars, which even after taxes is quite a lot of money.
    I’d say the nature of Garriott’s complaint is perfectly clear, although he does exaggerate his losses. His claim of “hundreds of thousands of dollars in costs” incurred, apparently, by sitting around and doing nothing (because what else can you do when the stock is worth less than the option price and you can’t sell the options themselves?) is especially amusing.

Comments are closed.