Korean Business and Management: Characteristics of Korean companies

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KNOWLEDGE OBJECTIVES
Define corporate governance and explain why it is used to monitor and control managers’ strategic decisions.
Explain why ownership has been largely separated from managerial control in the modern corporation.
Define an agency relationship and managerial opportunism and describe their strategic implications.
Explain how three internal governance mechanisms—ownership concentration, the board of directors, and executive compensation—are used to monitor and control managerial decisions.
Objective:

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KNOWLEDGE OBJECTIVES (cont’d)
Discuss the types of compensation executives receive and their effects on strategic decisions.
Describe how the external corporate governance mechanism—the market for corporate control—acts as a restraint on top-level managers’ strategic decisions.
Discuss the use of corporate governance in international settings, in particular in Germany and Japan.
Describe how corporate governance fosters ethical strategic decisions and the importance of such behaviors on the part of top-level executives.
Objective (cont.):

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Corporate Governance
Corporate governance is:
A relationship among stakeholders that is used to determine and control the strategic direction and performance of organizations.
Concerned with identifying ways to ensure that strategic decisions are made more effectively.
Used in corporations to establish order between the firm’s owners and its top-level managers whose interests may be in conflict.

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Risk capital –
No guarantee to the stockholders that:
They will recoup their investment
Or earn a decent return
ESOPs – Employee Stock Option Plans
Employees may also be shareholders
Stockholders are a company’s legal owners and the provider of risk capital, a major source of capital to operate a business.
Maximizing long-run profitability & profit growth is the route to maximizing returns to shareholders, as well as satisfying the claims of most other stakeholder groups.
The Unique Role of Stockholders

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Stakeholders and Corporate Performance
Stakeholders are in an exchange relationship with the company
Contributions: they supply the organization with important resources
Inducements: in exchange they expect their interests to by satisfied
Stakeholders are individuals or groups with an interest, claim, or stake in the company, what it does, and how well it performs.
Companies should pursue strategies that maximize long-run shareholder value and
must also behave in an ethical and socially responsible manner.

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Identify stakeholders most critical to survival:
Identify which stakeholders
The stakeholders’ interests and concerns
Claims stakeholders are likely to make on the organization
Stakeholders who are most important to the organization’s perspective
Identify the resulting strategic challenges
Usually the most important:
Customers • Employees • Stockholders
Stakeholder Impact Analysis
Companies must identify the most important stakeholders and give highest priority to pursuing strategies that satisfy their needs.

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Profitability, Profit Growth and Stakeholder Claims
Participating in a market that is growing
Taking market share away from competitors
Consolidating the industry via horizontal integration
Developing new markets through:
• Diversification • Vertical Integration • International Expansion
To grow profits, companies must be doing one or more of the following:
Stockholders receive their returns as:
Dividend payments
Capital appreciation in market value of shares
ROIC is an excellent measure of profitability.
A company generating positive ROIC is adding to shareholders’ equity and increasing shareholder value.

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Corporate Governance Mechanisms
Internal Governance Mechanisms
Ownership Concentration
• Relative amounts of stock owned by individual shareholders and institutional investors
Board of Directors
• Individuals responsible for representing the firm’s owners by monitoring top-level managers’ strategic decisions
Executive Compensation
• Use of salary, bonuses, and long-term incentives to align managers’ interests with shareholders’ interests
External Governance Mechanism
Market for Corporate Control
• The purchase of a company that is underperforming relative to industry rivals in order to improve the firm’s strategic competitiveness

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Governance Mechanisms
Governance mechanisms serve to limit the agency problem by aligning incentives between agents and principals and by monitoring and controlling agents.
The Board of Directors
Elected by stockholders
Legally accountable
Monitors corporate strategy decisions
Authority to hire, fire, and compensate
Ensures accuracy of audited financial statements
Inside directors
Outside directors
Stock-Based Compensation
Pay-for-performance
Stock options:
The right to buy company shares at a predetermined price at some point in the future
Financial Statements
Auditors • SEC • GAAP
The Takeover Constraint
Limits strategies that ignore shareholder interests
Corporate raiders

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Internal Governance Mechanisms
Ownership Concentration
Relative amounts of stock owned by individual shareholders and institutional investors
Board of Directors
Individuals responsible
for representing the firm’s
owners by monitoring top-level managers’ strategic decisions

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Internal Governance Mechanisms (cont’d)
Executive Compensation
The use of salary, bonuses, and long-term incentives to align managers’ interests with shareholders’ interests.
Market for Corporate Control
The purchase of a firm that is underperforming relative to industry rivals in order to improve its strategic competitiveness.

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Separation of Ownership and Managerial Control
Basis of the modern corporation
Shareholders purchase stock, becoming residual claimants.
Shareholders reduce risk by holding diversified portfolios.
Professional managers are contracted to provide decision making.
Modern public corporation form leads to efficient specialization of tasks:
Risk bearing by shareholders
Strategy development and decision making by managers

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An Agency Relationship

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Agency Relationship Problems
Principal and agent have divergent interests and goals.
Shareholders lack direct control of large, publicly traded corporations.
Agent makes decisions that result in the pursuit of goals that conflict with those of the principal.
It is difficult or expensive for the principal to verify that the agent has behaved appropriately.
Agent falls prey to managerial opportunism.

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Managerial Opportunism
The seeking of self-interest with guile (cunning or deceit)
Managerial opportunism is:
An attitude (inclination)
A set of behaviors (specific acts of self-interest)
Managerial opportunism prevents the maximization of shareholder wealth (the primary goal of owner/principals).

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The Challenge for Principals
Shape the behavior of agents so that they act in accordance with goals set by principals
Reduce information asymmetry between agents and principals
Develop mechanisms for removing agents who do not act in accordance with goals and principals
Confronted with agency problems, the challenge for principals is to:
Principals try to deal with these challenges through a series of governance mechanisms.

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Response to Managerial Opportunism
Principals do not know beforehand which agents will or will not act opportunistically.
Thus, principals establish governance and control mechanisms to prevent managerial opportunism.

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Examples of the Agency Problem
The Problem of Product Diversification
Increased size, and the relationship of size to managerial compensation
Reduction of managerial employment risk
Use of Free Cash Flows
Managers prefer to invest these funds in additional product diversification (see above).
Shareholders prefer the funds as dividends so they control how the funds are invested.

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Agency Costs and Governance Mechanisms
Agency Costs
The sum of incentive costs, monitoring costs, enforcement costs, and individual financial losses incurred by principals, because governance mechanisms cannot guarantee total compliance by the agent.
Principals may engage in monitoring behavior to assess the activities and decisions of managers.
However, dispersed shareholding makes it difficult and inefficient to monitor management’s behavior.

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Agency Costs and Governance Mechanisms (cont’d)
Boards of Directors have a fiduciary duty to shareholders to monitor management.
However, Boards of Directors are often accused of being lax in performing this function.

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Governance Mechanisms
Large block shareholders have a strong incentive to monitor management closely:
Their large stakes make it worth their while to spend time, effort and expense to monitor closely.
They may also obtain Board seats which enhances their ability to monitor effectively.
Financial institutions are legally forbidden from directly holding board seats.

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Governance Mechanisms (cont’d)
The increasing influence of institutional owners (stock mutual funds and pension funds)
Have the size (proxy voting power) and incentive (demand for returns to funds) to discipline ineffective top-level managers.
Can affect the firm’s choice of strategies.

INCENTIVE COMPENSATION

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Governance Mechanisms (cont’d)
Shareholder activism:
Shareholders can convene to discuss corporation’s direction.
If a consensus exists, shareholders can vote as a block to elect their candidates to the board.
Proxy fights.
There are limits on shareholder activism available to institutional owners in responding to activists’ tactics

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Governance Mechanisms (cont’d)
Board of directors
Group of elected individuals that acts in the owners’ interests to formally monitor and control the firm’s top-level executives
Board has the power to:
Direct the affairs of the organization
Punish and reward managers
Protect owners from managerial opportunism

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Governance Mechanisms (cont’d)
Composition of Boards:
Insiders: the firm’s CEO and other top-level managers
Related Outsiders: individuals uninvolved with day-to-day operations, but who have a relationship with the firm
Outsiders: individuals who are independent of the firm’s day-to-day operations and other relationships

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Governance Mechanisms (cont’d)
Criticisms of Boards of Directors include:
Too readily approve managers’ self-serving initiatives
Are exploited by managers with personal ties to board members
Are not vigilant enough in hiring and monitoring CEO behavior
Lack of agreement about the number of and most appropriate role of outside directors.

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Governance Mechanisms (cont’d)
Enhancing the effectiveness of boards and directors:
More diversity in the backgrounds of board members
Stronger internal management and accounting control systems
More formal processes to evaluate the board’s performance
Adopting a “lead director” role.
Changes in compensation of directors.

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Governance Mechanisms (cont’d)
Forms of compensation:
Salaries, bonuses, long-term performance incentives, stock awards, stock options
Factors complicating executive compensation:
Strategic decisions by top-level managers are complex, non-routine and affect the firm over an extended period.
Other variables affecting the firm’s performance over time.

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Governance Mechanisms (cont’d)
Individuals and firms buy or take over undervalued corporations.
Ineffective managers are usually replaced in such takeovers.
Threat of takeover may lead firm to operate more efficiently.
Changes in regulations have made hostile takeovers difficult.

THE MARKET FOR CORPORATE CONTROL

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Governance Mechanisms (cont’d)
Managerial defense tactics increase the costs of mounting a takeover
Defense tactics may require:
Asset restructuring
Changes in the financial structure of the firm
Shareholder approval
Market for corporate control lacks the precision of internal governance mechanisms.

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The General Environment: Segments and Elements
Defense strategy Category Popularity Effectiveness Stockholder among firms as a defense wealth effects
Poison pill Preventive High High Positive
Corporate charter Preventive Medium Very low Negative amendment
Golden parachute Preventive Medium Low Negligible
Litigation Reactive Medium Low Positive
Greenmail Reactive Very low Medium Negative
Standstill Reactive Low Low Negative agreement
Capital structure Reactive Medium Medium Inconclusive change
Source: J. A. Pearce II & R. B. Robinson, Jr., 2004, Hostile takeover defenses that maximize shareholder wealth, Business Horizons, 47(5): 15–24.

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International Corporate Governance
Germany
Owner and manager are often the same in private firms.
Public firms often have a dominant shareholder, frequently a bank.
Frequently there is less emphasis on shareholder value than in U.S. firms, although this may be changing.

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Responsible for the functions of direction and management
Responsible for appointing members to the Vorstand
Responsible for appointing members to the Aufsichtsrat
International Corporate Governance (cont’d)
Germany: Two-tiered Board

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International Corporate Governance (cont’d)
Japan
Important governance factors:
Obligation
“Family”
Consensus
Keiretsus: strongly interrelated groups of firms tied together by cross-shareholdings.
Banks (especially “main bank”) are highly influential with firm’s managers

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International Corporate Governance (cont’d)
Japan (cont’d)
Other governance characteristics:
Powerful government intervention
Close relationships between firms and government sectors
Passive and stable shareholders who exert little control
Virtual absence of external market for corporate control

CORPORATE GOVERNANCE: U.S VS. JAPAN
Owner-manager
relationship
Manager and
shareholder
relationship
Ownership
concentration
U.S
Adversarial
Through one
company
Control function
Japan
Co-operative
Through a Keiretsu
(group of interlocking
companies)
Monitoring function

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International Corporate Governance (cont’d)
Global Corporate Governance
Organizations worldwide are adopting a relatively uniform governance structure.
Boards of directors are becoming smaller, with more independent and outside members.
Investors are becoming more active.
In rapidly developing market economies, minority shareholder rights are not protected by adequate governance controls.

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Governance Mechanisms and Ethical Behavior
It is important to serve the interests of the firm’s multiple stakeholder groups!
Shareholders (in the capital market stakeholder group) are viewed as the most important stakeholder group.
The focus of governance mechanisms is on the control of managerial decisions to assure shareholder interests.
Interests of shareholders is served by the Board of Directors.

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Governance Mechanisms and
Ethical Behavior (cont’d)
Product market stakeholders (customers, suppliers and host communities) and organizational stakeholders may withdraw their support of the firm if their needs are not met, at least minimally.
It is important to serve the interests of the firm’s multiple stakeholder groups!

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Governance Mechanisms and
Ethical Behavior (cont’d)
It is important to serve the interests of the firm’s multiple stakeholder groups!
Some observers believe that ethically responsible companies design and use governance mechanisms that serve all stakeholders’ interests.
Importance of maintaining ethical behavior is seen in the examples of Enron, WorldCom, HealthSouth and Tyco.

1. Corporate Governance System of Korean firms
Key feature of large Japanese business group(Zaibatsu)

1. Corporate Governance System of Korean firms
Key feature of large Japanese business group(Keiretsu)

1. Corporate Governance System of Korean firms
Key feature of large Korean business group(Chaebols)

2. Corporate governance issues related to Korean Chaebols
What has made Chaebol’s ownership structure survive for long period of time?
Is Chaebol’s ownership structure truly inconsistent with goal of modern firm and shareholder profit maximization?

3. Controversies around Chaebol corporate governance
Chaebol’s family owns on average 3% of ownership of their conglomerates but still runs the whole companies like their own fiefdoms.
How this is possible?
→ cross funding!

3. Controversies around Chaebol corporate governance (cont.)
Government attitude toward Chaebol recently dramatically changed after the financial crisis→pushing restructuring toward holding company structure
However, still, lack of monitoring by financial institution and institutional investors is key characteristics of Korean Chaebol’s governance system