Questions regarding modifications to share-based payment arrangements

Case excerpted from the Ministry of Finance’s Accounting Department’s ‘Application Examples for the Share-Based Payment Standard — Modification of Share-Based Payment Resulting in an Increase in the Fair Value of Granted Equity Instruments’. Example: On January 1, 2X20, Listed Company A granted 1,000 stock options to each of its 30 senior executives. These executives must serve continuously at Company A from January 1, 2X20, for three years, after which they may purchase 1,000 shares of Company A’s stock (par value RMB 1 per share) at RMB 10 per share. The fair value of each option on the grant date was RMB 6. Company A estimated that none of these 30 executives would resign before December 31, 2X22. Assume that the following modifications occur to the above share-based payment plan after the grant date: Scenario One: On July 1, 2X20, Company A modifies the exercise price to RMB 9 per share and shortens the service period to two years—i.e., the 30 executives may purchase 1,000 shares of Company A’s stock at RMB 9 per share upon completion of service through December 31, 2X21. Assume that the fair value of each option immediately before the modification on July 1, 2X20, was RMB 5, and the fair value after the modification is RMB 7.5.

Latest Update: Supreme People’s Court Retrial Judgment Reverses and Remands Case on Directors’ Liability for Compensation Arising from Duty to Urge Shareholders’ Capital Contributions

The Shenzhen Intermediate People’s Court held: (1) Directors Hu Qiusheng and five others bore a duty of diligence to recover unpaid capital contributions from shareholders; (2) The board’s failure to adopt a resolution urging shareholders to pay their outstanding capital contributions had no inevitable connection with the shareholders’ failure to make such payments; Shenzhen Smat’s failure to receive full capital contributions resulted solely from shareholders’ failure to fully perform their capital contribution obligations—not from the passive non-performance or active obstruction of such obligations by Directors Hu Qiusheng and the other five; and (3) Although Directors Hu Qiusheng and the other five did not adopt a board resolution urging shareholders to pay outstanding capital contributions, this does not preclude Shenzhen Smat or other interested parties from lawfully pursuing corresponding liability against the shareholders who failed to make full capital contributions. In summary, in December 2015, the Shenzhen Intermediate People’s Court issued its first-instance judgment (2015) Shen Zhong Fa Po Chu Zi No. 8, dismissing all claims brought by the administrator. III. Second-Instance Ruling The Guangdong Provincial High People’s Court held: (1) Responsibility for shareholders’ failure to fully perform their capital contribution obligations should not be automatically attributed to company directors. If directors merely fail, through passive inaction, to urge shareholders who have not fully performed their capital contribution obligations—and if such inaction bears no direct causal relationship to the losses sustained by the company—then holding directors liable for shareholders’ failure to fully perform their capital contribution obligations lacks factual and legal basis; (2) As shareholder Cayman Smat failed to fully perform its capital contribution obligations, Shenzhen Smat may lawfully assert rights against it. The six directors served as Chinese directors of the shareholder at different times. In the absence of explicit provisions in the company’s articles of association imposing upon them a supervisory duty to ensure shareholders fulfill their capital contribution obligations—and absent evidence showing that their passive failure to urge the shareholder to contribute capital bore a causal relationship to the company’s losses—the claim seeking joint and several compensation liability from these six Chinese directors for the shareholder’s unpaid capital contributions lacks legal basis. In summary, in August 2017, the Guangdong Provincial High People’s Court issued its second-instance judgment (2016) Yue Min Po 70 Hao, upholding the original judgment. IV. Retrial Ruling Dissatisfied with the above second-instance judgment, the administrator filed an application for retrial with the Supreme People’s Court, which, in June 2018, issued Retrial Order (2018) Zui Gao Fa Min Shen Zi No. 1636, finding that the second-instance judgment involved errors in the application of law and deciding to conduct a retrial. After retrial, the Supreme People’s Court held: (1) Where shareholders fail or fail fully to perform their capital contribution obligations, directors and senior management bear a duty to urge such shareholders to make their capital contributions; (2) Directors Hu Qiusheng and the other five served as directors of Shenzhen Smat and simultaneously as directors of shareholder Cayman Smat; accordingly, they were expected to be aware of Cayman Smat’s asset status and operational conditions, and thus possessed convenient conditions to supervise Cayman Smat’s performance of its capital contribution obligations. Directors Hu Qiusheng and the other five failed to submit evidence demonstrating that, after the shareholders’ capital contribution deadline—March 16, 2006—they fulfilled their duty to urge the shareholder to make capital contributions. Their passive inaction constituted a breach of their duty of diligence; (3) The shareholders’ failure to pay the full amount of capital contributions actually harmed Shenzhen Smat’s interests. Directors Hu Qiusheng and the other five, through their passive inaction, permitted such actual harm to persist. The unpaid capital contributions constitute the losses suffered by Shenzhen Smat. The shareholders’ failure to pay capital contributions and the passive inaction of Directors Hu Qiusheng and the other five jointly caused the occurrence and continuation of such harm; thus, the directors’ failure to urge the shareholder to make capital contributions bears a legally cognizable causal relationship to the losses sustained by Shenzhen Smat.

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