The Reality of “Actions” by Activist Hedge Funds
and Public Policies on Chaebols –
Lessons from the Elliott-Samsung Dispute
JUNE 30, 2015
National University of Singapore
2. The Core Issue on “Undervaluation” - Who is Manipulating the Market?
3. Shareholeder Activism of Elliott - A “Holdout Fund”?
4. Shareholder Activism and Populism – Seeking the Anti-Chaebol Coalition
5. An Analysis of Differing Self-Interests and Constraints from National Interest in the Elliott-Samsung Dispute
6. Public Policies on Chaebols in Korea – “Victims” of Utopian Policies?
A titanic battle is ensuing between Elliott Associates, a pioneer of “vulture fund” or more commonly known as an “activist hedge fund”, and Samsung Group, Korea’s biggest chaebol which owns the world’s largest electronics company, Samsung Electronics. On June 4, 2015, Elliott suddenly raised its stake of Samsung Construction & Trading Corp. (Samsung C&T) to 7.12% to emerge as the company’s third largest shareholder. Since then Elliott has been leading the opposition to a proposed merger between the company and Cheil Industries. Elliott is suing the Samsung C&T board to halt the merger on grounds of “unfairness” to minority shareholders and “unlawfulness” of the merger decision, and is attempting to persuade foreign and domestic investors to take its side. Samsung for its part is trying to gain support for the merger by emphasizing the transaction as desirable and lawful ahead of a vote in a shareholder meeting scheduled on July 17, 2015.
The dispute between Elliott and Samsung has attracted global attention because the proposed merger is geared to completing the third-generation succession of management to Vice Chairman Lee Jae-Yong, by creating a ‘new Samsung C&T,’ which will become the de facto holding company of Samsung Group. The Elliott-Samsung dispute is also the first attempt by a foreign ‘activist fund’ to intervene in key management decisions at Korea’s largest chaebol (family-controlled business groups) to realize their own profits. The dispute thus raises the issue of how other Korean firms can prepare for such disputes in the future, and how the government and institutional investors should react to “actions” by such activist funds.
This paper begins by examining the controversy over the “fairness” of the stock swap ratio between the two companies. It argues that the controversy boils down to determining “who is manipulating the market”. If one assumes that the stock market functions efficiently, which is the basis of the Korean financial regulations governing mergers and acquisitions (M&As), it is difficult to say the share price of a company can be “undervalued” for an extended period of time. If one claims so, it is tantamount to alleging that somebody is manipulating the share price. In the same vein, if an activist fund argues that it can resolve the situation of “undervaluation” through its action, it is nothing more than saying that it can manipulate the share price through such action. The controversy can be better understood in view of an international study on hedge fund activism which concludes that campaigns by activist funds have, in most cases, failed to bring about a sustained appreciation in share prices (Section 2).
The paper then investigates how Elliott and other activist funds actually “promote” shareholder interests. Considering its past investment activities around the globe, one can name Elliott a “holdout fund”. It has earned big money in Third World countries including Peru, Argentina and Congo by devising holdout schemes to stall international efforts at helping these countries such as the Brady Plan and international aids to West African countries. It is also estimated to have earned at least $1.2 billion by applying a similar holdout scheme even to the U.S government’s efforts at reviving General Motors during the Global Financial Crisis of 2008-9 (Sections 3).
Elliott is certainly an extreme case of activist funds which stand on a broad spectrum of shareholder actions. But there is a common behavior of activist funds. They exploit populism for profits and ‘minority shareholders’ right’ is their mantra to gain public support. This paper analyzes how the populism-for-profit tactics were employed in the PSAM-Vivendi dispute and also in the Elliott-Samsung dispute (Section 4).
The paper then examines differing interests among parties involved in the dispute. In order to fathom the outcome of this dispute, we not only need to consider their own self-interests but also constraints from the national interest aspect. This is primarily because Korea’s National Pension Service, currently the fourth-largest pension fund in the world, is Samsung C&T’s second largest shareholder, owning about 10% of the company’s stock, and is going to make its decision on the vote by taking national interest into account. There is also room that domestic institutional investors will consider national interest to some extent, albeit in varying degrees. This would be more so if they believe that a healthy national economy will provide more opportunities for domestic institutional investors to increase their returns and that the interventions by activist funds are not desirable to the national economy. The paper also points out the fact that, as the decision on the merger would not only affect the share price of Samsung C&T but also those of other Samsung affiliates, both foreign and domestic investors who have stakes in multiple Samsung companies will carefully calculate the impact of the merger (or failure of the merger) on the value of their portfolios of Samsung companies, not simply on the value of Samsung C&T (Section 5).
Chaebols become easy preys of activist hedge funds, contrary to the conventional perception that they are formidable business groups. This paper attributes the reason to strong chaebol policies in Korea. The government’s regulations over the chaebols have continued to strengthen, especially with corporate reforms after the Asian Financial Crisis of 1997-8. As a result, Korea currently maintains the world’s most stringent fair trading regulations, as well as a highly punitive system for the inheritance of management rights. Korea’s commercial law is also the most rigid in the world in enforcing the “one-share, one-vote” principle. In a sense, chaebols are currently victims of excessively strict anti-chaebol policies. The paper posits that the underlying causes of the restrictive regulatory regime lie in a combination of anti-chaebol sentiment, utopian views about corporations, and a misdirected application of ‘economic democracy’ to corporate governance (Section 6).
The paper concludes that Korea should overhaul its chaebol policies based on a practical understanding of how a corporation functions in line with the global economic environment and the realities of the Korean economy. It then proposes practical measures to this end, including short-term measures like poison pills that protect corporations from speculative attacks, as well as long-term measures like allowing dual class shares by which longer-term investors have more say over shorter-term investors. It also suggests making it possible to inherit management rights through establishing public foundations as commonly done in most advanced countries.
2. The Core Issue on “Undervaluation” - Who is Manipulating the Market?
Activist funds typically intervene in corporate decisions by claiming that a corporation’s shares are undervalued, and argue that management should follow their advice to boost the share price. When they target corporations with large cashable assets, for instance, they argue that the share price will increase if a larger portion of those assets are returned to shareholders as dividends. According to their logic, shares are “undervalued” because the management does not take the necessary actions to reflect the true value of a company into the share price.
Elliott employs the same logic in the current dispute with Samsung. Elliott argues that the proposed stock swap ratio of 1 to 0.35 between Cheil and Samsung C&T is “unfair” and even “unlawful”, and that the proper ratio should be 1 to 1.6. As evidence of “undervaluation” of Samsung C&T, Elliott has submitted to a Seoul court a report from Ernst & Young that appraises the underlying asset values for both firms. By doing so, Elliott implicitly claims that the share price of Samsung C&T has can rise about 4.5 times (assuming that share price of Cheil remains same) if the merger does not go through and argues that the merger should be opposed.
Elliott’s claim might have some merit if Korean companies are allowed to exercise their discretion in setting stock swap ratios. But the Korean financial authority does not allow room for such discretion because it wants to protect minority investors and reduce the possibility of stock market manipulations. According to its regulations on capital markets and financial investment, companies should set the ratio by averaging the three closing market prices of the shares – those of one month, one week and one day before announcing merger plans. The merger ratios are a result of pure math in Korea. The 1-to-0.35 ratio simply reflects the market prices of the companies and does not use asset value in the calculation.
This regulation is based on the assumption of efficient markets - Share prices are end results that not only reflect a company’s asset value but also other factors such as growth potential and profitability. Players in the stock market, whether they are institutional investors or retail investors, try their best to make trading decisions based on information available. If all investors had believed that shares of a certain company were undervalued, the stock price would have increased because there would have been only buyers. But in reality, there are also those in the market who believe the stock price will decline. It is unreasonable to think that Elliott and its followers were the only investors aware of the “undervaluation” and the majority of other investors didn’t have this insight, so as to allow Samsung C&T’s shares to remain at around KRW53,000 before the merger.
If Elliott still argues that Samsung C&T’s shares are “undervalued”, it is tantamount to alleging that Samsung had been manipulating the price to remain low for such a long period. It might have been possible for big Korean companies to manipulate share prices in the past when they had sizeable slush funds and their book-keeping was opaque. But that is no longer the case today. After the 1997 financial crisis, Korea faithfully carried out financial and corporate reforms under the tutelage of the IMF. It has enforced a real-name financial transaction system and strengthened fair trading regulations. It is unthinkable that the Korean stock market is still so underdeveloped as to allow extensive share price manipulation of a corporation as large and visible as Samsung C&T.
If Elliott does not provide evidence that Samsung has manipulated the share price, one can argue that Elliott itself is in fact attempting to “manipulate” the company’s stock price by demanding the distribution of cashable assets to shareholders and recruiting other minority shareholders to its cause. If one assumes that the stock market functions efficiently, there is no ground to say share prices are currently “undervalued”. “Actions” by activist funds are therefore nothing more than trying to manipulate the market intended to push up share prices for short-term gains.
An empirical research on activist funds conducted by the European Corporate Governance Institute (ECGI) supports the efficient market view. After looking at 1,740 “engagements” by activist funds across 23 countries since 2000, it concludes that the majority of campaigns by activist funds have failed to result in a sustained rise in share prices, except in few cases where “restructurings” took place. Five years ago, French media conglomerate Vivendi had to reach a “compromise” to increase dividend and share buy-back program with a U.S. activist fund P. Schoenfeld Asset Management (PSAM). But Vivendi’s share price has been stagnant since then and the Financial Times pointed out that the Vivendi case is “not unusual” and consistent with the ECGI report. According to the study, activist funds don’t increase shareholder value in a sustainable manner, but rather “manipulate” the stock price by creating “events” and then taking short-term profits.
3. Shareholder Activism of Elliott - A “Holdout Fund”?
Elliott’s previous investment records around the globe are far from those contributing to increasing value for companies and countries. It is even possible to name it as a “holdout fund”, or “al-bak-gi fund” in Korean. “Holding out” refers to extortionate tactics where a speculator buys a portion of land in anticipation or with a priori knowledge of a development project and holds out the project by intentionally refusing to agree to compensation offered by the developer. Although other land owners have agreed to a reasonable level of compensation, the speculator demands a lot higher level of compensation for him with the pretext that his property and other rights have been seriously violated. The speculator does not care the development project at all or does not oppose the project itself, but normally buys the land with the sole purpose to earn super-normal profits by holding the entire development project hostage.
Elliott provides a model case for achieving profits through such tactics, and has been ruthless in pursuit of its aims. Elliott first attained notoriety as a “vulture fund” in Peru. Major international banks and Latin American countries had agreed on the Brady Plan in 1989, following active interventions by Nicholas Brady, then the U.S. Treasury Secretary. The plan was geared at making Latin America return to a growth path by allowing substantial debt reliefs and thereby sharing the fruits from future growth. However, Elliot purchased $20.7 million worth of defaulted loans made to Peru for a deeply discounted $11.4 million. Elliott then sued the nation and its Banco de la Nacion del Peru in a New York court for the original amount of the loan plus interest. This law suit effectively held the Brady Plan hostage. Elliott won a $58-million settlement and made a $47-million profit - a 400% return. Greg Palast says Peru’s president Alberto Fujimori ordered the treasury to pay everything Elliott asked for because Singer “seized” the presidential airplane by which Fujimori was escaping to Japan.
Elliott scaled up the size of its holdout scheme astronomically in Argentina. According to Palast, it purchased $630 million of bonds as the country was headed for default in 2001, reportedly at $48 million, about 7% of the face value, and demanded Argentina to pay $2.3 billion, including unpaid interest. It won a judgement from a New York court of $1.6 billion. The Argentinian government refused to pay it and Elliott countered it by making an unprecedented move. It seized the Argentine naval vessel ARA Libertad, which was anchoring at Ghana in West Africa, and demanded the payment.
Elliott’s “holdout” spread to Africa. And other funds followed suit. They even stopped international aids to African countries for famine and clean water to make their bonds paid (there was a cholera epidemic in West Africa due to the lack of clean water). Some African countries gave them money in order to receive aids. Palast says, as a result, Elliott received $90 million for Congo’s debts it bought at $20 million. The Wall Street Journal reported that Elliott was able to reach this settlement also by pressing forward on investigations into corruption by Congolese President Denis Sassou Nguesso.
Even in the U.S., Elliott profited by applying similar holdout methods against the U.S. government. When General Motors was on the brink of bankruptcy during the 2008-9 Global Financial Crisis, Elliott and other hedge funds, Paulson & Co. and Third Point bought Delphi Automotive, a former GM subsidiary whose auto parts remain essential to GM’s production lines. They purchased Delphi’s debts at “just 20 cents on the dollar of their face value” and held on to it. And they threatened the U.S. government to derail the GM rescue operation if it would not forego Delphi’s debts and provide the company with funds. Steve Rattner, who was in charge of the task force to negotiate with the troubled firms and their creditors, wrote in his memoir, Overhaul, that they told the Treasury and GM to hand over $350 million immediately, “because if you don’t, we’ll shut you down.” Delphi’s chief financial officer, John Sheehan, also said in a sworn deposition in July 2009 that the hedge fund debt holders backed up their threat with “an analysis of the cost to GM if Delphi were unwilling or unable to provide supply to GM,” forcing a “shutdown.” It would take “years and tens of billions” for GM to replace Delphi’s parts. Rattner likened the subsidies demanded by Delphi’s debt holders to “extortion demands by the Barbary pirates” but had to acquiesce to most of their demands. After cleaning up Delphi, the hedge funds took the company public. According to Palast, Elliott had at least “$1.29 billion in profits, about forty-four times their original investment”.
Elliott’s opposition to the merger between Samsung C&T and Cheil is an extension of its long history of hostage taking and holdout tactics. Elliott was never a long-term shareholder of Samsung C&T who was interested in the company’s future or its development projects. It did not appear on the roster of shareholders in 2014 and only began purchasing Samsung C&T’s shares in March 2015 when preparations for the merger began surfacing in analyst reports and the Korean media. It had increased its stake to 4.95%, just below the 5% disclosure threshold prior to the official merger announcement on May 26, 2015. Upon the announcement, Elliott increased its stake to 7.1% to become Samsung C&T’s third largest shareholder, and then commenced its campaign to oppose the merger. Elliott has never been on a campaign to oppose succession of family businesses. If this had been the case, it would have never invested in Samsung in the first place. Elliott only seized an opportunity to make good profits by holding Samsung’s succession plans hostage. And it is claiming that this is not only good for them but also for other shareholders.
4. Shareholder Activism and Populism: The Anti-Chaebol Coalition
Elliott is certainly an extreme case of activist funds which stand on a broad spectrum of shareholder actions. But there is a common behavior of activist funds. They exploit populism for profits and ‘minority shareholders’ right’ is their mantra to gain public support. Activist hedge funds originated from the “corporate raiders” of the 1980s, who typically bought a large block of shares of a company with their own money, took over the board of directors, and then pocketed profits by “restructuring” the company assets. From the 1990s, it became a more prevalent behavior of those activist funds to take a minority stake but up to the level to exert influence on the board for achieving their aims. As minority shareholders, activist funds need to form a united front by recruiting other shareholders to their cause. To this end, activist funds appeal to “investor populism,” claiming that minority shareholders are being victimized by majority shareholders, and that joining the opposition can protect their rights.
Populism (in a negative sense) is a tactic to pursue interests of special groups by appealing to public sentiment and by disguising theirs as public interests. Many disputes are a result of differences in interest and perspective among the parties involved. It is often difficult to make a decisive conclusion and take a side if one objectively considers the pros and cons of contending arguments. Employing populist tactics is effective in this situation to draw “swing votes”, which are in the middle of contending parties and ambivalent in their position on the issues concerned. Similarly, activist funds commonly use such populist tactics to recruit shareholders to their side. Mass media often becomes a conduit to mobilize wider public opinion in their favor.
A typical example of such populist tactics can be found in the dispute between P. Schoenfeld Asset Management (PSAM) and Vivendi Group of France. Vivendi originated from a state-run enterprise that managed France’s canal and water utilities before the French Revolution. Today, Vivendi is a media conglomerate that owns Europe’s largest film studio and TV channel Canal+. Under the former Chairman Jean-Marie Messier in the 1990s, Vivendi pursued an aggressive M&A strategy across the globe and even acquired Universal Studios, which earned him the nickname of “Napoleon” from the U.S. press and later led to the publication of a book entitled “The Man Who Tried to Buy the World.” However, Vivendi’s drive to become a global multimedia conglomerate stalled when it began to experience massive losses. Vivendi then streamlined its businesses to focus on media while shoring up cashable assets of approximately €15 billion by selling “non-core” assets including telecom businesses. Vivendi intended to pursue a long-term growth strategy based on these assets.
After acquiring a stake in Vivendi, however, PSAM demanded that Vivendi “return €9 billion of capital to shareholders via a special dividend”. PSAM then claimed that investors had bought Vivendi stocks due to its ample cashable assets and this was a major cause of strong performance of Vivendi’s share price. PSAM thus argued that Vivendi’s share price was stagnant because Vivendi failed to meet shareholder expectations for returning the capital to shareholders as dividends. PSAM claimed that a “lack of transparency regarding Vivendi’s use of cashable assets is the main culprit behind the devaluation of its stock price” and added that “investors could realize upside of up to 38% on their ownership of Core Vivendi following the distribution of excess cash and investments”.
The dispute between Vivendi and PSAM is a classic case that demonstrates conflict of interest between controlling shareholders seeking to grow their company with a long-term view and financial investors seeking to maximize their short-term returns. Vivendi management had built up cash reserves to use for its future growth strategy and carried out extensive restructuring for that purpose. In contrast, PSAM and other shareholders that sided with PSAM were mainly interested in Vivendi’s huge cash pile.
Activist funds typically resort to populism to mobilize support from other shareholder and the public by emphasizing “infringement of minority shareholders’ right” and discounting the management’s growth policies. PSAM claimed that the past rise of Vivendi’s stock price was mainly due to “investors’ confidence”: “Investors became confident that capital from asset sales would be returned. We believe that this confidence was the main driver of share performance”. And it criticized poor management practices in Vivendi, which were nowhere close to being “best practices”: “Vivendi is going to pursue an acquisition strategy that is designed for a private company. Investors own Vivendi as a public company and have a right to expect capital allocation consistent with the highest standards of public company gove