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The Samsung Digital City complex, in the South Korean city of Suwon, is home to the headquarters of Samsung Electronics. (Photo by Koji Uema)

South Korea's chaebol edge closer to democracy

The cozy ties with the government are on the wrong side of history

| South Korea

The investigation over the "Choi-gate" scandal has exposed deep flaws in South Korea's business culture that had been quietly accepted for decades. Cozy dealings between politicians and big business have long been embraced as necessary for driving economic growth, but the public is fed up, as demonstrated by the millions of protesters who flooded the streets of Seoul to demand President Park Geun-hye's resignation.

Even before the scandal -- which involves allegations of unsavory links between the president, her confidante Choi Soon-sil and major conglomerates -- South Koreans were showing a growing dissatisfaction over the widening income gap and what they see as an insufficient contribution to the broader economy by the powerful chaebol conglomerates. In a departure from the traditional thinking of the past, the working class no longer sees the success of the chaebol as synonymous with national prosperity.

Globalization and free trade have seen the chaebol increasingly invest in overseas production at the expense of domestic workers. The public feels that these groups have benefited from decades of government support in the form of subsidies, policy lending and tax breaks to achieve their competitive edge.

What the big companies have been paying back to the nation, however, has been seen as flowing primarily to the elite, or in the latest case, a few individuals who happened to have personal relationships with the president.

Tangled web

One unspoken government practice has been to craft financial regulations that allow the chaebol to hold minority stakes in their groups and yet be able to manage them as if they had majority ownership. This is supported in part by a labyrinthine network of cross-shareholdings that allow chaebol group companies to keep activist investors at bay.

To eradicate this inequality, the South Korean government has promoted the unwinding of cross-shareholding structures since 2001. This push has seen most of the groups convert to holding company structures. However, some of the largest players, such as Samsung, Hyundai and Lotte, still have cross-shareholding structures.

The push to make conglomerates shift to a holding company framework was kicked off by a left-wing government 15 years ago to rein in the rising power of the chaebol and put an end to the confusing and deceptive circular holdings the groups had been using to their advantage.

The idea was to enhance corporate governance and accounting transparency. Since calling on companies to make the shift, the government has postponed the deadline for conversion five times already; the right-wing ruling party granted the latest extension, for an additional three years, at the end of 2015.

However, the subsequent surprise general election win by left-wing parties last April means this may be the final delay. Among the parties, the Minjoo Party of Korea in particular has been campaigning aggressively for the need to clamp down on the excessive power of the chaebol. Should the opposition win this year's presidential election, the chaebol will likely be targeted by negative legislation in the form of punitive taxation on cross-shareholdings or even a forced breakup of groups that have yet to adopt a holding company structure.

But in the search for greater corporate transparency, adopting a holding company structure is just the start. The system through which the chaebol families have reaped unfair benefits also includes collusion among board members and the involvement of allied companies as supportive shareholders.

With the left-wing opposition coalition gaining more legislative power, reforms designed to break the collusive relationship between chaebol and the government will make progress. This may come as a surprise to investors who thought that an election loss by the ruling party would represent a huge setback for pro-business advocates.

"Economic democratization"

The Minjoo Party proposed 23 bills during the legislature's regular session, which ended in January. Of those, eight were related to "economic democratization," a buzzword for reining in the growing power of large corporations.

One bill that could have impacted the chaebol was an amendment to the Commercial Act. It would have opened the way for directors to be appointed independent of management involvement, including to board audit committees, and limited the voting rights of major shareholders to 3% when appointing audit committee members.

Many investors are nervous about how the legislation could impact Samsung Electronics, which has been proactive about raising dividends and buying back and canceling shares, among other shareholder-friendly measures. The resistance to shifting to a holding company structure is not about a lack of desire as the shift would actually formalize the family's control of the group affiliates.

Current law, however, requires holding companies to hold minimum stakes of 20% in their subsidiaries; simple math makes that nearly impossible for the Samsung group. Its presumed mothership company, Samsung C&T, has a market capitalization of about $21 billion, making it too small to take a 20% stake in Samsung Electronics, which is capitalized at about $260 billion. Recent announcements by the electronics company indicate it is desperate to appease the public and its shareholders. The Samsung group can set an important benchmark for other South Korean companies by leading the way in setting higher standards of corporate governance for all of South Korea Inc. It has pledged to appoint genuinely independent directors to its board and relinquished its membership in the business lobby group, the Federation of Korean Industries.

The traditional South Korean practice in which the chaebol families hold relatively minor stakes but manage their groups as if they are majority owners has been possible only with implicit government backing. The rising threat of new regulations and a public fed up with the status quo will force Samsung and its ilk to take more action to appease shareholders -- just like most any other publicly listed company around the world.

Pension reform

In addition to the punitive legislation likely to come from the opposition, another catalyst for change may come in the form of possible reform at the National Pension Service. The world's third-largest pension fund has come under scrutiny for supporting the merger of Samsung group units Samsung C&T -- in which the NPS is a key shareholder -- and Cheil Industries. The Samsung group allegedly got the nod from the pension fund operator because it gave money to foundations controlled by Choi Soon-sil, President Park's confidante.

Given that the NPS is already the largest owner of South Korean stocks, its independence as an objective investor -- rather than as a government-controlled unit of the health ministry -- is crucial. Discussion is already underway about spinning off its investment division, a logical move considering that the already massive fund is expected to grow five times larger over the next 30 years.

For all the advances that South Korea has made in the past 50 years, it still greatly lags behind its global peers in corporate governance. The concept of families with minority stakes running companies like majority shareholders is a legacy from the economic model initiated in the 1960s by then-President Park Chung-hee, father of the current president.

The crowd that amassed on Nov. 26 to demand Park Geun-hye's impeachment was almost twice as large as the one that gathered in the same plaza in June 1987 to demand, successfully, that South Korea hold its first democratic presidential election. Nearly three decades later, we may be witnessing the second wave of democracy, this time to help minority shareholders fight against an unfair system made possible by current regulations and business practices.

The Choi scandal and the impeachment of President Park threaten to send the South Korean economy into a decline. The upside is that the chaos may force a deep self-reflection on practices that other major economies have long since abandoned.

Peter S. Kim is a managing director and investment strategist at Mirae Asset Daewoo. The views expressed here are his own.

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