&#91OUTLOOK&#93Attack insider trading at the root

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[OUTLOOK]Attack insider trading at the root

The new president of Korea, Roh Moo-hyun, has pledged to continue with reform of the jaebol begun under the administration of Kim Dae-jung. But even before Mr. Roh was inaugurated, a new “toughness” towards the jaebol on the part of the Korean government was signaled.
Chey Tae-won, chairman of SK Corporation, was arrested days before Roh’s inauguration for alleged insider trading involving stocks of the Sheraton Walker Hill Hotel and SK Corporation. This was followed by a summons issued by government prosecutors to Son Kil-seung, the SK Group’s chairman, for questioning on these same matters. Also, the Korea Fair Trade Commission has announced plans to initiate investigations into the activities of the six largest jaebol (Samsung, LG, SK, Hyundai Motor, Hyundai and Hyundai Heavy Industries) later this year on possible insider trades and illegal assistance to affiliates. All of this raises questions as to what further reform of the jaebol is required.
My own view, speaking as a person who has studied the Korean jaebol (but who is, of course, himself an “outsider” who has no affiliation with any of these firms), is that the main priority for reform is to further increase openness. Transparency implies that passive shareholders of the member firms of the jaebol (i.e., those shareholders that do not participate actively in the management of the firms) have access to the same information regarding the financial and operating results of these firms as do managers of the firms, and on a timely basis.
This is important because, if passive shareholders and managers hold the same information, there would, in principle, be no basis for so-called “insider trading.” Insider trading is, in fact, made possible precisely because “insiders” (e.g., senior executives and managers who also are shareholders of a firm) possess information that other shareholders do not have, and are able to make profitable trades based on this information before it becomes more widely disseminated.
The potential for insider trading never can be eliminated entirely for the simple reason that managers of firms, who have daily contact with the operations of their firm, will always be in a position to know things about the firm that have the potential to affect its value sooner than passive investors, who do not have such daily contact. Nonetheless, the worst abuse of such “asymmetries” of information can be eliminated if firms are required to publish accurate financial and operating data on a regular basis, and such information has been audited (i.e., checked for accuracy and completeness) by independent agents.
Unfortunately, in recent years, abuse of informational asymmetries has become commonplace throughout the world, including in countries that long have prided themselves on transparency, such as the United States.
In the United States, such abuses have in fact been magnified by deceptive practices of top executives; for example, in the most famous case, the chief executive officer of Enron, Kenneth Lay, during the summer of 1991 urged investors to buy Enron shares, claiming that he possessed information that suggested that the shares were currently under-priced. But Mr. Lay was lying: the information that he possessed suggested the very opposite.
In fact, Enron shares were over-priced; moreover, he and other top executives of the firm were selling their personal shares at exactly the same time as they were urging investors to buy these shares. This deception at Enron was exacerbated by a conflict of interest involving the firm’s auditor, the Arthur Anderson accounting firm. This firm was selling management consulting services to Enron and, in order to protect this business, Arthur Anderson was willing to certify as accurate financial statements issued by Enron that were themselves incomplete and deceptive.
Enron (like many jaebol-affiliated firms in Korea) held “hidden liabilities” in the form of loans owed to “off-balance sheet” financial subsidiaries. Enron shareholders, other than a small number of insider-shareholders, simply were not informed of these liabilities and indeed had no knowledge of existence of the subsidiaries that held them.
In the matter of transparency, Korea has in fact made enormous strides during the years since the financial crisis of 1997. Firms must prepare financial statements on the basis of the globally accepted International Accounting Standards, and the large jaebol must prepare consolidated financial statements. Standards for auditors have been raised and, unlike in the United States, Korean auditing firms are not allowed to create conflicts of interest by selling both auditing services and management consulting services to the same client.
Even so, much more needs to be done. Although consolidated statements have been prepared by the largest jaebol, they are available for one year only and have not been made widely accessible to the public. In fact, this author has had difficulty finding consolidated information, except in very summary form. Annual reports of Korean companies do not typically contain detailed presentations of financial results and, worse, no equivalent exists in Korea of the U.S. Securities and Exchange Commission form 10K. (This is a financial statement that is required of every firm that is listed on a U.S. stock exchange, and the information on this form is considered to be more accurate than that which is given in firms’ annual reports.)
Moreover, I have found that even professional financial analysts who have access to more detailed financial statements pertaining to Korean firms than I have been able to obtain tend to doubt that these statements fully disclose all relevant information that an outside investor might wish to know about the company.
Until these problems of less-than-full disclosure of financial information are solved in Korea (and elsewhere), there will be opportunities for senior managers of firms to engage profitably in “insider trading.” The priority of the Korean government should not necessarily be to try to prosecute such insider trading every time it occurs. This would be at best a rear-guard action. Rather, the priority should be to take steps to reduce opportunities for such trading to be profitable. This can only be accomplished via creation and enforcement of requirements for significantly greater transparency than currently exists.
This is true even though Korea’s requirements are now much tougher than they were in 1997.

* The writer is a senior fellow at the Institute for International Economics in Washington, D.C. His book, “Reforming Korea’s Industrial Conglomerates” was published by the IIE on Wednesday.

by Edward M. Graham
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