An ESOP Primer from a Labor Law Veteran: 6 Cases and 5 Recommendations | ESOP Research

Foreword: ESOP is not just a commercial, legal, or tax issue. What a CEO truly needs is a comprehensive solution. To this end, Source Code Capital invited four teams of experts, each of whom has handled multiple TMT industry equity incentive cases in their respective fields. This is the first time they have all appeared on a single platform. They will analyze ESOP from four dimensions — management, legal, tax, and dispute resolution — covering the full process from multiple angles, to help everyone wield this tool effectively.

This is the fourth topic in the ESOP series. We will focus on: how to win option lawsuits against employees? How to handle options in employees' hands when they resign, especially vested options? How to handle disputes involving overseas options, particularly under VIE structures? How to choose between options and cash rewards? How to stipulate in option agreements, especially overseas option agreements, that employees of domestic companies who are granted options should undertake more obligations toward the overseas company and its affiliates? And how can domestic companies use options granted by overseas companies to ensure that their employees fulfill obligations such as non-competition, non-solicitation, and non-disparagement toward the domestic company?

Incentivize without falling into traps.

Mr. Hu Gaochong

Partner at Global Law Office, based in Beijing

[The following is the original speech]

From the sequence of topics arranged by Source Code, it's clear that Source Code put considerable thought into organizing this event. Previous speakers shared how to design option programs with a sense of value and participation during a company's early stages, analyzed how to set up domestic and overseas equity incentive structures, and examined how to use planning tools to ensure employees receive the full value of their equity incentives without tax discounts.

The ESOP dispute topic I'll discuss may not be as pleasant, but it's crucial for companies. Many startup teams begin their partnerships on very cordial terms, but once they "break up," the darker side of human nature emerges, and flaws in early agreements and program design can make subsequent dispute resolution extremely difficult. So we've compiled six real cases, hoping to approach this from the standpoint of protecting a company's legitimate interests, and preemptively avoid future risks through document and system design.

Below, I'll share five aspects of how to face and handle option-related disputes.

• Part One: How to win option lawsuits against employees. I'll share three cases whose lessons show how to design option documents from the perspective of protecting company interests.
• Part Two: How to handle options in employees' hands when they resign, especially vested options.
• Part Three: How to handle disputes involving overseas options, particularly under VIE structures. This has been a hot topic in Beijing recently.
• Part Four: How to choose between options and cash rewards. This was a topic Source Code requested based on collected feedback, and Teacher He and Lawyer Zhao have already touched on it.
• Part Five has two levels. First, how to stipulate in option agreements, especially overseas option agreements, that employees of domestic companies who are granted options should undertake more obligations toward the overseas company and its affiliates, such as non-disparagement and non-solicitation. Second, how domestic companies can use options granted by overseas companies to ensure that their employees fulfill obligations of non-competition, non-solicitation, and non-disparagement toward the domestic company itself.

1

How to Win ESOP-Related Disputes Against Employees?

Case 1: SouFun Case

The SouFun and Sun Baoyun case was a trailblazer for option disputes in the Beijing region. It occurred in 2012, with the cause of action being contract dispute. The first instance was at Beijing No. 1 Intermediate People's Court, the second instance at Beijing Higher People's Court, and the retrial at the Supreme People's Court. In this case, Sun Baoyun was an employee of a domestic company who directly sued the overseas SouFun company and obtained a final judgment in her favor. Both the first and second instance courts confirmed Sun's entitlement to options in the overseas company, and the Supreme Court rejected SouFun's application for retrial.

In this case, the overseas SouFun company's main substantive defense arguments included that when the domestic company employee resigned, she had signed a so-called one-time dispute settlement agreement with the domestic company. However, the court did not accept the overseas SouFun company's defense, reasoning that the stock option agreement was signed between the overseas company and the employee, while the resignation agreement was signed between the domestic company and the employee. These two agreements differed in nature, content, and contracting parties. The resignation agreement also did not dispose of Sun Baoyun's stock options or modify the stock option agreement's content. Therefore, the court ultimately determined that Sun Baoyun could directly assert her option benefits from the overseas SouFun company based on the stock option agreement.

This case actually embodies an important principle in judicial handling of option disputes: the principle of contractual relativity. An employee and a domestic company (the employer) cannot dispose of rights and obligations regarding stock/options granted by an overseas company in a way that constrains the legal relationship between the overseas company and the employee.

This case also had an important procedural impact: jurisdiction and applicable law for overseas stock option agreements. For overseas contract disputes, we now know that parties can agree on jurisdiction and applicable law. But in the SouFun case, precisely because such agreement was lacking, the court ultimately relied on the fact that the agreement was signed in China, the employee was a Chinese national, and the equity benefits would be realized in China. Applying the closest connection principle, the court confirmed Chinese court jurisdiction and the application of Chinese law. This case directly influenced the drafting of option agreements and option plans after 2012. Now, a large number of standard clauses in overseas equity or option agreements and option plans stipulate the application of overseas law (such as California or Hong Kong law) and submission to the jurisdiction of overseas courts or arbitration institutions.

In summary, the lesson this case offers companies is: it is recommended to have the overseas option grantor (rather than the domestic operating company or employer) directly sign an agreement with the domestic company employee who is granted options, with clauses stipulating jurisdiction and applicable law, and to have the overseas option grantor (rather than the domestic operating company or employer) directly adjust and arrange the rights and obligations under the option agreement.

Case 2: Beijing HC360 Case

The second case involves Beijing HC360 Company. The company may not be particularly well-known, but this case illustrates other dilemmas that employers frequently face in labor disputes.

The background of this case is relatively straightforward. It occurred in 2014–2015, with the same cause of action: contract dispute. The first instance was at Changping District People's Court, the second instance at Beijing No. 1 Intermediate People's Court. Contrary to the SouFun case where the employee sued the overseas company, the employee directly sued the domestic company at Changping District Court. The basis for the lawsuit was that the domestic company had directly issued a "Share Option Grant Notice" to the employee, which stipulated certain option-related rights and obligations and granted the employee a certain number of options in the overseas company. However, after the employee resigned, the domestic company failed to ensure the employee could exercise the options. The employee directly sued the domestic Beijing HC360 Company based on the "Share Option Grant Notice," demanding exercise of the options.

In this case, the domestic company cited the overseas company's "Prospectus" as a defense. The Prospectus stipulated that "share options shall lapse and become unexercisable on the date of termination of employment." However, the court still followed the principle of contractual relativity, holding that the "Share Option Grant Notice" signed between the domestic company and its employee did not reference such Prospectus or disclose its contents. Therefore, the overseas company's Prospectus could not be asserted against the domestic company's employee. The court ultimately ruled that the employee was entitled to the discounted value corresponding to the options based on the "Share Option Grant Notice" issued by the domestic company.

This case also has a highly typical aspect: it established the principle for calculating losses when option exercise is impossible. During first instance defense, Beijing HC360 explicitly stated that it could not guarantee the employee's exercise of options in the overseas company; objective impossibility of exercise existed. In this case, the defendant was only the domestic company, not the overseas company. The plaintiff was asserting option benefits granted by the overseas company, yet the court could not break through contractual relativity to order a third party outside this case (i.e., a party other than those to the "Share Option Grant Notice") to confer rights on the plaintiff. So the plaintiff had to choose whether to insist on option benefits or select discounted compensation. Most plaintiffs, being quite savvy, chose the latter. The court ultimately ruled that when exercise is impossible, the company should compensate the employee for losses based on the stock price on the date the employee applied to exercise the options, minus the purchase price the employee should have paid.

Here is another problem that causes companies significant trouble. As the Deloitte team just explained, exercising options requires tax payment, and converting the stock to cash after exercise also requires tax payment. However, the court will award the employee the net benefit without considering tax withholding, nor will it state in the operative part of the judgment what the employee's net benefit should be and how much tax should be paid.

For example, if the court determines that the employee's final cashable amount is 1 million, with a purchase cost of 100,000, the company should pay 900,000 in due benefits. When it reaches the enforcement stage, if the company fulfills its withholding obligation by deducting, say, 200,000 in individual income tax and remitting it to tax authorities, paying 700,000 to the employee — the employee can often then apply for enforcement of the remaining 200,000 shortfall. Even if the company produces withholding records, enforcement judges will find it difficult to accept. First, enforcement judges likely don't understand tax law. Second, even if they do understand tax law, they cannot independently determine the specific tax amount due. They only look at the amount in the judgment and the amount received by the employee; if there's a discrepancy, the employer must make up the difference. So the employer ultimately pays out a total of 900,000 plus 200,000, bearing an additional 200,000 tax burden.

Of course, this 200,000 tax should have been borne by the employee themselves. The company could file a so-called unjust enrichment lawsuit, but the likelihood of winning in practice is extremely low. Because the judge hearing the unjust enrichment case still won't understand tax law, won't know whether your 200,000 tax withholding constitutes unjust enrichment, who was unjustly enriched, or whether your calculation is accurate.

Actually, this problem is universally present in all labor dispute cases. Whether the judgment orders the employer to pay wages, year-end bonuses, performance bonuses, or termination compensation, the employer has a withholding obligation and frequently suffers losses from this pre-tax/post-tax differential. Parties may not be able to control how judgments are rendered, but during mediation, we recommend that employers specify pre-tax and post-tax amounts as clearly as possible in the mediation agreement.

Returning to the Beijing HC360 case itself, it tells us that whether a domestic or overseas company signs an option agreement with an employee granting options, the agreement must specify the treatment of options after resignation or upon other breach circumstances. When companies use options to attract and recruit core employees, they must first think through how to manage their exit — put the unpleasant terms upfront.

Case 3: Sankuai Company Case

When introducing the first two cases, I kept emphasizing the cause of action. Both were contract disputes, which is the conventional handling mode for option disputes. But after 2015, represented by Beijing No. 1 Intermediate People's Court, courts in Beijing's western district underwent a 180-degree shift in their handling mode for disputes where domestic company employees were granted options by overseas companies. The landmark case was the Sankuai Company case.

The basic facts of this case are as follows: during employment at a domestic company, an employee was granted relevant option benefits by an overseas company; after resigning from the domestic company, the overseas company refused the employee's exercise of options due to various failures to meet exercise conditions stipulated in the option plan and option agreement. The employee directly sued the domestic company in court, filing claims to confirm entitlement to options in the overseas company and to exercise them.

At the original first instance, the first instance court followed the usual handling mode, dismissing the plaintiff's complaint on grounds of improper plaintiff status. The reasoning was the previously mentioned principle of contractual relativity — the plaintiff sued the domestic company as defendant based on an option agreement signed with the overseas company, seeking option benefits from the overseas company. However, when this case reached the No. 1 Intermediate Court, the court issued a ruling vacating the first instance court's dismissal and ordering continued proceedings.

The No. 1 Intermediate Court's main logic was that it considered option benefits to actually be a type of welfare benefit, and moreover a benefit derived from labor remuneration obtained during the period of providing labor services. Such option benefits are closely related to the domestic company, so the domestic company can serve as defendant, and this case should be adjudicated as a labor dispute.

This established a principle: at least within the jurisdiction of Beijing No. 1 Intermediate Court, all option benefit disputes between employees and employers will be handled as labor disputes. From the company's perspective, being brought under labor dispute treatment puts the company in a very passive position, because labor dispute handling is tilted toward protecting workers, with greater judicial intervention. If handled as contract disputes, the vast majority of option agreement contents would be respected. But if handled under labor dispute thinking, the contents of option agreements can be challenged by judges at any time. Judges may consider some agreement contents as restricting workers' statutory rights or circumventing employers' statutory obligations. Judges can directly say NO to many clauses and directly change agreed rules.

How to Respond to Employees' Option Claims

Through these cases, we can extract the following key points to share:

At the first broad level, choice of handling mechanism. Try to have option dispute cases handled under equal civil/commercial thinking. Because if handled as ordinary contract disputes, when employees sue domestic companies based on option agreements with overseas companies, the domestic company has improper plaintiff status; and if suing overseas companies, the option agreements will stipulate application of overseas law and submission to overseas jurisdiction, leaving employees basically incapable of initiating such litigation/arbitration overseas.

How can we choose a handling mechanism favorable to employers in the Beijing region? Try to have statutory jurisdiction fall in Beijing's eastern district. Represented by Beijing No. 3 Intermediate Court, eastern district courts (such as Chaoyang District Court) currently still do not consider option disputes as labor disputes. How to have statutory jurisdiction fall in Beijing's eastern district? One factor is company registration location; if company registration is in Haidian due to preferential policies, the company's principal place of business or the employee's place of labor contract performance can be placed in Chaoyang District.

If statutory jurisdiction falls in the western district, even if the option agreement stipulates application of overseas law and submission to overseas judicial bodies, under labor dispute thinking, these jurisdiction and applicable law clauses will all be invalid, because labor cases have exclusive jurisdiction with arbitration as a prerequisite and two instances of trial.

From a national perspective, bringing option disputes under labor dispute treatment is a trend. Not long ago, Shenzhen Intermediate Court also held a seminar where judges expressed the view that they should be brought under labor dispute handling. But many courts nationwide still recognize the improper plaintiff status defense (such as courts in Shanghai). Therefore, from the perspective of responding to disputes, domestic companies must still raise the improper plaintiff status defense.

The second broad level is raising substantive defenses, such as lack of evidence proving employee entitlement to option benefits; failure to satisfy exercise conditions, material breach of option agreement, etc. These are common substantive defense arguments that defendants raise, which need to be tailored to the specific contents of the option agreement and factual circumstances.

How to Handle ESOP When Employees Resign?

For unvested options, they can lapse naturally. Because option grants are typically matched to the duration of the employment relationship, if an employee resigns early — for example, four years corresponding to 10,000 shares, but only two or three years of service — the remaining service period corresponds to unvested options. We can choose to have them naturally terminate through a natural lapse clause.

What companies mainly need to consider are vested but unexercised options, or restricted stock as mentioned earlier by Lawyer Zhao. Generally speaking, from most to least severe, there are five main treatment methods: complete forfeiture, repurchase at net asset value, repurchase at original capital contribution, repurchase at fair value, or continued retention.

Due to time constraints, I won't elaborate on each. What companies need to be reminded of is: try to embody these five treatment outcomes in the option agreement through prior agreement, specifying which consequence corresponds to which circumstance the employee violates. This allows constraining employee behavior (whether resignation or harm to company interests, etc.) through agreed terms.

How to Handle Disputes Involving ESOP Granted by Cayman Companies to Employees?

Actually, through the three cases just discussed, we can already draw conclusions. From a national perspective, although more and more courts and judges are gradually inclined to handle cases where overseas companies grant options to employees as labor disputes, a considerable number of courts (such as in some Shanghai areas) are still willing to handle them as contract disputes.

If handled as contract disputes, contractual relativity is a basic handling principle. Employees can only assert rights against the counterparty to the option agreement, and according to the option agreement's jurisdiction clause, they typically need to litigate/arbitrate overseas (but as in the Beijing HC360 case, if the employee did not sign an option agreement with the overseas company, and the domestic company issued an option grant notice or signed other contractual documents, the domestic company remains a proper party to the contract, merely having "disposed of a third party's rights without authority").

But if handled as labor disputes, VIE structures and red-chip structures may be considered by courts as reverse control. Courts will break through contractual relativity, treating options granted by overseas companies as labor consideration/welfare benefits granted under the control of domestic companies. Currently, courts are still gradually exploring in practice which handling mode — contract dispute or labor dispute — works better.

How to Choose Between ESOP and Cash Rewards?

The fourth part has already been covered by our designers and engineers. I'm not particularly expert in this area, so I'll offer only some superficial observations for reference. My superficial understanding is: when there's no money, give equity/options; when there's money, give cash — whatever is convenient for the employer.

But standing from a litigation lawyer's perspective, I still emphasize that companies should try to make a clean separation. If you don't want the domestic company as defendant, avoid disclosing option-related information in domestic company documents as much as possible. If domestic and overseas companies make a clean separation on option granting issues, reducing the domestic company's role in the option plan to the minimum, and not reflecting the domestic company in option benefit documents, the domestic company's improper plaintiff status defense will be much stronger.

How to Connect Granting ESOP to Employees with Imposing Non-Compete and Other Obligations?

Many entrepreneurs face this problem: how to grant option benefits to employees while having them fulfill additional obligations. Some additional obligations are inconvenient to impose at the labor contract level and may bring additional costs. We'll share this topic through three cases.

Case 1: ESOP and Service Period

——Cao Lin v. Shenzhen Fuanna Home Furnishings Co., Ltd. Contract Dispute

This Shenzhen case is still a contract dispute. The employer granted the employee some restricted stock, which the employee could convert into unrestricted common stock and obtain benefits through sale. At the same time, the company had the employee make a commitment to continue service for a certain number of years after the company's A-share listing, otherwise paying a penalty. After converting the stock to cash, Cao Lin resigned, violating obligations in the "Stock Incentive Plan" and "Letter of Commitment." Shenzhen Intermediate Court handled this dispute as a contract dispute and ultimately supported the employer's claim for return of proportional restricted stock cash-equivalent benefits (Guangdong Higher Court subsequently rejected Cao Lin's application for retrial).

This achieved the purpose of setting a service period through an equity incentive plan. Regarding service periods, according to the Labor Contract Law, a service period can only be agreed with an employee when specialized technical training has been conducted and training fees paid. If this case had been handled under labor dispute thinking, the result might have been different. The judge would consider whether you actually conducted specialized technical training or paid other costs beyond specialized technical training. If the latter, the service period agreement would basically be invalid.

Case 2: ESOP and Non-Compete Breach Liability

——Tencent v. Xu Zhenhua Non-Compete Dispute

The second case has received relatively more attention. Recently, Shanghai No. 1 Intermediate People's Court issued a white paper on non-compete restrictions, publishing this case. Media outlets then widely reported it as the highest penalty amount of 19.4 million yuan. But actually, this case was not a true non-compete penalty in the meaningful sense; it was merely a victory in returning non-compete compensation. The entire 19.4 million-plus was the price the employer paid premised on requiring the employee to fulfill non-compete obligations — using restricted stock as consideration, then imposing non-compete obligations on the employee. When the employee ultimately breached, the consideration should be returned to the company.

This case provided new thinking for consideration payment for non-compete obligations. Two years ago, a client consulted me: according to the Labor Contract Law, setting post-resignation non-compete obligations for employees requires the employer to pay non-compete compensation as a prerequisite. But the client said they didn't want to bear this additional cost — could they use payment of option benefits as a substitute for paying non-compete compensation? We gave a negative conclusion at the time, because the law explicitly stipulates that non-compete compensation must be in monetary form, paid monthly after resignation. If paid during employment or if option benefits are granted to employees, this cannot substitute for legally stipulated non-compete compensation.

But recent cases show — both this Shanghai case and the Haidian District Court case introduced below — that courts are increasingly respecting diversity in non-compete compensation methods. Through this Shanghai case, we can see that the court ultimately treated the restricted stock benefits as equivalent to non-compete compensation. If the employee violates non-compete obligations, they have a duty to return them. This respects the mutual agreement between the parties — that if the employee breaches, the company can require the employee to bear liability for breach of contract as agreed.

The lesson this case offers is: when domestic companies sign non-compete agreements with employees, they can add content regarding return of granted options/restricted stock in the liability for breach section. And whether domestic or overseas companies sign option agreements, option plans, or restricted stock grant agreements with employees, they can consider attaching certain obligations to employees in the agreement, such as non-compete, service period, etc., to protect the interests of the option-granting company and its affiliates.

Because even under Beijing No. 1 Intermediate Court's handling mode — treating these option agreements and option plans according to labor dispute adjudication principles (at which point jurisdiction and applicable law clauses become void due to the exclusive jurisdiction nature of labor disputes) — judges will still basically respect the mutual agreement between parties regarding additional obligations such as non-compete and service period in option agreements.

Case 3: ESOP and Non-Compete Compensation

——Tencent Digital (Tianjin) Co., Ltd. v. Liu Chunning Labor Dispute

This case deserves even more attention. The company and employee signed a "Confidentiality and Non-Compete Commitment Agreement," in which the company used granting of parent company options as a substitute for non-compete compensation payment, while the employee correspondingly undertook non-compete and confidentiality obligations. After the employee joined a competitor upon resignation, the company filed a contract dispute in Shenzhen based on the "Confidentiality and Non-Compete Agreement," suing the employee for breach of non-compete and confidentiality obligations, and won. However, the employee filed labor arbitration in Beijing, requesting termination of the "Confidentiality and Non-Compete Commitment Agreement," on the grounds that Judicial Interpretation IV on Labor Disputes stipulates that an employer's failure to pay non-compete compensation for three months allows termination.

Regarding the labor dispute to terminate the "Confidentiality and Non-Compete Commitment Agreement," Haidian District Court ultimately issued a first instance judgment in December 2017. Neither party appealed, so the first instance judgment took effect. Haidian District Court ruled that both parties should continue performing the previously signed "Confidentiality and Non-Compete Commitment Agreement." Most critically, the court characterized the option benefits, holding that from the agreement's stipulations, the employee's option benefits possessed multiple attributes including conditional welfare with equity incentive function and non-compete compensation, and did not belong to the legally mandatory consideration for labor activities under labor law — that is, a wage component in the labor law sense.

Two years ago, our feedback to clients was that non-compete compensation should be paid in monetary form. If substituted with other benefits of uncertain value, courts might challenge the agreement's validity. This was also the employee's defense in this case. But Haidian District Court's response in this case was to hold that option benefits are not merely labor remuneration but may possess multiple attributes, and the amount far exceeds the statutory standard for non-compete compensation — 30% of average monthly wages in the 12 months prior to resignation. Therefore, the employer had not violated the non-compete agreement obligation, nor was there any failure to pay compensation, and the employee should continue performing the non-compete agreement signed by both parties.

The positive signal these cases send to companies is that you can both stipulate non-compete obligations in option agreements and, in non-compete agreements, agree that option benefits serve as compensation for non-compete obligations. This way, options serve not only an incentive function but also achieve the purpose of setting special obligations for employees.

Conclusion: Adjudicatory bodies increasingly respect party autonomy in option agreements

Under current handling modes very unfavorable to domestic companies, even if ultimately brought under labor dispute treatment, courts will still relatively respect the mutual agreement of both parties compared to other labor dispute cases.

Therefore, we recommend that companies must include clauses protecting employer interests in option agreements and option plans, such as forfeiture clauses. Common forfeiture triggers include but are not limited to: employee gross negligence, dereliction of duty, solicitation activities, breach of non-compete obligations, disparagement of the company or affiliates, etc.

[Guest Expert Contributions]

This concludes the ESOP research series. Source Code Capital's Legal Department hereby invites contributions from senior legal professionals. If you have rich practical experience with a vexing legal issue at startups and are willing to share in depth, welcome to contact us to become our guest expert.

Thank you!

Contact email: xy@sourcecodecap.com

More ESOP Research

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• Detailed Explanation of Domestic and Overseas Enterprise (VIE) Equity Incentive Legal Structure Models and Issues | ESOP Research
• Clever Use of "Tax Planning" to Ensure Employee Incentives Don't Lose Value | ESOP Research

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