Samsung Electronic Corporation: Governance of Chaebols

Introduction Case
Samsung Electronics Prior to the Asian currency crises, South Korea was an investment destination for several institutional investors and emerging market funds. Throughout the early nineties the country experienced an economic boom.
South Korean conglomerates, locally know as chaebols, had diversified into various industries from cars to microchips. Samsung Electronics Corporation (Samsung Electronics), a rising star in the Samsung Chaebol was considered to be a high growth company. However, in 1997, the Asian currency crises magnified the problem of the Chaebol structure and highlighted the need for governance reforms. By 1999, a shareholder rights activist in South Korea – Prof. Hasung Jang had taken up the cause of minority shareholders of Samsung Electronics.

With the help of foreign institutional investors, he planned to fight for governance reforms in South Korea. As a corporate governance specialist, Samuel Smith, had been contracted by a large foreign institutional investor to help reform Samsung Electronics.
Korean Chaebols
Establishment, growth and structure. In order to accelerate economic growth in the 1970’s, the Korean government formulated industrial policies that encouraged investment in heavy and chemical industry (HCI). Funded largely by government-controlled banks, affluent families took advantage of the liberal policies and set up ompanies in these industries. By the end of the 1970’s approximately 80 percent of fixed investment in the manufacturing sector was in HCI businesses. Between 1962 and 1982, annual growth averaged 8. 4%, although by the end of the 1970’s production efficiency in priority sectors was falling. As a result, there was excessive investment in the HCI industries and little allocation efficiency in the capital markets. Due to over investment in the HCI industry and small domestic markets, companies began diversifying into unrelated businesses, giving birth to the Korean Chaebols.
Government intervention in resource allocation proved to be very costly. Enterprises that had access to preferential policy loans or tax incentives tended to expand their businesses.
Financial Services Liberalization in the WTO
Case Study of South Korea
Samsung Electronics rapidly without careful appraisal of investment projects. Since the government largely made lending decisions, creditor banks had little incentive for credit evaluations or loan monitoring.
As a result, firms were heavily leveraged and borrowed from informal credit markets as they were usually pressed for working capital. This structural weakness put the economy on the verge of a financial crises in early the 1970s and then again in the 1980s
However, public purse bailing out of large enterprises became the norm and people were made to believe that chaebols were too big to fail. When the government decided to open up the South Korean economy, many of the protective measures that local companies had enjoyed during the developmental era were removed.
Companies that had expanded into unrelated businesses found that they no longer had access to government capital. Initially, banks were also not interested in financing these projects, nor did they have the expertise to evaluate these new high-risk businesses. Hence, business groups started creating their own group wide internal capital markets. Transfer pricing, cross-shareholdings and cross-guarantee of debts were some of the mechanisms employed by chaebols to fund expansion. They pooled any funds available to the subsidiaries to supplement outside funding of new projects.
Operations of these internal finance markets were not necessarily based on efficiency in resource allocation but were often driven by the interests and concerns of the controlling families.
Many Chaebols invested overseas and ‘globalization’ was the new theme. However, the globalization strategy was not well planned. Chaebols held onto the management strategy that they had been practicing over the last thirty years: growth in size ignoring profitability; financial structure with high debt-to equity ratio and cross debt guarantee among affiliated companies. By 1997 there were over fifty chaebols in South Korea, each with a myriad of affiliated companies all linked to one another through a complex network of cross-holdings.
Family-Based Business Groups
Samsung Electronics Founded in 1938 by Mr. Byung Chul Lee, Samsung Group’s original line of business was exporting dried fish, vegetables and fruits produced around Korea to Manchuria and Beijing in China. Within a few years of incorporation, the company expanded its operations to include manufacturing and sales when it set up a flourmill and bought confectionary machines. In the 1970’s it diversified into the petrochemical, electronics and heavy industries. By early 1990’s, the Samsung Group had grown into the fourteenth largest company in the world.
It had diversified into four primary industries, and had over twentyfive affiliated companies. Like most Korean companies, the Samsung Group structure developed into a confusing maze of cross-ownership among affiliated companies.
Therefore, Samsung Company owns 4. 45% of Samsung Electronics, Samsung Life Insurance owns 8. 16% and so on. By 1997, combined annual revenues of all the businesses in the group were close to USD 100 billion, with profits reaching USD 290 million. The Samsung Group constituted approximately 10% of the total market value of all companies listed on the Korean stock market. However, like all other chaebols, its debt-to-equity ratio hovered around 365%.
Samsung Electronics Corporation
Governance of Cheabols. Samsung Electronics was established in 1969.
By the mid 1990’s, it had strategically invested in research and development of DRAM chips and had grown into a billion dollar company. By the late 1990’s, Samsung Electronics had 24 production subsidiaries, 35 sales subsidiaries and 20 branch offices around the world including North America, Europe, Southeast Asia, Central Asia, China and Latin America. It managed four strategic businesses in the fields of Home, Mobile, Office Network and Core Components.
However, in 1997, excess production capacity in the microchip industry lead to a downward spiral in chip prices. Profits at Samsung Electronics plunged to new lows. The Asian Currency crises compounded the problems facing the company. By late 1997, the company’s debt totaled 13 trillion won (approximately USD 9 billion) and more than 70 percent of it was in foreign currency loans5. The financial run on the economy by foreign institutional investors saw the country’s currency tumble 10. 6 percent. Domestic interest rates on threeyear corporate bonds hit 30. 1 percent.
The US rating agencies, in addition to downgrading the sovereign debt to “junk bond” status, also lowered the credit worthiness rating for several of the largest South Korean companies including Samsung Electronics6. The company’s share prices reflected the macro and micro economic turmoil faced by the company. However, a liner trend line indicates that, by and large, the share price was declining marginally but was above the 50,000 won mark.
After a period of negative results, minority shareholders started questioning governance practices of the company. They alleged that Samsung Electronics had neither internal or external corporate governance mechanism which acted as checks and balances and that all management decisions were made taken by the Chairman. The internal mechanisms such as Board of Directors and Auditors, did not function properly at least when it came to monitoring the Chairman. For example they questioned the board’s decision of acquiring shares of a firm, Ichon Electric, whose financial stability was shaky.
This acquisition cost Samsung Electronics 27. 6 billion won when the company went bankrupt a few years later. 7 When things starting going wrong, neither the Chairman nor the Board of Directors took any responsibility for failed investments or even for illegal activities. Instead the chaebol lobby issued a report attacking minority activism. They said, “Minority shareholders’ rights to demand compensation should be respected only in the event of embezzlement and other illIR on the net: How they did it at Samsung Electronics. http://www. ironthenet. com/feature. sp? current=1&articleID=2289 Washington Post Foreign Service: South Korea Takes Three More Punches by Steven Mufson. Korean IT News: Civic Group Challenges Samsung Chairman’s Alleged Mismanagement by Kim Deok-hyun. 5 intentioned behaviors. Managerial misjudgments should not be the subject of criminal liabilities. Activism can also harm the interests of majority shareholder and decision-making by management. ” In 1998, the Board of Directors of Samsung Electronics consisted of twenty-three members
This number had been trimmed from the previous year when the board comprised of fortythree directors. Some shareholders believed that accounting manipulation and improprieties had become standard practice and company funds had been used to make political contributions in the Chairman’s name. A minister in the Korean cabinet faced corruption allegation that he earned USD 1. 4 million when he was given an interest-free loan from Samsung Electronics and acquired the Company’s shares at a discount rate while he was an ‘outside’ director on the company board. External mechanism such as markets for corporate control also did not exist and legal protection of shareholder’s rights was limited.
Courts in Korea did not have experience of dealing with corporate governance cases and often their rulings seemed to go soft on the guilty. For example, the Suwon District Court ordered Samsung’s Chairman Lee to return to the Samsung companies 7. 5 billion won in damages on charges of providing bribes to former president Roh Tae-woo. However, the court did not demand that Lee take legal responsibility for the two mismanagement cases of his group’s ubsidiaries, saying he did not participate in the decision-making.
Samuel Smith wondered if the allegations of the minority shareholders held any merit. Internal and external economic forces had not changed much in the last decade, yet it was only after the Asian currency crisis that these allegations were being made. The Korean Herald: Chaebol face tough attacks from minor shareholders by Yoo Cheong-mo: February 25,1999. AFX News Limited: South Korean education minister resigns amid corruption allegations; August 31, 2000.
Corporate Governance and Economic Development
The Korean Experience by Hasung Jang. 1 Korean IT News: Civic Group Challenges Samsung Chairman’s Alleged Mismanagement by Kim Deokhyun. HASUNG JANG: The voice of minority shareholders. Dr. Hasung Jang is a well know minority shareholder rights activist in South Korea. He received his MA in economics from the New York State University and a Ph. D. in finance from the Wharton School. On returning to South Korea, he joined the Korean University as a professor of finance and the director of the Center for Finance and Banking Research.
As the Chair of the Participatory Economy Committee, a minority shareholder protection civil group, under the umbrella of the Peoples Solidarity for Participatory Democracy, Dr. Jang took up the cause of shareholder rights in Korea. He undertook investigations to evaluate the governance of chaebols and financial dealings among affiliated companies. Dr. Jang targeted Samsung Electronics and made allegations of self-dealing transactions. In particular he spoke about a transaction dated 24 March 1997, when Samsung Electronics made a private placement of unsecured convertible bonds worth 60 billion won (US $46. million). He was troubled by the fact that the bonds had been sold to company insiders. The Chairman’s son had purchased 45 billion won worth of bonds and another Samsung affiliate had purchased the remaining bonds worth 15 billion won12. Dr. Jang alleged that this issue was at unfavorable terms for the company and called into question the price of the bonds. On their part, company executives explained that Samsung Electronics was badly in need of fund and that international funding, which previously was the main source of capital had dried up after the Asian currency crises.
Further, as the company was finding it extremely difficult to raise money from domestic financial institutions they had little choice but to privately place the bonds. Besides the amount raised was less than one percent of existing long term loans. Dr. Jang also alleged that Samsung Electronics had both directly and indirectly funded the Samsung Groups’ doomed venture into the car industry at the expense of minority shareholders. Samsung Electronics had acquired a 21. 1% stake in Samsung Motors at the acquisition cost of 170 billion won (USD 106 million).
The indirect investment of Samsung Electronics into Samsung Motors was in the form of a joint investment agreement.
Nascent Stages of Corporate Governance in an Emerging Market
Regulatory change, shareholder activism and Samsung Electronics by Hasung Jang and Joongi Kim. Corporate Governance Volume 10 Number 2 April 2002. an Ireland-based paper company called Pan-Pacific Industrial Investments (PP) and Samsung Electronics (and two of its affiliated companies). At first lance the PP agreement looked like a direct investment into Samsung Motors by a foreign entity (PP) in accordance with Korean laws regulating foreign exchange. However, under the terms of the joint venture agreement, Samsung Electronics had guaranteed PP a certain rate of return through put and call options within a specified redemption period, on Samsung Motor shares it (PP) owned. This arrangement was made in addition to bridge loans made by Samsung Group to PP. Dr. Jang alleged that that this transaction was not a clear direct investment and in fact violated legal requirements for other types of transactions.
Samsung Electronics rebutted the allegations and explained that the put and call options were just clauses in the agreement put there to provide additional security for PP. The Company was more like a third party in the transaction and the agreement did not have any financial implications for the shareholders.
Samuel Smiths Task
1997 had been a troubled period for Korean companies. The country had experienced a severe economic shock, which had practically destroyed the economic structure that had developed over the past four decades.
It was confusing and upsetting times for companies and investors, all of whom has suffered tremendous loss. Sam had to objectively analyze the allegations made by the minority shareholders and check for fundamental problems at the company. Naturally, dealing with an emerging market came with its challenges. For one, economic data was scarce and very little corporate information was publicly available. As Sam sat down to prepare for his meeting with his client he made a list of questions he needed to answer.

What are the benefits and disadvantages of the Korean chaebol structure? In particular what governance issues can arise due to this structure?
Analyze the capital structure of Samsung Electronics. Compare it with the capital structure of a company in the similar line of business (primarily manufacture of chips) from another developed country and comment on the differences.
If Samsung Motors makes an after tax profit of USD100 million, what share of that would go to the Lee family (owners)? What percentage of Samsung Motors do they directly own? Note: You do not have to provide the exact number. A good approximation will be adequate. )
The client wants to recommend governance changes with special emphasis on the board of directors. Evaluate the current board of Samsung Electronics. What are the strengths and weaknesses in the current board composition? How many directors can be classified as non-executive? How many can be classified as independent? What are your criteria’s for assessing director independence? Do you think changes need to be made to the current board composition? If no – why not, if yes – what changes would you recommend?
Based on the company’s financials as of December 31, 1997 and publicly available information, investigate the allegations made by Dr. Jang. Do you think the convertible bond issue was a self-dealing transaction? How would you prove that claim? What evidence do you have on you claim? (Note: you are not expected to do a DCF. )
Does the agreement with the Pan-Pacific Industrial Investment resemble a simple direct investment or something else? Why was the guarantee clause included in the contract? Does it change the instrument? If you were on the Audit committee of the company what questions would you ask about this transaction?

Machinery & Heavy Industries
This table shows the most important affiliate companies within the Samsung Group for the period of interest.
Name of Firms

Samsung Electronics
Samsung Display Devices
Samsung Co.
Samsung Motors
Samsung Heavy Industries
Samsung Electro-mechanics
Samsung Life Insurance
Samsung Aerospace Industries Cheil Wool Textile
Samsung General Chemicals
Samsung Precision Chemicals
Samsung Corning Hotel Shilla
Samsung Securites
Samsung Engineering
Samsung Winners Card SI Corporation
Samsung Everland
Samsung Factoring Financing
The Joong-Ang Daily News Samsung
Petro-Chemicals Samsung Commercial
Motors Samsung