Breaking South Korea's 'Too Big to Fail' Doctrine

Op-ed in the Asian Wall Street Journal

April 11, 2005

The U.S., Japanese and European Union chambers of commerce recently feted the South Korean government for improving the treatment of foreign investors. Certainly there is a lot to celebrate. Transparency will undoubtedly improve with the adoption of the EU-developed International Accounting Standards. South Korea is developing class-action shareholder lawsuits against large businesses with accounting irregularities. The government is also leading political parties, the business sector and NGOs to sign a Social Covenant Against Corruption.

But the celebration may be premature. Despite progress in adhering to international business standards, there is reason to ask if South Korea will come through on its promises.

Foreign investors in South Korean companies—no matter the size of their stake, no matter how vocal they are—are still astonished to find that they can be considered passive investors. Recently, the Korean Government put into effect a requirement that foreign investors with stakes of more than 5% in any listed company must announce in advance if they intend to challenge the company’s management decisions—an obvious ploy to protect incumbent executives from shareholder challenges. These investors were required to state the source of their funding by the end of the first week of April. Other more draconian requirements have been aired but not yet put into effect.

The South Korean antitrust regulator, the Fair Trade Commission (KFTC), gave large conglomerates a one-year grace period before a reform law goes into effect preventing them from making large investments in other firms, including their affiliates. This enables incumbent management of chaebols to issue large blocks of new stock and to sell them to “allies” in the event that foreign or other “minority” shareholders seek management changes, thus diluting the votes of those shareholders. The overall result is that chairmen of many South Korean companies are still free to act by fiat, as though they are majority shareholders, without fear of being outvoted by outside shareholders.

Thus, for example, the SK chairman ousted a cousin from management who had an outstanding performance record and was supported by outside investors. The chairman did it despite being a minority shareholder. The KFTC reports that the chairmen and immediate family members of the leading 10 chaebols wield an average of 49% of the voting rights in their conglomerates, while owning an average of only 4.63% of the group companies. In short, the staying power of the current Roh Moo Hyun government’s push for reform of corporate governance is in question.

President Roh rode to power with labor backing by campaigning to reform the “chaebols”—conglomerates of often radically dissimilar enterprises in which a single family can dominate the holding company. But international investors are more concerned that chaebols subsidize failure. When one enterprise fails, managers often bolster it with capital transfers from stronger firms within the chaebol. If criticism of this practice arises, chaebol managers often sell shares to friendly interests to buttress their managerial rights and fend off shareholder activism.

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Edward M. Graham Former Research Staff

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