China Scam Week, Part 3: The China Stock Option Scam

Our China lawyers have over the last few months have been getting way more than the usual number of emails and phone calls from foreign companies (U.S. and European) telling us they’ve been scammed or seeking our assistance in determining whether they are about to get scammed.

Anyway, in recognition of this recent increase in scamming, we are doing this series of posts on the sorts of scams we usually see, along with providing tips on how to avoid them. This is part 4 of the series. In Part 1, we wrote about the scam of tricking someone to come to China to sign a deal. Part 2 was on the scam of getting money for supplying products and then supplying nothing or, more commonly, something that isn’t even close to what the foreign company bought and paid for. Part 3 was on the switched bank account, which is — by far — the most difficult to avoid scam.

This part 4 is on what our China team calls the China stock option scam — a relatively new, relatively sophisticated scam that has left many tech people and small tech companies in its wake.

This scam starts out with a Chinese company offering stock ownership as an alternative form of payment. The typical scam usually goes like this. 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 tells the foreign tech people or entity that it “needs your services but because we are just a start up we will need to pay you in stock instead of cash.”  So, instead of paying 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 has given out will then provide its recipients with big returns.

Unfortunately, this is nearly impossible because foreigners cannot own stock in Chinese domestic companies 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. Chinese companies will also use this 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/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 tech company. The Chinese company then says: “We need your services, but we are growing so fast we simply don’t have the ability 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 paying you in cash, we will agree to pay in you in stock options. Our stock will in the end give you way more money and by working with us, you will gain entry into the lucrative Chinese market and highly profitable work with other 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 and there will be no future profitable work available to it 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 variations 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 does actually take place, the holder of the scam option or stock in the Chinese company can legitimately be told: “your stock option (or stock) is with the Chinese parent company; you do not have an option with the affiliate actually listed. Sorry.”

For all intents and purposes, private companies in China are  locked out of China’s domestic IPO market. See this Wall Street Journal article from yesterday. 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.

The way to avoid this scam is easy. Do 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 a Chinese company in return for stock or stock options.

UPDATE: I got the following email today (3-11):

Nice series. There’s a new variation that has been tried on me and that’s blockchain “tokens” in a Chinese company “about to do an ICO” in lieu of cash. Since China takes an incredibly dim view on ICOs as a fund raising mechanism, this is an even more fraught method of “payment” than sham stock options. Of course the answer is “well, we’re doing our ICO outside of China, to which the response is “the company won’t be worth much if you’re in prison, though, will it?”

Good point.