When Do Foreign Institutional Blockholders Passively Promote Firm Innovation in a Local Market? Evidence from Korea

• Date: 01 April 2020
• Author: Chune Young Chung,Denis Yongmin Joe,Justin Morscheck
• DOI: http://doi.org/10.1111/ajfs.12290
• Published date: 01 April 2020

When Do Foreign Institutional Blockholders

Passively Promote Firm Innovation in a

Local Market? Evidence from Korea*

Denis Yongmin Joe

College of Global Business, Korea University, Republic of Korea

Chune Young Chung**

School of Business Administration, Chung-Ang University, Republic of Korea

Justin Morscheck

School of Business Administration, Gonzaga University, United States

Received 1 July 2019; Received in current form (3

rd

revision) 3 January 2020; Accepted 4 January 2020

Abstract

Using extensive hand-collected data on granted patents, we examine the effect of institutional

blockholder monitoring on corporate innovation in Korea. Specifically, we focus on the rela-

tion between institutional blockholding and firm innovation. We find that institutional

blockholders positively influence firm innovation and that this positive effect is driven

primarily by foreign institutional blockholders, particularly when they engage in passive

monitoring. The Korean market features limited participation by shareholders and pressure-

sensitive domestic institutions. Thus, we demonstrate the importance of corporate gover-

nance for firm innovation in emerging markets, where corporate innovation is increasingly

important for long-term economic growth, competitiveness, and value creation.

Keywords Chaebol; Corporate governance; Emerging market; Firm innovation; Institutional

blockholding; Patent

JEL Classification: G32, G34

1. Introduction

Product innovation is integral to sustaining growth and competitive advantage at

firm and national levels (Sorescu, et al., 2003; Hasan and Tucci, 2010; Goedhuys

*This research was supported by the New Scholars Grant Program of the Korean Securities

Association and Mirae Asset in 2019. The standard disclaimer applies, and all errors are our

own.

**Corresponding author: School of Business Administration, Chung-Ang University, 84

Heukseok-ro, Dongjak-gu, Seoul 06974, Republic of Korea. Tel: +82-2-820-5544, email: bizfi-

nance@cau.ac.kr.

Asia-Pacific Journal of Financial Studies (2020) 49, 196–233 doi:10.1111/ajfs.12290

196 ©2020 Korean Securities Association

and Veugelers, 2012), particularly in high-tech intensive emerging markets, such as

Korea. The Korean market provides a natural setting in which to examine the deter-

minants of innovation activity. The 2018 Bloomberg Innovation Index ranked

Korea as the most innovative economy globally for the fifth consecutive year.

1

However, innovation is a long and unpredictable process, with high failure rates

(Holmstrom, 1989). Thus, firms find it difficult to avoid underinvesting in innova-

tion, especially in less developed financial markets with weaker corporate gover-

nance structures (Holmstrom, 1989; Tian and Wang, 2014).

This study examines the channels through which institutional blockholders pro-

mote firm innovation, and the extent to which this occurs. We use a unique sample

of manually collected patent data from the Korean market. Our results show that

institutional blockholding in a given year is significantly positively related to firm

innovation in the following year, supporting the view that effective corporate gover-

nance practices by institutional blockholders promote innovation. Robustness

checks for potential endogeneity do not change our main findings. Specifically, we

consider a two-year lag between the application for a patent and the granting of

that patent.

2

A growing body of literature investigates the effect of corporate governance on

firm innovation, although most of these studies focus on the relation between

corporate governance characteristics and R&D intensity levels (Lee and O’Neill,

2003; Aghion et al., 2009; Munari et al., 2010; Driver and Guedes, 2012; Honor

e

et al., 2015). Empirical evidence on the relation between corporate governance

and firm innovation remains mixed and controversial. Earlier empirical contribu-

tions analyze the effect of the degree of ownership concentration on R&D inten-

sity (Lee and O’Neill, 2003; Tribo et al., 2007), owner identity (Hoskisson et al.,

2002; Kim et al., 2008; Munari et al., 2010), and the role and composition of the

board of directors (Kor, 2006). More recent contributions investigate the role of

corporate governance practices, such as CEO, manager, and director compensation

schemes (Barker and Mueller, 2002; Hoskisson et al., 2002; Coles et al., 2006); the

power separation between managers and board members (Driver and Guedes,

2012); and the rules for annual shareholder meetings (Lhuillery, 2011). These

studies report mixed results, including evidence of a negative relation between

corporate governance practices and R&D intensity (Lhuillery, 2011; Driver and

Guedes, 2012).

Building on this recent literature, we revisit the competing hypotheses of corpo -

rate governance with regard to firm innovation by examining the effect of institu-

tional blockholder monitoring on Korean firms’ innovation activity. As such, we

1

This index assesses countries according to six criteria, including R&D, high-tech companies,

manufacturing, research personnel, patents, and education. Korea ranks especially high for

R&D spending, education, and patents.

2

In addition, though unreported for brevity, we test for endogeneity using the instrument

variable approach, following Appel et al. (2016). The results are available upon request.

Foreign Institutional Blockholders and Innovation

©2020 Korean Securities Association 197

examine the period 2006 to 2013 in Korea, a fast-growing technologically advanced

emerging market.

3

As large outside shareholders, institutional investors are expected

to play a substantial corporate governance role that benefits all shareholders. Specif-

ically, we focus on institutional blockholders with at least 5% ownership of a firm,

because we assume they will have sufficient incentives, scales, and investment hori-

zons to engage in costly monitoring (Chen et al. 2007).

We parse institutional blockholdings into domestic and foreign investors, find-

ing that innovation activity is driven primarily by foreign blockholdings. This find-

ing is consistent with the competing explanations for the greater monitoring

effectiveness of foreign blockholders relative to that of their domestic peers. Grin-

blatt and Keloharju (2000) posit that foreign investors exploit their global informa-

tional advantage over domestic investors, whereas Huang and Zhu (2015) argue

that foreign institutions are relatively less prone to political, social, and business

pressure than are local fund managers. Moreover, Ng et al. (2015) provide interna-

tional evidence that foreign investors improve both firm value and operating perfor-

mance. However, these benefits are derived at the expense of high liquidity costs

and a high cost of capital.

To separate active and passive monitoring effects, we categorize blockholders as

short- or long-term investors, based on their portfolio turnover (Yan and Zhang,

2009). We find that short-term foreign institutional blockholders drive the positive

effect of foreign blockholdings on firm innovation, implying that the monitoring

influence of these blockholders works through passive rather than active channels.

Edmans (2009) and Admati and Pfleiderer (2009) argue that large institutional

investors affect managerial behavior, even if they can only sell their stakes (or threa-

ten to do so), rather than intervening directly in a firm’s operation. This credible

threat of exit encourages managers to align their behavior with shareholders’ inter-

ests (Parrino et al., 2003). Supporting this view, Edmans et al. (2013) suggest that

trading by institutions is a governance mechanism in itself.

Our evidence is consistent with passive monitoring being the most viable gover-

nance mechanism available, given the characteristics of the Korean market. If the

positive relation between institutional blockholding and firm innovation is driven

by the monitoring efforts of institutional investors, it should be stronger for firms

with poorer-quality corporate governance. To investigate this proposition, we

employ the Korea Corporate Governance Stock Price Index score, released annually

by the Korea Corporate Governance Service. This score provides a comprehensive

gauge of corporate governance practices at the firm level. It considers public

announcements, regulatory filings, and survey results for all firms listed on the

3

Korea’s main industries are heavy and chemical industries, automobiles, electronics, and

information and communication technology. Because these industries require continuous

innovation, the Korean government has encouraged innovation to such an extent that Korea

has consistently been ranked in the top 25 of the Global Innovation Index (GII) since its

introduction in 2007. See https://www.globalinnovationindex.org.

D. Y. Joe et al.

198 ©2020 Korean Securities Association