Monday, 31 July 2017

Bloomberg Businessweek/Stone, Kim and King: Summer of Samsung: A Corruption Scandal, a Political Firestorm—and a Record Profit

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Summer of Samsung: A Corruption Scandal, a Political Firestorm—and a Record Profit

A year after the exploding phones, Samsung is embroiled in the mess that brought down South Korea’s president. How is it still thriving?


By Brad Stone, Sam Kim, and Ian King
Thu Jul 27 00:09:20 2017

“How long does a horse live?”

On a Friday in June, Jay Y. Lee, the de facto head of the Samsung conglomerate, is enduring another afternoon at the Central District Court in Seoul, listening to the prosecution quiz a witness about the finer points of equine health. Lee is on trial for bribery and embezzlement, part of a series of scandals that led in March to the ouster of Park Geun-hye, South Korea’s first female president.

“It depends whether you’re talking about a competition horse, or …”
Featured in Bloomberg Businessweek, July 31, 2017. Subscribe now.
Photo Illustration: Victor Prado for Bloomberg Businessweek; Prop Stylist: Elizabeth Press

The windowless fifth-floor courtroom is packed with lawyers, journalists, and citizens who, like the rest of the country, are captivated by the proceedings. Some people are sitting on the floor; everyone is sweating. Clerks shake their heads in disbelief at the suffocating heat, waving their hands in frustration in front of the stagnant air-conditioning vents. Lee, his four co-defendants from Samsung’s executive team, and their phalanx of counsel sip water and mop their faces with handkerchiefs.

“It’s 20, no? It lives about 20 years and reaches its peak between 8 and 10?”

“Yes. I believe that’s the peak.”

Lee and his colleagues stand accused of bribing Park and one of her friends to facilitate a merger between two publicly traded Samsung companies—a combination, prosecutors contend, that was intended to strengthen Lee’s control over the Samsung empire. The form of the alleged bribe was Vitana V, an $800,000 thoroughbred show horse, plus $17 million in donations to foundations affiliated with the friend, whose daughter was hoping to qualify for the 2020 Olympics as an equestrienne. The Samsung executives describe the gifts as standard support for the country’s Olympic ambitions and deny allegations of bribery in this matter and others the prosecution has raised.

“Can the price of a horse drop if an incompetent athlete rides and fails to perform well?”

“I believe so.”

Lee, dressed in a dark blue suit and open-neck shirt, is a former equestrian himself; in his 20s, he won a medal at the Asian championships. Today, on what happens to be his 49th birthday, he listens intently to the proceedings, occasionally smiling, passing notes to his attorneys, and otherwise breaking his stoic pose only to apply lip balm. Late in the afternoon the judge asks whether the participants need a break, and Lee replies that he will “follow what everyone else wants.” No one else expresses a preference, so the judge snaps that they’ll just have to get on with it.

Hours of testimony later, the court adjourns. As Lee departs, no one wishes him a happy birthday—another small sign of the seemingly diminished fortunes of South Korea’s mightiest company.
Chung Yoo-ra, daughter of a friend of Park Geun-hye, in 2014.
Photographer: Kim Hong-Ji/Reuters

Founded in 1938 by Jay Y.’s grandfather, Lee Byung-chull, the Samsung group is a collection of about 60 interlinked companies, the kind of corporate family known in South Korea as a chaebol. There’s a shipbuilding division, a construction company, life insurance and advertising arms, soccer and baseball teams, and even a theme park 30 miles south of Seoul, called Everland.

Samsung Electronics Co. accounts for more than two-thirds of the conglomerate’s market value. Despite the accusations of corruption—and despite recalls in 2016 of some of its top-loading washing machines and, more famously, its Note 7 smartphone, which had a battery flaw that could cause it to burst into flames—Samsung Electronics remains associated, in the global public consciousness, with cutting-edge gadgetry. It’s also still making an extraordinary amount of money. In its most recent earnings report, released on July 27, the company said sales were up 20 percent from the previous year and operating profit had climbed 73 percent. The growth was fueled primarily by the memory-­chip division, but Samsung Electronics is now also the world’s top smartphone maker, thanks in part to the new Galaxy S8. And the company is close to surpassing Apple Inc. as the most profitable business in the world, and Intel Corp. as the largest maker of semiconductors.
Effigies of Park and others associated with the scandal.
Photographer: Ahn Young-joon/AP Photo

But while investors are applauding the company, South Koreans are protesting it. When the accusations against Lee and Park surfaced, weekly demonstrations in downtown Seoul against the government’s cozy relations with the chaebol swelled into the largest rallies since a 1980s democratic reform campaign. Protesters wielded papier-mâché puppets of Park and Lee; one sign read, “Send Jay Y. Lee to prison for being the real culprit in the scandal!”

“What’s good for Samsung is good for South Korea” was once an overriding national sentiment. Following the Korean War, chaebol drove the country’s development into a global economic power. Now, polls show that domestic support for them has collapsed, amid fresh accusations that they’ve been illegally buying influence. The government formed by Moon Jae-in after Park’s removal includes prominent chaebol critics who are agitating for greater shareholder rights and less family control.

Inside Samsung Electronics, the anger looks like just another obstacle in a series of them. The company remains confident of its engineering prowess, but it has been working to transform a hierarchical culture that has long prized loyalty, tireless work, and deference. Although this culture has been well-suited to a hardware company, executives know it will have to change if Samsung Electronics is to compete with Silicon Valley in technologies such as cloud services and artificial intelligence.

The shift may take place, depending on the outcome of Lee’s trial, without the guiding hand of Samsung’s longtime stewards. For years the Lee family and its top strategists have coordinated interactions among subsidiaries, dealt with the government, and approved large expenditures out of a department alternatively called the corporate strategy office, the restructuring office, and the control tower. But with the conglomerate under scrutiny, that office has been shuttered, and strategic planning among subsidiaries “no longer exists,” according to DJ Koh, president of mobile communications and one of several senior executives Samsung made available for this story. For the moment, the chaebol is like a headless octopus, its tentacles thrashing about without coordination.

“This is a new experience,” Koh says. “We must make our own decisions.”

The figure most closely associated with Samsung’s global rise is Lee Kun-hee, the son of founder Byung-chull and Jay Y.’s father. Kun-hee, who became chairman in 1987, was known as reclusive but charismatic. Under his guidance, Samsung invested in massive semiconductor and display-panel factories, prodding engineers to overcome the company’s early reputation for creating subpar knockoffs. In 1993, with sales of consumer appliances flat, he admonished executives to “change everything but your wife and children.” A few years later he commanded underlings to collect 150,000 defective cell phones into a pile and set them ablaze. Although not great for the environment, it sent a clear message about quality control.
Lee Kun-hee (middle) in early 2014.
Photographer: Yonhap News Agency

Despite his eccentricities, Kun-hee is widely lionized. In 1997, after the value of Samsung Electronics fell to $1.7 billion amid a wider Asian financial meltdown, he jettisoned peripheral businesses and doubled down on chips, screens, and phones. Within a decade, Samsung Electronics’ market value had grown sixtyfold. Song Jae-yong, a professor of strategy and international management at Seoul National University Business School, calls Kun-hee “one of the great business leaders of the 20th century.”

In 2014, at the age of 72, Kun-hee had a heart attack at his home overlooking the Han River. Samsung reported afterward that he was “recuperating in a stable condition,” but he hasn’t been heard from since, and the company won’t comment further. Multiple people familiar with the situation, who don’t want to be quoted discussing a private matter, say the chairman also had a stroke and remains in a vegetative state at the Samsung Medical Center on the outskirts of Seoul. When a Bloomberg reporter recently entered the VIP wing on the center’s top floor, he was immediately sent back to the lobby by a frantic security officer wearing a blue surgical mask.

Kun-hee’s health emergency set off a further crisis inside the family. The Lees’ control over Samsung has always been somewhat fragile, at least by the standards of Western corporations, which allow founders to protect their stature with special classes of stock that grant extra voting rights. By contrast, the Lees own relatively small stakes in individual Samsung entities, maintaining voting control through a tangle of cross-holdings. For example, according to Bloomberg data, Kun-hee owns only 3.8 percent of Samsung Electronics, but he’s the largest shareholder in Samsung Life Insurance Co., with 20 percent of the stock. Samsung Life in turn owns 8 percent of Samsung Electronics; that share, combined with those of other subsidiaries, adds up to a useful stake of more than 20 percent.

This convoluted structure limits the rights of other investors and frustrates activist shareholders. It’s also vulnerable to turns of fate like major illnesses. In the event of Kun-hee’s death, his son and presumed successor, Jay Y., would have to pay a steep tax bill to inherit his father’s stock and maintain control of Samsung—as much as $6 billion, according to Chung Sun-sup, chairman of Chaebul.com, which tracks executive wealth. This might require Jay Y. to sell some of the Lee family’s holdings, further diluting their tentative sway.

That’s where the horse comes in. Prosecutors say that in 2015, Jay Y. orchestrated the merger of two divisions: Samsung C&T Corp., which is dedicated to construction and trading, and Cheil Industries Inc., which owned several entertainment properties, including the theme park. The combination would have given the Lee family more power over the combined company and was allegedly intended to bolster its control over Samsung Electronics. The company says the move was designed to make the units more competitive.

To complete the merger over the objections of some activist investors, Samsung needed the approval of another major shareholder, the country’s National Pension Service. The prosecution theorizes that Samsung’s senior managers were unsure enough of the fund’s support—it had recently cast an anti-chaebol vote in an unrelated matter—that they sought for the president’s office to intervene on their behalf. Prosecutors have produced financial documents linking the horse to Samsung and Park’s friend, as well as records of text messages and phone calls between executives and Park’s office that they say demonstrate collusion.

However the judge decides—he will likely render a verdict by the end of the summer—the case has struck an exposed nerve in South Korea. The formerly supportive local media has abandoned the presumption that what’s good for Samsung is good for the country (not to mention for their own bottom lines; Samsung is a major advertiser). The company’s influence was once such that, in 2008, on a day when Kun-hee appeared for questioning by a special prosecutor, only one of the country’s three biggest newspapers covered the story on the front page; the others buried their articles deep inside. (Kun-hee was convicted of tax evasion the following year but was pardoned months later.)

Now Jay Y. is frequently photographed walking into court with a vacant expression on his face, shackled at the wrists and upper arms, and surrounded by as many as a half-dozen police officers. This daily, ritualized humiliation reflects a popular desire to bring down a chaebol businessman once known for hobnobbing with the global elite. And it’s only the latest embarrassment for the company.

A year ago, Samsung Electronics’ mobile communications division was jubilant. The company had enjoyed a stellar year, surpassing Apple in the U.S. smartphone market, and was preparing to cement this dominance with the August release of the Galaxy Note 7, which sported a stylus pen, an elegantly curved display, and fingerprint and iris scanners. A few days after the phone went on sale, the Summer Olympics kicked off with Samsung as a principal sponsor. Executives flew to Rio de Janeiro to bask in the attention. “It was a great moment,” recalls Lee Young-hee, Samsung Electronics’ executive vice president for global marketing.

A few weeks later, Lee, one of the few female senior executives at Samsung (and no relation to the Lees who control the company), was in Berlin for a conference when ominous reports started circulating on social media. Phones were bursting into flames and in some cases burning their owners. Lee says she didn’t believe the stories at first. Then more phones self-immolated. And still more. Airlines around the world banned the Note 7 from their flights. “It was a devastating experience,” she says. “The Note 7 was our pride.”

To contain the damage, executives at Samsung Electronics’ headquarters in Suwon, a suburb of Seoul, formed a task force under Koh, the mobile communications chief. For four months they met every day at 7 a.m., coordinating a response. Most important, they ordered the recall of the Note 7, which involved collecting millions of phones globally, and corralled hundreds of engineers into testing centers to figure out the cause.

Koh pegs the cost of the effort at more than $5 billion, but he doesn’t recall the Lee family blinking at the expense. When he met with Jay Y. during the saga, Lee just listened and pledged support. “I think he must have known how much it cost, but he never mentioned anything about money,” Koh says. “He just said, ‘Mr. Koh, please manage it properly.’ ”

In January, Samsung held a press conference to announce the results of its investigation. The cause of the exploding Notes, Koh said, was improperly designed batteries supplied by a Samsung subsidiary and then a backup vendor that had rushed into production. Samsung pledged to test its phones and their component parts more rigorously. The press conference ended with Koh bowing deeply in apology.

The explanation left some Samsung watchers unconvinced. The company denied reports that it had cut corners to beat the iPhone 7 to market, and it hadn’t acknowledged that its hierarchical culture might have discouraged junior employees from raising red flags. Employees at Samsung feel “pressurized to make decisions that please the powerful boss,” says Paul Swiercz, a management professor at George Washington University. “There is no one pushing back.”

For years, Samsung has quietly sought to reform its demanding culture. In 2009 an internal program called Work Smart urged employees to spend their office time more efficiently and take weekends off. In 2012 the company introduced its “119” program, which dictates that employees at formal outings—at which they often felt compelled to appear and keep up with the boss—be limited to one drink, at one bar, ending at 9 p.m. More recently it trotted out an initiative called Startup Samsung to streamline reporting structures and eliminate bureaucratic layers.

But deference remains ingrained, right down to the corporate vernacular. For example, workers at Samsung, as at other South Korean companies, typically address one another by title or position rather than by name, unless they’re speaking with a close friend. Such traditions make it difficult for employees to speak frankly or to warn of major mistakes on the horizon. “I hate it,” Koh says. “Juniors will freeze. They will not make any comment.” The company has been trying to get employees to call each other by their first names, adding the professional honorific “nim” as a suffix, and Koh has asked employees to call him “DJ” instead of “president.” But, he says, snapping his fingers, “For them it’s not easy to change in just a day.”
The new semiconductor plant in Pyeongtaek.
Source: Samsung

Regaining its technological footing has come easier to Samsung. The Galaxy S8 has been combustion-free, and in a remarkable sign of tenacity, the company just issued a refurbished Note 7 Fan Edition in South Korea. Where many companies would have abandoned a besmirched brand, Samsung charges ahead.

To appreciate how deeply such relentlessness is embedded in the company’s makeup, you must drive 45 miles south of Seoul, to flat pastures that were once populated by pigs and cows. After navigating a well-manicured path up a small hill in a newly fashionable neighborhood, you arrive at an outcropping with an expansive view of a stupendously large construction site. Towering cranes dot the skyline above a 3 million-square-meter campus. Scattered buildings with unironic signs such as “disaster prevention center” and “fire station” ring two enormous structures decorated with colored squares in the style of the Dutch painter Piet Mondrian.

This is Pyeongtaek, site of Samsung Electronics’ newest semiconductor plant. The facility is designed to extend the company’s dominance in memory chips and perhaps to expand its share of the more profitable logic processor business—competing with the likes of Intel to make the brains of smartphones and PCs. The plant, which broke ground in 2015, was one of the last projects Jay Y. approved before his legal troubles began. Already it’s producing its first chips, far faster than the industry norm of three to five years to get new plants up and running. Samsung Electronics can do this because it has mastered automation and precision manufacturing, and can draw on its corporate brethren to deploy hordes of construction workers with militaristic efficiency. It can also easily summon capital. Samsung says Pyeongtaek will cost $27 billion to build—a huge amount, but less than half the company’s $63 billion in reserves.
Galaxy S8+ smartphones on display at a launch event in New York on March 29, 2017.
Photographer: Mark Kauzlarich/Bloomberg

Over the years, deep pockets have allowed the Lee family to make investments during the memory-chip industry’s periodic, brutal downturns. When the inevitable rebounds occurred, Samsung Electronics would be ready to start selling the next generation of chips, leaving its competitors in the dust. “Even for us to build one factory we have to hedge risk,” says Mark Durcan, who stepped down as chief executive officer of Samsung rival Micron Technology Inc. earlier this year. “The numbers are so big. They don’t have those issues.”

Samsung isn’t shy about celebrating its dominance. On a trip to the Hwaseong chip plant, about 15 miles from Pyeongtaek, a digital clock in the visitors museum reports that it’s been “25 years, 17 days, 11 hours, 24 minutes, and 54 seconds” since the company became the world’s largest memory-chip maker. Nearby, a window opens onto one of the campus’s chip fabrication plants. Robots zip along ceiling tracks, zigzagging around a room that extends as far as the eye can see. Each metallic arm totes several silicon wafers encased in a clear brown cartridge, which it periodically lowers and inserts into refrigerator-size machines that burn layers of microscopic circuitry onto the surface of the disks. The only two humans in sight look on in their yellow cleansuits, supervising the production.

In May, Samsung created an independent foundry business that makes processors for competitors, such as Qualcomm Inc. and Apple, that can’t or don’t want to build chip plants themselves. This profitable sector is dominated by Taiwan Semiconductor Manufacturing Co. Now Samsung is coming for it, confident it can walk the tricky line of making processors for both its rivals and itself. “Once we start something, a new business,” says Yoon Jong-shik, the executive vice president in charge of the effort, “we always make it a good success in 10 years.”

For all Samsung’s triumphs over Japanese and American manufacturers, one dominion remains elusive: software. The company pines to compete with Amazon.com Inc. and Google Inc. by developing popular cloud services and intelligent personal assistants—and especially applications capable of linking its smartphones with its flatscreen TVs, washing machines, and refrigerators.

A few years ago, Samsung tried introducing a smartphone operating system, called Tizen, which didn’t catch on and is now used mostly in smartwatches and some appliances. Other apps, including Samsung Health, Samsung Cloud, and Milk Music, lag behind rival products. Only its Samsung Pay digital wallet has shown much promise, adopted in almost 20 countries thus far. The company is hoping its new virtual assistant, Bixby, will be its first big hit.

Koh, who has been at Samsung for 33 years and has the top-floor office to prove it, says he knows that becoming a leading software developer will require Samsung to attract creative, entrepreneurial employees. His pitch for Bixby, though, demonstrates some of the company’s familiar culture issues.

Koh asks a reporter, “Do you touch your assistant? Your secretary?”

Reporter: “I don’t have an assistant. Also, it would be a personnel violation.”

“Exactly! Touch is not allowed. Just say something. So if we change our interaction of touching [the phone] and [use our] voice, that would be perfect.”

When a reporter points out that Google has its own voice assistant, creating a potential point of friction with the company that makes the Android software powering most Samsung smartphones and tablets, Koh rolls out an old Woody Allen routine.

Koh: “I want to ask you: Are you married?”

Reporter: “I’m engaged.”

“Engaged! How many rings do you need?”

“Uh. … Two?”

“I would say three. An engagement ring, a wedding ring, and another ring is always necessary: suffering.”
Koh at a Galaxy S8 launch event.
Photographer: Drew Angerer/Getty Images

The joke draws hearty chuckles from Koh’s staff.

“In many areas, we’re working with Google very closely,” he explains. “But you know, even though you’re engaged, you never fight with your wife or your girlfriend?

“Anyway, our competitor is not in Mountain View,” Koh hastens to add, leaving unmentioned the company down the road in Cupertino.

A month after Jay Y.’s birthday court appearance, he’s due back on another sweltering summer day in Seoul. Today, the topic of testimony will be whether a Samsung pharmaceutical division illegally lobbied the government to get a listing on the national stock exchange. (Samsung’s response: no.)

Outside, beyond a heavily guarded gate, another battle is brewing. A small group of activists, led by a woman in a wheelchair, is waiting to confront Lee. The woman identifies herself as Han Hye-kyung and says she’s a former Samsung worker in her 30s with a brain tumor. She holds a sign saying “Punish Jay Y. Lee,” and her T-shirt reads, “No more death in Samsung”—a reference to former Samsung workers who contend that exposure to toxic materials caused disease, especially cancer. After years of fighting the workers and their families, Samsung created a roughly $90 million compensation pool, but many have refused to settle on its terms. The company says it’s keeping the application channel open and working to resolve the remaining cases.

As Lee’s lawyers and co-defendants enter the courthouse, the activists hurl invective at them. But Lee has supporters of his own—dozens of mostly older people, representative of a large group of South Koreans who have started to push back against the political changes wrought by the corruption scandal. The confrontation quickly gets heated.

“What did Jay Y. Lee do wrong? He was only trying to make our nation greater by making Samsung greater!”

“If you don’t like Samsung, just go to North Korea!”

“Samsung has fed us generation after generation. They made our nation famous! You’re shameless!”

Security guards step in, and things momentarily quiet down. A reporter asks Han why she blames Jay Y. rather than his father, Kun-hee. She replies that if the son has inherited his wealth, he must also embrace the responsibility. Nearby, Samsung’s supporters start to chant “Free Jay Y. Lee!”



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