Executive compensation and the split share structure reform in China

Abstract

The split share structure reform in China enables state shareholders of listed firms to trade their restricted shares. This renders the wealth of state shareholders more strongly related to share price movements. We predict that this reform will create remuneration arrangements that strengthen the relationship between Chinese firms’ executive pay and stock market performance. We confirm this prediction by showing that there is such an effect among state-controlled firms, and especially those where the dominant shareholders have a greater incentive to improve share return performance. Our results indicate that this reform strengthens the accountability of executives to external monitoring by the stock market, and therefore benefits minority shareholders in China.

Keywords:

• executive compensation
• split share structure reform
• state ownership
• China

JEL Classification:

• G32
• J33

Acknowledgements

We are grateful to the constructive comments from two anonymous referees, Martin Conyon (discussant), and the participants at the 2012 European Journal of Finance Special Issue Conference on the Chinese Capital Market at Durham. We also appreciate comments of the participants at the 2011 European Financial Management Symposium on Asian Financial Management in Beijing. We thank Chen Wang and Lei Zhang for their excellent research assistance. An earlier version of this paper was circulated under the title ‘The impact of the Split Share Structure Reform in China on the relationship between executive compensation and firm performance’.

Notes

1. There are two types of restricted shares in China: state shares and legal person shares. The state shares can be held by central and local government, either through bureaucratic agencies or affiliated state-owned enterprises (SOEs). The legal person shares can be held by any of the above or by private institutions.

2. There is much anecdotal evidence from the media suggesting that previously restricted shares held by state shareholders have been sold on the stock market following this reform.

• ‘29 firms this year experienced local government stock ownership reductions’ http://finance.ifeng.com/stock/zqyw/20110827/4474686.shtml

• ‘Selling shares – July wave of government stock ownership reduction’ http://stock.hexun.com/2011-07-29/131890710.html

• ‘Local government July stock ownership reduction in 25 listed firms to cash in 3.3billion RMB’ http://www.beelink.com/20110808/2808514.shtml

3. Cheung et al. (2010) show a positive relationship between corporate governance and the market valuations of Chinese listed firms, and find that this relationship is mainly driven by issues associated with shareholder rights. Thus, our finding that minority shareholders of Chinese state-controlled listed firms have benefited from the split share structure reform implies that this reform could contribute to the market valuations of such firms.

4. For similar reasons, Chen, Firth, and Rui (2006) show that the SASAC-based state-controlled firms are associated with significantly lower post-listing stock return performance than other state-controlled firms.

5. He, Wong, and Young (2009) find no empirical evidence that the mandatory adoption of IFRS improved the earnings quality of Chinese firms. Their result mitigates the possibility that the evidence we find in support of our hypotheses could be attributed to the IFRS mandatory adoption instead of the split share structure reform.

6. We thank a referee for this suggestion.

7. This policy was announced in the Ninth Five-Year Plan for National Economic and Social Development and the Outline of Long-Range Objectives Through the Year 2010 (see http://cpc.people.com.cn/GB/134999/135000/8104918.html, in Chinese).

8. For an example, see http://www.chinasecurities.com.cn/xwzx/11/200804/t20080430_1445678.htm (in Chinese).

9. Although the GTA/CSMAR database also provides details on CEO pay only, the data coverage on this variable is limited, therefore its use will substantially reduce our ability to generalize our findings to the cross-section of listed firms in the Chinese stock market.

10. We also replicated our analyses using the logarithm of executive pay and these additional analyses yielded similar inferences to our main findings. We also replicated the regression in Equation (1) using lagged independent variables and obtained qualitatively similar results. However, for brevity, we do not tabulate these findings.

11. Based on Core and Guay (1999), coefficient α₃ can also be interpreted as pay-to-performance sensitivity. There is some debate in the literature on the proper definition of incentives, that is, whether pay-performance sensitivity should be measured as the change in executive wealth due to a firm's percentage or ‘dollar’ return performance. The latter specification assumes that the executive marginal product of effort is constant across firm size, which is a valid assumption only when considering actions that do not scale with firm size, such as the purchase of a corporate jet (Baker and Hall 2004, 769). Our specification instead assumes that the marginal product scales proportionally with firm size, which is valid when considering executive actions that affect the overall value of the firm. We also add, independently, a proxy of firm size to control for its effect.

12. Incentive pay such as stock options was not introduced in China until 2007. Since there are no data prior to the split share structure reform, it is not possible for us to evaluate the impact of this reform on this type of executive pay. The introduction of executive stock options is likely to have influenced managerial incentives for both state-controlled and privately controlled listed firms. Therefore, this introduction is only likely to bias us against finding evidence in support of our hypotheses.

13. If general market conditions (i.e. bull markets) in our sample period drive our findings on an increased pay-to-performance association post-reform, then we should observe this impact among both state-controlled and privately controlled listed firms alike. The fact that we observe a greater change in this association among state-controlled firms, which are more sensitive to the reform than privately controlled firms, is consistent with our hypothesis and strengthens our inference that it is due at least partly (but also significantly) to the reform. It is important to note that our research design accounts for cross-sectional variations in a firm's sensitivity to the reform. We argue that the state-controlled firms are more sensitive to the reform than the privately controlled firms. The empirical evidence we find is consistent with this prediction. Any systematic market-wide impact, such as bear/bull markets, on the relations we investigate in this paper will only bias against us finding evidence consistent with our hypotheses, and not in favor of them.

14. Using the full sample, we also carried out further regression analyses that included an SASAC dummy variable (equivalent to 1 for firms controlled by SASAC and 0 otherwise) as well as the interaction terms of this dummy variable with SSSR × RET and SSSR × ROS in Equation (1) along with all the other independent variables. The results confirmed that the improvement in the association between executive pay and stock return performance following the reform was less pronounced among the SASAC group. For brevity, we do not tabulate these findings.

15. The results of all our regression tests of hypotheses H₁–H₃ are robust to standard errors clustered at the firm level.

16. We thank the two reviewers for suggesting these future research questions that can be conducted on the basis of the findings of our study.