Webb-site looks at the governance battle at GOME (0493), which culminates in an SGM on 28-Sep-2010 for which we give our voting recommendations. We also examine the claims in the SFC's civil action against Wong Kwong Yu.

Take the GM out of GOME
7 September 2010

As many readers will be aware, the incumbent management of GOME Electrical Appliances Holding Limited (GOME, 0493), led by its Chairman Chen Xiao (Mr Chen), is now in a governance battle with former Chairman Wong Kwong Yu (also known by the pinyin spelling of Huang Guangyu and formerly known as Wong Chun Kit) (Mr Wong) and his wife Du Juan (Ms Du). This battle will culminate in a Special General Meeting (SGM) to be held on 28-Sep-2010, and this article contains Webb-site's voting recommendations.

The players

Mr Chen is the former Chairman and President of China Paradise Electronics Retail Ltd, which GOME acquired in late 2006 after a brief listing. Shareholders of China Paradise received about 25.02% of the enlarged issued share capital of GOME. Mr Chen currently controls about 1.38% of GOME. In the interim report at 30-Jun-2010, one NED holds 0.01%, and other directors hold some minor share options which will have no material impact on the outcome of the battle even if exercised.

Mr Wong is the largest shareholder of GOME. At 30-Jun-2010, he held his 33.98% interest in GOME via two wholly-owned companies, Shinning Crown Holdings Inc. (Shinning) and Shine Group Ltd (Shine), plus two companies wholly-owned by his wife. From 24-Aug-2010 to 31-Aug-010 Shinning has increased its stake in the market from 28.22% to 30.22%. Mr Wong has not filed any increase in his deemed interest (indeed, his last filing dates back to 23-Apr-2008, before a 4:1 share split), but if his and his wife's other holdings are unchanged, then his interest has increased to 35.98%. Under the "creeper rule" of the Takeover Code (Rule 26.1(c) and (d)), a person cannot increase his stake by more than 2% in a 12-month period without triggering a general offer, so that is as far as he can go for now. Incidentally, his failure to file disclosures lines him up for a quiet parking ticket at the magistracy.

On 7-Jun-2009, GOME agreed to issue Convertible Bonds to Bain Capital Glory Ltd, owned by a fund managed by Bain Capital Investors, LLC (Bain), for about US$233m (denominated as CNY1,590m). The bonds pay interest at 5% p.a. semi-annually, are due 3-Aug-2016, and are redeemable in US$ at a 12% compound annual rate of return less the interest paid. They are convertible at HK$1.108 per share, using a fixed exchange rate of HKD1=CNY0.88, into 1,627,924,595 shares.

GOME also agreed to appoint 3 directors nominated by Bain and to use its best endeavours to procure that the nominated directors are not removed before the expiration of the maximum term, other than a removal proposed by the shareholders which shall not be initiated, solicited or recommended by GOME. A breach of that covenant, or certain others, would give Bain the right to redeem the bonds at 1.5x the principal or an IRR of 25% p.a., whichever is higher. This clause came into play at the AGM on 11-May-2010, when Mr Wong voted against the re-election of the 3 Bain nominees, resulting in their removal. Immediately after the AGM, the board of GOME re-appointed the same directors to avoid triggering the redemption right. However, if Mr Wong, as a shareholder, were to propose the removal of the nominated directors, then that would appear to fall within the exemption to the covenant.

The fact that GOME entered into such terms, tying its hands on board composition with someone who isn't even a shareholder, is questionable corporate governance in itself. In the circular dated 23-Aug-2010, convening the SGM, GOME said that Bain has confirmed that it "plans" to exercise its conversion rights at least 5 business days prior to the SGM. So at least they will now become a shareholder, taking equity risk without the fallback of high-yield redemption rights, and the rights to protected board seats will now drop away. Based on the current issued shares, Bain will receive 9.76% of the enlarged capital, and Mr Wong will be diluted to 32.47%. He will then be free to increase his stake to 34.47% without triggering an offer.

Mr Wong's conviction

On 18-May-2010 Mr Wong was sentenced by a mainland court to 14 years in jail for "illegal business dealings, insider trading and corporate bribery" while his wife received a 3.5 year jail term. She was released last week after her sentence was reprieved, but his appeal was rejected and his sentence was confirmed. They were fined CNY800m and CNY200m respectively. The insider trading related to Beijing Centergate Technologies (Holding) Co Ltd (Centergate), a Shenzhen-listed stock, of which he was also a substantial shareholder, and Shanghai-listed Sanlian Commercial Co Ltd (Sanlian), another retailer. Centergate, GOME, and another of his companies, Beijing Pengrun Real Estate Development Co (Pengrun), were also involved in bribing officials, in the total amount of CNY4.56m. GOME and Pengrun were fined CNY5m and CNY1.2m respectively.

We note that on 1-Mar-2008, GOME acquired 27m unlisted shares, or 10.69% of Sanlian at CNY19.9 or a total of CNY537.3m, becoming its largest shareholder. By 31-Dec-2008, the market price had collapsed to CNY4.03, resulting in a RMB449.6m impairment loss. The price recovered to CNY5.68 at 31-Dec-2009.

Mr Wong is also the subject of a civil action by the SFC, on the back of which GOME has recently launched its own action. Let's take a look at the background to that.

Sales and buybacks

On 20-Sep-2007, Mr Wong (via Shine) sold 170m shares at HK$13.74 (split-adjusted: 680m at $3.435) in a placing via CICC, cutting his stake from 48.06% to 42.84% and raising HK$2,336m gross. On 18-Apr-2008, Mr Wong (via Shinning) sold 125.43m shares at HK$17.00 (split-adjusted: 501.72m at $4.25)  in a placing via Goldman Sachs, cutting his stake from 39.48% to 35.55% and raising $2,132m gross.

In between those two placings, on 28-Jan-2008, Mr Wong (via Shine) transferred 50m shares (pre-split), or 1.51% of GOME, to his wife's wholly-owned company. On the same day, he and Shine transferred 900,087 and 136,037,394 shares (pre-split) or 4.15% of GOME, to other "family members", according to a GOME announcement of 1-Feb-2008. Those relatives did not include his wife or minor children, because his disclosed interest dropped by the same amount.

Between 22-Jan-2008 and 5-Feb-2008, GOME repurchased on-market 129.8m of its shares for $2,237m at an average price of $17.23 (split-adjusted: 519.2m at $4.31). Earlier, on 9-Jan-2008, they had reached a closing high of $20.70 (split-adjusted: $5.175).

On 7-Aug-2009, the SFC announced that it had obtained an interim injunction from the HK High Court to freeze assets of Mr Wong, Ms Du, Shinning and Shine up to $1,655m. Three days earlier, the SFC commenced civil proceedings against the two, alleging securities fraud. Unfortunately, the ex parte hearing was held in Chambers and not open to the public, so the full details of the claim have not been published. At a hearing on 8-Sep-2009, the injunction was continued against Mr Wong and Ms Du. Shinning and Shine have lodged a total of 779,255,678 shares with the court.

According to the SFC announcement, it alleges that Mr Wong and Ms Du organised the share repurchases to use company funds to "buy shares originally held by Wong" so that he could "use the proceeds to repay a HK$2.4bn personal loan from a financial institution" and that the share repurchase:

Of course, these allegations have yet to be tested in court. There are several areas which will need to be clarified. If his disclosures of dealings, as filed, are correct, then Mr Wong did not sell any shares on the market himself, but transferred them to family members. So it appears that the SFC is alleging that he benefitted from subsequent sales of the shares by those family members, who presumably passed the proceeds back to him.

Non-statutory Listing Rule 10.06(2)(c) states "an issuer shall not knowingly purchase its shares from a connected person and a connected person shall not knowingly sell shares to the issuer, on the Exchange". However, for individuals under this rule, the definition of "connected person" does not extend to relatives other than a spouse, or a minor child. Based on the filings, he does not appear to have breached that rule, unless it can be shown that he was the beneficial seller and the vendors were mere nominees. The transactions might, however, have breached the Chapter 14A Listing Rules on connected transactions, where the definition of "connected person" includes a broader class of relatives, but there is an exemption in Rule 14A.31(5) for on-market repurchases, unless the connected person knowingly sells shares to the listed company. That might be rather hard to prove, since you would have to show that the vendor knew that a particular buying broker in the market was acting for the listed company itself, and not for anyone else.

However, the SFC is not the enforcer of the Listing Rules, which carry no financial penalties. The SFC's allegations are much more serious, claiming that the buybacks caused GOME a loss of HK$1.6bn. The SFC will need to show that the market price was higher than it would have been without the buybacks. It may have some difficulty proving this given that after the buybacks ended, the share price remained quite buoyant. From 5-Feb-2008 to 18-Apr-2008 (the day before the placing that evening), the daily closing price of the shares rose 3.7% from $17.62 to $18.28. In the same period, the total return on the Hang Seng Index was -1.8%. So the stock out-performed, and this was apparently a price at which willing buyers were willing to purchase shares.

Not only that, but the market absorbed (split-adjusted) 501.72m shares in the placing by Mr Wong's on 18-Apr-2008 at $4.25, only 1.3% below the average buyback price, even though the placees knew that he was the seller. That was the day after the 2007 results came out. All of this rather contradicts the notion that the market price was artificial. If the buybacks yielded a higher price than he could have achieved with a larger placing in Apr-2008, it was at most a marginal difference, not a $1.6bn difference.

Given that the buybacks at an average $4.31 (post-split) cost $2.24bn and the SFC is alleging a loss of about $1.6bn, they appear to be basing their claim on an approximately 71% fall in the share price. From the last day of buybacks, the shares did indeed slide 74.6% from $4.405 (split-adjusted) to close at $1.12 on 21-Nov-2008, the last day of trading before a long-term suspension after rumours of Mr Wong's arrest circulated. They also accrued dividends of $0.0565 per share. However, In the same period, which included the onset of the global financial crisis, the total return on the HSI was -47.3%. In the same period, the Shanghai Composite Index plunged a similar amount as the mainland stock market bubble burst, cooling consumer demand. GOME also reported a weaker-than-expected outlook with its first-half results. So a large part of the fall in the share price had nothing to do with the actions of GOME or Mr Wong.

To say that the share buybacks caused the subsequent loss in market value of those shares would be a reversal of the arrow of time. Apart from not causing the global financial crisis, the bursting of the mainland market bubble, and the deteriorating retail environment, Mr Wong could not have known in Feb-2008 that he was going to be arrested and charged with economic crimes 9 months later, setting off a confidence crisis in GOME. Investors feared that this signalled some kind of fraud inside the company - after all, there had been plenty of precedents for this. After Mr Wong's arrest and detention, the board "suspended his executive duties" and his wife resigned as a director, both on 23-Dec-2008. He resigned as a director on 16-Jan-2009.

On 10-Dec-2008, GOME announced that it had appointed Ernst & Young (E&Y) to review internal controls and past transactions. At the time, GOME also reported that "the business, operations and relationship with its suppliers has remained normal". That's interesting, because the GOME management now claims in the SGM circular that there was a "sudden withdrawal of credit facilities" and an "acceleration of payment demands by suppliers" which "occurred following the arrest and conviction of Mr. Wong". That claim is inconsistent with the previous statements, and keep in mind that he wasn't convicted until 18-May-2010, just 4 months ago - so their claim is that these problems persisted after that. These claims are contradicted by the healthy 2010 interim report which includes claims of a close relationship with suppliers. Similarly, in two letters to shareholders published in newspapers on 26-Aug-2010 and 30-Aug-2010, letters which GOME has failed to file with HKEx, it states that following Mr Wong's arrest, "relations with banks and suppliers were strained almost to breaking."

On 22-Jun-2009, GOME announced the outcome of the E&Y investigation. Based on this, the board concluded that there were no material deficiencies in the internal controls system and there had not been any misappropriation of funds or assets. They did not express any concerns about the share buybacks, presumably because they had none.

It was only on the evening of 5-Aug-2010, a full year after the SFC launched its action, that GOME announced that "following an internal investigation over the past few months" the board had resolved to sue Mr Wong, and GOME had filed a writ that day, for compensation for his alleged breach of fiduciary duties as a director of GOME relating to the buybacks. The previous evening, GOME had received a letter from Shinning requisitioning the SGM which is now scheduled. GOME did not say exactly when the board decided to sue Mr Wong, but stated that the requisition was received after that decision.

 The SGM - our recommendations

At the SGM, GOME is proposing the re-election of the 3 Bain-nominated directors, whom it re-appointed right after the AGM. This is procedural - directors appointed by the board can only serve until the next general meeting. On the other hand, Mr Wong is seeking the removal of Mr Chen and Mr Sun Yi Ding (Mr Sun), and the appointment of Zou Xiao Chun (Mr Zou, Mr Wong's lawyer) and Huang Yan Hong (Ms Huang, Mr Wong's sister).

The choice for independent shareholders seems fairly clear on this - do you want candidates nominated by, and in one case related to, a convicted criminal who is now serving a long jail term, albeit for crimes mostly unrelated to the company, or will you support directors who have been running the company with some modicum of apparent success, and non-executive directors whose interests will be broadly aligned (after bond conversion) with those of other shareholders? We don't know any of them personally and your editor holds no shares in this company, but Webb-site recommends that shareholders vote AGAINST resolutions 5, 6, 7 and 8 proposed by Mr Wong, relating to the removal of Mr Chen and Mr Sun and the appointment of Mr Zou and Ms Huang. We also recommend in favour of the re-election of the three Bain directors (FOR resolutions 1, 2, and 3), but only if Bain honours its "plan" to convert the bonds into shares before the AGM. We see no reason why bondholders who could bring the company to its knees with onerous redemption rights should be entitled to board representation.

That only leaves resolution 4, proposed by Mr Wong, to revoke the general mandate to issue new shares for cash without offering them to existing shareholders first. For many years, independent shareholders in HK-listed companies have been voting by a substantial majority against the general mandate, and Webb-site has championed this cause through Project VAMPIRE (Vote Against Mandate for Placings, Issues by Rights Excepted), launched in 2003. See our articles on pre-emption rights and the general mandate for the history. It is only the lax Listing Rules and the controlling shareholders of HK companies which allow this situation to continue, by routinely giving themselves a mandate as directors to pick and choose the shareholders, thereby inverting the chain of governance.

So we find it rather amusing when a former Chairman and controlling shareholder, now on the outside of a company, decides that the general mandate that he used to enjoy granting himself is no longer a good idea. In fact, even at the 2010 AGM, he voted in favour of the issue mandate, as can be seen in the voting results. GOME attributed the opposition to the election of the Bain directors to "2 affiliated shareholders holding in aggregate 4,758,453,890 shares". That is slightly less than the holding attributed to Shinning and Shine in the annual report, but we'll take that figure for these purposes. Removing them from the "in favour" vote, we can see that other shareholders voted 54.5% against the mandate. Adding the 2 shareholders back to the opposition, the vote would have been 77.5% against the mandate, and these figures are probably even higher if Mr Wong voted all his holding.

AGM 2010

We see no reason why independent shareholders should change their opposition to the issue mandate. All the usual excuses for the general mandate are trotted out by the GOME management, and none of them holds any water. If GOME needs to raise cash (it does not claim such need), then it should conduct a rights issue and offer the shares to all shareholders. If there is a particular strategic investor to whom GOME wishes to issue shares, then it can seek shareholders' approval for that in the future. If it wants to issue shares in exchange for an acquisition, then it can seek approval at the time. It doesn't take long to do a rights issue or seek a specific approval. GOME can conduct a rights issue up to 1 new share for every 2 held without shareholders' approval.

Webb-site.com recommends that independent shareholders vote FOR resolution 4, to cancel the general mandate. Take the GM out of GOME.

© Webb-site.com, 2010


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