Corporate Governance Failure in GOME - Case Study Example

Executive summary

Corporate governance is a key aspect of any corporation as it can be considered to be a channel that ensures the safety of the shareholders’ investment as well as ensures that the company’s going concern is assured. Corporate governance simply refers to good and acceptable business ethic. In other words, corporate governance is a function of the company that ensures that the company or corporation does not engage in fraudulent or dubious activities that would in turn hurt the Corporation and or its shareholders. A pertinent body to corporate governance is the board of directors that acts as the oversight team within the company or in other words the stewards of the company on behalf of the company. The board of directors is very fundamental in corporate governance such that corporate governance can’t be what it is without the function of the board of directors. The board of directors ensures that the interests of the shareholders are not overlooked or sidelined in the course of the company’s operations. To ensure this, the directors of the corporation are mandated with various duties that they owe to the shareholders such as the fiduciary duties.

Corporate governance is governed by certain principles devoid of which corporate governance would be considered a failure. One of the principles governing corporate governance is accountability. The directors of a company are required to uphold accountability in the administration work they are mandated with, in their administrative functions in their control of other bodies within the company. Another principle governing corporate governance is transparency. This means that the directors are required to disclose all relevant information in time and present a clear and comprehensive report regarding the activities the corporation has been engaged in the course of any particular period. In addition to that CG requires that director exercises fair treatment to all of its shareholders without impartiality and protect the rights of all shareholders as well. Finally, the directors are required to be responsible for their decision making especially when it comes to getting into strategic alliances with other companies or undertaking major projects. The breach of any of these principles amounts to a failure of corporate governance as will be evidenced by the case study in this paper.

Introduction

Failures in corporate governance have been witnessed in many corporations, and this has prompted the investors and the shareholders to take measures to ensure that these trend does not persist. This paper will focus on the failure of corporate governance GOME Electrical Appliances Holdings Limited. The company was founded in the year 1987 by Huang Guangyu. Among other factors that would have contributed to the success of the company, application of the best price strategy or what Michael Porter referred to as cost leadership strategy was pertinent to the company’s success (Anan, 2011). The founder of GOME happened to be the chairman of the board of directors up until issues contravening the requirements and principles of corporate governance were unveiled within the company. This case presents the breach of the principles corporate governance and the violation of the duties of the directors to the shareholders in more than one aspect which makes it perfect for a study on failure in corporate governance. This case study exhibits failure of corporate governance through lack of transparency by the director, breach of the directors’ fiduciary duties to the shareholders, engagement in fraudulent activities which is primarily breach of accountability and trust as well as the directors giving priority to their interests over the interests of the shareholders.

GOME’s corporate governance

As mentioned above, one of the reasons that made GOME reach the heights of success that did was the application of the cost leadership strategy in which case the company provided products at the lowest prices in the market. Selling the electrical appliances for the lowest prices in China earned Huang, the then chairman of the board of directors of GOME, the title of price butcher. After reaching a particularly high level of growth, Huang decided to list the group on the Hong Kong stock exchange in the year of. This move would see the share prices of the group go up to the benefit of the shareholders and other private investors. However, not all of the stores operated by GOME were recorded for listing with the securities exchange instead some of them were left under the control of Huang and were managed through the management memorandum of agreement (Anan, 2011). The expiry of this agreement would mean that Huang would resume full control of the stores. Following the listing, the growth of GOME hit new highs placing the company at a market leadership position in its industry in the country. The growth of GOME contributed largely to earning Huang a net worth of $6.3 billion in the year 2005.

The success and growth of GOME under the management of Huang were remarkable, but the techniques and methods he applied to get the company to that position were not all that legitimate. This became evident when he was placed under arrest for corporate corruption. Huang’s arrest was followed by the cessation to trade GOMES shares on the exchange. Corporate governance requires the directors not to engage in dealings that are likely to harm the company or its shareholders. However, Huang acted in disregard for this requirement as one of the wrongs he was being accused of was bribery (Anan, 2011). The outcome of the investigation conducted in light of the bribery allegation indicated that Huang had been involved in direct and indirect bribery in return for special treatment and favors by certain government officials. In addition to that, the investigation proved that Huang had been involved in the bribery of some tax officials to ensure that they did not report that the company was evading tax by driving some of its capital to a shell company. Based on the principles of corporate governance, this was a mega violation of the director’s duty to care for the shareholders.

Insider trading is considered an offense as it entails getting information about certain plans crucial changes that are about to happen within the company that is likely to cause a favorable or adverse move in the share prices of the company. Huang was found to be guilty of this offense as well, and it exhibited material breach of transparency and yet another disregard of the adverse effects that this would have on the company and its shareholders. The insider trading involved the purchase of shares of Centergate Technologies holding company limited a company in which Huang was classified as a major shareholder. Besides buying the shares for himself, Huang also revealed the information to Beijing Eagle Investment Co. Ltd and required the company to purchase a lot of shares from Centergate. This company was under the control of Huang as well which meant that Huang would gain much more. The actual value of the shares that Huang instructed Eagle to buy was $940 million. The prices of the shares of Centergate escalated as was expected to allow Huang to make millions of dollars. Hung was also found to have been involved in insider trading in Sanlian Commercial. In addition to insider trading, the investigations showed that Huang had been involved in money laundering mischiefs. Corporate governance requires that if the directors interest conflict with those of the company, the interests of the company should be given preference. However, the fact that Huang indulged in these fraudulent and criminal activities clearly show that he gave preference to his interests over the interests of the company (Anan, 2011).

Share repurchase by a company happens when the company is considering issuing a new share that has different attributes than the one in circulation or the event that the company wants to reduce its share capitalization. However, this happens after serious considerations are made by the board of directors. Besides the unlawful activities that Huang was found guilty of, it was found out that he was engaging in unlawful activities outside China. Huang had a huge personal loan amounting to HK$2.4 billion and to repay it, he and his wife made plans to sell their shares in GOME back to the company. Huang’s wife had a company that she owned fully and so Huang transferred 50million share to this company. In addition to that, shine group limited, a company that was fully owned by Huang transferred about 136 million shares that it owned in GOME to persons purported to be Huang’s family members. Shortly after Huang’s mad the share transfers, GOME initiated the share repurchase process buying about 129.8 million of its shares from the market at a price per share of HK$17.23. The share repurchases cost GOME an approximate amount of HK$2.2 billion (Anan, 2011).

It is important to understand that Huang was a major shareholder in GOME and the fact that he was also the founder of the company and the chairman of the board of directors meant that he had the capability to convince the board to buy back the shares. Huang gained from this transaction, but the company, and the shareholders suffered. The securities and future Commission of Hong Kong pointed out that this buyback would have adverse implications on GOME and its shareholders as well (Anan, 2011). The buyback of the shares resulted in an increase in the prices of the company’s shares which allowed Huang to dispose his shares in the company at a good price but at the end of the repurchase process, the value of the shares dropped. This resulted in a loss of HK$1.6B of shareholder’s investments. The realization of this mischief by the securities exchange prompted it to freeze further movement of the stocks that Huang still owned in GOME, and this caused the share prices to dip ever lower. This was meant to secure the interests of the minority shareholders, but it was at the expense of non-controlling shareholders. This actions further exhibit that Huang acted in disregard of the interests of the shareholders but for his interests. The directors-shareholder’s relationship is one of trust, and these actions share repurchase plan by Huang was a clear violation of this trust.

All these criminal allegations tabled against Huang prompted him to resign in 2009 as the chairman of the board of GOME on the excuse that he was unable to continue playing his role in that capacity. The chairman who took over after Huang, who was called Chen, decided to take a completely different approach from that the one that had been enforced by Huang. His focus was directed to creating closer and stronger relationships with the suppliers to enjoy the economies of scale and safeguarding the interests of the investors and the shareholders. Chen’s moves were geared towards safeguarding the investment of the shareholders by improving the efficiency of the company through the closure of some stores that he considered to be non-performing due to their low-profit yields. Considering the hit that the company had suffered after the share repurchase, Chen opted to attract more shareholders and seek investments from private investors to boost the financial capability of GOME (Anan, 2011). The image of the company had been tainted by the actions of Huang, and Chen was on the path to restoring the favorable image of the company by bringing on board credible investors, a move that Huang disputed while in prison. Eventually, Chen made a deal with Bain Capital, who injected HK$418 million into the company hence acquiring 23% stake in the company. Following the closure and announcement of this deal, the value of shares of GOME escalated by 107%.

Regardless of the huge amount of shares that Huang had disposed of GOME, he remained to be the company’s largest shareholder while the capital injected into the company by Bain enabled it to be the second largest shareholder. Bain Capital was also allowed to nominate three individuals as its representatives to the board of directors of GOME, an arrangement that Huang opposed harshly even after he was sentenced to fourteen years in prison in May 2010. In August of the same year, a lawsuit for breach of fiduciary duties of a director was filed against Huang by the board of GOME. In retaliation to this lawsuit, Huang made begun making attempts to remove Chen as the chairman of the board and his attempts eventually bore fruits. Chen resigned from the chairman of the board of GOME, and his position was filled by Zhang, who initiated plans to expand GOMES operations.

This case study exhibits failure of corporate governance in many aspects. It exhibits the breach of trust that subsists between the shareholders and the directors, breach of fiduciary duties, breach of duty to care, directors sidelining the interests of the company and the shareholders in preference to their interests and engagement in fraudulent and corruptible activities. As evidenced by this case, the shareholders bear the brunt of failure in corporate governance due to their minimal involvement in the daily activities of the company. According to the agency theory, the directors act as stewards, managing a company that belongs to the shareholders and not the directors themselves (Anan, 2011). The fact that the shareholders exercise minimal control over the daily operations of the company puts their investment at risk in the event of corporate governance failure. The stewardship theory explains the role of the board of directors to act in the best interests of the shareholders. The criminal actions of Huang were in violation of this role while the measures taken by Chen to safeguard the interests of the shareholders and investors was in line with the requirements of the stewardship theory.

In the United Kingdom, corporate governance is based on a framework of complying or explain. This means that the directors are either supposed to comply with the principles of corporate governance in the UK or explain precisely when they contravene those rules. However, there are challenges that are attached to the application of this framework, and that arises especially when there lacks proportionality between substance and form of the issue at hand. This means that in most cases the directors do more explaining of their actions as opposed to complying with the rules, something that does not settle well with the investors who argue that explanations are not good enough. In the case cited above, the share repurchase scandal perpetrated by Huang was considered a violation of the principles of corporate governance by the director and was primarily the reason he was guilty in this regard. In the UK however, this accusation would have been dependent on whether or not the share of the company were covered by the listing rules of the exchange or whether the listing of the company was a standard listing. In this two scenarios, the code of corporate governance does not apply and so Huang would have been found guilty or not on other grounds other than breach of the corporate governance code.

One of the roles of the non-executive directors is to keep the executive directors on toes and ensure that they do not contravene the rules of corporate governance. However, the fact that Huang violated the rules of corporate governance many times on the watch of the non-executive directors means that the non-executive directors of GOME were not effective. The fact that Huang and his wife owned a significant portion of GOME and that Huang was the chairman of the board meant that there were high chances of there being conflicts of self-interests and those of the company (Anan, 2011). To avoid such a scenario, companies should consider electing to the position of chairman or director individuals who do not have material self-interests as far as the company is concerned. The CG rules in the United Kingdom are not are stringent as they ought to be to combat the issues raised by this case studies as they give the directors a lot of control over the companies. To minimize the possibility of such issues from arising in other companies in the United Kingdom, these rules should be made to be more stringent and well defined.

Conclusions and recommendations

Corporate governance is pertinent to sound management of a company, and the main essence of corporate governance is to ensure that the interests of the shareholders are taken care of and not ignored. Under corporate governance, a board of directors is created, and the role of these directors is essential to handle the operations and control of the company on behalf of the shareholders. The objective of corporate governance is to ensure that there are accountability, transparency and fairness in the conduct of business within the company and that the directors act responsibly in executing their roles and application of authority bestowed upon them by the shareholders. However, as seen in the case study presented in this paper, the rules of corporate governance can be violated by the directors.

One of the issues that could increase the possibility of violation of the rules of corporate governance having the members of the family that owns the company as part of the board of directors. In one of the violations of the rules of corporate governance, the director decides to settle his loan by prompting the company to repurchase its shares and ensuring that he sells his shares in the company to settle his debt. This is a clear violation of the CG principle that requires the directors to put the interest of the company before their interests. The only way that the shareholders get to know of the performance of their companies is through the interim financial reports of the company or the reports released at the end of the accounting period. However, to ensure that the directors act more responsibly, the corporate governance rules should require the directors to present detailed statements indicating all the activities the company has been involved in in the course of the accounting period. Additionally, measures should be put in place to facilitate more involvement of the shareholders in the operations of the company in a bid to increase security for their investments.