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Law and Economics

Research Monograph

Corporate Governance of Large Business Groups: Empirical Assessments and Policy Implications

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SUMMARY Since the economic crisis of 1997, Korea has adopted a number of measures to improve corporate governance, including the introduction of outside directors, restriction on inter-corporate equity investment, and promotion of holding company structure. This study aims to assess the effects of corporate governance measures and draw policy implications.

Chapter 1. A Study of Board Independence and Behavior

Chapter 1 looks at board independence and behavior, using a unique data set that includes information on board meeting items, board composition, individual attendance, voting, and demographic details of outside directors in 100 large listed companies in Korea for 2010-2012. Empirical results show that (1) dissents by outside directors are rare, and ‘friendly’ outside directors who have social ties to CEOs tend to be absent from board meetings; (2) dissenting outside directors face a higher likelihood of being replaced in the next year, whereas the board attendance rate does not affect the risk significantly; and (3) outside director attendance ratio tends to fall when a greater number of supervisory items are presented in the board meeting. The results suggest that friendly board members are not vigilant in monitoring CEOs as they tend to be docile and their absence may be arguably intended to make inside directors pivotal in the board decisions. In addition, the results imply that CEOs may use the board seat to tame outside directors and they have the windows of opportunity to take care of sensitive items without nagging outside directors. These effects would lead to board ineffectiveness even in the presence of a regulation on outside director ratio.

Chapter 2. A Study of Board Independence and the Sensitivity of CEO Turnover to Performance

Chapter 2 analyzes CEO turnover sensitivity to performance and examines whether it differs depending on the degree of board independence. An analysis of CEO tenure in Korean listed firms for 1999-2012 reveals an increasing trend of turnover sensitivity to performance. This implies that boards have become more active in removing underperforming CEOs over the time period. However, an additional empirical analysis suggests that board independence is tainted by social ties between CEOs and outside directors. Using a manually collected, unique data set containing board composition and demographic details about CEOs and board members for 100 large listed companies in Korea for 2010-2012, we find that friendly boards with outside directors having social ties to CEOs tend to retain underperforming CEOs as compared with independent boards. In sum, the results suggest that the regulation on the outside director ratio improves boards’ monitoring but the effect is limited by the presence of prevalent social ties between CEOs and outside directors.

Chapter 3. Effectiveness of Limiting the Total Amount of Inter-Corporate Shareholding

Chapter 3 analyzes whether the policy on limiting the total amount of inter-corporate shareholding achieved its stated objective: improving the ownership structure of large business groups. Empirical results show two results. First, when the regulation on inter-corporate shareholding was weakened, business groups increased within-group intercorporate equity investment, which worsened their ownership structure. Regression results show that the difference between the cash flow right and the voting right of the large shareholder increased in 2002 and in 2007, when the regulation was weakened. Second, business groups reinforced control over their firms by raising immediate equity reinvestment into within-group firms when the regulation was weakened. These results suggest that limiting the total amount of shareholding was effective in inducing good ownership structure by making it difficult to make immediate within-group intercorporate equity reinvestment. This implies that equity reinvestment regulation should be a key to the ownership structure policy. Regulation of circular ownership structure, which was recently introduced, should be aligned with such a principle.

Chapter 4. Desirable Policy on Circular Ownership Structure

Chapter 4 makes policy suggestions on the prohibition of creating or intensifying circular ownership structure, effective July 25, 2014. For this purpose, two objectives of the policy are considered: reducing agency cost and reducing fictitious capital created by immediate intercorporate equity reinvestment.

Agency cost is measured by the difference between (or the ratio of) the cash flow right and the voting right of the large shareholder. Regression results suggest that business groups with a circular ownership structure tend to have a high agency cost, but fail to show that individual firms in the circular ownership structure have a high agency cost. This implies that banning circular ownership structure would have limited effectiveness in reducing agency cost.

The chapter then focuses on reducing the amount of fictitious capital created by immediate equity reinvestment. Circular ownership structure inevitably creates a virtual portion of capital which cannot be used by any firm. Regression results show that the amount of immediate equity reinvestment by a firm is larger when the firm is in circular ownership structure. This implies that banning such structure would help reduce the amount of fictitious capital created by immediate equity reinvestment.

Chapter 5. Effectiveness Analysis and Improvement Measures of the Holding Company System

Chapter 5 empirically analyzes the various properties of the holding company structure of large business groups in Korea and makes policy recommendations on relevant regulations.

First, empirical analyses show that the growth rates of the number of member companies and the amount of fictitious capital in large business groups owning a holding company was significantly lower than those in the comparison group. Also, in most cases, the gap between ownership and control decreased with transition to the holding company system. These empirical findings suggest that policies inducing transition to the holding company system for large business groups can be socially desirable.

Next, the analysis of holding company regulations indicates that the current forced conversion system to a holding company may lead to an unintended effect of severely constraining corporate management activities. Therefore, it may be reasonable to change the policy to give corporate choices to small business groups, which are not the main policy target. The regulation requiring 100% stake in great-grandchild company needs to be mitigated as well. Finally, the measure allowing the retention of financial companies through an intermediate financial holding company is reasonable in the sense that it facilitates the transition of a large business group owning financial companies to the holding company system while maintaining the separation of financial and industrial businesses within the same group.
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