EIS registration before listing red-chip companies

To motivate its officers and key employees, retain talents and enhance core competencies, a Chinese company that is planning an initial public offering (IPO) as a red-chip company outside China usually develops and implements an employee incentive scheme (EIS) in the process of pre-IPO restructuring to grant a percentage of interest or equity in the company to its employees before the IPO application is submitted. In this article, the authors will explore how this works under the “small red-chip” model (i.e., IPO of Chinese private companies on overseas markets).

Implementation. Under the current red-chip structure, the “equity pool” under an EIS immediately before the IPO, generally consisting of shares in the special purpose vehicle (SPV, or the foreign company that will go public, or potential issuer) as transferred from the controlling shareholder or shares resulting from private offering of the potential issuer, takes forms that particularly include share options, stock appreciation rights and restricted stock units (RSU).

During the process of pre-IPO restructuring, in view of the number of incentive receivers and the minimal percentage that their shareholdings represent, typically the EIS (or stock incentive plan) is placed into a trust to facilitate implementation of the incentive plan as well as subsequent disposal of relevant shares or stakes. The shares transferred from the controlling shareholders or resulting from private offering by the potential issuer are moved into an offshore discretionary trust established for this purpose, under which the shares are held by the trustee, eligible incentive receivers are named as beneficiaries, and the controlling shareholder is designated as trust protector. Typically, the voting rights attached to the shares held in trust are exercised by the controlling shareholder before they are vested.

While eligible incentive receivers under the EIS in connection with an A-share IPO are restricted to employees of the potential issuer and its subsidiaries, the EIS in connection with a red-chip IPO can be provided additionally – and on most occasions it is provided particularly – to employees, directors or consultants of the domestic operating company and its affiliates. Moreover, it allows the participation of relevant individuals at the potential issuer’s clients or suppliers who meet conditions under the EIS.

Registration. According to the Circular of the State Administration of Foreign Exchange (SAFE) on Foreign Exchange Administration of Overseas Investments and Financing and Round-Trip Investments by Domestic Residents via Special Purpose Vehicles (SAFE circular No. 37), when a non-listed SPV grants shares or options in the SPV to its employees as equity-based incentives, the employees who receive these incentives may apply for foreign exchange registration relating to the SPV if the employees are domestic residents (registration under SAFE circular No. 37).

The SPV, as defined in SAFE circular No. 37, means any overseas company directly incorporated or indirectly controlled, for the purpose of conducting investment or financing activities, by a domestic resident through any domestic or overseas asset or equity legally held thereby. Pursuant to SAFE circular No. 37, no matter whether the equity in a foreign company granted to a domestic resident individual under an EIS is held personally by the individual, or through a trust, registration under SAFE circular No. 37 must be completed insofar as the domestic resident individual already owns or is entitled to a specific percentage of the total equity in the company or total beneficial interest in the trust.

Failure of the incentive receivers to complete registration under SAFE circular No. 37 as required can lead to restrictions on the domestic company’s foreign exchange activities, including, but not limited to, distribution of dividends or proceeds from capital reduction, share transfer or liquidation to its foreign parent or affiliates, receipt of capital inflow from the foreign company, and settlement of foreign exchange. The domestic company or relevant domestic resident individuals can also be subject to fines due to failure to complete registration.

Are domestic resident beneficiaries required to complete registration under SAFE circular No. 37? Based on the authors’ study of the relevant provisions of SAFE circular No. 37, the relevant employees are not required to complete registration under SAFE circular No. 37 unless their rights have been exercised before the IPO. However, we have found some cases where rights are exercised before the IPO without registration under SAFE Circular 37. We have identified some possible reasons for the relief of the registration duty. First, the incentive receivers under the employee equity plan may not have been ascertained. Second, although incentive receivers have been ascertained, they have not exercised their rights or the time for exercising such rights has not yet come before the IPO. Third, in the case where restricted stock units are used, the relevant shares or stocks have not been vested in specific domestic resident individuals before the IPO.

As a more practicable solution, the potential issuer may issue stock options or restricted stock units to the eligible employees via a trust before the IPO, thereby avoiding exercise of rights or vesting before the IPO. When exercise of rights or vesting of restricted stock units to relevant employees is about to take place after the IPO, the relevant employees may cause the foreign exchange registration procedures to be completed through a domestic agency as arranged by their employer, according to the SAFE Circular on Relevant Issues Concerning Foreign Exchange Administration over Involvement of Domestic Individuals in Equity Incentive Plans of Overseas Listed Companies.

Advice. In the authors’ experience, incentive receivers are seldom able to proceed with registration under SAFE circular No. 37 smoothly due to the varied opinions held by local SAFE offices. To prevent compliance risks relating to SAFE circular No. 37, allay the concerns of overseas exchanges and other regulators, and avoid the dilemma of being unable to complete registration under SAFE circular No. 37 as required, the authors suggest that potential issuers categorize and make detailed arrangements relating to shares or beneficial interests granted to incentive receivers in the pre-IPO restructuring process.

Lai Jihong and Chen Jingeng are partners at Zhong Lun Law Firm