ESOPs in a Transitional Economy: the China Case

Gongyun SITU, CIRD, China

This paper will examine the use of ESOPs /EO in several cases of the Chinese companies in the 1990s. The use of the ESOPs/ EO has increased and deepened over time, in part in response to local governments regulations. Although the practices of ESOPs/ EO are substantial and growing in China, they are discouraged due to the lacking of the support of a unified national policy. To promote the adoption of the ESOPs/EO, more efforts should be made in respect to several important elements of ESOPs.

I. Background: Developments of ESOPs/EO in China

The emergence of ESOPs/EO in the early 1990s had attracted great attention of many analysts and decision-makers in industry, governments and academics. In the last decade, ESOPs/EO has been widely experimented in SOEs, from the coastal areas to interior provinces, accompanying the transition of the Chinese economy from the planned system to a market-oriented one. The reform of the SOEs has also witnessed the focus change from the adjustment of the relations between governments and enterprises to that of the structure of property rights. Recently, the establishment of a long-term incentive mechanism in companies has been emphasized, in particular with information-technology firms. ESOPs/EO is believed to be the right choice.

The development of ESOPs/EO can be traced to the introduction of stock system in 1984 in China. Bu the widespread adoption of ESOPs/EO in the reform of SOEs and collectively-owned enterprises started in 1992. The around ten-years’ development can roughly be examined in the following three stages:

The 1^st stage: from the end of 1992 to 1995. In the stage, the employees were motivated to invest out of their own pockets in the small-sized SOEs and collectively-owned companies that they were working for. These enterprises were restructured to be cooperative companies. Workers in the mid and large-sized enterprises bought some shares of their own companies when these companies were undergoing share-based reforms. The property rights structure in this stage is characterized by that employees holding a slight ratio of shares of their own companies.

The 2^nd stage: from 1995 to 1998. In the stage, employees were encouraged to buy out all the assets of small SEOs, which were restructured to be collective companies or stock companies afterwards. In the case of mid and large-sized enterprises, employees bought part of the net assets of the companies collectively in the names of Employees Stock Ownership Association. These enterprises were then been reformed to the limited companies owned the state and Employees Stock Ownership Association.

The 3^rd stage: from 1998 to the present. In the stage, employees are encouraged to hold the majority shares of their companies. Big differences of share held by managers and ordinary workers are allowed. And in the city of Nanjing, Jiangsu Province, the managers are supported by the local governments to buy out their companies.

Up to the present, ESOPs/EO has become a widely applied instrument in SOEs reform with respect to property rights diversification. More than 30 provincial, municipal and county governments have drawn up the regulations or rules over ESOPs/EO. Although comprehensive evaluation cannot be made right now, it is fair to say that ESOPs/EO is a reform instrument full of vigor and vitality from the fact that it is widely recognized and adopted by SOEs and local governments in their efforts of enterprises reform.

II. ESOPs/EO: theoretic exploring

The practice of ESOPs/EO in China has not been smooth. The concept of privatization was a sword suspending over the heads of those pioneers. Although the country has far undergoing the transition from the planned economic system to a market-oriented one, the traditional socialist economic theory still has its influence. The reproach that ESOPs is privatization can be heard here and there. Some theorists have been trying to give a sound explanation. Prof. Wang Jue (1999), a senior economist from the Central Party School, argues that ESOPs is an effective realizing form of socialism, because the economic reform has been put forward in the background that market economic system and socialism are both immature in China. The socialist system can be promoted by redistributing rights and interests. Prof. Chi Fulin (1999, 2000), president of China Institute for Reform and Development (CIRD), puts forward a new concept called Labor Property Rights, according to which, the laborers should not only be paid but also to some extents enjoy property benefits. Labor property rights are mainly reflected in the ownership of part of the profits of the enterprises as employees’ shares. He argues that, in the situation of China, not only the role played by the workers in the immediate value increase should be recognized, but also their great contribution in the past value accumulation of the enterprises. He believes that the establishment of the labor property rights is beyond of the scope of general income distribution, and it directly touches the very foundation of income distribution.

International experts have recommended that the US model of ESOPs can be adapted to the Chinese situation of SOEs’ reform. David Elleman from the World Bank (1998) urges that the US ESOPs should be introduced into the transitional economy like China with some adjustment. He agrees with the China practice that the employees invest some of their own money in the ESOPs to share the risk of companies’ business. In the perspective of the marketability of employees’ shares, he recommends that the US model can be followed. John Manke, a senior consultant from San Francisco, and Dan Guttman, senior consultant from New York both suggest (1999) that an ESOP company with “I owe the state” may be set up to replace a SOE. The swap of debt to equity shall be completed with an agreed time until the ESOP owes the company at last.

From the perspective of application, scholars have urged the Central Government to formulate a unified regulation to direct the adoption of ESOPs/EO in China. Prof. Wang Baoshu (1999), dean of law school of Tsing-hua University, points out that the practice of ESOPs/EO needs the protection of a national law. Presently, more than 30 local regulations vary in some critical elements, which will increase the cost of the standardization in the future. In addition, the sluggish formulation of a national law over ESOPs has become a discouraging force. Some economists are worried that ESOPs will lock all the employees in their companies, which will block the solution of SOEs’ over-employment. Dr. Chen huai (1999), a famous economist from the Development Research Centre of the State Council (DRC), argues that the key issue of the SOEs is over-employment or under-employment. To increase companies’ market competitiveness needs to layoff some employees at present.

The arguments are there, though, more scholars and junior officials have held very positive attitudes towards ESOPs/EO. Their findings have been written into the local governments’ regulations in the form of ESOPs/EO adoption purposes, which can be summarized as the following:

---to promote the deepening of enterprise reform and setting up of the modern enterprise system;

---to facilitate the property rights diversification;

---to standardize the management system and operation mechanism of stock companies;

---to offer employees a real stake in their companies and share a common interest with other share-holders;

---to establish formal communication and consultation channels and encourage the participation of employees in management;

---to set up a supplementary scheme to the pensions of the employees.

III. Practice of ESOPs/EO: the Cases

The adoption of ESOPs/EO was initiated by the enterprises themselves with the assistance of consultants. That was followed by the local government intervention with supportive policies and technical assistance. Facts show that this new system has helped the majority of those companies developed steadily in the last decade. The following cases tell three different stories that ESOP/EO has been applied in the reform of SOEs for property rights diversification and company incentive establishment.

Case 1: Hainan Coconut Group, an ESOPs/EO pioneer

Hainan Coconut Group, a leading soft drink producer in the Chinese market, was a bankrupting SOE producing canned fruit in 1986. A competent manager, Mr. Wang Guangxing, was invited to be the general manager, who requested the right to take substantial reform measures with the enterprises. In 1992, the company became a very competitive soft drink producer in the Chinese market. More substantial reform measures including employees’ ownership were introduced into two plants of the company. In 1998, Hainan Coconut Group was developed into a national 4^th soft drink producer with the total assets of RMB 600million and 4,000 workers. In 2000, the company had to confronted with the fierce competition from several private companies and Sino-foreign joint ventures and its market share status deceased from the 4^th to the 7^th. To reverse the trend, in early 2001, CIRD joined the group in its further reform by offering training programs with ESOPs/EO in and outside China, ESOP plan designing for the whole group and seminars with local government officials. Presently, Hainan Coconut Group is owned entirely by its employees. An Employees’ Stock Ownership Association (ESOA) was set up to manage all shares. The detail key elements are the following:

---share distribution: ESOP 80%, reserve 20% for share bonus. Within the ESOP, top managers 20%, mid managers 20%, workers 60%.

---capital sourcing: investment from employees’ own saving (20%), compensation to the employees (17%), company balance of the salary and bonus (8%), discount (20%), borrowing (35%).

---marketability: ordinary workers, after retiring, can sell their shares within the company with the approval of ESOA. The new employees have the priority. The ESOA will have a guiding price for the shares based on the net assets of the company. Employees leaving the company before retiring can only sell part of their shares including shares obtained with their own investment and government compensation. The top managers and key technicians are not allowed to transfer their shares but to be inherited by their next generation, unless the company board gives a special approval.

Case 2: Dazhong Taxi, ESOPs control two listed companies, China’s Taxi giant

East Dazhong ( Pudong Dazhong ) and West Dazhong (Dazhong Communication) were two listed taxi companies in Shanghai city. West Dazhong was the biggest share- holder of East Dazhong. Before 1997, these two companies were competitors in the taxi market of the city. In 1996, Mr. Yang Guoping, general manager of West Dazhong and president of the board of EAST Dazhong, called on a meeting participated by the board members of two Dazhong, in which a decision was made to take substantial adjustment to the share and products structures of the two companies. In Feb., 1997, around 2,800 employees from the two Dazhong decided to set up an Employees’ Stock Ownership Association (ESOA) under the Labors Union of the companies. According to their plans, the top managers should invest RMB200,000, mid managers RMB100,000 and ordinary employees (taxi drivers) RMB 10,000 to 30,000. With the total investment of RMB70million from all the employees, their ESOA controlled 95.71% shares of Dazhong Enterprise Management Limited (Dazhong EM). Subsequently, Dazhong EM took over 20.08% shares of the East Dazhong from West Dazhong at the price of RMB 111.8 million with the help of bank loans and became the biggest share-holder of the East Dazhong. The Dazhong ESOA went further. In 1999, with the approval of the China Securities Supervision Commission, East Dazhong invested in West Dazhong with a package of 1,000 taxies, shares of the other companies and more than RMB37million, equivalent to RMB 465 million of investment. In this way, Dazhong ESOA controlled two listed companies with a total assets of RMB4.4billion. In Dazhong ESOA, ordinary employees are allowed to transact their share within ESOA, by selling shares at the price of the net assets per share of the company to ESOA, who in turn sells these shares to those who want hold more. As the value of shares has got an annual increase of 20%, there has been a shortage of shares transacted. But managers are obliged to keep a certain volume of the shares when at position.

Case 3: New Development: MBO

Nanjing Chengdguang Manufacturing Factory (Chengguang MF), a mid-sized SOE in Nanjing, capital city of Jiangsu Province, one of the most developed coastal provinces in China. In 2000, the factory had a total assets of more RMB50million and net assets of RMB 23 million, with an employment of around 300. The local government decided to use ESOP/EO to reform the SOE. At that time, there was a hot discussion on the technical elements of ESOPs. The key issue was that how the shares should be distributed among the employees, in particular the difference between managers and ordinary workers. Another issue that caused much attention was that how the ESOPs should be financed. Nanjing municipal government was trying to restructure the ESOPs in the city. It requested that ESOPs in the small and mid-sized companies be the biggest share-holder and in the ESOPs the managers hold dominated shares. So, it decided to go further and use MBO in the reform of Chengguang MF.

The factory was finally in 2001 sold to the five top managers at the price of RMB 23 million. The managers were required to pay around RMB8 million, deducting RMB15million of the government compensation to every employee while they were obliged to keep the life jobs of all the employees. The government also provided the financing support to them by offering loan guarantees.

IV. Why ESOPs/EO in China still at Experimentation?

ESOPs/EO in China is a substantial instrument of SOEs’ reform. Nevertheless, it is still at the stage of local experimentation. There are a lot of explanations for this phenomenon. John Logue (1999)concludes: “state and provincial legislative measures can encourage expanded ownership; regional and local programs are efficient providers of technical assistance to those seeking to implement employee ownership; and local action can encourage the creation of collaborative company networks, training cooperatives and employee-owned suppliers. But in present China the Central Government’s recognition is most relevant.

ESOPs/EO are favored by the local governments, because they have found it a good instrument in SOEs’ restructuring, in particular with those small and mid-sized companies. To adopt ESOPs/EO in the reform of SOEs is usually agreeable to the managers, who are frustrated with the establishment of companies’ incentive mechanisms. Moreover, the central government has decided that the state economy should retrieve from the highly competitive sector. Therefore, 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 setting up of a long-term incentive mechanism.

Nevertheless, the reform experimentation with ESOPs/EO has been almost halted due to the recognition differences, lacking of a national unified policy and legislation.

First of all, fundamental differences in theoretic recognition matter most. The proponents argue that the adoption of ESOPs/EO can be a strategic choice for the SOEs’ reform presently in difficulties. The ESOPs/EO applied in the reform of SOEs is an important creation for the state property rights diversification and should be in line with the establishment of modern enterprise system. The oppositionists react that the adoption of ESOPs/EO in the reform of SOEs will produce new inequity and block the market-oriented reform of SOEs.

Secondly, the system construction with ESOPs/EO remains at the stage of local regulations, lacking the support of a national unified legislation. Up to the present, we have had more than 30 local regulations formulated by the provincial, municipal and even county governments. The latest is a revised version of “Regulations of ESOPs in Shenzhen City” by Shenzhen Municipal Government in 2001. All of these regulations state, at the very beginning, that they are formulated according to the “Company Law of People’s Republic of China”, “Ordinances of Social Juridical Associations” and “Labor Union Law of P.R.C”. But there are no clauses in those laws and regulations supportive to the ESOPs. In addition, in “the Company Law” issued in 1999, there is a clause stating that no company stocks should be issued to employees in the newly established stock companies. The policies encouraging employees to participate in the stock reform of SOEs have become suspended in mid- 1990s. Hence, the local regulations over ESOPs/EO are varied and even in contradiction to the current laws. Problems arose here and there in the ESOPs/EO practice.

Thirdly, some of the bad operation of ESOPs/EO exerted negative influence on public opinion. In the adoption of ESOPs/EO of some SOEs, the companies promised to give a profit distribution much higher than bank interest and failed to do so. In other cases, employees were compelled to buy the company stocks, being connected with their job safety. They would be moved to the job positions with low salary or their salaries were cut down to an unreasonable level if refused to buy stocks. The worst case was that the employees were fired when they failed to obey. The managers in some companies may cooperate with the accounting firms to forge on the evaluation of the state assets and caused serious loss of the state interests. All these events, though not the main stream, have exerted much negative influence on the public opinion.

V. What to be done with ESOPs/EO in China?

To push forward the practice of ESOPs/EO in China, the governments, in particular the Central Government needs to take a few measures.

First and foremost, national and /or subnational legislation over ESOPs/EO is badly needed. At present, with the legal status of the ESOPs, there are four kinds of models in practice in China.

--juridical associations registered in the Civil Administrative Departments, Hainan Coconut Group case, and companies under the governance of Foreign Trade Ministry, Beijing city, Qinghai province ;

--under the Labor’s Union, Dazhong Case, and Shanghai city, Gangsu, Sangxi, Heilongjiang, Jiangsu and Guangdong provinces;

--under the Labors’ Union, but registered as an juridical associations, eg. Shenzhen city, Yunan province;

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 Labor’s 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. So, China Institute for Reform and Development (CIRD) is making efforts to push forward the legislation on ESOPs. CIRD put forward three options. It recommends to add regulation clauses over ESOPs in the revised Company Law of P.R.China; or to have a independent national legislation over ESOPs; or to legislate locally over ESOPs, starting in SEZs like Hainan Province. The legislation over ESOPs is extremely important because it provides legal protection to the interests of employees participating in ESOPs. Without it, the local government, enterprises and employees al become increasingly hesitant toward the adoption of ESOPs.

Secondly, to make appropriate policy changes of banks so that ESOPs/EO can be effectively financed. Presently, the capital sources of the ESOPs are quite limited, creating operational barriers to the practice of ESOPs. While it may be a good arrangement to have the employees investing out of their own saving to ESOPs, this arrangement is not very feasible because of the small saving capacity of ordinary employees due to the low and equal income distribution policy before. Currently, in practice, companies and local government have found some solutions, namely:

--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.

--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 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.

--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.

--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.

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.

Of the measures described above, surplus of wages and bonus as a capital source is only applicable in some SOEs. In most cases, SOEs have been suffered several years’ losses and the surplus can be only pocket money or simply zero. Government compensation is only used in a few cases when the SOEs have been reform into limited companies, in which the state becomes a minor share-holder. Personal borrowing helps little and bank loans are extremely difficult in operation. Therefore, to introduce leveraged ESOPs in China is of significance. This requires the banking policy be adjusted to make loans for investment of ESOPs of financially sound companies. Mingshen Bank, the only private bank in China, has started this service, but only to those ESOPs of the financially strong companies, in particular the 50 biggest listed companies. Local governments may set up funds offering ESOPs loan guarantees like what they have done to the risk investment in high tech companies.

Thirdly, preferential tax policy needs to be formulated to support the practice of ESOP/EO. In some provinces, preferential tax policies have been issued in favor of ESOPs. 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. The other local governments are not prepared to follow the suit. The preferential tax treatment from the Central Government will be of much more significance, because the Central government holds more of the relevant taxes. The tax holiday policy shall also be applicable to the financial institutions having supported the ESOPs, like what are being done in the U. S. In addition, services by the trust companies should also be encouraged.

At last, mechanisms should designed and set up to allow for marketability of employees’ shares. Most of the local regulations on ESOPs in China 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. In practice, companies are looking for solutions.

-- buying-back. Companies are creating a buying-back mechanism in the management of ESOPs. The Employees’ Share-holding Association or the Labors’ 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.

--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.

--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.

In the above operations, the share price matters most. The current situation is that the majority of the companies have just started to adapt to the new accounting system. In accordance to the accounting rules still in practice in many companies, it is very difficult to tell the net assets of the companies, which are the basis for share pricing. To make the restricted share market and buying back mechanism effective, the companies have to be obliged to the newly established modern accounting system, which much more efforts from the governments is required.

References:

1. Labors Should Have Their Shares, by Wang Jue, the Chinese Economic Press, 1999.

2. Reforms Determines Future, by Chi Fulin, the Chinese Economic Press, 2000.

3. [i]China’s Income Distribution System Reform and the ESOPs, by Chi Fulin, the Chinese Economic Press, 1999.

4. [ii]ESOPs in China: Standardized Practice and System Designing, by Chin Fulin, the Chinese Economic Press, 2001.

5. Think Globally, Acting Locally by John Logue, 2001.

6. [iii]Journal of Listed Companies, 10^th edition, 2000. Shanghai Securities Exchanges.