Since China opened up to the world with its sweeping economic reforms in the late 1970s, and especially in the past decade as private-sector enterprises have mushroomed, the model of executive compensation in the country has increasingly mirrored ones in the U.S. and Europe.
How is it, then, that Chinese executives are paid only a fraction of the compensation earned by their American counterparts in companies of equal size in the same industries? Or are they?
In China, executive compensation above tens of millions of yuan (1 yuan equals 16¢) would be seen as astronomical and would cause an uproar. In 2007, the latest year studied, China Stone Management Consulting Group used compensation disclosures in companies’ annual reports to analyze data on executive compensation at China’s 200 largest public companies by market capitalization. They found that 64.8% of executives received compensation ranging from 100,000 to 500,000 yuan (about $16,000 to $80,000) and 19.5% between 500,000 and 1 million yuan ($80,000 and $160,000).
A public outcry occurred in 2008 when it was disclosed that the annual salary of Ma Mingzhe, chairman and CEO of Ping An Insurance Group, an insurance and financial-services company, was 66 million yuan ($10.5 million). Yet his salary was nowhere near that of UnitedHealth Group CEO Stephen J. Hemsley, who was listed at the top of Forbes magazine’s 2011 list of highest-paid American executives, with annual income of $102 million, including gains from exercising stock options.
On the other hand, executive compensation in China has always been shrouded in mystery. The majority of Chinese public companies — those listed in Shanghai and Shenzhen — disclose only the individual executive’s aggregate compensation. This number does not usually reflect actual aggregate compensation because it omits such things as hidden payments and extra bonuses. As such, it can represent just the tip of the compensation iceberg.
Are the figures disclosed in the annual reports of public companies in China accurate? What is the true picture of executive compensation in China?
Indirect Compensation
The main source of income for top executives in China is not the disclosed annual compensation or bonuses and dividends, but hidden payments.
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A typical executive in a state-owned enterprise can easily receive hidden income because the on-duty expense level has high elasticity. According to one executive interviewed by China Knowledge@Wharton, the cost of a normal business meal can range from a thousand yuan to tens of thousands of yuan. For overseas business trips, benefits can be obtained and transferred through flexible allocations and use of consumption rights, such as office expenses, travel expenses, entertainment expenses, communication expenses, overseas training fees, expenses of the board of directors and conference fees.
Top-level managers have even greater room to maneuver in than middle-level managers. According to the financial magazine Securities Markets Weekly, the giant petrochemical corporation Sinopec (Guangdong branch) spent millions of yuan on wine in April 2011 for its top executives. It is also common for state-owned enterprises to build housing for their employees.
These types of expenditures fall in the categories of on-duty consumption or incentives. In the U.S., similar on-duty consumption accounts for only a small part of executive compensation and is explicitly provided for in employment contracts. In China, such consumption is not transparent and has become the major source of income for many top executives.
The curtain can be pulled back in some cases: the regulations of the Shenzhen and Shanghai stock exchanges on disclosures in annual reports stipulate that on-duty consumption by executives is to be accounted for as an administrative expense. Hence the “administrative expenses” of public companies can offer a glimpse of the hidden income of some executives.
Using administrative expenses, as disclosed in annual reports, Gao Minghua, director of the Research Center for Corporate Governance and Enterprise Development at the Beijing Normal University, compared on-duty consumption and annual revenue, and listed the top 100 public companies in China in 2010 in terms of on-duty consumption as a percentage of annual revenue for the year. In 10 of the companies, the on-duty expenses exceeded the revenues.
A study conducted in 2011 by Professor Yang Rong of East China Normal University showed that the average on-duty consumption of all individual companies in the data set — the research was based on 1,320 listed companies examined between 2002 and ’09 — exceeded average executive compensation by two to 50 times and has been growing over the years. Indeed, with the exception of a slight decline in 2008 due to the global financial crisis, the growth curve for on-duty consumption at public companies in China soared between the years 2002 and ’09.
Analyses by a number of researchers, including Professor Chen Donghua in the business school at Nanjing University, show that such covert on-duty consumption has no correlation with company earnings or has a negative correlation. In state-owned enterprises, on-duty consumption has a significant negative correlation with company earnings.
Besides on-duty consumption, under-the-table bonuses can sometimes be a major source of income for top executives as well. One interviewee noted that a securities company in China distributed 300 million yuan in cash as bonuses at the end of 2008. The main beneficiaries were those in senior management. Such generous bonuses usually undergo special accounting treatment so that the public is unaware of them.
Stock Options as Benefits
In terms of stock-option incentives, Chinese companies are rapidly adopting the U.S. model. Among 1,725 public companies in China, nearly 250 offer stock-option incentives, with close to half of them beginning to do so in the past two years. Offering such incentives had achieved positive effects, including revenue growth or earnings growth for some companies.
At high-tech companies, stock options are a common form of incentive and have become an important part of executive compensation. In the case of Shandong Sun Paper Industry Joint Stock Co., a public company in the private sector, the average annual compensation of its top three executives was raised from approximately 250,000 yuan to more than four million yuan with the implementation of stock-option incentives, bringing its executive compensation in line with its earnings. Sun Paper implemented its stock-option plan starting in 2008. The earnings-growth rate in 2009 was 52.97%; in 2010, it was 112.93%. At most private enterprises that are going public, stock options have become the norm.
However, stock-option incentives still are not widespread in China. In 2010, they were offered at only about 15% of the 1,725 public companies in the sample. Nor do they generally carry much weight, given that the average ratio of fixed salary to earnings-at-risk is 3:1, with fixed salary and earnings-at-risk accounting for 75.29% and 24.71% of total compensation, respectively.
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Gao acknowledges that stock options are not common in China and believes that they should remain so. Generally speaking, he says, the meaning of incentives is lost when it comes to stock options because of the serious distortions in their use.
Indeed, stock options are morphing into a welfare-system arrangement. In many Chinese companies, the beneficiaries of stock options cover a wide spectrum. For example, the stock-options plan of real estate developer Xinhu Zhongbao Co. in 2010 offered 299.85 million stock options to 851 individuals — approximately 70% of the staff. According to the announcement, the beneficiaries ran the gamut from the chairman of the board to the company’s security department, as well as customer-service representatives of some of the company’s real estate projects.
The strike, or purchase, prices of stock options are significantly lower than prices in the secondary market. The pricing of stock options has a direct bearing on their effectiveness as incentives. The strike prices of stock options at public companies in China are generally lower than their prevailing market rates. The strike prices of restricted stock options in the announced plans of 91 companies in 2010 were mostly lower than prices in the secondary market, with the strike prices of 70% of these companies at only 50% of the prevailing prices of their stocks (on the announcement dates). Some were even less than 30%. It meant that top executives could easily pocket high premiums by the exercise deadlines — a significant departure from the intended purpose of stock-option incentives.
The exercise conditions are extremely lax. For example, spiritsmaker Luzhou Laojiao Co. implemented stock options in 2010 with the condition that the options would not be exercisable if the company’s net profit failed to grow by more than 12% compared to the previous year. Given that the company’s net profit had posted a compound annual-growth rate higher than 33% in previous years, it would be hard to imagine that the options were an effective incentive. Some companies even artificially suppress or withhold their earnings prior to their stock-options implementation in order to lower the exercise conditions.
Executives cash in by resigning from their companies in order to sidestep the exercise period. Exercise periods are necessary for stock options to act as long-term incentives. Top executives are unable to sell the stocks they hold before the expiration of the exercise periods as a way to prevent any short-term actions on their part. However, in the past two years, many public companies in China have seen the departures of top executives soon after their companies went public so that the executives could sidestep the exercise period and quickly cash in their holdings. For example, as of May 31, 2011, a total of 327 executives from the 224 emerging companies listed on the Growth Enterprise Market (GEM), an independent exchange market launched in 2009, had tendered their resignations, equivalent to 8.6% of all senior managers at GEM companies.
Lack of Systems and Laws
China has always sought to learn about modern corporate management from the U.S. and Europe. So how did the philosophy and model it adopted from the West on executive compensation evolve to possess such uniquely Chinese characteristics?
As the Chinese saying goes, oranges grown at the south of the Huai River become tangerines when transplanted to the north. The executive-compensation model in China was shaped by two main factors.
First, China’s systems and laws are extremely inadequate. Taking its capital markets as an example, prevailing provisions in its securities and trading laws are lacking in terms of timely, complete and truthful disclosures. Public companies are only required to disclose the aggregates of their executive compensation. More important, they are not required to disclose their compensation structures. Consequently, most companies make no disclosure of their structures (except for stock options), and the general public has no access to details on the components of executive compensation such as basic salary, bonus, pension plans and on-duty consumption.
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Chinese Company Law also is a prominent issue. For example, the positions of boards of supervisors and independent directors are vague and can have overlapping functions, seriously weakening the roles they play in the supervision of executives. In addition, no provision in the Company Law restricts the selling of shares by executives when they leave their companies, as noted earlier. In China’s capital market, gains that come by complying with regulations are far less than gains that one can receive from contravening them.
Some shortcomings in the capital market emerged as early as a decade ago, but laws to rectify them were not introduced and therefore never passed.
Furthermore, a uniform salary-management system, rather than performance-based compensation contracts, is the norm at state-owned enterprises. Earnings at state-owned enterprises that are in competitive industries and are fully market-oriented come from the competence of management and staff. However, their executives generally can receive only half of what their counterparts in private-sector enterprises of the same size command. Therefore, these state-owned enterprises are inclined to compensate their executives with hidden income.
Second, a professional manager market has yet to take shape in China. In state-owned enterprises, the most important form of compensation for the performance of executives is promotion, and performance evaluation is a political rather than a market outcome. At many private enterprises, there usually is no open and clear contractual agreement between managers and companies, given the practice of “making contributions before talking about compensation.” Hence, specific information such as operating procedures and results, as well as a performance-evaluation process and outcome, are not transparent or announced. The value placed on a manager is the outcome of private maneuvers and is not determined by the market. There is little incentive from, or supervision by, the market.
Finally, because Chinese enterprises are young and eager to seize opportunities to gain wealth, their compensation incentives are usually crudely designed, and only a handful of them have comprehensive retirement plans. According to Liu Zhiqiang, a partner at Hejun Consulting, “with the exception of a small number of companies, such as Huawei, planning only takes one or two phases at many Chinese enterprises in terms of compensation design, and a phase lasts three or five years. Most of them have yet to consider the pension issue.”