Why should we discourage‘circular investments’?The term “circular investment” is often used these days, but what does it really mean?
The Fair Trade Commission, which polices big Korean conglomerates, is considering prohibiting this practice and the jaebeol are resisting.
Circular investment involves buying stocks in a series of companies and it works like a corporate version of a carousel. Say company A buys a stake of company B and makes the company its affiliate. After that, company B buys stocks of company C, becoming part owner of C. Finally, company C invests in company A’s shares and becomes an owner of A.
So the three companies are linked through a never-ending circle of investment. This relationship can be summarized thus: A-->B-->C-->A. This is called “circular investment.”
So, what benefits can the investor get from “circular investment?”
One benefit is that an owner of a big conglomerate can actually own and control other companies with a minimal stake.
For example, an owner holding a 30 percent stake in company A can actually end up holding a much larger stake if company A buys into company B which in turn buys into company C and then company C eventually buys a big percentage share of company A. The three companies are linked by investments. During the process the owner of company A effectively added a share of companies B and C to his portfolio.
Why did circular investment emerge as a popular aspect of Korean business? Industry experts say it was because of the financial crisis in 1997. The government at the time encouraged companies to decrease their debts. The companies found a way around this by investing in each other which increased their assets, but only on paper. And during the course of such merger and acquisition activities circular investment became inevitable.
The Fair Trade Commission has a different opinion. To the commission, circular investment is a means for conglomerate owners to control affiliate companies. The commission says that in some cases owners can amass power that far exceeds their shareholding.
What about other countries? Wallenberg in Sweden, Suez in Belgium, and Li Ka-shing in Hong Kong are some of the well known companies that are linked with affiliates by circular investment, the issuing of “golden shares” and other methods. Governments in these countries do not regulate the practice as strictly as in Korea.
But Kwon O-seung, head of the Fair Trade Commission, does not want to let Korean companies continue this kind of investment. “Korean jaebeol are different since they are linked by blood. They must be forced to stop the practice,” says Mr. Kwon.
The FTC called on 11 experts to discuss and schedule a ban on circular investing, but six of the experts were against the ban. Nevertheless, the FTC has already decided it wants to ban circular investing and is discussing the matter with the Ministry of Finance and Economy and the Ministry of Commerce, Industry and Energy. The commission does not want to stop at banning circular investing. It also wants to force circularly invested companies to sell their shares in each other.
Meanwhile, the government announced on Wednesday that it will not impose a ban on circular investments, but would continue to cap them. Mr. Kwon said that the ban would not be desirable at present because it would amount to another restriction on investments.
There are criticisms arising even within the government. “The number of investments is falling as it is and the commission is throwing in new regulations which will make that situation worse,” says a high official at the Ministry of Finance and Economy. Companies are also nervous because they fear the commission’s policy would mean less control which makes them vulnerable to hostile takeover bids, especially from foreign investment funds. Furthermore, if a company profits from selling the shares they will face a huge tax bill.
The issue is controversial and there is no simple answer to the question of how to bring about healthier company management structures.
What is the job of the Fair Trade Commission?
Originally it was established to protect consumers from monopolies and ensure healthy competition in the market. The organization is sometimes called an “economic prosecutor.” But these days the FTC is focusing on reforming company ownership structures by banning circular investment and enforcing caps on large conglomerates’ investments in other companies. In fact the FTC has been working on management restructuring for some time.
Let’s review a brief history of the government’s regulations on the jaebeol:
The “institution on preventing concentration of economic powers” was established in 1986, to stop jaebeol from expanding too fast without regard for their economic impact. The institution blocked circular investment and intervened by putting caps on large investments. In the 1990s the government even banned bilateral debt guarantees between affiliates along with insider trading, which is illegal.
But after the financial crisis that began in 1998 when companies were experiencing difficult times, the government abolished the cap on circular investments. It was to enable conglomerate owners to defend their management from foreign investors attracted by low stock prices caused by the crisis. The government had admitted that the cap on investments was a threat to ownership. The cap on investments was resurrected in 2001 when circular investments started to increase.
Exceptions were made in certain areas but regulations on jaebeol are on the rise. Circular investment was not a big problem until recently. Originally the government was scheduled to abolish or reconsider current caps on investment in other companies. But, it was on the premise that the management structures of jaebeol improve which the FTC thinks still needs work. The business community is demanding the FTC act like a traffic police, focusing its efforts on nurturing the market’s functions instead of regulating the jaebeol.
by Kim Joon-sool