Korean Corporate Governance Opinion
We urge SK Innovation and SK E&S BoDs re-evaluate merger
Managing business is more than just a “financial story”
SK Group incident clearly was rooted in strong appetite for debt and a lack of understanding of corporate governance.
Korea's M&A landscape is dominated by intra-group transactions, where the process is typically orchestrated by the controlling shareholder with minimal consideration for potential conflicts of interest among minority shareholders. Following the Doosan incident in July, Doosan management has asserted that they are legally in the clear as the merger ratio was calculated in compliance with the Capital Markets Act. However, minority shareholders and regulators are insisting on procedures and outcomes that align with global best practices. Despite the evolution of corporate governance and the rising expectations for ethical leadership, Doosan’s Park family and its management have demonstrated a disturbingly outdated approach to treating minority shareholders, reminiscent of the practices of the 1980s and 1990s.
SK Inc. is the controlling shareholder with respective stakes of 36% and 90% in SK Innovation and SK E&S that are scheduled to convene a shareholders' meeting on August 27th to seek approval for the proposed merger between the two. In the proposed merger, SK Innovation will absorb unlisted SK E&S at 1 for 1.19 share ratio (ie, proposed that for every SK E&S share. 1.19 SK Innovation shares will be distributed), resulting in the issuance of 55 million new SK Innovation shares, an increase of 58% in the total outstanding shares. This significant dilution of existing SK Innovation shareholders' equity underscores the importance of the quality of assets being acquired by SK Innovation and the fairness of the exchange ratio.
The SK Group’s current problems can be attributed to two primary factors: a disregard for debt financing and a lack of understanding of corporate governance. While debt can be a strategic tool for growth and enhance profitability, excessive leverage can pose significant risks. As evidenced by the experience of E-mart, high debt levels can hinder the share price appreciation and market capitalization.
SK Group, facing challenges in its core businesses including batteries, has seen its debt balloon to over W116 trillion as a result of aggressive investments. This excessive leverage has put its position as the most indebted Chaebol in Korea. Following the board of directors' resolution on July 17th, SK Innovation's share price declined by 14% and SK Inc. by 11%. SK Inc., the holding company of the second-largest conglomerate in Korea, and flagship affiliate, SK Innovation, have seen their market capitalizations plummet to just W10 trillion each. This significant decline is largely attributed to these companies' immense debt burden. As a result of Chairman Chey Tae-won's obsession with “financial storytelling”, and the recruitment of many subpar M&A experts who prioritized their own bonuses over the company's interests, the entire group is now deeply in debt. SK Group's push for "financial storytelling" under Chairman Chey since 2020, which prioritized growth narratives over traditional financial metrics, has been marred by a series of unprofitable deals and a lack of strategic coordination in investment activities across the group.
For the group, the top priority is to revive unlisted SK On, which reported a net loss of W1.1 trillion in the first half of the year, marking 11 consecutive quarters of losses. SK Group views the next one to two years as a critical juncture for the turnaround of SK On. Despite a domestic credit rating of A, SK On's W19 trillion net debt would place it firmly in the distressed debt category under US standards. Although SK On may need to seek a debt-for-equity swap to be alleviated, such a move is unlikely to be approved by influential shareholders like MBK Partners and Hillhouse. Prior to the merger announcement, SK Innovation, saddled with a significant debt load, was downgraded to a junk status, BB+ rating from S&P.
Contrary to their equity classification officially, SK E&S's W3.1 trillion in redeemable convertible preference shares (RCPS) should be categorized as debt in reality. Initially, the RCPS offered a guaranteed IRR of 7.5% upon cash redemption. However, due to the merger and the need for consent from the sole RCPS investor KKR, the IRR has been stepped up to 9.9%. Ultimately, this is still debt that must be repaid, and if cash redemption is not feasible, KKR can claim payment in the form of equity in seven city gas companies.
The merger highlights a significant corporate governance issue, in our view, as it appears to be a bailout of struggling SK Innovation by SK Inc. minority shareholders, by using a 90% controlled SK E&S equity and earnings. This decision, driven primarily by the interests of controlling shareholder Chairman Chey, undermines the interests of minority shareholders and raises questions about the soundness of the company's corporate governance. For the past several years, Chairman Chey has emphasized board-centered management at the group's Director's Summit, emphasizing to establish a governance structure that supports independent management.
However, the reality is that key members of the SK Group, including Chairman Chey himself, CEO and board members pushed forward with the merger without a solid grasp of fundamental corporate governance principles. As a result, such drive created more negative consequences as exemplified by the listing plan for SK On, a 90% subsidiary of SK Innovation and a grandchild company of SK Inc. SK On, a subsidiary split off from SK Innovation in October 2021, is a prime example of poor governance, similar to LG Energy Solution's split-off listing. If this practice continues at the subsidiary and sub-subsidiary levels, minority shareholders of SK Inc. and SK Innovation will continue to suffer.
We propose five key recommendations to the SK Group concerning the recent merger.
First, We urge SK Innovation and SK E&S hold separate board meetings to reassess the rationale and terms of the proposed merger from the standpoint of minority shareholders, prior to the August 27th shareholder meetings. As Professor Kyung-hoon Chun of Seoul National University Law School pointed out in a Law Times column, "In capital transactions such as mergers, it is a global standard for the board of directors to examine not only the business perspective but also whether it is in the best interests of minority shareholders."
Second, both boards should establish special committee comprised exclusively of independent directors to undertake a comprehensive review of the proposed merger. It has been reported that the National Pension Service, holding more than 6% stake of SK Innovation, has conveyed a similar recommendation to SK Innovation. Following the precedent set by Celltrion, which recently terminated its merger plans, a special committee, comprised of all outside directors, was tasked with conducting a comprehensive evaluation of the merger's feasibility. In the context of Japan's ongoing corporate governance reforms, Seven & i Holdings, the parent company of the renowned Seven-Eleven convenience store chain, has become the target of a public takeover bid by a Canadian retail company. To ensure that the best interests of minority shareholders are served in this deal, the company has announced the formation of an independent committee comprised solely of independent directors. This decision is in compliance with the Japanese government's 2023 guidelines governing M&A transactions aimed at gaining management control.
Third, we request that SK Inc. refrain from exercising its voting rights at the upcoming SK Innovation shareholders' meeting given that it's a related party transaction. Given the conflicting interests of various stakeholders involved in this merger, we propose that the decision be made solely by minority shareholders, including foreign investors.
Fourth, we strongly recommend that SK Innovation prioritize “Value-up” measures before any further consideration of the merger. Similarly, Doosan and Hanwha have recently prioritized the interests of their controlling shareholders over the broader goal of value enhancement, unfortunately.
Lastly, we question the credibility of SK Innovation's forecast of a 3.5-fold increase in EBITDA by 2030. The company has projected a W20 trillion EBITDA in 2030, contingent upon the completion of the merger, which is expected to generate W5.8 trillion in EBITDA for the combined entity in 2024. Can the management and board confidently assure minority shareholders that this target is achievable? We request that they present more conservative and attainable figures, rather than mere hopes or dreams. While the merger is anticipated to mitigate earnings volatility and enhance the company's equity valuation, it is important to acknowledge the potential drawbacks, including a share dilution due to 58% increase in SK Innovation shares outstanding and potential constraints on long- term growth.
The credibility of SK Group CEOs' statements is questionable. In a 2021 interview with Forbes, former SK On CEO Ji Dong-Sup confidently predicted that SK On would undoubtedly become the #1 manufacturer in the battery industry. Similarly, former SK Inc. CEO Jang Dong-hyun who also sat on the board of SK Innovation, promised SK Inc. investors at the 2021 annual shareholders' meeting that the company would strive to achieve a share price of W2 million by 2025. However, the share price has fallen from W270,000 in March 2021 to W140,000, less than one-tenth of the target price. This is the aftermath of a failed "financial story" fueled by debt addiction.
August 22, 2024
Korean Corporate Governance Forum
Chairman, Namuh Rhee
Korean Corporate Governance Opinion
We urge SK Innovation and SK E&S BoDs re-evaluate merger
Managing business is more than just a “financial story”
SK Group incident clearly was rooted in strong appetite for debt and a lack of understanding of corporate governance.
Korea's M&A landscape is dominated by intra-group transactions, where the process is typically orchestrated by the controlling shareholder with minimal consideration for potential conflicts of interest among minority shareholders. Following the Doosan incident in July, Doosan management has asserted that they are legally in the clear as the merger ratio was calculated in compliance with the Capital Markets Act. However, minority shareholders and regulators are insisting on procedures and outcomes that align with global best practices. Despite the evolution of corporate governance and the rising expectations for ethical leadership, Doosan’s Park family and its management have demonstrated a disturbingly outdated approach to treating minority shareholders, reminiscent of the practices of the 1980s and 1990s.
SK Inc. is the controlling shareholder with respective stakes of 36% and 90% in SK Innovation and SK E&S that are scheduled to convene a shareholders' meeting on August 27th to seek approval for the proposed merger between the two. In the proposed merger, SK Innovation will absorb unlisted SK E&S at 1 for 1.19 share ratio (ie, proposed that for every SK E&S share. 1.19 SK Innovation shares will be distributed), resulting in the issuance of 55 million new SK Innovation shares, an increase of 58% in the total outstanding shares. This significant dilution of existing SK Innovation shareholders' equity underscores the importance of the quality of assets being acquired by SK Innovation and the fairness of the exchange ratio.
The SK Group’s current problems can be attributed to two primary factors: a disregard for debt financing and a lack of understanding of corporate governance. While debt can be a strategic tool for growth and enhance profitability, excessive leverage can pose significant risks. As evidenced by the experience of E-mart, high debt levels can hinder the share price appreciation and market capitalization.
SK Group, facing challenges in its core businesses including batteries, has seen its debt balloon to over W116 trillion as a result of aggressive investments. This excessive leverage has put its position as the most indebted Chaebol in Korea. Following the board of directors' resolution on July 17th, SK Innovation's share price declined by 14% and SK Inc. by 11%. SK Inc., the holding company of the second-largest conglomerate in Korea, and flagship affiliate, SK Innovation, have seen their market capitalizations plummet to just W10 trillion each. This significant decline is largely attributed to these companies' immense debt burden. As a result of Chairman Chey Tae-won's obsession with “financial storytelling”, and the recruitment of many subpar M&A experts who prioritized their own bonuses over the company's interests, the entire group is now deeply in debt. SK Group's push for "financial storytelling" under Chairman Chey since 2020, which prioritized growth narratives over traditional financial metrics, has been marred by a series of unprofitable deals and a lack of strategic coordination in investment activities across the group.
For the group, the top priority is to revive unlisted SK On, which reported a net loss of W1.1 trillion in the first half of the year, marking 11 consecutive quarters of losses. SK Group views the next one to two years as a critical juncture for the turnaround of SK On. Despite a domestic credit rating of A, SK On's W19 trillion net debt would place it firmly in the distressed debt category under US standards. Although SK On may need to seek a debt-for-equity swap to be alleviated, such a move is unlikely to be approved by influential shareholders like MBK Partners and Hillhouse. Prior to the merger announcement, SK Innovation, saddled with a significant debt load, was downgraded to a junk status, BB+ rating from S&P.
Contrary to their equity classification officially, SK E&S's W3.1 trillion in redeemable convertible preference shares (RCPS) should be categorized as debt in reality. Initially, the RCPS offered a guaranteed IRR of 7.5% upon cash redemption. However, due to the merger and the need for consent from the sole RCPS investor KKR, the IRR has been stepped up to 9.9%. Ultimately, this is still debt that must be repaid, and if cash redemption is not feasible, KKR can claim payment in the form of equity in seven city gas companies.
The merger highlights a significant corporate governance issue, in our view, as it appears to be a bailout of struggling SK Innovation by SK Inc. minority shareholders, by using a 90% controlled SK E&S equity and earnings. This decision, driven primarily by the interests of controlling shareholder Chairman Chey, undermines the interests of minority shareholders and raises questions about the soundness of the company's corporate governance. For the past several years, Chairman Chey has emphasized board-centered management at the group's Director's Summit, emphasizing to establish a governance structure that supports independent management.
However, the reality is that key members of the SK Group, including Chairman Chey himself, CEO and board members pushed forward with the merger without a solid grasp of fundamental corporate governance principles. As a result, such drive created more negative consequences as exemplified by the listing plan for SK On, a 90% subsidiary of SK Innovation and a grandchild company of SK Inc. SK On, a subsidiary split off from SK Innovation in October 2021, is a prime example of poor governance, similar to LG Energy Solution's split-off listing. If this practice continues at the subsidiary and sub-subsidiary levels, minority shareholders of SK Inc. and SK Innovation will continue to suffer.
We propose five key recommendations to the SK Group concerning the recent merger.
First, We urge SK Innovation and SK E&S hold separate board meetings to reassess the rationale and terms of the proposed merger from the standpoint of minority shareholders, prior to the August 27th shareholder meetings. As Professor Kyung-hoon Chun of Seoul National University Law School pointed out in a Law Times column, "In capital transactions such as mergers, it is a global standard for the board of directors to examine not only the business perspective but also whether it is in the best interests of minority shareholders."
Second, both boards should establish special committee comprised exclusively of independent directors to undertake a comprehensive review of the proposed merger. It has been reported that the National Pension Service, holding more than 6% stake of SK Innovation, has conveyed a similar recommendation to SK Innovation. Following the precedent set by Celltrion, which recently terminated its merger plans, a special committee, comprised of all outside directors, was tasked with conducting a comprehensive evaluation of the merger's feasibility. In the context of Japan's ongoing corporate governance reforms, Seven & i Holdings, the parent company of the renowned Seven-Eleven convenience store chain, has become the target of a public takeover bid by a Canadian retail company. To ensure that the best interests of minority shareholders are served in this deal, the company has announced the formation of an independent committee comprised solely of independent directors. This decision is in compliance with the Japanese government's 2023 guidelines governing M&A transactions aimed at gaining management control.
Third, we request that SK Inc. refrain from exercising its voting rights at the upcoming SK Innovation shareholders' meeting given that it's a related party transaction. Given the conflicting interests of various stakeholders involved in this merger, we propose that the decision be made solely by minority shareholders, including foreign investors.
Fourth, we strongly recommend that SK Innovation prioritize “Value-up” measures before any further consideration of the merger. Similarly, Doosan and Hanwha have recently prioritized the interests of their controlling shareholders over the broader goal of value enhancement, unfortunately.
Lastly, we question the credibility of SK Innovation's forecast of a 3.5-fold increase in EBITDA by 2030. The company has projected a W20 trillion EBITDA in 2030, contingent upon the completion of the merger, which is expected to generate W5.8 trillion in EBITDA for the combined entity in 2024. Can the management and board confidently assure minority shareholders that this target is achievable? We request that they present more conservative and attainable figures, rather than mere hopes or dreams. While the merger is anticipated to mitigate earnings volatility and enhance the company's equity valuation, it is important to acknowledge the potential drawbacks, including a share dilution due to 58% increase in SK Innovation shares outstanding and potential constraints on long- term growth.
The credibility of SK Group CEOs' statements is questionable. In a 2021 interview with Forbes, former SK On CEO Ji Dong-Sup confidently predicted that SK On would undoubtedly become the #1 manufacturer in the battery industry. Similarly, former SK Inc. CEO Jang Dong-hyun who also sat on the board of SK Innovation, promised SK Inc. investors at the 2021 annual shareholders' meeting that the company would strive to achieve a share price of W2 million by 2025. However, the share price has fallen from W270,000 in March 2021 to W140,000, less than one-tenth of the target price. This is the aftermath of a failed "financial story" fueled by debt addiction.
August 22, 2024
Korean Corporate Governance Forum
Chairman, Namuh Rhee