Linking Corporate Governance to Firm Behavior

and Performance: The Case of Korean Chaebols

Viewed as a Leveraged CMS Firm
by Keun Lee, School of Economics, Seoul National University, Seoul, Korea
Abstract
This paper has conceptualized the Korean Chaebols as the leveraged controlling minority
structure (LCMS) firm, and explained their behavior and performance over long time pe-
riod. The paper has also looked at the institutional environment surrounding the firm and
saffecting the firm behavior. Chaebolsoften-unjustifiable aggressive, indebted expansion
can be attributed to the LCMS nature of the firm whose governance system cannot check
the discretionary decisions of the owner-controller, while their tendency for diversifica-
tion should be understood in relation with the industrial policy by the government which
had selected and promoted successively different industries during the course of eco-
nomic development. The paper has also reviewed the post-crisis reform of corporate gov-
ernance system in Korea from the point of view of the conditions for efficient
governance. The Korean system can be said to have been improving although several is-
sues still remains to be settled.
Introduction
Milgrom and Roberts (1992) starts with recognition that organization matters and corpo-
rate governance matters, and asserts that survival and prosperity of any organization de-
pends on how to tackle the critical matter of coordination and motivation inside
organization. This paper takes up such perspective, and tries to explain the behavioral and
performance-related characteristics of Chaebols, namely family-owned conglomerates in
Korea, by referring to their corporate governance system. For this purpose, we rely on the
concept of the controlling minority structure (CMS) firm that is first proposed by Beb-
chuk, Kraakman, and Triantis (2000).
In the controlling minority structure (CMS) firm, a shareholder exercises control
while retaining only a small fraction of the equity claims on a companys cash flows.
Such a radical separation of control and cash flow rights can occur in three principal
ways: through dual-class share structure, stock pyramids, and cross-ownership ties. These
three methods are exactly used by the Korean Chaebols.
The Korean Chaebols are often said to be able to save the agency costs of the hired
management because there are controlling family, which is perceived as one of their
source for strength. This paper considers such contrast between the owner and profes-
sionally-managed firm in the debate as misleading because the controlling families in
Chaebols are not really owning majority shares; they own only about 10 percent or less
of the shares in the group, and they are thus subject to greater agency costs. However, this
important distinction of Chaebol as a controlling minority structure from the concentrated
structure is missing in most literature on Chaebols.
This paper attributes Chaebols often-unjustifiable aggressive, indebted expansion
to the CMS nature of the firm whose governance system cannot check the discretionary
Volume 28 Number 10 2002 19
decisions of the owner-controller. In this paper, the main cause for the declining perform-
ance of the Chaebol firms is argued to be this unjustifiable expansion drive that has got
more and more serious in the 1990s.
In this paper the term, Chaebol(s), is used to indicate the whole business group as a
unit consisting of tens of the member or affiliate companies. The terms, member firm,
group-affiliate firm, or Chaebol firm (company), are interchangeably used to refer to indi-
vidual firm belong to a business group, namely a Chaebol. Actually, these affiliate firms
are the legal persons, often listed in the stock markets and inter-locked by circular share-
holdings, but a business group or Chaebol itself is not a legal person in itself.
The next section conceptualizes the Chaebols as leveraged CMS firms, and pro-
vides some evidence in this support. Section 3 discusses the behavioral consequences of
the Chaebol firms as a kind of the leveraged CMS firm, with focus on expropriation of
non-controlling minority shareholders and debt-holders. Section 4 discusses long term
performance of Chaebols in terms of three aspects: diversification and the business envi-
ronment, investment drive and its consequence, and impacts of the one-man manage-
ment. Section 5 first discusses what are the conditions for efficient corporate governance
system, and then provide a review of the post-crisis changes in the corporate governance
system in light of these conditions. Finally, a brief summary and concluding remarks are
provided.
Conceptualizing Chaebols as a Leveraged CMS Firm
The literature on corporate organization tends to perceive two kinds of the firms. The one
is the firm of concentrated ownership where there is an owner of the firm with controlling
share of the firm, and the other is the firm of dispersed ownership where ownership is
quite dispersed over a large number of shareholders each with only a negligible share of
the firm. The literature finds that the firm with concentrated ownership is free from
agency costs of hired management while it is exposed to the danger of management en-
trenchment. In contrast, the firm with dispersed ownership could enjoy the benefits of
professional management whereas it is potentially exposed to the agency costs of the
hired management. It is not hard to notice that neither form of the firm can command a
priori dominance over the other, and, as a matter of fact, so many empirical papers end up
with the conflicting results over the relative performance between the two types of the
firms.
In the Korean context, the debate has been the comparison between the Chaebols
and non-Chaebols. In this debate, Chaebols are considered as the firm under concentrated
ownership since they find a controlling family in each Chaebol group. This paper does
not buy this perception of Chaebol to argue that it is misleading and cannot explain the
observed behavior of the Chaebols. It is argued that Chaebol is neither dispersed owner-
ship firm nor a concentrated ownership firms, and is rather a kind of the CMS (control-
ling minority structure) firm. Bebchuk, Kraakman, and Triantis (2000) propose the CMS
firms as the third kind of the firms, and find that the firms of controlling minority struc-
tures are widespread around the world and thus important.
In CMS firms, a shareholder exercises control while retaining only a small fraction
of the equity claims on a companys cash flows. The CMS structure resembles controlled
structure insofar as it insulates controller from the market for corporate control, but it re-
Managerial Finance 20
sembles dispersed ownership insofar as it places corporate control in the hands of an in-
sider who holds a small fraction of equity. The CMS threatens to combine the incentive
problems associated with both the concentrated structure and the dispersed ownership in
a singly ownership structure.
If we perceive Chaebols as a kind of the CMS firms, it becomes quite easy to ex-
plain several important features of the Chaebols, including aggressive expansion which is
often unjustifiable in terms of the interests of the shareholders. Theoretical models in
Bebchuk, Kraakman and Triantis (2000) explain why inefficient projects are chosen and
unprofitable expansion is pursued under the CMS.
Suppose that there are projects which can produce a value of V that includes cash
flow (S) available to all shareholders and private benefits of control (B). Given any distri-
bution of opportunities to expand and contract, the likelihood that a CMS firm will make
an inefficient decisionand thus the expected agency costgrows larger as the control-
lers equity stake becomes smaller. In their model, a controller will prefer to expand (or
not to contract) a firm if (V-B) +BP, where P is the buying or selling prices of the asset.
For example, with a value of as 10%, the controller will refuse to sell the asset unless the
firm receives a price 45% higher than the real value of the asset to the firm. Equivalently,
the controller will acquire the asset unless the price is more than 45% higher than its real
value to the firm.
In this model, too, the deciding factor is the magnitude of private benefits accruing
to the controller when he keeps or acquires the asset, and private benefits tend to come
from self-dealing or appropriation opportunities. In the Korean context, typical private
benefits also took the form of arbitrary and preferential borrowing from the firms and
many kinds of outright cash payments to the controlling shareholders. These models sug-
gest that the unique agency costs structure of the Chaebols as a CMS firm pushes Chae-
bols to pursue more growth than otherwise.
Bebchuk, Kraakman and Triantis (2000) find that the similar kind of agency costs
happens to the borrower-controller of the firms as the debt-equity ratio increases. In other
words, the higher the debt-equity ratio, the more likely the controller is to take risky proj-
ects which provide more return upon success. This is the agency cost of the highly lever-
aged firm. Milgrom and Roberts (1992) also observes that unjustifiable expansion drive
can prevails when the controller of the firm expect that the costs of any failure were
shared or transferred to the lenders, whereas benefits of any success are monopolized by
the incumbent management.
This paper conceptualized the Korean Chaebols as the leveraged controlling minor-
ity structure firm (or LCMS firm hereafter). This way, we believe, we can explain most
effectively the behavior of Chaebols. Now, let us provide some evidence that Chaebols is
a LCMS firm. First, by forming a complex web of circular share-holdings, the founding
owner-manager in Chaebols was able to control the whole enterprise group even with a
very small share owned by his own family. It is well-known that on average, the owner
and relatives own only about 10 percent of the Chaebol groups stock in average business
group belonging to the top 30. More than 30 percent of the stocks are owned by the other
member firms in the same Chaebol group. In other words, the insiders share ratios (the
sum of the shares owned by the owner-relatives and the member firms) are as high as 44
percent in the 30 largest Chaebols in Korea. This way, the owner-families were able to
Volume 28 Number 10 2002 21
keep the control over a large number of the member firms with only a less than propor-
tional amount of real financial capital.
Also, as Chaebols financed their growth mainly by bank loans, their debt levels had
continued to increase. Finally, their debt/equity ratio had increased even to 500 percent
level (for top 30 Chaebol) just before the crisis in 1997 (Hyun 1999). It was a very rapid
increase since it was around 400 percent in 1996, and around 330 percent during the
1991-92 period (Nam, Kang & Kim 1999).
In sum, the Korean Chaebols is a leveraged controlling minority structure firm. The
owners-controllers consolidated their control over tens of the firms by resorting to stock
pyramids, circular shareholdings and dual class stocks, and they borrowed heavily form
banks to finance their growth. Then, the theory of the leveraged CMS firm predicts that
that kind of the firm should tend to pursue unjustifiable growth at the expense of the mi-
nority sharehoders interests. We turn to this issue below.
Behavioral Consequences of the Leveraged CMS Firm
1. Expropriating Other Shareholders Rights
The price gap between the common stocks and preferred stocks is a measure of the man-
agement premium, or rents accruing to the controller. In an international comparison, the
price of common stocks in the listed Korean firms was often twice as high as that of pre-
ferred stocks in Korea (Song 2000). Another measure of the shareholder rights should be
the amount of dividends. Table 1 shows the dividends to net income (profits) ratio in sev-
eral countries. Dividend rates relative to profits were also very low in the Korean Chae-
bols, only 14 to 20 percent or approximately 20 percent, compared to about 40 percent in
the US and Japan. One of the reasons for such a low dividend ratio is that the owner-
managers wanted to avoid the heavy income taxes imposed on their dividend incomes.
Instead, they wanted to be compensated in the form of arbitrary and preferential borrow-
ings from the firms and many kinds of arbitrary cash payments to the owner-
shareholders. In practice, the distinction between the official money of the firm and pri-
vate money of the owner were often blurred in Korea, as had been revealed in the several
cases of bankrupt Chaebols in 1997. Secondly, the return to dividends measured by the
ratio of dividends to the price per share (about 1.5 percent) is very low compared to inter-
est rates (9 to 10 percent) in Korea.
Managerial Finance 22
Table 1: International Comparison of Share Dividends
Dividends to Price per
Share
Average Official
Interest Rate (95)
Dividends to
Net Income
1995 (1990-96) (93-95)
Korea 1.30% 1.75% 9-10% 14-20% 21.9%(95)
U.S.A. 2.91% 2.48% 6% 79.6%(93) 39.9%(94)
U.K. 4.49% 4.43% 8%
Japan 0.85% 30-50%
Source: Korea Stock Exchanges
Furthermore, the institutional investors in Korea, including the pension funds, in-
vestment and trust funds, used to be forfeited their voting rights as shareholders, as a re-
sult of the over-protection of the incumbent manager-owners. Even for the individual
shareholders, their rights as shareholders were almost nil in terms of the right to call for
the shareholders meeting, to attain access to the accounting books of the firms, to raise
lawsuits against the management, and so on.
2. Expropriating Debt-holders Rights
In the Korean firms, another serious problem was the agency costs of the owner-manager
in its relation to the lenders. In comparison to the American firms, the firms in Korea, Ja-
pan, and Germany tend to rely more on borrowing from the banks. In Japan, the banks not
only lend to the firms but also own the shares, and the relationship between the banks and
the firms is characterized by the main banks system, where the main bank of each firm
plays the role of its monitor. In the German firms, the banks are able to participate ac-
tively, based not only on their own share holdings but also on the delegated voting rights
they have acting as monitor and advisor to the firms. The case of the Korean Chaebol
firms fits none of these representations.
What was the role of the Korean banks? Their role during the high growth period
was to provide the so-called money for growth whenever the firms needed it and when
the government asked or commanded the banks to lend to the firms. The banks were un-
der de facto control by the government, specifically the Ministry of the Finance (MOF),
even after the nominal privatization since the 1980s. Thus, the effective lending criteria
of the banks were the signals or orders from the government. That was the only way for
bankers to keep their positions. The banks were also very cooperative with the MOF be-
cause many high-level positions tend to be filled by the former staffs of the MOF. Conse-
quently, the basic behavioral pattern of the banks was passive and incentives did not exist
for them to keep watch of how money was spent in the firms. The primary lending crite-
ria, as applied by the government, was the promotion of specific export-oriented indus-
tries while the profitability of the project itself was only a secondary matter. For the
banks, there was no incentive to monitor the Chaebols since they have all their loans
backed by collateral and/or cross-guarantees by the member firms. As a result, the banks
did not have to examine the creditworthiness of the borrowing firms. Furthermore, the
Korean capital markets were always in sellers market conditions and closed from the
threat of foreign competition. So banks level of efficiency was quite low.
Explaining Long Term Performance of the Chaebols
1. Diversification and the Changing Business Environment
Diversification is one of the most salient features of Korean Chaebols. According to Pen-
rose (1995), diversification is a way of utilizing its available resources in a more profit-
able way for the firm. This means that for diversification to happen, two conditions need
to be satisfied. The first is that an opportunity for profitable expansion of the firm exists,
and the second is that the firm has extra resources to invest into a new business. Depend-
ing upon the situation, either of the two conditions may be binding. For example, when
there is ample opportunity for profitable expansion, a more binding constraint is the
firms (internal) resources. This seemed to the case for the Korean Chaebols.
Volume 28 Number 10 2002 23
During the high growth period of the 1960s and 1970s, the protected domestic mar-
kets and the preferential loans from the state-controlled banks opened up numerous prof-
itable business opportunities (namely rents) for the Korean Chaebols. For example,
during the heavy and chemical industry promotion drive by the government in the 1970s,
the government directed banks and non-banking financial institutions to supply more
than 50 % of total domestic credit as a heavily subsidized loan (Nam, Kang & Kim 1999;
originally from Cho and Kim 1995). Given this, Chaebols had to stretch their resources to
the maximum to fully take advantage of the growth opportunity, and, at the same time, re-
cruit more financial and managerial resources from the outside. The state granted two
kinds of rents to chaebols, the rents of extra profits associated with market protection
and entry control and the rents of preferential loans.
The year of 1997 saw the collapse of one-after-another Chaebol in Korea and fi-
nally of the economy itself, which led to Koreas situation of having to beg for the IMF
emergency loan. What went wrong with the Chaebols in Korea? The answer to this ques-
tion dates back to the origin of the growth of the Chaebols. As discussed earlier, the envi-
ronment nurturing the growth of the Chaebols was the economy which abounded with
artificial rents and protection. The fundamental change in the nature of the external eco-
nomic environment lies at the bottom of the crisis of the Chaebols and the economy itself.
We should note the two important changes in the external environment. First, the
government had gradually stopped the explicit promotion of, or giving favor to, the spe-
cific industries and the firms. It was actually during the 1980s that the government itself
declared it was switching from the policies of selective intervention to those of functional
intervention. The change meant that the government intended to recover the normal func-
tions of the market mechanism from the past distortions. In general, the change in the
government attitude and its actions toward the private sector contributed to the lowering
of the rents enjoyed by the Chaebols.
Second, we should note the rising wave of globalization and the WTO spirit of free
trade in the 1990s. The 1990s is the decade that the Korean economy saw the fulfillment
of most of its liberalization programs, including both trade and capital markets. Such lib-
eralization measures caught further momentum following the Korean entry into the
OECD. There was a clear downward trend of effective protection rates over the period of
1963-1990 (Lee, 2002). Toward the end of the 1980s, the effective protection rates for
manufacturing goods were reduced to less than 10 percent or even fell to negative levels.
Also, the average custom tax rates for the imported goods decreased from more than 20
percent in the early 1980s to about 5 percent in the mid 1990s (Lee, 2002). In general, this
trend of globalization and liberalization had contributed to the lowering of the rents and
decrease in profit rates enjoyed by the Korean Chaebols.
2. Aggressive Investment Drive: A Feature of the CMS Firm
If there were rents in terms of domestic market protection and preferential loans, it would
be natural for Chaebols to take advantage of these rents in pursuing growth with diversifi-
cation. However, existence of rents does not seem enough to explain the expansion ten-
dency of Chaebols, especially given the fact that there was substantial degree of market
liberalization and reduction of subsidized loans since the 1980s. As a matter of fact, the
Chaebols were perceived to acquire, or enter into, a business which was not justifiable in
terms of rate of return of investment even in the 1990s. In other words, we need to look at
Managerial Finance 24
the intrinsic mechanism leading to the unjustifiable investment drive which had contrib-
uted to the declining financial performance of the business groups. In this regard, we re-
sort to the concept of the CMS firms explained in the section 2. According to this model,
a CMS firm like Chaebols tend to pursue unjustifiable growth since the actual share of
the controller is so small. Such investment drive should lead to over-capacity and low
productive efficiency as confirmed by the regression analysis of the production functions
done in Lee, Ryu and Yoon (2001).
Table 2 examines the controllers share in the Chaebol and non-Chaebol firms to
show that the owner-controllers shares are significantly higher in non-Chaebol firms. It
confirms that in the Chaebol firms, the owners share continued to decline over the sam-
ple period, which is confirmed by a simple regression using time-trend as an explanatory
variable. We can thus infer that the decreasing share of the owner-controller aggravated
the agency costs of the controlling-owner, and led to the inefficient investment drive in
the Chaebol firms. To verify this argument, Lee, Ryu and Yoon (2002) have run the re-
gressions where the difference in the investment rate between Chaebols and non-
Chaebols is specified as a function of cash flow of the firm, the difference between Chae-
bols and non-Chaebols in the share of owner-controller, and a proxy for Tobins Q meas-
ured by the market value divided by the book value of the firms. They found that the
Volume 28 Number 10 2002 25
Table 2: Percentages of the shares held by the owner and his/her relatives
Year chaebol firms (mean) chaebol firms (median) Non-chaebol firms
(mean)
1984 23.66 21.30 28.61
1985 24.25 22.90 29.26
1986 22.63 19.73 29.02
1987 22.47 19.36 28.15
1988 21.96 18.85 28.69
1989 24.77 20.24 31.37
1990 24.90 20.40 31.68
1991 23.35 20.00 30.91
1992 21.86 20.02 30.12
1993 19.92 19.54 27.82
1994 18.87 17.83 27.11
1995 18.66 17.96 27.24
1996 18.54 16.13 27.32
1997 24.85 21.20 30.13
coefficient on time trend -0.282 -0.220 -0.074
p-value 0.065 0.041 0.489
Notes: This table compares ownership structure of Chaebol and non-chaebol firms using the data of the
listed companies provided by the Korea Investors Services Company. Here, Chaebols are referring to 22
Groups following Lee, Ryu, and Yoon (2001).
coefficient of the ownership difference variable is negative and significant in the 1990s,
while it is negative and not significant in the 1980s. It shows that the investment rate dif-
ference between Chaebol and non-Chaebol firms in the 1990s can be explained by the
difference in the shares held by the owner-controller, and that the smaller the owner-
controllers shares is in each firm as in Chaebol firms, the more the firms invest. As a
matter of fact, the Chaebol firms started to invest much more in the 1990s, compared to
non-Chaebol firms. This results show that the declining performance of the Chaebols has
to do with the intrinsic problem of the expansion drive associated with the CMS nature of
the firms.
3. Strength and Weakness of Management by One Man with No Checks and Balances
The complex matrix of circular shareholding within each Chaebol group allowed the
owner-controller to stabilize his command over the empire, and he had been able to do al-
most whatever he may want to do. Relative benefits of such stable leadership should be
the strong implementation power, strict internal discipline, and long-run planning. With
absolute authority within the firm, the owner-manager can override any countervailing
opinions, and push through the execution of the target projects. Such power was impor-
tant, especially when the government guided the economy by giving private firms clear
signals on the list of the industries or projects that the government planned to promote.
However, the importance of the implementation power of the owner-manager firms be-
came smaller as the government stopped the interventionist industrial policy, such as se-
lective protection of target industries or firms. In this situation, the uncertainty of the
owner-management grew larger.
Moving Toward More Efficient Corporate Governance
What would be the definition of efficient corporate governance? Shleifer & Vishny
(2000) states that efficiency of corporate governance system should be considered in
terms of the possibility that investors (shareholders) can get back the returns from their
investment. They also pointed out two concrete conditions to construct efficient corporate
governance system in firms. The first is the existence of large shareholders since holders
of negligible share would not have much interest in monitoring firm behavior and man-
agement, as they are subject to the free-rider problem. Here, there may be two types of
large shareholders. The one is the permanent large shareholder, like the main banks in Ja-
pan or German. The other is the contingent large shareholder, which appear as a take-over
bidder or LBO associations in M&A only when the firms perform bad. The large debt-
holder is also eligible since they too have a big stake in the firms they lend their money.
The second condition for efficient corporate governance is the protection of minor-
ity shareholders rights against possible expropriation by the controlling shareholders.
So, there have appeared diverse devices for this purpose, such as derivative suits, rights
of access to accounting books and so on.
We can see that the underlying idea for the conditions for efficiency of corporate
governance system is that there should be an owner-controller who has a vital stake in the
firms and takes responsibility for the outcomes, and at the same, while such person is
given authority and initiative to run the firms, he should be allowed to sacrifice the inter-
ests of non-controlling minority shareholders.
Managerial Finance 26
While these are general conditions for efficient corporate governance, we can ad-
dress another issue which is especially important in the Korean context. That is the reduc-
tion of the private benefits from being the controlling-owner. This is important since the
reason for the controlling-owner to want to set up the controlling minority structure is to
enjoy the private benefits from such control. The bigger the private benefit from control-
ling the firm, the more likely the controlling-owner is to take the otherwise-unjustifiable
projects. In a similar context, Bebchuk (1999) observes that the founder of the firm would
like to maintain the control over the firm, rather than take the firm to the public, when
there is available bigger private benefit. The same logic applies to the case of the CMS
firm; the controller would like to maintain the CMS structure as long as it continues to
give him/her private benefits. So, if the CMS is the source of the problem for the Chae-
bols, then we have to first reduce the private benefits from controlling the firm. Then, the
owner-controller would have less incentive to maintain the CMS setup of the firm by cir-
cular stock ownership and/or stock pyramids. In the Korean context, higher protection of
non-controlling shareholders rights, and more disclosure of accounting and financial in-
formation of the firm would be effective. Below, in light of the conditions for efficient
governance, let me explain the corporate reform in Korea since the 1997 crisis.
1. The Role of the Large Shareholders
First of all, to make the controlling shareholders accountable for their management re-
sults, the related laws were revised in December 1998 to regard a controlling shareholder
as a de factor director. This should be considered an important improvement since in the
old system, although the controlling shareholders were actively involved in the manage-
ment and makes all the important decisions, they did not take any responsibility for their
actions since they did not hold either the official title of the CEO or the directors in the
board.
The role of the bank as large debt-holders to monitor the firm management has also
been promoted. But, this required first to make the commercial bank really independent
plays from the government, and also to make them accountable and transparent them-
selves. Actually, the strategy of the Korean government was to reform the financial sys-
tem first so that the banks and other financial organizations may be in a good position to
deal with their corporate clients, namely giving them pressure for change (Hyun 1999).
Restructuring of financial system took off in June 1998 as the financial supervisory
authorities ordered the five commercial banks, out of a total of 20 or so in Korea, to be
closed. Since then, within the period of just one year, a total of 11 banks were closed or
merged, closing more than 1,000 branches, and sagging 40,000 staffs. Thus, financial re-
structuring is now regarded as one of the most successful aspect of post-crisis economic
reform in Korea. With the exit of non-viable financial institutions and the injection of fis-
cal resources, many Korean banks were reported to obtain a clean bank status with BIS
ratios of 10 to 13. Since then, the government has taken responsibility for enforcing more
strict regulatory and prudential standards in banks. Most importantly, most banks have
now become subject to better internal monitoring of management as they adopted a board
system with a majority of non-executive director; now most commercial banks in Korea
appoint 7 to 9 non-executive directors and 2 to 3 executive directors.
With more independent and accountable management, the commercial banks are
now much better place to monitor other firms. Their independence from the government
Volume 28 Number 10 2002 27
was much enhanced, especially owing to the increasing foreign shares in the banks. For
example, the Foreign Exchange banks introducing foreign capital from Germany, and the
Kukmin bank also sold the largest bloc of stocks to the Goldman and Sacks. Co. The
Cheil Bank, one of the top banks, became to be controlled by foreign management with
the take-over of controlling share by New Bridge Capital (an American investment capi-
tal).
Finally, to promote the role of other large shareholders in corporate governance,
formerly forfeited voting rights of institutional investors were fully recognized in Sep-
tember 1998, and thereby pension funds and trust and investment companies became able
to play the role as large shareholders. Also, various barriers for M&A were now substan-
tially removed, with the revisions of the related laws and provisions.
2. Protecting the Minority Shareholders.
Now let us turn to the issue of the rights of minority shareholders. Since the reform, many
revisions and additions were made in the laws related to rights of minority shareholders.
Thus, some people argue that the rights of shareholders are now even comparable to the
US standards (Kim 1999). For example, the US system requires more than 10 percent of
stock ownership to demand disappointment of executive directors, whereas it is only 0.5
percent in case of the listed companies in Korea. Furthermore, any shareholder is given
free access to the register of the shareholders and the records of the board meeting. Al-
though there is always gap between the laws and the actual practices, we can say in gen-
eral that rights of shareholders are now much better recognized and exercised in Korea
than before.
Actually, we are now seeing and hearing many cases, which we have never heard
before, where minority shareholders raise objections to, or raise sues to, the doings of the
top management or controlling shareholders, for instance in the cases of Mando Machin-
ery Co., Cheil Banks, and Samsung Electronics, and so on. Actually, increasing rights of
minority shareholders has become a part of social movement, involving a civil rights
movement organization called Solidarity for Participation. In the meantime, the man-
agement is now starting to say that the independence of the management is increasingly
threatened by such movement. Such voice from the management is understandable too,
given the lack of sufficient business judgment safe harbors as in the American system
(OECD 1998). Now, an increasing number of Korean companies are now buying their di-
rectors insurance for their legal liabilities in preparation for the increases of related law-
suit cases.
Increasing recognition of rights of non-controlling shareholders has also to do with
the rise of foreign shareholders. Not only serving as additional source for capital, foreign
portfolio investment is also perceived as being able to improve corporate governance of
the Korean firms when the foreign investors are encouraged to play active role in the
board or as shareholders or take-over bidders.
A more transparent and accountable management is a basic condition for increas-
ing rights of minority shareholders /investors. In this area, a number of measures have
been implemented. First, the business groups or Chaebols were required to produce the
so-called combined financial statements (CFS), beginning in fiscal year of 1999, which
would help disclosure the details of complicated intra-group transactions. The firms to be
Managerial Finance 28
included in the CFS are to be determined according to whether it is under the de facto
control by the same shareholders or not, which should be regarded as more comprehen-
sive and strict, compared to the past practices of the so-called linked financial statement.
Then, the combined financial statements offset within-group transactions, such as lending
or borrowing of capital, shareholding, sales or purchasing to report only the purely exter-
nal transactions so that one can clearly see the real picture of the groups business per-
formance and conditions. In addition, Koreas Generally Accepted Accounting
Practices (GAAP) was revised to be more in line with international accounting stan-
dards. Also, the top thirty Chaebols and all listed companies were required in February
1998 to introduce the independent audit committees with representations by minority
shareholders and creditors.
Summary and Concluding Remarks
This paper has conceptualized the Korean Chaebols as the leveraged controlling minority
structure (LCMS) firm, and explained their behavior and performance over long time pe-
riod. The paper has also looked at the institutional environment surrounding the firm and
affecting the firm behavior. Chaebols often-unjustifiable aggressive, indebted expansion
can be attributed to the LCMS nature of the firm whose governance cannot check the dis-
cretionary decisions of the owner-controller, while their tendency for diversification
should be understood together with the industrial policy by the government which had se-
lected and promoted successively different industries during the course of economic de-
velopment.
This paper attributes the declining performance of the Chaebol firms to the prob-
lem of unjustifiable expansion drive that had got more and more serious in the 1990s.
However, the often-acknowledged advantages of the business group firms can be said to
be still valid (Khana 2000), regardless of the problem with the CMS feature. As a matter
fact, Chang and Hong (2000) finds that using the 1990s data, Chaebols firms tend to be
associated with superior financial performance (profitability) owing to its advantage such
as group-level sharing of such resources as technology skills, advertising, and internal
transactions. In other words, inefficient investment is offsetting financial efficiency asso-
ciated with resource sharing in Chaebol firms. One important policy implication of our
findings should then be that the Korean business groups are required to check the ineffi-
cient investment associated with the agency costs of the owner-controller. In other words,
the question boils down to the problem of corporate governance.
The critical matter of reforming the CMS nature of Chaebols has to do with the
change in the ownership structure within the group. In this regard, the changes are already
taking place, and the directions for change can also be understood in terms of the origins
of the Chaebols. The old ownership structure in Chaebols had been shaped by the artifi-
cial blocking of the natural tendency of the separation of ownership and control with the
firm growth and by the owners desire to maintain his position as both the investor
(owner) and the manager. Then, the basic direction for change should be a recovery of the
natural tendency of separation of ownership and management, dividing the double roles
of the owner-manager. This means that two paths are emerging.
The first is the real separation of the ownership and control, or the separation of the
investor and the manager. The former owner-manager should now be the investor inter-
ested solely in the return of his portfolio investment. The former member firms in Chae-
Volume 28 Number 10 2002 29
bols would become more autonomous units as the owner-mangers limit their role to
investors or as non-managing shareholders. The owner-family might want to create a
foundation but would not interfere with the management. The Hewlett-Packard Corpora-
tion in the US is an example of the owners retreat into the back seat after he established a
foundation. Among the Korean firms, Samsungs highly centralized ownership and con-
trol pattern might make it suitable for this type of arrangement. The LG group also seems
to be on this track as they announced in 2002 the plan for transformation of the group into
a several holding company system.
The second path is the dissolution of the collective group organization, but the
owner-managers would be allowed to take control of the management over only a few
member firms. In this case, the owner-manager could concentrate his limited capability
or interests to one or two of the member companies and let the others become independ-
ent or be sold out. The Ssangyong, Daesang (formely Miwon), and Haitai have already
gone this process of reorganization, and more seem to follow this track. Of course, a natu-
ral dissolution of the group could happen if the founder gives the member firms to his
children and allow each inherited firm to become independent. Hyundai group has more
or less followed this path, after the death of the paramount founder, Chung Joo Yong.
The paper has also reviewed the post-crisis reform of corporate governance system
in Korea from the point of view of the conditions for efficient governance. The Korean
system can be said to have been improving although several issues still remains to be set-
tled. With more transparent and accountable system in place, the so-called Korean dis-
count that described the very low price-earning ratio in the Korean stock in 2000 and
early 2001 seems to have been disappearing as stock prices started to pick up since the
late 2001.
Managerial Finance 30
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