The effects of politically connected outside directors on firm performance: Evidence from Korean chaebol firms

• Author: Jae Yong Shin,Seungbin Oh,Hongsuk Yang,Jeong‐Hoon Hyun
• Date: 01 January 2018
• DOI: http://doi.org/10.1111/corg.12203
• Published date: 01 January 2018

ORIGINAL ARTICLE

The effects of politically connected outside directors on firm

performance: Evidence from Korean chaebol firms

Jae Yong Shin

1

|Jeong‐Hoon Hyun

2

|Seungbin Oh

3

|Hongsuk Yang

1

1

College of Business Administration, Seoul

National University, 1 Gwanak‐ro, Gwanak‐gu,

Seoul 08826, South Korea

2

NEOMA Business School, 59 rue Pierre

Taittinger, Reims 51100, France

3

College of Business, University of Wisconsin‐

Eau Claire, 105 Garfield Avenue, Eau Claire,

Wisconsin 54701, United States

Correspondence

Hyun, Jeong‐Hoon, NEOMA Business School,

59 rue PierreTaittinger, Reims 51100, France.

Email: jeong‐hoon.hyun@neoma‐bs.fr

Funding information

The Ministry of Education of the Republic of

Korea and the National Research Foundation

of Korea, Grant/Award Number: NRF‐

2015S1A5A2A03047893. Seed Money from

the NEOMA Business School for Jeong‐Hoon

Hyun.

[Correction added on 16 May 2017, after first

online publication: Additional funding by the

NEOMA Business School was previously

omitted and has been added in this current

version.]

Abstract

Manuscript Type: Empirical

Research Question/Issue: While most prior studies on the value of political connections

focus on the political connections of controlling shareholders and top management, we examine

the performance impact of appointing politically connected outside directors (PCODs) in Korean

chaebol firms.

Research Findings/Insights: Using a manually collected sample of PCODs in Korean

chaebol firms, we find that larger, high‐performing, less volatile firms with a larger board and

higher divergence between voting rights and cash flow rights are more likely to appoint PCODs

in the next year. We also report that firms with a high number of PCODs exhibit better operating

performance and enjoy lower risk. On the other hand, we find evidence of weak monitoring

ability by PCODs. Overall, we suggest that the number of PCODs correlates positively with firm

performance, and that the value effect of PCODs increases with the importance of internal trade

among group affiliates, the existence of inside directorship by controlling shareholders, and

potential settlements from pending litigation. We further differentiate between PCODs and find

that former government officials as PCODs drive our findings.

Theoretical/Academic Implications: This study contributes to corporate governance

knowledge by revealing the relationship between PCODs and firm performance via an empirical

inquiry into the role of PCODs on the board. As the controlling shareholders of Korean chaebol

firms obtain greater private benefits of control, and such firms may face active government

involvement in curbing controlling shareholders’rent extraction, we examine the role and effects

of PCODs in these situations and find evidence of the PCOD's value‐enhancing effect. We also

complement and extend prior studies by providing more direct mechanisms through which

PCODs can add value above and beyond firms’ownership structure. Additionally, we expand

the concept of political connection by analyzing outside directors’human and social capital from

the resource dependence theory perspective. Our attempt complements prior research's

exclusive focus on connections of large shareholders or top executives to political parties and

is more comprehensive in illustrating the firm's dynamic business environment.

Practitioner/Policy Implications: The results of our study are potentially useful to

regulators, who will benefit from an understanding of how the presence of PCODs on boards

affects firm performance. In particular, our results suggest that in countries where recent reforms

aim to improve minority investor protection and market confidence, regulators should consider

the composition of outside directors as well as explicit board independence. The results of our

study may also be useful to investors, financial analysts, and auditors, as they highlight the

importance of considering specific features of board composition when assessing firms’future

operating performance and risk mechanisms.

KEYWORDS

Corporate Governance, Chaebol, Korea, Politically Connected Outside Directors (PCODs)

Received: 3 March 2016 Revised: 8 January 2017 Accepted: 30 January 2017

DOI: 10.1111/corg.12203

Corp Govern Int Rev. 2018;26:23–44. © 2017 John Wiley & Sons Ltdwileyonlinelibrary.com/journal/corg 23

1|INTRODUCTION

As an important internal corporate governance mechanism, the board

of directors is expected to provide both advisory and monitoring

functions. While an extensive body of prior research has investigated

the impact of boards’structural features, such as size and

independence, on their ability to monitor and advise the firm, recent

studies suggest that the political connections of board members could

be another way in which boards can increase firm value (Goldman,

Rocholl, & So, 2009, 2013). Since the government is one of the major

external forces that have a significant impact on firms’operations and

survival, it is natural that firms would try to form connections to

government by appointing board members with such resources

(Pfeffer & Salancik, 1978).

Indeed, prior research on political connections argues that political

connections are valuable to firms since they can facilitate access to

resources for financing and operating activities (Boubakri, Cosset, &

Saffar, 2012; Faccio, 2006; Fisman, 2001; Li & Zhang, 2007). Most

studies on the value of political connections, however, focus almost

exclusively on the political connections of controlling shareholders

and top management (Claessens, Feijen, & Laeven, 2008; Faccio,

2006; Faccio, Masulis, & McConnell, 2006; Fan, Wong, & Zhang,

2007; Fisman, 2001), using empirical proxies for close relationships

between large company shareholders or the CEO and a ruling political

party, and firm‐level campaign contribution data.

In this paper, we intend to contribute to the literature on political

connections by examining the roles and effects of politically connected

outside directors (hereafter PCODs) in Korea using a much broader

definition of political connections than that used in prior research.

We choose to examine the roles and effects of PCODs using Korean

data for the following reasons. First, unlike the political connections

of controlling shareholders or CEOs, the value of a PCOD's political

connections is theoretically ambiguous. On one hand, adding a PCOD

to the board could be beneficial because the PCOD can provide valu-

able human and social capital for the board. In particular, the director

can help secure government contracts or improve relationships with

regulators (Goldman et al., 2009, 2013). On the other hand, PCODs

do not manage their firms and their compensation is usually fixed.

Thus, they may have less incentive to use their professional network

(social capital) or knowledge (human capital) to increase firm value.

Also, PCODs’political connections may not translate into higher firm

value if they simply help controlling shareholders and top management

enjoy greater private benefits of control. Last, while PCODs can

enhance firm value through their political connections, they can be less

effective monitors due to their lack of professional expertise and busi-

ness experience. Taken together, these ambiguous roles of PCODs in

firm value creation provide us with a theoretical tension as we conduct

our empirical analyses of the value impact of PCODs.

Second, Korean business groups (chaebol) provide an ideal

setting to study the performance effects of PCODs. While the

importance of maintaining close ties with government cannot be

overemphasized in virtually all firms, Korea is unique in the sense that

chaebol leaders have worked closely with government at every stage

of Korea's economic growth since the Korean War. Hence, we believe

that Korea provides a very powerful setting to test the roles of

‘politically‐connected’boards in helping firms form linkage with

government (Hillman, 2005).

Third, there is a large body of literature on the causes and

consequences of Korean chaebol (Almeida, Park, Subrahmanyam, &

Wolfenzon, 2011; Baek, Kang, & Lee, 2006; Byun, Choi, Hwang, &

Kim, 2013; Claessens, Djankov, & Lang, 2000; Joh, 2003). In chaebol

firms, the founding family is able to control all the subsidiaries of a

business group through an indirect pyramidal ownership and a circular

holdings structure (Almeida et al., 2011; La Porta, Lopez‐de‐Silanes, &

Shleifer, 1999). Consequently, controlling shareholders engage in

self‐dealing through related‐party transactions and tunneling (Cheung,

Rau, & Stouraitis, 2006; Peng, Wei, & Yang, 2011). However, specific

expropriation practices vary depending on the legal and regulatory

rules concerning such behavior (Johnson, La Porta, Lopez‐de‐Silanes,

& Shleifer, 2000), raising the possibility that firms could add PCODs

to the board to facilitate rent‐seeking beyond actively managing

relationships with government.

Fourth, since the Asian financial crisis, regulators in the Korean

government have taken an active role in governance by issuing a series

of governance reforms to regulate rent‐seeking by controlling

shareholders in chaebol firms. Coupled with potentially greater private

benefits of control by controlling shareholders in Korean chaebol firms,

the active government involvement in curbing controlling share-

holders’rent extraction in chaebol firms also makes Korea an interest-

ing setting to examine the roles and effects of PCODs as chaebol firms

could appoint PCODs because they expect PCODs to protect them

from risk: litigation from rivals, shareholder activists, or minority share-

holders; or formal government investigation. For example, KT&G, a

member in a large Korean business group, appointed Yoonjae Lee, a

former regulator, as an outside director in 2006 when the Icahn hedge

fund attempted a hostile takeover of KT&G. Also, after 2007 when

KT&G lost a lawsuit related to cigarette advertising, the firm appointed

Wonyong Kim, a director of the Korea Broadcasting System.

Moreover, in 2014, KT&G appointed Dongyeol Park, a former officer

in the National Tax Service (NTS) to prepare a lawsuit against this

department.

To fully address these unique institutional features of the Korean

corporate governance system in our paper, we use a much broader

definition of political connections than prior research, which focuses

exclusively on connections with political parties. In our paper, indepen-

dent directors are classified politically connected if they hold or have

held a position as judge, prosecutor, government official, member of

congress, journalist, or social activist. In line with the resource

dependence view of the role of directors, we define political connec-

tions as having the ability to access key constituents surrounding a firm

(Hillman, 2005; Hillman, Cannella, & Paetzold, 2000). For example,

Hillman et al. (2000) emphasize the need to categorize the resource

dependence roles of directors. Hence, our definition of political

connections is expanded to include positions that have traditionally

received little attention in the literature on political connections such

as judge, prosecutor, journalist, or social activist. In Korea, shareholder

activists nongovernmental organizations (NGOs) and the media have

played a major role as external monitors since the Asian financial crisis

(Kim & Kim, 2008). Judges and prosecutors play an increasingly

important role since numerous chaebol heads have recently been put

24 SHIN ET AL.