February 17, 2017 5:00 pm JST

Samsung leader's arrest imperils company and country

Conglomerate in crisis with Lee Jae-yong out of the picture

KIM JAEWON, Nikkei staff writer

Lee Jae-yong, center, vice chairman of Samsung Electronics, leaves after attending a hearing at the Seoul Central District Court in Seoul, South Korea, on Feb. 16. (Yonhap via AP)

SEOUL -- Samsung Electronics' Vice Chairman Lee Jae-yong was arrested on suspicion of bribery on Friday, after further probes by prosecutors. The arrest of the man leading South Korea's largest conglomerate pushes the company to the precipice. Management will need to be restructured immediately because Samsung's role in the South Korean economy is colossal. 

Son Young-ho, 44, vividly remembers when he first joined Samsung Card two decades ago. "I was so proud to be starting my career at Samsung, with its office in the center of downtown Seoul. I felt like my future was guaranteed."

Like Son, hundreds of thousands of college students every year dream of donning the official pin bearing Samsung's iconic blue logo, but only a few are able to join the top company in South Korea. Those who do make the cut are viewed as prime catches by matchmaking agencies, on the same level as doctors and lawyers.

Samsung is so large that its total assets account for one-fifth of South Korea's gross domestic product and the group accounts for more than 30% of total market capitalization in the country. People often speak of "the Republic of Samsung," a reference to the influence the company wields in Asia's fourth-largest economy.

All this does not mean, however, that Samsung always has the respect of the people. Repeated tax-dodging scandals and suspicions of bribery have made the company a regular target of anti-corporate sentiment. For more than a year, former employees and their family members have been staging sit-in rallies in front of Samsung's office in Gangnam demanding an apology and compensation for workers at its semiconductor factory who have been diagnosed with leukemia.

Perhaps the final straw came on Friday morning when the Seoul Central District Court approved the arrest warrant for Lee, which special prosecutors had sought. The 48-year-old heir is suspected of paying 43 billion won ($37.3 million) to two foundations controlled by Choi Soon-sil, a longtime friend of President Park Geun-hye, in return for political favors.

In January, the court denied prosecutors' initial request for an arrest warrant due to lack of evidence. But investigation into Lee and his connections with President Park continued, and on Feb. 3, prosecutors raided the country's financial regulator and anti-trust agency, seizing documents related to Lee. Investigators have reportedly collected testimonies that Park, in return for Samsung's bribes, pressured the National Pension Service to vote in favor of a merger of Samsung C&T and Cheil Industries in 2015, a controversial move that strengthened Lee's control of the group immensely.

The merger raised Lee's stake in C&T to 16.5%, thanks to his 23.2% stake in Cheil. C&T is a key company in the group's ownership structure, as it holds 4.2% in Samsung Electronics, the crown jewel of the conglomerate.

Kim Sang-bong, a philosophy professor at Chonnam National University in Gwangju, compared Samsung's Lee family to North Korea's ruling Kim family.

"Samsung is above the law and the country. It is similar to North Korea, where the 'great leader' is above the Workers' Party," said Kim, who urged a boycott of Samsung products in 2010. "Samsung's Lee family has uncontrolled power, which does not make sense in a democratic society. The political power is serving the interests of Lee Jae-yong's family."

Since his release from detention on Jan. 19, Lee has been taking actions to fulfill the promises he made during a parliamentary hearing in which he was questioned over the scandal. One of the most symbolic moves came on Feb. 6, when Samsung Electronics withdrew its membership from the Federation of Korean Industries, the lobby group for major companies. FKI played a key role in funneling funds from large corporations to two foundations controlled by Choi, the president's confidante.

Another change is internal. Samsung plans to close its Future Strategy Office, an organization said to be directly involved in the corruption scandal. Local media have reported that Lee may soon donate his private wealth to the society, with the amount reported to be at least $1 billion, though Samsung denies this.

These moves, however, did not guarantee Lee's escape from further investigation, and another arrest warrant eventually came on Friday.

Under pressure

Shareholders are also pressuring Samsung to get to the bottom of the scandal. In December, Netherlands-based APG Asset Management sent a letter to Samsung Electronics seeking an explanation of allegations that the company had made contributions to foundations linked to Choi. APG is believed to hold a 0.8% stake in the electronics titan.

U.S. activist hedge fund Elliott Management, which holds a roughly 0.62% stake in the company, has been asking it to pay more dividends and to diversify its boardroom. Elliott opposed the merger of C&T and Cheil, arguing that it was designed to benefit Cheil shareholders at the expense of those of C&T.

Politicians are also urging the company to embrace more transparent corporate governance, accusing the Lee family -- which controls the whole conglomerate despite holding a proportionately tiny stake in its companies -- of not taking responsibility for any of Samsung's setbacks and failures.

Moon Jae-in, of the opposition Minjoo Party of Korea, is seen as the likely frontrunner in the country's upcoming presidential election. He has vowed to bring Samsung to heel if he wins, saying the company should apologize for its misdeeds.

The lawyer-turned-politician has also raised the problem of corporate governance at Samsung, criticizing the circular shareholding scheme that gives the Lee family such disproportionate control. The family holds a 39.1% stake in Samsung C&T, which in turn owns a 19.3% stake in Samsung Life Insurance and a 4.2% stake in Samsung Electronics. Samsung Life controls the group's financial affiliates, while other subsidiaries are under the umbrella of Samsung Electronics.

Stopgap staff

For market watchers, a big question is who will replace Lee, Samsung's heir apparent, as he is no longer in the picture.

Analysts say Samsung Electronics' three key executives -- Vice Chairman Kwon Oh-hyun, President Yoon Boo-keun and President Shin Jong-kyun -- are strong candidates for the job. All of them are on the company's board of directors.

"Even if Lee Jae-yong is arrested, the company could be operated by the three executives who have led the company with no problems," said Park Ju-gun, president of CEO Score, a corporate information provider, before Friday's arrest.

Kwon, 64, has headed the company's device solutions business, which includes semiconductors, since 2011, while Yoon, also 64, has been in charge of the consumer electronics division for the last five years. Shin, 61, took the helm of the IT and mobile communications division in 2012.

Kwon has worked for the company more than three decades, having obtained a Ph.D. in electrical engineering from Stanford University. Yoon based his career on improving TVs and other consumer electronics over the nearly 40 years he has been with the company. He studied telecommunications engineering at Hanyang University in Seoul.

Shin, an expert in mobile telecommunications, was a driving force behind the company's success in the smartphone business for the last few years, though his reputation was tainted by last year's Galaxy Note 7 debacle.

"But because they are professional executives, they may not push for investing large amount of money in mergers and acquisitions, like the company did with Harman," said Park of CEO Score.

In November, Samsung Electronics agreed to acquire Harman International Industries of the U.S. for $8 billion. The largest M&A deal in South Korean history made clear Samsung's ambition to become the world's top player in the market for connected car solutions.

The missing leader

There is another key person whose absence could affect the company: Chairman Lee Kun-hee, who transformed Samsung into a global player in electronics. The 75-year-old has been hospitalized for almost three years since suffering a heart attack in May 2014.

Even though his son took over most roles, analysts say his death would likely raise inheritance tax issues for Lee Jae-yong and his siblings. The chairman's stocks, including his 3.58% stake in Samsung Electronics, are worth more than 15 trillion won. The country levies a 50% tax on inheritance exceeding 3 billion won, a potentially serious hurdle for the younger Lee and his plans of succession.

Some also suggest that the elder Lee's death would lead to a power struggle between the executives he had appointed and his son. "Lee Jae-yong may dismiss executives appointed by Lee Kun-hee to consolidate his power within the group," said Kim Sang-jo, an economics professor at Hansung University in Seoul who has led minority shareholders' activities against South Korean chaebol conglomerates for 20 years.

The death of Lee Kun-hee will also mark the end of Samsung's second generation of leadership. Under his watch, the company grew sharply, but many workers' rights were sacrificed.

Time to act

Many feel the time is ripe for Samsung and other chaebol to reform their corporate governance practices. Kim of Hansung University said parliament should revise the Commercial Act and introduce measures to strengthen shareholder rights, such as allowing them to vote online during shareholders meetings. He also said the National Pension Service should exercise its voting rights more aggressively to prevent chaebol from putting profits before the interests of shareholders.

Samsung is already making some moves to better protect shareholders. Responding to criticism that all nine of its board members are Korean, the company announced in November that it will add at least one independent board director with international corporate experience. Samsung also said it is reviewing the pros and cons of a holding company structure, a process that could take at least six months.

Core concerns

Despite the scandal, Samsung Electronics' earnings have remained upbeat thanks to its flourishing semiconductor business. Samsung's operating profit surged 50.2% on the year to 9.22 trillion won in the fourth quarter of 2016. This marked a rapid recovery from poor third-quarter results stemming from the discontinuation of the fire-prone Galaxy Note 7 smartphone in October. Fourth-quarter sales, however, at 53.3 trillion won, were virtually flat compared with the previous year.

Full-year sales for 2016 reached 201.9 trillion won, up 1% from a year before, while net profit attributable to shareholders jumped 19.9% to 22.4 trillion won. The company announced dividend payments of 27,500 won per share in 2016, with total payments coming to 3.85 trillion won, up 24.2% from a year ago.

Analysts say Samsung may continue to enjoy remarkable earnings this year thanks to strong demand for memory chips. "From the second quarter, the company is expected to post 10 trillion won of quarterly operating profit, driven by strong price trend of memory chips," said Choi Do-yeon, an analyst at Kyobo Securities.

But Samsung Electronics' stock price has been losing steam since Jan. 26, when it hit a record high of 2,000,000 won. It has dropped over 5% since then and closed the week on Friday at 1,893,000 won, while the larger KOSPI index remained virtually flat during the same period.

Another challenge for the company is the smartphone market. Samsung dropped to second place worldwide behind Apple in the fourth quarter of last year, with shipments declining 5.2% to 77.5 million units from a year ago, according to IDC. Apple shipped a record 78.3 million units during the same period thanks to the success of its new iPhone 7 and 7 Plus.

With the bribery investigation still hanging over the Samsung empire, analysts say the issuance of an arrest warrant for Lee would be a critical moment for the group.

"The arrest has no immediate impact on the credit rating of Samsung Electronics," said Shelley Jang, director of Asia-Pacific Corporates at Fitch Ratings on Friday. She points to the company's solid fundamentals and the strength of its businesses, along with its "market dominance and technology leadership."

However, she adds that the arrest "could negatively impact investors' sentiment in the short term." Even though a team of professional managers could run its daily operations, "its long-term strategic investment decisions like major M&A or overseas expansion plans could be delayed."

As the acquisition of Harman shows, Samsung is keen to secure new growth engines. In addition to smart cars, it is also looking into such areas as biopharmaceuticals and artificial intelligence technology. Such moves require strong leadership and bold decision-making, making Lee Jae-yong's arrest all the more devastating for the company.

Asia300

Samsung Electronics Co., Ltd.

South Korea

Market(Ticker): KRX(005930)
Sector:
Industry:
Electronic Technology
Telecommunications Equipment
Market cap(USD): 302,126.98M
Shares: 149.31M
Asia300

Samsung C&T Corp.

South Korea

Market(Ticker): KRX(028260)
Sector:
Industry:
Industrial Services
Engineering & Construction
Market cap(USD): 21,886.35M
Shares: 189.69M
Asia300

Samsung Life Insurance Co., Ltd.

South Korea

Market(Ticker): KRX(032830)
Sector:
Industry:
Finance
Life/Health Insurance
Market cap(USD): 19,929.19M
Shares: 200M

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