Executive Compensation, Tech Transfer and National Security
By Sanjai Bhagat, Michael Brogan, and Kevin Benson
China’s impressive military capabilities and increasingly hostile posture towards the U.S. and its allies causes significant concern among the top policy-makers in the U.S. As recently as the turn of the century, China was reluctant to challenge the U.S. military even in its own backyard. During the past quarter-century, however, China added significantly to its military capabilities, and now indeed challenges the U.S. military.
How did the Chinese military get so powerful and in such a short period?
The Chinese Communist Party focused on developing and modernizing its military via any and all means – legal and extra-legal. The legal mechanisms include China’s laudable investments in its higher education institutions, many of them focused on science, technology, engineering, and math (STEM). The extra-legal mechanisms include expropriation of dual use technology (useful for both civilian and military purposes) from cutting-edge U.S. (and allied) technology companies operating in China as well as outright theft of intellectual property. Why did U.S. technology companies that invested billions of their shareholder dollars (and trillions of U.S. taxpayer dollar investments in U.S. higher education institutions in STEM research) to develop their valuable dual-use technology allow China to expropriate this technology?
During the past three decades, U.S. companies relentlessly pursued a strategy of building manufacturing facilities in China. The over-arching rationale given by U.S. corporate leaders and international economists was that “trade benefits all countries.” U.S. CEOs shifted manufacturing to China arguing that lower manufacturing costs in China compared to the U.S. enabled them to price their product at a much lower price, and benefit their U.S. shareholders and consumers. A key building block of this narrative turned out to be false. The benefits to U.S. long-term shareholders of shifting manufacturing to China were, at best, temporary, and in most cases never realized, because China expropriated the technology of U.S. manufacturers using both legitimate and illegitimate methods.
Another serious problem with the all-trade-is-good position is the impact on U.S. national security. Many credit the Reagan Administration with accelerating the end of the Cold War by pushing the Soviet Union into an arms race its economy could not support. From the age of the Roman empire, economically weak nations were never militarily strong. When U.S. firms set up plants in China, they provide jobs there and directly strengthen the Chinese economy. Also, the expropriation of technology of U.S. firms that set up plants in China benefits their Chinese counterparts today, and the Chinese economy in the future because of the learning-by-doing aspect of gaining and improving manufacturing know-how. As their economy strengthened, China became more aggressive towards the U.S. armed forces.
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In a recent paper, researchers focused on the impact of incentive compensation of U.S. (and western) CEOs and transfer of technology to China. U.S. CEO incentive compensation is often based on corporate earnings, and stock and stock options that vest over one to three years. The authors document greater technology transfer to China by companies whose CEO incentive compensation made up a larger part of their total compensation. Furthermore, the study documents that when U.S. companies engage in China’s strategic emerging industries (that include biotechnology, advanced material and manufacturing, and energy related manufacturing), which are central to China’s industrial policy, the U.S. companies transfer even greater amounts of technology. This demonstrates that China’s policy of expropriating U.S. technology effectively furthers its industrial policy. These researchers also document that when U.S. companies move their tech manufacturing to other countries (not China), there is no relation between CEO incentive compensation and technology transfer; this provides further evidence that expropriation of technology when U.S. companies move manufacturing overseas is mostly a problem when the manufacturing is moved to China.
The above research highlights the critical role of misaligned executive incentive in transferring U.S. technology (especially, high-tech manufacturing technology) to China, contributing to the strengthening of China’s economy and military. We propose a simple and transparent executive compensation plan that would help U.S. companies to address this concern. We propose that the incentive compensation of senior corporate executives should consist primarily of restricted equity (i.e., restricted stock and restricted stock options). Restricted in the sense that the individual cannot sell the shares or exercise the options for six to twelve months after their last day in office.
Under this restricted equity compensation plan, total shareholder returns would drive most incentive compensation, instead of short-term accounting-based measures of performance such as return on capital, or earnings per share. The rationale for six to twelve months after the executive’s departure is to minimize the perverse incentives for executives to make self-interested decisions during the “end-game” immediately prior to retirement, i.e., an individual making decisions when he or she nears retirement. This delay would eliminate incentives for executives to engage in moving manufacturing to China just to sell their vested shares at an artificially inflated share price immediately after retirement.
Of course, our proposal imposes some costs on executives. To begin with, if executives must hold restricted shares and options, their investments may be under-diversified, with a resulting decrease in risk-adjusted expected return. In addition, if executives need to hold restricted shares and options post-retirement, they may be concerned with lack of liquidity.
To address these concerns, we recommend the amounts of equity awarded under our proposal increase slightly from current levels to bring up the risk-adjusted expected return. Additionally, boards may permit managers to liquidate annually a reasonable percentage of their awarded incentive restricted shares and options.
We recognize that one size does not fit all. Corporate boards need to use their understanding of the unique circumstances of their companies’ opportunities and challenges to amend their compensation plans and ensure that such plans focus on serving the interests of long-term shareholders and national security. In implementing the proposal, corporate board compensation committees should be the principal decision-makers regarding the mix and amount of restricted stock and restricted stock options awarded to a manager, the maximum percentage of holdings the manager can liquidate annually, and the number of months post retirement/resignation for the stock and options to vest. Directors must focus on these issues that impact not just their companies’ long-term value, but, more importantly, national security.
