Privatization of state firms

KT&G highlights importance of corporate governance reform

By Lee Ho-young

Several large government-owned firms have been privatized to improve their operating efficiency and financial health. As government-owned firms are established and operated with taxpayers’ money, they are expected to be managed with the utmost efficiency to provide public services to improve the national welfare.

The taxpayers’ concern with management’s moral hazard and information asymmetry leads to further expansion of privatization. Woori Bank and Incheon International Airport Corp. are recent examples of companies that are considered candidates for privatization.

By examining the KT&G case in mid-2000, it helps interested parties better understand what could happen after privatization. The KT&G case also emphasizes the importance of corporate governance to ensure a successful privatization.

KT&G originated from a government division, known as Jeonmae-Cheong, which literally means a monopolized government organization for dealing in tobacco sales in 1952. It changed its business structure to a government-owned firm in 1987 and then changed its name to KT&G in 1989 under the Framework Act on Management of Government-Owned Firms.

The primary objective of KT&G was to ensure a monopoly profit from tobacco and related businesses for the government. It became a corporation in 1997 and was listed on the Korea Stock Exchange in 1999. In October of 2002, the firm completed its privatization process by selling government-owned shares on the stock exchange.

After privatization, KT&G experienced changes in financial structure and corporate governance. Changes in corporate governance may also be related to operating efficiency. Privatization is one of the ways to reduce the likelihood of efficiency problems as hiring people for political reasons and bad management is much more prevalent within government-owned organizations.

Privatization may not be a perfect solution to these problems. However, it could improve the efficiency because of increased monitoring and the invisible hand inherent in the capital market system. A few expected benefits of privatization may include increased customer orientation, widespread ownership across people, increased monitoring by various interested parties, increased efficiency due to increased competition, and large cash inflows from sales of the ownership, and blocking of inefficient government decisions. Government may also own firms in order to increase employment, income redistribution, infrastructure provision, and achievements of other policy objectives.

On the other hand, the limitations of privatization may include price increase due to pressure for dividends from shareholders, decrease in service quality, a possibility of concentration of ownership by few shareholders, and market failure.

Changes after privatization

While the primary owner of KT&G was the Korean government prior to its privatization, the Industrial Bank of Korea became the largest shareholder owning 10.75 percent of total shares outstanding by purchasing government shares at the end of October 2002.

KT&G had also dramatically increased its foreign ownership after privatization. The foreign ownership of KT&G increased from 16.85 percent in 2001 to 27.03 percent in 2002, to 38.09 percent in 2003, and to 59.34 percent in 2004, suggesting that foreign investors view the privatization as a chance to acquire controlling shares of a profitable company.

Academic studies have stated that increased foreign ownership generally enhances the monitoring mechanism. The company experienced an aggressive acquisition attempt by a corporate raider, Carl Icahn in 2005.

After the privatization occurred, outside board (BOD) members of KT&G accounted for over 70 percent of its composition. As a result, outside board members possessed a greater influence over appointment or dismissal of management than before.

All of independent board members possess the necessary expertise required by the Act on Improvement in Management Structure Improvement and Privatization of Government Owned Firms, Article 9.

All of its outside board members have necessary have expertise in financial, legal, or technology related fields. Outside board members have remained active in terms of attendance rates after the privatization.

Fees paid to its external auditor have generally increased after the privatization while size measured in total assets generally decreased, suggesting that management is willing to pay more audit fees than before, which enhances external monitoring. KT&G did not purchase any non-audit services from its external auditors suggesting that its auditors were less likely to have potential conflict of interests in doing their audit work.

While KT&G did not pay salary to outside board members prior to the privatization, the compensation of independent board members has increased dramatically after its privatization, increasing the responsibility of outside board members.

Improvement in corporate governance

The examination of financial statements surrounding the privatization shows that KT&G increased efficiency and profitability. This may be because of dramatic changes in corporate governance due to BOD effectiveness, compensation and ownership structure in KT&G reducing potential moral hazard with management.

Changes in efficiency are evaluated based on profitability — measured with return on sales (ROS), return on assets (ROA), and/or return on equity ROE, operating activities — measured with sales over number of employees, and/or net income over number of employees, output (sales amount).

Examination of annual reports reveals the following: Profitability measured as ROS, ROE and ROA has significantly increased after the privatization. While sales related efficiency has not significantly improved after the privatization, cost efficiency has improved as indicated with the reduction of cost of sales.

Liquidity has slightly improved after the privatization while the size has decreased. Overall, the results suggest that efficiency improvement comes with the improved effectiveness of corporate governance.

Because of the benefits and limitations discussed, privatization should be carefully conducted in consideration of firm characteristics and circumstances as to achieve both efficiency and public policy objectives.

The objective of privatization can be better achieved when competition increases, preventing firms from forming a monopoly and concentrating their economic power. Privatized firms also need to overcome limitations of their own by improving their corporate governance effectiveness.

Lee Ho-young is a professor of accounting at the School of Business at Yonsei University.