Abstract In 1999, the Daewoo Group, one of the biggest transnational conglomerates, collapsed, committing a staggering $15. 3 billion in accounting fraud in the process, the largest in world history. In 2006, its chairman was sentenced to eight years in prison and a disgorgement penalty of $22. 7 billion. Daewoo’s problems, however, did not remain a case isolated to Korea and their mighty, family-controlled conglomerates called “chaebol. ” Daewoo’s demise foreshadowed corporate scandals that more recently ravaged confidence in financial markets around the world.
Leading financial institutions, investment banks, securities analysts, accounting firms and credit agencies from around the world failed to address its problems. Despite its warnings, policy discussion focusing on the importance of reputational intermediaries and gatekeepers in particular has only recently emerged. This forensic study analyzes the history of Daewoo, a major chaebol, focusing on the implications of its vast corporate governance meltdown. It surveys Daewoo’s internal corporate governance, particularly its controlling shareholder, boards of directors, officers, employees and banks.
Furthermore, the external corporate governance landscape and the failure of reputational intermediaries, gatekeepers and public institutions are explored. By analyzing an Asian conglomerate from a leading emerging market, this study also contributes to the comparative corporate governance literature regarding the importance of formal law and enforcement and the trends toward convergence. This study highlights the emergence of functional substitutes to traditional remedies under formal corporate law for the implementation of legal enforcement and creation of corporate governance discipline.
It also traces how Korean companies have converged toward a more shareholder-oriented corporate governance model from a state-oriented model. Finally, the ineffective corporate governance system in place at the time of the Asian financial crisis provides a backdrop for the reforms that followed. A Forensic Study of Daewoo’s Corporate Governance: Does Responsibility for its Meltdown Lie Solely with the Chaebol and Korea? ****** *** I. Introduction2 II. The Chaebol and the Financial Crisis7 A. The Making of the Great Universe7 B. Tragic Hero: Chairman Woo Choong Kim13 C.
Chaebol Business Practice and Culture16 D. Fatal Decisions during the Asian Financial Contagion22 E. Accounting Fraud and the British Finance Corporation28 III. Ineffectual Internal Corporate Governance35 A. Controlling Shareholder’s Imperial Control35 B. Ceremonial Representative Directors, Directors and Statutory Auditors44 C. Investor Passivity50 D. Compliant Commercial Banks and Silent Debt-Holders55 E. Labor Limitations63 IV. Where Were the Gatekeepers and Public Guardians? 66 A. Accounting Oversight: Chong-Un and San Tong68 B. Investment Banks, Securities Analysts and Credit Rating Agencies74 C.
Financial Supervisory Service, Fair Trade Commission and KDIC82 D. Prosecutors, Courts and other Public Guardians93 V. Conclusions103 Introduction At the end of 1999, one of the largest conglomerates in the world, the Daewoo Group, collapsed in spectacular fashion. During its peak, Daewoo was a sprawling enterprise with over 320,000 employees in 500 domestic and foreign companies that operated in over 110 countries.  Its management received widespread praise and academic recognition for its success.  Yet, when the financial crisis hit, it managed to commit 22. trillion won ($15. 3 billion) in deception that was termed the “biggest accounting fraud in history, surpassing WorldCom and Enron. ” Years later, inner-workings of the conglomerate are finally coming to light. After hiding as a fugitive overseas for over six years, Daewoo’s chairman, Woo Choong Kim, returned to Korea in June 2005 to face criminal charges. In 2006, he was sentenced to eight and a half years in prison and disgorgement of a staggering 17. 9 trillion won ($ 17. 9 billion).  This juncture serves as an opportune time to assess the ramifications of the Daewoo debacle.
Around the world, corporate governance has emerged as a focal point in the reform of companies. In Asia, a consensus exists that failure of corporate governance played a pivotal role in precipitating the financial crisis.  Contagion spread largely as a result of inherent weaknesses of conglomerates and banks; for Korea, for instance, problems with family-dominated chaebol provoked its collapse.  The trials and tribulations of a major Asian conglomerate such as Daewoo offer an understanding of the ramifications of poor corporate governance in an emerging market.
The tale of Daewoo, in particular, serves as one of the earliest warning signs of the corporate governance breakdowns that later plagued leading companies around the world. It predated Enron, WorldCom, Tyco, Vivendi, Ahold and Parmalat, scandals that devastated confidence in global markets. Daewoo, however, did not remain a case isolated to Korea. World-renowned, international financial institutions, investment banks, money managers, financial analysts, accounting firms and credit rating agencies, all failed to react to the situation. Daewoo’s meltdown was categorized as a remote problem in a faraway region.
The wave of policy discussion on the imperatives of having effective reputational intermediaries and gatekeepers, for instance, came later.  A case study of Daewoo within the context of comparative corporate governance also sheds light on the efficacy of formal law, the importance of enforcement and the potential for convergence among governance systems.  It will show how corporate governance mechanisms have been activated not only through statutory reforms but also through alternative ways for establishing legal compliance. Most notably, Korea has developed a unique eans of enforcement discipline outside traditional remedies based upon corporate or securities law. Finally, this study shows how a transplant country from a mixed civil law tradition has converged toward a more shareholder-oriented corporate governance model from a state-oriented model.  How much corporate governance problems relative to ill-advised business decisions and external factors played a role in the collapse of companies such as Daewoo remains a difficult question. Applying “modern” concepts of corporate governance might be inappropriate given Korea’s level of economic development at the time.
The term “corporate governance,” for example, did not exist in the Korean business vernacular.  Some insist Daewoo was a victim of external shocks or a scapegoat of political intrigue.  They cite how Daewoo affiliates have rebounded to profitability.  With benefit of hindsight, forensic studies can exaggerate faults and causes that might appear self-explanatory. These challenges will be addressed. This article begins with a comprehensive review of the history of Daewoo, particularly relative to other chaebol conglomerates.
Second, the article will provide a survey of the internal corporate governance of Daewoo, particularly through its board of directors, officers, shareholders and banks. Third, the external corporate governance landscape will be described through the failure of reputational intermediaries, gatekeepers and public institutions. This article will argue that while primary responsibility lies with Daewoo’s own internal problems and Korea’s underdeveloped corporate governance framework, other market players, particularly leading international ones, cannot escape derivative responsibility.
Corporate governance policy in emerging markets must be reformulated to reach a more balanced and comprehensive perspective. The Chaebol and the Financial Crisis This chapter provides the background of Daewoo from its beginning to its demise in the aftermath of the financial crisis. It explains how it became a leading conglomerate under Korea’s state-oriented corporate governance system. Woo Choong Kim’s role as founder, chairman and controlling shareholder of the Daewoo Group is then profiled. The chapter describes the characteristics of the chaebol, family-controlled conglomerates that dominated the economy.
An analysis of the impact of the financial contagion sets the stage for an examination into the historic accounting fraud and corporate governance failures that brought down the conglomerate. 1 The Making of the Great Universe In 1967, 31-year-old Woo Choong Kim founded Daewoo Industrial, a textile exporter, with just five employees and $10,000. The two Chinese characters for Daewoo meant “Great Universe,” true to the ambitions of the young entrepreneur. From its humble beginnings, business expanded rapidly and, by 1972, it became the second largest exporter in Korea.
Daewoo played a major role in Korea’s economic success when the country achieved the “Miracle of the Han River” and transformed itself from an underdeveloped backwater into a developed nation in the span of forty years. Under Kim’s guidance, by 1996, Daewoo became the world’s largest transnational entity among developing countries, surpassing such companies as Xerox, Amoco, Volvo, Fujitsu and Glaxo Wellcome.  Daewoo excelled at acquiring distressed companies, mostly from the government and then turning them around. In 1976, for instance, Daewoo assumed control over Hankook Machinery Ltd. a manufacturer of industrial machinery, rolling stock and diesel engines that had not shown a profit for thirty-eight years. Senior executives had opposed the acquisition, but Woo Choong Kim’s prevailed upon them.  After changing its name to Daewoo Heavy Industries, the company started generating profits in its first year. In another fabled example, in 1978, Daewoo acquired Okpo Shipping Company, a company teetering on bankruptcy.  Merged into Daewoo Heavy Industries, Kim guided the shipyard to positive returns by 1983.
Daewoo’s mode of acquisition, turn around and expansion became a trademark of the conglomerate. Moreover, major companies were not established by Daewoo but obtained through mergers or acquisitions. Another cornerstone of Daewoo’s business strategy was its orientation toward exports. Unlike other chaebol, Daewoo championed an international focus from its beginning. The group prided itself on its ability to spearhead the opening of new markets overseas. By 1979, it became the largest exporter in Korea, following the government’s economic development plans of export-led growth. 17] Daewoo launched a Global Management Strategy in 1993 to further expand its operations across the world.  By 1998, they established over 500 subsidiaries.  Over 320,000 employees worked worldwide in 110 countries, from South America to Africa and Eastern Europe.  Despite security risks, Daewoo was even among the first to try to develop business with North Korea.  Critics claimed that Daewoo succeeded because of its ability to extract support from the government through rent-seeking while leveraging itself that it had become too important to be allowed to falter.
In 1988, for example, they faced disaster when Daewoo Shipbuilding and Heavy Machinery verged on collapse due to a crushing 1. 2 trillion won ($1. 8 billion) in debt following deteriorating market conditions. Amid criticism that the company should have undergone insolvency proceedings according to market principles, the government bailed it out with a 400 billion won ($600 million) restructuring package in 1989.  The generous rescue package reasserted Daewoo’s lobbying ability while confirming the government’s inability to take decisive action.
This fueled the myth that Daewoo and other chaebol had become too big to fail. Chaebol engaged in increasingly riskier behavior in the belief that they could rely upon government intervention when in jeopardy. In 1978, Daewoo embarked on its tragic foray into the automobile industry through a 50 percent acquisition of Saehan Motor in a joint venture with GM Korea. What later became Daewoo Motor met both the strategy of turning around distressed companies and expanding through exports. The company sought growth and market share instead of focusing on profitability and research and development.
After first buying out GM’s remaining 50 percent stake in 1991, a series of entries into foreign automobile markets followed.  In 1994, they acquired the British International Automotive Design (Worthing Technical Centre) and entered into an automobile joint venture with Rodae in Romania for $300 million. In 1996, they entered the Polish automobile market with the $1. 1 billion acquisition of FSO.  They bought a southern Poland truck factory for $700 million, Czech Republic’s Avia truck manufacturer for $200 million, Uzbekistan’s Uz car plant and teamed up with other carmakers from Ukraine and India. 25] The acquisition spree led to 14 new vehicle plants in 13 countries that culminated with the purchase of a 51. 98% stake in Ssangyong Motor in January 1998 at the height of the financial crisis.  Reckless expansion into the automobile business overwhelmed the conglomerate.  Meanwhile, Daewoo’s financial structure precariously relied upon debt. While debt-to-equity ratios for chaebol exceeded 400 percent, Daewoo surpassed everyone in its over-reliance on debt. As early as 1988, with over $11. 2 billion in borrowings, Daewoo stood as Korea’s most indebted conglomerate. 28] Its debt gearing allegedly reached as high as 2,000 percent.  In fact, for foreign investment projects, Daewoo followed a “one-hundredth strategy. ” They boasted that they only required one percent of the total capital needed for a project because they could finance the rest through preferential loans from foreign country’s banks, inter-subsidiary debt payment guarantees, joint investment from local investors and other sources.  Another notable feature was that the de facto holding company, the Daewoo Corp. , was not the profit center of the conglomerate. 31] Daewoo Corp. primarily acted as a trading and financial company for products and services. In difficult times, therefore, it did not have capacity to provide financial support to weaker affiliates. Instead, it later served as the group’s nerve center that directed the use of offshore entities as conduits for the accounting fraud. Unsurprisingly, Daewoo received the lowest market valuations and had to pay the highest interest rates among the chaebol. Capital markets long discounted Daewoo companies. As of April 1997, for example, Daewoo had a 1. price-to-book ratio, the lowest among leading conglomerates, which averaged more than two.  Daewoo’s actual interest rates were 2. 6 percent higher than the average among the top-five chaebol in 1997.  The spread between Daewoo bonds and other chaebol was already one percent in 1998, but increased to two to three percent by early 1999.  The discounts and spreads reflected the market’s uncertainty over Daewoo’s earnings prospects relative to its risks. Of course, even these discounts were far too generous, considering what was concealed through the accounting and loan fraud.
Nevertheless, the valuations reflect the degree of knowledge that market participants, particularly sophisticated domestic and foreign ones, held of the risk in dealing with the conglomerate. Notwithstanding, the sustainability of the Daewoo brand name is evident in the fact that its brand image and brand recognition still remain strong in the international marketplace.  After the conglomerate’s collapse nearly a dozen companies continue to operate under the Daewoo brand name.  Leading Daewoo companies even retain the same senior management. 37] Yet, the success of the companies in many ways demonstrates the importance of corporate governance; they have only managed to become competitive enterprises after they unshackled themselves from the collective burdens of the conglomerate.  As independent companies, they can now operate for their own benefit without regard for the welfare of other affiliates. 2 Tragic Hero: Chairman Woo Choong Kim Daewoo cannot be separated from its legendary founder, Woo Choong Kim. He not only established it, but determined its course, dominated decision-making and handpicked executives.
In terms of business strategy, he maintained the same management perspective until the end: seize market share first, quash competition and seek collection later.  Toward this end, he maximized his expertise in corporate turn-arounds and rent-seeking. His global perspective on the need for Korean companies to develop overseas markets was visionary, particularly given reclusive tendencies of Koreans. He traveled around the world over 260 days out of the year seeking business opportunities.  His indomitable spirit, tireless energy and grand dreams for Korea attracted a legion of professionals.
In the end, he deserves the most credit for the conglomerates’ success but remains primarily responsible for its meltdown. Kim built the Great Universe of Daewoo into a multinational conglomerate in less than two decades. Recognized as one of the world’s most successful businessmen, he was profiled in leading business magazines everywhere. In 1984, he received the International Chamber of Commerce’s coveted International Business Award that was conferred by Sweden’s King Carl Gustaf XVI. He wrote a bestselling autobiographical book, “Every Street is Paved with Gold,” that sold over two million copies. 41] Published in 21 languages, it propounded his corporate philosophy on the need to expand internationally. In February 1999, he became captain of Korean industry when he was elected president of the influential Federation of Korean Industries (FKI), official organization of Korea’s largest businesses.  Politically, Daewoo benefited from Kim’s instincts and apparently his personal relationship with President Chung Hee Park, the controversial autocrat who ruled Korea from 1961 until 1979. 43] Although a latecomer compared to other established conglomerates, Daewoo blossomed under Park’s industrial policy during the 1960s and 1970s. Kim managed to extract concessions from the government, especially when taking over distressed companies. While the government would engage in predation of its own, time and time again, they would succumb to Kim’s requests for support. After Park died, Daewoo continued to rely on Kim’s political acumen to steer them out of difficulties. During the financial crisis, Kim’s political wherewithal and managerial judgment faltered, leading Daewoo to catastrophe.
By the summer of 1999, he departed the country in self-imposed exile.  He returned after six years of hiding on his volition to receive an eight-year prison sentence in 2006, with numerous civil trials still pending. In his own words, he claimed that “[m]y big mistake was being too ambitious, especially in autos. I tried to do too much too fast. ” Fundamentally, Kim failed to follow basic legal and managerial principles such as accounting, internal controls and financial discipline, placing too much emphasis upon generating sales and marketing. Corporate governance was unobserved.
He did not heed warnings to retract and instead chose to expand through unprecedented accounting and loan fraud.  In the end, ultimate responsibility for the catastrophe lies with him. 3 Chaebol Business Practice and Culture The chaebol that dominated Korea’s economy shared many common features. Nurtured under the government’s industrial policy, they followed the same financing methods, business models, ownership structures and operating practices. A state-oriented corporate governance modus operandi prevailed as the country unified behind the chaebol according to the dictates of policy makers. 47] Interested parties such as shareholders, employees, consumers and managers received secondary priority given the nation’s collective focus on economic development and employment during the 1960s and 1970s. First and foremost, chaebol maintained a patriarchic, management style that revolved around controlling shareholder domination. Excessive concentration of power became the source of most corporate governance problems. Chairmen, serving as both controlling shareholder and founder, reigned as moguls over empires of companies.
The participation of directors, statutory auditors, external auditors and non-controlling shareholders in the governance process was subsumed under the command of chairmen. Defiant managers that dared to challenge imperial orders faced swift retribution, leaving controlling shareholders with uncontested authority. The state of predominance was compounded, particularly at senior level, because executives lacked alternative employment options due to poor labor market flexibility. Under a state-oriented corporate governance system, government operated in an intertwined, symbiotic environment with the chaebol.
Chaebol operated according to government policy because by design they could receive “preferential policy loans, tax credits, subsidies, protection and even bailouts when [they] got into financial trouble. ” Government provided management-friendly labor laws, monopolies and oligopolies, special licenses and permits and trade and investment barriers from foreign competition. Chaebol received favorable treatment as long as they performed. From one perspective, Korea’s economic success evinces the merits of industrial policy based upon close industrial and government cooperation.
At its worst, however, collusion led to illegal rent-seeking and predation. In the most egregious example, for instance, a dozen leading chaebol chairmen, including Woo Choong Kim, contributed over 510 billion won ($638 million) in bribes during the 1980s and early 1990s to two Presidents.  Chairmen claimed they could not defy the Presidents’ solicitations for slush funds, yet the chaebol derived significant benefits in return. Policymakers also protected the control of chaebol families. Initially, like other Asian companies, families held large, concentrated ownership in their companies.
In the 1970s, however, the government browbeat chaebol into listing major companies on the stock exchange.  Listing served two purposes. Compelling chaebol families to disperse their ownership to the public would lead to sharing the benefits they derived out of the special preferences that chaebol received.  Second, rights offering served to provide much-needed liquidity to the fledgling stock market. Families initially resisted listing their companies out of concerns that dispersion of their ownership could threaten their control.
With generous indirect financing from banks, companies also had little need for equity financing. To convince them, the government decided to protect them from threats to ownership control by curbing shareholder and stakeholder rights, the corporate control market and challenges to the board Ownership dispersion coupled with weaker, not stronger, minority shareholders protections sowed the seeds for corporate governance problems. With control protected, entrenched families gradually allowed dilution of their cash flow rights with each rights offering.
Over time, families held only marginal ownership. They meanwhile were allowed to secure control through a vast web of crisscrossing share ownership between affiliates.  The wider the discrepancy between cash-flow rights and control rights became, the more controlling shareholder’s interests diverged with other shareholders and the greater inherent agency problems became. The anomalous situation of control without corresponding personal ownership and dispersed ownership without strong shareholder protections emerged as a fundamental issue.
Chaebol became vulnerable to empire-building and more serious ills such as misappropriation. During the developmental state period, chaebol routinely engaged in related-party transactions among affiliates. In fact, intra-conglomerate assistance among affiliates without regard to the corporate governance of individual companies was common practice. Not only was it not punished, governmental administrative guidance often required affiliate support for risky but strategically important companies as a condition for receiving bank loans. 53] Stronger companies helped start-ups and rescued troubled affiliates through equity infusions, debt guarantees and transfer pricing, on non-market terms, according to the mandates of industrial policy. In the worst cases, however, controlling families or senior managers used related-party deals to engage in self-dealing and to extract other private benefits of control. Chaebol adhered to a “too-big-to-fail (dae-ma-bul-sa)” doctrine.  Through their network of companies they accounted for a predominant share of the country’s employment, production, income, and exports.
Their impact on the economy was multiplied considering downstream and upstream industries, suppliers, outsourcers, transporters, retailers and distributors. Conventional belief held that bureaucrats did not have the nerve to endure the political costs and social dislocation generated by permitting the debacle of a chaebol, particularly one of the largest ones. Market participants therefore clung to this myth.  Sophisticated investors, creditors and reputational intermediaries, domestic and foreign alike, downplayed the importance of corporate governance because they believed chaebol had a sovereign guarantee from “Korea, Inc. Meanwhile, this nurtured a moral hazard that led chaebol to increase their size and assume undue risk because they believed that could rely upon the government’s safety net. Furthermore, chaebol companies and chairmen linked fates through debt or payment guarantees.  Guarantees were demanded as a condition for obtaining bank loans or making bond offerings, although the collective risk was not properly gauged. The collapse of one affiliate could endanger others that had guaranteed it and start a chain reaction that could threaten a string of companies if not the entire conglomerate.
By conjoined fates of companies, guarantees exacerbated the too-big-too-fail problem. Banks also routinely demanded that chaebol heads personally guarantee company debt as an additional form of security even though the size of guarantees was already beyond their capacity. When difficulties arose, nothing held back chairmen from assuming excessive risk because they no longer could limit their exposure to a manageable level. From an industrial organization perspective, many conglomerates followed a horizontal package approach.
They provided a diversified range of goods and services for a single large project.  Entire operations of a chaebol could be enlisted, for example, from construction to trading, to sales, marketing and financing. The construction company, for instance, would build a hotel, another company would obtain financing, another affiliate would provide automobiles and buses, another would train staff and another would promote the property. The organizational structure served as a justification to support weaker affiliates when in need. Finally, chaebol engaged in various forms of “earnings management. Financial figures were inflated partially due to historic reasons. Following the Japanese model, policy makers granted chaebol exclusive rights to establish general trading companies based upon the volume of revenues, assets, sales and stated capital.  Size, not profitability, was the key determinant. Bureaucrats similarly condoned window-dressing to receive licenses, permits and commercial lending, particularly when it was related to attracting precious foreign capital. With the emphasis on growth, companies were allowed to nflate records and manipulate balance sheets through related-party transactions to obtain extensions when maturity dates approached. Consolidated financial statements were not required so that a single asset could be sold through a chain of companies, generating artificial sales for all companies involved. Chaebol shared common characteristics, especially vulnerabilities arising out of weak corporate governance. Nurtured under a state-oriented corporate governance system, they became over-protected from scrutiny and lacked proper internal controls.
A weak ownership structure, autocratic management styles and too-big-to-fail mentality left them predisposed to excesses and opacity, particularly while business thrived. Most significantly, these problems were common knowledge, but little was done to address them. When the financial crisis hit, however, everyone fled because of a sudden awakening that the chaebol lacked the necessary discipline to sustain them. 4 Fatal Decisions during the Asian Financial Contagion As financial contagion swept across Asia, Daewoo made grave misjudgments, condoned by the government, which sealed its fate.
First, it pursued a counterstrategy of expansion with particular focus on the automobile industry that proved too ambitious. Daewoo then over-leveraged itself with $ 20 billion in debt to try to meet its financial burdens during the crisis. They did not appreciate the seriousness of the situation, offering restructuring plans to resurrect the conglomerate when it was too late. In the end, over a two-year period, everyone stood-by as Daewoo transformed into a financial black hole. In late 1997, the Korean won plummeted from 900 won to 1960 won to the dollar in less than four months. 59] The proud country, hailed for its economic miracle, capitulated to a bailout led by the International Monetary Fund (IMF), World Bank and Asian Development Bank, consisting of over $58 billion.  The IMF’s controversial prescription raised interest rates to over 30 percent in an attempt to stem capital flight.  Korea experienced negative 6. 7 percent growth in 1998, the worst in modern history. The timing could not have been worse for Daewoo. Daewoo might have weathered the storm had it restructured from the onset in early 1998.  Rejecting a contractionary pproach, Woo Choong Kim instinctively pursued aggressive growth, particularly in the automobile industry. He declared that “Daewoo will overcome the crisis through expansionist measures (like in the past),” because given the opportunity “[w]e cannot embrace the future if we flinch at a time of recession. ” Returning to his roots, he viewed the crisis as a chance for Daewoo to acquire distressed companies and turn them around. One commentator noted that “Daewoo’s response to the crisis came straight out of its old playbook: cooperate with the government, acquire failed companies to expand and continue to borrow.  While others retracted, the Daewoo Group’s sales therefore increased by 25 percent in 1998, Daewoo Corp. ’s, by 54 percent.  The group spent 10 trillion won ($7. 14 billion) in sales promotions during this critical period.  Automobile-related expansion in particular overwhelmed the conglomerate.  Daewoo Motor acquired Ssangyong Motor in January 1998 at the peak of the crisis, assuming 3. 4 trillion won ($2. 43 billion) debt.  Leading companies such as Daewoo Corp. and Daewoo Heavy Industries bore the burden.  All companies pressured employees to purchase Daewoo automobiles. 70] Executives personally marketed cars with sales results linked to their performance evaluations.  Daewoo’s financial balancing act foundered under the weight of the financial contagion.  First, debt burden more than doubled due to the plummeting Korean won. At the time, the group had $5. 1 billion in foreign currency loans and $1. 9 billion in foreign currency debt to foreign bond owners.  Second, the spike in interest rates further debilitated the conglomerate, its interest rate burden ballooning from three trillion won ($2. 4 billion) to six trillion won ($4. 3 billion).  Finally, Daewoo reportedly failed to collect payment on several large-scale projects such as $3 billion owed by Libya and $1 billion owed by Pakistan.  Relatively constant operating profits aside, the collective financial burden overwhelmed them. To meet the demands, Daewoo issued a flurry of corporate bonds and commercial paper throughout 1998 to cover its maturing debt. Despite high leverage, they still managed to raise 19. 7 trillion won ($14. billion) in debt issuances at interest rates that averaged 15 percent and reached as high as 25 percent.  In the third quarter of 1998 alone, Daewoo issued over 9. 2 trillion won ($6. 57 billion) in bonds, raising its total debt by 40 percent and accounting for 27 percent of total bond issues at the time.  Investment trusts and other institutions recklessly acquired the debt instruments, apparently relying on the assumption that the government would devise a solution.  In July 1998, after months of delay, the government finally acted to stem the hemorrhaging conglomerate.
Regulators restricted financial institutions from holding more than 5 percent of the commercial paper of a conglomerate. In October, a similar restriction followed for corporate bonds when banks and insurance companies were set to a 5 percent limit per conglomerate while investment trusts, a 15 percent limit. Though they had been in discussion with regulators about their financing woes since June 1998, Daewoo did not – or could not — prepare for the austerity measures.  The caps on debt severed the financing lifeline that had been sustaining the group. 80] To aggravate matters, Chairman Kim was suddenly hospitalized in November 1998.  In December 1998, the government attempted to broker a controversial “Big Deal” between the Samsung Group and Daewoo Group in which troubled Samsung Motors would be swapped in exchange for Daewoo Electronics.  The government believed they needed to intervene to help the rival conglomerates. Merging Daewoo Motor with Samsung Motors could revive the ailing companies through synergy and economies of scale. Policymakers also believed this could force Daewoo to focus its efforts on the automobile industry.
Daewoo meanwhile hoped to extract major concessions from the government to consummate the deal, but negotiations collapsed when Samsung withdrew from talks.  Twelve months after the crisis erupted, Daewoo made its first serious attempt at restructuring in late December when they entered into a Financial Structure Improvement Covenant with its creditor banks. They agreed to downsize 51 companies into ten core entities that would focus on trade and construction, automobiles, heavy industries and finance and services. These efforts, however, were inadequate and overdue and failed to yield substantive results.
In February 1999, Kim even became president of the Federation of Korean Industries (FKI), the powerful business organization led by chaebol, yet FKI’s influence did little to help Daewoo’s reorganization. In July 1999, Kim then announced that he would relinquish 1. 3 trillion won ($1. 08 billion) of his personal equity in Daewoo companies. His final proposal to salvage the conglomerate involved a breakup of the conglomerate and sell-off of its companies with only the automobile company remaining. In return, Kim demanded over ten trillion won ($8. billion) in the form of stock, real estate and other assets to use as a last injection to reorganize the group. A year had already elapsed since the government curtailed its financing and began close supervision of the group. Yet, the Financial Supervisory Service (FSS) approved the rollover of six trillion won ($5 billion) of short-term commercial paper for six months and four trillion won ($3. 3 billion) in additional funding.  The government to no avail tried to sustain the beleaguered conglomerate.  Weeks later in August, twelve main companies proceeded into court receivership workout procedures.
Representative directors submitted their resignations on November 1 and shortly thereafter Kim left Korea to begin life as a fugitive. When the financial crisis struck, Daewoo misjudged the situation and expanded its way to a meltdown. In the process, they were allowed to issue over 19. 7 trillion won ($14. 1 billion) in bonds and commercial paper and permitted to extend an additional ten trillion won ($8. 3 billion) in loans over a two-year period. All of this proceeded under the shadows of accounting and loan fraud. The collective response to the situation hence was grossly inadequate.
The Daewoo Empire had become a financial nightmare. 5 Accounting Fraud and the British Finance Corporation While pursuing its expansion strategy through excessive borrowing, Daewoo chose to commit unprecedented fraud, particularly by manipulating its overseas accounts. Many chaebol shared a legacy of accounting opacity, but what distinguished Daewoo was its scale, its manner and how it remained undetected.  The size sealed their fates in the annals of corporate scandals. Executives violated disclosure laws, accounting laws and foreign exchange laws.
The staggering fraud could be attributed corporate governance breakdowns on multiple levels. The “biggest accounting fraud in history” occurred as a result of Daewoo companies inflating assets by a total 22. 9 trillion won ($19. 1 billion).  Daewoo Corp. , Daewoo Motor and Daewoo Electronics together accounted for 90 percent of the conglomerate’s impaired capital.  In perpetrating the fraud, Daewoo Corp. , which was responsible for 14. 6 trillion won ($12. 2 billion), used its trading and management departments and its accounts in London.
In 1997, for example, they deflated assets by 10. 1 trillion won ($6. 7 billion) and liabilities by over 22. 9 trillion won ($15. 3 billion), and inflated equity by over 12. 8 trillion won ($8. 53 billion) to conceal 10. 1 trillion ($6. 73 billion) in impaired capital.  This transpired while net losses for the company climbed from 11. 8 trillion won ($7. 87 billion) in 1997 to 12. 1 trillion won ($8. 64 billion) in 1998.  On the domestic side, most of the fraud stemmed from reduction of debts, manipulation of export returns and utilization of affiliates.
Some of the largest violations involved fifteen trillion won ($12. 5 billion) in off-balance sheet liabilities.  Related-party transactions were also used for “asset swaps among Daewoo subsidiaries at exaggerated values. ” Stronger affiliates would prop up weaker companies by purchasing overvalued assets above market prices. Furthermore, scam subsidiaries were used to skirt accounting rules. Financial companies such as Seoul Investment Trust Management (SITM) played a key role in the transactions.  To a greater degree, Daewoo mobilized its overseas financial network.
The primary vehicle for the overseas fraud involved an entity called the British Finance Corporation (BFC).  Located in London, five persons in the finance department of Daewoo Corp. oversaw its secretive business.  The BFC’s intricate accounts acted as the nerve center for most of the conglomerate’s financial machinations.  What began as a construction account was later commingled with trading accounts.  The BFC later grew to an amalgamation of thirty-seven foreign accounts. By 1996, annual borrowings from the BFC accounts totaled between six and seven billion dollars. 98] Toward the end in August 1999, the accounts reportedly amounted to over $7. 5 billion.  The BFC and overseas affiliates were employed in a variety of ways. Foreign subsidiaries, for example, transferred funds borrowed from foreign banks to the BFC. This circumvented foreign exchange laws and skirted reporting requirements.  In addition, companies with questionable credit issued new stock that overseas financial institutions would acquire technically as equity investments.  The equities would then be secured through redemption agreements with other affiliates. 102] The affiliate would be obligated to repurchase the equity at a given price plus interest, if it failed to reach a certain price level.  In essence, the equity investment operated like a loan guaranteed by an affiliate. The scheme allowed Daewoo to avoid prudential regulations that governed chaebol borrowing in foreign currency. Funds that should have been recorded as debt were improperly recorded as equity. When overseas business operations declined and more pressing debts from overseas entities emerged, receivables from exports that should have been credited to domestic affiliates were instead diverted to BFC accounts. 104] Foreign debts held priority over domestic obligations.  During this critical period, overseas interest payments to foreign financial institutions alone amounted to $2. 49 billion in 1999.  Pressure from the BFC exacerbated the financial state of domestic companies. Later when foreign debts could no longer be met BFC-related paper companies were used to construct falsified bills of lading, commercial invoices and packing lists to defraud Korean banks.  Daewoo commingled real commercial documents with falsified ones to sustain the deception.  BFC personnel meanwhile worked under utmost secrecy. 109] Despite the BFC’s meticulous records, the destination of approximately $753 million remains unknown.  Speculation abounds that money was used as corporate slush funds for political lobbying purposes. Others believe that Woo Choong Kim and senior managers siphoned off funds for personal enrichment.  In 2006, a court in fact held that a special “KC(King of Chairman)” account established among the BFC accounts was used for personal expenses of Chairman Kim and his family.  Overall, operation of the BFC accounts contravened several key laws. First, executives violated accounting laws. 113] Daewoo, for instance, did not record or consolidate approximately five to eight trillion won ($4. 17 to 6. 7 billion) per year of off-balance sheet liabilities between 1996 and 1999. Second, executives violated the law prohibiting “hiding of personal property overseas” without appropriate disclosure.  They asserted that the BFC accounts were not concealed for any illicit purpose but solely to repay company debts.  They repaid foreign loans, for instance, with funds obtained by selling debt locally.  Courts rejected the argument because disclosure laws applied irrespective of an intention to repatriate missing funds later. 117] The law required accurate reporting so that authorities had sufficient information to make policy judgments.  Finally, the BFC accounts violated foreign currency laws. None of the accounts received official Ministry of Finance and Economy (MOFE) approval as required under foreign exchange regulations.  Not only did they transfer funds out of the country to cover BFC’s debt without permission, but also they fabricated documents to conceal it.  When faced with a financial emergency in the midst of its managerial blunders, Daewoo chose to engage in purposeful deceit.
They opted to manipulate secretive overseas accounts to avoid detection by authorities and accountants. The scheme violated accounting laws, disclosure laws and foreign exchange laws. Even evidence of personal enrichment surfaced. Overall, the staggering fraud transpired as the result of a breakdown in both internal and external corporate governance. Ineffectual Internal Corporate Governance Daewoo’s misjudgments and accounting troubles serve as a reminder of the catastrophic cost of neglecting corporate governance.
Weak internal corporate governance in particular was a common feature for many conglomerates leading up to the financial crisis. Internal corporate governance structures established under corporate law did not function to check and balance controlling shareholder mismanagement. Representative directors, boards, statutory auditors and shareholders alike did not act as effective monitors. Subsequently, internal corporate governance has improved significantly through legal reforms combined with an effective enforcement regime. 2 Controlling Shareholder’s Imperial Control
As with most chaebol heads, Daewoo’s founder and controlling shareholder, Woo Choong Kim, reigned in imperial fashion.  He operated the conglomerate with total command, unchecked and unsupervised. He pressed the campaign to expand internationally, particularly, in the crucial period leading up to and during the financial crisis.  The crisis exposed the weakness of the concentrated governance structure when his judgment faltered. Single-handedly, he was able to drive the conglomerate to perpetrate the largest accounting fraud in world history. Although Daewoo’s usiness was run with an international focus, Kim’s dominance of internal corporate governance fell far short of established global standards. Kim held the formal title “Daewoo Group Chairman. ” As head of the conglomerate, he acted as de facto chairman of the board of all Daewoo companies.  He conducted all major decision-making of the conglomerate through the Group Chairman’s Office that consisted of some 100 personnel conscripted from each affiliate. Serving as his personal secretariat, the Chairman’s Office oversaw senior personnel decisions, financing decisions and business strategy. 124] Representative directors and board members, for example, were not nominated by boards or through annual general meetings, but through the Chairman’s Office at the end of the year. This happened weeks before annual shareholder meetings that rubber-stamped approval in any event. Kim wielded “absolute influence over the careers” of executives.  Similarly, the Chairman’s Office maintained exclusive control over operation of the BFC. The concentration of power in the Chairman’s Office therefore allowed Kim to order executives to commit the accounting fraud. 126] Informal controls over the Chairman’s Office had existed in the past but suffered due to a changing of the guard at the conglomerate’s senior levels.  Originally, Kim surrounded himself with a host of key advisors who had been with him from the early years in the 1960s and 1970s. They had grown together with the conglomerate, many having been personally recruited from other companies by Kim. Similar or even older in age, many were also alumni of the same schools.  Hence, they could be blunt with him acting as an informal check and balance.
In the early 1990s, however, a generational change began when these original executives retired. The replacements, who rose through the rigid corporate hierarchy as career Daewoo men, could not as easily confront the legendary founder, especially when the crisis unfolded. Chairman Kim was able to control the conglomerate through a distorted yet tenuous ownership structure. In April 1997, for example, Kim and his family members, as controlling shareholders, only owned on average 6. 1% of the shares in the major companies within the Daewoo Group. 129] Daewoo companies apparently did not seek equity financing due to concerns that this might dilute Kim’s weak ownership position.  Kim maintained control through affiliated companies that on average cross-owned 31. 2% of each other’s shares and treasury shares that accounted for an additional 1%. Combined with his family ownership, he then could control on average 38. 3% of the shares.  Hence, while labeled a concentrated ownership system, Daewoo and other chaebol, also exhibited attributes more associated with dispersed ownership systems such as exaggerated accounting.
The low stock price of Daewoo companies reflected not only lack of profitability but also concerns surrounding the distorted ownership structure. Notwithstanding his imperial position, Kim did make many exemplary decisions. First, Kim declared when he founded Daewoo that he would not transfer the reins of corporate control to any of his family members.  He believed his successor should be a professional manager chosen based on merit. He trained managers and delegated authority to chief executives accordingly.  Subsequently, Kim withdrew all his relatives from executive positions throughout the conglomerate. 134] His anti-nepotistic succession plan and management philosophy distinguished him from other heads who viewed chaebol as personal possessions subject to dynastic succession.  To them, the interest of shareholders and stakeholders to have the most competent manager leading the company or the possibility that an heir might be unqualified were secondary issues. Hereditary entitlement to control was considered an established fact even for publicly listed companies. Although he displayed an unwillingness to relinquish control until it was too late, Kim’s professional approach was a novelty.
Unfortunately, Daewoo’s collapse denied him the opportunity to fulfill this pledge that would have had tremendous impact on the corporate world through the peer pressure it would have generated. Second, in 1980, Kim donated over twenty billion won ($22. 2 million) to the non-profit Daewoo Foundation that he had established in 1978.  The donation consisted of the bulk of his Daewoo Corp. shares that amounted to seventeen and a half billion won ($19. 4 million).  The foundation’s mandate provided for it to engage in public interest activities, primarily by conducting social welfare programs. 138] It established hospitals, supported museums, constructed low-income housing projects and supported academic research. Ostensibly, Kim established the foundation as a philanthropic effort to repatriate his wealth back to society. Third, Kim and his senior executives did not engage in widespread plundering.  Exhaustive investigations by prosecutors, regulators, creditors and investors have uncovered only partial evidence of misappropriation.  This contrasted with many other chaebol where personal enrichment by controlling shareholders and executives played a direct role in collapses.
The secretive BFC funds for example were allegedly used to help the conglomerate.  Kim loyalists argue that gross accounting and loan fraud was committed for Daewoo and not for personal benefit.  Critics, however, hold a more cynical view toward the donations, suggesting that they served ulterior purposes. At the time, the move allowed Kim to avoid a crackdown by the authoritarian government by preempting a threat to restrict his control.  The facade of a non-profit organization also allowed him to maintain control over the group while shielding his involvement. 144] In October 1993, for example, compared to other foundations established by the top 30 chaebol, the Daewoo Foundation owned the highest percentage of shares.  In the early 1990s, it held 11. 42% of Daewoo Corp. , 2. 67% of Daewoo Heavy Industries and 4. 3% of Daewoo Finance.  Initially, it operated as the de facto holding company of the conglomerate.  The foundation also acted as a tax shelter against personal inheritance taxes, a loophole used by many chaebol foundations. In fact, after the tax laws were amended, the foundation reduced its stake in Daewoo Corp. rom over ten percent to 5. 81% in August 1993.  Finally, the foundation operated not solely through Kim’s personal donations but through contributions conscripted from Daewoo affiliates. Enlisting such support particularly from listed companies diluted Kim’s personal, philanthropic intentions. Suspicions persist that Kim and his insiders reaped substantial private benefits of control. First, allegedly over $753 million from the secretive British Finance Corporation remain unaccounted for even after a comprehensive audit by regulators.  These funds could have been personally misused.
In its November 2006 decision, the Seoul High Court, in fact, affirmed that Kim embezzled over $116 million from a special BFC account.  Kim’s family used these funds for personal investments, purchase of art work and acquisition of real estate. Similarly, the Korea Deposit Insurance Corporation (KDIC) brought a civil action on behalf of creditors related to $2. 5 million in donations to Harvard University, where a son of Kim was attending, and nineteen billion won ($15. 8 million), to Ajou University. Both donations involved use of company funds without board approval for seemingly personal reasons. 151] Secondly, confidants, relatives, or pseudo-Daewoo affiliates allegedly hold most of Kim’s personal assets in proxy.  By concealing such funds under third party names, they can thwart claims by creditors. These assets conceivably could have originated from expropriated funds. All in all, as founder and controlling shareholder, Woo Choong Kim dominated affairs of the conglomerate without sufficient checks and balances. Autocratic control might have benefited Daewoo’s in its early years when its size was manageable and when Kim maintained his astute business sense.
Yet over time the organizational structure of unquestioning loyalty to the controlling shareholder without appropriate checks or balances led to the malfeasance and fraud proceeding to unthinkable heights. 3 Ceremonial Representative Directors, Directors and Statutory Auditors Daewoo’s boards of directors, representative directors and statutory auditors failed to understand and fulfill their roles as fiduciaries. They did not act to stem the primary conflict that arose out of controlling shareholder taking advantage of non-controlling shareholders, stakeholders and others. 153] As legal institutions established under corporate law they should have acted as internal counterweights to the domineering authority of the controlling shareholder. Instead, they maintained a passive existence due to historical legacies, weaknesses in the law and a misguided understanding of their purpose. Generally, Daewoo’s directors, representative directors and auditors suffered the same problems that plagued most Korean companies. In practice, boards did not formally function in a legal sense.  Boards did not even hold official meetings.
Upon receiving instructions from the conglomerate’s Chairman’s Office, the office of planning of each affiliate would draft fictional board minutes tailored accordingly. Minutes would be “approved by the board” with personal seals of all the directors that the office of planning kept under their care. At best, directors provided input through the representative director who would then relay advice to the chairman. The internal supervisory structure also remained weak because at the time companies did not distinguish between directors and officers and had no outside directors.
The director position served as the highest possible rung on the corporate ladder for an executive. Senior officers when promoted became directors. Combining the two together into a unitary position weakened their ability to act as checks and balances against each other and, more importantly, over the controlling shareholder. In addition, Korean companies as a general matter did not have any non-executive, outside directors until 1998.  A more serious problem was that directors and auditors were not answerable to non-controlling shareholders or other stakeholders in any meaningful way and did not understand their obligations.
Shareholder litigation, particularly derivative actions, did not exist until 1997.  The lack of civil legal actions meant that fundamental obligations such as fiduciary duty remained unapplied, theoretical exercises. Directors could not develop an understanding or appreciation of fiduciary duties to shareholders because no one was ever held accountable for violating them.  The chance of executives being held legally responsible was so low that director and officer liability insurance did not exist. 158] Lack of accountability to shareholders at large therefore left them subject to the dictates of the controlling shareholder. In case of conflict, they had little incentive to defy the wishes of the controlling shareholder and act on behalf of the interests of faceless, silent non-controlling shareholders. Controlling shareholders, on the other hand, made sure to reward loyal directors, executives and statutory auditors. After retirement, they bestowed an array of benefits, hiring them as consultants, using them as suppliers, or giving them outsourcing contracts or transitional support.
Having spent an average of twenty years of their lives to rise to senior positions, executives had no motivation to be “unfaithful” to the chairman, lose these benefits and be ostracized from one of their most important social circles. The defense strategy of Daewoo executives in their criminal trials in particular revealed how they did not understand their duties or responsibilities.  They argued that they merely followed Chairman Kim’s directions as obedient subordinates. They could not question his command, particularly when they received direct instructions to commit accounting fraud. 160] Furthermore, they committed accounting violations for the conglomerate because companies had to repay reoccurring debts. They suggested that their actions should be justified because they did not personally gain from the fraud or expropriate company funds.  They failed to grasp that allowing Kim to use the company to defraud others for any purpose could not be justified. They could not exaggerate Daewoo’s business operations, inflate its status and disguise its actual financial situation to borrow funds and issue corporate bonds. 162] They could not commit accounting fraud to meet reoccurring debts or because they believed it was the best time to expand operations and acquire distressed companies. Under this flawed reasoning, they perpetrated the financial crimes without a guilty conscience. Regardless of whether they personally benefited or whether Kim was a dominating figure, they failed to appreciate their duty to prevent the fraud. In the end, they allowed Daewoo to inflict “enormous damage upon the Korean people and the national economy. Furthermore, contrary to their belief, they did derive personal benefit because they would “not lose the chairman’s favor” and could “maintain their positions.  The ability of Daewoo directors might have been affected more than other conglomerates because so many hailed from a particular school–Kyongi High School, until 1973, Korea’s elite secondary school.  As a Kyongi graduate, Kim surrounded himself with an inordinate number of alumni. In Confucian Korea, high school ties constitute a powerful bond that often forms the basis of a lifelong, vertical social relationship.
Senior alumni traditionally have considerable authority over junior alumni. The old, schoolboy tie further consolidated the hierarchy in the upper echelons of management and weakened check and balances. Daewoo directors themselves believed that school background was a much more important factor in being chosen as a director compared to other chaebol.  Furthermore, in the late 1980s and early 1990s, Daewoo underwent the generational change where many, original executives who were senior Kyongi alumni comparable in age and status to Kim were replaced. 166] Junior alumni that succeeded lacked the same standing to counterweigh the legendary, domineering chairman. Overall, directors, representative directors and statutory auditors neglected their roles as fiduciaries. They ultimately acted for their personal gain by placing a higher priority in maintaining their executive positions over the duty to obey the law, monitor the company and protect the interests of shareholders and stakeholders. Senior executives not only did not prevent but also actively participated in the cover-up and fraud.
In the end, they demonstrated a confused understanding of fundamental duties and responsibilities. 4 Investor Passivity Daewoo’s shareholders could not have been more passive in overseeing managerial decisions.  They did not raise questions, request information, attend shareholders’ meetings, engage in litigation, or meet with management. Curiously, foreign institutional investors with considerable equity positions also remained complacent bystanders. Despite their sophistication, they neglected governance-related action like everyone else.
They did not seek board representation, accountability or transparency and failed to act as diligent monitors to curb fraud. Many factors such as legal restrictions and inherent apathy problems contributed to the investor passivity. After the meltdown, the restitution process has finally made shareholders more active participants. One problem for shareholders was that they could not easily exercise their rights.  Even after some of the most egregious corporate governance problems, they did not exercise their legal rights or take action.
For example, when the presidential slush fund scandal revealed in 1995 that 140 billion won ($155 million) of Daewoo’s money was used to bribe two former presidents, no legal actions let alone complaints ensued. One problem was that the regulatory framework set prohibitively high minimum holding requirement for most shareholder rights such as standing for derivative actions or inspection rights.  Without whistle-blowing by insiders or common law procedures such as discovery, shareholders also lacked the means to obtain information needed to question or challenge management.
Shareholders only brought civil actions against directors and controlling shareholders when they could use information obtained through regulatory actions or criminal prosecutions. Shareholder representation through voting likewise in particular faced many restrictions. Institutional investors, for example, could only exercise their votes through shadow voting, effectively neutralizing their participation. Shareholders’ meetings were also manipulated to deter shareholders from raising issues. Companies colluded to hold annual general meetings on the same day at the same time of the year to prevent active shareholders from participating. 170] Shareholders’ meetings when convened lasted no more than ten minutes according to scripts predetermined by the company. Agenda items such as approval of accounting statements and election of directors and auditors proceeded perfunctorily without discussion. Under this environment, investors, both domestic and foreign, behaved as though monitoring costs were too high to have merit. Foreign investors in particular acted no differently even though they owned on average 9. 5 percent of the top five Daewoo companies that committed the largest amount of accounting fraud. 171] When coupled with traditional collective action problems, the “Wall Street rule” of sell and move on prevailed when companies reported bad news, managers violated their duties or abused their powers. At the same time, equity investment, particularly on the retail side, proceeded on an exceptionally short-term basis. Trading turnover of Korean investors ranked among the highest in the world. A vicious cycle developed because the more short-term the ownership the more economically impractical monitoring became. 
Only after Daewoo’s breakup have investors, together with banks, creditors, suppliers and former employees, finally been stirred to take action. They have brought a host of legal actions against Daewoo companies, managers and accountants.  In May 1999, the Peoples Solidarity for Participatory Democracy (PSPD), Korea’s leading shareholder activist group, filed the first major civil action claiming twenty-four billion won ($20 million) in damages against Woo Choong Kim and senior executives.  Over forty cases seeking a total of 600 billion won ($500 million) apparently were pending in Korean courts at one point. 175] On September 12, 2002, shareholders even won their first civil decision arising out of claims related to Daewoo’s accounting fraud when Kim, former managers of Daewoo Electronics, its accounting firm Anjin and various accountants were held liable for 360 million won ($300,000) for completing false annual reports and audit reports.  During this process, shareholders have been assessed contributory fault for their negligence. In a 2005 case involving Daewoo Electronics, a court held investors partially at fault while allocating different degrees of responsibility between accountants