[The Trap of Treasury Shares] ② The 'Magic' Transforming into Strengthening Controlling Shareholders by Combining with Demerger

Controversy Over 'Treasury Stock Magic' Grows Amid Demerger Increase
193 Cases Over 22 Years "Controlling Shareholder's Stake in New Company Rises"

Editor's NoteThe Financial Services Commission is reviewing a reform plan for the treasury stock system. The key points include 'mandatory cancellation after treasury stock repurchase' and 'prohibition of new share allocation to treasury stock during spin-offs.' The financial investment industry and individual investors welcome these changes, expecting improvements in shareholder rights. On the other hand, the business community opposes the plan, arguing that one of the means to defend management rights may disappear. This article analyzes the current status and effects of treasury stock repurchases and cancellations by domestic listed companies to explore reform measures for the treasury stock system.

[Asia Economy Reporter Lee Seon-ae] Last year, major companies consecutively announced spin-offs, sparking heated controversy over the 'treasury stock magic.' According to an analysis of the Financial Supervisory Service's electronic disclosure system data by Asia Economy on the 25th, there were 13 spin-off disclosures last year, the highest in 12 years. Especially, disclosures were concentrated in the second half of the year. Ten companies including Isu Chemical, OCI, Kolon Global, Daehan Steel, Hyundai Green Food, Hyundai Department Store, Aju Industry, AJ Networks, Hanwha Solutions, and Dongkuk Steel made announcements. In the second half of 2021, there was only one such case. This was largely due to the scheduled expiration of tax deferral benefits related to the conversion to holding companies at the end of this year.

A spin-off involves dividing a company's assets to establish a new company and allocating new shares of the newly established company to existing shareholders according to their shareholding ratios. The spin-off itself is not particularly controversial. The problem arises when spin-offs are combined with treasury stock acquisitions. Treasury stock can be misused to strengthen the controlling shareholder's power. For example, Daehan Steel announced a trust contract for acquiring treasury stock worth about 65 billion KRW in July and August last year, followed by a spin-off announcement in November. Hanwha Solutions also announced a spin-off and a decision to acquire treasury stock worth about 70 billion KRW in September last year.

Hwang Se-woon, a research fellow at the Korea Capital Market Institute, explained, "During the process of spin-offs dividing companies into holding companies and business units and exchanging shares, treasury stock is conveniently used by controlling shareholders," adding, "Allocating new shares to treasury stock results in strengthening the controlling shareholder's control." The controlling shareholder thus strengthens control without incurring costs by utilizing treasury stock. Seo Ji-yong, a professor at Sangmyung University's Department of Business Administration, said, "When spin-offs, which are relatively easier to finance and cause less shareholder value dilution than physical divisions, lead to a drop in stock price, active dividends and other measures to enhance shareholder value are necessary."

Controversy surrounding treasury stock arises from the possibility of its misuse for the private interests of controlling shareholders. Kim Jun-seok, senior research fellow at the Korea Capital Market Institute, pointed out, "It is common to see controlling shareholders expanding their control by using treasury stock magic during spin-offs, and cases where treasury stock is sold to friendly shareholders to defend management rights during disputes are also easily found," adding, "There is also a constant possibility that treasury stock acquisition and disposal are linked to insider trading."

According to the Korea Capital Market Institute, from 2000 to 2021, there were a total of 193 spin-offs by listed companies over 22 years. Among them, 92 were related to conversion to holding companies. Senior fellow Kim explained, "Analysis of these cases showed that the controlling shareholder's stake in the newly established company increased by 11 percentage points to 45% compared to before the spin-off," adding, "This is the result of new shares of the newly established company being allocated to treasury stock held by the surviving company, i.e., the treasury stock magic effect." He further added, "The increase in the controlling shareholder's stake in the surviving company and the difference in the composition of controlling shareholder stakes between the surviving and newly established companies are due to paid-in capital increases through in-kind contributions made after the spin-off." The individual controlling shareholder contributed the newly allocated shares of the new company as an in-kind contribution to the paid-in capital increase of the surviving company and secured shares of the surviving company, increasing the individual controlling shareholder's stake in the surviving company from 27% to 41%, and the corporate controlling shareholder's stake in the new company from 18% (including 11% acquired through treasury stock magic) to 32%.

Senior fellow Kim continued, "The controlling shareholder's market capitalization holding ratio increased by 13 percentage points from 34% before the spin-off to 47% after, while the individual controlling shareholder's ratio decreased from 27% to 24%, and the corporate controlling shareholder's ratio increased from 7% to 23%," pointing out, "The fact that the conversion to a holding company was pursued despite the decrease in the individual controlling shareholder's market capitalization holding ratio, who is the decision-making entity, suggests that strengthening control over the surviving company (holding company) was the goal of the holding company conversion."

As spin-offs are expected to increase in the future, there is a strong call to urgently reform the treasury stock system. Choi Nam-gon, a researcher at Yuanta Securities, predicted, "Cases of spin-offs for the purpose of converting to holding companies will increase among mid-sized companies."

Senior fellow Kim emphasized, "If the contradictory situation of recognizing the asset nature of treasury stock, which economically cannot be considered an asset, is left unattended, controlling shareholders will have incentives to arbitrarily use treasury stock, so controversies surrounding treasury stock will inevitably continue," adding, "Denying the asset nature of treasury stock and making treasury stock acquisition synonymous with cancellation will not only align with economic substance but also reduce the possibility of controlling shareholders abusing treasury stock, and strengthen the signaling effect, which is the most common goal of treasury stock acquisition."

This content was produced with the assistance of AI translation services.