THE TROUBLED The World is wide open Caterpillar, founded in 1925 and headquartered in Peoria, Ilinois, is one of the world's METAMORPHOSIS OF most renowned manufacturers of construction and mining equipment, diesel and natural gas engines, industrial gas turbines and diesel-electric locomotives'. It has CATERPILLAR four main operating segments in Construction Industries, Resource Industries, Power Systems and Financial Products. When Douglas Oberhelman took over as CEO of Caterpillar in July 2010, he shifted the company's strategic focus to emerging markets, particularly China". Case overview We have got to win in China When Caterpillar Inc. ("Caterpillar") first acquired ERA Mining Machinery ("ERA") Oberhelman announced a plan to quadruple the production of excavators in in June 2012, the transaction was heralded as a triumph for the company, and a China within four years by leveraging on the extensive operations and broad milestone in its strategic expansion into the world's largest coal industry, China. dealer network established in China in the past 30 years". As part of its long-term However, barely five months later, Caterpillar discovered accounting irregularities business strategy to enter China and to support the growing base of Chinese that led to a goodwil impairment charge of US$580 million' - 86% of the value customers, it embarked on aggressive organic and acquisition growth strategies'. of the deal. While Caterpillar maintained that the acquisition was the right move, it continued to be embroiled in lawsuits and struggles with getting the acquired China produces almost half of the world's coal and the industry is forecast to have company back on its feet. Furthermore, despite decades of investment, China still further growth over the next several years. Having lost out on opportunities to gain accounts for only three per cent of Caterpilar's worldwide sales'. The objective market share in construction machinery in the past, Caterpillar did not want to of this case is to allow a discussion of issues such as board composition and miss the chance to ride on the wave of the boom in China's coal mining equipment structure and their impact on board effectiveness; the role of different stakeholders industry. in ensuring proper due diligence of acquisitions; the challenges of doing due diligence especially for acquisitions in markets such as China; challenges faced by multinational companies entering foreign markets; and the business culture in Why ERA? China and the challenges of managing cultural differences. However, while China's coal industry is the largest in the world, its distinctive feature lies in being extremely insular, as local companies, particularly state- owned enterprises, are loyal to domestic machinery brands. Therefore, to carry out an effective expansion into the coal mining equipment market, tying up with a Chinese company was an essential step. this is the abridged version of a case propared by Dong Qing, Luo Vilin, Solona Tan Rui Zhen, and Toh Wei Ni under the supervision of Professor Mak Yuan Toon. The case was developed from published sources solely for class discussion and is not intended to serve as illustrations of affective or inoffactive management or governance. The interpretations and perspectives in this case are not nocessarily those of the organisations named in the case, or any of their directors or employees. This abridged version was edited by Chloe Chua under the supervision of Professor Mak Y Copyright @ 2015 Mak Yuon Toon and CPA Australia.ERA primarily designs, manufactures, sells and supports underground coal mining Red flags missed equipment in mainland China through its wholly owned subsidiary Zhengzhou Siwei Mechanical & Electrical Equipment Manufacturing Co., Lid ("Siwer")". Being Caterpillar's failure to spot the danger signs at Siwei raised doubts about the way a former state-owned enterprise, Siwei has the advantage of having close ties it did business abroad. In the scramble to "win in China", did Caterpillar executives with the Chinese government". An additional advantage was that ERA was listed lose sight of the risks? on the Stock Exchange of Hong Kong (SEHK), which made it much easier for a foreign company like Caterpillar to acquire it. Public Listing Through Reverse Takeover Another factor that boosted Caterpillar management's confidence in pushing for Prior to the Caterpillar takeover, ERA was listed in the Growth Enterprise Market the acquisition was the fact that they trusted Siwei's major shareholders who had (GEM) of SEHK, which had been designed to accommodate companies with a American connections ?. However, it was later revealed these shareholders were higher risk profile". It had acquired Siwei through a reverse takeover in 2010, a only responsible for strategic decisions of the group and had limited participation corporate maneuver that had previously created controversy in the U.S. following in Siwei's daily operations. a series of accounting scandals involving small U.S.-listed Chinese companies ". This should have raised an alarm regarding the risks of the acquisition and called for greater due diligence to be undertaken. Takeover bid Questionable Loans From Directors 19 On 10 November 2011, Caterpillar and ERA jointly announced the pre-conditional voluntary offer by Caterpillar, through its wholly own subsidiary Caterpillar Another red flag was the fact that ERA had borrowed more than US$9.5 million (Luxembourg) Investment Co. S.A., to acquire all the issued shares of ERA. The from four directors at loan rates that were among the most expensive on its offer represented a 33% premium over the ERA stock price at that time". balance sheet, given that the interest rate paid to directors was eight percent compounded annually, while the interest rate that commercial banks charged ERA Four months later, Caterpillar announced the successful completion of its tender was only between 4.9% and 7.4%. This resulted in estimated interest payable of offer for ERA, after the approval from the Ministry of Commerce of the People's US$500,000. Republic of China ("MOFCOM )14. While company loans to directors in the U.S. are not permissible, loans from directors to companies are a grey area. Not only was this a questionable business move, it was also doubtful whether the transactions were on an arm's length basis. The game is up However, in the course of the integration process, Caterpillar began to notice Other Red Flags20 inventory discrepancies during a physical inventory count, which led to an internal investigation's. In November 2012, only five months after the completion of the Siwei had also issued the first of two profit warnings in March 2012 before the milestone acquisition, Caterpilar discovered serious accounting fraud at Siwei acquisition took place"'. While Caterpillar sought explanations regarding the profit after hours of grilling Siwei's Chairman and CEO, Wang Fu. The investigation warning from ERA executives, they nevertheless decided to push forward with the revealed inappropriate accounting practices -such as improper cost allocation deal without further questioning. Other red flags that should have surfaced during that overstated profit, and early and unsupported revenue recognition- practised the acquisition process include asset reshuffling, issues with working capital and by Siwei's management years before the completion of the takeover 15. unusual increases in inventory. 174 175In August 2013, Caterpillar's shareholder Michael Wolin sued two Caterpillar At the time of the acquisition, ERA'S Executive Chairman was Emory Williams, executives and 14 board directors for breaches of fiduciary duties in relation to the an American who was a pillar in the expat business community in China and Siwei scandal-3.34. In his suit, he claimed that the defendants had failed to heed who undoubtedly provided a confidence booster for foreign investors who were the warning signs that were present in Caterpillar's financial documents and had unfamiliar with business operations in China". Experienced China hands like continued with the acquisition process even though Siwei's financial position did Williams and Li Rubo (John Lee) were supposedly well-versed in the creative not warrant its asking price. accounting tricks employed by Chinese companies. Hence, although Caterpillar never accused the principals of involvement in the alleged fraud, there were A risk consultant who advises U.S. corporations in Asia said that key executives questions as to how such a massive fraud could have been perpetrated under might have overlooked the risks of the acquisition because they were too personally their noses without their knowledge". invested to pull the plugs. External Consultants CEO To facilitate the deal, external financial, legal and accounting advisers were Within the first five months of being appointed as CEO of Caterpillar, Oberhelman engaged. Citigroup Global Markets Asia Limited served as exclusive financial completed US$9.4 bilion in deals. In stark contrast, his predecessor Jim Owens had adviser for Caterpillar, while Freshfields Bruckhaus Deringer LLP served as legal only made US$1.9 billion in transactions during his tenure of more than six years. adviser. The Blackstone Group (HK) Limited served as the financial adviser for ERA, and DLA Piper served as its legal adviser". However, despite the precautions In addition, in 2010, Oberhelman also stepped up to become the Chairman of employed to ensure a robust and rigorous acquisition, the accounting misconduct Caterpillar, while retaining his role as CEO, further cementing his power within was ultimately concealed until five months later in November 2012. Caterpillarer. Board of Directors Aftermath Reuters reported that the Board's attention was diverted away from the ERA In January 2013, Caterpillar released a public announcement that there had been acquisition due to a larger acquisition during the same periodes. There was also "deliberate, multiyear, coordinated accounting misconduct" at Siwei, following evidence indicating that Caterpillar's board of directors did not ask for the results which, Wang Fu, then CEO of Siwei, was fired along with other key executives". of the due diligence investigation for the ERA acquisition. Given the sheer scale However, Wang denied the occurrence of fraud and instead claimed that it was of acquisitions that Caterpillar had entered into over the past few years, it may merely an incidence of mismanagement. have been advisable for the board to exercise more rigorous due diligence, such as having a committee specifically to assess special projects like mergers and Furthermore, Caterpillar took a US$580 million write-down in goodwill for the acquisitions. In fact, in 2011, Caterpillar only had four committees - Compensation, fourth quarter of 2012, which dented Caterpillar's profit during the quarter to Audit, Governance and Public Policy. US$697 million, nearly 55% lower than in the same period the previous year Although the size of the charge equated to less than one percent of Caterpillar's Furthermore, there were other signs that Caterpillar's board composition was less market capitalisation, the saga impacted investors' perception of Caterpillar's than optimal. First, the Board was large, with 15 directors in total. Second, at the China growth strategy". time of the acquisition, seven out of the 15 Caterpillar directors had sat on the board for more than a decade". 178 177In May 2013, Caterpillar announced that it had settled the dispute with Siwei's Emerging from the chrysalis shareholders regarding the consideration for the acquisitions. Four shareholder suits were filed in the U.S. in Caterpillar's home state of Illinois". With China's economy slowing and facing increasingly stiff local competition" Caterpillar's prospects in the Chinese market are far from optimistic. Just like how Critics believe that Caterpillar may have been too heavy-handed in its treatment a caterpillar must break down its first form to transform into a butterfly, Caterpillar of the ERA scandal. First, they dismissed key executives whose business needs to revamp its business strategy to better adapt to the cultural differences relationships were key to Siwei's business. Second, they strained their relationship and business reality in China. Only then can it truly become the global industry with Li Rubo, one of ERA'S key shareholders with extensive ties in the mining leader and realise its Chinese dream. community. Altogether, this could negatively impact their prospects in China". Despite the accounting scandal, Caterpillar had no intentions to "cut off ties" Discussion questions with Siwei. Instead, in November 2013, Caterpillar announced the phasing out of Siwei's brand and the renaming of the company to Caterpillar (Zhengzhou) Lid". 1. Evaluate the board composition and structure of Caterpillar and whether this may have contributed to the problematic acquisition of ERA. 2. Evaluate the extent of each stakeholder's role in performing due diligence Part of a bigger picture before the acquisition of ERA. [ie., Caterpillar's management, Caterpillar's board of directors, ERA's shareholders/directors, and external consultants, Caterpillar's scandal was only one of many cases where foreign investors have including bankers, auditors, lawyers] been victims of irregular accounting practices in China. Why is accounting irregularity so seemingly pervasive in Chinese companies? 3. How did the business culture in China contribute to Caterpillar's Siwei scandal? One possible reason is the governmental restriction on transfer of the Chinese currency to foreign countries, which may motivate Chinese businessmen to 4. Given the discovery of accounting irregularities in Siwei, do you believe that accumulate wealth offshore through foreign stock market listing, thereby window- the acquisition was the right move for Caterpillar? Would you recommend dressing their companies' accounts to increase their attractiveness to foreign other multinational companies to acquire Chinese companies as an effective investors*. way to break into the Chinese market? 5. How can foreign companies manage cultural differences when doing China also seems unwilling to cooperate with other countries' law enforcers and business in China? regulators, and this may send Chinese businessmen a message that accounting irregularities committed outside China may go unpunished". Lastly, with regards to due diligence, it is difficult for the auditors, lawyers, and bankers assessing Chinese companies before an overseas foreign investment to spot any accounting discrepancies, especially if they are working in an unfamiliar jurisdiction. In addition, they may possibly bring in local advisers who may be cooperating with the subject of the investigation*