February 2023
Jolene Chen and Teresa Huang
Equity incentive mechanism, as a long-term incentive mechanism implemented generally by conditionally giving employees part of the shareholders’ equity, plays an important role in motivating talents and promoting enterprises’ development. In recent years, judging from the announcements disclosed by listed companies, equity incentive mechanism has become a common corporate system. Meanwhile, even for non-listed companies, equity incentive mechanism is now accepted by an increasing number of enterprises, and it has become an important means for a company to retain talents and improve its cohesion. Because of the important value of equity incentives, it is more important to analyze and study the results of the relevant disputes as part of the implementation of the system. Therefore, this series of articles will discuss and analyze the rules and key points of the trial of equity incentive disputes. This article first analyzes the disputes that may arise when an equity incentive contract sets forth an employee’s employment with the company as one of the single or multiple conditions for receiving the corresponding equity interest.
1. Single Condition: In the process of receiving an equity incentive, if the malicious interference condition is fulfilled, the condition for receiving equity incentive shall be deemed as having been fulfilled.
As the essence of an equity incentive contract is to make an employee and the company move forward together through equity incentive mechanism to achieve a win-win goal, the equity incentive is often based on the premise that the employee is still employed by the company, and some of equity incentives even take the year of service provided by the employee as the condition for receiving the corresponding equity interest. So, there is a situation that the company, as the employer, unilaterally decides whether the employee is still employed by it or not, which in turn affects whether the conditions for the employee to receive equity interest are fulfilled. In this case, the court may invoke the rules on conditional contract when a dispute arises.
Case 1: The Civil Case of the First Instance Regarding Equity Transfer Dispute of Shu Zhenyu v. Duan Honghai (Case No. (2020) Hu 0118 Min Chu No. 23962)
Duan Honghai joined Hugong Welding Company on March 8, 2013 to engage in technical (type) work, and both parties signed a labor contract with a term from February 28, 2013 to February 27, 2023. Siyu Company is a shareholder of Hugong Welding Company and an ESOP（Employee Stock Ownership Plan）platform of Hugong Welding Company and its subsidiaries and branches. Shu Zhenyu is a shareholder and the chairman of the board of directors of Hugong Welding Company, and also the largest shareholder, legal representative and executive director of Siyu Company.
On July 25, 2013, Duan Honghai and Shu Zhenyu signed an Equity Transfer Agreement as an equity incentive, agreeing that Shu Zhenyu shall transfer his 3.32% equity stake in Siyu Company (with a capital contribution of RMB 471,700) to Duan Honghai at a transfer price of RMB 655,500. If Duan Honghai works in Hugong Welding Company and its affiliated enterprises for more than ten consecutive years, Shu Zhenyu shall confirm the waiver of the aforementioned equity transfer price, and Duan Honghai may not be required to pay the price. If Duan Honghai does not work in Hugong Welding Company within ten years from the date of such agreement, Shu Zhenyu shall have the right to require Duan Honghai to transfer his equity stake in Siyu Company to Shu Zhenyu or a third party designated by Shu Zhenyu without compensation within 60 working days from the date of the aforesaid situation. The articles of association of Siyu Company stipulate that any equity interest held by a shareholder may not be transferred to a third party other than the largest shareholder, i.e., Shu Zhenyu (or a third party designated by him) without the consent of the largest shareholder. The articles of association also provide that the price of equity transfer shall be equal to the consideration actually paid by the incentive recipient when he/she got the equity interest held by him/her, no matter the equity interest is withdrawn, transferred, reduced or executed by the people’s court. After the Equity Transfer Agreement took effect, both parties went through the industrial and commercial registration of changes, and Duan Honghai became a shareholder of Siyu Company, with a shareholding of 3.3226%. Duan Honghai did not pay for the equity transfer price.
On January 21, 2019, Hugong Welding Company issued a Notice on Termination of Labor Relation to Duan Honghai, and the labor relations between both parties were terminated on that date. It was later found that such act of Hugong Welding Company was a termination of the labor relation in violation of statutory procedures. As both parties had no basis to continue the performance of the labor contract, the labor relation was not restored.
Key Points of Judgment:
(1) Hugong Welding Company terminated the labor relation with Duan Honghai in violation of statutory procedures. As a shareholder and the chairman of Hugong Welding Company, Shu Zhenyu’s such improper act promoted Duan Honghai’s failure to work in Hugong Welding Company for ten consecutive years, therefore, the condition for Duan Honghai to be exempted from paying the equity transfer price should be deemed as having been fulfilled, and Duan Honghai does not need to pay the equity transfer price of RMB655,500 to Shu Zhenyu.
(2) Hugong Welding Company terminated the labor relation with Duan Honghai in violation of statutory procedures. Shu Zhenyu, as a shareholder and the chairman of Hugong Welding Company, promoted the termination of the labor relation by improper act. In this case, the conditions for equity transfer without compensation shall be deemed as not fulfilled, and Shu Zhenyu shall pay the corresponding consideration for the equity transfer involved in this case.
(3) The claim of measuring the consideration for the equity transfer involved in this case by market value is untenable. According to the articles of association of Siyu Company, the price of equity transfer shall be equal to the consideration actually paid by the incentive recipient when he/she got the equity interest held by him/her, no matter the equity interest is withdrawn, transferred, reduced or executed by the people’s court. Therefore, the court determined that Shu Zhenyu shall pay Duan Honghai the equity transfer price of RMB655,500.
2. Multiple Conditions: For an equity incentive mechanism that sets multiple conditions (including the grant of equity, lifting the selling restriction on equity, realization of equity, etc.), which belongs to the relationship of multiple causes and one effect. If the enterprise only prevents one or two of the conditions (not all of them) from being fulfilled, it does not necessarily lead to the deprivation of the equity that the employee should have received, and it is more difficult for the adjudicating body to make a decision through the fulfillment of the malicious interference condition.
The essence of equity incentive is that the company uses the equity interest to motivate employees, so that the employees and the company can form a community of interests and grow together and achieve a win-win situation. Therefore, generally speaking, the equity incentive system and the incentive results constitute a cause-and-effect relationship, that is, the employees work hard, the company generates earnings and then return them to the employees through the equity incentive system. Since the cause-and-effect relationship is mentioned, especially the relationship of multiple causes and one effect, we can draw on the most mature criminal law theory of interruption of causation. In criminal law, when multiple causes result in one effect, we often analyze whether a latter condition interrupts a previous one. The situation discussed here is also the same. For an employee working in an enterprise, both parties agree that if the employee works in the enterprise for a certain number of years, he/she has the right to receive the corresponding equity interest, but if both parties also agree the conditions for receiving equity incentive such as the employee’s performance assessment, the achievement of the company’s performance goals and other conditions (for example, Case 2). The essence of the system is that equal subjects work together to achieve a win-win situation and then distribute the earnings among them. Therefore, if the subjects fail to achieve a win-win situation, they are not able to distribute earnings. Such conditions make the relationship between the employee and the company a qualitative change, and are apparently intervening factors that make the employee feel an increased pressure, which can obviously interrupt the original cause-and-effect relationship that an employee working in the enterprise for a certain number of years has the right to receive the corresponding equity interest. As the length of service cause-and-effect relationship has been interrupted, even if the company’s termination of the labor contract is subsequently found to be unlawful, how can the employee protect his rights?
Of course, from another point of view, even if the adjudicating body finds that one or both of the conditions of the equity incentive have been fulfilled as a result of the company’s unlawful termination, the employee cannot prove that the conditions for the receipt or realization of the equity incentive have been fulfilled if there is no evidence that all the conditions have been fulfilled.
Case 2: The Case of the Second Instance Regarding Contract Dispute of Liu Lu v. Pharmaron Beijing Co., Ltd.(Case No. (2022) Jing 02 Min Zhong No. 7836)
On October 9, 2019, Pharmaron issued the Notice on the Grant of 2019 Restricted Stock to Liu Lu, stating that Liu Lu received 35,000 shares of restricted stock in the amount of RMB624,750 and that: …… (2) During the selling restriction lifted period, the company shall handle the lifting of selling restriction for the incentive recipients who meet the conditions of lifting of selling restriction. In each selling restriction lifted period, if the current performance of the company meets the performance assessment target condition and the personal assessment result of the incentive receipt for the previous year is qualified, all the restricted shares granted to the incentive receipt that can be lifted from selling restriction in the corresponding assessment year shall be lifted from selling restriction, otherwise, the restricted shares shall not be lifted from selling restriction and shall be repurchased by the company.
On October 31, 2019, Liu Lu (Party B) and Pharmaron (Party A) signed the 2019 Restricted Stock Grant Agreement. The Agreement stipulates that, III. Arrangements for the lifting of selling restriction on restricted shares and the assessment conditions: ….. .2. The arrangement for the lifting of selling restriction on restricted shares granted to Party B and the assessment conditions shall be implemented in strict accordance with the relevant provisions of the Incentive Plan and the Assessment Management Rules.
The Incentive Plan provides that in case of passive lay-off of the incentive recipient without any unqualified performance, negligence or violation of law and discipline, the restricted shares granted but not yet lifted from selling restriction shall not be lifted from selling restriction and shall be repurchased and cancelled by the company.
Liu Lu’s Appellate Facts and Reasons: Liu Lu claimed that she signed a labor contract with Pharmaron on January 11, 2019 and then started working for the company. In accordance with both parties’ agreement, Liu Lu purchased 35,000 listed shares (restricted shares) of Pharmaron at a price of RMB624,750, on which the selling restriction shall be lifted in three years, i.e., 40% in the first year, 30% in the second year and 30% in the third year. The conditions for the lifting of selling restriction are that the result of Liu Lu’s personal assessment is qualified, and the company’s performance reaches the target. The corresponding part of shares for 2019 (40% of the total amount) had been lifted from selling restriction, but Pharmaron forcibly terminated the labor contract with her on July 13, 2021 without any reason. Among the restricted shares purchased by Liu Lu, the shares that should be lifted from selling restriction in 2020 had already met the conditions for the lifting of selling restriction, and Pharmaron had not yet lifted the selling restriction thereon. Liu Lu considered that, for the restricted shares that had been sold to her and should be lifted in 2021, Pharmaron should be deemed as having waived its right to restrict such restricted shares because it unilaterally terminated the labor contract with her without reason, and Pharmaron should lift the restricted shares that had been granted to her and were planned to be lifted from selling restriction in 2020 and 2021.
The first-instance judgment held that in case of passive lay-off of the incentive recipient without any unqualified performance, negligence or violation of law and discipline, the restricted shares granted but not yet lifted from selling restriction shall not be lifted from selling restriction, even if Liu Lu did not have any performance assessment failure, the shares granted to Liu Lu cannot be lifted from selling restriction[1], so all of Liu Lu’s claims were rejected. Liu Lu considered that the first-instance judgment incorrectly ascertained facts, i.e., treating Pharmaron’s illegal termination of the labor relations as equivalent to downsizing and passive lay-off, and lacked legal basis and was against common sense, so she filed an appeal.
Key Points of the Second-Instance Judgment: A contract concluded according to law is legally binding on both parties, and both parties shall perform their respective obligations in accordance with the contract. In this case, as the 2019 Restricted Stock Grant Agreement entered into by and between Liu Lu and Pharmaron is the real intentions of both parties and does not violate any mandatory provisions of laws and regulations, the Agreement should be legal and valid. According to the agreement in the Incentive Plan that in case of passive lay-off of the incentive recipient without any unqualified performance, negligence or violation of law and discipline, the restricted shares granted but not yet lifted from selling restriction shall not be lifted from selling restriction, under the circumstance of Liu Lu’s passive lay off, the court of first instance’s following decision is not improper: Liu Lu’s claim to lift 21,000 restricted shares for 2020 and 2021 was not consistent with the Incentive Plan and the court did not support Liu Lu’s claims.
[1] The expression of the main idea of this judgment is obscure, and it should be understood that even if the condition of having a qualified assessment result has been fulfilled and the condition of the employee’s employment with the company has been fulfilled, there is still a condition (i.e. the company’s performance reaching the target) that may not be fulfilled, so the selling restriction shall not be lifted.
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