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Advanced Corporate Finance FMB 513E, Professor Ryoonhee Kim

Samsung’s Corporate Governance Issue

Table of Content

Introduction

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Synthesis

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What happened - Explanation of the scandal at Samsung

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Why did that happen? Typical case of a bad corporate governance issue

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The consequences of the bad corporate governance of Samsung

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Conclusion

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References

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Introduction Tightly related to the Corporate Finance, the Corporate Governance refers to the management and the decision process of the company. This mainly includes the distribution of power and responsibilities among the shareholders and executives and how those are used.

Corporate governance may be subject to issues for many different reason. In some cases, the executives controlling a company are not the same persons that actually own the company - the shareholders. While the principal goal of executives is to maximize wealth for the shareholders, their self-interested may be in conflict with this mission: we call this a conflict of interest between management and shareholders.

A fair corporate governance assume that shareholders receive equitable rights and treatments. Because shareholders are sharing the wealth the of the company, they should all benefit from the company’s growth equally. Therefore, one specific shareholder should not benefit more than another for a specific profit of the company. This equality among shareholders is not always respected when some shareholders have a great amount of power inside a company. We will analyze the recent scandal regarding Samsung vice-chairman, a large shareholder, but also with great executive’s power. He used those power to gain benefit to himself through bribery and embezzlement.

We think that analyzing this event may be an interesting illustration of the risks of bad corporate governance, and maybe give us key to avoid this kind of issue.

We will first review the main concept regarding the terms used in this analysis, then we will look at the details of the previously mentioned scandal. Following this, we will try to explain why this situation appeared, and what are the consequences for the governance policy of Samsung. Finally, a conclusion will wrap-up the major points of this analysis.

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Synthesis Corporation is the most widely used form of business organization that offers limited liability to its owners, while maintaining itself as a separate legal entity. In line with a number of advantages as easy access for capital fund and fast growth opportunity, the separation between ownership and management may create conflict of interests. Classically it occurs when managers pursue other goals rather than maximizing shareholders’ value. Well managed corporate governance system may be considered as an effective mitigation to decrease the agency costs of shareholders.

“Corporate governance is the system of controls, regulations, and incentives designed to maximize firm value and prevent fraud within a corporation” (Berk and DeMarzo, 2011).

Minimum standards of corporate governance are known to be the most efficient in US after the Sarbanes Oxley Act was passed in 2002. However, regulatory systems and traditions of business management differ among other countries. For example, dual class shares or cross-shareholding corporate structures are being the main reason for disputes among controlling shareholders and minority shareholders (Berk and DeMarzo, 2011).

The particular case discusses the conflict of interest raised among top managers of a cross-shareholding industrial conglomerate and its shareholders, external stakeholders, including a government. Classical cross-shareholding is when a public company owns shares of another public company, making companies valuations difficult to estimate. This kind of business practice is common in Japan and in South Korea. Interconnected in such way a business group protects each member company from market fluctuations, takeover threats, shareholder activism and precise analyst reports (Investopedia, 2018). This in turn, is creating non-transparency of management actions, disputes among shareholders, overall, failure of basic corporate governance mechanisms. Samsung is a perfect example as it regroups most of these issues.

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What happened - Explanation of the scandal at Samsung Samsung, the Korean conglomerate was involved in a case of bribery charges, in favor of the former Korean president Ms. Park Geunhye’s secretive confidante, Choi Soon-sil in the beginning of 2017. The former vice president Lee Jae-yong of Samsung was formally arrested on 17 February 2017 for using merger activities to bribe $36 million for political favors. The merger of two non-profit organizations would have needed support from the government-run national pension fund, therefore Lee was using donations, as he called them, to support the merger (BBC, 2018a).

Mr. Lee Jae-Yong or also called Jay Y Lee, is the vice-chairman of Samsung Group and the nephew of the founder of Samsung. He is the son of the current chairman Lee Kun-hee, who suffered under a heart attack in 2014 (Stout, 2014). After this heart attack Lee Jae Yong became the most important person in Samsung conglomerate. He is one of the wealthiest individuals in Korea with an estimated net value of almost $6bn. Beside of this, Forbes ranked him as the 40th most powerful person in the world. The bribery Mr. Lee Jae-Yong was involved in, was primarily to increase his own power at Samsung Electronics, because the restructuring which mainly was about merging two companies needed the agreement from a governmental board. Samsung wanted to use Cheil, a company under the Samsung Group umbrella, to buy Samsung C&T which would have lead to even more control for him for his future task of controlling the Samsung group (Daileda, 2017).

Mr. Lee also admitted that previously he gave a horse and money to help the career of Choi’s daughter to become a professional horse riding athlete (BBC, 2017). After Lee was imprisoned in 2017 prosecutors seeked for 12 year of jail. The court then ruled in the end of 2017 that the Samsung executive will be sentenced to 5 years of prison for bribery and perjury. Lee got released from prison already a year after the sentence was ruled in February 2018, when an appeal court reduced his original sentence to a two and half year sentence and suspended the remaining penalty for four years. He still rejected the charges against him. Beside of the vice chairman of Samsung Electronics, who claimed that he will not unseat his father as the chairman in the near future, two other high Samsung executives which were imprisoned for the same charge, have also been released (Armstrong, 2018).

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The former Korean President Park Geun-hye has been sentenced to 24 years in jail, because she was not only involved in the bribery scandal with Samsung, but in a whole string of corruption charges with other South Korean conglomerates (BBC, 2018b).

Why did that happen? Typical case of a bad corporate governance issue This part of the analysis will focus on the elements of the Korean business structure that enabled such scandals to happen. First of all, it is important to notice that in history of South Korea allowed the flourishing of a peculiar form of business called Chaebol. Chaebols are family business conglomerates, which had a pivotal role in the past in the transformation of South Korea from a devastated country to one of the biggest exporters in the world. Examples of Chaebols are Lotte, SK, Hyundai, LG and last but not least Samsung (the largest among them). All of them have something in common, which is a special relationship with the government.

It all started after 1963, when Park Chung-hee became president after a military coup d'état and began to pave the way to economic success to South Korea, by selecting certain companies and assign them some projects financially backed up by the government. Chaebols contributed significantly to the unprecedented rapid economic growth of the country. However, this exceptional development gave deep roots to the issues such as cronyism, corrupt relations and economic concentration. The failure of Hanbo group, the second largest steel manufacturing conglomerate, which has been accused for high level of corruption, illegal donations to presidential candidates in the form of cash flows for projects associated with government procurement and urban planning, was the first signal to illustrate the heavy costs of Korean capitalist model.

When the position and role of chaebols on global market arena started to increase in 1980s, the pitfalls of corporate governance began to emerge. In response, the government began to impose regulatory

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policies such as the Monopoly Regulation and Fair Trade Act, which controlled chaebols’ excessive loan reliance, speculative practices and cross shareholding, so as to prevent detrimental impact of conglomerates on Korean economy. Particularly, after the Asian financial crisis, the public perception of chaebols was turning into negative, hence, anti-chaebol campaigns and shareholder activism were enhanced. The bankruptcy of Daewoo group in August 1999 was an epitome of the fact that the age of political favors and unwavering guarantees for chaebols was over. Regardless of the continuous reforms being undertaken, the chaebols are still involving in price-fixing schemes, fraud, bribery and anticompetitive practices.

Notwithstanding the maladies of chaebol system (Refer to Table 1), it is still maintained owing to the following rationales: 

Increase efficiency of resource allocation or lower transaction costs due to availability of internal capital and labor market within the business group. When external financial markets are stressed or skilled labor force is scarce, chaebols may take advantage of their internal markets by transferring skilled workers, know-how or capital to the affiliated companies.

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Long-term vision in management. In comparison with professional CEOs who have more temptation to pursue short-term goals, relatives in the role of executives show more responsible attitude and focus on long term strategies of the company. For instance, one of the Japanese giants Toyota switched back from professional CEO appointment to the strategy of blood-related management in 2008.

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Economically effective entrepreneurship. Chaebols behave aggressively in undertaking new product line launching, penetrating new markets or merging with existing corporations.

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Diverse but sound management system. Certain “chongsu” (unofficial general manger making decisions for entire syndicate) might hold autocratic nature whilst others can be group oriented. For instance, Hyundai and Samsung are vertically organized, whereas remaining are horizontal.

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Agile decision making practice. CEOs of affiliated companies are led via regular meetings by chongsus, where strategically important investment and CEO succession decisions are discussed. Moreover, even though it is not officially allowed, majority of chaebols have “president

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rooms” or “strategy department”, and employees of such divisions (most precious human resource) are generally appointed as a CEO to affiliated firms. For example, the strategy department of Samsung group that is in charge of monitoring the whole business group and reporting to chongsu as an internal controller is located in Samsung Electronics affiliated firm. 

Successful practice in development of social capital, political lobbying and increasing the support of political leaders and government (Murillo and Sung, 2013).

Table 1. Drawbacks of the chaebol system. Absence of meritocratic assignment of higher positions in affiliated companies. In chaebols’ case the issue of nepotism is widely observed, since they prefer a practice of transferring the power to their heirs rather than considering the merits of candidates who can add value to the company. Tunneling or internal trading. Companies purchase products from affiliated firms at higher prices even if non-sister companies offer more attractive rates. Moreover, chaebols tend to focus on profit stability instead of maximization of shareholder’s value. As a result of resource allocation to another affiliated firm of the group, shareholders interest is deteriorated. Tendency to overinvest or to involve in risky projects owing to easy access to bank loans in domestic market. According to Kim and Paul (2009) chaebols show greater market value based debt ratios compared to non-chaebol counterparts. Moreover, they persistently involve in capital expenditures even in industries with poor performance. Inconsistency of investment diversification with financial rationality. In order to avoid political or economic risk of losing control over chaebol, accrue managerial power by establishing more companies, promote succession of property to the descendants, and to enhance position and image of chongsu in society and political arena, chongsus involve in investing procedure through novel firm in lieu of using existing one.

Nowadays, there are 45 so called Chaebol, where the top 5 of them own half of the Korean Stock Market.

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Samsung, especially, takes a huge slice of the pie with 30% of Korean Stock Index and between 14% and 20% of South Korea's GDP. This leads to a significant dependency of the South Korean economy on these few very concentrated businesses which are "too big to fail". Therefore, the government has no other choice but to support them.

It has been discussed whether these kind of business are still sustainable in the 21st century. As a matter of fact, the growing malcontent of the population coming from the limitless privileges of Chaebols, might lead in the future to protests and public pressure to change things.

Moreover, Chaebols are trading at a lower P/E when compared to their American, European and Japanese counterparts (a phenomenon called Korea Discount), and one of the possible explanation for this can be found in cross-ownership and cronyism. These two are intrinsic aspects of this unique Korean business structure.

Especially, when it comes to Samsung the cross-ownership structure appeared to have been very proficuous to its chairman Lee Kun-hee by allowing him to control of the company with a relatively small stake.

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The strong tight between government and Chaebols became a quid pro quod relationship, where the former gets financial support during political elections and the latter receives favorable legislation and policies.

The consequences of the bad corporate governance of Samsung In this part, we will focus our analysis on the consequences of such scandals for Samsung. We believe that first, it has consequences on its financial value and second on its structure.

We saw in the previous parts that Samsung achieved to have the full control of the conglomerate with only a small part of the stakes. In other words, we can notice that the power of shareholders due to a lack of separation of power was very low in the company. The scandal of the merger and the link with the government put the light on the corporate governance issue of Samsung.

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As a result, it had consequences on the value of the company's stocks:

In this graph, we can see the significant decrease in value on the Korean Stock Exchange after the announcement of the scandal. This example proves that corporate governance has an impact on the firm's value as it can change the perception of investors on the firm and their confidence about the company's future. However, the scandal had only a relative short impact on the stock price, as the stock price increased again shortly after we believe that in the long-term period, investors also looked at the company performance in the future, which was only partly impacted by the scandal.

Now, the company has to change its governance as the government asks for more transparency. The company announced a series of measures to be implemented in the near future. First, the company recently increased the number of independent directors on its board from nine to 11. This represents a real advance in terms of corporate governance. Samsung Electronics’ Board of Directors is now composed of five Executive Directors and six Independent Directors. Moreover, Samsung also separated the role of chairman from that of the chief executive officer to further empower the board of directors and enhance its independence.

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Source: Samsung website, https://www.samsung.com/global/ir/governance-csr/board-of-directors/

Second, Samsung has to change its policy regarding cross-shareholding. According to the Article of the Korean Times: “The first task facing Samsung is that Samsung SDI, a battery maker, should sell 4.04 million shares of Samsung C&T, which accounts for 2.1 percent of the total, by Aug. 26 as ordered by the FTC. “ This could be considered as the first step toward breaking the cross-shareholding structure.

According to Gompers Ishii, Metrick (2003), who calculated a measure for corporate governance called the GIM Index, stock returns of firms with strong shareholder rights outperform firms with weak shareholder rights: this paper highlights the positive impact of good corporate governance on the firm's value.

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In our case, this would mean that if Samsung is improving its corporate governance structure and is implementing changes, this would have consequences on the stock prices of the conglomerate. Is it the reality that currently faces Samsung?

Indeed, according to the article “Samsung's Stock Has Soared Despite Two Major Crises“ by Forbes, Samsung Electronics' stock rose by roughly 28% and this for several reasons.

This increase in the stock's price cannot be explained only by corporate governance improvements. It is also related to the good performance of Samsung’s semiconductor business over the last few quarters, driven primarily by tight supply-demand conditions in the memory markets. “During Q4, the company’s semiconductor revenues rose by 12.5% to 14.86 trillion won ($12.74 billion), while its operating profits grew by about 77% to a record 4.95 trillion won ($4.24 billion). “ In addition to that, investors seem to be confident about the new devices in Samsung's pipeline, which includes the next generation Galaxy S8 and potentially a new Note handset. However, the improvement in corporate governance may also have a positive impact on the stock's price as well: Samsung announced a series of measures to improve its shareholder returns. For instance, the company proposed to allocate 50% of its free cash flows towards shareholder returns. Moreover, the company also began to review its complex ownership structure, which includes circular and crossshareholdings involving other firms in the Samsung Group.

The measures taken by the Samsung Group have resulted in stronger shareholder rights, which could have a positive impact on the GIM Index of the company. The evolution of the stock's price could be seen as a result of such corporate governance effort.

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Conclusion This analysis explored the most important subjects regarding the recent scandal in Samsung's’ management. The main actor of the scandal inside the company is the Vice-Chairman Lee Jae-Yong, which was accused of bribery. Because he was also the “de facto” chief of the Samsung group, he could use his power to use performs illegal acts. His aim was to further increase his ownership of the Samsung group. We also saw that this type of behavior is not unusual among Samsung’s executives, and may be related to the long tradition of chaebols in South Korea.

Because the chaebols grew with close interaction with the government and were always family-managed, they developed complex shareholder structures and becomes a huge part of the Korean economy. Now that they are “too big to fail”, the relation between the chaebols and the government may affect the entire country economy. The families holding the chaebols wants to keep their management power over the conglomerates, at the expenses of other minor shareholders, and may attempt to corrupt the government to do so.

The overall bad governance of chaebols has effect on their stock prices. It is a cause of the underpricing phenomenon called “Korea Discount”. The stock price is further affected when news such as the Samsung scandal are getting publicly revealed, even though it can be on a short period of time.

The scandal led Samsung to improve its corporate governance by increasing the number of independent directors, as well as reducing the cross-shareholding among the Samsung group entities. Theses improvement have resulted in stronger shareholder rights, and this could partly explain the increase in Samsung’s stock price. This progress in the fair corporate governance of Samsung is not only important for the financial benefit, but also regarding the image of the company. The controversy regarding the management of chaebols keep growing as well as popular anger against them. Improving the transparency and the management of the Chaebols is indeed a key to the future of the Korean economy.

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References Armstrong P. (February 5, 2018) Samsung Scion Lee Jae-yong In Surprise Release From Jail After Appeal. Forbes online. Retrieved from https://www.forbes.com/sites/armstrongpaul/2018/02/05/samsungscion-lee-jae-yong-in-surprise-release-from-jail-after-appeal/#a55a8997c009 at Nov 16, 2018. BBC, (August 25, 2017) Samsung heir Lee Jae-yong jailed for corruption. BBC online News. Retrieved from https://www.bbc.com/news/business-41033568 at Nov 16, 2018. BBC, (February 5, 2018a) Samsung scandal: Who is Lee Jae-yong? BBC online News. Retrieved from https://www.bbc.com/news/business-39191196 at Nov 16, 2018. BBC, (April 6, 2018b) Park Geun-hye: South Korea's ex-leader jailed for 24 years for corruption. Retrieved from https://www.bbc.com/news/world-asia-43666134 at Nov 16, 2018. Berk, J. and DeMarzo, P. (2011). Corporate finance. 3rd ed. Pearson, pp.349 – 355 E. A. (2018, May 4). South Korea's Chaebol Challenge. Retrieved from https://www.cfr.org/backgrounder/south-koreas-chaebol-challenge at Nov 17, 2018. Daleida, C. (August 26, 2017) Samsung could be run from jail, and other details from an astonishing bribery case. Retrieved from https://mashable.com/2017/08/25/samsung-lee-corruptioncase/#qwDBMc31DqqT at Nov 17, 2018. Harris, B. (September 27, 2018) Samsung Electronics chairman indicted for alleged union sabotage. Retrieved from https://www.ft.com/content/7e7fd8c2-c223-11e8-95b1-d36dfef1b89a at Nov 16, 2018. Investopedia, 2018. Retrieved from https://www.investopedia.com/terms/c/cross-holding.asp J. J. (2018, April 02). Samsung: Last puzzle for corporate governance. Retrieved from https://www.koreatimes.co.kr/www/tech/2018/07/133_246621.html at Nov 17, 2018. Kim, H. & Paul, D. B. (2009). The Management Characteristics of Korean Chaebols vs. non-Chaebols: Differences in Leverage and its Ramifications: Myth or Reality? Advances in Management, 2(11): 26-35 Murillo, D. & Sung, Y. (2013). Understanding Korean Capitalism: Chaebols and their Corporate Governance. SADEgeo position paper (33). Barcelona: ESADE. Center for Global Economy and Geopolitics (ESADEgeo). P. P. (2018, October 5). South Korea's Chaebol. Retrieved from https://www.bloomberg.com/quicktake/republic-samsung at Nov 17, 2018. Stout, D. (May 12, 2014) Samsung Chairman in ‘Stable Condition’ After Heart Attack. Time Online. Retrieved from http://time.com/95647/samsung-chairman-lee-kun-hee-stable-condition-heart-attack/ at Nov 16, 2018. Trefis. (March, 2017) Samsung's Stock Has Soared Despite Two Major Crises, Forbes. Retrieved from https://www.forbes.com/sites/greatspeculations/2017/03/14/samsungs-stock-has-soared-despite-twomajor-crises/#ddbb3f9cd090 at Nov 17, 2018.

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