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The China Stock Option Scam
The China lawyers at my firm have been experiencing a big uptick in the number of companies and individuals contacting us after having been offered stock in a Chinese company as an alternative to payment in cash. This swapping of stock for pay is a relatively new phenomenon, so I want to explain how it works and, most importantly, why it cannot work for foreigners.
This is how this stock scam typically goes down. The Chinese company — usually in the tech sector — is in desperate need of the expensive skills or knowledge of a foreign person or entity. The Chinese company states: “we need your services, but we are a start up.” So, instead of paying hard cash, the Chinese company offers founders’ stock or employee stock options in their Chinese entity. Just as is the case with Silicon Valley founders stock/stock options, the idea here is that the Chinese entity will go public (“do an IPO”) and the stock it is giving will then provide a windfall benefit to the foreigners to whom they have given the founders stock or the stock options.
Unfortunately, this is all an illusion for the simple reason that no foreign person can 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. Whatever the sector though, 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/extracting the knowledge of foreign individuals in developing an innovative software or other high tech product.
This exploitation/extraction period typically lasts one to three years, at which point the Chinese company tells the foreign individual, “sorry, the Chinese government has now informed us that we cannot issue stock options to you.” Sometimes, to better hide the scheme, the Chinese company will propose a series of fantasy work arounds, such as elaborate nominee schemes illegal under Chinese law. These proposals often convince the foreign person 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 foreign individual with stock in the company and the foreign individual is left high and dry. 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 such rights.
A similar scam is often perpetrated on foreign entities. The foreign entity has a technical service of great value to the Chinese company. The Chinese company then says: “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. However, 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.”
This scam results in the same sad result as the employee stock option scam. First, as with employee stock options, a foreigner cannot own stock in the Chinese entity, so the option is void from the start. Second, the private Chinese entity never does an IPO on the Shanghai market, so the whole concept was an illusion. Third, the only thing the foreign entity achieved was to identify itself as an easy mark, which means there was no future profitable work available in China. Finally, the foreign company does not figure 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 Hong Kong or the United States or London, 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, so that when the IPO takes place, 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.
Bottom Line: 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. Any Chinese company that makes the offer of payment in stock is 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 kind of stock offer. We have seen many of these deals. None have ever worked out well, and it will not work out well for you.
We will be discussing the practical aspects of Chinese law and how it impacts business there. We will be telling you what works and what does not and what you as a businessperson can do to use the law to your advantage. Our aim is to assist businesses already in China or planning to go into China, not to break new ground in legal theory or policy.
Source: http://www.chinalawblog.com/2016/09/the-china-stock-option-scam.html
