Startup Legal Talks (18)

In the last issue, we talked about big red chips and small red chips, and focused on several models of small red chips. In this issue, we are going to talk about an important document that is closely related to the red chip structure - 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 ("Circular 37") The employees who obviously got the company's equity incentive plan, wants to exercise the right, but find that the initial option agreement is like a waste of paper, which results in vanishing of mature options. The culprit of all this is the No. 37 document.

Ⅰ. What is the "Circular 37"?

Circular 37 refers to the document which was enacted by State Administration of Foreign Exchange (SAFE). The full name of "Circular 37" is 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, which came into effect on July 14, 2014, replacing the original Circular. 75.

The general idea of "Circular 37" is that the foreign exchange registration procedures are in line with the round-trip investment by domestic residents through special purpose companies.

Then you will find three key words here: domestic residents, special purpose companies, round-trip investment. So let's look at these three concepts one by one exactly.

1. Domestic residents

First of all, let's look at what is meant by domestic residents. Domestic residents refer to Chinese citizens who hold Chinese resident identity documents, military identity documents, armed police identity documents, as well as foreign individuals who do not have legal identity documents in China, but habitually reside in China because of economic interests.

The operational guidelines of the later-issued "Circular 37" also clarifies the following two points: 1. For those who hold both domestic legal identity documents and overseas (including Hong Kong, Macao and Taiwan) legal identity documents, they are managed as if they were foreigners; 2. Those with permanent residency outside China are treated as foreign residents.

So this answers a question that many viewers have: Are Chinese people with U.S. green cards considered domestic residents? Quite simply, they are not. Because holding a green card means having permanent residency in the United States.

Note that the "Circular 37" registration requirement is only for individual investors. Domestic institutional investors who wish to make foreign direct investments should make ODI filings, not "Circular 37" registrations.

2. Special Purpose Companies (SPV)

What is a "special purpose company"? In fact, to put it plainly, it is a company set up specifically for the purpose of investing domestic interests or assets abroad. The Cayman and Viking in the red chip structure mentioned in the last issue are special purpose companies.

3. Round-Trip investment

Round-Trip investment refers to the aforementioned investment by domestic residents through a special purpose company outside the country, and then the special purpose company returns back to China to set up a wholly foreign-owned enterprise WFOE.

These three concepts can be seen that the "Circular 37" is basically tailored to the VIE structure. We commonly listed Chinese stocks to the United States using this set of structures. Therefore, the employees of these companies will not be able to escape the regulation of "Circular 37".

Ⅱ. Why "Circular 37" is so hated?

According to the provisions of "Circular 37", when domestic residents carry out the round-trip investment through special purpose companies, they must provide completed "Circular 37" registration documents to the relevant departments.

Foreign exchange regulations, in principle, do not allow Chinese rnatural persons to invest abroad. Under the existing foreign exchange management system, No. 37 is the only way for a natural person in China to become a shareholder of an overseas company legally and compliantly.

If you do not register for "Circular 37“, you cannot legally become a shareholder of an overseas company, and the income generated by the overseas company cannot be legally taken back to the territory for use.

Ⅲ. What happened to the employees of large domestic companies?

After introducing the background knowledge of Circular 37, let's go back to the topic: what has happened to the employees of these large domestic companies?

Due to the provisions of Circular 37, employees are not able to exercise their rights whenever they want. Employees can exercise of rights only after they have completed the Circular 37 registration. However, the process for the registration for Circular 37 is very complex, especially the company with the construction of the VIE structure includes hundreds of thousands of employees. If all emplyoees with matured options want to exercise the right, the company does not do anything else all day and night but is busy with the Circular 37 registration for employees.

Here, many viewers should find the crux of the problem, that is it is not the Circular 37 prohibits you from exercising the right, but your company does not allow you to exercise the right. That's right! But this can't be entirely blamed on the company, because the process of this Circular 37 registration is indeed very cumbersome and the degree of control varies from place to place. So the usual workarounds in real life are

Option 1: first let employees do pseudo exercise, that is, employees become a shareholder in a domestic company, and When the number of people is large enough, employees then go together for the registration of the Circular 37.

Option 2: The major shareholder will first hold the shares on behalf of the company, and then return them to the employees when the company goes public.

Option 3: For employees whose options have matured, they must continue to work until the company goes public, because the registration procedures will be much simpler after the listing, and if they leave before then, then all previous options will be automatically voided.

Guess which option is the most used in real life? The answer is option three. It is so unkind and unreasonable. This is also the most common situation among the hundreds of inquiries I have received, and even some of the big technology companies that we are familiar with are still using such a method to make empty promises for their employees.

So as an employee, what should you do? The answer is bearing with it. The reality is harsh indeed, and there is nothing that can be called as a very good way. There are many employees' options can actually be worth several million RMB, so if you can sue the company, I can only say that you can try. But I'm afraid it's more worthwhile to do that the next time you accept an offer from a VIE structured company, the salary part will focus on cash, and the options part is a pie in the sky.

This issue is a bit sad, so let's talk about it here.