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Korean J Financ Stud > Volume 53(6); 2024 > Article
신규순환출자 금지제도와 기업의 혁신*

Abstract

This study examines the effect of disproportional ownership structures on firm innovation. To establish a causal relationship, this study employs a difference-in-differences (DID) approach that utilizes Korea’s introduction of circular shareholding restrictions in 2014. The results show that circular shareholding restrictions negatively affect the level of firm innovation, as measured by the firm’s number of patents. This impact is more salient in R&D-intensive firms and industries with higher volatility. These findings suggest that disproportionate ownership promotes firm innovation by shielding managers from short-term equity market pressure.

요약

본 연구는 경영권 보호수단이 기업의 혁신에 미치는 영향을 분석하였다. 경영권 보호와 기업의 혁신의 인과관계를 실증적으로 검토하기 위해, 2014년에 도입된 신규순환출자 금지제도를 중심으로 이중차분법을 활용하였다. 분석 결과, 신규순환출자 금지제도 시행 이후 특허 건수를 기준으로 측정한 기업의 혁신 수준이 감소한 것으로 나타났다. 이러한 감소효과는 연구개발중심 기업과 변동성이 큰 산업에서 더욱 두드러지게 나타났다. 이는 경영자를 자본시장의 단기적인 압박으로부터 보호하는 수단이 기업의 혁신을 촉진할 수 있음을 시시한다.

1. Introduction

The theoretical literature offers two contrasting predictions of how disproportional ownership (Adams and Ferreira, 2008) impacts firm innovation. Disproportional ownership is defined as a mechanism through which controlling shareholders hold a larger proportion of voting than cash flow rights, a deviation from the “one share-one vote” principle. According to the moral hazard (or agency) view, managers who are not effectively monitored or pressured by outside shareholders may shirk or prefer to invest in routine projects that offer quicker and more certain, albeit lower value, returns (Grossman and Hart, 1988; Harris and Raviv, 1988). Therefore, disproportional ownership that shields managers from equity market discipline is likely to discourage their efforts to pursue innovative projects. The moral hazard perspective predicts that disproportional ownership weakens firm innovation.
In contrast, the long-term orientation theoretical literature makes the opposite prediction. Unlike routine projects, innovative activities involve long processes with substantial risk of failure (Holmstrom, 1989). Thus, managers may be more willing to undertake innovative projects when they are less likely to face termination for early failure and more likely to share in the surplus resulting from innovation (Manso, 2011). The long-term orientation view suggests that disproportional ownership can encourage firm innovation by insulating managers from short-term equity market pressures and mitigating managerial myopia.
Given the theoretical literature’s contradictory predictions, how disproportional ownership affects firm innovation becomes an empirical question. Previous research on disproportional ownership employs two primary methodological approaches. The first involves analyzing events that change the degree of proportionality between voting and cash flow rights, such as dual-class recapitalizations (Dimitrov and Jain, 2006; Partch, 1987) and share unifications (Hauser and Lauterbach, 2004; Smart et al., 2008). The second approach uses measures of the wedge between voting and cash flow rights that results from dual-class share structures, pyramids, and cross-shareholdings (Claessens et al., 2002; La Porta et al., 2002). However, using these approaches to identify the causal effect of disproportional ownership on firm innovation is challenging because firm decisions about dual-class adoption, dual-class recapitalization, share unification, and pyramidal and cross-shareholding investments are endogenous (Adams and Ferreira, 2008; Almeida et al., 2011). A firm’s ownership structure and innovation may be jointly determined by unobservable firm characteristics. Additionally, reverse causality, where the level of expected future innovation affects firm ownership structure decisions, may be present. These potential problems hinder drawing causal inferences.
This study addresses these endogeneity issues by utilizing a quasi-natural experiment in Korea—the legislation of circular shareholding restrictions, which were implemented in 2014. Korean business groups, known as chaebols, commonly employed circular shareholding to bolster a large, ultimate shareholder’s control over their affiliated firms. These arrangements formed indirect cross-shareholding loops that involved three or more affiliates (Almeida et al., 2011). This circular shareholding practice led to a significant disparity between cash flow and control rights within chaebols (Claessens et al., 2002). Controlling shareholders of business groups with circular shareholdings are more likely to prioritize their private benefits over minority shareholders’ interests, as their willingness to extract value is less restrained by their cash flow stake. In an effort to enhance the corporate governance of Korean chaebols, an amendment to the Fair Trade Act that was passed on December 31, 2013 became effective on July 25, 2014. The legislation prohibits firms affiliated with large business groups that have total assets exceeding 5 trillion won ($4.8 billion, in 2014) from creating new circular ownerships or making additional investments that reinforce existing ones.
Using firms listed on the Korea Stock Exchange from 2010 to 2018, the difference-in-differences (DID) method is employed to examine how circular shareholding restrictions impact firm innovation, where firm innovation is measured by a firm’s number of patents. The results show that, compared to non-affiliated firms, affiliated firms innovate less after the restrictions were enacted, given similar firm characteristics. Moreover, the negative impact of circular shareholding restrictions on firm innovation is more pronounced in R&D intensive firms and more volatile industries. These results are consistent with the long-term orientation view that disproportional ownership fosters innovation by shielding managers from equity market pressures.
This study contributes to the firm innovation literature by demonstrating the positive effect of disproportional ownership structures on firm patenting activities. Baran et al. (2023) find a positive association between dual-class structures and firm innovation. However, studies on dual-class structures and firm innovation may suffer from omitted variable bias and reverse causality (Adams and Ferreira, 2008; Almeida et al., 2011). This study employs a quasi-natural experiment to address these endogeneity concerns.
The study also contributes to the literature on Korean chaebols by suggesting that business groups positively influence firm performance. Prior research has primarily focused on business groups’ negative aspects, such as tunneling practices that allow controlling shareholders to increase their wealth by transferring resources out of firms (Johnson et al., 2000). These practices have been observed in acquisition activities (Bae et al., 2002), equity-linked private securities offerings, and related-party transactions (Kang et al., 2014). Notably, Mahmood and Mitchell (2004) find that Korean business groups facilitate innovation, showing a positive relationship between group market share and patenting activities. This study adds value to the literature by addressing the endogeneity of group share variables using a regulatory shock.

2. Data and Methods

2.1 Sample

The initial sample comprises all firms publicly traded on the Korea Stock Exchange (KSE) from 2010 to 2018. The list of affiliated firms within large business groups that are subject to circular shareholding restrictions was obtained from the Korea Fair Trade Commission website. Next, patent data were hand-collected from the Korea Intellectual Property Rights Information Service (KIPRIS), including patents awarded through 2020. Finally, financial and accounting data were gathered from DataGuide, which is published by FnGuide, a leading provider of financial data in Korea. To focus on potentially innovative firms, firms were excluded that had zero R&D expenditures in the year before the circular shareholding restrictions were implemented. After removing firms with missing data for the key variables of interest, the sample consists of 447 firms (89 affiliated firms and 358 unaffiliated firms with large business groups) and 3,796 firm-years (743 in the treatment group and 3,053 in the control group).

2.2 Measures

2.2.1 Innovation

To measure a firm’s innovation outcomes, the number of the firm’s subsequently granted patent applications in each year were counted, and then the natural logarithm of one plus the patent count was computed1) (Chen et al., 2017; Choi et al., 2012; Sunder et al., 2017). Consistent with the existing patent literature, patent dates were assigned based on the application rather than grant year, as the application year better captures the actual timing of innovation. Given that the median time lag between a patent’s application and grant dates is two years, the truncation issue, where we may not observe patents that were applied for during the sample period (2010-2018) and were still under review in 2020, may not be significant.

2.2.2 Large business group

The treated group in this study consists of firms prohibited from making new circular shareholding investments by the regulation that took effect in 2014. This restriction applies to firms affiliated with large business groups whose total assets exceed 5 trillion won ($4.8 billion, in 2014). An indicator variable, “Large business group,” is set to one if a firm is affiliated with large business groups subject to the circular shareholding restrictions in 2014, and zero otherwise.

2.2.3 Control variables

To control for time-varying variables that could be sources of omitted firm-level trends, the model includes firm and industry characteristics that may affect a firm’s innovation productivity (Tian and Wang, 2014), such as firm size; profitability, measured by return on assets (ROA); capital expenditure; leverage; growth opportunity, measured by Tobin’s Q; asset tangibility; and industry concentration, measured by the Herfindahl index. Detailed definitions of the variables are provided in Appendix A. All variables with the potential to be unbounded are winsorized at their 1st and 99th percentiles.

2.3 Estimation method

The 2014 amendment to the Fair Trade Act that bans new circular shareholding investments creates the opportunity for a quasi-natural experiment. This regulation acts as an exogenous shock to disproportional ownership in Korean firms. Therefore, the DID method was employed to study the causal effect of the circular shareholding restrictions on a firm’s patenting activities using Eq. (1):
(1)
Innovationi,t=αi+αt+β1Largebusinessgroupi×Aftert+γ'Χi,t+εi,t
where Innovationi,t is the natural logarithm of one plus the number of patents filed by firm i in year t; Large business groupi is an indicator variable that is set to one if firm i is affiliated with a large business group whose total assets exceeded 5 trillion won in 2014. Aftert is a binary variable that is set to one for years after the regulations was implemented (2014-2018) and zero otherwise (2010-2013). Xi,t is a vector of control variables for firm i in year t, αi and αt represent firm and year fixed effects, respectively, and εi,t represents the random error term. All standard errors are computed adjusting for sample clustering at the firm level.

3. Results

3.1 Descriptive statistics

Table 1 provides the main variables’ descriptive statistics. An average firm generates 36 patents (SD = 196) and has a book value of assets equal to $4,358 million in 2014 dollars (SD = 17,715), sales of $2,437 million in 2014 dollars (SD = 6,854), R&D of 1.2% (SD = 2.1), ROA of 1.7% (SD = 8.2), a capital expenditures-to-assets ratio of 3.8% (SD = 4.1), debt ratio of 49.0% (SD = 20.2), Tobin’s Q ratio of 1.158 (SD = 0.648), PPE-to-assets ratio of 34.3% (SD = 17.6), and a Herfindahl index of 0.477 (SD = 0.299).
<Table 1>
Descriptive statistics.
This table reports descriptive statistics for firms listed on the Korea Stock Exchange from 2010 to 2018. Firms with zero R&D expenditures in the year prior to the circular shareholding restriction enactment are excluded (the circular shareholding restrictions took effect in 2014). The sample includes 3,796 firm-year observations. The definitions of all variables are provided in Appendix A.
Mean SD P25 Median P75
Dependent variable
 Log(1+Patent) 1.208 1.633 0.000 0.693 1.946
Control variables
 Size 20.047 1.697 18.926 19.911 20.965
 R&D 0.012 0.021 0.001 0.004 0.013
 ROA 0.017 0.082 0.002 0.025 0.054
 CapEx 0.038 0.041 0.011 0.027 0.057
 Leverage 0.490 0.202 0.333 0.497 0.629
 Tobin’s Q 1.158 0.648 0.820 0.964 1.212
 PPE 0.343 0.176 0.220 0.348 0.463
 HHI 0.477 0.299 0.246 0.410 0.667

3.2 Baseline analysis

Table 2 presents the results of the regression examining the impact of circular shareholding restrictions on firm patenting activities. The results in Model 2 of Table 2 show that the coefficient of Large business group × After is −0.219 (p < 0.05), indicating that the circular shareholding restrictions decrease a firm’s number of patents (more precisely, one plus the number of patents) by 21.9%. The negative effect of the circular shareholding restrictions on firm innovation indicates that the long-term orientation view is more relevant for explaining managerial behavior than the moral hazard view. This finding demonstrates that disproportional ownership stimulates firm innovation.
<Table 2>
The impact of circular shareholding restrictions on firms’ patenting activities.
This table presents the impact of circular shareholding restrictions on the number of patents for firms listed on the Korea Stock Exchange from 2010 to 2018. Firms with zero R&D expenditures in the year prior to the circular shareholding restriction enactment are excluded (the circular share-holding restrictions took effect in 2014). The dependent variable is the natural logarithm of one plus the number of patents applied for during the year. After is an indicator variable set to one for years after the circular shareholding restrictions came into force, and zero otherwise. Large business group is an indicator variable set to one for firms affiliated with business groups whose total assets exceeded 5 trillion won in 2014, and zero otherwise. The definitions of the other variables are provided in Appendix A. Standard errors are clustered at the firm level, and the t-statistics are reported in parentheses. *, **, *** indicate significance at the 10%, 5%, and 1% levels, respectively.
(1) (2)
Dependent variable: Log(1+Patent)
Large business group × After -0.225** -0.219**
(-2.233) (-2.146)
Size 0.139**
(2.497)
R&D 4.913**
(2.435)
ROA -0.144
(-0.804)
CapEx 0.199
(0.440)
Leverage -0.041
(-0.201)
Tobin’s Q 0.042
(1.245)
PPE 0.349
(1.216)
HHI 0.423
(1.300)
Firm fixed effects Yes Yes
Year fixed effects Yes Yes
R2 0.887 0.889
Observations 3,794 3,794

3.3 Endogeneity test

The legislation of the circular shareholding restrictions may have coincided with gradual and unobserved changes in investment opportunities and economic factors specific to affiliated firms within large business groups. To check for the regulation’s potential endogeneity, the dynamics of the number of patents for affiliated and non-affiliated firms before and after the circular shareholding restrictions were implemented are first depicted in Figure 1. Panel A, which shows the average of the natural logarithm of one plus the number of patents (indexing innovation to zero in year t-1), demonstrates common pre-trends between affiliated and non-affiliated firms. This finding indicates that the parallel trends assumption, which is a requirement for the DID identification approach, is likely satisfied. Meanwhile, the trend shows a decline in innovation for both groups, with a steeper drop for affiliated firms after the restrictions were implemented. Therefore, the study findings are not likely driven by the argument that circular ownership structures deter innovation for non-affiliated firms rather than that they facilitate innovation for affiliated firms (Mahmood and Mitchell, 2004).
<Figure 1>
Dynamics of patenting activities.
This figure illustrates the dynamics of the number of patents for treatment and control firms from four years before and after the enactment of circular shareholding restrictions. The restrictions were enacted in 2014. The treatment sample consists of firms affiliated with business groups whose total assets exceeded 5 trillion won in 2014, while the control sample includes the remaining firms. Each point on the graph in Panel A (B) represents the average of the natural logarithm of one plus the number of patents applied for that year by treatment and control firms with (without) indexing the graphs to zero in year t -1.
kjfs-53-6-593-g001.jpg
Next, a formal statistical test is conducted to assess common pre-trends. Specifically, whether the innovation trends in the treatment and control groups are similar before the 2014 implementation of the circular shareholding restrictions is examined using the regression model in Eq. (2) (Jacobson et al., 1993):
(2)
Innovationi,t=αi+αt+k=4k=4βkLargebusinessgroupi×Dk+γ'Χi,t+εi,t
where Dk is a binary variable indicating if an observation occurs k years after the 2014 implementation of the circular shareholding restrictions. One year before the implementation (k = -1) is used as the baseline period, so the dummy variable D-1 is not included in the model. The remaining variables are defined the same way as in the Eq. (1). Standard errors are clustered at the firm level.
The results in Table 3 show that none of the coefficients of Large business group × Before (-4), Large business group × Before (-3), Large business group × Before (-2) are statistically significant. This indicates that there is no significant difference between the treatment and control groups before the circular shareholding restrictions were enacted. This finding of common pre-treatment trends alleviates concerns about endogeneity.
<Table 3>
Dynamic effects of circular shareholding restrictions on firms’ patenting activities.
This table presents the dynamic effects of circular shareholding restrictions on the number of patents for firms listed on the Korea Stock Exchange from 2010 to 2018. Firms with zero R&D expenditures in the year prior to the circular shareholding restriction enactment are excluded (the circular shareholding restrictions took effect in 2014). The dependent variable is the natural logarithm of one plus the number of patents applied for during the year. Before (-4, -3, -2, -1) and After (0, 1, 2, 3, 4) are indicator variables set to one for 4 years before (3 years before, 2 years before, 1 year before) and 0 years after (1 year after, 2 years after, 3 years after, 4 years after) the circular shareholding restrictions came into force, respectively, and zero otherwise. Large business group is an indicator variable set to one for firms affiliated with business groups whose total assets exceeded 5 trillion won in 2014, and zero otherwise. The coefficients of Large business group × Before (-1) are zero by construction. The definitions of the other variables are provided in Appendix A. Standard errors are clustered at the firm level, and the t-statistics are reported in parentheses. *, **, *** indicate significance at the 10%, 5%, and 1% levels, respectively.
(1) (2)
Dependent variable: Log(1+Patent)
Large business group × Before (-4) -0.100 -0.088
(-0.999) (-0.857)
Large business group × Before (-3) -0.025 -0.011
(-0.319) (-0.135)
Large business group × Before (-2) 0.035 0.033
(0.551) (0.509)
Large business group × Before (-1) 0.000 0.000
- -
Large business group × After (0) -0.048 -0.037
(-0.662) (-0.507)
Large business group × After (1) -0.191* -0.179*
(-1.859) (-1.746)
Large business group × After (2) -0.249** -0.224*
(-2.114) (-1.905)
Large business group × After (3) -0.310** -0.301**
(-2.426) (-2.355)
Large business group × After (4) -0.460*** -0.452***
(-3.149) (-3.081)
Firm-level controls No Yes
Firm fixed effects Yes Yes
Year fixed effects Yes Yes
R2 0.888 0.889
Observations 3,794 3,794
Meanwhile, economically substantial and statistically significant negative effects of the circular shareholding restrictions on firms’ technological innovation are observed from one year after the enactment, as shown in Figure 2, which plots the regression coefficient βk in Model 2 from Table 3 at the 90% confidence level. The coefficients gradually increase after the restriction’s enactment. This finding is intuitive, as time is required for changes in innovative behavior to fully impact patent filing and granting.
<Figure 2>
Dynamic effects of circular shareholding restrictions on firm innovation.
This figure illustrates the dynamic effects of circular shareholding restrictions on the number of patents for firms listed on the Korea Stock Exchange from 2010 to 2018. The restrictions were enacted in 2014. Each point on the graph represents the regression coefficient estimates from Equation (2), showing the average difference in the natural logarithm of one plus the number of patents applied for that year between treatment and control firms, controlling for firm characteristics and firm and year fixed effects. The treatment sample consists of firms affiliated with business groups whose total assets exceeded 5 trillion won in 2014, while the control sample includes the remaining firms.
kjfs-53-6-593-g002.jpg

3.4 Cross-sectional test

Cross-sectional tests are performed to more closely examine the negative effect of circular shareholding restrictions on firm innovation. Specifically, whether this effect is more pronounced for R&D intensive firms is examined first. Next, how industry volatility affects the relationship between circular shareholding restrictions and innovation is investigated.
The long-term orientation perspective suggests that managers in R&D intensive firms have stronger incentives to invest in innovative projects under circular ownership structures, as they hold a greater stake in these projects. Thus, the adverse effect of circular shareholding restrictions on firm innovation is expected to be more pronounced in firms with larger pre-reform R&D capital. Consistent with this prediction, the results for Model 1 in Table 4 show that the coefficient estimate for firms with high R&D expenditures in the year prior to the circular shareholding restrictions enactment is significantly more negative (β=−0.667; t=−2.302).
<Table 4>
R&D intensity and industry volatility.
This table presents the impact of circular shareholding restrictions on the number of patents for firms listed on the Korea Stock Exchange from 2010 to 2018 conditional on R&D intensity and industry volatility. Firms with zero R&D expenditures in the year prior to the circular shareholding restriction enactment are excluded (the circular shareholding restrictions took effect in 2014). The dependent variable is the natural logarithm of one plus the number of patents applied for during the year. After is an indicator variable set to one for years after the circular shareholding restrictions came into force, and zero otherwise. Large business group is an indicator variable set to one for firms affiliated with business groups whose total assets exceeded 5 trillion won in 2014, and zero otherwise. High R&D intensity (Low R&D intensity) and High volatility (Low volatility) are groups that include firms with R&D intensity in the year prior to the enactment of circular shareholding restrictions and industry volatility greater than (less than or equal to) the sample median, respectively. Industry volatility is measured by the average cash flow volatility across all firms in the same three-digit KSIC industry during the sample period. The definitions of the other variables are provided in Appendix A. Standard errors are clustered at the firm level, and the t-statistics are reported in parentheses. *, **, *** indicate significance at the 10%, 5%, and 1% levels, respectively.
(1) (2)
Dependent variable: Log(1+Patent)
Large business group × After 0.117 -0.007
(1.157) (-0.075)
Large business group × After × High R&D intensity -0.667***
(-3.883)
Large business group × After × High industry volatility -0.418**
(-2.302)
Firm-level controls Yes Yes
Firm fixed effects Yes Yes
Year fixed effects Yes Yes
R2 0.891 0.889
Observations 3,794 3,794
The long-term orientation hypothesis also suggests that managers’ protection from capital market pressure through circular shareholding ownership is greater in more volatile business environments, where the risk of termination is higher. Consequently, the negative effect of circular shareholding restrictions on innovation is expected to be stronger in industries with higher cash flow volatility (Serfling, 2016). The results for Model 2 in Table 4 support this prediction, showing that the impact of circular shareholding restrictions on firm patenting outcomes is significantly more negative in industries with greater volatility (β=−0.418; t=−2.302).

3.5 Alternative explanation

Additional subsample analyses are conducted to rule out an alternative explanation for the results. Internal financing for innovation may decrease following restriction of circular investments within large business groups. The internal financing hypothesis predicts that circular shareholding restrictions’ negative effect on innovation should be stronger for financially constrained firms. Therefore, the effect is expected to be greater for firms that are smaller in size, have lower ROA, higher leverage, and lower asset tangibility, as these characteristics are associated with financial constraints. However, the results in Table 5 show that the coefficients of the interaction between Large business group × After and these variables are statistically non-significant. Thus, the study findings are not likely driven by the internal financing channel.
<Table 5>
Financial constraints.
This table presents the impact of circular shareholding restrictions on the number of patents for firms listed on the Korea Stock Exchange from 2010 to 2018, conditional on the degree of financial constraint. Firms with zero R&D expenditures in the year prior to the circular shareholding restriction enactment are excluded (the circular shareholding restrictions took effect in 2014). The dependent variable is the natural logarithm of one plus the number of patents applied for during the year. After is an indicator variable set to one for years after the circular shareholding restrictions came into force, and zero otherwise. Large business group is an indicator variable set to one for firms affiliated with business groups whose total assets exceeded 5 trillion won in 2014, and zero otherwise. High size (Low size), High ROA (Low ROA), High leverage (Low leverage), High PPE (Low PPE) are groups that include firms with size, ROA, leverage, and PPE in the year prior to the enactment of circular shareholding restrictions, greater than (less than or equal to) the sample median, respectively. The definitions of the other variables are provided in Appendix A. Standard errors are clustered at the firm level, and the t-statistics are reported in parentheses. *, **, *** indicate significance at the 10%, 5%, and 1% levels, respectively.
(1) (2) (3) (4)
Dependent variable: Log(1+Patent)
Large business group × After -0.033 -0.297** -0.220 -0.134
(-0.209) (-2.252) (-1.153) (-1.033)
Large business group × After × High size -0.216
(-1.151)
Large business group × After × High ROA 0.186
(1.001)
Large business group × After × High leverage 0.002
(0.011)
Large business group × After × High PPE -0.145
(-0.778)
Firm-level controls Yes Yes Yes Yes
Firm fixed effects Yes Yes Yes Yes
Year fixed effects Yes Yes Yes Yes
R2 0.889 0.889 0.889 0.889
Observations 3,794 3,794 3,794 3,794

3.6 Robustness test

The circular shareholding regulation prohibits new circular investments but does not require untangling preexisting ownership loops. Consequently, large business groups are affected by this regulation regardless of whether they have preexisting ownership loops,2) as they lose the mechanism of new circular investments as a shield for managers against takeover threats. However, the legislation mandates that large business groups disclose their circular shareholding information, allowing the Korea Fair Trade Commission (KFTC) to pressure them to dismantle these ownership loops. Consequently, the number of ownership loops for large business groups significantly dropped from 97,660 in 2013 to 483 in 2014, eventually reaching none by 2021.3)
The results of Model 2 in Table 6 indicate that the circular shareholding restrictions negatively impact innovation for large business groups both with (β=−0.574; t=−2.147) and without (β=−0.160; t=−1.492) preexisting ownership loops, with a stronger effect on groups with ownership loops (β=−0.414; t=−1.457). These findings suggest that while the regulation affects all large business groups, those with preexisting ownership loops experienced greater impact due to the untangling process.
<Table 6>
Preexisting ownership loop.
This table presents the impact of circular shareholding restrictions on the number of patents for firms listed on the Korea Stock Exchange from 2010 to 2018, comparing firms with and without preexisting ownership loops. Firms with zero R&D expenditures in the year prior to the circular shareholding restriction enactment are excluded (the circular shareholding restrictions took effect in 2014). The dependent variable is the natural logarithm of one plus the number of patents applied for during the year. After is an indicator variable set to one for years after the circular shareholding restrictions came into force, and zero otherwise. Loop is an indicator variable set to one for firms affiliated with business groups whose total assets exceeded 5 trillion won in 2014 and have preexisting ownership loops, and zero otherwise. Non-Loop is an indicator variable set to one for firms affiliated with business groups whose total assets exceeded 5 trillion won in 2014 and have no preexisting ownership loops, and zero otherwise. The definitions of the other variables are provided in Appendix A. Standard errors are clustered at the firm level, and the t-statistics are reported in parentheses. *, **, *** indicate significance at the 10%, 5%, and 1% levels, respectively.
  (1) (2)
Dependent variable: Log(1+Patent)
Loop × After -0.551** -0.574**
(-2.086) (-2.147)
Non-Loop × After -0.170 -0.160
(-1.615) (-1.492)
Firm-level controls No Yes
Firm fixed effects Yes Yes
Year fixed effects Yes Yes
R2 0.887 0.889
Observations 3,794 3,794
Cohn et al. (2022) find that when the dependent variable is count-like, using the natural logarithm of one plus the outcome variable may produce biased estimates. Therefore, a robustness test is conducted using a fixed effects Poisson model. The results of Model 2 in Table 7 show a coefficient of -0.468 (z=−2.424), suggesting that the circular shareholding restrictions decrease the number of patents by 37.38% (computed as e−0.468−1). This study’s findings are robust to the Poisson model specification.
<Table 7>
Poisson regression.
This table presents the impact of circular shareholding restrictions on the number of patents for firms listed on the Korea Stock Exchange from 2010 to 2018 using a Poisson model. Firms with zero R&D expenditures in the year prior to the circular shareholding restriction enactment are excluded (the circular shareholding restrictions took effect in 2014). The dependent variable is the number of patents applied for during the year. After is an indicator variable set to one for years after the circular shareholding restrictions came into force, and zero otherwise. Large business group is an indicator variable set to one for firms affiliated with business groups whose total assets exceeded 5 trillion won in 2014, and zero otherwise. The definitions of the other variables are provided in Appendix A. Standard errors are clustered at the firm level, and the z-statistics are reported in parentheses. *, **, *** indicate significance at the 10%, 5%, and 1% levels, respectively.
(1) (2)
Dependent variable: Patent
Large business group × After -0.458** -0.468**
(-2.216) (-2.424)
Size 0.046
(0.231)
R&D 4.991
(1.231)
ROA 0.346
(0.272)
CapEx 1.037
(0.615)
Leverage 1.357
(1.476)
Tobin’s Q -0.010
(-0.094)
PPE 1.285
(1.377)
HHI 0.246
(0.224)
Firm fixed effects Yes Yes
Year fixed effects Yes Yes
Observations 3,070 3,070

4. Discussion

Contract theory literature suggests that optimal incentive schemes for motivating innovation differ from standard pay-for-performance schemes. Given the risky nature of innovation, which involves exploring new and untested approaches that often result in failure, standard pay-for-performance schemes that penalize failures with low rewards and possible termination can hinder innovation. Conversely, incentive schemes that demonstrate substantial tolerance for early failure and reward long-term success can foster innovation (Ederer and Manso, 2012; Manso, 2011). In the context of corporate governance, managerial slack boosts managers’ incentives to invest in innovative activities, such as developing new technology, because they face lower risk of termination for early failures and are more likely to benefit from the increased productivity resulting from innovation (Chemmanur and Tian, 2018; Sapra et al., 2014). This study contributes to the existing body of literature on the relationship between corporate governance and firm innovation by suggesting that disproportional ownership structures positively impact firm innovation outcomes.
Despite criticisms that disproportional ownership can lead to agency and entrenchment problems (Gompers et al., 2010), in recent years, U.S. technology firms have increasingly adopted dual-class share structures, the most extreme form of disproportional ownership, during initial public offerings (IPOs), as shown in Figure 3. The rationale behind such structures in tech firms often centers on the need to maintain a long-term strategic vision, protect against short-term equity market pressures, and retain control over the firm’s direction, particularly for innovation.
<Figure 3>
Percentages of Dual-Class IPOs in Technology and Non-Technology Firms
This figure plots the percentages of dual-class IPOs in technology and non-technology firms from 1980 to 2021. A dataset of dual-class IPOs was obtained from Jay Ritter’s website, and the definition of technology firms is based on Loughran and Ritter (2004), with some changes as described on Jay Ritter’s website.
kjfs-53-6-593-g003.jpg
In Korea, adopting dual-class share systems to enhance firm value and promote innovation among listed companies is the subject of an ongoing debate, especially following the restriction of circular shareholding practices, which were commonly used to defend against hostile takeovers (Almeida et al., 2011). Anti-takeover provisions in Korea are limited to supermajority requirements on director dismissals, mergers, and control-related charter amendments, as well as staggered boards and golden parachutes (Hwang and Kim, 2012). However, mechanisms such as dual-class shares, poison pills, and golden shares are not permitted. This study’s empirical findings contribute to this debate by advocating for alternative governance mechanisms that protect managers from hostile takeover threats, thereby fostering technological innovation within firms.

5. Conclusion

This study investigates how disproportional ownership impacts firm innovation. DID methodology is utilized to uncover the negative effect circular shareholding restrictions have on firms’ patenting activities. This finding aligns with the long-term orientation hypothesis, suggesting that disproportional ownership enhances firm innovation. This study’s results imply that ownership structures that shield managers from short-term equity market pressures facilitate establishing sustainable firm competitiveness through innovation. The study’s implications extend to the ongoing debate in Korea regarding the need for alternative governance mechanisms that promote a more conducive environment for innovative firm activities.

Notes

1) One is added to the patent counts to avoid losing observations with zero patents. Additionally, the logarithmic transformation is taken since the distribution of patent counts is highly right skewed.

2) The number of affiliated firms with and without preexisting ownership loops are 15 and 74, respectively.

3) The number of circular ownership loops among business groups with total assets exceeding 5 trillion won from 2010 to 2021 were 295,355; 322,497; 292,892; 97,660; 483; 462; 93; 63; 57; 5; 4; and 0, respectively.

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Appendices

Appendix A.

<Table A1>
Variable definitions.
Variable Definition
Log(1+Patent) The natural logarithm of one plus the number of patents applied for during the year
Large business group An indicator variable set to one if a firm is affiliated with business groups whose total assets exceeded 5 trillion won in 2014, and zero otherwise
After An indicator variable set to one after the circular shareholding restrictions came into force in 2014, and zero otherwise
Before (-4, -3, -2, -1) An indicator variable set to one 4 years before (3 years before, 2 years before, 1 year before) the circular shareholding restrictions came into force in 2014, and zero otherwise
After (0, 1, 2, 3, 4) An indicator variable set to one 0 years after (1 year after, 2 years after, 3 years after, 4 years after) the circular shareholding restrictions came into force in 2014, and zero otherwise
Size The natural logarithm of sales
ROA Operating income divided by total assets
CapEx Capital expenditures divided by total assets
Leverage Total debt divided by total assets
Tobin’s Q Total assets minus the book value of equity plus the market value of equity divided by total assets
PPE Net property, plant, and equipment divided by total assets
HHI The sum of the squared share of each firm in total industry sales at the four-digit KSIC industries


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