the role of corporate governance in south korean economic reform

Journal of Applied Corporate Finance W I N T E R 1 9 9 8 V O L U M E 1 0 . 4

The Role of Corporate Governance in South Korean Economic Reform by Kenneth Scott

Stanford University Law School

8JOURNAL OF APPLIED CORPORATE FINANCE

THE ROLE OFCORPORATE GOVERNANCEIN SOUTH KOREANECONOMIC REFORM

by Kenneth Scott,Stanford University Law School*

8BANK OF AMERICA JOURNAL OF APPLIED CORPORATE FINANCE

t the beginning of 1997, the “Asian tigers”had achieved decades of remarkablegrowth, and they were being held up asmodels for the rest of the less-developed

for some time to come, and of course there aremeaningful differences from one country to another.Whether the outcome will be significant and lastingreform in the way some of these economies are runremains to be seen, despite the conditions attachedto IMF assistance programs. As with all bailoutprograms, the problem is that they also tend toperpetuate flawed institutions and relieve borrowersand lenders from some of the losses resulting fromtheir decisions. In this respect, market discipline isundermined. But if there is such reform, one—among many—of the ingredients that will have to beconsidered is a change in the system of corporategovernance for banks and business firms. Such largeenterprises are now often run more in the interest ofthe government and the controlling shareholdergroup than in the interest of efficiency and maximiz-ing aggregate shareholder wealth.

This article will examine that general proposi-tion in terms of the structure of corporate gover-nance in South Korea. The IMF Staff Report on theKorean situation noted that “there is an urgent needto improve corporate governance and the corporatestructure.”2 The rest of this article falls into foursections. The first discusses the threshold issues ofwhy and when corporate governance is significant.The second looks at how corporate governanceinstitutions function in different countries, focusingprimarily on the United States, Japan, and Germany.The third undertakes to develop from the compara-tive analysis some criteria by which to appraisecorporate governance systems. The fourth and con-cluding section applies the analysis specifically toSouth Korean institutions and attempts to evaluatethe reforms now being suggested.

*This article draws on a presentation at the KDI-Hoover Joint Conference,“Agenda for Economic Reform in Korea: International Perspectives,” January 15-16, 1997, and on “Agency Costs and Corporate Governance,” in The New PalgraveDictionary of Economics and the Law (P. Newman, ed. 1998).

1. “Foreign Banks May Lend $10 Billion to Seoul,” Wall St. Journal, Dec. 30,1997, p. A6.

2. International Monetary Fund Document, “Republic of Korea—Request forStand-By Arrangement,” Washington, D.C., December 3, 1997, p. 15, ¶51.

world to follow. Their economies typically com-bined elements of both business free enterprise andgovernmental control of investment, usually exertedthrough the banking system. The ruling politiciansdirected the banks’ lending policies and even indi-vidual decisions; the banks received implicit govern-ment (central bank) guarantees; the favored borrow-ers could expand rapidly, if not necessarily pru-dently; and the politicians received large contribu-tions from the favored firms. It was a system exem-plifying not Western-style party democracy andchecks-and-balances, but “Asian values” of hardwork, social order, and deference to authority.

The second half of 1997, however, subjected theconcept of a new Asian model of economic devel-opment to a series of severe tests. Beginning in July,first Thailand and then the Philippines, Malaysia, andIndonesia were forced to abandon their attempts tocontrol exchange rates, and to let their currenciesfloat (and sink) in the open market. Companies andbanks with large amounts of short-term, foreign-currency-denominated debt quickly saw themselvesconfronting bankruptcy. The most recent, and mostimportant, addition to this list is South Korea. InDecember the International Monetary Fund re-sponded with a $57 billion loan and credit assistancepackage, which soon had to be supplemented withefforts to obtain another $10 billion in new creditfrom an international consortium of private banks.1

The causes and consequences of this series ofAsian economic crises will be examined and debated

A

VOLUME 10 NUMBER 4 WINTER 19989

WHEN AND WHY CORPORATE GOVERNANCEIS IMPORTANT

To make a coherent analysis of a set of corporategovernance institutions, it is necessary to specify theobjective being sought. Modern corporations, totake advantage of technological progress and scaleeconomies, are large organizations requiring heavycapital investment. The amounts of capital requiredoften can be raised only by pooling the savings of amultitude of investors, who must rely on others tomanage their investments and run the enterprise.The institutions—the particular set of legal rules,incentives, and behaviors—that support and under-lie that reliance by investors constitute the system ofcorporate governance in a given society.

In this paper I will assume that the objective isto maximize the economic efficiency of the firm.Discussions of corporate governance sometimesappear to be addressing other concerns—such asmonopolistic or oligopolistic power, the welfare ofparticular constituencies, or macroeconomic stabil-ity. Those are all valid issues, but the design ofcorporate governance is not a very direct or effectiveway to deal with them. It has a real and importantcontribution to make to economic efficiency, butonly a tangential bearing on numerous other matters.

It should be noted that other institutions andforces also come to bear on the operations of thefirm, pushing it toward greater efficiency. Foremostamong them are the pressures that arise fromcompetition in the product and factor markets.Perfect competition, domestically and internation-ally, would work to eliminate this and many otherproblems, but in its absence corporate governancecontinues to be a matter worth attention.

In terms of economic efficiency, my focus willbe on the cost of external equity capital to the firm—the price, in the sense of expected returns, that thefirm must offer outside investors to get them to buystock in the enterprise. Why are shareholders willingto turn large sums of money over to other people(managers) to invest in specialized assets on very ill-defined terms? The managers of the firm do not tellthem when they will get their money returned orwhat compensation will be paid for its use. Otherswho furnish inputs to the business are not so vagueabout arrangements for payment.

Why are shareholders’ property rights so poorlydefined? The usual answer is that the stockholders’essential function necessitates that condition. They

are the bearers of the residual risk of the firm,enabling others to contract with it on more definiteterms; their claims come last, after all other variouscontingencies and claims are satisfied, and hence itis impractical to try to spell them out in detail underall states of the world. The status of stockholdersprovides a paradigm of the (highly) “incomplete”contract. As such, it leaves the stockholder poten-tially quite vulnerable to managers acting incompe-tently or in their own interests.

If the position of stockholders cannot be wellprotected by contract, then how is it made viable?There are two principal mechanisms that serve thisfunction. One is law: fiduciary rules that requiremanagers (agents) to act in the best interests ofstockholders (principals). The other is governance:a set of provisions that enable the stockholders byexercising voting power to compel those in operat-ing control of the firm to respect their interests. Legalfiduciary rules can best address relatively clearconflicts of interest; issues of managerial compe-tence, except in egregious cases, fall in the domainof governance.

Obviously, corporate governance is not a prob-lem for the 100%-owner-manager of a business. Noris it much of a problem for the majority stockholder(or group) which controls the board of directors andcan fire the managers at any time. (Protection forminority interests in such a firm will have to comeprimarily from fiduciary rules, since their votingpower is generally ineffectual.) So corporate gover-nance is an issue mainly for minority stockholders incompanies that are controlled by the managers andwhere there are no significant stockholders that caneasily work together. In that situation, the stockhold-ers potentially can still exert control through theboard to protect their interests, but they face formi-dable difficulties (in terms of transaction costs andinadequate incentives) in acting together and actu-ally doing so.

In a practical sense, therefore, corporate gover-nance is important as a means of reducing the“agency costs” imposed by managers acting in theirown interests to the detriment of shareholders,mainly, again, in firms owned by dispersed stock-holders. How large a concern is this? That dependson the prevalence of such firms in the economy, andhence will vary across countries. Reliance on exter-nal equity finance displays a wide range, from firmto firm and nation to nation. The explanations forthat range constitute one of the major areas of


controversy and investigation in the field of corpo-rate finance and governance.

A starting point is to inquire why a firm wouldwish to rely on external equity finance at all. Theusual answer is that it is cheaper to finance throughthe stock market because portfolio investors candiversify away the “non-systematic” or firm-specificrisk, and the issuer thus pays a risk premium only forthe systematic or remaining risk. Stock market equityis also believed by many to reduce the corporate costof capital by opening up the potential supply ofcapital. A lower cost of capital for the firm (or anation’s economy) in turn increases, ceteris paribus,profitability, economic growth, and internationalcompetitiveness.

But recourse to public capital markets alsomeans greater exposure of owners to agency costs,and thus greater need for corporate governanceinstitutions and rules to limit the extent to whichmanagers can mismanage the firm, divert wealthfrom shareholders, and extract “control rents.” If theobjective seems desirable enough, then what iscontroversial? How best to achieve it.

A BRIEF OVERVIEW OF INTERNATIONALCORPORATE GOVERNANCE SYSTEMS

Since all countries and economic systems facethe problem of how to economize on principal-agent costs, one approach to an answer is to lookaround the world and see how it has been dealtwith. The comparative approach, which has at-tracted considerable attention over the last decade,focuses on the three largest and most developedeconomies: the United States, Japan and Germany.Each has a distinctive set of institutions. A fulldescription would be quite lengthy and go beyondthe scope of this paper, but each is usually charac-terized in terms of an “ideal type” (even though itdoes not reflect the actual diversity and complexityto be found in each nation).

For the United States, the ideal type is the so-called Berle-Means corporation,3 with equity owner-ship diffused among a multitude of small stockhold-ers and a self-perpetuating management firmly incontrol under most circumstances. A degree of

discipline over management is provided by thethreat, and occasionally the reality, of proxy contests,hostile takeovers, and leveraged buy-outs. Legalrules also impose on directors and officers certainfiduciary duties—particularly the duty of loyalty—which “require” them in conflict-of-interest situa-tions to act in the best interest of the stockholdersrather than of themselves. That general admonitionhas received development in a number of recurringpatterns, and is enforced through civil liability ac-tions brought by attorneys on behalf of shareholders.

Underneath the ideal type lie many questions.How accurate is it for the U.S. economy? Institutionalas opposed to individual investors now own almosthalf of the total U.S. equity market, but there arethousands of institutional investors (including pen-sion funds, mutual funds, insurance companies, trustcompanies, foundations, charities and endowments).How much less acute is their collective action prob-lem? In the 25 largest U.S. corporations, on average27.5% of the common stock is held by the top 25institutional investors.4 But, as capitalization sizedecreases, so in general does the institutional share(though exact data on this are lacking). And variousfinancial and securities statutes impose a set of tech-nical legal impediments to significant holdings andcoordinated action by institutional investors, althoughthe latter were somewhat eased in 1992.

As for fiduciary duties, just how effective arethey? There is a multitude of different rules for dif-ferent contexts, ranging from criminal penalties fortheft and embezzlement to civil liability for “unfair”self-dealing and to amorphous admonitions to treatminority shareholders with inherent fairness in aholding company formation. Enforcement also facesa collective action or free rider problem, handledwith the devices of derivative suits and class actions,but the latter in turn have their own agency costs.

In Japan, the ideal type is the “keiretsu,” thoughtof as a group of companies linked by stable cross-shareholdings and seller-buyer relationships. A par-ent company, or more often a main bank, is sup-posed to act as the administrator for the group,monitoring management performance of the mem-ber firms and intervening in cases of sufficientfinancial distress.5 Non-member shareholdings con-

3. This designation comes from Adolph Berle and Gardiner Means’s 1932classic, The Modern Corporation and Private Property (New York: Macmillan,1932).

4. Institutional Investment Report 1997, Vol. No.2 (New York: The ConferenceBoard, 1997) p. 36.

5. See Masahiko Aoki, “Monitoring Characteristics of the Main Bank System:An Analytical and Developmental View,” in, eds., Masahiko Aoki and Hugh Patrick,The Japanese Main Bank System (New York: Oxford University Press, 1994).


stitute a substantial minority of the ownership ofmost of the member firms; but the public sharehold-ers are inactive investors, and discipline exertedthrough market mechanisms such as hostile take-overs is almost unheard of.

Again, there are questions as to the extent towhich the keiretsu pattern describes the currentJapanese economy. Much of the literature is descrip-tive and assertive, not numerical or empirical. Therole of the main bank, which cannot itself own morethan 5% in any company, was not much tested beforethe crash at the end of 1989. And, in part because ofthe propensity in Japanese accounting and banksupervision to conceal rather than disclose financiallosses, the main bank system has not receiveddefinitive analysis since. It may be undergoingsignificant change, under current economic pres-sures.6 With the main banks themselves in trouble,rescue operations for keiretsu members seem tohave become hard to find.

The cross-shareholdings and transaction rela-tionships are laden with potential conflict-of-interestdangers for the interests of outside stockholders, andit is not known how they have fared. The Japaneselegal system does not rely on a general fiduciary dutyof managers to act in the best interest of stockhold-ers; instead, directors may be liable for gross negli-gence in performance of their duties, including theduty to supervise. The duty and liability run to thecompany, however, and enforcement by derivativesuits is a relatively new phenomenon.

In Germany, the standard account looks at onlya few hundred large firms, listed on the stockexchanges and operating under the two-tier (super-visory and management) board system required ofcompanies with more than 2000 employees (whoelect half the supervisory board). Major (over 25%)block-holders are common. Even more significant isthe role of the firm’s house bank and other banks interms of their voting power. German banks, asuniversal banks, can own corporate stock, unlikeU.S. banks. In addition, in a system of bearer shares,German banks are the primary depositaries forpublic stockholders and vote their proxies; the banksalso run investment funds and vote those shares. Theresult is that banks in 1992 cast on average 84% of

the votes at the annual shareholder meetings of the24 largest widely held stock corporations.7

Does this mean that in Germany banks act aseffective institutional monitors on behalf of share-holders? The answer is far from clear, since the samestructure applies to the banks themselves. The fivelargest universal banks as a group cast between 54%and 64% of the votes in 1992 at their own shareholdermeetings, though no one had an absolute majorityat its own meeting. If the banks’ managements arerelatively unconstrained by other shareholders orthe stock market, how is their discretion employed?

The legal system is not thought of as playingmuch of a role in German corporate governance.The civil law is not congenial to the broad fiduciaryconcepts of Anglo-American equity law. Supervi-sory board directors really do not have much deci-sion-making responsibility, and co-determinationhas been criticized as undermining even its moni-toring effectiveness.8 Management board directorscould act negligently or commit torts, but the insti-tutions of the derivative suit or class action areunknown. For stockholders to sue management insuch a situation, it would take a majority at angeneral meeting, or at least 10% to file a courtpetition; obviously it is a rare occurrence.

Suppose we leave the world of the most highlydeveloped market economies and go to the world ofthe less-developed countries and emerging marketeconomies. Now the typical pattern (to the extent theeconomy is not state-run) is one of companiesclosely held or dominated by a founder, his family,and associates. The role of external equity finance issmall; the business is financed by retained earningsand heavily by debt (often on a political or subsi-dized basis from government-controlled banks). Theeffective constraints of the legal system on managersmay be weak or non-existent, a condition whichRussia at this point seems to exemplify.

What explains all these variations? We do nothave convincing explanations, in part because we donot even have a good factual picture of corporategovernance variables across the world. Of course,even in the absence of comprehensive information,one can speculate. There is a large political compo-nent in the generation of these different institutional

6. See Paul Sheard, “Financial System Reform and Japanese CorporateGovernance,” working paper, Baring Asset Management (Japan) Limited (1997).

7. See Theodor Baums, “Universal Banks and Investment Companies inGermany,” in, eds., Anthony Saunders and Ingo Walter, Universal Banking:Financial System Design Reconsidered (Chicago: Irwin, 1996).

8. See Katharina Pistor, “Co-determination in Germany,” working paper,Harvard Institute for International Development, 1997.

If there is reform, one of the ingredients that will have to be considered is a changein the system of corporate governance. Large corporations in Southeast Asia are

often run more in the interest of the government and the controlling shareholdergroup than in the interest of efficiency and maximizing aggregate

shareholder wealth.


structures. Mark Roe, among other law and econom-ics scholars, has demonstrated how the Americanantipathy to private concentrations of economicpower led to statutes that geographically fragmentedthe banking industry and prohibited banks andinsurance companies from owning stock.9 Suchrestrictions, Roe argues, effectively prevented U.S.financial institutions from playing the governancerole of their counterparts in Germany and Japan.Germany, in particular, had by the end of the 19thcentury developed large, nationwide universal bankswith close relationships to industrial clients. As Roealso notes, however, the banks have both directlyand indirectly stymied the growth of the publicsecurities market, thus discouraging another poten-tial source of corporate monitoring. In Japan, thegoverment took control of the banking industryduring World War II and used it to allocate capital tothe industrial sector. After the war, with privatecapital exceedingly scarce, there was no significantstock market and government policy continued to beto finance industrial growth through bank debt,supporting the power of the main bank over itsgroup of client firms. Such thumbnail sketches arenot intended as explanations, but to suggest thatunderstanding existing corporate governance sys-tems goes beyond the pressures for economic effi-ciency to a consideration of historical “path-depen-dency” and other factors.

So which system is preferable? Is that even ananswerable question? I have already mentioned theproblem of data that are not available or have notbeen collected and tabulated. For no country, in-cluding the United States, can we paint a picture ofthe entire corporate governance structure. In com-parative terms, no one has even attempted to gobeyond a half dozen or so of the largest countries.10

But there are difficulties at a deeper level. Howwould one undertake to measure, in any rigorousway, the effectiveness of corporate governanceacross nations? How do you isolate and measureagency costs for an economy? In the 1980s, thetendency was simply to say that if economic growthrates in Japan or Germany had been higher than inthe U.S., corporate governance was one of thefactors at work and their systems might be better. If

that pattern reverses over the 1990s, does theconclusion reverse? In the absence of good directmeasures of corporate governance efficiency, somestudies have resorted to the use of proxies, such asthe rates of board turnover or management turnover,the level of discretionary spending or free cash flow,or the likelihood of takeover bids and acquisition. Allproxies have their flaws, and methodology remainsan issue and concern. At this time, we have moreplausible stories than well-tested hypotheses.

Furthermore, critics of corporate governancesystems and proposals argue that any system hascosts that must be accounted for along with theexpected benefits from the reduction of controlrents and mismanagement. One widely alleged costof the U.S. system is that market-based disciplinecreates an undesirable management orientation to-ward short-term stock price performance ratherthan long-term investment returns and growth. Theargument rests on the proposition that the stockmarket is “myopic”—that, in pricing companies, itconsistently overdiscounts longer-term expected cashflows and returns. There are various models of“asymmetric information” and accounts of short-term speculative bubbles that attempt to give more“structure” to this argument. Nevertheless, actualempirical evidence of consistent discount myopiain the stock market is weak;11 and, even if it werepersuasive, it would raise questions going far be-yond matters of corporate governance.

Another criticism of corporate governance asanalyzed here is that it should not be judged in termsof economic efficiency, the cost of capital, andshareholder wealth, but should take into accounteffects on other “constituencies” such as employees,suppliers, customers, managers, and the communityat large.12 All are characterized as “stakeholders,” andthe corporate governance system is to be judged byhow well all interests are served. A focus on share-holders, it is argued, does not take into account costsimposed on these other stakeholders. What is invari-ably omitted from the argument, however, is consid-eration of the extent to which these other interestscan protect themselves by contract. Moreover, manyof these stakeholders can not really be said to makefirm-specific investments that are subject to expro-

11. See Jeffrey Abarbanell and Victor Bernard, “Is the U.S. Stock MarketMyopic?,” working paper, Michigan Business School, 1995.

12. See Oliver Williamson, The Economic Institutions of Capitalism (NewYork: The Free Press, 1985), Chapter 12.

9. Mark Roe, Strong Managers, Weak Owners: The Political Roots of AmericanCorporate Finance (Princeton: University Press, 1994).

10. See Andrei Shleifer and Robert Vishny, “A Survey of Corporate Gover-nance,” Journal of Finance 52 (1997), pp. 737-83.


priation by management. Thus, we are returned toa point with which we began: what is unique aboutstockholder claims is the fact that they are long-term,residual, and necessarily poorly defined.

EVALUATING DIFFERENT CORPORATEGOVERNANCE SYSTEMS

But perhaps we do not need to be able toarrive at a logical and analytical answer to thequestion of which set of corporate governance rulesis to be preferred. We can employ the test ofeconomic survival—does not competition in theproduct market force evolution toward the mostefficient governance structure? We have noted onequalification of that argument; political forces canimpose fundamental constraints on the availableeconomic choices. That makes it hard to assert thatthe U.S. or German or Japanese system would bebest for others. Still, each of those systems hasworked well enough to sustain capital accumula-tion, investment, and economic growth in a leadingeconomy. By looking at their common elements,rather than their differences, we may be able todraw some tentative conclusions.

First, what can we say about their legal institu-tions? I do not feel altogether comfortable in goingbeyond the United States, but can at least offersome impressions. To begin, a distinction should bemade between legal rules that define and protectshareholder voting rights and their ability to assertcontrol, and legal rules that substitute for (or supple-ment) shareholder control by imposing enforceableduties on managers. There is a fairly well-devel-oped set of laws establishing voting and controlrights for shareholders in each country, although itis not difficult to suggest improvements. This wouldseem to be a minimum requirement for any effec-tive corporate governance system, but it is lackingin some countries.

The importance of fiduciary duties, or theirequivalent, has been less studied. One can postulatea continuum of situations involving conflicts ofinterest between managers and owners, with theconflict becoming less sharp (and perhaps the legalrules less essential). At one extreme would beoutright theft, embezzlement, and misappropriation;without effective legal sanctions in these cases, only

the gullible would part with their money. A some-what less transparent form of achieving the same endis the self-dealing transaction between the managerand his firm. By buying too low or selling too high,the controlling party transfers wealth from the firmto himself, but the picture can be confused byintricate transactions in non-standard assets or sub-ject to varying degrees of price unfairness. Enforce-ment becomes more difficult, but still seems essentialif agency costs are to have any bound. The appro-priation of corporate opportunities, excessive com-pensation, and consumption of managerial perkscan be still more judgmental, and probably the legalrules are less effective, but the order of magnitude isalso less. And when one reaches conflicts highlyintertwined with the regular operation of the busi-ness, such as excessive diversification or self-reten-tion by less competent managers, the fiduciary dutyof loyalty (or the Japanese duty of supervision)probably offers little protection.

The United States has, it is my impression, goneconsiderably farther along this continuum thanJapan or Germany. How effectively is hard tomeasure; the subject has not received much atten-tion.13 But it cannot simply be ignored by anycorporate governance system intended to sustainexternal finance, particularly for companies in whichthere is a controlling majority shareholder or group.They may still be constrained to some extent byconsiderations of reputation, or the need for re-peated dealings, but that is a constraint that disap-pears whenever the controlling party chooses to befree of it.

Second, all three systems have found methodsfor combining economic and control rights into largeblocks, in order to overcome the ineffectualness offragmented voting power. In Germany it takes theform of large investors, with their voting cloutsometimes augmented by proxy control. In Japan, ittakes the form of coordinated networks, actingthrough institutions like the presidents’ council andthe main bank. Both of those arrangements arerelatively stable, whereas in the U.S. the aggregationis often ad hoc; voting power is assembled for theoccasion, through a proxy contest or tender offer orleveraged buyout. The techniques differ, but theyappear to be addressing a common need in aneffective corporate governance system. Of course,

13. Notable very recent exceptions are Shleifer and Vishny (1997), cited infootnote 10; and Rafael LaPorta, Florencio Lopez-de-Silane, Andrei Shleifer, and

Robert Vishny, “Legal Determinants of External Finance,” working paper no.5879(Cambridge: National Bureau of Economic Research, 1997).

In the less-developed countries and emerging market economies, the typical patternis one of companies closely held or dominated by a founder, his family, and

associates. The role of external equity finance is small; the business is financed byretained earnings and heavily by debt (often on a subsidized basis from government-

controlled banks).


where the arrangement is stable, it can be turnedagainst outside minority stockholders.

In the last analysis, for many reasons we probablycannot point to an individual system as the best underall circumstances. There is some basis for identifyingshortcomings or proposing improvements, but a num-ber of quite distinctive institution arrangements seemto work at least passably and perhaps equivalentlywell.14 That suggests a strategy of not adopting orentrenching any single system, but creating, if possible,the opportunity for any of them to take root and dem-onstrate superiority, even if only in a special niche.15

For the U.S., that strategy would mean removingthe legal impediments to financial institutions accu-mulating more significant blocks, and to blockholdersworking together to monitor and, if necessary, toreplace management. For Germany, it would meanencouraging the deepening of the securities marketand the capacity of stockholders to oust manage-ment (currently usually protected in office by five-year contracts). For Japan, it would mean acceptingthe role of hostile tender offers and other forms ofcapital market discipline.

Of course, in each country there are politicalbarriers to such reforms, led by managements andsometimes unions, and so the reforms may not beattainable. But there are also those who would ben-efit from enhanced corporate governance, and thismight be a sensible strategy for them to follow; thetactics that would have the best prospect of successdepend upon local political institutions and forces.

REFORMING THE SOUTH KOREANGOVERNANCE SYSTEM

In conclusion, how does all of this apply toKorea? In the discussion that follows, my account ofthe Korean corporate governance system, as well asproposals to reform it, draws heavily on recent workby Korean governance scholars—in particular, a1996 study by Young Ki Lee.16

The “ideal type” for Korea seems to be thechaebol, best described as a conglomerate web offirms, linked by indirect cross-shareholdings and acommon founding-chairman in the core companies.The founder and his family on average own about 10%,

and through cross-holdings control another 30% to40%, of the group member firms. In those companiesthat are listed, financial institutions own about 30% ofthe equity. This is a picture of the family-dominatedfirm, mentioned earlier as typical for emerging econo-mies, in which control rents are likely to be high.

Professor Lee’s 1996 study does not describe theextent to which the legal system attempts to limitthose control rents, beyond noting that board mem-bers do not represent outside shareholders, who aresaid to be “overlooked.” The role of auditors isdescribed as “atrophied.” In addition, a set ofmanagerial prerogatives known as “managementright” was protected until 1997 by a prohibition ofhostile tender offers, and custodians of public sharesare prohibited from casting independent votes at theannual meeting (i.e., they “shadow vote”).

The government has pursued a number ofpolicies with the professed aim of “achieving widershareholding.” Listing on the first tier of the stockexchange now requires that over 40% of thecompany’s stock be held by shareholders owningless than 1%, and that the principal owner and hisfamily own not more than 51%. Cross-shareholdingsby a firm may not exceed 25% of its net equity capital.A bank cannot without permission own over 10% ofa company’s shares, and no shareholder can ownmore than 4% of a bank. As can be seen, these ruleswork mainly to disperse outside shareholder votingpower but do not threaten the continuance ofdominance by the insider control group.

Professor Lee’s study also reviews a number ofproposals that have been made to improve Koreancorporate governance. The suggested reforms haveincluded strengthening the position of internal andoutside auditors, allowing mergers and acquisitionsapproved by a panel, requiring more outside direc-tors on boards, introducing the German supervisoryboard or two-tier system, and allowing banks to owngreater equity shares in companies. Some of thesesame measures are promised in the government’srequest to the IMF for assistance.17

To aid in evaluating these and other reformproposals, there are a number of principles that wecan derive, at least tentatively, from the body ofexperience that is available:

14. See Steven Kaplan, “Top Executives, Turnover, and Firm Performance inGermany,” Journal of Law, Economics, and Organization 10 (1994), pp. 142-59;and Steven Kaplan, “Top Executive Rewards and Firm Performance: A Comparisonof Japan and the United States,” Journal of Political Economy 102 (1994).

15. Roe (1994), cited in footnote 9.

16. See Young Ki Lee, “Corporate Governance in Korea: The Structure andIssues,” working paper, Korea Development Institute, 1996; and see also YoungKi Lee and Young Jae Lim, “Corporate Governance in Korea: Issues and Prospects,”working paper, Korea Development Institute, 1997.

17. International Monetary Fund Document, cited in note 2, Anx. III, p. 10, ¶30.


(1) Attention should be paid to the state of legalprotection from transactions involving potentialconflicts of interest. Governance in the narrowsense—the exercise of voting rights—is of littleimmediate help to minority shareholders confront-ing a controlling block. This is particularly significantif one is concerned with start-up technology firms inthe Silicon Valley mode; venture capital firms aremedium-term investors who need an exit for theirinvestments in the form of an active IPO market.

(2) It is not enough to note that someone—a housebank, or main bank, or outside directors, or super-visory board—possesses the power to be an effec-tive monitor of management. One must also examineclosely their incentives to so act, and observe theirperformance in actual practice. Where direct incen-tives are mixed or weak, as in all of the above cases,it may be a mistake to have high expectations. Thereis no real substitute for the possession or acquisitionby the outsiders of a major economic stake in thefirm’s success.

(3) Charging management or the board with a legalmandate to “balance” the interests of various con-stituencies or stakeholders is merely to diminish anylegally enforceable responsibility to shareholders,without creating a definable obligation to any oneelse. In the United States, such statutes have beenused by management primarily to enlarge theirdiscretion to ignore shareholder preferences inhostile takeover situations. The result is to increasethe scope of potential control rents and agency costs.

(4) Who pays for (such an increase in) agencycosts? The existing owners of the firm, not newshareholders purchasing in the market—the pricethe new shareholders pay will reflect the reductionin their share of expected cash flows to the firm. Thismeans that it is the owners of family firms, when theysell shares to the public at a higher price, who are thebeneficiaries of effective legal rules and corporategovernance. If better understood, this fact wouldfacilitate the adoption of what are usually describedas “shareholder” protections.

(5) The largest beneficiary of a more effectivecorporate system, however, is the nation as a whole,since the improvements in management perfor-mance and reductions in cost of capital in theeconomy aid it in domestic productivity and interna-tional competitiveness.

Applying these principles to the reforms beingconsidered in South Korea suggests that the accom-plishments will be modest. To begin, I am not awareof serious attention to the protection of minorityshareholders from conflict-of-interest transactions,which have been commonplace in the chaebol struc-ture. There is mention of enhanced disclosure, throughconsolidated balance sheets and enforcement ofaccounting standards in line with GAAP. But thelegal rules to be applied to the disclosed transactionsare a separate matter. Reliance on capital marketdiscipline presupposes a capital market in whichoutside investors are willing to play a large role.

Further, capital market discipline also involvesthe possibility of outside investors being able todisplace poorly performing management, even whereit possesses a significant (though not controlling)ownership share. The only mechanism referred to inthis regard is a liberalization of restrictions onmergers and acquisitions, along with the interestingpromise that “bankruptcy provisions according toKorean law will be allowed to operate withoutgovernment interference.”18 There is also a some-what opaque statement that “[l]egislation concerninghostile takeovers will be submitted to the first specialsession of the National Assembly to harmonizeKorean legislation on abuse of dominant positions inline with other industrial countries’ standards.”19 It isdoubtful that the chaebols’ founding chairmen havemuch to fear.

One potentially important commitment by thegovernment, however, is that it will discontinue di-rected lending and permit commercial banks to be runby their boards in the interest of their shareholdersrather than the government.20 That step, if taken, wouldbe a rather drastic shift away from the Asian model.

18. International Monetary Fund Document, cited in footnote 2, Annex III, p.45, ¶35.

19. Ibid., p. 44, ¶32.20. Ibid., p. 45, ¶34.

KENNETH SCOTT

is Parsons Professor of Law and Business, Emeritus, StanfordLaw School, and Senior Research Fellow, Hoover Institution.

Charging management or the board with a legal mandate to “balance” the interests ofvarious constituencies or stakeholders is merely to diminish any legally enforceable

responsibility to shareholders, without creating a definable obligation toanyone else.

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