Financial Reporting by Business Groups and the Market's Ex ante Valuation of Tunneling: Evidence from Korean Chaebols

This study examines how the Korean stock market reacts to the release of group-level financial statements by Korean business groups (chaebols). I find. that chaebol firms that perform relatively well (measured by ROE) within their group but whose controlling shareholders have low levels of cash-flow rights experience negative price reactions particularly when their group ROE is low. In contrast, chaebol firms whose controlling shareholders have high levels of cash-flow rights do not experience negative price reactions even when their group ROE is negative. These findings are consistent with the market anticipating that "tunneling" will occur in low-cash-flow-right firms, but not in high-cash-flow-right firms, to provide support to poorly performing firms. To corroborate these results, I also examine whether tunneling actually occurs within one year after the group-earnings announcements. I find that in many cases, resources of low-cash-flow-right firms with relatively good performance are actually transferred to poorly performing firms (mostly, unlisted firms) through purchasing new equity of poorly performing firms. Moreover, the magnitude of negative price reactions at the time of group-earnings announcements is significantly related to the magnitude of resources transferred to poorly performing firms.