Corporate Governance in South Korea: the Chaebol problem

Corporate governance is the aspect of the corporation that concerns itself with the “structure of rights and responsibilities among the parties with a stake in the firm” (Aoki, 2000). Policy debates on corporate governance best practices is constantly influenced by internationalization and “international convergence” (Aguilera and Jackson, 2003). The most common framework in corporate governance literature is that of agency theory. Agency theory concerns itself with the conflict of interest between principals and agents in relationships where one is supposed to act in the best interest of the other. In the context of a corporation, the agency problem refers to this conflict of interest between its management and its shareholders. According to this theory, a company’s management, which is the agent, should aim to maximize value for shareholders, i.e. the principal. The problem arises when management objectives are swayed from the best interest of the principal due to other motivations.

Corporate governance aims to reconcile conflicts of interests between stakeholders by increasing management transparency and helping shareholders monitor management decisions. The relationship between the board directors, managers, controlling and minority shareholders play a crucial role in controlling and directing a corporation. Sound corporate governance involves greater transparency, information disclosure and accountability in management. A lack of corporate governance can contribute negatively to a firm’s profits, risk profile and overall corporate image, making it unattractive to investors. Additionally, it can prevent the firm from turning stakeholder concerns into opportunities for growth. Shareholder recognition ensures that everyone has a say in management decisions, which directly impacts a company’s stock valuation. The following sections consider the case of Samsung, one of the largest multinational corporations in South Korea. I chose to discuss South Korean corporate governance as it aptly illuminates on some important corporate governance issues, their impact on the economy and the role of a country’s institutions in regulating the corporation.

South Korea’s chaebol problem

Prior to the annexation of Korea by Imperial Japan between 1910-1945, the Korean peninsula was predominated by agriculture. The first industrial assets in Korea were left behind by their Japanese occupiers following the Japanese defeat in the second world war. Prior to this and for some time after the liberation of Korea, the idea of the corporation to support post-war economic recovery was non-existent. The origins of Korea’s modern day conglomerates can be traced back to this period. Domestic industrial growth in Korea gained momentum only since the 60s after Park Chung-Hee led a military government to power in 1961. The government laid the foundation for rapid industrial transformation of South Korea, with a special focus in the strategic sectors of shipbuilding, automobile manufacturing, consumer electronics, chemicals and construction.

The economic planning for this new era was modelled off the Japanese conglomerate structures known as the zaibatsu and keiretsu. The present day corporate giant Samsung began as a mere grocery business started by Lee Byung-Chul in 1938. By the 70s, the company had diversified its businesses, pioneering the development of modern-day Korean society. The company was later transformed into one of the world’s largest producers of consumer electronics, technology and electronic components by Lee’s son, the now deceased father of current chairman JY Lee. By 1985, South Korea’s top 50 corporate groups, or chaebols, contributed towards 94% of the South Korean GDP. In 2011, the big five chaebols namely Samsung group, Hyundai, SK group, LG and Hanwha accounted for over 55% of the GDP (Marlow, 2015).

The chaebol is a medium to large sized, family-controlled business conglomerate unique to South Korea. These multinational corporate groups often comprise of many diversified businesses that operate across different industries under the ownership of the founding family. Chaebols are distinct in terms of their organizational structure, management style, and corporate governance. In South Korea, chaebols are characterized by their close, often interdependent relationship with the government, large market capitalizations and complex structures of centralized, interlocking ownership that allows members of the controlling family to secure ownership of major subsidiaries.

Revenue of each chaebol group as a percentage of Korea's 2019 GDP [Source: CEO Score, Bank of Korea]

Due to the historic dependence of the Korean economy on chaebols, these firms have been heavily subject to the scrutiny of investors, media and the general public. Chaebols have repeatedly featured on the receiving end of criticisms directed at its corporate governance that leaves a lot to be desired for external investors.

Chaebol Corporate Governance

Some of the dominating issues in Chaebol corporate governance and an economy built around the Chaebols are summarized in this section.

• Lack of transparent corporate governance policies: Lack of transparency is not only inconvenient for investors but has often led to corruption, bribery, fraud and embezzlement charges on many of the top chaebols including Samsung. Lack of transparency protects the major shareholders but destroys shareholder value for minority shareholders and investors.

• Concentration of power: Ownership is passed down from one generation of the controlling family to the next and power is concentrated on the chairman or “owner” of the chaebol, often to the detriment of the stakeholders in the firm’s networks. These large firms act with low legal restraint, pay late, act arbitrarily, show poor shareholder accountability, and often abuse their power to dominate smaller firms (Kessler Topaz Meltzer & Check LLP, 2017). The dominance of the controlling family also means that executive leadership positions in the firm are inherited by the next generation, regardless of their suitability to lead. Chaebol leaders are often seen asserting their powers to make impetuous decisions which shows very little regard for the maximization of shareholder value.

• Korea discount: For many years, the Korean stock market index “KOSPI” has suffered from a chronically low valuation, trading at less than half the book value of other indices globally. This phenomenon, known as the “Korea discount”, is marked by lower price-earnings of Korean stocks compared to their global peers (OECD, 2018). The discount is commonly attributed to the presence of chaebols, its opaque governance and substantially low dividend pay-outs which has led to the undervaluation of Korean companies. With low dividends and inefficient capital allocation, firms continue to disregard corporate governance as merely a “box-ticking exercise” instead of a strategy to build shareholder value. This is reflected by the country’s low return on equity ratio, and the their valuation continues to decline in comparison with other global firms (Kim, 2020).

• Economic reliance on chaebols: The fact that the chaebols may be single-handedly responsible for much of the rapid economic development in South Korea adds to the growing concerns over the unsustainable nature of the country’s reliance on these conglomerates to support its economy. In the Covid-19 crisis, South Korea seems to be pushing limits of its export-dominance led economy. Over-reliance on chaebols have stifled others drivers of economic growth such as small businesses and innovation-led services. While chaebols can protect themselves by focusing on internationalization, the domestic economy is left with fewer jobs, rising household debt, failing small to medium-sized businesses and a lagging service sector. There is rising concern about the sustainability of Korean export-led strategy. By hoarding profits, leveraging close relationships with the government, absorbing resources from domestic suppliers and obstructing the growth of innovation-led SMEs, the large Korean chaebol groups are growing at the cost of other economic players (Marlow, 2015).

• Political relationships: Corruption is rampant within Chaebols. Due to the size and influence of these firms on the economy of an otherwise resource-less country, the idea of chaebols failing is unimaginably devastating. Low corporate tax, protection from competition, cheap loans and institutional backup for chaebols entering new and strategic industries where they stifle the growth of budding SMEs demonstrates the leniency often shown to these large business groups. Government policy and even the judicial system is easily swayed to protect the South Korean economy which is heavily reliant on these multinationals (Marlow, 2015). In fact, August 15, the day that marks the liberation of Korea from Japanese imperial rule, is associated with presidential pardons that is extended to jailed corporate leaders and politicians (White and Song, 2021).

The case of Samsung

In January 2021, following a retrial on bribery allegations, Samsung chairman Lee Jae-Yong was sentenced to prison for a year and a half, leaving the country’s biggest chaebol without its top decision-maker. Originally convicted in 2017, Lee received a five-year sentence for bribing Park Geun-hye, the former South Korean president to secure political support and extensive control over the conglomerate. The scandal famously led to the former president’s impeachment and consequent imprisonment. White-collar crime is a common corporate governance issue amongst the country’s big and influential corporate groups. In 2008, the former head of Samsung, Lee Kun-Hee had to publicly resign following a series of allegations that led to him and his son, the current chairman, being convicted for financial crimes involving tax evasion, accounting fraud and bribery in order to pass down control of the group to the next generation of their family (White and Song, 2021).

The sentencing of the Samsung chairman has been met with progressive support from denouncers of the cronyism associated with these powerful chaebols. To many, the sentence has come off as lenient, reinforcing the dominance of chaebol leaders over the law. However, amidst the covid-19 crisis, the decision has been met with resistance and concern amongst older Koreans, conservative politicians and the business community due to the importance of Samsung in driving economic recovery from the coronavirus pandemic (White and Song, 2021).

Implications for Samsung

In the chaebol model of corporate governance, the chairman holds exclusive authority when it comes to making the final decision on any significant investment or corporate strategy. In Samsung, this authority is passed down to the heir of the controlling family. The sentencing of Lee Jae-Young is a massive setback to Samsung, the world’s largest manufacturer of computer chips, electronic displays and smartphones (White and Song, 2021). Several investments and projects have been put on hold and legal troubles have consumed funds, time and energy, distracting the firm from new opportunities and weakening its competitiveness.

Unlike the previous governments, political support for Samsung has weakened in the aftermath of the scandal, forcing its chairman to accept responsibility and set an example by bringing reforms within the company. Samsung chairman Lee Jae-Young has responded by adopting a western style of corporate leadership by decentralizing decision-making and transferring some authority to professional managers. He demonstrated an inclination to introduce greater transparency and stronger compliance within the firm. Lee has also vowed to abolish the tradition of handing over management control and cross shareholdings to his children, resulting in speculations that the firm may be the first major chaebol without a family heir (White and Song, 2021).

The transfer of ownership within Samsung group is further complicated by the high inheritance taxes faced by the chairman and his siblings, which have been estimated to be as high as $10 billion. Footing the bill comes at the cost of selling parts of the group’s non-core units that have cross-shareholdings in Samsung Electronics, which along with the chairman’s imprisonment leaves the firm weakened and exposed (Lewis, 2021). Samsung, which represents more than 25% of the Seoul stock market value, has so far been regarded as crucial to South Korean nation-building (Lewis, 2021). The sentencing has illuminated the lack of transparency in governance and the extent of economic reliance on the conglomerate.

Impact of corporate governance on internationalization

Filatotchev et al (2007) explores how corporate governance may influence FDI decision and internationalization strategies in firms in newly industrialized economies (NIEs). According to the research, information asymmetries and agency conflicts are some of the main sources of risk and concerns associated with internationalization. The corporate governance characteristics of a firm therefore contribute to these concerns. La Porta et al. (1999) describes some defining characteristics of Asian corporations that provide an important framework for their internationalization process. First, these firms rely heavily on the controlling families to make and finance important strategic decisions. Secondly, insiders hold substantial decision making power due to significant equity stakes held by the firm’s top management and board members. Thirdly, institutional investors are growing in importance due to greater internationalization leading to foreign institutions holding equity stakes in these companies. Finally, business networks are extremely important to these firms. Redding (1996) defined these firms as “weak organizations linked by strong networks”. In the case of the Chaebol, these networks are more formally structured. Research based on the agency view suggests that family-controlled firms have limited diversification of financial portfolio and therefore limited liquidity. Concentrated shareholdings therefore contribute to higher financial risk. Such firms are more risk-averse as a result (Anderson and Reeb, 2004).

Reforms in Korean corporate governance

The current president of South Korea, Moon Jae-In took office in 2017. The new government resolved to reform corporate governance within chaebols. Despite the slowing economy and mounting expectations for the Moon Jae-In government to extend presidential pardon to Samsung, the ruling party has continued to introduce several reforms to shift economic reliance away from big corporates and deny presidential pardon for convicted corporate leaders. In 2020, South Korea witnessed several developments in corporate governance, with relatively fewer Korean firms being targeted by shareholder activists. Firms have also continued to improve their response to the concerns of minority shareholders. Strong shareholder activism is crucial in influencing regulatory changes in corporate governance. The following section summarises some key areas of legislative developments in corporate governance that came through the Moon Jae-In government.

• Through the Enforcement Decree of the Capital Markets Act, external directors have been prohibited from serving in a company for longer than 6 years to improve board independence. The law has been extended to prohibit owners and affiliated shareholders from getting involvement or appointed in the Independent Directors Recommendation Committee (IHS Markit, 2021).

• A stewardship code was introduced to encourage investors to exercise their shareholder rights in matters of corporate governance and push for transparency and better shareholder returns. The code aims to improve shareholder value. The response of many Korean firms have been positive and compliant. Samsung has responded by increasing its dividends. The Korean National Pension Service, a major shareholder in many Korean corporations adopted the code in 2018 and has taken a key role in implementing the code (Kim, 2017). Involvement and response from the country’s biggest organizations has proved crucial in boosting shareholder value.

• According to the Economic Reform Research Institute, almost 60% of Korean listed firms with over 2 trillion won of assets report that they do not have an independent auditor, despite a law passed in 2003 that mandates having one. Most of the independent auditors that were appointed are financially inexperienced ex-government officials or former lawyers (Kim, 2020). The Moon Jae-In government in a significant move last year, proposed amendments to allow minority shareholders to appoint board members independently, a move that will boost transparency in decision-making at the large corporate groups. The proposals require auditors to be chosen from outside the boards and limits the voting power of the controlling family and other big shareholders at 3% when appointing an auditor.

Conclusion

Chaebols have historically been run in the best interests of the controlling family and other major shareholders. The consequence is inefficient management of capital, business expansion and investment decisions that deter shareholder value, and poor governance in general. It follows from the previous discussion that removing economic reliance on these large business groups may help level the playing field and hold these firms accountable to stringent corporate governance policies. South Korea is faced with the challenge of restructuring their economy from one dominated by large chaebol groups to one fueled by new and emerging industries in innovation, high-value added service and technology. Supporting a start-up and SME-led economy will lead to lesser reliance on these large corporations and greater independence for the country’s institutions and other stakeholders to hold the firms accountable to good governance.

Good governance can be achieved with a combination of internal and external governance mechanisms. Good governance is characterized by an effective board, division of responsibilities and power, a balanced board composition, balanced voting rights, transparent decision-making and sound risk management systems. From an agency perspective, measures of good governance should include better incentives to align the interests of the management with minority shareholders. Shareholder protection and shareholder value creation should be incentivized across the management structure and its core values. External monitoring should be encouraged and perceived as an opportunity to secure a good corporate image and boost investor confidence.

Finally, institutions play an important role in enforcing good corporate governance. Legislative enforcement of tighter controls on corporate governance and accounting processes within these organization is necessary to help disperse the concentration of power on majority shareholders. The institutions of a country have a key role in restructuring the power balance and economic dominance of big corporations. Developments in the areas that boost the country’s financial risk profile such as encouraging shareholder rights and oversight can help secure a better position in global financial markets. Better governance has wealth-increasing effects on the national economy by reducing corporate blunders and attracting foreign investment.

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