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Nov 18, 2010

Trouble brews in corporate China

Company founders and management are lining up for a struggle

China may have seen its first proxy fight, but don’t expect too many more in the near future. The nature of the scrap at Gome – between the founder and majority shareholder on the one hand, and a management team backed by US private equity on the other – has stirred tensions in China to such an extent that companies will think twice, thrice and many more times before they allow themselves to fall into a similar situation.

The reality, however, is that Chinese companies are heading for more of the same: the same issues that caused major disruption at Gome are likely to keep reappearing as China’s economy matures.

True, there are many unusual details about the Gome proxy fight: most obviously, the fact that the major shareholder who called the special meeting fought his campaign from a jail cell. Furthermore, the contest pitted a Chinese folk hero against a management team backed by US capital, which inflamed nationalistic tensions. There have even been allegations of harassment and death threats between the two sides.

Gome, however, also shares strong similarities with other Chinese companies, which make its circumstances applicable to a wider group of firms. Chief among these is the fact that, despite new investment, Gome’s share register remains stubbornly dominated by the founder, Huang Guangyu, who still controls around 32 percent of the company.

Most Chinese companies are similarly controlled by a dominant founder or the founder’s family, whose interests dominate those of other shareholders. But these firms need capital to expand – global capital. And, in return for that backing, investors will increasingly want a say in the running of these corporations.

Professional management teams know this, and may end up siding with investors over the owner, as has been the case at Gome. The stage is therefore set for a struggle between professional managers and the founding owners of companies, who may not yet be ready to loosen their grip on the companies they built.

Fallen hero
Gome’s case heralds this new phase in the corporate development of China, according to one individual who worked on the Gome proxy fight.‘This is a fight between the professional managers of a company and its entrepreneurial founder, who has an amazing rags-to-riches story – that is the shift in China,’ he says.

That entrepreneurial founder was once the richest man in China but he was caught up in the country’s drive to prove it is serious about tackling corruption. That led to Huang being arrested two years ago on a wide variety of charges. In the end, he was jailed this May for 14 years for crimes including insider trading, bribery and illegal business operations.

The arrest wrecked confidence in Gome and caused a slide in market share. But the introduction of a new management team, led by chairman Chen Xiao, has brought performance back in line with the period before criminal proceedings began.

Chen has also helped broaden Gome’s shareholder base, most notably by bringing in US private equity firm Bain Capital, which currently controls about 10 percent of the company.

The fall of Huang upset many Chinese people, who view him as a national hero. Furthermore, the emergence of Bain Capital as one of the principal players opposed to his control at Gome gave the discussion a nationalistic edge. ‘Public opinion is all over the place,’ observes Woon-Wah Siu, a Shanghai-based securities lawyer for Pillsbury Law. ‘Some commentators say the proxy fight is a sign that corporate governance of Chinese companies has entered a new, more modern phase.

‘Others say China’s economy needs more non-family controlled enterprises like GE and IBM. I’d say those commentators possibly support the current management rather than Huang, the founder.’

Tensions continued to bubble away between Huang and Gome’s board throughout the summer of 2010, until finally Huang pulled the trigger and called a special meeting of shareholders, as is his right under Hong Kong securities regulations as a major shareholder.

The meeting was held on September 28 and the founder’s intention was to unseat Chen, along with executive board member Sun Yi Ding, as well as to cancel the general mandate allowing the board to issue new stock (which would enable it to dilute Huang’s shareholding). As board replacements, Huang nominated his own sister and a business associate.

In the end, the result was a blow to the founder, as neither of his appointments was approved by shareholders. Chen also clung on, with 52 percent of the vote. However, the founder succeeded in convincing shareholders to cancel the general mandate, which shores up his position as Gome’s dominant shareholder. Overall, it’s fair to say neither side came away with exactly what it wanted.

An uncertain future
All of this means Gome’s future remains cloaked in uncertainty, a fact that continues to have a decidedly negative impact on the company’s share price. The retailer’s shares have lagged on the Hong Kong market, suffering from a significant governance discount compared with its peers.

‘There is still a lot of uncertainty about the stock, about whether there will be a split in its retail operations, a rumored change of management involving Chen, subsequent moves by Huang, and so on,’ comments Mike Wong, CEO of the Chamber of Hong Kong Listed Companies. ‘All these factors cast doubt on the company’s performance.’

It is unclear how Gome will resolve the dispute. Despite his incarceration, Huang is still clearly very able to exert his significant shareholder rights over the company. Some feel the next step will be for Chen to step aside, leaving room for a compromise candidate to step in. There is also the possibility things could get a lot worse, though, as Huang has threatened to take back the roughly 400 stores of Gome he personally owns.

China has never seen anything like it before, and may not again for some time. But, while in the short run this corporate saga might encourage companies to work harder to sort out their problems in private, the changing nature of corporate China suggests Gome will be just the first of many battles set to take place between founders and management.

Counting the vote
It takes so long to process the votes for a shareholder meeting in Hong Kong that the proxy solicitor – if it is tapped into the custodian pipelines – can see negative and abstain votes coming in. It can then speak to those investors and try to get them to change their vote before the final count.

Ipreo did this while it was working on the Gome special meeting at the end of September. Investors who changed their minds did so for a variety of reasons. Some were convinced by the proxy solicitation effort of Gome’s advisers. Others had simply put the wrong answers on their proxy forms by accident.

Gome’s form was more complicated than other proxy literature: in order to support the board’s recommendations, shareholders had to vote for the first three resolutions and against the following five. This doesn’t sound too complicated, especially for sophisticated global investors, but Ipreo insists these kinds of mistakes happen on a regular basis.

Special meeting results

Resolution Votes for Votes against
1. To reelect Zhu Jia as a non-executive director of the company 94.76% 5.24%
2. To reelect Ian Reynolds as a non-executive director of the company 54.65% 45.35%
3. To reelect Wang Hong as a non-executive director of the company 54.66% 45.34%
4. To cancel the company’s general mandate to allot, issue and deal with the company’s shares, as passed at this year’s annual general meeting on May 11 54.62% 45.38%
5. To remove Chen Xiao with immediate effect from his office as executive director and chairman of the board 48.11% 51.89%
6. To remove Sun Yi Ding with immediate effect from his office as executive director of the company 48.12% 51.88%
7. To appoint Zou Chun as an executive director of the company with immediate effect 48.13% 51.87%
8. To appoint Huang Hong as an executive director of the company with immediate effect 48.17% 51.83%