Lawsuit Against Uber Alleges “Fraudulent Scheme”

By Glen Martin

While the ride-sharing service Uber has smashed transportation paradigms left and right, its performance has been controversial. The company’s business model—a digital go-between for car owners and riders—offers reliable transportation, but largely ignores the pesky regulations that shackle cab companies. People who need lifts generally think that’s pretty damn cool, given the convenience and affordability of an Uber ride. Cab drivers, regulators, and some employees are not as charmed, and they’ve dragged the company to court on numerous occasions to demonstrate their pique.

In 2015, California regulators decreed that the company had to manage drivers as employees rather than contractors, a determination that could ultimately disrupt the company’s business model (which, ironically, is widely considered an exemplar of economic sector disruption). In October, a British tribunal ruled that the company wasn’t compensating its drivers fairly, and declared it had to cough up minimum wages and holiday pay. And the company suffered a criminal conviction in a Paris (France, not Texas) court in June because its drivers weren’t properly licensed.

Now a new lawsuit has hit Uber from another angle. A case filed in San Francisco’s U.S. District Court by software engineer Lenza McElrath contends that Uber pulled an unconscionable switcheroo, wooing McElrath with the promise of a generous and easily redeemable equity package, but delivering one that was considerably less attractive once the engineer signed up (the suit follows a similar case McElrath filed in state superior court earlier this year).

The federal class action lawsuit contends that Uber “devised a fraudulent scheme” to recruit top software engineers and other high tech superstars by offering highly esteemed Investment Stock Options, or ISOs. Such options can make an employee rich, and are far more attractive than another stock offering variant known as Non-Qualified Stock Options (NSOs).

“Both ISOs and NSOs allow an employee to buy a company’s stock at a fixed price, but the tax implications of each make a huge difference in their real value to the employee,” says Nick Carlin, a partner at the firm of Phillips, Erlewine, Given & Carlin in San Francisco, the lead attorney representing plaintiffs in the case, and a guest lecturer at UC Berkeley Law.

An ISO, says Carlin, is usually taxed only on the sale of the stock, not on the exercise of the option by the employee. Further, such sales are considered capital gains, which are typically taxed at far lower rates than income. NSOs, on the other hand, are taxed as income when the option is exercised.

“It’s a huge difference, and it can mean millions of dollars to an employee,” Carlin says. “Uber was offering ISOs to top engineers, but once they joined, they gave them NSOs instead. And to exercise an NSO, an employee has to pay the taxes to the company up front as withholding. That can amount to hundreds of thousands of dollars that an employee may very well not have, meaning it can be impossible for him or her to even exercise the option.”

Uber employed stock option legerdemain, says Carlin, by accelerating the schedule for exercising the options. Several months after starting at the company, he says, employees typically received a notice stating that the options had to be exercised in six months rather than the four years that are typical for such packages. This is significant because the Internal Revenue code imposes a $100,000 limit on the fair market value of any ISO exercised in a given calendar year.  If the exercised option is greater than $100,000, it can be considered an NSO.

The policy helps Uber minimize its own taxes, says Carlin, because under the IRS code, the company is able to deduct the difference between the fair market value of NSO stocks and the amount the employee paid for them.

“We feel this is clear misrepresentation and breach of contract,” Carlin says. “Uber knew at the time they made those offers that those stock options were not all going to end up as ISOs. They promised they would be ISOs—but they had no intention of following through.”

Uber, for its part, maintains that McElrath isn’t characterizing his employment agreement and stock option offers properly and is out of step with basic contract law. For background purposes, the company released language from McElrath’s purported employment and stock option agreements to CALIFORNIA. The clauses stipulate that McElrath’s option would be considered an ISO to the maximum intent permitted by the tax code, but would be subject to additional terms and conditions covered in the company’s 2013 stock plan. Further, the option would be considered an ISO only to the degree that it qualified for such a designation under Section 422 of the tax code; otherwise, it would be considered an NSO.

“We want our employees to have a real stake in Uber’s success, and we’re proud to offer equity compensation in service of that goal,” Uber spokesman Matt Kallman wrote in an email. “Whereas our stock incentive plans are designed to work for all employees, we believe Mr. McElrath has misinterpreted his stock option agreement to benefit himself and his particular tax situation.”

Carlin says that Uber is arguing that the stock option offers are not technically enforceable, and that there is thus no misrepresentation on the company’s part.

“The fine print [in Uber stock option agreements] typically says that all options issuance is subject to board [of directors] approval,” Carlin says, “so the board can then change or negate options. That may be technically true in Delaware [where Uber is incorporated], but our position is that you have an obligation under good faith and fair dealing to provide the options you say you’re going to provide when an employee is hired.”

Moira McQuaid, a San Mateo attorney who specializes in employment law, says that the case against the ride-sharing company seems to have merit, but adds that a substantial burden of proof rests on the plaintiffs.

“At least one of the plaintiffs maintains that he was told by an Uber representative that regardless of the employment agreement and option offer, letters were always sent out within a couple of months of hiring stating that the ISOs were, in fact, NSOs,” McQuaid said. “If that’s true, it could be strong evidence of fraud. On the other hand, it can be assumed that the company will deny the allegations. It will all come down to what can be proven in court.”

In any event, neither the plaintiffs nor defendants, nor anyone considering employment at Uber, should expect a speedy resolution of the case.

“These things can take years,” McQuaid said. “I’m aware of another Silicon Valley employment suit involving Tesla. This was just about the time the company formed. About 50 employees later sued, claiming they agreed to lower pay up front in exchange for stock options. But later, they didn’t receive the options they said they were promised. Last I heard, they’re still filing documents in that case.”

Filed under: Law + Policy
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