The Practice of ESOPs in China
Paper prepared for the International Seminar on Employee’s Ownership in Kent University
Gongyun, SITU, CIRD, China
April 12,2001
The emergence of EO/ESOP in China had attracted great attention from enterprises, in particular mid and small state owned enterprises (SOEs) and local governments in the last decade. In recent years, the ESOP or EO (employees’ ownership) has been widely experimented. Some scholars and officials noted that answers could all or partly be found in the practice of ESOPs or the other forms of EO for such issues as how to set up effective incentive system, how to establish more reasonable income distribution system and how to reform the SOEs through property rights diversification. The paper will mainly discuss ESOP in practice after a review of EO and ESOP in China.
In
the state economic sector, the Employees’ ownership was initiated in the process
of SOEs share holding restructuring in China. In July, 1984, the first
share-holding company in China—Beijing Tianqiao Department Store, Ltd. had, in
its stock structure, set up internal employees stocks, which were bought by her
employees. That was referred as the first case in which EO was adopted in the
SOE’s reform. Subsequently, EO was widely applied in the stock based SOE
reforms. There are mainly three types
of EO in listed share-holding companies. 1). Newly listed companies funded by
social capital through issuing shares can allocate up to 10% marketable shares
to their employees and those shares held by employees can circulate on the
stock market six months after the new shares go public. This operation was
frozen in Nov. 1998. 2). Share-holding companies restructuring were banned to
have EO in Nov. 1994 when the Law of Corporation of P.R.China was issued.
Employees in those share-holding companies completed restructuring before the
law issuance date have to keep their shares three years after the companies go
public before they can be marketable. Some already listed companies can adopt
an ESOP indirectly and collectively with the help of the companies
share-holder.
Up
to the end of 1994, there had been 9069 share-holding companies, and in the
total share capital of RMB yuan 591.71 billion, internal employees’ share was
125 billion, accounting for 20.97%. In April, 1999, the internal employees’
shares in the listed companies were 4.93 billion, making up 1.87% of the total
shares of the listed companies.
In
the non-state economic sector, EO was mainly brought forth by the development
of shareholding cooperative system. Such processes of development and reform
were initiated by spontaneous actions taken by enterprise managers and
employees concerning the property rights determination of the collectively
owned enterprises in the cities and township. The shareholding cooperative
system reform rapidly gained ground in small state enterprises and collective enterprises.
The township enterprises waged a
massive campaign for reform by means of the shareholding cooperative system.
Statistics show that there were 204.1 thousand township enterprises with the
shareholding cooperative system in 1994, a 53.1% of increase from 1993. The new
system absorbed capital of 107.7 billion yuan and involved 8.04 million
employees. According to the data from the Township Enterprise Bureau of the
Ministry of Agriculture, township enterprises with the shareholding cooperative
system nationwide numbered 3 million in 1995 and those in provinces such as
Jiang Su, Zhe Jiang and Shan Dong accounted for approximately 50% of the total
township enterprises.
The
employees’ ownership held through what we called Employees’ Share-holding
Association or Workers’ Union, similar to the US ESOP came into being for
experiment in early 1990s and developed rapidly in the last four years. Here we
refer it as the Chinese ESOPs. This experimentation stared in the foreign trade
sector, when it was confronted with the difficulties to keep those highly
capable business managers. Those state owned foreign trade companies were
transformed into limited companies, with the Employees’ Share-holding
Association as the second share- holder. The fact that this kind of
experimentation was effective to attract good managers and increase the
profitability of the reformed companies gained attention of the scholars, local
government officials and managers of the mid and small SOEs. Subsequently,
experimentation widely started in the mid and small SOEs with the support of
the local governments. In 1999, the central government declared an important
policy change, that is, the state economy will retrieve from the highly
competitive sectors. This new policy stimulated the application of the ESOP in
the reform of the SOEs. Nevertheless, because of the lack of unifies regulation
from the central government, the local governments molded each other, meanwhile
adding their creation based on their own situation, with respect to the
regulations.
Up to the present, almost all the state foreign trade
companies have been reformed with the establishment of ESOPs. And all the
provinces and cities have been adopting ESOPs and EO to reform their mid and
small SOEs.
Option
incentive is a newly emerging thing in China, which could provide long-term
incentive as well as constraint over managers of enterprises. It has been
officially pointed out at the Fifteenth Party Congress that factors of
production such as capital and technique should be allowed and encouraged to
participate in the profit sharing according to the principle of distribution on
the basis of work and factors of production. With such justifications, the
option incentive system was experimented in some enterprises to integrate the
interests of managers with that of the enterprise and avoid short-term oriented
behaviors. Since 1999, the two largest hi-tech companies in Zhongguancun,
Beijing (the silicon valley in China), Lianxiang Group and Stone Group have
implemented stock option for the management, winning wide attention in the
field of enterprise reform.
The
option incentive system is currently encouraged in solely state-funded
companies with fast-growing and development potentials, limited liabilities
companies and shareholding companies where the state has a controlling stake.
The targeted group for option incentive system varies from company to company.
While most of the option incentive systems aim at the management, some extend
the scope to include department heads and chief technicians, with those covered
by the scheme accounting for 20%-30% of the total. The board of directors
offers incentives to the top management while the general manager offers
incentives to key department heads and technicians. After the adoption of such
an incentive system, companies can generally retain a relatively stable team of
strong capability.
China’s
gradual economic reform has entered a critical stage, confronted with challenges
posed by a host of deep-planted problems. Against such a backdrop, it is of
great importance to push forward the practice of ESOPs. At the macro social and
economic levels, ESOPs could improve the combination between workers and
productive resources. In the traditional ownership model under a planned
economy, workers merely acquire the use rights to production materials while
the possession is in the hands of the state, in spite of the claim that state
assets belong to all people and workers are the owners of production materials.
It is highly necessary to turn employees into real owners of enterprises and
realize the “reconstruction of workers’ individual ownership” as claimed by
Carl Marx in a socialist market economy. In addition, ESOPs lends itself to the
formation of a reasonable income distribution system. Under the traditional
system, enterprises follow the policy of offering its employees low salary but
high level of welfare. While low salary is true, the promise of high level of
welfare is not well fulfilled, especially when the reform of housing system,
social security system and education system went ahead. Moreover, there is an
obvious tendency of egalitarian distribution despite the narrow income gaps
between enterprises. Accelerating the income distribution system reform and
adopting various ESOPs are helpful for forming a rational income distribution
system, enhance the income level of urban and rural residents and give
incentives to all parties involved.
In
the perspective of the undergoing SOE restructuring, an important thing is to
diversify the property rights for the sake of the establishment of modern
enterprise system. Moreover, the central government has decided that the state
economy should retrieve from the highly competitive sector. ESOPs adapted to
the practical situation in China is instrumental for the diversification of the
investment structure in state enterprises, strategic restructuring of the state
economy, removal of government’s control and interference with enterprises and
the capital operations of state assets.
In the highly competitive sectors, the mid and small SOE are mainly
under the management of the local governments. In line with the policy set up
by the central government, more than 30 provincial or municipal governments
formulated and declared the guidelines for ESOPs application, push forward the
ESOPs all over China.
At
the micro level of enterprises, ESOPs can unify the interests of employees,
managers and the state, thus strengthening employees’ concern and sense of
owners over the enterprise. Apart from that, it is favorable for the reform of
the incentive and distribution systems and the maintenance of a stable backbone
team in enterprises. Furthermore, it facilitates the reform of mechanisms for
balance and checks as well as decision making. It is true that the maintenance
of a stable team of workers could possibly be achieved through the cultivation
of corporate culture, but economic ties between investors and enterprises are
more reliable.
While
helping with the clarification of property rights and diversification of
investment structure, ESOPs also raises funds for enterprises. Employees’
reserves or welfare funds are one of the important sources for ESOPs funding
and such conversion of part of the consumption fund into capital for enterprise
development is favorable for the improvement of the resources structure.
In
addition, ESOPs are helpful for the solution of a series of problems cropped up
in enterprise reform. First of all, the contradiction between state
enterprises’ huge demands for capital input and their poor ability in repaying
debts could be effectively alleviated. Owing to their chronic tasks of running
social functions and blind production expansions, state enterprises in general
suffer a high level of indebtedness, which in its turn creates huge bad loans
in banks. ESOPs could transfer employees’ savings into a source of enterprise
funding. Secondly, ESOPs can help with the downsizing of enterprise staff.
Without a sound social security system, laying off workers could result in
social unrest. Through the appropriate transfer of the state assets, employees
become the owners of enterprise assets which are synonymous with a considerable
sum for social insurance and pension purposes. Once the employees quit the
enterprise or are laid off, they can easily acquire their insurance fund by
selling their shares.
Up
to the present, ESOPs are gaining increasing recognition from the local
governments and employees, even though different opinions are all around and no
top level regulations are made.
The
ESOPs are experimented under the guidance of the local governments, whose
regulatory policies look similar, some fundamental differences remain, though.
The following important aspects will be discussed.
1. What kinds of enterprises
are experimenting with ESOP?
In
Practice, the local governments have set up limits on the enterprises to be
applied with ESOPs. The first limit is on the organizational types. In most
cases, listed companies are not allowed to practice ESOPs. Beijing also set the
limit on sino-foreign joint ventures and share-holding companies. Zhejiang
province set the limit on the provincially governed companies which have
already had entrusted management in practice. The second limit is on the
industrial sectors. Shenzhen city does not allow enterprises in the following
sector to apply with ESOPs, 1). Post and telecommunication, banks and insurance
; 2). Energy, airport and ports. Anhui province also set the similar limits on
finance, electricity, transportation, tobacco, and city public facilities. In
sum, ESOPs experimentation is allowed in the mid and small SOEs and
collectively owned enterprises in highly competitive sectors. The large scale enterprises
in the competitive industrial sectors but under the governance of the
provincial government have to proceed with strict approval. The SOEs in
monopolistic sectors and public facilities are generally forbidden to have
ESOPs.
2. Share ratio of the ESOPs
over the company shares
Generally
speaking, there are just a few specific limits on the share ratios of the ESOPs
over the total company shares. For instance, Shenzhen city stipulates that the
ESOPs’ share ratio shall be less than 35% over the total company shares when
the total company shares are 50 million to 200 million. ESOPs share ratio can
be 35% to 50% when the total share is 10 million to 50 million, and ESOPs share
ratio can be more than 50% when the total share is less than 10 million. In high-tech
companies and commercial companies, the ESOPs share ratio can be a little
higher the above stipulation. Heilongjiang Province limits the ESOP share ratio
less than 30% over the total company shares in most cases. But Gangshu Province
has the stipulations the other way. It stipulates that the ESOPs share ratio
shall be more than 10% over the total company shares and can be more than 51%
if the companies are not in the monopolistic sectors. After the Central
government has determined that the state economy shall retrieve from the highly
competitive sectors, the local governments have, in practice, been encouraging
the ESOPs hold more than 51% shares of the mid and small SOEs.
3. Capital sources of the
ESOPs’ share
Being
different from the US ESOPs, the ESOPs in China emphasize employee’s own
payment for the shares. Some of the local regulations even have specific
stipulations over it. Provinces like Heilongjiang, Gangshu, Qinghai and Nanjing
city require the capital for the ESOPs shall mainly come from the employees’
own pockets. But in practice, there are several capital sources of the ESOPs.
1).
Surplus of the salary and bonus. In the current accounting system of the SOEs,
there is an item called the surplus of wages and bonus. According to the relevant
government regulations, companies are allowed to set up their total wages based
on total assets, annual sales and other indicators. Companies can also take up
a certain percentage of the annual profit as their bonus. Therefore, the SOEs
usually have a balance of wages and bonus, and the actual amount of which
depends on their previous performance. In practice, companies can utilize this
surplus as a contribution to be the ESOPs’ capital source.
2).
Compensation to the employees. When the ESOPs’ share ratio is more than 51%
over the total company share or when the state is not the biggest among all the
share- holders, the SOE under restructuring shall make compensation to its
employees. The compensation is usually in the form of company assets or shares.
In the case, the reformed SOE is not a SOE any more and its employees have
changed their status as a result. Some cases called it status exchanges. The
compensation is made according to the positions and working years of the
employees. The actual compensation varies from cities to cities.
3).
Borrowing. In practice, a lot of provinces allow the reformed companies lend
part of their public welfare funds to employees, the borrowing shall be paid
back with the yearly share dividends. In a few cases, the biggest share-holders
of the reformed companies can also lend money to ESOPs, and in the cases the
share held by the ESOPs are used as collateral.
4).
Bank loans. Banks are not ready to make this kind of loans to ESOPs for the
following two reasons. First, ESOPs in China now are not the foundational
juridical persons, some in the name of the Workers’ Union and some are
registered as juridical associations, which are not qualified to borrow from
the banks. Secondly, banks in China now do not have the business of making
loans to individuals for share capital. In practice, companies having good
performance and with sound financial accounts did borrow from the banks in the
names of investment or any business acceptable to the banks and re-lend to
their ESOPs, in the form of so called
mirror loans.
5).
Government awards. In some provinces, if a reformed company has a good
performance in terms of state assets appreciation, the government can award up
to 10% of the state asset increments to the managers and other key personnel.
The awards are usually in the form of company shares.
In
addition, some provinces allow their employees to pay the share capital by
installments. But the employees cannot exercise their share-holders’ rights
before they have made a full payment.
4. Ratio structure of ESOPs
In ESOPs, the shares held by the managers
and ordinary employees shall be different. But to what extent shall the
difference is? The local governments have the specific stipulations. There are
five kinds of limits. First, setting the maximum limit, Shenzhen city limits
the shares held by the top manager 5 to 10 times over the average shares held
by the employees. Beijing limits the shares held by the top manager less than
the 5% of the shares held by the ESOPs. Secondly, setting the maximum limits
according to the company registered capitals. Heilongjiang province and Shanxi
province stipulate that the shares held by the board chairman or the general
manager shall be less than 3% of the shares held by ESOPs’ if the company’s
registered capital is below RMB yuan 30 million. If the registered capital is
RMB 30million to 50 million or above 50 million, shares held by the top manager
shall be less than 2% or 1%. Thirdly, setting the minimum limits to encourage
the managers to hold a big share. In Jiangsu province, the government limits
the shares held by the top manager more than 5 times over the averages
employees’ shares. And Hainan province has the similar stipulation.
Currently, there is a tendency that the top
managers are encouraged to hold the majority shares of their companies, in
particular with the small SOEs. There is a case in Nanjing city that five of
the top managers bought out their company with a very attractive price,
together with their promise to keep the jobs of the current employees. Similar
cases can be found quite a few in other cities or provinces, eg. Sichuan
Province and Shandong Province. Some people are worrying that this kind of the
share structure in ESOPs would fix the management, even when they are proved to
be nonqualified after reform and that there is a danger that the interests of
the ordinary employees in the ESOPs would be easily harmed.
5. Management of ESOPs
The
management of ESOPs is an important aspect of ESOPs in China. In practice, the
employees’ shares can be held directly by the employees’ themselves. But in
most cases, they are held through ESOPs managed by the Workers Union or the
Employees’ Share-holding Association subject to the Chinese Corporation law,
which stipulates the numbers of the share-holder for a limited liability
company shall be 2 to 50.
1). Legal status of ESOPs
On
the legal status of the ESOPs, there are four kinds of models in practice in
China.
a.
juridical
associations registered in the Civil Administrative Departments. eg. companies
under the governance of Foreign Trade Ministry, Beijing city, Qinghai province
;
b.
under
the Workers’ Union, eg. Shanghai city, Gangsu, Sangxi, Heilongjiang, Jiangsu
Guangdong provinces;
c.
under
the Workers’ Union, but registered as an juridical associations, eg. Shenzhen
city, Yunan province;
d.
ESOPs
entrusted to be managed by the Workers’ Union or other legal persons.
In
these models, the employees hold the shares of their companies indirectly
through the ESOPs. As the Civil Affair Ministry is attempting to freeze the
registration of ESOPs as the juridical associations, the legal status of the
ESOPs is being threatened. There is a hot discussion on the feasibility of
making use of the legal status of the Workers Union. Lots of the scholars and
officials disagree with it because the Union is an organization to protect the
workers’ interests against the company owners. When they become investors, they
are in the same boat with the company owners. Recommendations are made to set
up China’s ESOPs as funds and managed by the outsiders. But this is not
feasible because of the unavailability of the Trust Law and almost impossible
access to the establishment of funds. Therefore, most of the people agree that
the current arrangement is transitional. China Institute for reform and
development is making efforts to push forward the legislation on ESOPs in
Hainan Province, aiming to solve the legal status problem of ESOPs.
2). Marketability of employees’ shares
Most
of the local regulations on ESOPs stipulate that the employees’ shares are not
marketable, tradable and inheritable. While the regulations make the ESOPs
easier to manage, they are fundamentally decreasing the attractiveness of the
ESOPs, a danger to the success of the ESOPs implementation. In practice,
companies are looking for solutions.
a.
buying-back.
Companies are creating a buying-back mechanism in the management of ESOPs. The
Employees’ Share-holding Association or the Workers’ Union shall buy back the
shares held by those employees who left the companies. An employee left a
company when he/she retire, resign, be fired and dead. The share is priced on
the basis of the net assets per share determined by the company management.
b.
Restricted
market. Some companies allow the shares held by employees traded among the
members of the Employees’ Share-holding Association. They create this internal
stock market for restricted trading. Share prices are negotiable, but based on
the net assets per share announced by the company management.
c.
With
the above two solutions, the top managers of the companies are exceptional.
They have to keep their shares one year waiting for a strict auditing after
they left their positions before their shares can be bought back or allowed to
be tradable internally.
6. Related preferential
policies
The
local regulations have given some preferential policies to the ESOPs.
a.
Discounted
prices of shares The local governments
give discounted prices of shares to the employees when they invest with they
own money, eg. Jiangsu province gives 10% discount. Haikou city, Hainan gives
20% off. The latest version of Shenzhen ESOPs Regulation gives a high discount
up to 35%.
b. Tax free Anhui and Gangsu provinces stipulate that
the employees’ share dividends are exempted from personnel income tax when they
are reinvested. Shenzhen city has the similar treatment but only to the
difficult companies.
It
is pointed out, in the “CPC Central Committee’s Decision on Some Important
Issues in the Reform and Development of State-owned Enterprises” passed by the
4th plenary session of the 15th CPC Central Committee,
that modern enterprise system is the direction of the reform of state-owned
enterprises. The core of modern enterprise system is corporate governance, and
that diversification of ownership is conducive to the formulation of an
effective and standardized corporate governance. It is also emphasized that
state-owned enterprises should be revitalized as a whole and distribution of
the national economy should be strategically readjusted so as to accomplish a
strategic restructuring of state-owned enterprises. Nevertheless, corporate
governance under modern enterprise system does not inevitably relate to the
performance of a company. The final determinants of performance are the
inherent mechanisms underlying the corporate governance. That is to say the
incentive and constraining mechanisms. China’s reform practices have already
shown that, against the background of rapid economic and social transformation,
employee ownership has played an important role in establishing a modern
enterprise system characterized with clearly defined property rights, specific
identification of rights and obligations, separation of the administration from
enterprises, and scientific management. Meanwhile, some studies and experiments
of far-reaching significance have been conducted to explore the roles of ESOPs
in realizing public ownership under the new historic condition, in consummating
the ownership structure under the socialist market economic condition and in
establishing an income distribution system compatible with the socialist market
economy.
At
present, China’s economic reform has entered a critical period and is now
confronted with many important tasks. It can be expected that ESOPs will serve
as an important means to realize the strategic readjustment of the state-owned
economy and strategic restructuring of state-owned enterprises. ESOPs will also
play an active role in revitalizing small and medium-sized state-owned
enterprises, in establishing effective incentive and constraining mechanisms,
and in transforming the operating mechanisms of state-owned enterprises. With
the trend of non-state-owned economy growing stronger and stronger, constant
changes in the original enterprise organization modes will also take place.
Therefore, employee ownership system will have a larger role to play in the
transformation of the operating mechanism and development of private
enterprises, particularly in the growth and development of high-tech
enterprises. At the same time, with the gradual consummation of the socialist
market economic system, external environment for the practice of employee
ownership will further improved. Finally, employee ownership as an important
enterprise system will be legally recognized and standardized.