The 6th Asian Roundtable on Corporate Governance Implementation and Enforcement in Corporate Governance Youngjae Lim Kor

1. The 6th Asian Roundtable on Corporate Governance Implementation and Enforcement in Corporate Governance Youngjae Lim Korea Development Institute Korea Theme I Various experiences to ensure effective implementation – allocation of responsibilities and institutional frameworks Seoul, Korea 2-3 November 2004 The views expressed in this paper are those of the author and do not necessarily represent the opinions of the OECD or its Member countries or the World Bank Korea Development Institute

2. Korean Regulatory Agencies Enforcing Corporate Governance • Financial Supervisory Service: regulating banking, securities and insurance • Regulating listed companies in the securities market • Staffs are not government officials => Remuneration, recruitment, and training differ from those for the government officials. Korea Development Institute

3. Korean Regulatory Agencies Enforcing Corporate Governance • Fair Trade Commission: Regulating Chaebols • Regulating private (unlisted) subsidiaries belonging to business groups • In many countries, private companies are not the target of regulation since the public investors to protect are not involved: high cash-flow right and high control right • But, in Korean business groups, unlisted subsidiaries’ behavior has important implications on the public investors of the listed subsidiaries belonging to the same business groups: low cash-flow right and high control right Korea Development Institute

4. Role of Regulatory Agencies regarding the Implementation of Corporate Governance • Internal monitoring system: board of directors, audit committee, or minority shareholders’ rights • External monitoring system (market pressure): potential shareholders in the capital market, institutional investors, hostile takeovers • Regulatory agencies of the government: infrastructure for the external monitoring system to work • Financial Supervisory Service, Fair Trade Commission, Prosecutors, or Courts Korea Development Institute

5. Evaluating the Independence and Effectiveness of Financial Regulatory Agency in Korea • “Developing and Measuring an Evaluation Index for Market Reform” KDI Report, 2003 • Chapter 4. “Capital Market Transparency and Investor Protection: A Comparative Law Perspective” by Ok-riak Song and Taeyoon Sung • Since the 1997 financial crisis, Korea has introduced many changes in financial regulatory systems to improve the enforcement of corporate governance. • Evaluate these reform efforts from the perspectives of institution building and actual practices • Evaluate how the external monitoring system works as of 2003 in Korea Korea Development Institute

6. Index of the External Monitoring System in Korea • Sub-index: transparency index and accountability index • Transparency index: whether relevant information is distributed to shareholders (both current and potential) • Accountability index: how shareholders (both current and potential) place their pressures on the current management (hostile takeovers, etc.) Korea Development Institute

7. Index of the External Monitoring System in Korea • Contents of Transparency index • (1) Information-related legal system: distribution of relevant information in a timely and effective manners (2) Enforcement system: independent and efficient supervision for (1) Regulatory agencies Civil enforcement (civil liabilities regarding external auditors or class action suit) Korea Development Institute

8. Index of the External Monitoring System: Literature • Bernard S. Black, The Legal and Institutional Preconditions for Strong Securities Market, UCLA Law Review 48:781-855 (2001) [Black] • CLSA, CG Watch: Corporate Governance in Asia (April, 2003) [CLSA] • ISS, Corporate Governance Quotient Rating Criteria [ISS] • Rafael La Prota, Florencio Lopez-de-Silanes & Andrei Shleifer, What Works in Securities Laws?, Working Paper (October, 2002) [LLS] • Partrick S. McGurn, Keeping Score: Rating Governance in the Post-Enron World, Strategic Investor Relations 7-10 (fall, 2002)   • OECD, Questions for Rating Corporate Governance • Standard & Poor's Corporate Governance Service, Company Corporate Governance Score: Abbreviated Criteria and Methodology (February, 2002) [S&P] (w/ Questions) • World Bank / IMF, Template for Country Assessment of Corporate Governance (July, 2000) [World Bank] Korea Development Institute

9. 1-1. Transparency (Information-related legal system) Korea U.S. 0.7857 0.8750 Disclosure system 0.8750 1 Disclosure items 0.8571 1 External audit system 0.6250 0.6250 1-2. Transparency (Enforcement system) Korea U.S. 0.7222 0.9444 Independence of regulatory agencies 0.5 1 Effectiveness of regulatory agencies 1 1 Civil enforcement 0.6667 0.8333 Evaluating Institution Building* * As of August, 2003 18 Korea Development Institute

10. 1-1. Transparency (Information-related legal system) Practices Institution building 0.5 0.7857 Disclosure system 0.47 0.8750 Disclsure items External audit system 0.53 0.6250 1-2. Transparency (Enforcement system) Practices Institution Building 0.39 0.7222 Independence of regulatory agencies 0.47 0.5 Effectiveness of regulatory agencies 0.51 1 Civil enforcement 0.19 0.6667 Evaluating Practices in Korea (Experts Survey)* * As of August, 2003; Accountability index (practices, 0.45; institution building,0.9027) 18 Korea Development Institute

11. (Example) Institution Building: Independence of regulatory agencies • Korea : Members of the FSS can serve for three years ans can be reappointed once (Financial Supervisory Service Act Article 6, Clause 1). However, only the appointed members namely Chair and Vice Chair of the FSS are guaranteed of their position (0 point) • U.S. : members of the SEC can serve their position for five years (Securities Act of 1934, Article 4, Clause (a)). There is no precedent of SEC members being dismissed during their terms (1 point) Dismissal of regulatory agency members

12. Regulating Corporate Governance of Business Groups: Fair Trade Commission In Korea • OECD’s 2nd Principles of Corporate Governance • Question: Which regulatory agency should enforce the corporate governance of business groups? • Private (unlisted) companies belonging to business groups • Chaebols’ ownership structure in Korea Korea Development Institute

13. Chaebols’ Ownership Structure • Chaebol’s controlling shareholder owns only a small fraction of equities by cross-shareholding or by pyramiding (Controlling Minority System). • The separation between control and cash-flow rights can distort incentives. • The dispersed ownership also has agency costs but the market for corporate control would discipline the controller (or the management). • The CMS insulates the controller from the market for corporate control. => The agency costs cannot be constrained. • Concentrated ownership => Internalizing costs Korea Development Institute

14. Public Policy toward the Cross-shareholding Structure • The first best policy • Completing market discipline (legal protection of minority shareholders, reputation) • Removing (free) private benefits of control • The second best policy • Minimizing the destruction of firm value • Still the transfer of values from minority shareholders to controlling shareholders Korea Development Institute

15. Ownership Structure of SK Group Note: Author's estimation based on various business reports and audit reports (as of December 2001) Korea Development Institute

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19. Inside Owners 1996 1997 1998 1999 2000 Controlling Shareholder 3.7 3.1 2.0 1.5 3.3 Family 4.8 4.8 3.4 3.0 2.3 Affiliated Companies 33.7 35.7 44.1 36.6 35.2 Total 42.2 43.6 49.5 41.1 41.8 • Table Inside Ownership for the 30 Largest Chaebols (unit: %) Source: Press releases by the Korean Fair Trade Commission Korea Development Institute

20. Measuring the ownership structure of Korean chaebols • La Porta, Lopez-de-Silanes, Shleifer, and Vishny (2002) • South Korea: 20 large listed firms cash-flow right: 18 %, control right: 24 % • Calculating for the 11 largest chaebol groups • cash-flow right: 14%, control right: 41% Korea Development Institute

21. Explaining the differences of measurement in the literature • Large listed companies: usually investing companies => small wedges • Other subsidiaries: usually invested companies => large wedges Korea Development Institute

22. Explaining the differences of measurement in the literature • Private (unlisted) firms • Usually, not the target of policies • No public investors to protect • high cash-flow right and high control right • But, Korean business groups: (very) low cash-flow right and high control right • Public investors to protect Korea Development Institute

23. Private firms belonging to Korean business groups • Public investors in the investing large listed companies • Corporate veil between investing and invested companies => Public investors in the investing companies do not have any shareholder rights. • the target of policies: unresolved issue Korea Development Institute

24. The Monopoly Regulation and Fair Trade Act: Regulation on Chaebol subsidiary’s holding of other companies’ shares • A ceiling on equity investment ratio • all individual subsidiaries for large Chaebols except for financial companies (NBFI) Korea Development Institute

25. Ownership Structure of Samsung Group • Estimated from the business and audit reports as of December 2001 • Samsung Group had 63 companies under the control. The 19 companies in the figure account more than 80% of total assets. • Controlling shareholders own only four companies directly: Samsung Everland (28.82%), Samsung Life Insurance (4.54%), Samsung Electronics (2.0%), Samsung General Trading (1.42%). Among the four companies, Samsung Life Insurance plays the most important role in entrenching controller’s minority control. Korea Development Institute

26. Ownership Structure of Samsung Group Note: Author's estimation based on various business reports and audit reports (as of December 2001) Korea Development Institute

27. Pubic policy toward financial companies’ fiduciary duty • Investment trust companies or insurance companies can exercise their voting rights for controlling shareholder. • Fiduciary duty regulation is needed as a prudential regulation • Frequent and prompt disclosures on the portfolios of financial companies are also needed. Korea Development Institute

28. Pubic policy toward financial companies’ fiduciary duty • The KMRFTA allows Chaebol-affiliated financial companies to exercise their voting rights in such cases as: (a) appointment or dismissal of officers, (b) alteration of the articles of companies, and (c) merger of the said affiliated company with another company, or transfer of the whole or part of business to another company. Korea Development Institute

29. Pubic policy toward financial companies’ fiduciary duty • The KMRFTA allows Chaebol-affiliated financial companies to exercise their voting rights in such cases as: (a) appointment or dismissal of officers, (b) alteration of the articles of companies, and (c) merger of the said affiliated company with another company, or transfer of the whole or part of business to another company. Korea Development Institute