Beijing Appellate Court Sheds Light on Nature of Equity Incentive Disputes

A Beijing appellate court has expressed its view that a multinational employer’s equity plan for its employees constitutes an employment dispute, which would render it subject to Chinese law. This is the opposite position taken by the majority of courts and local labor arbitration commissions facing this issue. They have held that a multinational’s equity plan is not an employment dispute, which often resulted in the dismissal of the claim.

In China, where the currency is not freely convertible, the process for a publicly traded multinational corporation to grant equity or implementing stock purchase plans to its workforce in China is a cumbersome one. Once the plan is registered, most multinationals assume that the agreement that governs their equity plans, often under Delaware law for US-listed multinationals, will equally apply to the equity that is granted to or purchased by their employees in China.

However, the law and rules administering the offshore equity issued in China is not settled. Notably, the question of whether a multinational’s equity plan is a contractual dispute and not an employment-related dispute that would fall under the purview of the local labor arbitration commission (the mandatory first step dispute mechanism for the majority of labor and employment disputes in China) and whether the equity plan can be governed by foreign law have been largely open issues under Chinese law, seemingly until now.

In February 2023, People’s Judicature—an official law journal managed by the Supreme People’s Court of China, the highest court in the country—published an article authored by a study group comprised of judges from the Beijing First Intermediate People’s Court (Beijing Intermediate Court) titled “Preliminary Exploration on Path to Unified Adjudication of Civil Cases Involving Equity Incentive Plan – From the Labor Dispute Perspective” (Article).[1]

In the Article, judges from the Beijing Intermediate Court presented their views on how the nature of a dispute between a company and its employees or executives concerning an equity incentive plan and the rights and obligations relating thereto (Equity Incentive Dispute) should be determined, which, though not binding, provides important reference and guidance on this issue.

DIFFERENT JUDICIAL VIEWS ON THE NATURE OF EQUITY INCENTIVE DISPUTES

Currently, there is no national law or regulation providing unified standards regarding the nature of Equity Incentive Disputes. Thus, in practice, different courts have different interpretations regarding this issue. While many courts tend to hold that Equity Incentive Disputes are civil disputes as opposed to labor disputes, which should be governed by civil and commercial laws such as the PRC Civil Code and the PRC Company Law rather than employment law,[2] some other courts take a different position on this issue and hold that when the granting of the equity incentive is closely intertwined with the performance of the employment contract by an employee, a dispute arising from such equity incentive plan should be regarded as a labor dispute and thus should be governed by PRC employment law.[3]

The legal implications differ in various aspects (such as the burden of proof, the statute of limitations and the applicable dispute resolution process) depending on whether an Equity Incentive Dispute is a civil dispute or an employment dispute.

Generally speaking, PRC employment law is more protective of the employees, and therefore if Equity Incentive Disputes are deemed employment disputes, this would necessarily subject them to Chinese law, negating the plain language and terms of the offshore equity agreement. For this reason, the characterization of Equity Incentive Disputes is of significant importance to both the employee and the employer.

PROPOSED GUIDELINES FOR DETERMINING THE NATURE OF EQUITY INCENTIVE DISPUTES

In the Article, the judges proposed systematic guidelines for determining the nature of Equity Incentive Disputes.  

Two Key Factors

The judges listed the following two key factors for determining the nature of an Equity Incentive Dispute.

The Legal Relationship Between the Company and the Target Individual

According to the Article, an equity incentive dispute will be deemed as a labor dispute when there is an employment relationship between the company and the target individual. If the target individual under the equity incentive plan is not an employee, for instance, when the individual is a director or supervisor having no employment contract with the company, the dispute arising from the equity incentive plan is not a labor dispute and the employment laws and regulations will not apply.

Notably, the judges did not clarify which role has supremacy for the purpose of determining the nature of the equity incentive dispute when the target individual assumes both employment and corporate positions, but in this circumstance, the individual is expected to avail themselves under the protection of the employment laws.

The Nature of Entitlements Under the Equity Incentive Plan

The judges explained the concepts of “salary,” “labor remuneration,” and “labor income” in the Article as follows:

• Regarding the term “salary,” the judges cited the definition of this term under the “Opinions on Several Issues regarding the Implementation of the PRC Labor Law” (Opinions) issued by the former Ministry of Labor (currently known as the Ministry of Human Resources and Social Security) in August 1995, under which salary refers to
  • the labor remuneration directly paid by the employer to the employee in the form of currency in accordance with applicable laws and regulation and the employment contract, which generally includes salary based on working hours, salary based on work volume, bonus, subsidies and allowances, compensation for overtime work, and salary payable under other special circumstances.
• As for “labor remuneration,” the judges define it as “any consideration for services directly or indirectly received by the employee from the employer after performing manual work or brainwork for the employer,” which includes salary as well as non-currency entitlements and benefits provided by the employer.
• According to the judges, “labor income” is the broadest concept, which includes salary, other labor remuneration, and income received by the employee from third parties for their services (such as a monetary reward for an invention or translation fees or lecture fees paid by third parties).

To analyze the nature of the different types of equity incentives, the judges made the following two distinctions.

Equity Interest Plans v. Cash Payment Plans

The judges grouped together (1) stock options plans, (2) restricted stock unit plans, (3) employee stock ownership plans (ESOP), and (4) performance share plans under the category of equity interest plans. Under these plans, the applicable entitlements are provided to the employees in the form of equity interests until cashed out by the employees.

In contrast, the judges categorized incentive plans solely involving phantom stocks, stock appreciation rights, dividend rights, and deferred payments as cash payment plans because under these plans, there is no transfer of equity interest, and the applicable entitlements, despite their names, are provided to the employee in the form of cash payments.

Primary Entitlements v. Fruits

The judges also draw a distinction between the entitlements directly received by the employees under the applicable equity incentive plans such as the stocks granted to them (Primary Entitlements) and the benefits derived from the Primary Entitlements such as the dividends on the stocks and the profits earned by the employee by selling the stocks at a higher price (Fruits).

Summary of Proposed Rules

The Article proposes the rules for determining the nature of an Equity Incentive Dispute based on the two key factors noted above as follows:

• When there is an employment relationship between the target individual and the company, the Primary Entitlements, whether under an equity interest plan or a cash payment plan, shall constitute labor remuneration, and any dispute concerning the provision of the Primary Entitlements qualifies as a labor dispute in accordance with Article 2 of the “Law of the PRC on Mediation and Arbitration of Labor Disputes.” This includes disputes over matters directly related to the provision of the Primary Entitlements, such as time and method of provision, quantity of the entitlements to be provided and damages, and disputes over matters that may impact the provision of the Primary Entitlements, such as the validity of the equity incentive agreement.
• There is a difference between equity interest plans and cash payment plans in terms of whether the applicable entitlements constitute salary. While entitlements under cash payment plans are treated as deferred bonus payments by the judges (which constitute a form of salary under the Opinions), the entitlements under the equity interest plans do not qualify as salary, as they are not directly provided in the form of currency. This distinction is important to a company’s employment practices in China as the scope of “salary” will impact the calculation of certain other employment-related payments and benefits, such as severance and compensation for accrued but unused annual leave.
• The nature of the Fruits should not affect either the nature of the Primary Entitlements under the equity incentive plans or the nature of the disputes arising therefrom.
• After the Primary Entitlement under an equity incentive plan is provided in whole or in part, any dispute over the derivative rights and obligations between the target individual and the company (such as a dispute over shareholder qualification, entries on the shareholder register, or shareholder rights) is not a labor dispute and thus shall be determined in accordance with applicable civil and commercial laws.

PROPOSED APPROACH FOR HEARING EQUITY INCENTIVE DISPUTES

In the Article, the judges suggested that claims arising from the employment contract and claims arising from the equity incentive plan between a company and an employee be joined in one legal proceeding from the procedural law standpoint.

From the substantive law standpoint, the judges added that courts and arbitration committees should not shy away from applying employment laws or preclude the application of civil law when hearing Equity Incentive Disputes. According to the judges, provisions regarding minimum service periods and/or liquidated damages under an equity incentive agreement are not necessarily invalid. The judges recommend using the employment contract and the employment laws and regulations to supplement and specify the rights and obligations of the parties under the equity incentive agreement and making an interpretation in favor of the employee when there is any deficiency in the equity incentive agreement.

The Article makes clear that the judges oppose the rigid application of either employment law or civil/commercial law when adjudicating cases involving Equity Incentive Disputes between an employer and an employee and propose a more balanced and sophisticated approach taking both employment and civil/commercial laws into consideration.

PROPOSED STEPS TO TAKE

While the impact of the Article remains to be seen, it is likely that this Article will influence the courts and lawmakers both within and outside Beijing and that the courts will follow or adopt the judges’ proposed guidelines, particularly given that a member of the Chinese People's Political Consultative Conference raised a proposal to unify the application of law for Equity Incentive Disputes in the annual meetings of China’s top legislature and top political advisory body this past March (known as the Two Sessions or Liang Hui).

That said, before the proposed guidelines are adopted as law nationwide, it is likely that the judicial practice on this issue will continue to vary among different courts. Companies in China that offer or plan to offer equity incentives to employees should consider the following actions for risk prevention and mitigation purposes:

• Carefully review the incentive plan or agreement provided to the employees in China and make sure that it is drafted in a clear and unambiguous manner with sufficient protections for the company
• Engage counsel when formulating and implementing equity incentive plans to assess risks and address issues from the perspective of Chinese employment law.
• In the event of any dispute or potential dispute with employees or officers in connection with equity incentives, carefully evaluate the risk of the claim being treated as an employment claim based on the local regulations and judicial practice and formulate the arbitration/litigation strategy accordingly.

In summary, how an Equity Incentive Dispute will be decided remains unsettled in light of the Article, but the guidance in the Article provides employers with more insight into the potential risks and likelihood of their equity plans being adjudicated under Chinese law—and potentially as an employment dispute, as opposed to the foreign governing law stipulated in the plan document.