9.

The rise and fall of China’s corporate dragon: Kelon and its old and new owners
Guy S. Liu and Pei Sun

INTRODUCTION
The collapse of corporate empires in contemporary capitalist economies tends to be no less dramatic than the vicissitudes of political empires in history. While the political ones often slipped into a less than envious position through a gradual process, in which the decline could be discerned widely by both outside political observers and ordinary people, the sudden collapse of corporate dinosaurs nowadays can take even the closest, longterm corporate analysts by surprise. Unfortunately, this was the case in the example of Kelon, a domestic household appliance manufacturer that once enjoyed the honour of being cited as a typically successful case study on Chinese firms in international business schools. Entitled Kelon: China’s Corporate Dragon,1 the study regarded it as an exemplar of dynamic Chinese firms rising from China’s embracing of the market economy during the 1980s and 1990s.2 The timing of the publication, namely the year 2001, could not have been more embarrassing for both the authors and business school students. Guangdong Kelon Electrical Holdings Co. Ltd shocked investors and equity analysts alike by reporting an unprecedented net loss of RMB 1.5 billion (HK$17 million) in the same year, with appalling scandals of the controlling shareholder’s expropriation of company assets. The rise and fall of Kelon is deeply rooted in its corporate governance system, which was developed when China’s economy was under a complex transition that induced block shareholders to play a dual role – of helping on one hand and appropriating on the other – in controlling their publiclyowned corporations. Kelon rose due largely to the support of its largest shareholder – the local government; and it fell on account of asset stripping by the government as the controlling owner. Although Kelon’s huge losses were finally covered by the injection of private investment, thanks to a rapid development of private business in China, its sustainability in future still
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remains uncertain as there is no guarantee that a new private owner will not tunnel assets away from business when weak corporate governance is present. In short, there are profound lessons that we can learn from Kelon’s case, in particular, a complicated ownership arrangement that is mixed with a weak legal system in protecting minority investors, and its impact on corporate behaviour and performance. The rest of the chapter provides a detailed chronicle of Kelon from its emergence and successful growth to its abrupt operating and financial failures, and to the latest development that concerns the takeover by an aggressive entrepreneur – Mr Chujun Gu. It is then followed by intensive discussions on the lessons and policy implications of the case from the perspective of state-of-the-art corporate governance theories.

THE RISE OF KELON (1984–96): A MODEL OF PUBLIC–PRIVATE PARTNERSHIP
By all accounts the successful story of Kelon was a typical result of the boom of China’s township and village enterprise (TVE) sector in the 1980s and early 1990s. Unlike the traditional state-owned enterprises (SOEs), TVEs are founded, financed and directly controlled by very lowlevel governments, i.e. township and villages, who exhibited a tremendous degree of pro-business attitude to support local entrepreneurs. Despite the ambiguous property rights arrangements between township governments and TVE managers, they developed at least in the early stage of business a relatively efficient division of labour, in which managers in the startups demonstrated their entrepreneurial talent in China’s emerging market economy while the local governments offered a crucial helping hand to make TVEs overcome pervasive market failures and the volatile business environment.3 The following brief overview of the history of Kelon clearly demonstrates the point.4 The predecessor of Kelon was the Guangdong Shunde Pearl River Refrigerator Factory, which was founded in 1984 through collaboration between an entrepreneur and a local township government. The entrepreneur, Guoduan Wang, ran a small factory producing cheap transistor radios for a Hong Kong firm. The government was a state agency of a small town, called Rongqi township, which is under the subordination of Shunde county in Guangdong, China’s southern province adjacent to Hong Kong. Both Wang and the township government were keen to explore new business opportunities at the advent of economic liberalization in China. To discover new business opportunities, the township government investigated nationwide which consumer goods were in high demand. Despite the fact that they had

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neither experience nor technical capability in refrigerator production at that time, Rongqi township government provided the collaboration with both a seed capital of RMB 90 000 (roughly HK$30 000 at the prevailing exchange rate) and the security of a bank loan of RMB 4 million for the construction of the plant. Mr Ning Pan, a vice-head of the township, was assigned as the general manager to work with Wang.5 Another essential support from local governments was political. Apart from the collective ownership provided by the township as a political cap to cover private interests in ownership, local governments ranging from the township to the county, municipal and the provincial levels actively lobbied the central government on behalf of Kelon for a production licence in the mid-1980s. This was a time when China’s central government intended to implement a consolidating industrial policy in the increasingly fragmented white goods sector. The entry barrier was erected via a licence system, so that Kelon’s application was initially rejected by the Ministry of Light Industry because of its low status. However, local governments, especially the provincial one, offered critical help for Kelon to overcome the entry barrier by bargaining intensively with the central government.6 Eventually, it became the only non-SOE in the list of 42 firms that were granted the manufacturing licence, in spite of a volume limit of 50 000 to Kelon. The subsequent takeoff of Kelon in the household white goods sector was dramatic, which totally surprised both economic bureaucrats in Beijing and those multinational corporations that had been keen to grab a lion’s share of China’s domestic market. By 1991, Kelon had already leapfrogged to be the top refrigerator maker in China, producing 480 000 fridges and enjoying 10.3 per cent market share in terms of units sold. Figure 9.1 shows the explosive growth of Kelon’s production capacity between 1985 and 1996, the year when it was listed on the Hong Kong stock market. The listing was not until Kelon became a market leader in the refrigerator industry. The political recognition of Kelon’s success came from Xiaoping Deng’s visit in January 1992, and also Zeming Jiang in 1994. In China these two visits represented a crucial commitment of the central government in support of the enterprise. As a result, Kelon became the first Chinese TVE to be allowed by the central government to float as a firm in Hong Kong.7 In terms of corporate governance arrangements, Kelon was also a pioneer in the corporatization experiment. As early as 1992, the firm was transformed to a shareholding company, in which Rongqi township government held 80 per cent of shares via a holding company called Rongqi Township Economic Development Company, and managers and employees were offered the remaining 20 per cent stakes (see Figure 9.2). Thus the newly formed Kelon Electrical Holdings Co. Ltd was the envy of peers in the domestic sector at that time, in which it perfectly combined the high incentives for employees and the high commitment of government support.

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2000 1800 1600 1400 1200 1000 800 600 400 200 0 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996
Source: Zhang (2004).

Figure 9.1

The production volume of refrigerators at Kelon (1985–96, thousands)

During the first half of the 1990s, not only did Kelon maintain its top position in China’s highly competitive household appliance sector, but it also diversified into related segments, including freezers and air conditioners. Moreover, the significant corporate growth helped the company secure a nationwide presence in the white goods industry in terms of both production and distribution network. Kelon’s business peaked in 1996, when it started stock flotation in Hong Kong and the subsequent domestic listing in Shenzhen in 1999. The sales of shares resulted in a cash injection of HK$1.44 billion and RMB 1.06 billion by the public investors, while on the other hand the holding rights of the township government were sharply diluted to only around 34 per cent (see Figure 9.3). To sum up, the success of Kelon has been much to do with the synergy achieved from the joint ownership of government with private entrepreneurs in a unique market environment that was of high economic growth and rapid economic reform in China. The beauty of the mixed ownership is, on the one hand, the ‘local government entrepreneurship’ effectively offers administrative support for the firm to grow faster. On the other, private participation in ownership provides the management with a good incentive to compete in the market.

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Kelon Electrical Holdings Co. Ltd

Rongqi Township Economic Development Co. (80%)

Managers and Employees (20%)

Rongqi Township Government (100%)
Note: Percentages in the brackets are the fractions of stakes held by respective owners. Rongqi township government was the ultimate controlling shareholder of Kelon Ltd, since the government owned 100% shares of Rongqi Township Economic Development Co., who held the 80% share of Kelon Ltd.

Figure 9.2

The shareholding structure of Kelon (1992–96)

THE SUDDEN COLLAPSE OF KELON IN 2000: HOW GOVERNMENT’S HELPING HAND BECAME AN APPROPRIATING ONE
Representing the successful model of reformed Chinese enterprises, Kelon was once the king of ‘red chips’8 in the Hong Kong equity market. In 1999 Kelon’s sales revenues reached an unprecedented level of RMB 5.6 billion (HK$0.7 billion), despite a decline in profit margin over the last few years. It captured the largest market share in the domestic refrigerator sector in the 1990s and had already become one of the largest air-conditioner manufacturers in China. Actually even at the start of the year 2000, the company predicted an annual 11.7 per cent growth in sales and RMB 0.7 billion net income (Caijing 2001a). The year-end result could not have been more staggering: Kelon fell into the red for the first time in its history, reporting a huge net loss of RMB 0.83 billion, with a 30.9 per cent sales decline. A further financial loss of more than RMB 1.4 billion followed

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Kelon Electrical Holdings Co. Ltd

Managers and Employees (8.52%)

Guandong Kelon (Rongsheng) Group (34.06%)

Hong Kong Public Investors (46.33%)

Mainland Public Investors (11.09%)

Rongqi Township Government (100%)
Note: Just before the public listing in Hong Kong, Rongqi Township Government created the Guangdong Kelon (Rongsheng) Group Company (GKG) to take the place of Rongqi Township Economic Development Co. as the intermediate controlling shareholder. Numbers in parentheses are the percentages of shares held by respective entities. Rongqi Township Government was the ultimate shareholder of the Kelon Ltd.

Figure 9.3

The shareholding structure of Kelon after stock flotation (yearend 1999)

in 2001, which left Kelon on the verge of collapse. This section presents a corporate governance interpretation of the collapse and traces the abrupt failure to the deteriorating agency problems on the part of the township government during the post-listing period. The Agency Costs of a Government-controlling Shareholder It is commonly assumed that government-controlled firms that have gone public should have a significantly improved corporate governance mechanism, as they have rationalized the internal structure such as with the establishment of executive and supervisory boards and are presumably subject to the external discipline of capital markets. Unfortunately, the Chinese experience in the 1990s suggests otherwise. Despite cash windfalls contributed by public investors through initial public offerings (IPOs), listed firms have on average exhibited a significant decline in financial performance over their post-IPO years (for example Wang et al. 2004).

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Moreover, as suggested by Steinfeld (1998) and Tenev and Zhang (2002), a web of new agency problems can arise in this particular hybrid – ‘public’ companies controlled by government. How could it be the case? In this section we apply state-of-the-art corporate governance theory to the Kelon case, which can precisely explain why the government’s previous helping hand degenerated into an appropriating one under the new institutional environment. In modern public corporations ownership is diversified to individual stockholders so that those who have secured an absolute control of the company may not hold a vast majority of the total shares outstanding. And it is very likely, according to the corporate control theory developed by Cubbin and Leech (1983), that even a minority shareholder can obtain an effective control of the firm given a rather dispersed distribution of remaining shares. Taking Kelon as a case in point, whereas before the public listing the township government held 80 per cent of cash flow rights over the firm, its ownership stakes sharply reduced to little more than one-third of the total after the flotation (see Table 9.1). Nevertheless, the government maintained a larger shareholding than the ‘critical control level’ calculated in Table 9.1, which clearly indicates that the government control in Kelon remained incontestable. Therefore, a considerable deviation of cash flow rights from control rights prevents the dilution of the government control post the listing. That is, the government only contributed 34 per cent of cash flows but enjoyed nearly complete control of the company.9 In theory, the agency costs associated with such a controlling-minority structure (CMS)10 involve potentially a severe moral hazard problem on the part of the minority controller, since he or she has the power and incentive to expropriate the company and public investors. Controllers in the CMS internalize only a small fraction of the negative consequences induced by their own opportunistic behaviour, but can appropriate all of the private control benefits arising from entrenchment and some more significant ‘tunnelling’ activities such as fund diversion and asset stripping (Johnson et al. 2000; Cronqvist and Nilsson 2003). And when legal and regulatory constraints on controllers’ self-dealing behaviour are largely ineffective, which is the norm rather than an exception in transition economies and emerging markets, the chances are that even a highly supportive controlling shareholder may degrade into a corporate expropriator, as the Kelon case subsequently illustrates. Regarding government as a specific category of controlling shareholder, the agency problem is exacerbated by an additional dimension of incentive incompatibility between bureaucrats and managers. In comparison with many UK and American companies, where they have the higher

Table 9.1

Kelon’s top ten shareholders after Hong Kong and Shenzhen quotation

After Hong Kong but After Shenzhen listing before Shenzhen listing Top ten shareholders Shares held Top ten shareholders (%) Guangdong Kelon (Rongsheng) Group Standard Chartered Bank HSBC Co. Ltd The Chase Manhattan Bank Citibank N.A. Morgan Stanley Dean Witter Hong Kong Securities Ltd The Bank of Bermuda Ltd Jardine Fleming Broking Ltd Deutsche Bank AG Merrill Lynch Far East Ltd Critical Control Level 38.31 12.31 12.04 10.19 6.16 1.87 0.54 0.53 0.5 0.49 37.32 Guangdong Kelon (Rongsheng) Group Standard Chartered Bank HSBC Co. Ltd Franklin Templeton Group The Chase Manhattan Bank

Shares held (%) 34.06 8.63 7.47 6.92 5.87 5.24 2.85 0.74 0.64 0.17 0.17 33.44

225

Citibank N.A. Deutsche Bank AG Morgan Stanley Dean Witter Hong Kong Securities Ltd Jardine Fleming Broking Ltd Tongyi Securities Investment Fund Taihe Securities Investment Fund

Note: The ‘Critical Control Level’ is defined as a certain shareholding benchmark necessary for the largest investor to gain the effective control of a company under a pre-assigned confidence level. The critical control shares in the table are derived by applying a probabilistic-voting model developed by Cubbin and Leech (1983). To calculate the critical level of shareholdings, the model requires the two pieces of information: shareholding concentration and the probability that a given stockholder would attend the general shareholder meeting. We assume that all the shareholders will attend the meeting for sure.

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degree of separation of management and ownership, state-controlled public corporations are not very much different from them in terms of the separation perspective, which explains why they have similar agency problems – managerial discretion and opportunism. Moreover, when government is in control of public companies, another problem in addition to the lack of management accountability is possible expropriation11 by the large shareholder of state from other minority investors. The large shareholder’s expropriation problem is often found in Continental European and Southeast Asian companies with family as the controlling shareholder, where ownership is concentrated with less separation of managers and family owners.12 In the next two subsections, we present a detailed examination of the two facets of agency problems at Kelon, which we ascribe to Kelon’s sudden collapse in 2000. The Failure in Incentive Alignment of the Management It has been argued that the long tenure of Mr Pan and Mr Wang, which spanned from 1984 to 2000, is one of the most crucial contributing factors to Kelon’s success (Huang 2003). However, it proved that the incentive schemes of the management lagged far behind the fast business growth in the 1990s to align their interests with those of the company as a whole. For instance, the government persistently failed to offer ownership stakes as material incentives to company managers, so that it is not surprising to find out that Kelon’s two corporate founders were not rewarded with any share options. They only held a negligible number of shares in the listed firm: as can be seen in Table 9.1 none of the corporate insiders enter the list of the top ten shareholders and the tenth largest shareholder in Table 9.1 only has less than 1 per cent of total stocks. When management efforts could not be rewarded via formal incentive contracts such as share ownership and stock options, they chose to capture their control rents through value-subtracting activities. A typical abuse of their operational control of the firm was transfer pricing. Various anecdotes from the business press reveal that before the 2000 collapse many managers at Kelon were engaged extensively in related party transactions with firms owned by the relatives and friends of the managers. Although there are large economies of scale in procurement, Kelon usually paid abnormally higher prices for parts procurement, and also large discounts in the distribution network, for the manager-related suppliers or dealers. The upshot of this managerial agency problem can be reflected in the soaring operating expenses during 1996–2000. Following Yafeh and Yosha (2003), we identify selling and administrative expenses as a key measure of activities

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related to managerial moral hazard. Figure 9.4 then shows the time trend of Kelon’s selling and administrative expenses deflated by sales revenues, and we compare the expenses with two competing refrigerator producers, namely Haier Ltd and Meiling Ltd, who are competitors of Kelon in the domestic market. Clearly, Kelon not only underperformed in comparison with its two rivals in this aspect, but also experienced a sharp rise in the post-IPO years.

45% 40% 35% 30% 25% 20% 15% 10% 5% 0% 1996
Note:

Kelon Haier Meiling

1997

1998

1999

2000

Expenses to sales ratio = selling and administrative expenses/sales revenues.

Source: Calculated from data disclosed in the annual reports of Kelon, Qingdao Haier Co. Ltd, and Hefei Meiling Co. Ltd.

Figure 9.4

Expenses to sales ratios at Kelon and its competitors (1996– 2000)

Another dimension of the failure is related to a series of turbulent managerial turnover events triggered by the retirement of corporate veteran Mr Ning Pan in June 1999. It is widely known that in China’s politicized business environment senior managers typically maintain intimate patron– client relations with local bureaucrats. Although Mr Guoduan Wang, the former No. 2 figure in the firm, took the positions of board chairman and CEO as expected, rumours abound that internal power struggles were

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intensified behind the scenes. In March 2000, at the risk of triggering a corporate earthquake, Mr Wang reshuffled the management team by replacing all the vice-CEOs formerly working for Pan with outsiders. This unpopular reshuffle resulted largely in Wang himself being forced to leave the CEO post three months later.13 Mr Tiefeng Xu, a vice mayor of the Rongqi township with little business experience, became the new CEO, which later proved a typical case of government intervention and a big blow to Kelon’s performance. The Weak Constraint of Monitoring and Asset Tunnelling Managerial agency cost aside, the distorted incentives provided by the government as the controlling owner to management and the significant transfer of Kelon’s cash flows to non-business uses on government projects have proved fundamentally responsible for the failure. It will become clear if we briefly examine the payoff structure of Chinese local governments during the transition. Liu et al. (2005) argue that the benefits of local governments owning an industrial firm are composed of three parts: 1. dividends and corporate income tax arising from firm profits; 2. value-added tax (VAT) derived from sales revenues; and 3. the private benefits that can be captured from corporate control, which can span from pecuniary favours to political interests. Our discussion in the first subsection immediately leads us to predict that the weight the government assigns to the first component of its three benefits would be much smaller than those it puts on the other two. The dilution of income rights rather than the control rights makes the government not care much about dividends it receives from the listed firm; rather, it may capture private control benefits at the expense of long-run profitability. Second, the Chinese tax system was traditionally designed in a way that government revenues rely predominantly on indirect turnover tax (VAT) collected from firm sales, rather than corporate income tax. And this further dampens the government’s interest in profitability but misdirects the company to pursue excessive sales growth.14 Figures 9.5 and 9.6 perfectly illustrate how the government directed Kelon in the post-IPO years to seek more sales at the expense of profitability. Despite a superficial boost of sales from 1996 to 1999, operating profits experienced an annual 6 per cent decline in the three consecutive years from 1997. Over the same period, a significant deterioration in profitability measured by both ROA and ROE was in evidence, which indicates that the government as the largest owner destroyed the value of the company for its

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own self-interest. What’s more, the sales slump in 2000 and the resultant enormous decline in profits suggest that earning quality in the previous years could be problematic. Specifically, the accounts receivable at Kelon remained considerably large during those years. For instance, more than 20 per cent of sales shown in the 1997 income statement came from the accounts receivable. It is widely believed that during the period Kelon took undue credit sales to boost revenues in an artificial manner (Zhang 2004).

6000 5000 4000 3000 2000 1000 0 –1000 –2000 2000
Source:

Sales Operating Profits

1999

1998

1997

1996

The annual reports of Kelon Electrical Holdings Co. Ltd (1996–2000).

Figure 9.5

Sales and operating profits at Kelon (1996–2000, RMB million)

However, the promotion of value destroying sales for more tax revenues by the state owner is not the worst. The worst conduct of the government owner that is finally revealed is that the township government actually acted in a manner that regarded its controlled public corporation as a ‘cash cow’ and transferred the corporate cash assets, arising from bank borrowings or private invested money, to public uses. The cash asset stripping by the government gave a vital and final impact to the collapse of Kelon. Similar to other corporate scandals around the world, the clue of corporate funds being tunnelled to non-business uses was not obvious to the public in Kelon’s quarterly and annual reports, except for the report on deteriorating corporate performance. The cash transfers remained under cover until the

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0.25 0.2 0.15 0.1 0.05 0 –0.05 –0.1 –0.15 –0.2 –0.25 1996 1997 1998 1999 2000 ROA ROE

Note: Return on assets (ROA) is defined as net income divided by total assets. Return on equity (ROE) is defined as net income divided by equity capital. Source: Calculated from data disclosed in the annual reports of Kelon Electrical Holdings Co. Ltd.

Figure 9.6

Profitability at Kelon (1996–2000)

perpetrator was no longer able to disguise them. When Rongqi government realized that the accumulated crisis at Kelon had reached a point that could hardly be settled by its own fiscal capability, it had to decide painfully to give up its controlling stakes to Mr Chujun Gu, a refrigerant-manufacturing entrepreneur, in late 2001. Only then was the financial black hole finally revealed by both the new entrant and the regulatory bodies. Plainly speaking, Rongqi township government via its controlled Guangdong Kelon (Rongsheng) Group diverted a total of RMB 1.26 billion (HK$0.15 billion) from the listed Kelon Electrical Holdings Co. Ltd through a string of secretive related-party transactions from 1997 to 2001. Table 9.2 organizes the main part of them into three categories and displays them in detail. It is worth noting that such related-party transactions are a two-edged sword. That is to say, on balance the controlling shareholder could either tunnel funds from its listed subsidiary or inject cash into the company for the benefit of all shareholders (Friedman et al. 2003). As Table 9.2 shows, in 1997 the holding group in effect contributed more than RMB 100 million net to Kelon. The dynamics, however, was a reversed trend that signified

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the increasing expropriation of Kelon’s funds, especially in 2000 and 2001. Taking the year 2001 as a case in point, it can be seen from Table 9.2 that the government-owned holding company managed to channel more than RMB 1 billion from Kelon in less than 12 months,15 given the fact that the net assets Kelon possessed in year-end 2000 was RMB 3.96 billion! Table 9.2 Major fund diversion between Kelon and Guangdong Kelon (Rongsheng) Group (1997–2001) Kelon→ Rongsheng Group Rongsheng Group →Kelon

Year

Balance (RMB)

1997 1998 1999 2000 2001

2001 2001

Bank loans and interest payments 308 373 000 410 299 000 7 163 622 000 7 106 870 000 4 389 922 000 4 362 194 000 4 599 826 000 4 496 662 000 5 083 814 000 4 378 515 000 Sub-total Loans guarantee 211 220 000 Payment transfer 101 370 000 Total

–101 926 000 56 752 000 27 728 000 103 164 000 705 299 000 791 017 000 211 220 000 101 370 000 1 103 607 000

Notes: 1. Kelon→Rongsheng Group means that the direction of fund diversion is from Kelon to its parent; and Rongsheng Group→Kelon suggests the other way round. 2. Bank Loans and Interest Payments denote the situation in which Kelon and its holding company share their respective lending quota in commercial banks by obtaining loans in the name of each other. That is, the holding company has access to banks loans borrowed by Kelon, and the reverse also holds. Moreover, they pay back the debt and interest with each other. For example, Kelon may have to pay the principal and interest its parent owes to the banks. The annual and accumulated balances of the fund exchange are shown in the ‘balance’ column. 3. Loans Guarantee suggests the incident that the holding company illicitly asked one of Kelon’s subsidiaries to stand guarantee for a bank loan worth RMB 0.21 billion in mid2001. Since the holding company failed to service this debt afterwards, Kelon had to pay the principal and interest instead. 4. Payment Transfer suggests the incident that the holding company asked Kelon to buy products in 2001 from a joint venture between Kelon and the Sanyo Group (Japan) at a cost of RMB 101.4 million that Kelon paid for in cash. Source: The annual report of Kelon Electrical Holdings Co. Ltd (2001), and the announcement of Kelon Electrical Co. Ltd on 14 March 2002.

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The expropriation of Kelon’s assets also is reflected in a particular account in the balance sheet of Chinese public corporations – ‘other receivables’. It is a Chinese-style item that incorporates all the miscellaneous receivables other than normal accounts receivable based on credit sales. Cash appropriated by the dominant shareholder is often recorded in ‘other receivables’, which the firm is supposed to be able to collect from its controller. So it is believed that this account has in practice become a rough proxy to indicate the extent of the large shareholder’s tunnelling. Figure 9.7 clearly shows the exponential growth of ‘other receivables’ during 2000 and 2001, which coincided with the time when the new CEO was appointed directly by the government to replace the former corporate hero, Mr Lin Pan, who created Kelon.
1,600,000 1,400,000 1,200,000 1,00,000 800,000 600,000 400,000 200,000 0
Source:

1996

1997

1998

1999

2000

2001

2002

2003

The annual reports of Kelon Electrical Holdings Co. Ltd (1996–2003).

Figure 9.7

The amount of ‘other receivables’ at Kelon (1996–2003, RMB thousands)

In sum, the vicissitudes of Kelon so far suggest that the governmentdominant ownership arrangement of corporate governance was helpful for Kelon’s success when the company was small and the business was at an early stage of development. During this period, the government can be a good supporter by providing public resources for facilitating the growth of the business, and this support is essential for business at an infant stage, and therefore the agency problem of both government and

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government-appointed management could be covered or mitigated by the state’s constructive and significant support. When the company becomes bigger, and less dependent on the support of the government, the role of government ownership will become different. This change, in particular, after the stock flotation of the firm, can turn the firm towards a difficult situation where both the moral hazard problem of the government as the controlling owner and the agency problem of the management will become more acute, in which the problems could offset the benefits gained from government ownership. Kelon’s story illustrates clearly this argument that the government changed its role from a supporting one to a predatory one at the time when the company built up its value to trade its ownership for public funds. The trade of ownership for finance dilutes cash flow rights, but not the corporate control of the government. Therefore, one pound of private control rents becomes more valuable than one pound of profits gained from efficiency improvement, inducing the government as the largest owner to change its interest from profit seeking to fund stripping. For Kelon, the government’s predatory behaviour towards corporate cash assets was evident. The government seemed to develop a self-destructive strategy for the business, in which this suicidal behaviour is inconsistent with the conventional wisdom of rationality in choosing a chance to survive. One possible explanation is that the short-term opportunism dominated the long-run commitment, which induced the government to take a chance and ended up with what is in Olson’s (2000) term called a ‘roving bandit’, who, even worse than a ‘settled bandit’, maximizes the amount of extraction without internalizing any damages he/she will have caused simply because of his/her exit option. Clearly, the discussion above raises an interesting question of how corporate governance can help when the largest shareholder becomes irrational.

THE ARRIVAL OF A PRIVATE OWNER: SAVIOUR OR NEXT EXPROPRIATOR?
The richness of the case is manifest not only in the complicated government– enterprise relationships just elaborated, but in the ownership transfer from government to the private sector and the associated question of whether an effective corporate governance mechanism would necessarily emerge after privatization. In particular, what role has the new private owner played in restructuring Kelon? Can the arrival of the new private owner dispel our misgivings about potential governance failures such as the large shareholder expropriation?

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Perhaps few people in the Chinese white goods sector heard of Mr Gu prior to his surprising takeover of Kelon. On 31 October 2001, Kelon announced that its holding company – Guangdong Kelon (Rongsheng) Group – had signed a share transfer agreement with Shunde Greencool Enterprise Development, a ‘shell’ company then owned by Gu and his father.16 According to the agreement, the government wholly-owned group released 20.64 per cent out of 34.06 per cent of shares it held17 to Gu at the price of RMB 2.7 per share, which made Gu the ultimate controller of Kelon18 (see Figure 9.8). From then on Gu and his business have been in the limelight, since people wondered about the real intention of this new owner and how he could possibly reverse the deteriorated Kelon. Is he a saviour of the troubled company or simply the next expropriator who attempts to extract wealth again from vulnerable minority investors? Public information reveals that before the takeover Gu’s main business was producing his patented Greencool Refrigerants for use in the refrigeration and air-conditioning systems. In mid-2000, he succeeded in merging the commercial distribution and service segment in a company called Greencool Technology Holdings Ltd and got this listed on the Hong Kong Growth Enterprise Market (GEM) which is the counterpart of the US’s NASDAQ. In return, more than RMB 500 million of cash was raised for the company through the IPO. Interestingly, the newly floated company sells refrigerants that are supplied exclusively from a connected party called Greencool Refrigerant (China) Co. Ltd (the ‘Tianjin Greencool Factory’), Gu’s manufacturing centre of refrigerants in China (see Figure 9.8). In general, people are quite sceptical of Gu’s motives for the acquisition and his business capability of revamping Kelon. Against this scepticism, Gu explains that the move from the upstream sector into the downstream whitegoods-manufacturing sector is a natural and rational business strategy. The press questions the reliability of accounting numbers in Greencool Technology Holdings, not least because it is virtually a trading firm in that all the goods sold are provided by an unlisted related party whose financial status is not verifiable. A number of anecdotes, through field investigations, point out the inconsistency between sales leapfrogging in the listed firm during 1998–2001 (see Table 9.3) and the dubious financial situation of its Tianjin supplier, suggesting a considerable possibility of earnings manipulation (Caijing 2001b, 2002). Moreover, in late 2001 Greencool Technology Holdings gave an enormous amount of advance payment worth nearly RMB 230 million to Tianjin Greencool, which can be identified in the receivables column in Table 9.3. Since the advance payment coincided with Gu’s purchase of Kelon’s controlling stake, it is widely suspected that Gu channelled funds from his controlled HK-quoted company to finance his acquisition, but to the detriment of Hong Kong

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Gu Chujun

Home Appliance (Shunde Greencool Enterprise Development)

Refrigerants (Greencool Capital Limited)

Automobile and Kelon Electrical Hefei Meiling Components Holdings Co. Ltd Co. Ltd (Yangzhou Greencool (20.64%) (20.03%) Venture Capital)

Tianjin Greencool (83.7%)

Greencool Tech. Holdings (62.6%)

Yangzhou Yaxing Motor Coach Co. Ltd (60.67%)

Xiangyang Automobile Bearing Co. Ltd (29.84%)

Notes: The figure depicts the group structure of Gu Chujun’s fast expanding businesses as of year 2004, which consists of three sectors: refrigerants, home appliance and automobiles. In the refrigerants sector, Gu uses Greencool Capital Limited, his wholly-owned firm registered in the British Virgin Islands, as the holding company of both Greencool Technology Holdings Co. Ltd, a Hong Kong listed firm, and unlisted ‘Tianjin Greencool’, the official name of which is Greencool Refrigerant (China) Co. Ltd. Regarding the home appliance industry, Shunde Greencool Enterprise Development Limited (SGE) is the holding company employed by Gu to control two newly acquired downstream listed firms, namely Kelon Electrical Holdings and Hefei Meiling Co. Ltd. Gu and Tianjin Greencool held 60 per cent and 40 per cent of shares in SGE respectively. Besides, Gu enters the sector of automobile and auto components by taking over two listed firms, namely Yangzhou Yaxing Motor Coach and Xiangyang Automobile Bearing. Yangzhou Greencool Venture Capital, wholly owned by Gu and his father, is used as the intermediate control device for the two firms. Numbers in parentheses corresponding with all the downstream companies are the percentage of shares held by Gu’s respective holding companies. The arrow between Tianjin Greencool and Greencool Technology denotes their close business link.

Figure 9.8

Gu Chujun’s business conglomerate as of year-end 2004

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minority investors. And this has eventually invited the censure issued on 31 August 2004 by the listing committee of Hong Kong GEM for the company board in gross negligence of stock exchange regulations (see the document titled ‘Exchange’s Announcement in relation to GREENCOOL TECH’ on website: http://www.hkgem.com/company). A more thoughtprovoking message that Table 9.3 conveys is a significant decline in turnover and profitability after 2001, which further undermines Gu’s credibility on business performance and corporate governance. Table 9.3 Key financial and accounting data at Greencool Technology Holdings Co. Ltd (1998–2003, RMB thousands) Sales EBIT ROA (%) ROE (%) Receivables Payables to from related related parties parties

Year

1998 1999 2000 2001 2002 2003

113 92 827 363 897 516 330 321 420 106 834

–6 816 41 300 269 217 339 365 103 368 10 550

–9.7 –10.0 10.4 10.6 22.3 23.6 22.0 24.3 5.6 6.2 0.6 0.6

10 701 0 229 983 1 024 238

2 722 31 585 6 963 17 002 16 658

Notes: EBIT denotes earnings before interest and tax, i.e. operating profits. ROA and ROE are net earnings divided by total assets and equity capital respectively. Receivables and Payables are accounts exclusively due from and to the company’s related parties, that is other firms controlled by Gu. The data for 1998 are unaudited. Source: Annual reports of Greencool Technology Holdings Co. Ltd (1998–2003).

Nevertheless, it would be wrong, at least in respect of the Kelon case, to perceive Gu’s entry as totally negative. In effect, it is Gu who, under his presiding over the board, unveils the disguised financial scandal that shows the government’s tunnelling of the assets (see Table 9.2). After he signed the initial agreement with Rongqi government, Gu and his team undertook a comprehensive audit of Kelon between December 2001 and March 2002. Of course Gu acted out of his own interest as he found that he had overpaid the target without prior knowledge of such large-scale asset stripping. Hence he subsequently revised the terms of agreement with Rongqi government, in which the price was lowered to RMB 1.7 per share and the total amount was changed from RMB 560 million to 348 million. Kelon in Gu’s ownership control, at least up to now, seems to continue the bright side of the story. A U-turn of key financial indicators before

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and after the acquisition is evident in Figures 9.9 and 9.10. Sales have maintained a steady growth, reaching an unprecedented level of more than 6 billion in 2003. In contrast to sales, the profitability is less impressive, but at least helps the firm recover from the haemorrhage. Intensive cost-cutting measures adopted by Gu are reported to have contributed to the recovery, which can be reflected in the trend of expenses to sales ratio shown in Figure 9.11. Concretely speaking, the ratio has fallen to the 1999 level due to the reportedly effective streamlining of procurement and distribution networks (Xin Caifu 2002; Xin Caijing 2004). On the dark side, sceptics such as Professor Larry Lang, a corporate finance expert at the Chinese University of Hong Kong, argue that the positive effect of Gu’s entry is overestimated, since he intentionally reported an abnormally large loss in year 2001 via earnings management techniques including the exaggeration of expenses.19 In so doing, it would make the profitability figures look relatively more attractive in subsequent years. Hence, Gu still needs more time to prove his business and management competence as profitability indicators at Kelon have yet to get back to the 1999 level (see Figures 9.9 and 9.10).

7000 6000 5000 4000 3000 2000 1000 0 –1000 –2000 1999
Source:

Sales Operating Profits

2000

2001

2002

2003

The annual reports of Kelon Electrical Holdings Co. Ltd (1999–2003).

Figure 9.9

Sales and operating profits at Kelon (1999–2003, RMB million)

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0.2 0.1 0 –0.1 –0.2 –0.3 –0.4 –0.5 –0.6 –0.7 1999 2000 2001 2002 2003 ROA ROE

Source: Calculated from data disclosed in the annual reports of Kelon Electrical Holdings Co. Ltd.

Figure 9.10 50% 45% 40% 35% 30% 25% 20% 15% 10% 5% 0%

Profitability at Kelon (1999–2003)

Kelon Haier Meiling

1999 Figure 9.11

2000

2001

2002

2003

Expenses to sales ratios in Kelon and its competitors (1999–2003)

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Another key concern is about the role Gu will play as the new controlling shareholder. Could it be possible that Gu will fail to resist temptation and become the next expropriator of Kelon through asset stripping and fund diversion? A glance at the disclosure of the ‘other receivables’ account in 2002 and 2003 endorses the feeling that Gu has so far refrained from tunnelling Kelon20 (see Figure 9.7). However, it is still rumoured that considerable cash flows generated in Kelon’s sale of refrigerators and air conditioners are a potentially important source of finance for Gu’s takeovers in 2003 and 2004.21 Shown in Figure 9.8, Gu acquired another key domestic refrigerator maker – Hefei Meiling – from its ultimate controller Hefei city government in mid-2003. Several months later, he made a further bold move to enter the highly competitive automobile industry by buying controlling stakes in Yaxing Motor Coach and Xiangyang Automobile Bearing from their respective local governments. More interestingly, each of the three targets has surprisingly similar characteristics to Kelon: while they have sound production capacity and substantial market shares in their respective domestic industries, they all suffered from the severe agency problem of moral-hazard-prone government and managers. Government predators and managerial moral hazard are so prevalent in these listed companies as to result in poor financial performance. A space limit prevents us from detailing each of the acquisitions, but the fascinating Kelon story we elaborated tends to have been repeated in these firms to a significant degree.

FURTHER DISCUSSION AND CONCLUDING REMARKS
[T]he process of transition in general and privatization in particular demonstrates an old lesson of market economies – incentives matter; but it also demonstrates a key lesson that was lost on many of the so-called reformers: only under highly idealized situations do incentives result in efficient outcomes; misdirected incentives can provide incentives for asset stripping rather than wealth creation. In many of the countries in transition, that is precisely what happened. (Stiglitz 2001)

The case of Kelon, we believe, supplies one of most perfect illustrations of the profound corporate governance lessons for us. Our discussion of the case finds that Kelon has experienced two plunders: one from the largest shareholder’s irregularity in using company assets and another from management’s moral hazard of taking related party transactions to such a significant extent as to transfer investors’ assets. In the West, a conventional wisdom is that an ownership-concentrated company is concerned more about the controlling shareholder’s expropriation, an ownership-dispersed company is concerned more about the moral hazard

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of the inside management’s control. Thus, which concern is dominant for a firm depends on its ownership structure. In China, Kelon enriched the wisdom: the dominance of a governance problem is not really relevant to the ownership structure. Kelon has a relatively concentrated ownership, but it suffered, first, the predatory action of the controlling owner, and second, the moral hazard of the inside management’s control. The lost control of a government as the controlling shareholder over the management’s conduct was a result of: the incompetence of the government in business management; the separation of cash rights and control rights; and the mis-specified incentives for the government to run a firm, since a performance appraisal for a government is on the basis of the economic development of the whole region rather than a firm. These three points explain why an ownership-concentrated firm with state control can result in two contradictory problems appearing at the same time for the same company: large shareholder’s expropriation and inside management’s control. Although Kelon showed a failure in setting up effective governance to prevent the firm from asset stripping by the largest shareholder and the management, we believe that a private controlling shareholder could not have guaranteed such prevention. Effective corporate governance to prevent asset stripping from related parties must come from an arrangement that is on the basis of both a contextual analysis of corporate dynamics in close relation to the unique institutional environment and the careful selection of independent directors on the board. Government ownership of control is like a two-edged sword. Government ownership can help the firm to success, but it can also bring the firm to collapse. This is the typical lesson of Kelon. The company rose from the effective shield of local government at the very lower administrative tier so that the usual symptoms associated with large fossilized SOEs were minimized, while the government’s help was provided for strengthening the firm’s capability to compete in the market where competition is incomplete, regulations are poor and the judicial system is inefficient. When Kelon became big and transformed itself to a public-traded company, the improvement of corporate governance did not match the corporate ownership changes from highly concentrated state ownership to a diluted one. The gradual deviation of local government interests from company’s profitability resulted largely from the separation of cash rights and control rights: diluting substantially cash rights from 80 per cent to 30 per cent, but the control rights still remained intact. On account of the pursuit of fast local GDP growth which requires a lot of investment to support, the corporate cash assets arising from the IPO inevitably became governmentcontrolled capital that could be channelled for public uses to support local

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economic development and also for financing some high-risk projects that promoted short-term sales to boost a rise in tax revenues but at the expense of long-run profitability of the firm. Meanwhile, the government decreasing its interest in profits created an opportunity for the management to raise costs via related party transactions. The management’s moral hazard was further worsened since poorly designed incentive contracts were introduced for the company directors. This resulted finally in entrepreneurship giving way to predatory action. The entry of Mr Gu after the abrupt failure of Kelon seems a mixed blessing. On the one hand, he has had initial success in turning the troubled Kelon into a fairly profitable business; on the other, it is still a vital concern that Gu, a controlling shareholder, similar to the previous owner of Rongqi government, could one day be lured to substitute rent-seeking for profitmaking. Indeed, being a private owner alone does not mean immunity from the generic agency problems deeply seated in the system, which is also evidenced by a recent glaring collapse of D’Long Ltd, China’s largest private business group (Far Eastern Economic Review 2004). The preceding account of the case clearly implies that the agency problem of an expropriating blockholder is endogenous to the institutional environment characterized by a weak legal system and poor regulatory protection of investors (La Porta et al. 2000). Given the few efficacious internal organizational constraints on the blockholder’s self-dealing behaviours (Holderness and Sheehan 2000), the reform of the legal and government regulatory system to better monitor and punish the large shareholder’s opportunism definitely should be on the top agenda of corporate governance reform. Both statutory provisions22 and legal enforcement must be put in place to deter those potential corporate expropriators. Needless to say, this is a difficult task and a painful institution-building process for a transitional and developing economy, not least because on many occasions the predatory offender is the government itself. However, unless there are significant improvements in corporate governance, Chinese public companies will repeat the experience of Kelon, regardless of whether the government or private sector23 is a controlling owner. Investor protection aside, China’s regulatory bodies should endeavour to redress the current short-termist ethos prevalent in large Chinese shareholders. Worse than the similar charge on the part of Anglo-American corporate managers, who allegedly pursue short-term stock market valuation at the expense of long-run competitiveness (for example Porter 1992), Chinese controlling shareholders seem to maximize the funds that they can tunnel from the listed firm before their eventual exit! To prevent such egregious opportunism, the Chinese reform of corporate governance should be advanced in two dimensions. One is to improve the legal environment.

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That is to say, it needs appropriate regulations to ensure that no one can get away with their prior value-destroying behaviours even after they retreat from business. Another is to improve the board for more independence from its large shareholders. This requires the board to consist of more independent directors for ensuring the effective monitoring of the decision process. Furthermore, new private shareholders should be asked to hold their newly acquired stakes for a minimum of several years, which may reorient their incentive structure towards long-term wealth creation.

QUESTIONS FOR DISCUSSION
1. In 1999, the retirement of corporate veteran Mr Ning Pan, who had been the general director of Kelon since 1984, marked a turning point of Kelon from its successful rise to a fall in business. Does this suggest that a corporate hero is more important than corporate governance in influencing the fate of a company, in particular, a Chinese company? 2. Government ownership is like a two-edged sword, in that it can be helpful for business, but also it can be predatory. In the case of Kelon, how did the government as the largest shareholder behave in controlling the business? Does the case of Kelon imply that government ownership is always bad for business? 3. Which of the following problems was dominant in attributing to the fall of Kelon: (a) government ownership and its predatory behaviour; (b) managerial moral-hazard; (c) the weaker constraint of corporate governance on the largest shareholder; (d) failure in selecting a capable CEO to replace Mr Pan; and (e) all of the four above? Discuss.

NOTES
1. Huang, Yasheng and David Lane (2001), Harvard Business School Case Study No. 702– 039 (March 22). 2. In the late 1990s Kelon was lauded to the skies by the business media as well. For example, it was ranked in the top 20 of the world’s 300 best small companies by Forbes. For more details, see Huang (2003, p. 185, note 47). 3. For a rigorous presentation of the argument on TVE success, see Li (1996) and Tian (2000).

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4. The factual details of Kelon in the section are primarily based on Huang (2003, Chapter 4), Bruton et al. (2000) and various Chinese sources. 5. Since township leaders are in the lower bottom of the bureaucratic hierarchy in China, their interests are better aligned with the local community and they show more entrepreneurial spirit than those in higher bureaucratic ladders. For more discussion on this, see Huang (2003, pp. 149–50). 6. One of the key measures taken was to make Kelon artificially affiliated to (guakao) the Machinery Building Bureau of Guangdong province, so that it would look like a provincial-level SOE. Such arrangements were quite common during the early years of transition, and were called ‘wearing red caps’ in Chinese. For an elaboration of the reasons why local governments are highly motivated to support their firms, see Liu et al. (2005). 7. The listing process of Chinese enterprises is highly regulated by the central government in the sense that it has the complete authority to determine which firm can be listed on international or domestic equity markets for financing. Of course SOEs constitute the bulk of the firms selected by the centre. 8. The term denotes mainland firms quoted on the Hong Kong market. 9. It can also be evidenced by the board structure of Kelon: a majority of the directors are company insiders and only one position is filled by a representative of foreign institutional investors. 10. The term is borrowed from Bebchuk et al. (2000). 11. It is verified by La Porta et al. (1999) and Claessens et al. (2000). 12. It seems that reputational constraints on controlling families alone fall short of preventing tunnelling activities. The blatant fraud and embezzlement conducted by the founding family at Parmalat, Europe’s largest dairy-products group, are a highly publicized case in point (e.g. Business Week 2004; Economist 2004). 13. Wang remained the board chairman until June 2001, when Xu formally took the chairmanship as well. But he disappeared from the public scene after he resigned the CEO position in June 2000, and was reportedly enthusiastic about tourism. 14. Local tax revenues are crucial for local governments to create more jobs and initiate public projects that can promote local GDP growth in the short run. 15. The corporate board in Kelon was restructured in November 2001, when representatives of the township government left the board as a result of a control transfer agreement signed in October. Gu Chujun and his associates henceforth dominated the board. 16. It was founded in October 2001, so it seems obvious it was formed for ease of the planned acquisition. There was a minor change in the ownership structure of the holding company later on; see the note in Figure 9.8 for details. 17. Rongqi Township shortly sold the remaining shares to several local companies in 2002 for a complete exit. 18. Negotiated block transfers, rather than the Anglo-American style tender offers, are the norm in the Chinese equity market. For institutional backgrounds of the phenomenon, see Liu and Sun (2005). 19. Otherwise it would be very hard to understand how the expenses to sales ratio could be reported as high as 46.5 per cent in 2001, which was previously unheard of in the white goods sector (see Figure 9.11). 20. The extremely high level in 2002 is mainly related to the funds tunnelled by the previous government shareholder in 2000 and 2001, which are recorded as amounts due from the township government. When they are written off in 2003, the account drops to a fairly small amount. 21. Another speculation is that Gu obtained bank loans in the name of Kelon and used them to take over his other targets. 22. For example, corporate and securities law reform and the adoption of best-practice corporate governance codes. 23. China Securities Regulatory Commission (CSRC) releases the fact that at the end of 2002, 676 out of 1175 listed firms in China were engaged in the appropriation of funds by the large shareholders, the amount of which totalled RMB 96.7 billion.

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