Danone learns perils of business in China

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In the annals of international investment, SCC Arbitration V (061/2007) will be remembered as a case study in how not to do business in China.

Technically, the “partial award” judgment handed down by a Swedish arbitration tribunal on September 30 was a victory for Danone over Zong Qinghou, the French food group’s Chinese joint venture partner since 1996 and founder of beverage-maker Wahaha Group.

Many of Danone’s claims against Mr Zong were not upheld, including an allegation he defrauded their joint venture. But a three-member tribunal convened by the Stockholm Chamber of Commerce’s Arbitration Institute ruled that he had breached confidentiality and non-competition agreements – allegations that the self-made billionaire categorically denied.

The tribunal also ordered that he “cease forthwith using, or assisting in/procuring any unauthorised usage of the Wahaha Trademarks and any other intellectual property rights which belong to the [joint venture], and orders that Mr Zong transfer them to or cause their transfer to the [joint venture]”.

Meanwhile, as victories go, it was a limited and pyrrhic one for the French food group. On the same day that the confidential judgment was handed down, Danone and Mr Zong formally ended a feud that had gone public more than two years earlier and featured in discussions between the two countries’ presidents, Nicolas Sarkozy and Hu Jintao.

Under the terms of the embittered partners’ peace agreement, Mr Zong agreed to pay Danone €300m ($450m) for its controlling 51 per cent stake in their joint venture operations.

Danone had valued those operations on its books at €380m. At the time, Danone and Mr Zong did not reveal the tribunal’s decision, a copy of which has been seen by the Financial Times. Danone had publicly alleged that Mr Zong undermined the joint venture by establishing a parallel production and sales network. But neither the extent of Mr Zong’s parallel operations nor Danone’s self-professed ignorance of them, in spite of its controlling stake, has been made public.

SCC Arbitration V (061/2007) relates the behind-the-scenes story of one of the most embarrassing foreign-investment failures in China.

The tribunal’s findings cite the humble origins of Mr Zong, who worked as rural labourer in coastal Zhejiang province for 15 years until 1978 before getting a job at a paper box factory in Hangzhou, the provincial capital.

“He worked there until 1986 when, following market-oriented reforms in China, he was able to borrow Rmb140,000 ($20,506) to set up a small business selling ice creams, sodas and pollen oral solutions.”

Mr Zong’s popular pollen oral solutions – especially a product known as “Wahaha Children’s Nutritious Liquid” – were the cornerstone of the Wahaha Group’s success in the early and mid-1990s.

In 1996 Danone, in partnership with now-defunct Peregrine investment bank, purchased controlling stakes in four Wahaha subsidiaries and a newly created distribution company, Hangzhou Wahaha Health Food Co. While Danone enjoyed board control, Mr Zong remained group chairman and managed the five joint venture companies – or “JVs”.

For his services at the JVs, Mr Zong was paid more than $60m over a 10-year period, not including dividends. He also retained control of six other Wahaha subsidiaries – referred to by the tribunal as “the original non-JVs” – in which Danone chose not to invest.

Danone’s interests in the JVs were represented primarily by Stephen Yau, a finance director. The French company’s few other personnel at the JVs included Mr Yau’s assistant, a marketing director and a research and development director.

According to the judgment, Danone alleged that “Mr Yau, while technically financial director, was not permitted to take part in the management of or decision-making processes regarding any joint ventures, such that his role was reduced to acting as a ‘bridge’ between Wahaha Group and Danone Asia regarding finance-related matters.”

Mr Zong countered, the tribunal added, that Mr Yau in fact “had access to . . . all the financial information pertinent to the operation of the JVs”.

Over time, the number of Danone-invested JVs would expand to 39, while the number of non-JVs privately controlled by Mr Zong would mushroom to at least 96.

Danone alleged that the non-JVs competed against its own JV companies, received preferential treatment from distributor Hangzhou Wahaha Health and were managed by Mr Zong through a deliberately opaque web of British Virgin Island, Samoan and Seychelles companies, some of which were held by his family members and associates including a truck driver from Shenzhen, the special economic zone bordering Hong Kong.

Mr Zong denied hiding anything from Danone or giving preferential treatment to his non-JVs, and expressed irritation when questioned on his vast network of offshore companies. “Just like me making love to my wife, it’s none of your business,” he told the tribunal.

Mr Zong also noted that the proliferation of non-JVs stemmed in part from a clash of cultures, as he grew frustrated with his French partner’s relatively cautious approach towards expansion.

As a result of the September 30 agreement, which superseded the tribunal’s ruling, Danone’s stake in – and full legal control of – all Wahaha group companies was returned to Mr Zong at a 21 per cent discount to book value.

Last week the entrepreneur vaulted 15 places up Forbes’s China rich list, to the number three slot, with a fortune estimated at $4.8bn.

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