The State of Corporate Governance in South Korea

with Taehoon YOUN (Research Fellow, Korea Development Institute)
interviewed by MIYAJIMA Hideaki

August 10, 2007

On August 9-10, 2007, Dr. Hideaki Miyajima and Dr. Taehoon Youn, Research Fellow at the Korea Development Institute (KDI), participated in the KDI Conference in Seoul titled "Market for Corporate Control: Comparative Perspectives." Following the conference, Dr. Miyajima interviewed Dr. Youn about the current status of corporate governance in South Korea with an emphasis on the market for corporate control and the role of institutional investors.

Miyajima:  First, could you explain the background of the corporate governance situation in Korea? After International Monetary Fund (IMF) intervention, Korea implemented a lot of reforms in corporate governance. What are the major corporate governance problems unique to Korean companies? A typical governance problem for listed firms in developed countries is an agency problem between manager and dispersed owners. But in Korea the main agency problem is between the controlling shareholder or owner, and the minority shareholder. In this context, what happened after IMF intervention and at what stage is corporate governance reform in Korea?

Youn:  I would like to refer to my former presentation in China about that. I'll say that a lot of reforms have been going on for the past 10 years, except for the market for corporate control, which was dealt with in today's conference. And as far as institutional settings, legislations, and detailed regulations are concerned, every possible component has been introduced. There are still some loopholes, like class actions, which are currently limited to the securities-related issues.

Miyajima:  Class action was introduced partly, but it is limited.

Youn:  The scope is still limited. But as far as corporate governance is concerned, even this limited version covers a lot of those governance-related issues. Its introduction itself was a huge improvement, but we hope that the coverage of class action will be expanded in the near future. So, other than class actions or hostile takeovers, pretty much everything has been implemented.

Miyajima:  Is an outside director now mandatory for all listed firms?

Youn:  Yes, but there are some variations. For a listed company with assets exceeding 2 trillion won, which is comparatively large, the company must fill more than half of the board of directors externally. And for all financial institutions the number should be greater than or equal to half the members. So for larger firms this is very strictly imposed. And there is also the issue of disclosure. We have had fair disclosure rules introduced, which make insider trading or unfair disclosure heavily regulated. An audit committee has also been introduced. So for those listed companies with assets exceeding 2 trillion won, it is mandatory to establish an audit committee, not just an auditor, and two-thirds of the committee members must be outside directors. So it's very strict. There is actually one more requirement. When you choose outside directors who are to be audit committee members, the voting right of the controlling shareholder is limited to 3% of all shares issued. So they are restricted in order to have minimal influence on selecting outside directors for the audit committee.

Miyajima:  So, many measures have been introduced. These reforms have basically been completed within Korean companies, and are now in the fine-tuning stage. Is my understanding correct?

Youn:  Yes, you could say that. For companies with assets exceeding 2 trillion won, reforms are all pretty much in place. Among companies with assets less than 2 trillion won, more and more are also introducing these types of systems. This is because we do have corporate governance services that evaluate and rank these firms and publish the results.

Miyajima:  Is this service run by a non-profit organization?

Youn:  That's correct. I'm a member of the research committee. We annually award the best firms, and place the information online. Investors, especially foreign and domestic institutional investors, are keenly aware of these kinds of corporate governance issues. So they are very aggressive on persuading the firms to adopt these kinds of measures.
This corporate governance index service was first introduced by what was then the Korea Stock Exchange (KSE), I think this was in 2001. Then in 2002 it was transferred to the Korea Corporate Governance Service (KCGS), an independent, non-profit organization sponsored by the Korea Exchange (KRX), Korea Securities Dealers Association, Korea Listed Companies Association, and other securities-related associations. They provide funds for running the service.

Miyajima:  Let's touch on the current situation of the market for corporate control in Korea. In Japan, there is something of a merger and acquisition (M&A) boom. But M&A is mainly occurring among corporate groups or independent firms with friendly relationships. What is the situation in Korea?

Youn:  I would say that it's about the same for Korea. There has been a tremendous increase in the number of M&As. But actually I once did some study on hostile M&A in Korea after the financial crisis with Professor Yong-Seok Choi, who commented on the Oliver Rui paper yesterday. Similarly, this was about how they perform and what the motivation was. Was there any difference in motivation for friendly and hostile M&As? We had to rely just on attempts rather than completed hostile M&As as there haven't been any major ones for firms listed on the stock markets.

Miyajima: Is this kind of friendly M&A quite common after IMF intervention?

Youn:  Well, it wasn't actually common. I mean, we had some big deals run by the government, which wanted to do some restructuring of industries. So it enforced the chaebol to actually trade their businesses. For instance, in the semi-conductor industry, there were many, but later they were reduced to just Hynix and Samsung. So that kind of friendly mega-merger was led by the government, it was not on a voluntary basis.

Miyajima:  So M&A between chaebol was initiated by the government.

Youn:  We still do have a lot of those friendly mergers other than the ones led by the government. But they are mostly between the chaebol and other independent companies, or just between independent companies. Actually, before the crisis, the most common form of M&A was the chaebol just absorbing, merging the smaller independent companies, so they could actually diversify more.

Miyajima:  It seems M&A is used as a growth strategy. I heard that before the financial crisis, Korea had its 30 largest chaebol. But after the financial crisis, some of the chaebol faced financial distress and now the number has decreased to 15.

Youn:  The 30 largest, or 10 largest, five largest is just how they actually categorize the companies. I would say most of the companies listed on the stock market have, to some extent, a pyramidal or circular holding structure. They can always be sorted out as the largest - 100 largest, 50 largest, etc. However, it used to be that most of the regulations were applied to these 30 largest chaebol. But now, instead, the standard changed to large business groups with total assets exceeding a certain amount. That's why the number of those large chaebol has been reduced or even fluctuates annually. That's because of this current government. As there were so many voices or so much lobbying against restrictions on shareholdings, the shareholdings of affiliates, and the ban of crossholdings, the government tried to reduce the extent of this kind of regulations. The argument that they are facing these hostile takeovers has played some role in this deregulation.

Miyajima:  Let me try to summarize. During the process of recovering from financial crisis, corporate restructuring is highly needed, and as a tool of corporate restructuring, merger and acquisition is used by chaebol. But these M&As were basically initiated by government.

Youn:  Well, yes. Those mega-mergers were initiated by the government. But there are also many mergers performed on a voluntary basis, to merely restructure their businesses from the chaebol headquarters' point of view.

Miyajima:  Then in this voluntary based M&A, which is a major form, inter-chaebol or intra-chaebol (within chaebol)? Inter-chaebol means that the Hyundai group acquired the Kia group, another chaebol group. Within chaebol means that in member firms of the Samsung group, in order to reconstruct, to streamline operations, they did some M&As.

Youn:  As far as the number of cases is concerned, I'd say the latter, mergers within. There were also simple divestures including management buyouts (MBO), or just sell-outs to outside, independent companies. It's a little different story, but when Daewoo collapsed, all its subsidiaries became independent companies. Although the group itself has collapsed, each company is really doing very well nowadays.

Miyajima:  So the Daewoo family sold its holding stock to the public, and these former subsidiaries went public?

Youn:  For the most part they had no chance to sell those stocks because after they defaulted it was all taken by the creditors.

Miyajima:  So sometimes MBO is implemented by a division manager or another among the company's management?

Youn:  Yes. MBO had also been a very frequently observed form when companies were distressed. Overall there still has been an increase in the number of mergers. From 2003 to September 2006, there were around 2,500 mergers.

Miyajima:  That's a big number.

Youn:  It's more than 600 per year. But overall I'd say the number of M&As has been increasing. Just to be cautious, the number includes both listed and non-listed firm M&As since the data is from the Korea Fair Trade Commission (KFTC). So, some of these cases involve non-listed firms as well, because they come under scrutiny as long as they have meaningful market shares.

Miyajima:  As a tool of corporate reconstruction, and as a tool of their growth strategy, Korean companies have been using M&A frequently over the past several years. But the only exception is hostile takeovers.

Youn:  Well, the very first hostile takeover was in 1994. That was Nike, the U.S.-based company, which acquired Samna Sports. That's the first and only successful case of a hostile M&A by foreigners on Korean listed firms. There are some more famous M&A attempts. SK Corp. versus Sovereign Asset Management (Sovereign) was the most well-known case, and the one which started all this turmoil.

Miyajima:  In addition, in the case of SK Telecom versus Tiger fund, its attempt did not succeed.

Youn:  They did not. Well, I'm not sure whether there have been some hidden deals, but both have just voluntarily retreated, but with a great deal of gains (profited from the increased value of their shares).

Miyajima:  So they succeeded in getting money.

Youn:  Yes, they succeeded in making money and many of the shareholders actually benefited. There are other cases, like Samsung Corp. versus Hermes Investment Management in 2004 and the Korea Tobacco and Ginseng Company (KT&G) versus Carl Icahn in 2006. In all these cases, these activist funds retreated, but made huge money. At the same time, the shareholders made a lot of money as well because the stock prices rocketed.

Miyajima:  The third question is how the stock price of SK Corp. or Samsung has been increased. Since the efficiency level is expected to increase due to the threat or pressure from these funds, is the market likely to highly evaluate this effect?

Youn:  I would say, for the SK Telecom and SK Corp. cases, they had to make many corporate governance improvements after these incidents. These were all part of the capital market phenomenon, so they didn't actually cause direct improvement in efficiency. But as far as corporate governance is concerned, SK Group is now, somewhat ironically, known as a very transparent company. It even announced it would enter into a very simple, neat holding company structure. Its shareholding structure has been simplified as well. That goes for others as well. Actually, for KT&G, Carl Icahn succeeded in nominating an outside director in 2006. All these cases had some influence on corporate governance improvement.

Miyajima:  Those cases are quite famous. How can we understand why SK Telecom and SK Corp. were targeted by foreign funds? Is it due to a free cash flow problem? Or is it that these companies have a lot of trouble in corporate governance and intervening and introducing reforms will improve firm value?

Youn:  Foreign funds often claim that they plan to run the company, but in the case of Sovereign, it denied the willingness to run the company and it was just portfolio investment. But even so, looking at these companies, there are some common factors, I'm not sure about KT&G, but for the SK Corp. and Samsung Corp., there was surely a phenomenon we call the "parent company discount." Since these companies are in the middle of a pyramidal or circular shareholding structure, they have many securities of other affiliates. And, funnily enough, their stock price and the market value were lower than their amount of assets. Therefore, the PBR (Price Book-value Ratio) was actually lower than one, and somehow those funds acknowledged that fact.

Miyajima:  So Sovereign suggested that some of the interlocking relations would be cut off after it became a major shareholder.

Youn:  It was a situation where if Sovereign succeeded in taking SK Corp., it would actually have gained controlling power in SK Telecom and even in other SK subsidiaries. So it was in a very important position as far as this controlling structure was concerned. And for that reason their shares were undervalued, as with their PBR being less than one. So SK Corp. and Samsung were the best targets.

Miyajima:  After these funds bought a block of shares, the stock market responded positively?

Youn:  Oh yes, very positively. Let me show you a chart that shows how the price responded

Miyajima:  Is that the estimated cumulative abnormal return?

Youn:  No, this chart shows it's actually just the price response of SK Corp. So you can see that the stock market responded very positively. Then, even after they sold out their stocks, the price remained very stable. So, maybe due to it not being transparent enough, the stockholders were not informed about the profit gains. Thanks to Sovereign the price became more realistic.

Miyajima:  I see. After Sovereign intervened, the PBR continued to be over one. The next question is after these events such as Sovereign or Tiger fund intervention how do top managers of the chaebol perceive a takeover threat? Chaebol managers, it seems, are very aware of the possibilities, and it's quite common that a chaebol will be a target of another fund. Is this a common perception among chaebol leaders right now?

Youn:  Yes, that's true in some sense, and in some sense not. As far as what they say to outsiders, they are always under the threat of being taken over. Even Samsung Electronics might be taken over by foreigners. I think perhaps more than 40% of shares are already owned by foreigners, mainly institutional investors though.

Miyajima:  And if a fund suggests a good business plan, then institutional investors will be willing to sell the stock?

Youn:  That's what they claim. So, in the research we did about two years ago, we were trying to find out whether the general foreigners are harmful to our economy, and the answer was apparently not. We estimated the effect of general foreign funds capital on the stock price or stock movements or corporate governance structures; pretty much everything. And it turned out there is nothing like general foreign capital. So it's always the players, one of those major players, who can do the tricks. But there's no guarantee that other general foreigners will follow whatever these funds are doing. I heard that even in the case of the dispute between SK Corp. and Sovereign, some foreigners did go for SK Corp. when they engaged in a proxy fight over the control right. Actually, SK barely won over Sovereign. We calculated the number of votes, though I don't have it right now. It appears that many of those foreigners actually took sides with SK Corp. because they knew that Sovereign was not really willing to run the company. So people don't really buy the argument that Samsung Electronics is under the threat of acquisition. It is true that foreigners hold many shares there, but since Samsung is doing quite well there is no reason to believe that other funds or other stakeholders would run it better than the current management. There must be a "Korean discount" in which shares of chaebol are traded at prices below those of comparable companies due to the lack of transparency in their ownership and controlling structures or behaviors. But as far as Samsung Electronics, the company itself is concerned, it's doing quite well.

Miyajima:  To reiterate you said, as for which type of the company is likely to be targeted for a hostile takeover; one interpretation is that a company has low PBR, which implies that the capability, or effort level, of the top manager is poor, so this manager should be replaced or the top management team should reconsider its strategy. In this sense, a takeover threat is effective in disciplining the low effort level of a manager or replacing an incapable manager. In this context, the current situation in Korea is adequate, or will you still try something to encourage M&A through the market for corporate control?

Youn:  The fact that there has been no real takeover, that there hasn't even been any tender offer bid, this alone proves we may be below the optimal level for hostile takeovers. I would be very reluctant to say that we are under the optimal level if there were one or two, because that could be optimal. If it is zero, I think then we should allow more takeovers.

Miyajima:  But the threat itself definitely affected the corporate behavior in the cases of the Sovereign and Hermes funds. Therefore, due to corporate governance reform and due to increasing foreign investors, the potential threat of takeover may play a significant role.

Youn:  That alone played a very positive role in improving corporate governance. But then there is also a negative side, because these business groups are more aware of the threat. Like I said, they would like to be equipped with more treasury stocks. They would like to hold cash instead of investing it. That actually hasn't been proven, but it is what management claims.

Miyajima:  But holding cash is not such a good idea for avoiding a takeover bid, is it? Normally a cash-rich company is a good target for corporate raiders.

Youn:  That's true. So if there's excess cash which can be cashed out then they'll be an easy target for takeover. But on the other hand, if you see the whole, group-wide picture, some cash is necessary to help out of a firm targeted by a takeover. So there is some role for cash on both sides. It can be a lure to the takeover, but it can also be a remedy, a defense, from the group-wide point of view. On top of that, those business groups also are more aware that this threat exists. So they try to fortify their structure, double-checking for loopholes, and thus making it more takeover-proof, and lobbying the government much more than they used to. They lobby for deregulation of all the regulations on shareholding. Lobbying is one negative implication.

Miyajima:  So from the viewpoint of economies, the possible positive role of hostile takeovers is a disciplinary role, and the areas suited to this kind of discipline are companies holding excess cash, and situations where there might be an insider control problem, for example corporate restructuring is delayed by inside control or controlling shareholder autonomy. In this context, is the Korean economy facing this kind of serious agency problem in listed firms? If corporate restructuring is already completed in the major field, and if the current situation is right, should we not expect a more significant role in hostile takeover?

Youn:  Before I answer the question, I would like to clarify one point. I don't mean that takeovers themselves are bad or have negative implications. But the way the chaebol respond to it is not the way they're supposed to. They should start to think about how to maximize firm value instead of lobbying to the government. Excess cash is one area for attention, and the incapability of current management. Korean management after the financial crisis is more efficient than before, I believe, in many senses. In its investment behaviors, it tries to refrain from excess investments. It just wants to go ahead with this optimal or proper level of investment.

Miyajima:  So is the chaebol discount problem already gone or still a problem?

Youn:  I think it still exists, like the grandfather, father, son, grandson inheritance problem still exists. This whole group is inherited by the descendents of the family whose management capability is never proven. Maybe they have become more capable, but a lot of tunneling or inside trading practices still exist.

Miyajima:  So a takeover may play a significant role in correcting this kind of problem.

Youn:  As far as each company is concerned, its efficiency is a lot better than it used to be. But for this whole business group there are still a lot of areas for improvement. Hostile takeovers only take place if there is a chance. It is as if there is some duty to report to the authority every day. It's not a regulation. So if anything that blocks hostile M&A is just deregulated, and then if firms are doing fine, then there are not supposed to be any takeovers. So it's absurd that even before these things happen, they simply try to block it. There are some arguments against hostile takeovers, but none of them, in my personal view, really persuade me.

Miyajima:  From the viewpoint of standard economics, M&A has double-edged sword. Of course there is a positive effect of M&A, but if there is a negative effect, there are two possibilities. One possibility is deals motivated by private gains for the manager. For example, a bidder's corporate governance structure is not effective, which makes it possible for a manager mainly motivated by empire building, or some perverse incentive to take an M&A deal. A bidder would like to buy, say, Samsung, or POSCO, or a good company. This is one possibility for M&A to become a worse deal. Another possibility is if the market is not working efficiently and the bidder's stock is evaluated highly, and that this company is allowed to do M&A through stock swap. Then the overvalued stock of the bidder is paid to the target's shareholders, resulting in just a transfer of wealth. If these kinds of situations are realistic, M&A should be defended from the viewpoint of economic efficiency.

Youn:  So transparency goes both ways. We need some transparency on their current status and their proposed plans for the company need to be clarified as well. So if we know the real picture of both the target and acquirer, as long as the market is efficient, shareholders can surely choose whatever option is the best for them. Sometimes with hedge funds it hasn't been clear before, which is the weakness of these kinds of takeover attempts.

If there is a real type of takeover, one efficient fund, with a lot of funds to invest, and the target is lacking something; managerial capability, cash, etc., then we definitely want to allow these kinds of takeovers. But at the current stage, there is no way that even the good takeovers can happen. Bad takeovers are actually easier to defend against. That is the role of the shareholders, as long as they know the true picture. But in the current situation, even if everybody, including the government and minority shareholders, wants M&A to happen, there is no way this kind of takeover can happen. That is the only direction which is blocked.

Miyajima:  The next question is related to legal issues. Are foreign companies are already allowed to buy Korean companies through stock swap, which is called a triangle merger and acquisition? Of course a domestic company, a chaebol, can buy other company through stock swap, instead of cash. But how about foreign companies buying Korean companies via paying in foreign company's stock?

Youn:  I'm not an expert on this, so I will have to get back to you with an answer. This has actually never happened before, because all such attempts were like cash offers. The buyer, the bidder, acquired stock in the open market with cash. That kind of issue was never truly realized. That was only the issue in friendly attempts, among firms established in Korea. What I mean is that even a foreign-owned firm needed some establishment in the Korean territory or Korean market. However, in the proposed amendment to the commercial law, allowing triangle mergers is included. So we'll have to wait and see.

Miyajima:  At the conference, Dr. Randall Morck suggested this kind of a situation, looking at late-1980s Japan. There were not so many M&As inside the Japanese market, but there were a lot of M&As by Japanese firms to foreign firms. At that time, Japan was in a bubble situation, so companies had large amounts of cash and tried to buy foreign companies. The representative example was the purchase of the Rockefeller Center in New York City. But the bid price was much higher than its fundamental value and Mitsubishi lost a lot. That's an episode of the Japanese economy. But almost the same thing may happen with the Chinese company, or Russian energy firms. Korean companies which currently have a large amount of cash and try to buy Korean firms at a high premium may have some reason to protect this kind of M&A from other M&A deals by Chinese or Russian firms, or foreign firms in general. Are there any arguments in Korea on this point?

Youn:  There have been some arguments on that. Luckily enough for them, our asset price recently has been increasing very rapidly. For example, a foreign fund that acquired the buildings in the southern part of Seoul made billions of dollars. However, it is always possible that some foreign funds will lose money due to a fall in the price of assets in which they invested. As Dr. Morck said at the conference, there is the same possibility of their losing money as that of making money, and it is impossible for foreign funds to bring the asset out of the country.

As far as these kinds of assets are concerned, there is no need for us to really care about it. It's like if you opened a casino here and just let foreigners play poker or blackjack. The difference with the assets of manufacturing industries is that there are technology issues concerned. I always try to think with a global mind, so efficiency gains in China will benefit us in Korea as well. It's not really a big deal to me, but many people in governments or the general public care very much about this national kind of competition. If they think from that perspective then it is certainly a loss for Korean firms. For example, Ssangyong Motors was acquired by a Chinese auto company. They said there would not be any shift of production from Korea to China. But apparently Chinese companies are not sticking to what they promised. Naturally there are many leakages of technology from Korea to China. I think that is actually part of the deal when a company is sold to a Chinese company. That's why they paid that much money. So it's inevitable. But the only problem is that, are there any technologies that need to be protected at a national level? That's a very tough question. I don't think that the ability to make automobiles is that kind of technology.

Miyajima:  Let us think about the actual Korean economy. For example POSCO is targeted by, say, Arcelor Mittal, so a fund enters into Korea, buys a block of shares, and sells to Arcelor Mittal. This scenario is possible. Are government officials and POSCO very aware of this kind of scenario?

Youn:  But there isn't anything really happening right now. So we don't know how the scenario will go. A lot of those technologies actually are embodied in the people and the facility itself. It's not something you can actually bring it out of the country readily. And it's very hard to believe a company like POSCO will be taken by Arcelor Mittal. Former cases show that it's very not likely.

Miyajima:  The best way to avoid this kind of scenario is to increase the firm value and raise the stock price.

Youn:  So the basic approach here is the best approach, I believe. Just stick to the fundamentals and try not to deal with minor financial kinds of issues.

Miyajima:  I completely agree. But even admitting this point, if the bidder clearly has some perverse incentive, such as empire building or abusing monopoly power over the Korean market, or misvaluation, that is, undervaluation of a target company's shares, then can government intervene into this kind of M&A attempt?

Youn:  Instead of expecting the government to do something to inhibit the Chinese or other countries from trying to acquire Korea-based firms, I recommend that these people invest their money into the Korean firms. The funny thing is these people never previously paid attention to the Korean stock market and now that it's booming with the presence of all these foreigners, they start to complain. I would like them to invest before they complain about foreigners taking out our assets. Once they become the partial owner of the company, they are doing a kind of duty, and they can say something about the companies being taken over by foreigners. But not putting any money into the company and just complaining about the possibility, that's very irresponsible and a funny kind of response.

Miyajima:  Then let me move on to the last question. What are the current legal issues concerning M&A in Korea? Please tell me your views on issues such as poison pills or other anti-takeover measures, and triangle mergers by foreign companies.

Youn:  Currently the hottest issue would certainly be the poison pill. There is also some other debate about a dual-class share structure in which a company can issue different classes of shares that confer different (multiple, single, or no) voting rights on the holder. Well, I and many others are opposed to that kind of approach. We just have to evaluate the current situation correctly, even though there are many among management, or controlling shareholders that are complaining about having threats. It is curious that they have never opposed foreigners' acquiring the share itself. They must get rid of their dual standards. They like foreign money, but they don't want foreigners to say anything to their management.

Miyajima:  They are willing to sell cash flow rights, but not willingly to give the control rights to foreigners.

Youn:  If they want to say that, then those family owners first have to put all their money into the shares of the company. But they don't do anything with their money and then just ask for the government to protect them from those kinds of pressures. It's ridiculous. Like I said, there may be some cases where we need to protect them from bad takeovers, but I just cannot think of them at the moment.

Miyajima:  So far there are no such cases.

Youn:  Even in the bad takeover cases, government regulatory discretion may not be the best possible way to deal with that. It's even absurd to introduce all these defense measures on top of the current situation. I'd say with this controlling structure, poison pills, and treasury stockholdings, we're not going to see any takeovers in our lifetime. So I don't believe that that's the way we want it in the future. It may be true that too many takeovers are not optimal, but some takeovers, or at least some pressures or threats themselves, are healthy for the economy and/or the stock market.

Miyajima:  Your general point is that introducing or allowing takeover defenses is not appropriate?

Youn:  In the current situation, yes.

Miyajima:  On the other hand the chaebol are now quite eager to stabilize ownership structure by using treasury stocks and so forth. Do you think there is any need to regulate treasury stockholdings or other kinds of shareholder stabilizing schemes in Korea?

Youn:  Yes. At the conference we talked about the importance of shareholders. So, as long as those kinds of treasury stock-related transactions are approved at the general shareholders meeting, then there will not be any problem. Of course there are other matters like disclosure. Everyone needs to know what the management and controlling shareholders are doing. Other nations strictly regulate insider trading. Apparently there have been many cases of this, so they introduce all these strict regulations. As far as I know, every country has very strong restrictions on insider trading in connection with treasury stock holdings or purchase or sales. The more that is implemented the better. And approval by shareholders should come first. Also, I think that we should deregulate restrictions on shareholdings or change the current shareholding structure into a more transparent one, and then ask the government to introduce some more defensive tactics. But it is always a chicken or egg kind of problem. Business always asks the government to do something first, and then starts to discuss how to deal with this kind of complexity. I think it's very hard to solve this problem, but it needs to be solved. We know that there have been no real takeovers, so how about if the chaebol companies start to improve.

Corporate governance-related institutional settings in Korea are of an international standard, but the implementation itself is not satisfactory. KDI did some study on the level of implementation and some comparison with the United States. It appears the level of the institutional settings are quite satisfactory, quite comparable to U.S. cases, but the implementation was evaluated a lot lower; even though it's improving it's still lower than the U.S. standard. That can be one area of improvement. But to speed up the implementation of corporate governance reform, the threat of takeover or a well-functioning market for corporate control is critical. Otherwise they will just spend a lot of time waiting for the government to do something.

Miyajima:  One area that made an impression on me at this conference was learning that after financial crisis, the chaebol experienced a lot of transformation and corporate reorganization. Yet according to you, and Dr. Lim's presentation, a sophisticated stabilizing shareholder scheme was newly introduced by the chaebol. So agency problems between controlling and minority shareholders still exist in Korean firms. This is one of the main problems which should be solved by government and other concerned parties. In this context, the market for corporate control is good pressure for encouraging Korean firms to be more transparent and efficient.

Youn:  I always believe that that's the last resort for all the corporate governance-related issues. If there is no market for corporate control, any effort to improve corporate governance may turn out to be just for show. For all these changes to be effective you need some real tension from the outside. Even if you have bad corporate governance, as long as you make a lot of money in the product market, your stock price will be just fine. But that doesn't tell you that your company's healthy. However, all these changes can be ignited by the presence of a threat, a real threat from outside. I think an internal control mechanism is important, but an outside control mechanism, the product market and the market for corporate control, these are actually more important factors in making these companies healthier. I have to tell you the voices of the businesses are always the bigger ones. I would say many researchers, even the managers in financial firms and economists and business specialists are very concerned about corporate governance. They are not worrying about the current situation, but they hope it can be improved a lot more in the near future. And this is an area on which we need to focus. The other issues of corporate governance are just a matter of implementation. But this is a very controversial issue and a very hotly debated topic nowadays because it is directly related to the control power of the controlling shareholders.

Miyajima:  The term corporate governance has many meanings, but one of the criteria of good or bad corporate governance is if the company shows bad performance, who will pull the trigger and replace incompetent mangers. From this criterion how can you describe the corporate governance structure in Korea? If the manager of the chaebol proves less competitive and competent, then who will change the management?

Youn:  The stock price always signals to the buyers about a bad performance. Nowadays the controlling shareholders or the managers are very concerned with the stock prices. So they are very responsive to what the market reflects in the stock price. It's kind of self-regulatory for daily tasks. But if the issue is some hidden agenda or private incentives, then there really isn't any way for others to know. Also, sometimes it is done at group-wide level, so it's not at the disposal of each company's management.

Miyajima:  And what is the reality? Japan used to be a bank-based economy. In the heyday of the main bank system, the main bank played a critical role for corporate governance in the sense that if a client firm faced financial distress, the main bank systematically intervened in the board of the firm, fired the incumbent manager, and brought in an appropriate replacement. But now the main bank is gone and the market for corporate control is plugged in but not yet completely established. So identifying a new governance mechanism in Japanese firms is a critical issue to be solved. And in the case of Korea, I think the controlling shareholders have strong power in that even if a top manager of a chaebol is showing bad performance, and the stock price is falling, the direct pressure of the capital market is not so effective. This was the situation at least before financial crisis. Following crisis has the situation changed?

Youn:  Like you said, basically, the controlling shareholder and the management are still very concerned with the stock price. Before the crisis we were supposed to be a bank-based system, but the bank didn't really play that role. The government and bank both continually supported business groups. But after the crisis we were shifting rapidly toward a market-based system. You are right in the sense of how the market can punish controlling shareholders or management if they perform poorly. They want to respond to what the market signals. If the stock price plunges, then they try to boost it. That works to some extent, but there is something beyond it, like pursuing private benefits, that cannot be corrected by the capital market alone.

Miyajima:  My sense is that the effect of market pressure on incumbent managers in Korea is not so direct like in the U.S. or UK. So in the case of Japan, after the 1997 banking crisis the big companies came under the pressure of institutional investors. Now, they have to pay a lot of attention to the capital market, because the bond rating is very important, and the stock price is also a very important signal to the capital market. Given this situation, even takeover threats are not so realistic for certain types of firms. The top manager is under pressure from the capital market through the voice of the employees. If the top manager is incompetent and makes poor decisions, the stock price goes down, employees will complain, and the manager will have to resign and be replaced with other talented candidate within the firm. So the pressure from the capital market might not take the direct form of a takeover threat, but the capital market certainly affects the decision-making process, as well as manager succession. I sense that is also the case in Korean companies. The chaebol are relatively free from the threat of takeover. But if the stock price goes down the family regards its son as less capable, and requires him to appoint a more talented person. These kinds of internal mechanisms are encouraged by capital market in Korea, aren't they?

Youn:  Yes. I fully agree with you as far as top management, the professional managers are concerned. This is a mechanism which works perfectly. The controlling shareholders will not endanger their position by coming under the blame of shareholders and/or employees. So as long as companies are performing very poorly, they just switch the management. This happens frequently. But what I'm worried about is the level beyond that. Who takes care of the controlling shareholders? We introduced the clause to have those controlling shareholders responsible. First of all, the fiduciary duty of the director has been introduced and fortified. And then there's this de facto director. These controlling shareholders are actually in the position of director, but they are, in a sense, just out there pretending they are not related to any of the firms. So the government in 1998 enforced, in the commercial law, that if they were actually at the position of making those decisions they must bear the burden of an actual, real director. So that made, in some sense, those controlling shareholders bear responsibility to shareholders. So there were some penalties, punishments for wrongdoings. Actually, after that, some of those controlling shareholders in fact went to prison. So this system works in some sense. But even if after they went to prison they may resume their positions, or their sons just take over the positions. It works, to some extent, but it is not fully holding these controlling shareholders responsible for the decisions they make. The market plays a positive role in replacing these incompetent managers, but it's doing only a partial job for these controlling shareholders. For that, we need a somewhat stronger mechanism to actually punish or replace them. Many of those professional managers are available if the controlling shareholders are willing to take them on. Thousands of them are in line, willing to work for those companies.

Miyajima:  In Korean companies is the professional manager highly mobile? In the case of Japan, the top manager, the executive officer, is basically promoted within a company, so that there is no market for external managers. How about in Korea?

Youn:  That is more typical in Korea as well. But the privatized state-owned enterprises, or the financial institutions, and even some chaebol-related companies hire from the open market. But I would say that internal promotion is a more popular way.

Miyajima:  There is some argument, I am not sure if this is right or not, but Japanese firms' competitive edges are based on firm-specific skills. For instance, Toyota has a Toyota production system, and the Toyota CEO must have enough knowledge on the unique system generated within the firm. The firm's private information is very important. Therefore hiring from outside the firm doesn't make sense. This might be a common understanding for the manufacturing sector in Japan. Is this the case in Korea or is the market for managers more open and the skills required for a manager are more generalized?

Youn:  It depends. For example, at Samsung Electronics, Mr. Jin De-Je started his career as a researcher and later became the CEO. So he knows the semiconductor business, and later he became minister of the Ministry of Information and Communication. He used to be Samsung man.

Miyajima:  So he is a professional manager and does not require firm-specific skills.

Youn:  No. It depends on the type of business. The top management for POSCO, the steel company, does not really need someone who knows how to make steel. It needs someone who knows about the world market, or what the markets are like. But in semi-conductor business, a technician may be needed so that person knows how technical trends are going. The goal in this sector is always faster, smaller, cheaper, which is the technician's job. A business-oriented person cannot actually figure the way out. But nowadays companies in this sector are expanding their businesses. For TVs or cell phones, a company may need someone more alert to outside opportunities instead of technological developments. As a firm becomes larger and diversifies its business, it may need someone with managerial skills, and resource allocation may be the most important job for the top manager. So it all depends.

Miyajima:  Thank you very much for this long interview. I believe our readership will gain plenty of useful information from this on what is going on in corporate governance in Korean firms, along with rich ideas for considering Japan's situation.

*Transcript was compiled by MIYAJIMA Hideaki, YAOITA Shumpei, and the RIETI Editorial staff, with substantial contribution from Dr. Taehoon YOUN

August 10, 2007