China

China Stock Option Scams

Foreign individuals and companies should not accept promises of stock options or stock in a Chinese company in place of employment compensation or payment for services.

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US china flagsThe China lawyers at my firm have been experiencing an increase in companies and individuals contacting us after having been offered stock in a Chinese company as an alternative to cash. Mainland Chinese companies offering company stock is a scam that cannot work for foreigners.

This is how this stock scam typically goes down. The Chinese company — usually in the tech sector — desperately needs the expensive skills or knowledge of a foreign person or entity, but either lacks the funds to pay or the desire to do so. So, instead of paying hard cash, the Chinese company will offer founders’ stock or employee stock options in their Chinese entity and talk about its plans to go public (“do an IPO”) and of how profitable that will be for the stock recipients.

Unfortunately, this is all an illusion for the simple reason that foreigners cannot own stock in a Chinese domestic company not already listed on a stock market. So any such option or stock transfer is void from the start. Foreigners are not permitted to be shareholders of Chinese domestic companies, nor does China recognize the concept of nominee shareholders.

Even though the offering of stock in Chinese companies is a fraud, we are still seeing many foreign individuals and companies taken in by such offers, most commonly in the fintech sector. The Chinese company will use the “standard” Silicon Valley approach of offering a stock option package as a key benefit in the employment package. By offering stock options, the Chinese company can pay less and secure greater loyalty, while still exploiting the skills and extracting the knowledge of foreign individuals in developing an innovative software or other high tech product.

This exploitation period typically lasts one to three years, at which point the Chinese company tells the foreign individuals, “Sorry, the Chinese government has now informed us that we cannot issue you any of our stock.” Sometimes, to prolong the scam, the Chinese company will propose elaborate nominee schemes illegal under Chinese law. These proposals often convince the foreign employees to waste another year or two with the Chinese company. But, in the end, the result is always the same. The Chinese company defaults on its promise to provide the foreigners with stock in the company. Since the founders’ stock/stock option scheme was void from the start, there is nothing the foreigners can do to enforce their rights in China, since they never had any rights.

A similar scam is often perpetrated on foreign companies with technical services of great value to the Chinese company. The Chinese company will win over such a company with the following type of pitch:

We really need your services, but we are growing so fast these days that we simply do not have the free cash to pay you in cash for that. Since we are growing so fast, it is certain we will soon do an IPO on the Shanghai stock exchange. So, instead of our paying you in cash, we will agree to pay in you in stock options. Our stock will provide you with far more monetary value than the paltry fee we would pay you for your services and by working with us, you will gain entry into the lucrative Chinese market and highly profitable work for Chinese companies will follow.

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This scam results in the same result as the employee stock option scam. Just as with employee stock options, a foreign entity cannot own stock in a Chinese domestic entity, so the option is void from the start. Also, the private Chinese entity never does an IPO on the Shanghai market, so the whole concept was an illusion. The foreign company virtually never figures out the scam until after it has already transferred its service or valuable information to the Chinese entity.

There are a couple of elegant variants Chinese entities use to implement the Chinese stock scam. In the rare case where a private Chinese company actually completes an IPO, the listing is on a foreign exchange — usually either on a Hong Kong or United States or London exchange, where due to Chinese law requirements, the actual listing entity is not the Chinese company for which stock options or stock were purportedly given. Instead, the listing entity is some form of subsidiary or other affiliate of the Chinese company. This means the holder of the scam option or stock in the Chinese company can be told: “Your stock option (or stock) is with the Chinese parent; you do not have an option with the affiliate actually listed. Sorry.”

Private companies in China are effectively locked out of China’s domestic IPO market. On the other hand, such companies have become attractive targets for private equity financing. But the story here is the same. The private equity financing occurs in China, resulting in a big payout to existing shareholders of the Chinese entity. The foreign stock option holder looks for an equivalent benefit. The Chinese entity then responds: this was a private equity deal, not an IPO. You did not own any stock at the time of the private financing, so you are not entitled to any benefit.

Foreign individuals and companies should not accept promises of stock options or stock in a Chinese company in place of employment compensation or payment for services. Chinese companies that offer payment in stock are either ignorant of the requirements of Chinese law or intentionally committing fraud. Either way, foreign individuals and companies should refuse to work with any Chinese company that makes this sort of stock offer. We have seen many of these deals and none have worked out well.

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Dan Harris is a founding member of Harris Moure, an international law firm with lawyers in Seattle, Portland, San Francisco, Barcelona, and Beijing. He is also a co-editor of the China Law Blog. You can reach him by email at firm@harrismoure.com.

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