Research Paper

Circular Equity Investment Prohibition Bill in South Korea

By
James Jung
(363183)

Trinity Western University

MBA 663: Canadian & International Law
Instructor: Rita Borzillo
December 1, 2015

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In many countries around the world, individuals or families control and manage a large
number of companies through complex arrangement of ownership chains. Although some of
them hold direct stakes in group firms, in many cases, they hold indirect stakes through other
firms in the group to control their companies in the group. One of the typical ownership
structures is a cross-shareholdings, which means that firms in the group have mutual ownership
relations. Specifically, one company in the group holds a stake in another, which, in turn, has a
stake in the first company. It leads to a complex web of ownership. Cross-shareholdings was also
commonly used by the Korean business groups (Chaebols) in South Korea for growing
corporations scale until 2000s. In spite of cross-shareholdings (circular equity investment)
allowed companies to maximize advantage of economic of scale and scope on economic
development process in 1990s when Korea had high economic growth rate, circular equity
investment caused several negative effects on companies and the Korean economy as it limits
influx of external funds, and the Korean companies were expanded affiliation by force. In
addition, controlling stockholder could have retained voting right without inserting real capital,
and it consequently had occurred side effect: distortion of corporate governance. Therefore, the
Korean government decided to regulate the circular equity investment by passing the circular
investment equity prohibition bill. However, there are debates about circular investment equity
prohibition bill because of its pros and cons. This paper will discuss whether circular investment
equity prohibition bill must be passed or not with analyzing the advantages and disadvantages of
the bill.
In past Korea, many companies had used mutual and circular equity investment for
growing corporations scale. Circular equity investment can be explained simply as A Company

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invests in B Company, which invests in C Company, and then C Company invests in A Company
making circle shaped investments as Figure 1 shown below.
Company
A
Company
B

Company
C

Figure 1. Circular Equity Investment

For example, according to Korea Investment &Securities Co, Ltd. (2012), Samsung Group that is
consisted of 81 affiliated companies has 17 circular shareholding relationships within the group.
The 17 circular shareholding relationships are grouped in three pillars: Samsung Everland
(Everland), Samsung Life Insurance (Samsung Life) and Samsung Electronics (SEC) as you see
Figure 2.

Figure 2. Samsung Groups circular shareholding structure (Source: Korea Investment &
Securities).
Circular equity investment allowed the Korean business groups to grow rapidly and become the
global group such as Samsung Electronics and Hyundai motor. Moreover, it also allowed the
group owners to control the affiliated companies successfully with small amount of capital. With

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the rapid growth of the Korean companies, South Korea became a developed country that has
13th largest market economy in the world by both nominal and purchasing power parity GDP
from one of the poorest countries after the Korean War of 1953. Furthermore, inter-company link
among affiliated companies through cross-shareholdings increases the effectiveness of group
operations. For instance, Samsung Electronics that produces smartphones purchase the
components of their products from affiliated companies such as LCD screens and semiconductors. It can reduce the cost of Samsung Electronics for manufacturing their products, and
increase the revenue of affiliated companies.
While there are several positive effects of circular equity investment, several negative
effects were continuously suggested by many economists and analysts. Circular equity
investment leaded the business group to poor financial structure due to limitation on influx of
external funds. Since many affiliated companies are linked by owning shares of another, one
companys problem negatively affects many other affiliated companies like a domino effect.
Moreover, polarization between large company and small company is significantly deepening.
Many analysts stated that cause of polarization is excessive centralization of economic power to
major companies. Major companies purchase the raw materials or components of their final
products from another affiliated companies in their group. It is very difficult for small companies
to survive in the market. Therefore, an opinion, limitation of the circular equity investment,
steadily has brought up as solution. The Korean government is trying to pass the bill to prohibit
the circular equity investment. However, in matters of introduction the system, pros and cons is
in confrontation.
Four reasons that people agree on regulating circular equity investment can be suggested.
First, people agree with regulating circular equity investment because it can minimize the

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hollowing out of capital through fictitious capital and address the gap between ownership and
governance. Circular equity investment generally forms a chain, ABCA, within a group.
Through Company Cs purchase of Company As shares, Company A can rule Companies B and
C with a capital amount less than what it has on the book. The owners can control several
companies with using a small amount of capital. The regulation can prevent it. Second,

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The extensive descriptions of the ownership structure of Asian (Claessens et al., 2000) and
European (Faccio and Lang, 2000) rms contain some discussion of the eect of
crossshareholdings on ultimate ownership. However, their results likely undertstate the eects of
cross-shareholdings. For example, Faccio and Lang manually check for the incidence of direct
cross-shareholdings (A owns shares in B which owns shares in A), and do not nd many cases in
their data. However, we the Korean data will show, cross-shareholding loops that include more
than two rms are very common. In fact, Faccio and Lang say that most countries impose a 10%
cap on direct cross-shareholdings, which eectively limit the extent to which direct crossshareholdings can occur. As discussed by Claessens et al., the manual computations used in their
paper and most of the previous literature have a hard