Executive Compensation, Chinese Style
Tuesday, September 16th, 2008While many of us have been scanning financial headlines by the minute to see if the fabric of our financial system has yet to come completely unglued (and who can blame us), apparently there are other newsworthy stories outside of Lehman, Merrill, AIG, WaMu, and the like.
I found an article about executive compensation in China that appeared in last week’s issue of the Economist especially fascinating (see False Options). As the article explains…
How executives are rewarded is one of the many mysteries of China’s increasingly powerful companies. Unravelling it is important, not least because it should help to explain corporate China’s transformation from a state-controlled to a consumer-driven creature.
Research on this question has been surprisingly sparse. A new study by Zhihong Chen and Yuyan Guan, of the City University of Hong Kong, and Bin Ke, of Pennsylvania State University, casts a rare beam of light.
…Senior executives’ cash pay [at 83 large companies operating in China but trading in Hong Kong] was low by global standards: $180,000 a year on average. Almost every firm awarded stock options, worth an average of $140,000, giving bosses healthy top-ups as well as equity stakes—if those options were exercised. Remarkably, a lot never were. At more than half of the firms, no options were exercised within four years of vesting.
The authors of the study pose the following question:
“What forces make them [executives] throw away money [in the form of unexercised options] on the table?”
The article goes on to conjecture that the reason that executives in China do not cash out their options is likely cultural. I agree that there is a large cultural component to the differences in behavior between Chinese and American executives with respect to cashing out in-the-money options.
The authors of the study then add:
“If executives in general do not exercise stock options, how can the option scheme align executives with the interest in shareholders?”
Actually, I think that having management in place that does not exercise in-the-money options is, in some ways, a good thing for shareholders. After all, once executives have exercised their options and cashed out, their interests are no more aligned with those of the shareholders than if they never had shares at all. If executives are forced to hold in-the-money options, they have every incentive to continue working in the shareholders’ best interests to maximize share price. This not only makes their options more valuable, but more importantly for individuals from collectivist cultures such as China, it avoids the the public humiliation that would result from a drop in the share price.
I believe the point that the authors of the study were trying to make, however, is that if executives do not consider options a potential income-generating mechanism ex ante, then options provide no incentives ex post. If executives treat those options as if they don’t exist and never intend to act on them, then in theory, they could care less whether they have options in the first place.
But if the explanation for why Chinese executives are less likely to exercise in-the-money options is truly cultural, then the incentives likely still work as intended. It’s simply that executives are reticent to exercise the options on the way up for fear of how they will be perceived if they do so, and incentivized to continue to keep the share price above the strike price for fear of public humiliation if they do not. In my opinion then, they still serve a purpose.
So in this respect, shareholders of American corporations might be better served if their executives followed the example set by their Chinese counterparts.
For more on executive compensation and options, see my earlier posts A New Approach to Executive Compensation? and Is Restricted Stock the Answer to Executive Compensation?






