Corporate governance reforms launched in 1998 have succeeded in bringing Korea's standards of corporate governance up to international standards. Wide-ranging reforms have helped to enhance management accountability and independence, protect minority shareholder interests, promote transparency and disclosures, and strengthen accounting standards as part of overall corporate and financial restructuring. Today, the question is enforcement - whether the promise of Korea's world-class statutes will be matched by actual practice.

Historically in Korea, corporate governance reform has been driven by the perceived need to achieve greater transparency and accountability on the part of the Korean chaebol, or conglomerates, that have dominated Korean economic activity for the last half-century. Despite modest shareholding, chaebol founders and their families have continued to wield substantial control over companies through cross shareholdings, with little oversight by regulators. With this lack of regulatory oversight, and plentiful credit from banks and financial institutions to fund expansion into new business sectors, many highly leveraged chaebol became insolvent in the late 1990s. Rather than call for greater discipline, creditor banks - which were largely controlled by the government - extended more financing to the chaebol in an effort to stave off bankruptcy. The consensus today is that the failure of many of these chaebol - starting with Hanbo and Kia and culminating in the collapse of Daewoo in 1999 - and the failure of their bank creditors, were instrumental in bringing about the current exchange crisis in 1997/1998 and subsequent domestic financial crisis.

Since 1998, the Korean government has, with the urging of the IMF, pushed through substantial reform of Korean corporate governance and of the Korean financial sector. These reforms go beyond amendments to laws and regulations governing internal controls within a corporation, and encompass laws relating to mergers and acquisitions, accounting standards and practices, regulation of the financial sector, and bankruptcy. Specifically, reform was effected through amendments to the Korean Commercial Code, the Securities and Exchange Act, its Enforcement Decree and related regulations (the SEA), the Act on External Audit of Joint Stock Companies, and the Monopoly Regulation and Fair Trade Act and its implementing regulations. In addition, new laws such as the Securities-Related Class Action Act were passed.

Recently, corporate governance has again become a policy issue both in the aftermath of Enron and Worldcom and because of a number of high-profile cases of alleged accounting fraud at a number of chaebol companies in Korea. Further, the government and business community are increasingly concerned that foreign investors' perception that Korean corporate governance is weak has led to a persistent undervaluation of Korean companies, in what is commonly referred to as the Korean discount. Accordingly, there is a growing awareness that weak corporate governance has tangible, quantifiable costs for the Korean economy.

Recent developments

Developments in corporate governance legislation over the last few years have addressed the following areas of reform:

• strengthening the board of directors as the main decision-making body of a company and making it independent of controlling shareholders;
• strengthening minority shareholder rights;
• increasing the accountability of controlling shareholders and directors on the board;
• enhancing transparency and disclosures;
• strengthening accounting standards and internal controls; and
• facilitating corporate takeovers

Strengthening the board of directors

Reforms have been undertaken to strengthen the role of the board of directors as the central decision-making organ of a company, to make the management independent from controlling shareholders, and to enhance effective monitoring of the board's activities. One aspect of the reforms was to introduce the concept of the outside director. Today, the SEA requires that at least one-quarter of the boards of directors of all listed firms are outside directors. In the case of companies listed on the Korea Stock Exchange (the KSE) whose assets total W2 trillion ($1.9 billion) or more: (i) such companies must have at least three outside directors, who account for the majority of the directors; (ii) outside directors must be nominated by an outside director nominating committee, 50% of which must be filled with outside directors; and (iii) minority shareholders may nominate candidates for outside directors with the outside director nominating committee. Companies listed on the technology stock-laden Kosdaq are subject to the same requirements, with limited exceptions.

Another reform was the amendment to the Commercial Code to permit companies to replace internal auditors with an audit committee, a committee under the board of directors, which is intended to ensure the integrity of external audits and the adequacy of internal control systems. The SEA requires all companies with W2 trillion or more in assets to have an audit committee. Two-thirds of the members of an audit committee must be independent and at least one member of the committee must be an accounting or finance expert. Further, companies are encouraged to establish board committees on such matters as compensation, legal compliance, and the nomination of outside directors.

As a result of the reforms, the board of directors in listed companies has become a more important organ of corporate decision making than in the past. In many listed companies, the board has input into management decisions and decides on many of them. Because of the outside director system, boards tend to be more independent of the controlling shareholders than previously, and outside directors have become more expert and proficient in their roles with experience. The establishment of optional committees on compensation, compliance and risk management, and the nomination of outside directors has further helped to foster board independence.

However, some observers are of the view that many boards, especially those of the chaebol, are still not sufficiently independent of the controlling shareholders, particularly in deciding on the appointment, evaluation, and remuneration of the representative director of the company. This has been attributed largely to the tendency for controlling shareholders to have a large say in the appointment of directors in the first place, including outside directors.

Strengthening minority shareholder rights

Improvements have been made since 1998 to increase minority shareholder rights, such as:

• lowering or eliminating threshold ownership requirements for filing derivative suits against directors, statutory auditors and controlling shareholders, for exercising the right to request the dismissal of directors and internal auditors, and other actions;
• increasing disclosure requirements;
• strengthening penalties for violations of corporate governance laws and regulations; and
• strengthening regulation of related-party transactions.

Today, as a result, minority shareholders have a greater say in big decisions, including the appointment and removal of directors, and they have greater access to information than previously.

However, observers point to two recent developments to show that the trajectory towards stronger corporate governance is not a straight one.

First, Sovereign Asset Management, a Dubai-based investment fund, recently sold off its 14.9% stake in SK Corp, Korea's largest oil refining company, after failing to bring about corporate governance reforms in the company. In particular, in March of this year, Sovereign sought to urge other shareholders to vote against a resolution to re-elect the chairman and nephew of the company founder, Chey Tae Won, to another three-year term on the board. Chey had been convicted of accounting fraud at SK Corp. Sovereign could not persuade any of the board's 10 directors - of whom seven are outside directors - to remove Chey. Nevertheless, Sovereign's activism does appear to have contributed to changes in corporate governance; for example, in addition to seven of the ten directors being outside directors and outside directors have direct oversight of the company's audit committee.

Second, the entering into effect of class action lawsuits for select securities law violations - intended to impose discipline on managers and majority shareholders - has effectively been postponed until 2007. Under the Securities-Related Class Action Act that was passed in December 2003, class action lawsuits were to be allowed in respect of companies with W2 trillion or more in assets for damages caused by window dressing, inadequate audits, false disclosures, stock price manipulation and insider trading. This right was to commence January 1 2007, with respect to smaller companies, except that lawsuits for damages from stock price manipulation and insider trading would be allowed from January 1 2005.

However, due to continued objections by the business community, which expressed concern about the possibility of crippling lawsuits under the new law, the government acquiesced to a certain extent earlier this year, effectively giving companies a two-year grace period to clean up their books and come into compliance with accounting rules; the Financial Supervisory Service (FSS) announced guidelines providing that, if violations of the Korean Gaap included in financial statements as of fiscal years ending on or before December 31 2004 are corrected by December 3 2006, such violations would be exempt from FSS audits of companies' financial statements.

Increasing accountability of controlling shareholders and directors

Corporate governance reforms have also substantially increased the duties of directors and enlarged the scope for potential liability for breach of their fiduciary duty to their companies. Directors are personally liable to the company for breach of fiduciary duty and can be found personally liable to third parties for damages caused by breach of fiduciary duty to the company. Directors can also be found criminally liable for actions or omissions of the company for which the directors are personally responsible.

In the last few years, directors of many failed large companies such as Daewoo have been convicted of accounting fraud. Many faced civil liability as well, as shareholders and banks sued them for damages under the External Audit Act and SEA. In cases brought by creditors, the government is reported to have urged creditors to file the lawsuits. Government regulators such as the Korea Deposit Insurance Corporation have been particularly aggressive, as they have the statutory right to require banks that benefited from injection of public funds to sue responsible third parties to seek recovery of the funds.

After many years living abroad, former Daewoo chairman Kim Woo Jung returned to Korea this year, to immediately face charges of accounting fraud and embezzlement in connection with the collapse of Daewoo in 1999. The case is being watched closely, and the outcome will be seen as a litmus test for corporate governance reform. Proponents of reform argue that Kim should be convicted and the laws upheld. Those sympathetic to Kim feel he should be shown leniency for his contributions to the Korean economy and feel that it would be unfair to single him out for accounting fraud when the practice was fairly widespread at the time and regulators failed to clamp down on the practice.

Lawsuits against directors outside the context of failed chaebol have not been numerous but some recent high-profile cases suggest that such cases will become more commonplace. The most prominent case has been the derivative suit brought against the directors of Samsung Electronics Co by certain minority shareholders. In December 2001, the trial court imposed an unprecedented W97.7 billion damages award on the company's chairman and nine other directors for having breached their duty to the company. The appellate court confirmed the lower court decision on some issues and struck down on others but reduced the damages in recognition of the contribution of the directors to the growth of the company. The decision is now on appeal with the Supreme Court.

Enhancing transparency and disclosures

Korea's disclosure requirements for listed companies have been much strengthened in recent years and are on par with disclosure standards in most OECD countries. As for disclosures to the investor community, listed companies are today required to file quarterly reports as well as the annual and semi-annual reports that were previously required, with the Financial Supervisory Commission and the Korea Stock Exchange. They must also notify both agencies when a material event occurs that could affect investors' decisions.

A recent development in this context was the announcement by the FSS in June 9 2005, that it would establish and operate guidelines requiring listed companies to disclose financial information such as sales, operating losses, and current net income when the year-end settlement of accounts is completed. The announcement reflects the importance of disclosing a company's business performance after the settlement of accounts at the end of the year. The FSS added that, if the date of the board of directors' meeting for approval of the financial statements is established, companies should issue prior notice that the company will disclose its performance after the board of directors' meeting.

Strengthening accounting standards and internal controls

There has also been substantial improvement in accounting and auditing standards and practices and in strengthening institutions responsible for issuing and enforcing standards.

One change in recent years was the amendment to the SEA on December 31 2003 (effective as of April 1 2004), which was intended to increase the transparency of corporate accounting and management, and that adopted portions of the US's Sarbanes-Oxley Act. In particular, under the amended SEA, the representative director of a company - that is, the legal representative of a company under Korean law - and the director in charge of public disclosures must confirm the accuracy and absence of any misstatements or omissions as to material information required to be stated in material public disclosure documents and sign such documents. Details of such material information are specified in SEA, and they relate to information regarding public offerings or the issuer company that materially affect investors' decisions and the valuation of securities. Material public notice documents consist of registration statements, annual reports, semi-annual reports and quarterly reports. Further, the amended SEA widened the scope of persons potentially liable for damages to investors caused by misstatements or omissions in material public notice documents to include: (i) shadow directors, that is, persons who, while not directors, have de facto management control of a company, who order a material public notice document to be prepared; and (ii) those persons who have stated their evaluation, analysis and confirmatory opinion on relevant documents and confirmed the contents of the statements.

Facilitating hostile takeovers

Since 1998, reform was undertaken to allow hostile takeovers. For example, the Securities and Exchange Act was amended in February 2002 to abolish mandatory stock purchase requirements, which had required any party acquiring 25% or more shares of a company to purchase 50% plus one share.

However, the amendment to the Securities and Exchange Act passed on January 17 2005, which became effective on March 29 2005, contained two provisions aimed at strengthening defensive measures against hostile M&As.

One relates to tender offer rules. It removes the restrictions prohibiting investors from making multiple tender offers within a six-month period and those restrictions preventing a company that is subject to a tender offer from issuing voting stocks and other equity-linked debt securities during the tender offer period.

The other is the amended 5% disclosure rule, which requires investors with 5% or more in listed companies (or in certain other circumstances) to disclose whether they intend to exercise influence over the management of the company. Even if a 5% report had already been filed before the effective date of the amendment, investors who intend to exercise influence over the company are required to file a few 5% report within five days from the effective date of the amendment. Violation of this requirement or false disclosure could result in criminal sanctions. This rule also adopted the concept of the cooling-off period, whereby if an investor files the 5% report with the purpose of exercising influence over management, that investor is prohibited from acquiring additional shares in the company and exercising voting rights of the additionally acquired shares for five days from filing the report.

The second amendment caused substantial controversy, with some foreign investors complaining that the change was intended to protect domestic firms from foreign acquisitions. The Korean government defended the measure, arguing it is not intended to protect against foreign takeovers but rather a tool used in other countries that Korea has adopted to secure transparency of capital flows.

Time to put reform into practice

Corporate governance reform continues today, although much of the legal reform necessary to achieve world-class corporate governance standards has been effected. Further, there is growing awareness within the domestic business community of the importance of strong corporate governance to maintaining competitiveness. Bringing actual practice up to world standards will require continued government commitment to further reform, vigorous enforcement of the laws, and greater shareholder activism.

Author biographies

Kyung Taek Jung Kim & Chang Kyung Taek Jung is a senior partner at Kim & Chang Law Offices. After more than 20 years in corporate practice with the firm, he has extensive experience in the areas of corporate structure and governance, mergers and acquisitions, joint ventures, antitrust, and commercial contracts. He is the head of the firm's corporate department and chairs the firm's fair-trade practice group and pharmaceutical and food practice group. He is a standing adviser to the Korean government on fair trade and antitrust issues. Jung received his BA in law from Seoul National University and his LLM from Harvard Law School. He is a member of the Korean Bar and the Bar of the state of New York. Apart from his career at Kim & Chang, Jung was a visiting associate at Skadden Arps Slate Meagher & Flom in New York City from 1986 to 1987. He speaks Korean and English. Hwa Soo Chung Kim & Chang Hwa Soo Chung is a foreign legal consultant at Kim & Chang Law Offices, which she joined in 1992. She has a broad-based corporate and commercial law practice, which includes commercial contracts, joint ventures, mergers and acquisitions, and corporate structure and governance, and has extensive experience representing multinational clients in the pharmaceutical, food, and cosmetic sectors. Chung received her AB from Harvard College, a Masters in Public Affairs from the Woodrow Wilson School, Princeton University, and a JD from the University of California, Hastings College of Law. She is a member of the California Bar. Chung speaks English and Korean and is a proficient in French.