The Costs of Poor Corporate Governance in South Korea

Investing has become almost borderless. Anyone with a terminal or a broker can buy stock on dozens of exchanges.

But investors need to keep in mind that companies are nearly borderless, too. Multi-national corporations with operations all over the world can and do move their official corporate domiciles to whichever country will give them the best deal - the lowest taxes, the most lax disclosure rules, and protection of management from accountability to investors. The transaction may feel the same whether you are buying stock in US-based General Electric or South Korea-based Samsung C&T - until you find out that even the limited shareholder rights and protections we take for granted in the US do not exist in some other jurisdictions.

An American investor is finding that a costly lesson right now. Hedge fund manager Elliott Associates, Samsung C&T's third-largest investor, is objecting to a proposed deal that diverts value from the outside shareholders to the insiders -- The Lee family, which runs Samsung under a system widespread in South Korea called chaebol, that sells stock to outsiders but keeps control in a small, related group.

The deal Elliott objects to moves a valuable affiliate organization under the control of the family, drastically underpricing the purchase price at an enormous cost to the shareholders.

As heir apparent Lee Jay-young (known as JY Lee) takes over the group from his father, Lee Kun-hee, the family is trying to consolidate control even more. JY was effectively given a controlling stake in Cheil, which functions as a quasi-holding company for the group, in a controversial transaction two decades ago. By taking over Samsung C&T in an all share deal, JY will have acquired C&T's 4.1% stake in Samsung Electronics at the expense of only a few percent of his holdings in Cheil, rather than the billions of dollars he would have to pay the shareholders in the open market.

This transaction is legal in South Korea. But it is not fair. Both of the leading proxy advisors in the US have recommended that shareholders vote against it. Indeed it is so outrageous that South Korea's smaller retail investors have started an unprecedented campaign to stop the deal. At least 2,500 shareholders have pledged to vote against the merger at the July 17 shareholder meeting. Some even submitted a petition to the Korean District Court opposing the deal, following a similar suit filed last week by Elliott, complaining they are "left utterly dejected at the current situation where we have to stand by and watch our assets being stolen."

Another South Korean deal that is disastrous for outside shareholders involves SK Holdings and SK C&C. It would leave the company's chairman - who is currently serving a jail sentence for embezzlement - as the largest shareholder of the combined entity. Indeed, the terms were so bad that National Pension Service (NPS), which has a substantial stake in SK Holdings but is generally unwilling to speak out against management, surprisingly announced that it opposed the deal. That was not sufficient to prevent it from going through.

In yet another example, Hyundai recently purchased real estate in Seoul's wealthy Gangnam district for approximately $10 billion - three times its assessed value - apparently simply because the company's chairman demanded it.

South Korea's own NPS, the fourth largest public pension fund in the world and Korea's largest investor, should take the lead in speaking out and voting against the chaebols. The government should look to best practices around the world and adopt laws with better protection for shareholders. If South Korean executives, boards, investors, and the government allow these abusive, self-dealing practices to continue, they will find themselves downgraded by the OECD and by investors. They will sharply increase their cost of capital and reduce their ability to compete in the global economy.

The same investment capital that flows so easily across borders into the country can flow just as easily out, as investors will find a better return on investment in countries with better assurance of fair dealing with outside shareholders.