Unlocking South Korea’s Market Potential: Overcoming Governance Challenges

Most emerging market investors are aware that the “Korea discount”, the term used to describe South Korean stocks consistently trading at valuations below global peers, results from poor corporate governance. Fewer investors understand the root causes of the poor governance. In a recent letter to our investors, I have identified them and outlined specific mechanisms controlling shareholders use to benefit at the expense of minority shareholders, and how we intend to respond. 

Root Causes of Poor Governance

There are two primary causes of poor governance:  unusual, not fit-for-purpose securities rules, that help a tiny number of families who control companies, but at the expense of all other investors and Korea’s capital markets; and an inheritance tax rate, which can be as high as 60% for large estates. 

Controlling families, because of the high inheritance tax rate and their ongoing ability to at any time compel minority shareholders to effectively sell their stocks to controlling stockholders in terms of a ‘restructuring’ at market price, are incentivised to keep stock prices persistently low. A low dividend pay-out ratio helpfully (for them) both reduces cash directly held by the families and keeps stock prices low (as lower yielding stocks attract fewer investors). Should families need to access cash, they are allowed (without minority shareholder approval) to transact with the companies they control, such as by selling property to the companies, often at subjectively-determined and eye-catching prices. 

Families are further able to take advantage of low stock prices (often caused by minority shareholder mistreatment) by directing companies they control to buy back stock. Unlike in other countries, though, such stock typically remains uncancelled and thus the buybacks do not benefit minority shareholders. Instead, the objective is to benefit the families alone, including by helping to secure control. 

Aside from the inheritance tax incentives, families are also able to use unusual rules to compel unwilling minority stock holders (who don’t have a separate say) to swap their stock for (inevitably less attractively priced) other family-controlled companies. Directors appointed by the families can even influence relative stock price movements prior to any swap to the family’s advantage.

Directors do not have a fiduciary duty to shareholders that might discourage poor conduct. They simply need to be “loyal” to the company, a concept subject to widely differing interpretations.

Should control change, unlike in the case with other stock markets, minority shareholders are pointedly excluded from participating in any control premium, which can be more than double an intentionally-supressed stock market price. 

In an annual tradition, directors found guilty of criminal offences are pardoned, and may be permitted to again help manage the very companies they in some instances have been convicted of harming. 

Those who speak out against perceived minority shareholder mistreatment risk defamation lawsuits because, unusually in Korea, truth is not an absolute defence. 

Challenges and Inspiration from Japan

While our 14-year effort to fight against mistreatment (including appeals to directors, courts, proxy providers and controlling shareholders) has until now been unsuccessful, my team and I have been inspired by developments in Japan, a country previously twinned with Korea as a governance laggard as far as capital structure is concerned.

The Tokyo Stock Exchange, spurred on by the efforts of its new president, Mr Hiromi Yamaji, has encouraged companies, particularly those trading below book value, to focus on capital cost, return on equity and stock prices, with impressive results. In Japan, dividends and buy backs (with cancellation) have increased sharply of late and stock prices have risen.

While the recent statements by Korea’s President Yoon regarding  possible changes to taxes on inheritance and stock market gains are well-intentioned and encouragingly suggestive of a shift in attitude, they unfortunately do not address key issues and won’t on their own meaningfully reduce the Korea discount.

Prospectively, our team will, save for certain exceptions, presume to vote against the re-election of all directors of Korean companies trading persistently below book value - especially when it seems that the directors prefer a lower stock price. We will also do so if the company enters into unfair related party transactions or forces stock swaps on minority shareholders, have a change of control excluding fair minority shareholder participation, retain senior management that have previously been convicted of an offense involving dishonesty (even if they are subsequently pardoned), buys back stock without cancelling it, or otherwise demonstrates poor corporate governance. 

While we don’t expect to win any proxy voting contests (after all, the companies are family controlled), we are hopeful that if this approach gains traction, with most minority stockholders expressing consistent, unambiguous disapproval of directors, companies will be encouraged to change and regulators to act.