South Korean Chaebols

1. South Korean Chaebols National hero as well as public enemy

2. 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.

3. The Dominance of Chaebols • Top 30 Chaebolsproduce 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.

4. 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% respectively on average for 10 largest chaebols. • Convoluted cascades or Stock pyramiding without Dual-class shares.

5. 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.

6. Convoluted Cascades 2 - Circular 49 49 Owner 51 51-a A B a 51 ☎ Owner C ≥49 + a 49

7. Formational Background • Chaebols are exactly the outcome of Korean development policies. • Firm-Specific Subsidies under Sovereign Debt Guarantee and Credit Rationing • Performance-based selection of companies to subsidize.

8. Firm-Specific Subsidies • Scarcity of entrepreneurial capabilities invited the development policy of firm-specific subsidies. • Government selected out a few number of promising entrepreneurs and subsidized them intensively. ※Inviting MNCs.

9. Firm-Specific Subsidies 2 • Foreign-loan-based development strategy adopted sovereign guarantee for commercial 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.

10. Why Sovereign Guarantee? • Financial market was not able then to successfully select out promising entrepreneurs and business projects. • Sovereign debt guarantee was an effective signal to international lenders. • Later commercial banks induced bank loans directly to allocate the fund to selected companies.

11. Selection Procedures • Selection was made after careful examination of business plans at first. • Number of projects to develop far exceeded that of capable entrepreneurs. • Subsequent selection reflected fully the previous performances. Performance-based selection. • Government preferred old faces with good performance records to new faces.

12. 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.

13. Periodic Industry Restructuring • No matter how carefully the selections had been made, failures always occurred. • South Korean government led the entrepreneurs with good performance record, with additional subsidies, to take over troubled projects, whenever they were found.

14. 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 enterprises as possible with limited personal funds.

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

16. Economic Concentration • Top 30’s VA amounts to 10% of annual GDP. • Their total profit assumes at most 2% (=10X0.2) of GDP. • Top 30 owners’ share: below 0.1% (2%X0.05) of GDP.

17. 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.

18. Delimiting Expansion • Impose restriction on the total amount of investment of Chaebol enterprise in acquisition of other enterprises. * Green field investment is excluded. * Unfair handicap on domestic firms in M&A market. • Implementation of this policy had been on and off.

19. Chaebols’ Internal Trading • Discriminatory Trading of Intermediate Inputs • Discriminatory Trading of Financial Assets • Mutual Assistance, Antitrust Issue. • Tunneling and Evading Inheritance Tax

20. Internal Trading of x U OU s p pp D OD

21. Intermediate Input Trading 1 • D and U are two member companies of a Chaebolgroup. • 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)

22. 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.

23. Intermediate Input Trading 3 • The internal price s is simply redistributing 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 attains the highest dividend! • It is x, not s, which matters competition, and joint profit maximization is by no means anti-competitive.

24. Internal Trading U 100 u = 5% 0 D 0 d = 20% 100

25. Asset Trading • U provides fund, D makes investment. • 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)

26. Anti-Competitive? Chaebol Non-Chaebol U Discriminatory Internal Trading D N Illegitimate Funding v. Market Competition Competition v. Competitors

27. Penalizing the Victim • Korean competition law views unfair internal trading as an undue extension 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 sufferers.

28. Issues of Sub-Contracting • Sub-contracting is a mode of contracting with some structural hierarchy. • Small and Medium-Sized suppliers of parts and components are formally independent, but are subject to tight control of the (Chaebol group) buyers. • Out-sourcing for cheap wages.

29. Chaebols Stifle New Ventures • 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.

30. Uncontrolled Reckless Decision-Making • The owner’s Emperor-like management had driven reckless expansion for many Chaebolsuntil 1997 economic crisis. • There was no inherent mechanism in Chaebolsystem which effectively controls the behavior of owner, who holds 5% cash-flow right but exercises 40% voting right on average.

31. Corporate Governance Issue • How to control the owner from Tunneling and Uncontrolled Reckless Decision-Making? • Insiders System? – The Owner selects Directors and Auditors. • Outsiders System? – No Hostile Take-Over may intimidate 40% Voting Right.

32. Governance 2 • All the controversies about Chaebolboils down to transparency and corporate governance issue. • General stockholders, who owns 95% of cash-flow rights, must be able to expand their voting right to an equivalent level.

33. Justice Issue • Chaebols are an outcome of intensive state subsidies. • People provided the subsidies, suffering from long labor and low wages. • “Chaebols earning must be redistributed to the people.”

34. Justice 2 • State subsidies had been awarded for the sake of establishing enterprises that would be globally competitive and provide people with many solid jobs. • “As Chaebols had successfully fulfilled the original sake while many others failed to do so, the share of Chaebol owners is legitimate and just.”

35. Inheritance of Owner Status • Stock pyramiding ownership structure is a very effective means for an owner with limited amount of personal fund to control 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.

36. 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%?

37. 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 Chaebolownership system disappears. • After certain level of Development, Solid Governance Scheme will be necessary.