Opinion on Extending the Fair Trade Commission’s Deadline for Requesting Financial Transaction Information

- August 20, 2003. Fair Trade Commission Advance Notice of Legislation on the Monopoly Regulation and Fair Trade Act -

1. Background and Focus

The right to request financial transaction information (commonly called the account tracking right) was introduced in February 1999 as a system under which, when suspicions are found that a large business group with assets of 2 trillion won or more (currently 49 groups) has engaged in unfair internal transactions, the Fair Trade Commission may require the relevant financial institutions to submit financial transaction information. The Fair Trade Commission may invoke this authority directly without a court warrant. At the time of its introduction, the Fair Trade Commission was granted the account tracking right temporarily for two years to investigate unfair internal transactions by the five largest business groups, and in 2001 it was extended for three more years, with its current expiration scheduled for February 2004.

However, the Fair Trade Commission is now promoting legislation to extend it for another five years on the grounds that 87% of unfair internal transactions by large business groups are carried out indirectly through financial transactions and that the account tracking right is therefore essential to cracking down on unfair internal transactions. Its position is that the situation regarding unfair internal transactions should be evaluated again after five years and then reviewed.

2. Issues and Review

First, the Fair Trade Commission argues that the account tracking right is essential because 87% of unfair internal transactions by large business groups are carried out indirectly through financial transactions. But in today’s monetary economy, almost all transactions involve the transfer of money. Therefore, that reasoning cannot itself be the issue at stake in deciding whether the Fair Trade Commission should have the account tracking right; the real issue is whether internal transactions among affiliated companies are unfair in themselves.

Since the reason the Fair Trade Commission seeks the account tracking right lies in internal transactions within large business groups, its justification must first be supported by the logic that internal transactions among affiliated companies harm either the companies engaging in them or the economy as a whole. Of course, the Fair Trade Commission does not make all internal transactions among affiliated companies illegal. Where legitimate reasons such as cost reductions are proven, such transactions are not regulated.

(1) What Are Internal Transactions?

Transactions are divided into external transactions and internal transactions. External transactions, called market transactions, refer to transactions that individuals or firms conduct with other individuals or firms in the market, while internal transactions refer to transactions carried out within a firm or among affiliated companies within a business group.

Goods and services can also be produced through market transactions. Take the example of a wooden desk. To make a wooden desk, one must first obtain suitable lumber. That lumber is then transported to a sawmill and cut to the proper size, after which a carpenter planes, saws, and nails it together, and then a painter applies paint, completing the wooden desk. Since there are many people in the market who perform such tasks, one can make a wooden desk by using them. However, producing in this way through market transactions involves substantial transaction costs. In other words, it costs a great deal of money.

Accordingly, when the raw materials, equipment, and labor needed to make a wooden desk are gathered in one place, wages and the like are determined by contract, and production is organized, that is precisely an internal transaction. Thus, a firm is fundamentally a productive entity organized in order to carry out internal transactions. Yet it is rare for a firm to make every component that goes into producing a wooden desk. If buying something in the market is cheaper than producing it within the firm, the firm will choose a market transaction instead of an internal transaction. In the production of wooden desks, nails and paint are examples. In other words, a firm compares the costs of market transactions and internal transactions and decides whether to make something itself or buy it. The more developed the market is, the fewer components the firm will produce in-house; this is self-evident.

At this point, both the reason firms emerge as productive entities and the cause of internal transactions have become clear. The same conclusion can be reached even if this discussion is extended to affiliated companies in a business group. In other words, transactions among affiliated companies also arise fundamentally as a means of reducing costs.

(2) Internal Transactions Among Affiliated Companies

The current Monopoly Regulation and Fair Trade Act imposes no sanctions whatsoever on internal transactions within an independent firm. It may be said to reflect a proper understanding of the nature of the firm. However, transactions among affiliated companies in a business group are, in principle, made illegal under the label of “unfair,” except where legitimate reasons such as cost reductions are proven. Let us now examine the Fair Trade Commission’s logic concerning unfair internal transactions and criticisms of it.

First, it argues that through internal transactions, funds of Company A, whose shareholders differ from those of Company B, may be improperly transferred to Company B, thereby harming interested parties such as minority shareholders. Of course, that can happen. But in that case, not only minority shareholders but all shareholders of Company A suffer losses. Therefore, if managers—who have little incentive to act against the interests of all shareholders—engage in internal transactions while accepting short-term losses, this is based on a managerial judgment that such transactions will increase the profits of the business group as a whole and benefit Company A in the long run as well. There is no reason for a third party, who bears no responsibility for the results of that managerial judgment, to intervene.

Second, it is argued that internal transactions exclude independent firms that are not affiliates and thereby block the entry of potential competitors. But in this age of internationalization, in which domestic and foreign economies are being integrated at a rapid pace, internal transactions cannot function as barriers to entry.

Third, it is argued that flotilla-style management, including diversification through internal transactions, causes the entire business group to become unsound. This too may happen. However, it should be recognized that Korea’s large business groups have evolved into production structures that can reduce various transaction costs through diversification.

Fourth, it is argued that firms occupying monopolistic positions in market structure may use internal transactions as a means of shifting monopoly profits to affiliated companies and thereby evading regulation of monopoly profits. But given that the ultimate cause of monopoly is barriers to entry created by the government, this argument is likewise unpersuasive. If only a single firm exists in a competitive market with free entry and exit, then although the market structure may be monopolistic, it simply means that the firm is more efficient than others, and there is no problem.

Fifth, it is said that regulating internal transactions can induce independent management and a governance structure in which ownership and management are separated. But it should be recognized that there is neither theory nor empirical evidence showing that management by professional managers is more efficient. Roe points out that the concept of the separation of ownership and management did not evolve through the market process but was shaped by various legal constraints created for political reasons.

Finally, it should also be recognized that Korea is the only country that imposes legal sanctions on internal transactions among affiliated companies under the label of “unfair.”

(3) Korea’s Large Business Groups

As discussed above, firms are organizations that originally emerge in the process of converting external transactions (market transactions) into internal transactions in order to reduce production costs. Large business groups are also a production structure found not only in Korea but commonly in newly industrializing countries where markets are underdeveloped; they were formed as a means of generating market information and reducing various transaction costs through mutual transactions. In other words, there are good reasons why various business projects are not all absorbed into and internalized within a single independent firm, but instead are carried out through affiliated companies that retain a considerable degree of legal and accounting independence.1)

In this regard, according to Ghemawat and Khanna (1998), many diversified business groups exist in Belgium, Chile, Costa Rica, Hong Kong, France, India, Indonesia, Japan, Malaysia, Mexico, Nicaragua, Pakistan, the Philippines, Russia, Korea, Taiwan, and Thailand.

3. Summary and Conclusion

A firm is an organization that emerges in order to earn profits in the course of reducing transaction costs by converting market transactions into internal transactions in the production of goods and services. Business groups in newly industrializing countries, including Korea, have likewise evolved as entities that create market information and reduce transaction costs through diversification using affiliated companies. Therefore, just as internal transactions within an independent firm are natural, transactions among affiliated companies should also be understood as natural. Since the points that the Fair Trade Commission identifies as the unfairness of internal transactions are, as seen in the analysis above, not logically valid, the argument that it should have the account tracking right in order to crack down on unfair internal transactions is also unpersuasive.

How laws are enacted and enforced greatly affects resource allocation in an economy, and accordingly has a major impact on economic efficiency. It is necessary to think carefully about whether giving the Fair Trade Commission the account tracking right will help create the business-friendly environment the government claims to seek and thereby contribute to achieving per capita national income of $20,000, or whether it will instead drive even existing firms abroad.

Youngyong Kim (Professor, School of Economics, Chonnam National University)

References

Ghemawat P. and T. Khanna, "The Nature of Diversified Business Groups: A Research Design and Two Case Studies," Journal of Industrial Economics, March 1998, pp. 35-61

Jeon, Yoong-Deok and Young-Yong Kim, "Diversified Business Groups and Economic Calculation," mimeo, 2002

Mises, Ludwig von, Economic Calculation in the Socialist Commonwealth, in Hayek, Friedrich A., ed., Collectivist Economic Planning, Clifton, NJ, Augustsa M. Kelly, 1975[1935], pp. 87-130

Roe, M. J., Strong Managers, Weak Owners: The Political Roots of American Corporate Finance, Princeton University Press, 1994

1)

Whether a firm decides to produce a particular component itself or purchase it in the market is also possible only when there is market information generated by market transactions. However, in newly industrializing countries, because markets are underdeveloped, market information on the opportunity cost of specific resources is lacking or inaccurate. Therefore, entrepreneurs can create market information by establishing new affiliated companies and having them transact with one another, rather than internalizing new business opportunities within existing firms, and then use that information in the firm’s profit-and-loss calculations. On this point, see Jeon Yoong-Deok and Young-Yong Kim (2002). In the socialist calculation debate, Mises (1935) pointed out that the principal reason those countries collapsed was that, because private property rights were not recognized, there were no stock or bond markets through which the opportunity cost of capital could be known.

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Original title: 공정거래위원회의 금융거래정보요구권 시한 연장에 관한 의견

Author: Young-yong Kim

Date: 2003-09-09

Source: https://www.cfe.org/bbs/bbsDetail.php?cid=bill&pn=4&idx=25824