A New Relationship between Ownership–Control Wedge and Overinvestment Practices: Evidence from Korean Business Groups (Chaebol)

• Author: Jaimin Goh,Jungeun Cho,Jaehong Lee
• Published date: 01 April 2016
• Date: 01 April 2016
• DOI: http://doi.org/10.1111/ajfs.12128

A New Relationship between Ownership–

Control Wedge and Overinvestment

Practices: Evidence from Korean Business

Groups (Chaebol)

Jaimin Goh

College of Business Administration, Inha University

Jaehong Lee*

College of Business, Sangmyung University

Jungeun Cho

College of Business Administration, Pukyong National University

Received 31 August 2015; Accepted 15 February 2016

Abstract

This study examines the effects of controlling shareholders’ ownership–control wedge on

firms’ overinvestment practices. In addition, it further investigates the incentive effects of

controlling shareholders’ cash flow rights on firms’ overinvestment. We find a non-mono-

tonic relation between controlling shareholders’ ownership–control wedge and a firm’s over-

investment. Specifically, the relation between controlling shareholders’ wedge and

overinvestment is significant for certain wedge levels. Thus we conclude that controlling

shareholders with certain levels of wedge expropriate minority shareholders’ benefits since the

marginal benefit exceeds the marginal cost. We also document that cash flow rights are effec-

tive to reduce a firm’s overinvestment to certain levels.

Keywords Controlling shareholders; Chaebol; Ownership–control wedge; Overinvestment;

Value creation; Emerging market; Korea

JEL Classification: G11, G30, G34

*Corresponding author: Jaehong Lee, College of Business, Sangmyung University, 20 Hongi-

mun 2-gil, Jongno-gu, Seoul 03016, Korea. Tel: +82-2-2287-5206, Fax: +82-2-2287-0060,

email: jaehong321@gmail.com.

Asia-Pacific Journal of Financial Studies (2016) 45, 222–253 doi:10.1111/ajfs.12128

222 ©2016 Korean Securities Association

1. Introduction

Using a sample of large business groups in Korea (chaebol), this study examin es the

effects of controlling shareholders’ ownership–control wedge on firms’ overinvest-

ment practices, which represent an important part of managers’ investment deci-

sions.

1

Controlling shareholders’ opportunistic behavior may induce agency

problems because they receive the benefit of their decisions based on control rights

while assuming the risks of decisions based on cash flow rights.

Chaebol in Korea have two distinct corporate governance characteristics: a pyra-

mid-shaped governance structure and indirect control through complex cross-share-

holding arrangements. Because of these characteristics, controlling shareholders’

ownership (cash flow rights) tends to be smaller, whereas their control rights (rights

established indirectly) tend to be expansive. La Porta et al. (1999, 2000) suggest that

under a governance structure in which controlling shareholders dominate, the possibil-

ity of infringing on the benefits of minority shareholders increases. More specifically,

in the case of a large wedge between control rights and cash flow rights, controlling

shareholders may ignore the rights of minority shareholders or transfer corporate ben-

efits to other firms with more control rights through related party transactions for pri-

vate benefits. This is more likely for firms with a pyramid-shaped governance structure

and indirect control established through cross-shareholding arrangements (Shleifer

and Vishny, 1997; Faccio and Lang, 2002). Such characteristics are common among

firms in East Asia and Europe, including Korea (Claessens et al., 2000).

Korea is one of the few countries where such a wedge exists and has consider-

able influence on the market. Kim and Yi (2006) find that Korea has more large

firms owned by family members than the USA and thus the cases in which family

members act as controlling shareholders and make business decisions are more fre-

quent in Korea than in the USA. Some chaebol groups have not only a pyramid-

shaped governance structure but also a circular investment structure through cross-

shareholding arrangements. Therefore, a wedge between control rights and cash

flow rights arises in most cases. In addition, Korea is one of the few countries

where detailed data on firms’ ownership structure and business group affiliation are

publicly available for both privately held and publicly traded firms (Kim and Yi,

2006). In this regard, the use of a Korean sample to examine the effects of this

wedge is expected to provide a better understanding of corporate governance.

Controlling shareholders are more likely to seek private benefits when there is an

asymmetric balance between cash flow rights, which are the only benefits from a firm’s

1

According to Jung et al. (2000), a distinct characteristic of Korean firms is that an owner is

commonly regarded as a manager. Even when controlling shareholders’ ownership stake in

the firm does not exceed 10%, they can augment it through the ownership stake of their fam-

ily members, which can grant them exercise control over the firm. In this way, these control-

ling shareholders can directly and indirectly participate in management. From this

perspective, Korean firms’ controlling shareholders can be viewed as owner–managers in Jen-

sen and Meckling (1976). This study considers controlling shareholders as managers.

Ownership–Control Wedge and Overinvestment

©2016 Korean Securities Association 223

disposable income, and control rights, which can increase through indirect control based

on cross-shareholding arrangements or a pyramid-shaped governance structure (Claes-

sens et al., 2000, 2002). That is, controlling shareholders of a firm with a large wedge

may establish barriers to protect themselves (entrenchment effect

2

)andgainmorepri-

vate benefits at the expense of minority shareholders because the benefits derived from

controlling shareholders’ decisions are distributed based on their control rights, whereas

the risks associated with those decisions are assumed basedon their cash flow rights.

Schumpeter (1934) notes that managers inherently emphasize empire building,

and Marris (1964) points out growth maximization as a key objective of managers .

This implies that an increase in firm size can not only guarantee the stability of

business operations but also enhance the ability to absorb external shocks. Because

managers’ empire building can develop into overgrowth or overinvestment, most

prior studies have suggested that managers are likely to emphasize overinvestment

if their empire-building nature is not contained through strict corporate governa nce

(Dominguez-Martinez et al., 2006). If there is some information asymmetry

between managers and minority shareholders, then the managers are more likely to

focus on overinvestment, and if there are no appropriate monitoring mechanisms

for minimizing the information gap between managers and investors, then the man-

agers may invest in projects whose net present value (NPV) is negative.

This paper examines the effect of the wedge between the cash flow rights and

the control rights of controlling shareholders in terms of whether it increases infor-

mation asymmetry and causes overinvestment. If controlling shareholders use the

entrenchment effect to maintain their control over the firm, then external monitor-

ing groups such as the board of directors and the audit committee or internal con-

trol mechanisms may not be effective in limiting their power. In such a case,

controlling shareholders may show moral hazard by maximizing private benefits

through overinvestment (Shleifer and Vishny, 1997; La Porta et al., 1998). However,

not all controlling shareholders expropriate minority shareholders’ benefits. That is,

their opportunistic behavior may depend on their marginal cost and the benefit of

overinvestment. If there is a large wedge between the control rights and cash flow

rights of controlling shareholders, then their marginal benefit from overinvestment

exceeds their marginal cost. On the other hand, if it is small, then their marginal

cost exceeds their marginal benefit, which limits the agency problem.

In addition to the effects of controlling shareholders’ ownership–control wedge

on firms’ overinvestments, the study examines the incentive effects (La Porta et al.,

2002) of controlling shareholders’ cash flow rights on firms’ overinvestments. Con-

trolling shareholders’ benefits must be grounded in their sufficient financial incen-

2

The entrenchment effect derives from a silent and cooperative relationship between firms

with the same controlling shareholders. Here, in the long term, affiliated firms may not mon-

itor controlling shareholders’ decision-making practices. Instead, they may support such prac-

tices and protect themselves from external parties, facilitating controlling shareholders’

pursuit of private benefits (Morck et al., 1988).

J. Goh et al.

224 ©2016 Korean Securities Association