Equity Incentive and Company Law Theory and Legal Practice

Author: Chen Wen
Publisher:
Publishing Date: 2005-07-01
Features: The vast majority of companies in our country face the practical issue of introducing and establishing equity incentive mechanisms. Equity incentive mechanisms are an extremely important component of modern corporate governance, and the establishment and implementation of equity incentive systems are closely linked to effective corporate governance. To address this, the author of this book analyzes and explores the various legal issues faced in implementing equity incentives in China, proposing feasible solutions. The author provides a detailed introduction to the operational practices of equity incentives and corporate governance, examines typical cases of various types of equity incentives, and offers various solutions and contract texts for equity incentives and corporate governance. With the establishment of modern corporate systems, issues of corporate governance have become prominent. The characteristics of modern corporate systems are the diversification of corporate equity and the separation of ownership and management. The direct contradiction arising from the separation of ownership and management is the long-term interests of corporate managers not aligning with the long-term interests of shareholders. Driven by the desire to gain benefits, many corporate managers may risk sacrificing the long-term interests of shareholders and the company to pursue their own interests maximization, leading to the emergence of agency risks in modern corporations. To mitigate or avoid such agency risks, economic and legal experts in Western countries have designed and established the executive stock option incentive system. Companies grant stock options to managers, allowing option holders to exercise the options at a predetermined price and gain the difference in stock price when the stock price rises within a specified period, with the option to sell immediately or wait for a more favorable stock price. If the stock market price falls below the predetermined exercise price during the exercise period, option holders can choose not to exercise. In reality, option holders are granted the right of choice. This stock option incentive system, which provides long-term incentives to corporate managers, effectively resolves the conflict between the interests of shareholders and the interests of managers, integrating the long-term interests of managers with those of shareholders and reducing agency risks. The United States and some other developed Western economies were the first to adopt the corporate stock option incentive system, effectively addressing the conflicts arising from the separation of ownership and management in modern corporate governance and improving the corporate governance structure. The reform of China's company system began in the early 1990s. Since May 15, 1992, when the State Commission for Reform and other organizations jointly issued the "Pilot Measures for Shareholding Enterprises" and subsequently the "Regulations on the Standardization of Joint Stock Limited Companies" and "Regulations on the Standardization of Limited Liability Companies," state-owned enterprises in China entered the stage of company reform and began to establish modern enterprise systems. In November 1994, China promulgated the Company Law, legally standardizing and guaranteeing the establishment of modern enterprise systems. To date, China has more than 1,200 listed companies. In just over a decade, China's company system reform has innovated and advanced the path that other developed Western countries took decades to achieve. Due to China's unique historical background, the vast majority of joint-stock companies and listed companies were reformed from original state-owned enterprises, with substantial state-owned assets resulting in absolute control of equity in modern companies after reform. The absolute control of state-owned equity has led to the formalization of the shareholders' meeting and the concentration of power, creating the characteristic of state-owned equity dominating the market. The centralized control of state-owned equity has effectively transferred the power of the highest authority, the shareholders' meeting, to the company's decision-making body, the board of directors. The agents of the major shareholders of state-owned equity hold the positions of chairman and general manager, completely controlling the company's management. Although companies have formally adopted the joint-stock system, many listed companies remain essentially administrative companies, with chairmen and managers appointed by government departments. The corporate governance structure of China's joint-stock companies has always suffered from serious problems from the beginning. Due to decades of planned economy, the ideology of egalitarianism has deeply rooted in state-owned enterprises. When companies were reformed, this ideology was naturally carried over to the reformed joint-stock companies. State-owned enterprises had long emphasized spiritual incentives for outstanding leaders while neglecting material and financial incentives, a trend that continued in joint-stock companies after reform. In China's modern corporate governance structure, attention has been focused solely on the main roles of the shareholders' meeting, board of directors, and supervisory committee, while the rights and obligations of managers, who are also key subjects in corporate governance, have been long ignored. As a result, incentives for managers have rarely been formally discussed, and there is no legal recognition or protection of long-term incentives for managers. A peculiar phenomenon in China's joint-stock companies is that state-owned equity, although holding an absolute majority of about 60% of the total equity, cannot be listed and traded. The property owners of state-owned equity have long been vacant, and their agents, not being the true owners of the equity, are not fully committed to its preservation and appreciation. China has long lacked legal and policy provisions for material incentives for the agents of state-owned equity and company managers. When managers work hard to increase corporate profits but see no direct financial benefits, they are naturally inclined to act or inact in their own self-interest, ultimately harming the interests of shareholders, including those of state-owned shareholders. The experience of China in establishing modern company systems over the past decade tells us that the management team of company executives is a crucial subject in the corporate governance structure, and the equity incentive system is the core of effective corporate governance. For a long time, how to establish and improve the corporate governance mechanism has been a difficult issue for China's legal and economic scholars to research and explore. In the study of corporate law theory on corporate governance and the practice of improving corporate governance, the most challenging and least resolved issue is how to align the interests of the company's management team with those of shareholders and the overall interests of the company. Many cases of listed companies and joint-stock companies in China have proven that if long-term material incentives are not provided to the management team, the long-term interests of the company and shareholders will not be directly linked to the management team, leading to intentional actions or inactions by the management team in the actual operation and management of the company, increasing unnecessary costs and management expenses. The growth of corporate profits is unrelated to the management team, resulting in some senior executives taking risks to sacrifice shareholder and company interests to receive rebates or embezzle company assets, a situation that has occurred multiple times in the high-level management of many companies in China. This is particularly severe in corporate governance structures dominated by "insider control." According to the current normal compensation methods, levels, and compositions of most management teams, their rewards are far out of proportion to their efforts, and their labor does not receive corresponding financial returns, inevitably creating psychological imbalances. For the management teams of many listed companies, since the company cannot link their performance and compensation to the company's economic performance, they are compelled to prioritize their own interests over those of shareholders and the company. Under the system of labor distribution, "more work does not mean more gain," which clearly violates the laws of value and economics. If this continues, it will deviate from the original purpose of our reform and modern enterprise system establishment. The economic base determines the superstructure. In developed economies, legislation advances with economic development, while in underdeveloped economies, legislation lags behind. At the same time, we know that economic reforms or economic activities always lead the way, while relevant legislation follows. The theoretical research, practical activities, and corresponding legislation on equity incentives in the United States and other developed Western economies have long been mature, indicating that these countries have earlier adopted corporate equity incentive practices, with their legislation accordingly leading the way. Therefore, when researching and discussing corporate equity incentive issues, we can draw on their experience and absorb beneficial components. Currently, China's relevant laws, especially those closely related to company organization and operations, such as the Company Law, Securities Law, Tax Law, and Accounting Law, do not contain provisions on equity incentives, indicating that legislation in this field is still a blank. Only policies from the Central Committee of the Communist Party of China and regulations from relevant state departments and local government provisions address equity incentives, but they have not yet reached the level of law. In my opinion, China's enterprise reform and establishment of modern enterprise systems have their own unique historical background and characteristics. When establishing an equity incentive system, China should fully consider its own characteristics, neither neglecting the regulation of stock option issues in legislation nor blindly copying Western legislative and management models. Through an in-depth understanding and investigation of the operational processes of Chinese joint-stock companies and listed companies, we can identify the general patterns and characteristics of their operations, analyze the problems of the management team in modern Chinese enterprises, and conduct in-depth legal research on the equity incentive system of Chinese companies from the perspective of legal relations and legal systems. This will provide a new legal understanding of stock option issues, thereby improving the regulation of stock option incentives and related legal issues in China's Company Law, Securities Law, Tax Law, and other relevant laws. In the theoretical research and practice of the Company Law, if the core role of the stock option incentive system in corporate governance is ignored, the corporate governance structure will fail to achieve a balance of interests in resource allocation, ultimately hindering effective corporate governance. In modern enterprises, the separation of ownership and management is an inevitable trend, especially in the knowledge-based economy of today. According to human capital theory, the material capital of shareholders and the human capital of the management team together create value. Therefore, the management team, as managers, has the same right as the material capital investors—shareholders—to share in the residual value. Although the management team is not legally shareholders and has not directly invested cash capital in the company, they have practically invested their professional knowledge and management experience into the company's daily operations, and this investment is continuously ongoing. From the perspective of investment, the management team has actually invested in the company, just like shareholders, but the form of investment is different. Shareholders' investment is solid and one-time, while the management team's investment in management skills and knowledge is continuous. Therefore, the company's return to the management team should be in the form of long-term incentives, with stock options being the most appropriate. Due to the rapid pace of China's modern company system establishment, many laws that should accompany it have not yet been issued, especially those related to stock option incentives. The lack of a long-term equity incentive mechanism for the management team in China's current company system reform innovation has, to some extent, hindered the progress of modern company system reform. Although some listed companies have independently tried to implement stock option incentives, due to the lack of theoretical guidance and legal protection, they have not achieved the desired results. As the modern enterprise system spreads in China, an increasing number of state-owned enterprises and other companies will be reformed into joint-stock companies, and more joint-stock companies will go public. If China cannot effectively regulate the stock option incentive issues of the management team through law, the problem of "insider control" in companies will be difficult to resolve, ultimately failing to protect the interests of the state, shareholders, the company, and even the public interest. Our enterprise reform and innovation will also face obstacles. In recent years, some of China's listed companies have also tried to implement stock option incentives, but due to the lack of theoretical research on stock option incentives in both the economics and legal fields, as well as the absence of supporting legislation, the implementation of the corporate stock option system has not yielded satisfactory results. The stock option incentive mechanism is an important part of improving the corporate governance structure. If the stock option incentive system is established and legally protected, it will inject new vitality into the management team in the corporate governance structure. The current state of legal research on stock option issues by China's legal scholars is unsatisfactory. Although the economics and legal fields have recently engaged in lively discussions on corporate stock option issues, with some scholars publishing articles, most of them draw heavily on foreign theories and views, with fewer substantive discussions specifically tailored to the particularities of Chinese companies. Especially from a legal theory perspective, there is even less discussion on stock option incentives, with almost no legal monographs on stock options. Therefore, it is even more important to conduct in-depth research on stock option legal issues in light of China's current situation. Therefore, when discussing the legal issues of stock option incentives, we should fully consider China's unique political and historical background in company reform, analyze the current status and legal issues of stock option implementation in Chinese joint-stock companies, explore methods to resolve the series of legal issues arising from the implementation of stock option incentives in Chinese companies, and remove legal obstacles to stock option incentives. At the same time, we should discuss the significance and legal value of implementing the corporate stock option incentive mechanism in China, further study how to legally recognize and regulate the stock option system, and fundamentally resolve the issue of aligning shareholder interests with those of the management team in modern Chinese enterprises. In this book, the author concludes: 1. The equity incentive system plays a very important role in establishing modern enterprise systems, but the implementation of stock options in China cannot be detached from the country's realities. Establishing an equity incentive system is essentially establishing a comprehensive governance system, which requires supporting legal and policy environments. Only under conditions of sufficient competition, reasonable and effective interest balance in corporate governance, a sound legal capital market, and a mature professional manager market can stock option incentives be truly implemented. 2. In a well-improved corporate governance structure, it should not merely be the traditional tripartite structure of the shareholders' meeting, board of directors, and supervisory committee, but should also include the management team as a key subject of corporate governance. In modern enterprises, the management team actually controls the daily operations and management of the company, making their position in the corporate governance structure extremely important. 3. The diversification and decentralization of modern company equity in corporate governance?book_contents=Preface Upper Part: Stock Options and Modern Corporate Systems Chapter 1: The Legal Connotation of Stock Option Incentives 1.1 The Legal Nature of Stock Options 1.1.1 The Origin of Stock Options 1.1.2 Types of Stock Options 1.1.3 Legal Characteristics of Stock Options 1.2 Distinctions Between Stock Options and Related Concepts 1.2.1 Standard Stock Options in the Option Market 1.2.2 Stock Options and Standard Stock Options 1.2.3 Stock Options, Equity Options, Technical Shares, and Management Shares 1.2.4 Stock Options and Warrants 1.3 Legal Relationships Arising from Stock Options 1.3.1 Quasi-Shareholders Before Exercising 1.3.2 Shareholder Relationships After Exercising 1.3.3 Resulting Interest Distribution 1.4 The Legal Substance of Stock Option Contracts 1.4.1 Affirmation of Future Rights 1.4.2 Supplementation of Labor Contracts 1.4.3 Constraints and Limitations 1.5 Examples and Practical Analysis of Stock Option Contracts 1.5.1 Stock Option Contract 1.5.2 Practical Analysis Chapter 2: The Theoretical Basis of Stock Options 2.1 Principal-Agent Theory 2.1.1 Principal-Agent Theory in Economics and in Law 2.1.2 Formation of Agency Costs 2.1.3 Regulation of Agency Costs 2.2 Human Capital Theory 2.2.1 Interdependence of Human Capital and Material Capital 2.2.2 Recognition of Human Capital Value 2.3 Corporate Governance Structure Theory 2.3.1 Preconditions for the Formation of Corporate Governance Structure 2.3.2 Formation of Power, Interests, and Supervision Mechanisms 2.3.3 Methods of Aligning Goals Chapter 3: Stock Option Incentives and Corporate Governance 3.1 Marks of Modern Enterprise Systems 3.1.1 Conflict of Separation of Ownership and Management 3.1.2 Resolution of Conflict—Stock Options 3.1.3 Foreign Practices of Stock Options 3.2 Incentive and Constraint Balancing Mechanism 3.2.1 Necessity of Incentive Settings 3.2.2 Necessity of Supervision and Constraint Mechanisms 3.2.3 Role of Incentive and Constraint Mechanisms in Corporate Governance 3.3 Analysis of Corporate Governance Without Incentive 3.3.1 Review of the Path of State-Owned Enterprise Reform 3.3.2 Legal Consequences of Incentive Shortage 3.3.3 Historical Analysis of Incentive Shortage 3.3.4 Obstacles to the Development of Modern Enterprise Systems 3.4 Case Analysis of Stock Option Incentive Plans 3.4.1 Analysis of a Stock Option Incentive Plan of a Certain Joint-Stock Company 3.4.2 Case Analysis of Various Incentive Plans Middle Part: Implementation and Obstacles of Stock Options Chapter 4: Legal Environment for Stock Options Chapter 5: Internal and External Constraints of Stock Options Chapter 6: Systemic Obstacles of Stock Options Lower Part: Guarantee Mechanisms for Stock Options Chapter 7: Equity Structure Adjustment and Comprehensive System Management Chapter 8: Legal Guarantee for Stock Options Conclusion