Tunneling by Related‐party Transactions: Evidence from Korean Conglomerates

• Author: Kyung‐Mook Lim,Sungbin Cho
• DOI: http://doi.org/10.1111/asej.12146
• Published date: 01 June 2018
• Date: 01 June 2018

Tunneling by Related-party Transactions:

Evidence from Korean Conglomerates*

Sungbin Cho and Kyung-Mook Lim

Received 22 July 2015; Accepted 22 December 2017

This study analyzes tunneling created by related-party transactions (RPT) in rela-

tion to controlling shareholders’cash-flow rights. Results of the analysis confirm

a statistically significant relation between cash-flow rights and the earning rates of

major controlling shareholders, indicating a transfer of wealth through RPT

among affiliates of business groups. Furthermore, it is found that more sales made

through RPT out of the total sales result in a higher earning rate, which implies

that RPT affect the differences in earning rates among affiliates.

Keywords: related-party transactions, tunneling, cash-flow rights.

JEL classification codes: G30, G32, G34.

doi: 10.1111/asej.12146

I. Introduction

Traditionally, corporate governance that is supposed to control agency problems

in an effective way has mainly dealt with the conflicts between shareholders and

managers. The financial crisis in East Asia in 1997 and corporate scandals in the

USA have changed this view on corporate governance, such that the problem of

expropriation of minority shareholders by controlling shareholders is attracting

increasingly more attention. In this vein, La Porta et al. (1999; p. 474) argue that

‘the central agency problem in large corporations around the world is that of

restricting expropriation of minority shareholders by controlling shareholders’.

Conflict between controlling shareholders and minority shareholders can be a

serious problem when minority shareholders are unable to properly monitor and

effectively control the discretionary behavior of controlling shareholders. In the

absence of mechanisms to protect minority shareholders, controlling share-

holders have incentives to divert resources of firms to maximize their private

benefits. This is particularly true for East Asia, including Korea, where

*Cho (corresponding author): Department of Economics, Soongsil University, 369 Sangdo-Ro,

Dongjak-Gu, Seoul 06978, Korea. Email: sungbin.cho@ssu.ac.kr. Lim: Futures Management Insti-

tute, CJ CheilJedang Center, 330, Dongho-ro, Jung-Gu, Seoul 04560, Korea. We thank Hideaki

Miyajima for his valuable comments and Seokyun Hur, Taehoon Youn for many discussions. The

views expressed in this paper are those of the authors and do not necessarily reflect those at the CJ

Corporation.

© 2018 East Asian Economic Association and John Wiley & Sons Australia, Ltd

Asian Economic Journal 2018, Vol.32 No. 2, 147–164 147

controlling shareholders with relatively low cash-flow rights control affiliated

firms belonging to business groups.

Since Johnson et al. (2000) coined the term ‘tunneling’to describe situations

of controlling shareholders’self–dealing, several attempts have been made to

investigate the existence and magnitude of tunneling (or propping). A few stud-

ies closely examine related-party transactions (RPT), defined as transactions

among related entities such as shareholders, boards of directors, and affiliated

firms or subsidiaries. Regulatory bodies, investors and other corporate stake-

holders often regard these transactions as a source of potential conflicts of inter-

est that can be detrimental to firm performance. This ‘conflict of interest ’view

on RPT is supported by Johnson et al. (2000), Chang and Hong (2000) and

Betrand et al. (2002), among others. Of course, an alternative view emphasizes

that RPT efficiently fulfill the underlying economic needs of a company. Despite

the current debates on the nature of RPT, relatively little rigorous academic

research has been conducted to evaluate the causes and consequences of RPT.

In this paper, the factors that instigate RPT are explored and evidence on tunnel-

ing is found by examining RPT in relation to the cash-flow rights of controlling

shareholders.

This paper makes the following contributions to the existing literature. First,

we offer a comprehensive description of RPT in Korea during the period

1999–2013. Other studies investigating RPT are conducted for a relatively short

time period.

1

It is therefore difficult to check for any time-series variation, espe-

cially when regulatory and institutional changes have been made. In addition,

most studies use only the aggregated amount of RPT, which does not reflect the

variety of trade situations. Depending on the trading partner, some transactions

could be beneficial and others detrimental. When using aggregate data, one

transaction cannot be differentiated from another transaction because important

characteristics of transactions might be mixed in the process of aggregation. We

therefore use disaggregated trade data instead of aggregate data to check the

different natures of RPT.

Second, we use the detailed ownership data and investigate the association

between ownership structures and RPT. Because of the complex ownership

structures among affiliated firms, the cash-flow rights of controlling shareholders

are not a simple sum of the direct ownership share held by controlling share-

holders and their family. We take this feature of ownership structure into

account, which was not considered in previous studies.

The rest of the paper is organized as follows. Section II reviews the related

literature and Section III examines the nature of RPT in Korea. Section IV

presents the sources and characteristics of the dataset and reports the results of

empirical analyses. Section V concludes.

1 A notable exception is Buchuk et al. (2014), which analyzes intra-group loans in Chile for the

period of 1990 to 2009.

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