Democratization and Corporate Governance in ... Back? Joongi Kim (Yonsei University)

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Law & Democratization Conference, University of Wisconsin Law School, Oct. 19-20, 2007
Democratization and Corporate Governance in Korea: One Step Forward, Two Steps
Back? Joongi Kim (Yonsei University)
I. Introduction ................................................................................................ 1
II. Transition from a State-Oriented Corporate Governance Framework ................... 2
A. Background ............................................................................................ 2
B. Legal Structure: Commercial Code and Securities Exchange Act ................... 3
III. The State’s Declining Role in the Banking System ......................................... 4
A. Bank Ownership, Privatization and Reforms .............................................. 4
B. The Rise of NBFIs ................................................................................. 5
IV. Soft Regulatory Enforcement: The Tax Authorities ......................................... 7
V. Corporate Governance and Corruption ............................................................ 9
VI. Conclusion ............................................................................................. 12
I.
Introduction
The transition to democracy in 1987 under a new Constitution and the
beginning of Korea’s Sixth Republic set into motion a reconfiguration of Korea’s
corporate governance landscape.1 A prominent transformation involved the role of the
state in corporate governance. From a domineering force in monitoring and supervising
corporates through industrial policy, the state’s influence significantly receded. This
paper will seek to analyze the effect of democratization upon the corporate governance
landscape in Korea.
By comparing the legal framework before and after the onset of
democratization in 1987, this paper will seek to argue that counter-intuitively the state
of corporate governance initially declined with democratization. Shedding the
authoritarian state demanded effective internal and external protections and monitoring
mechanisms to replace it. But they remained lacking. External forces that should have
emerged to shape corporate governance such as banking supervision, legal enforcement
and regulatory oversight, accounting, and investor protections remained in a fledgling
state. Corporate laws remained relatively unchanged, while gatekeepers and watchdogs
did not develop. The state of limbo without effective monitors in place eventually
served as a significant contributor to the rapid spread of the Financial Contagion in
1997. Democratic transitions must accompany sufficient protections to provide
1
President Roh Tae Woo, the first President to hold office in the Sixth Republic, began his 5-year, single
term in February 1988.
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corporate accountability and transparency in order to be successful in the long run.
This paper will attempt to assess the immediate changes in corporate
governance that were brought about by democratization through an analysis of several
sectors. Korea’s leading companies as represented through the large family-controlled
conglomerates, called chaebol, will be the focus for assessing these changes. First, it
will review the reforms that transpired in the financial and banking sector. The changes
in the banking industry through the emergence of non-bank financials institutions in
particular will be reviewed together followed by an analysis of the securities market.
Next the paper will provide an examination of the changes in regulatory enforcement
primarily through the actions taken by tax authorities against companies. Finally, an
examination of the relationship of corporate governance and government corruption will
be conducted to try to understand the changing role of the state. In the end, it will argue
the declining influence of the state that occurred with the consolidation of democracy
beckoned a corresponding need to strengthen market-oriented protections and oversight.
II.
Transition from a State-Oriented Corporate Governance Framework
A. Background
The establishment of the Sixth Republic in 1988 marked the first time in over
17 years that a president was democratically elected based upon popular vote. Under the
new Constitution, a new era of political accountability began to be established. The
heavy hand of the “state-oriented model” of corporate governance began its steady
decline. In the past, as described by Chalmers Johnson, the developmental state was
"plan rational" as opposed to a regulatory state that was "market rational." 2 This
entailed a state that dominated all facets of industrial policy and in turn corporate
governance, from financing to regulatory supervision. Technically, until the early 1990s,
Korea did not even have a common term for “corporate governance.”3
The state managed everything instead. Internal corporate governance in the
form of boards of directors, shareholder meetings, shareholder rights, auditors and
various other institutions existed on a technical level at best. They did not serve as
effective monitors to promote shareholder value and protect the interests of the
2
Chalmers Johnson, MITI and the Japanese Miracle: The Growth of Industrial Policy, 1925-1975
(Stanford: Stanford University Press, 1982), pp. 18-19; Robert Wade, Governing the Market: Economic
Theory and the Role of Government in East Asian Industrialization (Princeton Press 1990).
3
Joongi Kim, A Forensic Study of Daewoo's Corporate Governance: Does Responsibility Solely Lie
With the Chaebol and Korea? Northwestern Journal of International Law and Business, Vol. 28, No. 3
(forthcoming 2007), footnote.
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corporation from expropriation or abuses as designed. Board meetings usually
amounted to a pro forma exercise under which controlling shareholder decisions were
ratified. Shareholder rights in particular were rarely if ever exercised. Shareholder
litigation was practically non-existent and correspondingly director and officer liability
insurance did not exist.
B. Legal Structure: Commercial Code and Securities Exchange Act
Starting from the Sixth Republic, economic policymaking transformed as it
began to be subject to “far greater popular demands and scrutiny.”4 The chaebol, found
themselves in a liberalized atmosphere. 5 Controlling shareholders, who already
dominated their conglomerates, began to adjust to extrication of the state’s influence.
The Sixth Five-Year Economic Plan that started from 1987 consisted of a host of
reforms that dictated reforms in the banking sector and financial sector, chaebol
conglomerates, labor laws, industrial policy and various efforts to guarantee the
freedom of the press. Korea further adopted a host of reforms to fulfill the conditions to
become a member of the OECD and to adopt the Code on Liberalization of Capital
Movements. This entailed additional liberalization of its banking, financial and
corporate system such as lifting ownership restrictions and deregulation.
From a statutory standpoint, however the onset of democratization did not bring
about major legal reforms in corporate or securities law, the two fundamental laws for
corporate governance. Korea’s modern Commercial Code, established in 1962, for
instance, was revised in 1984 and 1995.6 Both revisions, however, did not involve
substantial changes related to corporate governance. Similarly, the Securities Exchange
Act did not undergo any major revisions related to corporate governance during the ten
years leading up to the financial crisis in late 1997. After an amendment in December
1997, the Securities Exchange Act was revised in December 1991, January 1994, and
December 1995, yet none of them involved changes directly related to corporate
governance issues.7 In August 1990, the ownership cap that existed for individual
investors was lifted to stem the sale of equity by the dominant shareholders of major
4
Noland, Marcus. 2000. Avoiding the Apocalypse: The Future of the Two Koreas. Washington, D.C.:
Institute for International Economics. p. 25.
5
Due to overwhelming and representative influence, this paper will assess changes in corporate
governance from the perspective of the chaebol.
7
Nov. 28, 1987, Law No. 3945; Dec. 31, 1991, Law No. 4469; Jan. 5, 1994, Law No. 4701; Dec. 29,
1995, Law No. 5041; Jan. 13, 1997, Law No. 5254. Issues peripheral to corporate governance such as
dividends or par value were adopted.
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listed companies. Individual investors were then allowed to purchase up to the amount
of stock that the dominant shareholder held at the time the company was listed. The
1991 amendments concerned insider trading and strengthening disclosure requirements.
The 1994 revisions include provisions on treasure shares and disclosure. Only in
January 1997, 10 years after the democratization process began, did substantive
corporate governance-related changes such as shareholder rights, tender offers or
stronger auditor provisions appear.
III. The State’s Declining Role in the Banking System
A. Bank Ownership, Privatization and Reforms
Gradual, but significant, changes in the decline of state control occurred in the
banking sector. In the past, bank financing served as the primary means for the
government to implement industrial policy and served as the basis for state-oriented
corporate governance. With an underdeveloped equities market, companies heavily
relied upon debt financing and fiercely competed to obtain it. Hence, the state could
easily use the banks to monitor and supervise corporate behavior. Financial institutions
“largely remained under effective governmental control.”8
In particular, the government channeled this bank credit to the chaebol for them
to serve as the engines for economic development. Perhaps the most powerful example
of the state’s influence and consequently precarious state of the chaebol involved the
Kukje Group’s dismantlement in 1985. The Kukje Group, one of Korea’s largest
conglomerates, was disassembled within a matter of weeks when the government
severed its credit.9
During the 1980s, however, the 5th Republic that existed between 1981 through
1987 commenced the privatization of commercial banks, leading to the fall in state
ownership. By 1983, seven of the largest commercial banks had completed the
privatization process through extensive public offerings. Out of concern that dominant
controlling shareholders might seize control of the banks, ownership in commercial
banks was strictly limited. Over-reaching by the chaebol or foreign banks in particular
was a concern. Most importantly, privatization marked the first step in the
government’s relinquishment of control over direct financing for companies.
Privatization meant that the government would be relinquishing this type of financial
8
9
Graham 2003:59.
Joongi Kim, Legal Change in Post-Authoritarian South Korea, 6 Review of Korean Studies (2003).
work in progress; comments welcome, quotation with permission only
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influence.10
The arrival of democracy in a way negatively transformed government
intervention in the banking sector. A decentralized, weakened state and remnants of
governmental control fueled corruption. Companies obtained loans not based upon
merit but by bribing government officials, family members of powerful politicians, and
bank directors. Banks assumed began to assume disastrous amounts of uncreditworthy
loans. Without the state as the dominant owner and guiding lending decisions, bank
directors became less prone to act on behalf of their shareholders. By 1995, policy loans,
for instance, had declined to 18 percent of bank credit.
B. The Rise of NBFIs
The banking sectors role in chaebol corporate governance significantly
transformed due to the rapid expansion of non-bank financial institutions (NBFI) that
transpired as democratization proceeded. Democratization spurred an atmosphere of
liberalization in the financial industry.11 The rise of NBFIs was an outgrowth of the
changing times. The composition of corporate financing for the chaebol shifted with a
decline in the traditional reliance upon commercial banks that was replaced by the
emergence of NBFIs. NBFI’s share of deposits went from 46.4% in 1985, to 72.2% by
1995, while the relative portion of commercials banks fell from 31.2% to 19.9%.
Similarly, NBFI’s occupied 63.5% of loans in 1995, up from 41.6% in 1985. The share
of specialized banks such as the Korean Development Bank also fell considerably
during the same period for both deposits and loans.
Critical problems emerged with the rise of the NBFIs, many that would later
play a role in the spread of financial contagion to Korea in 1997. First, relative to
banks, not only did the government lack ownership, but also NBFIs remained poorly
regulated and monitored. The state played a much weaker role in the corporate
governance of NBFIs. Furthermore, unlike commercial banks, many of these NBFI’s
were in fact controlled by chaebol. The lax environment allowed NBFIs to engage in
indiscriminate short-term borrowing in foreign currency without proper hedging for
foreign exchange risks. No one later anticipated that the rapid expansion of NBFIs
would lead to the catastrophic results during the financial crisis.
10
Nevertheless, for a considerable period thereafter, the government maintained residual power over the
banks through their ability to hold sway over the selection of bank presidents. Only after the financial
crisis in 1997 when the largest banks faced insolvency did this influence substantially wane as the
government was forced to lift ownership restrictions and allow foreign acquisitions.
11
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<Graph 1 > Corporate Finance: Financial Institution Deposits 1980~1998
Deposit
Market Share(%)
100
80
60
Commercial Banks
40
Specialized Banks
20
NBFIs
0
1980
1985
1990
1995
1998
End of period(year)
Source: Bank of Korea; Hahm
<Graph 2> Corporate Finance: Loans and Discounts 1980~1998
Loans & Discounts
Market Share(%)
100
80
60
Commercial Banks
40
Specialized Banks
20
NBFIs
0
1980
1985
1990
1995
1998
End of period(year)
Source: Bank of Korea, Hahm
With a generous supply of capital from NBFIs, chaebol became more
undisciplined and unsupervised. They assumed too much risk while transparency and
accountability further falling behind as major imperatives. This coincided with the
declining role of the state. Chaebol became adept at utilizing NBFIs, primarily through
life insurance companies, liability insurance companies, investment trusts, and merchant
banks for their financing. They rapidly increased their borrowing from these largely
unregulated and unprotected entities. By 1991, the portion of borrowing from these nonbank financial institutions reached 45 percent among the top 30 chaebol. 12 Meanwhile,
the debt to equity ratio of the top 30 chaebol remained around four-to-one for most of
12
Sakong, Il. 1993. Korea in the World Economy. Washington: Institute for International Economics.
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Law & Democratization Conference, University of Wisconsin Law School, Oct. 19-20, 2007
the period. Hence, bank-based corporate governance monitoring of the chaebol became
increasingly inconsequential. Democratization fostered the lax banking sector.
IV. Soft Regulatory Enforcement: The Tax Authorities
Democratization appears to have softened the impact of regulatory supervision
in corporate governance. As a general matter, prior authoritarian regimes including most
of the 1980s, one of the most powerful government organs to be utilized to check the
chaebol’s corporate governance was the tax authorities.13 Indicators suggest that in the
period starting with the Sixth Republic, tax-related regulatory monitoring declined,
particularly with respect to the chaebol and larger companies. Enormous accounting
problems later surfaced during the financial crisis.
From one perspective, the state abused its regulatory function for political
purposes or as tool for predatory corruption. Regulation themselves was often poorly
designed and difficult to meet compliance. 14 Companies feared the haphazard and
inconsistent application of regulations and rules by the authorities. These problems were
perhaps most pronounced in the tax and accounting arena. The tax authorities were
directly employed to collect political contributions from corporations.15 As revealed in
the slush fund trials, during the authoritarian 5th republic, one of the main reasons the
chaebol made the enormous payments to the President was to seek favor in their tax
audit investigations. 16 Democratization brought greater regulatory transparency,
accountability and consistency. The same slush fund trials revealed that during the 6th
Republic in contrast none of the payments were explicitly made in relation to tax
investigations.
Several presumptions can be gleaned through an analysis of the data on tax
audits that were carried out by the National Tax Administration. As noted in Table _, the
number of tax audits as a percentage of companies declined in 1983 from a high of
18.2% to 3.7% in 1987.17 A declining trend continues thereafter throughout the postauthoritarian period from 5.6% in 1988 to 3.7% in 1994. The decline suggests that one
of the most powerful and effective means to keep companies in check steadily
13
In terms of the state’s regulatory function as a monitor for corporate governance, the other primary
regulator was the Fair Trade Commission (FTC). Yet, the FTC was not active in regulating chaebol
behavior until the early 1990s.
14
Compliance protests.
15
See next section. Slush fund trials.
16
The data however does not distinguish between size of companies that were audited or investigated.
17
1983 is the earliest available data.
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weakened. 18 At first blush, it appears the trend coincides with democratization,
suggesting that the process became fairer and more transparent. Nevertheless, it cannot
be denied that companies might have been becoming more transparent so fewer tax
audits were needed. Tax audits likewise could have become more effective, making
frequency less necessary. The advancement in information technology might have
contributed to transparency and regulatory effectiveness. These possibilities aside a
decrease in the number of audits did occur following the post-authoritarian period.
Another interesting trend is that starting from 1990 the amount of taxes charged
following a tax audit dramatically increased. The amount charged from 1983 through
1989 was approximately 20 million won per company. This increased to 52 million won
in 1990, 55 million won in 1991, 142 million won in 1992, 107 million won in 1993,
109 million won in 1994. Hence, while fewer companies were being investigated,
among those later charged, the paid far higher taxes. This could reflect stronger
determination of the tax authorities to establish regulatory discipline.
18
The next section shows how tax audits were improperly used.
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<Table > Corporate Tax Audits
Year
Companies①
Self-Assessed
Audits
Total
Payment
Audit-Based % of Total
Taxes
Taxes Paid
Taxes
Collected
Companies② ①/②(%)
Taxes④ (million won)
(million won)
(million won)
③
% of
Total
Taxes④
1983
35,424
863,691
6,460
18.2
145,327
16.8
718,364
83.2
1984
38,740
923,535
3,458
8.9
74,328
8.0
849,207
92.0
1985
40,678 1,126,731
3,161
7.8
56,763
5.0 1,069,968
95.0
1986
42,719 1,191,401
2,961
6.9
52,194
4.4 1,139,207
95.6
1987
45,844 1,682,444
2,549
5.6
57,807
3.4 1,624,637
96.6
1988
50,723 2,247,429
2,831
5.6
62,032
2.8 2,185,397
97.2
1989
56,615 3,107,894
3,846
6.8
99,556
3.2 3,008,338
96.8
1990
65,224 3,226,128
3,256
5.0
170,678
5.3 3,055,450
94.7
1991
76,638 4,585,547
3,766
4.9
207,995
4.5 4,377,552
95.5
1992
90,553 5,941,051
2,335
2.6
333,813
5.6 5,607,238
94.4
1993
102,136 5,862,329
4,467
4.4
479,505
8.2 5,382,824
91.8
1994
112,262 7,387,569
4,209
3.7
460,174
6.2 6,927,395
93.8
① Number of companies in operation as of Jan. 1 of each year
② Number of fully or partially audited companies
③ Tax amount collected in the year concerned.
④ Ratio of taxes paid to the total taxes paid by company
Source: Korean National Tax Service, Statistical Yearbooks of National Tax (1983-1994 )
<Graph 3> Corporate Audits
V. Corporate Governance and Corruption
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The effects of democratization upon corporate governance can be gleaned from
another angle through the different nature of corruption that existed before and after
1988 with the transition from the Fifth Republic to the Sixth Republic. The evidence
presented during the 1988 National Assembly Hearings and the 1996 Slush Fund Trials
provide fertile ground to study the effects of democratization and the declining
influence of the state upon chaebol corporate governance. The hearings and slush fund
trials revealed how the bilateral nature of corruption shifted more from a predatory
mode to a rent-seeking manner. Authoritarian states had a greater tendency to threaten
uncooperative companies with disincentives, forcing conglomerates to grant illicit
payments to avoid targeted investigations or sanctions. After democratization, however,
the state shifted toward granting lucrative benefits while the chaebol engaged in rentseeking to obtain these favors. The predatory mode under the authoritarian state
arguably provided a more powerful monitoring function in terms of corporate
governance.
The predatory manner in which the state exercised control over the corporate
sector during the authoritarian Fifth Republic first came to light during the 1988
National Assembly Hearings.19 The Hearings revealed the government’s involvement in
the break-up of companies such as the Kukje Group and 57 other companies that were
abruptly determined to be in “financial distress” in the early part of the regime.20 Kukje,
in particular, was one of the largest conglomerates in the country, but was ostensibly
dismantled for political reasons. It had a tremendous impact in setting an example of the
negative consequences of falling out of favor with state. The investigations also
revealed that the beneficiary companies that acquired the distressed companies received
considerable, preferential governmental incentives during the restructuring process.
Senior government officials and even the Blue House who were directly involved in this
process extracted rents from these companies in return. The distress sales acted as
powerful discipline for the state in taming the corporate sector.
The infamous slush fund trials of that started in 1996 against former President
Chun Doo Hwan and Roh Tae Woo provided further evidence of how the state’s
interaction with conglomerates evolved.21 The defendants in the slush fund aspect of the
trial included not only the former Presidents and former senior government officials but
19
National Assembly Act, Article 65.
White Paper on Restructuring of Defunct Companies, July 21, 1988.
21
Judgment of Aug. 26, 1996, Seoul District Court, 95 Kohap 1228, 95 Kohap 1237, 95 Kohap 1238, 95
Kohap 1320, 96 Kohap 12, 96 Kohap 95; aff’d, Judgment of Dec. 16, 1996, Seoul High Court, 1st
Criminal Division, 96 No 1892, 96 No 1893, 96 No 1894; aff’d, Judgment of Apr. 17, 1997, Supreme
Court, 96 Do 3376, 96 Do 3377. The slush funds corruption charges comprised only one aspect of a trial
that involved multiple, criminal actions.
20
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Law & Democratization Conference, University of Wisconsin Law School, Oct. 19-20, 2007
also a dozen chaebol chairmen.22 Payments ranging from 4 billion won (US$5 million)
to as much as 15 billion won (US$18.8 million) were made to the Presidents on
numerous occasions. Conglomerates collected the funds through complex schemes
under which they laundered illicit corporate money throughout their network of
companies. They then delivered the payments in a clandestine nature usually during
individual, informal closed meetings at the residence of the Presidents.
The trials revealed the enormous power that the presidents could wield to curb
corporate behavior. The courts highlighted the ability of the state to affect “positive
incentives” such as decisions involving large infrastructure projects, social overhead
capital all aspects of corporate operations, financial support, and “negative
disincentives” such as tax audits, trade regulation and withdrawal or denial of licenses
and permits. The Presidents as the head of the government had comprehensive authority
to influence practically any governmental decision.23
Several characteristics emerged that demonstrate the differences between Chun
and Roh and that perhaps partially reflect the transition to a democratized system.24
First, in general, during the Chun administration, more examples can be found where
the payments were made with specific requests to avoid negative disincentives. For
instance, several instances can be found where chaebol chairmen made payments to
avoid regulator action or sanctions such as tax audits.25 In contrast, from a relative
standpoint, the payments made during the Roh administration were generally without
specific requests associated with them or specific consideration in mind and sought
positive incentives. A tremendous amount of benefits and advantages were granted
during the Roh Presidency from the privatization of the telecommunications industry to
infrastructure construction projects and massive defense contracts. Both Presidents
employed the tax authorities to collect campaign funds for party officials before
elections. While funds were expended for political purposes to finance campaign for
party candidates, the Presidents also retained a considerable amount in personal bank
accounts even after they left office.26
Overall, the courts found a sufficient nexus existed between the payments and
22
Lee Gunhee, Samsung Group, Kim Woojung, Daewoo Group, Choi Wonsuk, Donga Group, Chang
Jinho, Jinro Group, Lee Junyong, Daelim Group, Kim Junkee, Dongbu Group, and Chung Taesu, Hanbo
Group.
23
Judgment of Apr. 17, 1997, supra note 21.
24
Chun receiving a total of 225.95 billion won ($282 million) and Roh, 283.896 billion won ($355
million).
25
Hanjin Group, Miwon Group.
26
Although they were not collected according to the Law Prohibiting Solicitations of Contribution, the
defendants tried to argue that the payments were good will contributions to elected politicians. Law No.
224, Nov. 17, 1951.
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Law & Democratization Conference, University of Wisconsin Law School, Oct. 19-20, 2007
the specific acts done by the ex-presidents to declare them as bribes. Although many
payments were not accompanied without any specific requests, the comprehensive
nature of the payments made them bribes given as general compensation for “preference
over other competing companies or at least to avoid any negative consequences.” 27 The
reconfiguration of predation relative to rent-seeking in terms of corruption that
transpired during the two presidential regimes demonstrated another aspect of how the
influence of the state changed with respect to corporate governance.
VI. Conclusion
Although some trends might be coincidental in causation, this paper tries to
provide a framework under which to gain an understanding of the corporate governance
changes that followed Korea’s transition to democracy. Overall, the post-authoritarian
state did not properly provide an alternative to state-oriented model of corporate
governance that had prevailed for Korea’s developmental period. The arrival of
democracy unleashed decades of pent-up demand that sought to shed the state’s heavy
hand. With the decline of the state, the lack of effective checks and balances such as
regulatory supervision and enforcement, rigorous accounting, bank-based monitoring or
shareholder rights created a void. The failure to establish alternative models such as
shareholder or stakeholder-oriented forms of corporate governance to protect investors
and creditors enfeebled Korean conglomerates, leaving them exposed to the disastrous
consequences of the financial crisis.
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27
Judgment of Aug. 26, 1996, supra note 211.
work in progress; comments welcome, quotation with permission only
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Law & Democratization Conference, University of Wisconsin Law School, Oct. 19-20, 2007
Henry Hansmann, Reinier Kraakman, “The End Of History For Corporate Law,” 89
Georgetown Law Journal 439 (January, 2001).
Chalmers Johnson, MITI and the Japanese Miracle: The Growth of Industrial Policy,
1925-1975 (Stanford: Stanford University Press, 1982).
Joongi Kim, “A Forensic Study of Daewoo's Corporate Governance: Does
Responsibility Solely Lie With the Chaebol and Korea?” Northwestern Journal of
International Law and Business, Vol. 28, No. 3 (forthcoming 2007).
------, Legal Change of Post-Authoritarian South Korea, 6 Review of Korean Studies, 6
Review of Korean Studies, 2003
Marcus Noland, Avoiding the Apocalypse: The Future of the Two Koreas, Washington,
D.C.: Institute for International Economics, 2000.
Robert Wade, Governing the Market: Economic Theory and the Role of Government in
East Asian Industrialization (Princeton Press 1990).
work in progress; comments welcome, quotation with permission only
13
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