Asia Pac J Manag (2011) 28:853–879 DOI 10.1007/s10490-009-9184-x
Corporate governance failure and contingent political resources in transition economies: A longitudinal case study Pei Sun & Kamel Mellahi & Guy S. Liu
Published online: 30 December 2009 # Springer Science+Business Media, LLC 2009
Abstract This paper explores the dynamic relationship between politicians and entrepreneurs in the governance of business organizations in transition China. A longitudinal case study of Kelon (1984–2001), a product of politician-entrepreneur alliance in China’s household appliance sector, reveals how certain political resources that once assisted the entrepreneurs in creating competitive advantages in transition economies may turn into political liabilities during the course of institutional transition. Drawing upon the resource-based view (RBV) of the firm, the rent appropriation literature, and the agency theory, this paper sheds light on the contingent impacts of political resources on corporate governance and firm performance in transition economies. Although prudence requires anonymity for government officials and business managers that cannot be publicly acknowledged, we are eternally grateful to the essential help they have offered for us to conduct fieldwork in China. Meanwhile, we are indebted to Garry Bruton (the Senior Editor) and the two anonymous reviewers for their insightful and constructive comments. We also acknowledge Andy Lockett, Mike Wright, Qiren Zhou, and the audience of our presentations on the Strategic Management Society 26th Annual International Conference in Vienna, October 2006 and on the Launch Conference of the British Inter-University China Centre in Oxford, June 2007, for their valuable comments on earlier versions of the paper. Financial support from China’s national “211 Project” (project code: 211xk06), Shanghai Pujiang Program, and Nottingham University Business School is greatly appreciated. P. Sun School of Management, Fudan University, 670 Guoshun Road, Shanghai 200433, China e-mail:
[email protected] K. Mellahi (*) School of Management, University of Sheffield, 9 Mappin Street, Sheffield S1 4DT, UK e-mail:
[email protected] G. S. Liu Department of Economics and Finance, Brunel University, Uxbridge, Middlesex UB8 3PH, UK e-mail:
[email protected]
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Keywords Political resources . Corporate governance . Resource-based view . Agency theory . Transition . China
Organizational failure, an important topic in business studies and a major challenge for management practice, has been extensively examined in the developed economies (e.g., Hambrick & D’Aveni, 1988; Mellahi & Wilkinson, 2004). While it has been well recognized that a large number of the recent high-profile failures, such as Enron and Parmalat, have deep roots in their corporate governance mechanisms (Buchanan & Yang, 2005; Healy & Palepu, 2003; Mellahi, 2005), detailed investigations of the link between governance failure and company failure in transition economies have been largely off the academic radar screen. Moreover, extant research has paid inadequate attention to the institutional and political factors that may lead to governance failure, and to how it further induces organizational failure in the transition economies context (Bruton & Lau, 2008). Recently scholars have called for research to address this important gap in our knowledge on the association between corporate governance mechanisms and performance in emerging and transition economies (Li & Nair, 2009). This paper intends to narrow this gap by examining the role of political resources in corporate governance and organizational failures in transition economies. Specifically, a longitudinal case study of Kelon, a famous home appliance company in China, serves to explore the complex relationship between political resources and corporate governance dynamics. Previous studies show that the ability to capture political resources constitutes a critical building block for competitive advantage for many firms operating in transition economies, where the competitive landscape is characterized by “institutional void” (Khanna, Palepu, & Sinha, 2005). For instance, Frynas, Mellahi, and Pigman (2006) found that firms that were able to generate rents via the exploitation of political resources tended to gain a head start (first-mover advantage) over their rivals. The financial benefits of firm-specific political connections in transition economies have also been estimated to be substantial by a number of empirical studies (Faccio, 2006; Fisman, 2001; Khwaja & Mian, 2005). The case for painstaking cultivation of political resources may be more compelling for entrepreneurial start-ups in transition economies such as China, where the government still controls a wide range of financial and regulatory resources and maintains a tendency of channeling them to the state sector (Huang, 2003; Peng, 2000). In particular, start-ups that can link themselves to the government through ownership arrangements often enjoy a privileged treatment by the local governments and less policy discrimination from the central government agencies ( Li, 1996; Nee, 1992; Tian, 2000; Walder, 1995). Consequently, it is not surprising that firms in transition economies make extensive use of political resources not only to avoid arbitrary fees and charges and other forms of government extortions, but also to gain access to various critical resources that the politicians could confer. However, just as core capabilities may become core rigidities under certain circumstances (Leonard-Barton, 1992), an emerging body of research shows that political resources, like other capabilities, are contingent by nature: A firm’s competitive advantage generated with the aid of political actors could be lost as a result of sudden changes in the political environment (Leuz & Oberholzer-Gee,
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2006; Siegel, 2007), evolutionary changes in the business environment (Li, Zhou, & Shao, 2009; Sun, Mellahi, & Thun, 2010a), or intense bargaining over firm surplus between politicians and other corporate stakeholders (Sun, Wright, & Mellahi, 2010b). In this paper, we contribute to the above emerging body of research by exploring how a firm’s initial political affiliation shapes the evolution of corporate governance mechanisms in the unique institutional environment of transition economies, and show how political resources contribute to the destruction of competitive advantages that were created by them in the first instance. By examining the dual nature—upside and downside—of political resources, we aim to document the process in which political resources over time generate unintended adverse consequences that run counter to the initial reasons for the pursuit of them. The rest of this paper is structured as follows. After a discussion of the extant literature on the strategic value of political resources, we undertake an in-depth longitudinal case study of Kelon and analyze the process through which political resources contribute to both business success and corporate governance failure in the context of institutional transition. Concretely, Kelon rose from the effective shield of the local government at the very lowest administrative tier. The government’s helping hand stood it in good stead in a transition economy with pervasive market failures, misguided regulations, and ineffectual judicial systems. However, when it became a big business and transformed itself to a publicly traded company, new corporate governance problems arose. The gradual deviation of local government interests from those of the company as a whole resulted in a large part from the substantial attenuation of shareholdings with undiluted corporate control. Owing to the pursuit of fast local GDP growth and the extraction of private control benefits, IPO proceeds and productive assets were channeled to promote short-term sales at the expense of long-run profitability, and to the government coffer through a series of related-party transactions. Meanwhile, the previously ambiguous relationship between the government and the management was not rationalized in a fashion that could provide the latter with long-term commitment to the firm through properly designed incentive contracts. In the end, long-term commitment degenerated into short-term opportunism, and entrepreneurship gave way to predation. By examining the rise and fall of Kelon in relation to rent extraction by local political institutions, the findings of the case study help us identify a blind spot in the extant political resources literature. That is, while the resource-based view (RBV) was applied to interpret the role of political resources in generating organizational rents in the initial stage, the current RBV literature fails to explain the dynamics of rents once they are generated by political resources. Accordingly, we advocate the need for theoretical pluralism by introducing rent appropriation literature and agency theory as complementary lenses to develop theoretical propositions that explain how political resources lead to corporate governance and organizational failures. The final section concludes with both theoretical and practical implications.
The strategic value of political resources Political resources can be defined as “any firm attributes, assets, human resources or any other resources that allow the firm to use the political process to improve its
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efficiency and profitability” (Frynas et al., 2006: 324). This broad conceptualization is also consistent with Barney’s (1991) threefold typology of resources: (1) physical and financial resources associated with political support; (2) human capital resources, such as personal connections with powerful political actors; and (3) organizational capital resources, such as organizational legitimacy through affiliation with government organizations. Furthermore, the three types of political resources may well be interrelated. For example, both political affiliation at the organizational level and political connection at the interpersonal level can help a firm to obtain more physical/financial resources during the political process. A substantial body of research (e.g., Hillman, Keim, & Schuler, 2004) has attempted to explain the benefits that firms could derive from nurturing, managing, and exploring political resources. The existing research on the strategic importance of political resources has been dominated by the assertion that, whether in developed or in emerging economies, successful firms tend to understand, nurture, and exploit political resources better than their rivals. Further, to the extent that firms’ ability to cope with political regulations governing business operations is highly unevenly distributed (Leone, 1981; Oster, 1982), political resources fit the requirement of the RBV fairly well, because they are frequently in scarce supply and are difficult for rivals to match (Boddewyn & Brewer, 1994; Dahan, 2005).1 Boddewyn and Brewer (1994: 136) argued that “the most effective political behaviors are often covert in nature, whether legal or not” thus “barriers to imitation may be higher in the case of political competences because of their lower visibility.” Therefore, the RBV of the firm has been proposed as a useful perspective for understanding why and how political resources can help a firm to achieve significant competitive advantages over its rivals. For firms competing in the unique environment of institutional transition, the relevance of political resources cannot be emphasized enough. Furthermore, their bearing on different organizational forms tends to vary as well. In the case of China, the incumbents—large state-owned enterprises (SOEs)—are endowed with abundant political resources throughout the transition, whereas the fringe players—entrepreneurial start-ups—must try their best to develop and seize political resources for their own survival and growth. Therefore intensive networking with government officials and “boundary blurring” strategies have been adopted by the start-ups to navigate the discriminatory non-market environment (Ahlstrom, Bruton, & Yeh, 2008; Nee, 1992; Peng, 1997, 2001, 2003; Peng & Heath, 1996; Xin & Pearce, 1996). As a result, many start-ups with strong political connections in China blurred the pubic– private boundary by registering themselves as collective firms subordinate to grassroots level governments, such as the township and village enterprises (TVEs). Dubbed “wearing a red hat” in Chinese (Chen, 2007), the strategic affiliation with government agencies was very common in the early stage of economic transition in China, where ideological hostility to and policy discrimination against the pure private ownership died hard. Given the strategic importance of political resources in transition economies like China, one would expect most firms to seek political resources. However, just as the 1
For early discussions of the RBV, see Barney (1991), Peteraf (1993), and Wernerfelt (1984).
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value of a generic resource is larger in an organization where it is rare (Powell, 1992), the urgency of exploiting political resources is much stronger on the part of local startups, while large SOEs always take their possession of political resources for granted. Thus, it ends up with an irony that the former rather than the latter exhibit a higher capability of political resources development. This is confirmed by the previous empirical finding that, other things being equal, managers in non-state firms helped their firms to benefit more from their ties with government officials in terms of performance than their SOE peers (Peng & Luo, 2000; Xin & Pearce, 1996). Having said that, political resources alone may not necessarily lead to significant competitive advantages. Rather, political resources become more valuable when combined with market-based capabilities and functional experience such as excellence in technical, marketing, and entrepreneurial skills. For example, Bruton, Lan, and Lu (2000) enumerated various market-based resources developed by Kelon in physical, human capital, and organizational dimensions. In other words, it is not political resources per se, but the way in which firms bundle political resources and market-based capabilities that make them generate superior returns. Despite the persuasive arguments for the benefits of political resources exploitation, they should be qualified with the realization of the potential harms they may generate over time. Traditional political risk analysis concerns the appraisal of macro factors such as the stability and strength of governments and the socio-economic trends in host countries for multinational corporations (MNCs) (Bremmer, 2005). It does touch upon the adverse effects of political actors but fails to offer any systematic examination on why and how political resources can turn into liabilities for individual market players. In recent years, a stream of firm-level studies has emerged examining the dark side of political resources. Some scholars focused on the vulnerability of political connections in response to exogenous political shocks such regime change or coups d’état. Leuz and Oberholzer-Gee’s (2006: 411) study of change in firms’ returns as a result of regime changes in Indonesia concluded that “the performance of closely connected firms might vary dramatically over time depending on the political fortunes of their backers … political connections can lose their value overnight when the government fails to win an election.” Siegel (2007: 625) finds that changes in political regimes can result in “negative cascades of discrimination, resource exclusion, and even expropriation and sabotage” for South Korean firms that were tied to the sociopolitical networks that lost power. In the absence of political shocks, other studies reveal other channels through which political resources may harm firm performance. For instance, Party control and politically-connected CEOs have been found to jeopardize managerial autonomy and professionalism in Chinese listed companies (Chang & Wong, 2004; Fan, Wong, & Zhang, 2007). Li and colleagues (2009) find that multinational enterprise (MNE) managers’ ties to government officials in China negatively moderate the positive performance effect of their product differentiation strategy. Moreover, a longitudinal study of multinationals in the Chinese auto industry revealed that a multinational’s deep embeddedness in China’s local political institution networks can result in cost inefficiency and underdevelopment of market-based capabilities (Sun et al., 2010a). In sum, emerging research on the liability side of political resources focuses either on the potential damages that derive from personal connections to political actors in
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the course of political shocks, or on the impacts of political resources on marketbased strategies/capabilities during economic liberalization. A key reason for undertaking this in-depth case study of a single company and research site, is that managers and policymakers alike may be exploring alternative methods of governance for their firms and economies, such as the public-private partnership. In doing so, they will quite naturally look to what seem to be successful models, such as China’s township and village collectives. It is, therefore, important to clarify their performances—to get below the mainline financial reports and headlines about their performances and really follow these firms all the way through (Johnson & Kaplan, 1991). This study conducts such an in-depth case study of white goods maker Kelon, an important mixed ownership firm—a public-private partnership in China. In this paper, we believe the longitudinal case study enriches the aforementioned cutting-edge literature by unraveling new underlying dynamics and operating mechanisms leading to the negative value of political resources. It will be seen below that institutional affiliation to local governments can result in organizational failure even in the absence of external political shocks and negative spillovers to market-based capability build-up.
Methodology and data We believe the use of case study methodology is appropriate to explore the complex, non-linear relationship between political resources and long-run organizational performance. Specifically, we aim to explore why and how political resources help and/or damage organizational performance over time. Longitudinal case studies can presumably do a good job of revealing the very processes and mechanisms in which business organizations evolve and the particular circumstances and contingencies when these mechanisms operate (Van de Ven & Huber, 1990). As Shaffer (1995: 510; original emphasis) remarked, “The qualitative nature of the research emphasizes description of complex organizational processes and interdependencies; and the use of longitudinal research designs allows description of the evolution and variation in political strategies, corporate strategies and public policies over long time periods.” In terms of case selection, this paper’s single-case research design can be justified by the fact that Kelon represents a critical case (Yin, 2003: 40) in testing, extending, and challenging extant theories—the RBV theory of political resources in this context. Analogous to a critical experiment in natural science, even a single case would suffice if it represents a critical test of a theory, thus generating novel analytical perspectives, exploring new theoretical relationships, and reorienting future investigations in the field (Dyer & Wilkins, 1991; Lee, 1989; Yin, 2003). In the case of this paper, Kelon was among the well-known examples that demonstrate the strategic synergy of local politicians and entrepreneurs and its significant effects on the competitive advantages of the TVEs. The subsequent decline of Kelon in the late stage of transition, therefore, provides a unique opportunity to advance new theoretical development on the co-evolution of political resources and organizational performance in transition economies.
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Within the single case, we followed Yin’s (2003) approach of embedded case research design, which incorporates three embedded units of analysis. The main unit of our study is the firm as a whole, while the other two crucial analytical units are the township government and the management. At each level of analysis, efforts have been made not only to understand the behaviors and incentives of the two subunits, but also to understand how they interacted to impact the organizational performance. The case analysis employs multiple data collection methods. Given the sensitive socio-political environment in China, interviews with key players in failing organizations, especially the government-controlled ones, are very hard to arrange for outside researchers. In the case of Kelon, all the former top managers have been away from the company since 2002 and have led a secluded life either in China or overseas. Nevertheless, we have managed to alleviate the problem by approaching a Chinese scholar who was kind enough to give us the transcripts of his own and his friend’s interviews with Kelon’s senior management in the late 1990s. Moreover, the scholar has a close relationship with the authors and was thus happy to share his intimate knowledge about the firm and its interaction with the government agencies. To complement the secondary, albeit unique, source of data, we conducted four interviews with two local company managers and two local government officials in Guangdong province during April 17–19, 2006, each lasting about one and a half hours in a semi-structured manner. Consistent with the replication logic (Eisenhardt, 1989), the study developed an iterative process of data gathering and analysis. Interview questions were structured according to the category of the informants (managers versus government officials). Questions normally started off with their general impression and observation of the Kelon debacle, proceeded to identify the most important factors they believe accountable for the firm’s failure (e.g., competitive dynamics, relationship with government and regulatory agencies, management problems, etc.), and then moved on to broader issues, such as whether they think the factors and logic identified in this case also applied to failures of similar companies in transition China. Given the concern that retrospective interview data might involve faulty memory and retrospective sense-making on the part of our informants, we compare our interview data with the early transcripts and find no significant discrepancies. To further strengthen construct validity and triangulation (Eisenhardt, 1989; Yin, 2003), we employ a wide range of archival records, both qualitative and quantitative, to supplement the interview transcripts. Although little-known in the West, the coverage of Kelon in the Chinese media has been extensive because of its high profile, its previous success, and the depth of the crisis. Academic papers examining the success and failure of Kelon are available in both English and Chinese (e.g., Bruton et al., 2000; Huang & Lane, 2001; Liu & Sun, 2006; Zhang, 2004). In addition, the annual reports and other public statements of the listed firm provide a wide range of quantitative and qualitative information since the mid 1990s. All these materials have been carefully examined with reference to data and information about the external environment, such as the dynamics of home appliance industry competition and the evolution of government policies. Finally, we have constantly cross-checked information and data from the diverse sources to ensure the reliability
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and accuracy of our explanations. For example, assertions made in secondary sources will not be reported in the paper if they were not supported by the interviewees.
Case study findings Kelon once was a highly successful Chinese household appliance company, which was among the first batch of case studies on Chinese firms by the Harvard Business School (Huang & Lane, 2001). In 1999, it was ranked by Forbes in the top twenty of the world’s 300 best small companies (Huang, 2003: 185). It is well-known that local government support played a significant part in the rise of Kelon, a typical TVE established in the early 1980s. The local start-up obtained crucial assistance from the local governments and later political blessing from the central government, which helped it to achieve a strong competitive position in China’s white goods sector. However, the sudden collapse of Kelon shocked investors and even the closest, long-term observers alike by reporting an unprecedented net loss of RMB 1.5 billion ($170 million at the prevailing exchange rate) in 2001, with appalling scandals of controlling shareholder expropriation unfolding. The rest of the section is devoted to a detailed examination of the rise and fall of Kelon with special reference to the evolution of its corporate governance mechanisms and the changing impacts of political resources. The rise of Kelon (1984–1996): A public-private hybrid The success story of Kelon is typical of the phenomenal boom of China’s TVE sector in the 1980s and early 1990s. Unlike the traditional SOEs, TVEs were founded and financed by the very grass-roots level of authorities, i.e., townships and villages, which exhibited a tremendous degree of pro-business attitude to cooperate with local entrepreneurs. The institutional analysis of the pro-business attitude of the grass-roots level governments in transition China has been well covered in previous literature (e.g., Nee, 1992; Oi, 1992, 1999; Walder, 1995). Despite the ambiguous property rights arrangements between township governments and TVE managers, they, at least at the early stage of business, developed a relatively efficient division of labor, in which managers in the start-ups demonstrated their entrepreneurial flair in China’s transition economy while the local governments offered a crucial helping hand for the TVEs to overcome pervasive market failures and volatile business and political environments. The following overview of the history of Kelon clearly demonstrates the point.2 The Guangdong Shunde Pearl River Refrigerator Factory, the predecessor of Kelon, was founded in 1984 through collaboration between an entrepreneur and a township government. The former, named Wang Guoduan, ran a small factory producing cheap transistor radios at that time for a Hong Kong firm. The latter is a small town called Rongqi under the subordination of Shunde County in Guangdong, 2
Regarding the takeoff stage of Kelon, this paper draws heavily on Huang (2003: Chapter 4), and Huang and Lane (2001).
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a South China province adjacent to Hong Kong. Both Wang and the township were keen to explore new business opportunities at the advent of economic liberalization in China and the township government sent workers across China to investigate which consumer goods were in high demand. This type of rudimentary market research was yet unheard of in China, as the legacy of a centrally-planned economic system still dominated the country at that time. Despite having neither experience nor technical capability in refrigerator production at that time, the Rongqi township provided a seed capital of RMB 90,000 (roughly $30,000) and helped to secure a bank loan of RMB 400,000 ($130,000) for the construction of the plant. It should be noted that political support for the financing of business projects was essential in transition China: In the 1980s it was virtually unimaginable for the state-owned banking system to provide private enterprises with access to credit. Tsai (2002: 2; original emphasis) reported that “as of the end of 2000, less than 1% of loans from the entire national banking system had gone to the private sector.” Even today it would be very hard for a private firm in China to obtain large bank funds without dedicated government support (Brandt, Li, & Roberts, 2005; Liu, Sun, & Woo, 2006). In addition, Pan Ning, a vice-head of the township government, was henceforth assigned as general manager to work with Wang. Since the township leaders are in the very 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 (Huang, 2003: 149–150). This is also consistent with the general observation that a large number of former communist cadres become entrepreneurs in transition economies (Peng, 2000, 2001; Rona-Tas, 1994). Another essential support from the local governments was a political one. Apart from the political cover of the collective firm status provided by the township, local governments ranging from the township to the county, municipal, and provincial levels actively lobbied on behalf of Kelon for a production license from the central government in the mid 1980s. This was a time when the central government, intended to carry out a consolidating industrial policy in the increasingly fragmented white goods sector. The entry barrier was erected via the license system and it is understandable that Kelon’s application was initially rejected by the Ministry of Light Industry in Beijing because of its low status.3 However, local governments, especially the provincial ones, offered a critical helping hand for Kelon to overcome the entry barrier by intensive bargaining with the central government.4 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. As mentioned earlier, such “red hat” arrangements were quite common during the early years of transition in China. Eventually, it became the only non-SOE in the final list of 42 firms that were granted manufacturing approval, in spite of the fact that an annual output ceiling of 50,000 refrigerators was imposed on Kelon. The subsequent takeoff of Kelon in the white goods sector was dramatic, which totally surprised both economic bureaucrats in Beijing and those MNCs keen to grab 3
The central government initially granted 41 production licenses out of the existing 116 domestic refrigerator makers and ordered the rest to cease production (Liu, 2005: 37). 4 For elaboration on the reasons why local governments are highly motivated to support firms under their jurisdiction, see Liu et al. (2006).
862 Figure 1 The production volume of refrigerators at Kelon (1985–1996, thousands)
P. Sun et al. 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).
a lion’s share of China’s domestic market. By the year 1991, Kelon had already become the top refrigerator maker in China, producing 480,000 fridges and enjoying 10.3% market share in terms of the units sold.5 Figure 1 shows the explosive growth of Kelon’s output between 1985 and 1996, the year when it was listed on the Hong Kong Stock Exchange. Ironically, it was not until Kelon’s obtaining the leadership of the refrigerator industry that the key political support from the central government arrived. In January 1992, Deng Xiaoping visited the firm, as did Jiang Zemin in 1994. In China this represented a crucial commitment the central government would make to support a business enterprise. As a result, Kelon became the first Chinese TVE allowed by the central government to float on the Hong Kong Stock Exchange. It needs to be emphasized that 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 and domestic equity markets for equity financing (Walter & Howie, 2006: 107–130). Of course, SOEs constitute the bulk of the firms selected by the central government (Liu & Sun, 2005). In terms of ownership distribution, Kelon was also a pioneer in corporatization experiments. Table 1 shows that as early as 1992 the firm was transformed to a shareholding company, in which the Rongqi township government held 80% of shares via a holding company called Rongqi Township Economic Development Company, and managers and employees were offered the remaining 20% stakes. Thus the newly formed Kelon Electrical Holdings Co. Ltd. was an envy of peers in the domestic sector at that time, in that it combined committed government support with a high-powered incentive scheme for employees. During the first half of the 1990s, Kelon maintained the top one position in the highly competitive domestic refrigerator market and diversified into related segments including freezers and air conditioners. Moreover, its significant growth resulted in a nationwide presence in the white goods industry in terms of both production and distribution networks. All of these culminated in the year 1996 with high profile stock flotation in Hong Kong and the subsequent domestic listing in 5
In hindsight, it must be the case that the annual output ceiling imposed by the central government was never strictly enforced due to the implicit support of the local governments ranging from provincial to township levels. Therefore, support from local governments plays a crucial role in the growth of business firms during transition.
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Table 1 The evolution of Kelon’s shareholding structure, 1992–1999. Between 1992 and 1996
Major shareholders
After Hong Kong listing (Year end 1996) Shares held (%)
After Shenzhen listing (Year end 1999)
Major shareholders
Shares held (%)
Major shareholders
Shares held (%)
Rongqi Township Economic Development Corporation
80
Guangdong Kelon (Rongsheng) Group
38.31
Guangdong Kelon 34.06 (Rongsheng) Group
Managers and Employees
20
Standard Chartered Bank
12.31
Standard Chartered Bank
8.63
HSBC Co. Ltd.
12.04
HSBC Co. Ltd.
7.47
The Chase Manhattan Bank
10.19
Franklin Templeton Group
6.92
Citibank NA
6.16
The Chase Manhattan Bank
5.87
Morgan Stanley Dean Witter Hong Kong Securities Ltd.
1.87
Citibank NA
5.24
Deutsche Bank AG
2.85
Both Rongqi Township Economic Development Corporation and Guangdong Kelon (Rongsheng) Group Company were wholly-owned subsidiaries of the Rongqi township government. The latter was created before the public listing in Hong Kong to replace the former as Kelon’s intermediate controlling shareholder. Source: The annual reports of Kelon Electrical Holdings Co. Ltd. (1996–2000).
Shenzhen in 1999. The trade of shares for equity finance resulted in a cash injection of HK$ 1.44 billion and RMB 1.06 billion ($132.5 million) by the public investors, while the holding rights of the township government were sharply diluted to around 34% (See Table 1). To sum up, the success of Kelon resulted largely from the synergy achieved between grass-roots level governments and the TVE entrepreneurs under the unique environment of economic transition in China: On the one hand, the local government offered an essential helping hand for the firm to survive and grow in a deficient institutional environment filled with discrimination against non-state firms, unfair competition, and pervasive market uncertainties. The critical political resources contributed by government bodies ranged from organizational legitimacy to seed capital, to bank and equity finance, and to the production license in association with market entry barrier. On the other hand, the government granted sufficient autonomy to the firm managers, who were free to build up market-based, firm-specific competences and capabilities. That the township government generally refrained from short-sighted predation of the firm assets at this stage is owing to the fact that local government officials had considerable encompassing and long-run interests in the TVEs. They are encompassing because the officials had relatively complete income rights from the TVEs which were generally not subject to arbitrary reallocation by higher government departments. They remained long-run because, unlike their
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superiors and large SOE managers, grass-roots bureaucrats typically work in their localities for life and thus share much enduring interests with the TVEs. The decline of Kelon: How a political helping hand became a grabbing one Representing a role model of the reformed Chinese enterprises, Kelon became the king of “red chips”6 in the Hong Kong equity market. In 1999, Kelon’s sales revenues reached an unprecedented level of RMB 5.6 billion ($700 million), despite a somewhat eroded profit margin since 1996. It captured the largest market share in the domestic refrigerator sector in the 1990s and had already become one of the largest air conditioner makers in China. Even at the start of year 2000, the company predicted an annual 11.7% growth in sales and RMB 0.7 billion ($87.5 million) net income (Caijing, 2001). Nevertheless, the year-end result was rather staggering: Kelon fell into the red for the first time in history, reporting a huge net loss of RMB 0.83 billion ($103.75 million) with a 30.9% sales decline. A further financial hemorrhage of more than RMB 1.4 billion ($175 million) net losses followed in 2001, which left Kelon on the verge of bankruptcy. This section traces the causes of the abrupt failure on the basis of our qualitative and quantitative evidence. The failure in incentive alignment of the management It has been argued that the entrepreneurial and managerial skills of Pan and Wang, whose tenure spanned from 1984 to 2000, are one of the most crucial contributing factors to Kelon’s success (Huang, 2003; Huang & Lane, 2001). However, the incentive scheme of the senior management lagged too far behind the fast business growth in the 1990s to align their interests with those of the company as a whole. For instance, the township government persistently refrained from granting more ownership stakes to company managers so that even the two corporate founders held negligible shares in the listed firm. It can be seen in Table 1 that none of the corporate insiders were among the major shareholders. In the interview transcripts we find that the Party secretary of the Rongqi township believed that the government should only give up controlling stakes in loss-making firms and made the following analogy: “There are two kids in a family. One can make money and help the family; the other cannot, and is even disabled. If we were to dispose of one of them, which one should we choose? Of course the disabled one!” In the case of Kelon, he said: “Kelon could be sold at RMB 4–5 billion. There would still be a lot after paying back RMB 600–700 million bank loans. This means that I could lead a happy life by doing nothing in the next 3–5 years. But what shall we do after that period?” While the governance mechanism at Kelon did not allow managerial talents and efforts to be rewarded via formal incentive contracts such as share ownership and stock options, it failed to prevent the management from capturing their rents through 6
The term denotes Mainland Chinese firms quoted on the Hong Kong market.
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value-subtracting activities either. A typical abuse of their operational control of the firm was transfer pricing: Various anecdotes from business press revealed that many managers engaged in extensive self-dealing activities with firms owned by their own relatives and friends. Kelon usually offered abnormally high prices for its parts suppliers and large discounts for its distributors, both of whom were run by manager-related firms. As Kelon’s new CEO Xu Tiefeng7 finally admitted, “… when Kelon was doing some contractual work for other firms, if the customer was related to the managers, we would give them price discounts. This damaged the company’s financial health as well as the credibility of the management team” (Huang & Lane, 2001: 10). 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 sales and administrative expenses as a key measure of activities with large scope for managerial moral hazard. Table 2 shows the time trend of Kelon’s selling and administrative expenses deflated by sales revenues, in comparison to its two domestic competitors in the refrigerator sector, namely Haier and Meiling. Clearly, the expenses-to-sales ratio at Kelon was not only significantly higher than its peers, but also experienced a sharp rise during the post-IPO years. Another dimension of the failure is related to a series of turbulent managerial turnovers triggered by the retirement of the corporate veteran, Pan Ning, in June 1999. Both our interviews and the interview transcripts we obtained suggest that he had not been on good terms with the township government for some time before his retirement. According to one of our informants, he once contrasted his experience in Hong Kong8 to that in the Mainland: “When I am in Hong Kong, I can concentrate on business and there is no special need of making friends with government officials. But here I have no choice but to deal with the local politics.” Furthermore, he disagreed with the government on the lack of ownership incentive plans for managers and repeatedly prevented the government from extracting firm resources at its own will. For example, one interviewee told us that during his tenure he repeatedly refused to take over other unrelated loss-making firms owned by the local government. Hence the ensuing forced retirement at the age of 62. Although Wang Guoduan, the former Number 2 figure in the firm, took the positions of board chairman and CEO as expected, rumors abounded that internal power struggles intensified behind the scenes. In March 2000, at the risk of triggering a corporate earthquake, Wang reshuffled the management team by replacing with outsiders all the vice CEOs formerly working with Pan, only to find that he himself was forced to leave the CEO post three months later.9 Xu Tiefeng, a vice mayor of the Rongqi township with little business experience, became the new 7
As will be noted below, he replaced Wang as the company CEO in mid 2000. Since Kelon is listed on the Hong Kong Stock Exchange, Pan took business trips to Hong Kong quite frequently. 9 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. 8
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Table 2 Expenses-to-sales ratios (%) at Kelon and its selected competitors (1996–2000). Year
Kelon
Haier
Meiling
1996 1997
13.0
8.8
8.2
19.6
11.6
9.6
1998
19.9
11.7
12.2
1999
20.8
11.3
12.1
2000
40.0
10.4
13.7
Expenses-to-sales ratio Selling and administrative expenses/sales revenues. Source: Calculation from data disclosed in the annual reports of Kelon, Qingdao Haier Co. Ltd. and Hefei Meiling Co. Ltd.
CEO. This appointment signalled the end of the entrepreneur-politician alliance at Kelon and proved to be a big blow to Kelon’s subsequent performance. Perverse government incentives and its looting of Kelon Managerial agency problems aside, the distorted incentives of the government shareholder and its extraction of Kelon’s cash flows are directly responsible for the corporate failure. While before the public listing the township government held 80% of ownership rights over Kelon, its stakes sharply reduced to little more than 1/3 of the total after the flotation (see Table 1). Nevertheless, the government still maintained corporate control. That is, the control of Kelon remained incontestable in the sense that the government only contributed 34% of cash flows but enjoyed a nearly complete control of the company. 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. Therefore, the government can virtually extract financial resources at its own discretion and its relatively low shareholding level encouraged it to do so. By way of illustration, for one unit of cash the government appropriates from the company, it only internalizes 0.34 unit of loss from its appropriation. This is in sharp contrast to the case where the government has, say, 80% of interests in the firm. More importantly, the payoff structure of a local government during the transition is not congruent with the long-run performance of this firm. The benefits of local governments from owning an industrial firm are normally composed of three parts: dividends and corporate income tax arising from firm profits, value-added tax (VAT) derived from sales revenues, and the private benefits that can be captured from its control, which can span from pecuniary favors to political interests (Liu et al., 2006). The weight the government assigns to the first component of its payoff function would be much smaller than those it puts on the other two. The reduction of shareholding size rather than control rights makes the government not care much about the 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 relied predominantly on indirect turnover tax (VAT) collected from firm sales, rather than corporate income tax. Since local tax revenues are crucial for local governments to create more jobs and initiate
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Table 3 Sales revenues and profitability at Kelon and its selected competitors (1996–2000). Year
Sales revenues (RMB million)
Operating profits (RMB million)
ROE (%)
Kelon
Haier
Chunlan
Kelon
Kelon
Haier
Chunlan
1996
2,761
2,644
1,969
1997
3,410
3,826
1,672
1998
3,813
3,823
1999
5,598
2000
3,870
Haier
Chunlan
459
201
256
21.9
19.7
31.2
624
290
265
19.1
13.0
31.1
1,914
561
281
309
17.7
14.7
19.2
3,974
1,947
547
361
313
13.4
12.0
17.2
4,828
1,825
−992
371
309
−21.0
14.7
15.3
Return on equity (ROE) Net profits divided by equity capital. Source: The annual reports of Kelon Electrical Holdings Co. Ltd., Qingdao Haier Co. Ltd., and Jiangsu Chunlan Co. Ltd., all from year 1996 to year 2000.
public projects that can promote local GDP growth in the short run, the reliance on turnover tax revenues further dampens the government’s interests in profitability but misdirects it to pursue excessive sales growth. Table 3 reports sales revenues and profitability data for Kelon in its post-IPO years, juxtaposed by comparable data from its main competitors in the domestic airconditioner market—Haier and Chunlan. It is evident that Kelon showed a different trend from its peers, so its sudden fall in revenues and profits cannot be attributed to industry-wide factors. Instead, we can infer from the table that the government treated Kelon as a sales maximizer at the expense of profitability: Despite a superficial boost of sales from 1996 to 1999, operating profits experienced an annul 6% decline in the three consecutive years from 1997. Relatedly, those years saw a significant deterioration in profitability measured by return on equity (ROE). What is more, the sales slumped in 2000 and the resultant enormous loss reported in 2001 suggests that the earnings quality in the previous years must be treated with a pinch of salt. Specifically, accounts receivable at Kelon remained considerably large during those years. For instance, more than 20% of sales shown in its 1997 income statement came from accounts receivable. And it is widely believed that Kelon during that period used undue credit sales to boost revenues in an artificial manner (Zhang, 2004). But perhaps the more appalling picture this case finally reveals is that the township government actually treated its listed subsidiary like a “cash cow.” Similar to other corporate scandals around the world, public investors barely can find any clue of such tunnelling activities in Kelon’s quarterly and annual reports, except for the deteriorating corporate performance. The cash transfer remained disguised until the perpetrator was no longer able to disguise them. Just before the accumulated crisis at Kelon reached a point that might be beyond its own control, the Rongqi government transferred its controlling stakes in October 2001 to Gu Chujun, an entrepreneur making refrigerants. Only after the old controlling shareholder left did the new entrant and the regulatory bodies uncover the financial black hole it once made. Concretely speaking, the Rongqi township government via Kelon’s holding company—Guangdong Kelon (Rongsheng) Group—diverted a total of RMB 1.26 billion ($150 million) from the listed Kelon Electrical Holdings Co. Ltd. through a string of secretive related-party transactions from 1998 to 2001. Table 4
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Table 4 Major fund transfer between Kelon and its controlling shareholder (1997–2001, RMB thousands). Year
Fund transfer from Kelon to Rongsheng Group
Fund transfer from Rongsheng Group to Kelon
Balance
1997
308,373
410,299
−101,926
1998
7,163,622
7,106,870
56,752
1999
4,389,922
4,362,194
27,728
2000
4,599,826
4,496,662
103,164
2001
5,396,404
4,378,515
1,017,889
Total
21,858,147
20,754,540
1,103,607
Concretely speaking, the fund transfer between Kelon and its holding company was exercised through the following channels: 1. Bank loans and interest payments. This is the situation in which Kelon and its holding company share their lending quota in commercial banks. That is, the holding company had access to banks loans borrowed by Kelon, and the reverse was true as well. Moreover, they paid back the debt and interests together. For example, Kelon may have to pay the principal and interests that Rongsheng Group owed to the banks. 2. Loans guarantee. It suggests the case in which the holding company illicitly asked one of Kelon’s subsidiaries to stand guarantee for a bank loan. Since the holding company failed to service this debt afterwards, Kelon had to pay the principal and interests instead. 3. Payment transfer. It means that the holding company asked Kelon to pay for some goods that Rongsheng Group bought from other parties. Source: Calculation from data disclosed in the annual report of Kelon Electrical Holdings Co. Ltd. (year 2001), and in the announcement of Kelon Electrical Co. Ltd. on March 14, 2002.
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, Johnson, & Mitton, 2003). As Table 4 shows, in 1997 the holding group in effect contributed more than RMB 100 million ($12.5 million) net to Kelon. The dynamics, however, were reversed later on, implying the increasing expropriation of Kelon’s funds, especially in year 2000 and 2001. Take the year 2001 as a case in point, it can be seen from Table 4 that the government-owned holding company channelled more than RMB 1 billion ($125 million) from Kelon in less than 12 months,10 given the fact that the net asset that Kelon had in year-end 2000 was merely RMB 3.96 billion ($495 million). The expropriation of Kelon’s assets also was reflected by a particular item in the balance sheet of Chinese public corporations—“other receivables.” It is a Chinesestyle item that incorporates all the miscellaneous receivables other than normal accounts receivable based on credit sales. Our interviewees told us that cash appropriated by the dominant shareholder is often recorded as “other receivables,” which the firm is supposed to collect from its controlling shareholder in the future. 10
The corporate board in Kelon was restructured in November 2001, when representatives of the township government left as a result of the control transfer agreement signed in October. Gu Chujun and his associates henceforth dominated the board.
Corporate governance failure and contingent political resources in transition economies Figure 2 The amount of “other receivables” at Kelon
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1, 600, 000 1, 400, 000 1, 200, 000 1, 000, 000 800, 000 600, 000 400, 000 200, 000 0
1996 1997 1998 1999 2000 2001 2002 2003
Source: The annual reports of Kelon Electrical Holdings Co. Ltd. (1996-2003).
So this item has in practice become a rough but parsimonious proxy for the extent of large shareholder expropriation in China. Figure 2 shows the dramatic growth of “other receivables” during 2000 and 2001, which coincided with the removal of the former management by the township government. Summary The sudden fall of Kelon documented in this section suggests that the previously successful rent-generation mechanism at Kelon is inherently unstable for aligning the interests of the key stakeholders—township government and managers—with the firm as whole, especially after its stock flotation. Government ownership stakes were diluted with corporate control intact, and incentive contracts were not put in place to ensure long-term managerial commitment. When the artificial sales growth was no longer sustainable and a series of internal purges led to management paralysis, the government might have realized that the downturn of Kelon was irreversible. Then came the predation of corporate cash flows during the 2 years before it opted for exit. The government’s seemingly self-destructive behaviors are nonetheless consistent with the rational choice of an economic agent: On expectation of exit, short-term opportunism dominated erstwhile long-term commitment, and the government maximized the amounts of rent extraction without internalizing substantial damages the predation would cause.
Discussion: Rent appropriation, agency problems, and the downside of political resources The preceding discussion of the Kelon case clearly reveals that certain types of political resources, such as affiliation with government-controlled organizations, have the potential to destroy rather than enhance organizational performance. This is owing to the fact that powerful political institutions, under certain circumstances, may opt to extract the “spoils” once generated with their help. Given their power in transition economies, political actors may grab an unduly large portion of the rents created within the organization. In short, the case study shows that in transition economies today’s helpers may become tomorrow’s grabbers. Although the RBV perspective has been widely used to explain the value of political resources, inadequate attention has been paid to the destructive swing in the
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functioning of political resources. In particular, while the RBV literature has long recognized that rent allocation arrangements have a significant impact on the development of sustainable competitive advantage (Barney & Hansen, 1994; Wang, Barney, & Reuer, 2003; Young, Peng, Ahlstrom, Bruton, & Jiang, 2008), this insight has yet to be applied to explore the potential downside of political resources. That is, existing application of the RBV into the study of political resources only provides one half of the story, leaving open the question of when and how political resources may negatively impact upon organizational performance because of excessive rent appropriation. To help us understand the observed changes in the value of political resources in the Kelon case, we supplement the RBV perspective with insights from the rent appropriation literature and agency theory. According to Coff (1999), the dynamics of organizational rents11 involves a continuous sequence of two stages: Rents are generated in the first stage by a nexus of explicit and implicit contracts involving investors, managers, employees, etc., and at least some of them are appropriated in the second stage by the same groups of stakeholders. Therefore, the sustainability of competitive advantage, among other things, depends on whether an organization can retain a significant portion of these rents while preventing them from being dissipated by its stakeholder groups. Consistent with Coff’s (1999) conceptualizaiton, corporate governance has been reinterpreted by organizational economists as a complex set of institutional arrangements that regulate the ex post bargaining over the organizational rents generated by the “teamwork” of the corporate stakeholders (Zingales, 1998, 2000). Since corporate governance mechanisms can be seen as institutional arrangements used for managing the rent generation and appropriation processes, we can reexamine the two classic agency problems in corporate governance from the rent appropriation perspective. The managerial agency problem (principal–agent conflict) identified in the financial economics literature (Jensen & Meckling, 1976; Shleifer & Vishny, 1997) can be viewed as the grab of rents by the management through a variety of channels such as excessive executive compensation, on-the-job consumption, and the pursuit of pet projects.12 The integration of rent appropriation and corporate governance is particularly important in transition economy contexts. This is because while the Anglo-American corporate sector is characterized by the significant separation of ownership to control due to the highly dispersed shareholding structure, large-block shareholders in Continental Europe and East Asia can often appropriate considerable rents at the expense of minority shareholders and other stakeholders (La Porta, López-de-Silanes, Shleifer, & Vishny, 2000; Young et al., 2008). Therefore, what the RBV calls the rent appropriation by blockholders is similar to the “tunneling” (principal–principal conflict) concept widely used in the law and finance literature (Johnson, La Porta, López-de-Silanes, & Shleifer, 2000). In short, organizational failure may result from corporate governance failure, which in turn implies the inability of a governance 11 They are defined as above-normal returns of an economic organization (Amit & Schoemaker, 1993). They are also called “quasi-rents” by organizational economists, since if a firm runs well, it must be worth more than the sum of its components valued on the factor market. 12 Indeed, what the RBV calls the rents appropriated by the management is simply what financial economists mean by the private benefits of control.
Corporate governance failure and contingent political resources in transition economies Figure 3 The operating mechanism in which original political resources contribute to corporate governance failure during transition
Absence of incentive plans due to government rent capture
Presence of the controlling-minority shareholding structure
2
3
Managerial Agency Problem
2
871
Government Agency Problem
3
Excessive rent appropriation by political institutions and management 1
Corporate governance failure in entrepreneurpolitician alliances
mechanism to effectively regulate excessive rent appropriation by key stakeholder groups over time, such as managerial opportunism and large shareholder expropriation. In the context of the entrepreneur-politician alliances in transition China, both previous literature and our case study suggest that the rents of many hybrid firms stemmed largely from the unique alliance between human capital provided by cadreentrepreneurs and political capital offered by grass-roots governments. With regard to rent creation, the local government is of course a rightful stakeholder in the firm and entitled to a significant portion of the rents generated. Nevertheless, corporate governance failure in entrepreneur-politician alliances, as the Kelon case illustrates, can manifest itself in excessive rent extraction by both local governments and the management. Figure 3 serves to sketch out the operating mechanism in which political resources may turn into liabilities over time, highlighting the role of government and managerial agency problems in causing corporate governance failure and linking the problems to rent appropriation by politicians and managers. First, a baseline proposition can be stated linking corporate governance failure, the extent of rent appropriation and the potential downside of political resources (arrow 1 in Figure 3): Proposition 1 The likelihood of corporate governance failure in an entrepreneurpolitician alliance is positively associated with the volume of rent appropriation by both political institutions and the management. Regarding rent appropriation by political institutions (arrow 2 in Figure 3), it can be seen that the local government’s evolving incentive structure to a large extent determines the amounts of rent it wishes to extract over time. Although the township government also has vested interests in the continued success of local enterprises, the specific incentive/payoff structure of the local government, which is in turn embedded in and endogenous to the rapidly changing institutional environment, gives rise to the potential
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risk of expropriation once rents are generated. In addition, when the managers start to claim the rents, especially in the form of ownership rights, the local government rejects their demand but is not able to check their rent extraction through other value-destroying channels. This in turn contributes to the final disintegration of the original synergistic rent-generation mechanism. Building on the Kelon case, we below explore the logic of failure in politically-connected firms during institutional transition. The boundary-blurring strategy adopted by local start-ups in the early stage of transition suggests that the interests of entrepreneurs and grass-roots politicians converged with respect to the establishment of public-private hybrids. The local government provided essential political resources in its capacity as the legal owner of the firm, and local entrepreneurs/managers contributed to the development of market-based competitive capabilities. As the firm grew up and flourished, problems however arose on the distribution of previously generated organizational rents. Owing to the ambiguous ownership arrangements at the founding stage, both the grass-roots government and the management felt themselves entitled to the majority of the rents created through their synergy. While the local government, the official owner of the firm, believed that the firm would not have survived without its dedicated political shield and support, the entrepreneurs thought themselves the real founders of the successful business, despite the political expediency of affiliating it with a government institution in the unique transition environment. Understandably, the government, via its legal owner capacity and political prowess, is in a significantly advantageous position in this ex post rent bargaining. Ironically, however, the Kelon case suggests that the persistent capture of ownership and control rights failed to prevent the management from appropriating rents through a range of value-destroying activities: transfer pricing with manager-related firms and the inflation of sales and administrative expenses. That is, when the politicians do not wish to put in place incentive alignment mechanisms and lack the requisite information to monitor the management, the managerial agency problem will be exacerbated, eventually leading to the erosion of original organizational rents. The effect of government rent capture on managerial rent extraction is summarized by the following proposition: Proposition 2 The higher the degree of rent capture by political institutions in an entrepreneur-politician alliance, the greater the managerial agency problem in the form of more rents appropriated by the management through value-destroying channels. Moreover, the subsequent clarification of ownership rights via corporatization and stock market flotation provided the local government with additional incentives for rent extraction. As has been shown in the case study, government’s ownership stakes in Kelon were considerably diluted through the initial public offerings but effective government control remained intact. In theory, the agency costs associated with large shareholder expropriation and such a minority-control structure involve potentially severe moral hazard on the part of the controlling minority shareholder. That is, unlike majority shareholders, minority controllers only internalize a small fraction (less than one half) of the negative consequences induced by their own opportunistic behaviors such as fund diversion and asset stripping (Cronqvist & Nilsson, 2003; Johnson et al., 2000; La
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Porta et al., 2000; Young et al., 2008). When legal and regulatory constraints on the controllers’ self-dealing behaviors are largely ineffective, which is the norm rather than an exception in transition economies, a once supportive dominant shareholder may degrade into a robber as its ownership level in the company is gradually reduced. In the case of the local government as a specific controlling minority shareholder, it clearly does not maximize firm value for all shareholders, as the vested interests that the government has in the continued success of the listed firm decline with the dilution of its ownership stakes. Instead, the local government may be tempted to use the profitable firm as a social instrument for its own political and financial ends. For example, local politicians may find it desirable to pursue sales growth at the expense of long-run profitability and/or extract financial resources from the firm to crosssubsidize other businesses under their jurisdiction. Summarizing the agency problem on the government side, we propose the following (arrow 3 in Figure 3): Proposition 3 The greater the divergence between shareholding rights and control rights for a government controlling shareholder, the greater the government agency problem in the form of more rents appropriated by the political institution.
Conclusion and research implications Nowadays, emerging economies in general and transition economies in particular, have been recognized as “fertile grounds not only for testing existing theories but also for developing newer ones” (Wright, Filatotchev, Hoskisson, & Peng, 2005: 27). This paper contributes to the emerging strand of literature on the dark side of political connections by revealing organizational-rent dynamics in entrepreneurpolitician alliances. Drawing on the RBV, rent appropriation literature, and agency theory, we have employed the in-depth longitudinal case study to explore the contingent factors that moderate and the operating mechanism that regulate the potential liability of political resources during institutional transition. To the extent that understanding the institutional context in strategy research of transition economies cannot be emphasized enough (Hoskisson, Eden, Lau, & Wright, 2000; Peng, 2000; Wright et al., 2005), it is worth noting that the use of agency theory in the paper is grounded on our institutional analysis of the transition environment. Specifically, the agency problems of controlling shareholder appropriation are endogenous to the institutional environment characterized by weak legal and regulatory investor protection (La Porta et al., 2000). Moreover, the exploration of the agency problems on the part of the government would have been less fruitful without our clear identification of the local government’s incentive structure, the evolution of which is in turn embedded in a wider institutional environment. Thus, we contend that a contextual analysis of particular corporate governance arrangements and their dynamics yields more relevant theoretical insights and strategy and policy implications. With special reference to its theoretical implications for corporate governance research, this study links the rent appropriation perspective (e.g., Coff, 1999) to the agency problems identified in the financial economics literature and apply the two
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complementary theoretical angles into the analysis of corporate governance failure. This case study implies that, not only does corporate governance matter in the rent creation stage when stakeholders can be effectively organized to generate competitive advantage, it also matters much in the subsequent rent appropriation stage, so that various stakeholder groups could be satisfied with the distribution of the rents and therefore have adequate incentives to engage in further wealth creation activities. Although this paper focuses on the rent struggle between politicians and entrepreneurs and links the stability of their alliance to the long-term organizational performance, this clinical study does expose a general link between corporate governance mechanism and the sustainability of competitive advantage. Further research can examine how governance structure regulates the appropriation of rents by other types of stakeholders and how this complex process consequently impacts upon a firm’s competitive advantage in other institutional contexts. The practical implications of this piece of work can be presented at both firm and institutional levels. At the firm level, both indigenous players and foreign entrants need to develop a more nuanced understanding of the strategic significance of political resources exploitation in transition economies. The rich case documented in this paper implies a profound challenge for market players in this complex environment: While developing and exploiting political resources seems to be a must in the first place, they need to find ways and mechanisms to avoid or at least mitigate the potentially excessive rent extraction by their political partners. How to achieve this delicate dynamic balance is certainly beyond the scope of this paper, but entrepreneurs and managers should put into place self-protective mechanisms and develop a more accurate understanding of the evolving incentive structure of politicians when bargaining with local political institutions. On the part of political actors, they need to recognize that the ownership rights of their institutions did not arise by default but are subject to bargaining by other key stakeholders, especially the management team, so it is in their own interests to award the entrepreneurs significant income rights, without which managerial opportunism cannot be effectively checked and the competitive advantage of the firm is very hard to sustain. At the institutional level, reform of legal and government regulatory systems aiming to better monitor and punish large shareholder opportunism should definitely be on the top policy agenda, given the few efficacious internal constraints on blockholders’ self-dealing behaviors (Holderness & Sheehan, 2000). Both statutory provisions and bona fide enforcement should be put in place to deter these potential corporate predators. In particular, appropriate regulations need to be established to ensure that local governments and their leaders cannot get away with their prior value-destroying behaviors even after they retreat from business. Needless to say, this is a daunting task and a painful institution-building process for transition economies, not least because on many occasions the perpetrator is the government itself. However, unless there are significant improvements in this aspect, business enterprises will repeatedly fall prey to their controlling shareholders, be they governments or private businesses.13 13
Ironically, it was found in mid 2005 that, far from a savior of Kelon, the next owner, Gu Chujun, was the next “robber” funneling millions of funds out of the firm. The only material difference between the two perpetrators, however, seems to be the fact that Gu is in jail now, while the local government officials are not.
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As a suggestive step in exploring the dynamic, contingent value of political resources in transition economies, the paper has some visible limitations, some of which nonetheless point to promising avenues for future research. First and foremost, we should be cautious to generalize the findings of this single case study to other cases even within China, though the utility of a case study is to achieve analytical, rather than statistical, generalization (Yin, 2003: 10–11). On the one hand, the underlying mechanisms of corporate governance failure revealed by this case study has significant explanatory power in many other high-profile business failure cases in China, such as the Sanjiu Pharmaceutical Group once led by Zhao Xinxian and the Changhong Group once under the leadership of Ni Runfeng. On the other hand, however, it must be noted that such a downward spiral is by no means inevitable, as many other hybrid firms with similar initial conditions do manage to keep the rent bargaining activities to a limit and have achieved smooth transition in their corporate governance. Famous cases include the TCL Group led by Li Dongsheng and the Midea Group by He Xiangjiang. Consequently, although rapid institutional transition may make it easier for politicians and entrepreneurs to cause a sharp break between the rent generation and the rent appropriation processes, future research needs to employ multiple case study and survey approaches identifying the conditions under which rent appropriation and agency problems are so severe that erstwhile political resources evolve into liabilities. Another limitation of this study is that, for simplicity, we focus almost exclusively on a dynamic two-party game between local politicians and entrepreneurs within this firm despite having controlled for some industry-wide conditions. Thus, we cannot rule out the possibility that, besides salient corporate governance failure, the lack or erosion of market-based capabilities also contributed to Kelon’s failure. Moreover, introducing other market players into the case analysis could have yielded additional insights into corporate governance research in transition economies. For instance, although Kelon was listed on Hong Kong Stock Exchange and had several famous foreign institutional investors as the stockholders (see Table 1), they seemed to play a negligible role in constraining the large government shareholder and the management from extracting resources from the company. Did they fail to recognize the secretive expropriation activities behind the normal operation or were they aware of this but simply opted to “exit” rather than “voice”? While Table 1 suggests the latter one may be more plausible, future detailed investigation of this issue is warranted for assessing the role of overseas flotation and institutional shareholder activism in transition economy corporate governance systems.14
References Ahlstrom, D., Bruton, G. D., & Yeh, K. S. 2008. Private firms in China: Building legitimacy in an emerging economy. Journal of World Business, 43: 385–399. Amit, R., & Schoemaker, P. 1993. Strategic assets and organizational rent. Strategic Management Journal, 14(1): 33–46. Barney, J. B. 1991. Firm resources and sustained competitive advantage. Journal of Management, 17: 99– 120. 14
We thank an anonymous referee for offering this observation.
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Pei Sun (PhD, University of Cambridge) is associate professor at the School of Management, Fudan University, China. He is currently undertaking research on corporate governance, business strategy, and industrial organization in transition economies. His papers have appeared in academic journals like the Cambridge Journal of Economics, Economics Letters, Management and Organization Review, Journal of International Business Studies, and World Development. Kamel Mellahi (PhD, University of Nottingham) is professor of strategic management at the University of Sheffield Management School, UK. His current work focuses on organizational failure and business strategy in transition economies. He has published three books and numerous articles in such journals as the Strategic Management Journal, Journal of International Business Studies, and Journal of Management Studies.
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Guy Liu (PhD, University of Oxford) is professor in economics and finance at the School of Social Sciences, Brunel University, UK. He specializes in industrial economics with a particular interest in China’s enterprise reform. His research papers have been published widely in internationally leading journals such as the Economic Journal, Journal of Industrial Economics, Journal of Comparative Economics, Oxford Bulletin of Economics and Statistics, and World Development. He is an editor of the Journal of Chinese Economic and Business Studies.