Korea: Growth Without Governance?

WHEN SOUTH KOREAN PROSECUTORS were investigating a former Arthur Andersen executive, Kim Jae Rok, for influence-peddling early this year in Seoul, they could not believe what they found. Kim's documents included evidence of massive slush funds and illegal lobbying by the Hyundai Motor Business Group. The prosecutors decided to arrest Chung Mong Koo, Hyundai Motor's chairman and among the country's most powerful executives. Chung now runs his global business from a tiny cell in a Seoul jail—the size of the bathroom in his former office.

From a governance perspective, one of the most shocking elements of the scandal was the role played by an auditor, Kim Dong Hoon, former CEO of the Anjin accounting firm and also a former Andersen associate. At this year's annual general meeting, Hyundai Hysco, a publicly listed affiliate of Hyundai Motors and thus controlled by Chung, appointed Kim as an outside director and as head of the audit committee. But Kim turned out to be a Chung crony who undertook lobbying activities for the Chung family that were not connected with his board role. He too was arrested on influence-buying charges.

Kim's case is not uncommon in Korea. Another outside director of Hyundai Hysco has been drafted to defend Chung. Isn't that a conflict of interest? "Yes," says a senior official of the Financial Supervisory Board, the Korean version of U.S. Securities & Exchange Commission. "However, there is nothing we can do, since the laws and regulations have not addressed such conflicts of interest."

Foreign portfolio investors own 40 percent of Korea's total market capitalization, which now stands at $690 billion, and obviously want to feel comfortable with management practices. But as the Hyundai case shows, "there is still plenty of room for abuse," says James McCormack, senior director and head of sovereign ratings at Fitch Ratings.

A study by the Korea Corporate Governance Center shows that nearly 92 percent of all outside directors are nominated by the largest shareholder (often the owner) or by boards controlled by the largest shareholders. Only 8 percent of outside directors were nominated by minority shareholders or others not directly related to management. Recently, seven publicly listed affiliates of the Lotte Group appointed 10 outside directors—and six of them were former executives of Lotte companies.

Even when a board includes legitimately independent directors, their impact is limited. "We listened to management's position," says a former bank executive, describing his role on the boad of Samsung Electronics. "And in most cases we vote 'yes' without comment. In my two terms as an outside director, I don't remember having a heated debate or a rebellion or anything of the sort."

For the past several years, Korea's minority shareholder activist group, People's Solidarity for Popular Democracy, tried hard to get one minority shareholder-nominated person elected to Samsung Electronics' board. At one point, a raucous debate went on for 13 hours non-stop—and nothing happened. Today, Samsung has 13 directors; seven are outside directors, including Goran S. Maim, former CEO of Dell Computer's Asia Pacific division. He is the only non-Korean outside director with technology management experience.

And Samsung is ahead of the curve. The concept of outside directors was unknown in Korea until relatively recently. The system began only in the late 1990s, after major chaebols, or business groups, declared massive defaults and bankruptcies in the wake of the 1997-98 Asian financial crisis. The regulations hurriedly cobbled together by the government less than 10 years ago are subject to frequent abuse by powerful shareholders and owners like Hyundai's Chung.

With foreign investors, including hedge funds, deeply invested in Korea, the notion of independent boards should gain a stronger foothold. Earlier this year, U.S. hedge fund Steel Partners and Carl Icahn launched a bitter battle to get two directors elected to the board of Korean tobacco giant KT&G. The U.S. investors managed to get one seat on the board, mustering 32.8 percent of shareholder votes -- even though foreigners own 56 percent of KT&G. Analysts in Korea say that this is only the first round of a long fight between Korean management and foreign investors accustomed to independent-minded boards.