Democratization and Corporate Governance in Korea One Step Forward, Two Steps Back

Law & Democratization Conference, University of Wisconsin Law School, Oct 19-20, 2007 Democratization and Corporate Governance in Korea: One Step Forward, Two Steps Back? Joongi Kim (Yonsei University) I Introduction II Transition from a State-Oriented Corporate Governance Framework A Background B Legal Structure: Commercial Code and Securities Exchange Act .3 III The State’s Declining Role in the Banking System A Bank Ownership, Privatization and Reforms B The Rise of NBFIs IV Soft Regulatory Enforcement: The Tax Authorities V Corporate Governance and Corruption .9 VI Conclusion 11 I Introduction The transition to democracy in 1987 under a new Constitution and the beginning of Korea’s Sixth Republic set into motion a reconfiguration of Korea’s corporate governance landscape.1 A prominent transformation involved the role of the state in corporate governance From a domineering force in monitoring and supervising corporates through industrial policy, the state’s influence significantly receded This paper will seek to analyze the effect of democratization upon the corporate governance landscape in Korea By comparing the legal framework before and after the onset of democratization in 1987, this paper will seek to argue that counter-intuitively the state of corporate governance initially declined with democratization Shedding the authoritarian state demanded effective internal and external protections and monitoring mechanisms to replace it But they remained lacking External forces that should have emerged to shape corporate governance such as banking supervision, legal enforcement and regulatory oversight, accounting, and investor protections remained in a fledgling state Corporate laws remained relatively unchanged, while gatekeepers and watchdogs did not develop The state of limbo without effective monitors in place eventually served as a significant contributor to the rapid spread of the Financial Contagion in 1997 Democratic transitions must accompany sufficient protections to provide President Roh Tae Woo, the first President to hold office in the Sixth Republic, began his 5-year, single term in February 1988 work in progress; comments welcome, quotation with permission only Law & Democratization Conference, University of Wisconsin Law School, Oct 19-20, 2007 corporate accountability and transparency in order to be successful in the long run This paper will attempt to assess the immediate changes in corporate governance that were brought about by democratization through an analysis of several sectors Korea’s leading companies as represented through the large family-controlled conglomerates, called chaebol, will be the focus for assessing these changes First, it will review the reforms that transpired in the financial and banking sector The changes in the banking industry through the emergence of non-bank financials institutions in particular will be reviewed together followed by an analysis of the securities market Next the paper will provide an examination of the changes in regulatory enforcement primarily through the actions taken by tax authorities against companies Finally, an examination of the relationship of corporate governance and government corruption will be conducted to try to understand the changing role of the state In the end, it will argue the declining influence of the state that occurred with the consolidation of democracy beckoned a corresponding need to strengthen market-oriented protections and oversight II Transition from a State-Oriented Corporate Governance Framework A Background The establishment of the Sixth Republic in 1988 marked the first time in over 17 years that a president was democratically elected based upon popular vote Under the new Constitution, a new era of political accountability began to be established The heavy hand of the “state-oriented model” of corporate governance began its steady decline In the past, as described by Chalmers Johnson, the developmental state was "plan rational" as opposed to a regulatory state that was "market rational."2 This entailed a state that dominated all facets of industrial policy and in turn corporate governance, from financing to regulatory supervision Technically, until the early 1990s, Korea did not even have a common term for “corporate governance.”3 The state managed everything instead Internal corporate governance in the form of boards of directors, shareholder meetings, shareholder rights, auditors and various other institutions existed on a technical level at best They did not serve as effective monitors to promote shareholder value and protect the interests of the corporation from expropriation or abuses as designed Board meetings usually Chalmers Johnson, MITI and the Japanese Miracle: The Growth of Industrial Policy, 1925-1975 (Stanford: Stanford University Press, 1982), pp 18-19; Robert Wade, Governing the Market: Economic Theory and the Role of Government in East Asian Industrialization (Princeton Press 1990) Joongi Kim, A Forensic Study of Daewoo's Corporate Governance: Does Responsibility Solely Lie With the Chaebol and Korea? Northwestern Journal of International Law and Business, Vol 28, No (forthcoming 2007), footnote work in progress; comments welcome, quotation with permission only Law & Democratization Conference, University of Wisconsin Law School, Oct 19-20, 2007 amounted to a pro forma exercise under which controlling shareholder decisions were ratified Shareholder rights in particular were rarely if ever exercised Shareholder litigation was practically non-existent and correspondingly director and officer liability insurance did not exist B Legal Structure: Commercial Code and Securities Exchange Act Starting from the Sixth Republic, economic policymaking transformed as it began to be subject to “far greater popular demands and scrutiny.” The chaebol, found themselves in a liberalized atmosphere.5 Controlling shareholders, who already dominated their conglomerates, began to adjust to extrication of the state’s influence The Sixth Five-Year Economic Plan that started from 1987 consisted of a host of reforms that dictated reforms in the banking sector and financial sector, chaebol conglomerates, labor laws, industrial policy and various efforts to guarantee the freedom of the press Korea further adopted a host of reforms to fulfill the conditions to become a member of the OECD and to adopt the Code on Liberalization of Capital Movements This entailed additional liberalization of its banking, financial and corporate system such as lifting ownership restrictions and deregulation From a statutory standpoint, however the onset of democratization did not bring about major legal reforms in corporate or securities law, the two fundamental laws for corporate governance Korea’s modern Commercial Code, established in 1962, for instance, was revised in 1984 and 1995.6 Both revisions, however, did not involve substantial changes related to corporate governance Similarly, the Securities Exchange Act did not undergo any major revisions related to corporate governance during the ten years leading up to the financial crisis in late 1997 After an amendment in December 1997, the Securities Exchange Act was revised in December 1991, January 1994, and December 1995, yet none of them involved changes directly related to corporate governance issues.7 In August 1990, the ownership cap that existed for individual investors was lifted to stem the sale of equity by the dominant shareholders of major listed companies Individual investors were then allowed to purchase up to the amount of stock that the dominant shareholder held at the time the company was listed The 1991 amendments concerned insider trading and strengthening disclosure requirements Noland, Marcus 2000 Avoiding the Apocalypse: The Future of the Two Koreas Washington, D.C.: Institute for International Economics p 25 Due to overwhelming and representative influence, this paper will assess changes in corporate governance from the perspective of the chaebol Nov 28, 1987, Law No 3945; Dec 31, 1991, Law No 4469; Jan 5, 1994, Law No 4701; Dec 29, 1995, Law No 5041; Jan 13, 1997, Law No 5254 Issues peripheral to corporate governance such as dividends or par value were adopted work in progress; comments welcome, quotation with permission only Law & Democratization Conference, University of Wisconsin Law School, Oct 19-20, 2007 The 1994 revisions include provisions on treasure shares and disclosure Only in January 1997, 10 years after the democratization process began, did substantive corporate governance-related changes such as shareholder rights, tender offers or stronger auditor provisions appear III The State’s Declining Role in the Banking System A Bank Ownership, Privatization and Reforms Gradual, but significant, changes in the decline of state control occurred in the banking sector In the past, bank financing served as the primary means for the government to implement industrial policy and served as the basis for state-oriented corporate governance With an underdeveloped equities market, companies heavily relied upon debt financing and fiercely competed to obtain it Hence, the state could easily use the banks to monitor and supervise corporate behavior Financial institutions “largely remained under effective governmental control.”8 In particular, the government channeled this bank credit to the chaebol for them to serve as the engines for economic development Perhaps the most powerful example of the state’s influence and consequently precarious state of the chaebol involved the Kukje Group’s dismantlement in 1985 The Kukje Group, one of Korea’s largest conglomerates, was disassembled within a matter of weeks when the government severed its credit.9 During the 1980s, however, the 5th Republic that existed between 1981 through 1987 commenced the privatization of commercial banks, leading to the fall in state ownership By 1983, seven of the largest commercial banks had completed the privatization process through extensive public offerings Out of concern that dominant controlling shareholders might seize control of the banks, ownership in commercial banks was strictly limited Over-reaching by the chaebol or foreign banks in particular was a concern Most importantly, privatization marked the first step in the government’s relinquishment of control over direct financing for companies Privatization meant that the government would be relinquishing this type of financial influence.10 Graham 2003:59 Joongi Kim, Legal Change in Post-Authoritarian South Korea, Review of Korean Studies (2003) 10 Nevertheless, for a considerable period thereafter, the government maintained residual power over the banks through their ability to hold sway over the selection of bank presidents Only after the financial crisis in 1997 when the largest banks faced insolvency did this influence substantially wane as the government was forced to lift ownership restrictions and allow foreign acquisitions work in progress; comments welcome, quotation with permission only Law & Democratization Conference, University of Wisconsin Law School, Oct 19-20, 2007 The arrival of democracy in a way negatively transformed government intervention in the banking sector A decentralized, weakened state and remnants of governmental control fueled corruption Companies obtained loans not based upon merit but by bribing government officials, family members of powerful politicians, and bank directors Banks assumed began to assume disastrous amounts of uncreditworthy loans Without the state as the dominant owner and guiding lending decisions, bank directors became less prone to act on behalf of their shareholders By 1995, policy loans, for instance, had declined to 18 percent of bank credit B The Rise of NBFIs The banking sectors role in chaebol corporate governance significantly transformed due to the rapid expansion of non-bank financial institutions (NBFI) that transpired as democratization proceeded Democratization spurred an atmosphere of liberalization in the financial industry.11 The rise of NBFIs was an outgrowth of the changing times The composition of corporate financing for the chaebol shifted with a decline in the traditional reliance upon commercial banks that was replaced by the emergence of NBFIs NBFI’s share of deposits went from 46.4% in 1985, to 72.2% by 1995, while the relative portion of commercials banks fell from 31.2% to 19.9% Similarly, NBFI’s occupied 63.5% of loans in 1995, up from 41.6% in 1985 The share of specialized banks such as the Korean Development Bank also fell considerably during the same period for both deposits and loans Critical problems emerged with the rise of the NBFIs, many that would later play a role in the spread of financial contagion to Korea in 1997 First, relative to banks, not only did the government lack ownership, but also NBFIs remained poorly regulated and monitored The state played a much weaker role in the corporate governance of NBFIs Furthermore, unlike commercial banks, many of these NBFI’s were in fact controlled by chaebol The lax environment allowed NBFIs to engage in indiscriminate short-term borrowing in foreign currency without proper hedging for foreign exchange risks No one later anticipated that the rapid expansion of NBFIs would lead to the catastrophic results during the financial crisis Corporate Finance: Financial Institution Deposits 1980~1998 11 work in progress; comments welcome, quotation with permission only Law & Democratization Conference, University of Wisconsin Law School, Oct 19-20, 2007 Source: Bank of Korea; Hahm Corporate Finance: Loans and Discounts 1980~1998 Source: Bank of Korea, Hahm With a generous supply of capital from NBFIs, chaebol became more undisciplined and unsupervised They assumed too much risk while transparency and accountability further falling behind as major imperatives This coincided with the declining role of the state Chaebol became adept at utilizing NBFIs, primarily through life insurance companies, liability insurance companies, investment trusts, and merchant banks for their financing They rapidly increased their borrowing from these largely unregulated and unprotected entities By 1991, the portion of borrowing from these nonbank financial institutions reached 45 percent among the top 30 chaebol 12 Meanwhile, the debt to equity ratio of the top 30 chaebol remained around four-to-one for most of the period Hence, bank-based corporate governance monitoring of the chaebol became increasingly inconsequential Democratization fostered the lax banking sector 12 Sakong, Il 1993 Korea in the World Economy Washington: Institute for International Economics work in progress; comments welcome, quotation with permission only Law & Democratization Conference, University of Wisconsin Law School, Oct 19-20, 2007 IV Soft Regulatory Enforcement: The Tax Authorities Democratization appears to have softened the impact of regulatory supervision in corporate governance As a general matter, prior authoritarian regimes including most of the 1980s, one of the most powerful government organs to be utilized to check the chaebol’s corporate governance was the tax authorities.13 Indicators suggest that in the period starting with the Sixth Republic, tax-related regulatory monitoring declined, particularly with respect to the chaebol and larger companies Enormous accounting problems later surfaced during the financial crisis From one perspective, the state abused its regulatory function for political purposes or as tool for predatory corruption Regulation themselves was often poorly designed and difficult to meet compliance.14 Companies feared the haphazard and inconsistent application of regulations and rules by the authorities These problems were perhaps most pronounced in the tax and accounting arena The tax authorities were directly employed to collect political contributions from corporations 15 As revealed in the slush fund trials, during the authoritarian 5th republic, one of the main reasons the chaebol made the enormous payments to the President was to seek favor in their tax audit investigations.16 Democratization brought greater regulatory transparency, accountability and consistency The same slush fund trials revealed that during the 6th Republic in contrast none of the payments were explicitly made in relation to tax investigations Several presumptions can be gleaned through an analysis of the data on tax audits that were carried out by the National Tax Administration As noted in Table _, the number of tax audits as a percentage of companies declined in 1983 from a high of 18.2% to 3.7% in 1987.17 A declining trend continues thereafter throughout the postauthoritarian period from 5.6% in 1988 to 3.7% in 1994 The decline suggests that one of the most powerful and effective means to keep companies in check steadily weakened.18 At first blush, it appears the trend coincides with democratization, suggesting that the process became fairer and more transparent Nevertheless, it cannot be denied that companies might have been becoming more transparent so fewer tax 13 In terms of the state’s regulatory function as a monitor for corporate governance, the other primary regulator was the Fair Trade Commission (FTC) Yet, the FTC was not active in regulating chaebol behavior until the early 1990s 14 Compliance protests 15 See next section Slush fund trials 16 The data however does not distinguish between size of companies that were audited or investigated 17 1983 is the earliest available data 18 The next section shows how tax audits were improperly used work in progress; comments welcome, quotation with permission only Law & Democratization Conference, University of Wisconsin Law School, Oct 19-20, 2007 audits were needed Tax audits likewise could have become more effective, making frequency less necessary The advancement in information technology might have contributed to transparency and regulatory effectiveness These possibilities aside a decrease in the number of audits did occur following the post-authoritarian period Another interesting trend is that starting from 1990 the amount of taxes charged following a tax audit dramatically increased The amount charged from 1983 through 1989 was approximately 20 million won per company This increased to 52 million won in 1990, 55 million won in 1991, 142 million won in 1992, 107 million won in 1993, 109 million won in 1994 Hence, while fewer companies were being investigated, among those later charged, the paid far higher taxes This could reflect stronger determination of the tax authorities to establish regulatory discipline Corporate Audits work in progress; comments welcome, quotation with permission only Law & Democratization Conference, University of Wisconsin Law School, Oct 19-20, 2007 V Corporate Governance and Corruption The effects of democratization upon corporate governance can be gleaned from another angle through the different nature of corruption that existed before and after 1988 with the transition from the Fifth Republic to the Sixth Republic The evidence presented during the 1988 National Assembly Hearings and the 1996 Slush Fund Trials provide fertile ground to study the effects of democratization and the declining influence of the state upon chaebol corporate governance The hearings and slush fund trials revealed how the bilateral nature of corruption shifted more from a predatory mode to a rent-seeking manner Authoritarian states had a greater tendency to threaten uncooperative companies with disincentives, forcing conglomerates to grant illicit payments to avoid targeted investigations or sanctions After democratization, however, the state shifted toward granting lucrative benefits while the chaebol engaged in rentseeking to obtain these favors The predatory mode under the authoritarian state arguably provided a more powerful monitoring function in terms of corporate governance The predatory manner in which the state exercised control over the corporate sector during the authoritarian Fifth Republic first came to light during the 1988 National Assembly Hearings.19 The Hearings revealed the government’s involvement in the break-up of companies such as the Kukje Group and 57 other companies that were abruptly determined to be in “financial distress” in the early part of the regime.20 Kukje, 19 20 National Assembly Act, Article 65 White Paper on Restructuring of Defunct Companies, July 21, 1988 work in progress; comments welcome, quotation with permission only Law & Democratization Conference, University of Wisconsin Law School, Oct 19-20, 2007 in particular, was one of the largest conglomerates in the country, but was ostensibly dismantled for political reasons It had a tremendous impact in setting an example of the negative consequences of falling out of favor with state The investigations also revealed that the beneficiary companies that acquired the distressed companies received considerable, preferential governmental incentives during the restructuring process Senior government officials and even the Blue House who were directly involved in this process extracted rents from these companies in return The distress sales acted as powerful discipline for the state in taming the corporate sector The infamous slush fund trials of that started in 1996 against former President Chun Doo Hwan and Roh Tae Woo provided further evidence of how the state’s interaction with conglomerates evolved.21 The defendants in the slush fund aspect of the trial included not only the former Presidents and former senior government officials but also a dozen chaebol chairmen.22 Payments ranging from billion won (US$5 million) to as much as 15 billion won (US$18.8 million) were made to the Presidents on numerous occasions Conglomerates collected the funds through complex schemes under which they laundered illicit corporate money throughout their network of companies They then delivered the payments in a clandestine nature usually during individual, informal closed meetings at the residence of the Presidents The trials revealed the enormous power that the presidents could wield to curb corporate behavior The courts highlighted the ability of the state to affect “positive incentives” such as decisions involving large infrastructure projects, social overhead capital all aspects of corporate operations, financial support, and “negative disincentives” such as tax audits, trade regulation and withdrawal or denial of licenses and permits The Presidents as the head of the government had comprehensive authority to influence practically any governmental decision.23 Several characteristics emerged that demonstrate the differences between Chun and Roh and that perhaps partially reflect the transition to a democratized system.24 First, in general, during the Chun administration, more examples can be found where the payments were made with specific requests to avoid negative disincentives For Judgment of Aug 26, 1996, Seoul District Court, 95 Kohap 1228, 95 Kohap 1237, 95 Kohap 1238, 95 Kohap 1320, 96 Kohap 12, 96 Kohap 95; aff’d, Judgment of Dec 16, 1996, Seoul High Court, 1st Criminal Division, 96 No 1892, 96 No 1893, 96 No 1894; aff’d, Judgment of Apr 17, 1997, Supreme Court, 96 Do 3376, 96 Do 3377 The slush funds corruption charges comprised only one aspect of a trial that involved multiple, criminal actions 22 Lee Gunhee, Samsung Group, Kim Woojung, Daewoo Group, Choi Wonsuk, Donga Group, Chang Jinho, Jinro Group, Lee Junyong, Daelim Group, Kim Junkee, Dongbu Group, and Chung Taesu, Hanbo Group 23 Judgment of Apr 17, 1997, supra note 21 24 Chun receiving a total of 225.95 billion won ($282 million) and Roh, 283.896 billion won ($355 million) 21 work in progress; comments welcome, quotation with permission only 10 Law & Democratization Conference, University of Wisconsin Law School, Oct 19-20, 2007 instance, several instances can be found where chaebol chairmen made payments to avoid regulator action or sanctions such as tax audits 25 In contrast, from a relative standpoint, the payments made during the Roh administration were generally without specific requests associated with them or specific consideration in mind and sought positive incentives A tremendous amount of benefits and advantages were granted during the Roh Presidency from the privatization of the telecommunications industry to infrastructure construction projects and massive defense contracts Both Presidents employed the tax authorities to collect campaign funds for party officials before elections While funds were expended for political purposes to finance campaign for party candidates, the Presidents also retained a considerable amount in personal bank accounts even after they left office.26 Overall, the courts found a sufficient nexus existed between the payments and the specific acts done by the ex-presidents to declare them as bribes Although many payments were not accompanied without any specific requests, the comprehensive nature of the payments made them bribes given as general compensation for “preference over other competing companies or at least to avoid any negative consequences.” 27 The reconfiguration of predation relative to rent-seeking in terms of corruption that transpired during the two presidential regimes demonstrated another aspect of how the influence of the state changed with respect to corporate governance VI Conclusion Although some trends might be coincidental in causation, this paper tries to provide a framework under which to gain an understanding of the corporate governance changes that followed Korea’s transition to democracy Overall, the post-authoritarian state did not properly provide an alternative to state-oriented model of corporate governance that had prevailed for Korea’s developmental period The arrival of democracy unleashed decades of pent-up demand that sought to shed the state’s heavy hand With the decline of the state, the lack of effective checks and balances such as regulatory supervision and enforcement, rigorous accounting, bank-based monitoring or shareholder rights created a void The failure to establish alternative models such as shareholder or stakeholder-oriented forms of corporate governance to protect investors 25 Hanjin Group, Miwon Group Although they were not collected according to the Law Prohibiting Solicitations of Contribution, the defendants tried to argue that the payments were good will contributions to elected politicians Law No 224, Nov 17, 1951 27 Judgment of Aug 26, 1996, supra note Error: Reference source not found1 26 work in progress; comments welcome, quotation with permission only 11 Law & Democratization Conference, University of Wisconsin Law School, Oct 19-20, 2007 and creditors enfeebled Korean conglomerates, leaving them exposed to the disastrous consequences of the financial crisis Bibliography James A Fanto, “The Role Of Corporate Law In French Corporate Governance,” 31 Cornell International Law Journal 31 (1998) Joon-ho Hahm, "The Government, The Chaebol and Financial Institutuions before the Economic Crisis," in S Haggard, W Lim and E Kim, eds, Economic Crisis and Corporate Restructuring in Korea, Cambridge University Press, January 2003 Henry Hansmann, Reinier Kraakman, “The End Of History For Corporate Law,” 89 Georgetown Law Journal 439 (January, 2001) Chalmers Johnson, MITI and the Japanese Miracle: The Growth of Industrial Policy, 1925-1975 (Stanford: Stanford University Press, 1982) Joongi Kim, “A Forensic Study of Daewoo's Corporate Governance: Does Responsibility Solely Lie With the Chaebol and Korea?” Northwestern Journal of International Law and Business, Vol 28, No (forthcoming 2007) , Legal Change of Post-Authoritarian South Korea, Review of Korean Studies, Review of Korean Studies, 2003 Marcus Noland, Avoiding the Apocalypse: The Future of the Two Koreas, Washington, D.C.: Institute for International Economics, 2000 Robert Wade, Governing the Market: Economic Theory and the Role of Government in East Asian Industrialization (Princeton Press 1990) work in progress; comments welcome, quotation with permission only 12 ... bank-based corporate governance monitoring of the chaebol became increasingly inconsequential Democratization fostered the lax banking sector 12 Sakong, Il 1993 Korea in the World Economy Washington: Institute... term for ? ?corporate governance. ”3 The state managed everything instead Internal corporate governance in the form of boards of directors, shareholder meetings, shareholder rights, auditors and various... of its banking, financial and corporate system such as lifting ownership restrictions and deregulation From a statutory standpoint, however the onset of democratization did not bring about major