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July 29, 2005

Guest Column: Share Options Give Market a Boost

[Editor's Note: More than a few multi-national businesses have foregone international adoption of employee stock option plans due to local regulation. Employees in-country may come to believe, wrongly, that headquarters has decided to treat them unfairly when the real obstacle to a corporate benefit is law. A well-intentioned incentive scheme may create a tangle leading to dissension and even disloyalty. Indeed, such a situation has occurred in China.

Over the past few years, Chinese regulators have devoted some thought to a remedy, recently enacting regulation. Today, we turn to Seung Chong, an attorney with Simmons & Simmons in Hong Kong, for a discussion of this development, which, it is interesting to note, involves the non-tradable shares issue. Seung advises on mergers and acquisitions and foreign investment in China.]

Share options give market a boost
By Seung Chong

Last week’s decision by the China Securities Regulatory Commission (CSRC) to allow listed companies to issue share options to employees is a salutary step to boost the domestic markets.

It gives companies the opportunity to add an important constituency to their shareholder base. It also gives the companies a powerful tool to incentivise and retain employees, in particular, senior management who can be rewarded by reference to share performance.

But, in order to take advantage of the regime, a company must apparently have first converted its non-tradeable shares into tradeable shares.

The overhang of non-tradeable shares has been blamed for the underperforming stock market, so the desire to issue options may be a powerful inducement to management to convert the non-tradeable shares.

Multinational companies seeking to standardise their global employment practices have been among the first to implement share incentive schemes in China. But the existing legal regime was not devised with share option schemes in mind.

Grey areas can be found in the rules on securities offerings and “safe harbours” designed to implement a share option scheme. There are also practical obstacles such as the difficulty of remitting foreign currency to exercise options. One solution is to implement cashless schemes. Under this plan, arrangements are made for the option holders to fund the exercise of options, and they are paid the net proceeds of the equity sale. But the problem with cashless schemes is that they defeat the very aim of encouraging long-term holdings by employees.

Some multinational companies have introduced phantom stock schemes or share appreciation rights. These are essentially cash bonus schemes, where the amount is linked to share price rises. Phantom schemes are often seen as undesirable because the payment has to be taken through the profit and loss account.

In devising a new regime, it is hoped that Chinese regulators will create a seamless and internally consistent regime for domestic companies and multinationals. But this may be a tall order.

Several factors need to be taken into account. First, the regulator is in the process of introducing new legal concepts such as the prohibition on companies to provide financial assistance to purchase its own shares.

Second, new option schemes will have to dovetail with the expected amendments to China’s company law. Third, any new regime will have to be an inter-agency effort as State-owned Assets Supervision and Administration Commission oversees many companies that may want to introduce share schemes.

Finally, share option schemes can only work in an environment where good governance is the norm. China needs, among others, tighter rules and enforcement on insider trading and an improved culture of compliance.

[Contact Seung Chong directly by e-mail. This article first appeared in the Financial Times, and is posted here with permission of the author.]

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