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Korea’s Path to Better Corporate Governance

Korea’s Path to Better Corporate Governance

Korea has struggled with corporate governance issues for decades, driven by the concentration of power and opaque business practices. But significant efforts to reform these practices have gained momentum, with government initiatives paving the way for more transparent and accountable business standards.

For international investors, these reforms are crucial, not only to reduce the risks of governance scandals, but also to align Korean business with international standards. This can create new investment opportunities and create a more attractive market.

Historical challenges to effective corporate governance in Korea include inadequate regulation of complex ownership structures and related-party transactions, a lack of accountability for poor capital allocation decisions, and a culture in which it is considered disrespectful to question the decisions of those in authority.

But one of the biggest challenges is the large, family-controlled conglomerates known as chaebols. Chaebols often wield considerable power, which can result in decision-making that prioritizes family interests over those of other stakeholders.

In 2021, nearly 60% of South Korea’s gross domestic product (GDP) came from the 10 largest family-run chaebols. Members of these families have resisted changes in corporate governance that could reduce their personal wealth and power.

As a result, chaebols often fail to meet global standards for board independence. There is little transparency in ownership structure (affiliates often hold shares in each other), accountability for conflicts of interest, and protection of minority shareholder rights. Weak governance has also contributed to low returns on investment (ROI) and uncertainty about capital allocation.

An additional problem arising from the influence of chaebols is the lack of a dividend culture, as valuations are not supported by the return of cash to shareholders through dividends. The dividend tax rate in Korea is 49.5% for high-income earners such as those in chaebol families, which is a clear disincentive to increase dividends.

We believe that successful corporate governance reforms in Korea require changes to the tax system, which is a key driver of corporate behavior. However, dividend tax policy is politically sensitive, as it would likely be unpopular to be seen as helping the rich.

But if Korean companies were to increase their dividend payouts to match those in other regions, that could potentially improve Korean valuations by 20% to 25%.

Both Korea and Japan have dominant corporate groups – chaebols in Korea and keiretsu in Japan – where corporate governance primarily serves the interests of insiders (management, family members, buyers and suppliers, affiliated companies and banks).

But in the 1990s, both countries took steps to reform corporate governance, improve national economic performance, and revitalize capital markets. More recently, Korea and Japan have added reforms aimed at addressing chronic valuation discounts in their respective stock markets.

In Japan, however, more progress has been made as the interests of key groups have become better aligned.

For example, Japan’s Ministry of Economy, Trade and Industry (METI) and the Tokyo Stock Exchange (TSE) have pushed for board independence and better capital allocation decisions. Underperforming companies are required to report on how they are improving their return on equity (ROE).

The METI and TSE promote greater shareholder involvement and activism as part of their market structure reorganizations; the TSE has also promoted shareholder involvement by requiring English versions of financial and nonfinancial disclosures. Major government pension funds, which are major shareholders in most Japanese companies, also encourage corporate reforms.

In addition, leading Japanese companies are becoming case studies of success after embracing management changes and following through with higher dividend payouts, buybacks and divestment of underperforming assets. This helps to create peer pressure on lagging companies.

These improvements, plus macroeconomic factors such as inflation and a weak Japanese yen, have pushed the Japanese stock market to record highs.

In response to these governance challenges, the Korean government has introduced several initiatives aimed at improving corporate governance.

One key reform is the Korea Corporate Value-Up Program, a comprehensive initiative of the Financial Services Commission (FSC) aimed at improving corporate governance standards to enhance transparency, accountability and shareholder rights, as well as the market value of Korean companies.

Key elements of the programme include disclosing plans to improve financial performance (e.g. price-to-book value, return on equity, etc.); improving dividend payments; enhancing transparency around material divestitures, insider trading, public takeover bids and mergers and acquisitions; and strengthening minority shareholder protection.

Companies are expected to disclose information in English and to intensify their investor relations activities. Investors, including foreign institutions and Korean government pension funds, are expected to engage with companies on their Value-Up plans.

In addition, the Korean government has established a Corporate Code of Governance for companies and a Stewardship Code for investors in these companies.

The Corporate Code of Governance consists of guidelines for listed companies to improve governance practices, including recommendations on board composition, independence and the protection of shareholder rights. The Stewardship Code was adopted in 2018 and encourages institutional investors to actively participate in corporate governance by voting on key issues and holding companies accountable for their actions.

While these are steps in the right direction, implementation is relatively weak, as compliance with the Corporate Code of Governance guidelines is not mandatory. However, companies that choose not to adhere and believe their governance practices are sufficient must disclose their non-compliance.

There is also a proposal for an exchange-traded fund (ETF) of companies making progress toward the Value-Up goals, alongside a new benchmark called the Korea Value-Up Index, which consists of listed companies that demonstrate best practices.

The Korea National Pension Service (KNPS) is a major institutional investor and public pension fund management organization in Korea. Founded in 1988, it is responsible for the administration of the national pension program and management of the National Pension Fund. Today, it owns about 7% of the top 100 companies in Korea and manages about $795 billion.(1)

KNPS plays a proactive role in corporate governance by exercising its voting rights and working with companies to promote better governance practices, all in conjunction with its support for the Korean Stewardship Code guidelines for institutional investors.

In addition, KNPS aims to fulfill its fiduciary duties by closely monitoring the companies it invests in and working with them on strategies to achieve medium- and long-term goals. We believe this can enhance investment returns for KNPS beneficiaries and support the overall development of capital markets and the overall economy.

Overall, the KNPS has been effective in raising awareness of the importance of governance reforms. However, change is likely to be slow and take a long time to develop.

Korea’s corporate governance landscape is currently undergoing significant reforms, bringing the country’s governance practices more in line with international standards.

However, despite ongoing challenges, including resistance from vested interests and the need for continued enforcement, we believe that the progress made to date underscores Korea’s commitment to improving corporate governance and fostering a more transparent, fair and competitive market environment.

It also offers promising opportunities for global investors. By taking into account the positive shift in the Korean approach to corporate governance, investors can better evaluate the potential for higher returns in the Korean market.

Rita Spitz, CFA, Partner, is a global equity research analyst with a focus on ESG integration.

(1) Sources: NPS, Bloomberg and William Blair, as of June 2024. The National Pension Service Investment Management was launched in 1999 as an investment arm of the National Pension Service (NPS), with the aim of effectively dealing with rapidly changing economic and financial conditions and managing the National Pension Fund (NPF) in a systematic and professional manner, as commissioned by the Minister of Health and Welfare. Supported by the efforts, the NPF has grown into one of the world’s largest pension funds, with assets under management of KRW 1.101 trillion, with a cumulative return of KRW 639 trillion from its inception in 1988 to March 31, 2024.