Employee stock ownership plans, often referred to as ESOPs outside the United States, have evolved into a critical instrument for companies. In the United States, the term ESOP or employee stock ownership plan instead refers to a specific type of tax-qualified defined contribution plan that invests in employer securities under U.S. tax and employee benefits laws, and is not the subject of this alert. ESOPs not only enable companies to attract and retain top talent without immediate cash outflow but also help align employees’ motivations with the companies’ long-term objectives. In this alert, we dive into some of the distinctive legal considerations in designing ESOPs in four major jurisdictions that are commonly seen in the Asian market: the Cayman Islands, the People’s Republic of China (the PRC; for the purpose of this alert, this excludes the Hong Kong Special Administrative Region (Hong Kong)), Macau Special Administrative Region and Taiwan), Hong Kong and Singapore.
What is an ESOP?
An ESOP is designed to give employees an ownership interest in the company in the form of shares. In designing an ESOP, in addition to the most important economic terms of the equity pool, the number of shares under each award and the exercise price or purchase price per share, there are several other key considerations.
- Eligible participants: Participants would typically be employees of the company and other service providers such as consultants, advisers and nonemployee directors.
- Types of awards: The most common type of award is an option, pursuant to which a participant is entitled to purchase shares of the company at the applicable exercise price. Another common type of award is a restricted share award, which, among other considerations, permits U.S. taxpayer participants to accelerate tax to the time of grant by filing an election under Section 83(b) of the U.S. Internal Revenue Code of 1986, which could be beneficial if the share value is low at the time of grant. (Without a Section 83(b) election, a U.S. taxpayer will pay tax on a restricted share award when it becomes vested, i.e., the restrictions lapse).Other types of awards include share purchase rights and restricted share units.
- Vesting schedule: Awards are typically subject to a vesting schedule, which could be based on service period (e.g., four years) and performance target. A participant will have full benefits of the relevant portion of the award only after the vesting schedule is satisfied (i.e., vested). The employee needs to remain continuously employed (or providing services if not an employee) through each vesting date in order to receive that portion of the award. The purpose is to promote employee retention and incentivize employees.
- Other restrictions: In addition to a vesting schedule, the company may impose transfer restrictions. For example, transfer of shares that are acquired under the ESOP could be subject to prior consent of the board of directors and right of first refusal of other shareholders of the company. With respect to participants who are resident in the PRC, in order to comply with applicable foreign exchange regulations of the PRC—including Notice on Relevant Issues Concerning Foreign Exchange Administration for Domestic Residents Engaging in Overseas Financing and Investing Through Round-Trip Investment via Special Purpose Companies or Circular 37—share options granted by a company incorporated outside the PRC are not exercisable until relevant registration with the PRC governmental authority is completed following its initial public offering.
In addition to the key considerations that are applicable throughout jurisdictions, there are certain legal considerations and distinctive market practices in each of the four jurisdictions.
The Cayman Islands is the most commonly adopted jurisdiction for companies that are seeking initial public offerings in the United States and Hong Kong. Under the laws of the Cayman Islands, companies can authorize a certain number of ordinary shares for future issuance (the concept of “reserved shares”) under ESOPs. The Cayman Islands generally permits parties to contract to any terms they wish, and there is no mandatory rule regulating administration of an ESOP. Therefore, an ESOP can be structured to accommodate various considerations. For example, depending on tax and legal regulations of jurisdictions that participants are subject to, a company can adopt different forms of share award agreements for its participants, including U.S. forms (either incentive stock options (ISOs) or nonqualified stock options (NSO), each as defined under the Code) and PRC forms (mainly to comply with foreign exchange regulation as discussed above). In addition, we have observed increasing market practice of establishing a trust in connection with ESOP management.
The People’s Republic of China
Different from the requirements in Cayman Islands, share capital of a company incorporated in the PRC is required to be fixed, and there is no such concept of authorized but unissued share capital (or reserved shares) in the PRC. Therefore, a shareholding platform structure is commonly used by a PRC company for the purpose of its ESOP. Under the structure, all share capital under the ESOP will be issued to the shareholding platform, and such shareholding platform will enter into relevant arrangements with participants. The most commonly used structure of shareholding platforms is a limited partnership incorporated in the PRC. In this structure, the company’s founder or his/her designee serves as the general partner, and the voting rights attached to such shares are controlled by the founder. Upon grant of an award, a participant is admitted to be a limited partner by acquiring membership units or alternatively has contractual entitlements to equity interests in the partnership.
Another key consideration for a company incorporated in the PRC is the number of ultimate beneficial owners of a non-listed company. Unless certain safe-harbor rules are in place and accepted by the PRC regulators, the number of ultimate beneficial owners of a non-listed company shall not exceed 200 individuals, including participants in a shareholding platform structure. Due to such limitation and look-through of a shareholding platform structure, participants in an ESOP are limited to its key employees.
Under Hong Kong law, there are generally no restrictions on the terms of an ESOP by a private company. Similar to Cayman Islands companies, unless restricted by its articles of association, a Hong Kong company can reserve shares for an ESOP.
However, due to the stamp duty imposed on each share transfer and the fact that information about an ESOP is publicly available via its filing of return of allotment with the Companies Registry of Hong Kong, prior to its initial public offering (IPO), a Hong Kong company usually conducts a pre-IPO restructuring, pursuant to which a listing vehicle is incorporated in an offshore jurisdiction (e.g., the Cayman Islands and the British Virgin Islands) and the existing ESOP of the Hong Kong company will be mirrored at the level of the listing vehicle.
With respect to a publicly listed company in Hong Kong, whether it is incorporated in Hong Kong or an offshore jurisdiction, its ESOP is subject to the applicable listing rules of Hong Kong, including requirements and restrictions under Chapter 17 of the Hong Kong Exchange Main Board Listing Rules (e.g., one grantee cannot receive more than 1% of the relevant class of shares on a rolling 12-month basis). In addition, companies should be mindful of the prospectus requirements under the Companies (Winding Up and Miscellaneous Provisions) Ordinance. An ESOP that does not fall within one of the statutory safe harbor exemptions could be considered an offer to the public, thereby requiring that a prospectus be issued.
Finally, for employees in Hong Kong, an ESOP should not have the effect of diminishing an employee’s wages or affect the employee’s rights qua employee under the employment laws of Hong Kong.
In Singapore, a company’s ESOP would typically be set out in a document containing all relevant rules and provisions, and would also normally include the form of the letter that grants shares or options to employees as well as the form of the exercise notice for the options. The plan is required to be approved by both the board of directors and the shareholders of the company, and the ESOP share pool is also typically reflected in the capitalization table and list of shareholders of the company. The most common form of award in Singapore is options.
Under Singapore law, while there are generally no prohibitions on how a private company (i.e., a company that (i) restricts transfer of its shares and (ii) has 50 or less shareholders) may structure an ESOP, there are limitations applicable to public companies (i.e., a company that is not a private company, whether listed on a stock exchange or not). Options granted by public companies are subject to a limit on the exercise period for share options in general (typically five years, but can be up to 10 years).
Additionally, public companies listed on the Singapore Exchange (SGX) are subject to rules under the applicable SGX listing manuals, including limits on the type of participants and the maximum number of shares. Listed public companies must restrict participation in ESOPs to directors and employees of the company, unless the participants are directors or employees of an associated company (i.e., the listed company or its group holds between 20% and 50% of the shares in that company), or are directors and employees of the listed company’s parent company and subsidiaries and who have contributed to the success and development of the listed public company. The total number of shares available in all ESOPs of the listed public company must not exceed 15% of the total number of issued shares.
Similar to companies subject to Hong Kong’s laws, companies incorporated in Singapore should also be mindful of the prospectus requirements under the Singapore Securities and Futures Act 2001 and ensure that the ESOP is structured to meet one of the statutory safe-harbor provisions in order to avoid prospectus requirements.
Although ESOPs are widely adopted, they also vary across jurisdictions, with each jurisdiction bearing its own legal subtleties. Companies with U.S. participants should also be aware that U.S. awards are subject to an array of tax, securities and other laws and regulations not addressed here.