almost all the stock option plans issued by listed companies last for quite short time.
According to Qu Hai Xiang and Cao Yan Dong, “concerning the effective duration of stock option, the average duration period is 5.64 years. Comparing to average 10 years’ duration in western countries, stock option compensation in China actually encourages short-termism, which means it is highly possible that executives will take some illegal behaviors to benefit themselves.”59 Zhu Rui Min and Li Chang Qiang believe that “the vesting time in Chinese executives’ stock option compensation is relatively short, only one year. How long executives shall wait before they can exercise rights and how can they exercise their rights are two key issues in stock option compensation and they are shall be designed to provide long-term incentives.”60 Recently, in order to totally avoid the limitation and restriction on them and make “quick bucks”, many executives in Chinese listed companies resign from their companies, which enhances their already existed short-termism.61
Specifically, there are two influential alternatives: one is made by Sanjai Bhagat and Roberta Romano; another is made by Lucian A. Bebchuk and Jesse M. Fried.
(1) According to Sanjai Bhagat and Roberta Romano’s proposal, “(80-90%) incentive compensation plans should consist only of restricted stock and restricted stock options, restricted in the sense that the shares cannot be sold (or the option cannot be exercised) for a period of at least two to four years after the executive’s resignation or last day in office.”65 The reasons why they choose two and four years are “two years should be the short end of the waiting period because managers’
discretionary authority, under current accounting conventions in the United States, to manage earnings unravels within a one-to two-year period. On the other side, four years is a reasonable time for at least the intermediate-term results of the executives’
decisions to come to realization.”66 Under this proposal, executives will have
“diminished incentives to make public statements, manage earnings, or accept undue levels of risk, for the sake of short-term price appreciation,”67 hence, “the proposal will diminish the perverse incentives (to manipulate or emphasize short-term stock prices over long-term value), yet retain the benefits of equity-based incentive compensation plans.”68 There are three important concerns about their proposal: (a) It will lower the risk-adjusted expected return for the executives. Their solution to this concern is to grant additional (restricted) shares and options to them and prohibit them from buying financial derivatives to hedge risks.69 (2) It will cause executives to lack of liquidity. Their solution to this concern is to raise cash compensation deduction ceiling, for example, to $2 million (comparing to $1 million according to current tax law ) and allow 10-15% incentive compensation in a given year not covered by their proposal.70 (3) It will lead to early management departures. They admitted this scenario would happen, but it was not so serious. Because, “managers who develop a reputation for early departures from firm to firm are likely to negatively impact their future career opportunities.”71
2. According to Lucian A. Bebchuk and Jesse M. Fried’s proposal, “after allowing
65 Sanjai Bhagat & Roberta Romano, Reforming Executive Compensation: Focusing and Committing to the Long-Term, 26 Yale J. on Reg. 359, 363 (2009). Such proposal has also been made by other scholars, see Lloyd Blankfein, Do Not Destroy the Essential Catalyst of Risk, FIN. TIMES, Feb. 2009 (“Senior executive officers should be required to retain most of the equity they receive at least until they retire, while equity delivery schedules should continue to apply after the individual has left the firm.”).
66 Bhagat &Romano, supra note 65, at 363.
67 Id.
68 Id.
69 Id. at 367-368.
70 Id. at 368-369.
71 Id, at 371.
for any cashing out necessary to pay any taxes arising from vesting, equity-based awards should be subject to grant-based limitations on unwinding that allow them to be unwound only gradually, beginning some time after vesting.”72 Even executives retire from the company, this requirement is still applied to them, thus (1) removing any incentive for the CEO to accelerate her retirement; and (2) making it less likely that she will focus on short-term results while making decisions for the firm just prior to retirement.”73 Because “each equity grant is made at a different point of time and must be unwound gradually, the executive does not face a situation in which she can cash out almost all of her unliquidated equity at once. Thus, even when the executive is in her last year or two in office, she will still have an incentive to consider the effect of her decisions on long-term share value,”74 hence, executives will be encouraged to pursue long-term interests for shareholders.
2. How to address the short-termism problem in China
This chapter agrees that “the optimal term (of executives’ compensation contracts) would vary considerably by industry, firm, and executive. ... ‘one-size-fits-all’ targets for executive pay term that have real bite will inevitably exceed the optimal mark for some firms and executives.”75 So, this chapter suggests that the CSRC shall make rules to require the listed companies to comply with my following suggestions in order to address the short-termism problem of executive stock option compensation, however, the companies could disobey or change these rules and provide their own solutions as long as they disclose detailed explanations to shareholders. For the focus of this chapter, my suggestion is:
(1) Prolonging the vesting time from 1 year to at least 3 years. It is also suggested by other scholar that “if the effective duration of stock option plan is 10 years, the vesting time shall be 3-5 years; if the effective duration of stock option plan is five years, the vesting time shall be 2-3 years.”76
(2) In China, listed companies do not grant stock options to executives every year.
Considering this reality, the CSRC may require that executives shall only exercise no
72 Bebchuk & Fried, supra note 24, at 1928-1931. Similar approach has also been suggested by David Yermack, see Yermack, supra note 55 (“Companies might benefit by imposing more restrictions on how and when managers can sell their holdings, perhaps by considering limits on the amount that can be liquidated each year or requiring advance notification to the market before a sale takes place (current law requires 48-hour retroactive disclosure).”).
73 Bebchuk & Fried, supra note 24, at 1931.
74 Id. at 1929.
75 Walker, supra note 5, at 461-462. Also see Zhu & Li, supra note 60, at 58-59 (“For each listed company, how long the vesting time shall be and when executives can exercise their rights are determined by the company’s unique conditions.”).
76 Zhu Yong Guo, Studies on the Executives’ Equity Incentives in Chinese Listed Companies(Beijing: Capital University of Economics and Trade Press, 2012), at 80.
more than 20% options that they are granted for the first time every year after 3 years’
vesting time.77 For example, if one executive is granted 1 million stock options at a given year, after waiting for 3 years, in the fourth year, she can exercise no more than 200,000 stock options, in the fifth year, she can also exercise no more than 200,000 stock options, and so on. Then, at least after 8 years, she can exercise all her 1 million stock options. Besides, the CSRC may also require that even executives resign from the companies, they shall still be subject to this requirement, which can prevent the executives from avoiding this requirement through resigning. This approach may deter some executives from taking stock option compensation because they will bear more firm-specific risks and illiquidity, which is not good for shareholders. In order to resolve this concern, I also suggest that if executives are subject to this requirement, the stocks which they gain from exercising their rights are exempting from the restrictions of Article 142 (2) of the Company Law (restriction on selling stocks) and Article 47 (1) of the Securities Law (restriction on short-swing trading),78 which means they can freely sell the stocks and keep the profits. This is a proper balance between long-time holding (from the perspective of shareholders) and risk aversion and needs for liquidity (from the perspective of executives). As Bebchuk and Fried believed, “an efficient contract can be expected to strike a balance between maintaining these incentives and satisfying managers’ legitimate liquidity and diversification.”79