The “Korea Discount,” the amount by which foreign investors undervalue Korean stocks, stems largely from structural problems with the governance of the country’s major conglomerates, a brokerage said in a recent report.

In a paper titled “2012 Korean Corporate Governance,” Tongyang Securities Inc. argued that governance problems had flared up in the last decade, during which the top five conglomerates saw their combined market capitalization jump from 28.4 percent to 44.9 percent.

The report, based on the country’s top 80 companies and their earnings, auditing and governance-related data, argues that Korea’s governance system is now in “chaos” and there was no guiding model that companies can follow.

“The primary icon for Korean governance was ownership,” the report says. But a major paradigm shift is afoot, the report adds, forcing the outmoded “ownership” structure to give up its decades-long control of the country’s industrial sectors.

A growing number of Koreans are calling for tougher regulations and scrutiny against the business practices honed and implemented by the conglomerates, many of which have sparked public protest by profiting at the expense of smaller firms and social groups.

This year, civic organizations and individual investors filed suit against such practices, which prompted well-known conglomerate leaders to pledge to donate their private wealth to charities.

The crisis of chaebol governance has been in the offing, largely because of their own rule-bending practices, the report says.

It highlights three practices that have been perfected by Korean conglomerates: tunneling, propping and expropriation.

Tunneling refers to the act of artificially channeling new projects and business deals to key units whose stake are in large part owned by chaebol family members. Once such deals pile up, the benefits lead to huge, easy profits.

Propping is sharing of risks among affiliates in a chaebol under the assumption that a financially nonviable unit will get support from other affiliates.

Expropriation is a broader term that includes both tunneling and propping, while carrying a connotation of irregular transfer of wealth by higher and bigger conglomerate units.

The three practices, or “TPE,” helped Korean conglomerates achieve faster growth, while also ensuring that Korean shares traded at a discount compared with other economies, a phenomenon known as the “Korea Discount.”

The brokerage warns that major conglomerates are likely to engage in more irregular transfers of wealth to complete the inheritance process for the third-generation members of the chaebol families.

By Yang Sung-jin (insight@heraldcorp.com)