A Korean Case Book Series on Wide Range of Companies Can Serve As a Benchmark for Other

HGCY Asian Corporate Governance Case Studies Series (Korea):

Practice Perspective

Anatomy of an Asian Conglomerate:

The Rise and Fall of Daewoo and the

Formation of Modern Corporate Governance

June 2005

Joongi Kim

GraduateSchool of International Studies

YonseiUniversity, Seoul, Korea

This working paper was financed by the World Bank and produced through support by theHillsGovernanceCenter at YonseiUniversity. This may not be commercially reproduced without the publisher’s permission.

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Contents

I.INTRODUCTION

II.ASIAN CONGLOMERATES & KOREAN CONGLOMERATES

1.Business and Government Relations

2.Ownership Structure

3.Related-Party Transactions and Self-Dealing

4.Accounting Fraud and Loan Fraud

5.Financial Structure

III.CONCENTRATED DECISION-MAKING AND THE FAILURE OF OVERSIGHT

1.Concentrated Decision-Making

2.Inadequate Oversight by Representative Directors, Boards of Directors and Statutory Auditors

3.Shareholders and Stakeholders

IV.CONCLUSIONS

I.INTRODUCTION[1]

Many Asian companies collapsed during the financial crisis in 1997 and 1998, but none compared to the demise of the Daewoo Group, imploding under the weight of 22.9 trillion won in accounting fraud. The Daewoo saga provides an understanding of the state of corporate governance in a major Asian conglomerate. As later discovered, weak corporate governance of conglomerates and their vast network of companies had a devastating effect when the 1997 financial crisis hit. Corporate governance reforms since then have mainly focused on the large listed companies of these conglomeratesand have proved vital to the restructuring efforts of Asian economies.

Daewoo shared many common features with other Asian conglomerates in terms of its corporate governance. Generous government concessions, substandard regulatory oversight, weak bank supervision, ineffective boards of directors, and complicated ownership structures represented some of the more prominent common elements. Daewoo’s total domination by its controlling shareholder and chairman who served as its patriarch remained a central problem. A key focus of this case study will be to trace the development of this type of structurally weak corporate governance system, and try to place it in the context of other Asian companies.

This case study will first review the background of Daewoo’s corporate governance,particularly from the perspective of Asian conglomerates. The paper will next analyze how key players of the Daewoo conglomerate, including the board of directors, creditors, accounting firms, officers, shareholders and employees, failed to act as active monitors. This study will then explore the structural and functional corporate governanceproblems that plagued Daewoo. In the end, this paper will provide a comprehensive review of the institutional corporate governance failures in a large Korean conglomerate in the hope that it can provide valuable policy lessons for other emerging markets in Asia.

II.ASIAN CONGLOMERATES & KOREAN CONGLOMERATES

This chapter will review the basic characteristics of large conglomerates in Asia. Within this framework, it will then provide a history of Daewoo leading up to the financial crisis. First, a description of the general characteristics of the relations between the government and conglomerates will be provided. Second, a general account of the ownership structure of Daewoo will be analyzed. Third, the chapter will offer a review of the fundamental governance problems such as related-party transaction and self-dealing. Fourth, Daewoo’s vulnerable financial structure will be discussed, particularly in comparison with its ownership arrangement. Finally, Daewoo’s historic accounting fraud during the financial crisis will be described.

1.Business and Government Relations

From an economic perspective, large conglomerates played a dominant role in the development of Asian economies, particularly Korea’s.[2]Asian conglomerates tended to possess many common attributes. Nurtured under the government’s industrial policy, Korean conglomerates, in particular,often shared comparableownership structures, management styles, financial structures, business models, and business cultures. Economic policy makers played the leading role in guiding business decisions, and ultimately shaping how corporate governancefunctioned.

Founded in 1967, Daewoo, or “Great Universe,” started out as a small textile company.[3]In less than three decades, based upon foreign assets, Daewoo became the largest transnational company among developing countries. Daewoo specialized in buying distressed companies from the government, extracting concessions in the process and then successfully restructuring and turning around these entities. Daewoorapidly expanded into a conglomerate through this mode of acquisition as most of its major companies were procured in this manner under Korea’s industrial policy during the 1960s and 1970s. In these early years, Daewoo apparently benefited from the personal relationship between its Chairman, Woo Choong Kim, and President Chung Hee Park. Largely throughtheseconnections, Kim obtained critical incentives from the government when taking over troubled companies. In 1976, for example, when Daewoo acquired Hankook Machinery, a manufacturer of industrial machinery, rolling stock and diesel engines that had not shown a profit for most of its history,the government provided generous financing and debt forgiveness to make the deal attractive. Under the new name, Daewoo Heavy Industries, Daewoo returned the company to profitability in its first year. Again, in 1978, when Daewoo acquired Okpo Shipping Company, another troubledcompany, government concessions allowed Daewoo to restructure the shipyard so that it started to generate positive earnings soon thereafter.[4] Other distressed companies that the conglomerate acquired included Daewoo Motor, and parts of Daewoo Electronics and Daewoo Securities. During these transitions, requirements or conditions concerning corporate governance did not enter the dialogue.

Daewoo, therefore,largely succeeded in turning around these troubled companies through their rent-seeking ability. Chairman Kim would continue to rely upon his political acumen to extract these generous incentives from the government and to steer Daewoo out of difficulties. In 1988, for example, Daewoo faced its first serious crisis when Daewoo Shipbuilding and Heavy Machinery underwent a severe liquidity emergency due to suddenly deteriorating market conditions. The companyemployed over 14,000 workers and thousands more when suppliers and other downstream and upstream industries were included. The political economy consequences of allowing the company to collapse were enormous. The government thus reluctantlydecided to bail out the company through an 840 billion won rescue plan despite heavy criticism that it should have been dissolved. The government’s inability to deal decisively at the time convinced many that major conglomerates such as Daewoo had indeedbecome too big to fail. Everyone involved with large conglomerates such as Daewoo became more and more dependent upon this government-guaranteed social safety net, contributing to a dangerous moral hazard. Banks, investors, creditors, accounting firms and other stakeholders blindly followed this myth that the “Daewoos” in Koreawould not be allowed to collapse. When the financial crisis hit, everyonenaturally presumed that the government bureaucracy and Kim’s political clout would rescue the conglomerate.

Operationally, Asian conglomerates tended to follow the dictates of strong central management that revolved around the controlling shareholder. Controlling shareholders in turn managed their conglomerates like personal kingdoms. While providing a certain degree of efficiency, this highly centralized decision-making structure in the end became the source of most of corporate governance ills in Asian conglomerates. Accountability and transparency received secondary priorities. The legal framework failed to provide effective board of directors, corporate officers and statutory auditors that acted independently according to their fiduciary duties. These internal stakeholders did not act as active monitors overseeing the conduct of thedominant controlling shareholder.

At best, government technocrats used the state’s control andindustrial policy to control the excesses of businesses. Large conglomerates such as Daewoo designed their business plans according to the government’s policies and credit control. The potential incentives included preferential financing, subsidies, tax benefits, tariff protection and even bailouts if serious trouble arose. Disincentives included targeted administrative fines, tax audits, criminal investigations and prosecutions.[5]

Daewootherefore closely followed the government industrial policy concerning export-led growth to develop the economy. Through policy loans, export guarantees, export insurance, tariff protections, subsidies and other financial incentives, Daewoo became one of the leading conglomerates in the development of new trading markets around the world. By 1979, Daewoo became Korea’s largest exporter. Starting from 1993, to further its overseas commitment, Daewoo launched its Global Management Strategy. By 1998, the Daewoo Empire consisted of over 590 subsidiaries and over 250,000 employees worldwide across all the major continents. While becoming a global conglomerate many latent problems emerged.

Throughout the industrialization process, conglomerates with close government ties reaped enormous windfalls. In the worst cases, government and business collusion, led to clientelism, cronyism and corruption. Bureaucratic and political interests engaged in predation vis-à-vis their relationship with large conglomerates. The notorious slush funds scandal in the 1990s revealed that two former Korean Presidents solicited a combined total of over 39 billion won($ 50 million) from Daewoo alone. In the end, dozens of government officials and politicians were convicted for receiving bribes from Daewoo in return for their support.

State-oriented corporate governance remained a defining feature of conglomerates such as Daewoo. The government controlled the primary modes of financing, regulatory landscape, and determined the major business direction. The government in turn acted as the primary monitor with regards to the operations of the board and potential excesses of the controlling shareholders. With the privatization of financial institutions, the expansion of equity markets and the decline of the state influence, however, the state’s ability to act as a monitor weakened. This left a vacuum in terms of the checks and balances and general oversight of the controlling shareholder and the board of directors.

2.Ownership Structure

As with other Asian conglomerates, Korean conglomerates generally shared similar ownership structures based upon family-control.[6]From generation to generation, family-control has been a defining characteristic among Korean conglomerates. Initially maintaining high ownership concentration, ascommon in most Asian countries, families secured control through a vast web of, interlocking share ownership between affiliates.[7] The ownership structure of Korean conglomerates gradually began to differ from other Asian conglomerates starting in the early 1970s.

In the 1970s, the government decided to compel conglomerates to list their companies on the stock exchange. Policymakers intended for conglomerates to disperse their ownership as a means to return their earnings back to society since they were the primary beneficiaries of industrial policy. The fledgling securitiesmarket also desperately needed the liquidity that public offerings from these large conglomerates could offer. Controlling families in turn feared that such dispersion could threaten their controlling interests and invite excessive scrutiny. Furthermore, given the generous indirect financing from state-controlled banks, they believed that their companies did not need to tap into capital markets for additional equity financing. To persuade these controlling families to list their company’s shares, therefore, the government designed the legal and regulatory system to protect their interests. Any potential threats to their ownership control and potential“interference”were thus thwarted. Institutional investors had to shadow vote their shares, unfriendly mergers and acquisitions were curbed, disclosure standards remained minimal, and minority shareholder rights such as shareholder proposals, inspection rights and derivative litigation faced high ownership requirements. Boards of directors, statutory auditors, external auditors, officers, shareholders, employees, and other stakeholders all were relegated to weak positions through formal and informal restraints in exercising their rights.

This protection from outside scrutiny and challenges to corporate control had the negative side effect of weakening market discipline and oversight. Controlling shareholders gradually lowered their ownership stakes and remitted their shares because they were satisfied that they could withstand threats of control. While helping the development of Korea’s capital markets, this ownership dispersion policy led to a gradual misalignment between the interests of controlling shareholders and other minority shareholders. Korean controlling families developed much higher disparities between cash flow rights and controls rights than their counterparts in other Asian conglomerates. Furthermore, unlike in many common law countries, the dispersed weak ownership was not matched with correspondingly stronger shareholder protections. This created an anomalous situation that left conglomerates increasingly vulnerable to expropriation because weak controlling shareholder ruled in an environment of weak minority shareholder rights.

Daewoo’s controlling shareholders,Woo Choong Kim and his family, followed this ownership structure and they controlled the group through a severely distorted ownership pattern. They did not holda high cash-flow position of any of the Daewoo companies they controlled. As of 1998, for instance, Woo Choong Kim and his family members owned non-negligible stakes in only 4 companies. Among the 10 largest companies, they owned on average only 0.7% of the total shares (Table 1).[8]In fact, one reason that Daewoo did not seek equity financing when the financial crisis struck was due to concerns that Kim’s weak ownership position would be further diluted. Daewoo-affiliated companies, of course, owned another 33.87% of each other and treasury shares accounted for 0.93%. Combined together,this created a 41.02% block of ownership for Kim to control the Daewoo companies. Daewoo’s low stock pricesalso reflected not only its lack of profitability, but also its complicated and unaccountable ownership structure (Diagram 1).As the market feared, in the end, this interlockingownership structure forced stronger companies such as Daewoo Corp. to subsidize struggling affiliates such as Daewoo Motor. It also allowed Kim to dominate all decision-making without any appropriate oversight.

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<Table 1> Daewoo Group Intraconglomerate Ownership (1997,unit:%)

Source:ChaebolInformationCenter, InhaUniversity (*: average stake of affiliates)

<Diagram 1> Daewoo Group’s Ownership Structure in 1997

(Unit: %; companies larger than 1 billion won)

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3.Related-Party Transactions and Self-Dealing

This vulnerable ownership structure of Korean conglomerates where weak owners acted without adequate monitoring,inevitably led to various forms of expropriation.Related-party transactions among conglomerate affiliates, for instance,when improperly done was a common practice that represented a prime example of failed corporate governance. The central problem occurred when related-party transactions proceeded on non-market conditions and did not receive proper scrutiny by the board of directors. Until 1993, in fact, the regulatory agencies tacitly allowed this practice and did not seek to sanction improper support of weaker affiliates by stronger affiliates. In 1998, the Fair Trade Commission (FTC) finally issued its first regulatory sanctions against such illegal subsidization. The FTC has since continued to attempt to scrutinize the largest chaebols for these types of abuses.

<Table 2> Improper Internal trading and Subsequent FTC Subcharge by Group

(Unit: No. of; 100 million won)

Source: FTC; *: Average of other top 4 conglomerates (Hyundai, Samsung, LG and SK); The FTC launched its first investigation in 1993 and at the request of the FTC SK Corp. received criminal fines of 100 million won and its president 50 million won in 1995.

Historically, in Korea’s early stages of development when credit and financing was scarce, the government promoted these types of related-party transactions among affiliates. Conglomerates could only enter new markets through initial financing and support from their sister companies. Korea’s most successful companies, for example, including Samsung Electronics and Hyundai Motors, can trace their origins to this type of subsidization. Many conglomerates in fact engaged in a package approach to business. Conglomerates boasted that they could provide a diversified range of goods and services for a large single client. Daewoo in particular would engage in country projects in which the entire conglomerate would participate. This would include the entire range of business of the conglomerate including construction, sales, marketing, financing and others. The construction company, for instance, would build a hotel, the financial companies would obtain financing for it, others would grant guarantees, another affiliate would provide management training for the hotel staff, and another would promote the hotel.

Individually affiliated companies, therefore, became predisposedto the wishes of the controlling shareholder concerning the overall direction of the conglomerate. Healthier affiliates supported risky new ventures or struggling companies. Commercial banks and government-owned banks routinely required payment guarantees from stronger affiliates for loans made to weaker companies. As with other Asian conglomerates, affiliated companiesprovided problematicsupport through interlocking debt guarantees.[9] Whether it was a bond offering or a bank loan, companies within the same group routinely granted payment guarantees to each other on non-market terms. Sister companies likewise gave guarantees for all forms of debt instruments. As of December 1997, cross-guarantees among Daewoo affiliates were estimated to total 8.5 trillion won, the highest among all the major Korean chaebols. The problem was that under this structure a weaker affiliate’s default could start a chain reaction of payment demands and collapses that could ultimately threaten the entire network of companies within a conglomerate. This feature exacerbated the too-big-to-fail mentality because forcing one chaebol affiliate to default on a loan could thus threaten the entire group. This also evolved into a moral hazardunder which companies engaged in riskier ventures and in the worse case more improper acts.