November 2023
Jolene Chen and Teresa Huang
In today’s business environment, equity incentive plans have become a critical tool for motivating employees and retaining talent. However, the implementation of these plans often comes with its own set of challenges, not the least of which is proxy holdings. This article examines the risks associated with proxy holdings in equity incentive plans and offers solutions.
I. Equity Proxy Holding and its Causes
1. In equity incentive plans, the prevalence of equity proxy holding stems from several reasons:
Facilitating Investment Attraction: For startups or businesses seeking financing, employing equity proxy holding can be instrumental in attracting investors. This approach mitigates the impact of frequent shareholder information changes on company control, and circumvents cumbersome industrial and commercial registration procedures.
2. Shareholder Limitations: The Company Law restricts limited liability companies to a maximum of 50 shareholders and joint-stock companies to 2 to 200 shareholders. Consequently, within these constraints, companies might opt for equity proxy holding as an alternative solution to grant shares to a larger number of employees.
II. Risks of Equity Proxy Holding
Although a flexible solution, the use of proxies to implement equity incentive plans presents significant risks. Often orchestrated by large shareholders, this practice is susceptible to abuse. Given the significant influence these stakeholders wield at shareholder meetings, they could use this power to manipulate the process and potentially transfer the benefits to the company. Ultimately, such actions could lead to the deprivation of dividend rights for eligible employees.
In court cases, it is common to observe cases in which controlling shareholders take advantage of their position to divert company profits. For example, in the case of (2016) Supreme Court Civil Final No. 528, the controlling shareholder, Taiyi Industry and Trade Company, transferred profits from Taiyi Thermal Company to other companies without the consent of the general meeting. As a result, this action deprived Juli Menye Company, a minority shareholder, from receiving dividends.
While the law generally considers anonymous shareholdings to be valid unless specific invalid circumstances exist, confirming the identity of anonymous shareholders remains a formal process. This lack of formal recognition complicates the protection of dividend rights due to limited access to information. According to Article 24 of the Provisions of the Supreme People’s Court on Certain Issues Concerning the Application of the Company Law of the People’s Republic of China (3), disputes over contracts between actual and nominal shareholders in limited liability companies are recognized by the courts unless there are specific invalid circumstances in the Civil Law. In the case of proxy shareholding, if there are no provisions in the Civil Code that invalidate the contract, it’s considered valid and protected by law. However, the identity of the anonymous shareholder isn’t confirmed until the actual shareholder obtains the consent of the majority of the other shareholders. Under the Equity Incentive Share Plan, the employees who receive incentives aren’t listed in the company’s share register as prominent shareholders. Access rights are granted to prominent shareholders, which poses a challenge to incentivized employees who, although actual contributors, are anonymous. This anonymity makes it difficult for them to exercise the rights and obligations of shareholders. As a result, incentivized employees do not have standing as plaintiffs in shareholder information lawsuits, which affects their access to information.
III. Solutions
This unfair practice has created anxiety among eligible employees, and their rights and interests have not been adequately protected. Such a situation deviates from the basic purpose of the equity incentive program, which is to motivate employees. To address this issue, companies need to take a series of measures to improve the management and refinement of the equity incentive shareholding system while ensuring the protection of employees’ legitimate rights and interests. To mitigate the risks associated with equity incentive shareholding, companies can consider the following measures:
1. Establish a robust equity compensation program: Companies should develop a comprehensive framework that requires employees and agents to sign representation agreements. These agreements must explicitly confirm that the shares belong to the incentivized employees. Proxies should represent only incentivized employees and outline terms such as the amount of shares held, exercise procedures and transfer restrictions.
2. Strengthen regulatory oversight: Increased oversight of proxy holders includes regular evaluations of their conduct, periodic audits of the company’s operations, and access to information for incentivized employees.
3. Implement a risk alert mechanism: Companies should implement a proactive mechanism to quickly identify and address proxy-related issues and risks. At the same time, fostering communication and dialogue with employees will be critical to understanding their thoughts and opinions in a timely manner and enabling prompt action to address them.
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