Chaebol-affiliated analysts: Conflicts of interest and market responses

Some Korean business groups, or chaebols, have a large stake in securities firms that issue analysts’ reports on their member companies. This structure is unique in that industrial companies and securities firms are affiliated and operate within the same group. We investigate the informational content of earnings forecasts, stock recommendations and target prices made by the chaebol-affiliated analysts, using data collected between 2000 and 2008. The chaebol analysts tend to make more optimistic earnings forecasts for the member companies. The mean EPS forecast error (5.36%) of the affiliated analysts for the same chaebol company are significantly larger than that (3.23%) of other chaebol and independent analysts. The chaebol analysts also assign better recommendations by almost one level and set target prices 2.5% higher to the member companies after controlling for company and analyst characteristics. These results are consistent with the hypothesis that chaebol analysts’ reports are biased by conflicts of interest. Stock market reactions do not differ in response to announcements of stock recommendations issued by affiliated vs. non-affiliated analysts. This suggests that capital markets do not recognize the conflicts of interest inherent in chaebol analysts’ reports.     

Corporate governance in South Korea: the chaebol experience

Utilizing a large sample of South Korean firms, this paper explores the impact of corporate governance in an emerging market country dominated by a few large business groups. Firms affiliated with the top five groups (chaebol) exhibit significantly lower performance and significantly higher sales growth relative to other firms. Furthermore, top executive turnover is unrelated to performance for top chaebol firms, indicating a breakdown of internal corporate governance for the largest business groups. Internal corporate governance appears much more effective for firms unrelated to the top chaebol as managers at poorly performing firms are significantly more likely to lose their job. These results imply that the lack of properly functioning internal corporate governance among the top chaebol, which dominate the Korean economy, may have increased the severity of the recent financial crisis.     

Internal Funds Allocation and the Ownership Structure: Evidence from Korean Business Groups

We examine the relationship between the controlling shareholder’s cash flow rights and the funds transfer in the internal capital market within Korean business groups (chaebols) during the period from 1998 to 2001. We find that the funds allocation in the firms where controlling shareholders have high cash flow rights is better aligned with the investment opportunities and therefore, more efficient than in the firms where they have low cash flow rights. This effect is stronger when they have controlling powers large enough to expropriate minority shareholders. However, during the financial crisis period, funds simply move toward the firms where controlling shareholders have high cash flow rights. The results evidence the tunneling behavior in the internal capital market within a chaebol that the ownership structure distorts the allocation of internal funds in such a way as to benefit the controlling shareholders.JEL Classification: G31, G30     

Business Groups and Tunneling: Evidence from Private Securities Offerings by Korean Chaebols

We examine whether equity‐linked private securities offerings are used as a mechanism for tunneling among firms that belong to a Korean chaebol. We find that chaebol issuers involved in intragroup deals set the offering prices to benefit their controlling shareholders. We also find that chaebol issuers (member acquirers) realize an 8.8% (5.8%) higher (lower) announcement return than do other types of issuers (acquirers) if they sell private securities at a premium to other member firms, and if the controlling shareholders receive positive net gains from equity ownership in issuers and acquirers. These results are consistent with tunneling within business groups.     

Internal capital markets,corporate investment,and the COVID-19 pandemic: Evidence from Korean business groups

This paper examines whether the investment of Korean business group (“chaebol”) affiliated firms behaved differently from that of non-chaebol firms in response to the COVID-19 outbreak. I show that chaebol firms cut back investment to a lesser degree than similar non-chaebol firms. Chaebol firms with higher-than-industry-median market-to-book ratios invested more and experienced less decline in their stock prices, while I do not find such relationships for non-chaebol firms. This paper provides evidence that chaebol internal capital markets helped mitigate the negative effects of the pandemic on firm investment and value.     

How Do Capital Structure Policies of Emerging Markets Differ from Those of Developed Economies? Survey Evidence from Korea

We examine the capital structure policies of Korean firms using survey data for business group (chaebol) firms and independent firms. Our results are compared with findings in earlier studies for developed economies: Graham and Harvey (2001) for the United States and Brounen et al. (2004, 2006) for Europe. Korean chief financial officers are concerned about financial flexibility and volatility of earnings when issuing debt; they are concerned about target debt ratio maintenance and recent stock price increases when issuing equity. In contrast to independent firms, chaebol firms are more concerned about differences in corporate tax rates between foreign and domestic markets and the risk of refinancing in bad times. Chaebol firms are less likely to issue debt when faced with insufficient internal funds, which indicates that active internal capital markets are at work among the firms in a business group. Our results suggest that, compared to U. S. and European firms, Korean firms are under more pressure from their peers in formulating capital structure policies, consider equity a cheap source of financing, are less concerned with the dilution of earnings per share, and less frequently provide shares to employees as compensation.     

The Wealth Effects of Capital Investment Decisions: An Empirical Comparison of Korean Chaebol and Non‐Chaebol Firms

Abstract:   This paper investigates the capital investment decisions of Korean firms and their impact on shareholder wealth. Overall, we find positive abnormal returns surrounding the announcements of 697 cases of investment projects during the period 1992–1999. This paper also finds that the investment decisions of business group ( chaebol ‐affiliated) firms do not increase shareholder wealth, while the capital investment decisions of non‐ chaebol firms generate significantly positive abnormal returns. The multivariate tests provide consistent evidence that the announcement effects for chaebol firms are lower than for non‐ chaebol firms, after growth opportunities, investment size and firm size are controlled for. The findings support the view that the organizational structure of Korean chaebols creates an incentive for managers to make non‐value maximizing capital investment decisions.     

A flight to Q? Firm investment and financing in Korea before and after the 1997 financial crisis

We examine investment behavior among exchange-listed Korean manufacturing firms before and after the 1997 financial crisis using firm-level panel data. Starting with the standard Q-theory of investment, we augment it by allowing for a sales accelerator and the possibility of cash constraints, categorizing firms based on their age, size and affiliation to an industrial conglomerate (i.e., chaebol). We find that Tobin’s Q is a robust determinant of investment in a pooled sample for 1992–2001, but that it became more important for small firms and less important for chaebol-affiliated firms after the crisis. Investment by chaebol firms also became more sensitive to the availability of internal cash balances after the crisis. We interpret this as reflecting a shift in the Korean economy to a stronger market orientation after the crisis and to a business climate in which the quality of potential projects became more important relative to capital market imperfections in determining the destination of investment funds.     

Changes in Korean Corporate Governance: A Response to Crisis

In the last months of 1997, the value of the Korean currency lost over half its value against the dollar, and the ruling party was swept from power in presidential elections. One of the fundamental causes of this national economic crisis was the widespread failure of Korean companies to earn their cost of capital, which contributed to massive shareholder losses and calls for corporate governance reform. Among the worst performers, and hence the main targets of governance reform, were family‐controlled Korean business groups known as chaebol. Besides pursuing growth and size at the expense of value, such groups were notorious for expropriating minority shareholders through “tunneling” activities and other means. The reform measures introduced by the new administration were a mix of market‐based solutions and government intervention. The government‐engineered, large‐scale swaps of business units among the largest chaebol—the so‐called “big deals” that were designed to force each of the groups to identify and specialize in a core business—turned out to be failures, with serious unwanted side effects. At the same time, however, new laws and regulations designed to increase corporate transparency, oversight, and accountability have had clearly positive effects on Korean governance. Thanks to reductions in barriers to foreign ownership of Korean companies, such ownership had risen to about 37% at the end of 2006, up from just 13% ten years earlier. And in addition to the growing pressure for better governance from foreign investors, several newly formed Korean NGOs have pushed for increased transparency and accountability, particularly among the largest chaebol. The best governance practices in Korea today can be seen mainly in three kinds of corporations: (1) newly privatized companies; (2) large corporations run by professional management; and (3) banks with substantial equity ownership in the hands of foreign investors. The improvements in governance achieved by such companies—notably, fuller disclosure, better alignment of managerial incentives with shareholder value, and more effective oversight by boards—have enabled many of them to meet the global standard. And the governance policies and procedures of POSCO, the first Korean company to list on the New York Stock Exchange—as well as the recent recipient of a large equity investment by Warren Buffett—are held up as a model of best practice. At the other end of the Korean governance spectrum, however, there continue to be many large chaebol‐affiliated or family‐run companies that have resisted such reforms. And aided by the popular resistance to globalization, the lobbying efforts of such firms have succeeded not only in reducing the momentum of the Korean governance reform movement, but in reversing some of the previous gains. Most disturbing is the current push to allow American style anti‐takeover devices, which, if successful, would weaken the disciplinary effect of the market for corporate control.     

Financing constraints and internal capital markets: Evidence from Korean `chaebols'

We compare the investment–cash flow sensitivity of Korean chaebols (conglomerates) and non-chaebol firms. We show that investment–cash flow sensitivity is low and insignificant for chaebol firms but is high and significant for non-chaebol firms. On the other hand, a chaebol firm's investment is significantly related to the growth opportunities but that of a non-chaebol firm is not. A chaebol firm's investment is significantly affected by the cash flow of other firms within the same chaebol even though they are independent legal entities. With these findings, we argue that there is an internal capital market in a chaebol and the internal capital market reduces the financing constraints of the chaebol. However, the operation of the internal capital market does not improve the efficiency of allocation of scarce funds in the Korean economy since we find that chaebols invest more than non-chaebol firms despite their relatively poor growth opportunities.     

Earnings,institutional investors,tax avoidance,and firm value: Evidence from Taiwan

This study examines the valuation of earnings from China and Taiwan by foreign and domestic institutional investors across a sample of Taiwanese electronics firms. We further compare the valuation of firm earnings reported in tax havens and non-tax havens, and whether these firms have changed tax avoidance activities since 2004 when the Taiwanese government enacted stricter auditing of transfer pricing regulation.Our findings show that both operating income from the home country and investment income are positively associated with firm value. Operating income from China, however, is not significantly related to firm value when institutional ownership of the firm exceeds fifty percent. This result indicates that operating income is valued differently, depending on the location from which the income was generated. Non-operating income enhances firm value regardless of the revenue source. We also report that foreign institutional investors favor operating income from domestic and investment sources over earnings generated from non-domestic sources and other non-operating income. Furthermore, our results suggest that firms rearrange reported profits from subsidiaries located in tax havens to affiliates in other countries following the transfer pricing audit guide Taiwan implemented in 2004. Results also indicate firms may have been shifting profits to other low-tax-rate countries, or to countries which do not require firms to pay taxes, even if they are not doing business in that country.     

Economic shock,owner-manager incentives,and corporate restructuring: Evidence from the financial crisis in Korea

We examine how owner-managers incentives and firm-specific measures of corporate governance affect restructuring decisions during an economy-wide shock. Using a large sample of Korean firms that had experienced a severe financial crisis during 1997–1998, we find that the likelihood of restructuring is negatively related to the divergence of cash flow rights and control rights of controlling shareholders, and that the announcements of restructuring by chaebol firms with such divergence are greeted more negatively by investors. However, firm-specific measures of corporate governance such as total debt, bank loans, and equity ownership by unaffiliated financial institutions mitigate these negative effects, thereby influencing firms to choose value-maximizing restructuring policies. Our results suggest that the controlling shareholders' incentives to expropriate other investors are high during an economic shock. Our results also highlight the importance of corporate governance in mitigating such expropriation incentives, and provide important implications for the role of corporate governance during an economic shock, such as the 2007–2008 global financial crisis.     

Do auditors constrain intertemporal income shifting in private companies?*

This study investigates the association between private company auditing and intertemporal income shifting. Using a large reduction in the Finnish corporate tax rate as a strong incentive for income shifting and financial statement data coupled with proprietary information from the tax authorities, we analyse accruals and cost stickiness of small private companies. Our results reveal significant differences in accrual income shifting between audited and unaudited companies, but only among companies that on average could anticipate the tax reduction the most. Further, we find auditors to restrict sticky selling, general, and administrative cost behaviour that we hypothesise is associated with illegal actions. Additional tests expose a nontrivial number of incorrectly unaudited companies which are the ones mostly associated with income shifting. Taken together, our study highlights the effects of audit exemption and the importance of enforcement while also suggesting that the audit process is value adding for the tax authorities.     

How Much Do Taxes Discourage Incorporation?

The double taxation of corporate income should discourage firms from incorporating. We investigate the extent to which the aggregate allocation of assets and taxable income in the United States between corporate and noncorporate firms responds to the size of this tax distortion during the period 1959–1986. In theory, profitable firms should shift out of the corporate sector when the tax distortion is large, and conversely for firms with tax losses. Our empirical results provide strong support for these forecasts, and imply that the resulting excess burden equals 16 percent of business tax revenue.     

Family ownership and performance in Korean conglomerates

We review the ownership structure of 15 Korean chaebols (conglomerates) using data from published combined financial statements to determine whether, as commonly believed, controlling family ownership in private firms is higher compared with public firms within the same chaebol. We then examine whether firms with high family ownership and lower outside investor participation shift wealth from firms with lower family ownership, which would support the assumption that private firms outperform public firms. Our results do not support either assumption. First, we show that the simple average of family ownership is lower for the private firms than the public firms within the same chaebol. Second, we find no relation between controlling family ownership and the performance of a firm.     

Does Private Country-by-Country Reporting Deter Tax Avoidance and Income Shifting? Evidence from BEPS Action Item 13

To combat tax avoidance by multinational corporations, the Organisation for Economic Co-operation and Development introduced country-by-country reporting (CbCr), requiring firms to provide tax authorities with a geographic breakdown of their profitability and activities. Treating the introduction of CbCr in the European Union as a shock to private disclosure requirements, this study examines the effect on corporate tax outcomes. Exploiting the €750 million revenue threshold for disclosure and employing regression-discontinuity and difference-in-differences designs, I document a 1–2 percentage point increase in consolidated GAAP effective tax rates among affected firms. I also find evidence consistent with a decline in tax-motivated income shifting, starting in 2018. These results suggest that, although private geographic disclosures can deter corporate tax avoidance, so far, the regulations have had a limited effect on tax-motivated income shifting. My findings have policy implications for the global implementation of private CbCr and extend the debate on public versus private disclosure of tax information.     

Income Shifting in the Spanish Dual Income Tax*

Based on a model of behavioural response to taxes, and using the Taxpayers Panel from the Instituto de Estudios Fiscales for the period 1999–2009, we analyse whether the dual nature of the Spanish personal income tax (PIT), reinforced by the 2007 reform, has influenced taxpayers’ behaviour, causing them to convert part of their ‘general income’ (from labour, real estate or economic activities) into ‘savings income’ (from movable capital or capital gains). We also extend the analysis of income shifting and study whether Spanish taxpayers also responded to the different tax treatments given to the two types of savings income (from movable capital and capital gains) until 2007, transforming savings income from one type to the other. The results of our study demonstrate three facts. First, Spanish taxpayers did respond to the different tax rates, shifting income from the general base to different forms of savings, especially capital gains. The highest‐income individuals and the self‐employed and business owners are the groups where this behaviour was most marked. Second, the self‐employed and business owners also turned income from movable assets into capital gains, guided by their different tax rates. And third, we find signs of ‘anticipation’ and ‘learning’ effects caused by the 2007 tax reform. We believe that the results obtained will enrich the growing literature on income shifting.     

Brand royalty flows within large business groups: The effect of holding company structure and related party transactions committees

This study investigates the intragroup flows of brand royalties within large Korean business groups, known as chaebols. We find that member firms pay a greater amount of brand royalties when the business groups they are part of adopt a holding company governance structure, consistent with the bitter denunciation that chaebols transfer wealth from member firms to holding companies over which they have direct control. However, member firms pay a smaller amount of brand royalties when their related-party transactions (RPTs) are monitored by a designated RPT committee on the board of directors. The results show that monitoring RPTs is effective in mitigating the alleged unethical wealth transfer through excessive brand royalties within large business groups. Our study adds to the literature on RPTs by shedding new light on brand royalty, specifically by illustrating how intragroup brand royalties are determined and charged to member firms, and by introducing the RPT committees as a new internal governance mechanism to discourage abusive RPTs.     

Product Market Competition and the Ownership Choice of Business Groups: Evidence from Korean Chaebols

This study investigates the effect of product market competition on the ownership choice of controlling shareholders in the Korean business groups known as chaebols. We find that member firms in more competitive markets have less disparity between the control and cash flow rights of controlling shareholders. The adjustment in ownership due to product market competition is implemented mainly through an adjustment in the ownership of affiliates rather than in the direct ownership of controlling shareholders. The disciplinary effect of product market competition is observed only in member firms with lower market power in their own industries. The result implies that product market competition works as a disciplinary mechanism that reduces the incentive of chaebols’ controlling shareholders to pursue the private benefits of control.     

Does corporate diversification by business groups create value? Evidence from Korean chaebols

We investigate the valuation effects of diversification activities by Korean business groups known as chaebols. Employing an extensive dataset of Korean firms and accounting for the endogeneity problem associated with firms' diversification decisions, we offer reconciling evidence that unrelated diversification by Korean firms erodes firm value, but their related diversification does not decrease firm value. Undocumented in the existing literature, we further provide new evidence that a firm's affiliation to a large business group amplifies the valuation effect of firm-level diversification, such that the non-negative or weak positive valuation effect of related diversification is stronger for large business group firms. These findings are supportive of the notion that the unique characteristics of large business group firms such as stronger internal factor markets enable these firms to take advantage of the synergic benefits associated with related diversification. Our findings are robust to different model and sample specifications.