South Korean Chaebols

National hero as well as public enemy

Structure of Corporate Sector in South Korea

• Business groups (Chaebols) : A group consists of 20+- large enterprises controlled by a single agent, the owner.

• Independent large enterprises • SME sector : Numerous small and

medium sized enterprises.※ Public enterprises.

The Dominance of Chaebols

• Top 30 Chaebols produce directly 10% of annual GDP in terms of value added since 2000.

• They control innumerably many SMEs in the form of subcontracting.

• Corporate sector of the South Korean economy is dominated by chaebols.

Ownership Structure

• Controlling Minority Structure : For each firm in the group, the owner’s cash flow right is 5%, while her/his voting right is 40% on average.

• Recent data revealed owner’s cash flow and voting right as 1% and 60% respec-tively on average for 10 largest chae-bols.

• Convoluted cascades or Stock pyramid-ing without Dual-class shares.

Convoluted Cascades 1- One Way

• Stock Pyramiding 49 49 49

Owner 51 51 51 A B C Cash flow right : 51, 26.0, 13.3.

51/198.

Convoluted Cascades 2 - Circular

49 49Owner 51 51-a A B

a 51☎ Owner C ≥49 + a 49

Formational Background

• Chaebols are exactly the outcome of Korean development policies.

• Firm-Specific Subsidies under Sover-eign Debt Guarantee and Credit Ra-tioning

• Performance-based selection of com-panies to subsidize.

Firm-Specific Subsidies

• Scarcity of entrepreneurial capabili-ties invited the development policy of firm-specific subsidies.

• Government selected out a few number of promising entrepreneurs and subsidized them intensively.

※Inviting MNCs.

Firm-Specific Subsidies 2

• Foreign-loan-based development strategy adopted sovereign guarantee for commer-cial loans.

• This practice continued until the mid-1980s. (Domestic saving exceeded investment in 1986 for the first time in Korean history.)

• Sovereign guarantee was virtually business license in modern manufacturing.

• All the Industry-Specific Subsidies became virtually firm-specific.

Why Sovereign Guarantee?

• Financial market was not able then to successfully select out promising en-trepreneurs and business projects.

• Sovereign debt guarantee was an ef-fective signal to international lenders.

• Later commercial banks induced bank loans directly to allocate the fund to selected companies.

Selection Procedures

• Selection was made after careful ex-amination of business plans at first.

• Number of projects to develop far exceeded that of capable en-trepreneurs.

• Subsequent selection reflected fully the previous performances. Perfor-mance-based selection.

• Government preferred old faces with good performance records to new faces.

Controversial Issues

• Continued favor only to a fixed few raised the issue of equity.

• Japanese MITI also selected strategic auto producers to subsidize, but the successful ones such as Toyota and Honda were those not selected!

• Possibility of corruption from rent-seeking.

Periodic Industry Restructur-ing

• No matter how carefully the selec-tions had been made, failures always occurred.

• South Korean government led the en-trepreneurs with good performance record, with additional subsidies, to take over troubled projects, when-ever they were found.

Restructuring 2

• In a word, government encouraged entrepreneurs, proven to be capable, to undertake as many business projects as they can.

• Cascade ownership structure enabled owners to control as many enter-prises as possible with limited per-sonal funds.

Problems

• Economic concentration?• Reckless expansion? • Anti-Competitive behaviors? - monopoly, oligopoly or collusions? - abusing dominant market power!• Corporate governance (“Emperor-like

owner”)!

Economic Concentration

• Top 30’s VA amounts to 10% of an-nual GDP.

• Their total profit assumes at most 2% (=10X0.2) of GDP.

• Top 30 owners’ share: below 0.1% (2%X0.05) of GDP.

Reckless Expansion

• Economies of Scale and Scope. ※GE : Samsung = 5 : 1 as of 2008

• Scale and diversification is the very source of competitive advantage of modern enterprises.

Delimiting Expansion

• Impose restriction on the total amount of investment of Chaebol en-terprise in acquisition of other enter-prises.

* Green field investment is ex-cluded. * Unfair handicap on domestic firms in M&A market.• Implementation of this policy had

been on and off.

Chaebols’ Internal Trading

• Discriminatory Trading of Intermedi-ate Inputs

• Discriminatory Trading of Financial Assets

• Mutual Assistance, Antitrust Issue.• Tunneling and Evading Inheritance

Tax

Internal Trading of x

U OU s p p p

D OD

Intermediate Input Trading 1

• D and U are two member companies of a Chaebol group.

• D buys an intermediate input x from U at price s.

• D(x,s) = R(x) – sx, U(x,s) = sx – C(x)• The joint profit U(x,s) + D(x,s) = R(x)

- C(x) is free of s.• The owner’s share is O(x,s) =u U(x,s) + d D(x,s)

Intermediate Input Trading 2

• Choose (x,s) to maximize O(x,s) =u U(x,s) + d D(x,s)= d[U(x,s) + D(x,s)]+ (u-d)[sx – C(x)] If u < d holds, then lower s until you

get sx = C(x) or U(x,s) = 0. • O(x,s) =u U(x,s) + d D(x,s) = u[U(x,s) + D(x,s)]+ (d-u)[R(x) – sx]If u>d holds, then set s to have D(s,x)

= 0.

Intermediate Input Trading 3

• The internal price s is simply redis-tributing profit between U and D.

• The owner maximizes the joint profit R(x) – C(x) first, then tunnels profit to the member company where he at-tains the highest dividend!

• It is x, not s, which matters competi-tion, and joint profit maximization is by no means anti-competitive.

U 100 u = 5% 0

D 0 d = 20% 100

Internal Trading

Asset Trading

• U provides fund, D makes invest-ment.

• Asset Trading at price lower than normal: U donates its corporate funds to D.

• Lending : no donation.

• u > d Lending u < d Donating trade (tunneling)

Anti-Competitive?

Chaebol Non-Chaebol

U Discriminatory Internal Trading D NIllegitimate Funding v. Market Competi-

tionCompetition v. Competitors

Penalizing the Victim

• Korean competition law views unfair internal trading as an undue exten-sion of aid to member companies, and blames it to be anti-competitive.

• Competition authority imposes fine to the company who extended the aid.

• But the general stockholders of the penalized company are the only suf-ferers.

Issues of Sub-Contracting

• Sub-contracting is a mode of con-tracting with some structural hierar-chy.

• Small and Medium-Sized suppliers of parts and components are formally independent, but are subject to tight control of the (Chaebol group) buy-ers.

• Out-sourcing for cheap wages.

Chaebols Stifle New Ven-tures

• Seek for promising ventures• Propose to take-over• If the venture refuses, then scout a

core member familiar with the core competence of the venture.

• The original venture is squeezed out of business.

Uncontrolled Reckless Decision-Making

• The owner’s Emperor-like manage-ment had driven reckless expansion for many Chaebols until 1997 eco-nomic crisis.

• There was no inherent mechanism in Chaebol system which effectively controls the behavior of owner, who holds 5% cash-flow right but exer-cises 40% voting right on average.

Corporate Governance Issue

• How to control the owner from Tun-neling and Uncontrolled Reckless De-cision-Making?

• Insiders System? – The Owner selects Directors and Auditors.

• Outsiders System? – No Hostile Take-Over may intimidate 40% Voting Right.

Governance 2

• All the controversies about Chaebol boils down to transparency and cor-porate governance issue.

• General stockholders, who owns 95% of cash-flow rights, must be able to expand their voting right to an equivalent level.

Justice Issue

• Chaebols are an outcome of inten-sive state subsidies.

• People provided the subsidies, suffer-ing from long labor and low wages.

• “Chaebols earning must be redis-tributed to the people.”

Justice 2

• State subsidies had been awarded for the sake of establishing enter-prises that would be globally compet-itive and provide people with many solid jobs.

• “As Chaebols had successfully ful-filled the original sake while many others failed to do so, the share of Chaebol owners is legitimate and just.”

Inheritance of Owner Status

• Stock pyramiding ownership structure is a very effective means for an owner with limited amount of personal fund to con-trol a maximum number of companies.

• The founding owners had been selected carefully, monitored by performances, and awarded with their position of owner by government policy in face of shortage of entrepreneurial talent.

Inheritance 2

• Now Korean economy no longer suffers from the shortage of entrepreneurial talent.

• The second generation owners had never gone through the tough process of performance based selection, as their fathers had done.

• Cash-flow right 5% is certainly their due share, but how about voting right 40%?

Conclusion

• Incipient Stage of Industrialization : The Owners are devoted to build their personal Industrial Empires, No Tunneling actually occurred.

• As the economy grows up, the need of Chaebol ownership system disap-pears.

• After certain level of Development, Solid Governance Scheme will be necessary.