Why do firms adopt stock options and who benefits? A natural experiment in China

Abstract

A regulatory change in 2006, permitting equity compensations in China, offers a natural experiment to investigate drivers and outcomes of stock options. There are two unique features. First, adoption of stock options occurred rapidly com-pared to the US, where stock options have been around for more than 100 years with periods of high (1990s) and low (before 1950s) adoption. Second, stock options have been issued by stateowned enterprises (SOEs), an unusual aspect. This study analyzes all listed companies in China from 2004 to 2014, testing two competing theories: optimal contracting and managerial power. If managers own more equity, if the CEO also serves as board chairman and if compensation committees exist, managers are more likely to receive stock options. Ownership type and firm characteristics are also essential factors in granting stock options.In non-SOEs, evidence suggests that controlling shareholders award stock op-tions less frequently but if they do they seem to induce managers to collude in tunneling. Applying a propensity score matching approach to account for an alleged self-selection bias, we do not observe any improvements in firm perfor-mance or shareholder value after stock options have been issued. Accordingly, managerial power seems to be the predominant driver for the introduction of stock options. Hence, managerial accountability and better disclosure are es-sential to ensure that stock options do contribute to value creation. This is the accepted version of an article published by Elsevier in International Licencedifferent from mainland China. Chen et al. (2013) analyze the stock options of red chip firms listed in Hong Kong and argue that stock options granted by state-controlled red chip firms are not effective. For mainland China, Chen et al. (2010) based on the managerial power perspective argue that CEO duality and CEO shareholding entrench managers to extract firms' assets; however, they only analyze cash compensation. Conyon and He (2012) investigate the deter-minants of CEOs' share-ownership and equity compensations based on agency theory. 1 They argue that there is little evidence that governance variables in-fluence CEO pay. By contrast, a more recent study by Fang et al. (2015) yield conflicting results while investigating the employee stock options covering almost the same period.They find no relationship between executive stock ownership and options granted and report a negative correlation between board size and stock options. They also argue that employee stock options in China improved firm performance, and that better corporate governance enhanced this positive impact. Therefore, the understanding of equity compensations in China is far from clear, and it is essential to evaluate recent data.This paper attempts to fill this gap by addressing the following research ques-tions. First, why and under what circumstances did Chinese firms adopt stock options? Particularly, are stock options in Chinese firms an incentive device to solve agency problem or just a form of manageri...

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