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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


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.