esponding to ocietal forces - sage publications inc€¦ · purchase agreement or a joint venture....

4RESPONDING TO

SOCIETAL FORCES

391

The subject of ethics forms a central element in managerial responses to societalforces. In many situations, an individual must reach a personal decision in regardto what is the right thing to do. This component of the course encourages students

to focus on principles that may help them when confronted by ethical dilemmas. In thisprocess, the individual may look to philosophy or religious beliefs concerning what is rightand wrong or may turn to history and laws for guidance. Some situations may requirethe student to consider resigning from the corporation or becoming a “whistle-blower” bygoing to law enforcement authorities. Alternatively, the student may decide that it wouldbe best to attempt to change corporate decisions over time by working from within theorganization.

The case of “John McCulloch—United Beef Packers” introduces this subject witha clear personal challenge in which McCulloch believes strongly that many corporate poli-cies are wrong in an ethical or societal sense. The objective of profit maximization has ledto exploitation of particularly vulnerable immigrant workers, whereas lax enforcementof product safety regulations has put consumers’ health at risk. “NES China: BusinessEthics” extends this discussion of ethics to national differences in generally acceptednorms and values—in this case, concerning bribery. In the “Textron” case, managementrecognizes that to shift manufacturing facilities to China would reduce costs substantially,but that cost reduction would involve working conditions and labor standards grossly infe-rior to those in the United States. In considering these issues, students will find many help-ful articles in the Journal of Business Ethics and the Business Ethics Quarterly. ThomasDonaldson (1996), in a Harvard Business Review article, has focused on culture relativismand the search for guiding principles when making decisions in countries whose normsand values differ from those in one’s home country.

Recent years have seen a proliferation of academic articles and media commentaryconcerning “corporate social responsibility,” with the search for consistent corporate posi-tions on these issues. Many firms have sought to develop guidelines and formal statementsthat can assist employees when they confront ethical dilemmas. Management may look to

04-4702-Conklin.qxd 5/10/2005 5:58 PM Page 391

such pronouncements rather than having to focus solely on personal evaluations of eachissue. However, it is not easy for an organization to develop clear and useful pronounce-ments. Values, cultural behaviors, and even ethical standards differ significantly amongcountries. For some issues, such as those relating to social interaction, there may be a gen-eral acceptance of local norms. For certain issues, such as prohibitions against bribery ofgovernment officials, some firms attempt to enforce their home-country code of conductglobally while realizing that this could handicap their financial success; other firms adaptto local practices. In each country, managers need to understand such cross-cultural dif-ferences and consider what adjustments in corporate practices would be appropriate.

Recent years have also witnessed a proliferation of stakeholder groups who believethat their views should be incorporated into the decision-making process of the firm.Stakeholders may use a variety of mechanisms to influence corporate decisions. Lawsand regulations, lobbying, media relationships, and boycotts all differ substantially amongcountries, and so the nature and power of stakeholders also differ. Confronted with thisreality, students may find it helpful to develop a decision-making framework in which theydelineate the stakeholders in a particular decision, seeking to understand their interests andpower in the context of social norms. Students may discuss appropriate mechanisms forconsultation with relevant stakeholders, in which they can better understand the objec-tives of each. Such an approach can be used to generate alternative courses of action thatstudents can then compare, recognizing that they must differentiate between the short termand the long term in reaching their decisions. Short-term gains may well lead to expensivelong-term costs. With many issues, stakeholder interests and strength will vary over time,requiring continual revisitation of corporate decisions.

Several subject areas have become particularly important as the focus for corporatesocial responsibility and stakeholder actions. Concerns about environmental pollution nowcover a host of corporate activities. Investments in new technologies to reduce pollutionmay be expensive, and so investment decisions can also be affected by differences inenvironmental regulations and labor standards, as firms locate in countries with lowerstandards and/or lax enforcement. Alternatively, a firm’s subsidiary in a country with lowstandards could decide to adhere to the higher levels required in economically advancednations. Here the subject of ethics again enters the cross-country analysis of comparativecosts. Examining such societal differences and their impacts on business draws studentsinto ethical perspectives that might not be raised in a traditional course with a domesticfocus. There is a concern that corporations may tend to invest in less developed countriesbecause they have lower environmental standards. At the same time, air and water crossnational boundaries, and so corporate pollution has increasingly become an internationalconcern, with new international agreements creating new environmental regulations. Fromthis perspective, corporate decisions may have to be based on expectations concerningfuture stakeholder and government actions rather than solely the current situation.

Government programs and policies are affected by societal pressures, and societal pres-sures may also affect a firm directly. Societal forces differ significantly among countries,and they change significantly over time. Corruption and human rights violations havebecome international concerns rather than just domestic issues and have led to new inter-national agreements that seek to create common standards. For businesses, trade sanctionsin response to human rights violations pose a recurring dilemma. The repressive violationof human rights has led people throughout the world to urge their governments to placeembargoes on certain countries, placing a halt to trade and investment with them.

392 • CASES IN THE ENVIRONMENT OF BUSINESS


The current “anti-globalization debate” deserves consideration because many expressthe view that poverty and inequality have been exacerbated by the reduction of trade andinvestment barriers (Held & McGrew, 2002; Oestreich, 2002). Anti-globalization protes-tors blame corporations for exploiting less developed countries in their trade and invest-ment decisions, and the “Planet Starbucks” case provides the context for a discussionconcerning the validity and implications of this movement. This debate extends to theobligations that rich nations should accept in assisting poor nations in the developmentprocess, including criteria for foreign aid and debt forgiveness (Dragsbaek Schmidt &Hersh, 2000; Torres, 2001). This debate also extends to the appropriate role for interna-tional institutions, especially the International Monetary Fund (IMF) and World Bank(Stiglitz, 2002). Students have to make specific managerial decisions in the context ofthese societal forces.

Both shareholders and stakeholders look to boards of directors for leadership andcorporate decision making in many of these societal issues. Consequently, the role andresponsibilities of boards of directors have tended to increase in many countries. Mean-while, with the extension of business activities internationally, board members face anincreasingly complex array of information that they must understand and evaluate.

The recent proliferation of literature on corporate social responsibility and the role ofboards of directors attracts considerable interest in the context of recent corporate scan-dals, as well as debates about appropriate corporate reporting (Bulik, 2002; Hartman,2002; Hatcher, 2002; “Special Report,” 2002). In examining the implications of these soci-etal forces for management decisions, a key question is, “Whose decision is it?” For firmswith branches in many countries, this question raises the allocation of responsibilitiesbetween local management and the head office. In many countries, governance practiceshave been changing significantly in recent years. For some societal issues, employees mayhave the right to participate in the decision process. The board of directors may feel thatit should be the final decision maker with regard to certain societal issues, and the law mayin fact require the board to bear responsibility (Grundfest, 1997; “Special Report,” 2003;Stiles, 2001).

JOHN MCCULLOCH—UNITED BEEF PACKERS

John McCulloch took a job as assistant general manager at a meat packing plant witha large number of immigrant workers. After a short time in the job, he discovered it wasnothing like he expected; worker safety was constantly compromised, the safety of thepublic from consuming tainted food was compromised, and everything was subordinatedto the production line’s constant movement. He had to decide whether he would stay withthe company.

NES CHINA: BUSINESS ETHICS (A) & (B)

NES was one of Germany’s largest industrial manufacturing groups. The company wantedto set up a holding company to facilitate its manufacturing activities in China. It authorizedrepresentatives in its Beijing office to draw up the holding company application and tonegotiate with the Chinese government for terms of this agreement. To maximize their

Responding to Societal Forces • 393

04-4702-Conklin.qxd 5/10/2005 5:58 PM 93

chances of having their application accepted, the NES team in Beijing hired a governmentaffairs coordinator who was a native Chinese and whose professional background hadfamiliarized her with Chinese ways of doing business. NES’s government affairs coordi-nator found herself in a difficult position when she proposed that gifts should be given togovernment officials to establish a working relationship that would improve NES’s chanceof having its application approved. This method of doing business was quite common inChina. The other members of the NES team were shocked at what would be consideredbribery and a criminal offence in their country. The complementary (B) case (9B01C030)gives a brief summary of the eventual solution to this problem.

TEXTRON LTD.

Textron Ltd. was a family-owned manufacturer of cotton and sponge fabricated items.The company wanted to expand its business with an offshore manufacturing enterprisethat would fit with the company’s policy of caring for its employees and providingquality products. The company was looking at two options: a guaranteed outsourcingpurchase agreement or a joint venture. After several meetings with offshore alliance can-didates, the vice president of the company had to analyze the cross-cultural differencesto established corporate guidelines of global ethics and social responsibility that the com-pany could use in its negotiations with a foreign manufacturing firm.

NOTE ON THE POLLUTION PROBLEM IN THE MEXICO-U.S. BORDER REGION

Many argue that the global expansion of capitalism threatens to create an environmentalnightmare as countries compete to attract investment and generate growth, even at the costof acting as “pollution havens” for foreign multinationals. Others point to the rising tideof environmental consciousness, along with more stringent regulations at the national andinternational levels, as heralding a new era of “sustainable development.” Managers needto understand the various aspects of the issue to formulate and implement effectiveenvironmental strategies.

PLANET STARBUCKS

The case details the history and development of the company, highlighting the evolutionof the corporate concept of a “third place,” and the key individuals in the organization inthis development. The second part of the case details the international expansion activi-ties of the firm, highlighting the potential cultural and economic challenges that it mayincreasingly face as it expands to more traditional coffee-drinking markets and low-income emerging markets. The third and final section of the case details the increasingpressure placed on Starbucks by the anti-globalization movement. Although Starbucks hasactively pursued a number of socially responsible operating policies, such as the purchaseof Fair-Trade coffee, the subsidization of health care facilities in Central America, and theintroduction of a number of socially responsible coffee products in its stores, it continuedto be the target of anti-globalization activities. Ultimately, the case is useful for debating



whether a firm can be successful internationally employing a different strategy and structurethan it employed in the construction of its already successful domestic business.

SIAM CANADIAN FOODS CO., LTD.

Although relatively undeveloped compared to the rest of Southeast Asia, Myanmar(Burma) had been experiencing increasing levels of foreign investment activity in recentyears. Siam Canadian Foods, which had considered entering Myanmar (Burma) in the pastbut declined, needed to determine if the time was now appropriate to enter the market. Thiscase introduces the issue of human rights violations and the imposition of trade sanctionsin response to these.

ROYAL TRUSTCO

This case examines the role of the board of directors with regard to decisions that mightjeopardize the future of the company. How should the board ensure that it is made awareof all necessary information, how should it analyze this information, how should it focusthis analysis on the concrete issues facing the company, and how should it relate with man-agement, shareholders, and other stakeholders? These questions were complicated by thefirm’s expansion to other countries.


JOHN MCCULLOCH—UNITED BEEF PACKERS

Prepared by Eric Dolansky under thesupervision of Professor James A. Erskine

Copyright © 2003, Ivey Management Services Version: (A) 2003–06–12

In August 2003, three months after JohnMcCulloch had started working as assistantgeneral manager at the United Beef Packers BlueRiver processing plant in Nebraska, he alreadyfelt trapped. He reread the latest memo from hisboss ordering him to terminate the employmentof a line worker. McCulloch was not sure hecould go through with it. McCulloch began won-dering why he had taken this job in the first placeand how he was going to get out of this mess.

THE MEAT PACKING INDUSTRY1

By the turn of the 21st century, the Americanmeat packing industry had gone through manychanges since the early 1900s. First dominatedby independent ranchers, corporations tookcontrol and created the Beef Trust, a councilwhereby the major beef packers could controlprices, wages and supplies and therefore maxi-mize profits. Inspired by Upton Sinclair’s book


The Jungle, an exposé of the industry fromthe point of view of a laborer, President TeddyRoosevelt ordered the Beef Trust dismantled andanti-competitive actions ended.

Regional competition and small playerskept competition in the industry active until the1970s, when large food processors began consol-idating the industry again. In 1980, the top fourmeat packers processed 20 per cent of the beef inthe United States; by the year 2000, the top fourcompanies processed 82 per cent of the beefavailable for sale in the United States.

A trade association, the American MeatInstitute (AMI), represented meat packingcompanies. According to the AMI, major meatpacking companies were at the cutting edge ontechnology, worker safety, hygiene, and environ-mental responsibility. Recent attacks on theindustry were explained by jealousy of thesuccess of these companies. The AMI pointedto advances in ergonomic tool design (to reducerepetitive stress disorders) as an example of thecompanies putting the well-being of the employ-ees first. Furthermore, complaints of taintedmeat and food poisoning (by salmonella, E. coli,or other pathogens) were deemed frivolous andinappropriate by AMI. According to the AMI,the highest standards of cleanliness were beingobserved and if there were cases of food poison-ing, they were the fault of improper preparationof the meat (by the restaurant or the chef) and notthe meat itself.

UNITED BEEF PACKERS

United Beef Packers (UBP) was one of the “bigfour” meat producers in the United States, andwas owned by Wholly Pure Foods, Inc. UBPoperated several plants across the Great Plains,primarily in states such as Nebraska, Texas, Iowa,Colorado and Kansas. Founded in the late 1960s,UBP represented the pinnacle of what could beachieved when management and employeesworked together with common goals and ideals.The founder of the company, Ken Hill, was agreat believer in communication and teamwork,

and he treated his employees well. The workersat Hill’s Blue River plant enjoyed high wages,a clean work environment, and a general sensethat the company was looking out for them. Therelationship between the union and the companywas amicable, and each tried to help the other outwhen necessary.

Then towards the end of the 1970s and inthe early 1980s, the recession hit, and it hit themeat packing industry hard. Consolidation of theindustry began. Hill found he could no longerenjoy profits and still treat his employeeswell, so he opted for the former and cut wages.Conditions in the various plants deteriorated.Hill bought a new slaughterhouse a few milesdown the highway and fired the unionizedworkers there upon purchase of the plant. Hereopened it shortly thereafter without a union,staffing it primarily with recent immigrants andpoorly educated locals. The union at the BlueRiver plant decided to hold a strike in protest.Hill hired “scabs” as retaliation, and soonreceived numerous death threats. Unionizedworkers who were let back into the plant posingas scabs committed acts of sabotage. In frustra-tion, Hill closed the Blue River plant and firedthe entire unionized workforce. After six months,he reopened the plant with immigrants andnew employees. The days of cordial relation-ships were gone.

In the mid-80s, amidst the consolidationboom, Wholly Pure Foods, Inc. (WPF) boughtUBP in a friendly takeover. Hill retired fromactive duty and accepted a seat on WPF’s board.Consultants, industry experts and top managersfrom other divisions of WPF were brought in tostudy and direct UBP. By 1994, no upper man-agement from the early days of the companyremained.

PLANT OPERATIONS

Despite technological advances, cattle slaughterand processing in 2000 was done in much thesame way it had been done 100 years before.Because cows were not grown to uniform size



(unlike chickens), automation of meat processingwas not possible. It was still a very labor-intensiveprocess. Cattle were led into the plant and struckon the head with a mallet, rendering them uncon-scious. After this “knocking,” a worker wrappeda chain around the hind legs of the cow andthe live cow was hoisted far up into the air. Therethe cow encounters the “sticker,” an employeewhose job it was to kill the cow with one lanceof a long, thin blade, severing the animal’s carotidartery and causing death as quickly as possible.From there the carcass had its hide removed, wasdecapitated, disemboweled and the body split intwo by a worker with a large chainsaw. After this,workers began their individual tasks of removingmeat and organs from the cattle, grinding thebones (for fertilizer and animal feed), anddisposing of the useless and possibly infectiousparts of the animal, such as the brain, spine andlower intestines.

In the 20 years leading up to 2000, line speedsin cattle plants increased from approximately175 cattle an hour to 400 cattle per hour. Becauseof this, safety and sanitation in the plants haddeclined. For example, there was a team of work-ers whose job it was to remove the bowel of thecarcass. This was a job that must be donecarefully, because if the intestine or bowel waspierced, manure would spray the area and raisethe chance of infecting the meat. Even the mostcompetent people on this job still pierced theintestines of one out of every 200 cattle. Thismeant that, at best, pathogens were released intothe plant twice an hour. There were cleaningtechniques for the meat, but these were typicallyreserved for whole cuts of meat (steaks, roasts,etc.). For ground beef, there was no way toensure that meat sold was clean. Because someplants could produce 400,000 pounds of groundbeef per eight-hour shift, one or two accidentscould have serious health consequences.

Per-capita beef consumption in the UnitedStates had remained flat with little growth inthe 12 years leading up to 2000 (see Exhibit 1).The high line speeds, according to the AMI, werenecessary to meet demand for beef. New tech-niques of ensuring safety were under review,

such as irradiation of meat (or, as the meatproducers prefer to call it, “cold pasteurization”).The concern of the United States Department ofAgriculture (USDA), which regulates beef, wasthat better end-of-line safety mechanisms wouldcause health standards throughout the line todecline because of the fail-safe at the end. Asone journalist, commenting on irradiation, put it,“Irradiation is fine; I just don’t want irradiated[manure] with my meat.”

PLANT EMPLOYEES

By 2000, most meat processing plant employeeswere immigrants, legal and otherwise. The bigfour companies used Mexican radio to advertisejob openings. Many workers who had earned $7a day in Mexico jumped at the chance to earnmore than that per hour at the U.S. meat plants.The migrant immigrant worker had changedfrom going from farm to farm to pick seasonalfruits and vegetables into an individual who wentfrom meat plant to meat plant to work until theywere injured, fired or otherwise forced off thejob. Annual industry turnover was extremelyhigh. On average, an employee remained at ameat packing plant for six months.

Until the industry consolidated, meat pro-cessing plant employees were some of the mosthighly paid workers in the country. In 1983,however, the national average hourly wage forsomeone working in industry passed the averagemeat packer’s wage. Since then, the industryaverage wage was typically 25 per cent to 40 percent higher than the meat industry’s averagewage (see Exhibit 2), which was due to a numberof factors, not least of which was the lack ofunions in the sector. Today, less than one-third ofall meat packers are unionized. Because of highindustry turnover, it was difficult to maintaina union; twice a year, a whole new group ofemployees must be sold on the idea.

The area where the meat companies hadreally taken power was in the field of employeesafety. All the major meat companies were self-insured, which meant that every dime paid out in



worker’s compensation claims came from thecompany’s bottom line. As a result, the meat pro-ducers did everything they could to avoid payingfor employees’ medical costs. The powerful AMIlobby had rendered the U.S. government’s regu-latory body, the Occupational Health and SafetyAdministration (OSHA), virtually powerless.OSHA had to announce all plant visits at least48 hours prior to the inspection. It was even legalfor plant managers to keep two sets of workeraccident records; one log for OSHA, and one thatlisted all the accidents.

Worker injuries remained very common inthis industry. On-the-job injuries such as lacera-tions, repetitive stress disorder, infections, ampu-tations and chemical burns occur frequently (seeExhibit 3). The level of repetitive stress disordersin meat packing plants was 75 times the nationalaverage. Despite all this, the AMI and the meatproducing companies claimed they met all neces-sary standards for worker safety.

JOHN MCCULLOCH

John McCulloch was born in Chicago, Illinois, in1972. Because both of his parents were Canadian(his father was studying at university), McCullochwas given dual citizenship so, when the timecame, he could decide where he wished to liveand work. With his undergraduate degree inengineering, McCulloch found a job in an autoparts plant in Albuquerque, New Mexico. Hetruly enjoyed working there; the people werefriendly, the management/union relations werecordial and he enjoyed living in a culture andcommunity so different from his Welland,Ontario, upbringing. McCulloch even learnedSpanish from some of the employees he super-vised. He married a local Albuquerque girl,Selena, and they had a son, Theodore.

A reduction in the workload at the plant gaveMcCulloch the opportunity to continue his edu-cation. Using his “golden parachute” from the


Turkey Beef Pork Chicken Total Red MeatYear Pounds Pounds Pounds Pounds & Poultry

1990 13.9 64.1 46.7 42.7 169.3

1991 14.2 63.3 47.3 44.4 171.2

1992 14.2 63.0 49.9 46.4 175.3

1993 14.1 61.6 49.2 46.6 174.5

1994 14.1 63.7 49.8 47.1 177.5

1995 14.1 64.2 49.2 46.7 177.1

1996 14.6 64.4 46.1 48.1 175.5

1997 13.9 63.6 45.7 49.2 174.4

1998 14.0 64.8 51.0 51.2 182.7

1999 14.1 65.8 51.1 53.2 186.0

2000 14.1 66.1 50.5 55.8 188.0

2001 14.1 63.4 50.8 57.1 187.8

Exhibit 1 U.S. Per Capita Meat Consumption

Source: Research Education Advocacy People (REAP) 2001 Annual Report.



Year Meat Packing Processing Meat Packing Slaughter U.S. Manufacturing

1975 $5.36 $5.67 $4.831976 $5.87 $6.06 $5.221977 $6.28 $6.57 $5.681978 $6.73 $7.09 $6.171979 $7.40 $7.73 $6.701980 $8.06 $8.49 $7.271981 $8.73 $8.97 $7.991982 $9.08 $9.00 $8.491983 $8.83 $8.58 $8.831984 $8.89 $8.17 $9.191985 $8.74 $8.10 $9.541986 $8.76 $8.24 $9.731987 $8.85 $8.41 $9.911988 $9.04 $8.48 $10.191989 $9.22 $8.64 $10.481990 $9.37 $8.74 $10.831991 $9.43 $8.92 $11.181992 $9.62 $9.16 $11.461993 $9.89 $9.26 $11.741994 $10.06 $9.44 $12.071995 $10.41 $9.61 $12.371996 $10.47 $9.82 $12.771997 $10.74 $10.03 $13.171998 $11.03 $10.34 $13.491999 $11.17 $10.81 $13.912000 $11.80 $10.94 $14.382001 $12.27 $11.38 $14.84

Exhibit 2 Average Hourly Wage Comparison: Meat Packing Compared to U.S. Manufacturing Accordingto the U.S. Bureau of Labor Statistics

Source: REAP 2001 Annual Report.

Year Poultry Slaughter Processing All Private Industry

1996 17.8 30.3 16.3 7.41997 16.6 32.1 16.7 7.11998 16.8 29.3 13.4 6.71999 14.3 26.7 13.5 6.32000 14.2 24.7 14.7 6.1

Exhibit 3 Occupational Injuries and Illness Per 100 Full-Time Workers U.S. Bureau of Labor Statistics

Source: REAP 2001 Annual Report.


plant as funding, he enrolled in an MBAprogram. Though it was nice to be close to hisfamily again, McCulloch was anxious to get outinto the workforce. He loved working in opera-tions, and he made that the focus of his studiesand job search. McCulloch found UBP throughan independent job search on the Web. Thepictures on the site and the description of thejob sounded great: he would supervise a largenumber of employees, work for a large multina-tional with lots of room for advancement, receivegood pay (especially relative to the cost of livingwhere the plants were located), and there weremany process/control challenges to tackle.

Through e-mail, McCulloch applied for theposition of assistant general plant manager and hefollowed up with a phone call. He met with a con-tingent from UBP’s human resource departmentfollowing a successful phone interview, and hehad the opportunity to ask about the plants, theemployees and the day-to-day mechanics of thejob. A few weeks later, McCulloch was flown toUBP headquarters in Omaha, Nebraska, where hemet with the vice-president of plant operations.Following a short conversation, McCulloch waspresented with an offer sheet. After discussing thematter with Selena, he accepted the position.

THE FIRST DAY

When McCulloch reported to the plant forhis first day of work and orientation, he did notknow how he would possibly be able to workthere. The place stank of blood and meat. It washot and humid. There were hundreds of workers,mostly Mexican, walking around in bloodyaprons that looked like chain-mail armor, andcarrying knives, lots of knives; long, short, thin,it seemed like everyone had at least one. Theplant general manager, Greg Kramer, was wait-ing for him. Kramer was the only one dressednormally. He had been with UBP for four years,having taken the job after earning his businessdegree.

The two retired to Kramer’s office to discussMcCulloch’s role at the plant. Even in Kramer’s

clean office, McCulloch could still smell theplant and hear the shouting, the grinding ofthe machinery and general sounds of a slaughter-house. According to Kramer, the Blue Riverplant was the best-functioning beef plant in thestate. The processing line moved at an average of350 cattle per hour, and that average was main-tained no matter what. Any shutdowns would bemade up for by speeding up the line later. Theline, however, was Kramer’s responsibility; as heput it, he got paid to ensure that the right amountof meat came out of the plant every day.

McCulloch’s responsibility was to be muchmore operational. He was to work closely with thefloor supervisors to make sure that all workerissues were taken care of quickly. He would reportdirectly to Kramer. The message was receivedloud and clear: no problems that could shut downthe line would be allowed. Kramer then showedMcCulloch to his office and suggested they tourthe plant.

Both men suited up in what looked like space-suits. They ventured out into the plant. The floorwas covered in blood, inches deep in some places.The line, or chain as it was called, moved above,carrying beef carcasses in various stages of dis-memberment. And everywhere, the workers cutand hacked at the pieces of meat in front ofthem, in a constant, repetitive motion. McCullochnoticed that he and Kramer were the only peoplewearing protective garb. Other than the aprons, theworkers had only metal gloves and chest-plates toprotect them from the many knives in motion.

THE FIRST THREE MONTHS

Over the next four weeks, McCulloch met withthe floor supervisors and tried to learn fromthem. These meetings, unfortunately, made himdepressed. It seemed that his direct reports wouldfeel more at home as slave drivers than as a plantsupervisors. They had no respect for the workersand were trained to care only about keepingthe line moving and keeping workers working.McCulloch decided to try to get a different viewby talking to others in the plant.



Concerned with the high incidence ofworkplace accidents, McCulloch went to seethe plant nurse. She was a friendly woman whoresponded to McCulloch’s naïveté by letting himknow that this was just how the industry worked.They were interrupted by a pair of workers com-ing in with deep lacerations. The nurse said“I guess they’re making up for lost time today.I can always tell how fast the chain is moving byhow many injuries there are.”

Just then, one of the supervisors came in. Heshoved a piece of paper in front of one of theinjured workers and ordered him, in Spanish, tosign it. When McCulloch asked what it was, thesupervisor explained in English that all injuredworkers had to sign a waiver that allowed UBP toadminister medical treatment and disallowedthe worker from getting an outside medical opin-ion, seeing a non-company doctor, or suing thecompany. Signing waivers was standard operat-ing procedure, according to the supervisor. Thesupervisor then demanded that the other workersign a copy of the waiver. Because this worker’slacerations were to his hands, he had to sign it bywriting with a pen in his mouth.

McCulloch then went to see Kramer and askedabout the waiver procedure. Kramer told him thatbecause the company was self-insured, it had aright to insist that all medical treatment comefrom company personnel. When McCullochasked what happened when a worker did not signthe waiver, he was told that the worker was thenfired. Because an employee could not collect ben-efits if fired, almost everyone signed the waiver.Kramer assured McCulloch that everything waslegal and that he had better get on board withthe policy if he was going to last at the plant.Although McCulloch had tried to talk to individ-ual workers on the line, no one would give himthe kind of low-down, nitty-gritty information hewanted. McCulloch felt it was all well and goodto know how the plant was supposed to operateand how it was suppose to look to the outsideworld, but if he was going to be an effectivemanager, he had to know what really went on.

On his way into his office one day, McCullochsaw a large, muscular man in a wheelchair sorting

files. He had never seen this man before. Afterintroducing himself, McCulloch asked this man(Bobby Vasquez) if he would be willing to tellMcCulloch what went on in the plant. Vasquezseemed more than happy to oblige.

Vasquez started working at the plant in thelate 1970s at the age of 24. In 1994, he heardsomeone yell “watch out!” and, looking up fromhis work, saw a 100-pound box of meat fallingtowards him. He reached out and caught it withone arm, but the force of the box caused him tofall backwards hitting his back on a metal table.The company doctor told him it was a pulledmuscle, but after months of excruciating pain hegot a second opinion and found out he had twoherniated discs. A month after surgery, Vasquezwas back doing heavy labor in the plant. Takingon an extra shift, one night he was ordered toclean the gigantic blood tanks with liquid chlo-rine. Because no protection was given to him, heended up in the hospital with severe chemicalburns to his lungs. He still returned to work.Subsequent accidents included a shattered ankleand a broken leg, the reason for his being in awheelchair and restricted to “light duty” work.

McCulloch could not believe the litany ofhorrors that had befallen Vasquez. But what theman said next chilled McCulloch even more:

John, you should get out as soon as you can. Youreally don’t want to know what goes on in theplant. Your supervisors are loyal only to the com-pany, because they know they’d never get a jobmanaging others anywhere else. They sell drugs tothe workers so that they can work faster and longer.They harass and abuse female employees inexchange for easier work. They let tainted meat goout for sale. Trust me, the less you know the better.

A few days later, Vasquez was back on theline, cutting meat.

THE MEAT RECALL AND

THE LOADING DOCK

Around two months after McCulloch had begunworking at UBP, head office sent a task force to



the Blue River plant. UBP had gotten some badpress after several E. coli infections were tracedback to some ground beef produced at BlueRiver. UBP upper management wanted to hold apress conference at the plant to announce a recalland show that they had nothing to hide. The com-pany was recalling 250,000 pounds of groundbeef, though by now, McCulloch knew that therewas no way the company could be certain of howmuch meat had been infected. It mattered little;the USDA could only ask for a recall of taintedmeat; it did not have the power to force the com-pany to pull the meat from the shelves.

Greg Kramer was furious because thisepisode meant that the line had to be shut downfor extensive cleaning. Shifts were added forthe sanitation effort, and others were cancelledso the line did not look as frenetic when thereporters arrived. “We’ll be running at 400 anhour for a month to make up for this,” Kramercomplained.

The task force assigned McCulloch the dutyof inspecting the non-core areas of the plant, suchas the offices and loading dock, for anything that

would look out of the ordinary. Upon arrival atthe loading dock, McCulloch saw several boxesof beef sitting on the dock with no truck to pickthem up. The time stamp on the box was six hoursold, and the meat was sitting in 30-degree Celsiustemperatures. When he asked the dock foremanwhy this meat was there, the man looked atMcCulloch quizzically. McCulloch repeated hisquestion, and the foreman explained that thismeat was “seconds,” not of high quality, andwould be sold under a brand name other thanUBP’s, so it was okay that it sat outside for awhile until the truck came to get it.

BREAKING POINT

After three months of lost sleep, no appetite,depression and the stench of cattle constantlyaround him, McCulloch wondered how muchmore he could take. He was in constant fear: ofpublic exposure, of legal liability, of his wife andson’s health and of the loss of his own sanity. Heknew he had made a mistake coming to work for


Date: August 12, 2003

To: John McCulloch, Assistant General Manager

From: Greg Kramer, General Manager

Re: Bobby Vasquez

John:

If you haven’t already heard from the floor supervisors, plant employee Bobby Vasquez is seriously incapacitatedand unable to work at the plant for the next several months due to a heart attack.

Vasquez has never been that valuable an employee and is quite accident-prone. He was recently confined toa wheelchair because of a broken leg, and he has had problems with his back in the past as well. He has alsodisplayed contempt for the company and is not considered loyal.

Head office and I agree that we would benefit from no longer having this individual on our payroll and enrolled inour benefits plan. Please ensure his employment is terminated as soon as possible. Do not wait until Vasquezcontacts the plant; track him down and serve him with his termination papers. I understand he is recuperating atBlue River General Hospital, room 1115.

Greg

Exhibit 4 Memorandum


UBP, but there seemed to be little he could doabout it now, short of uprooting his life and thoseof his family.

Looking through his in-box tray, McCullochfound a memo from Kramer (see Exhibit 4). Itseemed that Vasquez suffered a heart attack theprevious week and was in the hospital. The doc-tors said he would no longer be able to work inthe plant, and his recovery would be long andexpensive. Kramer was ordering McCulloch tofire Vasquez, as the company did not want to pay

for his medical bills any longer. McCulloch satdown, put his head in his hands and wished hewere someplace else.

NOTE

1. Based on information from Fast Food Nation,by Eric Schlosser. Published by the Houghton MifflinCompany, 2001.


NES CHINA: BUSINESS ETHICS (A)

Prepared by Xin Zhang under thesupervision of Professor Joerg Dietz


By April 1998, it had been almost a year sincethe Germany-headquartered multinational com-pany NES AG had first submitted its applicationto the Chinese government for establishing aholding company in Beijing to co-ordinate itsinvestments in China. The application documen-tation had already been revised three times, butthe approval by the government was still out-standing. Lin Chen, government affairs co-ordinator at NES AG Beijing RepresentativeOffice, came under pressure from the Germanheadquarters and had to find a way to obtainapproval within a month.

During the past year, Chen had almost exclu-sively worked on the holding company applica-tion. In order to facilitate the approval process, shehad suggested giving gifts to government officials.But her European colleagues, Steinmann andDr. Perrin, disagreed because they thought suchconduct would be bribery and would violate busi-ness ethics. Confronted with the cross-culturalethical conflict, Chen had to consider possiblestrategies that would satisfy everybody.

COMPANY BACKGROUND

NES and NES AG

NES was founded in Germany in 1881. Overthe following 100 years, by pursuing diversifica-tion strategies, NES had grown from a pure tubemanufacturer into one of the largest industrialgroups in Germany, with sales of US$14 billionin 1997. NES built plants and heavy machinery,made automotive systems and components,manufactured hydraulic, pneumatic and electricaldrives and controls, offered telecommunicationsservices and produced steel tubes and pipes.

NES was managed by a holding company—NES AG—that implemented value-orientedportfolio management and directed its financialresources to the areas with the greatest profitpotentials. In 1997, NES AG owned NES’s 11companies in four business segments: engineer-ing, automotive, telecommunications and tubes.These companies generally operated indepen-dently and largely at their own discretion, as


NES AG was interested in their profitability andnot their day-to-day operations.

NES had always been committed to movealong the road of globalization and international-ization. Headquartered in Germany, NES hadbusinesses in more than 100 countries with over120,000 employees. In the process of globaliza-tion and internationalization, NES established abusiness principle that demonstrated its responsi-bilities not only to shareholders, employees andcustomers, but also to society and to the coun-tries where it operated. As an essential part of thecompany’s corporate culture, this principle per-vaded the decentralized subsidiaries worldwideand guided the decision-making and conduct ofboth the company and its employees.

NES China Operations

NES’s business in China dated back to 1889,when it built the flood barrages for the CantonRiver. In 1908, NES supplied seamless steeltubes for the construction of a waterworks inBeijing. Through the century, NES continued tobroaden its presence. From the mid-1950s to1997, NES supplied China with an enormous5.2 million metric tons of steel tube and 1.6 mil-lion tons of rolled steel.

Since China opened up to foreign trade andinvestment in the late 1970s, NES’s presence hadgrown dramatically. From 1977 to 1997, NEShad completed more than 40 technology transferand infrastructure projects. It had also set up 20representative offices, six equity joint venturesand three wholly owned enterprises.

In developing business links with China, NESadhered to its business principle. Most NESenterprises in China had highlighted this princi-ple in their codes of conduct in employmenthandbooks (see Exhibit 1). These codes requiredemployees to pursue the highest standards ofbusiness and personal ethics in dealing withgovernment officials and business customers,and to avoid any activities that would lead tothe involvement of the company in unlawfulpractices. Instead of tendering immediate favorsor rewards to individual Chinese officials and

customers, NES relied on advanced technology,management know-how and top quality productsand service as a source of its competitive advan-tage. NES emphasized long-term mutual benefitsand corporate social responsibility. Since 1979,NES had trained more than 2,000 Chinese engi-neers, master craftsmen, technicians and skilledworkers in Germany. It had also offered exten-sive training programs in China. Moreover, NESwas the first German company to adopt thesuggestion of the German federal government toinitiate a scholarship program for young Chineseacademics to study in Germany. As a result, NEShad built a strong reputation in China for being afair business partner and a good guest company.

NES Beijing Representative Office

In 1977, NES was the first German com-pany to open its representative office in Beijing.Along with NES’s business growth, the BeijingRepresentative Office continued to expand. In1997, it had 10 German expatriates and morethan 40 local staff in nine business units. Oneunit represented NES AG. This unit was respon-sible for administrative co-ordination and officeexpense allocation. The other eight units workedfor the German head offices of their respectiveNES companies in the engineering, automotiveand tube segments.

Chinese legal restrictions severely limitedthe activities of the Beijing RepresentativeOffice. It was allowed only to engage in admin-istrative activities, such as conducting marketingresearch for the German head offices, passing onprice and technical information to Chinese cus-tomers, and arranging for meetings and trade vis-its. Moreover, it could not directly enter intoemployment contracts with its Chinese employ-ees. Instead, it had to go through a local laborservice agency designated by the Chinese gov-ernment and consult with the agency on almostall personnel issues including recruitment, com-pensation and dismissal. As a result, the Germanmanagers of the Beijing Representative Officefound it difficult to effectively manage theirChinese employees. In the absence of direct



employment contracts, the managers had to relyon an internal reporting and control system.

CURRENT SITUATION

Establishing China Holding Company

In early 1997, NES AG had decided to estab-lish a holding company in Beijing as soon as

possible after carefully weighing the advantagesand disadvantages of this decision. Establish-ing a China holding company was advantageousbecause, unlike a representative office, a holdingcompany had its own business licence and couldtherefore engage in direct business activities. Inaddition to holding shares, a holding companycould co-ordinate many important functionsfor its enterprises, such as marketing, managinggovernment relations, and providing financial


Article 3 Employment and Duties

3.1 The Company employs the Employee and the Employee accepts such employment in accordance with theterms and conditions of the Employment Contract and this Employment Handbook.

3.6 The Company expects each Employee to observe the highest standards of business and personal ethics,and to be honest and sincere in his/her dealings with government officials, the public, firms, or othercorporations, entities, or organizations with whom the Company transacts, or is likely to transact.

3.7 The Company does business without favoritism. Purchases of materials or services will be competitivelypriced whenever possible. An Employee’s personal interest or relationship is not to influence any transaction with abusiness organization that furnishes property, rights or services to the Company.

3.8 Employees are not to solicit, accept, or agree to accept, at any time of the year, any gift of value whichdirectly or indirectly benefits them from a supplier or prospective supplier or his employees or agents, or anyperson with whom the Company does business in any aspect.

3.9 The Company observes and complies with all laws, rules, and regulations of the People’s Republic of Chinawhich affect the Company and its Employees. Employees are required to avoid any activities which involve orwould lead to the involvement of the Company in any unlawful practices and to disclose to the proper Companyauthorities any conduct that comes to their attention which violates these rules and principles. Accordingly, eachEmployee should understand the legal standards and restrictions that apply to his/her duties.

3.10 All Employees are the Company’s representatives.This is true whether the Employee is on duty or off duty.All Employees are encouraged to observe the highest standards of professional and personal conduct at alltimes.

Article 13 Discipline

13.1 The Company insists on utmost discipline. The Employee’s misconduct or unsatisfactory performance willbe brought to the attention of the responsible Head of Department or Member of the Management when it occursand will be documented in the Employee’s file.

13.2 Some offences are grounds for immediate dismissal and disciplinary procedures will apply to otheroffences.

13.3 Offences which are grounds for immediate dismissal include:(i) Breach of the Company’s rules of conduct.(j) Neglect of duties, favoritisms or other irregularities.

Exhibit 1 Excerpt from the Employment Handbook of one of the Nes’s Enterprises in China

Source: Company files.


support. As a “country headquarters,” a holdingcompany could also unite the NES profile inChina and strengthen the good name of NES asa reliable business partner in the world’s mostpopulous country. Moreover, it could hire staffdirectly and thus retain full control over its ownworkforce. In light of these advantages, NES AGexpected substantial time and cost efficienciesfrom the China holding company.

Several disadvantages, however, potentiallyoutweighed the advantages of a China holdingcompany. First, Chinese legal regulations stillconstrained some business activities. For example,a Chinese holding company could not balanceforeign exchange accounts freely and consoli-date the taxation of NES’s Chinese enterprises,although this might be permitted in the future.Second, the setup efforts and costs were high.To establish a holding company, NES had tosubmit a project proposal, a feasibility study,articles of association and other applicationdocuments to the local (the Local Department)and then to the central trade and economicco-operation departments (the CentralDepartment) for examination and approval.Third, there was only a limited window of oppor-tunity for NES AG. Once the China holdingcompany had received its business licence,within two years, NES AG would have to con-tribute a minimum of US$30 million fresh capi-tal to it. The Chinese regulations prescribed thatthis capital could be invested only in new pro-jects, but otherwise would have to remain unusedin a bank account. NES currently was in a posi-tion to invest the capital in its new projects, butthe company was not certain how much longer itwould be in this position.

Working Team

NES AG authorized the following three indi-viduals in the Beijing Representative Office to takeup the China holding company application issue:

Kai Mueller, 58 years old, had worked for NESin its China operations since the 1970s and hadexperience in several big co-operative projects in

the steel and metallurgical industries. He would bethe president of the holding company.

Jochen Steinmann, 30 years old, was assigned toBeijing from Germany in 1996. He would be thefinancial controller of the holding company.

Dr. Jean Perrin was a 37-year-old lawyer fromFrance who had an in-depth understanding ofChinese business laws. He would work as the legalcounsel. His previous working experience inclu-ded a professorship at the Beijing InternationalBusiness and Economics University in the 1980s.

The trio had advocated the idea of a Chinaholding company to NES AG for quite some timeand were most happy about NES AG’s decision,because the future holding company would givethem considerably more responsibilities andauthority than did the Beijing RepresentativeOffice.

Considering the complexity and difficulty incoping with the Chinese bureaucratic hurdles,Mueller decided in March 1997 to hire Lin Chenas a government affairs co-ordinator for the work-ing team. Chen, a native Chinese, was a 28-year-old politics and public administration graduatewho had worked four years for a Chinese state-owned company and was familiar with theChinese way of doing business. Mueller expectedthat Chen would play an instrumental role inobtaining the holding company approval from theChinese government. He also promised that Chenwould be responsible for the public affairs func-tion at the holding company once it was set up.

Chen’s View of Doing Business in China

Chen officially joined the Beijing Representa-tive Office in June 1997. She commented on doingbusiness in China:

China’s economy is far from rules-based; basically,it is still an economy based on relationships. Inthe absence of an explicit and transparent legalframework, directives and policies are open tointerpretation by government officials whooccupy positions of authority and power. In such



circumstances, businesspeople cultivate personalguanxi (interpersonal connections based implicitlyon mutual interest and benefit) with officials tosubstitute for an established code of law that busi-nesspeople in the Western society take for granted.

In building and nurturing guanxi with officials,gifts and personal favors have a special place,not only because they are associated with respectand friendship, but also because in today’s China,people place so much emphasis on utilitariangains. In return for accepting gifts, officials pro-vide businesspeople with access to informationabout policy thinking and the potentially advanta-geous interpretation of the policy, and facilitateadministrative procedures. Co-operation leads tomutual benefits.

Although an existing regulation forbids govern-ment officials to accept gifts of any kind,1 itremains pervasive for businesspeople to provideofficials with major household appliances, electricequipment, “red envelopes” stuffed with cash, andoverseas trips. There is a common saying: “Thebureaucrats would never punish a gift giver.”Forbidding what the West calls bribery in a guanxi-based society where gift giving is the expectedbehavior can only drive such under-the-table trans-actions further behind the curtain.

While sharing benefits with officials is normalbusiness conduct in China, it is interpreted asunethical and abnormal in the West. Faced withtheir home country’s ethical values and businessrules, Western companies in China cannot handlegovernment relationships as their Asian counter-parts do. They often find themselves at a dis-advantage. This dilemma raises a question for amultinational company: Should it impose the homecountry’s moral principles wherever it operates orshould it do what the Chinese do when in China,and, if so, to what extent?

Different Opinions on Bribery

When Chen started working in June 1997,Mueller was sick and had returned to Germanyfor treatment. Steinmann and Dr. Perrin toldChen that NES had submitted the holdingcompany application to the Local Department in

April 1997 and that the Local Department hadtransferred the documents to the Central Depart-ment at the end of that month. But nothing hadhappened since then. Chen felt that she had tofall back to her former colleague, Mr. Zhu, whohad close personal guanxi with the CentralDepartment, to find out first who had the author-ity in the Central Department to push the pro-cessing and what their general attitudes towardsthe application were.

In July, Chen reported her findings toSteinmann and Dr. Perrin:

The approval process at the Central Department isdifficult. Because holding companies are a rela-tively new form of foreign investment in China, theofficials are unsure whether they are a good ideafor China. They have been very prudent to grantapproval. Hence, we don’t have much negotiatingleverage, although we are a big company and haveproducts and technologies that China needs. Theofficials say that they will consider a holding com-pany’s application within 90 days of its submis-sion. They issue approval however, only when theapplication is deemed “complete and perfect” (inthat all issues have been resolved to the CentralDepartment’s satisfaction). The Central Depart-ment is under no real obligation to approve anyholding company application. They can alwaysfind some minor issues. So the approval proceduremay be lengthy. The legal basis for establishingholding companies is provided by the HoldingCompany Tentative Provisions, SupplementaryRules and some unpublished internal policies.This provisional and vague status allows theofficials to be flexible in authorizing a holdingcompany. In such circumstances, maintaining closeconnections with the responsible officials isabsolutely critical.

Chen suggested:

The quickest and most effective way to build suchconnections is to invite the responsible officials todinner and give gifts. It won’t cost the company toomuch. But what the company will gain in return—efficiency in obtaining approval and flexibility inthe interpretation of the wording within the scopepermitted by law—is worth much more.



Upon hearing Chen’s report and suggestion,Steinmann was shocked:

That would be bribery. In Germany bribing anofficial is a criminal offence for which both thebriber and the bribed are punished. NES is a pub-licly traded company with a board of directors thatreports to shareholders and monitoring authoritiesin Germany.

We have met the criteria for setting up the holdingcompany. What we should do now is organize aformal meeting with the officials and negotiatewith them. This is the way we have done it in thepast, and it has always worked. I am not aware thatwe ever had to use bribery. NES does not have ahistory of wrongdoing.

Knowing how critical it was to follow China’scustomary business practices in tackling suchissues, Chen argued:

Yes, it is correct. NES did not have to give gifts ofthis kind in the past. But don’t forget: virtually allof NES’s projects or joint ventures in the past wereapproved by agencies responsible for specificindustries or local governments that were verykeen on having access to NES’s technology. As aresult, NES always has had considerable bargain-ing power. It is different this time: we need tofound a holding company, and we have to deal withthe Central Department that we have never con-tacted before. Even Mueller does not have relationsin this department. Moreover, our contacts atthe industrial and local levels won’t help muchbecause they have very limited influence on theCentral Department and, hence, the holding com-pany application issue.

Moreover, you can’t equate gifts with bribes. Theapproval letter doesn’t have predetermined “prices”and no one forces us to pay. We give gifts just toestablish relationships with officials. We developgood relationships, and favorable considerationof these officials comes naturally. According toChinese law,2 to give gifts to government officialsand expect them to take advantage of their positionand power to conduct illegal actions is bribery. Ourintent is to motivate officials to handle our applica-tion legally but without delay. I see no seriousethical problem.

In some ways it’s also hard to blame officials forfeathering their nest because they are poorly paid.Whether they process our application quickly orslowly has absolutely no impact on their US$200monthly income. Then, how can we expect them togive our case the green light? They are not morallywrong if they accept our gifts and don’t createobstacles for us in return.

Negotiation doesn’t help much. Unless we haveclose relationships with them, they will always findsome minor flaws in our documents. After all, theyhave the authority for interpreting the regulations.Therefore, we have to be open-minded and getaccustomed to the Chinese way of doing business.

Chen hoped that Dr. Perrin would supporther, as she had a feeling that the French were moreflexible and less ethically sensitive than theGermans. Dr. Perrin, however, shared Steinmann’sview. Perrin said:

We should not give officials anything that hassome value, with the exception of very small objects(pens, key holders, calendars and the like) givenmainly for marketing and advertisement purposes.I also think that these officials should not acceptany gifts. It’s unethical and illegal. If we think it isunethical, we should combat it and refrain from it.

Nonetheless, Dr. Perrin understood theimportance of guanxi as an informal solution toChinese bureaucracies. So he agreed that Chencould invite one of the two responsible officialsto dinner through Mr. Zhu and present a CDplayer to this official as an expression of respectand goodwill, although he thought it went too farand was approaching bribery.

On a Saturday evening in July, Chen met theofficial at one of the most expensive restaurantsin Beijing. At the dinner, the official promised towork overtime the next day on NES’s documentsand give feedback as soon as possible.

The following Monday, Chen got the govern-ment’s official preliminary opinion demanding arevision of 16 clauses of the application docu-ments. Steinmann and Dr. Perrin found it diffi-cult to understand this. NES had drafted thedocuments with reference to those of another



company, whose application had been approvedby the Central Department a few months ago.Why didn’t the Central Department accept thesimilar wording this time? Chen again contactedher former colleague Zhu, who told her:

You should never expect to get things done soquickly and easily. It takes time to strengthen yourrelationships. I can ask them to speed up the pro-cedure without changing too much of the wording.But you’d better offer them something generous toexpress your gratitude since they would consider ita great favor. RMB3,000 (US$360) for each of thetwo will be OK. Don’t make me lose face anyway.

Steinmann and Dr. Perrin thought it wasstraightforward bribery even if gifts were giventhrough a third party. If they agreed to do so, theywould run high personal risks by violatingthe corporate business principle and professio-nal ethics. As controller and lawyer, they wereexpected to play an important role in implement-ing strict control mechanisms in the companyand keeping the corporate conscience. Moreover,they were worried that the potential wrongdoingmight damage the strong ethical culture of theBeijing Representative Office and the goodcorporate image among the Chinese employeesof the office, although it likely would notaffect the whole company because NES was sodecentralized.

However, Chen thought that renqing (socialor humanized obligation) and mianzi (the notionof face) were more important and that NES’sbusiness ethics and social responsibility couldbe somewhat compromised. In Chen’s eyes,Steinmann and Dr. Perrin were inflexible andlacked knowledge of the Chinese businessculture. Steinmann and Dr. Perrin told Chen thatshe needed to learn Western business rulesand values in order to survive in a multinationalcompany.

Recent Developments

In August 1997, the vice-president of NES AGled a delegation to visit China. Chen arranged ameeting for the delegation with a senior official

of the Central Department. It turned out just to bea courtesy meeting and did not touch upon thedetails of the holding company approval issue.

In November, Steinmann and Dr. Perrin metthe two responsible officials in hopes of negoti-ating with them such that the officials wouldallow NES to leave some clauses unchanged. Butthe officials insisted on their original opinionwithout giving a detailed explanation of the rele-vant legal basis. The negotiation lasted only halfan hour, and Steinmann and Dr. Perrin felt that itaccomplished nothing.

Because of the limited window of opportunity(that is, new investment projects required animmediate capital injection), they felt that theyhad no choice but to modify the documentsaccording to the officials’ requirements. Modify-ing the documents was an administrative strugglewith NES AG, because due to company-internalpolicies, the German headquarters had to approvethese modifications. The application was res-ubmitted at the end of November. When Cheninquired about the application’s status inDecember, the officials, however, said that thecase needed more consideration and then raisedsome new questions that they said they failed tomention last time. This happened once againthree months later in February 1998.

WHAT NEXT?

In April 1998, Steinmann, Dr. Perrin andChen submitted the newest revision of theapplication. As NES AG could not defer fundingthe new projects, it demanded that the Beijingworking team obtained approval within a monthso that NES AG could use the China holdingcompany’s registered capital of US$30 million.Otherwise, NES AG would have to re-evaluatethe China holding company and might abandonit all together. In that case, Mueller, Steinmannand Dr. Perrin would miss opportunities forcareer advancement. As for Chen, she wasconcerned about her job because the BeijingRepresentative Office would no longer need herposition.



Being very anxious about the current situation,Mueller decided to come back to Beijing imme-diately. Chen wanted to be able to suggest a prac-tical approach that would gain the co-operationof the bureaucrats while conforming to theGerman moral standards. Chen also contem-plated some challenging questions. For example,what constituted bribery? When ethical valuesconflicted, which values should people follow?How could these differences be resolved? Towhat extent should a multinational companylike NES adapt to local business practices?Should the future China holding companydevelop special ethical codes to recognize theChinese business culture? The answers to thesequestions were very important to Chen, becauseshe expected to face similar ethically sensitiveissues in the future.

NOTES

1. The China State Council Order No. 20 promul-gated on 1988.12.01. Article 2 Any State administra-tive organization and its functionary shall not giveand accept gifts in activities of domestic public ser-vice. The China State Council Order No. 133 pro-mulgated on 1993.12.05. Article 7 Gifts accepted inactivities of foreign public service shall be handled

properly. Gifts above the equivalent of RMB200(about US$24) according to the Chinese market priceshall be . . . handed over to the gift administrativedepartment or acceptor’s work unit. Gifts of less thanRMB200 belong to the acceptor or to the acceptor’swork unit. P. R. China Criminal Law (revised edition)promulgated on 1997.03.14. Article 394 Any Statefunctionary who, in his activities of domestic publicservice or in his contacts with foreigners, accepts giftsand does not hand them over to the State as is requiredby State regulations, if the amount involved is rela-tively large, shall be convicted and punished in accor-dance with the provisions of Article 382 and 383 ofthis law. (Article 382 and 383 regulate the crime ofembezzlement.)

2. The China State Council Order No. 20 promul-gated on 1988.12.01. Article 8 Any State administra-tive organization and its functionary who give, acceptor extort gifts for the purpose of securing illegitimatebenefits shall be punished in accordance with relevantstate law and regulations on suppression of bribery.The P. R. China Criminal Law (revised edition) pro-mulgated on 1997.03.14. Article 385 Any State func-tionary who, by taking advantage of his position,extorts money or property from another person, or ille-gally accepts another person’s money or property inreturn for securing benefits for the person shall beguilty of acceptance of bribes. Article 389 Whoever,for the purpose of securing illegitimate benefits, givesmoney or property to a State functionary shall beguilty of offering bribes.


NES CHINA: BUSINESS ETHICS (B)

Prepared by Xin Zhang under thesupervision of Professor Joerg Dietz


Mueller was coming back to the office the nextday. His secretary was sorting out the mail andfaxes on his desk, when Chen came in and acci-dentally found a letter sent from a Chinese lawfirm a few month’s earlier. The firm had learnedfrom the Central Department that NES was

applying for a holding company and would liketo provide consulting service. Chen thought thatusing this firm would be a solution to the ethi-cal conflict that her working team was facing.

The next day, Chen talked to Mueller aboutthe letter. Mueller liked the idea because it could


solve the problem in a legal way. That sameafternoon, Mueller met a partner of the firmwho promised to help NES get approval within amonth. The partner also said that his firm hadgood relationships with the Central Departmentand was experienced in handling holding

company applications. Mueller decided to havethis law firm involved.

Ten days later, the Central Department issuedapproval for NES China holding company andthe NES Beijing Representative Office paid thelaw firm US$10,000.


TEXTRON LTD.

Prepared by Lawrence A. BeerCopyright © 2001, Ivey Management Services Version: (A) 2002–01–24

INTRODUCTION

Gary Case, executive vice-president of TextronLtd., sat at his desk and slowly drew a circlearound the words ethics and social responsibility.Above the circle he wrote in bold letters thephrase “public opinion,” and sat back to ponderhis symbolic illustration of a potential problemthat only he seemed to envision.

Case was thinking ahead and letting his mindfocus on an issue that seemed out of the realm ofthe tenants of basic managerial principles that hisundergraduate and MBA studies had preparedhim for during his scholastic years. While he wellappreciated the strategic decision-making con-cepts of running a transnational business, he felthimself personally wondering how to approachthe complex subject of applying global ethics andsocial responsibility to an international venturethat was being pushed on his company.

BACKGROUND

Textron Ltd. was a 65-year-old, family-heldbusiness based in Youngstown, Ohio. As a pro-ducer of cotton and sponge fabricated items forthe beauty trade, selling to intermediate users ascomponents in their make-up compact cases aswell as direct to the retail trade for onward sale

to consumers, the company was under constantattack from Far Eastern manufacturers. The needto enter into some type of offshore manufactur-ing enterprise was now evident in order to main-tain a cost competitive position for the firm tocontinue to prosper and grow.

As a maker of cotton puffs for the applicationof make-up cosmetics, the company had grownfrom a loft in Brooklyn, New York back, in themid-1930s to a medium-sized enterprise withsales of $25 million and pre-tax earnings of $1million plus. In the category of cosmetic applica-tors, Textron’s fine reputation had been built onyears of excellent service to the trade with atten-tion to detail. Using, at first the hand sewing abil-ities of seamstresses from the garment centresof lower Manhattan, the company had been apioneer in developing customized machinery toproduce quality cotton puffs to the precise customrequirements of modern cosmetic manufacturers.Today, 100 per cent virgin cotton rolls would enterTextron’s factory at one end and exit as soft velourpads in numerous shapes, contoured sizes andcolors at the other end of the process.

These puffs would be either sewn or gluedwith ribbon bands and satin coverings bearingthe well-known brand names of the major fran-chised cosmetics companies of the world fromRevlon, Estee Lauder, Maybelline and MaxFactor as well as numerous others. They might


also contain the names of retail store housebrands or the internationally recognized trade-marks of their own company. Currently, a newcollection had been created through a licens-ing arrangement bearing the name of a highlyrespected fashion beauty magazine, whoseinstant recognition with the teenage trade waspropelling the company to new sales levels.While historically Textron Ltd. primarily hadproduced components, supplying cosmetic com-panies with custom applicators tailored to theircosmetic ingredient requirements, the growth ofits retail business in this sub-category was devel-oping at a rapid pace. Major drug store chains,supermarkets and specialty shops featuredTextron brands and their lines were becomingsynonymous with the best in cosmetic applica-tors and assorted beauty accessories. With thelaunch of an additional range under the guise ofa high fashion authority, featuring highly styl-ized “cool shapes” and “hot colors” designed toentice younger adolescent buyers, their reputa-tion was achieving enhanced public notice. Suchproducts using uniquely descriptive trendyphrases evoked an image of “hip to use appli-cators” and a whole new generation of teenageusers was being developed.

The firm also was a key purveyor to theentertainment industry directly servicing theHollywood movie and TV production compa-nies, Broadway and the theatrical community,along with indirect sales to professional make-upartists and modeling studios thanks to thequickly developing beauty store trade. All in all,the future for Textron Ltd. was most promising.

Gary Case, a college friend of the company’spresident and principal owner, was brought intothe business because of his experience at theretail sales and marketing level. The chief execu-tive officer, who possessed an engineering back-ground was more than capable of overseeing themanufacturing side of the business; however, thestrong movement of the organization into directconsumer goods, coupled with the overall expan-sion of the company, necessitated Case’s hiring.

As the company began to prosper in the early1970s, other stateside competitors emerged, but

none could match the quality and inherentreputation of Textron Ltd. Their attention todetail and expertise of their original equipmentmanufacturer (OEM) sales staff servicing thefranchise cosmetic companies gave Textron acompetitive edge. They were called upon to workclosely with their industrial customers to developcotton puffs that matched the trends in newcosmetic ingredients and application methods atthe research and development (R&D) stage ofsuch developments. Such progressive fashion-oriented but facially skin-sensitive cosmeticformulas required applicators that matched thedemanding specifications of these new advancesin the cosmetic field. Cotton materials wereneeded to sustain the look on the skin and pro-vide the user with the same result that the cos-metic cream, lotion or powder promised. Whilewomen, the prime purchasers of such products,wanted to obtain the dramatic results the franchisecosmetic companies advertised, professionalmake-up artists had long known that the choiceof applicators to transfer the pressed powder inthe compact, the lotion in the bottle or the creamin the jar, was the key to the process. The rightpuff was therefore needed to compliment themake-up process.

In the late 1980s, Far Eastern manufactures ofcosmetic applicators began to emerge, offeringcheaper versions of such items. While thedetailed processing of the raw cotton materialused in such production was inferior to the qual-ity and exacting details of those manufacturedby Textron Ltd., the cost considerations necessi-tated a strong consideration of their offerings bythe company’s clients. As textile manufacturingbegan to develop in the Indochina region andmore and more American firms brought theirexpertise to the area, the overall quality of goodsas well as the base materials used began toimprove. As an outgrowth of improvements inthe generic textile business emerged, bettermethods of production, selection of raw materi-als and attention to quality filtered down into thecosmetic cotton applicator category.

Case, along with the president of the com-pany, David Grange, and the head of product



development group, Nancy Adams, had madeperiodic trips to the Hong Kong Beauty Exhibitionto constantly gauge Far Eastern competitors. Formany years, they observed a display of poorofferings and found themselves returning fromsuch trips visits confident that the threat of off-shore competition was not yet emerging as aviable alternative for their clients. Their regularcustomers, both beauty companies and retailingorganizations, were rarely evident at such con-ventions and hence their positive feelings werecontinuously strengthened.

CURRENT ISSUES

Over the last few years, however, it became evi-dent that startup companies, beginning as deriv-ative plants of the large textile manufacturersthroughout China, Taiwan, Korea and Thailand,could become a real danger to their ever-growingglobal business. While many of these enterprisesstill produced inferior merchandise, Textronnoticed that a number of their American com-petitors were now forming alliances with suchorganizations. These associations brought withthem the knowledge of how to deal with thebeauty industry both in America and Europe,instilling in them a deep appreciation for qualityand endurance of raw materials to work withthe new cosmetic preparations. Once such con-siderations took a foothold and a reputationfor delivering such competitively detailed qualitymerchandise with vastly lower costs was dis-covered by Textron’s clients, the company couldbe in for some rough times ahead. During thelast visit to the Hong Kong show, Grange hadbumped into a number of his key franchise cos-metic component buyers as well as a few of hisretail chain merchandise managers. They had allacknowledged the quality advances made bythese emerging new players. It was felt howeverthat the distance of such suppliers from their ownfactories and key decision-making staffs and thefact that the shapes and designs were still not upto the innovative expertise of the Textron companycreated a hesitation among clients wanting to

deal with them. Grange knew full well howeverthat with advanced global communication tech-nology and the alliances with American-basedrepresentative organizations, the gap would beclosed shortly. If such alterations were made anda fully competitive quality product could beoffered with the inherent deep labor and over-head cost advantages that Far Eastern firmspossessed, Textron was due for some major salescompetition in the future.

After their last trip to the Asian convention inSeptember of 1999, Grange and Case spent thehours on the return trip discussing strategic alter-natives for the company in the years ahead. Thiswasn’t the first time such matters were approachedand, in fact, two years earlier, the company enteredinto an alliance with a United Kingdom manufac-turer for the production on a joint basis of cosmeticsponges. Grange had always been reluctant toplace his production facilities out of his geograph-ical everyday domain. He was a “hands on” entre-preneur who felt strongly that all facets of one’sbusiness should be at arm’s reach. Grange wasdeeply committed to his people and his door wasalways open to everyone in his organization. Hewas involved in every area of the business and itwas not until Case joined Textron that Grangebegan to relinquish control over selective dailyoperations. This desire to closely preside over andmonitor his people was born out of a heritage offamily involvement as exemplified by his father.His dad had instilled in Grange a great empathyfor workers and staff, and even today the com-pany’s culture still carried such roots of benevo-lent carrying.

When the firm had moved from the greaterNew York area to Youngstown, key personnelwere given liberal incentives to move to the newlocation, and great care was given to those whocould not make the journey. Still today, the com-pany showed great pride in its relationship withemployees. Textron’s human resources depart-ment was not merely a conduit for processingapplications for employment and overseeingpayroll but a large fully functional multitalentedgroup that ran off-site improvement seminarsand cross training exercises. Besides offering a



full array of benefit packages, the company hada well-supervised child-care facility on thepremises at no charge to employees. The humanresources director attended all managerial meet-ings, thereby maintaining a strong presence inall company decision-making and the positionwas considered on par with senior manage-ment executives. The commitment to maintain-ing hands-on control of his organization and thestrong, caring relationship with his people madefor a close-knit family and a kind of patriarchalrole for Grange. He prided himself on the factthat union attempts to organize his factory laborforce never got off the ground, as his employeesfelt that they were best represented by Grangehimself.

Years ago, a satellite retail packaging assem-bly plant and distribution facility in San Antonio,Texas, which had been part of the purchase of asmall professional beauty applicator business,was dissolved in favor of consolidating alloperations in Youngstown. All personnel at thisredundant factory were given an opportunity torelocate in Youngstown or they received goodtermination benefits.

The United Kingdom alliance was finalizeddue to Grange’s long and valued friendship withthe principal of that company. The two alsoshared similar feelings about managing peopleand a common cultural background. Both par-ties had spent many years working together andenjoyed a special relationship, which had beenfostered by the fact that the U.K. managing direc-tor’s family resided in Ohio, thereby bringing thetwo executives together on a monthly basis as theEnglishman came home often. Grange also vis-ited the British facility every two months and thetwo executives spoke weekly on the phone. Bothmen viewed the alliance as more of a partnershipthan an arm’s length sourcing arrangement.

Grange always felt that one of his primedifferentiated product marketing characteristicswas that up until the U.K. association for spongematerial applicators, all his products were madein the United States. He believed that such desig-nation symbolized quality of material and manu-facturing excellence as well as innovative styling

and technologically advanced, state-of-the-artcompliance. Even with the English spongeproduction unit, all the cotton puff applicatorswere still made in the States. To drive home thisimportant selling issue, all packages of retailcotton finished goods bore the American flagproudly stamped on them next to the words“Made in the U.S.A.” Grange had recently seenconsumer products bearing the slogan “Designedin America” as well as “Product Imported FromChina and Packaged in the U.S.A.” but felt thatthe global customer still valued the U.S.A. sloganindicating the country of origin on his retail line.But in Grange’s recent discussions with compo-nent buyers in the cosmetic and fragrance indus-try, such designation did not seem so important,given the fact that both the sponges and cottonpuffs were slightly undistinguishable or hiddenparts in the total presentation of the makeup com-pact, the accent being on the brand name, ingre-dients and plastic case; imported items could beutilized if quality was maintained. The recentacceptance of the sponges made in England byTextron’s clients gave credence to the fact thatquality, price and service were the prime criteriafor the industry, rather than the country of origin.

DECISION-MAKING TIME

Following the conference on the plane ride homefrom the Orient, Grange and Case had assembledtheir managerial staff and charged them withputting together a preliminary plan to form anassociation with a Far Eastern manufacturer ofcotton puffs. At the initial briefing meeting, sam-ples of cotton puff merchandise collected from avariety of Far Eastern producers were evaluatedby the manufacturing quality control people aswell as by representatives of the marketing andsales groups from the retail and OEM divisions.The immediate consensus was that with a littledirection in fashion styling composition andadjustment in fixative dyes to sustain color in thecotton velour, a quality comparative range tosupplement their domestic manufacturing outputcould be produced abroad. When Case presented



the factory cost quotations for the samples beingreviewed, the vice-president of finance exclaimed,“Such values were way below our own manu-facturing standard costs before administrativeoverhead.” He further added that “even withanticipated duty and freight via containerizedshipments, the projected landed price at our doorwould eclipse our costs by a good 20 per cent ormore reduction.” When Case noted that, “Theseforeign price quotations were based on minimumquantities and could be subject to economiesof scale discounting,” all participants quicklyrealized that their projected stock keeping unit(SKU) sales for 2000 would easily allow foreven greater margins.

When the meeting broke up, Chris Jenkins,the vice-president of finance, cornered Grangeand Case in the hallway.

Guys, if these numbers can be confirmed, and iffuture production of these Chinese puffs can bemodified to accommodate our quality stabilitycolor standards and slightly altered for designmodification, we need to jump on this as soon aspossible. Better still, if we can manufacture overthere ourselves via our own factory or through ajoint venture, our profit potential would be magni-fied at least three times.

ALTERNATIVE PROPOSALS

It was now six months since that initial meeting.In the interim, Case had been back and forth anumber of times, holding substantial discus-sions with what was now a short list of twopotential alliance candidates, both of which wereco-operative ventures, with local Chinese gov-ernmental bodies holding a share in them. Whilethese companies’ abilities to alter their produc-tion to accommodate changes in the color addi-tive process and make design modifications wereverified, and the exchange of cost quotationswere proceeding well, Case had not yet proposedthe final type of alliance he wanted.

In the back of his mind, Case wanted toform his own subsidiary but felt that such initialmarket entry strategy was both costly and risky,

given the large investment required. BesidesCase and Grange, the company did not haveany other executives familiar with managingabroad. Given such considerations, Case’s dis-cussions to date with his Chinese associates hadproduced only two feasible alternatives to beginthe relationship:

1. An initial three-year guaranteed outsourcingpurchase agreement wherein, following thedetailed specifications of Textron Ltd., suppliesof cotton powder puffs would be produced atbase prices. Such quotations would be subjectto preset quantity discounting but offset slightlyby an inflationary yearly adjustment. The rightto pre-approve the samples of each and everyshipment before departure would also beincluded in the arrangement. In essence a sim-plistic arm’s-length purchasing association wascontemplated.

2. The creation of a joint venture wherein TextronLtd. would own 48 per cent of the company andthe alliance partner would own the rest. Textronwould be primarily responsible for sales andmarketing worldwide along with periodic on-site technical assistance as to product design,quality assurances and engineering considera-tions by their technical staff. The plant facility,the manufacturing process itself and everydayoperations would be under the direct controlof the Chinese partner. Textron Ltd. wouldcontribute a yet-to-be-finalized small dollarinvestment to help upgrade machinery and ingeneral modernize the physical facilities. Thepartners would share the revenue generated bythe sales efforts of Textron for the itemsproduced in the plant.

Although exacting details of either proposedstrategy needed to be worked out, with the for-mer option requiring more legal and regulatoryconsiderations, Case was confident that bothsituations could be accomplished. With the addi-tional help of some local Chinese alliance spe-cialists whom Case had utilized during the dayswhen he had actually lived and worked in HongKong for a former employer, all seemed to beprogressing nicely. Case knew he had to giveadditional thought to many other operational and



administrative issues, and he wanted to obtainsome sound advice form his internal teamsbefore deciding which alternative to pursue.Questions as to the capital investment and howsuch funds would be utilized would require morediscussions with the potential partners if thejoint-venture route was chosen, but such issueswould be addressed during Case’s next trip to theFar East.

CHINA AS THE PRIME CHOICE OF SUPPLY

The focus on China was due mainly to Case’sfamiliarity with the people and business environ-ment. He felt very comfortable, given his priorexperiences in the region and his knowledgeableappreciation of the culture and the way relation-ships were constructed. Beyond Case’s personalconsiderations, the Chinese manufacturers he hadencountered already had the necessary machineryand were well versed in the production of cottonpuffs. Many already supplied the worldwidebeauty trade, but did not possess the sophisticatedmarketing and sales competencies practised byTextron, nor had they gained the reputationTextron historically enjoyed with the franchisecosmetic industry. An alliance with Textronwould enhance the Chinese manufacturers’ tech-nical abilities and provide them with a widerentrée to the trade. The annual beauty show inHong Kong attracted a global following, whichwould allow Textron to even create an offshoresales office and showroom close to the primeproduction facility to entertain prospectiveclients. Besides the Chinese connection, Case hadopened initial discussion with makers of spongeapplicators and other beauty accessories in Japanand Korea so that his trips to the China could becombined with other business opportunities hewanted to pursue in the Far East.

Case had entertained pursuing a Mexicanmanufacturer, as he had had prior dealings withcompanies producing a variety of cotton prod-ucts in Mexico. Given the background of manyof them in the cotton and aligned textile trade,this seemed a natural consideration, especially

given the NAFTA accords and geographicalproximity to Textron’s major market, the UnitedStates. All potential companies Case visited,however, were located in central part of thecountry, none near the border where theMaquiladores were available. Case’s Mexicancontacts were not familiar with the specificproduction of cotton puff applicators as theircotton experience was in the manufacturing ofsurgical dressings, bandages, feminine hygienepads and simple cotton balls. They would needto buy machinery and train a staff in such man-ufacturing operations. If Textron would fundsuch investment and provide technical assis-tance, a number of them agreed to manage sucha facility on the U.S.-Mexican border through ajoint venture. Case was hesitant to provide thefunding, and he was worried that starting up anew plant would not let Textron achieve theinherent historical benefits that the more matureexisting production in China would instantlyallow.

Besides the economic considerations, Casefound the Mexican manager’s attitude a bit trou-blesome. Textron had once used a Mexican plantto supply, in final packaged form, cotton pads forthe removal of facial cosmetic make-up. Whilehis dealings with the principles of this familyowned and operated business was most cordialand personally gratifying, Case had found thattheir attention to manufacturing details left muchto be desired. The quality inspection of the rawcotton coming into their plants had given Casecause for concern. Many openly told him theymixed first quality fibres with “seconds” andremnants from the textile manufacturers in theirlocal areas to achieve cost efficient production.As Textron always claimed its materials forcotton puff applicators were of “100 per centvirgin cotton,” such an assertion using might bedifficult to enforce and supervise, given thepronouncements by his prior supplier. When dis-cussions as to the importance of schedules toinsure timely supply arose, the Mexican sourcesseemed to give the impression that they would dotheir best to comply. This slight hesitation both-ered Case, as his component buyers demanded



on-time delivery and were always changingspecifications at the last minute.

Case had deep reservations on the businesscompetencies exhibited by such Mexican firms,as his communications with them in the past,wherein days would go by before he heard fromthem, had left a poor impression on him. Manytimes, when he had repetitively inquired by e-mail,fax and telephone as to shipping dates for pack-aged finished products, he was eventually toldthat third-party suppliers of the packaging mate-rials for the cotton pads caused the assemblydelay. Inquiring further, during a visit with hisMexican supplier, Case learned that when localMexican firms contract with each other, timepromises are flexible and it seemed that an atti-tude of “when they are available, we get them”took precedence over definite schedules. Duringthe year the company utilized the Mexican sup-plier, not one shipment was dispatched withinthe required period, and Case had given up con-tacting them, even paraphrasing the Mexicanexplanation when queried by his own inventory/warehouse manager.

The decision to go with a Chinese partner insome format seemed to be the best solution.

CASE’S PERSONAL REFLECTIONS

As Case pondered what other matters needed tobe resolved, his mind began to focus on histhree-year posting, back in the early 1990s inHong Kong, with an electronics manufacturer tooversee their Chinese network of suppliers.When Case and his family had first arrived in thethen-British colony, the excitement of this newforeign land and it’s unique culture had made alasting impression on him. He had marveled atthe sights, sounds, smells and overall ambienceof the city state that mixed East and West. Comingfrom a middle class American lifestyle, the treat-ment the family received was like being trans-formed into a rich conclave of the elite. Hischildren went to a specialized English-typeboarding school and rarely mixed with localnatives of their own age. In fact, such young

Chinese children were lucky to get a basicelementary school education before being forcedout into the real world and into the workingcommunity. The outskirts of the city, and evensections within, contained deep pockets thatwere below some extreme poverty levels Casehad seen in other depressed regions of the world.Within a severely overpopulated area that wasstrained every day with new immigrants from themainland, the concept of work, any job, took ona new meaning. People would work for whatseemed like slave wages to Case, and he won-dered how they survived, just attaining a meresustenance level. His wife could afford house-hold maids and cooks that were more like inden-tured servants than domestic employees. Theyworked long hours at meagre wages and nevercomplained.

During Case’s visits to plants in mainlandChina, both during his expatriate posting yearsand subsequent trips back in the mid-1990s, theconditions at such facilities had initially deeplydisturbed him. The environments he witnessedwere nothing like he had ever seen in the UnitedStates. Factories were like prison compounds.The laborers seemed to toil at their job stationsnever looking up, never smiling and alwayslooked like they were staring out with blankfacial expressions. Rarely had Case seen themtake a break, with many workers eating lunch attheir desks and at their worktables or machinery.He seldom witnessed the laborers even takingbathroom breaks. The air in the facilities wasalways stale with no ventilation except for afew fans, and it was always very hot or very cold,depending on the outside temperature. He wit-nessed children, younger it seemed that his twoadolescent kids, toiling in the plants alongsidethe elderly. He watched infants placed alongsidetheir mothers on the floor of the factories beingrocked by feet as the mothers’ hands moved onthe table above them. As these visits becomemore frequent, Case’s disdain for such initiallyhorrific working conditions began to lessen andhe began to accept what he saw.

Many times, in social conversations withother executives and managers, Case had voiced



his concerns about the treatment of the workers.He listened as they tried to get him to understandand appreciate that while the conditions wereterrible, the alternative might be even worse.With the expanded population, growing at amassive rate, the supply of people outstrippedemployment opportunities. In order to survive,people would take any job and children as wellas the elderly all had to work. Public govern-mental assistance was not only inadequate butalmost impossible to administer, even if theresources could be found. The old communistphilosophy of all society working for the good ofthe common proletariat, and hence the state, hadbeen indoctrinated with the birth of the Maoregime; people saw it as their duty and obligationto endure hard times.

Case’s Chinese friends had often remarkedthat if China were to catch up to the Westerncapitalistic nations and be a participant in theworld’s expanded trading economies, its peoplewere its greatest competitive asset. In order to bea member in the world community and to pro-vide enrichment for future generations, sacrificeshad to be made. Capital for the improvement offactory environmental conditions was secondaryto the need to update basic machinery and gaintechnology. The government had to build a soundinternal infrastructure of roadways, rail and portfacilities to ship its goods before the physicalwelfare of its people could be considered. Withpower still a scarce commodity, any electricityflowing into a factory needed to be first usedto run the machinery and not for hot or cool airto be produced. The only way to achieve the goalof making mainland China competitive with therest of the world was through the exportationroute which was founded in the country’s abilityto produce cheaper goods than the rest of theglobe. This simple fact necessitated low laborand overhead operating costs that contributed topoor working conditions in the factories.

Obviously, Case understood this economicargument was the main reason his company—and therefore he himself—had come to theregion. In order for his own organization toremain competitive in the cotton puff business

both at home and abroad, it would have nochoice but to locate a portion of its operations inChina or some other emerging nation.

Case had seen the TV footage of the protestersat the 2000 WTO conference in Seattle who haddestroyed that meeting and in latter months haddone the same in Washington, D.C., and Ottawa,Canada. He heard them voicing and physicallydemonstrating their deep concerns against govern-ments and transnational companies as to workerrights and environmental conditions in emergingand developing nations. Case was well aware ofthe attention the press gave to large multinationalcompanies like Levi Strauss, Reebok and othersover their treatment of employees accusing themof almost slavelike practices in their foreign facto-ries. Even personalities that lent their names to thelabels of garments, like Kathy Lee Gifford, hadcome under strong pressure for allowing theirthird party licensees in the United States to oper-ate sweat shops and mistreat workers. Companiesthat did not even have a direct relationshipwherein they exercised straight control overemployee conditions were still questioned aboutthe suppliers they used abroad as the social con-science of the world seem to be focused on theseissues.

Although Case himself deplored the hiring ofadolescent children, he understood the economicand social context that existed in China for theiruse. China wasn’t America. Young kids grewup much faster and much more was expected ofthem as contributors to the family unit. Evenwith the government mandate, made within theframework of the message of a collective goodof the nation for families to have only one child,did not alleviate the problem. In fact, in manyfamilies it just made the burden deeper. MostChinese families were made up of extendedrelatives who grouped together to pool theirresources for their common survival. In thesefamily units, all members had to work. The sim-ple luxury of going to a public school, playinggames and watching TV, as American childrenenjoyed, was not part of their world. In numerousfamilies, children, mostly young girls, were sentaway from their rural villages to emerging urban



industrial centres to look for work. After payinglarge portions of their meagre weekly salariesback to their employees for dormitory housingand food within the confines of the factorycompound, any amount left over was sent to thefamily.

Even the elderly felt such pressure to work, asretirement after years of service and a reasonablepension was almost a non-existent consideration.No true governmental program like social secu-rity existed, and the family had to care for theelderly in their homes, putting a great burden onthe whole extended unit. Political dissidents andeven criminals were conscripted into the laborforce to help offset the cost of the State having toprovide for them. Plant conditions, treatment ofworkers and even caring about the environmentwere not primary issues for an emerging countrytrying to first find work for it’s population duringthe transformation process into a competitive worldeconomic nation.

Case pondered if it was time for the companyto prepare a written corporate moral compass.Should it publish a code of ethics, as manytransnational firms had been doing? What shouldit consist of, what specific criteria definingnorms of behavior should be stated? and shouldit be incorporated as an obligation in the arm’slength purchasing agreement being consideredwith the Chinese supplier? If the announcedprovisions were violated, should this be viewedas an automatic right for Textron to terminate theagreement, or should there be a time frame inwhich to cure such conditions? Case also won-dered how his firm could monitor such matters toensure compliance. If the alternative joint ven-ture were chosen, how should such values beincorporated into the partnership agreement andhow should Case process such matters during thenegotiation?

Case was comfortable with discussions oncosts, quality and delivery specifications as theyhad a finite measurable logic to them. Socialresponsibility and ethics touched upon manyemotional areas that were harder to define. Hehad seen firsthand how different culturesapproached them from divergent viewpoints, and

he had gained a respect for the saying “when inRome do as the Romans do.” He also, however,maintained the feeling that there were corehuman values that at times transcended suchlocal traditions and social context.

MORAL DILEMMAS—UNANSWERED QUESTIONS

What worried Case was even if the businessdecision were the right one, could the companybe entering a relationship that might some daybackfire? If a factory that Textron brought mer-chandise from or, because of the joint venture,was more deeply involved in was alleged tobe mistreating employees, would public opinioninjure the company’s reputation? Was the focusof the world now on China and its historic prac-tices of human rights abuse? Would someone bewatching companies more closely that associ-ated themselves with Chinese partners in anyform?

What if Textron’s buyers of components, thefranchised cosmetic houses, were themselves chas-tised for using slave-type labor in the suppliesused in their own manufacturing of their brandnamed products? Would they in turn cease tobuy from Textron Ltd.? What if consumers ofthe retail packaged lines decided to boycott theproducts for similar reasons? What if the licensorof the new collection felt that such foreignsourcing of items bearing their trademark wasinjurious to their image and reputation, and theyobjected?

Given his company’s strong traditional orga-nizational culture of placing employees first,Case also wondered what effect any such ethicaland socially responsibility issues stemming froma Chinese association could have on his owndomestic operational employees.

He wondered about such matters again as hethought to himself that going global was morethan just an exercise in financial, legal and oper-ational logistical decision making; it involvedtaking a moral position in Textron’s commercialrelationships with overseas entities.



History has shown that pollutionincreases in the first part of thecountry’s major growth and this iscertainly where Mexico is right now.

—Adolfo Gonzalez Calvillo,Director of Baja California’s

Department of Ecology

You don’t solve problems in underde-veloped areas just by passing outmoney; 90 per cent of the problem ishuman attitude.

—Victor Miramontes, Managingdirector of the North American

Development Bank

The Chilpancinco settlement in Tijuana sits inthe shadow of Otay Mesa, on top of which sprawldozens of the city’s maquiladora factories, on theCalifornia-Mexico border. Many of them areowned by U.S. corporations, including a nowclosed battery recycling plant. A white chemicalcrust rims the clods of dirt in the field outside theplant, and pools of strange, yellow water dot thebarren landscape. Lead and heavy metal depositshave been measured in the soil on the mesa atconcentrations 40,000 times over safe levels. Inthis unincorporated settlement, or colonia, sixbabies were reported born without brains in1993, and 13 in 1994, just one of several clustersof this rare birth defect, called anencephaly, onthe border.1

In the wake of the passage of the NorthAmerican Free Trade Agreement (NAFTA)in 1994, numerous national and binational

organizations were created to study and attemptto alleviate the environmental crisis in theMexican-U.S. border region. This crisis, precipi-tated by 30 years of exponential growth inmanufacturing activity along the Mexican side ofthe border, had a direct impact on the 11 millionpeople that inhabited the region and the naturalenvironment that struggled to sustain them.

Contrary to what was often portrayed in thepublic press, solutions to the pollution problemin the border region were neither obvious noreasy to implement. Many economists arguedthat it was misplaced for a developing countrylike Mexico to implement U.S. and Canadian-level environment standards. In fact, the chiefeconomist for the World Bank, LawrenceSummers, had written an internal memo (subse-quently leaked to the press) stating that “theeconomic logic behind dumping a load of toxicwaste in the lowest wage country is impeccable.”According to this view, environmental con-sciousness, along with greater enforcement ofenvironment laws should—and surely would—follow Mexico’s long march out of povertytoward economic prosperity. To environmentalgroups, such arguments were misconceived, andignored both the very real costs of the pollutionhazards for those living in the region, as well asthe long-term costs of a badly degraded naturalenvironment.

In the political sphere, the environmentalproblems in the border region were just one morein a litany of economic, social and politicalproblems that had plagued the U.S-Mexico rela-tionship in the post-NAFTA era. Between the1994 peso crisis, Mexico’s growing political


NOTE ON THE POLLUTION PROBLEMIN THE MEXICO-U.S. BORDER REGION

Prepared by Dan Campbell, David Eaton, and Tony FrostCopyright © 1997, Ivey Management Services Version: (A) 1999–02–18


instability, the drug problem, the continuedinflux of illegal immigrants into the U.S. and therapidly escalating trade deficit with Mexico, thevoice of free trade in U.S. politics had grownincreasingly dim. Although in 1997, PresidentClinton was again asking the U.S. Congress for“fast track” authority to further the free tradeagenda, stories of massive environmental degra-dation and lax and/or corrupt enforcement ofpollution regulations did little to further thatagenda.

One thing was clear: stakeholders, activistsand policymakers were operating in an “infor-mation vacuum” with respect to the environmen-tal situation in the border region. Argumentson both sides of the issue were plagued by thepaucity of data and scientific evidence. Hadthe environmental situation along the borderimproved under NAFTA, as some claimed? Hadit gotten worse? Who exactly was responsible forthe “white chemical crust” and “pools of strange,yellow water”? And, most importantly, whatshould be done?

THE MEXICO-U.S. BORDER REGION

In 1965, new Mexican legislation permittedthe creation of a new form of manufacturingoperation in the Northern border region, called amaquiladora. Under a set of rules outlined inthe Mexican Border Industrialization Program(BIP), a maquiladora factory could temporarilyimport supplies into Mexico duty-free. Afterthe manufacturing process, the goods could bereturned to the U.S., again duty-free. Only thevalue added in Mexico was taxed by the Mexicangovernment as the goods left the country.

With few exceptions, the next 30 years in theborder region were characterized by rapid andsustained industrial growth. In the early years,development was limited to low capital factoriesthat relied heavily on cheap manual labor.Without the commitment of fixed capital, investorswere quick to move or close facilities if they

became dissatisfied with local conditions. As aresult, the Mexican government offered excep-tions from its stringent labor laws to continue toattract U.S. investment. Under a program calledEL PACTO, the Mexican government, workingwith co-opted union officials, guaranteed prefer-ential wage rates in order to attract direct foreigninvestment and curb inflation.2 In later years,under pressure from external sources such as theInternational Monetary Fund (IMF) to encouragemore permanent industry, Mexico began to sup-port capital intensive activities that, althoughrequiring fewer laborers, were hoped to providea more stable economic base.

By 1997, the border region, 3,200 kilometreslong and just 200 kilometres wide, was one ofNorth America’s fastest growing regions.3 It wasalso the only geographical boundary in the worldin which a free trade zone existed between anadvanced industrial country and a developingcountry neighbor. Exhibit 1 shows a map of theregion.

With output estimated at US$150 billion, theeconomy of the border region was larger thanPoland’s and nearly the size Thailand’s. Growthwas not projected to slow in the years ahead,despite the fact that NAFTA would eliminatemost of the tariff advantages accruing to maquilaoperations. Proximity to the U.S. market and thefurther decline of real wage rates in Mexicofollowing the peso crisis ensured that foreigncompanies—and not just U.S. companies—would continue to invest heavily in the borderregion. Indeed, the rapid influx into the region ofmajor Asian companies such as Sony, Samsungand Daewoo had led the mayor of Tijuana todeclare: “This is going to be the Hong Kong ofNorth America’s Pacific coast.”4

THE BORDER ENVIRONMENT

The rapid growth rates of the past 30 years hadnot come without cost. Infrastructure developmentwas largely unable to keep up with the expansion.



Standards of living were extremely low:maquiladora workers earned between US$5and US$7 per day. The daily struggle for sur-vival left precious little for “luxuries” suchas running water and proper sewage disposalthat might contribute to a cleaner environment.Economists estimated that the entire borderregion required additional infrastructure invest-ment of $8 billion to bring drinking water,sewage treatment and garbage collection to allresidents. Others put the price tag at closer to$20 billion.

INFRASTRUCTURE AND LAX OF TAX BASE

Environmental activists argued that low wageswere not all that foreign multinationals were

taking advantage of in the maquiladoras.Andrea Durbin, policy analyst with Friendsof the Earth made the following commentsbefore the House Ways and Means Subcommitteeon Trade:

Annex III of the La Paz Agreement and the 1988Mexico Law of General Equilibrium requiremaquiladora industries to export their hazardouswaste to the country of origin for treatment anddisposal. The thinking behind the agreement is thatMexico lacks facilities to treat these wastes in amanner equivalent to the treatment they wouldreceive in the U.S.

The U.S.-owned maquiladoras widely flaunt thislaw. The Environmental Protection Agency esti-mates that only about one-third of the hazardouswaste generated in the maquiladoras is returned to


Exhibit 1 U.S.-Mexico Border Region


the U.S., leaving somewhere around 20,000 tons inMexico.

This situation is not in the Mexican or the U.S.interest. The improperly dumped toxic wastes canlead to public health problems and huge long-termclean-up costs for Mexico. Industries may relocateto Mexico to take advantage of the situation andavoid the costs of proper disposal in the U.S. Theproblem is not isolated to Mexico, since the toxics[sic] can cross back into the U.S. through the air,water, or groundwater.5

Although Durbin was not alone in predictingthat NAFTA would precipitate the migrationof dirty industries from Canada and the U.S. toMexico, others disagreed. The U.S. EnvironmentalProtection Agency (EPA), for one, dismissed thisprediction as unlikely:

NAFTA will not encourage U.S. firms to relocateto Mexico for environmental reasons becausepollution abatement costs represent a small shareof total production costs in most industries.

MEXICAN ENVIRONMENTAL

LAWS AND ENFORCEMENT

Based on U.S. legislation, Mexican environmen-tal laws and regulations were relatively strict.Where Mexico and the U.S. diverged in terms ofenvironmental legislation was mostly in areasthat were only secondarily related to the environ-ment, such as so-called “right to know laws” andprovisions for civil liability. For example, com-panies in Mexico were not required to makepublic the nature of their manufacturing activi-ties to interest groups or the general public. Evenwhen individuals or groups were able to collectevidence of damages caused to them by a pollut-ing company, the Mexican legal system did notprovide an adequate opportunity to seek restitu-tion. Multi-million dollar class-action settlementswere non-existent in Mexico.

Most of the criticism surrounding Mexico’senvironmental record was aimed at the country’s

ability to enforce the legislation already in place.Fears of lax enforcement were, in fact, centralto the so-called “pollution haven hypothesis”—the notion that free trade would precipitate a raceto the bottom in environmental standards ascountries competed for foreign investment. CarlosDe OrduZa, former president of the NationalCouncil of Macquiladoras, commented that:

On the environment, Mexico has more difficultrules to comply with than the United States. Now,how well they can enforce the law is another story.

Under Mexican law, authorities had fourenforcement mechanisms at their disposal:

Plant Closings: Ordered by an inspectorwhile visiting a facility, plant closings werereserved for situations in which there is animminent risk of “ecological disequilibrium” orif contamination exists that has “dangerousrepercussions” for the environment.

Fines: Fines could be imposed on companiesfound to be violating environmental regulationsranging from 20 to 20,000 times the daily mini-mum wage.6 A fine could only be issued after anadministrative resolution, not at the time of theinspection.

Criminal Penalties: Depending on the sever-ity of the crime, penalties could be issued againstofficers of offending companies ranging fromone month to six years in prison, as well as finesof up to 20,000 times the daily minimum wage.If the environmental crime was carried out ina populated area, an additional three years ofimprisonment could be imposed.7

Administrative Arrest: In extreme cases,corporate officers could be held for up to 36hours by Profepa, Mexico’s attorney general forthe protection of the environment.

Until 1991, Mexico had only 109 environ-mental inspectors for the entire country. Manylacked basic training and tools, such as laborato-ries to test soil, water and waste. Moreover, the



environmental bureaucracy in Mexico waswidely viewed as an inept, if not openly corrupt,agency. As a result, orders were often routinelyignored. Inspections were thought to be rare andwere targeted mainly at highly visible compa-nies. One Mexican manager of a major multina-tional firm commented:

Unless a small company is being visible aboutits environmental contamination, environmentalauthorities don’t bother them. They go to the bigcompanies. That’s where the money is.

Not surprisingly perhaps, the level of enforce-ment of environmental regulations appearedto improve as talks about the NAFTA intensi-fied. In the two years leading up to the signingof the NAFTA, the number of inspectors tripled,while inspections and enforcement actionsincreased dramatically. However, in 1994, a pres-idential election year, inspections dropped offsubstantially. Many argued that the ruling partydid not want to risk potential backlash fromplant closures and lost jobs. The severe economiccrisis in 1995 made enforcement initiatives thatcould lead to job losses even less politicallyappealing.

NAFTA AND THE ENVIRONMENT

The controversey over the environmental impactof NAFTA led the Clinton administration tonegotiate a parallel side agreement pertaining tothe environment. The agreement established sev-eral bodies designed to deal with environmentalissues and to investigate “persistent patterns offailure to effectively enforce (a country’s) envi-ronmental law.”8

Under NAFTA, the United States, Mexicoand Canada were also expressly forbidden tolower environmental standards to attract invest-ment. The agreement also supported harmo-nizing environmental standards and allowedthe three nations, as well as states and cities toadopt more rigorous standards. Under NAFTA,the United States and Canada maintained the

right to block the importation of goods that failedto comply with its health or environmentalstandards.

Despite claims that NAFTA was the “greenesttrade agreement in history,” its environmentalprovisions had been criticized on severalaccounts. First, environmentalists complainedthat the dispute resolution process was secretive,exclusive and lacked provisions for enforcement.No apparent means existed for public commenton environmental matters presented beforeNAFTA panels. A second complaint was with theburden of proof provisions, which required thechallenging party to establish that the sanitary(health) or phytosanitary (plant health) measurein question is inconsistent with or in violation ofNAFTA. In addition, no specific trade sanctionswere provided as a means to combat noncompli-ance with the provisions of either NAFTA or theside agreement on the environment. Moreover,the sanctions specified under NAFTA were con-sidered to be unenforceable and too complex tobe of much use.

The signing of NAFTA had also establishedthe Border Environmental Co-operation Commis-sion (BECC) and the North American Develop-ment Bank (NADBank), which were createdto complement existing funding to improve theborder region’s environmental infrastructureand to strengthen co-operation on addressing theregion’s environmental problems. The BECC’spurpose was to certify environmental infrastruc-ture projects—primarily for drinking water, waste-water treatment and municipal solid waste—forsubsequent financing by the NADBank in theform of loans and loan guarantees at marketinterest rates with flexible repayment terms. Theagreement was intended to encourage privatesector investment in projects funded through userfees paid by polluters and the border communi-ties benefiting from these projects.

The remainder of this note describes twocompanies operating in the border region: SanyoNorth America Corporation, a subsidiary of theJapanese electronics giant Sanyo Electric; andGuillermo Jiron Y Asociados, a Mexican com-pany, which provided hazardous waste disposal



services to Sanyo and other maquiladoras in theborder region.

SANYO NORTH AMERICA CORPORATION

The border operations of Sanyo North AmericaCorporation (Sanyo) consisted of nine plantsin Tijuana, Mexico, which bordered San Diegoin the U.S. Although Sanyo had a long history ofsales and manufacturing operations in the U.S.,it had decided in 1996 to relocate its NorthAmerican headquarters from New York to SanDiego—closer to its manufacturing operationsin Tijuana.

The Tijuana plants consisted mainly of low-cost assembly operations that manufacturedproducts for the U.S., Canadian and other exportmarkets: two refrigerator plants, two video cas-sette recorder plants, two plants manufacturingrechargeable batteries, and three others makingtelevisions, appliances and laptop computersrespectively. Most of the raw materials for thesefactories arrived as goods in process from facto-ries in Japan. Materials entered the United Statesat the port of Long Beach in Southern California.

Sanyo’s environmental policies were estab-lished by headquarters in Japan. In 1995, thecompany had launched a worldwide initiative toestablish an environmental management systembased around ISO 14000, an international stan-dard of environmental management similar tothe well known ISO 9000 quality standard.Sanyo had set the ambitious target of havingeach of its domestic and overseas factory sites aswell as business headquarters, regional manage-ment centres, and research and developmentlaboratories receive ISO 14000 certification bythe end of the 1997 fiscal year.9

In part, to show its commitment to the borderregion, Sanyo had presented its corporate envi-ronmental policies to the North American orga-nization at a conference in July at the company’sNorth America headquarters in Tijuana. Theconference brought together company manage-ment, environmental consultants, academics, andrepresentatives from the EPA. Speaking at the

conference, Mr. Yasuo Ohira, managing directorof Sanyo Electric outlined the fundamentalpremise behind the company’s environmentalphilosophy:

Sanyo cannot overcome competitors withoutsuperior, environmentally-conscious products.

Mr. Ohira went on to explain what this meantfor Sanyo in terms of its corporate environmentalpolicies. He stated that Sanyo needed to:

• Define the environment as one of our majormanagement issues.

• Strictly observe environmental laws, regulationsand international accords.

• Achieve compatibility between sustainabledevelopment and environmental preservation,and promote business activities that harmonizethe environment.

• Determine voluntary regulations and standards,and implement ongoing programs for continu-ously improving the environment.

• Develop products that harmonize with theenvironment, including: introduction of lifecycle assessment (LCA); improved recyclingand energy-conserving qualities of products;and reduced use of environmentally hazardouschemical substances.

As part of its environmental managementeffort, the company had laid out a broad set ofinternal environmental targets to be reached bythe year 2000. These targets were known as the“Second Voluntary Plan” and are summarized inExhibit 2.

Sanyo EnergyCorporation—Battery Division

Sanyo’s North American battery divisionwas created in 1986 with the construction of acell assembly plant.10 In 1990, the division wasexpanded with the addition of a battery assemblyplant that linked multiple cells together to formrechargeable power packs for a variety of applica-tions. The most common were wireless hand toolssuch as drills and radio controlled model vehicles.



426

Act

ion

ob

ject

ives

of

the

seco

nd

vo

lun

tary

Pla

n

SA

NY

O E

lect

ric C

o.,

Ltd.

Item

sTa

rget

for

2000

Mea

sure

s ag

ains

t D

evel

opm

ent

of e

nerg

y-sa

ving

pro

duct

sP

ower

usa

ge le

vels

com

pare

d w

ith le

vel i

n 19

90gl

obal

war

min

gA

ir co

nditi

oner

(m

ain

mod

els)

35

% (

Coo

ling

mod

e) r

educ

tion

20%

(H

eatin

g m

ode)

red

uctio

nR

efrig

erat

or (

mai

n m

odel

s)

30%

red

uctio

nC

ompa

red

with

leve

l in

1995

TV

(m

ain

mod

els)

5

-20%

red

uctio

n

Red

uctio

n of

ene

rgy

cons

umpt

ion

Com

pare

d w

ith le

vel i

n 19

90

per

unit

sale

s va

lue

25%

or

mor

e

Pro

duct

ass

essm

ent

Incr

ease

of

recy

clab

ility

70%

or

mor

e (m

ain

prod

ucts

)R

educ

tion

of d

isas

sem

blin

g tim

e55

% o

r m

ore

(mai

n pr

oduc

ts,

com

pare

d to

199

2)R

educ

tion

of p

acka

ging

use

foam

sty

rene

50%

or

mor

e (m

ain

prod

ucts

, co

mpa

red

to 1

990)

Mea

sure

s ag

ains

tIm

prov

emen

t in

tot

al v

olum

e of

was

te70

% o

r m

ore

(com

pare

d to

199

0)in

dust

rial w

aste

per

unit

sale

s va

lue

Pro

mot

ion

ofR

educ

tion

of g

loba

l env

ironm

enta

l loa

dF

ulfil

lmen

t in

acc

orda

nce

with

gui

delin

een

viro

nmen

tal

man

agem

ent

syst

em

Env

ironm

enta

lly

Red

uctio

n of

ER

S u

se(1

) S

elec

tion

of E

RS

con

cern

ed,

esta

blis

hmen

t of

inve

stig

atio

nre

leva

nt s

ubst

ance

s sy

stem

for

cont

ent

in p

rodu

cts

until

end

of

1997

(ER

S)

(2)

Com

plet

ion

of c

onte

nt in

vest

igat

ion,

con

stru

ctio

n of

dat

a ba

se,

adop

tion

of r

isk

asse

ssm

ent

guid

elin

es a

nd r

educ

tion

targ

ets

until

end

of

1998

(3)

Est

ablis

hmen

t of

ER

S m

anag

emen

t sy

stem

in p

rodu

ctio

n st

age

cove

ring

who

le S

AN

YO

com

pany

unt

il en

d of

the

yea

r 20

00

Pro

mot

ion

of L

CA

Red

uctio

n of

glo

bal e

nviro

nmen

tal l

oad

Beg

inni

ng o

f tr

ial i

n 19

96 fo

r m

ain

prod

ucts

caus

ed b

y pr

oduc

ts

Exh

ibit

2Sa

nyo

Ele

ctri

c C

o.,L

td. A

ctio

n O

bjec

tives


Assembly

The cell assembly plant, using goods-in-process from Japan, manufactured singlenickel-cadmium (NICAD) rechargeable cells.Manufacturing involved the winding togetherof nickel and cadmium plates into a cylinderapproximately four centimetres long and twocentimetres in diameter. The windings were thenplaced in a metal cylinder casing and filled witha chemical electrolyte before being sealed ateither end with another metal plate.

During the winding of the plates, nickeland cadmium dust were created. Although thenickel dust was relatively harmless, the cadmiumparticles, while invisible to the naked eye, wereextremely hazardous if ingested. To protectMexican employees working within the plant, aventilation system had been installed, with vacuumopenings at each work station. Employees alsowore masks and followed other procedures asdictated by the Materials Safety Data Sheet(MSDS) for cadmium dust that was publishedunder the Workplace Hazardous Materials Infor-mation System (WHMIS).

Ultimately, the air from the ventilation systemwas vented into the external atmosphere, but notbefore being cleaned thoroughly. Plant manage-ment frequently tested the air leaving the ventila-tion system. Plant management admitted thatthey were unaware of any Mexican standard forthese types of emissions, but levels were heldbelow guidelines set out by the parent companyfor similar plants in Japan. As one plant managernoted:

There is no way that a company like Sanyo ispolluting. We are checking, watching everything.We test water going out into sewage, even thoughall we use it for is our restrooms. Our factories arepractically brand new, newer than what we have inthe United States.

In fact, the majority of the production processhad been designed and implemented in Japan.Sanyo had several almost identical factories inother parts of the world, and the Tijuana opera-tion was a copy of the Japanese factory. Most

of the equipment came to the Tijuana plantsecond-hand as it was replaced in a Japanesemanufacturing operation. This included a wastewater treatment facility. Philipe Rujana, theMexican plant manager, recalled the installationof the facility:

I wasn’t even consulted about the installation ofthe water treatment facility. Management in Japandecided it was necessary for the operations inJapan, so they installed it here too. Where Sanyoand the environment are concerned, money has notbeen an issue. Even without local pressures, wewould still have the same high level of environmen-tal protections. They are willing to do “whateverit takes.”

GUILLERMO JIRON Y ASOCIADOS

Located in Tijuana, Guillermo Jiron y Asociados(GJyA) was a waste management companythat offered a complete range of services requiredto dispose of hazardous wastes generated inmaquiladora manufacturing operations. Sanyowas the company’s largest client and provided itwith 15 per cent to 20 per cent of total revenues.

Maquiladoras contracted companies likeGJyA to classify and remove hazardous wastesdirectly from their manufacturing operations andto ensure that they were properly transportedback into the U.S. To legally transport and dis-pose of hazardous waste materials was a multi-step process that included waste characterization,brokering and transportation.

Waste Characterization

Before waste materials could leave the manu-facturing facility where they were created, thenature of the waste had to be determined andclassified under a complicated set of guidelinesoutlined by the Mexican and U.S. governments.Because classifications were so narrow, a singlemanufacturing operation could generate wastematerials that fell under numerous categories,



each with their own handling and documentationrequirements. The situation was further compli-cated by poorly defined requirements that weremodified so frequently that even government andcustom officials had a limited understanding ofregulations and jurisdictions. The problem wasexacerbated by confusion as to jurisdictionalresponsibilities in Mexico. For example, themanagement and movement of hazardous wastewas considered federal jurisdiction whereaswaste water treatment fell under state and localjurisdictions.11

Brokering

Due to the complexity of regulation, theservices of a broker were required to worktogether with customs and other regulatory offi-cials. The capacity and condition of customsfacilities, as well as the training and staffing ofofficials at points-of-entry into the U.S. wereinsufficient to handle the large volume of trafficin the border region. The broker also negotiatedwith hazardous waste storage and disposal facil-ities in the U.S. to place or destroy the numerouscategories of hazardous materials.

Transportation

GJyA had almost no transportation equipmentof its own. Instead, the company contracted thetransportation of the materials to several inde-pendent transport companies. Two differentcompanies needed to be contracted to returngoods to the U.S. because Mexican trucks werenot permitted to cross the U.S. border. GJyAincluded the use of transportation contractors intheir overall service package to end users. Often,clients of GJyA did not know which carrier wasactually transporting their waste products.

Industry Conduct

Because maquiladoras were legally requiredto return their wastes to the U.S., Mexico hadnever developed a large hazardous waste storageor disposal capacity in the border region. The

transportation industry, however, had developedrapidly and competition to provide hazardouswaste trucking and disposal services was intense.

Guillermo Jiron, president of GJyA explained:

This is a cost driven business. You’d be amazed atsome of the operations we compete with. It doesn’ttake much to get into the industry . . . just a truckreally.

Less stringent safety requirements for trucksand low levels of enforcement, reduced barriersto entry, allowing numerous carriers with sub-standard capital equipment to offer hazardouswaste transportation services to the region’s manu-facturers. Another factor affecting competition inthe industry was the nature of the liability affect-ing producers and handlers of hazardous waste.Jiron explained:

In the U.S. and Canada, manufacturers arestill liable for hazardous wastes produced in theirfacilities when the wastes are being transported bya third-party contractor. This is not the case inMexico. Liability for hazardous waste infractionsby transportation companies can only be placed onthe carrier itself. As a result, manufacturing opera-tions are generally less concerned with the levelof safety in the transportation companies theycontract with . . . price is one of the few meansof differentiation . . . carriers are forced to reducecosts whenever possible.

Costs were often reduced by cutting cornerson measures taken to comply with regulations.Such activities included: not purchasing emer-gency response equipment, failing to train dri-vers to deal with emergencies and carryingnoncompatible wastes in one trailer or container,which laws state should be kept separate.Perhaps the easiest way to cut costs was simplyto dump the waste in one of the many illegalsites in the country’s northern deserts, wherethousands of barrels of toxic waste dotted thecountryside.

The incentive to cut corners was intensifiedby several other factors:



Minimal Enforcement: Generally, transportersof hazardous waste did not fear a punitive reac-tion from government officials.

Lack of a Civil Liability: The absence ofcivil liability mechanisms, similar to those inthe U.S., eliminated the risk of civil suits in theevent of damage to individuals or the naturalenvironment.

Limited Use of Insurance: Because the riskof civil liability was not present, few companiesfelt the need to carry insurance. In the U.S. andCanada, where insurance companies were res-ponsible for damages, they either demandedthat responsible risk management procedures befollowed, or charge higher premiums. Mexicancompanies, lacking the need for insurance, alsolacked the incentive toward responsible behaviorthat was imposed on their U.S. and Canadiancounterparts.

Jiron also pointed to upcoming provisions,stipulated under NAFTA, as providing a poten-tially important change in the structures andincentives governing the handling of hazardouswaste in Mexico:

In the year 2001, goods entering Mexico from theU.S. will no longer require a temporary importa-tion permit to cross the border duty free. Instead,they’ll fall under the NAFTA and move freely fromone country to another.

Basically, what that means is that hazardous wastesproduced in Mexico will be able to remain inMexico. My guess is that many companies willstart to look for domestic options for hazardouswaste storage and disposal. Hey, I would, too: whyexpose myself to U.S. civil law by bringing wasteback into the U.S.? Trucking waste across bordersis also a real administrative headache: not only areMexican regulations different than U.S. regula-tions, but California’s are different than Arizona’s,which are different than Texas’s.

In 1997, some estimates suggested that onlyone-sixth of Mexico’s domestic demand fordisposal facilities was being met. Attempts to

create new facilities had met with strong opposi-tion from interest groups such as GreenpeaceMexico. David W. Eaton of the Center for Inter-american Trade and Commerce at the MonterreyInstitute of Technological and Superior Studiescommented:

We don’t know exactly what is going to happen tothe hazardous wastes generated in the maquilasafter the year 2001. The whole hazardous wasterelationship that exists currently must be changed.

THE POST-NAFTA EXPERIENCE

In the two plus years following NAFTA’spassage, numerous claims had been advancedabout the environmental impact of the agree-ment. Several assumptions that had underpinnedthe green aspects of the agreement appeared notto have been correct.

The first was that NAFTA would fuel invest-ment into Mexico’s interior, thus relieving thepressure on the border ecosystem. However, thenumber of maquiladora workers had increasedby more than 25 per cent from 546,000 in 1993,to 689,000 in September 1996. Nearly 400 newfactories had opened along the frontier in 1996alone. If anything, foreign investment in Mexicohad become even more concentrated in theborder region following NAFTA.

A second assumption was that rising incomein the region—an outcome of greater trade andinvestment—would allow for greater investmentin infrastructure to clean up the environment.However, the collapse of the peso in 1994, whichreduced Mexican incomes by about half, causedfederal and local governments in Mexico to cutenvironmental spending dramatically. Accordingto some estimates, over 50 million gallons ofuntreated waste were still being dumped dailyinto the Rio Grande River in the town of Juarez,which lacked a waste treatment facility, threaten-ing exposure to cholera, hepatitis and dysentery.Hepatitis rates on the border were two to fivetimes the U.S. national average. In 1997, 40 percent of the population on the Mexican side of the



border were still thought to lack sewers, potablewater or both.

A third assumption was that NAFTA institu-tions such as the BECC and NADBank wouldcreate a pool of funds for environmental pro-jects. However, by mid-1997 BECC had certifiedonly 16 projects for financing. Moreover, theNADBank, which was to fund these projects,was not expected to be fully capitalized until1998. To date, it had only approved funding forfour projects.

Supporters of the agreement, including theClinton administration, countered with argumentsand evidence of their own. A report issued bythe U.S. government noted that while environ-mental problems along the US-Mexico border“were decades in the making and cannot realisti-cally be corrected overnight . . . progress is evi-dent.” Since NAFTA’s passage, enforcement ofMexican environmental law appeared to haveimproved. The number of Mexican environmentalinspectors had increased, and an environmentalcrimes unit had been created. From 1993 to 1996,Mexico reported a 72 per cent reduction in seriousviolations from maquiladora facilities. This viewwas echoed by Jeanette Moorhouse of the BorderEnvironmental Technology Resource Center:

With (Mexican President) Zedillo and his prede-cessor, there has been a lot less corruption, and thatmeans better enforcement of environmental laws.Today, businesses in Mexico can’t just pay off afine and keep continuing to illegally pollute likethey could a few years ago.

In this atmosphere of uncertainty and incom-plete information, the environmental situation onthe U.S.-Mexican border was unlikely to disap-pear either from the public conscience or fromthe impending debates on the expansion of tradein the Americas.

EPILOGUE

More than 3,200 kilometres to the east ofTijuana, in Brownsville, Texas, a rash of birth

defects, similar to those that occurred inChilpancinco, saw 25 children born with spinabifida and another 30 babies born with anen-cephaly. Families of the dead and deformedbabies subsequently filed a suit, claiming thatcontamination from factories, located across theRio Grande, but owned by U.S. corporations,caused the defects.

In 1995, the defendants, comprised of multi-ple U.S. corporations including General Motors,agreed to an out-of-court settlement of US$17million. General Motors, in a letter to the CableNews Network (CNN), commented that “theprimary cause of these types of birth defects is lackof sufficient folic acid in the diet” of the expectantmother. In 1997, Time Magazine reported that“many companies cleaned up their worst envi-ronmental excesses after the outbreak of fetaldeformities, [and the outbreak] ended assuddenly as it began.”12

NOTES

1. Environmental Action Magazine, “AfterNAFTA,” September 22, 1995.

2. Maquiladora development history taken fromKopinak, Desert Capitalism: Maquiladoras in NorthAmerica’s Western Industrial Corridor, 1996.

3. The width of the border region was defined bythe La Paz Agreement in 1983. The La Paz Agreementwas signed by Mexico and the United States for theProtection and Improvement of the Environment in theBorder Area.

4. Ibid.5. Testimony of Andrea Durbin, policy analyst,

Friends of the Earth before the House Ways andMeans Subcommittee on Trade, September 21,1993.

6. In 1997, the daily minimum wage was roughlyUS$3.25.

7. Economist Intelligence Unit, ManagingMexico’s Environmental Challenge.

8. Business and Society Review, September 22,1994.

9. Similar to ISO 9000 quality certification, ISO14000 required that the environmental policies andpractices be evaluated by recognized ISO 14000 audi-tors. Unlike ISO 9000 where objectives were measured



by an absolute set of quality standards, ISO 14000 wasbased on the identification of, and progression toward,goals determined by each company on an individualbases. Within Sanyo, there were 34 sites in Japan and48 overseas applying for certification.

10. Single units, often referred to as a battery bythe general public, are actually a single cell. A batteryis created when multiple cells are linked together.

11. The majority of wastes which were dumpedillegally were liquid poured into the municipaldrainage system.

12. Information about the Brownsville birthdefects and ensuing legal action taken from, “TheBorder Babies; Did Toxic Waste from U.S. FactoriesAcross the Border Damage the Environment of aTexas Town?,” Time Magazine, May 26, 1997.


PLANET STARBUCKS (A)

Prepared by Professors Michael H. Moffett and Kannan Ramaswamy Copyright © 2003 Thunderbird, The American Graduate School of International Management. All rightsreserved.

You get more than the finest coffeewhen you visit Starbucks. You getgreat people, first-rate music, a com-fortable and upbeat meeting place,and sound advice on brewing excel-lent coffee at home. At home you’repart of a family. At work you’re partof a company. And somewhere inbetween there’s a place where youcan sit back and be yourself. That’swhat a Starbucks store is to manyof its customers—a kind of “thirdplace” where they can escape, reflect,read, chat or listen.”

—1995 Annual Report,Starbucks Corporation

During the World Trade Organizationtalks in November 1999, protestersflooded Seattle’s streets; and among

their targets was Starbucks, a symbol,to them, of free-market capitalismrun amok, another multinationalout to blanket the earth. Amid thecrowds of protesters and riot policewere black-masked anarchists whotrashed the store, leaving its win-dows smashed and its tasteful green-and-white decor smelling of tear gasinstead of espresso. Says an angrySchultz: “It’s hurtful. I think peopleare ill-informed. It’s very difficultto protest against a can of Coke, abottle of Pepsi, or a can of Folgers.Starbucks is both this ubiquitousbrand and a place where you can goand break a window.”

—“Planet Starbucks,”BusinessWeek,

September 9, 2002, p. 100.


Ubiquitous—that was the term often applied toStarbucks. It had indeed become omnipresentwithin the United States and Canada throughoutthe 1990s. Now the company—and its founder,Howard Shultz—had set its sights on the globalmarketplace. Howard Schultz had stepped downas Chief Executive Officer and President in 2000and taken on the title with associated duties ofChief Global Strategist (he remained Chairmanof the Board). Between 1999 and 2002, the com-pany averaged sales growth of over 25% perannum, and despite the recession wracking theglobal economy, 2003 was expected to showthe same rapid growth. But the North Americancoffee markets were quickly reaching saturation.Howard Schultz and Starbucks knew that ifStarbucks was to continue to meet the market’sexpectations for growth, the global marketplacewould have to support it. By 2003, Starbucks hadbecome the growing target of the anti-globalistmovement, and many questioned its ability tosuccessfully expand the U.S.-based businessmodel to the global marketplace.

STARBUCKS HISTORY AND ORIGINS

Starbucks was founded in Seattle by GeraldBaldwin, Gordon Bowker, and Ziev Siegl in1971 as a gourmet coffee bean roaster and dis-tributor. The Starbucks name was a combinationof Seattle’s past, the Starbo mining camp of thenineteenth century and the first mate’s name inMoby Dick, the classic American novel of whal-ing on the open seas. In 1982, Howard Schultzjoined the company as a member of their mar-keting team. After a visit to Italy, Schultz urgedthe partners to consider opening Espresso barsin conjunction with their coffee sales. In 1984,Starbucks opened its first Espresso bar, a smallcorner of the company’s downtown SeattleStarbucks store, to rave reviews. AlthoughSchultz urged the company to expand theEspresso bar line, the controlling partners, nowBaldwin and Bowker, were unwilling to enterwhat they considered the fast-food business,wishing to focus on the coffee-roasting niche

market. The company had recently purchasedPeet’s Coffee and Tea, a Berkeley, California,coffee roaster and distributor, straining the com-pany’s management and financial capabilities.The partners wished to focus on these two mainbusinesses.

Howard Schultz then left Starbucks and,actually with the financial backing of his for-mer partners, opened Il Giornale in 1985, anespresso bar that sold coffee and assorted coffeebeverages made exclusively with Starbucks’beans. Two years later, Schultz bought the for-mer Seattle Starbucks company, six stores androasting plant, for $3.8 million from Baldwin(who wished to focus on managing Peet’s) andBowker (who wished to cash out of the busi-ness). Schultz now was in control of Starbucksand with new investors, began building a globalbusiness which reached sales of $3.3 billion in2002 and was acclaimed one of the top 100growing global brands.

The Starbucks Concept

Howard Schultz’s dream was to take the con-cept of the Italian—specifically Milan—espressobar to every corner of every city block in theworld. By the fall of 2002, the Starbucks businesswas a complex three-legged stool for global devel-opment: (1) retail coffee and assorted specialtyitems; (2) specialty sales; and (3) Frappuccinocoffee drinks and specialty coffee ice creams soldthrough other retailers globally.

What We Are About. Starbucks purchases androasts high-quality whole bean coffees and sellsthem along with fresh, rich-brewed, Italian-styleespresso beverages, a variety of pastries andconfections, and coffee-related accessories andequipment—primarily through its company-operatedretail stores. In addition to sales through its company-operated retail stores, Starbucks sells primarilywhole bean coffees through a specialty sales group,a direct response business, supermarkets, andonline at Starbucks.com. Additionally, Starbucksproduces and sells bottled Frappuccino® coffeedrink and a line of premium ice creams throughits joint venture partnerships and offers a line of



innovative premium teas produced by its whollyowned subsidiary, Tazo Tea Company. TheCompany’s objective is to establish Starbucks as themost recognized and respected brand in the world.

To achieve this goal, the Company plans to con-tinue to rapidly expand its retail operations, grow itsspecialty sales and other operations, and selectivelypursue opportunities to leverage the Starbucksbrand through the introduction of new productsand the development of new distribution channels.(starbucks.com)

Starbucks’ initial public offering was in 1992(NASDAQ: SBUX). The company had, however,broken new ground the previous year when itbecame the first privately held company in theUnited States to offer its employees a stock own-ership plan. The plan, termed Bean Stock, offeredshares to both full-time and part-time employees.

The company had seemingly re-energized theentire coffee industry. Although Starbucks itselfmade up a relatively minuscule percentage of theentire North American coffee industry, it hadsparked the expansion of coffee cafes like itself,rejuvenated the traditional mass market coffeesellers, and expanded all facets of the industry asdistributed through the traditional supermarketdistribution system. This Starbucks Effect as itwas termed, was based on the perceived pre-mium product’s cachet extending to all of thecollateral products, both complements and sub-stitutes. In the case of Starbucks itself, the per-ceived premium was both in the product’s qualityand in the method of its delivery.

First, every company must stand for something.Starbucks stood not only for good coffee, butspecifically for the dark-roasted flavor profile thatthe founders were passionate about. That’s whatdifferentiated it and made it authentic.

Second, you don’t just give the customers whatthey ask for. If you offer them something they’renot accustomed to, something so far superior that ittakes a while to develop their palates, you can cre-ate a sense of discovery and excitement and loyaltythat will bond them to you. (Howard Schultz, PourYour Heart Into It, Hyperion Press, 1997, p. 35.)

THE STARBUCKS EXPERIENCE

The concept of Starbucks went far beyond beinga coffeehouse or coffee brand. Emerging fromHoward Schultz’s original idea of an ItalianEspresso coffee bar, it had evolved into its ownAmericanized version of a specialty coffeeprovider of coffee shop services. As described inthe introductory quote from Howard Schultz,Starbucks based its customer’s retail experienceon high quality coffee, arabica bean-basedcoffee, but then surrounded the delivery of thecoffee with specialty services and atmosphere.1

Special pastries and selected music provided anatmosphere of both warmth and comfort.2

Employees were trained to not only provide awide array of advice on coffee selection andappropriateness to potential customer needs, butto engage the customer. The customer was tofeel they were not at home, not at work, but “athird place.”

The People

The maintenance and development of thisquality experience required a strong organiza-tional commitment. The decade of the 1990s sawStarbucks expand its talent pool on the mostinfluential senior levels, with key additions con-tributing greatly to the evolution of the com-pany’s business lines. Howard Schultz beganassembling an experienced team of professionalsto drive Starbucks’ growth.

In 1989, Howard Behar, with more than 20years in retail, joined the company as the direc-tor of store operations. Behar refocused much ofthe Starbucks development away from the pureproduct itself—coffee, to the consumer’s experi-ence in a Starbucks. Behar believed the core compo-nent of the experience was in quality of service.Starbucks’ employees (termed partners byStarbucks) needed to be highly motivated to paycontinuing attention to repeat customer needs.The company invested in extensive employeetraining, but this investment was lost if thecompany could not retain its people. One ofthe biggest barriers to retention was, in turn,


04-4702-Conklin.qxd 5/10/2005 5:58 PM 3

compensation and benefits, in which the serviceindustry was notoriously deficient.

Starbucks’ solution was to offer health carebenefits to all employees who worked more than20 hours per week. Although an expensive bene-fit to provide by industry standards, Beharargued that if employee retention was improvedand quality of service preserved, it would morethan pay for itself. The company followed thisfirst instrumental move with the introductionof the employee stock ownership plan in 1991(Bean Stock), which was intended to increase theownership culture of store management. HowardBehar would eventually become President ofNorth American operations.3

In 1990, Orin Smith joined the company asChief Financial Officer and quickly filled therole of the company’s right-brain to HowardBehar’s left-brain. Smith had extensive experi-ence in a number of organizations and con-sulting, and was a strong believer in processdevelopment. Where Behar had focused on thepeople, Smith focused his development effortswithin Starbucks on the organizational processeswhich would support effective execution ofstrategies. Smith believed in strict organizationaldiscipline, including careful use of the Starbucksbrand and insisted for many years on company-owned and operated stores, rather than the fran-chising common among most American retailers.Behar became the unofficial defender of thequality of the Starbucks brand. Orin Smith would

eventually become President and Chief ExecutiveOfficer of Starbucks. As illustrated by Exhibit 1,the Starbucks experience was based on people.

The Supply Chain

The pursuit of premium quality also droveStarbucks back up the coffee supply chain.Coffee, although second only to petroleum involume of global trading, was highly frag-mented. It was estimated that a full one-third ofthe world’s coffee farms were three acres or lessin size. This typically resulted in a consolidationprocess which handed off coffee from farmer tocollector, collector to miller, miller to exporter orbroker, and finally to importer. In the past, theimporter and brokers then sold coffee to the largemass-market coffee roasters and producers.

Starbucks wished to improve the quality andintegrity of its coffee by working back up thesupply chain to the actual growers. As a result,Starbucks refined its coffee quality while effec-tively bypassing much of the middle market.As Starbucks developed expertise and relation-ships with the coffee growers themselves, thecompany worked tirelessly to increase the qual-ity of the green coffee (unroasted beans) pur-chased while taking cost out of its supply chain.This would eventually prove a point of exposurefor Starbucks politically, but also position thefirm for opportunities in sustainable economicinitiatives with these growers.


Establish Starbucks as the premier purveyor of the finest coffee in the world while maintaining our uncompro-mising principles as we grow.

The following six principles will help us measure the appropriateness of our decisions:

1. Provide a great work environment and treat each other with respect and dignity.

2. Embrace diversity as an essential component in the way we do business.

3. Apply the highest standards of excellence to the purchasing, roasting, and fresh delivery of our coffee.

4. Develop enthusiastically satisfied customers all the time.

5. Contribute positively to our communities and our environment.

6. Recognize that profitability is essential to our future success.

Exhibit 1 Starbucks Mission Statement

Source: starbucks.com


Howard Schultz continued to add key leadersin the business in the early 1990s—people whowould continue to fill out the gaps in the organi-zation and solidify a corporate culture whichwas a difficult balance between entrepreneurshipand disciplined growth. These decisions provedcritical, as Starbucks embarked upon a massiveexpansion which would test the organization’scapabilities.

Expansion

At McClintock Drive and Ray Road, you can walkout of a Starbucks, built into a grocery store lobby,and gaze across the parking lot–at a brand newStarbucks. With the retailer’s rapid expansion,it isn’t unusual to find multiple sites within a mileor two of each other. And although having two inthe same parking lot certainly isn’t the norm, it’ssomething that does happen on occasion. (“2Starbucks, 1 Lot,” Arizona Republic, October 21,2002, p. B5.)

As Starbucks moved into a market, it focusedon location. Providing ready access to consumerfoot traffic, such as commuting routes, allowedStarbucks to place its third place directlybetween the other two places. Stores werelocated in pivotal positions for consumer recog-nition and access. Corner locations, the hallmarkof the early store growth, provided high visibilityand maximum exposure. As stores expandedin North America to more and more of the auto-mobile-based cities, plentiful parking becamecritical to any store’s accessibility.

The company was also admired and criticizedfor its market-swarming expansion techniques.As stores proliferated, Starbucks broke withmany retail distribution traditions by in-filling,introducing stores which could not help but can-nibalize existing store sales. This also led to thecharacterization of Starbucks as ubiquitous. Withstores appearing across the street from existingstores, the firm did often actually appear to beeverywhere you looked. The strategy, althoughnot acknowledged officially, prevented com-petitor entry in established Starbucks marketsthrough store proliferation. It had, however, led

to a disquieting downward trend in sales perstore. Between 1995 and 1998, Starbucks hadaveraged $0.69 million per store per year.Beginning in 1999, this revenue per store valuehad continuously declined, falling to $0.559million per store in 2002.

The company was widely considered ruthlessin its real estate practices. Practices includedpaying premiums over existing rental prices topush square footage prices up, retaining closedproperties to prevent competitor entry, andgenerally aggressive property negotiations. Therefusal to franchise allowed the firm to pursuereal estate and store proliferation strategieswhich did not conflict with corporate goals; allstores were Starbucks-owned and operated, andtherefore “turf” was not an issue.

Through the later 1980s and early 1990s,Starbucks focused expansion in the PacificNorthwest and California markets. HowardSchultz’s expansion strategy revolved aroundestablishing regional beachheads which thecompany needed to provide logistical supportfor stores while maintaining quality. In 1993, thecompany entered the Washington D.C. market,followed soon after in 1994 by Boston.4 TheBoston entry was through acquisition, buyingout the Coffee Connection chain in the region.Beginning in late 1994, the company expandedrapidly to the major metropolitan areas ofMinneapolis, New York, Atlanta, Dallas, andHouston. By the mid-1990s, Starbucks hadstores in more than 40 states and was starting tolook to the limitations of market saturation.

There were no hard and fast rules for storegrowth or saturation. Starbucks itself believedthat only Seattle, with one store per 9,400 people,was actually at the saturation point. The island ofManhattan, with one store per 12,000 people,was still considerably below that point.

INTERNATIONAL EXPANSION

“We remain highly respectful of the culture andtraditions of the countries in which we do busi-ness,” says Howard Schultz, chairman and chief



global strategist. “We recognize that our success isnot an entitlement, and we must continue to earnthe trust and respect of customers every day.”

Although the first Starbucks store outside theUnited States was opened in Vancouver, BritishColumbia in 1988, this was essentially a regionalexpansion—from Seattle outwards and north-ward in the Pacific Northwest—rather than anintended international expansion. Beginning inthe mid-1990s, the company aggressively pursuedtrue international expansion. Starbucks used twobasic structures for international expansion—company-owned and licensing agreements—tomove first across Asia (1996), the Middle East(1998), and finally Europe (2001) and LatinAmerica (Mexico, 2002).5

The company had defied many of its criticswith the growth and success of its internationalstores. Market analysts and critics had arguedthat Starbucks’ premium prices, paper cups, andsmoke-free cafes would not fit within traditionalcultural practices in places like Tokyo and Vienna.Once again the chain proved the naysayers wrongby seemingly creating their own market and theirown third place experience in some of the largestcoffee-consuming cultures in the world.6

Japan

Starbucks’ true international expansion hadbegun in Japan in October 1995 with the formationof a joint venture (JV) with Sazaby, a Japaneseretailer and distributor with its own chain ofAfternoon Tea stores. Sazaby proved to be anexcellent partner, with expertise in both retailbeverages and real estate.

The JV had opened its first store in Ginzain 1996 and had flourished. By 2002, it hadmore than 250 stores nationwide, and projectedmore than 500 stores by 2003. Although averageJapanese store sizes were half that of the UnitedStates, they averaged nearly twice the sales. TheJV had proven so successful that it undertook aninitial public offering in October 2001, the onlyunit within Starbucks’ international network tobe listed independently of the parent.

Sazaby was also the prototype of the qualitiesStarbucks looked for in potential businesspartners. Starbucks officially listed the follow-ing characteristics as desired in its internationalpartners:7

• Shared values and corporate culture• Strong multi-unit retail/restaurant experience• Dedicated human resources• Commitment to customer service• Quality image• Creative ability, local knowledge, and brand-

building skills• Strong financial resources.

China

With the opening of its first store in January1999 in the World Trade Centre in Beijing,Starbucks added the People’s Republic of Chinato its growing list. In the next three-and-a-halfyears, its footprint had been expanded to 35 shops,focused in and about Beijing and Shanghai. Thereception to Starbucks in a culture groundedin tea was remarkably successful. AlthoughStarbucks was heavily criticized for opening anoutlet in a souvenir shop in Beijing’s ForbiddenCity in 2001, the shop flourished.

Europe

The company’s entry into Continental Europehad been anticipated for years, but with muchtrepidation. Europe’s longstanding traditionsof coffee consumption and independently ownedand operated coffeehouses constituted an estab-lished market which was not considered opento American entry. Starting in Switzerland andAustria in 2001, the company then expanded intoSpain, Germany, and Greece in 2002. Althoughmany critics argued—as they had in Japanbefore—that local customers would not beattracted to smoke-free, paper-cup coffee con-sumption, the lines had been long.

Each country of entry was evaluated in detail,including focus groups, quantitative market assess-ment, and detailed identification of appropriate



business partners. As part of the expansionprocess, Starbucks brought all foreign managersto its Seattle offices for a rigorous 13-week train-ing course in the Starbucks experience. By theend of 2002 Starbucks had 1,312 of its total5,886 stores outside of the United States. Thecurrent plan was to open two international storesfor every one new domestic store.

CORPORATE SOCIAL RESPONSIBILITY

Starbucks defines corporate social responsibilityas conducting our business in ways that producesocial, environmental, and economic benefits to thecommunities in which we operate. In the end, itmeans being responsible to our stakeholders.

There is growing recognition of the need forcorporate accountability. Consumers are demand-ing more than “product” from their favorite brands.Employees are choosing to work for companieswith strong values. Shareholders are more inclinedto invest in businesses with outstanding corporatereputations. Quite simply, being socially responsi-ble is not only the right thing to do, it can distin-guish a company from its industry peers. (CorporateSocial Responsibility Annual Report StarbucksCoffee, Fiscal 2001, p. 3.)

Starbucks had found itself, somewhat to its sur-prise, an early target of the anti-globalist move-ment. Like McDonald’s before it, it appearedto be yet another American cultural imperialist,bringing a chain-store sameness to all countrieseverywhere. Like McDonald’s, Starbucks foundthat its uniquely defined brand and experiencedid not have to conform to local cultural norms,but could exist alongside traditional practices,creating its own market and successfully alteringsome consumer behaviors.

Unlike McDonald’s, however, Starbucks wasthe purveyor of a commodity, coffee, which waspriced and sold on global markets. Coffee wassourced from hundreds of thousands of smallgrowers in Central and South America, many ofwhich were severely impoverished by all globalincome and purchasing power standards. As

coffee prices plummeted in the late 1990s,companies like Starbucks were criticized forboth benefitting from lower-cost sourcing andfor their unwillingness to help improve theeconomic conditions of the coffee growersthemselves.

By 2001, Starbucks had implemented a multi-tude of programs to pursue its program forcorporate social responsibility (CSR) and pursuesustainable economic development for thepeople in its supply chain. Although not wishingto own the supply chain, Starbucks’ strategy wasa complex combination of altered business prac-tices in procurement, direct support to the coffeegrowers, and the formation of brands whichwould provide conduits for consumers wishingto support CSR initiatives. Exhibit 2 provides abrief overview of some of these programs.

Procurement

Coffee was traditionally bought and soldusing market pricing, buying from wholesalersat a global market price—the so-calledNew York “C.” Since Starbucks purchased onlyarabica bean premium grade green coffee, italways paid a premium above New York “C.”Both New York “C” prices and the premium,however, moved up and down with global marketconditions. Traditional robusta bean purchasesby mass-market labels were made on the whole-sale markets through brokers and buyers.

Starbucks, however, preferred to purchaseusing outright pricing, in which the price wasnegotiated directly with small and medium-sizedfarmers, cutting out the segment of the supplychain which the wholesalers usually occupied. Inprinciple, a greater proportion of the price wentdirectly to the producers, assuring a higher returnto the small farmer. In addition to the pricingstructure, Starbucks was also attempting to breakfrom traditional market practices of always buy-ing in the cash market. As illustrated in Exhibit 3,the company was moving aggressively to pur-chase more and more of its coffee under long-termcontract (3 to 5 years, on average), guaranteeingprices to growers over multiple crop years.



A long-term dilemma of coffee farmers wasthe lack of access to affordable credit. Farmerswithout adequate working capital financing wereoften forced to accept low prices for coffee frombuyers—so-called coyotes in Central and SouthAmerica—in relative desperation. In an effort tostop this financial exploitation, Starbucks had

initiated a number of loan guarantee programs in2002 to provide pre-harvest and post-harvestfinancing for coffee farmers. As a result,Starbucks provided financing for more than1.2 million pounds of coffee in 2002 (205 farmersreceived pre-harvest financing, 691 post-harvestfinancing).8


Exhibit 2 Starbucks’ CSR Programs Focusing on Coffee Growers

Starbucks’ coffee buyers work with coffee wholesalers and directly withsmall farmers and farmer cooperatives in procurement

Supplmental funding forfarm credit programs to

support farm capital needs

Contributions to CARE,the non-profit international

relief organization

Infrastructure, includingschools, clinics, and coffee

processing facilities

Shade Grown Mexico Brand

Partnership formed in 1998,encourages production of shadegrown coffee using ecologically

sound growing practices to promotebio-diversity and to financially support

farms employing these practices(with Conservation International, CI)

Fair Trade Certified Brand

Partnership in which Starbuckspromises consumers that the

farmers who produced the coffeebeans were paid a guaranteed

minimum price that helps support a better life for farm families

(with TransFair USA)

Percentage of Total Coffee Purchased

Fiscal 2001 Fiscal 2002

Price BasisMarket pricing (New York C-basis) 88% 26%Outright pricing (negotiated) 12% 74%

RelationshipsDirect relationships (from farms and co-ops) 9% 32%Indirect relationships (through wholesalers) 91% 68%

Purchase TermsPurchased under long-term contract 3% 36%Purchased in cash market 97% 64%

Exhibit 3 Starbucks Coffee Sourcing Practices, 2001–2002

Source: Corporate Social Responsibility Annual Report, Starbucks Coffee, Fiscal 2002, p. 6.

Amounts by category are not mutually exclusive.


Direct Support

Starbucks was a regular and growing giver,supporting relief organizations such as CARE,the nonprofit international relief organization,as well as providing direct support to farmersand farm communities around the world.9 Forexample, Starbucks had contributed $43,000 in2001 to the construction of a health clinic andschool in Guatemala and a health clinic in EastTimor. The company was also providing aid in avariety of ways to the improvement of coffeeprocessing facilities in a number of the countriesof origin.

Conduit Brand Development

Much of the growing pressure on all multina-tional companies for sustainable developmentand social responsibility arose directly from con-sumer segments. In an effort to provide a directconduit for these consumer demands, Starbuckshad initiated a company program called Commit-ment to Origins, “dedicated to creating a sustain-able growing environment in coffee originatingcountries.” Under the program, Starbucks hadintroduced Shade Grown Mexico coffee, FairTrade Certified coffee, and Serena OrganicBlend coffee.

Shade Grown Mexico coffee was introducedin 1998 in partnership with Conservation Inter-national (CI), a nonprofit environmental organi-zation. Coffee purchased by Starbucks from CI’s

Conservation Coffee Program was cultivatedunder the canopy of shade trees in origin coun-tries. This practice was considered ecologicallysound and helped support bio-diversity. ShadeGrown Mexico coffee purchases had grown from304,000 pounds in 2000 to 1.8 million pounds in2002 (see Exhibit 4).10 The Shade Grown Mexicocoffee had been selectively introduced inStarbucks stores in North America and throughonline sales at starbucks.com.

Beginning in 2000, Starbucks began workingwith TransFair USA, a non-profit organizationwhich provided independent certification for allFair Trade coffee in the United States.11

The concept of Fair Trade addressed the questionof the just distribution of the burdens and benefitsof trade. The Fair Trade movement argues thatwhen most of the customers’ purchasing dollargoes to the retailer, the marketer, the wholesaler,and the speculator and very little goes to thelaborer or the farmer, something is wrong with themutual benefits of the exchanges, particularlywhen those who provide the product have earningsthat do not even cover subsistence costs.12

Although Starbucks had introduced FairTrade coffee in North American stores, and pro-moted it through various brochures and promo-tions (“Coffee of the Day” monthly), it continuedto be heavily criticized for not expanding theprogram faster. Fair Trade coffee purchases alsoexpanded rapidly, rising from 190,000 pounds in2002 to more than 1.1 million pounds in 2002.


Pounds of Coffee Purchased

2000 2001 2002

Conduit Brand Fair Trade Certified Coffee 190,000 653,000 1,100,000Certified Organic Coffee 570,000 874,000 1,700,000Conservation (Shade Grown) Coffee 304,000 684,000 1,800,000

Exhibit 4 Conduit Brand Coffee Purchases by Starbucks, 2000–2002

Source: Corporate Social Responsibility Annual Report, Starbucks Coffee, Fiscal 2002, p. 8.

Volumes are by fiscal year. Certified Organic includes Organic Fair Trade and Organic Conservation (Shade Grown) coffee.Amounts by category are not mutually exclusive.


The third category of conduit brand develop-ment was Serena Organic Blend coffee. Organiccoffee was grown without the use of syntheticpesticides, herbicides, or chemical fertilizers.Like Shade Grown coffee, Organic Blend was anenvironmental-sustainable development conduit.As illustrated in Exhibit 4, Starbucks’ purchasesof organic coffee had more than tripled between2000 and 2002.

These product brand programs allowedconsumers wishing to support these sustainabledevelopment initiatives to express their interestthrough purchasing—at a price.13 All threecoffees were roughly 20–25% more expensivecompared to Starbucks’ traditional blends (wholebean coffee sales).

GROWING PRESSURES

By the spring of 2003, Starbucks was at whatmany thought the pinnacle of its prospects.

• It was operating nearly 5,700 stores in 28countries.

• It had made more than $215 million in profit on$3.29 billion in sales in 2002, and sales andprofits were both expected to grow 25% in 2003.

• It was named by Interbrand one of the mostrecognizable global brands, although the com-pany still spent less than $20 million per year inadvertising.

• The New York “C” coffee prices remained atnear-record lows, decreasing sourcing costs andincreasing gross operating margins.

Starbucks was one of the few companies tocontinue rapid sales and earnings growth throughthe 2001–2002 period and the company was con-tinuing to expand international operations at abreakneck pace. But all was not aromatic in theStarbucks marketplace.

Service quality and employee motivation andretention were continuing issues. Although bar-rista (the coffee brewers in Starbucks lingo) paywas still superior to other low-end wage jobs,rapid expansion was confronting the firm withemployee fatigue. Store managers and employ-ees were overworked and underpaid. Requiredovertime for store managers had only been elim-inated in 2000 as a result of the settlement ofa class action suit brought in California bydisgruntled store managers.14

The limits to remaining expansion opportuni-ties in North America were now in sight. Seattle,with a Starbucks store for every 9,400 people, was


Participate in the Organic Consumers Association “Global Week of Action Against Starbucks,” September 21–28.

In October 2001, Starbucks made a commitment to buy 1 million more pounds of Fair Trade coffee and brew FairTrade coffee once a month. Don’t let Starbucks stop there—Send a Free Fax to demand that Starbucks brew FairTrade Coffee of the Day EVERY WEEK!

The coffee industry is in crisis. Coffee prices are at an all time low, remaining below $.50 since August with noincrease in sight. This means that farmers are becoming even more impoverished, going further into debt andlosing their land. Meanwhile, coffee companies such as Starbucks have not lowered consumer prices but arepocketing the difference, even taking into account the quality premiums in the specialty industry.

The Fair Trade Labeling Organizations International recently released figures that show a total production bygroups on the Fair Trade Coffee Register of 165,000,000 pounds in year 2000, whereas total sales were only30,000,000 pounds. This leaves an additional 135,000,000 pounds of Fair Trade coffee produced by cooperativesthat are not receiving a Fair Trade price.

Exhibit 5 The “Starbucks Campaign”

Source: Global Exchange, Global Economy, www.globalexchange.org/economy/coffee/starbucks accessed 10/6/02.


considered by the company the limit.15 Manhattan,with 124 stores or one store per 12,000 people,was considered still open to further development.But same store sales in the United States, Canada,and even Japan were now beginning to showdeclines which persisted; in the past, in-fillingstore entry had caused only temporary same-storesales declines for the most part.

Although very aggressive in the eyes ofmany, the anti-globalization movement contin-ued to focus much of its efforts on Starbucks.Plummeting coffee prices on world markets in2001 and 2002 had led to more and more pressureon Starbucks to increase the prices it paid togrowers. Howard Shultz himself increasinglybecame the target of mail, fax, and e-mail cam-paigns to pressure Starbucks into more pro-active policies for grower income support (seeExhibit 5). Although Starbucks had activelypursued a number of corporate social responsibil-ity initiatives, it was accused of polishing itsimage more than truly working to improve thelives of those its existence depended upon: thecoffee growers.

Rapid international expansion seemed toonly magnify the growing pressures. AsStarbucks moved into more and more countries,labor and real estate practices came underincreasing scrutiny, as did its image as globalimperialist. Wall Street looked on with a criticaleye as the firm entered the global marketplacethrough joint ventures which assured the firm ofless profits per store than in the domestic past.Earnings growth was sure to slow. The questiongrew as to how far and how fast the companycould still go.

NOTES

1. The traditional coffee sold by U.S. massmarket brands like Folgers and Maxwell House wasthe lower grade and cheaper robusta bean.

2. The experience itself had evolved. In his earlyattempts to reproduce the Italian coffee bar, Schultzhad provided little seating with opera music. Theseating was expanded and the music replaced, asAmerican customers complained.

3. Behar had retired in 1999, but returned to thecompany on a full-time basis in 2001.

4. The choice of Washington, D.C. was a surpris-ing choice to everyone but Starbucks’ managementteam. The company had tracked closely the cataloguesales of Starbucks products in the early 1990s, identi-fying the Washington, D.C. area as an extremelystrong market for Starbucks mail order products, andtherefore a logical first step on the East Coast.

5. A third structure, company ownership, hadbeen confined to the United Kingdom, Thailand, andAustralia.

6. According to the Coffee Research Institute, the10 largest coffee importing countries for the decade ofthe 1990s were the United States (25.6% of globalimports), Germany (14.2%), Japan (7.7%), France(7.5%), Italy (6.3%), Spain (3.8%), Holland (3.4%),the United Kingdom (3.4%), Canada (2.8%), andSweden (2.2%). Note that these are importationstatistics, and not consumption. Source: www.coffeere-search.org/ market/importations, accessed 10/6/02.

7. www.starbucks.com/aboutus/international.asp,accessed on 9/28/02.

8. Corporate Social Responsibility AnnualReport, Starbucks Coffee, Fiscal 2002, p. 8.

9. Starbucks was one of CARE’s largest NorthAmerican corporate donors. Cumulative contributionsto CARE by Starbucks over time totaled more than $2million. Starbucks work with CARE had begun in 1991.

10. Starbucks also noted that growers of ShadeGrown Mexico coffee received price premiums of60% over local coffee prices in fiscal 2001.

11. TransFair USA is associated with EqualExchange, a Fair Trade organization promotingsocially responsible business practices with coffeegrowers in Central and Latin America.

12. John Kohls and Sandra L. Christensen, “TheBusiness Responsibility for Wealth Distribution in aGlobalized Political-Economy: Merging MoralEconomics and Catholic Social Teaching,” Journal ofBusiness Ethics, February 2002, p. 12.

13. Starbucks reported that buyers paid $1.26/lb.for non-organic green and $1.41/lb. for organic greenin 2001, when New York “C” prices were hovering atroughly $0.50/pound. Although production costs var-ied significantly across countries and regions, coffeegrowers associations estimated average productioncosts to be $0.80/pound.

14. In a highly publicized settlement, Starbuckshad settled a class action suit in 2001 brought by storemanagers in California who complained the companyrefused to pay legally mandated overtime. Prior to the



case, managers were required to sign affidavits uponhiring that they agreed to work 20 hours per weekovertime without additional compensation.

15. “Planet Starbucks,” BusinessWeek, September9, 2002, p. 101.


Income items 1998 1999 2000 2001 2002

Net revenues $1,308.7 $1,686.8 $2,177.6 $2,649.0 $3,288.9Retail 1,102.6 1,423.4 1,823.6 2,229.6 2,792.9

Specialty 206.1 263.4 354.0 419.4 496.0Less cost of sales & occupancy costs (578.5) (747.6) (961.9) (1,112.8) (1,350.0)

Gross operating income 730.2 939.2 1,215.7 1,536.2 1,938.9

Less store operating expenses (418.5) (543.6) (704.9) (875.5) (1,121.1)Less general & admin expenses (77.6) (89.7) (110.2) (151.4) (202.2)Less other operating expenses (52.4) (54.6) (78.4) (93.3) (127.2)Income from equity investees — 3.2 20.3 28.6 35.8

EBITDA 181.8 254.5 342.5 444.6 524.3EBITDA margin (%) 13.9% 15.1% 15.7% 16.8% 15.9%

Less depreciation & amortization (72.5) (97.8) (130.2) (163.5) (205.6)

Operating income 109.2 156.7 212.3 281.1 318.7

Net interest income (expense) 7.1 7.3 7.1 10.8 9.3Internet investment losses & other — — (58.8) (2.9) 13.4

Earnings before tax (EBT) 116.4 164.0 160.6 288.9 341.4

Less corporate income tax (48.0) (62.3) (66.0) (107.7) (126.3)

Net income or earnings 68.4 101.7 94.6 181.2 215.1Return on sales (%) 5.2% 6.0% 4.3% 6.8% 6.5%Effective tax rate (%) 41.2% 38.0% 41.1% 37.3% 37.0%

Shares outstanding 358.5 363.7 376.3 380.0 385.6Earnings per share (EPS) $0.19 $0.28 $0.25 $0.48 $0.56EPS growth rate 11.4% 46.6% −10.1% 89.8% 17.0%

Source: Starbucks Coffee Company, Annual Report, 1999, 2000, 2001, 2002. EBITDA = Earnings before interest, taxes,depreciation and amortization.

APPENDIX 1: STARBUCKS CONSOLIDATED STATEMENT

OF EARNINGS, 1998–2002 (MILLIONS OF US$)


APPENDIX 2: STARBUCKS CONSOLIDATED

BALANCE SHEET, 1998–2002 (MILLIONS OF US$)


1998 1999 2000 2001 2002

AssetsCash & cash equivalents $123.5 $117.8 $132.2 $220.6 $402.2Accounts receivable 51.0 47.6 76.4 90.4 97.6Inventories 143.1 180.9 201.7 221.3 263.2Prepaid expenses & other 19.7 40.2 48.0 61.7 84.6

Total current assets $337.3 $386.5 $458.2 $593.9 $847.5

Investments in 38.9 68.1 55.8 63.1 106.0unconsolidated subsidiaries

Property, plant & equipment, net 600.8 760.3 930.8 1,135.8 1,265.8Other assets 15.8 37.7 46.7 58.2 73.5

Total fixed assets $655.5 $866.0 $1,033.3 $1,257.1 $1,445.2

Total Assets $992.8 $1,252.5 $1,491.6 $1,851.0 $2,292.7

Liabilities & Equity

Short-term debt $33.6 $63.8 $56.3 $62.0 $74.9Accounts payable 49.9 56.1 73.7 127.9 136.0Accrued payroll 35.9 43.9 69.7 81.5 105.9Accrued occupancy costs 17.5 23.0 29.1 35.8 51.2Income taxes payable 18.3 30.8 35.8 70.3 54.2Other current liabilities 24.2 33.6 47.0 67.7 115.3

Total current liabilities $179.5 $251.2 $311.7 $445.3 $537.5

Long-term debt — 7.0 6.5 5.8 6.1Deferred taxes & other 19.0 33.3 21.4 19.1 22.5

long-term liabilitiesCommon equity 794.3 961.0 1,152.0 1,380.9 1,726.6

Total liabilities & equity $992.8 $1,252.5 $1,491.6 $1,851.0 $2,292.7

Source: Starbucks Coffee Company, Annual Report, 1999, 2000, 2001, 2002.



1998 1999 2000 2001 2002

Operating Activities

Net earnings $68.4 $101.7 $94.6 $181.2 $215.1

Adjustments to reconcile to net cash:Depreciation and amortization 80.9 107.5 142.2 177.1 221.1Gain on sale of investment — — — — (13.4)Internet-related investment losses — — 58.8 2.9 —Provision for impairment 7.2 2.5 5.8 11.0 26.6and asset disposalsDeferred income taxes, net 2.1 0.8 (18.3) (6.1) (6.1)Equity in income of investees 0.0 (2.3) (15.1) (15.7) (22.0)Tax benefit from exercise of stock options 10.5 18.6 31.1 30.9 44.1

Cash provided/used bychanges in working capital:

Net purchases of trading securities — — (1.4) (4.0) (5.7)Accounts receivable (19.8) 3.8 (25.0) (20.4) (6.7)Inventories (23.5) (36.4) (19.5) (19.7) (41.4)Prepaid expenses and other current assets (2.5) (7.6) 0.9 (10.9) (12.5)Accounts payable 4.6 4.7 15.6 54.1 5.5Accrued compensation and related costs 9.9 7.6 25.4 12.1 24.1Accrued occupancy costs 5.3 5.5 6.0 6.8 15.3Accrued taxes 7.2 12.4 5.0 34.5 (16.2)Deferred revenue — — 6.8 19.6 15.3Other accured expenses 1.8 10.3 5.7 2.8 34.0

Net cash provided by $152.2 $229.2 $318.6 $456.3 $477.3operating activities

Investing Activities

Purchase of available for sale securities $(51.4) $(122.8) $(118.5) $(184.2) $(340.0)Maturity of available for sale securities 5.1 3.6 58.8 93.5 78.3Sale of available for sale securities 112.1 85.1 49.2 46.9 144.8Purchase of businesses, — (15.7) (13.5) — —net of cash acquiredAdditions to equity and other investments (12.4) (30.9) (43.9) (12.9) (6.1)Proceeds from sale of equity investment — — — — 14.8Distributions from equity investees 2.8 9.0 14.3 16.9 22.8Additions to property, plant and equipment (201.9) (257.9) (316.5) (384.2) (375.5)Additions to other assets (3.2) (6.9) (3.1) (4.6) (24.5)

Net cash provided (used) $(148.8) $(336.4) $(373.2) $(428.5) $(485.3)by investing activities

Financing Activities

Increase (decrease) in short-term debt $4.8 $29.9 $(7.5) $5.7 $12.9Proceeds from sale of common 4.6 9.4 10.3 13.0 16.2stock under esop*Proceeds from exercise of stock options 20.8 33.8 58.5 46.7 91.3Principal payments on long-term debt (2.0) (1.2) (1.9) (0.7) (0.7)Repurchase of common stock — — — (49.8) (52.2)

Net cash provided by financing activities $28.3 $71.9 $59.4 $14.8 $67.4

Source: Starbucks Coffee Company, Annual Report, 1999, 2000, 2001, 2002. esop = employee stop ownership plan

APPENDIX 3: STARBUCKS STATEMENTS OF

CASH FLOW, 1998–2002 (MILLIONS OF US$)


Ave

rage

Ann

ual

Gro

wth

Uni

ted

Sta

tes

& C

anad

a19

9219

9319

9419

9519

9619

9719

9819

9920

0020

0120

02R

ate

Com

pany

-Ow

ned

162

261

399

627

929

1,27

01,

622

2,03

82,

446

2,97

13,

496

36%

Lice

nsed

311

2649

7594

133

179

530

809

1,07

880

%

Inte

rnat

ion

alC

ompa

ny-O

wne

d—

——

19

3166

104

173

295

384

Lice

nsed

——

——

217

6517

735

263

492

8

Tota

l Sto

res

Com

pany

-Ow

ned

162

261

399

628

938

1,30

11,

688

2,14

22,

619

3,26

63,

880

37%

Lice

nsed

311

2649

7711

119

835

688

21,

443

2,00

692

%

Tota

l Sto

res

165

272

425

677

1,01

51,

412

1,88

62,

498

3,50

14,

709

5,88

643

%

Per

cent

of t

otal

lice

nsed

2%4%

6%7%

8%8%

10%

14%

25%

31%

34%

Rev

enu

es &

Pro

fits

Rev

enue

s (m

illio

ns)

$93

$164

284.

9$4

65$6

98$

975

$1,3

09$1

,680

$2,1

69$2

,649

$3,2

8943

%C

hang

e (%

)76

%74

%63

%50

%40

%34

%28

%29

%22

%24

%N

et p

rofit

(m

illio

ns)

$4$

910

.2$

26$4

2$

55$

68$

102

$ 95

$181

$215

49%

Cha

nge

(%)

107%

20%

155%

62%

31%

24%

50%

−7%

92%

19%

Rev

enue

/sto

re$0

.564

$0.6

01$0

.670

$0.6

87$0

.688

$ 0.

691

$0.6

94$0

.673

$0.6

20$0

.563

$0.5

590%

Cha

nge

(%)

7%12

%2%

0%0%

1%-3

%−8%

−9%

−1%

Net

pro

fit/s

tore

$0.0

25$0

.031

$0.0

24$0

.038

$0.0

41$

0.03

9$0

.036

$0.0

41$0

.027

$0.0

38$0

.037

4%C

hang

e (%

)26

%−23

%60

%8%

−6%

−7%

13%

−34

%42

%−5%

Ear

ning

s pe

r sh

are

(EP

S)

$0.0

3$0

.04

$0.0

5$0

.09

$0.1

4$

0.17

$0.1

9$0

.27

$0.2

5$0

.46

$0.5

634

%C

hang

e (%

)33

%25

%80

%56

%21

%12

%42

%-7

%84

%22

%S

hare

Pric

e (e

oy)

$1.8

9$

.42

$2.8

8$4

.73

$8.2

5$

10.4

5$9

.05

$12.

39$2

0.03

$14.

84$1

4.84

23%

Cha

nge

(%)

81%

−16

%64

%74

%27

%−13

%37

%62

%−26

%0%

Sour

ce:

Com

pany

Rep

orts

and

Tho

mas

Wei

sel P

artn

ers

LL

C,“

Star

buck

s C

orpo

ratio

n,”

Febr

uary

6,2

002,

pp.1

4–17

.

APP

EN

DIX

4:ST

AR

BU

CK

SC

OR

POR

AT

ION

STO

RE,R

EV

EN

UE

AN

DPR

OFI

TG

RO

WT

H,1

992–

2002

AV

ER

AG

E

55


APPENDIX 5: STARBUCKS’ INTERNATIONAL OPERATIONS


Asia-Pacific Middle East Europe

Australia Bahrai Austria

Guam Israel Germany

Hong Kong Kuwait Greece

Indonesia Lebanon Portugal

Japan Oman Spain

Malaysia Qatar Switzerland

New Zealand Saudi Arabia United Kingdom

P.R. of China United Arab Emirates

Philippines North America

Singapore Canada

South Korea Mexico

Taiwan United States

Thailand

Source: Starbucks.com, 10/07/02.


447

$2 $0$4$6$8$10

$12

$14

$16

$18

$20

$22

$24

$26 33

781 33

875 33

973 34

071 34

169 34

267 34

365 34

463 34

561 34

659 34

757 34

855 34

953 35

051 35

149 35

247 35

345 35

443 35

541 35

639 35

737 35

835 35

933 36

031 36

129 36

227 36

325 36

423 36

521 36

619 36

717 36

815 36

913 37

011 37

109 37

214 37

312 37

410 37

508

APP

EN

DIX

6:ST

AR

BU

CK

SC

OR

POR

AT

ION

,CL

OSI

NG

SHA

RE

PRIC

E(W

EE

KLY

,AD

JUST

ED

FOR

SHA

RE

SPL

ITS)


In July 1996, Jim Gulkin, Managing Directorand founder of Bangkok-based Siam CanadianFoods Co., Ltd., was considering the emergingbusiness opportunities in neighbouring Burma(also known as Myanmar). Although relativelyundeveloped compared to the rest of SoutheastAsia, Burma had been experiencing increasinglevels of foreign investment activity in recentyears. Gulkin, who had considered entering Burmain the past but declined, needed to determine ifthe time was now appropriate for him to enter themarket.

COMPANY PROFILE

Siam Canadian Foods Co., Ltd. (SC) was abrokerage business based in Bangkok, Thailand.It was started in April 1987 after Canadian JimGulkin quit his job in the oil industry andinvested his life savings of Cdn$130,000 in thebusiness. Gulkin was raised in Montreal wherehe remained until he graduated from grade 11“with a stratospheric 51 per cent average.” Withschool out of the way, he began travelling andworking in various parts of the world andbecame enamoured with Thailand after holiday-ing there in 1979. SC’s role as a food broker wasto identify overseas customers, usually foodimporters, and negotiate sales with them onbehalf of food processors in Thailand. SC’s ini-tial activity was limited to brokering cannedpineapple and tuna; however, it graduallyexpanded its offerings to include a wide range ofproducts such as frozen seafood, frozen poultry,canned and frozen fruit and vegetables as well as

dehydrated fruit and juice concentrates. Overtime, SC also began to source various productsfrom both Burma and India on an ad hoc basis.

When first starting out, Gulkin was admit-tedly very inexperienced in the food brokeringbusiness. He commented:

I didn’t have a clue what I was doing . . . I didn’tknow what a letter of credit, invoice or cross-checkwas. I didn’t even have a business plan or amarketing plan.

Adding to this inexperience, Gulkin foundthat local processors were reluctant to deal withhim, despite the fact that he spoke fluent Thai. Asa newcomer to an industry tightly controlled byThailand’s highly assimilated Overseas Chinesecommunity, Gulkin struggled to develop com-fortable levels of trust and confidence with theprocessors.

The food brokerage business generally oper-ated on low margins, thus necessitating move-ments of large volumes of goods in order toachieve profitability. As the business evolved,SC began to focus mainly on brokering frozenseafood because the commissions were the mostattractive. The company earned an average com-mission revenue of 1.25 per cent on sales con-tracts, usually denominated in U.S. dollars, thatit negotiated on behalf of the food processors.During the late 1980s and early 1990s, the frozenseafood business was in a state of expansion inNorth America and Europe. At the same time,Thailand was quickly becoming a globallyrecognized source of frozen seafood, largelyon the strength of overseas market acceptanceof Black Tiger Shrimp. Gulkin estimated that


SIAM CANADIAN FOODS CO., LTD.

Prepared by Tom Gleave under thesupervision of Professors John Kennedy and Tony Frost



Thailand harvested about 200,000 tons of BlackTiger shrimp in 1995, 90 per cent of which camefrom aquaculture facilities.

The following is an estimate of Thailand’srecent fresh and frozen shrimp exports:

Year 1990 1992 1994

Baht (Billions) 20.5 31.7 49.2

25 Baht = US$1.00

In 1991, Gulkin opened up a representativeoffice in Vietnam with the help of Philippe Vo.Vo was born in France to a French mother andVietnamese father and, prior to moving toVietnam, managed a seafood exporting businessin California. The purpose of the representativeoffice was to procure frozen seafood products forsale to overseas importers. Several months later,Gulkin, Vo and another local partner started aseparate importing and distribution business, SCFood Services, in Ho Chi Minh City.

In 1992, Gulkin began to investigate thepossibility of setting up a representative officein Burma but decided against it because he felt“very uncomfortable” with the local players inthe seafood industry. This investigation madehim realize that, apart from the necessary start-up capital which would be required, he alsoneeded “connections” to people favoured by theruling military junta, SLORC. He returned toBurma in 1994 when he discovered that newactivity in the seafood industry was being gener-ated by independent, non-politically connectedbusiness people. Discussions with the new play-ers gave him a much higher level of comfort thatbusiness could be done in Burma without theneed for buying favours. However, Gulkin alsofound that these new players were “sincere butincompetent” given that his attempt to exportUS$100,000 of frozen seafood collapsed due toinsufficient raw material supplies of acceptablequality, resulting in a net loss to SC of aboutUS$30,000. He later recalled that “it was a cheaplesson for the market knowledge we gained.”

In 1994, SC secured one of the most signifi-cant contracts in the company’s history on the

strength of the relationship it had establishedwith one of its key German importers. The con-tract called for SC to procure 600 tons ofbreaded shrimp to be shipped for ultimate sale toMcDonald’s Restaurants in Germany. A secondcontract for 450 tons was awarded to SC in 1995,with shipments this time going to McDonald’sin Germany and Austria. The trading valueof the 1995 shipment was US$7 million to US$8million. Under the terms of the contracts, SCreceived a commission from the processor aswell as a supervision fee paid by the importer.The latter was paid because SC dispatchedquality control personnel to the processor’s siteto oversee the production and packaging of thebreaded shrimp.

SC first achieved profitability in 1991 andhad remained in the black ever since. In 1995,SC’s trading volume was valued at aboutUS$85 million, 90 per cent of which was attrib-utable to frozen seafood. By 1996, SC employed15 staff who were involved in sales, quality con-trol and administration. The main destinationsfor the company’s shipments were importersfrom the following countries, in descending orderof sales value: United States, France, Germanyand Canada.

The combination of increasing success in thefood brokering business and the growing afflu-ence in Bangkok in recent years, led Gulkin toform a separate sister company, Siam CanadianGourmet Ltd., in early 1996. This importing anddistribution business was initially focused onimporting wines and coffees for sale to hotels,restaurants and specialty food retailers. It waslater expected to expand its product range toinclude imported cheeses, sauces and othergourmet cuisine items. Initial results were con-sidered “very promising.”

SC’S VIETNAMESE EXPERIENCE

Gulkin’s motivation for entering Vietnam in1991 was largely based upon his assessment that,as an undeveloped country with a large, intelligent



and hard-working population, many opportunitieswere becoming available to small firms withlimited resources such as SC. As well, enteringVietnam was also consistent with Gulkin’s viewthat in order to succeed in the food brokeringbusiness, firms had to adopt a diversificationstrategy in terms of both supply sources andproduct line offerings. Furthermore, the amountof foreign investment in Vietnam had been esca-lating, due largely to the implementation of theVietnamese government’s so-called “doi moi” or“renewal” policy, which was designed to attractforeign investment. This meant that there wouldbe a limited window of opportunity for SC toenter the market before being shut out perma-nently by bigger players. Therefore, with thehelp of Vo, Gulkin opened up Siam CanadianFoods (Vietnam) in order to gain access to frozenseafood for shipment overseas. Apart from Vo,SC (Vietnam) employed four quality controlstaff and an administrative assistant. Gulkin held100 per cent ownership of SC (Vietnam) whilemaintaining a 50 per cent profit-sharing arrange-ment with Vo. Later, Gulkin, Vo and a localVietnamese partner opened up SC Food Services,a separate distributorship that imported meatsand dairy products, and sourced local fruits andvegetables, for sale to hotels and restaurants inthe Ho Chi Minh City area.

Gulkin’s view on the performance of SCFoods (Vietnam) was mixed. The business hadexperienced modest profitability since its incep-tion, something that he felt was “very good, allthings considered.” On the other hand, daily oper-ations were frustrating, particularly with respectto the honoring of contracts by food processors.Gulkin offered the following as a simple, typicalexample of a Vietnamese contract gone bad:

We enter into a contract with a Vietnamese pro-cessor to supply us with 30 metric tonnes (mt) offrozen cuttlefish tentacles per month for 12months. We, in turn, contract to sell this quantity ofproduct to a European buyer. One month into thecontract the Japanese, all of a sudden, becomeinterested in this particular commodity. The rawmaterial price, therefore, goes up and out of 360 mtcontracted, we might get to ship 15 or 30 mt. The

Vietnamese processor has absolutely no intentionof honouring our contract if it means that he losesmoney or even makes less than he originallyhoped. The contract is meaningless to him. It isnothing more than a piece of paper. His word or hisreputation are not tangible concepts to him. Mycompany, however, has to find a way to pacify ourbuyers who are none too happy. Sometimes it costssome money but fortunately our relationships withour buyers are strong. We do tend to make it veryclear to our buyers beforehand that a contract inVietnam is basically worthless and we, therefore,give ourselves a very wide notwithstanding clausein any contract we involve ourselves in.

These frequent experiences left Gulkin withthe impression that local processors only consid-ered the short-term implications of their busi-ness, often leading him to ponder the question“why bother?”

BURMA

Burma, also known as The Union of Myanmar,was the largest mainland country in SoutheastAsia and had a population of about 47 million.The country bordered on Bangladesh and Indiain the northwest, China in the northeast, Laos inthe east and Thailand in the southeast. It was adiverse nation with over 135 distinct culturalgroups, the predominant one being the Bamars,representing about 69 per cent of the population.The country was considered by the World Bankto be among the poorest in the world, with a percapita income of US$676, based on purchas-ing-power parity. The capital city of Rangoon(also known as Yangon) had a population ofapproximately six million and was the nation’smain port through which over 90 per cent of allocean going trade passed. The physical geogra-phy of the country was a mixture of tropicalmountains, plains and delta lowlands. Burma hada coastline that totalled over 2,830 kilometresbordering along the Andaman Sea and the Bay ofBengal. The country was thought to have abun-dant natural resources, particularly in teak wood,oil and seafood. (See Exhibit 1 for a Regional




Exhibit 1 Map of Southeast Asia

Cambodia, Myanmar, Laos


Map of Southeast Asia and Exhibit 2 for RecentEconomic Indicators on Burma.)

Burma’s seafood resources were plentifulgiven its exclusive economic fishing zone of486,000 square kilometres along its coastline.Prior to 1994, the Myanmar Fisheries Enterprise,a state-run company controlling the nation’sseafood harvesting and processing, was the dom-inant player in the Burmese fishing industry.This company was dissolved in 1994 in an effort

to improve the industry through attracting privateinvestment. The total marine harvest for Burmawas estimated to be as follows:

Year 1990 1992 1994

Tonnes (Thousands) 645.7 650.7 689.0

Gulkin estimated that the total current annualharvest of all shrimp species in Burmese waterswas about 20,000 tons. Given that the state of


1991/1992 1992/1993 1993/1994

Nominal GDP (kyat—billions) 187 248 339

Real GDP* (kyat—billions) 50 55 58

Real Per Capita GDP (kyat—millions) 1,202 1,289 1,341

Real GDP Growth Rate (%) −0.6 +9.3 +6.0

Consumer Price Index (1986 = 100) 349.30 460.49 541.51

Total Exports (kyat—millions) 2,932 3,655 4,071

Total Imports (kyat—millions) 5,337 5,365 7,218

GDP Area of Economic Activity (%)

Agriculture 37.5 38.5 38.3

Trade 22.1 22.1 22.1

Processing/Manufacturing 8.9 8.8 9.2

Livestock/Fishing 7.6 7.3 7.2

Social Administration 7.2 6.7 6.7

Rental and Other Services 4.8 4.5 4.4

Transportation 4.0 4.0 3.9

Construction 2.9 3.0 3.0

Other 5.0 5.1 4.2

Exhibit 2 Recent Economic Indicators—Burma

*Real GDP figures given use 1985/1986 fiscal year as benchmark.

1994 exchange rates: US$1.00 = 5.08 kyat; Cdn$1.00 = 3.78 kyat

Source: Investing in Myanmar, Union of Myanmar Investment Commission, 1995


development within the seafood industry wasrelatively low, he felt that the placement ofmodern fishing fleets and aquaculture facilities,spurred on by recent measures to liberalizethe industry, would increase Burma’s seafoodoutput considerably over the next severalyears, but not to the extent that it would matchThailand’s output.

In 1988, Burma passed the Foreign InvestmentLaw which, much like Vietnam’s “doi moi” pol-icy, was designed to attract foreign capital toindustries which would promote exports andprovide for the acquisition of new technologies.This Law was seen by the Burmese governmentas a market oriented measure because it allowed100 per cent foreign ownership of firms, repatria-tion of capital and an “unequivocal guarantee”against the nationalization or expropriation ofbusinesses. Firms operating under the guidelinesof the Law paid a flat tax of 30 per cent; however,there existed numerous provisions which could

be used to lessen a firm’s tax burden, includingthe following:

• a tax holiday period of three consecutive yearsinclusive of the year of start-up with a possibleextension if the Myanmar Investment Commis-sion deemed it appropriate

• exemption or relief of tax paid on profits whichwere held in reserve and re-invested into thefirm within one year

• accelerated depreciation of capital assets• exemption or relief from customs duties paid on

various equipment and instruments importedduring the start-up phase of the firm

By 1994, 113 enterprises involving foreignownership were engaged in a variety of agricul-tural, seafood processing, manufacturing, mining,energy and transportation activities in accor-dance with the provisions of the Law, eight ofwhich were directly related to the seafood indus-try. (See Exhibit 3.)


Firm Activity Origin of Foreign Investor

1. Myanmar Bangladesh Shrimp farm management BangladeshFisheries Ltd.

2. Myanmar American Fish and marine products United StatesFisheries Co., Ltd.

3. General Fisheries Co., Ltd. Fishing, breeding, processing of fresh Thailandand saltwater products

4. Myanmar Niino Joint Culturing and marketing JapanVenture Co., Ltd. of high quality pearls

5. Hanswaddy Fisheries Fishing, prawn farming, processing and ThailandCo., Ltd. marketing of fresh and saltwater products

6. Myanmar P.L. International Ltd. Prawn farming, processing and marketing Singapore

7. Myanmar Garming Fisheries Ltd. Shrimp cultivation, fish processing Hong Kongand marketing

8. Myanmar Seafoods Ltd. Procurement, processing, handling and Singaporemarketing of fresh and saltwater products

Exhibit 3 Recent Joint Venture Investments in the Burmese Fisheries Sector


Recent Political History

In April 1947, Burma took a significant steptowards gaining independence from British colo-nization by having its first free elections afterWWII. The winner of the election was Aung San,the leader of the Anti-Fascist People’s FreedomLeague (AFPFL.) On July 19, 1947, Aung San,along with six of his senior cabinet colleagues,was assassinated. This became known asMartyr’s Day. U Nu, the ranking AFPFL politi-cian remaining, took over the leadership of thecountry and gained Burma’s independence fromBritain in early 1948. During these early years, UNu attempted to establish his party’s concept ofBuddhist based socialism. However, in March1962, General Ne Win led a left-wing militarytakeover of Burma in support of the BurmeseSocialist Programme Party (BSPP) and subse-quently imprisoned U Nu and his supporters.In July 1962, several students who protestedthis takeover were shot to death at RangoonUniversity. These killings were followed by thecomplete destruction of the student union build-ing on the campus. In the ensuing years, Ne Winbegan to direct the country towards the “Burmeseway to socialism” in accordance with the doc-trine of the BSPP. As a consequence, virtually allbusinesses were nationalized and there was agradual closure of trade with most of the outsideworld. This eventually led to the collapse of theBurmese economy.

In 1987 and 1988, many Burmese organizedmass demonstrations protesting the legacy ofincompetence of the Government and callingfor the removal of Ne Win. In July 1988, Ne Winstepped down following six weeks of bloodyconfrontations between pro-democracy demon-strators and the military, in which an estimated3,000 people were killed. The BSPP did notrelinquish power, however. In September 1988, aBSPP-backed military coup was staged result-ing in the establishment of the new StateLaw and Order Restoration Council (SLORC),under the leadership of General Saw Maung,Commander-in-Chief of the armed forces. SawMaung immediately imposed a state of martial

law while promising to hold a democraticelection in the near future. This quickly led to theforming of the National League for Democracy(NLD), a coalition of parties opposed to theBSPP, under the leadership of Aung San’sdaughter, Aung San Suu Kyi. The NLD went onto win the election which was held in May 1989,despite allegations that SLORC had attempted tomanipulate the outcome. After the election,SLORC refused to allow the NLD to assume therole of government and arrested the party’s lead-ership and soon after placed Suu Kyi underhouse arrest.

On July 10, 1995, Suu Kyi was released fromhouse arrest after six years of detainment, andfour years after she had won the Nobel PeacePrize, in absentia, for her dedication to demo-cratic reform in Burma. Despite SLORC’s warn-ing that Suu Kyi should abstain from politicalactivism, she continued to hold press confer-ences and political rallies outside of her housingcompound on University Avenue in Rangoon.Furthermore, she repeatedly called upon theUnited States and the European Community toimpose economic sanctions against Burma as ameans to force democratic reform in the countryand was successful to some degree. During 1995,the four U.S. cities of Santa Monica andBerkeley, California, Ann Arbor, Michigan andMadison, Wisconsin passed “selective purchas-ing” legislation which barred these cities frombuying goods and services from companiesdoing business in Burma. Similar legislation hadalso been tabled and was awaiting ratification bythe cities of Oakland, San Francisco, New Yorkand Colorado Springs.

By July 1996, several recent events hadcaused the issue of human and democratic rightsin Burma to gain political attention and presscoverage worldwide. Two months previously, inMay, the Burmese government arrested 262NLD members, thus preventing them from hold-ing their first national congress since the 1990election. This incident was followed by themysterious death of James Nichols, a Burmeseresident and former honorary consul in Burmafor Denmark, Finland, Norway and Switzerland,



who died in jail under vague circumstances. The69-year-old Nichols, a close friend of Suu Kyi,had served two months of a three-year prison sen-tence for possessing an unlicensed fax machine.

These events led Suu Kyi to escalate her call tothe Western powers for sanctions against Burma.At one point, she was able to have a video-tapedspeech smuggled out of the country. The message,which was played to members of the EuropeanParliament, prompted the European Union tosupport Suu Kyi’s position that economic sanc-tions were needed in Burma in order to move thedemocratic reform process forward. The culmina-tion of these events led Heineken to announce onJuly 1 that it would divest itself of its interest inits Burmese joint venture. Soon after, Carlsbergannounced that it had cancelled its plans to developa brewery in the country. These announcementsoccurred about four months after Pepsi sold off its40 per cent stake in a Burmese joint venture.

That same July (1996), leaders from theAssociation of Southeast Asian Nations (ASEAN),whose members included Thailand, Vietnam,Malaysia, the Philippines, Brunei, Singapore andIndonesia, met in Jakarta for their annual confer-ence. ASEAN was a forum used to discuss issuesthat were of mutual interest to its members,including political, economic, security and envi-ronmental concerns. Burma had been invited tothe conference as an observer for the first time, amove that was seen by many as the first steptowards eventually granting it full membershipstatus. Interestingly, by the time the conferenceconcluded in late July, the United States Senatehad passed a bill approving the use of sanctionsagainst Burma if SLORC engaged in any actswhich suppressed the pro-democracy movementof the NLD. The only hurdle which remainedfor full passage of the bill was the signature ofPresident Clinton who, only several monthspreviously, approved the Helms-Burton Bill, ameasure designed to penalize firms and firmmanagers who continued to conduct businesswith Cuba.

The issue of democratic and human rightsabuses in Burma was very prominent at theconference. However, while the United States

and the European Union considered applyingeconomic sanctions on Burma, ASEAN’s policyposition called for “constructive engagement”with SLORC. ASEAN’s view was that theregion’s economic and security interests wouldbe better served if Burma was not isolated. Tothis end, many ASEAN firms were encouragedby their governments to invest in Burma. In fact,Singapore-based Fraser and Neave immediatelyoffered to take over Heineken’s ownership stakein its Burmese joint venture. Similarly, discus-sions about building a new brewery between theGolden Star Group, Carlsberg’s former Burmesepartner, and Malaysia’s Asia-Euro Brewery werealready underway, less than three weeks afterCarlsberg announced its pull-out.

GULKIN’S PERSPECTIVE

ON BURMA’S POLITICS

In considering his position on the question ofdemocratic and human rights in Burma, Gulkinoffered the following:

Aung San Suu Kyi is a decent, intelligent,well-intended, brave and selfless person. I realizethat the politically correct trend is to call for sanc-tions against Burma, but economic isolation simplydoes not work. Take a look a Cuba, Chile, NorthKorea and Iraq. All of those countries have experi-enced economic sanctions of varying degrees, buttheir leaders still remained. People will often useSouth Africa as an example that sanctions work,but their case was unusual. The new South Africanswere an island of Europeans isolated both withintheir own country and from the rest of the world.

Economic empowerment raises hope for democ-racy. Just take a look at Taiwan, South Korea andeven here in Thailand. All of these countries wentfrom dictatorships to democracies as their level ofwealth increased. In 1992, when the Thai militarytried to take over the government, the people said‘No!’ and what happened? Democracy prevailed.Many Thais had started to enjoy the benefits ofincreased economic power and were not going togive them up. It is the economically deprived that



lack money and education. These people are easyto keep in place.

On the question of human rights, Burma is noworse than Indonesia or China. The Indonesiangovernment has brutally occupied East Timorfor over 20 years. As for China, there are tensof thousands of executions happening there eachyear, some even for economic crimes. AmnestyInternational is constantly citing China as a majorhuman rights offender but I don’t see Pepsi orCarlsberg pulling out of there.

RECONSIDERING BURMA IN 1996

Gulkin recognized that time was of the essence ifhe was going to finally commit to Burma. On thepositive side, Rangoon had seen the developmentof at least five new seafood processing plants inpast two years financed by independent firms.Having had preliminary discussions with someof the independents, Gulkin’s instincts led him tobelieve that corruption would not be a problemand that he would be able to quickly developrelationships of trust and confidence with them.As well, the lack of economic development withinthe country meant that smaller firms such ashis own might be able to gain a sustainablefoothold before many larger, well-financed firmsentered the market. It was Gulkin’s view thatbigger multinational corporations could affordto be “politically correct,” while smaller firmsneeded to take advantage of the windows ofopportunity while they existed. A further incen-tive for establishing operations in Burma washis belief that, given the underdeveloped stateof the Burmese seafood industry, he would beable to realize significantly larger commissionmargins than he was currently receiving inThailand or Vietnam.

Investment in Burma was also consistent withGulkin’s business philosophy of developing andmanaging diverse supply sources and productranges. This was particularly important when heconsidered that the Thai seafood market wassimultaneously experiencing increased levels

of competition as well as dwindling supplies ofraw materials. He estimated that the seafoodindustry in Thailand had reached the saturationpoint in terms of the number of processors oper-ating and that raw material supply levels wouldgradually deplete to the point where the industrywould be in definite decline within ten years.At the same time, relations between Thailandand Burma had moved in a decidedly favourabledirection in recent months. In March 1996,Banharn Silpa-archa became the first Thai PrimeMinister in 16 years to visit Burma. The primaryobjectives of the trip were twofold: first, tore-establish border trade between the two coun-tries, given that cease-fires between insurgentethnic groups along the border had been sus-tained, and second, to give Thai business inter-ests a chance at gaining a stronger foothold inthe country given the recognition of increasedinterest that other nations in the region wereshowing in Burma.

Gulkin’s view was that most of the othernations in the region did not offer the samepotential for developing his seafood exportingbusiness further. For instance, although neigh-bouring Cambodia had a sizeable coastline alongthe Gulf of Siam and thus strong potential as aseafood exporter, the country was still experienc-ing the devastating effects that years of brutalwar and governance under the Khmer Rougehad brought to the country. A strong consensusamong many business people living in Thailandwas that Cambodia was not a secure place totravel, let alone conduct business. Evidence ofthis insecurity was shown by the recent kidnap-ping of a British landmine disposal expert, alongwith 20 Cambodian colleagues who were work-ing on behalf of the Mines Advisory Group.Additionally, in a highly publicized incident in1994, three foreign backpackers were kid-napped and subsequently murdered by theKhmer Rouge.

Gulkin had also dismissed the possibility ofentering Malaysia because it had experiencedvery strong economic growth in recent yearswhich, in turn, allowed the seafood exportingindustry to become well-developed. Gulkin



viewed Indonesia as having potential, giventhat it was a large, resource rich archipelago;however, he dismissed this option because of itsconsiderable distance from Thailand. Further-more, Indonesia was currently experiencingpolitical turmoil of its own, brought on by thearrest of Megawati Sukarno, daughter ofIndonesia’s founding President Sukarno and theprincipal political foe of the current President,General Suharto.

Several factors existed which were working todissuade Gulkin from making the leap to Burma,however. First, Gulkin was concerned aboutcompeting against PL Corporation, a localseafood exporting company controlled byGeneral Ne Win’s son-in-law, particularly sincelocal companies were often shown preferentialtreatment by local suppliers and producers.Additionally, there was increased interest in theregion from two of SC’s key competitors, theHong Kong-based Sun Wah Trading Companyand a sourcing division for the Japanese tradinggiant, Mitsui. Sun Wah was a well-financed firmwhich maintained its own fleet of transport shipsand had a well-established reputation in theseafood trading business. Its solid financial posi-tion allowed the firm to extend million dollarfinancing arrangements to processors, thusenabling them to remain open in times whencash flow was squeezed, something SC was notable to do for its customers. Mitsui’s sourcingdivision was interested in Burma’s raw materialsupply so that other members of the Mitsuikeiretsu would be assured of having inputs fortheir value-added food processing operations.Gulkin viewed Mitsui, as well as the increasinginterest of Japan’s other big trading companies,as his largest threat in Burma. This was becausethe Japanese giants would be able to outbidmany of the smaller players, and in turn, limittheir ability to secure reliable supply sources.Additionally, the recent trend of the JapaneseYen was also cause for some concern because itsrising value gave the Japanese greater purchasingpower throughout the world.

The recent political attention given to Burmaalso worried Gulkin. While Gulkin viewed

economic isolation as harmful, he also needed toconsider the view of his overseas customers. Heremained cautiously optimistic that his customerswould not view his possible foray into Burma asunduly harmful. At the same time, however, herealized that if the economic sanctions movementgained momentum, some of SC’s customersmight “black list” Burma. Adding further confu-sion to this situation was the recognition that anincreasing number of Asian firms were makinginroads into Burma, despite the calls for sanctionselsewhere in the world. It was quite clear thatAsia’s view of Burma was considerably differentfrom that of the Western powers.

The level of development of Burma’s infra-structure was also cause for some concern. Itwould clearly be difficult to conduct business ina country which lacked an adequate system ofroads or communication linkages. The port facil-ity in Rangoon was especially problematic andwas considered to be the biggest bottleneck inthe country. It was not uncommon for vessels towait for several days or even weeks before theycould be loaded or unloaded. The matter was sograve that it prompted several foreign investorsfrom Singapore and Hong Kong to begin thedevelopment of a new port across the river fromRangoon; however, it was expected to be about ayear before the port became operational.

DECISION

In considering his Burmese investment decision,Gulkin had to consider several trade-offs. Couldhe afford to take a “wait and see” approach toBurma while other Asian firms started to tap intothe market? Similarly, could he afford to allowthis opportunity to pass him by given that otherseafood exporting opportunities in the regionwere quite limited? Alternatively, if Gulkinentered Burma, could he be assured that hisinvestment was secure given the state of politicalgovernance in the country? At the same time,would he run the risk of losing some key clientswho would discontinue doing business with himbecause of his involvement in Burma?




ROYAL TRUSTCO1

Prepared by Alan W. Andron under thesupervision of Professor David Conklin


You have a board of directors thathas worked diligently, assiduously,in your interests. I never in my lifehave known a better group of peopleand I think you should recognize thatthey have saved this company.

—Hartland MacDougall,Royal Trustco Chairman,

comments to a shareholders’meeting as quoted in “A question

of governance,” Globe & Mail,July 19, 1993, Pg B1.

You know, it’s like in my game.Second guessing after somethinghappened is much easier than whenyou have to make the decision.

—Jean Beliveau, Royal TrustcoDirector, as quoted in “A question

of governance,” Globe & Mail,July 19, 1993, Pg B1.

COMPANY BACKGROUND

Royal Trust2 opened for business in Montreal onNovember 24, 1899. The company started withone employee and a desk located in the Bankof Montreal on Place D’Armes. The company’sfirst president and board of directors were thesame as the Bank’s, although the Bank did notown Royal Trust.3

By the early 1980s, Royal Trustco had grownto have corporate assets of $11.1 billion, andassets under administration of $37.6 billion.4 The

company had diversified to include intermediaryand real estate brokerage businesses. RoyalTrustco classified business into three broadgroups: 1) intermediary services, which con-sisted of deposit accounts, chequing accounts,personal loans and mortgages; 2) trustee servicesfor both corporations and individuals, whichincluded managing stock transfers and adminis-tering estates; and 3) managed assets, whereRoyal Trustco would manage a person’s assets(not estates), provide financial advice, and otherinvestment management services such as mutualfunds on a fee for service basis.5 Exhibit 1 pro-vides a five-year income statement and balancesheet for Royal Trustco.

1980: THE CAMPEAU

CORPORATION TAKEOVER BID

On August 28, 1980, Ottawa-based CampeauCorporation, a property developer headed byRobert Campeau, announced a take-over bid forRoyal Trustco. Originally an Ottawa homebuilder, Campeau had moved into land develop-ment and built several large office complexes indowntown Ottawa and Hull. In recent years,Campeau had expanded into several majorCanadian and United States markets. Campeau’sbid for Royal Trustco surprised many investmentanalysts.6

Royal Trustco’s management recommendedto the board that the offer be opposed.7 To helpfight the take-over bid, Royal Trustco filed suit inboth Canadian and U.S. courts,8 as well as com-plaints with the Ontario Securities Commission



CONSOLIDATED INCOME STATEMENT 1988 TO 1992($ millions)

1992 1991 1990 1989 1988

Net Investment Income 352 484 453 542 479Provision for Loan Losses (421) (155) (209) (22) (18)Fees and Other Income 351 337 291 278 229

Net Revenues 282 666 535 798 690

Operating ExpensesSalaries and Benefits 296 281 282 252 223Premises, Computer & Equipment 160 154 149 131 115Other Operating Expenses 179 167 186 186 150Write-off of Good Will 93 — — — —Income Taxes 213 19 (85) (35) (10)

Income from Operations (659) 45 3 264 212

Sale of Stock Transfer Business — 21 — — —International Restructuring — — (30) — —Write-down of investments — — (84) — —Income–Discount’d Operations (193) 41 46 1 —

Net Income (852) 107 (65) 265 212

CONSOLIDATED BALANCE SHEET 1988 TO 1992($ millions)

1992 1991 1990 1989 1988

Cash and Short Term Investments 3,131 3,227 4,810 5,265 5,310Securities 2,905 4,581 4,526 4,605 3,920Loans and Investments 17,790 20,320 22,649 21,457 18,803Other Assets 417 698 688 510 444Net Discontinued U.S. Assets 817 998 582 444 —

Total Assets 25,114 29,824 33,255 32,281 28,477

Demand Deposits 4,120 4,026 3,828 3,906 4,451Term Deposits 16,928 20,038 23,572 22,516 19,361Bonds, Debentures, Borrowings 1,436 2,253 2,510 2,789 2,243Other Liabilities 234 209 179 203 235

Total Liabilities 22,718 26,526 30,089 29,414 26,290

Minority Interest 9 8 7 26 42Subord. Notes; Capital Debent. 1,419 1,334 1,335 766 661Shareholders’ Equity 968 1,956 1,824 2,075 1,484

Total Equity 2,396 3,298 3,166 2,867 2,187

Total Liabilities and Equity 25,114 29,824 33,255 32,281 28,477

Exhibit 1

Source: Royal Trustco Annual Report 1992.

All values are quoted in Canadian funds.


(OSC). Both the courts9 and the OSC10 ruled thatthe Campeau bid was valid.

During the take-over bid, a group of Canada’stop corporations, including Toronto DominionBank (TD), Noranda, Olympia & York Develop-ments (O&Y), actively purchased Royal Trustcostock.11 Campeau eventually withdrew the offerbecause the desired number of shares were nottendered.

1982/83: THE BRASCAN REVOLUTION

Brascan, which was a part of the Edper Group(Exhibit 2 outlines the member companies of theEdper Group; Exhibit 3 lists directors of keyEdper companies) controlled by Edward andPeter Bronfman, purchased its original interest(14.9 per cent) in Royal Trustco in early 1981.12

In 1983, Trilon, a member of the Brascan family,purchased the Brascan interest in Royal Trust, aswell as the large interest held by O&Y. Trilonindicated that it was interested in purchasingmore shares in the future.13 By 1983, Trilon hadgained control of Royal Trustco14 through aseries of share purchases from other share-holders. Michael Cornelissen was appointed tothe position of President and Chief ExecutiveOfficer of Royal Trustco and its operatingsubsidiaries.

1983–1992: THE CORNELISSEN

ERA OF ENTREPRENEURSHIP

Michael Cornelissen was a chartered accountantby training. He had worked for Touche Ross inhis native South Africa, and in Montreal, wherehe met Jack Cockwell, who in 1975 would hireCornelissen to work for the Hees-Edper group.Following his time in Montreal, Cornelissenreturned to South Africa to return to school, andlater worked for a large public company inJohannesburg. In 1975, Cornelissen became oneof the original group of employees to work onthe building of the Hees-Edper businesses (Hees

was one of the subsidiaries of Edper, and JackCockwell, Cornelissen’s new boss, was one of thekey personnel in the organization). Cornelissenrose to prominence in the early 1980s after man-aging a turnaround at the Edper-controlled TrizecCorp, a Calgary-based real estate developer.15

At the time Cornelissen was appointed presi-dent and CEO of Royal Trustco, the companywas described with such terms as “ossified,”“hierarchical,” “inwardly oriented,” and “unex-ceptional.”16 His assignment was to develop anentrepreneurial culture within Royal Trustco.The goal was to give the organization a salesand marketing orientation, and transform itsculture from one that was risk averse.17 UnderCornelissen, Royal Trustco set a target of annualgrowth in earnings per share of 15 per cent,18 andformulated a strategic plan which outlined howthe earnings growth would be achieved.19

To achieve these goals, Cornelissen followedthe Hees philosophy20 of how to run a firm. Hereduced the levels of management and bureau-cracy within Royal Trustco. Senior managerswere required to start at 7 a.m., traditional longlunches were eliminated, and everyone wasrequired to work flat-out; those who couldn’twork in the new environment were replaced.21

An extensive internal communications plan wasimplemented to deliver the customer servicemessage to the employees in the branches.22

In order to motivate senior and middle levelmanagers, Royal Trustco required enrolment inits stock purchase plan.23 Royal Trustco provided100 per cent financing of the stock purchases;stocks were kept in a trust account for a five-yearperiod, managers repaid 20 per cent of the prin-cipal each year and took possession of the stock,or could wait five years, pay off the loan in onepayment, and take possession of the stock.24

Loan interest payments were set to equal the div-idends available on the stock.25 The assumptionsbehind the plan were that: a) an ownership posi-tion would ensure that managers acted in the bestinterests of the stockholders, and b) stock pricewas the best indicator of the performance ofthe company.26 Management salaries were signif-icantly lower (an estimated 30 to 50 per cent)




51%

49% 49%

49%

25%

25%75%

71%

EdperEnterprises

Ltd.*

HeesHoldings

Inc.

75%

HeesInternationalBancorp Inc.*

47%Brascan Holdings

Inc.

CarenaDevelopments*

62%

Brascan Ltd.*49%

BrookfieldDevelopments

Ltd.**

NorandaForest Inc.*

83%

Trilon SecuritiesInc.

100%

Lake SuperiorPower100%

ConsolidatedCarma*

47%

Noranda Minerals100%

Royal Trustco*47%

Louisiana Hydro-Electric Power

50%

CoscanDevelopment*

56%

Noranda Energy100%

LondonInsurance Group*

55%

Northern OntarioUtilities Division

100%

The HahnCompany

100%

WestminResources Inc.*

74%

TrilonFinancial*

48%

TrizecCorporation Ltd.*

32%

Noranda Inc.*49%

TrilonHoldings Inc.

100%

Carena HoldingsInc.

* Public companies ** Convertible secured loan

Great LakesPower Inc.*

Exhibit 2 Edper Enterprises Ltd Corporate OrganizationSource: Edper Enterprises Ltd Annual Report 1992.


than those paid by competitors; this differencewas to be compensated by increases in the valueof the manager’s stock.

Royal Trustco’s accounting system wasrevamped so that management could track itsproducts on a client-centred basis, thereby easingthe process of cross-selling related financialservices.27 Account managers at the branch levelwere placed on a compensation system thatrewarded results, including a commission com-ponent based upon the amount of loan business(and other fee-based services) written.28 Thecompany also set out to increase the size of its

branch network from 111 to 190 branches, inorder to improve its access to depositors as asource of stable and inexpensive funds.29

Royal Trustco survived the recession of theearly 1980s, and enjoyed profitability for theremainder of the decade. The Canadian economyhad climbed out of recession, and by the end ofthe decade was “running full steam ahead.”Royal Trustco met its target of 15 per centearnings growth every year until 1990; from1985 to 1989, earnings had doubled. At the 1989shareholders’ meeting, Cornelissen spoke ofprofits doubling again in the next five years.30


ROYAL TRUSTCO BOARD OF DIRECTORS

Hartland MacDougall C.V.O.; James Miller; Hon. James Balfour, Q.C.; Jean Beliveau O.C.; Thomas R. Bell; BrianCanfield; Kenneth R. Clarke; Adrienne Clarkson O.C.; Jack L. Cockwell; Gordon R. Cunningham; David L. Donne;Hon. J. Trevor Eyton Q.C.; Fraser Fell Q.C.; Paul Gobeil; Melvin Hawkrigg; Dr. Warren McFarlan; Neil McKelveyO.C., Q.C.; Earl Orser; Roger Phillips; Richard Pound, O.C., Q.C.; Hon. Maurice Riel P.C., Q.C.; MargaretSouthern C.M., L.V.O.; James M. Tory Q.C.; Marshall Williams

Source: Royal Trustco Annual Report 1992.

TRILON FINANCIAL BOARD OF DIRECTORS

Hugh Aird; Peter F. Bronfman; Kenneth R. Clarke; Jack L. Cockwell; George Cormack; Gordon R. Cunningham;William Dimma; Gary Goodman; Melvin Hawkrigg; Alan Hockin; Joseph Jeffery OBE, CD, LLD; Allen Lambert O.C.;Frank Lochan; Donald Lowe; Hon. Edward Lumley; Hartland MacDougall; David McCamus; Ross McKenzie;George Myhal; Earl Orser

Source: Trilon Financial Annual Report 1992.

BRASCAN LTD BOARD OF DIRECTORS

Roberto P. Cezar De Andrade; Hon. Conrad M. Black P.C., O.C.; Bruce A. Bronfman; Edward M. Bronfman; PeterF. Bronfman; Jack L. Cockwell; Robert A. Dunford; Hon. J. Trevor Eyton O.C., Q.C.; Rhys T. Eyton; Hon. Edwin A.Goodman P.C., O.C., Q.C.; Lewis B. Harder; Patrick J. Keenan; David W. Kerr; Allen T. Lambert, O.C.; Hon. E.Peter Lougheed, P.C., C.C., Q.C.; Paul M. Marshall; Harold P. Milavsky; Alfred Powis, O.C.; John A. Scrymeour;Peter N.T. Widdrington

Source: Brascan Ltd Annual Report 1992.

EDPER ENTERPRISES LTD BOARD OF DIRECTORS

Bruce A. Bronfman; Edward M. Bronfman; Linda E. Bronfman; Peter F. Bronfman; Donald Carr, Q.C.; Jack L.Cockwell; Hon. J. Trevor Eyton, O.C., Q.C.; Jack Rabinovitch; Manfred J. Walt; Sheila Zittrer

Source: Edper Enterprises Annual Report 1992.

Exhibit 3 Royal Trustco Board of Directors


During the 1980s, Royal Trustco introducedseveral innovative products to the Canadian mar-ket. One popular product was the “Double Up”Mortgage, which allowed customers to make anadditional mortgage payment without penalty.31

Through its affiliation with Royal LePage RealEstate, Royal Trustco created the concept of the“pre-approved mortgage” for the residentialmarket. The mortgage applications and paper-work were handled through the realtor, while themortgage itself was issued by Royal Trustco. Inaddition to these innovative mortgage products,loans officers in Royal Trustco branches weregiven generous lending limits within which towrite loans.32

In addition to its innovations in the residentialmortgage market, Royal Trustco placed heavyemphasis on the commercial loans sector, partic-ularly commercial real estate. In 1990, RoyalTrustco’s Canadian portfolio included $5 billionin commercial loans. The U.S. and U.K. sub-sidiaries were also aggressively lending into thecommercial real estate market.

EXPANDING INTERNATIONALLY

In 1988, Royal Trustco moved into the Europeanand U.K. markets, primarily through its U.K.subsidiary, Royal Trust Bank. The stated goalwas to serve the same type of clientele as inCanada (older and affluent customers dealingwith branches specifically located in neigh-bourhoods with high populations of wealthy andhigh income citizens), based upon a “relation-ship banking” theme. However, growth in theU.K. was fuelled by moving downscale andlending to the mid-market of small-businessloans and commercial mortgages.33

In 1989, Royal Trustco made further movesinto the United States market,34 purchasingSeattle-based Pacific First Financial Corporation,considered to be a financially solid thrift.35

Within twelve months, Royal Trustco purchasedtwo savings and loan firms from ResolutionTrust, the U.S. Government’s liquidator of failed

thrifts. Cornelissen’s goal was to merge the threeU.S. institutions, realize operating economies,and in the process, create a super regional bankin the U.S. Pacific Northwest.36

Royal Trustco’s international expansion wasdriven by several factors. The federal governmentwas actively reviewing the Bank Act and otherfinancial legislation. It was expected that trustcompanies, banks, and insurance companieswould be able to enter into each other’s traditionallines of business, thus increasing competition.Canada’s market was seen by management asbeing too small to enable Royal Trustco to main-tain its earnings growth at the expected levels.37

Royal Trustco (and the Edper group in general)had frequently been the target of comments bypoliticians, academics, and media commentatorsabout the concentration of commercial and finan-cial companies. Cornelissen was noted to havesaid that the protests were driving Royal Trustcointo other markets, such as the United States.38

Finally, the U.S. market was seen as being frag-mented, providing room to develop a large finan-cial institution with scale efficiencies.39

1990: THE RECESSION HITS

The U.K. economy went into a severe recessionearly in 1990. The Canadian and U.S. economiesstarted to slow down in late 1990, and went intofull recession in 1991. In all three cases, therecession resulted in a decline in values in thereal estate market, into which Royal Trustcohad lent funds.40 Further, the housing market insouthern Ontario, where Royal Trustco had alarge residential mortgage portfolio, declinedalong with the commercial markets.41,42

Royal Trustco’s fourth quarter loss in 1990was $251 million, the total loss for the year was$65 million. Loan loss provisions for the yearincreased from $23 million in 1989 to $220 mil-lion; the largest portion of the increase was forEuropean loans.43 This loss only affected share-holders in part. While the value of the stockdropped, the firm maintained its common sharedividends at previous levels.44



1991: HAPPY DAYS ARE HERE AGAIN

The U.S. operations had been affected becauseof declines in the value of the California realestate market. First Pacific had been hit by non-performing loans, especially in California whereit had a large loan portfolio in the commercialreal estate market. While the recession hadweakened the market, it was predicted that even-tually the continuing growth in California’spopulation would pick up the slack.45

In spite of the apparent gloom coming fromthe U.S. operations, 1991 turned out to be a goodyear for Royal Trustco. The company reporteda net income for the year of $107 million.Shareholders were told that the worst of RoyalTrustco’s loan problems were behind it, withappropriate provisions having been made forpotential loan losses.46

1992: THE LOAN-LOSS STEAMROLLER

In 1992, Royal Trustco sold its United Statesoperations. First Pacific was draining cash out ofits Canadian parent, and U.S. regulators hadstarted to watch the company.47 In their efforts toclean-up First Pacific, regulators and managersdiscovered even more problems in the lendingdepartment.48 Furthermore, a wave of mergers inthe U.S. had created several large regional com-petitors to the Royal Trustco operations.49 Inorder to complete the sale of its U.S. subsidiary,Royal Trustco had to keep $900 million in non-performing loans; with the sale of First Pacific,Royal Trustco took a charge of $193 millionagainst earnings.50

The publicity surrounding Royal Trustco’sproblems led to further revenue problems for thecompany. Depositors started taking their moneyout of Royal Trustco and placing it elsewhere.The result was that earnings from operationsdeclined for the 1992 fiscal year.51

In 1992 came the announcement that MichaelCornelissen would be stepping down as presi-dent and CEO of Royal Trustco, and serving as

vice-chairman in a non-executive role.52 Followinga search for a successor, James Miller, an accoun-tant formerly with Touche Ross (now DeloitteTouche) in Vancouver, was appointed presidentand CEO.

DIVIDENDS

Even though Royal Trustco had lost moneyin 1990, it maintained its policy of holdingdividends constant. In 1991, the company paidout $73 million in preferred dividends, and $108million in common dividends; earnings in 1991were $107 million. In 1992, despite losing $852million for the year, the company declared andpaid out $55 million in preferred dividends(meeting the full obligations on preferred shares),and $80 million in common dividends. Commondividends had been changed for 1992: for the sec-ond quarter onward, common dividends had beenreduced from 18.5 cents per share to 10 cents pershare; for the third quarter onward, they werereduced to five cents per share.53

MILLER AND THE END OF THE DREAM

Upon taking over in December 1992, Millerbrought in independent consultants to review theloan portfolio. The conclusion of the review wasthat provisions for loan losses were inadequate.54

Miller’s action had been prompted, in part, by avisit from Michael Mackenzie, the federal gov-ernment’s top bank and trust company regulator.Mackenzie had visited Miller to issue a warningto watch out for Toronto real estate, as priceswere in what he called a “free fall.”55

Miller’s conclusion was that in order to savethe trust company, especially its depositors andassets, the only option was to sell the companyoutright.56 Earlier in 1992, Royal Trustco hadstarted looking for a partner willing to injectequity into the firm—in Miller’s view, that wasno longer an option. The response to Miller’s



analysis by the Royal Trustco board was disbelief;members did not believe things were as bad asMiller claimed.57

NOTES

1. This case has been written on the basis of pub-lished sources only. Consequently, the interpretationand perspectives presented in this case are not neces-sarily those of Royal Trustco or any of its employees.

2. The name “Royal Trustco” is used in thebalance of the case. Although founded as Royal Trust,the parent company eventually came to be known asRoyal Trustco, with Royal Trust as one of its operat-ing divisions.

3. Ivey Business School Case #9A86B044“Royal Trust (A).”

4. Ibid.5. “Royal Bust,” Canadian Business, November

1992, p. 46.6. “Campeau makes bid for Royal Trust,” Globe

& Mail, August 28, 1980, pp. B1, 4.7. “Royal Trustco management to fight Campeau

takeover,” Globe & Mail, August 29, 1980, p. B1.8. “Battle heats up for Royal Trustco,” Globe &

Mail, September 9, 1980, p. B1.9. “Royal Trustco to appeal ruling,” Globe &

Mail, September 17, 1980, p. B1.10. “OSC allows Campeau to take up Royal

Trustco shares,” Globe & Mail, September 19, 1980,p. B1.

11. TD buys interest in Royal Trustco,” Globe &Mail, October 7, 1980, p. B1.

12. “Brascan buys 14.9 per cent of RoyalTrustco,” Globe & Mail, March 26, 1983, p. B1.

13. “Trilon purchases 42 per cent of RoyalTrustco,” Globe & Mail, July 29, 1983, p. B1.

14. “Royal Bust,” Canadian Business, November1992, p. 36.

15. Ibid, p. 38.16. Ibid, p. 37.17. Ibid, p. 38.18. “Blue chip turns red, investors go white,”

Globe & Mail, March 30, 1993, p. B1.19. Royal Trustco Annual Report 1984.20. The philosophy, as described in “Royal Bust,”

included such aspects as managers becoming share-holders to unlock their entrepreneurial flair, a cultureof hard work and dedication.


22. Ibid, p. 40.23. Ibid.24. “How the loan plan went wrong,” Globe &

Mail, March 29, 1993, p. B1.25. “The Hollow Men,” Report on Business

Magazine, August 1993, p. 13.26. “Royal Bust,” Canadian Business, November

1992, p. 40.27 Ibid.28. Ibid.29. Ibid, pg. 42.30. “A question of governance,” Globe & Mail,

July 19, 1993, pp. B1, 6.31. Royal Trustco Annual Report 1984.32. “Royal Bust,” Canadian Business, November

1992, p. 42.33. “Royal Bust,” Canadian Business, November

1992, p. 44.34. In 1987, Royal Trustco had purchased 9.9 per

cent of a California savings and loan called GlenFedInc.

35. “Royal Trustco,” Canadian Research Flash,Prudential–Bache Securities, February 9, 1989.

36 “Royal Bust,” Canadian Business, November1992, p. 44.

37. “The Hollow Men,” Report on BusinessMagazine, August 1993, p. 12.

38 “Royal Trustco to buy U.S. financial firm,”Globe & Mail, February 7, 1989, pp. B1, 6.

39. Ibid.40. “Blue chip turns red, investors go white,”

Globe & Mail, March 30, 1993, pp. B1, 8.41. Royal Trustco Annual Report 1990.42. According to the 1992 Royal Trustco Annual

Report, as of December 31, 1992, Royal Trustco’snet Ontario residential mortgage portfolio stood at$4,604 billion, or 51.4 per cent of its total Canadianresidential mortgage portfolio. Net commercial realestate loans in the Ontario market totaled $2,463 billion,or 52.8 per cent of the company’s Canadian commer-cial real estate loan portfolio.

43. Royal Trustco Annual Report 1990.44. “Blue Chip turns red, investors go white,”

Globe & Mail, March 30, 1993, pp. B1, 8.45. Royal Trustco Annual Statutory Report 1991,

p. 17.46. Ibid, pp. 28,29.47. “Royal Bust,” Canadian Business, November

1992, p. 44.



48. Ibid.49. Ibid.50. “Royal Trust sells prize assets,” Globe & Mail,

March 19, 1993, pp. B1, 6.51. Royal Trustco Annual Report 1992. “Net

investment income” dropped by $132 million in 1992over 1991. During this same period, “Fees and otherincome” increased by $14 million, for a net decreasein operating income before allowances for loan lossesof $118 million.


53. Royal Trustco Annual Report 1992.54. “A question of governance,” Globe & Mail,

July 19, 1993, p. B3.55. Ibid.56. Ibid.57. Ibid.



esponding to ocietal forces - sage publications inc€¦ · purchase agreement or a joint venture....

Documents