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
Graduate School of International Studies
Yonsei University, Seoul, Korea
This working paper was financed by the World Bank and produced through support by the Hills Governance Center at Yonsei University. This may not be commercially reproduced without the publisher’s permission.
I. INTRODUCTION 4
II. ASIAN CONGLOMERATES & KOREAN CONGLOMERATES 5
1. Business and Government Relations 5
2. Ownership Structure 8
3. Related-Party Transactions and Self-Dealing 9
4. Accounting Fraud and Loan Fraud 12
5. Financial Structure 15
III. CONCENTRATED DECISION-MAKING AND THE FAILURE OF OVERSIGHT 18
1. Concentrated Decision-Making 18
2. Inadequate Oversight by Representative Directors, Boards of Directors and Statutory Auditors 21
3. Shareholders and Stakeholders 24
IV. CONCLUSIONS 27
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 conglomerates and 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 governance problems 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.
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 comparable ownership 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 governance functioned.
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. Daewoo rapidly 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 through these connections, 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 troubled company, 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 company employed 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 reluctantly decided 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 indeed become 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 Korea would not be allowed to collapse. When the financial crisis hit, everyone naturally 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 the dominant controlling shareholder.
At best, government technocrats used the state’s control and industrial 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
Daewoo therefore 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.