Corporate Governance in Korea: How to Improve Corporate Governance and Transparency

Hwa-Jin Kim, Seoul National University

Globalization of the Korean Capital Markets Walter H. Shorenstein Asia-Pacific Research Center, Stanford University

April 20, 2012

Introduction

•  Corporate governance has been one of the most contentious and actively discussed economic, social and legal issues in Korea since the outbreak of financial crisis in late 1997.

  Since early 1998, large-scale regulatory reforms for corporate governance have changed not only the way that Korean firms and financial markets function, but also the fundamentals and dynamics of Korean society and culture.

  This talk will illustrate and evaluate developments in Korean corporate governance that took place for the past fifteen years by looking at the Korean economy’s adaptation to global standards prevalent in a globalizing market.

  Special attention will be given to the corporate governance of banks and other financial institutions, as it exemplifies many of the Korea-specific corporate governance and control issues.

Korea, Inc.

Population (South) 50 million Cf. 60 m. in UK, 40 m. in Spain

World’s 8th largest exporter Surpassed UK, Russia and Canada

World’s 11th largest oil consumer

World’s largest shipbuilder and 5th largest automobile maker

Samsung, LG, Hyundai, Kia and POSCO

Korean Economy: The Epic Journey

Korea is a crash course on the Western capitalism offered in East Asia.

Korean government and firms learned everything about the business and finance in the shortest amount of time.

  1945 liberated from the 36 years of Japanese colonial regime; divided into South and North

  1950 – 1953 Korean War: the new nation devastated

  43 years of hard working: one of the poorest countries in the world became Spain within a half century

  1996 joined OECD

1997 crashed

The US in 2008 Korea in 1997

2008 – 2009 US

DavisPolk

2008 – 2009 US

DavisPolk

1997 – 1998 Korea

Too Indebted To Fail? Debt-to-Equity Ratios

Woosung Construction 3,323%

Hanbo Steel 1,893%

Sammi Steel 1,762%

30 Largest Groups average 519%

1.  Directed Lending Practices

The Restructuring of Financial Institutions in Korea 1997 – 1999

Number as of the end of 1997

Revocation of Business License

Merger Bankruptcy Number as of Sept. 1999

Commercial Banks 33 5 5 - 23

Merchant Banks 30 17 2 - 11

Securities Companies 36 5 - 1 30

Insurance Companies 50 4 1 - 45

Mutual Savings & Finance

231 25 4 7 195

Securities Investment Trust

31 2 - 5 24

Leasing Companies 25 - - 5 20

Total 436 58 12 18 348

“In cross-country regressions, corporate governance variables explain more of

the variation in exchange rates and stock market performance during the Asian crisis than do macroeconomic variables.”

“[C]orporate governance in general, and the de facto protection of minority

shareholder rights in particular, matters a great deal for the extent of exchange rate depreciation and stock market decline in 1997-98.”

Johnson, Boone, Breach & Friedman, Corporate Governance in the Asian Financial Crisis, 58 Journal of Financial Economics 141 (2000)

McKinsey Investor Opinion Survey 2000

Country Willing to Pay a Premium Average Premium

Korea Mexico

91 90

24.2 21.5

Thailand Brazil Taiwan Indonesia Malaysia US UK Argentina Chile Japan France Spain Sweden Switzerland

89 89 89 88 88 84 84 82 82 82 82 82 82 82

25.7 22.9 20.2 27.1 24.9 18.3 17.9 21.2 20.8 20.2 19.8 19.2 18.2 18.0

Germany Belgium Netherlands Venezuela Colombia Italy

79 79 79 78 78 71

20.2 19.6 18.5 27.6 27.2 22.0

Investors’ Willingness to Pay a Premium for a Well-Governed Company (%)

The So-Called ‘Korea Discount’

The Economist, Feb. 11th, 2012

Corporate Governance Behavior and Firm Value

  Black-Jang-Kim’s Study

  Documented that corporate governance is an important factor explaining firm value and firm return in the Korean market.

  Showed that an increase in corporate governance index by 10 (out of 100) units results into an increase of Tobin’s Q by 0.003 or market-to-book ratio by 0.007.

  Showed also that an increase in corporate governance index by 10 units increases the level of excess return by 4-6 percent over a year period.

  Helped to clear the skepticism on the link between corporate governance and firm performance in the Korean market.

  Helped also to justify the existence of corporate governance funds that reap capital gain by influencing the firms they invest to adopt better governance structure.

IMF Bailout + Conditionality

Golden Efforts The Korean government and government officials, in particular, have heroically performed the implementation of comprehensive reform programs in various sectors while also endeavoring to achieving national political consensus on such reforms and acquiring international recognition on the seriousness and permanency of the reforms.

Jang

Control-Ownership Disparity of the Top 10 Chaebol (as of April 2004) E. Han Kim & Woochan Kim

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

Dongbu

Doosan

Kumho-Asiana

Hyundai Heavy Industries

Hanwha

Hanjin

SK

Hyundai Motors

LG

Samsung cash flow rightdisparity

Improving Corporate Governance Through Legal Reform

  The Korean Securities and Exchange Act which stipulated rules governing public companies regarding their corporate governance went through 16 revisions since 1997.

  The Korean Banking Act went through 11 revisions.

  The Korean Commercial Code has also been subject to six revisions and the most recent and major revision has become effective as of April 15, 2012.

  Securities Class Action Act   - Enacted on July 3, 2007, went into effect on January 1, 2007   - First suit filed on April 13, 2009, approved on January 21, 2010

Securities Class Action

  Rafael La Porta Harvard Econ Department   Florencio Lopez-de-Silanes Harvard Government School   Andrei Shleifer Harvard Econ Department   Robert Vishny Chicago B School

LLS&V

LLS&V Thesis - Implications

  An active securities market is an engine for economic growth. How to develop deeper and more liquid securities markets?

  LLS&V: Securities markets require a strong legal foundation that protects the minority shareholder in order to become deep or liquid – sweeping legal reforms are needed. Legal reforms toward which model?

  Transitional economies must adopt the rules of common-law legal systems in order to develop their economies because civil-law legal systems provideinadequate protections to minority shareholders.

  To support this conclusion LLS&V showed: The depth and liquidity of securities markets around the world correlate closely with particular families of legal systems, with common-law systems consistently outperforming civil-law systems.

Corp Gov Sh Value

Tobin’s Q

% GDP

Venture Capital

IPO & M&A

Common Law

Civil Law

LLS&V Thesis

Macro Econ

Cap Market

Legal System

Legal Approach to Corporate Governance – LLS&V

  Corporate governance is, to a large extent, a set of mechanisms through which outside investors protect themselves against expropriation by the insiders.

  The key mechanism for the protection of outside investors is the legal system, meaning both laws and their enforcement.

  The laws and the quality of their enforcement by the regulators and courts are essential elements of corporate governance and finance.

  The legal families shape the content of the law, which in turn influence financial markets: Common law is more protective of investors than civil law. Why?

  Corporate law plays an important role in the development of corporate governance structures as suggested by the close correlation seen between capital market success and legal system characteristics.

  One implication: Emerging economies must improve the legal system and its enforcement to induce the international capital that is needed for development.

A New Era of the Korean Capital Markets   ‘Capital Market Integration Act’ passed on July 3, 2007 - went into effect on February 4, 2009

  Contested mergers and acquisitions emerged in the business world of Korea in the mid-1990's.

  In the recent years, two or three hostile takeover attempts have taken place every year, even targeting member companies of the largest corporate groups like Hyundai and SK.

  The largest company in Korea, Samsung Electronics, is also said to be vulnerable to potential takeover threat by foreign competitors and/or hedge funds.

  KT&G’s fight against Carl Icahn in early 2006 provoked public discussions on the market for corporate control and hedge fund activism in Korea.

Market for Coporate Control

http://ouclf.iuscomp.org/articles/kim2.shtml

LG Group: Before and After E. Han Kim & Woochan Kim Holding Structure

Board of Directors Best Practice – Hynix Semiconductor

  Korea-US Free Trade Agreement signed on April 2, 2007 - Opening-up of the legal services market - As of March 2012, nine global law firms have applied for a license to do business in Korea

  The “Law School Act” passed on July 3, 2007 - Graduate level legal education started from March 2009 - Law Colleges closed down - Passing rate of current bar exam less than 2% - Passing rate of new bar exam set at 80%

Fear Factor or Noble Challenge?

http://www.bizjournals.com/washington/news/2012/03/12/covington-burling-plans-south-korea.html

Legal Education and Profession

Samsung Group

World’s No. 2 Cell Phone Manufacturer (20%) after Nokia

World’s No. 1 D-Ram Memory Semiconductor Producer

World’s No. 1 TV Manufacturer

2009 Turnover = 20% of Korea’s GDP; 2/3 of Government’s Budget

2006: The total value added by the Samsung Group to Korea’s GDP: 8% •  Cf. 2005:The total value added by the US financial sector to US GDP: 7.7%

Number of Employees: 277,000

Chain of Unfortunate Events?

October 1996 – Everland issues CBs to Mr. JY Lee •  - Mr. JY Lee became the 40% shareholder of Everland June 2000 – 43 law professors brought charges against former managers of Everland •  - allegedly, price was too low December 2003 – Everland managers indicted one day before the statute of limitation •  lapsed October 2007 – Former general counsel spoke out, special prosecutor appointed April 2008 – Chairman Lee steps down May 2009 – Supreme Court judgment •  - 6 : 5, sided with the Everland managers (acquitted) •  - overturned district and high court decisions August 2009 – Chairman Lee convicted for tax evasion December 2009 – Mr. JY Lee promoted to COO of Samsung Elec. December 2009 – Chairman Lee pardoned February 2012 – Family Feud

Koreans are quick learners, have short memories though

http:/www/bbc.co.uk/news/business-17309144

Puzzle and Answer (?)

  “While corporate governance is one of the matters on the list of what determines economic success or failure, it is only one, and it is probably a good ways down the list in its importance.”

Mark Roe (1994)

  Especially when your company flies, economy goes well..

  Korea Exchange (KRX)   KT (former Korea Telecom)   POSCO   KB Financial Group - Independent directors’ self-entrenchment, or the ghost of directed lending practices?

The Government is Back!

“Four Kings”

The CEOs of the four largest bank holding companies in Korea.

They are called so due to their powerful stature in the Korean political economy backed by the close relationship with the President of Korea.

One of them even served as Vice Prime Minister. The current chairman of the Korea Financial Services Commission used to be his junior in the chain of command within the government.

They also symbolize the role of the government and politics in the corporate governance of Korean banks.

Corporate Governance of Banks

Has poor corporate governance of banks contributed the global financial crisis?

•  - Bankers’ pay

What is special about financial institutions in terms of corporate governance?

•  - Shareholder model v. stakeholder model again

Board of directors and bank directors’ fiduciary duties •  - Risk management as risk center •  - Internal control and compliance

Did Corporate Governance 'Fail' during the 2008 Stock Market Meltdown? The Case of the S&P 500 Brian R. Cheffins Business Lawyer, Vol. 65, No. 1, 2009 In 2008, share prices on U.S. stock markets fell further than they had during any one year since the 1930s. Does this mean corporate governance “failed?” This paper argues generally “no,” based on a study of a sample of companies at “ground zero” of the stock market meltdown, namely the 37 firms removed from the iconic S&P 500 index during 2008. The study, based primarily on searches of the Factiva news database, reveals that institutional shareholders were largely mute as share prices fell and that boardroom practices and executive pay policies at various financial firms were problematic. On the other hand, there apparently were no Enron-style frauds, there was little criticism of the corporate governance of companies that were not under severe financial stress and directors of troubled firms were far from passive, as they orchestrated CEO turnover at a rate far exceeding the norm in public companies. The fact that Given that corporate governance functioned tolerably well in companies removed from the S&P 500 and given that a combination of regulation and market forces will likely prompt financial firms to scale back the free-wheeling business activities that arguably helped to precipitate the stock market meltdown, implies that the case is not yet made out for fundamental reform of current corporate governance arrangements practices as a general matter.

Bank Directors’ Liabilities - 1

  The Korean judiciary rules the fiduciary duty of bank directors more

strictly than that of general firms' directors.

The Korean Supreme Court (The Korea First Bank Case, 2002) ruled that the failure of bank directors to get the loans repaid per se does not constitute a breach of their fiduciary duties. However, the role of banks differs from that of other companies. Banks are required to contribute to the stability of the financial markets and to the development of the national economy in the following ways: bank directors must fulfill their fiduciary duties with utmost (enhanced) care in

(1)   the protection of the properties of depositors; (2)   the maintenance of credit systems; and (3)   the promotion of efficiency in finance brokering.

Bank Directors’ Liabilities - 2

The court set out the following criteria which the directors of the

banks were to assess when they decided on whether to grant loans:

(1)   the terms and conditions of the loan; (2)   the loan amount; (3)   the repayment plan; (4)   the existence of collateral and its substance; (5)   the status of the debtor's assets and business operations; and (6)   the debtor's future business prospects.

http://ouclf.iuscomp.org/articles/kim.shtml

New Legislation

  After a few scandals took place in recent years, the Korean

government has proposed a new law on the corporate governance of financial institutions which is expected to become effective sometime in 2013.

  Independent Directors   Risk Management Committee   Compliance Officer   Risk Manager   Minority Shareholder Rights

Risk Management

How to Improve Corporate Governance PRACTICE and Transparency

  Legal reforms are not sufficient to bring about significant improve

ment..

  Culture and crony capitalism issues remain largely unsolved.   Culturally, most Asian business people feel Confucian. They usually turn to their

personal network, which certainly includes politicians, for information, business opportunities, and problem solving. They prefer to do business with members of their network, certainly on trust, not contracts.

  According to a poll, only 30% of Koreans regard the law as an effective means of solving social conflicts. The remaining 70% think that political power, money, and relationships are more useful in solving problems.

  “Sunlight is said to be the best disinfectants; electric light the most efficient policeman.” (Louis Brandeis)

  Disclosure, disclosure, disclosure!

  Documentation, documentation, documentation!