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  • Hanwha's Chaebol-Style Governance An Issue

    On August 16, 2012, Kim Seung-youn, chairman of Hanwha Group, South Korea's tenth largest conglomerate, was sentenced to four years in jail and fined KRW5.1B ($4.5M) at a Seoul district court for KRW 288B ($254M) in damages as a result of his embezzlement.

    This was a bit of a shock. In the world's 11th largest economy, a tycoon, however serious his crime, rarely goes to jail. Just as with many chairmen of chaebols, the country's family-owned conglomerates, in the past or currently awaiting trial, Mr. Kim embezzled large amounts of funds from his conglomerate's strong units to prop up its weaker affiliates. However, other tycoons engaged in similar transgressions have had their jail terms usually waived upon being sentenced. Instead, Mr. Kim now finds himself in jail.

    Asked by reporters about the sentence before leaving the courthouse, Mr. Kim quipped, "I have a tough fate."

    Mr. Kim, who had the reputation of being a talented businessman, was only 29 years old in 1981 when he took the helm of Hanwha after the death of his father, who founded the group. In the past three decades, he has transformed Hanwha into a conglomerate of 55 chemical and financial services affiliates from an explosive maker with a few subsidiaries.

    Hanwha is a typical chaebol. Mr. Kim is a product of the chaebol system of South Korea where top-down corporate governance, buttressed by cozy business-government ties, has helped spearhead rapid industrialization. South Korea is now an economic powerhouse, but its governance regime is still dominated by the legacy of the development era.

    Mr. Kim has a 25% stake in Hanwha Corporation, which is central to the conglomerate's cross-shareholdings. The de facto holding company controls a significant 37.9% stake in Hanwha Chemical. Hanwha Chemical controls 100% of Hanwha L&C. Hanwha L&C controls 15.4% of Hanwha Securities. Hanwha Securities controls 76% of Hanwha Venture Capital, and a 17.1 % stake in Hanwha Venture Capital shares is controlled by Hanwha Chemical. Hanwha Corporation in turn has a 30% stake in Hanwha Chemical, rounding out the web of cross-shareholdings.

    At chaebols, managerial control is now in the hands of a few patriarchs who often use complex cross shareholdings and political influence to skate the law and skirt shareholders' rights. A fervent and rapid drive to expand business is given as a justification for their control of conglomerates, which in turn provides a misguided rationalization for their overt - and often illegal - attempts at staying in control of their conglomerates.

    Because they control large numbers of corporations with far less than core shareholdings, chaebol tycoons often craft public images approaching that of an infallible sage. For example, an internal memo seized by the prosecution said that Mr. Kim, who has achieved the status of "deity" is the object of absolute obedience.

    In the past three decades under Mr. Kim, Hanwha's rush for growth has unfolded against a backdrop of Mr. Kim's business practice irregularities and corruption. In 1993, he misappropriated $4.7M from an offshore account of Hanwha and bought a mansion once owned by Hollywood star Sylvester Stallone. In 2003-04, he paid KRW1B in bribes to a lawmaker. In 2005, the government unearthed KRW8.7B, parts of larger slush funds which Mr. Kim had raised to buy a securities brokerage, now Hanwha Securities.

    In 2007, Mr. Kim even committed a violent felony. Apparently flanked by cleaver-wielding gangsters, he abducted and beat a bar bouncer with a steel pipe because the bouncer had had a brawl with Mr. Kim's son in the bar. Despite all these run-ins with the law, Mr. Kim was jailed only twice for less than two months in total. All other sentences were commuted or waived.

    The August 16 jail sentence and fines against Mr. Kim signal that South Korean society has begun to question the efficacy and need for the traditional top-down governance regime. The chaebol-centered governance regime alienates outside shareholders and hampers entrepreneurship inside and outside the chaebol. This is no longer a domestic issue, given the fact that South Korea's stock market, now bigger than Italy's or Spain's by capitalization, is 28% controlled by international investors.

    Now that the relevancy of the current governance regime is in question, South Korea still appears to be at a loss for clear direction. Mr. Kim's four-year jail term is about half the nine years demanded by the prosecution. Indeed, this was the latest of a series of half measures. On the late afternoon of Friday February 3, 2012, when he was convicted, the Korea Exchange announced it would comply with its own regulations and suspend Hanwha Corporation from trading, where Mr. Kim is Representative Director and Chairman. On Monday, February 5, 2012, the exchange retracted its first-of-its-kind decision against a chaebol chairman and his de facto holding company.

    Meanwhile, on August 17, 2012, a day after Mr. Kim's sentence, all major Hanwha shares went up. For investors, Mr. Kim was the quintessential risk, and now he is gone. However, the risk has not yet vanished completely. Mr. Kim appealed the sentence although he had admitted wrongdoing. As of August 20, 2012, Mr. Kim has not resigned from any post at Hanwha. Local news reports said that he is now considering managing the group from the prison cell.

    Region: All Other

    Sector: Industrials

    Industry: Industrial Conglomerates

    Market Cap: KRW 2,068,861.1mm (Mid Cap)

    ESG Rating: D

    AGR: N/A

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

    Additional disclosure: I am a corporate governance specialist.

    Tags: chaebols, hanwha
    Aug 21 4:23 PM | Link | Comment!
  • Caterpillar Employees Take Pay Freeze As Company Profits

    Last week, noted that China had cut its 2012 growth target to an eight-year low of 7.5%, and the "detrimental effect" that the decreased spending on infrastructure and construction would have on Caterpillar. Indeed, first among the company's stated Risk Factors is a high sensitivity to global economic conditions. The company stands to be heavily impacted by prolonged downturns in the energy, mining, housing, and commercial construction industries.

    The pessimistic interview from Caterpillar's CEO Douglas Oberhelman comes on the heels of a contentious employee strike. The three and a half month strike ended Friday when the company approved a one-time ratification bonus of $3,100 per worker after initially proposing $1,000 per worker. The worker strike came about as Caterpillar sought to freeze the pay of veteran workers and shift an increased burden of the health-care cost to employees despite the posting of record setting sales and revenues. The increased bonus was about the only concession the hard negotiating company was willing to make on the six-year contract, as salaries will remain frozen with the company receiving nearly all of the concessions it sought to achieve.

    The company asked employees to make concessions on pay, healthcare, and pensions even as pay for its CEO rose 42 percent in 2011. In addition to a 32 percent rise in base salary, Mr. Oberhelman's $16.9 million in total summary compensation included more than $8 million in stock options, half of which are time-vesting, a cash bonus of almost $5 million, and shareholder sponsored corporate aircraft and home security costs. Five other named executive officers were awarded discretionary cash bonuses "to reward significant efforts that may not be reflected in the performance objectives". Recently, Caterpillar's former CEO James W. Owens received one of the highest severance packages of all companies we've covered in the past few years when he retired in July 2010. After six years as CEO, he received almost $52 million in total realized compensation.

    The board of Caterpillar Inc. is not only large, with 16 current members, but also well paid. Non-employee directors earned between $266,089 and $313,218 in total compensation for service on the company's board last year. Of 16 board members just one is female, seven have served for at least a decade, and there are certain relationships on the board that skirt the SEC rules for independence, but signal camaraderie among board members. For instance, two directors serve together on the board of Abbott Laboratories and two more serve together on the board of The Boeing Company. In fact, Caterpillar's board is a virtual who's who of blue-chip directors.

    Currently, half of Caterpillar's board sits on at least three boards we rate. The board members include Miles White, the Chairman and CEO of Abbot Laboratories, who also sits on the board and two committees at McDonald's Corporation. David Goode, who chairs the compensation committee, has served on the board for 19 years, as has fellow compensation committee member Joshua Smith. The most recently elected board member to join the compensation committee is David Calhoun, whose full time job is as CEO of Nielsen Holdings N.V. and who also serves on the boards of Medtronic, Inc. and The Boeing Company.

    Caterpillar Inc. is also rated Very Aggressive in terms of Accounting & Governance Risk (AGR). With an overall AGR score in the 4th percentile, Caterpillar's financial statements indicate accounting and governance risk higher than 96% of the company's we cover. We have flagged the company on 10 metrics pertaining to Revenue Recognition, Expense Recognition, and Asset-Liability Valuation. The company has scored "Aggressive" or "Very Aggressive" in its AGR for the past three years while industry peers typically scored as "Average" over the same time period.

    Employees at Caterpillar chose to accept a pay freeze and decreased benefits against the recommendation of their local union, and on terms that greatly favored the company even as it made profits. However, the CEO has unexpectedly warned that the company could face lean times in the face of a global economic downturn. It's too early to tell whether the statement was made to ease the public sentiment over a controversial employee strike settlement or if it's the foreshadowing of a real threat to investor confidence.

    Region: North America

    Sector: Industrials

    Industry: Construction/Agricultural Machinery

    Market Cap: $56,219.4mm (Unknown Cap)

    ESG Rating: D

    AGR: Very Aggressive (4)

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    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

    Additional disclosure: I am a corporate governance specialist.

    Tags: CAT
    Aug 21 10:19 AM | Link | Comment!
  • Many Pharmaceuticals Accused Of Fraud Have Unusually Poor Corporate Governance

    The pharmaceutical industry has grown notorious after collectively paying out multi-billions amid allegations of fraud. But many among those to receive fines stand out from the others, and continue to expose their investors to possible losses related to regulatory problems.

    When the government announced a health care fraud prevention and enforcement action initiative in May 2009, Attorney General Eric Holder said that tens of billions in Medicare and Medicaid funds were lost to fraud every year. Since then, regulators have recovered more than $10.2 billion related to such matters. While warning that the government would be "turning up the heat on perpetrators who steal from the taxpayers and threaten the future of Medicare and Medicaid," Health and Human Services Secretary Kathleen Sebelius had added the caveat that most "providers are doing the right thing and providing care with integrity."

    Indeed, most North American and Western European companies in the diversified and biotech sector exhibit typical characteristics. Around 60% of those we monitor are rated "C" on their corporate governance overall and half have financial statements reflecting AGR scores that indicate average accounting and governance risk.

    In contrast, several companies that have experienced scandals in recent years are also among those with lower ratings. In September 2009 regulators announced that Pfizer Inc. (NYSE:PFE) and its subsidiary Pharmacia & Upjohn Company Inc. agreed to a $2.3 billion settlement of fraudulent marketing charges; the New York-based global giant is rated "F" and its AGR score is 1, suggesting it has higher accounting and governance risk than 99% of comparable companies. In another example, the U.S. Department of Justice said May 7 that Abbott Laboratories Inc.(NYSE:ABT), which is rated "F" and has an AGR of 22, agreed to pay $1.5 billion to resolve allegations that it illegally promoted the drug Depakote. Johnson & Johnson (NYSE:JNJ) has developed an impressive record of run-ins with regulators, including its tentative $2.2 billion settlement with the Department of Justice over its promotion of Risperdal, according to the Wall Street Journal and a regulatory filing on August 1. The New Jersey company is rated "F" and has an AGR score of 26. Amgen Inc.(NASDAQ:AMGN) recorded a $780 million hit to its earnings during the three months ended September 30, 2011 that was tied to investigations into its marketing practices, and the Thousand Oaks, Calif.-based company is rated "D" and has an AGR of 17.

    To be sure, some of those to receive fines have average ratings. For example, GlaxoSmithKline plc(NYSE:GSK) had to pay $3 billion after allegations that the U.K. manufacturer marketed the drugs Paxil and Wellbutrin for uses not approved by the U.S. Food and Drug Administration, including the treatment of children for depression and of other patients for ailments ranging from obesity to anxiety. Unlike others that have experienced such large penalties, Glaxo is rated "C." Its AGR score of 52, which indicates higher risk than 48% of comparable companies, has improved from a 28 as of June 2010.

    As regulators call out pharmaceutical companies for misconduct, it seems logical that the people affected will take steps to avoid having such problems again in the future. Which ones will succeed in the coming years remains an open question. In the meantime, the few to experience scandals in recent years have not helped the industry's reputation.

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    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

    Additional disclosure: I am a corporate governance specialist.

    Aug 17 4:53 PM | Link | Comment!
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