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KIM Yong-Ki

Korea’s Response to Hedge Fund Activism

KIM Yong-Ki

July 20, 2007

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The emergence of hedge funds has changed the way global financial markets operate. The number of hedge funds has skyrocketed from roughly 5,000 in late 2002 to 11,000 in late 2006; hedge funds’ total managed capital has also steadily rose totaling $1.5 trillion in 2006. Along with hedge funds’ increasing influence, however, so have government concerns over how to regulate these non-transparent, sizable pools of private capital. Apprehension is particularly palpable among corporate managers who may become a takeover target of a special breed of hedge fund: “hedge fund activists” resemble activist shareholders of the 1980s but are far more aggressive and disruptive in their tactics. Korean firms are particularly vulnerable to activist hedge funds due to the existing shareholder structure and regulatory framework.

Before looking at Korea’s specific situation, it first pays to differentiate how hedge fund activist differ from traditional activist shareholders. Although activist shareholders, such as Carl Icahn, took Wall Street by storm in the 1980s targeting poorly run companies, hedge fund activists may well eclipse their predecessors’ impact. Indeed, overall hedge funds have deeper pockets and their behavior is more pre-emptive, strategic, and active in nature than traditional activist stakeholders. The current high liquidity and low volatility market conditions have amplified hedge funds’ influence, leading yield-hungry investors into emerging markets to boost returns.

In the current investment environment, Korean firms are particularly vulnerable targets for hedge fund activists’ due to the prevailing shareholding structure and regulatory framework. As of April 2007, foreign investors held a stake exceeding 50% in seven of Korea’s largest companies; they held a stake ranging from 40-49.9% in another six. Foreign investment, in itself, is a healthy phenomenon that should be encouraged. However, firms should also recognize that hedge fund activist pick their targets based on the likelihood that other shareholders will support the proposed changes. Therefore, companies with foreign investors, or perceived sympathetic domestic investors, will often times become a target. In the two most high-profile cases in Korea to date, Carl Ichan’s proposed takeover of KT&G and Sovereign’s (a private investment vehicle) targeting of SK Corp, both companies had foreign investors and underutilized assets.

Furthermore, while Korea’s corporate governance has improved since the 1997 financial crisis, the nascent regulatory framework impairs firms’ ability to properly defend against takeovers. Two rules illustrate problems with the existing framework. First, shareholders with a stake greater than 3% currently cannot exercise voting rights in excess of that amount. Although controlling shareholders typically hold a stake exceeding 10%, their voting rights in audit committee elections are limited to 3%. Hedge funds, on the other hand, can scatter their shares over multiple legal entities all holding less than 3% each through establishing shell companies in tax haven areas. Therefore, hedge funds take advantage of the current loophole to increase its influence over corporate decision making.

In fact, Sovereign diffused its total stake of 14.99% into six different paper companies each having under 3% shares of SK Corporation, while the voting rights of SK C&C, the major shareholder of SK Corporation, was limited to 3% in spite of its total holding of 8.63%.

Current disclosure standards in securities market also lack transparency to give domestic firms adequate notice regarding potential takeover activity. Korea has adopted the “5% rule” regulating that any entity that purchases a stake exceeding 5% in a listed company must publicly disclose the investment at the end of five days. This regulatory rule, also adopted by major industrialized economies such as the US, France and Japan, flattens the playing field allowing both investors and the target firm access to common information. In Korea’s case, however, the rule adopted actually provides a seven-day working notification period for investors (five-day notification plus a two-day settlement period) that functions as a legal loophole allowing investors to acquire a 10% stake before public disclosure. The private investment entity Sovereign exploited this loophole when acquiring a stake in SK Corporation in 2004.

With these challenges in mind, what should Korea do? Korea undoubtedly faces tough policy choices in order to keep open and transparent markets, while at the same time giving firms the legal tools necessary to properly defend themselves. These choices, however, need not be mutually exclusive. For example, revising the 5% rule to mandate filings at the end of five days (without a settlement period) would help all market participants involved make more informed decisions. Although the pending Capital Markets Consolidation Law corrects the loophole, the law will not go into effect until 2008 exposing firms to continued risk. Furthermore, mandatory regulatory filings, in line with best practice corporate governance standards, should require investors to disclose the ultimate shareholder and source of funds in order to increase overall transparency. Finally, Korean firms must understand that the best defense is sometimes a good offense. Traditional methods to scare off potential acquirers through increasing stock prices will not likely work with deep-pocketed hedge funds. A better strategy maybe to strengthen communication with existing shareholders, maximize existing asset value and improve overall transparency.

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