On Tuesday, Riot Games issued a competitive ruling against Cloud9, one of the teams that competes in North America’s League of Legends Champion Series (“LCS”) for violations of LCS Rules. Specifically, Cloud9 ran afoul of Rule 2.5, which requires that anyone deemed to be a “team owner” cannot be reported on the team’s full roster, which includes the team’s reserve players. According to the ruling, seven of Cloud9’s players violated this rule as a result of playing while being paid partially with something called Restricted Stock Units, or “RSUs.”
In issuing this ruling, Riot raised a number of questions with some unclear answers. What makes someone an owner under these rules? How will these rules be enforced going forward?
Let’s start with the most obvious question, what in the world is an RSU? Think of it like a stock option. Instead of — or in addition to — getting paid a standard salary, the employee earns stock in the employer company as the employee works there. That said, RSUs differ from stock options in two important ways.
First, the an RSU isn’t an “option;” it “vests” (or becomes actual held stock) automatically according to a schedule set out in the initial contract. It most commonly vests according to some calendar schedule, but can also allow for performance and other factors to impact the vesting speed. The second difference is connected to the first: stock options carry an exercise price, while RSUs do not. In effect, RSUs are stock guarantees that vest automatically without a transaction cost.
Unfortunately, just because RSUs don’t have an exercise price, doesn’t mean there isn’t a cost associated with an RSU vesting. An RSU is still compensation, which means it’s time for everyone’s favorite subject: taxes.
Until an RSU vests, the Internal Revenue Code (“IRC”) declines to treat it as income or tangible personal property. It’s instead considered “nonqualified deferred compensation,” which is a fancy way of saying that the RSU is not taxed, yet. However, the moment it vests, the IRC treats it as ordinary income. That means federal and state income taxes and associated withholding apply. Frequently, RSU holders will elect to sell the stock immediately, pay the tax, and pocket the difference. Other times, the RSU holders will elect to instead pay the tax and hold onto the stock, hoping it will increase in value. At that point, the stock becomes a capital asset (like normal stock), subject to capital gains tax (or capital loss treatment if the stock decreases in value) whenever the holder decides to sell it.
Alright, that’s enough tax technical (for now). What does this have to do with the LCS ownership rules?
The LCS rules don’t attempt to define the word “owner.” In the ordinary sense of the word, “ownership” generally means interest in and ultimate control over something. However, there’s reason to believe that Riot defines it differently. In summarizing Cloud9’s violations, Riot wrote the following:
“Over the course of sixteen months, Cloud9 issued equity through its employee stock plan to a total of seven players in violation of League rules.”
“Since November 2017 the League has prohibited an owner from serving on his or her team’s Full Time Roster and this effectively makes it a violation of the Official Rules for a player to hold an ownership interest, direct or indirect, in any LCS team for which the player competes.”
In other words, Riot defines ownership through equity, not through control. Any shareholder of any class of stock necessarily becomes an owner for purposes of applying these rules. By extension, any RSU holder becomes an owner.
Some people have raised concerns about the fact that players’ RSUs may or may not have actually vested yet, which means the players do not yet have equity. For competitions’s sake, it probably makes sense to treat an RSU as immediately giving ownership to a player rather than booting the player mid-season because their first share vested.
But is mere equity the best definition of ownership? There’s a natural conflict of interest where a player has a financial stake in a team other than the one he or she is playing for, but that conflict becomes less obvious where the player remains on the team.
To provide a contrasting example, tax law measures ownership by both equity and control. Control, here, means voting power. That makes some inherent sense; it would seem reasonably damaging for a team to have some players with control over their teammates and coaches.
Finally, defining ownership only by equity makes it difficult to create a structure where players can own equity in limited circumstances, which Riot is reportedly working on. In addition, they’ve allowed equity ownership in the case of another competing LCS player, Bjergsen.
What does this mean for Cloud9 and the LCS moving forward?
In the immediate future, the Competitive Ruling mandates that Cloud9 immediately renegotiate the terms of the player contracts in order to extinguish the RSUs. If those renegotiations contain any type of buyback or payment for the extinguishing of those rights, the player would likely owe ordinary income taxes on that payment based on recent tax rulings. Otherwise, it probably means a standard salary increase for those players.
In the further future, this ruling sends unclear signals to LCS teams regarding their ability to issue equity to players. Riot may have given the green light for player-held equity in at least one instance, but the limitations on that form of compensation are unknown. Can the player keep the equity if he changes teams? Does it matter whether the player has voting power? Does Riot need to approve all equity awards? Hopefully, the updated 2020 rules shed some light on this dark corner of the rulebook.
Finally, the Competitive Ruling included one seriously alarming statistic:
“Only two of the seven players had a lawyer or other representative review the RSU grants.”
Please, players, get a lawyer. Teams, get a lawyer. And throw in an accountant for good measure.