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Chang Min, Lee

Current research status and Issues of Corporate Governance -Focusing on issues of Korean Corporate Governance. Chang Min, Lee. August 20 10. Table of Contents. Introduction Forms of corporate governance Existence, Forms, and Management participation of Controlling Shareholders

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Chang Min, Lee

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  1. Current research status and Issues of Corporate Governance-Focusing on issues of Korean Corporate Governance Chang Min, Lee August 2010

  2. Table of Contents • Introduction • Forms of corporate governance • Existence, Forms, and Management participation of Controlling Shareholders • One share-One vote Principle deviation • Family firm control structure and Succession of control • Family firm control structure • Succession of Control • Business group structure • Business Group structure in Emerging market 2

  3. 1. Introduction Increasing Trend of theoretical and empirical study Family firm Business Group • A family firm is the firm which the founder and his or her family hold shares or are the members of the management or board of directors of the company in a broad sense. In a narrow sense, it refers the firm which the founder and his or her family are the controlling shareholders<1> • A business group indicates the form of the firm where several independent companies are connected because of shares or family relations 3

  4. 1. Introduction Rafael La Porta et al (1999) • Analyzed corporate governance of large companies in 27 developed countries. • Many of large companies have controlling shareholders<2>. • Many of large companies are controlled by the family and the state. • Many firms are out of One share-One vote principle through Pyramid or management participation. • Cross-shareholding is rare, except in Sweden and Germany. • Controlling family participates in management in 75% of family firms in countries with good shareholder protection<3>, while the family does so in 64% of family firms in countries with poor shareholder protection.

  5. 1. Introduction Anderson and Reeb (2003) • Motivation: Empirical research about recognition that Founding-Family Ownership is less efficient than separation of ownership and control. • Analyzed US S&P 500 companies in 1992(except bank and utility industry) and Classified firms where the founder and related family own shares or are the members of the board of directors as family firms<4>. • One-third of S&P 500 companies are classified as family firms • The family owns 18% of shares on average. • The family control and influence is much more powerful than shareholding • Ex) Control power over election of directors is 2.5 times more powerful than their holding shares • Performance of family firms is superior to that of non-family firms.

  6. 1. Introduction Rafael La Porta et al (1999) Anderson and Reeb (2003) Two studies above trigger follow-up studies through arousing following issues • Existence and forms of controlling shareholders of firms in each country. (family, financial institutions, etc.) • Fact that whether controlling shareholders participate in management or not. • Advantages and disadvantages, and effects on corporate value of difference in ownership and control structure. • The proportion of family firms, corporate structure, and performance in each country. • Succession of control in family firms. • Characteristics of a family business group.

  7. 1. Introduction Issue 1 Issue 2 Issue 3 Issue 4 Issue 5 • ▣ Major issues on corporate governance structure in Korean conglomerate • ▣ The follow-up study has significant importance in terms of its intimate connection with corporate governance issues of conglomerates in Korean society • Most Korean conglomerates can be defined as family business groups, and show properties of both a family firm and a business group. • Existence of a controlling shareholder (ownership concentration) and control by the founder and family • Ownership-Control deviation by controlling shareholder: Problems of pyramid, circular equity investment, etc. • Controlling shareholder’s management participation and management stabilization • Control of financial capitals over industrial capital • Succession of control in family firms

  8. 1. Introduction • ▣ Issue 1: Existence of a controlling shareholder (ownership concentration) and control by the founder and family • Cons • Dispersed governance structures are more efficient. • Control of companies by family members is the phenomenon appearing in developing countries.  • Pros • A controlling shareholder has positive influence on corporate value since he or she has plenty of incentives for monitoring management. • It is not proved that family business is inefficient.

  9. 1. Introduction • ▣ Issue 2: Ownership-Control deviation by controlling shareholder: Problems of pyramid, circular equity investment, etc.   • Cons • A controlling shareholder exercises more powerful control through pyramid or circular equity investment compared to shares he or she owns. • ※ Possible conflict of interest between a controlling shareholder and minority shareholders • Ex) When the controlling shareholder has considerable amount of shares of company A and controls company B through company A there is possibility to redirect company B’s assets in favor of company A, thus causing conflict with shareholders in company B. • Mutual assurance through circular equity investment or mutual investment brings the problem of concentration of financial power<5>.

  10. 1. Introduction • ▣ Issue 2: Ownership-Control deviation by controlling shareholder: Problems of pyramid, circular equity investment, etc.   • Pros • It is correlation among companies in a business group through mutual investment or pyramid that performs a role of risk sharing. • Deviation of ownership and control is needed to stabilize management • Possibility of resource redirection substantially low due to the development in the market and the monitoring functions.

  11. 1. Introduction • ▣ Issue 3: Controlling shareholder’s management participation and management stabilization  • Cons  • Direct management by a controlling shareholder leads absence of monitoring body; there arises a problem that who check management board when the controlling shareholder and the one who is in charge of management are the same, because advantage of existence of the controlling shareholder is effective monitoring on management board. • Since a controlling shareholder executes powerful control and manages the company directly with few shares, it builds trenches around the management power and no one can check management

  12. 1. Introduction • ▣ Issue 3: Controlling shareholder’s management participation and management stabilization  • Pros  • Direct management by the controlling shareholder reduces possible moral hazard induced by CEOs. • Management stabilization not only facilitates long-term investment but also is the only protection mechanism from hostile merger and acquisition activities of foreign capital.

  13. 1. Introduction • ▣ Issue 4: Control of financial capitals over industrial capital  • Cons • One of the main functions of financial capital is monitoring management of industrial capital. • ※Financial capital loses its independent monitoring ability if financial capital and industrial capital are included under conglomerates and correlated by mutual investment or other methods.  • Pros • Financial capital has competence in rich information and management monitor. • Holding industrial capital of financial capital in a certain degree helps resolve potential conflict of interest. • ※If a bank makes relationship with a company only through a loan, there exists the possibility of conflict of interest between the bank (lenders) and shareholders in that company when monitoring management of the company. • ※One of the solutions is increasing shares holding

  14. 1. Introduction • ▣ Issue 5: Succession of control in family firms • Cons • Election of management board in family members brings decline in competency of management board, thus has negative impact on corporate value and performance.  • Pros • Management by family members directs companies with long-term view and reduces agency cost because the executive from family is also the controlling shareholder.

  15. 1. Introduction • ▣ This paper classifies follow-up studies in following three categories, summarizes results, and offers implications on Korean conglomerates: (1) Diverse forms of corporate control, (2) corporate governance structures and business succession of family firms, and (3) business groups • (1) Diverse forms of corporate control • (2) corporate governance structures and business succession of family firms • (3) business groups

  16. 1. Introduction • (2) • (3) • (1) Diverse forms of corporate control • Governance structures have various forms in each country, depending on the law, the system, the degree of market development, or management-union relations. • Firms in which a controlling shareholder exists are common globally. • Most controlling shareholders are families and financial institutions (banks, insurance companies, etc.) • The ratios of participation in management of a controlling shareholder (family) in US and Asia are equal. • Deviation of ownership and control is largest in Asia and US has larger deviation than Europe.

  17. 1. Introduction • (2) Corporate governance structures and business succession of family firms • (1) • (3) • Most family firms(US, Europe, and Asia) show deviation of ownership and control • Studies result in different research results on the influence of pyramid or others upon corporate value. • Ratio of firms that is controlled and managed by the family is highest in Europe, and about the same in US and Asia. • The impact of succession of control on corporate value and performance depends on various conditions, showing different results.

  18. 1. Introduction • (2) • (1) • (3) Business groups • Business groups, especially family business groups, generally appear in developing countries. • Internal market in a business group performs as capital market and labor market, which are underdeveloped: complicated governance structure, such as pyramid or mutual investment, has been made under that historical circumstance. • Risk sharing exists in conglomerate groups in Japan, Korea, and Thailand.

  19. 1. Introduction • (1) Diverse forms of corporate control • (2) corporate governance structures and business succession of family firms • (3) business groups • ▣ In conclusion, implications on Korean conglomerates are summarized as following: "(1)Corporate governance structure of the conglomerates, represented by pyramid or circular equity investment, is the product of circumstances and has both advantages and disadvantages. (2)It is not an exceptional phenomena in Korea that, the controlling shareholders exists, participates in management, and shows deviation of ownership and control. (3)It is hard to draw definite conclusion on the influence of Korean corporate governance upon corporate value and performance.

  20. Table of Contents • Introduction • Forms of corporate governance • Existence, Forms, and Management participation of Controlling Shareholders • One share-One vote Principle deviation • Family firm control structure and Succession of control • Family firm control structure • Succession of Control • Business group structure • Business Group structure in Emerging market 20

  21. 2. Forms of corporate governance – a. • Existence, forms, and management participation of controlling shareholders • ▣ Analysis on controlling shareholders of US firms • <Chart 1: Analysis of controlling shareholders in US, Europe, and Asia> • Gadhoum et all. (2005) analyzed controlling shareholders of listed companies(Family and Non-family firms) in US

  22. 2. Forms of corporate governance – a. • ▣ Analysis on controlling shareholders of US firms • Data: Controlling shareholder analysis of 3,607 US firms in 1996 • Firms with controlling shareholder: 59.74%(Asia 79.72%, Europe 86.28%) • ※ Though the rate is lower than Asia and Europe, considerable number of US firms have controlling shareholders • ※ Define controlling shareholder as a shareholder with voting rights more than 10% • Firms controlled by the family: 36.6%(Asia 45.05%, Europe 55.87%) • ※ As size of firms gets bigger, the rate of family firms gets lower. However, family firms consist 20.36% of top 20% firms based on size Gadhoum et all. (2005)

  23. 2. Forms of corporate governance – a. • ▣ Analysis on controlling shareholders of US firms • Firms controlled and managed by the family<6>: 24.57% (Asia 24.57%, Europe 37.32%) • ※ Practically, US and Asia has same rate of firms that the family has strong management power • Firms controlled by Widely-Held Financial Institutions: 16.33% (Asia 17.80%, Europe 18.34%) • ※ In case of US, Pension Fund, Mutual Fund, and Insurance companies, not banks, controls 12.38% of firms • In conclusion, though there is powerful protection for minority shareholders by law<7>, many firms are controlled by the family or by financial institutions Gadhoum et all. (2005)

  24. 2. Forms of corporate governance – a. • ▣ Analysis on controlling shareholders of US firms • <Chart 2: Comparison of Corporate governance in 5 developed countries>

  25. 2. Forms of corporate governance – a. Germany (40.9%) Japan<8> (38.5%) France (23.68%) Germany (37.26%) Japan (28.26%) UK (37.04%) US (36.6%) Us (20.36%) Germany (16.66%) Germany (22.35%) France (34.3%) US (16.48%) France (20.73%) Japan (6.66%) UK (25.27%) UK (16.21%) UK (4.05%) Japan (13.1%) France (14.47%) US (16.33%) Financial Institution controlled firms within top 20% based on distribution Family firms within top 20% based on distribution Family controlled firms Financial Institution controlled firms • ▣ Analysis on controlling shareholders of US firms • Corporate governance figures of 5 developed countries(US, Japan, Germany, France, UK) are.. • Family firm rate of US is relatively high compared to developed countries

  26. 2. Forms of corporate governance – a. • ▣ Analysis on controlling shareholders of US firms • How to explain figures shown in <Chart 2> theoretically is a problem • Assume that Corporate governance which maximize shareholder value(either family control or financial institution control) is chosen: Compare Resource Tunneling Costs by family control and Agency Costs by financial institution control and choose the option with lower cost. • In countries where protection for shareholder rights is weak, control by financial institution is more general<9>. • ※Possibility that control by financial institution, rather than family, can reduce conflict between major and minor shareholders: family control may leads to Resource Tunneling

  27. 2. Forms of corporate governance – a. • ▣ Analysis on controlling shareholders of US firms • In countries with advanced system of protection for shareholder rights, control of family, rather than financial institution, is more general<10> . • ※In case where minor shareholder rights are well protected, since the possibility of Resource Tunneling is scarce(Lower cost of ‘Private Benefit of control’), Agency Costs by financial control is inferior<11>. • ※ Control of firms by financial institution is rare in US, not only because of Glass-Steagall act which restricts banks from owning stocks, but also because optimal structure under given legal environment has been chosen.

  28. 2. Forms of corporate governance – a. • ▣ Analysis on controlling shareholders of European firms • Faccio and Lang (2002) analyzed Corporate governance in Europe • Data: 5,232 firms of Austria, Belgium, Finland, France, Germany, Ireland, Italy, Norway, Portugal, Spain, Sweden, Switzerland, and UK • Including large, medium, small-sized companies, financial and Non-financial institutions • Distributive structure: 36.93%, Family contorlled fims: 44.29% (Define controlling shareholder as a shareholder with voting rights more than 20%) • ※Countries with distributive structure: UK(63.08%), Ireland(62.32%) • ※Countries with family firms: Continental Europe(France:64.82%, Germany:64.62%, etc) Faccio and Lang (2002)

  29. 2. Forms of corporate governance – a. • ▣ Analysis on controlling shareholders of European firms • Distributive structure by financial institutions: 39.92%, Control by the family: 26.54% • ※Countries mainly with distributive structure: UK(60.11%), Ireland(63.64%) • ※Countries mainly with family control structure: Continental Europe(France:33.16%, Germany:37.58%, etc) • In case of Major-corporations(top 20 companies), ratio of distributive structure rises overall Faccio and Lang (2002)

  30. 2. Forms of corporate governance – a. • ▣ Analysis on controlling shareholders of Asian firms • Claessens et al. (2000) analyzed Corporate governance of East-Asian firms • Data: Ownership data of 2,980 firms from Hong Kong, Indonesia, Japan, Korea, Malaysia, Philippines, Singapore, Thailand, and Taiwan in 1998 • Tendency not to use stocks with Superior Voting Right • 38.7% of the firms with Ultimate Owners have pyramid structure (Indonesia 66.9%, Korea 42.6%, Thailand 12.7%) • 10.1% are Cross-Holdings Claessens et al. (2000)

  31. 2. Forms of corporate governance – a. • ▣ Analysis on controlling shareholders of Asian firms • Firms with only one controlling shareholder (have no second-largest shareholder with shares more than 10%) accounts for 67.8% (Japan 87.2%, Korea 76.7%, Philippines 35.8%) • Case where controlling family is directly participating in management(CEO, Board Chairman, or Vice-Chairman) accounts for 57.1% (Malaysia 85%, Korea 80.7%, Japan 37.2%) Claessens et al. (2000)

  32. 2. Forms of corporate governance – a. • ▣ Analysis on determinants of family control • Mueller and Philippon (2008) suggested theory and empirical analysis on determinants of family control • Family firms are (1)efficient in dealing with difficult(hostile) labor relations (2)appear much in countries where labor relations are difficult(labor-management relations is hostile) • ※Family firms are more likely to have more paternalistic labor-management culture because, (1)the controlling family of the firm is more likely to have long-term perspective and, (2)since the controlling family is interested in stability of the firm, interest of both sides is likely to be matched • In France, family firms offer better employment insurance compared to firms with distributive structure Mueller and Philippon (2008)

  33. 2. Forms of corporate governance – a. • ▣ Analysis on determinants of family control • Analyzed correlation of labor-management relation and family control in 30 countries around the world • ※The more hostile labor-management relations a country had, the more it has family firms • ※The argument that family firms appear much in countries with weak protection for minor shareholders only explain part of the phenomenon Mueller and Philippon (2008)

  34. 2. Forms of corporate governance – a. • ▣ Control of firms by financial institutions • Analysis on control of firms by Bank Holding Company of US and Universal banking of Germany • Santos and Rumble (2006) analyzed control situation of US S&P 500 firms by US banks • Data: Analyzed 71 Bank Holding Company among top 100(based on asset size) in 2000 Santos and Rumble (2006)

  35. 2. Forms of corporate governance – a. • ▣ Control of firms by financial institutions • 71 Bank Holding Company invested in stocks of 5,513 corporations through Trust, and 4,641 were Non-financial firm → 403 firms among 4,614 Non-financial firms were S&P 500<12>. • ※Bank Holding Company invests 86% of Trust asset in stock • ※Bank Holding Company holds more than 5% of ownership for 44 firms in S&P 500 through Trust and holds more than 10% of ownership for 12 firms: Trust is the key factor in Financial-Industrial connection in US • ※Bank Holding Company holds 12% of stocks and 10% of voting rights from S&P 500 corporation through Trust • ※Bank Holding Company holds 12% of stocks and 10% of voting rights from Major corporation(185 firms, over $10billion) through Trust • ※Bank Holding Company holds 5% of stocks and 4% of voting rights from total Non-financial firms through Trust Santos and Rumble (2006)

  36. 2. Forms of corporate governance – a. • ▣ Control of firms by financial institutions • This study analyzed possession of stocks and voting rights from Non-financial firms by Bank Holding Company through Trust. If we consider direct possession and possession through other channels additionally, ratio will get even higher. • The higher the ratio of voting rights Bank Holding Company has, the higher the probability that management of Bank Holding Company acts as outside director of the firm • Overall, despite America’s strict separation policy<13>, banks exercise dominance over Non-financial firms by holding considerable amount of voting rights and putting their management as outside director of the firm Santos and Rumble (2006)

  37. 2. Forms of corporate governance – a. • ▣ Control of firms by financial institutions • Gorton and Schmid (2000) analyzed an influence that the control of firms by Universal Banking in Germany does to a performance of the firm • Data: 283 firms in 1975 and 280 firms in 1986 • Existance and form of Ultimate Owner: One who has more than 25% of voting rights based on stock holding is defined as Ultimate Owner Gorton and Schmid (2000)

  38. 2. Forms of corporate governance – a. • ▣ Control of firms by financial institutions • <Chart 3: Corporate governance of German corporation> • Analyzed how banks exercise dominance over firms Gorton and Schmid (2000)

  39. 2. Forms of corporate governance – a. • ▣ Control of firms by financial institutions • <Chart 4: The way Universal banking of Germany exercise dominance> • ※Bank’s control through stock is far less than 25% • ※As we can see in <chart3>, the rate of Non-financial firms as Ultimate Owner is quite high and the rate that these Non-financial firms are the only Ultimate Owner is also high • ※However, most of the firms have voting restriction: 5% or 10%%<14> • ※Proxy voting by banks representing minor shareholders is exception of the restriction and this makes bank’s control power stronger Gorton and Schmid (2000)

  40. 2. Forms of corporate governance – a. • ▣ Control of firms by financial institutions • Various theories on how bank’s control over firms influence their performance exist • ※Possibility that performance is positively influenced because interest of banks and shareholders of the firm is likely to be matched • ※Possibility that banks gain monopoly profits by abusing their position as a controlling shareholder in situation where capital market is not competitive: Negative influence on performance • ※Possibility that two effects described above are mixed and, as a result, negative influence arises when bank’s control power is weak and positive influence arises when bank’s control power is strong Gorton and Schmid (2000)

  41. 2. Forms of corporate governance – a. • ▣ Control of firms by financial institutions • Effect that proxy voting by banks will do to a performance • ※Proxy voting makes ownership and control different ※Hypothesis that the effect of proxy voting would be similar to the effect of difference between ownership and control does to performance • Result of empirical study: (1)Bank’s control over firms through stock holding gives performance a positive influence and the positive influence is larger than what Non-financial controlling shareholder can give, (2)Proxy voting does not affect performance Gorton and Schmid (2000)

  42. Table of Contents • Introduction • Forms of corporate governance • Existence, Forms, and Management participation of Controlling Shareholders • One share-One vote Principle deviation • Family firm control structure and Succession of control • Family firm control structure • Succession of Control • Business group structure • Business Group structure in Emerging market 42

  43. 2. Forms of corporate governance – b. • Existence, forms, and management participation of controlling shareholders • ▣ The core of One Share-One Vote Principle is.. • Voting right based on number of shares is reasonable in economic incentive sense • Since shareholder is the most interested in maximizing corporate value, Voting right or Control right should be given based on number of shares: Based on logic that shareholder is the only Residual Claimants • Argument above is now under debate: Some say other stakeholders should also have Control right(Shareholder is not the only Residual Claimants), and others say giving Control right only to shareholders may not maximize corporate value (Allen and Gale (2002), Allen (2005), Allen et al. (2006))

  44. 2. Forms of corporate governance – b. • ▣ Pros and cons of One Share-One Vote Principle Deviation • Adams and Ferreira (2007) analyzed benefits and costs of One Share-One Vote Principle Deviation • <Chart 5: Pros and cons of One Share-One Vote Principle Deviation> Adams and Ferreira (2007)

  45. 2. Forms of corporate governance • ▣ Pros and cons of One Share-One Vote Principle Deviation • Problem of One Share-One Vote Principle Deviation: Most family firms show deviations through ways like pyramid structure and this is thought to be the problem • ※ Distorted investment decisions: Exercising more Control right than shares they are holding may lead to investment decisions that is against shareholder value Ex) Empire Building • ※Resource Tunneling Ex) Unfair support among affiliates • ※Inefficiency in Corporate dominance market: Powerful ownership and management power with only a few share distorts outside M&A market • ※Monopoly: Through relations with affiliates, secure the monopoly position in the market • ※Inefficient Perk Consumption Ex) Excessive management compensation Adams and Ferreira (2007)

  46. 2. Forms of corporate governance • ▣ Pros and cons of One Share-One Vote Principle Deviation • Benefits of One Share-One Vote Principle Deviation • ※Business Group replaces underdeveloped system(underdeveloped capital market and etc): Formation of Internal capital market/Risk sharing within Business Group/Replacement of labor market<15>(Khanna and Yafeh (2006)) • ※Large Shareholders’ Control has many benefits: Large shareholders have enough incentive to monitor management and have better ability than minor shareholder to monitor management • ※Management protection benefits other stakeholders<16> Adams and Ferreira (2007)

  47. 2. Forms of corporate governance – b. • ▣ Effect the One Share-One Vote Principle Deviation does to corporate value • Claessens et al. (2002) analyzed correlation between One Share-One Vote Principle Deviation and corporate value<17> • Data: Ownership data of 1,301 firms from Hong Kong, Indonesia, Korea<18>, Malaysia, Philippines, Singapore, Thailand, and Taiwan in 1996 (Except financial and regulated industry) • Results of research • ※The higher the raio of Large shareholders' Share of Cash-Flow Rights, the higher the corporate value become(Incentive effect) • ※소유와 지배의 차이(Control minus Ownership)는 기업가치에 부정적 영향 (특히 가족기업) Claessens et al. (2002)

  48. 2. Forms of corporate governance – b. • ▣ Choice between Pyramid VS Horizontal structure within Business Group • Prior explanation for Pyramid structure was deviation of ownership and control: To exercise powerful control with small Cash Flow Rights • However, Almeida and Wolfenzon (2006) said, • it is not general that deviation of ownership and control to appear in Pyramid structure and, • even in case where deviation can be reached through other ways, Pyramid structure appears widely. Ex) Allowance of Dual-Class Share<19> Almeida and Wolfenzon (2006)

  49. 2. Forms of corporate governance – b. • ▣ Choice between Pyramid VS Horizontal structure within Business Group • Analyzed determinants of Family Business Group control structure under two hypothesis • ※Investor protection by law is not perfect • ※Firms expend to new business with time difference • If investor protection by law is weak, Pyramid structure becomes attractive: Private Benefit of Control increases Almeida and Wolfenzon (2006)

  50. 2. Forms of corporate governance – b. • ▣ Choice between Pyramid VS Horizontal structure within Business Group • In case where internal financing for new business through Pyramid structure is Optimal • ※Outside investors’ discount on Resource Tunneling: Financing cost from External Capital Market increases • ※Lack of External Capital Market • ※When it needs large funds and is long-term investment that has long payback period, internal financing through Pyramid structure is optimal Almeida and Wolfenzon (2006)

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