Question 1 The Chaebol structure Benefits of the chaebol structure: •
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The centralized management system provides strategic vision, administrative administrative support and muscle for affiliates, necessary in the early stages of the industrialization industrialization Low costs since there are fewer contractors contractors and since we are talking about economies of scale Market dominance which allows those powerful groups to be competitive enough to expand abroad -> source of national pride Provides enough resources resources for R&D Pillars of the economy and large employers for for the country (Samsung accounts for 20% of the country’ country ’s exports)
Disadvantages of the chaebol structure •
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Lack of transparency transparency Centralized planning office and strong hierarchic relationships between top managers Tangled cross-shareholdings of affiliates and complex internal ownership structures obscuring o bscuring accountabilit accountability y Provoke tensions within South Korean society between capitalist profit-making and social egalitarianism Involved in political games and corruption schemes
Ex: In 2005, Lee Kun Hee left the country for five months for what Samsung described as health reasons while he was under investigation for allegedly making big illegal donations in 1997 to presidential presidential candidates. •
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Some of those schemes lead excessive state state lending and to dangerous leverage leverage of the t he chaebols Tax evasion ev asion
Governance issues •
Shareholders who own few shares monopolize power and finance in the chaebols
Ex: the Lee family have a final say over chaebols Samsung Electronics while having only 3% of the shares (through and a pyramidal structure of ownership and a centralized management system – the Strategic Planning Office (SPO), whose employees are technically paid by Samsung’s affiliates ) (Businessweek, April 28, 2008) •
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The SPO can’t be legally hold responsible “even if it makes serious blunders” Minority shareholders are neglected – the protection of their rights is limited and they are never consulted Imperialistic (“Byzantine”) way of governing
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"Samsung simply doesn't have a system where the controlling shareholder's management can be checked and monitored“ "Such a system can't be sustainable.“, says Korea University corporate governance expert Park Kyung Suh. -> therefore doubtful transactions occur, such as buying company shares for much less than the market price, are easily concealed
Question 2 Capital structure analysis: Samsung Electronics All figures in Billion won
1997
1998
1999
Debt(long term and short
12979
10219
5745
Total debt to total asset
41%
42%
20%
Debt to equity
223%
147%
43%
Cash and cash equivalence
1367
1187
46
Interest expenses
1581
1116
721
EBITDA
3812
4778
7300
Interest covering ratio
2.41
4.28
10.12
term)
Source: Samsung Electronics Annual Report Year 1998 and 1999
Intel capital structure analysis All figures in million dollar
1997
1998
1999
Debt(long term and short
770
903
861
Total debt to total asset
3%
3%
2%
Debt to equity
4%
4%
3%
Cash and cash equivalence
4102
2038
3695
Interest expenses
27
34
36
EBITDA
9887
9171
11264
Interest covering ratio
366.19
269.74
312.89
term)
Source: Intel Annual Report Year 1998 and 1999
Difference between Samsung and Intel •
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From the first table, we can see in the year 1997 and 1998, Samsung Electronics was financed mainly by raising debt. The debt to equity in these 2 years both outnumbered 1 and the interest cover ratio is relatively low. The cash and equivalence just covered the interest payments. But this high leveraged capital structure seem to improve in 1999. We chose Intel as the comparable company in year s 1997 to 1999. From the second table , we can see that Intel’s capital structure is healthier than Samsung Electronics through financing by equity rather than debt. Its leverage is only 4% during those 3 years, while Samsung Electronics has soared to 223% in 1997.
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The difference in capital structure between Samsung Electronics and Intel is enormous. Before the economy liberalization policy, the Korean government enforced large lending decisions to support the chaebols. Therefore, the banks had little incentives to evaluate credits or monitor loans, As a result, the Korean chaebols took advantage of the “allowed” leverage. In situations in which banks were not willing to lend them more money, the chaebols managed to create their own internal capital markets through cross-shareholdings and cross-guaranteeing of debts. This comportment, as well as the 1997 Asian currency crisis, aggravated the high-leverage problem.
Question 3: Samsung Motors controlled by the Lee family? •
According to exhibit 3a, we have the following information:
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Family Lee owns:
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5.41% of Samsung Electronics
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2.32% of Samsung Co.
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15% of Samsung Life Insurance
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0.85% of Samsung Securities
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0.30% of Samsung Engineering
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67.30% of Samsung Everland
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41.8% of Joon-Ang Daily News
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0.36% of Samsung Fire & Machine Insurance
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According to exhibit 3b, we learn that: Samsung Electronics owns 21.11% of Samsung Motors
Samsung Display Devices owns 7.45% of Samsung Motors Samsung Heavy Industries owns 2.48% of Samsung Motors Samsung Electro-Mechanics owns 6.08% of Samsung Motors Samsung Everland owns 1.24% of Samsung Motors
Percentage owned directly by the Lee family •
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If we sum the two percentages, we obtain that Family Lee owns 1.97% of Samsung Motors. Hence, if Samsung Motors makes an after tax profit of USD 100 million, the Lee family would receive: 1.97%*100,000,000= USD1.970 million According to Exhibit 3a, the Lee family does not own any percentage of Samsung Motors.
Question 4 Evaluation of the current Board of Directors of Samsung Electronics: Number: •
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No universal agreement on the optimum size of a board of directors. But large number represents a challenge in terms of effectivness and having any kind of meaningful individual participation. According to the Corporate Library's study most boards range from 3 to 31 members.
Samsung Electronics board counts 23 members instead of 43 which seems to be a better size.
Evaluation of the current Board of Directors of Samsung Electronics:
Content: Strenghts -
Weaknesses
Adequate number of members -
No regulation or external mechanisms: frauds, self-dealing, accounting manipulations, corruption
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Various branches of the Samsung Group represented
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Convergent interests, easier to find agreements
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Chairman is in a superiority position No checks and balances
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Synergies and good group dynamic
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Minority shareholder’s rights neglected
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Lack of independence from the Samsung group
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Mixed interests: Samsung Group’ interests are favoured over Samsung Electronics ( size)
Directors’ classification: Non-executive/ independent •
Non Executive: A member of acompany's board of directors who is not part of the executive team. A non-executive director is not involved in the day-to-day management of the organization, but is engaged in policy making and planning exercises. Thus, we can assess that directors outside Samsung Electronics are nonexecutives.
Thus, 16 out of 23 directors can be classified as Non-Executive directors •
Independent: Director out of the Samsung group (explanations on next slide)
Thus, only 3 out of 23 directors can be classified as Independent directors
Assessing directors’ independence An indepenent director is a person who: « has not been employed by the Company or its Related Parties in the past five years is not, and is not affiliated with a company that is an advisor or consultant to the Company or its Related Parties; is not affiliated with a significant customer or supplier of the Company or its Related Parties; has no personal service contracts with the Company, its Related Parties, or its senior management; is not affiliated with a non-profit organization that receives significant funding from the Company or its Related Parties; is not employed as an executive of another company where any of the Company's executives serve on that company's board of directors; •
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Assessing directors’ independence (second part) •
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is not a member of the immediate family of an individual who is, or has been during the past five years, employed by the Company or its Related Parties as an executive officer; is not, nor in the past five years has been, affiliated with or employed by a present or former auditor of the Company or of a Related Party; or is not a controlling person of the Company (or member of a group of individuals and/or entities that collectively exercise effective control over the Company) or such person’s brother, sister, parent, grandparent, child, cousin, aunt, uncle, nephew or niece or a spouse, widow, in-law, heir, legatee and successor of any of the foregoing (or any trust or similar arrangement of which any such persons or a combination thereof are the sole beneficiaries) or the executor, administrator or personal representative of any Person described in this sub-paragraph who is deceased or legally incompetent, »
Assessing directors’ independence (third part) •
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Thus, an independent board of directors is normally made of members who have no material interests in a company. This means that none of the members on such boards should have had any business dealings with customers of the firm or firms with which the company has any business dealings, in the past five years and not be involved in day-to-day management of the firm. In our case, we can consider that a director who doesn’t belong to the Samsung Chaebol is independent because he will not share the Samsung Group’s interests but will focus on the Samsung Electronics’ best interest .
Recommended changes to be made on the Board
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Include external Directors (from the Samsung Group) in the Samsung Electronics Board to implement regulation and checks and balances . Increase the proportion of independent directors, that is people who have no material interests in the chaebol other than their directorship to improve Samsung Electronics’ corporate governance. Better representation of minority shareholders
Question 5 The convertible bond issue: a self-dealing transaction? •
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Several arguments lead to the fact that the convertible bond issue was a self-dealing transaction: The bonds were sold to insiders; this is not common and questions may arise on the fact that the bonds might have been undervalued; We also know that convertible bonds can be converted into common shares. If it occurs, this conversion could modify the equity structure of the company. We will see further why this can be considered as an important proof of self-dealing transaction (dilution, etc.) We can prove that claim by calculating the dilution of shareholders (dilution that benefits to the son of the CEO).
Question 5 The convertible bond issue: a self-dealing transaction? •
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Unsecured convertible bonds worth 60 billion won were issued on March 24, 1997. In the year 1997, these bonds were converted into common shares at the price of 49,931 won (see: http://www.samsung.com/tr/aboutsamsung/ir/financialinformatio n/auditedfinancialstatements/downloads/parent/97_end_05_note _eng.pdf ) This conversion modified the equity structure of the company. Information provided by exhibit 5: We see that in March 1997, the share price was approximately 53,000 won. In the same Note to Financial Statements, we learn that at December 31, 1997, 121,963,467 shares of common stocks outstanding. Therefore, the market capitalization of Samsung Electronics was: 5198 billion won.
Question 5 The convertible bond issue: a self-dealing transaction? •
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According to the exhibit 5 of the case study, closing price of Samsung Electronics Shares was about ￦ 53,000 on March 1997. Market cap estimation to ￦ 6,464 billion in 1997. To raise 60 billion in capital for a 6,464 billion company requires issuing shares worth 0.93% of the company. The project to raise capital to ￦ 60 billion doesn’t really have influence on capital structure since it represents less than 1% of existing long terms loans (p6. of case study) Following this raise of capital, shareholders will now own: 90.07% * ￦ 6,464 billion = 6,390 billion in the company.
Question 5 The convertible bond issue: a self-dealing transaction? •
The main evidence we have on our claims are:
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Dilution of the shareholders, they lose some of their equity.
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The son of Samsung’s chairman bought most of the convertible bonds which were converted into common shares. Therefore he increased his personal ownership (an insider increases its ownership). In addition, this action reduces the weight of minority shareholders.
Question 6 Pan-Pacific = simple direct investment or something else? •
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Direct investment: An investment, which is sufficiently large to affect a company's subsequent decisions. This is sometimes a majority ownership, but sometimes it's just a significant minority ownership. “At first glance, the Pan-Pacific (PP) agreement looked like a direct investment into Samsung Motors by a foreign entity (PP)”. But there was a clause that provided a return with a system of call/put options. PP bought shares of Samsung -> Samsung issued call/put options on those underlying assets to provide a certain return to PP. There is a counterpart to the investment of PP into Samsung, so it is no longer a direct investment, and it is not in accordance with the Korean law regarding other types of transactions.
Question 6 Pan-Pacific = simple direct investment or something else? •
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Guarantee clause?
Guarantee = put/call clause. It was put in the contract to provide more security to PP: to make sure PP would earn money and to make the investment more attractive. Because of that, it is no longer a direct investment according to Korean regulation.
Audit questions:
Why sign an agreement with such a clause? What is the hidden reason? Did PP really earn money on the options provided by the clause?
