Does an equity incentive fall within the scope of labour remuneration?
Xuchao Feng (Charles)
T&C Law Firm, Shanghai
An employee stock ownership plan (ESOP) is an employee benefit plan that enables employees to have ownership interests in a company. It is designed to bind employees’ and companies’ interests and to encourage employees to provide companies with long-term service. It is conducive to the long-term development and growth of enterprises and can effectively attract and retain core human resources. In China, ESOPs have been implemented by hundreds of listed companies and thousands of non-listed companies, such as Huawei, Alibaba and Tencent, since ESOPs were first introduced in the 1980s. ESOP forms include, among others: share options, restricted share units (RSU), stock appreciation rights and phantom stocks. They have become an indispensable management tool for improving the performance of modern enterprises.
In recent years, ESOP-related disputes have become quite common. A related argument concerns whether an equity incentive falls within the scope of labour remuneration. This is an issue of concern to the nature of ESOP disputes: whether they are commercial contract disputes, accepted and tried by the courts directly, or labour disputes that are subject to the procedural prerequisite of labour arbitration. This still remains a controversy in practice, in particular for the nature of share options and RSUs.
ESOPs as labour remuneration
The first view is that equity incentives belong to the category of labour remuneration. According to those holding this view, they are a tool to maintain mutual trust between employers and employees, to maintain stable labour relations, and to improve employee efficiency. Therefore, equity incentives granted to employees are based on the relationship between the employer and employees. Consequently, they constitute a part of the labour compensation given by employers. Furthermore, the benefits that employees will enjoy when the stock’s price rises are also generated due to the existence and continuity of the employment relationship between both parties.
Another basis for this view is China’s current individual income tax policy for ESOPs. Under the relevant tax rules, when employees exercise their options, the difference between the actual purchase price (exercise price) of the stocks obtained from the company and the fair market price of those stocks on the purchase date, should be the income obtained due to the employee’s employment with (and performance for) the company. Therefore, the individual income tax associated with this difference should be calculated and paid in accordance with the tax rules for wage and salary incomes.
In practice, however, only a small number of judges support this view. That said, if an equity incentive is expressly stated in an employee’s employment agreement, offer letter, or other documents, as part of that person’s established compensation, it is highly likely that the court will recognise this equity incentive as labour compensation.
ESOPs as other incentives
The second view, which is also the prevailing view of the courts in China, diverges from the above. Although equity incentives granted to employees arise from an employment relationship, the equity incentive agreements signed by the employees and the employer are independent from the employment agreements (in some cases, the equity incentive agreements may be signed by the employees and the parent companies or associated companies of the employers). While ESOPs are based on the establishment and continuity of employment relationships, they are not statutory labour benefits and are conditional, time-limited and uncertain incentive mechanisms. The rights and interests associated with the equity incentives carry risks. Therefore, the legal disputes arising from them should fall into the category of commercial contract disputes.
The following is an example concerning stock options: a company launching a stock option incentive plan executes relevant agreements with its employees and grants them the right to purchase an equity interest in the company at a predetermined price and on predetermined terms, within a certain time period. Under this incentive mechanism, both parties share performance incomes and the interests of the participants are linked to the interests of the company. This will cause the participants to treat the interests of the company as if they were their own and contribute their maximum personal value to the company. Furthermore, as the employees have already obtained remuneration from the employer for their labour, the stock option incentives given by the company in exchange for employees’ enthusiasm and loyalty are contractual considerations given to the employees for them to assume additional obligations. These obligations are separate from the employees’ performance of normal labour duties. Therefore, the property benefits/incomes involved in the stock options should not be a part of labour remuneration, such as salary and bonus, and associated disputes should not be subject to the established procedure of labour arbitration.
To summarise, the leading standpoint in China is that share options and RSUs are not a part of labour remuneration (despite some courts having issued contrary judgments), while the view of the nature of phantom stocks seems less contentious in practice.
Phantom stock, a special form of ESOP, is very likely to be recognised as labour compensation. It involves phantom shares that bestow upon eligible participants the right to a cash payment at a designated time, or in association with a designated future event. This is to be paid in an amount tied to the value of a certain number of shares (eg, appreciation and dividends), but without the participants actually receiving any shares or becoming shareholders of the granting company. In light of this, under the phantom stock model, the shares or equity constitute only a tool for measuring the value of incentives. Therefore, phantom stock is essentially a cash reward, and most courts tend to think it belongs to labour remuneration.
If the employer is not the grantor of a share option or RSU, the employee may have difficulties furnishing a claim or bringing a lawsuit against the employer directly. In practice, the grantor of the equity incentives (options or RSUs) may not be the company that hires the employees. Instead it may be its parent company or affiliated company, domestic or overseas (eg, a parent company located in the US, a Special Purpose Vehicle located in the Cayman Islands or in the British Virgin Islands). When disputes arise, employees tend to take the company that has hired them to court, ignoring the entity that actually granted them the equity incentive, and often the judge will dismiss the employees’ claims on the grounds that the defendant lacks standing.
Here are some practical suggestions for individuals and companies.
For individuals, in the event of any dispute, attention should be paid to distinguishing the specific form and nature of the equity incentives granted, in order to identify whether to institute a civil lawsuit with the court directly, or file for labour arbitration first. If employees do not verify this and adopt the wrong strategy, the protection of their rights may be substantially undermined. This is also the first issue that the employee’s attorney should consider when developing litigation strategies.
As for companies, they should lay emphasis on the details of the ESOP’s operation. For instance, when granting equity incentives, the company should first determine what form of incentive to adopt based on its own business operation: cash flow, purpose of the incentive and other factors. Depending on the specific form of ESOP, there are varying costs, management difficulties and dispute resolution methods. Another example involves whether the equity incentives (and how much should be given to employees) should be specified in the employment agreement and/or letter of appointment. It can be better for companies to have as few as possible or no references to equity incentives in the employment agreement and letter of appointment. As discussed above, doing so may increase the likelihood of equity incentives being recognised as labour remuneration, which may be unfavourable for the company when facing a related dispute.
Additionally, there are other related issues of concern, such as:
- whether employees are required to sign the ESOP documents and relevant notices;
- whether electronic signatures should be adopted;
- how to link the departure of employees to the grant;
- vesting, exercise, transfer and forfeiture of equity incentives; and
- how to localise the incentive plans of overseas enterprises, so as to ensure they apply to their employees in China.
 Under PRC law, a labour dispute must be first handled by a labour arbitration committee. If either party is not satisfied with the arbitral award, it may bring a lawsuit to court. If either party is not satisfied with the judgment of the first instance, it may appeal to a higher court, whose judgment will be final. Also, in labour disputes, labour arbitration committees and courts are inclined to side with employees (who are in a relatively weak position). Commercial/civil disputes are directly submitted to court for trial.
 Appeal case in a contract dispute between Fu Jun, Taobao (China) Software Co, Ltd and Alibaba Group Holding Limited (Case No (2016) Zhe Min Zhong No 504), rendered by the Higher People's Court of Zhejiang Province on 23 March 2017
 For example, the appeal case in a labour dispute between Boyan Technology (Shenzhen) Co, Ltd, Boyan Technology Co, Ltd. and Wen Jian (Case No (2017) Yue 03 Min Zhong No 1326), rendered by the Shenzhen Intermediate People’s Court of Guangdong Province on 10 July 2017
 The strengths of phantom stock are that employees will not receive shares and thus will not affect the total capital and ownership structure of the company. However, its negative aspects are also apparent, as the company will suffer relatively high cash pressure when cashing out the incentives (therefore, it is not suitable for start-ups). The price at which incentives should be realised is often difficult to determine (especially for non-listed enterprises); and as employees do not actually own equity, the incentive role of phantom stock and the employees’ sense of belonging are relatively low, compared with stock options and RSUs.