Evidence that Stock Options for Chinese SOEs are not Genuine

KE, Bin | GUAN, Yuyan | CHEN, Zhihong

In the 1990s, some Chinese state-owned enterprises (SOEs) started providing stock options for directors, following in the footsteps of the US and other countries. The intention was to signal alignment of managerial interests with those of shareholders. But rumours and reports over the years put a question mark over whether these options were bona fide. For example, CNOOC admitted in 2009 that a large proportion of chairman Chengyu Fu’s income was handed to the parent company and not received by Fu. In addition, the data disclosed in CNOOC’s annual reports show that Mr. Fu never excised any share of his granted options during his tenure in CNOOC over the period 2001-2011, and forfeited all of his outstanding stock options in CNOOC when he was assigned to head Sinopec in April 2011.

Now, some of the uncertainty can be cleared up. Zhihong Chen, Yuan Guan and Bin Ke have looked at the nature of stock compensation options in state-controlled Red Chip firms, how they are implemented and their impact on firm performance. They have come to a stark conclusion: “Our results are consistent with the media’s allegation that the stock options granted to directors of many if not all state-controlled Red Chip firms are not genuine compensation.”

They focused on state-controlled Red Chip firms, which are incorporated outside China and listed in Hong Kong, because they started offering stock compensation options in the early 1990s. By 2005 91 per cent of firms offered stock compensation.

To understand why this was done, the authors interviewed two former directors of state-controlled Red Chip firms and two investment bankers familiar with the IPOs of such firms about the firms’ executive compensation practices. They then tested their insights on data from a sample of state-controlled and non-state-controlled Chinese firms from 1990-2005.

The interviewees suggested that managerial stock compensation had been adopted primarily in response to demand from foreign investors. In the 1990s the Chinese government was keen to attract foreign investment but because most SOEs and their managers were unknown outside China, corporate governance measures were adopted to reassure investors, including stock compensation.

However, this appears to be window dressing. The interviewees pointed out that directors of state-controlled Red Chip firms were prevented from exercising their options or were asked to turn gains over the parent company because it was seen as unacceptable that they would profit financially while also accruing the substantial security and other benefits of working for an SOE. This was backed by the data, which found directors of state-controlled firms forfeited far more of their vested in-the-money stock options (equivalent to an average 2.487 times their annual compensation) than those from non-state-controlled firms (equivalent to 0.455 times their annual compensation).

It was also clear that stock compensation had had an impact in non-state-controlled Red Chip firms but not state-controlled ones, supporting the conclusion that they were of little consequence in the latter.

“Directors’ stock option ownership is negatively associated with dividend payout, while directors’ annual stock option grant is positively associated with future accounting performance change for non-state-controlled Red Chip firms but not state-controlled. This evidence is consistent with the hypothesis that state-controlled Red Chip firms’ stock option compensation for directors is not genuine and therefore has little impact on corporate decisions,” the authors said.

The results have implications for researchers, regulators and investors. First, they show the importance of considering hidden institutional forces in understanding the behaviour of state-controlled Chinese firms. Second, Hong Kong securities regulators and investors should re-examine the appropriateness of the disclosure and accounting practices of state-controlled Red Chip firms with regard to stock option compensation. And third, foreign investors should exercise caution in forcing state-controlled Chinese firms to adopt US-style executive compensation.

“The conventional wisdom about equity compensation from the US literature may not apply to firms from emerging markets that often face unique local institutional environments,” the authors said.

CHEN, Zhihong

Associate Professor