Corporate Governance and Finance in East Asia

A Study of Indonesia, Republic of Korea, Malaysia,Philippines,andThailand

Country Studies

Edited by: Juzhong Zhuang SeniorEconomist RegionalEconomicMonitoringUnit AsianDevelopmentBank David Edwards AssistantChiefEconomist ProjectEconomicEvaluationDivision AsianDevelopmentBank Ma. Virginita A. Capulong SeniorSectorAnalyst AgricultureandSocialSectorsDepartment(West) AsianDevelopmentBank

© Asian Development Bank 2001 Allrightsreserved. ThispublicationwaspreparedundertheAsianDevelopmentBank’sregionalTechnical Assistance 5802: A Study on Corporate Governance and Financing in Selected DMCs. The views expressed in this book are those of the authors and do notnecessarilyreflecttheviewsandpoliciesoftheAsianDevelopmentBank,or itsBoardofDirectorsorthegovernmentstheyrepresent. The Asian Development Bank does not guarantee the accuracy of the data includedinthispublicationandacceptsnoresponsibilityforanyconsequencesfor theiruse. Use of the term “country” does not imply any judgment by the authors or the AsianDevelopmentBankastothelegalorotherstatusofanyterritorialentity . ISBN 971-561-323-3 Publication Stock No. 100800 Published and printed by theAsian Development Bank P.O. Box 789, 0980 Manila, Philippines


List of Tables List of Figures Foreword Preface Abbreviations 1 Indonesia 1.1 Introduction 1.2 OverviewoftheCorporateSector 1.2.1 HistoricalDevelopment 1.2.2 TheCapitalMarket 1.2.3 The Banking Sector 1.2.4 ForeignCapital 1.2.5 GrowthandFinancialPerformance 1.2.6 LegalandRegulatoryFramework 1.3 CorporateOwnershipandControl 1.3.1 CorporateOwnershipStructure 1.3.2 ManagementandInternalControl 1.3.3 ExternalControl 1.4 CorporateFinancing 1.4.1 FinancialMarketInstruments 1.4.2 PatternsofCorporateFinancing 1.4.3 CorporateFinancingandOwnershipConcentration 1.5 TheCorporateSectorintheFinancialCrisis 1.5.1 CausesoftheFinancialCrisis 1.5.2 ImpactoftheFinancialCrisisontheCorporateand BankingSectors 1.5.3 Responses to the Crisis 1.6 Summary, Conclusions, and Recommendations 1.6.1 SummaryandConclusions 1.6.2 Policy Recommendations References vi ix x xi xii 1 1 3 3 4 5 7 8 15 17 17 25 30 32 32 34 35 36 36 39 42 45 45 48 51

2 Republic of Korea 2.1 Introduction 2.2 OverviewoftheCorporateSector 2.2.1 HistoricalDevelopment 2.2.2 Rise of the Large Business Groups (Chaebols) 2.2.3 RoleoftheCapitalMarketandForeignCapital 2.2.4 GrowthandFinancialPerformance

53 53 55 55 60 62 65

iv 2.3 CorporateOwnershipandControl 2.3.1 PatternsofCorporateOwnership 2.3.2 InternalManagementandControl 2.3.3 ShareholderRights 2.3.4 ControlbyCreditors 2.3.5 TheMarketforCorporateControl 2.3.6 ControlbytheGovernment 2.3.7 EmployeeParticipationinCorporateGovernance 2.4 CorporateFinancing 2.4.1 Overview of the Financial System 2.4.2 PatternsofCorporateFinancing 2.4.3 FinancialStructure,Diversification,andCorporate Performance 2.5 TheCorporateSectorintheFinancialCrisis 2.5.1 WeaknessesinCorporateGovernance 2.5.2 TheRoleofGovernmentIntervention 2.5.3 ManifestationsofWeakCorporateGovernanceand GovernmentIntervention 2.5.4 ShortcomingsinMacroeconomicPolicy 2.6 Responses to the Crisis and Policy Recommendations 2.6.1 CorporateRestructuringActivities 2.6.2 PolicyMeasuresforCorporateReform 2.6.3 Policy Recommendations References 3 The Philippines 3.1 Introduction 3.2 OverviewoftheCorporateSector 3.2.1 HistoricalDevelopment 3.2.2 GrowthandFinancialPerformance 3.2.3 LegalandRegulatoryFramework 3.3 CorporateOwnershipandControl 3.3.1 PatternsofCorporateOwnership 3.3.2 CorporateManagementandShareholderControl 3.3.3 TheRoleofCreditorsinCorporateControl 3.4 CorporateFinancing 3.4.1 TheFinancialMarketandInstruments 3.4.2 PatternsofCorporateFinancing 3.4.3 OwnershipConcentration,FinancialLeverage,and Performance 3.5 TheCorporateSectorintheFinancialCrisis 3.5.1 TheFinancialCrisis:CausesandManifestations 3.5.2 ImpactoftheCrisisontheCorporateSector 3.5.3 Responses to the Crisis 74 74 94 103 105 108 110 111 113 113 118 128 130 132 134 134 137 139 139 143 148 153 155 155 156 156 158 167 171 171 186 198 199 199 202 209 210 210 212 214

v 3.6 Summary, Conclusions, and Recommendations 3.6.1 SummaryandConclusions 3.6.2 Policy Recommendations References 216 216 219 226

4 Thailand 4.1 Introduction 4.2 OverviewoftheCorporateSector 4.2.1 HistoricalDevelopment 4.2.2 DevelopmentofCapitalMarkets 4.2.3 GrowthandFinancialPerformance 4.2.4 LegalandRegulatoryFramework 4.3 CorporateOwnershipandControl 4.3.1 PatternsofCorporateOwnership 4.3.2 CorporateManagementandControl 4.3.3 ExternalControl 4.4 CorporateFinancing 4.4.1 OverviewoftheFinancialSector 4.4.2 PatternsofCorporateFinancing 4.5 TheCorporateSectorduringtheFinancialCrisis 4.5.1 ImpactoftheFinancialCrisisontheCorporateSector 4.5.2 Responses to the Crisis 4.6 Summary, Conclusions, and Recommendations 4.6.1 SummaryandConclusions 4.6.2 Policy Recommendations References

229 229 230 230 233 235 239 240 241 244 248 252 252 257 261 261 264 270 270 273 277

vi List of Tables 1. 1988-1996 Table 1. 1996-1998 2. Indonesia Table 1.18 GDP Growth by Sector.19 DER and ROE of Publicly Listed Companies by Sector.4 Development of the Stock Market. 1992-1999 Table 1.7 Growth Performance of the Top 300 Conglomerates.15 V alue of Stocks Issued and Stock Market Capitalization. 1992-1997 Table 1. 1996-1999 Table 1. 1992-1998 Table 2. 1992-1995 Table 1.3 Subsidiaries of the 30 Largest Chaebols Table 2.5 Financial Performance of Publicly Listed Companies by Sector. 1985-1998 6 7 9 11 12 14 14 18 19 21 26 27 28 32 33 34 36 39 40 41 41 54 56 61 63 .9 OwnershipConcentrationofPubliclyListedCompanies by Sector. 1992-1997 Table 1. 1993-1997 Table 1.13 Presence of Board Committees in Listed Companies Table 1.3 GrowthandFinancialPerformanceofPubliclyListed Companies. 1997 Table 1.8 OwnershipConcentrationofPubliclyListedCompanies.17 DER of Listed Companies by Degree of Ownership Concentration Table 1. 1996-1998 Table 1.1 Growth of the Banking Sector. 1990-1997 Table 1.1 Listed Firms with Positive Economic V alueAdded.2 KeyMacroeconomicIndicators Table 2. 1986-1996 Table 1.10 Anatomy of the Top 300 Indonesian Conglomerates. 1990-1998 Table 1.4 Growth Performance of Publicly Listed Companies by Sector. 1992-1997 Table 1.6 GrowthandFinancialPerformanceofState-Owned Companies. Republic of Korea Table 2. 1992-1999 Table 1.11 CharacteristicsoftheBoardofCommissioners Table 1. 1992-1997 Table 1.21 Nonperforming Loans by Type of Bank.16 FinancingPatternsofPubliclyListedNonfinancial Companies.20 ROE of the Banking Sector.12 CharacteristicsoftheBoardofDirectors Table 1.2 Foreign Capital Flows. 1993-1999 Table 1.14 Banking Sector Outstanding Loans.

21 Table 2. 1988-1997 FinancingPatternsoftheNonfinancialCorporateSectorby Industry Financing Patterns of Listed Companies. 1993-1997 The Top 30 Chaebols’ Debt-to-Equity Ratio.25 Table 2. 1987-1997 FlowofFundsoftheNonfinancialCorporateSector.5 Table 2. 1997 Ownership Composition of Listed Nonfinancial Firms by Control Type.15 Table 2. 1999 InternalShareholdingsofthe30Largest Chaebols. 1994-1997 Cross-Payment Guarantees of the Top 30Chaebols.26 Table 2.9 Table 2.20 Table 2. 1988-1997 Features of the 30 Largest Chaebols GrowthandFinancialPerformanceofthe30Largest Chaebols.22 Table 2.11 Table 2.7 Table 2. 1997 Ownership Composition of Listed Firms in Selected Countries. 1988-1997 Ownership Concentration of the Survey Sample of 81 Listed Firms. 1988-1997 FinancingPatternsoftheNonfinancialCorporateSector. 1994-1998 Financing Patterns of the Top 30 Chaebols.6 Table 2.27 Table 2.24 Table 2.30 Private Capital Flows to Korea. 1990-1997 InternationalComparisonofRatiosofOrdinaryIncome toSalesinManufacturing GrowthandFinancialPerformanceofSelectedIndustries GrowthandFinancialPerformanceofListedCompanies. 1995-1997 Ownership Composition of Listed Companies.vii Table 2.16 Table 2.14 Table 2.13 Table 2. 1990 and 1997 Ownership Composition of Listed Nonfinancial Firms by Size. 1985-1997 GrowthandFinancialPerformanceofListedCompanies by Size.10 Table 2. 1997 OwnershipConcentrationofListedNonfinancialFirms by Firm Size.19 Table 2.18 Table 2.17 Table 2. 1985-1998 GrowthandFinancialPerformanceoftheNonfinancial Corporate Sector.23 Table 2. 1992-1997 OwnershipConcentrationofListedNonfinancialFirms.28 Table 2.29 Table 2. 1993-1997 64 66 66 68 70 71 72 73 75 78 80 82 82 83 84 85 86 87 90 91 120 121 122 126 126 127 . 1988-1997 OwnershipConcentrationofListedNonfinancialFirms by Industry.8 Table 2. 1988-1997 Ownership Composition of Listed Nonfinancial Firms by Industry. 1997 Ownership Concentration ofAll Listed Firms.12 Table 2.

6 GrowthandFinancialPerformanceoftheCorporateSector by Firm Size.1989-1997 Table 3. 1997 Table 3.10 Composition of Top Five Shareholders of Philippine Publicly Listed Companies by Sector.9 OwnershipConcentrationatCriticalLevelsofControl Over Publicly Listed Companies.2 Growth and Financial Performance of the Top 1. 1989-1997 Table 3. 1988-1997 Table 3.5 GrowthandFinancialPerformanceoftheCorporateSector by Control Structure. 1988-1997 Table 3.20 Financing Patterns by Industry. andAffiliated Banks of Selected Business Groups. 1988-1997 Table 3.Profitability andFinancial .8 Ownership Composition of Philippine Publicly Listed Companies by Sector.1 Public Companies Registered. 1989-1997 Table 3. 1989-1997 Table 3.2 Public Offerings of Securities. Flagship Company.21 OwnershipConcentration. 1990-1999 Table 3. 1985-1997 Number of Firms with Dishonored Checks. 1997 Table 3.11 TotalandPerCompanySales.19 Financing Patterns by Firm Size. 1989-1997 Table 3.1 GDP Growth of SoutheastAsian Countries. 1983-1997 Table 3. The Philippines Table 3.32 Table 2.4 GrowthandFinancialPerformanceoftheCorporateSector by Ownership Type.3 TheCorporateSectorandGrossDomesticProduct. 1988-1997 Table 3. 1995-1998 4. 1992-1996 Table 3.13 ADB Survey Results on Shareholder Rights Table 3.000 Companies. 1990-1998 131 137 138 158 159 160 161 163 164 166 173 175 176 180 184 191 201 203 204 205 206 207 208 209 212 235 236 3.31 Table 2. 1992-1999 . 1997 Table 3. Thailand Table 4.7 GrowthandFinancialPerformanceoftheCorporateSector by Industry.viii Table 2. 1988-1997 Table 3.16 CorporateFinancing PatternsbyOwnershipType. 1997 Table 3.18 Financing Patterns by Control Structure.17 Composition ofAssets and Financing of the Publicly Listed Sector.33 Net Profit Margins of Chaebols. Leverage Table 3.22 Foreign Investment Flows.SectorOrientation. 1978-2000 Table 4.14 Philippine Stock Market Performance.12 Control Structure of the Top 50 Corporate Entities. 1986-1998 Nonperforming Loans of General Banks.15 Financing Patterns of the Corporate Sector. 1988-1997 Table 3. 1997 Table 3.

1990-1996 External Debt.15 Table 4. 1992-1999 Common-Size Statements for Companies Listed in SET. 1990-1998 StatisticalRelationshipsbetweenCorporateProfitability.2 Figure 3.10 Table 4.16 Table 4.12 Table 4. 1993-1999 Key Financial Ratios of Publicly Listed Companies.5 Table 4. and Company Size Top-Five Shareholder Composition of Publicly Listed Companies in Thailand.14 Table 4. 1985-1996 Average Key Financial Ratios by Company Size. 1990-1996 Financial Ratios of Listed Companies by Ownership Concentration.1 Figure 1. 1985-1999 237 238 239 241 242 243 251 252 256 258 259 260 261 262 264 List of Figures Figure 1. 1985-1996 Top-Five Ownership Concentration of Publicly Listed Companies in Thailand.6 Table 4. 1993-1999 Size and Composition of the Thai Financial Sector. 1990-1998 Merger and Acquisition Activities.3 Table 4.9 Table 4. 1990-1996 Financial Ratios of All Listed Firms.1 Figure 3.13 Table 4.4 Table 4.2 TheSuhartoGroup TypicalInternalOrganizationalStructureofaPublicly Listed Company in Indonesia CorporateControlStructure:TheCaseofAyalaCorporation CorporateControlStructure:theCaseofLopezGroup 24 25 195 197 .7 Table 4.17 StatisticalHighlightsoftheStockExchangeofThailand. Leverage.8 Table 4. 1990-1996 Common-Size Statements of Public Companies by Ownership Concentration. Ownership Concentration. 1992-1999 Offerings of Debt Securities.11 Table 4. 1986-1999 NumberofNewlyRegisteredandBankrupted/Closed Companies.ix Table 4.


Corporate governance has become a major policy concern in the wake of the Asian financial crisis. Weak governance structure, poor investment, and risky financingpracticesofthecorporatesectorintheaffectedcountriescontributedto their sharp economic recession in 1997-1998. The weaknesses in corporate governanceandfinanceunderminedthecapacityofthesecountriestowithstandthe combined shocks of depreciated currencies, massive capital outflows, increased interestrates,andlargecontractionindomesticdemand. Tohelpunderstandcorporategovernanceissuesandtheirimpact,aswell astoidentifyneedsforinterventionsinaddressingpolicyandinstitutionalweaknesses, the Economics and Development Resource Center of theAsian Development Bank (ADB) undertook a regional study on corporate governance and finance in selected developing member countries. The countries covered are Indonesia, Republic of Korea, Malaysia, Philippines, and Thailand. This book presents the major findings of the study. The policy recommendations will supportADB’s financialsectorworkinitsdevelopingmembercountries.

Arvind Panagariya ChiefEconomist


Corporate Governance and Finance in EastAsia presents the findings of a regionalstudyofcorporategovernanceandfinanceinselecteddevelopingmember countries of theAsian Development Bank (ADB). The study attempts to identify theweaknessesincorporategovernanceandfinanceincountriesmostaffected by the 1997Asian financial crisis, and recommends policy and reform measures to address the weaknesses. The study covers Indonesia, Republic of Korea, Malaysia, Philippines, and Thailand. The findings of the study are presented in two volumes. Volume One,A ConsolidatedReport,presentsaframeworkforanalyzingcorporategovernance and finance, summarizes the major findings of the five country studies, and provideskeypolicyrecommendationsforstrengtheningcorporategovernanceand improving the efficiency of corporate finance inADB member countries. Volume Two,CountryStudies,collectsfourcountryreports.Wewouldliketothankcountry experts Saud Husnan of Gadsab Mada University, Indonesia; Kwang S. Chung andYen Kyun Wang of Chung-Ang University, Republic of Korea; FazilahAbdul Samad of University of Malaya, Malaysia; Cesar G. Saldaña of PSR Consulting, Inc., the Philippines; and Piman Limpaphayom of Asian University of Science and Technology, Thailand, for their efforts and cooperation in conducting the countrystudies.CesarG.Saldañaalsoprovidedusefulinputstothepreparation oftheconsolidatedreport. The volumes benefited extensively from constructive comments from ADBstaffandofficialsoftheministriesoffinance,centralbanks,securitiesand exchangecommissions,stockexchanges,andcorporaterestructuringagenciesof theeightADBmembercountriesthatparticipatedinthestudy’sfinalizationworkshop in Manila, on 18-19 November 1999. Our deep appreciation goes to Jungsoo Lee, former Chief Economist, and S. Ghon Rhee, former Resident Scholar, for their strong support at various stages of the study; Manabu Fujimura, for his efforts in organizing the finalizationworkshop;MarceliaGarcia,MarinieBaguisa,Ma.ReginaSibal,andRosanna Benavidez, for their administrative support and assistance; and JosefYap, Leah Sumulong, Graham James Dwyer, Judith Banning,andLynetteMallery, for their editorialassistanceandadvice.


ADB AGM AGSM AMU APEC B BDC BIBF BIS BOC BOD BSDC BSP BUN CB CDRAC CEO CP CRA DER ESOP EVA FDI FSC GAAP GATT GDP GNP HCI IBRA IDFR IEFR IFS IMF IPO IPP JSX NBFI NEFR NPL OECD OTC Asian Development Bank annualgeneralmeeting annualgeneralshareholders’meeting assetmanagementunit Asia-Pacific Economic Cooperation baht Bond Dealers’ Club BangkokInternationalBankingFacility BankforInternationalSettlements board of commissioners boardofdirectors BangkokStockDealingCenter BangkoSentralngPilipinas(CentralBank) Bank Umum Nasional convertiblebond CorporateDebtRestructuringAdvisoryCommittee chiefexecutiveofficer commercialpaper CorporateRestructuringAgreement debt-to-equityratio employee stock ownership plan economicvalueadded foreigndirectinvestment Financial Supervisory Commission generallyacceptedaccountingprinciples GeneralAgreementonTariffsandTrade grossdomesticproduct grossnationalproduct heavyandchemicalindustries IndonesianBankRestructuringAgency incrementaldebtfinancingratio incrementalequityfinancingratio InternationalFinancialStatistics InternationalMonetaryFund initialpublicoffering investmentprioritiesplan JakartaStockExchange nonbankfinancialinstitution newequityfinancingratio nonperformingloan OrganisationforEconomicCo-operationandDevelopment over-the-counter

xiii P PCO PD PICPA PLDT PSE PTB ROA ROE Rp RSA SBL SCS SEA SEC SET SFR SMC SSS SOC TIE TQ W US peso planningandcoordinationoffice PresidentialDecree PhilippineInstituteofCertifiedPublicAccountants Philippine Long Distance Telephone Co. Philippine Stock Exchange principaltransactionsbank returnonassets returnonequity rupiah Revised SecuritiesAct singleborrowerlimit shareofacontrollingshareholder Securities and ExchangeAct Securities and Exchange Commission StockExchangeofThailand self-financingratio SanMiguelCorporation Social Security System State-ownedcompany timesinterestearned Tobin’s Q won UnitedStates

Note: In this volume, “$” refers to US dollars, unless otherwise stated.

1 Indonesia
Saud Husnan1



The currency crisis that began in mid-1997 in Thailand spread quickly to Indonesia and the rest of Southeast Asia. Initially, Indonesia’s monetary authority tried to defend the domestic currency, the rupiah, by widening the intervention band, while maintaining its managed floating system. From 5 to 8 percent in June 1997, when the currency crisis hit Thailand, the band was widened to 12 percent on 11 July 1997 when the crisis started spilling over to Indonesia. After resisting pressure for a short period, the rupiah fell by 6 percent against the dollar on 21 July 1997, the biggest one-day fall in five years. Finally, the Indonesian monetary authority realized that the system could not cope with the continuing pressure on the currency, as the risk of losing all foreign exchange reserves to prop up the rupiah was too high. On 14 August 1997, the monetary authority decided to adopt a free floating exchange rate system. The currency fell further because of strong demand for dollars. As the rupiah weakened, nervous lenders refused to refinance maturing loans, investors cut down and then reversed the flow of funds, borrowers tried to obtain dollars before the rupiah fell further, and individuals joined the chase for dollars. At that time, several banks ran out of dollar notes. From Rp4,950 to the dollar at the end of December 1997, the exchange rate fell to more than Rp15,000 at the height of the crisis in June 1998, although it later stabilized at about Rp9,000. At that exchange rate, it is estimated that half of Indonesian corporations became technically insolvent. The crisis also exacerbated an already deepening political turmoil. The financial crisis devastated the Indonesian economy. In 1998, gross domestic product (GDP) contracted by 13 percent and the inflation

Associate Professor, Faculty of Economics, Gadsab Mada University, Yogyakarta, Indonesia. The author wishes to thank Juzhong Zhuang, David Edwards, both of ADB, and David Webb of the London School of Economics for their guidance and supervision in conducting the study, the Jarkata Stock Exchange for its help and support in conducting company surveys, and Lea Sumulong and Graham Dwyer for their editorial assistance.

Section 1.2 presents an overview of the Indonesian corporate sector. In many instances. Lending activities of affiliate banks that were not sufficiently backed by owners’ equity and the reliance by foreign lenders on the strength of political connections paved the way for risky investments. the Indonesian economy seemed to be in generally good shape. particularly those with large foreign loans. placed a high premium on these political connections in assessing the chances of being repaid. When the crisis hit the country. and analyzes their importance to the corporate sector in Indonesia.6 percent) and trade (-18 percent). these controlling families had political connections that allowed their companies to enjoy special privileges.5 percent. contracting by 36. On the other hand. These were already contributing to high levels of nonperforming loans (NPLs) in the Indonesian banking sector several years before the 1997 crisis erupted. and how it contributed to the crisis. no doubt. The scale of the financial crisis exposed weaknesses of the country’s corporate sector. These banks were allowed to operate even if they violated minimum capital adequacy requirements. In this setup. The highly concentrated and family-based ownership structure of corporate groups and companies resulted in a governance structure where corporate decisions lie in the hands of controlling families. were the ones most affected. regulatory framework. patterns of financing. this left the Indonesian economy extremely vulnerable. prior to the financial crisis. followed by finance (-26. Foreign creditors. To facilitate even easier access to credit. The study also identifies family-based companies and corporate groups. However. The construction sector was the worst hit. or Thailand. highly leveraged companies. II rate reached 58. Section 1. It analyzes the weaknesses of corporate governance in Indonesia. how it has affected corporate financial performance and financing. the currency composition and term structure of corporate foreign indebtedness were causes for concern.2 Corporate Governance and Finance in East Asia. This study reviews the Indonesian corporate sector’s historical development. Malaysia. except utilities. the controlling families of corporate groups often established banks to provide funds to affiliated nonfinancial companies.5 percent. posted negative growth.3 looks at patterns of corporate ownership and control. short-term loans were used to finance long-term investments. All sectors. Vol. and . and responses to the financial crisis. Foreign debt reached more than $100 billion. patterns of ownership and control. Although as a percent of GDP the stock of outstanding foreign debt owed directly by the private sector was smaller than that of the Republic of Korea. Economic growth reached more than 7 percent per year and the inflation rate was kept at single digit levels.

Chapter 1: Indonesia 3 profiles the corporate sector’s governance characteristics. . how it was affected by the crisis. Section 1. Section 1.5 examines the corporate sector during the financial crisis in terms of its role. With the relatively liberal laws governing foreign and domestic private investments introduced by the New Order Government in 1967 and 1968. The Government became directly involved in industry as a result of the nationalization of Dutchowned shipping firms and oil companies. substantial volumes of private investment entered the scene. medium.2 1. textiles. This section reports the results of an Asian Development Bank (ADB) survey on corporate management and control practices in Indonesian publicly listed companies. In the early 1970s.and large-scale companies were dominated by state-run industrial concerns. 1. The industries that emerged were highly import-dependent and reliant on tariff protection. It also examines the statistical relationship between corporate performance and corporate governance characteristics. while Chinese and indigenous entrepreneurs ran some large businesses in trading.1 Overview of the Corporate Sector Historical Development The marked permeability between the State and business in Indonesia goes back to the country’s struggle for independence.4 analyzes corporate financing patterns. in the course of the fight for nationhood from 1942 to 1950. Up until the mid-1960s. Despite the oil revenues. Not all items in the questionnaires were answered by the respondents.2 Section 1. only 40 companies replied—39 are private companies and one state-owned company (Bank BNI). and tobacco industries. a gradual shift in public investment away from manufacturing took place. Subsequently.6 summarizes the major findings of the study and suggests recommendations to improve governance in the Indonesian corporate sector. the windfall from oil and gas revenues was an important factor that allowed the Government to promote industrial development via import substitution.2. 2 Survey questionnaires were sent to 280 companies listed in the Jakarta Stock Exchange. However. and its response.

mostly nonbank financial institutions and stockbrokers. produced consumer goods. the value of manufactured exports overtook the value of oil and gas exports for the first time. Regulations in the banking sector led to equities having higher risk but lower returns than bank deposits. Vol. wood. which dominated their respective sectoral outputs and markets. II the currency needed to be devalued periodically under a managed floating exchange rate system to avoid large current account deficits. 1. Export credits with low interest rates were granted to industries that were intensive in the use of local labor and raw materials. Second.4 Corporate Governance and Finance in East Asia. the number of firms quoted in the stock market was only 24. the Indonesian industrial sector was quite diverse. even when new shareholders do not threaten the control exercised by the original owners.2. . the Government shifted its industrial policy toward the promotion of labor-intensive exports. Generally speaking.2 The Capital Market The Government reactivated the stock exchange in 1977. In the 1980s. But these proved counterproductive because they limited the potential for capital gains to prospective investors. But until the end of 1988. and employed the bulk of the industrial labor force. potentially subjects companies to greater regulatory scrutiny. Third. the stock exchange was also unattractive to companies trying to raise capital as they could borrow from state banks at very low interest rates. there were also many rapidly growing large-scale companies and business groups or conglomerates. Last. A number of underwriters emerged. investors were reluctant to supply funds to the stock market because they did not know whom to trust and the mechanisms that could protect small investors and shareholders against expropriation by controlling shareholders were underdeveloped. Partly as a result of various government policies. While most of the companies were small. the dilution of corporate ownership. In 1992. a distinct industrial elite started to emerge. exports of nonoil products (particularly textiles and footwear. and related products) had shares in total exports that were rapidly increasing. The equity market remained largely unappealing due to a number of factors. the Capital Market Executive Agency and National Investment Trust tried to attract small investors to the stock market by setting prices and preferring small orders in initial public offerings (IPOs). During this period. These were families with strong links to the political elite of the New Order. many founding owners of companies were reluctant to go public and dilute their corporate ownership. By 1987. First.

These included the opening of the banking industry to new entrants.5 trillion.3 The Banking Sector Despite the development of the stock market.2. six SOCs had issued equities in the market. state-owned banks were still among the biggest. reduced restrictions on foreign exchange transactions. which up to then was channeling oil revenues to priority sectors. The Government also allowed foreign investors to buy up to 49 percent of listed shares.1 shows that from 1994 to 1998. Further reforms along the same direction and affecting state-controlled banks came in the 1990s. Consequently. Since 1977. However. with a total value of more than Rp8 trillion. The initial banking sector reform was introduced in 1983. . The banking sector. the liberalization of the banking industry allowed banks to determine lending rates for nonpriority loans. companies could no longer enjoy low-interest credit from state banks. priority credits still enjoyed subsidized interest rates and funding from the Central Bank. to date. the number of listed companies in the stock exchange increased substantially. private domestic banks dominated the sector in terms of number and total assets. Conglomerates carried out 210 out of 257 IPOs. 1. Table 1. from 24 in 1988 to more than 300 in 1997. more significant reforms were introduced. began to face competition. Thus. But in terms of assets per bank. the number of private domestic banks increased. During this period. the capital market played an increasing role in raising long-term funds needed by the corporate sector. Interest rate regulations on state banks and credit ceilings in general were removed. which were previously constrained to 4 percent per day. the legal infrastructure that was supposed to guide the evolution of the banking sector was not backed by effective enforcement. the banking sector has been and still is the major source of credit for the corporate sector. Through the years. However. However. the banking sector has undergone many reforms.Chapter 1: Indonesia 5 At the end of 1988. Partly as a result of these reforms. with a total value of Rp16. The development of the Indonesian stock market also provided a vehicle for the privatization of state-owned companies (SOCs). The Government also abolished the practice of setting prices for IPOs and removed restrictions on price movements in the secondary market. the controlling shareholder of these SOCs is still the State. and increased access of domestic banks to international financial markets. The dominance of state banks started to erode. In 1988.

6 7 12. and Bank International Indonesia (ranked 9th).3 27 51.6 240 1996 1997 1998 1999 141.2 10 14.0 234 1994 104. In terms of assets.4 789. the 10 largest were all affiliated with major business groups.1 240 1995 122. Bank Danamon. Of these. .1 Growth of the Banking Sector.5 528. banks could earn profits even when they did not gather and process information about risk.5 7 7 7 5 15. But the banking system proved incapable of performing its intermediation function.8 391.4 34 12.8 31 10.8 27 200.8 10 37.2 161 214.4 10 35.7 351.5 7 9. private domestic banks among the top 10 in 1997 included Bank Central Asia (BCA) (ranked first and linked to the Salim group).8 29 6.9 31 9.8 27 147.8 166 248.5 27 66.9 27 113. 1993 100. Vol. 1993-1999 Type of Bank State-Owned Banks Assets (Rp trillion) Number of Banks Foreign Banks Assets (Rp trillion) Number of Banks Joint Venture Banks Assets (Rp trillion) Number of Banks Regional Government Banks Assets (Rp trillion) Number of Banks Private National Banks Assets (Rp trillion) Number of Banks Total Assets (Rp trillion) Number of Banks Source: Bank Indonesia.1 10 47.9 39 18. Bank Danamon (ranked 7th). Because regulation was weak.5 27 88.9 291.4 239 222 208 173 Assets and liabilities were concentrated in the top 10 banks. and Bank Umum Nasional (BUN) have failed and the first two are now under management of the Indonesian Bank Restructuring Agency (IBRA). while BUN has been closed down by the Government.6 Corporate Governance and Finance in East Asia.5 165 308.9 10 11. Both BCA and BUN have shareholders linked to the former President Suharto.6 164 144 130 92 387. II Table 1.9 762.8 10 19.6 34 14.6 7 7.7 27 37.9 248. The other banks among the top 10 were state banks.3 201. Among private domestic banks.3 30 7. The deregulation of the banking industry and the liberalization of the capital account created a variety of new sources of financing for the corporate sector.9 304. BCA.3 10 17.

Although these inflows were not nearly as large as those received by Thailand (10 percent of GDP) and Malaysia (9 percent of GDP). when the financial crisis hit Indonesia.78 2.88 4. But FDIs were only one form of foreign capital inflows to Indonesia. From the mid-1980s until July 1997. Net FDI flows increased to $5. Table 1.63) (1. initially from Japan and the Republic of Korea.2. 1.01 (2. they still amounted to a large sum for the economy to absorb.2 Foreign Capital Flows.87 7.59 4. Until the onset of the crisis. foreign creditors were eager to provide financing to Indonesia. as shown in Table 1.4 Foreign Capital The years of rapid industrial growth attracted a large amount of foreign direct investments (FDIs).40) (0. In the 1990s. .00 2. Most FDIs came in through joint ventures with business groups having strong political connections.10 5. there was an explosion of credit for which the probability of repayment was based on little but blind faith in the sustainability of rapid growth and on the presumption that political connections were as good as government guarantees against bankruptcy of borrowers. September 2000. Source: IFS CD-ROM. In effect. such as metal goods.09) (0.88) — — — — — — 8. Indonesia received capital inflows averaging about 4 percent of GDP. especially through bank loans. Increasingly. November 2000.74 5. IMF.09 1.01) (0. Successive policy deregulation facilitated FDIs in various light manufacturing industries. and footwear. textiles.48 1. Between 1990 and 1996.Chapter 1: Indonesia 7 Foreign and domestic banks defaulted on their responsibility of deciding where capital should go and ensuring that it was used in the most effective way. there was a phenomenal growth in direct borrowings by Indonesian corporations. FDI flows were strong. 1990-1998 ($ billion) Type of Flows Net FDI Net Portfolio Investment Foreign Bank Loans 1990 1991 1992 1993 1994 1995 1996 1997 1998 1. foreign investment also had a strong presence in the services and infrastructure sectors.81 3. Joint BIS-IMF-OECD-World Bank Statistics on External Debt.2. In 1994. except in certain strategic sectors.15) — = not available. the Government allowed foreign investors to own 100 percent of an Indonesian company.50 (0.33 (13.09) 1.59 billion in 1996.11 3.

Vol. the analysis focuses only on publicly listed companies. In September 1997. From 1987 to 1996. allowing foreign investors to buy up to 49 percent of stocks of a publicly listed company. Capital account liberalization permitted the inflow of foreign capital that fueled the credit boom in the country. 1. Private borrowers preferred foreign loans since these were relatively cheaper. II Up until the late 1980s. Domestic corporate debt was about $50 billion equivalent. . Between 1989 and 1992. The following section looks at the growth and financial performance of the corporate sector. of which two thirds were rupiah-denominated. In November 1998. The Government relaxed this restriction in 1988.4 trillion in 1997. foreign banks became a significant source of financing for the corporate sector. participation in the Indonesian stock market was exclusive to domestic investors. The private sector left foreign loans unhedged because the depreciation of the rupiah had never reached more than 4 percent annually since the 1986 devaluation under the managed floating system. state-owned companies (SOCs). This increased to 30 percent by the end of 1993. with the onset of the Asian crisis. the average foreign ownership of listed companies was 21 percent. This is lower than the average borrowing rate of 18 percent for loans in domestic currency.8 Corporate Governance and Finance in East Asia. especially the short-term ones.2. the limit on foreign portfolio investment was removed and foreign investors were allowed to buy up to 100 percent of shares of a listed Indonesian company. Consequently. The excessive dollar borrowings made the corporate sector vulnerable to sudden currency fluctuations. increasing the total trading value from Rp8 trillion in 1992 to Rp120. In the 1990s. an interesting question is whether standard measures of corporate profitability and performance also indicated the same. and conglomerates. foreign investors began to dominate daily trading. the average borrowing rate for dollar loans was 9 percent. By the end of 1997. but declined to an average of 25 percent during 19951997. Due to data constraints.5 Growth and Financial Performance While it was obvious that the term structure and currency composition of debt suggested problems in the run-up to the crisis. plus 4 percent for the depreciation of the rupiah. The external corporate debt owed to foreign commercial banks was $67 billion. more than 50 percent of total Indonesian private debt and 60 percent of total foreign exchange debt were owed to 175 foreign banks and other foreign financial institutions. total corporate debt reached nearly $118 billion.

while total assets grew at 43 percent.7 — 250. 1992-1997 (percent) Item Growth Indicators Sales Growth Share of Value Added in GDPa Asset Growth Financial Indicators Debt-to-Equity Ratio Return on Equity Return on Assets Asset Turnoverb 1992 — 3. The debt-to-equity ratio (DER) was high compared to those of listed companies in Malaysia and the Philippines.0 12. Average return on equity (ROE) of listed firms was 11. Table 1.8 230.0 10.6 1994 50.0 64.4 percent. In 1997.2 30. 1994.0 33.3 6.9 37. Source: JSX Monthly (several publications).1 4. a Value added was assumed to be 30 percent of total sales.7 3.3 3.6 percent in 1997.1 percent in 1997 when the crisis began to buffet Indonesia. averaging 3. Note: The number of firms is not identical for each year. 1996. When the crisis battered Indonesia in 1997. and 1992.0 12. total sales of listed companies grew at an annual average rate of 31 percent.6 3. Asset turnover was above 30 percent until 1996.2 7. but declined to 0.3 shows the growth and financial performance of Indonesian publicly listed companies.7 — = not available. Despite such rapid growth.6 48. although the contribution increased over time. Net profits grew at an annual rate of more than 20 percent from 1992 to 1996.7 percent in 1997.1 0. 250 firms.0 6. the average DER increased to 310 percent from 230 percent the .3 Growth and Financial Performance of Publicly Listed Companies. 226 firms.5 34.0 1.8 6. there were 204 firms.5 37. 246 firms. ranging from 220 to 250 percent between 1992 and 1996. b Asset turnover is defined as sales over assets.2 1995 37. 174 firms. 1993.5 34.8 percent between 1992 and 1996.8 220.0 3. but turned negative in 1997.0 11.6 24.4 1997 7. but dropped to 1.4 1996 18. 248 firms.4 38.4 1993 45.5 240.4 31. 1995.5 3.0 12. The growth of listed companies was sustained by continuing investments.Chapter 1: Indonesia 9 Publicly Listed Companies Table 1. During 1992-1997.9 310. publicly listed companies as a group contributed less than 10 percent to GDP. but fell to 24.1 220. Return on assets (ROA) was also relatively stable during 1992-1996.

miscellaneous industry. due mainly to the domination of the International Nickel Company of Canada. The same applied to the trade sector. meanwhile. Most companies in the sector that had unhedged dollar-denominated loans suffered exchange rate losses when the rupiah weakened. The ROE levels suggest that high leverage enabled listed companies to achieve high returns on equity. Four sectors (basic industry and chemicals. still posting a positive but lower ROE. the companies in the sector did not operate with a high leverage. the mining sector ranked first. Vol. Overall. The consumer goods sector ranked second in terms of ROE.5 presents the financial performance of listed companies by sector. although asset turnover was slow. in terms of growth of sales and assets. which operated in nickel and copper mining in 1992 and 1993. the mining sector had the highest ROE. and trade. Also. ROE fell drastically because the sector had one of the highest DERs. mining. finance. the banks eagerly provided credit to property development companies. Table 1. property. trade.7 percent during 1992-1996. Before the crisis. and property. it appeared that the performance of listed companies was quite satisfactory prior to the crisis.4). the dominant sector was the finance sector. However. ROA of all sectors dropped in 1997.3 percent between 1992 and 1996. the fluctuation in nickel and copper prices contributed to the oscillation of ROE. only two sectors (mining and finance) showed a consistently increasing trend from 1992. During those years. the mining sector had the lowest DER. Meanwhile. But the sector’s ROE fluctuated a lot. the property sector was severely affected by the crisis. property. averaging 21. This sector was less affected by the crisis. indicating its reliance on equity to support growth. miscellaneous industry.73 percent in 1992 to 1. real estate. real estate. when the property sector was booming during 1993-1997. When interest rates increased. This indicates that a substantial part of corporate debt was denominated in dollars and unhedged. and services. The Jakarta Stock Exchange (JSX) classified listed companies into nine sectors: agriculture. and building construction. followed by agriculture (Table 1. and trade) even posted . helped in part by the relatively strong demand for consumer goods. and services.2 in 1997. From 1995. The finance. basic industry and chemicals.10 Corporate Governance and Finance in East Asia.64 percent in 1997. In terms of share of value added to GDP. II previous year. investment. and building construction sectors had the highest DERs because companies in these sectors found it easy to obtain credit from banks. The finance sector’s contribution to GDP. with ROE falling to -11. increased from 0. In terms of sales and asset levels in 1997. investment. consumer goods. averaging 17. For instance. infrastructure.

Investment.1 0.7 34.9 1. and Bldg.1 0.7) 17.4 44.6 26.Table 1.5 1.1 32.4 31.9 59.0 0.4 Growth Performance of Publicly Listed Companies by Sector.0 0.7 — 36.5) 49.2 11.2 5.9 25.5 1.3 0.1 1.7 133. and Bldg.2 0.6 (41.5) 13.9 (7.8 50.3 (203.1 0.4 38.8 66.3 0.1 35.9 31. Investment.2 14.6) 25.4 64.4 1993 155.7 24.1 0.2) 0. and Bldg. Real Estate.0 31.0 64..9 8.3 0.9 64.8 29.8 32.5 95.0 (20. Real Estate.7) (113.9 54.9 36.1 71. 1992 — — — — — — — — — — — — — — — — — — — — — — — — — — — 0.3 0.5 0.6 83.6 15.4 1.1 (41.4) 6. Infrastructure Finance Trade.1 — 39.1 23..0 68.6 1.8) 0.5 53.8 1.4 77.0) 46.0 0.6 1994 (75.5) 6.2 35.0 0.4 170. Industry Consumer Goods Industry Prop.5 28. Investment.4) 8.7 17.3 340.3 17.4 103.6) 119.7 54.7 21.4 43.7 62. Industry Consumer Goods Industry Prop.9 0.8 62.1 1.1 16. Real Estate.3) 39. Real Estate.6 85.7 — — 11.0 (192.5 13.3 31.7 1995 51.8) (12.3 31. Infrastructure Finance Trade.3) 53.1 0.1 67.8 0. Constn.6 0. and Services Share of Value Added in GDP Agriculture Mining Basic Industry and Chemicals Misc.6 (0.5 (11.5 45. Constn.2 13.9 54.4 1.3 92.7) 26.6 22.0 43.9 14. and Bldg.1 1.7 28.8 27.3 1. Constn.0 22.0 (28.7) (27.5 61.8 24.7 40.6 28.8 1.6 0.5 (8..4 1.9 .1 0.0 0.4 30.5 92. 1992-1997 (percent) Indicator/Sector Sales Growth Agriculture Mining Basic Industry and Chemicals Misc. Industry Consumer Goods Industry Prop.9 0.5 68. and Services Net Profit Growth Agriculture Mining Basic Industry and Chemicals Misc.3 0.6 133.5 1. Source: JSX Monthly (several publications). Infrastructure Finance Trade.0 16.4 0.1 0.0 1.1 42.1 (11.5 0.7 43.6 0..5 9.6 24.6 0.9 53.0 24.7 112.2 59.8 51.6) 19.8 (76.1 0.1 0.1 0.7 0. and Services Asset Growth Agriculture Mining Basic Industry and Chemicals Misc. Industry Consumer Goods Industry Prop.3 51.6 135.2 41.4 30.7 90.7 0.5 23. Constn.7 (82.1 1.2 41.4 (149.1 1.8 28. Investment.1 28.0 0.9 123.0 18. Infrastructure Finance Trade.0 1996 1997 58.2 0. and Services — = not available.4 21.6 51.

2 3.1 8.0 120.5 14.9 10.9 14.8 25.4 13.0 110.2 8.0 39.2 3.0 70.4 13. and Bldg. Constn.6 74.0 120.5 Financial Performance of Publicly Listed Companies by Sector.0 190.5 4.3 73.5 7.8 16.8 81. Infrastructure Finance Trade.1 10.1 (5.0 180.9 4.1 3.4 4.0 220.3 7.2 7.0 630..1 1994 80.0 70.1 1.6 (11. Industry Consumer Goods Industry Prop.6 23. 1992-1997 (percent) Indicator/Sector Debt-to-Equity Agriculture Mining Basic Industry and Chemicals Misc.2 1993 130.7 8.0) 7.0 14.6 1.4 71.7 8..1 4. Investment. Industry Consumer Goods Industry Prop.7 46.3 18.5 5.8 11.5 17.1 9. and Bldg. Infrastructure Finance Trade.9 40.4 . and Services Return on Assets Agriculture Mining Basic Industry and Chemicals Misc.8 5.1 7.8 8.0 17.7 4.0 160.0 210.2 7.0 80.0 700.0 120.3 17.0 9. Industry Consumer Goods Industry Prop.0 100.6 13.0 69.4 46. and Services Source: JSX Monthly (several publications).7 10.7 10.2) 15.0 100. and Bldg.3 38.7 26.4 35.0 110..5 4.9 38.6 8.0 190.0 560.7 71.0 110.7 (3. Infrastructure Finance Trade.1 63.0 150.3 13.4 35. Infrastructure Finance Trade.6 13.6) 36. Real Estate.1 10.0 680.0 130.1 13.3 5.7 12.0 120.6 14. Investment.6 19.0 180. Investment.2 111.6) 18.0 80.2) 7.9 41.0 170.8 479.0 15.7 4. Real Estate.9 29.0 650.0 60. Real Estate.0 46. Investment.4 6.1 4.0 8.1 9.0 380. Real Estate.4 20.8 67.1 (3.0 140.7 12.8) 8.1 89.0 150. Constn.6 (2.0 160.7 4.4 1.7 5.1 1996 100.5 56.2 11.9 42. Constn. 1992 20.7 9.0 8.0 160.0 190.0 86.0 110.2 (4. and Services Return on Equity Agriculture Mining Basic Industry and Chemicals Misc.8 44. Constn.8 20.9 7.0 1997 230.0 90.7 1.7 1.2 23.2 53.8 9.7 13.7 5.0 650.0 140.9 17. Industry Consumer Goods Industry Prop.5 13.0 180.3 17. and Bldg.5 19.2 30.8 382.0 100.3 33.7 12.1 10.6 8. and Services Asset Turnover Agriculture Mining Basic Industry and Chemicals Misc.4 79.4 6.4 5.0 110.0 100.0 11.2 13.0 70.5 11.0 19.0 3.9 38.8 168.0 50.0 3.4 17.3 0.1 2.2 39.0 66.1 4.8 11.1 65.1 6.Table 1.0 (0.0 80.0 150.6 18.9 87.8 3.5 43.3 1.1 11.3 64..4) (1.2 15.0 110.5 1995 80.3 7.4 46.7 61.0 110.3) 5.7 10.0 12.2 6.

ROA had been at high levels from 1992 to 1995. Just like private companies.1 percent in 1992 to 28. Asset turnover rates were lower relative to those of publicly listed companies. SOCs actively operated in various sectors4 under the supervision of “technical” departments. the Department of Finance supervised 30 SOCs. The finance and miscellaneous industry. respectively.4 percent the following year. the ratio decreased from 8. increasing from 21. While asset turnover rates of publicly listed 3 4 SOCs are those in which the State has at least a 51 percent equity interest. there were 58 SOCs with subsidiaries and affiliates. However.1 percent in 1993. which collectively had the largest assets. much lower than that of companies listed in the stock exchange. the subsidiaries and affiliates number 459 with total assets of Rp343.Chapter 1: Indonesia 13 negative ROA. between 1993 and 1995.6). indicating SOCs’ declining contribution to GDP. insurance (11 companies). . the SOCs’ value added as a percentage of GDP ranged from 6 to 8. registering an average annual rate of 10 percent.7 percent in 1990 to 6 percent in 1996. Trade had the highest ROA of 39. State-Owned Companies At the end of 1995.3 trillion.3 percent in 1995.8 percent between 1992 and 1995 (Table 1. By 1995. there were 165 state-owned companies (SOCs)3 in Indonesia. For instance. growth of net profits and assets was erratic. Similarly. banks (seven companies). The Department of Mining and Energy ranked first in terms of sales of SOCs under its control. but dropped dramatically to 4. Assuming a fixed ratio of value added to sales.7 percent. Taken together. and basic industry and chemicals sectors had relatively stable ROA before the crisis.7 to 7 percent for publicly listed companies. Six SOCs were listed in the Jakarta Stock Exchange. This was relatively high compared to the 3. SOCs diversified into many businesses. These growth rates were low compared to those for listed companies during the same period. This was due to large sales by the National Oil Company (Pertamina). averaging 24 and 31 percent. The DER was slightly higher than for listed companies. The sectoral distribution of 165 SOCs is as follows: nonfinancial (143 companies). SOCs’ ROE ranged from 6. SOCs’ sales growth fluctuated during 1990-1996. Only the agriculture sector showed an increase in ROA in the couple of years before 1997. but it continuously declined from 370 percent in 1992 to 250 percent in 1995.6 to 8. and finance company (four companies).

2 percent in 1997 (Table 1.3 12. mostly private companies.7 13. the contribution of conglomerates to GDP increased from 12.1 6.3 250.7 1994 (9. these conglomerates owned 9.3 30.6 percent in 1994. but climbed to 30.1 trillion in 1990 to Rp234 trillion in 1997.0 6.6 1995 25.4 13.1) 5. but dropped to 11.0 17. Their total sales increased from Rp90. 1992 — 7.0 28.1 310.4 percent in 1994.0 8.8 12. Vol.7).1 32.7 16. Assuming a constant ratio of value added to sales.0 12.4 16.8 21.6) 260.766 business units.14 Corporate Governance and Finance in East Asia.4 13. Source: Indonesian Data Business Center.6 28. a Value added was assumed to be 30 percent of total sales.4 7.5 percent in 1995.2 — 370. 1992-1995 (percent) Indicator Growth Indicators Sales Growth Share of Value Added in GDPa Assets Growth Financial Indicators Debt-to-Equity Ratio Return on Equity Return on Assets Asset Turnoverb — = not available.0 7.1 30.6 28.7 (2. a Value added was assumed to be 30 percent of total sales.5 Conglomerates This study used available data on the top 300 conglomerates in Indonesia.7 Growth Performance of the Top 300 Conglomerates. II companies consistently declined over time. b Asset turnover is defined as sales over assets.2 23.2 18.8 percent in 1990 to 13. SOCs’ asset turnover rates showed a downward trend from 32.1 19.1 12.0 8.4 13.0 24.4 1993 16.8 11. Table 1.2 — = not available. 1990-1997 (percent) Item Sales Growth Share of Value Added in GDPa 1990 1991 1992 1993 1994 1995 1996 1997 — 17.4 percent in 1992 to 28.5 3.6 Growth and Financial Performance of State-Owned Companies. Table 1. In 1997. Source: Indonesian Data Business Center. .

tasked with supervising the firm. such as the appointment (or replacement) of directors. however.2. The law mandates the BOC and BOD to work for the best interests of the company and not just of the shareholders. mergers. For instance. By international standards. The law also specifies that the highest “institution” in the limited company is the shareholders’ meeting. the decision to use certain company assets as collateral for bank credit might need BOC approval. tasked to provide direction to the company. For mergers. a member company might sign a disadvantageous contract with another company where the same controlling shareholder has a higher stake. For instance. The meeting decides on important issues. the legal and regulatory framework of the corporate sector was far from adequate. In general. The 1995 law requires limited liability companies to set up two boards: the board of commissioners (BOC). and the board of directors (BOD). If the BOC does not perform well. The law replaced an earlier statute that was based on the Dutch system. The law explicitly requires approval during the meeting of decisions on strategic issues such as amendment of the company charter (articles of incorporation). and declaration of bankruptcy. This guards against shady intercompany dealings within a group of companies. The company charter details the issues that need shareholder meeting approval. For example. and the accountant. an approval needs the majority (50 percent plus one) vote. commissioners. The BOC. A chairman heads the BOC while a chief executive officer (CEO) heads the BOD. is the only shareholder mechanism for monitoring and controlling the BOD. and consolidations. shareholders lose control. The actual responsibilities of BOCs vary by company and are stipulated in the company’s charter. the Government promulgated a number of laws and regulations to protect investors. acquisitions. The law also holds the directors and commissioners jointly responsible for decisions made by the company. . the decision to amend the company charter should be approved by two thirds of shareholders present in the meeting.Chapter 1: Indonesia 15 1.6 Legal and Regulatory Framework During the 1990s. The BOD undertakes operating decisions while the BOC participates in strategic decisions and operations review. as representative of shareholders. except in strategic issues stated in the law. The Corporate Law The Corporate Law of 1995 governs the establishment and operation of limited liability companies in Indonesia. and the attendance should at least be two thirds of total shareholders.

(v) preemptive rights on new share issues. transparency requirements. investment advisors. (vii) the right to call an emergency shareholders’ meeting. (ix) mandatory shareholders’ approval of interested transactions. The Capital Market Law The Capital Market Law (1995) regulates companies listed in the stock exchange. (x) mandatory shareholders’ approval of major transactions. (viii) the right to make proposals at the shareholders’ meeting. (vi) one share one vote. the decision should be approved by three fourths of the shareholders present. . brokers. decrees of the finance minister. and administrative and legal punishment. A tender offer is also required for acquisitions of up to 20 percent of listed shares. (xiii) mandatory disclosure of nonfinancial information. The law provides the following rights to or protection of shareholders: (i) access to regular and reliable information free of charge. (xvii) mandatory independent board committee. and guidelines promulgated by the head of capital market supervision. Controlling shareholders have no vote on the matter. Examples in the area of corporate governance are guidelines for situations that can potentially lead to conflicts of interest and for acquisitions of substantial shares of listed companies. insider trading (including market rigging and manipulation) investigation. It regulates the requirements of investment companies. (xv) mechanisms to resolve disputes between the company and shareholders. underwriters. and other supporting agencies. (xii) mandatory disclosure of connected interests.16 Corporate Governance and Finance in East Asia. (xiv) mandatory disclosure of intercompany affiliation such as affiliated lending or guarantees. The law is supplemented by Government regulations. consolidations. An important rule is the requirement for independent shareholders’ approval for arrangements that might lead to conflicts of interest. and (xviii) severe penalties for insider trading. (xi) mandatory disclosure of transactions by significant shareholders. delineating the tasks and responsibilities of the Capital Market Supervisory Agency. (iii) proxy voting by mail. II acquisitions. It also regulates reporting and auditing procedures. (ii) proxy voting. Vol. investment managers. (iv) cumulative voting for directors. some listed companies sell no more than a small proportion of shares to the public in order to retain the freedom of the founders to make strategic decisions. securities companies. and bankruptcy. Because of such requirements. (xvi) independence of auditing. and the attendance should at least be three fourths of total shareholders. such as custodian banks and the securities registration bureau.

Ownership concentration is usually measured by the proportion of shares owned by the top one. Banking regulations also set lending limits.g. five. A new bankruptcy law was passed in August 1998. However. capital adequacy. For instance. The court can declare the debtor bankrupt upon the request of at least two creditors and default on one loan.3 Corporate Ownership and Control This section looks at the ownership structure of the corporate sector and reports the results of an ADB survey on corporate management and control of publicly listed companies. the collateral could take the form of nonphysical assets (e. The two most important elements of ownership structure are concentration and composition. A Commercial Court was also set up to deal with bankruptcy cases. etc.. Discussions on corporate ownership cover listed companies and conglomerates. or 20 shareholders. The old bankruptcy law based on the Dutch system was biased in favor of debtors and made it almost impossible for creditors to seek court resolution when debtors defaulted. Banking Laws Affecting the Corporate Sector Some elements of the banking law also affect the corporate sector. 1. or financial institutions. net open positions.3.1 Corporate Ownership Structure Quality of corporate governance is closely related to corporate ownership structure (see discussions in the Consolidated Report of this study). the Banking Law (1992). holding companies.Chapter 1: Indonesia 17 Bankruptcy Law Despite loan covenants. . It aimed to protect creditors by providing easier and faster access to legal redress. amended in October 1998. Unsecured creditors could proceed against a debtor in default based on loan covenants and through the legal process of collection against the latter’s assets. the viability of a project). whether they are individuals. It reveals characteristics of controlling shareholders. families. for instance. creditors of unsecured loans are unprotected when borrowers fail to meet their obligations. 1. states that a bank is not allowed to provide credit without collateral.

6 68. issued 93. When a company goes public.9 percent of total outstanding shares.7 3.2 11.6 3.1 1. 13.0 67.3 1995 47. This is partly due to the prevailing practice of raising equity through rights issues in Indonesia. 1993-1997 (percent) Shareholder Rank First Largest Second Largest Third Largest Fourth Largest Fifth Largest Total 1993 50. Data from the Indonesian Capital Market Directory (various publications) show that between 1993 and 1997.5 16.0 0.0 0. The percentage owned by each of the five largest shareholders was 48.6 13.6. about two thirds of publicly listed companies’ outstanding shares were owned by corporations that were directly or indirectly controlled by families.6 percent. II Publicly Listed Companies Table 1. The pattern of ownership concentration changed little over this period.9.5 percent.5 1997 48. Vol.9 2. ownership widely held by the general public is highest in the infrastructure and transportation sector (not shown in the table). and 0.0 2. the founder usually continues to own the majority of shares through a .5 72.9 Source: The Indonesian Capital Market Directory.7 1994 48. This is because a few companies in the transportation sector issued high proportions of shares to the public.7 1996 48. Rig Tenders Indonesia (shipping services) issued 51.6 3.0 4. mining.6 4. Table 1. and basic industry and chemicals sectors than in others.8 Ownership Concentration of Publicly Listed Companies.5 12. for instance.9 2.2 1. This preserves the pro rata share of existing shareholders.9 14. the controlling shareholders usually act as standby buyers. 2. Table 1. Zebra Nusantara (taxi services). 3. On average.4 2. respectively. the five largest shareholders owned 68.9 0. Meanwhile.8 1.1 0.1 4.4 percent.8 shows average proportions of shares owned by the five largest shareholders of publicly listed companies during 1993-1997.6.18 Corporate Governance and Finance in East Asia. When a company makes a rights issue. and Berlian Laju Tankers (liquid bulk maritime transportation services) issued 48.9 shows that ownership by the largest shareholder in 1997 was more concentrated in the agriculture.8 68.8 68.8.2 67. consumer goods.1 13.5 Average 48.0 1.

3 2. Investment.0 5. as well as the existence of corruption.1 percent) of Indonesian publicly listed companies were in family hands.9 3.6 0.7 percent of the market.7 1.1 0.9 44.6 1. Table 1.1 1. that the correlation between the share of the largest 15 families in total market capitalization. the rule of law. and Services Average Source: The Indonesian Capital Market Directory.4 6.8 14.1 2. Infrastructure. in a cross-country study.5 4. which shows that in 1996.2 2.. Most of the five largest owners of Indonesian publicly listed companies are limited liability companies rather than individuals.6 percent were widely held. two thirds (67.6 percent of total market capitalization while the top 15 families control 61.3 0.2 46.7 13.1 2.1 0. (1999).6 9.9 50. 1997 (percent) Sector Agriculture Mining Basic Industry and Chemicals Misc.2 0.7 6.7 9.4 54. (1999) also found. the top family controls 16.4 4.1 2. Legal and regulatory developments may have been impeded by the concentration of corporate wealth in .2 10. and Transportation Finance Trade. on the one hand.9 0.9 44. on the other.2 15. Real Estate.3 48.. and Bldg. Claessens et al.9 1.7 4.4 11.1 13.Chapter 1: Indonesia 19 fully-owned limited liability company (Perseroan Terbatas).6 2. Constn. Industry Consumer Goods Industry Prop.5 58. These figures suggest that ultimate control of the corporate sector rests in the hands of a small number of families. First Second Third Fourth Fifth Biggest Biggest Biggest Biggest Biggest 54.6 8.9 Ownership Concentration of Publicly Listed Companies by Sector.1 1.3 14.4 1. and corruption.1 1.4 44.1 1.3 36.1 11. Indonesia has the largest number of companies controlled by a single family. The findings suggest that the concentration of corporate control in the hands of few families is a major determinant of the evolution of an inefficient legal and judicial system. and the efficiency of the judicial system. Util. In terms of capitalization. and only 0. In fact.5 1.2 This is confirmed in Claessens et al. Thus the founder keeps the proportion of shares necessary to retain control over management of the listed firm. is strong.3 0.

Family control is said to have positive effects in that it allows group members in conglomerates to make strategic decisions quicker. or other ethnic groups. and Padang. Among the top 300 conglomerates. During 1988-1996. the onset of the crisis negated this development. their number increased to 5 In 1997. political affiliation. was able to create a favorable environment for business development. ethnicity.55 percent in August to 25. In 1993. with all its regulations. there is a dichotomy between corporations owned by indigenous and nonindigenous businesspeople. conglomerates established before 1969 dominated in terms of sales. The nonindigenous businesspeople are usually Chinese. If the role of a limited number of families in the corporate sector is so large and the Government is heavily involved in and influenced by business. This may indicate that the New Order Government. foreign ownership increased to 21 percent.42 percent in December. II the small number of families and the tight links between companies and the Government. However. In September 1997. Coordination is easier because informal communication channels exist. The corruption and regulatory problems generated by high ownership concentration by families in Indonesia are likely to overwhelm its benefits. and family origin. Vol. but later declined and steadied at around 25 percent. Sundanese. From 193 in 1988. nonindigenous groups owned a larger proportion of the top 300 Indonesian conglomerates. it rose to 30 percent.5 Conglomerates Table 1. resulting instead in a decline in the proportion of foreign investor ownership. Indian. numbering 162 in 1988 and 170 in 1996. the legal system is less likely to evolve in a manner that protects minority shareholders. accounting for 64 percent of total conglomerate sales in 1988-1996. . But these benefits are few and often dubious compared to the high costs of concentration. the proportion of foreign ownership declined from 27. However. the Government allowed foreign investors to buy up to 100 percent of listed shares. Batak.10 shows the anatomy of the top 300 conglomerates in terms of year of establishment. most were established during the New Order Government. When the Government allowed foreign investors to buy up to 49 percent of listed shares in 1988.20 Corporate Governance and Finance in East Asia. In Indonesia. Indigenous businesspeople include the Javanese.

9 73.4 59.9 35.2 29.4 trillion in 1996.0 58.8 Source: Indonesian Business Data Centre.4 81.6 trillion in 1988 to Rp137.9 137. due to their “go public” activities.1 42.4 69.8 36.1 46.0 44.1 21. its sales reached Rp1.5 106.2 48.Chapter 1: Indonesia 21 Table 1.4 19.7 64.6 54.6 12.7 49. In 1996.3 80.0 18.8 49.0 15.0 28.9 trillion.8 28.10 Anatomy of the Top 300 Indonesian Conglomerates.1 103.2 159.4 22.0 116. Conglomeration Indonesia 1997.6 95.5 22. the number of mixed groups declined from 86 in 1988 to 68 in 1996.8 38.7 28.3 36.5 21.7 89.9 42.1 179.3 43.4 15.4 18.1 33.3 20.2 76. Meanwhile.9 47.9 billion.4 86.2 12.1 percent of total .8 25.4 31.4 68.6 77.1 52.4 57. 204 in 1996.2 23.6 114.7 95.3 120.6 17.7 106.0 31.4 32.6 34.4 52.1 46.8 12.8 57.0 58.2 30.1 41.7 40.1 25.4 59. While they supplied 20.8 30.9 14.1 58. For instance.2 33.4 31.3 134. more than five times its 1988 level.7 24. sales of the Bakrie group before it went public in 1990 were only Rp369.9 13. 1988-1996 Item Number of Groups Year of Establishment Before 1946 1946-1968 1969 Forward Ethnicity Mixed Nonindigenous Indigenous Political Affiliation Nonofficial Official-Related Origin Family Nonfamily Sales (Rp trillion) Year of Establishment Before 1946 1946-1968 1969 Forward Ethnicity Mixed Nonindigenous Indigenous Political Affiliation Nonofficial Official-Related Origin Family Nonfamily 1988 1989 1990 1991 1992 1993 1994 1995 1996 13 125 162 86 193 21 260 40 176 124 13 125 162 83 196 21 259 41 175 125 13 123 164 80 196 24 260 41 171 129 13 120 167 76 199 25 260 40 174 126 13 118 169 76 198 26 262 38 172 128 12 122 166 71 201 28 263 37 171 129 12 122 166 69 205 26 262 38 172 128 11 120 169 71 204 25 260 40 177 123 10 120 170 68 204 28 259 41 175 125 9.4 37.8 68.4 48.9 77.5 120.1 87.3 101. Their total sales also increased from Rp38.4 16.

More recent alliances were between Bambang Trihatmodjo (former President Suharto’s son) and Johannes Kotjo. The Suharto family is the largest stockholder in Indonesia. which is the largest conglomerate in Indonesia. or have resulted from alliances between entrepreneurs and officials. and Ibrahim Risyad of the Salim group. Average sales of official-related conglomerates were substantially greater than nonoffficial-related ones during 1988-1996. Official-related groups have owners (or founders) who are or are allied with former or current government officials (or their families).and officialrelated groups.22 Corporate Governance and Finance in East Asia. owns four groups with many subsidiaries and affiliate companies. In 1996. The high NPLs accumulated by banks within official-related groups could be partly attributed to this practice. Political alliances between entrepreneurs and officials have often led to the violation of regulations meant to promote prudent business practices in the banking industry. including Indofood Sukses Makmur (food industry). Only about 13 percent were formed by official or ex-official families. compared with the less than Rp700 billion of a nonofficial-related conglomerate. Prudential credit analysis tends to be ignored. 117 are jointly owned by the family and 57 are owned by individual family members. most of the 16 liquidated banks had violated the legal lending limit set by the central bank. Vol. there were 175 groups that originated from a family business. The contraction in the number and economic contribution of mixed groups may be an indication of increasing social polarization along ethnic lines. average sales of official-related conglomerates reached Rp1. In 1997 and 1998. and Wisnu Suhardhono of Apac-Bhakti Karya. In November 1997.2 trillion. Conglomerates were also classified into nonofficial. Most of the top 300 conglomerates were established by ordinary citizens. Out of 174 companies. their contribution declined to 13.7 percent in 1996. The Salim group. Bambang Rijadi Soegomo. and Fast Food (restaurants). for instance. Bank Indonesia. The well-known official-business alliances are those between Sudwikatmono (former President Suharto’s cousin) and Soedono Salim. Banks owned by groups or conglomerates typically act as a “cashier” that provides credit to companies within the group. collectively controlling . But listed companies within conglomerates were few. Djuhar Soetanto. II sales in 1988. Indocement Tunggal Prakarsa (cement industry). In 1996. But only a handful of these companies are listed in the market. banks that had to be closed down included Bank Surya (owned by Sudwikatmono) and Bank Andromeda (owned by Bambang Trihatmodjo). Some of them later became public companies by listing in the stock market.

the controlling shareholders are able to maintain their special relationship with officials. or someone very close to and trusted by the controlling shareholders. Both are listed companies and members of the Salim group. but those of the entire group. In 1996. with no restrictions. But it is difficult to obtain data on cross-shareholding among firms. This is because cross-owned banks had to consider not only their own interests. Indonesian law allows cross-shareholdings. for instance. Although they are not actively involved in the daily operations of the companies. The families retain control of the companies through ownership. While the source of the . Indofood Sukses Makmur (food industry) was owned by Indocement Tunggal Prakarsa (cement industry).1). continue receiving some kind of protection and special treatment. besides Suharto himself. He or she could either be the biggest shareholder. or both. Cross-Shareholdings Cross-shareholding is one way to enhance corporate control and occurs when a company down the chain of control has some shares in another company within the same chain. The family controls 417 listed and unlisted companies through a number of business groups led by the Suharto children. Although some groups employ professional managers. In so doing. The officials (or their family members) often own a small portion of shares given to them freely by controlling shareholders. as well as other relatives and business partners. which were liquidated or recapitalized after being acquired by the Tirtamas group that owns a listed cement company. management. It is generally believed that there are cross-holdings between financial and nonfinancial companies and among nonfinancial firms. families mostly manage the groups and make strategic decisions themselves. Cases in point are the Bank Papan Sejahtera and Bank Niaga. they still control the work of the directors. Semen Cibinong.Chapter 1: Indonesia 23 assets worth $24 billion (Claessens et al. 1999). If the family members cannot actively manage the companies as directors. Some of the groups related to officials have a unique share ownership structure. The BOC chairperson often represents the controlling party of the company. and hence.. Cross-holdings between financial and nonfinancial firms potentially create more serious problems. served in some government function (see Figure 1. they maintain their position as commissioners. The Salim Group is also in part controlled by the Suharto family. many of whom.

and Larry H. Simeon Djankov. Financial Sector Practice Department. P. 1999). (Feb.1 The Suharto Group Usaha Mulia Group (cousin Hasim) Cemen Cibinong Hanurata Group Suharto Family Citra Lamoro Group (daughter Mbak Tutut) Bank Yama Bob Hasan Group (Mohamad Hasan) Gatari 22 firms with control over 20% Citra Marga Persda Tollroad Trias Sentosa Bank Central Indomobil Mercu Buana Group (step brother Probo) 11 firms with control over 20% Kedaung Indah 14 firms with control over 20% Kedaung Group (Agus Nursalim) 18 firms with control over 20% Tirtamas 21 firms with control over 20% 262 firms with control over 20% Salim Group (friend Soedono) Sempati Air Humpuss Group Bank Utamar 17 firms with control over 20% Bimantara Group (son Bambang) TPI Andromed Tripolita 8 firms with control over 20% Kabelindro Kiani Murmi Sakti Source: Stijn Claessens. Who Controls East Asian Corporations? Financial Economics Unit.Figure 1. World Bank. Lang. .

2 Management and Internal Control A company’s internal organizational structure determines how shareholders control management. The BOD leads the company and makes strategic and operational decisions. The discussions are based on the ADB survey of 40 companies listed in the Jakarta Stock Exchange. request a shareholders’ meeting. and. the directors. This is based on the Dutch system.3. and accounting and auditing procedures. seek an audience with directors.2 Typical Internal Organizational Structure of a Publicly Listed Company in Indonesia Shareholders Board of Directors Board of Commissioners M a n a g e r s Employees The succeeding discussions examine some aspects of the internal management and control system in practice in Indonesian listed companies. The typical structure of a publicly listed company in Indonesia is shown in Figure 1. Therefore.2. the BOC supervises the work of directors. The managers execute the BOD’s decisions and lead employees in their departments. including the boards. Figure 1. one possibility is that legal lending limits had been violated. if necessary. both controlling and minority. Shareholders are at the top of the organization. As the owners’ representatives. 1. role and protection of minority shareholders.Chapter 1: Indonesia 25 problem is inconclusive. the BOC has the right to obtain any information concerning the firm. . management and managerial compensation.


Corporate Governance and Finance in East Asia, Vol. II

Board of Commissioners and Board of Directors Table 1.11 presents a summary of some characteristics of the BOC. The table reveals that 29 out of 40 companies surveyed did not have independent commissioners. Although 23 companies reported that commissioners were elected based on professional expertise, nine companies reported that selection was based on relationships with controlling shareholders, and another nine reported that commissioners were the company’s founders. Table 1.11 Characteristics of the Board of Commissioners
Number of Firms Responded 11 29 23 9 9 10 22 7 27 7 8 8 30 6 4

Questions Presence of Independent Commissioners a. Yes b. No Basis for Electing the Board of Commissioners a. Professional expertise b. Relationship with controlling shareholders c. As founders of the company Procedure in Electing the Board of Commissioners a. Nominated by the management and confirmed by the AGM b. Nominated by significant shareholders and confirmed by the AGM c. Nominated and elected by shareholders during the AGM Basis for Electing the Chairman of BOC a. Professional expertise b. Shareholdings c. As founders of the company d. Relationship with controlling shareholders Relationship between the Chairman and CEO a. Not related by blood or marriage b. Related by blood or marriage c. No answer

Note: Since companies could answer more than one alternative, the total does not necessarily add up to 40 for each question. Source: ADB Survey.

In most companies (22 out of 40), members of the BOC were nominated by significant shareholders and confirmed at the annual general meetings (AGMs). A nominee that was not supported by significant shareholders

Chapter 1: Indonesia


was unlikely to be chosen as a commissioner. Most companies (27 out of 40) elected their BOC chairman based on professional expertise. The majority of firms (30 out of 40) also reported no relationship between the chairman and CEO either by blood or marriage. A similar picture is obtained for the BOD (Table 1.12). Most companies (30 out of 40) reported not having independent directors. Professional expertise was an important basis in electing directors for 29 companies. Relationships with controlling shareholders and founders of the company were the basis for selecting directors in 11 companies. Table 1.12 Characteristics of the Board of Directors
Number of Firms Responded 10 30 29 7 4 13 22 6 29 3 7 8

Questions Presence of Independent Directors a. Yes b. No Basis in Electing Board of Directors a. Professional expertise b. Relationship with controlling shareholders c. As founders Procedure in Electing Board of Directors a. Nominated by the management and confirmed by the AGM b. Nominated by significant shareholders and confirmed by the AGM c. Nominated and elected by shareholders during the AGM Basis in Electing the Chief Executive Officer a. Professional expertise b. Shareholdings c. As founders of the company d. Relationship with controlling shareholders

Note: Since companies could answer more than one alternative, the total does not necessarily add up to 40 for each question. Source: ADB Survey.

Twenty-two out of the 40 respondents elected their directors through nomination by significant shareholders and confirmation by the AGM. Most companies (29 out of 40) selected the CEO based on professional expertise, although some companies based it on relationships with controlling shareholders.


Corporate Governance and Finance in East Asia, Vol. II

Management and Managerial Compensation The Corporate Law mandates the BOD to lead the company and make strategic and operational decisions, and the BOC to supervise the work of the directors. The BOC also reviews the results of operations and participates in strategic decision making. This indicates some overlapping functions for the BOC and the BOD, which is confirmed in the ADB survey. This overlapping of responsibilities, particularly in making strategic decisions, may result in conflicts. However, since the BOC appoints members of the BOD and determines their remuneration, the BOC is in a strong position to dominate the BOD. Twenty-five out of 40 firms indicated that the CEO makes important decisions after consulting the chairman of the BOC. In carrying out their tasks, the majority of firms reported not having committees to assist the BOD and BOC, as shown in Table 1.13. Only a few companies have nomination, remuneration, and auditing committees, most of which were set up between 1995 and 1997. In 1995, Bank Indonesia required commercial banks to have an auditing committee. Table 1.13 Presence of Board Committees in Listed Companies
Type of Committee Nomination Committee Remuneration Committee Auditing Committee None Total
Source: ADB Survey.

BOD 5 5 5 23 38

BOC 1 1 3 35 40

Most firms reported terms of appointment of three to five years for the BOD and BOC. In some companies, the term differs for commissioners and directors. Although the term is for three to five years, in 13 out of 40 companies, the directors and commissioners have been in service for more than five years. Results of the ADB survey show that in 18 companies, the CEO is given fixed compensation plus a profit-related bonus. In 14 companies, only fixed compensation is given. For the BOC chairman, 10 companies

Chapter 1: Indonesia


provide fixed compensation plus profit related bonus, while 14 companies provide fixed compensation only. Role and Protection of Minority Shareholders Indonesian law requires publicly listed companies to have at least 300 shareholders to help ensure share liquidity and dispersed ownership. The highest number of shareholders is found in Bank BNI (a state-owned bank), reportedly having 27,568 shareholders. Small companies simply comply with the minimum shareholder number requirement. Most companies reported that their shareholders enjoy all mandated rights and protection, except those on proxy voting by mail, cumulative voting for directors, and the independent board committee. A company charter (articles of incorporation) stipulates the quorum requirement during annual meetings, which is usually two thirds of total shareholders. The ADB survey showed that more than 67 percent of shareholders attended the last annual meeting in most companies. While proxy voting is allowed, proxy votes accounted for less than 10 percent of shareholders on average. Brokerage companies and management were the usual proxies. A change in the company charter requires a two-thirds majority vote by shareholders. The ADB survey revealed that in the last three years, only one management proposal (i.e., director’s fee) was rejected during the AGM. This is not surprising because management usually seeks prior approval of proposals from controlling shareholders. Accounting and Auditing Procedures Thirty-five out of 40 respondents in the ADB survey claimed to have substantially followed international accounting standards even prior to the financial crisis. Accounting authorities, however, can easily change acceptable accounting methods. After the crisis, for instance, the Indonesian Accountants Association recommended that potential foreign exchange losses be reported as losses at the end of the accounting year. Later, the association allowed companies to choose between declaring it in the profit and loss statement at the end of the accounting year or in the balance sheet. All companies in the survey reported the presence of an independent auditor, which is usually an international audit company. Most companies have been associated with their independent auditors for more than five years. Shareholders appoint the external auditor during the AGM.


Corporate Governance and Finance in East Asia, Vol. II


External Control

Control by Creditors The control of creditors over a debtor company rests on assets used as collateral for loans. Unsecured creditors resort to the legal process when problems arise. Based on the ADB survey, each company was associated with an average of five creditors, the majority of which were banks. Some companies were associated with an excessively large number of creditors, reaching up to 30. Most of the companies have been dealing with their institutional creditors for less than three years. Although the banking law requires collateral for bank loans, some creditors did not enforce the requirement. Only 10 companies reported that they were required to provide collateral by all creditors. Twelve companies claimed having creditors that did not ask for collateral. Twenty-five out of 32 companies reported having renegotiated loans with creditors in the last five years, mostly after the Asian crisis. This indicates that many companies experienced serious difficulties in repaying debts as a result of the crisis. But most of these companies stated they would possibly borrow from the same creditors, indicating their relatively strong bargaining position. The majority of firms (22 out of 29) also said that creditors had no influence in management decision making. In 1998, the Bankruptcy Law was passed to protect creditors and the Commercial Court was set up to deal with bankruptcies. This paved the way for unsecured creditors to proceed against a debtor in default based on loan covenants and through the legal process of collection against the debtor’s assets. However, enforcement of the law was a disappointment to those who hoped that it would put corporate restructuring and the settlement of corporate debts on a running start. Only 17 cases had been filed with the court by late November 1998. Just two companies had been declared bankrupt, and three suits were dismissed by the Commercial Court. The Government’s political will and support are still very much needed in order to set up a well functioning Commercial Court. Long and hard work is required to restore creditors’ confidence in Indonesia’s legal system. The Market for Corporate Control Between 1992 and 1997, there were 40 cases of acquisition and takeover of Indonesian companies. Most of these, however, were internal acquisitions (i.e., acquisition of a company in the same group). Only five cases were

A more recent case was the acquisition by Nutricia (the fourth largest baby food firm in the world) of PT Sari Husada (another baby food firm) in 1998. The Government appoints the BOD and BOC of these firms. except for publicly listed SOCs. the acquiring parties were trying to obtain operating synergies because they had companies in the same industry. 6 7 Later in March 1999. Since the NPLs reached up to Rp300 trillion. Bank Niaga was under a recapitalization program. In the massive restructuring of the banking sector that commenced after the crisis. the takeover brought significant losses to Djojohadikusumo when share prices plunged7 during the crisis. or direct subsidies.6 In this case. One famous takeover was Bank Papan Sejahtera. the acquiring interest was apparently seeking economic profits. which was acquired by Yopie Wijaya in 1995. the bank was liquidated. The bank was reported to have high NPLs and had broken the legal lending limit. IBRA found itself tasked with managing large amounts of assets in the private sector. appointment of management. with the minister’s approval. In April 1999. at a large profit. a state-owned insurance company may invest its funds in a private firm. it was common for the Government to invest in certain private companies. Before the financial crisis. They then replaced the BOD and later sold the bank. to Hashim Djojohadikusumo. Control by the Government Government control could be in the form of state ownership. Most Indonesian state companies are 100 percent owned by the Government. A study by Connie Tjandra (1993) shows that internal acquisitions were often initiated for tax shelter purposes. who was acquiring his second commercial bank. Another case was the takeover of Bank Niaga in 1997 by Djojohadikusumo. In these two latter cases. The Government is thus able to appoint some officials to be members of the private firm’s BOD or BOC. restrictions on market entry. Wijaya and his friends bought shares of the bank on several occasions until they gained control. State ownership for listed SOCs ranges from 25 to 35 percent. The BOD and BOC of PT Sari Husada were allowed to complete their terms before they were replaced.Chapter 1: Indonesia 31 external acquisitions. For instance. the Government took over NPLs and put them under IBRA management. the owner of Tirtamas group. This used to be a common practice in companies associated with the Suharto regime. . However.

1992-1999 (Rp trillion) Type of Bank State-Owned Banks Foreign Banks Regional Govt Banks Private National Banks Total Source: Bank Indonesia. this market was not well developed.3 14.6 6. Vol.0 487. private national banks overtook state banks as the dominant credit source.9 trillion in 1992 to Rp487. Private national banks and state-owned banks were the biggest domestic creditors.14 Banking Sector Outstanding Loans. new instruments have been introduced to the corporate sector.8 193.1 Corporate Financing Financial Market Instruments Prior to 1977.5 80. however. Table 1.3 188.2 27.4. jointly providing almost 90 percent of loans until 1997.2 5. and others offered by nonbank financial institutions or finance companies.9 378.4 percent in 1992. Data from Bank Indonesia show that from 1994 to 1997.9 150.4 225.6 48.2 6.32 Corporate Governance and Finance in East Asia.3 9.7 18.9 153.0 6.6 292. bank loans were the only instruments available to the corporate sector for short term (working capital) or long term (investment) financing.6 percent in 1997. the share of private national banks in outstanding total loans increased to 44. Bank loans.6 3. Bank Credit As shown in Table 1.6 150.7 50.2 71. companies considered alternatives to bank loans. including bonds. bank credit surged from Rp122.5 7. 1992 1993 1994 1995 1996 1997 1998 1999 68.1 Equities In 1977.6 4. . II 1. However. stocks.4 1.0 168.5 108. when the Government reactivated the stock exchange.4 56.7 112.4 24. equities became available to the corporate sector.1 220.7 122. because of the restrictions discussed below. remain the major financing instrument for the corporate sector.3 111.5 42.9 234. Since then.4 86. From 34.0 93.14.0 3. When the Government liberalized the banking industry at the end of 1988 (which allowed for higher interest rates).3 66.3 60.4 trillion in 1998.

. Table 1.8 48.15).6 91. however.. the activities of finance companies were not covered by regulations on prudential practices in the banking sector (e. finance companies were increasingly used as channels for the inflow of foreign loans. Most banks therefore set up subsidiary finance companies to circumvent banking regulations.0 206.Chapter 1: Indonesia 33 Some companies went public.7 percent in 1997. but dropped to 8 percent in 1991 when the Government tried to stabilize an overheating economy. i.1 1994 26.1 10.0 15.g.6 310. During the 1990s. capital adequacy ratio. allowed to accept deposit accounts from the public.4 207. thus increasing the role of the capital market in raising long-term funds.5 1995 35. In 1988.6 123. and consumer credit.5 333. funds raised in the stock market were less than 5 percent of the credit disbursed by the banking sector. when foreign investors were not yet allowed to purchase listed shares. legal lending limit.5 Financing by Finance Companies Finance companies first emerged at the end of 1980. Overall. The ratio of funds raised by finance companies to credit disbursed by the banking sector has been increasing from about 5 percent in 1992 to 13 percent in 1996.2 16. credit cards. limiting loans to a maximum of 15 times equity and foreign loans to five times the equity.4 1996 1997 1998 50.7 15.15 Value of Stocks Issued and Stock Market Capitalization.7 14. and net open position).1 18.9 1999 76. .7 9.1 17. the Government issued regulations to supervise and promote prudential practices in finance companies.e. 1992-1999 (Rp trillion) Item Stocks Issued Outstanding (As % of Outstanding Bank Credit) Market Capitalization Source: Bank Indonesia. They were not. offering services such as leasing. In 1995. 1992 1993 11.6 301. the stock market has gained a bigger role in corporate sector financing (Table 1. shooting up to 18. Prior to 1995.6 859. The ratio reached 8.9 406. factoring.0 70. It gradually increased again starting in 1991.3 percent in 1990 when the stock market was liberalized and foreign investors were allowed to purchase up to 49 percent of listed firms’ shares.

0 39. While banks had some exposure to these instruments.1) 23. have been popular in Indonesia since 1990.7 22. Banks could invest only in commercial papers that were rated by the Indonesian Rating Agency (which was set up only in 1995 to rate debt instruments).0 — = not available.2 Patterns of Corporate Financing Table 1. 1996.5 percent and 36. Source: Author’s estimates based on the Pacific-Basin Capital Markets (PACAP) Databases.3 (0.8 percent.2 26. Bank Indonesia prohibited banks from underwriting issues of commercial papers but allowed them to act as paying agents. PACAP Research Center. Table 1.1) 23.0 1991-1996 16.4.0 100.5 21. In the second half of the 1980s. short-term borrowings were greater than long-term debts.3 37.9 16. In terms of composition.8 7. Vol. they were not rated by a rating agency.34 Corporate Governance and Finance in East Asia. 1986-1996 (percent) Financing Source Internal Borrowings Short-Term Long-Term Debentures/Equity Debentures Equity Trade Credit Others Total 1986-1990 36. II Commercial Papers Commercial papers. Thus in November 1995. publicly listed nonfinancial companies had high proportions of equity and internal finance (retained earnings).3 14.6 23. which are unsecured negotiable promissory notes with a maximum maturity of 270 days. .5 (0.4 8.3 16.6 100.6 8. averaging 26.16 Financing Patterns of Publicly Listed Nonfinancial Companies.6 100.5 — 26. This is in contrast to the lower share of borrowings during the same period.4 13.16 shows financing sources of Indonesian publicly listed nonfinancial companies estimated by using flow-of-funds analysis.5 11. respectively.6 12.0 1986-1996 17. otherwise it would be classified as a loss in the banks’ books. at 81 percent of total borrowings. 1.4 23.0 3.8 17.

the corporate sector’s high leverage. which was masked by the rapid growth in investments. .17 compares the DER of listed firms by degree of ownership concentration. Bank loans also surged when the banking sector was liberalized in 1988.9 trillion in 1996. as evidenced by an average DER of 230 percent during 1992-1996 that rose to 310 percent in 1997. The high share of equity financing was due to the surge in capital market activity following the 1988 reforms. The results indicate that firms with higher ownership concentration tend to have a higher DER. the pattern changed.4. with longterm debts increasing rapidly.3 percent during 1991-1996. They also do not want to dilute corporate control and are more likely to finance growth with debt. All companies in the cement industry suffered from foreign exchange losses.9 trillion.3 Corporate Financing and Ownership Concentration It has been suggested. in the context of Indonesia and some other countries. respectively. Most corporate charters require commissioners to approve debt issues or sign debt agreements. Two telecommunications companies. The analysis of ownership patterns in Section 3 indicated that founders (the controlling party) or the five biggest owners held at least 50 percent of total shares.1 trillion. Indofood registered losses of almost Rp1. was due largely to a rapid rise in long-term debts. Large shareholders are inclined to undertake risky projects intended to generate high returns using borrowed funds. The corporate sector invested heavily from 1991 to 1993 and slowed down its investment spending a few years before the 1997 crisis.2 trillion (mostly foreign exchange losses). This amount doubled in 1997. rising from Rp54.4 trillion in 1993 to Rp112. Many companies suffered big losses in 1997 due to their high exposure to dollar loans. while Semen Cibinong’s losses reached Rp2. Corporate debts grew over time.Chapter 1: Indonesia 35 In the 1990s.2 trillion. that ownership concentration may be associated with heightened risk-taking by companies.6 trillion and Rp1. reaching Rp229. These liabilities grew significantly because corporate expansion was largely financed by debt. Note that the corporate sector’s high leverage existed side by side with sizable equity capital raised from the capital market. Hence. also suffered from foreign exchange losses but managed to post profits of Rp0. except Semen Gresik (an SOC). Of the various financing sources. which managed to post significant profits due to low exposure to dollar-denominated loans. 1. For instance. corporate debts accounted for 39. Table 1. Indosat and Telekom.

ultimately.5.0 1. This section highlights those that were seen to have contributed significantly to the crisis in Indonesia: inadequacy of the regulatory framework under the financial liberalization. The availability of bank credit brought by the rapid rise in the number of banks and the free capital flow system led to a credit boom.0 351. the private sector borrowed heavily in unhedged dollars.358. Between 1987 and 1996. heavy reliance of companies on bank credits to finance investments. In addition.36 Corporate Governance and Finance in East Asia. Inadequate Financial Regulatory Framework Liberalization of financial markets increased the corporate sector’s access to domestic and foreign private capital. As a result. 1. The test of the difference between the two means found the t-value of 1. Source: Author’s estimates. The low cost of foreign loans and the relatively stable exchange rate created a false sense of security for corporations. II However. the free capital flow system allowed private companies to borrow dollars offshore without any restriction. the borrowings swelled. and high ownership concentration among families with political affiliation. to maintain control of the company.0 Notes: Firms with high ownership concentration have more than 50 percent of shares owned by the top five shareholders. since commissioners represent the controlling party.56 significant at the 10 percent level.1 The Corporate Sector in the Financial Crisis Causes of the Financial Crisis Many intertwined factors led to the crisis.0 386. Controlling parties rely on external financing to maintain their equity share and. decisions on debt are made with the implicit endorsement of owners. Vol.5 1. Table 1. aided .17 DER of Listed Companies by Degree of Ownership Concentration (percent) Item Mean Standard Deviation DER of Firms with High DER of Firms with Low Ownership Concentration Ownership Concentration 699.

substantial amounts were also funneled into projects that guaranteed repayment mainly on the strength of borrowers’ close political connections. The banks served as a “cashier” that provided easy credit to nonfinancial companies within the group. large amounts of credit were directed to the companies within the group. It also meant that the cashier bank had neither the independence nor the incentive to exercise ex ante and ad interim monitoring of borrowers. However. did finance many viable ventures. many firms became highly leveraged. after all. The Government later specified the legal lending limit and the net open position that banks had to follow. to circumvent these banking regulations. It was doubly difficult to exercise supervision when groups with political clout owned the banks.e. the level of corporations’ foreign debt could not even be ascertained. only created to serve the companies to which they lent. A lot of short-term foreign funds were used to finance long-term investment projects. Heavy Reliance on Bank Credits to Finance Investments Companies relied heavily on bank loans to finance rapid corporate expansion because internal financing was insufficient and the capital market was not developed. It is not known if these regulations had an effect on nonbank intermediaries. In the process. and the negative net open position (short position in dollars) continuously rose to precarious levels. This left them vulnerable to interest rate surges as well as sudden currency fluctuations in the case of dollar loans. There was also a smaller demand for equity compared to external debt financing since controlling shareholders preferred the latter to maintain their control of the companies. averaging about 4 percent of GDP. The removal of entry barriers in the banking sector caused the number of private national banks to soar from only 65 in 1988 to 144 in 1997. This often led to the violation of prudential credit management practices. . As a result. It was only in 1995 that some regulations on the activities of finance companies were contemplated.Chapter 1: Indonesia 37 by the lack of an existing mechanism to supervise and monitor foreign transactions. Conglomerates that had difficulty in getting loans (i. conglomerates set up finance companies and used these as channels for the unfettered inflow of foreign loans in lieu of banks. Decisions to borrow in dollars made sense to many borrowers because dollar loans were cheaper than rupiah loans.. They were. those with high DERs) established their own banks. The large supply of foreign funds. However. The supervising agency was caught unprepared. A director at Bank Indonesia revealed that in 1995.

politicians. Family-controlled corporations were generally structured as a complicated web of affiliates and associated companies.5 billion. In early 1998. Aside from the fact that many of these loans were channeled through banks and corporations of politically connected families.38 Corporate Governance and Finance in East Asia. Collusion between big businesses and the political elite was widespread in Indonesia. or both. Since the Government could not afford to undertake these projects. Families retain control by keeping the majority percentage of outstanding shares. where private banks are usually in the hands of big businesses. . This was often the case in the banking industry. there was also almost universal confidence that the economic growth would continue indefinitely. as they had done so in the years before the crisis. This fact was usually not disclosed in financial statements. Projects involving massive capital investments and long-term operating deals (in telecommunications. Corporations were certain that they could roll over short-term loans when these fell due. There were cases where banks and borrowing companies were controlled by the same groups or families with strong political connections. but on the basis of who the borrower was. They ensure that commissioners represent their interests and maintain close relationships with the chairperson. total private sector foreign debt stood at $72.5 billion was owed directly by corporations. Controlling shareholders also prefer to use debts to finance expansion so as not to dilute their ownership. partly because they used nominee accounts to register ownership rather than set up a holding company. II By mid-1997. and power generation) require huge capital. The ultimate control of the corporate sector rests in the hands of a small number of families who own groups of companies. banks did not lend on the basis of the soundness of the project. In many cases. Vol. of which $64. and in the process maintain control of the company. $35 billion of Indonesia’s foreign debt owed to private foreign banks was about to mature in less than one year. High Ownership Concentration High concentration of corporate ownership (particularly by families) led to poor financing and investment practices. and investing shares among nonfinancial companies within the group and in other groups’ companies. toll roads. by setting up their own banks. contracts were granted to the private sector. most often to people who were close to the ruling regime. They enhance their control over companies through cross-shareholdings.

0 2. and Fisheries Mining and Quarrying Manufacturing Electricity.0 5. real estate.1 5. Livestock. when all sectors. and 128 companies reported a total loss of Rp46.3 Source: Central Bureau of Statistics (Biro Pusat Statistik. This continued in 1998.5.8) (13. The construction sector was the worst hit. followed by property. Sectors with lower ROE generally had higher DER.24 trillion for the first six months of 1998.2 8.6 13. Using the financial statements as of 30 June 1998 of 161 publicly listed companies.18 shows that growth in most sectors significantly fell in 1997.7 1998 (0. Real Estate.8 7.370 percent. except utilities. and Business Services Other Services GDP 1996 3. and Water Supply Construction Trade. 1996-1999 (percent) Sector Agriculture.58 trillion (meaning their losses were greater than the paid-up capital).7) 2.52 trillion.8 1997 1.4 7. The JSX Monthly reported that total losses of 214 listed companies amounted to Rp39.4) 2. indicating a rapid rise in .3 11. as shown in Table 1.3 12.4 7.6) (0. and building construction. and Restaurants Transport and Communications Financial.Chapter 1: Indonesia 39 1.2 (1.5) (18.1 6. much higher than the 307 percent registered in December 1997.8 8.6 8. Only 86 companies reported profits.7 6.7) (2.9 3.4) (0.0) 1999 2.19. Most sectors showed significant increases in leverage.1 (1.7) (8. 53 companies reported negative equity of Rp6.0 3. The consumer goods industry reported the lowest ROE.1) 1. DER and ROE were calculated per sector.6 (36. followed by the finance and trade sectors. Forestry.6 12. Gas. posted negative growth rates.0) (15.4 5.1) (26. BPS). The average DER was found to be 1.6 4.18 GDP Growth by Sector. Table 1. Hotels.8 0.2 Impact of the Financial Crisis on the Corporate and Banking Sectors Impact on the Corporate Sector Table 1.8) (11.6) (3.

losses in operation were due to declines in sales and increases in the cost of imported inputs. The table also reveals that although private national banks dominated the banking sector in terms of assets and credits.2) (264.0 97.6 (11.1 (92. II Table 1. foreign exchange losses came about with the use of unhedged foreign debt.0 163.5 8.0 864. Financial and banking analysts estimate that by September 1998. As the rupiah weakened and interest rates increased. Mostly suffering from a liquidity squeeze.3 7.8) 36.20 reveals that the banking sector’s ROE decreased significantly in 1997.21.1) 7. Third.0 307.0 191.0 219.625.7) 6.0 177.0 65.9 12.4) 8. but annualized to approximate full year values. and would have kept on increasing if interest rates had not declined.0 108.0 177.1 1.1 (3. interest expenses rose as credit rates increased from 20 percent in early 1998 to 40 percent in mid-1999.1) Note: DERs were calculated for only 161 companies (out of 214) that had positive equity.6) (115.19 DER and ROE of Publicly Listed Companies by Sector.370.0 193.7 percent in July 1998.40 Corporate Governance and Finance in East Asia. This figure further increased to 47.1 (124.8 17. the NPL ratio rose to 25. private banks posted negative ROEs in the same year.0 1.0) 10.4 5. Source: JSX Monthly.2 13.0 92.0 158.7 1.8 (373.0 205.1 30.0 72.8 percent in 1996.0 1.0 108. small foreign banks enjoyed the highest profits.0 2.0 2.0 a ROE 1996 1997 1998a 14. a Actual data for 1st semester only.097.271.0 697.4) 18. The huge losses suffered by most companies were caused by three factors. .0 1997 234.0 1. Second. the NPL ratio had reached more than 60 percent.2 (4.2 23.0 111.6) 15. several publications.0 105.1 (5. Vol. 1996-1998 (percent) DER Sector Agriculture Mining Basic Industry Miscellaneous Industry Consumer Goods Industry Property Infrastructure Finance Trade/Services Average 1996 104.395.0 1998 186.0) (78. from only 8.0 635.0 12.4 (6.0 631. as shown in Table 1. First.5 percent in April 1998. rupiah values of dollar-denominated debts due to the weakening of the local currency and the rapid decline in equity because of losses.0 229. Impact on the Banking Sector Table 1.

8 14. July No.30 5.8 3.21 Nonperforming Loans by Type of Bank.1 198.25 22.07 13. 230/1998.2 10.2 37.1 47.6 — 13.20) Table 1. Source: The National Banking Association.8 8.43 10.67 8.8 187.7 106.5 57.73 30.3 445.12 15. however.47 20.5 2.4 7.09 11.24 (4.69 14.7 29.8 11.72 16.2 — 19.39 13.86 11.Chapter 1: Indonesia 41 Table 1.2 47.91 21. put pressure on the banking sector.20 ROE of the Banking Sector.3 361.70 1995 7.06 20. private national banks overtook State-owned banks when their NPL ratio jumped to 57.84 27.2 — 8.7 Item Total Loans Dec 1996 July 1997 Dec 1997 July 1998 NPLs Dec 1996 July 1997 Dec 1997 July 1998 NPL Ratio (%) Dec 1996 July 1997 Dec 1997 July 1998 Total 331.07 1994 14.15 20.3 22.81 13. .7 — 1.5 31. Source: Infobank.68 1996 1997 8.2 48.45 — 1993 15.9 11.38) 11.09 (11.9 — 11.3 Private National Banks — 179.6 — 4.2 1.9 297.2 8.1 30.6 — 1.0 129. State-owned banks initially had the highest NPL ratio.37 19. 1992-1997 (percent) Type of Bank State-Owned Banks Foreign Banks Joint Venture Banks Regional Development Banks Private National Banks Total — = not available. coupled with negative spreads (deposit rate was higher than the credit rate).1 274. 1992 7.7 — = not available.89 27. 227/1998 and October No.24 15.0 622.28 5.0 — 32. 1996-1998 (Rp trillion) State-Owned Banks — 140.0 — 4. The high and increasing NPLs.5 222.34 16.6 6.1 1.9 percent. In July 1998.7 4.50 9.2 8.5 34.5 128.1 13.44 15.45 21.9 Regional Foreign and Development Joint Venture Banks Banks — 9.

2 billion debt. the scheme failed. Vol.7 percent ($64.6 billion) of Indonesia’s total external debt in March 1998. have been subject to restructuring deals under the initiative. The scheme encourages negotiation between creditors and debtors. companies were not servicing their debts. II 1. assembling the legal and policy framework to facilitate corporate restructuring. the Jakarta Initiative Task Force had conducted negotiations for 52 companies with Rp2. by mid-September 1998.3 Responses to the Crisis Corporate Restructuring Measures At the end of 1997. However. and Ciputra (property business). Semen Cibinong (cement industry) became the first Indonesian company to resume paying part (25 percent) of the interest on its $1. Unfortunately. a more comprehensive scheme to tackle domestic and foreign corporate debt. only a .4 trillion of domestic debt and $6. On 9 September 1998. the committee launched the Jakarta Initiative. the corporate sector had more than Rp600 trillion ($75 billion at Rp8. By end-November. Total amortization payments due on foreign debt in 1998 were placed at $32 billion (before restructuring). Thus. Corporate debt accounted for 46. particularly in terms of debt resolution. In addition. the Government and private sector formed a committee to help corporates deal with the crisis. One premise of the initiative was that creditors should agree to a standstill for a certain period (creditors would desist from exercising their claims on a distressed company’s assets) to allow debtors to operate normally after obtaining fresh financing. Another option that companies could take under the Jakarta Initiative was debt restructuring via debt-to-equity swaps. Aside from being described as overly complicated. While the process of restructuring was in progress.000 eligible firms had signed up for the scheme. few companies were in a position to resume interest payments.5. The scheme offered a hedging facility against rupiah devaluations for restructuring agreements. a number of prominent companies. such as Garuda (a national flag carrier).7 billion of foreign exchange debt. The committee was tasked to ascertain the level of private corporate sector debts and arrange negotiations between debtors and creditors. about 80 percent of which was private. IBRA was formed to offer Mexican-style resolution for private sector foreign debt. none of the 2.42 Corporate Governance and Finance in East Asia.000/$1) in debt from domestic commercial banks. In June 1998. More than two thirds of private debt was short-term and the average maturity of all private debt was estimated to be only 18 months. Since September 1998. Astra International (automotive). In November.

mining. A Commercial Court was set up to handle corporate restructuring and debt settlements. consolidate business units. and sell noncore businesses or nonoperating assets. Astra International. Procedural rules are also being introduced to ensure certainty and transparency in the proceedings. as well as general commercial disputes. Qualified professionals from the private sector will act as receivers and administrators in the management of estates of companies in bankruptcy or reorganization. for equity infusion. Rabobank and Citibank. focused on its core business of car and motorcycle manufacturing and sold off its subsidiaries in semiconductors. Some listed companies with relatively “rich” shareholders decided to replace their loans with additional equity through rights issues and privileged subscription (limited offering). aiming to modernize the bankruptcy system and promote the fair and expeditious resolution of commercial disputes. Meanwhile. The Commercial Court can be asked to hold off creditors and impose strict guidelines on the negotiating process . i. lay off workers. plantations. Bank Bali agreed on a debt-to-equity swap with its creditor. with the requirement that adequate compensation and protection will be provided to such creditors during that period. In the banking industry.e. limitations will be imposed on the ability of secured creditors to foreclose on their collateral during bankruptcy proceedings (as is provided for in the bankruptcy laws of most other countries). under which the latter would become one of the bank’s shareholders. When credit from the banking sector became unavailable and interest rates increased significantly. Protection against insider and fraudulent transactions taken by a debtor prior to the adjudication of bankruptcy will be enhanced.. Bank Niaga also negotiated with some of its creditors. a publicly listed company operating in the automotive industry. the companies’ financial performance deteriorated. Debtors. Moreover.Chapter 1: Indonesia 43 few companies reached agreement with their creditors on this. Bankruptcy Reform The Bankruptcy Law was passed in August 1998. who fail to reach agreements with creditors in out-of-court workouts under the Jakarta Initiative or fail to gain the requisite creditor support for the workout plan can resort to the Commercial Court. some companies attempted to restructure their businesses on their own. and mining equipment. For instance. Astra International (automotive industry) and Bakrie Brothers (a holding company in several sectors) explored this option. Standard Chartered. especially in preventing unjustifiable delays in the adjudication of bankruptcy. forcing them to cut costs.

44 Corporate Governance and Finance in East Asia. is also reviewing the Bankruptcy Law. including procedures for handling operational issues and processing bankruptcy cases. . the measure had only a minimal impact. companies were allowed to sell shares only by issuing stock rights. However. (iii) the merger. the Capital Market Supervisory Agency allows companies to offer additional shares directly to the public. Some companies simply decided not to pay their loans knowing that it would be difficult for creditors to take the case to court. since the market reflects the condition of the economy. The Government. the Government did not impose restrictions nor did it attempt to regulate capital flows. Rather. collusion. and nepotism (anti-KNN) was signed in 1999. in consultation with IMF and the World Bank. To push bankruptcy reforms. There will be changes in the implementation of the bankruptcy law. with only 17 cases filed as of November 1998. The Government has also been concerned with the issue of capital controls. it is envisaged that the Commercial Court will play a central role in modernizing the commercial legal system. (ii) the resolution of nonviable private banks. Realizing that they undermine investors’ confidence. Capital Market Reform In the capital market. the monitoring system for foreign exchange transactions will be strengthened to improve transparency and better assess the credit exposure of the corporate and banking sectors. and recapitalization of state banks. and (v) a strengthened banking supervision system. reform. Vol. Previously. the Court’s early record has been a disappointment. The bias in favor of debtors has retarded the pace of corporate restructuring. (iv) measures to recover liquidity support previously extended to troubled banks by Bank Indonesia. II to achieve liquidation of the company. legislation against corruption. Banking Sector Reforms The Government’s banking sector reform strategy is focused on (i) government-assisted recapitalization programs for potentially viable private banks. The Court has also declared only two companies bankrupt. In the longer term. The significance of a sound bankruptcy system cannot be understated as it provides a backdrop for negotiations in the workout and restructuring process against which parties often gauge their legal rights. The Agency also allowed companies to buy back up to 10 percent of outstanding shares to improve the condition of the stock market. However.

the Government required banks to be audited by international external auditors. However. Other Regulatory Reforms To push corporate restructuring further. regulations will need to be issued to permit debt-toequity swaps in the context of corporate restructuring plans. Some 175 groups that originated from family businesses controlled .Chapter 1: Indonesia 45 In 1997. or sold (after transferring NPLs to the AMU). BBD.6 1. To obtain a clearer picture of the banking sector.1 Summary.6. A new central banking law. The Bank Indonesia 21st package includes recapitalization. 1. The importance of this legislation may need to be emphasized. In October 1998. Bank Indonesia has announced a recapitalization program for potentially viable private banks. providing Bank Indonesia with substantially enhanced autonomy. Conclusions. and Recommendations Summary and Conclusions Corporate Ownership and Structure Most of Indonesia’s top conglomerates were established as family businesses. The Company Law at present can be interpreted as severely limiting the scope for debt-equity swaps. The agency set up an Asset Management Unit (AMU) to directly manage problem loans of banks under its supervision. was enacted in 1999. Liquidity support given to troubled banks should be repaid in four years. The merger process will be finished within two years. it is doubtful whether pure holding companies are able to enter into swaps. improvement of rules and prudential regulations. To overcome these problems. merged. Parliament approved amendments to the banking law that were geared toward strengthening the legal powers of IBRA and its AMU. the Government has drafted a regulation providing tax neutrality for mergers and removing other tax disincentives for restructuring. and follow-up action on bank restructuring. It has also drafted regulations to remove obstacles for converting debt to equity. the Government established IBRA to supervise problem banks. depositors will be fully protected by the Government. BEII. Banks deemed ineligible for recapitalization will be closed. In particular. The four state banks (BDN. and Bapindo) will be merged into one bank named Bank Mandiri.

Rapid growth in investments masked the corporate sector’s increasing leverage. corporate debts grew over time. allowing them to maintain their equity shares and. This study reveals that Indonesian listed companies with higher ownership concentration had higher levels of leverage. On the one hand.46 Corporate Governance and Finance in East Asia. Financing Patterns Controlling shareholders opted to use debts to finance expansion. On average. this financing pattern supports the claim that family-based controlling shareholders relied on excessive borrowing to finance corporate expansion . conglomerates set up finance companies to bring in cheap foreign loans as these companies were not adequately regulated. when barriers to entry in the banking sector were lifted. lacked the information necessary to allow them to assess projects’ risks and chances for success. As a result. while a single family controlled 16. families control 67. These banks also obtained cheap offshore funds. However. meanwhile.6 percent of the total stock market capitalization in 1996 and the top 15 families controlled 61. Indonesian companies borrowed short term. When the Government regulated the legal lending limit and the net open position of banks. Companies preferred to borrow in dollars because interest rates of foreign loans were lower than for domestic loans and the exchange rate was relatively stable. Foreign creditors. conglomerates set up their own banks to serve as “cashiers” providing credit to companies within groups. However. Companies relied heavily on bank credit. the majority remains family-controlled. Vol.7 percent.1 percent of publicly listed companies in Indonesia. not all of the conglomerate-affiliated companies are publicly listed. These figures show the extent of power wielded over the corporate sector by a small number of families. however. Among those listed in the Jakarta Stock Exchange. put a significant amount of corporate assets of conglomerates in the hands of creditors or the Government. II 53 percent of total assets of the top 300 Indonesian conglomerates. The free capital flow system permitted the inflow of foreign capital to fuel the credit boom in the economy. retain ownership control of companies. banks were unwilling to provide credit to highly leveraged companies. thus. Therefore. But because foreign creditors were reluctant to lend long term. The financial crisis created opportunities for addressing the inefficiencies in the legal and judicial system that supported corruption. The restructuring and resolution of financial distress may.

and the rapid decline in equity due to losses.1 trillion in 1997 from Rp13. particularly those with large short-term foreign loans. corporate-initiated debt restructuring .24 trillion in the first half of 1998.1 percent in 1997 to -124. When the crisis hit Indonesia. The significant increases in leverage indicate a rapid rise in the rupiah value of debts due to the revaluation of dollar-denominated debts.1 percent in 1998. Meanwhile. Impact of the Financial Crisis Prior to the crisis. and registered a net loss of Rp39. Bank Indonesia extended emergency loans to many banks. Total profits of publicly listed companies dropped to Rp3. the consumer goods industry was the worst hit. As the rupiah weakened and interest rates increased. Net profits of publicly listed companies had consistently been growing at an average rate of 20 percent each year. the highly leveraged companies. At the height of the crisis. the corporate sector was in quite good shape in terms of growth and profitability. Responses to the Crisis The impact of the financial crisis on the corporate sector was serious. The Government introduced reforms to improve bankruptcy procedures. the high domestic interest rates that prevailed from 1998. financed by issuing nearly $80 billion worth of bank restructuring bonds.Chapter 1: Indonesia 47 without diluting their control. it also reflects the failure of the financial sector to channel funds to the corporate sector efficiently due to weak prudential regulation and supervision. ROE dropped from 1. To restructure the corporate sector. On the other hand. DER increased to 307 percent in 1997 and further surged to 1. Sales of conglomerates as well as those of publicly listed companies were increasing.370 percent in 1998. The problem was in the maturity structure of its dollar-denominated debt and high debt-to-equity ratios in some sectors. The financial crisis led to the closure of several dozen banks. although at a declining rate. the Government initiated corporate debt restructuring measures (Mexican-style foreign debt resolution and the Jakarta Initiative). and strengthen prudential regulations and supervision of the financial sector. facilitate debt restructuring.21 trillion in 1996. The Government and the private sector responded with measures to mitigate the negative effects. were the most adversely affected. NPLs rose and capital adequacy ratios fell. followed by the property sector.

and (iii) strengthening transparency and disclosure requirements. 1.g. (ii) delineating the functions of the board of directors and commissioners. the legal system is less likely to evolve in a manner that will allow it to protect minority shareholders. Amendments should include (i) empowering minority shareholders by raising the majority percentage of votes required on critical corporate decisions and mandating minimum representation of minority shareholders on the board. Most companies claim to have adopted international standards of accounting and auditing procedures.2 Policy Recommendations The Government should introduce measures to address the weaknesses in corporate governance identified in this study. minority shareholders have not been able to oppose controlling shareholders’ decisions to invest in unprofitable projects financed by unhedged foreign currency debts. cost cutting and business consolidation) and acquisitions by creditors or foreign investors through debt-to-equity swaps and equity infusions. In particular. improving the legal and regulatory framework for bank supervision. Specific recommendations include protecting the rights of minority shareholders. and protecting creditors’ rights. but inadequate protection to minority shareholders from the dominance of large shareholders. the regulatory environment was not prepared to supervise the increasing number of banks and nonbank . The Government should ensure that all laws and regulations are effectively enforced. Vol.. Improving the Legal and Regulatory Framework for Bank Supervision After the liberalization of the financial sector. Protecting Minority Shareholders’ Rights The Corporate Law provides sufficient rights and protection for all shareholders. but it is not clear whether in practice these standards are in place. The Corporate Law should be reviewed and amended in the context of pervasive control by large shareholders. II measures included internal business restructuring (e. If the role of a limited number of families in the corporate sector is so large and the Government is either heavily involved in or influenced by business.6.48 Corporate Governance and Finance in East Asia.

Chapter 1: Indonesia 49 financial institutions. The Government should also continue strengthening the monitoring system for foreign exchange transactions. it is likely that future private financial flows for the corporate sector will continue to conform to a short-term structure. This is a significant factor in . and liquidation of corporate assets. the Indonesian corporate sector directly owes an inordinate amount and a greater portion of its loans to foreign banks. the Court has been slow and ineffective in processing bankruptcy suits. The Central Bank needs to monitor and control dealings by banks within business groups and improve enforcement methods to prevent circumvention of prudential regulations. the Government lost monitoring and control powers over foreign fund flows. The tendency of foreign creditors to lend short term is a problem that must be confronted once private capital flows to Indonesia recover. the banking regulatory framework was inadequate in regulating banks’ dealings with affiliated nonfinancial companies. with necessary legal sanctions for violations. With credit being coursed through the domestic banking system rather than directly to numerous local corporations. most of banks’ NPLs resulted from credit to companies within the same group. Further. orderly restructuring. However. Because these banks are neither easily convinced nor compelled to submit their claims to the jurisdiction of Indonesian commercial and bankruptcy courts. When finance companies were used to channel offshore loans in lieu of commercial banks. Because foreign creditors are faced with more information asymmetries than domestic creditors. Protecting Creditors’ Rights To protect creditors’ rights. in contrast to the Republic of Korea and Thailand. The ownership of banks (including finance companies) by shareholders of nonfinancial companies undermined the capability of these banks to conduct prudential credit management. The regulatory framework was also weak in supervising and monitoring foreign transactions. In the first place. recapitalization. Consequently. it has been difficult to implement standstills. a new bankruptcy law was passed in the aftermath of the crisis and a Commercial Court was set up to deal with bankruptcy cases. One way is to set limits on lending activities by banks to affiliated nonfinancial companies. the Republic of Korea and Thailand were more successful in getting foreign creditors to collectively solve their problems during the crisis. Banks should be required to provide data on such transactions and charged penalties for noncompliance.

despite the smaller level of capital inflows (as a percentage of GDP). Vol. The Bankruptcy Law should thus be reinforced and creative means should be introduced to avoid a prolonged and costly paralysis of corporate activity and financing. II explaining the greater depth of the crisis in Indonesia. Only when creditors have the confidence that their rights are protected will they resume financing companies.50 Corporate Governance and Finance in East Asia. .

Conglomeration Indonesia: Regeneration and Transformation into World Class Corporate Entities. Delhaise. various publications. P. 1998. and M. World Bank. 1997. Indonesia Country Report. The Economist Intelligence Unit. University of Maryland. Indonesia: Sustaining Manufactured Export Growth. Jakarta Stock Exchange. 1995. The Private Debt Anatomy.Chapter 1: Indonesia 51 References ADB Programs Department (East). . 1998.. various publications. 1995. 1996. Stijn. P. 1999. Working Paper #58. Indonesian Business Data Centre. and Remuneration. Maryland. Indonesia Country Profile. and Larry H. The Impact of Acquisition to Shareholders Wealth: Comparison Between Internal and External Acquisition. Manuscript. Wright. Embassy of Indonesia. JSX Monthly Statistics. Asia in Crisis: The Implosion of the Banking and Finance System. Institute for Economic and Financial Research. Michael Krill. Jonathan. Simeon Djankov. 1996. Yogyakarta. Claessens. Economy of Indonesia. Forest. Indonesia: An Emerging Market. Financial Sector Practice Department. Indonesian Central Bureau of Statistics. The Economist Intelligence Unit. Unpublished thesis MMUGM. and Richard Turtil. John Wiley and Sons. Who Controls East Asian Corporations? Financial Economics Unit. various publications. Indonesian Business Data Centre. Lang. Risks. Indonesian Capital Market Directory 1992-1998. K. Keasey. Bank Indonesia. Center for International Business Education and Research. John Wiley and Sons. Embassy of Indonesia Homepage. various publications. Conny Tjandra Rahardja. 1999. Economic and Financial Statistics. 14 May 1999. Large and Medium Manufacturing Statistics. Corporate Governance: Responsibilities. 1997. Letter of Intent of the Government of Indonesia to the IMF. F.

the Korea Stock Exchange for its help and support in conducting company surveys. and Graham Dwyer for his editorial assistance. Chung-Ang University. A national consensus is emerging that a democratic system based on free market principles should be firmly established to promote more intense competition in every sector of the economy. David Edwards.1 Introduction The economic crisis that began in Thailand and swept through Asia starting in the summer of 1997 hit the Republic of Korea (henceforth. Seoul. both of ADB. Poor corporate governance and political and government intervention in the business and financial sectors are widely viewed as contributory factors. a practice that was not checked by creditors. Business managers and controlling shareholders were maximizing firm size at the expense of profits. As the Korean currency. Chung and Yen Kyun Wang1 2. This has been the crux of the corporate governance problem in Korea. and corporates were sent reeling. 1 Professors. The country’s winners would then emerge based only on economic efficiency. and curtailing of morally hazardous behavior that has been prevalent among economic decision makers. Further. timely exit of poor performers from the market. or capital market discipline. Inefficient investment coupled with excessive financial leverage was found to be at the root of the economic crisis at the corporate level. the Republic of Korea. Department of Economics. markets.2 Republic of Korea Kwang S. internal control mechanisms. and David Webb of the London School of Economics for their guidance and supervision in conducting the study. The extent of inefficient investment can be seen from the fact that more than 70 percent of listed firms had negative economic value added (EVA) before the crisis while those with positive EVA declined (Table 2. It had been the norm in Korea to conduct business based on political and administrative favoritism rather than on competitive merits. the Government and business sector had good reason to reflect on the causes of the crisis. The authors wish to thank Juzhong Zhuang. . banks as major creditors had governance problems of their own and failed to monitor or exercise the control rights generally afforded to lenders via loan agreements. Korea) in November of that year.1).

and J Murrin (1995). aiming to identify the areas in need of further reform and to provide policy recommendations for improved corporate governance.1 1998 490 164 33. Koller. This study collects and analyzes data on the Korean economy. Government reform goals for the corporate sector include enhancement of corporate transparency. June 1999. The EVAs are the same as the economic profit as explained in T. Dividend payments were at less than 2 percent annually as opposed to the double-digit interest rates in the past decades. Self-dealings by controlling shareholders—crosssubsidization and cross-guarantees among member firms within a chaebol (a conglomerate/large business group)—and the lack of transparency hindered the development of an efficient capital market capable of mobilizing low-cost equity funds. Restructuring efforts have focused on reduction in the degree of business diversification and in the financial leverage of large-sized firms.1 Listed Firms with Positive Economic Value Added. accountability of controlling shareholders and boards of directors.1 1997 518 104 20. Source: Korea Stock Exchange. This study also reviews the legal and 2 The survey was conducted mainly through the Korea Stock Exchange.1 1995 560 163 29. and individual companies. which distributed and collected the questionnaire.54 Corporate Governance and Finance in East Asia. Inefficient investment undermined the competitiveness of Korean firms in the global marketplace.4 1993 513 174 33. Many firms left some questions unanswered. The total number of respondents was 81 out of about 550 nonfinancial firms listed on the Exchange. where NOPAT is the net operating profit after taxes and WACC is the weighted average cost of capital multiplied by invested capital.1 1996 561 163 29. T. 1992-1998 Item Total Number of Firms Firms with Positive EVA Percentage of Firms with Positive EVA 1992 508 180 35. Vol. A survey was conducted for the nonfinancial listed companies using a questionnaire developed by the Asian Development Bank (ADB)2 to supplement official data. This broad perspective can help clarify the ongoing reform efforts of businesses and the Government. Copeland. and improvement of bankruptcy procedures. II Table 2.5 Note: The EVAs are calculated as: EVA = NOPAT – WACC. capital market discipline. .9 1994 531 165 31. especially chaebols. Weaknesses in the overall corporate governance system in Korea had many ramifications. the corporate sector.

and other necessities domestically. and Yim (1998).4 contains analyses of corporate financing and its relationship to performance. Section 2.6 discusses responses of the Government and the business sector and explains in detail their reform and restructuring efforts. the import liberalization rate was below 7 percent and the average tariff rate was in the range of 25 to 30 percent. corporate control by the Government. and employees and their role in shaping corporate governance practices.Chapter 2: Korea 55 regulatory framework for the corporate sector and reform measures taken after the crisis. Section 2. This chapter is composed of six sections. the Government relied heavily on aid from the United States (US) and United Nations to alleviate poverty and high inflation. Section 2. clothing. In the period 19481961. The Government tried to produce food.2.2. Major economic indicators for some of these periods are shown in Table 2. . 2.3 identifies characteristics of corporate governance by analyzing the ownership structures and control patterns of listed companies and the largest chaebols. and naturally adopted an import substitution policy. The evolution of the modern Korean economy can be divided into four periods. reviewing government policies responsible for the development of the modern corporate sector. It traces the country’s economic development. Section 2.5 describes the state of the corporate sector in the financial crisis and draws on the results of the foregoing sections to outline the causes of the crisis. the board of directors system. It reviews such elements as shareholders’ rights.2 2.1 Overview of the Corporate Sector Historical Development3 The development of the Korean corporate sector is closely related to the progress of the economy. Import Substitution: 1948-1961 The Korean War (1950-1953) devastated Korea’s industrial capacity. Yang. From 1948 to 1961. Section 2. which account for a substantial portion of the Korean economy. creditors. It then presents recommendations for further reform in corporate governance and financing. 3 The review of historical development of the Korean economy draws substantially from the book by Sohn.2 presents an overview of the corporate sector.

the Government was not successful in solving the problems of slow growth.2 314.5) 8. e For maturities of one year or more.265. unless otherwise indicated) Indicator GNP Growth Rate Inflation Rate Savings Rate Investment Rate Manufacturing/GDP Interest Rate on Time Depositse Exchange Rate (won/$) Export Growth Rate Import Growth Rate Trade Balance (million $) Current Account (million $) Capital Account (million $) 1962-1971 1972-1979 8. International Financial Statistics.447.4 29.8 (8. The Government tried .0 27. and inconsistent economic policies.5 38. This goal required very high savings and investment rates. and implementing new budget and tax measures. IMF.0 41.855.4 24.1 29. modernizing the industrial structure. and large current account deficits. d Refers to 1997. b Refers to 1979.2 1980-1989 8.4 1990-1997 7. c Refers to 1989.4 29.9 — — 21.949.0) (297.8 15.4 10.6 11.2 1.102.8 12.1 9.4 (1.2 452.56 Corporate Governance and Finance in East Asia.5 250. Vol. high unemployment and inflation.7 14. the Government redirected the policy focus away from import substitution to an export-led manufacturing-based economy.3 8. a Refers to 1971.9) (7. Economic Statistics Yearbook.7 37. However.9b 15.2 31.9) 1.332. In the Plan.1 15.7c 11.1 percent with moderate rates of inflation and introduced a series of reform packages aimed at developing key industries.753.2 757.2 Key Macroeconomic Indicators Annual Average (percent.8 (724. Source: Bank of Korea.1 35.5) (1.2 6. the Government called for an unprecedented average annual economic growth rate of 7. lack of strong drive. II Table 2. largely because of political instability. Large amounts of aid in the form of agricultural goods from the US kept prices of local goods low and discouraged efforts to increase agricultural production.1d 9.1a 21.7 30. In 1961 it devalued the won from W65 to W130/dollar and announced its first Five-Year Economic Development Plan (1962-1966).2 32.8 24.0) 492.9 794. Export Drive: 1962-1971 Between 1962 and 1971.1 — = not available.2 30.

Also. and maximizing mobilization of domestic savings on the other.3 percent to 60. This change raised the import liberalization rate from 9. Korea normalized political and economic relations with Japan to encourage inflows of Japanese capital that could finance big development projects. The exchange rate system was a kind of crawling peg until 1974. In 1964. the growth of gross domestic product (GDP) raised domestic savings.2 billion in 1972. the Government tried to provide exporting firms with a free trade environment. However. These were considerably liberalized in 1967 when Korea joined the General Agreement on Tariffs and Trade (GATT). the import liberalization rate was 55 percent. and cheap labor force was well utilized by the export-led growth strategy.3 percent average between 1954 and 1959. due to continuous current account deficits. and almost doubled the foreign exchange rate from W130/dollar to W256/dollar to enhance the international competitiveness of exports. but the average growth rate for 1965-1969 shot up to 10 percent. But the liberalization trend turned out to be short lived as current account deficits continued. the Government changed the multiple and fixed exchange rate system to a unitary floating exchange rate system. Bank deposits increased rapidly. abundant.4 percent. but tariff rates were raised to 40 percent in the 1960s. The well-educated. Exports increased sharply from $41 million in 1961 to $2. a modest improvement over the 4. the Government undertook important economic reforms in two areas: the foreign exchange rate and the interest rate. channeling funds from curb markets into the banking sector. During the first five-year plan period. The interest rate reform enabled banks to allocate large funds to the industrial sector and reduced the high inflationary pressure that had built up in the economy. During this period. The Government abolished temporary direct subsidy measures and introduced a new comprehensive export promotion system. In 1963-1964. boosting internal investment resources. which laid a solid foundation for a steady growth path. The average growth rate of the economy from 1960 to 1964 was 5. The positive list system for imports was replaced with a negative list that indicated only those items that could not be imported.Chapter 2: Korea 57 to meet its targets by borrowing large amounts of foreign capital on the one hand. . up from 30 percent in the late 1950s. imports of consumer goods and luxury items were highly restricted. In 1965 the interest rate on one-year deposits doubled from 15 to 30 percent. In 1971. resulting in high real interest rates. while the average tariff rate was 39 percent.5 percent.

investing a total of $9. the emergence of competition of other low-wage. it tried to substitute imports and export high value-added HCI products. the Government felt the need to strengthen the defense industry. the Government changed its industrial policy emphasis from light industries to heavy and chemical industries (HCIs). The Government took emergency measures. It included a detailed construction and investment schedule over a 10-year time frame and mandated coercive implementation.58 Corporate Governance and Finance in East Asia. where preferential export credit was given to almost every exporter. Vol. and allocating virtually unlimited amounts of credit at below-market rates while controlling the financial system. faced the danger of bankruptcy. less developed countries forced Korea to adjust its industrial structure. reducing or exempting debts of farmers and fishermen. becoming a seed of the economic crisis in 1997. overburdened with debts and high interest rates. The HCI promotion policy was much more comprehensive than past economic development plans. the Government felt that continuous trade deficits arising from increasing intermediate and capital goods imports could be prevented by developing import substitution industries. This strategy formally took off with the announcement of the HCI Promotion Plan in June 1973. The Government encouraged a variety of business projects. It promoted HCIs by supplying massive capital for construction and development. nonferrous metal. II Heavy and Chemical Industry Promotion: 1972-1979 In the Third Five-Year Economic Development Plan (1972-1976). and giving low interest rate loans to banks from the central bank. One industrial policy adopted during the heavy and chemical industrialization drive was administered credit rationing. and assigned them to specific chaebols. These included rescheduling business debts. There were three reasons for the switch: first. in the face of a world economic slump. Third. shipbuilding. electronics. machinery (including automobiles). this new strategy had the Government explicitly allocating credit only to those firms deemed vital to HCIs in the form of below-market interest rates . and chemicals—as future core industries. Second.6 billion between 1973 and 1981 into these sectors. The Government targeted six industries—steel. the domestic economy was stagnant and many businesses. By promoting HCIs. In 1972. The Government has since used similar emergency rescue measures for large businesses and banks almost once every 10 years. announcing rescue packages for businesses and banks. These practices contained an implicit government guarantee that large businesses and banks could never fail. Unlike the previous system.

including denationalization of banks. and the won depreciated by 20 percent with the adoption of a Basket-Currency Gliding System in 1980. a heavy foreign debt burden. Macroeconomic policies became hostages of the industrial strategy. However. faced with high inflation. New start-up firms. the Government adopted comprehensive measures to promote economic stabilization. as it had to control only a few large chaebols. In order to improve economic efficiency. and their utilization ratios were very high. the Government restructured some large businesses through forced liquidation and M&As. the policy wasted substantial amounts of resources in the short and medium terms. Meanwhile.2). and the large excess capacity of HCIs. fiscal expenditure maintained zero growth. Cheap credit and distorted prices resulted in overexpansion in the HCIs. exacerbated the overcapacity problem. This required industrial restructuring by the Government. imports were further liberalized while tariff rates were lowered. coupled with political uncertainty due to the assassination of President Park in 1979. with many turning into the now well-known chaebols. Such an approach gave the Government increased control over the economy. met increased difficulty. Korea recorded current account surpluses and rapid economic growth due to the “three lows”: low value of the US dollar. The industrial and trade policy resulted in high inflation in the 1970s and serious excess capacity problems by 1979. including forced liquidations and mergers and acquisitions (M&As). various measures to increase competition were taken. Gross national product (GNP) growth rates on average were higher in the 1972-1979 compared to 1962-1971 (Table 2. The plan of the 1970s was thought to be successful in the long run.Chapter 2: Korea 59 through state-controlled banks. light manufacturing and service industries were weakened by disadvantages such as a lack of credit. In 1986-1989. Firms that followed the Government expanded greatly. since during the second half of the1980s many of the promoted firms became world-class competitors and exporters. The growth rate of the money supply was reduced drastically. The two important ones were import liberalization and deregulation of the financial sector. low . such as widespread underutilization of capacities of HCIs and related plants. The incentives available became more market-based. Evaluations of HCI promotion policies are mixed. Economic Liberalization and Globalization: 1980-1997 In 1979. The severe world recession caused by the second oil shock. price controls were abolished. especially between 1979 and 1985. however. Meanwhile.

the Government committed itself to further liberalization of the goods and capital markets. The most important element characterizing chaebols is the concentration of ownership. and declaring that it would follow Article XI of GATT. 45. with the 30 largest in the total economy in 1997 standing as follows: value-added. total debts. giving up its foreign exchange controls related to the current account. and total workforce. but it chose to liberalize gradually. while continuous and large current account surpluses saved Korea from the foreign debt problem.2 Rise of the Large Business Groups (Chaebols)4 The Korean Fair Trade Act defines a business group as “a group of companies. 47. 2.9 percent.1 percent and average tariff rates 8.3 percent. Meanwhile. and acceded to the World Trade Organization (WTO) in 1994. further increasing its pace of import liberalization. total sales. 4. The low value of the dollar led to a low won and high yen.1 percent. in which the official rate for the day would be based on the interbank transaction volume-weighted average of rates of the previous business day. the import liberalization ratio reached 98.60 Corporate Governance and Finance in East Asia. and low oil prices. Korea adopted a market average exchange rate system.2.2 percent. Korea began participating in many multilateral trade negotiations during the Uruguay Round. In 1988. The official rate fluctuated within a band. The birth of chaebols can be traced to the selling of Japanese colonial properties that were reverted to the Korean Government after World 4 The historical review of chaebols draws substantially from the paper of Lee and Lee (1996). 46.” A large-scale business group is called a chaebol.9 percent. joined the Asia Pacific Economic Cooperation (APEC) Group in 1993. Korea became a signatory country to the International Monetary Fund (IMF) Article VIII. Industrial and trade policies were modified to be consistent with WTO. Korea abolished remaining direct subsidy systems for export activities as well as some traditionally managed trade systems. Vol. the importance of chaebols was increasing. . The Government tried to adjust economic policies and regulations to meet global standards. whose business activities are controlled by an identical person. total assets.9 percent. where particular individuals and their family have de facto control of the management of all subsidiary companies of groups. In 1990. By joining the Organisation for Economic Co-operation and Development (OECD) in December 1996. which gradually widened. 13. In 1993. II world interest rates.

of Subsidiaries 604 616 623 669 Average No. Large-scale companies owned by the Japanese were sold to individuals under preferential terms and later enjoyed a relatively favorable position for accumulating capital. In this sense.1 20.when the Government put a great deal of emphasis on development of the HCIs. . chaebols that maintained a close relationship with the political authorities were able to grow fast. Subsidiary companies of chaebols are subject to “fleet-type management” in that they are controlled by the overall managerial system of chaebols. the Korean Government has set the national goals of economic development and offered all kinds of support and incentives to achieve them. Table 2. Table 2.3 shows that the number of subsidiaries of the 30 largest chaebols increased considerably since 1993. In the mid-1970s. The Government provided subsidies. and tax breaks to key industries to promote exports and industrial upgrading. the ownership and management of a chaebol’s subsidiaries are not separate. Chaebols are also excessively diversified. One reason for this controlling power is inter-company shareholding among subsidiaries. Since the 1960s. reaching 669 in 1996.Chapter 2: Korea 61 War II. large-scale businesses and chaebols were thought to be appropriate actors because they could meet the huge investment requirements of these industries. Chaebols have a history of substantial concentration of ownership. However. it was more effective to deal with a small number of companies to secure tangible outcomes. financial assistance. The Government provided financial and fiscal incentives to chaebols and trading companies with relatively abundant financial resources.8 22.5 20. after the financial crisis. of Subsidiaries per Chaebol 20. Since the Government controlled most business activities. Important managerial decisions are made primarily by owners. and they are aided and supported by one another.3 Subsidiaries of the 30 Largest Chaebols. From the standpoint of the Government. 1993-1996 Year 1993 1994 1995 1996 No. This policy contributed greatly to the expansion of chaebols. This galvanized the fast growth of chaebols.3 Source: The Fair Trade Commission. the number of subsidiaries declined drastically due to corporate restructuring.

Vol. years since establishment.62 Corporate Governance and Finance in East Asia. Another law that contributed to the development of the stock market was the Act to Expedite the Going Public of Corporations of 1972. . profitability. They had to meet certain requirements in terms of firm size. For example. The law also allowed employees of listed firms to get 20 percent of the subscription rights in offerings of new shares. In the early years after the enactment of the law. the Government reviewed the financial performance of companies and recommended (or ordered) selected ones to go public. the Government’s efforts to develop the stock market culminated in the Capital Market Development Act of 1968. Diversification may raise chaebol profitability but could also work to eliminate more efficient competitors because bigger chaebols have a higher capability to enforce unfair methods of competition. On the other hand. there are many negative assessments of organizational structures and practices of chaebols. if a chaebol has an unsound financial structure but strong financial links through mutual payment guarantees among their subsidiaries. listed companies enjoyed corporate tax rates that were 10 to 20 percentage points lower than those imposed on privately held firms. diversification can make chaebols stable through the portfolio effect. Under this law. and were allowed extra depreciation charges for tax purposes. Since chaebols are engaged in many different businesses. Related to this is the tendency of chaebols to assist unprofitable firms at the expense of profitable ones. including the “economies of organizational size” inherent in multi-product and multiplant firms. This law was in effect until 1987 when it was partly absorbed into the Capital Market Development Act. However. chaebols can benefit from synergies. Meanwhile. they can reduce uncertainties and dilute risks through sharing of information and diversification. 2. internalization of the market that could enhance the internal efficiency of a chaebol may close the market to other firms.3 Role of the Capital Market and Foreign Capital In the 1960s. II Theoretically. in addition to the usual economies of scale. the bankruptcy of one or a few marginal subsidiaries could lead to a chain of bankruptcies for the entire chaebol. This could ensure their stable growth and enhance their investment abilities. The law also contained provisions to afford tax and other benefits to firms that went public and to impose tax-related penalties on those that refused to comply with government recommendations. etc. which may ultimately lead to the decline of social efficiency.2.

0 49.4 40. Korean firms were allowed for the first time to issue in international financial markets equity-related securities such as convertible bonds (CBs) and depository receipts.4 Development of the Stock Market. the Government announced the gradual opening of the capital market to foreign investors in January 1981.9 34. This reversal in policy reflected declining stock prices and was generally maintained until the outbreak of the economic crisis in 1997. in 1986 the Government imposed limits to bond issues on firms that were recommended to go public but refused. The policy to expand the size of the stock market. a country fund. Also that year. . 1985-1998 No. mainly by increasing the supply of shares by initial public offerings (IPOs) and seasoned issues. In this regard.570 95.9 833. The Korea Fund.5 406.989 137.1 Market Capitalization (W billion) 6. As shown in Table 2.370 70.0 79.2 44. Inc.4 654. Because of government policies and the booming economy.1 16.6 747. especially those paying small or no dividends.020 151. of Listed Firms 342 626 669 699 721 760 776 748 Stock Price Index 138. Second.476 79.217 141. the Government attempted to stabilize the stock market by limiting IPOs and share issues by listed companies. Beginning 1990. The aggregate Table 2.7 934. the number of firms listed on the Korea Stock Exchange almost doubled in the five-year period from 1985 (342 firms) to 1990 (669 firms). however. the Government announced measures to increase the demand for shares by providing tax and financial incentives to individual investors.4.6 Year 1985 1989 1990 1994 1995 1996 1997 1998 Source: Monthly Review (Securities Supervisory Board) and the Financial Supervisory Service.9 918. the stock market grew rapidly during the 1980s.151 117.0 965. several important policy measures were implemented to promote the development of the stock market.Chapter 2: Korea 63 During the 1980s and 1990s.798 Market Capitalization as a Ratio to GDP (%) 8.. Third.1 30. continued until 1989. was established to invest in domestic shares beginning in September 1985. First.

II market value of all listed firms represented only 8 percent of GDP in 1985.875 21.008) (3.642 21. The relative size of the stock market diminished to 44 percent in 1990.150 5. but increased sharply to 79. and other liabilities.255 2.347 3.858 4. Bank of Korea. Vol.870) (1.910) 2.500 7. Korean companies borrowed substantial amounts of foreign capital due to the excess of investments over savings and chronic current account deficits—except in the period 1986-1989.450 24.433) (9.296) (6.440 1. due to declining stock prices. and stayed at the 30-40 percent level up to 1996. Table 2.413) 56.737 (333) (297) (607) (2) 218 2.650 (1.785 (1.382 Permit basis.924 (1.264) (3.149 13.953 10.339) (9.546 (2.455) 13.59 percent in 1998 and to more than 50 percent in the early months of 1999. Other investments include loans.800 (7.126 (1.534) 1.942) 42.017) 1.5 Private Capital Flows to Korea.583 25 10.141 4. The number shrank for the first time in 1998 to 748 firms from 776 the previous year. trade credits.944) 8.2 percent by 1989. The aggregate market value of listed shares bottomed at 16. The growth in the number of listed firms also slowed in the 1990s.86 percent of GDP in 1997.817 16.123 3.338 4.5 shows net FDI—inward investments by foreigners less outward investments by Koreans—in the period 1985-1998.326 1.542) (1.001 4.085 2.694) 2.287 (340) 73. and 1993. Source: Balance of Payments. Table 2. but rose again to 34. However.352 471 3. The reasons for the decline include increases in bankruptcies and mergers involving listed companies since the outbreak of the economic crisis.714 1.414) 5.571 2.658) (3.239 19.553 8.742 (3. 1985-1998 ($ million) Year Net FDIa Portfolio Investments Other Investmentsb Of Which Loans Trade Credits 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 Total a b 313 (9) 696 809 147 (808) (115) (311) (832) (2. foreign direct investment (FDI) has been very small relative to GDP and compared to other East Asian countries.453 (2.183 12.64 Corporate Governance and Finance in East Asia.852) (2. currency and deposits.868 (518) (418) 63 1. .

Japan’s was consistently higher. and (iii) chaebols. weak incentives for attracting FDI. but dropped in 1996 and were negative by 1997.China. increased substantially in 1994-1996 due to accelerated liberalization of capital movements (Table 2. The contribution of the corporate sector to GDP was 73.Chapter 2: Korea 65 Complicated government regulations. Net private capital inflow.4 Growth and Financial Performance This section looks at the performance of (i) the aggregate corporate sector. The Aggregate Corporate Sector The aggregate corporate sector in this study excludes the financial sector.5).6 percent in 1997. Large amounts of outward investment by Koreans in the mid-1990s arose out of increased liberalization of foreign exchange regulations. 2. equity. (ii) listed firms. Taipei. Of this. In addition to FDI. However.6).9 billion.2. Table 2. This would lay the foundation for evaluating the effect of corporate governance on performance.7 billion and loans $42. This indicates that a substantial proportion of debt was denominated in dollars. other net private capital inflows amounted to $130 billion during 1985-1998.China and the US. The debt-to-equity ratio (DER) averaged 311 percent for the period 1990-1996 and peaked at 424. following the sharp depreciation of the won. and high production costs were the main reasons for low FDI in Korea. The growth rates of total assets. Return on equity (ROE) and return on assets (ROA) showed similar patterns. Corporate sector net proft margins increased from 1993 to 1995. and sales of the aggregate sector during this period were very high (Table 2. The dismal performance of the Korean corporate sector compared to the . and US. Profit rates of Korean firms were relatively low compared to those of Taipei. portfolio investments amounted to $73. Korea had substantial current account surpluses and experienced net private capital outflow. but between 1988 and 1993. The same categories will be analyzed in later sections. The ratio is generally in the same range for Japan and Korea.7 compares the ratio of ordinary income to sales of Korea’s manufacturing sector with those of Japan. Between 1986 and 1989. the growth rates of equity and sales dropped sharply in 1996 and 1997. excluding FDI.2 percent in 1987. increasing to 76 percent in 1997.

6 (4.9 18.3 21.5 2.6 13.7 2.8) 297.1 5.5 1.7 4.2 1.6 4. . ROE = return on equity (ratio of net income to stockholders’ equity).1 8.5 3. 1990-1997 (percent) Growth Performance Year Total Assets Equity Sales Financial Performance Net Profit Margin DER ROE ROA 1990 1991 1992 1993 1994 1995 1996 1997 23.0 3.7 4.9 16.6 1.8 3.5 4.5 7.4 4.2) (0.3 312.9 5.3 14.0 6.4 1.0 4.3 17.2 13.9 3.5 1. Source: Bank of Korea.0 10.5 4.3 — 3.5 1.9 5.1 2. Note: Ratio of ordinary income to sales = (ordinary income/sales).9 8.4 1.0 8.9 18. Ordinary income = operating income + nonoperating income (from financial activities) – nonoperating expenses (from financial activities).5 (0.9 2.0 13.7 1.1 2.0 0.China 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 2.3 3.2 1.6 9.8 2.9 5.3 11.0 305.8 1.2 19.6 318.0 (0.9 13.7 3.7 15.6 Growth and Financial Performance of the Nonfinancial Corporate Sector.9 3.1 — — — = not available.6 1.6 2.3 335.4 10.4 2.2 9.Table 2.7 15.0 13.7 4.9 2.2 13.1 2.9 16.3 21.3 308.8 21.7 3.9 2.6 3.9) DER = debt-to-equity ratio.4 — 6.7 325.8 8. Financial Statement Analysis Yearbook.3 1.0 7.1 6.6 424.4 19.9 4.5 0. Table 2.2 18. Net profit margin = ratio of net income to sales.4 2.3) 5.8 22.3 6. Financial Statement Analysis Yearbook.4 1.7 International Comparison of Ratios of Ordinary Income to Sales in Manufacturing (percent) Year Korea US Japan Taipei.8 1.2 1. Source: Bank of Korea.4 2. ROA = return on assets (ratio of net income to total assets).

Small listed firms were hardest hit by the financial crisis. and steam supply industry. both ROA and ROE were lower for the listed firms compared to the latter. and ROAs of all listed firms declined substantially in 1996 and turned negative in 1997. and transport sectors recorded negative profit rates in 1997. Listed Companies The number of listed firms increased from 334 in 1985 to 775 in 1997 (Table 2. the sales growth of listed firms was higher than that of the aggregate sector (see Table 2.5 percent while the aggregate sector recorded only 13. gas. sales of listed firms grew 18. It is notable that the construction sector’s profit rate began its decline in 1995. construction. a year ahead of the other industries. In 1997. while their average net profit margin was lower than that of medium firms. the average ROE was lowest for large firms. trade. Profit rates of different industries also mirrored the downward trend of the aggregate corporate sector prior to the crisis. The other financial ratios follow the general pattern of the aggregate corporate sector. The superior performance of listed firms in terms of sales growth may be due to large firms’ easy access to credit and the inclusion of financial firms in the listed firms category. However.10). A comparison of performance by firm size reveals some interesting results. Performance followed similar patterns across different industries (Table 2.Chapter 2: Korea 67 other three economies can be attributed to the emphasis on growth in sales and market shares rather than on profits.4 percent. this may be an indication of the bias toward large firms in terms of access to credit. with equity in wholesale and retail trade even contracting. All sectors experienced a sharp decline in equity and sales growth in 1997. This preference of Korean firms has its roots in the structure of corporate governance.9).6). the exception being the electricity. However. Net profit margins.and small-scale firms (Table 2. with the wholesale and retail trade sector and the construction sector having the highest figures.8). This may be related to its having the lowest DER. but higher than that of small firms. The manufacturing. followed by mediumsized firms and large ones. The growth performance of large firms for the 1988-1997 period was better than that of medium. ROEs. Profit rates of most industries are also quite low. . Growth rates of total assets are generally high. Again. The profit margin of listed firms was generally higher than that of the aggregate corporate sector. In most years.

5 5.3 2.9 (0.7 1.9 1.0 15.0 23. and Business Activities 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 11.3) (1.2 7.3 14.5 473.7 7.3 13.2 423.0 2.6 6.9 538.8 22.1 0.0 18.2) 22.3 15.5 14.6 15.8 16.4 291.7 9.2 25.9 428.5 5.0 254.0 24.7 0.5 1.6 0.8 3.5 4.6 655.8 2.5 306.9 2.1 0.2 15.1 10.5 (1.0) 0.1 1.8 12.8 16.5 3.2 5.6 14.5 483.7 22.1 0.6 7.1) (3.2 315.0 2.6 1.9 29.8 16.5) 0.7 228.1 2.0 1.4 1.5 23.1 17.4 2.5 28.7 317.4 0.0 12.5 1.8 526.0 37.8 32.0 24.8 7.8 35.0 19.5 270.5 19.9 16.1) 0.3 14.4 15.4 348.4 .8 3.0 7.2 20.9 31.1 28.8 14.9 10.9 13.7 17.4 14.6 5.0 15.2 0.5 (5.3 18.6) 3.8 1.4 10.9 25.1 1.0 2.0 21.6 17.7) 2.8 562.5 1.2) 6.0 (0.6 3.6 1.2 18.8 302.9) 1.7 21.2 12.9 3.5 1.8) 0.6 318.7 30.0 5.3 288.0 1.2 16.5 16.8 22.2 (1.6) (6.8 Real Estate.1 7.2 16.4 2.4 740.5 6.5 1.9 16.1 290.3 8.5 13.1 (0.4 12.9 9.3 10.8 345.1 16.7 5.3 10.6 12.4 5.9 (0.2 36.8 10.1 22.4 10.7 (0.8 2.2 5.9 (0.3 31.4 350.4) 0.6 375.0 1. Renting.5 (0.5 27.6 3.3 15.6 16.6 24.8 2.0 1.3 285.3 1.3 15.9 19.2 20.7 294.1) 3.0 5.3 11.8 616.8 12.4 17.5 239.0 22.6 2.4 (0.Table 2.2) (0.1 1.9 340.2 2.4 10.9 10.4 5.8 23.5 30.1 21.6 12.0 2.3 15.2 6.1 1.9 14.5 6.0 16.4 2.9 16.4 2.9 5.0 245.6 0.4 0.8 0.8 24.9 0.7 10.5 432.2 241.7 4.8 34.6 14.0 22.1 2.2 0.2) 15.0 1.1 296.8 14.4 4.3 8.8 13.0 18.4 5.6 14.0) 4.8 Growth and Financial Performance of Selected Industries (percent) Growth Performance Year Assets Equity a Financial Performance NPM b Sales DER ROE ROA Manufacturing 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 13.3 8.4 474.9 2.4 9.0 (4.7 514.3 1.0 3.7 16.8 461.8 0.4 10.0) 0.0 1.6 17.4 458.0 22.5 1.0 (0.5 286.8 1.7 (3.8 17.2 6.0 16.5 338.1 (0.8 10.6 11.8 24.4 1.1 20.5 569.3 25.0 9.4 3.3 11.4 2.0) 1.1 396.2 24.5 Construction 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 18.2 0.3 2.2 5.1 27.0 1.3 8.7 520.

4 3.7 15.6 172.6 3.0 89. and Communication 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 15.6 19.7 11.5 11.3 524.2 143.6 15.5 2.9 321.6 (2.0) (0.8 7.6 9.2) 9.4 1.6 9.3 0.3) (1.9 1.2 14. a New equity does not include capital surplus.0 106.3 8.7 0.6 2.9 8.2 10.4 15.2) 13.2 18.9 10.3) 4.4 3.5 16.8 14.6 6.4 12.2 18.6 14.6 34.2) 0.1 1.0 2.7 14.4 — — — — — 448.3 18.3) 15.5 4.7 2.0 21.2 10.5 14.0 Transport.1) (0.8 3.6 8.3 17.9 7.2 7.1 15.3 543.4 633.4 2. Storage.7 — — — — — 14.1 3. Gas.5 14.8 0.4 6.2 1.3 4.7 — = not available.3 4.7 0.6 6.1 21.7 20.3 740.8 6.4 0.0 921.0 14. .0 5.3 2.1 17.3 (2.5 15.1 15.4 21.8 0.0 1.7 2. Financial Statement Analysis Yearbooks.3 8.8 14.1 14.9 6.1 11.5 14.6 19.2 — — — — — 2.0) 1. and Steam Supply 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 12.3 18.8) (12.9 8.0 98.5 117.6 12.4 6.1 2.5 0.6 8.1) 1.5 482.4 341.0 (1.5 14.9 3.2 14.5 344.8 8.6 16.0) 1.9 4.1 16.3 — — — — — 10.2 11.7 187.4 1.8 9.2 90.7 7.4 7.8 3.6 (2.9 Electricity.5 13.8 (Cont’d) Growth Performance Year Assets Equitya Sales NPMb Financial Performance DER ROE ROA Wholesale/Retail Trade 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average — — — — — 31.5 307.5 26.7 16.5) 22.0 (15.8 529.1 11.6 12.3 9.5 30.9 9.4 367.8 11.3 3.4 14.5 8.1 6.3 34.9 4.4 11.5 539.6 18.4 0.5 47.4 2.3 23.6 6.8) 1.6 1.2 2.2 15.8 6.1 (11.0 1.8 15.4 (2.9 18.7 11.5 11.7 116.9 10.9) (8.3 12.4 10.4 16.2 3.4 3.3 0.0 13.7 7.9 18.7 19.3 1.0 14.2 122.3 112.6 0.1 (0.7 510.4 (0.4 7.9 17.6 8.4 169.0 7.1) (0.2 10.3) 11. b NPM denotes net profit margin.1 4. Source: Calculated using data from Bank of Korea.8 4.4) (1.6 1.4 9.1 323.2 698.0 2.9 17.5 12.062.Table 2.1 8.4 1.5 (2.6 — — — — — 17.9 (10.7 12.5 612.6 21.4 0.3 125.6 4.7) (4.4 13.1 (2.4 12.8 12.9 (11.9 12.3 1.6 4.5 462.9 12.1) 5.7) 0.6 9.8 111.3 4.0 1.3 19.6 20.9 456.7 11.6 — — — — — 0.9 9.4 30.8 12.2 18.6 512.1 15.0 5.1 12.9 332.5 15.

Kis-Fas.5 19. It should also be noted that when the financial crisis struck in 1997. The smallest group had 16 members in 1995.5 5.3 0.9 Growth and Financial Performance of Listed Companies.6 (1.4 0. but the number of designated groups has been fixed at 30 since 1993.5 ROA 0. the 30 largest chaebols accounted for 13. Vol.7 1. unless otherwise indicated) Financial Performance Year 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average No. and net profits (46.4) 1.9 2.3 20.4 1.8 6.2 0. The criteria for selection of largest chaebols have changed a few times.1 6.9 0. Hyundai Group.9 1.3 2.2 9.1 1.8 0.9 percent). debts (47.1 1.7 (5. Generally.70 Corporate Governance and Finance in East Asia.6 and 2.9 Source: Constructed using data from Korea Investors Service. Between 1993 and 1997.5 19.2 9.8 5.9 21.2 2.3 percent).6 1. The top five chaebols registered the highest growth rates.12). had 46 member companies.3 4.6 3. and close to half of total assets (46. followed by the top 6-10 (Table 2.9 6. The number of Hyundai member companies rose to 57 in 1997. sales (45.7 Net Profit Margin 0. II Table 2. the growth of sales of the top 30 chaebols exceeded that of the aggregate corporate sector (compare Tables 2.3 (0.5 0.4 1.6 23. it is the chaebols’ large firms that are listed.0 0.0 18.5 ROE 3.9 11.4 22.4 2.9 2.7 percent) of the corporate sector.12). of which 16 were publicly listed (Table 2.2 6.9 percent).1 percent of the economy’s total value added (excluding the financial sector).6 2. of which four were listed.4 1. Chaebols have been the most important actors and engines of growth in the Korean economy.0 3. 1998.8 24. In 1995.6 22. 1985-1997 (percent.11).7) 0.7 1.3 15. the largest chaebol. Performance of Chaebols This section uses available data on the top 30 chaebols. In 1997. the top 11-30 chaebols experienced a decline of . of Firms 334 351 386 503 626 669 680 681 687 698 715 754 775 Sales Growth 10.6 0.9 26.1) 4.

Source: Korea Investors Service.5 5.6 1.2 10.7 4.3 9.6 2.2 13.8 3.3 1.8 6.3 3.5) 1.9 14.4 1.7 (1.5 17.8 0.7 (0.2) (1.6 3.3) 0.9) (6.0 19.8 7.7 18.3 15.0 1.7 (1.6 3.0) 0.1 8.0 6.9 6.2 Small 13.5 (1.2 (0. Others are medium firms.6) 0.0 1.9 25.10 Growth and Financial Performance of Listed Companies by Size.2) (1.2 7.8 0.6 1.8 16.1 2.2 3. 1998.0 1.4 3.9 22.7 2.9 5.6 2.0 (4.9 (0.9 0.8 1.9 2.9 1.6 5.8 6.3 (0.0) 1. 1988-1997 (percent) ROE Large 9.6 13.1 2.9 0.2 Note: Large firms have a capital base greater than W15 billion and small firms smaller than W5 billion.7 2.8 0.7 1.3 15.0 4.1 1.2) 0.8 10.9 2.4 2.3 6.6 8.0 10.4) 1.7 3.2 2.6 7. .4 Medium Small Large Medium Small ROA Growth Performance Large 17.6 0.4 1.5 25.5 0. Kis-Fas.2 2.9 1.0 16.2 13.4 3.Table 2.1 11.2 1.6 2.5 1.9 3.4 16.6 0.9 0.9 2.6 1.4 11.8 (5.8 0.1 0.6 (1.6 6.4 5.6 (0.1) 5.0 15.0 17.5) 1.5 Net Profit Margin Year Large Medium Small 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 2.3 (0.8 17.5 5.3 11.3 Medium 14.2 0.4 6.5 3.9 6.3) 5.2 12.8) 1.8) 6.5 2.6 9.0 1.

761 31.574 3.445 4.873 2.398 — 2.Table 2.458 6.177 — 6.129 2.455 22. Source: Fair Trade Commission.853 1997 53.486 6.303 3.346 3.158 1.090 6.427 9.475 2.309 14.376 35.766 3.951 3.956 3.990 2.457 14.935 2.996 1.640 4. of Listed Companies 1995 16 14 11 9 5 11 9 5 8 4 4 9 5 2 4 3 2 7 4 4 4 6 8 2 5 2 2 2 0 4 — = not available.677 3.774 7.395 31.910 3.180 2.690 3.117 4.131 3.599 — 2.11 Features of the 30 Largest Chaebols Total Assets (W billion) Name Hyundai Samsung LG Daewoo Sunkyung Ssangyong Hanjin Kia Hanwha Lotte Kumho Doosan Daelim Hanbo Dong-A Halla Hyosung Dongkuk Jinro Kolon Tongyang Hansol Dongbu Kohap Haitai Sammi Hanil Keukdong New Core Byucksan 1995 43.995 2.287 10.798 — No.743 40.967 7.651 38.924 2.501 13.929 12.597 351. .370 6.313 14.423 5.433 3.246 11.927 16.147 5. of Member Companies 1995 46 55 49 25 32 23 24 16 31 28 27 26 18 21 16 17 16 16 14 19 22 19 24 11 14 8 8 11 18 16 1997 57 80 49 30 46 25 24 28 31 30 26 25 21 — 19 18 18 17 24 24 24 6 8 2 15 — 7 — 18 — No.364 5.756 5.158 7.

0 19.1) 0.4) (0.5) (0.1 27.7) Source: Bank of Korea.7) ROE 5.7 1.6 19.2) (2.5) (0.4) (14.5) (0.1) (0.0 31.8 0.1) (1.0 0.2 (2.1) (0.4 38.1 (2.7 13.2 0.3 15.4 30.0 2.2 (16.3 1.2 1.7 4.5 32.8 18.7 10.5 19.2 (2.3) 0.6 1.7 0.6 25. 1993-1997 (percent) Growth Rates Year Top 1-5 1993 1994 1995 1996 1997 Top 6-10 1993 1994 1995 1996 1997 Top 11-30 1993 1994 1995 1996 1997 Top 30 1993 1994 1995 1996 1997 Sales 12.2 11.9 18.9 3.8 Assets 12.1 19.4 12.9 17.7 10.2 3.1) 0.12 Growth and Financial Performance of the 30 Largest Chaebols.6 18.0 2.2 (5.3 0.Table 2.7 15.0) 12.3 14. .1 (3.9 1.2) (0.3 3.0 0.0 17.2 0.5 5.9 20.4) 1.0) 3.2 0.6 4.0 1.5 2.4 (2.5 27.7 15.0 6.1 (1.5 20.6 Financial Performance Net Profit Margin 1.3 16.1 10.3 19.4 26.3 11.4 0.8 27.3 27.0) ROA 1.5 (0.3 9.0 2.3 0.2) 1.9 24.9 3.1 2.3 1.2 20.6 (0.9 20.

95 percent. By the end of 1997. includes the largest shareholder. The better showing of the top five chaebols was a direct result of their dominance in human resources. . resulted in the chaebols’ excessive leverage. loopholes and inconsistent policies spawned strategic behavior and agency problems.3 Corporate Ownership and Control This section looks at the key aspects of corporate governance in Korea. technology. However. The Commercial Code stipulates the basic governance framework and applies to all corporations.3. The ROE of the top 30 chaebols was consistently higher than that of the aggregate corporate sector.” This “identical person. his/her relatives.” in Korea’s legal and regulatory framework. Only the top five chaebols registered a positive net profit margin in 1997. The absence of a well-developed equity market and the provision of subsidized credit. and government intervention interacted through a set of laws and regulations to bring about the existing structure. In general. the average DER of the 30 largest chaebols reached 519 percent. and led to a high concentration of ownership. a pyramidal structure of corporate ownership is prevalent. from 190 to 3. Vol. 5 While “ownership concentration” can be defined and measured differently in different contexts.765 percent (Table 2. There has been a wide range in DER among chaebols. and access to credit. Ownership patterns. 2. The financial performance of the top 11-30 chaebols deteriorated during 1993-1997.1 Patterns of Corporate Ownership The ownership of most Korean listed firms is highly concentrated.5 Founding families are mostly still the largest shareholders and. However.7 percent growth in total assets. more important. Attempts to rectify the corporate structure were halfhearted and it was only after the onset of the crisis that many of the most serious reforms were instituted. chaebols had a higher average DER than the corporate sector as a whole. 2. and the companies that are under the control of the largest shareholder. coupled with weak corporate governance. internal and external control mechanisms. the net profit margin of the aggregate sector exceeded that of the top 30 chaebols. weak corporate control. II 2 percent in their sales and a very low 4.74 Corporate Governance and Finance in East Asia. Their worst year was 1997 when ROE hit -15. it refers to the degree of concentration and shareholdings in the hands of an “identical person. except for 1995. and vulnerable balance sheets.13). in this instance.

Kukdong Construction 29.764. Hyosung 18. Hyundai 2. Jinro Debt-to-Equity Ratio 376. Byucksan 1996 1.7 688.3 297.8 336. Kia 9.8 313.3 328. Haitai 26.9 751.5 383. Hanwha 10. Daelim 14. Kia 9.1 674. Hanjin 8. Doosan 13.0 506. Hyosung 18.7 416. Ssangyong 7. Daewoo 5.9 321.5 464. Kolon 21. Sunkyung 6. Dongbu 24.4 622.2 2.2 292. Samsung 3. Hansol 23.6 2.441. Sunkyung 6.0 486.2 346.4 192.13 The Top 30 Chaebols’ Debt-to-Equity Ratio.5 337. Kumho 12.6 .0 436. Tongyang 22.1 477. Jinro 20. Hyundai 2.0 218.7 620. Doosan 15.7 267. Kumho 12. Dongah Construction 16. LG 4.7 621.2 924.244. Sammi 27.6 936. Daelim 16. Dongkuk Steel 19.2 423.065. Dongah 14. Lotte 11.7 354.4 556. Hanbo 15. Halla 13.0 370. 1995-1997 (percent) Chaebols 1995 1. Newcore 30.1 3.1 385. Samsung 3.2 328.3 315. Kohap 25. LG 4.6 516.5 343. Halla 17.4 205. Daewoo 5.5 2.1 190.4 175.8 312. Hanwha 10. Dongkuk Steel 19.855.3 572.Table 2. Lotte 11. Ssangyong 7. Hanjin 8. Hansol 17.1 278.6 409.5 3.2 471. Hanil 28.

7 1.7 944.5) 404.1 375.5 (893. Dongah 11. Kumho 10. Saehan Average of All Chaebolsa 1995 1996 1997 Average of All Industries Excluding Financial Sectorb 1995 1996 1997 Debt-to-Equity Ratio 317.5 519.784.3 399.6 416.5 576.498.5 261. Ssangyong 8.9 472. Kohab 22. Halla 13.5 386.8 658.600. Kohab 18.6 Sources: aFair Trade Commission. LG 5. Keopyong 29.7 370. Dongbu 21.3 347.8 647.9 1. Tongyang 24.9 216. Miwon 30.501. Dongkuk Steel 20.1 472. Shinho 1997 1. Hansol 16.6 478.4 1.214.1 438. Hyundai 2.6 335. Anam 27. bBank of Korea. Newcore 28. Financial Statement Analysis Yearbook.225.9 578. Hanwha 9. Kamgwon Industrial 30. Hanjin 7.13 (Cont’d) Chaebols 20. Doosan 15. Haitai 25.8 307.8 468.8 590. Daesang 27.9 465.1 433.8 347.6 590. Dongbu 23.3 1.Table 2.5 323. Haitai 25. Jinro 23.3 676. Hyosung 17.8 338.5 (1.0 505. Hanil 28. Tongyang 24.6 424. Lotte 12.1 359. Samsung 3. Keopyong 29.9 490.0 305.5 1. Kolon 21. Kolon 19. . Anam 22. Daelim 14. SK 6. Shinho 26.8 399.0 907.0 419. Newcore 26.4) 513. Daewoo 4.

i. the extent of ownership by these individuals declined gradually after 1988. large ownership can also bring about the entrenchment effect. the percentage of holdings by individuals slipped to 60. individuals were also the largest shareholder group. the ownership structure can bring about an incentive effect.. the entrenchment effect outweighs the incentive effect.” foreigners.7 percent by 1997. However. the entrenchment effect and problems of agency may be more pronounced in chaebols than in independent firms. including investment trust companies. Thus. Composition of Ownership Among listed companies. The percentage of shares owned by “other corporations. the Government. Financial institutions owned as much as 28 percent of the total corporate shareholdings in 1992. Beyond that range. Among listed nonfinancial companies. that is. Most non-chaebol listed firms in Korea are believed to have ownership concentrations within the 10-30 percent range. The next important group was “other corporations. an entrenched manager is insulated from market pressure and can pursue personal goals without the fear of being replaced. The controlling shareholders of chaebols hold comparatively smaller percentages of shares. an increase in their ownership may bring their ownership incentives to converge with those of the minority shareholders. the individual owners—the portfolio investors as well as the controlling shareholders and their family members—formed the largest shareholder group (Table 2. When managerial holdings are reinforced by artificial control mechanisms such as pyramiding. From 69. and then steadily declined after 1993. fluctuated widely during the period.1 percent. Theoretically.e. while those owned by banks. resorting to extensive use of pyramiding to maintain control. but their shares declined to 21. Securities companies reduced their holdings over this period of falling stock prices as the size of investment trust companies’ stock portfolios declined. and state-owned companies and securities companies declined. 10 to 30 percent). the year the stock market was in a frenzy due to buying sprees. with a given range of managerial shareholdings (for instance. The pattern of distribution changed little through 1992-1997. including banks and other financial firms.Chapter 2: Korea 77 When controlling shareholders hold a very small percentage of the shares. The holdings of financial institutions. However. The reduction can be . and insurance companies increased during the period.6 percent by 1997.” followed by banks. the incentive effect once again dominates. managerial entrenchment becomes more likely.14).

Table 2.3 1994 521 1.2 7.6 16.2 9.6 Year No.1 11.3 5.9 2.8 1995 548 2.1 60.6 13.8 2.0 7.0 4.0 5.0 59.9 19.9 5.7 18.2 3.5 6. All Listed Companiesc 1992 681 1993 687 1994 698 1995 715 1996 754 1997 775 9.6 1991 505 0.2 17.2 9.6 2.3 2.9 37.1 21. and finance companies.7 1990 531 0.5 Note: Ownership is based on number of shares. a The State covers the Government and state-owned companies.0 5.1 68. merchant banks.1 18.5 1.6 19.2 5.1 8.7 59. Listed Nonfinancial Companiesd 1988 406 0.6 9.6 12.3 8. 1988-1997 (percent) Financial Institutions Securities Firms Total 28.2 8.1 4.5 12. etc.5 1992 508 2. b “Banks.8 17.8 5. c Data from Korea Stock Exchange.2 5.8 59.4 13.4 Insurance Firms Other Corporations Foreigners Individuals 39.2 4.4 5.” includes commercial banks. .2 2.4 13.4 34.7 4.0 28.9 2.9 26.b A.1 17.2 8.9 15.0 8.6 9.7 7.5 6.2 1.1 1.3 18.6 8. etc.1 2.8 17.6 22.8 69.3 1.0 9. mutual savings.1 10.9 1.5 7.5 7. d Constructed from data files of the Korea Listed Companies Association.6 20.9 4.5 62.9 1.4 6.0 27.8 5.7 3.5 4.2 18.3 17.4 1997 551 1.14 Ownership Composition of Listed Companies.3 26.5 16.2 B.3 1.5 18.9 36.6 36.8 2.6 16.4 14.8 4. of Firms The Statea Banks.7 6.1 18.1 3.0 60.4 18.3 18.5 1989 498 0.7 9.3 1996 570 2.7 14.7 8.3 39.7 9.8 59.1 8.9 17.4 5.3 5.5 60.2 1993 511 2.6 16.3 17.1 21.5 1. investment trust companies.

In most instances. the holdings of institutional investors were expected to increase significantly with the Government’s introduction of US-type investment companies in 1998 and . and service of motor vehicles (Table 2. The Government’s and state-owned institutions’ (including some banks) ownership was generally small except in the power sector. Corporate holdings averaged 16 percent throughout 1988-1997. In 1998. medium. The holdings of other corporations are mainly equity investments in affiliate companies. However. of some banks. However.17). and US (Table 2.Chapter 2: Korea 79 ascribed to prudence in staying away from the stock market—as part of their risk management strategy—as the stock market was in doldrums throughout the 1990s. and small companies. categorized into large. indicating their heavier reliance on inter-firm financing investments. The ownership distribution in listed nonfinancial firms.18). the Government was the sole owner. the Government acquired an even bigger share in several banks as part of its program to bail out these distressed institutions. This is low compared with those in Japan. did not vary significantly (Table 2. Over the years. One minor difference is that the percentage of shareholdings by corporations is slightly higher in large-sized firms. Compared with its holdings in all listed companies. Individuals held the majority of the shares in all industries except in telecommunications. UK. held 26. When independent companies are distinguished from firms affiliated with the 30 largest chaebols. there appears to be no significant difference in the overall shareholding patterns between the two groups (Table 2. In general. electricity. whether partial or absolute. government ownership in nonfinancial companies was remarkably smaller and more concentrated. Foreigners gradually increased their equity shares in 1992 when direct purchases by them were first permitted. Institutional investors. foreign holdings were derived from purchases through country funds and direct capital investments. other corporations’ holdings shifted toward service industries. a more detailed breakdown of the data on majority shareholdings in the next section shows significant differences in the two groups’ composition and level of majority shareholdings. with the Government continuing to hold a sizable share in the Korea Electric Power Corporation.15). as distinguished from individual and foreign investors. Before such liberalization. indicating their increased investments particularly in the service industries with high growth rates.16).8 percent of listed shares in 1997. financial institutions had more shares in the manufacturing sector than in primary industries. This trend can be explained by government ownership.

4 Banks.5 85.7 29.2 0.2 1.7 2.1 4.3 2.6 3.0 9.1 8.9 0.5 19.2 22.b Securities Firms Insurance Firms Other Corporations Foreigners — — 0.1 0. 1990 and 1997 (percent) Financial Institutions The Statea — — 0.2 7.0 2.9 59.1 0.7 59.4 7.5 — 0.7 20.7 2.7 14.4 1.3 11.2 — 0.7 17.1 0.3 0.4 62.7 6.8 Individuals 83.0 10.7 64.2 0.2 64.7 2.9 19.3 2.2 9.3 10.4 56. Etc. Motor Vehicles Electricity.9 55.7 20.1 7.5 4.5 — — 0.7 22.6 8.8 1.3 0.8 3. and App. and Steam Supply Precision and Optical Instruments Other Manufacturing Construction Service of Motor Vehicles Wholesale and Retail Trade Transport Telecommunications Other Business Activities Nonmetallic Mineral Products Average .4 5.3 1. Elecl Mach.0 9.5 12. Paper.Table 2.9 52.3 1.5 7.1 19.2 0.1 27.1 1.8 3.8 5.4 2.3 57.4 8.7 63.5 3.6 5.1 88.9 23.0 9.1 10.5 0.5 — 1.6 18.5 0.0 Industry 1990 Fishing and Fish Farms Mining Food Products and Beverages Wearing Apparel and Fur Articles Wood.6 11.8 8.1 0.3 38.5 0. and Printing Pulp.0 — 0..2 1.0 1.3 4.0 0.7 22.8 7.2 — — 0.4 1.5 17. Paper.9 8.8 73.2 9.0 9.9 42.9 60.0 20.9 10.2 9.2 17.4 — 0.0 7.3 6.3 62.9 16.4 56.6 1.9 1.3 7.4 0.4 14.7 14.6 24. and Printing Chemicals.2 0.7 1.4 8.0 8.3 9.3 13.8 7.6 — — 2.3 0.5 0.5 6.8 7. and Plastics Basic Metal Fabricated Metal and Machinery Office and Computing Machinery Electronics.0 — 39.8 7.9 4.8 6. Rubber.9 66.1 65.9 15.15 Ownership Composition of Listed Nonfinancial Firms by Industry. Gas.8 7.1 8.2 2.4 8.9 1.2 54.

7 2.4 76.0 8.3 57.7 6.5 5.7 4.8 0.1997 Fishing and Fish Farms Mining Food Products and Beverages Wearing Apparel and Fur Articles Wood.5 12.3 7.6 — = not available.3 1.9 2.6 2. etc.9 1.4 6.4 1.1 6. Motor Vehicles Electricity.6 6.7 2.6 7.7 2.1 — 1.8 54.1 4.4 68.4 4. and Printing Chemicals.2 0.0 11. Paper. Paper.9 69. Rubber. and Steam Supply Precision and Optical Instruments Other Manufacturing Construction Service of Motor Vehicles Wholesale and Retail Trade Transport Telecommunications Other Business Activities Nonmetallic Mineral Products Average 1.9 7.8 11.0 1.2 4. Gas.4 9.2 3.3 31. merchant banks.5 3.2 4.5 4.6 60.8 12.0 3. .8 5.8 5.6 6.4 0.9 7.1 54.9 1.8 2.2 4.0 7.5 0.1 — 0.9 5.6 59. b “Banks. investment trust companies.8 6.3 2.5 63.5 3.4 3.6 75.4 20.2 13.9 20.2 5.2 0.7 23.3 6.9 78.4 1.8 27.6 2.4 — 1.9 2.6 2.9 57.5 6.6 1.8 2.4 4. a The State covers the government and state-owned companies.5 7.5 3. and App.9 6.4 2.2 7.3 65.1 18.1 1.1 1.2 6.9 0.4 1.9 18.4 58.8 2.8 57.9 20.6 20.5 3.7 5.3 6.6 14.5 — 2.1 9.6 3.9 5.5 1. and finance companies. and Printing Pulp.8 0.9 2.6 0.7 17.2 5.0 4.4 2.3 15.4 43.4 16.3 60.4 58.2 23.1 9.3 8.5 4.4 45.9 1.9 2.8 4.7 19.2 1.6 18.78 81.1 3.0 5. and Plastics Basic Metal Fabricated Metal and Machinery Office and Computing Machinery Electronics.3 0.2 1.0 6.6 0. Note: Ownership is based on number of shares.1 2.1 2.7 1.7 2.” includes commercial banks.1 25.2 4.0 60.9 6.0 6. mutual savings.4 2.1 3.8 3. Source: Constructed from data files of the Korea Listed Companies Association.2 49.6 5.0 43. Elecl Mach.3 1.2 8.5 59.

Others are medium firms.6 60.3 Banks.4 1. c “Banks.7 Control Type No.4 2.5 Individuals 60.5 4.4 5. investment trust companies.4 61.8 2.8 3. of Firms Large Medium Small Total 211 208 80 499 a Large firms have a capital base greater than W15 billion and small firms smaller than W5 billion.16 Ownership Composition of Listed Nonfinancial Firms by Size.1 2.4 21.0 1. merchant banks.17 Ownership Composition of Listed Nonfinancial Firms by Control Type.5 2.4 5.5 8. Securities Firms Insurance Firms 2.1 Banks.5 19.5 62.7 0.7 4.Table 2.8 1.0 Other Corporations 16. .” includes commercial banks.8 60. etc. b Table 2.7 Foreigners 4.9 4. mutual savings.7 1.7 8. 1997 (percent) The State 1. 1997 (percent) The Stateb Foreigners 4.4 2.9 2.1 8.0 6.5 18. etc. etc.8 4.3 6.6 16.4 Firm Sizea No. The State covers the government and state-owned companies. and finance companies. of Firms Independent Firms Affiliates of 30 Largest Chaebols Total 316 117 433 Source: Constructed from data files of the Korea Listed Companies Association.8 4. Source: Constructed from data files of the Korea Listed Companies Association.5 6.1 6.c Securities Firms Insurance Firms Other Corporations Individuals 58.2 1.4 17.7 6.8 6.4 4.9 5.4 61.5 16.

6 39. and other shareholders who do not belong to either the minority shareholders or the majority shareholder group. the majority shareholder group on average held 23-30 percent of outstanding shares in the period 19881997 (Table 2. including those of the largest shareholder.3 6. Institutional Investors 42.China United Kingdom United States Source: Stock Exchange of Korea. only closed-end investment companies and traditional investment trust companies are allowed. Generally.8 56.3 47.20). investors (Table 2. defined as those holding less than 1 percent of shares.1 percent and appear to be similar to the proportion of foreign holdings in the four other countries.8 10.18 Ownership Composition of Listed Firms in Selected Countries. At the moment.6 Foreigners 9. In 1997.19).Chapter 2: Korea 83 Table 2. This has had profound implications for corporate governance and the market for corporate control in Korea. Concentration of Ownership The analysis of ownership concentration in this section focuses on shareholdings of the majority shareholder. The more popular open-end investment companies (mutual funds) were expected to come into existence by the end of 1999 with the Government’s deregulation of the capital market. Among nonfinancial listed firms. 1997 (percent) Country Japan Korea Taipei. corporations held 70 percent of the controlling blocks of shares. and the companies under the control of the largest shareholder.3 54.8 9. the majority shareholder group in all listed companies consists of the corporate.1 8. his/her family members.7 16.5 45. while family members accounted for only 30 percent.4 26. rather than the individual. minority shareholders.5 20. Foreign holdings of Korean shares were 9.6 Individuals 23. But these may .1 financial institutions’ establishment of corporate pension fund accounts. for example. The majority shareholder group’s shareholdings in listed nonfinancial firms steadily declined from 1990 to 1996.

Table 2.2 2. 1992-1997 (percent) Majority Shareholders Corporation 15.6 46.0 Year Corporation Individual 1992 1993 1994 1995 1996 1997 41.1 32.6 22.7 Note: The majority shareholder includes the largest shareholder.0 4.1 23.0 2.0 22.2 2. .4 5.5 43.9 7.9 6.1 37. and the companies under the control of the largest shareholder.6 5.4 3.0 29.1 5.2 Minority Shareholders Subtotal 71.1 4.6 26.1 28.3 18.4 7.2 26.7 6. Source: Stock Exchange of Korea. his/her family members.9 3.8 72.3 30.8 Individual Subtotal Other Shareholders Corporation 3.9 Individual 2.7 7.1 21.9 32. Other shareholders are those who do not belong to either the minority shareholders or the majority shareholder group.8 8.8 73.6 73.0 1.9 33.0 25.1 14.7 18.1 5.6 2.7 16. Minority shareholders are those holding less than 1 percent of shares.9 2.3 2.0 69.1 15.7 44.3 Subtotal 5.19 Ownership Concentration of All Listed Firms.0 66.

Besides. have been underestimated because it was widely believed that the largest shareholder often had hidden shares registered in the names of relatives and subordinates of the company.4 23.8 25.7 18.22).6 11. thereafter.6 58. which held less than 1 percent of a company’s outstanding shares as of 1997.9 29.8 12.9 12.0 58.8 28. . Ownership concentration tended to be lower in large compared to medium and small listed firms. In most industries.8 57.3 62. 1988-1997 (percent) Year 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Minority Shareholders 53. It was highest in medium-sized firms before 1993 and. The shareholders that held more than 1 percent but did not belong to the majority group held about 20 percent on average. Across industry.6 57.21]).9 27.9 48.5 12.2 15.0 20.5 23. in the small firms. the Government has retained a large number of shares. ownership was relatively diffused due to government regulation. Majority ownership is also high in the chemicals.Chapter 2: Korea 85 Table 2.5 13. utility companies have a relatively higher degree of ownership concentration with the majority shareholder owning nearly 45 percent of an average company (partly because these companies were owned solely by the Government before their privatization [Table 2. minority shareholders. The percentage of shares held by minority owners (with less than 1 percent of outstanding shares) was highest for large firms at more than 55 percent (Table 2. In telecommunications.1 50. rubber and plastics.9 25.8 54.3 25. The practice of hidden shares seems to have been less prevalent in recent years.5 60. the majority owner held more than 20 percent of an average firm. hiding shares offers no additional tax or other benefits.9 Other Shareholders 18.20 Ownership Concentration of Listed Nonfinancial Firms. Meanwhile.0 22.8 Majority Shareholders 27. In such cases.4 Source: Constructed from data files of the Korea Listed Companies Association. collectively owned less than 50 percent of an average firm.4 28. and mining categories.

6 25.4 16.0 54.0 51.4 Industry Fishing and Fish Farms Mining Food Products and Beverages Wearing Apparel and Fur Articles Wood.5 20.5 44.5 21.21 Ownership Concentration of Listed Nonfinancial Firms by Industry. and Plastics Basic Metal Fabricated Metal and Machinery Electronics.7 24.. 1997 (percent) Number of Firms 3 2 43 49 12 16 90 39 31 71 34 8 9 49 40 15 1 10 29 551 36. Motor Vehicles Electricity.2 26.5 47.2 48.5 52.8 55.2 20.3 19.8 51.8 24.4 53. and Printing Chemicals.8 21.1 43.8 44.1 49.4 11. Paper.2 46.7 29. Paper.2 23.9 26.6 34.5 23.0 30. .7 21.2 19.9 44.9 10.2 22.0 39.9 Minority Shareholders Majority Shareholders Other Shareholders 12.8 25.6 50.8 29.5 19.0 21.3 26.7 17.3 39.8 41.6 53. Elecl Mach. and Printing Pulp.5 41. Gas.5 16.7 26.8 31. and App.6 38.1 19.Table 2.7 27.7 36.6 19.1 17. and Steam Supply Other Manufacturing Construction Wholesale and Retail Trade Transport Telecommunications Other Business Activities Nonmetallic Mineral Products Total Source: Constructed from data files of Korea Listed Companies Association.2 37. Rubber.2 34.

9 26.8 52.1 16.5 12.Table 2.6 62.8 11.3 19.2 32.1 20.2 11.8 50.6 11.2 26.6 27.8 17.8 62.5 21.5 19.0 55.9 16.1 27.3 55.0 59.0 26.1 48.7 28.0 24.6 15.7 57.6 24.5 Other Shareholders 19.5 26.5 51.2 Source: Korea Listed Companies Association.22 Ownership Concentration of Listed Nonfinancial Firms by Firm Size.5 49.5 27.9 53.2 21.9 22.3 26.2 Majority Shareholders 26.4 51.8 28.4 30.1 58.5 12.3 27.4 29.4 30.1 15.2 18.2 50.9 21.9 12.6 31. of Firms 66 81 72 76 80 67 78 102 134 115 148 197 219 212 210 217 216 216 215 215 165 213 220 217 218 217 227 230 231 221 Minority Shareholders 53.6 55.7 57.4 21.7 22.7 15.7 16.5 28.8 52.9 23.7 14.2 55.9 28.6 65.8 27.5 33.3 25.9 17.3 21.4 30.0 66.2 56.4 47. 1988-1997 (percent) Year Small 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Medium 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Large 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 No.2 21. .9 55.2 21.5 19.2 52.2 12.8 56.5 10.9 56.6 59.7 17.7 31.9 60.

which can then pass the equity capital to a third. For example. TQ is below 1. H. The relationship between TQ and SCS shows a similar pattern. the firm destroys value. thus a firm destroys value. Hong. which is the company holding more than 40 percent of outstanding shares of its subsidiary. Kim (1992) found the relation between TQ and SCS to be nonlinear. called “pyramiding”— commonly (though incorrectly) known as “indirect cross-shareholding”— is prevalent in Korea. and Kim (1995) studied the empirical relationship between the degree of ownership concentration and financial performance in Korea. This type of inter-firm investment. If SCS is below 10 percent. one company can still place equity investments in another. Inter-Firm Investments and Pyramiding in Chaebols The Commercial Code imposes limits on direct cross-shareholding. and Vishny. J. Vol. The pattern of the relationship between SCS and TQ is similar between Korean and US firms (Mork. If SCS is below the range of 20-25 percent. often at terms unfair to one of the transacting parties. The study by Kim. it means the firm creates value. 1988). One of the merits of pyramiding. If SCS is above 20-25 percent. Hong. thus a firm creates value. They analyzed firms in which controlling shareholders participate as managers. TQ increases as the SCS increases. TQ has a maximum value. This refers to the situation wherein Company A holds shares of Company B and simultaneously Company B holds shares of Company A. H. and the shareholding of a controlling shareholder (SCS) as the degree of ownership concentration. one company from a chaebol group could obtain debt payment .88 Corporate Governance and Finance in East Asia. Then TQ declines until SCS reaches 45 percent and increases until it reaches 50 percent. if TQ is lower than 1. affiliated companies have been able to conduct inter-firm transactions. TQ was calculated by dividing the market value of a firm by the substitution price of its assets. II Ownership Concentration and Financial Performance J. If TQ is higher than 1. Both studies used Tobin’s Q (TQ) for the value of a firm as an index of financial performance. although turning points in the value of firms are different. If SCS reaches 10 percent. In Korea. The Code prohibits a subsidiary company from owning shares of its parent company. TQ is above 1. is effective control of a certain group of companies even with a smaller investment. Kim (1992) and Kim. Where direct cross-shareholding is not allowed. from the standpoint of the controlling shareholder. and Kim (1995) reached a similar conclusion. Shleifer.

In Table 2.23. For the same year. If we define the internal shareholdings of a . for example.Chapter 2: Korea 89 guarantees from other members of the group at no cost. there are instances of direct cross-shareholding in Korean firms. and 319 foreign subsidiaries. The fact that corporations. Thus. standalone setups. 34 percent were foreign companies. the top five shareholders consisted of 2. although they are likely to be insignificant. Partial results are shown in Table 2. 53 percent were domestic nonfinancial firms. Twenty-two of the 81 respondents were independent. together owning an average of 37. Among the subsidiaries or firms receiving investments. or about five subsidiaries each. or an average of 13 firms per company. financial institutions that are subsidiaries of a chaebol also hold shares in its member firms.14. Only six firms (or 13 percent) indicated that their subsidiaries also owned shares in themselves. the average shareholding of the controlling owners and their families was 8. neither the investors nor the relevant government authorities were active in monitoring such unfair dealings between firms. Until recently. This also partly explains why chaebols frequently opted to expand by establishing new firms rather than placing investments internally. Thus. and about 11 percent were domestic financial institutions.5 percent of shares.9 percent of shares.5 percent. In the case of the 30 largest chaebols. 59 were parent firms with one or more subsidiaries. firms linked through partial equity investments could enjoy the advantage of consolidation without an actual formal consolidation or merger of operations taking place. dominated the majority shareholder group in chaebol-affiliated companies is consistent with the results of the ADB survey conducted for this study. The top five shareholders of the chaebol-affiliated firms consisted of one individual and 3.4 corporations. Of the 81 respondents. These shares should be added to the control block although the financial institutions belonging to the 30 largest chaebols are prohibited from exercising their voting rights in the member firms of the chaebol. Among chaebol affiliated firms. The extent of pyramiding can be seen in some of the previous tables. the top 30 chaebols’ shareholding by subsidiaries was 34.5 corporations and two individuals. For the whole sample. But the controlling power of the owners also stems from inter-company shareholdings of the subsidiaries. or about four firms each. Among the 81 listed firms in the ADB survey. corporations hold about 20 percent of the outstanding shares of all listed nonfinancial firms. 59 parent companies collectively had investments in 759 firms. together owning an average of 38. together having a total of 292 domestic subsidiaries.5 percent as of 1997. not individuals. In many instances. 62 percent (16 out of 26) had a corporation as the largest shareholder.

7 37.4 11.4 18.9 21. .0 2.0 3.7 39.1 1.5 2.5 31.4 21.3 12.5 1.4 25.4 42.3 26.8 Note: The survey was conducted during the period January through May 1999 and included nonfinancial listed firms only. 1999 Five Largest Shareholders No. of Firms Largest Shareholder’s Holdings (%) Compositiona Individuals Firms Shareholdings (%) Individuals Firms Total Classification Total Sample Non-Chaebol Affiliated Largest Shareholder is Largest Shareholder is Largest Shareholder is Chaebol Affiliatedb Largest Shareholder is Largest Shareholder is Largest Shareholder is CEO an Individual a Firm CEO an Individual a Firm 81 55 31 10 14 26 3 7 16 20.0 13.4 38.0 1.5 4.0 21.9 34.2 37.8 8.6 3.8 31.0 17.8 37.9 29.9 5. A few companies reported less than five largest shareholders.8 38.6 3.5 24.5 18.0 1.1 3.6 16.5 2.5 2.6 3.4 2.0 3.2 25.5 4.7 19. b The chaebol affiliated firms are those belonging to one of the 30 largest groups.6 34.7 5.23 Ownership Concentration in the Survey Sample of 81 Listed Firms.4 1.1 22.5 38.Table 2.8 18. a Number of shareholders.7 0.5 2.

“The Ownership Structure and Family Control in Korean Conglomerates: With Cases of the 30 Largest Chaebols. Lee. Table 2. 79-95. 1987-1997 Type of Shareholding Internal Shareholdings Family Member Companies Source: Korea Fair Trade Commission. Based on these studies.6 Later studies by Lee (1997) and Lim (1998)7 find similar patterns.4 1993 43. 15 October 1998.1 1997 43. 1987 56. 1998.2 15. the controlling families owned 8. 6 7 Hattori. Ungki Lim.4 13.” Paper presented at the Annual Conference of Financial Management Association.0 8.2 1994 42.8 33. the average internal shareholding ratio of the top 30 chaebols was at least 43 percent. As of 1997.7 31. The family and member companies’ shareholdings have been declining over time. edited by K. Chicago. Family holdings include shares owned by the family members and by parties considered to be under the influence of the family. Table 2.8 40. Internal shareholdings in some chaebols also include shares owned by nonprofit organizations operated by the controlling family.7 9.6 33. Tamio. it appears that the chaebol families have had a strong desire to expand their business bases.Chapter 2: Korea 91 chaebol as the shareholdings of the controlling family and the member companies of the group. 1997. Lee.24 Internal Shareholdings of the 30 Largest Chaebols. . “Japanese Zaibatsu and Korean Chaebols. C. Hattori (1989) identified three patterns based on data in the early 1980s. 34. H. New York: Praeger. Many attempts have been made by researchers to identify the typical patterns of ownership structures in chaebols.5 percent.5 34.4 10.” In Korean Managerial Dynamics. “Is the Fair Trade Policy Fair?” Korea Economic Research Institute.2 12.7 1992 46. the ownership patterns can be described as follows.4 1990 45. Thus it can be inferred that their strategy in designing the ownership structure of their business groups was to minimize the financial resources required to maintain their grip on the management of the member firms while maximizing their control.5 Judging from the historical record. The relatively high internal holdings of the 30 largest chaebols were due partly to the fact that many of the chaebols’ firms are still privately held. Chung and H.2 33. pp.5 percent and member companies. Jae Woo.24 shows the average internal shareholdings in the 30 largest chaebols. 1989.

The second (Type B). completely dissolved under financial distress. Investments between the lower level subsidiaries are rare. Chaebol Reforms Various measures have been taken to improve the transparency of chaebols with regard to accounting. there is no controlling shareholder. But the former chief executive officer (CEO). Also. Kia Motors was the base company and had such strategic shareholders as Ford Motors of the US and Mazda of Japan. and his management team exercised full control over the group without much interference from major investors.” shows a simple pyramidal structure. One of the . Sun Hong Kim.” Here the family directly controls a base company and a nonprofit foundation. is an example of this type. and subsidiaries’ equity participation. It consists of seven listed and 24 privately held firms. The Hanwha Group can be classified as such a company. and business activities. A nonprofit foundation under the family’s control is the largest shareholder of one of the base companies. The two base companies have investments in three other base companies. The fourth type (Type D) is “management control. II The first (Type A) is called “direct family ownership. Vol. consisting of eight listed and 16 privately held firms as of 1997. it had 18 listed and 39 private companies. The Kia Group was about the only management-controlled group but was out of existence by 1999. investments made by the base companies. As of 1997. the family controls the group’s member companies by its own shareholdings. called the “indirect control via base company. The third (Type C) is “indirect control via complex shareholding.” Under this type of ownership pattern. subsidiaries have extensive investments in other subsidiaries. holdings of the nonprofit foundation. The controlling family has sizable investments in two base companies and smaller investments in many others. which in turn hold shares in some of the other subsidiaries. Here the family is the controlling shareholder of one or more strategic base companies that have enough equity participation in the subsidiaries. For example. The family itself holds shares in some subsidiaries. The Hanjin Group. other firms.92 Corporate Governance and Finance in East Asia. Thus. or merged into. Most of its member firms were acquired by. The Hyundai Group exemplifies this. Its controlling family holds shares in three base companies through which they exercise control over the other member firms. which then make investments in the subsidiaries.” A family owns a substantial portion of shares of member firms and becomes the controlling shareholder of each. Hyundai Motors acquired Kia Motors via an international auction. financial.

and limited the amount of total investments made by a member firm of a chaebol in other firms to less than 40 percent of its net assets. These conditions are aimed at restricting excessive pyramiding and expansion of chaebols. The Fair Trade Act was amended in 1998 to allow pure holding companies to be established under restrictive conditions. It remains to be seen whether they will adopt the holding company structure in the future. At this early stage. The Fair Trade Act was also revised in February 1998 to prohibit cross-guarantees of debt among members of a chaebol. the act did not have any important provisions except the standard clauses prohibiting monopolization of an industry through business combinations. A third disallows multiple layering of holding companies. These amendments prohibited holding companies and direct cross-shareholding. . This was the reason why chaebols chose to employ pyramidal structures. The limit on investments was reduced to 25 percent in 1994 and completely eliminated by 1997. Existing guarantees had to be resolved by March 2000. only operating holding companies were allowed to be established. the Credit Management Regulation rules were amended to prohibit financial institutions from requiring guarantees from affiliated firms when extending new loans.Chapter 2: Korea 93 pronounced purposes of government intervention in the corporate sector has been to prevent concentration of economic power in the hands of a few large chaebols. One condition requires that the DER of the holding company should not exceed 100 percent. Also. The prohibition of holding companies was also abolished in 1999. They hindered early exits (liquidation. Another is that the holding company should own more than 50 percent of the shares of a nonlisted subsidiary company and more than 30 percent of a listed company. However. Cross-guarantees are believed to constitute a form of wealth transfer from financially strong members to weak ones. there are reports that some top chaebols are studying the feasibility of transforming their organizational structure. Until the end of 1998. The first serious attempt to deal with this issue was the introduction of the Monopoly Regulation and Fair Trade Act of 1980 (hereinafter. This limit was also applicable to banks and insurance companies. An operating holding company is defined by the Fair Trade Act as one whose investment in others does not exceed 50 percent of its total assets. direct control of the management of chaebols was attempted through amendments of the act in 1986 and 1990. thus hurting the shareholders of stronger firms. the Fair Trade Act). The Government is also considering whether to allow consolidated taxation for pure holding companies. following the amendment of the law. Initially. bankruptcy reorganization.

Some chaebols operated “group management boards” attended by top executives (presidents or chairpersons) of larger member firms. Their operating costs were borne by the member companies rather than by the controlling shareholder. It also acted as the secretariat for the unofficial “presidential meeting” of the member firm presidents. Since the economic crisis. until urgent restructuring is complete. unlike the regular consolidated statements that only cover those firms that are related through direct equity participation. II etc. even though they were legally independent with their own board of directors and the outside shareholder groups were not identical. the Commission has strengthened its investigative activities to eradicate cross-subsidization and wealth transfer activities among group members. and transferred funds generated by one firm to another. there have been no significant changes. The Fair Trade Commission has been deeply involved in promoting managerial transparency by exercising its power to investigate and levy penalties on “unfair internal transactions” among member firms of chaebols. The office established strategies for the group as a whole. The staff of these organizations were employees of member firms.3. which put together the accounts of all members of a chaebol. usually in the rank of a company president. In 1998.2 Internal Management and Control Monitoring of corporate management by shareholders. who is universally called the “group chairman. These offices were legally informal and functioned as the headquarters of chaebols.) of nonviable member firms and helped afford a disproportionate advantage to chaebols in obtaining favorable bank loans because (it was generally believed) the Government would not let large chaebols go bankrupt. boards of directors. planned for capital raising and allocation on a groupwide basis. Vol. Some chaebols have disintegrated or shrunk in size.” The group chairman operated through these offices and treated the individual member firms as if they were the divisions of a single legal entity. Despite chaebols’ decision to dismantle the chairman’s offices. The chairman’s office had its own chief executive officer.94 Corporate Governance and Finance in East Asia. chaebols dismantled their “planning and coordination offices” or “chairman’s offices” under pressure from the Government. and the capital market was almost nonexistent until the recent reform . 2. Chaebols maintain that the restructuring headquarters will exist only for a limited period. The 30 largest chaebols are now required to publish “combined” financial statements. but the larger and stronger ones still operate their newly named “restructuring headquarters” under the control of the group chairperson.

creditors were not active in monitoring debtor firms and relied mainly on guarantees and collateral. Under such circumstances. as the major creditors. especially chaebols. the concept of fiduciary duty of managers was not well established. Even when the covenants were violated. Board of Directors General Characteristics of the Boards Under the Commercial Code. Most companies have one representative director. or at least acts as the de facto CEO. corporations should have a board of directors consisting of at least three members. in most Korean firms. the creditors did not declare defaults. There are many reasons for this. but some large ones have two or more. In most listed companies. Directors are elected at the general shareholders meeting for a term not exceeding three years. had their own governance problems. With few exceptions. . This implies that the typical agency problems in Korean corporations stem from conflicts of interest between inside (the largest) and outside (minority) shareholders. control is not separate from ownership. Even where the largest shareholder is not the representative director. Loan agreements and debt indentures did not include strict covenants. this was complicated by the prevailing attitude that large companies. The Government’s policy and securities law provisions to protect control rights of the incumbent management had been in place until the early 1990s. only the Government could play an effective role in monitoring corporations. were too big to fail. The board elects one or more representative directors from among the board members. However. the representative director was also the chairperson of the board. the controlling shareholder (or a member of the controlling group) was the legally registered representative director in 354 out of 551 nonfinancial listed firms. he or she generally approves major decisions made by the management. This policy managed to hamper any monitoring initiatives from the capital market. except for banks. As of 1997.Chapter 2: Korea 95 efforts. the controlling shareholder is officially the representative director and the CEO. Professionalism in management was not well developed and managers were content with receiving orders from controlling shareholders. Legal provisions to protect investors were limited. Meanwhile. and takeover codes were not accommodative to active monitoring. Thus. Banks.

In order to address this concern. II When the Commercial Code first introduced the corporate board system in the 1960s. A few large companies had more than 50 directors. Despite the qualification requirements. However. the listing rules of the Korea Stock Exchange were revised to require that listed companies have one or more “independent outside directors” by the 1998 annual shareholders meeting. they were virtually under the full control of the CEOs and in practice functioned only as management councils without any decision-making power—at least until 1998. the attendance rate of outside directors. it has been common practice that candidates for directorship are handpicked by the controlling shareholder/CEO from among the senior managers and are automatically approved at the general shareholders meeting. Vol. . almost all companies succeeded in adopting cumulative voting. the listing rules restrict the eligibility of independent outside directors to those who have no family ties with the managers and no significant business transactions with the company. there is concern that newly elected outside directors still lack independence from the management or the controlling shareholder. Further. The exchange is also expected to recommend company charters to have provisions that allow for information demanded by outside directors to be promptly supplied to them. In the 1999 annual shareholders meetings. The rules further require that the number of outside directors be not less than a quarter of the size of the board by the annual shareholders meeting in 1999. The Commercial Code was also revised in 1998 to introduce cumulative voting for the election of directors. the stock exchange recently amended the listing rules to require that companies disclose a detailed profile of the candidate and the person who made the nomination. companies have to disclose in their annual reports the frequency of board meetings.96 Corporate Governance and Finance in East Asia. With the boards consisting only of insiders. cumulative voting is not mandatory and a company can exclude itself from its application by amending its charter. were supposed to be outside directors. Recent Reform Efforts on the Board System In 1997. members of the board. and their positions (accept or reject) on matters voted on in board meetings. However. Moreover. other than the representative director(s). Most of the outside directors in those days were the controlling shareholders of chaebols or executives of affiliated companies. all of whom were managers.

which had extended financial support in their recent recapitalization efforts. ADB Survey Results on Boards The ADB survey results confirm the above assessments and provide early indications on the effects of the reforms. a blue-ribbon committee.1 percent and outside directors 1. In March 1999. was established under the auspices of the Ministry of Finance and Economy and the Korea Stock Exchange.9 percent on average. Almost all (92 percent) of the respondents had one or more outside directors and 70 percent were elected after the Asian financial crisis. On average. Among others. who would comprise at least 50 percent of the boards.Chapter 2: Korea 97 The committee structure of the board as found in the US has not yet been adopted by listed companies. he or she held 6.2 percent and the CEO 14. having no controlling shareholders. the chairperson of the board was also the CEO and on average held 10. although some banks recently have established board committees. In 78 percent of the responding firms.5 percent of the shares.1 percent of outstanding shares of a listed company. The Securities and Exchange Act will require large listed firms with W2 trillion or more in total assets to adopt the audit committee system. the OECD principles of corporate governance were the minimum standard for the Korean Code of Best Practice. Meanwhile. an audit committee. Where the two were separate.4 directors. The average board had 8. Directors were also chosen on the basis of their relationship with the controlling . Among the firms with no outside directors. are required to have a majority of outside directors. 88 percent had plans to hold elections in the near future. The controlling shareholder of some banks is the Government. and a nominating committee. The Commercial Code is being amended to allow a choice between the audit committee system and the current internal auditor system. Directors were most frequently elected because of their professional expertise (74 percent of the respondents marked this answer). Where the chairperson was not the CEO. they had a parent/child relationship in 20 percent of the cases. In September of the same year. These results are in accordance with the new listing rules introduced in 1998. this committee adopted the Code of Best Practice in Corporate Governance. the Korean Code recommends that large listed firms should have at least three independent directors. inside directors owned 16. the Corporate Governance Reform Committee. This is because most banks.

II shareholder (30 percent). relationship with controlling shareholders (21 percent). In a very small number of firms. in 23 percent. the management determines the remuneration. the package for the chairperson is directly proposed at the annual shareholders meeting either by the board (31 percent of the firms) or by the management (9 percent). These were established only recently. Less frequently. However. compensation for directors must be approved by the annual shareholders meeting for each fiscal year. Chairpersons of the board were elected on the basis of professional expertise (33 percent of the firms). in some firms. the management nominated director candidates (64 percent of the directors). the term of appointment of directors and board chairpersons is three years. and shareholding (10 percent). About five directors per firm have been in office for more than one term. the board had a nomination and an audit committee. including stock options. In 1997. Members of controlling shareholder families or their trusted company personnel often act as directors for multiple chaebol firm boards. the board had no committees. In some instances.98 Corporate Governance and Finance in East Asia. . election of directors was based on shareholdings (7 percent) and status as founder (7 percent). As discussed earlier. most firms just began to elect a small number of outside directors to meet a new requirement in the listing rules and thus have no experience in the AngloAmerican type of board processes. In most firms.2 years on average. The general practice is that shareholders approve the upper limit on the total amount to be paid to all directors. Some directors were nominated by significant shareholders (18 percent) or introduced (and elected) at the shareholders meeting. In 13 percent. In one case. among the 81 sample firms. a total of 562 directors were sitting on two or more corporate boards. According to the Commercial Code. In 91 percent of the sample firms. Most frequently. founders of the company acted as the chairperson (22 percent). and fixed fees plus performance-related pay. The reason for this high frequency of interlocking directorship is that many listed firms belong to chaebols. The current chairperson has been in office for 6. The board or the management then determines compensation packages for individual directors. The survey results indicate that boards determine remuneration packages for chairpersons in 42 percent of the firms. one person was sitting on nine boards and this person was the CEO of a chaebol firm. Remuneration for chairpersons include only fixed fees in 76 percent of the sample firms. Vol. This rather long tenure must be due to their status as controlling shareholders in most firms.

the survey tells a slightly different story than is generally believed in Korea.2 years. and was appointed by the Government in five firms. shareholding in three firms. The firms in the survey consider steady growth of a company and maximization of the shareholder value as the most important responsibilities of CEO. In 4 percent of the cases. When CEO is not the chairperson. and in another 21 percent CEO bought shares in the market.Chapter 2: Korea 99 Management CEO In the survey sample. Ensuring that a company serves the public interest is considered a less important responsibility of CEO. in which there is no controlling shareholder. A smaller number of firms consider maximization of a company’s market share and looking after the interests of such stakeholders as creditors and employees as very important. CEO generally has the ultimate power to decide on corporate affairs. These results show that the incentive compensation scheme for professional CEOs is not well developed in Korean firms. In 20 percent. In the survey. it was proposed by CEO and approved by the board. compensation is by fixed salary in 74 percent of the firms. According to the survey. In a handful of sample firms. In cases where CEO is not the largest shareholder and chairperson. CEOs have been in their positions for an average of 9. CEO was given shares by the family. he or she was selected on the basis of professional expertise in 15 firms. It indicates that CEO. CEO simply follows the orders of the chairperson. In such cases. decides on important matters on his/her own in 13 out of the 44 firms. In the 25 firms where CEO was not the chairperson of the board. fixed salary plus net profit-related bonus in 9 percent. CEO decides on important matters after consulting the chairperson in the majority (55 percent) of the firms. . CEO is entitled to a large sum in cases his/ her contract is terminated before its expiration. The remuneration package was proposed by the board (and approved by the annual general meeting) in 56 percent of the firms. and fixed salary plus performance-related pay including stock options in 13 percent. In less than 20 percent of the firms. the payment is about five times the CEO’s annual salary. 86 percent of the firms answered positively when asked whether the largest shareholder was CEO. who is not the chairperson. In 21 percent of cases. CEOs generally maintain their positions for a long time because they are frequently the founders or largest shareholders of their firms. However. CEO is also the founder in 52 percent of the firms. he or she does not enjoy much power.

One area has been to enhance the reliability of financial statements of corporations in line with internationally accepted standards. Senior managers were even often called directors although they were not official members of the board. but in practice is fixed and understood as part of a fixed salary. Vol.100 Corporate Governance and Finance in East Asia. disclosure. This action was in response to calls by international investors and. in particular. executives sometimes have the opportunity to buy company shares at favorable prices because the board of directors (CEO. II Senior Executives In the past. However. (ii) establishment of accounting standards for financial institutions. Reforms in accounting standards since May 1998 have proceeded in several areas: (i) revision of financial accounting standards that are primary sources of the Korean Generally Accepted Accounting Principles. The commission has played an active role in introducing new rules on corporate governance. Transparency and Disclosure Accounting Standards The Financial Supervisory Commission (FSC) was established in April 1998 to take charge of supervising the financial markets and institutions. The bonus is supposed to be linked to company performance. Korean firms have rarely used shares for executive compensation. from IMF and the World Bank. and . in practice) allocates the unsubscribed portion of new shares issued in rights offerings to executives. Usually CEO suggests the maximum amount of all the directors’ compensation at the shareholders meeting to get approval and then sets the base salary and bonus for individual executives. About 40 percent of the listed companies had amended their charters to introduce incentive stock options by the 1999 shareholders meetings. Incentive stock options have become a popular compensation method since the Securities and Exchange Act was amended in 1996 to allow the issuance of stock options to managers and other employees. but as of March 1999 only 27 firms actually had given stock options to their executives or employees. it was common for all senior executives to be elected as directors at the shareholders meeting. and accounting standards. The term of appointment of executives did not have any real meaning because they had to leave the company if and when the controlling shareholder demanded. Penalties for fraudulent financial reports were increased.

The External Audit Act and its Decree require financial statements of corporations with total assets of W7 billion or more to be prepared and audited according to the financial accounting standards and working rules set by FSC. Most of the companies following all or some of the international standards in the past adopted such standards before the crisis started. 41 percent of the companies believed that they have followed some international accounting standards. Thus. The internal auditors are supposed to play the role of the audit committee found in the board of directors in US corporations without being members of the board. the internal auditor is considered to be a subordinate of the . they also have the power and duty to monitor the activities of executive directors. Korean listed companies with subsidiaries are required to compile consolidated balance sheets. Those that never adopted international standards show their willingness to do so once the Government introduces international standards. Only 10 percent of the respondents have followed all international accounting standards. Under the Commercial Code. however. The primary sources of reference in the revision were International Accounting Standards and US Accounting Standards. financial institutions must report their securities holdings at market value and recognize 100 percent of unrealized holding gains or losses in the current year’s income statement. The revised accounting standards apply to the firms subject to external auditing for the fiscal year starting on or after January 1999. but 49 percent confessed that they have not followed international standards at all.Chapter 2: Korea 101 (iii) establishment of accounting standards for “combined” financial statements of chaebols. In the ADB survey. The new rules also require financial institutions to recognize realized losses and allowances for potential losses arising from guarantees in the current year’s financial statements. Notwithstanding a regulation limiting the votes of the largest shareholder to a maximum of 3 percent of the outstanding voting rights in selecting an internal auditor. Consolidated reporting was introduced before the outbreak of the crisis. The new accounting standards for financial institutions adopt the mark-to-market basis to account for securities. In practice. they cannot be expected to discharge this responsibility because the representative director selects the internal auditor and can force him or her to resign. Internal and External Auditing The Commercial Code requires a corporation to have at least one internal auditor elected at the general shareholders meeting.

Big Korean accounting firms are affiliated with US accounting firms. Responsibilities of the External Auditors Committee include recommending a selection to the annual shareholders meeting and ensuring that external auditors conform to new transparency standards. underdeveloped market discipline for accounting firms. outside directors. In the ADB survey. External auditors are selected for a term of three years. About 100 listed firms will be subject to this requirement. The general organizational/social culture in Korea abhors conflict and may also have hindered effective functioning of internal auditors. Accepting these arguments. II controlling shareholder/CEO. In order to increase independence. Previously. But this problem can be mitigated if auditors function under the umbrella of the board. but since 1998 a committee consisting of internal auditors. Listed and registered corporations must publish financial statements audited by external accounting firms.6 years. The Commercial Code will be revised to allow corporations to choose from the two options: the internal auditor or the board audit committee system. this problem will largely disappear. The current external auditors have been associated with the surveyed companies for an average of 4. This is because the auditor. almost all firms affirmed that the external auditor is independent from the company. as a monitor of management in the Korean (and also the Japanese) system. The problem of misconduct on the part of the external auditor was caused partly by weak penalties on wrongdoing. . and creditors selects it. If the company changes its external auditor for reasons that are not listed in the relevant regulation. If the status of internal auditors is elevated to that of independent board members. the Korean Code of Best Practice also recommends that large firms adopt the audit committee structure with two thirds of its members consisting of independent directors. The internal auditor in the Korean corporate system can be argued to be inferior to the Anglo-American audit committee and the German supervisory board. In the past. Vol.102 Corporate Governance and Finance in East Asia. and lack of strong professional ethics in the accounting profession. the relevant laws and regulations were changed after the Asian crisis to require at least one of the internal auditors to be full time and to recommend that listed firms have outside (independent) auditors. The Securities and Exchange Act will also be revised to require an audit committee for large listed companies with total assets equal to or exceeding W2 trillion. does not have the power to hire and fire the managers. there were many cases where external auditors failed to detect omissions and false numbers in financial statements of listed firms. however. the board of directors had the power to appoint an external auditing firm. then the Securities and Futures Commission can appoint a new one.

small shareholders do not attend the annual meeting and that. However. Under the Commercial Code. About one fifth of the listed firms issued nonvoting preferred shares. and dismissal of directors and internal auditors require a “special resolution. or 10. the only purpose of allowing the Depository to vote was to help listed companies to meet the quorum requirement for the general shareholders meeting.” The survey shows that the Korea Securities Depository holds 69.53 percent of the total shareholdings. The above results indicate that.77 percent of the shares. The securities companies and banks are the second and third. The Depository represented 20 percent of the shares attending the meetings. corporations cannot issue common shares without voting rights. These voters represented only 5.” Companies can increase the number . No companies have so far introduced voting by mail. About 100 shareholders per firm voted by proxy at the last annual general meetings (of the 40 firms answering the relevant questions). This shows that a relatively larger number of shareholders send in their proxies. One common share should have one vote. A “special resolution” requires two thirds of the votes attending and one third of total votes outstanding. Citizens’ coalitions sometimes solicit proxies in order to file lawsuits against a management. The Korea Securities Depository can exercise the voting rights of shares left thereto by the investors (beneficial owners) if the owner of the share does not indicate his or her intention to vote personally. amendments of the articles of incorporation require a “special resolution.3. the Depository is subject to “shadow voting. A total of 326 shareholders per firm.3 Shareholder Rights Voting Rights and Practices Under the Commercial Code. Internet. the Depository is instrumental in getting resolutions passed.21 percent of total shares issued. Preferred shares can be nonvoting and issued up to one quarter of the total number of shares. representing 62. Approval of mergers and major divestitures. charter amendments.93 percent of the shareholders but 26. However.Chapter 2: Korea 103 2. or telephone.79 percent of the shareholders. The management is the most important proxy. attended the last annual general meeting.” meaning that it should divide its votes in accordance with the accept/reject ratio of votes cast by other shareholders attending the shareholders meeting. Thus. in general. voting by the Depository can influence the outcome of votes because an “ordinary resolution” of the general shareholders meeting requires a majority of the votes attending and one quarter of total votes outstanding. for some firms. respectively.

an activist citizens’ coalition has brought shareholder derivative suits against several large listed firms. and for access to unpublished accounting books and records. Only two out of 62 respondents to this question have had cases in which proposals were rejected. Those that are most likely to be rejected relate to election of directors.01 percent. As an example. an institutional investor based in the US. but these can be waived by an amendment of the articles of incorporation. It also attended the shareholders meeting of several companies to present the views of outside shareholders. Vol. the Tiger Fund.0 percent.5 percent. II of votes required for a resolution to amend the articles. Due to the changes in rules for investor protection. The amendment included a provision requiring the company management to get prior approval of shareholders to undertake major investments and raise capital in international markets. However. the board of directors decides on issues of shares within the limit of the authorized capital. from 3 to 1. In four out of 62 respondents. and major investment projects (only five firms answered this question). Proposals put forward by management are rarely rejected at the general meetings. was able to force a change in the charter of SK Telecom. This citizens’ coalition actively contacted the management of selected companies and negotiated measures to protect shareholders. Shareholder Protection Before the economic crisis. Changes in the authorized capital require an amendment of the articles of incorporation. Various measures have since been taken to improve investor protection. The charges included self-dealing by a controlling shareholder and unfair subsidization of affiliated companies by a chaebol firm. In February 1998 and again in March. the Securities and Exchange Act was revised to lower the representation requirement for shareholder derivative suits from 1 to 0. or block charter amendments considered harmful to minority shareholders.104 Corporate Governance and Finance in East Asia. For recommendations for dismissal of directors and internal auditors. This coalition also attempted to cooperate with domestic and foreign institutional investors to find their way into general shareholders meetings. mergers and acquisition plans. laws and regulations were generally very loose in protecting the rights of minority shareholders. the requirement was lowered from 1 to 0. demand changes in business policy. dividend proposals. the annual general meeting passed a resolution that was not proposed by the management nor the board of directors but rather by shareholders. Shareholders have preemptive rights. The company also agreed to the right of the fund .

As for bond issues. The laws and regulations of the country protect shareholders from interested transactions. In 1974. simple. bond indentures are only a few pages long compared to a few dozen pages found in advanced bond markets. However. and not strictly enforced.Chapter 2: Korea 105 to recommend two directors to the corporate board. The Commercial Code has a new clause that regards the controlling shareholder as a de facto director if he or she uses personal influence to affect business decisions of the management. After the economic crisis. affiliated lending or guarantees. the Government introduced the Credit Management Regulation system whereby chaebols were required to seek the approval of their main banks prior to undertaking large investments.4 Control by Creditors Role of Creditors in Corporate Monitoring Traditionally. This was one of the most significant developments with respect to shareholder activism in the Korean capital market. 2. This has strengthened the accountability of controlling shareholders as de facto CEOs. creditors did not interfere with the management of a debtor. Before the amendment. mergers and acquisitions. managers were considered to be subject to the duty of care. . The Code has also been amended to state more clearly the fiduciary duty (of care and loyalty) of the management. In fact. but it was not entirely clear whether they had the duty of loyalty as well. the Government had for some time pushed for the enactment of class action suits on false statements and omissions in disclosure materials. Banks themselves were poorly governed and bank managements had little incentive to monitor borrowers. it now appears that it has backed away from its earlier efforts to introduce legislation on class action suits. Thus. Banks have played some limited role in monitoring the investment activities of chaebols. controlling shareholders have become more susceptible to liability claims by other (minority) shareholders. For further protection of investors.3. loans to directors. and transactions with major shareholders. These have to be disclosed under the Securities and Exchange Act or approved by shareholders under the Commercial Code and other laws. there was the usual conflict of interest problem and the trustee did not have the incentive to strictly enforce the covenants. The covenants in loan agreements and bond indentures were very loose. underwriting securities firms acted also as trustees.

the main banks should review the feasibility and financing plans of projects undertaken by the core companies and monitor their financial conditions and prospects. On the other hand. In 1994 the approval requirement was abolished. Emphasis on the monitoring role of banks has been growing since the beginning of the Asian crisis.106 Corporate Governance and Finance in East Asia. However. recently banks have been increasingly interested and successful in electing former bank officers as outside directors of firms that underwent workout processes. and purchases of real estate. Besides the setting up of an “External Auditors Committee” by firms. Vol. 11 banks. In turn. The objective of the system is to improve the financial condition of the largest business groups and promote the soundness of bank management. this proposal has only a slim chance of being accepted by the Government or legislature. ADB Survey Results on Borrowing and Lending Practices The ADB survey shows that a typical nonfinancial company is associated with various types of creditors. including. The 10 largest business groups are required to select no more than three core companies in consultation with their respective main banks. creditors now have a bigger say in court proceedings for receivership and composition. as discussed earlier. Purchase of real estate should be financed by equity capital and not by borrowed funds. The main bank should also monitor and restrict extension of loans to the controlling shareholder and other firms in the group. The firms subject to the system are required to get the approval of the main bank prior to purchasing real estate. However. 10 nonbank . on average. The view that is more popular among theorists is that creditors would pursue goals that are not in harmony with value maximization and the decision-making role should be bestowed on the shareholders as residual claimants. a main bank is charged with collecting and analyzing financial information of the firm and delivering its opinion on various applications and matters requiring consultation among lenders to the firm. In 1996. there have been concerns that the Government might use the system to intervene in the management of the business groups. Some proponents argue that creditors should have the right to send their representatives to boards of directors of borrowers. the main bank system was introduced and has been applied to the 51 largest business groups to which banks extended more than W250 billion in loans and payment guarantees. Under the system. II acquisitions.

mutual guarantee agreements. and other financial institutions. Most firms feel that requirements for collateral have been tightened since the crisis started. A few creditors exercise influence through covenants relating to major decisions by the company. penalty was involved in rescheduling. For more than half of such firms. Only a few feel that creditors have very strong influence. most frequently in the form of loan guarantees and less frequently by arrangement of guarantees by a third party. More than half of the firms think that creditors have no influence on their management and decision making. banks are most likely to require collateral. 16 percent . Breakdown of loan guarantors is as follows: about 40 percent of loans are without any guarantees. With respect to the types of loans. For a small number of firms. renegotiation took place after the crisis. Most of the financial institutions are not affiliates of the borrowing company. whereas seven of the 17 nonfinancial corporations are. About 60 percent of the firms have experienced renegotiation of loan repayment with creditors during the last five years. Among the creditors. 35 percent are guaranteed by the company itself (by collateral and purchase of guarantee insurance).Chapter 2: Korea 107 financial institutions (NBFIs). in order of importance: affiliated companies. or creditors filed for receivership. holding shares of another company by both the borrower and the guarantor. while a third think that creditors have weak influence. Most of the 43 firms with renegotiation experience were able to borrow from the same creditors afterwards. or through their shareholdings. holding companies. Creditors usually exercise their influence through covenants relating to the use of loans. subsidiaries. The borrower’s relationship with most banks has lasted for more than five years. The assistance came from. NBFIs infrequently ask for collateral. One tenth of the firms received assistance from the Government in loan applications. collateral was taken away. and purchase or supply of raw materials. About half of the respondents received assistance from other sources in the form of loan guarantees and/or provision of collateral. When loans could not be repaid on time. collateral is more likely to be required of loans for working capital than for fixed investments. The typical company has also maintained its relationship with five of the 10 NBFIs for more than five years. payments were usually rescheduled through negotiation without any penalty. Relationships with affiliated companies providing guarantees or collateral include ownership of each other’s shares. controlling shareholders. and 17 nonfinancial corporations.

including commercial and merchant banks. In this connection. the Corporate Restructuring Coordination Committee (CRCC) will provide arbitration. the creditor banks will send a delegation composed of bank officers to the workout firm to oversee its management. a Lead Creditor Council Agreement was signed for restructuring the top five chaebols.5 The Market for Corporate Control Government Policy Toward Hostile Takeovers Until 1994. the lead creditor banks formally signed Capital Structure Improvement Plans with chaebols. In cases where the creditors are unable to reach an agreement on a workout plan. and in continued monitoring of debtors. Second. This agreement will provide guiding principles in coordinating diverse interests among creditor institutions and promoting cooperation.108 Corporate Governance and Finance in East Asia. Role of Creditors in the Corporate Restructuring Process In the current process of business restructuring and workouts of an unprecedented number of firms under financial distress. especially banks. 2 percent by holding companies. the main vehicle for implementing the workout concept (or the London Approach) is the Corporate Restructuring Agreement (CRA) signed by 210 financial institutions in July 1998. Under a contract signed between the creditors and the debtor. 4 percent by subsidiaries. 2. major creditors. the delegation has the right to approve wide-ranging financial activities of the firm. and 1 percent by the Government. will get involved in the restructuring and workout processes.3. Behind these new strengthened roles of creditors is the newly set-up FSC. banks and other institutional lenders are playing more important roles than ever before. First. the Korean Government maintained a policy of protecting the incumbent management of listed companies. This committee was set up in accordance with the provisions of the CRA. Third. The leading creditor banks will continuously monitor the progress in implementing the signed Plans. II by other affiliated companies. The new ways through which creditors. have been the driving forces for restructuring activities of the largest 64 chaebols. Representative of the policy was the stipulation under the Securities and Exchange Act that no one can accumulate more than 10 percent of the voting shares of a listed company . are summarized below. Vol. Separate from but emulating the CRA.

Stock purchases by tender offer were also exempted. As far as institutional arrangements are concerned. more than half of these attempts failed. listed firms rely mainly on shareholdings by the largest shareholder. turning to white knights.Chapter 2: Korea 109 unless he or she obtains prior approval of the Securities and Exchange Commission. A company cannot issue new shares to a third party without first amending the corporate charter. Korea does not have the mandatory takeover rules applying to those who amass more than 30 percent of the shares outstanding (until 1998. For takeover defense. Poison pills cannot be used mainly because companies cannot distribute stock options as dividends to shareholders. and announcing competitive tender offers by the controlling shareholder. It was generally believed that the securities authority would use its power to review and order revisions of the tender offer statement to halt any hostile takeover attempt. Between 1994 and 1997. Companies have also utilized share repurchases. Unlike Germany. The policy to protect the incumbent owners/managers was formally dropped when the Securities and Exchange Act was amended in 1994 to abolish the 10 percent limit. Limits on acquisitions of shares of a Korean firm by a single investor were gradually increased over a six-year period beginning in 1992. However. Takeover Activity As soon as the Act was amended. a total of 13 hostile takeover attempts occurred. The shareholders already owning more than 10 percent at the time the company went public were exceptions to the rule. . the outside shareholders did not want to sell shares because the share price went above the offer price due to a share repurchase by the target and anticipation of a competitive bid from a third party. In one case. In the early 1990s the Government shifted its policy toward freer activities in the market for corporate control. The reasons for failure are diverse. hostile takeovers by tender offers began to appear in the capital market. Publicly issued CBs require three months before their owners can convert them to shares. but were completely eliminated in 1998. Privately placed CBs cannot be converted into shares in one year. an acquirer of shares wishing to own more than 25 percent of the issued shares was required to make a tender offer to buy at least 50 percent). it can be safely stated that Korea now has one of the most accommodating capital markets with respect to hostile takeovers in the region. Unlike the UK. The incumbent controlling shareholders used various tactics such as issuing privately placed CBs. corporations cannot limit the voting rights of large shareholders to a given maximum.

it is not certain whether the Government will ever fully privatize them and whether it will hold a golden share in the case of a complete sale of Government-held shares. In 1999. Currently the limit is 3 percent.7 percent on average as of the end of 1997 for nonfinancial listed firms). Another reason is that many listed firms belong to chaebols. the Government became the largest shareholder of several commercial banks through equity participation purporting to recapitalize them out of financial distress. Golden parachutes are almost unknown in Korea because the total amount of director compensation has to be voted on at the general shareholders meeting each year. As of the end of 1997. an electric power company. Many of the takeover targets in the past did not have a controlling shareholder (group). Hostile takeovers in Korea will be rare in the future. the limit will be eliminated when it is fully privatized in two years. are designated as public companies. The Government-owned listed companies. a steel company. except for the banks. II The Securities and Exchange Act was revised in 1998 to abolish the 10 percent limit on share repurchases and the Government simultaneously eliminated the limit on foreign ownership of shares of listed firms. Some had two or more large shareholders who had joint control of the firm but could not cooperate. For the steel company.6 Control by the Government State-Owned Enterprises Government ownership of listed companies is very limited. As of February 1999. . Korea Telecom. In 1998. It is harder now to find such firms. 172 firms (or 22 percent of listed firms) belong to the 30 largest chaebols. Charter amendments have also been employed by some firms to limit the maximum number of directors. For the others. One reason is that the percentage of inside shareholdings (by the controlling shareholder group and the firms under its control) for an average listed firm is very high (26. and a bank had government ownership. in which the Government still holds the largest ownership. was newly listed. some firms have included a supermajority provision for the dismissal of directors and provided for a staggered board.3. Firms affiliated with a large group are generally regarded as difficult targets as the other members of the group will come to the rescue or act as white knights. 2. Vol.110 Corporate Governance and Finance in East Asia. which are allowed by the Securities and Exchange Act to set the limit on the ownership of shares by one single shareholder. In their charters.

Meanwhile. The objective of the system was to improve the financial condition of the chaebols and to promote the soundness of bank management. which limits the total amount of bonds issued by the five largest chaebols. Even where employees hold . nominated by the minister in charge of the company in question. is being applied to the 51 largest business groups to which the banks extended more than W250 billion in loans and payment guarantees. each of the 10 largest chaebols was allowed to raise funds no more than 4 percent of the total market capitalization of the member firms. Labor is not represented in corporate boards. The nonexecutive directors are now recommended by a committee. Beginning in 1999.Chapter 2: Korea 111 The Government used to appoint a few public officials to the boards of state-owned corporations. as applied to four large corporations. But this rule. Control Over Private Companies One of the pronounced purposes of government intervention in the corporate sector has been to prevent concentration of economic power in the hands of a few large chaebols (see 2.7 Employee Participation in Corporate Governance Employee participation in corporate governance is very limited.1). more state-owned corporations became subject to this new board structure. 2. It was abolished before the economic crisis but another regulation. went into effect in 1998 to prevent them from absorbing too much of the funds available in the market. This was aimed at limiting the supply of bonds thereby stabilizing interest rates. was amended in 1997 to introduce a board structure consisting of a majority of nonexecutive directors. The Government has frequently imposed restrictions on the use of capital markets by large companies.3. the main bank system.3. There were also limits on the amount raised and the number of issues per year. Further. the Government. The Government’s right to send public officials to the boards was eliminated. and approved by the Chairperson of the Planning and Budget Commission. especially those belonging to chaebols. For example. only qualified firms could issue new shares. administering through a self-regulatory committee of the securities industry. There is no active debate or discussion going on about this potentially difficult issue. controlled the total amount of corporate bonds issued per month and allocated amounts to individual corporations. In addition. which was introduced in 1996.

. but 27 percent of them felt that it was strong. union members account for 54 percent of the employees. and 2. The union had no influence on the management in 17 percent of the firms. of which 2 percent were senior managers.654 employees per firm on average. In these firms. In 1987.112 Corporate Governance and Finance in East Asia. Collective bargaining is. employees of listed firms issuing shares through rights offerings are entitled to 10 percent of the rights. About half of these firms considered the influence of the union on the management of the company to be weak. employers are required to meet with representatives of labor unions at least once every three months. the council meetings have been superficial. they delegate their voting rights to plans’ representatives. Under another law enacted in 1972 to induce private companies to go public. This law is not intended for wage negotiations but for employers to seek cooperation and productivity increases from workers. operation. the management usually consults the union on major issues relating to the management. carried out at the enterprise level. Vol. and 66 percent manual workers.5 in 1990. Trade unions are organized on an enterprise basis. Under the Capital Market Development Act of 1968. II shares of their companies through employee stock ownership plans. Local unions in the same industry have established industrial labor federations. The relevant regulation was amended recently in order to facilitate voting by individual employees. In 70 percent of the firms with organized unions. Employee stock ownership plans became popular in 1974 when the Government allowed tax and financial benefits for stock purchases by employees.9 in 1980. in principle. which were generally much lower than estimated values.1 in 1997. At the national level. The typical collective bargaining agreement has a one-year duration. In actuality. there are two federations of labor unions. the subscription rights given to employees when a company goes public and when a listed company issues shares were increased to 20 percent of the new shares. Under the Labor Management Council Law. Two thirds of the respondents had an organized union. 2. these firms have to offer 20 percent of the shares being issued to their employees at the public offer prices. and development of the company. 32 percent technicians and professional staff. The percentage of shares held by the employee stock ownership plans in listed companies was 1. The respondents of the ADB survey had 2. Employees of companies have had the opportunity to buy shares of their employing businesses at favorable prices. This practice may be due to the fact that employees are typically submissive to their employers and that their total shareholdings are minimal.

Chapter 2: Korea 113

2.4 2.4.1

Corporate Financing7 Overview of the Financial System

The foundation of the modern financial system in Korea was laid during the early 1950s. Specialized banks were established during the 1960s to facilitate capital mobilization and strengthen financial support for underdeveloped or strategically important sectors. Most NBFIs were introduced during the 1970s to diversify financing sources, promote the development of the money market, and attract funds into the organized market. From the early 1980s, several commercial banks and NBFIs were added as part of a series of broad measures to spur financial liberalization and internationalization. These measures coincided with a shift from a government-oriented economic policy toward a market-oriented stance. Recently, the Korean financial system has been undergoing substantial changes through a comprehensive financial reform program. This program was agreed upon by the Korean Government and IMF upon the signing of a financial aid package. At present, financial institutions in Korea may be divided into three categories by function: the central bank (the Bank of Korea); banking institutions, including commercial and specialized banks; and NBFIs, including development, savings, investment, insurance, and other institutions. Corporations raise funds through direct loans from the banks and NBFIs, and by transactions with the public through the money market, stock market, and bond market. Banks To a certain extent commercial banks have engaged in long-term financing in addition to their short-term banking operations. They still tend to depend heavily on borrowings from the Bank of Korea to cover persistent shortages in their own loanable funds, although the ratio of these borrowings to their total sources of funds has decreased. Commercial banks in Korea may, as in most countries, engage in a wide range of business. In addition to their core activities, they also handle such businesses as guarantees and acceptances, own-account securities investment, and receipt and disbursement of Treasury funds as agencies of the Bank of Korea. Specific authorization is required for each area of nonbank business they engage in: such as trust ac7

The authors gratefully acknowledge the help of Prof. Bong-Han Yoon who contributed several sections of this part.

114 Corporate Governance and Finance in East Asia, Vol. II

counts, credit card business, and some aspects of securities business. Specialized banks, which function as deposit money banks alongside commercial banks, conduct a similar range of business in addition to their own areas. From the early 1980s, banking institutions moved into a number of new business areas and developed a variety of innovative products to raise their competitiveness against NBFIs, and to meet the growing and diversified demand for financial products. Examples are credit cards, sale of commercial bills discounted by themselves, factoring business, trust business, certificates of deposit (CDs) business, and sale of cover bills. They also entered such security businesses as sales of government, public, and corporate bonds under repurchase agreements; the acceptance, discount, and sale of trade bills; and lead underwriting and over-the-counter sales of government and public bonds. In the early 1980s, the trust business, which had been limited to Bank of Seoul and Trust Company, was opened to all banks. Nonbank Financial Institutions NBFIs can be broadly classified into the following categories: (i) development institutions comprising the Korea Development Bank and the ExportImport Bank of Korea; (ii) savings institutions including the trust accounts of banking institutions, mutual savings and finance companies, credit unions, mutual credit facilities, and postal savings; (iii) investment companies comprising investment trust companies and merchant banking institutions; and (iv) contractual institutions such as insurance companies and pension funds. In addition, there are various nonbank institutions that handle specialized lending such as leasing, factoring, credit cards, consumer loans, housing loans, and venture financing without receiving deposits. NBFIs have increased their share of total funds supplied since the 1980s as they have been permitted greater freedom in management and operations. The market share of banking institutions in terms of Korean won deposits dropped sharply from about 71 percent in 1980 to 30 percent in 1997; while that of NBFIs increased from 29 percent to 70 percent during the corresponding period. Differences in regulatory treatment accounted for the greater freedom in management for the NBFIs. They were allowed relatively greater flexibility in their management of assets and liabilities and, most important, were permitted to apply higher interest rates on their deposits and loans. Evenness in regulatory treatment concerning such interest rates has, however, largely been achieved following the completion of a four-stage plan for deregulation of interest rates from 1991 to 1997.

Chapter 2: Korea 115

Money Market The money market is composed of the call market and a wide range of other short-term financial markets including those for Treasury Bills, Monetary Stabilization Bonds (MSBs), negotiable CDs, repurchase agreements (RPs), commercial papers (CPs), trade bills, and cover bills. The beginning of the organized money market in Korea dates from when MSBs and Treasury bills were first issued in 1961 and 1967, respectively. However, the money market remained underdeveloped until the early 1970s when the Government took a series of measures designed to channel curb market funds into financial institutions and to systematically organize the short-term financial market. In 1972, with the passage of the Short-Term Financing Business Act and the establishment of investment and finance companies, the sale of papers issued by nonfinancial business firms and investment and finance companies was initiated. This was a first step toward the formation of an advanced money market. In 1974, negotiable CDs (large-value time deposits at banks) were introduced. In addition, call transactions, which had previously taken place between individual banks, were put on a systematic basis. In 1977, the Korea Securities Finance Corporation initiated repurchase agreements with securities companies involving bonds on a shortterm basis. Various new financial instruments, including CPs, were introduced in the early 1980s. Since 1985, there has been a sharp increase in the outstanding balance of money market instruments. This is chiefly due to product innovation and expansion in the number of financial institutions handling such instruments. The volume of money market transactions expanded from W7,995 billion in 1985 to W44,201 billion in 1990, and W98,100 billion in 1995 (as of the end of June). Stock Market Activity in the primary (new issues) stock market was extremely brisk during the period 1986 through 1989. The value of shares sold in IPOs and in rights offerings by listed companies grew 48 times from W294 billion in 1985 to W14,176 billion in 1989. But the stock market sagged in 1990, resulting in a decline in IPOs and seasoned issues. The composite stock price index declined substantially during 1990-1992 due to continued labormanagement disputes and a slowdown in economic growth. Though the market recovered temporarily from 1993 to 1995, it again went into a slump

116 Corporate Governance and Finance in East Asia, Vol. II

after 1996 until the index hit 350 in December 1997 with the onset of the financial crisis. A new stock market was organized in April 1987 to provide a new means of trading stocks for small- and medium-sized companies and venture businesses not eligible for listing on the Korea Stock Exchange. A corporation satisfying less stringent criteria can register with the Korean Securities Dealers Association under the sponsorship of at least two securities companies. This market, named KOSDAQ, is not exactly an over-thecounter (OTC) market in that, unlike the National Association of Securities Dealers Automated Quotations (NASDAQ) in the US, there are no active dealers for registered shares. Still, investors are assured of a certain degree of liquidity of the shares registered at the KOSDAQ. Though the KOSDAQ is still in its infancy, it has been showing a great potential for growth by providing liquidity to shares of small and large firms before they are eventually listed on the Korea Stock Exchange. Despite the considerable growth and good performance of the Korean stock market, many problems were exposed with the onset of the financial crisis in 1997. The major problems may be identified in the following areas: (i) corporate disclosure system; (ii) reliability of accounting information; (iii) protection of small shareholders; and (iv) inactive takeover markets. Bond Market Public and corporate bonds are issued in the Korean bond market. Public bonds include government and other bonds that are issued by provincial and municipal governments, government-owned enterprises, and government-owned financial institutions. All public bonds are implicitly or explicitly guaranteed by the central Government. Corporate bonds are those issued by private companies under the Commercial Code. The value of listed public bonds became larger than listed corporate bonds in 1986 and remains to be so. The secondary bond market consists of the exchange and the OTC market. However, as in most other countries, the OTC market has dominated trading in bonds. Almost all of the bond transactions still take place on the OTC market despite government efforts to develop a separate exchange market for bonds. Most corporate bonds were issued as guaranteed bonds where the payment of principal and interest is guaranteed by financial institutions. Nonguaranteed bonds or debentures accounted for only 15 percent of the

Chapter 2: Korea 117

total issued in 1997, although their proportion reached 30 percent in 1995. This implies that most bonds were issued according to similar conditions regardless of the financial standing of the issuing company and that the bond rating system has not been well developed in Korea. However, all of this is changing. Bond rating agencies are now applying tighter criteria. Banks have strengthened their credit reviews in extending debt payment guarantees because of tighter regulatory and market pressures on their own financial conditions. Most securities companies have all but stopped extending guarantees. One of the dramatic changes in the bond market after the IMF bailout is that most corporate bonds are now issued on a nonguaranteed basis. The proportion of nonguaranteed bonds accounted for 69 percent of the total offerings of corporate bonds in 1998. This is in contrast with the prebailout period, when the proportion of guaranteed bonds was more than 80 percent of the total offerings. One problem for the corporate bond market is that most bonds are issued with maturities of less than four years. The maturity of corporate bonds should be lengthened to generate stable longterm funds for corporations. Financial Deregulation Discriminatory government regulations in the financial sector were prevalent during the 1970s. Entry into financial industries such as commercial banking, investment banking, securities brokerage, merchant banking, and insurance was strictly controlled. Ownership of commercial banks and their internal governance structures were controlled for many decades. These factors resulted in a serious structural imbalance in the financial industry. It diminished the role and profitability of banks while encouraging growth of NBFIs. In addition, the capital structure of business firms worsened and the unorganized money market rapidly expanded. In order to reduce government intervention and to restore the balanced development of the financial market, interest rate deregulation was initiated in June 1981. A significant advance occurred in December 1988, when most of the lending rates of banks and NBFIs were liberalized. Only interest rates on long-term deposits were regulated to avoid excessive competition among financial institutions. Interest rates on remaining deposits were gradually deregulated. However, in 1989, when interest rates rose rapidly and macroeconomic conditions deteriorated, the Government again placed extensive control over interest rate movements, including window guidance. In August 1991, the Government announced the Four-Stage

the Korean Government announced its Financial Liberalization and Market Opening Plan. flow of funds analysis was used to examine patterns of financing of the aggregate corporate sector.1). In addition. and liberalization of foreign and capital transactions. Some policy loans were also abolished. budget. The Government began to considerably deregulate foreign exchange in 1987 due to the shift of the current account into surplus in 1986 (see 2. as a first step toward liberalization of capital account transactions. especially the domestic bond market. the Government simplified various directives and instructions regulating personnel management. and organization of commercial banks. Internal funds include retained earnings. Moreover. the Government announced a plan in 1981 that substantially improved foreign investors’ access to the domestic capital market. implementing the first stage in November 1991.2 Patterns of Corporate Financing Corporate Financing Practices In this section. the required reserve ratio was substantially lowered from an average of 23 percent in 1979 to 3. It included such important issues as interest rate deregulation. The Government handed over its controlling stakes in four commercial banks to private hands in 1981-1983. With the privatization of nationwide commercial banks.4.118 Corporate Governance and Finance in East Asia. revision of the credit control system. which resulted in the establishment of a number of new banks. and the 30 largest chaebols. etc. the business scope of financial institutions was greatly widened from the early 1980s. The capital market. . Meanwhile.5 percent in November 1981. On the basis of flows of funds. Also. entry barriers to banks and NBFIs were lowered in an attempt to promote competition. listed companies. Since 1985. short-term finance companies. finance companies. was liberalized drastically in 1998 after the financial crisis. Vol. the following measures can be constructed: Self-financing ratio (SFR) is the ratio of change in internal funds to change in total assets. development of the money market. mutual savings. In June 1993. II Interest Rate Deregulation Plan. opting to bring in the plan step-by-step to avoid market dislocation from a sudden shift in the system. The plan was launched partially to accommodate US demands for comprehensive structural deregulation and market opening of the financial sector. The Government adopted a cautious approach. depreciation. Korean firms have been allowed to issue CBs in international financial markets. 2.2.

but it remained less than 10 percent of total financing. Additional equity capital used to finance growth reduces the financial cost and the financial risk of investment. except in 1991. It measures the degree of financing growth in total assets by additional debts. comprising internally generated capital (retained earnings. This high proportion deprived Korean businesses of flexibility during recession periods due to high financial costs. Equity capital represents the shareholders’ commitment to the business. the corporate sector’s most important source of external finance was bank borrowings. on average. The share of external financing. and 1997. In 1988 when the stock market boomed. particularly in the 1990s in response to the liberalization of the capital market. capital surplus. Incremental equity financing ratio (IEFR) is the ratio of change in stockholders’ equity to change in total assets or 1-IDFR.25 shows the flow of funds of the nonfinancial corporate sector in Korea during 1988-1997.Chapter 2: Korea 119 and net capital transfers from the Government. the proportion of foreign borrowings in total finance rose steadily.26 shows the four measures of corporate financing calculated from Table 2. 1994.25. but do not include capital surplus (asset revaluation allowance and the excess of current value over issue value of stock). and allowances) and new equity capital. Meanwhile. New equity financing ratio (NEFR) is the ratio of change in equity (stocks issued + equity other than stocks) to change in total assets. Securities finance became a more important source from 1988 onwards. was 71 percent during the period.4 percent in the precrisis period 1988-1997. The corporate sector used . including all sources other than retained earnings. This means that internal funds after dividend payment were insufficient to finance growth in total assets. In securities finance. The use of additional debt to finance growth increases financial risks as the company may not be able to pay interest during periods of recession or high interest rates. Financing Patterns of the Aggregate Corporate Sector Table 2. depreciation. Table 2. except for the stock market boom of 19871988. Before 1988. particularly in the short term. the proportion of borrowings from NBFIs fell to its lowest value at 4 percent. financing by corporate bonds and CPs was more significant than by new equity. The SFR averaged 28. Incremental debt financing ratio (IDFR) is the ratio of change in total borrowings to change in total assets. and government transfers. It measures the degree of financing growth in total assets by additional equity. depreciation.

6 1.0 22.7 71.1) 4.3 72.1 17.6 10.7 4.4 (2.3 16.4 2.0 70.6 2.8 -2.7 4.9 10.5 29.4 27. .8 1.4 — 28.3 6.3 — — — — 8.3 3.1 2.7 11.7 6.4 1.1 (1.0 — — — — 8.0 1997 26.3 6.0 11.4) 13.7 14.5 2.9 6.3 2.2 34.8 1.6) 5.2 — — — — 9.4 0.6 0.7) 11.3) 15.8 17.3 1.2 6.6 0.3 1.7 14.2 13.0 2.7 10.1 1.8 4. and Flow of Funds.6 9.6 0.7 10.2 15.7 7. Bank of Korea.4 11.6 77.1 36.6 4.3 — 30.1 72.8 1.2 14.7 10.2 2.7 2.7 8.6 Sources of Funds Internal Financinga External Financing Bank Borrowings Banks Nonbanks Merchant Banks Insurance and Others Securities Natl.1 3. b Includes capital surplus.1 0.2 13.0 9.1 2.6 3.7 2.3 3.4 0.2 (0. and net capital transfers from the Government.6 9.4 15.6 25. 1988-1997 (percent) 1988 43.5 13. which is the excess of current value over issue value of stock.3 27.2 6.4 27.0 (0.5 0.1) 6.2 10. Source: Understanding Flow of Fund Accounts.5 2.4 2. depreciation.4 21.1 27.1 3.5 9.8 1.5 0.8 56.7 12.3 5.7 (0.4 27.6 (0. a Includes retained earnings.7 1.7 — — — — 9.7 73.9 34.4 9.4 2.1 3.9 28.3 30.6 0.8 — 26.8 8.2 5.6 11.4 3.7 32.6 4.6 11.8 0.9 10.5 2.0) 12.0 0.5 16.4 10.0 5.0 3.5 2. and Public Bonds Commercial Paper Corporate Bonds Stock Issuesb Equity Other than Stock Foreign Loans Foreign Current Bonds Trade Credit Direct Investment Others Others Government Loans Business Credit Other Financial Debts — = not available.1 23.7 13.9 2.9 38.7 1.0 9.8 1.2 1.1 1.9 72.7 1989 1990 1991 1992 1993 1994 1995 1996 22.3 10.1 (0.2 26.9 9.1 8.7 15.8 (0. Bank of Korea.4 2.4 1.2 0.5 16.0 10.4 (0.0 3.0 17.2 — 28.5 0.1 — — — — 12.1 10.6 5.0 3.1) 4.3) 11.6 3.6 14.8 27.25 Flow of Funds of the Nonfinancial Corporate Sector.1 — 27. 1994.1 1.4 8.0 1.9 73.8 30.4 71.6 9.6 4.1 0.9 0.6 8.3 6.0 0.Table 2.7 2.3 1.1 12.8 15.3 25.0 16.7 8.

IDFR reached 73.26 Financing Patterns of the Nonfinancial Corporate Sector. Bank of Korea.5 31. SFR peaked at 44 percent.7 40.2 IDFR 36. Source: Calculations from Understanding Flow of Fund Accounts. but plunged to 5.7 30. NEFRs.0 42. Incremental financing from equity was 40.1 26. While SFRs. dropping to 26. was financed by additional debts. Bank of Korea.Chapter 2: Korea 121 Table 2.3 60.27).3 12.0 57. There were significant time trends.5 68.3 59.4 percent.9 22.3 59.5 and 76. IEFR ranged from 32 percent to 64 percent of asset growth during the boom years.6 percent. Across industry.8 28.5 12.0 11. It dropped to 28 percent the following year. but also continuously fell.4 IEFR 63.9 percent by 1997 when net profit margins were negative. respectively. Lower income diminished the industry’s equity position toward crisis year 1997.7 percent in 1997.7 28. and the total debt ratio was much higher in 1996 and 1997 at 62.0 27.4 percent.1 17.9 28.5 percent.4 27. higher than the aggregate 28.6 Excludes capital surplus. declining to 26.3 73. NEFR registered 20.1 39.7 40.8 10.7 40. 1988-1997 (percent) Year 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average a SFRa 43.4 37.1 12.0 5.4 percent (Table 2.9 60.3 11. indicating a high financial risk position.7 9. In periods of high economic growth such as in 1988. Its IEFR and NEFR dropped to 23. additional equity to finance 12. in the manufacturing sector. The balance. higher than the aggregate 40.7 26.6 62. .1 percent in 1988 during the stock market boom. 1994. 45. respectively.6 26. the corporate sector relied heavily on external financing for its expansion.6 percent over the 10-year period. On average. Manufacturing financed 54.9 46.3 percent in 1997.2 37.5 percent in 1997.6 percent and 1.4 NEFRa 20.3 27.1 53.8 percent of its total asset growth through debts.8 62. average SFR was 37. an average of 59.4 12.2 percent of incremental asset growth was financed by equity.6 percent.2 percent of the growth in total assets. and IEFRs were declining. and Flow of Funds.

7 37.4 47. storage. Since large firms were more profitable.6 54. their average SFR was higher. On the other hand.7 percent in 1996.6 3. one year ahead of the other industries. Vol.6 62. this dropped further to 15.4 45. Total debt financed an average 74.5 7.6 53.5 1. retail.122 Corporate Governance and Finance in East Asia.3 52.2 62.4 3. from 17.6 4.9 IDFR 34.27 Financing Patterns of the Nonfinancial Corporate Sector by Industry (percent) Year Manufacturing 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average SFRa 50.4 63.and medium-sized firms.6 37.2 3.7 47. then increased to 20.8 percent in 1990.0 57. explaining partly the collapses of several construction companies in 1995. II The construction industry showed the most cyclical pattern in annual asset growth.2 21.7 47. and steam) and the transportation.0 30. gas.9 percent of asset growth. the utilities (electricity. and fell to about 10 percent in 1997.8 50.6 36. Since 1992.4 54.0 42.6 37.2 5. and low total debt and short-term borrowing ratios. the two sectors also had low equity financing ratios and high debt financing ratios.1 percent of total asset growth for the period.2 percent in 1993. large firms showed more cyclical patterns in these financing ratios than small.0 42.8 IEFR 65. Table 2.6 53.2 .5 76. These sectors had relatively low equity financing ratios and high total debt ratios in financing asset growth between 1988 and 1997. the proportion of short-term borrowings in total financing has been high. Financing patterns of the wholesale. with the total debt ratio much higher in 1995-1997 at 82 to 84 percent. and communication sector had relatively high incremental equity ratios.4 37.8 percent in crisis year 1997.8 4.7 37.1 29. Equity financed an average 25.5 23.4 46.9 6.3 28.5 NEFRa 9.0 3.9 percent.6 45. which decreased to 8. It had the highest average SFR in 1988 at 31. Categorized according to company size. and hotels sector and realty/renting/business activities sector were similar. In 1997.

9 33.8 70.4 28.1 25.9 16.0 74.0 1.0 1990 50.4 2.8 25.6 37.1 4.9 1. Storage.9 9.0 17.9 52.1 Trasport.0 3.3 10.7 7.7 15.2 70.2 25.0 4.8 54.9 80.0 10.5 29.7 78.7 1989 26.4 62.0 60.9 Average 19.7 53.2 18.8 9.7 6.9 15.1 19.3 7.0 1990 12.9 1.6 8.7 Wholesale/Retail Trade.0 31.5 1996 42.3 21.4) 2.6 7.0 82.1 84. Household Goods.2 3.6 4.5 1.0 65.3 84.9 1993 63.6 37.7 1997 8.2 4.2 23.Table 2.7 80.4 IEFR 46.6 14.0 34.27 (Cont’d) Year SFRa NEFRa IDFR 53.2 8.9 47.5 20.1 70.5 87.6 9.9 1992 56.3 (9.0 40.7 78.3 4.7 1994 53.2 5.9 30.2 74.8 76.6 71.3 4.8 1994 15.0 68.5 76.8 1991 51.9 1989 63.0 .9 29.5 70.2 Average 53.6 9.4 26. Hotels 1988 33.1 66.5 62.5 21.2 46.1 69.2 29.7 41.3 19.6 8.4 1995 53.3 57.3 1996 16.8 81.2 10.9 Construction 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 31.1 59.8 4.7 15.8 2.0 0.9 20.5 1993 22.6 1997 29.7 42.5 23.3 8.8 29.2 20. and Communication 1988 64.9 2.2 1995 16.0 1992 24.9 1.5 12.6 73.1 1991 14.6 2.8 74.3 47.

2 63. and Business 1988 51.7 14.0 1997 24. Financial Statement Analysis Yearbooks.4 7.4 (107.1 70.1 42.9 65.3 7.3 3.6 1997 23.9 Average 75.8) (35.4 1995 62.1 35. NEFR = new equity financing ratio.8 17. Source: Calculated using data from Bank of Korea.6 1989 118.3 92.7 69.6 1991 18. Renting.3 31.and mediumscale firms.6 7.7 18.5 22.4 IEFR 69. when large firms had much lower equity financing ratios and higher debt financing ratios than small.6 52.6 Real Estate.8 36.7 37.6 1990 82.7 1996 18.1 1989 34.0 67.6 1995 17. Their average IEFR was also higher and IDFR smaller. Gas. and Steam Supply 1988 118.0 56.6 IDFR = incremental debt financing ratio.0 79.1 1993 55. however.9 IDFR 31.4) 3.4 0.3 85.4 5.3 81.7 70.7 1994 8.9 29.0 (0.4 47.124 Corporate Governance and Finance in East Asia.1 71.3 62.4 1.0 53.4 0 0 0 0 1.0 0.0 1.1 54. Vol.1 34. SFR = self-financing ratio.0 46.0 1992 51.4 1996 45.1 0.8 1990 19.0 33.5 8. II Table 2. .3 207.3 29.0 43.8 Average 22.4 1994 72.1 1991 56.8 135. Long. IEFR = incremental equity financing ratio. The large firms had a higher proportion of external financing in 1996-1997.9 28.2 1992 18.8) 7.5 77.9 57.9 45.0 0.6 1. Higher growth in total assets and sales and easier access to debts by large firms could be reasons for this.8 1993 11. The trend was reversed in 1996-1997.27 (Cont’d) Year SFRa NEFRa 6.9 64.3 Electricity.and short-term borrowings of these firms shot up in that period.0 21. a Excludes capital surplus.

In 1996-1997. respectively. compared with 89. the NEFR of the top 30 chaebols plunged while the debt ratio increased substantially. The proportion of their short-term financing averaged 72.9 percent. The average IEFR of the top 30 chaebols of 29. at an average 70. and higher than that of listed companies (Table 2. Group-member firms borrowed less.7 percent. the average SFR was 28. The average IEFR and IDFR were 10. Cross-payment guarantees have been declining since 1993 and reached 91. the top 6-10 chaebols.28). Financing Patterns of Chaebols For chaebols.3 and 89.8 percent of their total finance in 1997. and the top five chaebols. The largest borrowers were the top 11-30 chaebols.6 percent of total asset growth. All of the top 30 chaebols relied heavily on short-term borrowings. compared with the entire corporate sector’s 35 percent and 65. 91. They had easier access to bank loans and the markets for corporate bonds and CPs than nonlisted companies. Another key feature of corporate finance in Korea is the widespread use of loan guarantees among the top 30 chaebols.29). about the same as that of the corporate sector as a whole. and were large borrowers. Many firms affiliated with the top 30 chaebols saw loan guarantees turn into their own debts because of defaults in debt payments.4 percent.2 percent.5 percent and their total external financing. the IDFR of listed companies increased to 93.5 percent is lower than that of the corporate sector in general.7 percent for all listed companies. The debt financing ratio of listed companies was high since they relied more on external financing. and using cross-payment guarantees among affiliated companies. but higher than that of listed companies.30). In 1997.1 percent of their equity capital. the top 11-30 chaebols had the highest guarantees commitments at 207.Chapter 2: Korea 125 Financing Patterns of the Publicly Listed Firms The average SFR of listed companies in 1994-1997 was much lower than that of the corporate sector as a whole (Table 2.9 percent. for listed companies. External financing reached 94. 153. Their shortterm borrowings accounted for 86. In 1997.3 percent of their equity capital in 1997 (Table 2. They were able to borrow easily from banks by issuing corporate bonds and CP.6 percent.8 percent. . the lowest ratio of 58.7 percent. The chaebols’ drive to expand their empires resulted in heavy borrowings.

1 1.7 1.1 8.4 29.5 2.5 91.5 8.2 NEFRa 1.8 76.9 6. 1994-1997 (percent) SFRa 41. Korea Federation of Industries. 1994-1998 (percent) SFRa IDFR 85.3 Year 1994 1995 1996 1997 Average a Excludes capital surplus.7 13.6 0.28 Financing Patterns of Listed Companies. Table 2.2 36.4 38.5 Year 1994 1995 1996 1997 Average a Excludes capital surplus.6 IEFR 42.Table 2.8 22.9 NEFRa IEFR 14.5 2.3 IDFR 57.2 23. Source: Calculated using data of Seung No Choi.5 8. Largest Business Groups in Korea.6 1.7 12.3 1.6 70.6 61.4 1.2 1.29 Financing Patterns of the Top 30 Chaebols.3 86.4 88.1 93.3 5.4 12.8 89.2 10. .9 7.3 28.6 11. Source: Calculated from data obtained from data files of the Korea Listed Companies Association.

Firms now prefer internal funds and new equity capital.3 64. Further.Chapter 2: Korea 127 Table 2.9 — — — 1996 105. more than half of bank loans were priority loans with low interest rates.9 — — — 1994 258. This attitude appears to have changed after the crisis because reserves and retained earnings and rights issues became the preferred financing choices. the Korean economy was plagued with high inflation. There were several reasons for this. Second. chaebols could easily borrow funds from banks and NBFIs by using cross-payment guarantees. in order of ranking.1 — = not available. and loans from NBFIs. so that the firms engaged in lobbying to gain access to them.3 58. and reserves and retained earnings. and extended loans based on cross-payment guarantees. 1993-1997 (as percentage of equity capital) Rank Top Top Top Top 30 Chaebols 5 Chaebols 6-10 Chaebols 11-30 Chaebols 1993 469. the Government provided implicit guarantees on bank lending and large businesses.3 200. rights issues.0 1997 91. Source: Fair Trade Commission and the Federation of Korean Industries. Few firms ranked loans from NBFIs as their first preference. bond issues. Factors Influencing Corporate Financing Choices Until recently. the Government applied high tax rates on net profits of corporations. Financial institutions did not strictly screen their loan projects and monitor their debtors.1 — — — 1995 161. According to the ADB survey. poor financial and corporate governance resulted in overlending by banks. Controlling shareholders usually tried to avoid dilution in their shareholdings for fear of losing control. and underdevelopment of the stock market. loans from banks. Fourth. First.7 150. Third. bond issues. These are followed by loans from banks. Korean firms preferred debt financing (bank and nonbank borrowings). This change implies that firms now give more attention to financial risks. . especially in the 1970s when real interest rates of bank loans were negative.0 207. inefficient investment and excessive diversification of corporations. company preferences in financing investment projects before the crisis were. And fifth.9 153.30 Cross-Payment Guarantees of the Top 30 Chaebols. Interest payments on debts were considered a loss when calculating taxes.

and futures and other financial derivatives. they survived for two to three . more than half (53 percent) hedged against exchange rate fluctuations. many firms (or 42 percent) never considered hedging. II In seeking external financing. A futures exchange launched in 1999 trades foreign exchange options. in selecting financing sources. and others (29 percent) expected the local currency to appreciate in value. About half of the respondents of the ADB survey borrowed foreign currency denominated loans from foreign banks. Among those that never hedged against exchange rate risks. Korea now provides a better environment for financial risk management. Among the responding companies that had foreign currency denominated loans. ensuring the liquidity of the company. and Corporate Performance Corporate Performance and Financial Structure Many chaebols were vulnerable to unfavorable cyclical shocks such as the business downturn at the end of 1995 and the terms of trade shock in 1996. 2. According to the survey. Other factors include. Vol. These survey results indicate that many companies were not very attentive to exchange rate risks (and possibly to financial risks in general). Diversification. and reduction in tax burden.128 Corporate Governance and Finance in East Asia.36 percent on average for these companies.5 percent at the end of 1997. the majority (60 percent) of the firms responding to the ADB survey look first for nonaffiliated financial institutions. Nonetheless. the percentage of foreign currency denominated debt in the portfolio was 14. Only a few firms sought foreign loans because domestic loans were not available. some (36 percent) thought that a hedging facility was not available or not working properly. Few companies felt that hedging was too costly or was unnecessary as the exchange rate was considered fixed. even with a heavy debt burden.4. The most important reasons why they chose to borrow foreign currency denominated loans were that terms of foreign loans were more favorable and/or these loans were considered cheaper. This preference has changed little after the crisis. in order of importance. The percentage of foreign currency denominated loans hedged against exchange rate risks was 21.3 Financial Structure. firms give their first consideration to minimization of transaction and interest costs. maintenance of the existing ownership structure. For these firms.

3. Operating earnings are earnings before interest payments and taxes plus depreciation and amortization (EBITDA). They were also higher than those of the top five chaebols until 1991. However. except in 19931995 when semiconductor prices were extraordinarily high. the ratios of independent firms were higher than those of the top five and top 6-70 chaebols during the entire period. Table 2. But since 1992. (ii) In terms of net income to total assets. These findings indicate that independent firms have had a lower leverage and performed better financially. The ratios of the top 6-70 chaebols were lower than those of the top five chaebols. (1999) compared the financial positions of 504 chaebol affiliates and non-chaebol independent firms during the period 1986-1998. In order to determine the relationship between financing patterns and corporate performance. 1999). The extremely high leverage and the ability of chaebols to survive for several years with huge debts are evidence of poor internal governance of both the corporate and financial institutions.. except in 1991. but the ratios of independent firms were much lower.13). the ratios of nonchaebols were remarkably higher than those of the top 670 chaebols during the entire period.2. (iv) In terms of EBITDA to total assets. Nam et al. the top five chaebols and the top 6-70 chaebols had similar ratios. Interest coverage ratios of non-chaebols were higher than those of the top 6-70 chaebols during the entire period.Chapter 2: Korea 129 years before collapsing at the time of the 1997 financial crisis (2. (iii) Interest payment coverage ratios are calculated as operating earnings over interest expenses. The ratios of the top five chaebols were similar to those of the top 6-70 chaebols until 1991 when the top five chaebols’ ratios shot up. the trend was reversed in 1993 when the interest coverage ratios of the top five chaebols exceeded those of the independent firms. Among the main findings were the following. . as well as lax financial supervision (Nam et al. They were also higher than those of the top five chaebols until 1992. Those firms whose interest payment coverage ratios are below 1 are likely to go bankrupt. (i) In terms of total borrowings to total assets. the top five chaebols’ ratios were much higher.

130 Corporate Governance and Finance in East Asia.5 The Corporate Sector in the Financial Crisis This section looks at the various causes of the crisis in 1997. The differences in the degrees of diversification among the three groups are substantial. The diversification of the top five chaebols remained at about the same level within the period. and lowest in the top 3172 chaebols. The more diversified top five chaebols performed better than the less diversified top 6-30 because they were better established in most business areas and have superior personnel and technology. the top 6-30 and 31-72 chaebols gradually increased their diversification beginning 1990. 2. the degree of diversification was highest in the top five chaebols. Vol. except in the recession years of 1996-1997. debt guarantees for free. The diversification of chaebols under workout was much lower than that of the top 6-30. court receivership. the top five chaebols outperformed the top 6-30 chaebols for most of 1985-1997.31). But the net profit margins of the top 31-72 chaebols were higher than those of the top five in 1985-1992. too. Chaebols have been subsidizing new or low-profit industries by transferring resources from high-profit industries through inside dealings. however. its profit rate declined. and easier access to cheap credit. II Corporate Performance and Diversification As a chaebol further diversified into nonrelated areas. had a significant role. This indicates that excessive diversification and inefficient investment of the top 30 chaebols resulted in relatively low net profit margins (Table 2. and composition was lower than that of the top 6-30 but higher than that of the top 31-72 chaebols on average. Meanwhile. or outright transfer of resources due to poor corporate governance practices. rising nonperforming loans (NPLs) and falling . then declined to levels lower than those of the top five in the years of economic downturn 1993-1997. Indicators such as increasing debt-to-equity ratios. The degree of diversification of chaebols that fell into default. In terms of the net profit margin (the ratio of net profits to sales revenue). During 1985-1997. larger research and development expenditure. second highest in the top 6-30. net profit margins of the top 31-72 chaebols were always higher than those of the top 6-30. Their subsidiaries. had easier access to credit than the top 31-72 chaebols. Government intervention. Factors related to weak corporate governance were closely intertwined with shortcomings in macroeconomic policy and vulnerabilities in the financial sector.

0) (0.5 4.1 (0.6 0.1 1.9 1.2) (4.1 (4.7 2.3 1.6) (20.4 (0.6 0.Table 2.7 (4.1 (4.0 1992 1994 1.3) 0. Management Research Institute.8) (3.5) (7.3 1.1 (3.3) 0.1) 2.9) (1.4 (0.2 1.1 1.4) (0.8 0.6) 0.8) 0.4 2.9 0.1 0. Chung Ang University.8) 0.2) (4.2 (0.1) (1.3) (12. and Reconciliation Kia Jinro Hanbo Sammi Newcore Haitai Chungku Kukdong Daenong Halla Workout Target Kuhpyong Kangwon-sanup Pyuksan Sinho Tongil Kohap Sinwon Anam Donga 1985 1.2 1.2) 2.9) (8.0 1. Background and Task of Structural Adjustment.4 1.6) 0.6 1.6) (0.4 (2.7 (0.1) 2. Court Receivership.3) (0.5) (2.3 (0.1 2.5 (0.8) 1997 0.0 1.6 1.4 0.2 (0.9 0.6 0.1) — = not available.2 1.7 1.2) 1.8) (37.8) (11.8 0.9 (0.1 1.4) (6.3 1.9) 0.4) (1.2) 0.3 1.7 — (0.3 (0.5 0.1) (1.5 1.3) (0.4 1.2) 1.2 (0.6 5.1 0.4) (4.6 1.4 (1.8 1.0) (4.8) 0.0 0.8) (20.2 1.3) 0.8) 1.2) (0.7) 0.6 1989 1.0) (3.7 (1.3 1.7 1.0 6.0 (7.7 0.5 (0.7) (0.1 0.4 0.0) 0.7 0.3 (0.1 0.6 1.4 (1.1 1.5 (6.3 (3.2) (13.8 (0.2 1.6) (12.1) 1.8) 0.0 (2.0) 0.8 (0.5 1.8) 0.4 0.4 (0.8) (1.5) (2.7) (0.8 3.2 1.5 1.3 1.1 4.6) 0.6 7.3 0.1) 1.2) (0.2 (0.9 1. p.3) 1.0 0. .6 (10.3 3.3 0.8 1990 0.3 1.4 (1.4 1996 0.0 (0.5 2.0) (0.0 1987 1.7 (0.7 0.8) 2.1 0.3 0.3 (0.1 1.6 (0.4) (1.1 1. 1985-1997 Item Top 5 Hyundai Samsung LG Daewoo SK Top 6-30 Top 31-72 Default.1) (6.3 1. Beyond the Limit.8) (4.0 4.2 (1.1) 0.1 (1.1 0.6) 0.7) (1.2 0.2) 2.3) 1.8 (0.2) (13.9) 2.6 1.3) 0.1 0.9 0.1) 0.7 3.1) (2.3) 0.5) (1.5 1.6 3.3) 0.3 1.5 (0.3) 0.3 0.5) 0.6) (0.9 0.8) (1.6) (12.7 0.9) 2.9 1.6 (0.4 1.8 0.7 1.2) (4. 1998.8 3.2 4.5) (0.9 1.1 0.9 8.9) 2.3) (1.8 1.1 1.3 1.4) (1.6 0. Source: Whan Whang.7) 0.4 1.7 0.5 (0.7 1.31 Net Profit Margins of Chaebols.2) 1.3) 12.3 1.5 1.4 0.1 0.6 0.0) 0.8) (0.2 (17.11.4) (2.8 0.1 (9.1) (5.6 0.6 0.9) (9.5 (4.6 0.2 1995 3.7 0.2) (3.3 0.8 0.

The Code of Best Practice recommends board audit committees for large listed firms and the Commercial Code is being amended to introduce the audit committee system as an alternative to the internal auditor system. the boards of all listed companies were composed of insiders only. and creditors should select (recommend) the external auditor. after the crisis. a firm’s board of directors had the power to appoint an external auditor. . They were then almost automatically elected at the general shareholders meeting. and to the development of the market for corporate control. internal auditors cannot be expected to perform their function independently of management. Until 1997. Internal and External Control Concentration of ownership has been and will be the major obstacle to the independence of the board of directors from management. Thus. The most serious problem among most Korean listed firms has been that a controlling shareholder acting as CEO could never be replaced. a committee composed of internal auditors. this has led to entrenched management. Ownership concentration also had ramifications on corporate transparency.132 Corporate Governance and Finance in East Asia. Now.5. the Korea Stock Exchange introduced listing rules requiring that listed firms elect “independent outside directors” to comprise not less than a quarter of the board members. Vol. 2. But in 1998. the independence and objectivity of the external auditor were often questioned. outside directors. the controlling shareholder or CEO generally selects the internal auditor despite a legal provision limiting the votes of the largest shareholder to a maximum of 3 percent. Thus. Moreover. The hold was tightened by the practice wherein candidates for directors were handpicked from among the managers by the controlling shareholder. Meanwhile. the recently adopted Code of Best Practice in Corporate Governance recommends the strengthening of the board system.1 Weaknesses in Corporate Governance Concentration of Ownership and Entrenched Management Concentration of ownership has been the root cause of many problems related to corporate governance. Until 1997. II corporate profitability were signs that the Korean economy had reached the edge of a slippery slope. A remote trigger in the Thai crisis was all that took to push the economy over the edge. Along with government policies to protect the status quo.

as a whole. when a large diversified chaebol. prevalent window dressing practices. as well as institutions. Many of the takeover targets in the past did not have a controlling shareholder. Many changes were introduced to promote M&A in the 1990s.Chapter 2: Korea 133 There had been some devices to protect management so that companies could indulge in business activities without fear of takeover. These internal dealings made strong firms weak and helped marginal firms survive. There were no effective monitoring mechanisms for its management. In this situation. Another reason is that firms affiliated with a chaebol are generally regarded as difficult targets as the other members of the group will come to the rescue or act as a white knight. has an unsound capital structure and . Representative of the policy was the stipulation under the Securities and Exchange Act that no one other than founders could accumulate more than 10 percent of the voting shares of a listed company unless he or she obtained prior approval of the Securities and Exchange Commission. restrictions of voting rights of shares of institutional investors. Diversification can reduce chaebols’ risks through the portfolio effect. Meanwhile. a large issuance of preferred stocks with no voting rights. however. profitable firms within a chaebol tended to subsidize unprofitable firms. These included restrictions of shareholdings of institutional investors. and restrictions on hostile takeovers. However. hostile takeovers in Korea will likely be rare in the future. the Government maintained a policy of protecting the incumbent management of a listed company. Banks did not function as monitors of corporate management although they were shareholders as well as the most influential creditors. usually a member of the founding family. One reason is that the percentage of inside shareholdings for an average listed firm is very high. participated in the stock market as short-term traders rather than long-term investors. regulatory and practical difficulty in implementing proxy voting. corporate accounting information was not reliable due to the lack of independence of external auditors. individuals. Traditionally. The purpose was to increase the size of the stock market by having financially sound private firms go public with an assurance that they would not be taken over. and some differences in Korea’s generally accepted accounting principles from international standards. Under the direction of the controlling shareholder. Dominance of Chaebols A chaebol is tightly controlled by the largest shareholder.

Such problems may eventually cause ripples through the entire economy. the authorities did not properly check on banks’ lending practices—banks did not screen the lending projects and evaluate the creditworthiness of corporations properly.3 Manifestations of Weak Corporate Governance and Government Intervention Preference of Debt Over Equity Financing in the Precrisis Period Before the crisis. As mentioned earlier. The Government and the Bank of Korea did not have accurate information on the extent of transactions that corporations and financial institutions had abroad. Net profit margins of the top 31-72 chaebols were higher than those of the top five or of the top 6-30. while (non-chaebol) independent firms had much lower borrowing ratios. Further. 2. and internal funds. prevalence of rent-seeking and morally hazardous behavior by economic decision makers. share issues. Financing preferences changed drastically after the crisis. the typical chaebol firm had an extremely high DER. and a high degree of inefficiency in the economy. The new preference ordering is as . as the latter are well established in most business areas. Profitability of the top 6-70 chaebol firms has been lower than that of the top five chaebol firms. II strong financial links among its member firms through investments and cross-guarantees. Vol. financing choices of listed firms in order of preference were bank loans.2 The Role of Government Intervention Strong government intervention in the early stages of economic development was useful for overcoming inefficiencies in financial and capital markets and for managing high investment risks. The Government’s supervision and regulation of financial institutions were poor. bond issues. This indicates that too much diversification and overinvestment in the top 30 chaebols resulted in relatively low net profit margins. the intervention later resulted in the accumulation of adverse side effects: underdeveloped product. and other individual markets. However. although their subsidiaries had better quality workforce and easier access to cheap credit than the top 31-72 chaebol affiliates. capital. the financial distress of one or a few marginal firms can lead to a chain of bankruptcies across the entire chaebol.134 Corporate Governance and Finance in East Asia. This effectively becomes an exit barrier for chaebols and would justify the intervention and support of the Government.5.5. 2.

In November 1997. The ratio of external debts to GDP reached 48 percent at the end of 1998. . share issues.5 billion. total foreign debt amounted to $157. The foremost reason why listed companies preferred debt financing over issues of new shares lies in the largest shareholders’ desire to keep control of the management by preventing dilution of their ownership. As of the end of 1997. which is far higher than the average ratio of around 400 percent for nonfinancial listed firms. However. 63 percent of which was short-term. were advantageous to chaebols because they were in an “ideal” position to meet the loan requirement through cross-guarantees among their member firms. large-scale bailouts of financially distressed firms. won/dollar nondeliverable forward rates increased rapidly. and bond issues. The lending practices of banks. the size of the stock market was not adequate to digest all the potential supply of new shares to finance the rapid growth of corporations. obviously contributed to overlending and aggravated the situation. as evidenced by occasional. bank loans. Implicit guarantees by the Government on bank loans to large businesses. reducing foreign exchange reserves to a dangerous level. Bank loans. the exchange rate (won/dollar) increased sharply and the financial crisis erupted in Korea. the Government and the Bank of Korea defended the currency. The high proportion of foreign debt led to a mismatch problem where borrowers were unhedged against foreign exchange risk. Other factors also contributed to this preference. consisted of high proportions of policy loans. The preference for debt finance also led to a relatively large foreign debt. Although the ratio of stock market capitalization to GDP in Korea was not very different from those in the Philippines and Thailand. the top 30 chaebols showed a DER of 519 percent. which generally required guarantees or collateral. which were the most important financing source until 1987. overseas borrowing became difficult and higher interest rates were charged on foreign borrowing. After the financial crisis erupted in Indonesia and Thailand. signaling a bearish speculative move on the won. This change implies that firms are now more attentive to financial risk and inefficient investment financed by external funds is less likely to recur in the future. The financing choice of listed firms was also influenced by the underdevelopment of the stock market. At the end of 1996. In the international financial market.Chapter 2: Korea 135 follows: internal funds. The poor state of corporate governance in the banking and financial sectors was responsible for overlending by banks and NBFIs through perfunctory screening of loan applications. Nonpolicy loans were also considered to be cheap because of interest rate regulations.

According to the “six months” definition. and shareholders’ equity of all industries. the NPL ratio reached 7. excluding the financial sector. and there is collateral.6 percent in June 1998. The monthly number reached more than 3. and there is no collateral.136 Corporate Governance and Finance in East Asia. They utilized mutual payment guarantees among their affiliates and believed that they would never fail.000 in September 1998 (Table 2. In 1997 they became negative.000 during January-September of 1998. Further.000 per year starting 1992. reaching highs of 6 percent in 1997 and 8. the NPL ratio8 of banks and other financial institutions began to increase. Doubtful loans are those for which interest is not received for six months or longer. starting 1 July 1998. the NPL ratio of commercial banks increased rapidly from 4. regardless of whether it is caused by large personal holdings of the controlling shareholder or by pyramiding.1 percent in 1996. a large number of construction companies failed due to the recession in the real estate market and decline in real estate prices. It jumped to 17. Financial Sector Vulnerability Because of financial losses in the corporate sector. especially chaebols. and returned to about 1.32). they are defined as loans for which interest payments are overdue by three months or more. the ratios of net profits to sales. These were the definitions until 30 June 1998. has given rise to various types of self-dealings by the controlling shareholder. then 20. Overlending and inefficient investment were also a result of moral hazard due to implicit government guarantees and “too big to fail” legacies to large businesses. decelerated from March 1998.000 from December 1997 to February 1998. The number of insolvent companies increased rapidly in 1991 and doubled to more than 11. Meanwhile. Moreover. and estimated losses. were low in 1996 and 1997. without strictly evaluating the creditworthiness of businesses and the profitability of projects. Following the “three months” definition. The banks and merchant banks lent to large businesses. The inevitable result of inefficient investment was a fall in corporate profits.200 in 1997. However. legal and other barriers prevented the exit of financially nonviable firms. total assets. . nine out of the 30 top chaebols failed. The bank supervisory 8 NPLs of banks comprise fixed (substandard) and doubtful loans. The Government could hardly help them because of the number and magnitude of business failures.7 percent in 1997. Fixed loans are those for which interest is not received for six months or longer. Vol. II Inefficient Corporate Investment and Low Profitability Ownership concentration among Korean firms. Before the crisis. and the pursuit of growth through excessive diversification and inefficient investment.

5.859 3.855 6. Compared to ROAs and ROEs of domestic branches of foreign banks.69 20.751 1. 2.259 2.244 3.856 7. and Taipei.553 3. and continuous and large current account deficits. 1986-1998 Year 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 Total 4.850 3.517 2.637 6.4 Shortcomings in Macroeconomic Policy The macroeconomic framework also contributed to the crisis in 1997.417 Others 152 132 108 97 88 161 326 252 274 302 553 861 952 Note: 1998 figures cover only January-September.250 2. Meanwhile. and large government-directed loans. European countries.573 3.135 1.673 Construction 380 354 242 195 294 585 1.992 11. This was mainly due to the high ratios of NPLs.255 13.China.985 Services 3.053 5. those of domestic banks were lower in the 1990s.265 6. This speculation was said to be one of the causes of the financial crisis in Korea.114 811 706 696 866 1. authorities were not too concerned about the high NPL ratios at Korean banks in 1997 simply because the high and rising ratios had precedents.502 11.133 3.027 Manufacturing 1.759 6. Policymakers thought that economic growth would resolve the NPL problem without the need for corrective action.159 10.544 2. As a result they had largely overvalued currencies.33).457 2. The current account deficits in terms .754 3. the ratio reached 7-8 percent.647 8. Source: Bank of Korea. In 1990-1993.979 8.131 1. ROEs and ROAs of Korean and Japanese banks were low compared with those of the US.32 Number of Firms with Dishonored Checks.238 4. low efficiency.Chapter 2: Korea 137 Table 2.386 5. and declined to 4-6 percent in 1994-1996 (Table 2.472 2.657 3. Exchange rates were virtually pegged to the US dollar in all troubled Asian countries.107 6.589 171. The difference between the Korean and Western definitions of NPLs left foreign investors with suspicions that the size of NPLs in Korea might be much larger than the government-announced magnitude.890 4.210 1.769 9.

929 11.077 NPL Ratio (%) 8.639 1.170 1. of percentage of GDP were as follows: Malaysia -8. Meanwhile large businesses could not legally lay off workers.33 Nonperforming Loans of General Banks.739 241.954 9.8 5. even in times of economic slowdown. It was estimated that the Korean won was overvalued by 20 to 30 percent from 1989 to 1997. judging from the real effective exchange rate indexes using unit labor cost indexes as a deflator and 1985 as a base year.1 7.0 7.0 7. . b Doubtful loans are collateral-free loans for which interest is not received for six months or longer. Related to this. and 30 percent in 1996.266 10.874 22. 1990-1998 (W billion) Year 1990 1991 1992 1993 1994 1995 1996 1997 1998 a Total Loans 90.1 percent (1995). Thailand -8.537 10. In addition to the overvaluation of the won.237 Estimated Loss (C) 958 920 840 816 213 385 490 490 648 NPL (A+B+C) 7.China.910 1.562 18. the hourly wage rate in the Korean manufacturing sector was higher than in Singapore or Taipei.1 6. The pegged currency also encouraged foreign borrowing as investors believed that the exchange rate would remain stable.2 4.221 8.584 Fixed (A)a 5. the terms of trade deteriorated 12 percent in 1996 and 11 percent in 1997.832 337. which led to large corporate losses.652 29.160 11.484 11. Businesses served as a social safety net.138 Corporate Governance and Finance in East Asia. Mass layoffs became legally possible only after the economic crisis.6 percent (1995).6 percent (1995). because of the rigid labor market.705 160.556 118. Source: Bank of Korea.192 Doubtful (B)b 952 1.310 6.8 percent (1996).6 Fixed loans are those requiring collateral and for which interest is not received for six months or longer.649 375.997 9.475 143. In 1997.4 5.736 8.190 9.584 2.390 12.600 10.176 7.0 8. Vol. Real interest rates in Korea had been two to three times higher than those of Japan or Taipei.116 1.827 289. Land prices and real estate rents were also high compared to trading partners.China. The main result of the rigid labor market was a “high-cost and lowefficiency” economy.520 194. Korea -4. although per capita income in Korea was much lower. II Table 2. the ratio of short-term debt to foreign reserves was very high. and Indonesia -3.430 12.

Downsizing by curtailing employment has been prevalent. Other firms experiencing financial distress were subjected to workout procedures through negotiations between debtors and creditor institutions.Chapter 2: Korea 139 2. To achieve this. and subsidizing money-losing units. had been forced into bankruptcy proceedings or merged into healthier entities.6 2.6.1 Responses to the Crisis and Policy Recommendations Corporate Restructuring Activities Restructuring activities in the corporate and financial sectors of the Korean economy were aimed at enhancing their long-term viability and competitiveness. Corporations. A guideline informally promulgated by FSC required the 30 largest chaebols to lower their DER of 412. which were laden with huge amounts of debt and were on the verge of bankruptcy.6 percent as of the end of June 1998 to no more than 200 percent by the end of 1999. Measures have been taken by several chaebols to streamline operations and improve incentives of managers and employees. has been actively utilizing its influence to motivate institutions to coordinate debtor firms’ restructuring activities. . Ailing banks needed to be recapitalized after the huge amount of NPLs was disposed. The FSC—later called the Financial Supervisory Service (FSS)— which is in charge of prudential regulation of financial institutions. They have been pressured to stop such practices as providing loan guarantees. They have also been urged to divest themselves of strategically ill-fitting businesses and sell equity holdings of attractive business units to foreign firms to reduce debts. including banks. Nonviable firms and financial institutions. ‘Voluntary’ Restructuring Chaebols have been under pressure from the Government to abolish their informal group headquarters to increase the managerial independence of member firms. embarked on their own restructuring programs and/or implemented restructuring demands of the creditor banks. the immediate objective centered on restoring the international investment community’s confidence in the Korean economy. the excessive amount of debt of Korean corporations had to be reduced to a sustainable level. However. although efforts to lay off thousands of blue-collar employees at Hyundai Motors encountered fierce opposition from labor and ended up in mediation after intervention by politicians from the ruling coalition.

Locally. potential foreign buyers waited for the price of acquisition targets to come down further. The data also show that about 24 percent of acquisition negotiations ended up in actual deals.045 in October. More than 59 percent of potential buyers were foreign firms.140 Corporate Governance and Finance in East Asia. Banks did not have the incentive to force financially nonviable firms to liquidate. Noticing this disincentive. More important. A debtor whose liquidation value was estimated to be greater than its going concern value was subject to “exit”—meaning the creditors would altogether stop lending and not allow renewal of the existing debt. Korean firms have been slowly stepping up their restructuring since the latter half of 1998 as the economy began to show signs of recovery. In many cases. II Divestitures to raise cash for debt reduction and to focus on core businesses have not proved to be easy. while only 14 percent of the negotiations were completed from the beginning of the crisis up to April 1998. the creditor . Involuntary Exits The Government has been involved in the restructuring process mainly through its supervisory capacity over banks.281 in April to 2. Data collected by the Korean Chamber of Commerce and Industry show that the number of potential domestic and foreign buyers in the M&A market increased by about 50 percent over the six-month period from April to October 1998. banks and other creditors were reluctant to absorb losses realized by debt compositions. On the other hand. FSC directed banks to appraise the long-term viability of client firms showing symptoms of failure. Internationally. they were reluctant to allow recontracting for fear of further deterioration in the capital adequacy ratio. Vol. sellers could not find buyers as almost all domestic firms struggled to raise cash for debt reduction and for working capital needs while there was a severe credit crunch following the outbreak of the crisis. This number was at 779 firms in April and grew to 1. The process of voluntary debt recontracting by creditors was prolonged because Korean lending organizations lacked experience and expertise when it involved a multitude of creditors.138 by the end of October. because liquidation of debtor firms would exacerbate the banks’ already weak balance sheets. The reasons are manifold. or to agree on debt-equity swaps demanded by potential purchasers as a precondition for the deal. the number of potential sellers decreased somewhat from 2. It was frequently observed that the negotiating parties could not agree on a price due to large discrepancies in valuation. In their first review.

interest reductions. and 12 were sold off to other firms. These chaebols submitted plans for restructuring to improve their respective capital structures. More than 200 financial institutions signed the Corporate Restructuring Agreement to carry out corporate workouts with the top 6-64 chaebols. Based on these plans. Although the intention of the Government and the banks was to effect immediate liquidation of these selected firms. Also. 11 were merged into other group members. and/or conversion of debt into equity have been applied to those firms that are considered to be viable in the long run and have voluntarily entered into negotiations with creditor banks. The creditor banks and the advisory groups also drafted such plans for the top 6-64 chaebols. The plans were put into action immediately following finalization. write-offs. Upon completion of the evaluation. the results thus far have not entirely been as desired. provided by the World Bank. by their creditors. Corporate Workouts Workouts in the forms of debt rescheduling. workouts are being applied to non-chaebol firms identified as financially weak. Among the 55 firms selected. Among the sell-offs. three filed for courtsupervised bankruptcy reorganization. . FSC has been monitoring the processes from a prudential regulation standpoint. By the end of 1998. was allocated to the six largest banks for them to employ outside experts as advisors. the creditor banks drafted their own restructuring plans with assistance from outside advisory groups led by foreign investment banks. not only for the design of corporate workout programs but also their implementation. A second round of review to select more firms for exit was conducted by the Major Creditors’ Council organized for each of the top five chaebols. Negotiations were then held between the chaebols and the creditors’ councils to finalize the financial structure improvement plans. two were acquired by newly organized employee stock ownership plans. A portion of the Technical Assistance Loan of $33 million.Chapter 2: Korea 141 banks selected 55 firms as targets for exit. The workout plans were completed for most firms by early 1999. but viable. 24 were liquidated. creditor banks completed evaluation of the financial status of 35 subsidiaries belonging to 13 chaebols. These included 20 firms from the top five chaebols and 32 from the top 6-30 chaebols. and 16 non-chaebol corporations that had been selected as possible workout candidates.

automobiles. purchase of divested assets. Vol. labor union demands of the seller were not acceptable to the transacting parties. In another. Thus. most of the big deals have entered their final stages of negotiation. As of April 1999.142 Corporate Governance and Finance in East Asia. However. Big Deals Ever since the outbreak of the economic crisis. aircraft. power plant facilities.5 billion on agreement basis during the 10-month period after December 1997. chaebols did announce their agreements on big deals in seven industries excluding the automobile industry. Foreign investment—in the form of acquisition of controlling interests. II creditor banks and the corporations will devise detailed workout programs based on the rehabilitation plans submitted by the corporations. The less than satisfactory state of foreign capital infusion in the early days stems from a number of factors. Restrictions on foreign ownership of land were also abolished. oil refineries. and petrochemicals. inducement of foreign direct investments was considered to be the most effective means of achieving that end. it is hoped. In one case. the Government has been urging the largest chaebols to strike “big deals” or business swaps among themselves to consolidate overlapping manufacturing facilities. Big deals have been elevated to the status of the most important means of effective corporate restructuring. These deals could eliminate excess capacity in such industries as semiconductors. some of the acquisition agreements have been discarded for various reasons. On 3 September 1998. Korea adopted and implemented policies to open its capital market completely. enable chaebols to streamline their overly diversified operations and focus on several core business areas. In the early days after the outbreak of the crisis. and equity participation—reached about $8. vessel engines. This figure contrasts sharply with the total of $700 million for all of 1997. Big deals would. the foreign buyer demanded specific protections against adverse developments in the business environment. railroad cars. First. In the case of automobiles. uncertainty over the future . Foreign Acquisitions Confidence in the Korean economy depends critically on the lowering of the level of corporate debt. Hyundai Motor Corporation won the international auction of Kia Motors in its third bidding and Daewoo Motors agreed to acquire Samsung Motors.

these goals were: (i) to enhance managerial transparency. some of the potential acquirers demanded terms that were unreasonable or unacceptable from the sellers’ point of view. The presence of . Seventh. In effect. the Government and chaebols reached an agreement on the goals of restructuring and reform efforts. As set forth in the agreement. Overhaul of Bankruptcy Procedures In February 1998. legal procedures pertaining to corporate rehabilitation and bankruptcy filings were simplified to expedite rulings on the exit of nonviable firms and to ensure better representation of creditor banks in the resolution process for court receivership or court-supervised composition. Fourth.Chapter 2: Korea 143 course of the Korean economy remains high. (iv) to focus on a small number of core businesses.2 Policy Measures for Corporate Reform Goals and Policy Measures for Reform in the Corporate Sector Based on their assessments of what caused the economic crisis in Korea and what needs to be done to overcome it.6. many of the potential buyers believed that prices asked by sellers were still too high and there would be opportunities to buy assets on fire sales in the future. (ii) to remove cross-guarantees of loans among group members. Second. the improved procedures stipulated in the Bankruptcy Reorganization Act and the Composition Act reduced what had previously been legalistic exit barriers. local creditor banks were reluctant to absorb losses arising from debt compositions and debt-equity swaps that were necessary in deals involving insolvent sellers. (iii) to reduce financial leverage. Fifth. but it also has important implications with respect to corporate workouts. Third. Not only does this represent progress in terms of an improved institutional framework for market competition. and (v) to improve the accountability of controlling shareholders and the board. the widespread practice of cross-guarantees of loans and the lack of corporate transparency could potentially give rise to contingent liabilities to the buyer and this has posed a bottleneck problem to the speedy consummation of deals. many of the businesses that Korean firms put on sale did not prove to be attractive to foreign firms. 2. With this in mind. foreign buyers were concerned with the inflexibility of the labor market. Sixth. foreign buyers usually employed discounted cash flow methods of valuation while local sellers often put greater emphasis on replacement costs of assets.

(iii) the representation requirement for shareholder derivative suits was drastically relaxed from 1 percent to 0. the maximum grace period on loans to the firm being reorganized was shortened to 10 from 20 years. (v) all listed companies are required to appoint outside directors beginning 1998 9 This and the following two subsections draw on the Ministry of Finance and Economy. II an expeditious exit scheme is expected to better induce negotiation for workouts between creditor banks and corporations. the new rules made it clear that a court receivership order is available only when the going concern value of the firm under consideration is greater than its liquidation value. Also. (iv) restrictions on institutional investors’ voting rights were eliminated in June 1998. the changes in the institutional setting for corporate reorganization will enable creditors and debtors to promptly respond to the development of financial problems. The court can refuse to accept the application for composition if it finds it inappropriate considering the size of corporate assets. the court may annul its previous decision and force the firm into immediate liquidation. Third. First. Improving Transparency and Corporate Governance9 Transparency and accountability in corporate governance will be promoted by the following measures: (i) consolidated financial statements are required beginning 1999. .144 Corporate Governance and Finance in East Asia. Also. accounting. Vol. Fifth. and economics professions should be organized to provide for expeditious proceedings in court. October 1998. Second. etc. The changes in the reorganization procedures can be summarized as follows. In the past this stage usually extended for as long as two to three years. the right to revoke court receivership is allowed to the creditors. number of creditors. if a final reorganization plan is not worked out within one year from the date of the court order placing a firm in receivership. Fourth. Korea’s Economic Progress Report. thereby preventing abuses by controlling shareholders/managers of financially distressed firms. a “Management Committee. (ii) legal changes have been made so that domestic accounting practices conform to international standards.” comprised of experts in the legal.01 percent in May 1998. The creditors can form a “Creditors Committee” among themselves to allow them to participate in the decision processes in court. the Composition Act was amended to narrow the eligibility of applying for court-supervised composition. The purpose of this rule is to shorten the reorganization planning period.

These new standards are and will continue to be strictly enforced. administrative procedures for FDI will be dramatically simplified and made transparent. and (vi) all current laws related to FDI have been streamlined and incorporated into a single legal framework represented by the Foreign Investment Promotion Act. beginning on 1 April 1999. and (viii) as of 1 April 1998. financial institutions could no longer require cross-debt guarantees. Existing cross-debt guarantees should be completely eliminated by the end of March 2000. 21 industries were further liberalized or newly opened to FDI (now. As for promotion. Measures for improving standards in corporate governance are already effecting a generally more open corporate culture and greater transparency in business practices. A recent case in point is the penalty imposed by the Fair Trade Commission on chaebol subsidiaries found to be involved in unfair transactions among group members. have been instituted for FDI: . to FDI). (ii) full liberalization of foreign exchange transactions was legislated and will be put into effect in two stages. either partially or fully. crossdebt guarantees totaling about W10 trillion—about 30 percent of the total guarantees among the 30 largest chaebols—were dissolved. an additional nine industries will be opened or further liberalized. Capital Market Liberalization Since 1998. In addition. Foreign Investment Promotion Act The Foreign Investment Promotion Act was put into effect in November 1998. According to the law. Foreigners are now able to invest in local bonds and short-term money market instruments without any restrictions. Korea has rapidly liberalized the capital market by adopting the following measures: (i) the ceiling on foreign equity ownership was completely eliminated in May 1998. (iii) hostile mergers and acquisitions by foreigners were fully liberalized in May 1998. which was passed in August 1998. the Korea Trade and Investment Agency (KOTRA) will provide a one-stop service with respect to FDI.148 industries remain closed. (iv) during April and May 1998. (vii) by the end of March 1998. 514 listed companies had appointed 677 outside directors).Chapter 2: Korea 145 (as of the end of May 1998. including tax exemptions and reductions. including financial subsidization. only 31 out of 1. (vi) bankruptcy laws were revised in February 1998 to facilitate the exit of insolvent firms. (v) by the end of May 1999. various supporting measures.

such as the high-tech industry. the Korean Government is strengthening prudent regulations and market monitoring. for 10 years (full exemption for the first seven years and 50 percent tax reduction for the remaining three years). Free Investment Zone (FIZ): A free investment zone will be developed to accommodate large-scale FDI. Low cost rental facility: National and public real properties will be rented to foreign-invested firms for up to 50 years. The location of the FIZ will be determined at the request of foreign investors. however. Three-year government bonds will be used to establish a benchmark. The majority of government bonds to be issued in the next two to three years will carry a maturity of three years. To minimize potential risks. These liberalization measures. It aims to establish a benchmark by consolidating various government bonds. Capital Market Augmentation Bond Market The Government recently introduced a policy plan to deepen Korea’s bond market. The primary aims of the law are the liberalization of the capital account and the development of the foreign exchange market. The law allows rental cost exemptions and reductions for FDI. as well as building an early warning system. will be provided to foreign firms in the FIZ. Liberalization of Foreign Exchange Transactions In September 1998 the Foreign Exchange Management Act was replaced by the Foreign Exchange Transaction Act. Various local taxes will also be exempted or reduced for eight to 15 years at the discretion of local governments. Also. Various support measures. These bonds will be issued . Vol. are not risk-free. including infrastructure and tax support.146 Corporate Governance and Finance in East Asia. II (i) (ii) (iii) Tax exemption and reduction: Corporate and income taxes will be exempted or reduced for FDI in target industries. the Government intends to supplement these measures with a sound macroeconomic policy in order to secure more effective protection against systemic risks.

In order to promote a greater market demand for government bonds.6 trillion for the debt restructuring fund. If interest rates stabilize at a low level. and the demand for longerterm bonds increases in the future. a primary dealers system will be introduced for healthy financial institutions. The Government established specific qualification criteria and selected the primary dealers in 1999. These are expected to operate for the next three years. Moody’s signed a joint venture contract with Korea Investors Service. and W1 trillion divided equally between the three balanced funds. According to the law. No qualification requirements are being imposed on investors who are sponsoring new mutual funds. a debt restructuring fund and three balanced funds (funds that invest in both equity and debt) were established in September 1998. both domestic and foreign. the Government will correspondingly expand the issuance of government bonds that have a maturity of five years or more. It is now easy for private investors. including the Korea Development Bank. but it will also help improve financial institutions’ risk management. Mutual funds (or open-end investment companies) will be allowed starting 2001. It also opened the credit rating service market to foreign competition. Investment Companies Korea has developed an institutional framework for closed-end investment companies so that they function as a key instrument for long-term financing. Related legislation was put into effect in September 1998. To ensure transparency and efficiency of the fund operations.Chapter 2: Korea 147 monthly. and is promoting joint ventures between foreign and domestic agencies. to establish closed-end investment companies. but may be extended as required. they will be managed by foreign investment management companies. Prior to the introduction of this system. with only minor standard exceptions.6 trillion in these funds: W0. commercial banks were allowed to carry out dealing operations for government bonds starting in October 1998. As a pilot program. financial institutions . In August 1998. Twenty-five domestic financial institutions. Asset-Backed Securities A new law providing for asset-backed securities (ABS) was passed in September 1998. invested a total of W1. This law will not only provide an effective institutional environment for the disposal of NPLs.

It would be more desirable for the market-oriented measures to be put into place and strictly enforced. Policies aiming to improve the corporate governance system should take into account the high ownership concentration often created by pyramiding. considering that there is no other effective way to limit circular investments among chaebol affiliates (e. The corporate governance structure cannot be expected to function efficiently if this issue is not addressed. One way of strengthening independence of the boards is to require that listed companies accept nominations for directors by institutional . There must be stronger rules to control agency problems. Vol. greater efforts to improve corporate governance are preferable to regulation of interfirm investment. the role of the board of directors as the internal control mechanism must loom large in corporate governance.) and the level of interfirm investments is very high. Direct controls of interfirm investments and/or pyramidal ownership structures will not be persuasive.6. B investing in C. then the regulation will inhibit efficient investment of firms. and C investing in D. However. which is the case for many chaebols.. this regulation may not be effective in curtailing pyramidal structures. foreign business corporations with good credit standing are now also permitted to issue ABS. can utilize ABS. when the limit is binding. However. etc. A investing in B. For instance. More important.3 Policy Recommendations Poorly performing markets and the resulting lack of market discipline justified the government intervention in recent corporate and financial restructuring activities. as stipulated by the government measure. cross-subsidization. II and qualified public corporations. there is another view that placing a maximum limit on interfirm investments. such as the Korea Asset Management Corporation (KAMCO).g. this can only be a temporary measure. and other unfair internal transactions among affiliated companies should be stopped primarily by improving rules on corporate governance rather than by boosting the Government’s policing role. is inevitable. Selfdealings.148 Corporate Governance and Finance in East Asia. However. The Government has restored a previously abolished regulation that imposes a ceiling on the total amount that a chaebol company can invest in other firms. As markets become more efficient. A good governance system is essential for the healthy growth of corporations and financial institutions. the government intervention will have to be refocused so that it only sets the rules of the game in the marketplace. In principle. On the other hand. 2. unless the limit is tight and binding.

Each listed firm should be required to disclose the extent of its compliance with the Code in its annual report. 23-26. More effective measures to protect investors will enhance corporate transparency and also the accountability of directors to shareholders. the Korea Stock Exchange could incorporate provisions of the Code of Best Practice in Corporate Governance in its listing rules. thereby helping to strengthen board independence and enlisting boards’ more active involvement in monitoring corporate management. and requiring that all directors hold shares of their companies. The Securities and Exchange Act will then require large listed companies to switch to a board audit committee system from an internal auditor system.10 Other means to improve independence of the boards include mandating that independent outside directors form the majority. 1997. using audit. Companies could also invite nominations from such organizations as the Korea Listed Companies Association or citizens’ coalitions that have been active in monitoring corporate management through proxy solicitations. and other committees. If and when the law is introduced. Since the economic crisis. Class action suits are an efficient means for corporate monitoring. pp. Proposed: A Governance Monitor. governance. There has recently been a general shift in individual investor preference from direct personal stock trading to investing in traditional investment trust companies and the newly introduced (closed-end) investment funds. The annual shareholders meetings could also elect reputable “monitoring companies” to recommend director candidates (Latham. Latham. The Corporate Board. The Government can prompt institutional investors to contribute more to good corporate governance by paying greater attention to corporate affairs. Institutional investors will play an increasingly important role in corporate governance.Chapter 2: Korea 149 investors or their trade associations. it will have to include making self-dealings by directors and officers. One action that has yet to be taken is the introduction of an act to facilitate class action suits against corporate directors and internal and external auditors for their wrongdoings. various measures have been implemented to promote investors’ rights. The Government has already announced that it intends to amend the Commercial Code to introduce Anglo-American type audit committees as an alternative to the current internal auditor system. One way of motivating institutions to do this is to 10 M. and also negligence of external (independent) auditors actionable. Listing rules may recommend that all or large listed companies adopt an audit committee. Further. . September/ October 1997. 1997).

Measures that are being implemented or introduced will require that the management of institutional investors be closely monitored by a board consisting of a majority of independent outside directors. strengthen its supervisory activities. and thus cannot be expected to be actively involved in monitoring portfolio firms. Shareholdings concentrated in investment companies and other institutional investors pose a serious dilemma. more drastic in nature. etc. Many of the larger investment trust companies. could prepare such guidelines. securities companies. The Government recently proposed the revision of bankruptcy-related laws. These guidelines would recommend shareholder activism and faithful discharge of fiduciary duties by actively participating in shareholder voting. Another measure. II provide comprehensive guidelines for their actions in matters related to corporate governance. The institutions’ respective trade associations. strengthening incentive compensation schemes for executives. the Government will have to come up with appropriate policy measures to solve these problems. such as the Korea Investment Trust Association. The Government can also lower the limits on investments in affiliated companies. an audit committee. Also. Another concerns whether the court-appointed receiver should be given the power to convene board and shareholder meetings and also to replace directors and officers with court approval. objecting to certain defensive measures proposed by the management. insurance companies. and other NBFIs are subsidiaries of chaebols— especially the five largest ones. One issue that is being debated is the necessity of the court ordering a firm into bankruptcy once it is found to be nonviable during deliberation on composition or receivership. Application of more stringent bankruptcy-related rules to firms in financial distress will effect greater discipline over corporate management. An efficient means to control problems arising from ownership of financial institutions by industrial capital is to strengthen the accountability and fiduciary duty of the very management of these institutions. and compliance officers. possibly. In the coming years. important pension funds including public employee funds and teacher funds seem to have their own governance problems because their top management and portfolio management policies are controlled by the Government. and impose stronger penalties on violations of the rules on portfolio investments. is to restrict ownership of investment trust companies and NBFIs by the five largest chaebols and.150 Corporate Governance and Finance in East Asia. by all nonfinancial companies (or “industrial capital”). Vol. . Rights of minority shareholders should also be strengthened for these institutions. reviewing independence and expertise of candidates for outside directors.

An effective policy package is needed for chaebols to dispose of marginal firms with low profitability at the earliest date. and thus full-scale education programs should be developed. Banks should adopt strong incentive compensation schemes for management. Such measures include providing an effective corporate governance system. The Government should substantially reduce the proportion of policy loans from bank loans. In turn. such as application of higher interest rates by banks to chaebols with higher DERs. and (iii) a good corporate governance system to protect investors. the limit on ownership of bank shares will have to be eased so that strategic investors (shareholders) can act as true effective monitors of bank management. large firms. the banks have great leverage over the management of debtor firms. through them. Chaebols are overly indebted. Banks need to play a bigger role than they do at present in monitoring corporate investment and management. The current obligatory system of disclosure that emphasizes “hard” . excessively diversified into nonrelated business areas. and introducing disincentive schemes for excessive borrowings. lessening the degree of double taxation of dividends (or further reducing personal income taxes on dividends).Chapter 2: Korea 151 There still exist widespread concerns that the Government will continue to exercise a great deal of discretionary power over banks. This means that the Government can control the banks and. the important issues to be addressed are: (i) improvement of the corporate disclosure system. Bank boards also need to be made more independent from management. which could provide alternative sources of long-term corporate finance. therefore are vulnerable to economic shocks. private firms. The Government needs to sell off at the earliest feasible dates the bank shares that it acquired in the course of recapitalizing banks. Many corporations are burdened with excessive debt and. In order to minimize government intervention in bank and corporate management. The Government should put more efforts into developing the capital market. the elimination of implicit guarantees for financial support to chaebols. to concentrate instead on a small number of core businesses. and financial institutions. Many concepts regarding good corporate governance are still new to a lot of market players in Korea. The public and corporations should be taught or fully informed of the best practices in corporate governance. and consistently show low profit rates. and stop unfair internal transactions. bank managers should be made accountable to shareholders but not to the Government. reduction of protection of domestic markets and entry barriers. (ii) provision of reliable accounting information. For this. To facilitate the development of the Korean stock market.

and measures to reduce corruption. One of the significant changes in the bond market after the economic crisis is that most corporate bonds are now issued nonguaranteed and on the basis of credit quality of the issuer. . The network should cover not only the exchange market but also OTC transactions of investors and dealers.152 Corporate Governance and Finance in East Asia. In determining optimal exchange rates. and bureaucrats. on a real time basis. Currently. Overvaluation of exchange rates should be avoided in order for export and import-substitution industries to stay internationally competitive. the information system of the bond market should be better organized to transmit. Policies are needed to help develop more reliable services by bond rating agencies. More effective punitive means need to be devised to penalize both corporations in violation of disclosure rules and the officers in charge. politicians. Future research could include causes of corruption. The establishment of a Corruption Prevention Institute will be helpful in this regard. Without successfully addressing this problem. wage rates. The development of the OTC bond market requires a well-developed dealer system. Maintaining current account surpluses for a considerable period is needed to pay back foreign debts. The function of securities companies as dealers of bonds should be improved. data on quotations and trading volumes. and labor productivity should be considered. Prevalent corruption. no economic reforms will be effective. is considered to be one of the major causes of the economic crisis. especially among business people. Vol. penalties on violations of disclosure rules are not effective enough to have a significant impact. reasons for different degrees of corruption in various countries. At the same time. These should be lengthened to make them a source of stable long-term funds. Another problem with the corporate bond market is that most bonds are issued with maturities of less than four years. II information on past performance needs to be transformed into a system in which corporations voluntarily announce “soft” information on future prospects. profitability of export industries and real effective exchange rates that account for changes in nominal exchange rates.

Proposed: A Governance Monitor. 1996. September 1998. Ju Hyun. Determinants of Diversification of Korean Business Groups. Chon. Corporate Restructuring. pp. H. 1996. various issues. 1993. 1994. The Corporate Board. D. in Korean Managerial Dynamics. C. 1997. 23-26. and H.Chapter 2: Korea 153 References Bank of Korea. Tomio. . Lee. and 1998 issues. Financial Studies. 1995. Hong. Economic Statistics Yearbook. C. Maeil Daily Economic Newspapers. 1989. Chon. KERI. International Financial Statistics. Hong Moon Sa. An Empirical Evidence on Value of a Firm and Ownership Structure. Kim. A Study on the Relationship between Ownership Structure of a Firm and Value of a Firm. New York: Praeger. pp. W. Kim. 1992. W. Market Concentration and Diversification of Business Groups. September/October 1997. Y. Cho. Financial Studies. I. 1996. H. M. Kwon.. H. H.. various issues. 1998. September 1997. W.). S. Choi. Korea Economic Research Institute. and J. Lee. Is the Fair Trade Policy Fair? Korea Economic Research Institute. Cho. D. Korean Managerial Dynamics. K. 1999. H.. International Monetary Fund. S. 1997. 1995. Hattori. Bibong Publishing Co. Korea’s Chaebol. pp. various issues. Bank of Korea. Chung and H. 1997. Korea Development Bank. Center for Free Enterprise. Evolutionary Chaebol. KERI. Kang. C. Lee (eds. 79-95. N. Jae Woo. Jua. 1998. 7995. Lee. K. S. 1997. various issues. Korea’s Financial System. Latham. and K. Bank of Korea. 1989. S. Survey of Facility Investment Plan. W. Financial Statement Analysis Yearbook. Bank of Korea. Japanese Zaibatsu and Korean Chaebols. September 1998. S. Kim. edited by K. Korea Economic Research Institute. New York: Praeger. Understanding Flow of Fund Accounts. Korea’s Large Conglomerates. S. T. Chung. KERI. I.

Korea Institute for Industrial Economics and Trade. U. Yang. Lee. 1998. 1999. 1995. Sohn. J. September 1998. and J. and H. Chicago. I. J. 1996. Kim. Background and Task of Structural Adjustment. J. January 1995. Capital Liberalization. Whan. H. H. March 1999. 1996. Yonsei University. Y. K. Korea Finance Institute. Korea’s Economic Progress Report. KIEP Working Paper 98-05. November 1996. Lee. October 1998. Nam. 1999. A New Trade and Industrial Policy in the Globalization of Korea. KIET Occasional Paper No. Joh. October 1998. Annual Conference of Financial Management Association. S. Beyond the Limit. W. and J. Conference on Corporate Governance in Asia: A Comparative Perspective. Business Groups in Korea: Characteristics and Government Policy. . Ministry of Finance and Economy. 2nd Sangnam Forum. II Lee. Korea’s Trade and Industrial Policies: 1948-1998. 1998. The Pattern of Ownership Structure and their Characteristics in Korean Conglomerates: With Cases of the 30 Largest Chaebols. The Ownership Structure and Family Control in Korean Conglomerates: With Cases of the 30 Largest Chaebols. K.. Whang. Kim. 23. 1998. Y. Korea Institute for International Economic Policy. K. Corporate Governance in Korea. S. Vol. Ungki. Real Exchange Rate and Policy Measures. Yim. Management Research Institute. Wang. C. Lim. Korea Development Institute and World Bank. Seoul. I. S.. 1998. S.. C. Chung Ang University. Lim. Ungki.154 Corporate Governance and Finance in East Asia. Korea Institute for International Economics and Trade. Kang. Y.

after the completion of debt negotiations with the IMF and Paris Club. This has come about following a political and economic upheaval from 1983 to 1987. the Philippines. staff. and David Webb of the London School of Economics for their guidance and supervision in conducting the study. overall. Issues such as State ownership of businesses. .. Saldaña1 3. When the Asian crisis erupted in 1997. in particular Francisco C. From 1993 to 1996. PSR Consulting. healthy profits from the previous five years and new equity raised through successful initial public offerings (IPOs) in a robust stock market allowed the corporate sector to accelerate investments and borrowings. Companies of other Asian countries were already using these markets to finance investment and growth.1 Introduction In recent years. Serrana. and Liza V. The lifting of the debt moratorium in 1991. both of ADB. the Philippine nonfinancial corporate sector had managed its borrowing risks relatively well by largely avoiding imprudent use of debts and risky investments. the Philippine economy and corporate sector were in a relatively sound financial position. David Edwards. the Philippine Stock Exchange for its help and support in conducting company surveys. The Government pursued the privatization of various state-owned corporations as part of its financial rehabilitation programs sponsored by the World Bank and the International Monetary Fund (IMF). Roble. and government subsidies were tackled during that period. Inc. Inc. and Lea Sumulong and Graham Dwyer for their editorial assistance. aiming at eventually limiting the Government’s role to economic policy setting and allowing the private sector to conduct most economic activity. state-sanctioned monopolies. for their research assistance. the Philippine corporate sector has played a leading role in the government’s efforts to get the country on track toward sustainable economic development. The author wishes to thank Juzhong Zhuang. about a decade before the recent Asian crisis. Denise B.3 The Philippines Cesar G. allowed the Government and the corporate sector to gradually access foreign debt markets after a long absence. Pineda. The Asian financial crisis revealed that. the PSR Consulting. 1 Principal.

and on the financial crisis. Vol. Companies were profitable because of protection from foreign competition. Investments of large corporate groups tend to focus on obtaining market shares and industry dominance. patterns of ownership.156 Corporate Governance and Finance in East Asia. usually with the acquiescence of bank creditors. regulatory framework. II Still. yet they did not risk new capital required for modernizing and expanding manufacturing capacity. Corporate financing relies excessively on bank loans. These early industrialists naturally opposed any initiative to reduce tariffs. control by internal and external governance agents. Government interventions under the notion of “master planning” for economic and social development characterized the 1970s and early 1980s. An industrial elite. composed mostly of families previously in trading businesses.2. It analyzes the impact of corporate governance on company financial performance and financing.1 Overview of the Corporate Sector Historical Development During the 1950s and 1960s. the Government overvalued the local currency and imposed high import tariffs. their growth could not be sustained. on family-based and controlled conglomerates.2 3. Banks have significant presence as members of affiliated business groups. The highly concentrated and family-based ownership of corporate groups has resulted in governance structures that depend largely on internal control systems. the corporate sector showed structural weaknesses similar to those in neighboring Asian countries. patterns of financing. 3. emerged to influence industrial policies. therefore. which leads to their easing of due diligence and monitoring standards when lending to group members. While new manufacturing industries were successfully established. The Board of Investments (BOI) was created to draw up an investment priorities . Companies finance long-term investments with short-term debt. and responses to the financial crisis. Sugar refining and textile mills are examples of industries that floundered in the 1980s because of government import substitution policies. nationalist sentiments led to policies that favored import substitution and heavy government intervention in business. To implement these policies. This study reviews the Philippine corporate sector in terms of its historical development. The policy was crafted by the martial law regime at that time. But protectionist policies made labor relatively more expensive and. companies were necessarily large and capital-intensive.

and initiated the development of alternative energy sources in response to the oil crises. made less associated with capital investments. the Government continuously revised the enabling law of BOI so that incentives were reduced in number. In 1991. Foreign ownership was allowed only in industries with high technological and market barriers.. In many industries. the “pioneer” industries identified in the IPP. the top three companies accounted for a disproportionately large share of total sales and assets. clearly shifted economic management toward reliance on markets rather than on decisions by bureaucrats in the Government. The 1980s were marked by a peaceful transition of political power.” No strategic industry could take off without the Government’s participation in its management and operations. It limited the bureaucratic cost and discretion that accompanied the necessary approvals of foreign investments. BOI incentives retained a strong bias in favor of capital-intensive enterprises and domestic-oriented industries. Following government initiatives in the control of the infrastructure and utilities sectors. the State took over the generation and distribution of electricity. Nevertheless. The Government signaled through the IPP its intent to shape the future industrial landscape. advance notice of areas where the country disallowed or restricted foreign investment. Probably the most significant effects of tariff protection and biases for capital intensity were the corporate sector’s high degree of concentration.Chapter 3: Philippines 157 plan (IPP) to encourage private sector investments by offering tax and other incentives. Quantitative restrictions and tariff protection of preferred industries remained firmly in place. Starting in 1981. In the early 1990s. Exports were not competitive because of the high costs of imported materials. assumed ownership of the largest petroleum refining company. including the reduction of tariffs. The high industrial concentration led to practices of price leadership and output restrictions and the rise of industry lobby groups—common features of an oligopolistic . quantitative restrictions.e. Reforms in policies. and orientation toward domestic markets. The FIA allowed foreign equity investment in many areas and at the same time provided a transparent. i. the Government narrowed the range of tariff rates by commodity categories and reduced the average tariff rate from 28 to 20 percent. organizing industries into sectors and picking “winners. and import licensing requirements. the legislative body passed the Foreign Investment Act (FIA). Better access to cheaper imported raw materials improved the competitiveness of local manufacturers. dominance by large companies. and oriented toward exports.

158 Corporate Governance and Finance in East Asia.2) 0.0 (6.0 7.5 percent per year (Table 3.8 5.7 5. of 9.8 5.9 6.9 (1. . which was taken as a representation of the Philippine corporate sector.2 9.000 Philippine companies grew 17.7 8.1 4.2 Korea. Its growth rate began to catch up with others in 1996. Key Indicators of Developing Asian and Pacific Countries 2000.7) 10.8 4.2 8.3 7.2 7.2).4 4.9 5. only nonfinancial companies were used.2 (0.5 9.8 8. competition from liberalized imports had somewhat reduced oligopolistic tendencies and concentration in many industries.1 5. II market.3 9. With economic reforms introduced in the 1980s and 1990s.8 percent growth in fixed 2 The SEC-BusinessWorld Annual Survey of the Top 1.000 Corporations covers financial and nonfinancial companies.3 2.2 During 1988-1997.8 10. The Philippines substantially lagged behind other countries from 1990 to 1995 (Table 3. In this section.2 Growth and Financial Performance Performance of All Companies The analysis of corporate performance in this section used financial data from the Securities and Exchange Commission (SEC)-BusinessWorld Annual Survey of Top 1.2) 4. net sales of the top 1.5 8.5) 5. only to be unsettled by the crisis of 1997. 1990-1999 (percent) Year 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 Indonesia 9.0 (0.1 5. Rep.5 (7.0 8.000 corporations. A comparison of the Philippines’ economic performance in terms of real gross domestic product (GDP) growth with selected countries in Southeast Asia places the succeeding review of the corporate sector’s performance in context. however.5 8.2 Source: ADB.7 Malaysia 9.6) 0. This rate of growth was sustained by a comparable 18. Table 3.0 8.6 7. 3.5) 3.7 (13.2 Thailand 11.1).1 GDP Growth of Southeast Asian Countries.2 7. Vol.3 9.3 8.9 7.4 Philippines 3.1 8.7) (10.2.8 8.

5 887 0.3 121 12.781.6 900 1.2 2.9 149 6.1 54 11.1 714.6 1.4 411.6 149 12.9 2.978. turnover = net sales/total assets.1 1.1 881.209.0 148.160.5 51 4.6 896 0.4 1.8 22.332.2 27.1 51.3 60 10.9 896 2.3 862.4 898 1.1 95. Source: SEC-BusinessWorld Annual Survey of Top 1.4 188.8 411.9 96.225.8 26.8 902 1.191.341.8 5.2 4.5 64.4 776. return on equity (ROE) = net income/ stockholders’ equity. 1988-1997 1989 519.1 66 12.7 73 6.6 144.2 338.697.000 Corporations in the Philippines.5 192.4 861.5 14.1 6.1 197 14.512.317.5 446.6 35. net profit margin = net income/net sales.4 Financial Ratios (%) Leverage ROE ROA Turnover Net Profit Margin 222 14. of Companies Sales per Company (P billion) 899 0.1 181 11.647.9 78 6.9 1.2 Average 146 12.8 741.1 468.5 193.394.5 1.1 72.4 260.5 1.8 77 7.1 73 5.6 290.7 903 0.0 1.2 Indicators 1988 Growth Indicators (P billion) Net Sales Net Income Fixed Assets Total Assets Total Liabilities Stockholders’ Equity Retained Earnings 464.7 238.7 218.Table 3.6 102 16.5 72 7.8 4.1 615.2 Compound Growth (%) 17.1 1.2 Growth and Financial Performance of the Top 1.7 1.6 109 12.9 952.3 306. .5 570.7 443.000 Companies.4 555.0 1.4 63.5 4.6 954.8 6.9 629.3 68 7.9 480.6 18.9 617.3 898 1.6 5.2 1.3 382.7 20.4 602.131.7 28.3 941.3 107 13.1 4.6 75 6.0 900 1. return on assets (ROA) = net income/total assets.123.6 1990 1991 1992 1993 1994 1995 1996 1997 1.2 2.4 8.1 Other Indicators No.2 378.8 618.9 3.5 1.1 5.6 426.2 707.177.4 3.3 46.9 898 1.5 119 12.2 136.2 900.1 33.7 1.893.5 Leverage = total liabilities/stockholders’ equity.561.5 508.

160 Corporate Governance and Finance in East Asia. Vol.8 17. but the extent of the increase was not as dramatic as in other Asian countries.5 Value-added is assumed to be 30 percent of net sales. The debt-toequity ratio ranged from 222 percent in 1988 to 102 percent in 1994.394 1.000 Companies Year 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average Growth (%) a GDP (P billion) 799 925 1.3 percent.5 Ratio of Estimated Value Addeda to GDP (%) 17.3 The Corporate Sector and Gross Domestic Product.6 percent and 5. Assuming Table 3. for the 10-year period. 1988-1997 Top 1.8 19.1 Net Sales (P billion) 465 519 630 741 862 954 1. indicating that the corporate sector’s exposure to foreign currency-denominated loans was not as significant as in other countries. various years.5 16. The growth rates of corporate sales for the period 1988-1997 exceeded those of the country’s GDP for the same period (Table 3. This is high compared with developed countries but compares favorably with other Asian countries. Total assets grew at an average annual rate of 22. and the SEC-BusinessWorld Annual Survey of Top 1. Further. The data suggest no evidence of excessive borrowing in the run-up to the crisis in 1997.979 17. Sources: ADB.697 1.172 2.352 1. Return on equity (ROE) and return on assets (ROA) averaged 12. Key Indicators of Developing Asian and Pacific Countries 1999.906 2. . These rates of return are high compared with other Asian countries.178 1.3). II assets.4 24.9 percent for the period.8 percent per year. Asset growth was funded by debt that grew at an average of 20.474 1. leverage increased from 109 percent in 1996 to 149 percent in 1997. Net profit margins for the top 1.077 1.7 percent.5 17.693 1. and by equity that grew at a higher average annual rate of 26. Net income consistently increased from 1988 to 1996 and declined only in the crisis year 1997.000 Corporations in the Philippines.1 19.4 20.9 23. respectively.000 companies averaged 7.9 21.427 13.2 percent.248 1.

.8 2.9 17.5 Other Indicators Share of Sales (%) 17.1 22 10.1 12.3 22.1 ROA 8.4 Stockholders’ Equity 32.4 Growth and Financial Performance of the Corporate Sector by Ownership Type.4 Total Liabilities 26. Performance by Ownership Type The Philippine corporate sector can be categorized into four groups based on ownership: (i) publicly listed.5 Source: SEC-BusinessWorld Annual Survey of the Top 1.0 28.4).8 percent of the corporate sector’s total sales between 1988 and 1997.8 22. various years. privately owned companies constituted the largest group (Table 3.9 26.3 27.6 Total Assets 29.0 5. %) 17.3 22.5 27.8 3. and industry reveals further structural characteristics of the growth and financial performance of the corporate sector. size.7 2.3 42.5 Retained Earnings 30.5 GovernmentOwned 4.8 ForeignOwned 21.2 9.8 No. Averaging 42.7 22.3 11.Chapter 3: Philippines 161 a constant ratio of value added to sales.8 606 0.4 190 5. A study of company performance by ownership type. (ii) foreign-owned.3 9. these figures suggest a significant and increasing contribution of the corporate sector to GDP. The foreign-owned companies were the Table 3.0 142 22. and (iv) privately owned.3 146 6.8 Growth Indicators (Compound Annual Growth Net Sales 20. 1988-1997 Indicators Publicly Listed Privately Owned Rate. of Companies 73 Sales per Company (P billion) 2.0 Turnover 53 Net Profit Margin 15.0 5.9 22.0 Net Income 19. corporate control structure.9 158 13. (iii) Government-owned. The premise is that these variables have a direct bearing on corporate performance and growth.4 Fixed Assets 19.4 28.0 4.5 23 4.2 103 5.8 14.0 31.9 196 1.000 Corporations in the Philippines.1 Financial Ratios (%) Leverage 89 ROE 15.

75 billion per company for foreign-owned companies.000 companies in 1997. foreign-owned companies borrowed more than publicly listed ones. the asset base is large. With an average leverage ratio of 142 percent. they generated the highest return on investments. Publicly listed companies had the lowest leverage at 89 percent. registered the largest per company sales at about P9 billion in 1997. selling an average of P4. Bases Conversion Development Authority. followed by publicly listed ones.8 percent for foreign-owned companies and 20 percent for publicly listed companies during 1988-1997. However. . although small in number. the second best ROE and ROA. were among the top 1.000 list. It should also be added that the profit margin of Government-owned companies is distorted by the presence of holding companies such as the Philippine National Oil Company. with an average ROE of 22. Governmentowned companies in the top 1. The privately-owned companies were only about one third of the average size of per company sales of the publicly listed companies. the highest net profit margin of 15. but lower than those of foreignowned and publicly listed companies. these companies were comparatively large. compared with P2. II second largest at about 27. and the second lowest asset turnover. But by being most efficient in employing assets. exceeding the 17. These were mostly large public utilities. a level high by Western standards but at par with those of other Asian countries.2 percent and ROA of 9.1 billion per company in 1997.5 percent average growth rate of the entire corporate sector.3 percent. or 38 percent.9 percent. The compound annual sales growth rate was 21. and low return on investment is the norm. Publicly listed companies had a minor though steadily increasing share in total sales.5 percent. Their ROA and ROE were both more than twice as high as those of government-owned companies. The privately-owned companies had a high average leverage ratio of 158 percent. and government-subsidized agencies such as the National Food Authority and Local Water Utilities Administration. while there were few of them. Privately-owned and Government-owned companies grew at slower rates. reflecting the significant presence of holding companies as the gross revenues of holding companies flow through to operating income. Vol.162 Corporate Governance and Finance in East Asia. The government-owned companies had the highest leverage at 190 percent but lowest ROA and ROE because these are primarily public utilities and companies in the energy sector where turnover is low. Only 84 of the 221 public companies listed on the Philippine Stock Exchange (PSE). meaning that the remaining 62 percent were relatively small in sales and assets.

1988-1997 Indicators Group Member Independent 18. The independent companies contributed about 56 percent of corporate sales on average during the period 1988-1997.Chapter 3: Philippines 163 Performance by Control Structure By control structure.3 percent for the conglomerates. compared with 32.8 Growth Indicators (Compound Annual Growth Rate.0 166 15. a company can be a member of a conglomerate or independent.5).8 6.3 Total Liabilities 30. had a lower leverage ratio. Performance by Firm Size By firm size. grew faster. Table 3.8 ROA 8. medium. the corporate sector is divided into large.2 Net Income 21.2 23.3 Other Indicators Share in Sales (%) 32. and small companies.0 55.4 24. But the conglomerates were larger measured in sales per company. of Company 159 Sales per Company (P billion) 2. various years.7 2.1 124 5.3 Financial Ratios (%) Leverage 98 ROE 15.0 25.000 Corporations in the Philippines.7 Total Assets 32.2 Fixed Assets 25.1 Retained Earnings 32.6 26.0 Turnover 67 Net Profit Margin 12.5 Growth and Financial Performance of the Corporate Sector by Control Structure. Sales and resources of the . depending on assets and sales. %) Net Sales 20. and achieved higher returns on invested assets than independent companies (Table 3.1 Source: SEC-BusinessWorld Annual Survey of Top 1.7 Stockholders’ Equity 34.6 715 0.3 No.0 22.

5 Growth Indicators (Compound Annual Growth Rate.6 Growth and Financial Performance of the Corporate Sector by Firm Size. indicating that they deployed resources more efficiently than large and small companies.0 32.5 128 10. averaging 16 percent.9 Financial Ratios (%) Leverage 158 ROE 13.6). averaged only P920 million in per company sales during the same year. referring to the remaining companies in the list.7 44.1 ROA 5.6 47.164 Corporate Governance and Finance in East Asia.0 7.3 Turnover 65 Net Profit Margin 8. Vol.0 730 0. for this study. Medium-sized companies also performed better in terms of ROE.5 25. II Philippine corporate sector are highly concentrated among the large companies. Table 3.9 26.000 list.5 Total Assets 18. which. various years. are defined as the largest 100 companies in the top 1.5 73 6.2 25.2 Other Indicators Share in Sales (%) 56.6 Small 19.6 49.2 Stockholders’ Equity 18.1 percent of the total sales of the corporate sector.000 list. . %) Net Sales 15.3 Source: SEC-BusinessWorld Annual Survey of Top 1.1 No.5 12. Sales per company in this group averaged P13.2 29.4 28. although they comprised only 8. However.7 Net Income 1.6 36.1 4.8 percent of the total number of companies in the list (Table 3.000 Corporations in the Philippines.0 156 16. 1988-1997 Indicators Large Medium 19.4 billion in 1997.1 81 9.9 89 1. sales of mediumsized companies grew faster than large companies. Large companies accounted for 56.4 Total Liabilities 18. while small companies. Medium-sized companies. averaged a far less P3 billion in per company sales.9 Retained Earnings 13. defined in this study as the next 200 largest companies in the top 1.3 Fixed Assets 15. of Companies 79 Sales per Company (P billion) 7.1 25.9 32.6 31.

and utilities and services sectors. real estate. net income. with their ROE dropping to 3. utilities. But small companies’ leverage was significantly lower. and construction. but suffered its largest decline in net profits in 1997. Sales revenue and net income declined from P76. at -12. at 156 percent. The sector showed consistent growth in sales. and the construction sectors than for the manufacturing. although the largest in number.7 percent a year earlier.7. are shown in Table 3. Growth of sales. Manufacturing companies represented more than half of the corporate sector in number in the period 1988-1997 and accounted for about 82 percent of total sales.8 percent in 1997.8 billion in . especially during the period 1994-1996. The growth and financial performance of selected industries.5 percent for medium-sized companies and 8. compared with 9. Performance by Industry This study also looked at corporate performance by industry.Chapter 3: Philippines 165 Small companies. and utilities and services sectors. reflecting to some extent a “bubble” phenomena in the former two sectors.7 percent in 1997 for medium-sized companies. i.and medium-sized companies did not substantially increase their leverage in years running up to the crisis in 1997. profits. ROE dropped from 10. at 158 percent on average during 1988-1997. Mediumsized companies’ leverage level was slightly lower. unlike their counterparts in other Asian countries. showed the lowest ROE. The leverage ratio of the manufacturing sector was higher than that of the real estate and property sector. Medium-sized companies apparently enjoyed efficiencies associated with economies of scale and made more productive use of their assets.7 percent in 1996 to 8. ROE dropped to 7. as indicated by the negative annual growth. Large. and profitability in 1997 when the crisis started.. specifically those industries least and most affected by the financial crisis.1 billion in 1996 to P4.2 percent for large ones. at 128 percent for the period. and equity up to 1996.6 percent. Poor returns appear to have been caused by the low profit margin at 6. but lower than that of construction. net income.7 billion and P35. assets. The real estate and property sector also suffered significantly in sales. and assets was much higher for the real estate and property.1 percent. The Asian financial crisis affected large companies most severely. averaging 10.e.8 the previous year.4 percent in 1997 from 11. of net income.2 billion in 1997 for this sector. For small companies. manufacturing.8 percent. Net income declined from P54. from 14. Leverage was the highest for large companies.

9 billion and P24. and was also much more limited compared with the property sectors in other Asian countries. various years.3 Fixed Assets 20.9 2.0 31 0.7 192 9.6 Total Liabilities 18. As a result.9 23. .7 ROA 5.2 37.7 Net Income (12.4 19.7 Indicators Manufacturing Construction 27.4 Total Assets 19.5 12. II Table 3.7 28.1 10.8) 17.4 percent.5 Other Indicators Share in Sales (%) 82.0 23.6 No.6 Financial Ratios (%) Leverage 142 181 ROE 13.9 5.8 48.4 Source: SEC-BusinessWorld Annual Survey of Top 1.7 percent to 10. Vol.7 19.4 3.4 16.166 Corporate Governance and Finance in East Asia.0 21.8 Stockholders’ Equity 21.3 20. respectively. of Company 454 17 Sales per Company (P billion) 1.0 Turnover 112 24 Net Profit Margin 5.7 10. But the impact of the Asian crisis on the real estate and property sector was much smaller than that on the manufacturing sector.7 52.7 billion in 1997. 1996 to P56.0 25. 1988-1997 Utilities Real Estate and and Services Property 39.3 5. With a modest increase in total liabilities and leverage level of less than 100 percent in 1997.2 45. %) Net Sales 16. the sector’s ROE dropped from 15. Its knock-on effect on the economy was small as it accounted for less than 3 percent of the top 1.1 24 42.6 Growth Indicators (Compound Annual Growth Rate.2 12.6 69 16.9 17.9 2.7 83 2. it does not appear to have been excessively exposed to foreign currency-denominated loans.1 2.000 companies’ total sales on average during 19881997.3 55.000 Corporations in the Philippines. The sector’s buildup in equity during the stock market boom of 1994-1996 may have cushioned the impact of the crisis.2 8.3 Retained Earnings 17.7 Growth and Financial Performance of the Corporate Sector by Industry.8 41.2 28 0.

nationalities. which is also the organic law governing the operations of SEC. The General Banking Law. and residences of incorporators and directors. and (viii) names. The currency devaluation bloated the foreign currency-denominated loans of these companies. and amount of authorized capital stock. (v) number of directors (not less than five nor more than 15). which regulates banks and nonbank financial institutions except insurance companies. . For publicly listed companies. which was based on American corporate law. and restrictions. The articles of incorporation may also include other matters such as waiver of preemptive right and classes of shares such as founders’ or redeemable shares describing their rights. the Revised Securities Act (RSA) and PSE’s public listing requirements also apply. Amendments to the articles of incorporation require approval by a majority of the board of directors and a two-thirds vote of outstanding capital stock. administrative regulations. par value. unlike in neighboring countries hit by the Asian crisis. and dissolution of corporations.Chapter 3: Philippines 167 The utilities sector had the second highest leverage during 19881997 at 181 percent on average. It specifies the minimum information to be indicated in the articles of incorporation. nationalities.3 Legal and Regulatory Framework The Corporation Code of 1980 is the main law governing the corporate sector. It provides the basic constitutional structure for the organization. the Code requires a corporation 3 A company’s articles of incorporation should include: (i) corporate name. the Corporation Code of 1980 is a compilation of important juridical rulings. and amount subscribed and paid by each. (iii) principal office. the leverage of all four industries was low. and recognized rules on corporate practices. Overall. privileges. operation.3 which serve as the company’s declaration that the minimum percentage of authorized capital required by law has been subscribed and paid-up. and the Insolvency Law. 3. Corporation Code of 1980 Supplanting the old Corporation Law of 1906. (vii) number. (iv) term of existence. (vi) names. reaching up to 313 percent in 1997.2. contains some provisions affecting corporations’ dealings with banks. the ownership of Filipino citizens in the corporation is not less than the legally required percentage of capital stock. Two other pertinent laws are Presidential Decree (PD) 902-A. (ii) purpose of the corporation. and residences of original subscribers. One month after registration. Under the Code.

shareholders may delegate this power to the board of directors by a two-thirds vote of outstanding capital stock. must be general. and compensation of directors. (ii) controversies arising out of intra-corporate relations. . and forms of proxies and manner of voting them. manner of voting. (vi) penalties for violation of the bylaws. place. PD 902-A also granted SEC the exclusive jurisdiction to hear and decide cases involving: (i) complaints about devices or schemes employed by the board of directors and officers amounting to fraud and misrepresentation that may be detrimental to the interest of the public or shareholders. Its mandate is to supervise corporations in order to encourage investments and protect investors.168 Corporate Governance and Finance in East Asia. In 1976.4 Philippine corporate law distinguishes between management decisions that require only a majority vote of the board and major decisions that require a two-thirds majority vote of shareholders. 4 Some of the items that a corporation may provide in its bylaws are the following: (i) time. A majority of the outstanding shares of shareholders must vote to authorize amendments to the bylaws. among shareholders. and public policy. PD 902-A expanded SEC’s mandate to include absolute jurisdiction. Vol. and control (adjudicative) of all corporations. directors. (iv) time for holding annual election of directors and manner of giving the election notice. However. (v) manner of election or appointment and term of office of all officers other than directors. duties. or officers. between the shareholders and the corporation. It implements rules and regulations that protect minority shareholders from possible fraud and misbehavior by controlling shareholders. (iii) qualifications. uniform. To be valid. and (iv) petition of corporations to be declared in a state of suspension of payments in cases when their assets cover all debts but they cannot pay these debts when they fall due. and employees. and should not impair vested rights. In addition. supervision (regulatory). the corporation’s articles of incorporation. and between the corporation and the State concerning its franchise or right to exist. and reasonable. and manner of calling and conducting regular or special meetings of the directors and shareholders. and (vii) manner of issuing certificates in the case of stock corporations. officers. (iii) controversies in the election or appointments of directors and officers of corporations. II to adopt a code of bylaws or rules for its internal governance. the bylaws must be consistent with the law. Securities and Exchange Commission: PD 902-A SEC is the government agency responsible for implementation of the Corporation Code. (ii) required quorum in shareholders’ meetings.

Chapter 3: Philippines 169

The last item of PD 902-A is the special jurisdiction granted to SEC over applications by corporations for “suspension of payments” to creditors, a role of the regular courts that was originally part of the Insolvency Law. Under this authority to approve applications for suspension of payments, SEC has the power to appoint rehabilitation receivers or management committees for petitioning corporations. A presidential writ issued in 1981 placed SEC under the supervision of the Ministry of Finance, but in 1998, control of the agency was returned to the Office of the President. Insolvency Law The Insolvency Law is designed to effect an equitable distribution of insolvent debtors’ properties among their creditors. It permits debtors to be discharged from their liabilities to enable them to start afresh with property set apart for them from assets to be used as payment to creditors. The regular courts have jurisdiction for insolvency proceedings including suspension of payments for individual debtors. A debtor can petition the court to suspend payment of debts or to be discharged from liabilities and debts by voluntary or involuntary insolvency proceedings. Revised Securities Act: Law on Securities Dealing Like its predecessor, the 45-year-old Securities Act, the RSA was patterned after several US securities acts. The RSA is primarily designed to prevent the exploitation of investors through the sale of unsound or fraudulent securities. For this purpose, the law requires full and accurate disclosure of all material facts concerning the issuer and the securities it proposes to sell, and prohibits misrepresentations, manipulations, and other fraudulent practices in the sale of securities. To enforce these regulations, the law requires the registration of securities. The registration requirement covers full and accurate disclosure of the character of the securities to be sold to the public, including detailed information regarding past dealings between the issuer and its directors, officers, and principal shareholders. Public Listing Rules of the Philippine Stock Exchange PSE is the country’s facility for secondary trading of shares of publicly listed companies. In 1998, SEC, which originally supervised PSE, granted the exchange the status of a “self-regulated” organization. Thus, PSE now

170 Corporate Governance and Finance in East Asia, Vol. II

has the authority, within general guidelines set by SEC, to set rules and regulations for PSE members and listed companies. The general requirements for maintenance of listed status include submission of financial reports that conform with generally accepted accounting principles (GAAP) and regulations established by PSE, and compliance with laws relating to securities and exchange regulations, board resolutions, and agreements executed with the agency. Violations of PSE requirements are subject to sanctions, including delisting. PSE is responsible for ensuring that listed companies follow the exchange’s rules of disclosure and fair treatment of investors. It has the power to impose sanctions on any company that fails or erroneously discloses material information that affects the rights and benefits of investors and misrepresents information in its application, prospectus, financial statements, or reports. In the area of corporate governance, PSE requires corporations to resolve, and, where possible, eliminate arrangements within groups of companies and own-company dealings that can lead to conflicts of interest. Upon complaints by minority investors, PSE can review the deals in question, using such criteria as benefits to the company, adequate disclosure to shareholders, and internal control procedures to ensure fair and reasonable terms. Banking Laws Affecting Corporations Some aspects of banking laws affect the governance of corporations. The important ones concern: (i) the capacity of officers of corporations to assume positions as members of the board of directors of banks, (ii) limits on ownership of banks by nonfinancial corporations, (iii) limits of lending by banks to corporations, and (iv) rules on lending to directors and other insiders. The General Banking Law governs the regulation of the establishment, management, and operations of banks. As the highest policymaking body of the banking system, the Monetary Board prescribes the qualifications of bank directors and reviews the qualifications of those appointed as bank directors and officers. It could disqualify anyone found, for whatever reason, unfit for the position. There are no other restrictions on corporate officers to be appointed as members of the board of directors of banks. A corporation, including its wholly or majority-owned subsidiaries, can own common shares of banks up to a maximum of 30 percent of banks’ voting stock. In the event that the corporation is majority-owned by one person or by relatives, the limit is 20 percent of banks’ voting shares.

Chapter 3: Philippines 171

Regulations on the single borrower limit (SBL) put a ceiling on the maximum amount that a bank can lend to a debtor. SBL rules limit the total liabilities of any borrower of a commercial bank to 15 percent of the bank’s unimpaired capital and surplus, and an additional 15 percent for “adequately secured loans,” to a maximum 30 percent (“unimpaired capital and surplus” refers to the total paid-in capital, surplus, and undivided profits, net of valuation reserves of a bank). SBL limits exclude risk-free loans such as Government-guaranteed loans and loans secured by cash deposits. Total corporate liabilities include all liabilities of the debtors and their majorityowned subsidiaries. The Monetary Board may prescribe the consolidation of the liabilities of subsidiaries with the parent corporation under certain conditions. Central Bank (Bangko Sentral ng Pilipinas [BSP]) regulations do not prohibit loans by the bank to its directors, officers, shareholders, and other related interests, known as DOSRI. However, they are subject to certain prudential requirements under banking laws, as follows: (i) a director or officer of a bank can only borrow or become a guarantor, endorser, or surety for loans from the bank with the written approval of all other directors of the bank (i.e., excluding the director concerned); (ii) the amount of outstanding credit accommodations that a bank extends to its shareholders shall be limited to an amount equal to the sum of their unencumbered deposits and book value of their paid-in capital contributions; and (iii) loans and advances given to officers in the form of fringe benefits shall not form part of liabilities under DOSRI.

3.3 3.3.1

Corporate Ownership and Control Patterns of Corporate Ownership

The historical development of Philippine corporate ownership is rooted in the country’s colonial past, the industrial policies of the Government, and the recent emergence of industrialists and an entrepreneurial class. During the Spanish and American period up to World War II, a small number of families acquired land and owned large businesses. These families built and preserved their businesses over several generations. Many of them became controlling shareholders of family-based corporations and business groups that are major players in the present-day Philippine corporate sector. Ownership is a key element in corporate control and governance. Public listing rules of PSE require that a minimum of 10 to 20 percent of

172 Corporate Governance and Finance in East Asia, Vol. II

outstanding shares, depending on the size of the company, be available for trading in the stock exchange. As companies usually only issue the minimum required number of shares, large blocs of controlling shareholders often dominate corporate decision making in publicly listed companies. Public investors and minority shareholders are not in a position to influence management. Moreover, the presence of large controlling shareholders makes takeovers by other companies difficult. For these reasons, the resolution of conflicts between the interests of controlling shareholders, minority shareholders, public investors, and creditors in Philippine companies depends very much on the effectiveness of internal control systems. Ownership Concentration of Listed Companies This study measures ownership concentration in terms of shareholdings by the top one, five, and 20 shareholders.5 Table 3.8 shows that the top shareholder owned 40.8 percent of the market value of an average nonfinancial company. The shareholding of the top shareholder varied across sectors. It was highest for the property sector at 54.8 percent, followed by holding companies (as a sector) at 53 percent. One shareholder held majority control of an average company in these two sectors. The average shareholding of the largest shareholder was less than 25 percent only in sectors with large market capitalization, such as power and energy, and transportation, and in sectors with high risks, such as oil exploration and mining. These figures suggest that for publicly listed companies, a single shareholder often has substantial or even dominant control. Combined, the holding of the top five shareholders in an average company was about 65.3 percent for the nonfinancial sector and 59.2 percent for the financial sector. The five largest shareholders held majority control over an average Philippine publicly listed company, except in three sectors—transportation; food, beverage, and tobacco; and oil exploration. Ownership by the five largest shareholders was on average most concentrated among holding companies (78.4 percent), and in construction (74 percent), property (69.8 percent), manufacturing and trading (68.4 percent), and communications (67.3 percent).


The study derived ownership data for 194 (169 nonfinancial) companies out of 221 (190 nonfinancial) listed on the Philippine Stock Exchange as of 1997. Shareholdings by the top one, five, and 20 shareholders were estimated for each company and averaged by using the market capitalization of each company as a weight.

Chapter 3: Philippines 173

Table 3.8 Ownership Concentration of Philippine Publicly Listed Companies by Sector, 1997
Sector Financial Institution Banks Financial Services Average Shareholdingb Nonfinancial Company Communication Power and Energy Transportation Services Construction and Other Related Products Food, Beverage, and Tobacco Holding Companies Manufacturing, Distribution, and Trading Hotel, Recreation, and Other Services Property Mining Oil Average Shareholdingb

Top 1 26.9 41.3 27.2 35.4 21.5 23.8 47.7 22.7 53.0 37.4 28.9 54.8 23.4 19.9 40.8

Top 5 59.2 63.2 59.2 67.3 55.4 48.4 74.0 44.1 78.4 68.4 55.3 69.8 56.0 45.1 65.3

Top 20a 76.4 65.8 76.2 76.9 72.1 69.2 86.2 69.7 86.0 42.6 68.0 74.5 51.9 64.3 75.9

Information on the top 20 shareholders is not available for five holding companies, 10 manufacturing companies, and two property companies. b Weighted by market capitalization. Source: PSE databank.

The shareholding of the 20 largest shareholders in an average company was 75.9 percent for the nonfinancial sector and 76.2 percent for the financial sector. In 12 out of 13 sectors, the top 20 shareholders owned more than 50 percent of the voting shares of an average company. In 10 out of 13 sectors, the top 20 shareholders held more than a two-thirds majority control of an average company. Ownership Concentration at Critical Levels of Control PSE listing rules require that a minimum of 10 to 20 percent of outstanding shares of a company be issued to the public, depending on its size. An interesting question is whether in reality Philippine publicly listed companies issue enough shares to be truly widely held or whether they barely meet this minimum requirement. The answer to this can be gleaned from an

10. Vol. or 14 percent of the total. a single shareholder held two-thirds majority control. a single shareholder held operating control of a company.9 shows that in 44 companies. large and family-based shareholders pool the family’s ownership over many . II analysis of the number of companies in which the top one. controlling an average of 52. five. the top five shareholders owned more than 50 percent of the voting shares. The limited volume of shares issued to the public is one of the causes of the underdevelopment of the Philippine stock market. or 20 shareholders owned more than 50 percent (signifying operating control). There are advantages to establishing pure holding companies. nonfinancial corporations held majority control. Parent companies usually spin off operating units into new companies that they continue to control as affiliates. or about 30 percent of the total. or almost 75 percent of the total. Individuals did not constitute a significant shareholder group among the top five shareholders. including pure holding companies. or 80 percent (only nominally publicly listed) of outstanding shares. Table 3. In 111 companies.1 percent of publicly listed companies in the Philippines in 1997. holding only an average of 2. and share prices are sensitive to movements of foreign funds. Through these. In four companies. the top 20 shareholders collectively owned a majority of a company’s shares. The largest group is nonfinancial corporations. five. In 116 companies. The shares of publicly listed companies are thinly traded and illiquid. Nonfinancial corporations with controlling shareholdings are likely to be holding companies. the top five controlling shareholders were classified into eight groups. a single owner owned more than 80 percent of outstanding shares.174 Corporate Governance and Finance in East Asia. minority shareholders are unlikely to be able to influence the strategic and operating decisions of a company without the support of one or more large shareholders.2 percent of outstanding shares of publicly listed companies. In four of 11 nonfinancial sectors. In 21 companies. Composition of Ownership of Publicly Listed Companies Another important issue concerning corporate ownership is the composition of the controlling shareholders. 66 percent (signifying strategic control). Who are the top one. which are mostly privately owned and controlled by family-based shareholder blocs. or 78 percent of the total. In 76 companies. or 51 percent of the total. and 20 shareholders? In Table 3. or 3 percent of the total. With such high levels of ownership concentration. the top five shareholders held more than two-thirds majority control of a company.

a Data for top 20 shareholders were not available for five holding companies.9 Ownership Concentration at Critical Levels of Control Over Publicly Listed Companies. 1997 % of Firms with Top Shareholders Controlling more than 50% of Shares Top 1 30 40 50 20 31 — 14 24 30 90 80 86 72 73 50 57 72 74 100 87 93 36 82 100 100 80 78 20 13 43 8 14 — — 8 14 70 60 57 48 49 50 14 52 51 Top 5 Top 20a Top 1 Top 5 Top 20a 90 80 86 36 76 100 71 76 72 % of Firms with Top Shareholders Controlling more than 66% of Shares % of Firms with Top Shareholders Controlling more than 80% of Shares Top 1 — 13 7 — 2 — — — 3 Top 5 40 33 50 28 27 50 — 28 30 Top 20a 60 67 64 20 47 50 43 36 45 Sector Communication Construction Food. Beverage. and two companies in the property sector. 10 manufacturing companies. and Tobacco Manufacturing. Source: PSE databank.Table 3. Distribution. and Trading Holding Power Transportation Property Total — = not available. .

2 0.6 0.0 0.1 7.0 1.3 37.0 5.0 1.6 0. .0 0.0 2. Distribution.4 19.7 0.0 4.6 1.0 0.6 0.8 0.7 0.6 0.6 2.0 1.3 12.1 5.5 0.3 0.2 3.6 0.0 10.0 45.5 2.0 2.5 26.3 1.10 Composition of Top Five Shareholders of Philippine Publicly Listed Companies by Sector.0 0.0 5.5 0.1 9.2 59.1 8.7 0.1 0.0 0.0 0.7 3.3 26.5 4.2 3.1 0.8 0.2 3. and Trading Hotel.2 1.6 5.2 0.0 0.7 0.2 5.0 0.0 0.3 2.9 0.2 3.0 1.5 4.0 0.8 66.1 1.0 1.0 0.6 18.6 0. and Other Services Property Mining Oil Average Shareholdinga 33.3 0.0 0. Beverage.7 3.0 1.0 7.4 29.4 5.9 6.7 67.3 0.3 0.4 0.8 0.9 36.Table 3.4 8. Recreation.2 0.0 0. 1997 (percent) Nonfinancial Investment Nominee Commercial Company Trust Fund Company Individual Bank Government Securities Broker Insurance Company Sector Financial Company Banks Financial Services Average Shareholdinga Nonfinancial Company Communication Power and Energy Transportation Services Construction and Other Related Products Food. Source: PSE Databank.1 6.9 0.4 1.1 a Weighted by market capitalization. and Tobacco Holding Companies Manufacturing.0 1.7 1.0 0.0 1.6 9.8 11.8 21.4 2.5 13.3 5.0 0.9 52.7 0.7 0.2 0.5 53.6 12.3 1.6 33.6 2.2 0.5 12.2 10.6 0.3 0.3 5.0 5.0 5.

Because of limited ownership by institutional investors.2 percent shareholding by the financial institutions was even inflated to some extent because securities brokers held trading portfolios for their clients rather than long-term investments. Insurance companies were very minor investors in the stock market because prudential regulations prevent them from investing significant amounts even in equities of large companies.7 percent of market capitalization of the nonfinancial publicly listed companies.6 percent of market capitalization in 1997.5 to 12.1 percent). and insurance companies (0. These are mainly the Social Security System (SSS) and the Government Service Insurance System (GSIS). . Such advantages have contributed to the popularity of holding companies among publicly listed companies.1 percent). commercial banks (1.3 percent). while still allowing the public to own minority shares. Petron and MERALCO in power and energy. As a group. and San Miguel Corporation (SMC) in food and beverages.7 percent of shareholdings).6 billion or 26. respectively. financial institutions did not have a significant ownership in nonfinancial corporations.Chapter 3: Philippines 177 companies and share in the risks and profits of the group. there was no real market for investment information. securities brokers (1. Privately-owned pure holding companies own a majority of shares and exercise control of publicly listed holding and operating companies through a multilayered pyramid structure. The Philippine capital market did not have an active analyst community comparable to those in more developed capital markets. Investment trust funds were the most important institutional investors. Funds of SSS and GSIS consist mainly of compulsory contributions from members of the country’s private sector and government workforce. with an average of only 7. This complex layering of ownership masks the identity of individuals or families that actually own and control operating companies. Holding companies were themselves 66 percent owned by other nonfinancial corporations. The financial institutions among the top five shareholders of nonfinancial corporations are investment trust funds (with 4. They can also better manage their income taxes because income from affiliated companies passes through a holding company. The 7. accounting for P258. Holding companies as a sector had the largest market capitalization in PSE in 1997. The investment funds’ presence in these sectors ranged from 8.2 percent in 1997. These include Philippine Long Distance Telephone Company (PLDT) in telecommunications. These institutions keep a stock portfolio mostly in shares of a few companies with large capitalization and high liquidity in select industries.

identified the companies belonging to each of these groups. using data on the Philippines’ top 1. and tracked the financial performance of each company from 1992 to 1997. This could further increase the concentration of ownership and expand the scope of own-group lending by these larger banks. the Central Bank’s reforms are probably changing the conduct but not necessarily the structure of the banking system. The Central Bank deregulated interest rates and foreign exchange. Banks that are members of business groups have an advantage in raising funds from the internal capital market of the group.6 The total sales of these groups in 1997 were estimated at P806 billion (Table 3. including 16 commercial banks. so far limiting their involvement to selected products.7 6 7 The study used publicly available shareholder information and published reports.000 companies.11). More than three fourths of the respondents are either a parent or subsidiary (about 70 percent of these are domestic nonfinancial companies). The process identified a total of 238 companies belonging to 39 business groups from the SEC-BusinessWorld Annual Survey of the Top 1. Family-based groups have larger companies since their total sales were about 33. Vol.000 Corporations in the Philippines. For this reason. Some 20 financial institutions were affiliated with these groups. Prudential regulations. many companies in family-owned groups are not publicly listed.8 percent of total companies in number. a nonfinancial company that owns a commercial bank has better access to loans at favorable rates and terms. A common feature of corporate ownership of a business group is the centrality of a commercial bank. All major industries were represented.4 percent of the top 1. This is significant considering that there were only 31 local commercial banks in the country in 1997. . suggesting that business groups are common in all major markets. including SBL and DOSRI rules. of the financial resources in the country. remain in force to control excessive lending of banks to insiders. Most family businesses that went public did so because they wanted to raise capital and to gain the prestige associated with being a public company. Foreign banks have a growing presence but have not necessarily increased the supply of credit to the corporate sector. Corporate financing depends on intermediation by banks. liberalized the regulations on entry of foreign bank branches and foreign ownership of local banks. and increased the capital requirements for all types of banks. the study put together a list of prominent business groups. II Family-Based Ownership and Business Groups The Asian Development Bank (ADB) survey of publicly listed companies conducted for this study reveals that about one third of responding companies started out as family businesses. about three fourths.178 Corporate Governance and Finance in East Asia. Large shareholders and their families own these banks directly or through their controlled companies.000 corporations’ sales. suggesting that most publicly listed companies are parts of business groups. To understand the ownership and governance characteristics of family-owned business groups. but they comprised only 23. Commercial banks hold the largest share. Still. However.

It is also noteworthy that. which was majority-owned by the Henry Sy group. In terms of sales.6 percent of the total sales of the top 1. Foreign-owned companies mainly serve the export markets. an average group in the Philippines has fewer member companies. To show this. Gokongwei. For the Ayala group. the biggest private company in the Philippines. Commercial banking contributed about 40 percent of group profits for the Ayala group and Gokongwei group. The significance of family-based business groups in the Philippine corporate sector is immediately evident in the 50 largest corporate entities. In the meantime.12). the top 10 family-based business groups had only 119 companies in the top 1. broadcasting (49. or an average of about 12 per group. for the Lopez group.2 percent). nonfinancial companies contributed about 36 to 60 percent of total profits for these groups. the largest family-based business group was the Ayala Corporation Group. with the exception of Banco de Oro. Also. the largest was the Eduardo Cojuangco group. Cojuangco.000.1 percent). In terms of number of companies.4 percent of the group’s 1997 profits).000 companies. and banking. and Henry Sy—as examples. real estate. These corporate entities accounted for 53. Lopez. with 27 affiliated companies in the top 1. Commercial banks are often affiliated to a particular business group. as discussed in previous sections. The main constraint may be the availability of family members that could be drawn for top management positions.000 corporations in 1997. Together. the three largest entities were family-based groups. for each of these groups. and more than 20 percent for the Lopez group and Henry Sy group. for the Gokongwei Group.Chapter 3: Philippines 179 Compared with other Asian countries. a substantial proportion of group profits came from its financial subsidiaries. construction. in most . Lopez. the study used the four largest business groups—Ayala. In 1997. the principal owner of SMC. it was manufacturing (36. Significantly. the two were closely related through their affiliations to business groups. Interlocking Relationship between Financial and Nonfinancial Firms Although financial institutions as a whole did not own directly significant proportions of shares of nonfinancal corporations in the Philippines. 25 out of the 50 top corporate entities were familybased groups. and Ayala. ranged according to their sales (Table 3. the nonfinancial sector was real estate (60. and for the Henry Sy group.8 percent). retail merchandising (69. including business groups and independent companies. Family-based business groups are most dominant in sectors such as manufacturing. namely.

5 13.1 4.6 3. 11. Real estate.5 46. Flagship Company.3 11. and tourism Credit card 18.3 3. telecom.0 5. of Affiliated Companies Total Sales (P billion) 123.0 Average Sales Per Company (P billion) 6.5 47. food. and dairy products Investments.6 2.1 2. 13. and personal care prods Shipping. 1997 Business Group 19 15 27 12 12 9 4 6 11 4 8 9 5 4 5 6 Major Sector Orientation Estimated No.1 4. Consunji 4 3 Food and dairy products Construction and mining 10. 2. and tobacco Telecommunications Cement and construction materials Pharmaceutical and distribution 12. 16. and car manufacturing Car manufacturing and real estate Food and telecommunications Department store and real estate Airlines. 3.7 98.5 6.2 1. Group George Ty John Gokongwei Henry Sy Lucio Tan Ramon Cojuangco Family Group Del Rosario/Phinma Group Zuellig Group First Pacific/ Metro Pacific Group Aboitiz Family Group Jose Concepcion/RFM Group Alfonso Yuchengco Andres Soriano Family Group George Go Wilfred Uytengsu/ General Milling Group David M. 17. beverages.4 48.0 26.9 2. 7. 8. and food Food.Table 3. 6.5 49.9 3.4 6.6 3. 10. 14. and Affiliated Bank of Selected Business Groups. power.2 16.0 17.5 26. beverages.8 84. coconut oil. 5. and packaging Power distribution and mass communications Real estate. real estate. 9. 4.5 44.6 7.3 2.5 17. agriculture. and mining Management.4 10.11 Total and Per Company Sales.2 1.4 .0 13. Eduardo Cojuangco Lopez Family Group Ayala Corp. construction.5 2. 15. Beverages. food.3 15. Sector Orientation.

0 0.4 5.8 1.9 0. 32.2 6.7 4.4 1. mining. and various company annual reports.6 2.8 Jollibee Foods Luis Lorenzo Family Group Alcantara Family Group Bienvenido Tantoco Elena Lim Andrew Gotianum Brimo Family Group Andrew Tan J. . 27. distribution.3 2.6 3. 22.6 5.7 0. 25. 21. 37. and real estate Retail merchandising Ceramics and real estate Department store and real estate Cement and sugar central Real estate and securities trading Bookstore. 31. 33. 38.1 805.3 7.6 Fast food Beverages and agro-industrial products distribution Cement and wood products Retail merchandising Electronic appliances Real estate Mining Real estate Telecommunication. 4 238 1. 23.2 4.5 2.8 1.9 7.0 2. SEC-BusinessWorld Annual Survey of Top 1.000 Corporations (1997). Ramos Gaisano Family Group Felipe Yap Felipe F.9 1.2 1.9 1.3 2. 29. Cruz Jose Luis Santiago Keppel Group Robert John Sobrepeña/ Fil-Estate Group Total Real estate Sources: PSE Databank. 39.0 1. and real estate Department store Mining Construction Telecommunication Shipyard and power 4 7 5 2 4 4 3 2 5 7 5 5 2 3 2 3 2 2 2 2 8.7 3.9 6.0 5. 26. 24. P.8 1.19. 28. Enrile/JAKA Group Jaime Gow Guoco Group Jose Go Jardine Davies Gerardo Lanuza Alfredo C.9 1.9 0.1 2.8 6.1 1. 20.7 0. 35.1 1.1 0.7 0.4 3. 36. 30.7 1. 34.4 3.6 0.5 8.

2. Jollibee Foods Corporation Pepsi Cola Products Alsons Cement . Sector Orientation. 5. Consunji Jollibee Foods Luis Lorenzo Family Group Alcantara Family Group Large Large Medium Medium Medium Large Large Large Medium Large Medium Medium Medium Medium Medium Medium Medium Medium Medium Small Small San Miguel Corporation MERALCO Ayala Corporation Toyota Motors Robinson Shoe Mart Philippine Airlines Phil. 7. 16. 21. 1997 Business Group Size Classa Flagship Company Affiliate Bankb UCPB PCIBank BPI Metrobank/Global Bank PCIBank Banco de Oro Allied Bank Bank of Commerce Asian Bank PDCP Bank Union Bank Consumer Bank (Savings Bank) RCBC Asian Bank Equitable Banking Corp. 13. Eduardo Cojuangco Lopez Family Group Ayala Corp. and Affiliated Bank of Selected Business Groups. 1. Alaska Milk Corporation DM Consunji. 15. 18.11 (continuation) Total and Per Company Sales. 19. Group George Ty John Gokongwei Henry Sy Lucio Tan Ramon Cojuangco Family Group Del Rosario/Phinma Group Zuellig Group First Pacific/Metro Pacific Group Aboitiz Family Group Jose Concepcion/RFM Group Alfonso Yuchengco Andres Soriano Family Group George Go W. 8. 17. 3. 20. Flagship Company. 11. 6. 10. Uytengsu/General Milling Group David M. 9. Inc. 14. 4. Long Distance Telephone Phinma Zuellig Pharmaceutical Metro Pacific William Gothong and Aboitiz Swift Foods/RFM House of Investment Anscor Equitable Card Network Inc. 12.Table 3.

SEC-BusinessWorld Annual Survey of Top 1. Cruz & Co. Sources: PSE Databank. P.48 billion. Fil-Estate Development Inc.. 22. 33. small = less than P1. 34. 25. 28. 35. Refers to commercial banks. a b Size class is measured in terms of sales: Large = greater than P4. and various company annual reports. 24.65 billion to P4. 39. 36.65 billion. unless otherwise indicated.000 Corporations (1997). 32. 26. .East-West Bank International Exchange Bank Ecology Bank (Savings Bank) Dao Heng Bank Orient Bank International Exchange Bank International Exchange Bank Philbanking Corp.48 billion. 29. 31. Keppel-Monte Bank Bienvenido Tantoco Elena Lim Andrew Gotianum Brimo Family Group Andrew Tan J. medium = P1. 23. PT&T Corp. Inc. 38. Enrile/JAKA Group Jaime Gow Guoco Group Jose Go Jardine Davies Gerardo Lanuza Alfredo C. Kepphil Shipyard Inc. 30. F. Ramos Gaisano Family Group Felipe Yap Felipe F. 27. Cruz Jose Luis Santiago Keppel Group Robert John Sobrepeña/Fil-Estate Group Medium Medium Small Medium Medium Small Small Small Small Medium Small Medium Small Small Small Small Small Small Rustans Solid Group Filinvest Philex Mining Megaworld Properties Jaka Investment Corporation Uniwide Corporation Guoco Ceramics Ever Gotesco Republic Cement PhilRealty National Bookstore Gaisano Department Store Lepanto Consolidated Mining F. 37.

beverages.4 19.5 26. 8. 1997 Sales (P billion) Control Structure Major Industrial Orientation 123.). 24.1 60. Aboitiz Family Group Jose Concepcion/RFM Group Alfonso Yuchengco Philippine Associated Smelting and Refining Corp. Petron Corporation Pilipinas Shell Petroleum Corporation George Ty John Gokongwei Henry Sy Lucio Tan Ramon Cojuangco Family Group Caltex (Philippines) Inc. coconut oil.8 53. 4. Philippine National Bank Mercury Drug Corp. and dairy products Investments. food.0 38.6 18.5 77. 20. and mining Gold and other precious metal refining . 19.8 22. 17. 12.4 48. and personal care products Shipping. Del Rosario/PHINMA Zuellig Group Toshiba Information Equipment (Phils.5 17. power. 11. bank.1 17. and bank Real estate. food. 3. banking. agriculture.7 98.0 24. car manufacturing. and packaging Power distribution. 16. 13.and Foreign Jointly Owned Business Group Business Group Business Group Government-Owned Publicly Listed/Foreign-Owned Foreign-owned Business Group Business Group Business Group Business Group Business Group Foreign-Owned Foreign-Owned Business Group Business Group Foreign-Owned Privately-Owned Publicly Listed/Foreign-Owned Privately-Owned Business Group Corporate Entity 1. Texas Instruments (Phils. 15.5 46. and tobacco Telecommunications and banking Refined petroleum products Radar equipment and radio remote control apparatus Cement and construction materials Pharmaceutical and distribution Electronic data processing equipment and accessories Electronic data processing equipment and accessories Bank Drugs and pharmaceuticals goods retailing Real estate.2 16. construction. and car manufacturing Power Refined petroleum products Refined petroleum products Banking. First Pacific/Metro Pacific Group 21. 7.5 47. 6. Inc. 2. 18. and telecommunications Department store and banking Airlines. and real estate Banking.0 37. beverages.2 49.8 84. 10. Inc. mass communications. 5.6 26. telecommunication. food.5 15. 22. and food Food. Fujitsu Computer Products Corp. 9.2 Business Group Business Group Business Group Government.5 44. 14.Table 3. Beverages.3 15. Eduardo Cojuangco Lopez Family Group Ayala Corporation Group National Power Corp.12 Control Structure of the Top 50 Corporate Entities. 23.). of the Phils.

40. 31.7 10. 30. Luis Lorenzo Family Group United Laboratories Development Bank of the Philippines Alcantara Family Group Bienvenido Tantoco Elena Lim Brimo Family Group Andrew Tan Total Share in Top 1. 29. 35. 47. 27. 46. radio and remote control apparatus Fast food Bank Beverages and distribution of agro-industrial products Drugs and medicines. Inc.6 9. 34. Philip Morris Philippines.9 6. 37.9 7. 42.8 9. 14. Inc. 44.1 9. including biological products Bank Cement and wood products Retail merchandising Electronic appliances Mining Real estate Sources: SEC-BusinessWorld Annual Survey of Top 1.25.9 14. Amusement and Gaming Corporation Mitsubishi Motors Phils.000 Companies Sales (%) Cigarettes Bank Soap and detergents Management. 32. W. corn (unmilled).8 Privately-Owned Government-Owned Foreign-Owned Business Group Business Group Foreign-Owned Government-Owned Government-Owned Government-Owned Foreign-Owned Business Group Business Group Foreign-Owned 38. and tourism Banking Radar equipment and radio remote control apparatus Operation of rolling mills Palay.7 10. real estate.3 8.9 7.6 12. 36.7 13. Jollibee Foods Citibank N.5 8.0 13. 49. 45.290 53.4 8.2 7.5 10. Corp. PSE Databank. National Steel Corporation National Food Authority Phil.000 Corporations (1997). and apparatus for line telephony and line telegraphy Tobacco products wholesaling Cigarettes Radar equipment. Inc. . and other grains wholesaling Other amusement and recreational activities Motor vehicles Food and dairy products Construction and mining Television and radio transmitters. 48.0 12. 33.. EAC Distributors Inc.0 5. 28. 9.8 6.A.6 1. 26. 39. 41.3 13. Consunji Uniden Philippines Laguna. 43. Philips Semiconductors Phils. 50.5 8.6 Foreign-Owned Foreign-Owned Foreign-Owned Business Group Foreign-Owned Business Group Privately-Owned Government-Owned Business Group Business Group Business Group Business Group Business Group La Suerte Cigar and Cigarette Factory Land Bank of the Philippines Procter and Gamble Philippines Andres Soriano Family Group George Go Hitachi Computer Products (Asia) Corp.4 10.0 11. and various company annual reports. Uytengsu/General Milling Group David M.

8 The ADB survey of corporate governance practices was conducted in the first semester of 1999 using a questionnaire prepared by Juzhong Zhuang of the Asian Development Bank. issuance of corporate bonds. shareholder voting in general meetings and legal protection of their rights. determination of compensation to board members. Actual control of the banks was still held by the groups. They are likewise liable if they pursue financial interests that conflict with their duty as directors. business groups had only minority ownership. However. Of course. removal of directors. the board of directors plays a crucial role in corporate governance. This section reviews practices of corporate management and shareholder control in Philippine publicly listed companies. and financial disclosure. jointly and individually. voluntary dissolution. The Corporation Code holds members of the board of directors liable.2 Corporate Management and Shareholder Control The main mechanisms by which shareholders control corporate management are the board of directors. corporate mergers or consolidations.8 The Board of Directors As the representative of shareholders in a company. approval of management contracts. accounting and auditing. these were dispersed shareholdings. Shareholders limit the broad power of the board by ratifying their decisions on critical corporate affairs. such as amendments of the articles of incorporation. The review is based on an ADB survey of listed companies in the Philippines conducted in 1999 for this study. II publicly listed commercial banks affiliated to these groups. investments of corporate funds in other companies or purposes. A total of 44 companies responded to the survey (out of about 221 financial and nonfinancial listed companies). although public investors held a majority of shares. appointment and compensation of senior executives. 3.186 Corporate Governance and Finance in East Asia. issuance of stocks. Vol. . sale or disposition of a substantial portion of corporate assets. to the corporation and its shareholders for damages caused if they agree to unlawful corporate acts.3. Shareholders have the right under the Code to file derivative suits against directors and officers and other third parties to redress any wrongdoing committed against the corporation for which the board refuses to sue or to remedy. and declaration of cash dividends. The Philippine Corporation Code mandates the board of directors to exercise its control over a corporation. amendments in the bylaws.

the average number of years of holding office was 6.7 percent). The majority of respondents indicated that board directors and chairpersons were elected mainly on the basis of either relationship with major shareholders (31. . Board chairpersons in a substantial number of responding companies did not own significant amounts of shares in their personal capacities. The ADB survey results show that a chairperson is compensated either by a fixed fee (52 percent of respondents). Such a short tenure may to some extent suggest that large shareholders want to keep their board members under close control.6 for board chairpersons and 7. or representatives of creditors. In a few cases. appointed by the Government. According to the ADB survey. The longest was 27 years for board chairpersons and 14 years for board directors. But professional expertise is also an important criterion (28. This can partly be explained by the fact that many family-based large shareholders control companies through holding companies in which they have majority ownership. a typical chairperson owned 3 to 5 percent of outstanding shares of a company on average. ensuring that a company follows legal and regulatory requirements. The average stipulated term of office of the chairperson and members of the board for most responding companies was one year. More than half of respondents indicated that board directors were elected during the shareholder general meetings.9 percent). The ADB survey shows that the number of board directors ranged from six to nine among the responding companies. board directors were the founder of a company.7 percent). a fixed fee plus performance-related bonuses (30 percent). with a maximum of 36 percent. or the Government without approval by shareholder general meetings. Financial compensation is another means by which shareholders can motivate boards and board members to manage companies in their interests. Making day-to-day management decisions was not regarded as an important board responsibility. But half of respondents indicated that they also had board directors directly nominated by controlling shareholders or management.Chapter 3: Philippines 187 actual practices of board functions and the role of shareholders may diverge somewhat from the legal framework. In practice. or percentages of shareholdings (28. and determining remuneration for board directors and senior management. in a descending order. protecting shareholder interests.5 for board members. appointing senior management. Respondents of the ADB survey ranked the following as the most important responsibilities of the board: making strategic decisions. or a per diem for meetings (18 percent).

In the ADB survey. by tenure and compensation. relationship with controlling shareholders (35 percent). large shareholder-dominated companies often view such committees as unnecessary formalities. and reviews the findings of external audits. The Corporation Code prohibits the removal of any director without cause if that act would deprive minority shareholders of representation in the board. only 35 percent of responding companies have set up board committees. the parent company or company bylaws (21 percent). When the CEO was not the chairperson. Vol. the chairperson of the board was also the chief executive officer (CEO). or management (15 percent). or amount of shareholding (15 percent). Senior Executives The Corporation Code does not specify the role and responsibilities of senior executives. CEOs apparently cannot increase their shareholdings because family-based owners restrict the number of shares available to management. It is also not clear whether the outside directors were elected before or after the financial crisis. Companies may set up special board committees to strengthen due diligence procedures. Unlike in Western corporate models. The ADB survey shows that in 41 percent of the responding companies. About half of the active committees were audit committees and the other half nomination committees. The compensation committee reviews and recommends remuneration plans of key officers and employee stock option plans. These committees were established only recently.9 In practice. A CEO that was not the chairperson of the board was selected on the basis of professional expertise (42 percent of respondents). II Compensation for the chairperson was determined either by the board (54 percent of respondents). audit. Ninetythree percent of the respondents had one or more outside directors. . The audit committee selects external auditors. But the independence of these outside directors is often doubtful. the CEO 9 The three most common board subcommittees are the compensation. There was no case found in the ADB survey where a minority shareholder invoked such a provision of the Corporation Code. negotiates the audit fees and scope of audits. This suggests that large shareholders control CEOs by means other than shareholdings.188 Corporate Governance and Finance in East Asia. In some companies. owners brought prominent political or civic leaders into their boards with the intention of improving the visibility of the corporation rather than improving the quality of board decisions. however. The nomination committee searches and reviews candidates for key management positions. namely. and nomination committees.

and prohibits the removal. (ii) disposes of or mortgages a substantial portion or all of corporate properties and assets. Shareholder Rights and Protection Under the Corporation Code. i. The longest service rendered was 27 years. Among others. A substantial number of respondents also considered looking after interests of other stakeholders and the general public as among the important responsibilities of the CEO.Chapter 3: Philippines 189 was not related to the chairperson by blood or marriage in all of the cases except one. including electronic means. or (iv) enters into a merger or consolidation with another corporate entity. An overwhelming 70 percent of respondents said a CEO who was not the chairperson of the board could make key decisions only after consulting the chairperson or the entire board. The majority of responding companies compensated their CEOs by using a fixed salary plus a performance-related bonus. (ii) contracts with companies linked through interlocking directorship. But about 27 percent viewed it to be ensuring steady growth of the company. without cause. shareholders enjoy a number of rights and protection. Only one respondent indicated that its CEO was entitled to a substantial amount of compensation. About 60 percent of respondents of the ADB survey considered maximizing shareholder values as the CEO’s most important responsibility. shareholders may exercise appraisal rights. first. the rights to demand payment for shares of those who do not agree with the board’s decisions when a company (i) amends the articles of incorporation. if the CEO’s contract was preterminated. equal to three years’ pay. shareholders have preemptive rights to maintain their proportionate ownership of a company under any financing plan that may be undertaken by the company. Fourth. the Corporation Code requires that the following types of transactions involving potential conflict of interest between shareholders and management be reviewed and approved by the board: (i) dealings of a company with directors or officers. Third. (iii) invests in another company for a purpose different from that of the corporation.. and (iii) involvement of directors in businesses that compete with the company. to help ensure the representation of minority interests in the board. . the Corporation Code allows cumulative voting for directors.2 years. Companies are not allowed to issue shares with different voting rights. of directors representing minority shareholders.e. They can vote through proxy. Second. The “golden parachute” was apparently not a common feature of CEOs’ compensation packages. The average service length of CEOs was 5. Fifth.

During annual general meetings where minority shareholders could exercise their rights. SEC proceedings were costly and time-consuming. In the case of preemptive rights. Being appointees of controlling shareholders. Sixth. Last. There was only one case. there were often no real discussions of board proposals or actions. Those who did were usually offered below-market values for their shares. because of the dominance of large controlling shareholders. that of Interport Resources Corporation. In practice. In the past. But an action by the regular court on a petition by the company’s owners/officers prevented SEC from pursuing the investigation. in the Philippines. minority shareholders were often vulnerable to the expropriation of their interests by controlling shareholders and management. Regardless of the amount of shares held. the Revised Securities Act has strict provisions designed to deter insider trading. no one has been successfully prosecuted for insider trading. in cases of corporate takeovers. it is doubtful whether this legal protection for shareholders will achieve what it intends to in practice. hostile takeovers are not common because in most companies ownership is concentrated . Dissenting minority shareholders did not necessarily have recourse to a third party for an objective appraisal of their shares. board members are likely to be under pressure to approve transactions that benefit controlling shareholders to the detriment of minority shareholders. potential buyers are required to make a tender offer to minority shareholders at a price equal to the offer it is making to controlling shareholders. In cases of derivative suits against directors for wrongdoings or actions against insider trading. However. The company was dissolved before indictment. a shareholder could file a derivative suit against a director to redress a wrongdoing. where SEC made substantial progress in investigation. the Corporation Code allows a company to waive this in the article of incorporation upon registration or in a subsequent amendment.190 Corporate Governance and Finance in East Asia. Although transactions involving potential conflict of interest need to be reviewed and approved by the board. because of poor compliance and enforcement as well as some loopholes in corporate laws. Few minority shareholders actually exercised their appraisal rights. An effective market for corporate control may provide some protection for minority shareholders against the expropriation of their interests by the incumbent management. There was little chance that a proposal from minority shareholders could ever get approved. there are no requirements for disclosing such transactions to shareholders under the Corporation Code. Consequently. II shareholders are allowed to inspect a company’s stock and transfer books. Vol.

0 63. followed by management and banks. An average of 327 shareholders per company attended the last annual meeting and they represented about 63 percent of total shares. The ADB survey provides further evidence on shareholder rights.6 Independence of Auditing The ADB survey revealed that all the responding companies had an independent auditor. The responding companies had on average 43. Table 3. the successful hostile takeover by First Pacific Group of PLDT.13 summarizes rights that the shareholders of the responding companies enjoyed. The brokers or securities companies were the most important proxy voters.0 36.4 percent of shareholders but 58 percent of outstanding shares. protection. About 333 shareholders per company voted by proxy. Table 3.8 92.900 shareholders per company did not vote during the last annual general meeting. About 93 percent of the respondents contracted . Yes 100.8 30. demonstrates the feasibility of developing a market for corporate control if publicly listed companies were widely held.4 No 0. Nevertheless.522 shareholders each. a company that is widely held but has a large shareholder. representing 3.Chapter 3: Philippines 191 in a few controlling shareholders and families.2 69. and their activism in the corporate sector. appointed either by the board or shareholders during the annual general meetings.7 43.8 56.4 70.0 51.2 7. representing about 24 percent of outstanding shares.3 56. 1999.13 ADB Survey Results on Shareholder Rights Percentage of Respondents Shareholder Rights One Share One Vote Proxy Voting by Mail Preemptive Rights on New Share Issues Prohibition of Loans to Directors Mechanisms to Resolve Disputes with Company Independent Audit Mandatory Independent Board Committees Severe Penalty for Insider Dealings Source: ADB Survey of Philippines Publicly Listed Companies. Nominees held about 45 percent of the outstanding shares.0 48. An average of about 4.6 30.2 43.

long-term leases. . intangible assets. the international accounting standard. foreign currency-denominated liabilities. On average. the information statement transmitted to every shareholder should contain the audited financial statements. a management discussion of the business. An auditor can choose among three alternative sets of GAAP.. namely. In practice. SEC requires all registered companies to periodically submit reports for the purpose of updating their respective registration statements filed at the agency. The accounting profession in the Philippines is considered fairly developed and Manila is a known regional center for accounting expertise. a preferred independent auditing firm either reported assets that did not exist (Victorias Milling Corp. investments in subsidiaries. Meanwhile. although closely related. independent audits do not guarantee the absence of questionable accounting practices. In two celebrated cases. II their annual audit to an international auditing firm. with the longest being 50 years. Nevertheless. intra-company receivables and payables. a hostile takeover case). and consolidation policy. More than 20 percent of the respondents have been dealing with their auditors for 20 years or more. and an analysis of financial statements. Disclosure and Transparency The disclosures required by the Corporation Code are achieved through shareholders’ inspection of a company’s books and an “information statement” that companies should regularly issue to shareholders. revaluation of fixed assets. the responding companies have been associated with their present auditors for 13 years. Vol. The Code grants a shareholder the right to inspect business records and minutes of board meetings. independent auditors are likely to be quite familiar with the operations and financial aspects of their clients. the local standard (i.. vary in their evaluation of some major accounts such as securities and other liquid assets. or the accounting standard of a specific developed country (for example. the US GAAP). Nevertheless.e. These different versions of GAAP. financial reporting standards allow room for interpretation by independent auditors. imposing penalties on violators. Because of such long relationships.192 Corporate Governance and Finance in East Asia. the agency also requires reports on important details about their operations and management. a bankruptcy case) or hid a large amount of liabilities and losses (PLDT. there are many cases of poor financial reporting by large companies. as practiced in the Philippines). From publicly listed companies. Most major international auditing firms operate in the Philippines.

they also make it easier for controlling shareholders to expropriate interests of minority shareholders. and publicly listed. Publicly available financial information was often of low quality.. because of the highly concentrated ownership of Philippine corporations. and financing. The popularity of holding companies in the Philippine corporate sector is evident: with a market capitalization of P258. Pure holding companies can be privately owned. Even for widely held public companies. Holding companies enable controlling shareholders to collectively own shares of other companies in a business group and to centralize the group’s management. They allow risk pooling and can achieve economies of scale in management. large shareholders can use their control to transfer wealth from a company in a business group where they have low cash flow rights to another where they have high cash flow rights.Chapter 3: Philippines 193 Many small. which are controlled by large shareholders with public investors in a minority position. “Selective public listing” is a strategy of many business groups for channeling funds from public investors to member companies. Such expropriation is due to gaps between control rights and cash flow rights that pyramiding structures of business groups centered on holding companies create. which are closely held by large shareholders and family members. When control rights exceed cash flow rights. Laws of many Southeast Asian countries allow the establishment of pure holding companies (with the exception of Korea up to 1999). sometimes did not penalize independent auditors for poorly prepared audited financial statements. from a minority-controlled to a majority-owned subsidiary. they formed the largest group of corporate entities in the Philippine stock market in 1997. Controlling shareholders usually select member companies that require large .g. namely SEC and the Philippine Institute of Certified Public Accountants (PICPA).and medium-sized businesses did not have quality financial statements.6 billion. controlling shareholders in the Philippines usually exercise their corporate control through the setting up of business groups. the authorities. arguably. Family-based controlling shareholders use them as vehicles for controlling business groups. Corporate Control by Controlling Shareholders As in many other Asian countries. accounting for 27 percent of the total stock market capitalization that year. However. which are usually controlled by holding companies. e. as large shareholders had no need for financial statements to monitor their companies and management that were under their own control. marketing.

controlling shareholders of a parent company hold these shares as “strategic investments” that they could increase or reduce depending on business opportunities.. and a passive minority investment at 15 percent in Honda Cars (Philippines). namely. Controlling shareholders gain additional leverage in management control over minority-owed companies. controlling shareholders of the parent company do not participate in management. Public investors collectively hold a minority of 41 percent. Ayala Land fully owns Makati Development Corporation and holds a minority stake. controlling shareholders of the parent company may eventually increase their shares to a majority position. especially its management. In cases of minority ownership. Honda Cars (Philippines). minority control at 42.1). They are operating companies but at the same time have majority or minority share ownership in other operating companies. Some holding companies are not pure holding companies. as an example (Figure 3. The first three companies are publicly listed while the fourth.194 Corporate Governance and Finance in East Asia.4 percent of Bank of the Philippine Islands. In an active minority-owned operating company. Selective public listing combined with use of pure holding companies to own and control member companies lead to various organizational structures of business groups.2 percent. It is majority-owned by Mermac. This is most evident when a minority-owned company transacts with other members of the group where the controlling shareholders hold majority control. of Cebu Holdings (a publicly listed government-owned company). II equity investment for public listing. They may have a representative in the board. and customers. These investments can be classified according to the role of the controlling shareholders in the management of the invested company. Ayala Corporation then holds a sufficient number of shares to achieve various degrees of control in two types of holding companies and two types of operating companies. It has a majority control at 71. Minority-owned companies may also need access to resources of the group. Ayala Corporation is a publicly listed pure holding company. Ayala Corporation.1 percent of Ayala Land. Ayala Corporation’s majority. Inc. an active minority share at 44. Depending on the performance of the company. active minority or passive minority holdings. at 47. a family-owned pure holding company.6 percent of Globe Telecom. In a passive minority-owned operating company.and minority-controlled operating companies are also holding companies. The stylized features of control structure of business groups in the Philippines can be illustrated by using a leading Philippine family-based conglomerate. with 59 percent of shares. is privately owned. Vol. the parent company plays an active role in management. financing. .

(15%) MinorityControlled Operating and Holding Company Bank of the Philippine Islands (42.2%) >50% MajorityControlled Pure Operating Company BPI Family Savings Bank (100%) <50% MinorityControlled Pure Operating Company Note: Data as of 31 December 1998.44%) >50% MajorityControlled Pure Operating Company Makati Development Corporation (100%) <50% MinorityControlled Pure Operating Company Cebu Holdings. (58.Figure 3.. Inc. (47. Inc.1 Corporate Control Structure: The Case of Ayala Corporation Family Members 100% Mermac.6%) <15% Passive MinorityOwned Pure Operating Company Honda Cars Phils. .96%) Privately-Held Pure Holding Company Public Investors (41. Inc.04%) <50% Ayala Corporation >50% Publicly Listed Pure Holding Company >50% MajorityControlled Operating and Holding Company Ayala Land (71.06%) <50% >15% &<50% Active MinorityOwned Pure Operating Company Globe Telecoms (44.

11 The Lopez family’s control rights over MERALCO was 5. Diversification and Efficiency of Investment by East Asian Corporations.8%] 5.10 The Ayala family’s control rights over BPI was 1.44%] / [58. they exercise far greater control (two to five times more) than they are entitled to by virtue of their ownership rights. The situation offers large shareholders tremendous incentive to move resources 10 For details.5% x 14.7 times 12 .7 times its cash flow rights by virtue of the double layer pyramid structure of the Ayala group. MERALCO. The control of companies through indirect corporate shareholdings.76%)] [39. and First Philippine Industrial Corporation are indirectly held by a majoritycontrolled holding company. P. 1999b. First Philippine Holdings Corporation.44%] = [42. Rockwell Land. P.7 times Ibid.3% x 1.7 times its cash flow rights by virtue of its cross-holdings via Benpres and First Holdings.196 Corporate Governance and Finance in East Asia. defined as control by large shareholders of an operating company through minority ownership by several companies. and Larry H. Who Owns and Controls East Asian Corporations? 11 Ibid. The Separation of Ownership and Control in East Asian Corporations. Vol. [control right] [control rights via Ayala Corporation] = [cash flow right] [cash flow rights via Ayala Corporation] = [42. Simeon Djankov.14%] / [6. 1998. and Larry H. Expropriation of Minority Shareholders: Evidence from East Asia. H. companies in the Lopez Group are large and minority-controlled.5%] / [(88. Being in the public utilities sector. Generally. and a minority-controlled holding company.64%) + (37. Lang.2). See also Stijn Claessens. see the World Bank research papers by Stijn Claessens.12 These examples show that even when large shareholder groups are minority shareholders.3% x 5. and 1999c. however. Lang: 1999a. [control right] [cash flow right] = = = = = [sum of control rights via Benpres and First Holdings] [sum of cash flow rights via Benpres and First Holdings] [1. a privately owned company. II Bank of the Philippine Islands owns 100 percent of the BPI-Family Savings Bank. Joseph P. Simeon Djankov. Fan.64% +37. The Lopez Family owns a significant portion of shares of these companies if these indirect shareholdings are summed up and attributed to the beneficial owners. Benpres Holdings.5%] [39.98% x 42.14%] / [1.44%] / [25%] = 1. indirect shareholdings do not appear to be a prevalent practice in the Philippine corporate sector. is illustrated in the Lopez Group (Figure 3.

Inc.64% MinorityControlled 14.2 Corporate Control Structure: The Case of Lopez Group Public Investors Family Members Lopez.7% 62.5% Operating Company MajorityControlled Operating Company Rockwell Land Corporation 24.5% First Philippine Industrial Corporation 50% 50% Note: Data as of 31 December 1998. Privately-Held Pure Holding Company 88.Figure 3.76% Operating Company MinorityControlled 24. .5% Minority-Controlled Publicly Listed Pure Holding Company First Philippine Holdings Corporation Benpres Holding Corporation Majority-Controlled Publicly Listed Pure Holding Company Manila Electric Company 1.3% 11.

Some 85 percent of respondents believed that creditors had no influence or only weak influence on corporate management. However. while 80 percent reported that creditors with which they had renegotiated loans were still willing to lend to them. Control by Creditors According to the ADB survey. The controlling shareholders could also use the resources of minority-owned subsidiaries to engage in overexpansion and empire building investments. The average company. 3. a publicly listed company dealt with an average of eight banks and six nonbank financial institutions. Suspension of Payments of Debts Under PD 902-A. SEC could suspend the rights of a creditor to demand payment from a borrower in accordance with the terms of the loan . Vol. it was not common for creditors to take legal action against debtors or foreclose on those assets held as collateral in cases of default. Most responding companies had dealt with their commercial bank creditors for more than five years and nonbank creditors for only about two years. Sixty-one percent of respondents indicated that creditors usually asked for collateral for all types of loans.3.3 The Role of Creditors in Corporate Control This study examines the role of creditors in corporate control by looking at (i) how corporate borrowers perceive the control power of their creditors. whether for working capital or capital expenditure.198 Corporate Governance and Finance in East Asia. and (ii) how the legal framework protects creditor interests and rights. II from their subsidiaries to their majority-owned publicly listed holding company or elsewhere up the pyramid. The survey results also revealed that creditors did not intervene in the management of borrowing companies and wanted to maintain business relationships with corporate borrowers even when they were in trouble. Most respondents (81 percent) indicated that they had renegotiated with their creditors on loan repayment when they faced liquidity problems. Only a minority of respondents (18 percent) indicated that they had faced adverse creditor actions such as a collection lawsuit or foreclosure of collateral. the data suggest. accessed nonbank creditors for specific purposes but dealt with commercial banks on a long-term basis.

it is not clear whether the corporate borrower’s assets are of sufficient value to cover its liabilities. the borrower requests to defer payments for a certain period to enable it to generate the necessary liquidity. Commercial banks hold about three fourths of the resources of the financial system. SEC could intervene to avoid asset dissipation. The corporation continued to be under rehabilitation receivership as of June 1999. a company’s assets are of sufficient value to cover all of its debts. could take an indefinite period. In practice. Under such circumstances. which determines the viability of the rehabilitation plan and appoints a Mancom or a rehabilitation receiver to implement the proposal if approved. the litigation process. profitable companies from going public. bank credit is the main source of corporate financing. The first mode is for simple suspension of payments. including the rehabilitation of the corporation. Inc. The borrower will propose a rehabilitation plan to SEC.. Under this mode. This explains why creditors invariably oppose any move by borrowers to file for suspension of payments at SEC. Markets for equity and debt instruments are small and there are serious structural problems that discourage large. For example. There are no legal or practical limits to the time period of suspension of payments. The second mode is for suspension of payments with the appointment of a management committee (Mancom) or rehabilitation receiver.4 3. Publicly listed companies do not represent a cross section of the Philippine corporate . 3.1 Corporate Financing The Financial Market and Instruments The Philippine financial market has remained underdeveloped compared with other countries in the region. Consequently. The law on suspension of payments envisions resetting the corporation’s business for a temporary period to prevent its irreversible collapse. a real estate-based business group.4. An impending conflict between the two parties could result in dissipation of assets of the company due to creditors’ action to liquidate the company’s assets they hold as collateral. SEC and the court required that the creditors of BF Homes. PD 902-A granted SEC blanket powers to intervene and adjudicate claims. under which. wait for 14 years from the time the company petitioned for suspension of payments in 1984.Chapter 3: Philippines 199 agreement. There are two modes of suspension of payments under PD 902A.

preferred stocks. and less engaged in risky investments. Most publicly listed companies issue only up to 20 percent of total shares to the public. Malaysia. The market capitalization of the Philippine stock market in August 1997.14 shows that the average volume of daily trading in 1997 stood at P2. Table 3.4 billion (or $59 million using the average exchange rate). the Republic of Korea (henceforth. Equity instruments include common stocks.g. Equity financing through IPOs was active.000 companies. and fiscal management were among interrelated factors explaining the underdeveloped state of the Philippine financial market.200 Corporate Governance and Finance in East Asia. this is because. The period 1993-1997 was one of lower inflation and declining lending rates. Rising stock prices during the Ramos administration reflected to some extent the business optimism. The ratio of market capitalization to GDP over the last 15 years put the development of the Philippine stock market at par with other developing markets in the region (e. Korea) ($143 billion). the country experienced double-digit inflation. is far ahead of the flock. however. inflation. less exposed to foreign debt. Foreign funds were wary of the Philippine stock market because of its limited liquidity. Most companies invested only in projects that met hurdle rates as high as 20 to 30 percent and had short payback periods. Interest rates.7 billion. Vol. and Indonesia ($61.5 billion). As a result. the collapse of the stock market during the Asian financial crisis suggested that the earlier stock price surge in part reflected the “bubbles” common to other stock markets in the region. The Government financed its chronic fiscal deficits by issuing short-term Treasury bills. II sector. compared with other economies. The corporate sector raised a substantial amount of . From the 1970s up to the early 1990s. In part. The crisis affected the Philippine corporate sector. but not to the same extent as it did in other Asian economies. Of the 221 companies listed in the Philippine Stock Exchange in 1997. was one of the smallest in the region at $47. companies expanded only at a moderate pace. only 84 had sales large enough to be placed in the top 1. Foreign portfolio investments also remained small. about the size of Thailand’s.. Even in the real estate sector. They invested in only a few large companies whose shares were relatively liquid. and convertible securities. compared with Malaysia ($186 billion). Philippine companies were less leveraged. However. The stock market was depressed up to the early 1990s. most listed companies are controlled by their five largest shareholders. The Philippine stock market is not a liquid market. while interest rates were at high levels and volatile. especially short-term debt. Korea and Thailand). the minimum required to qualify as a public corporation.

7 41.5 1.906.5 Year 369.9 114.3 314.3 Market Capitalization (year end.7 0. P billion) 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 19.6 1.9 682.2 3.6 1.2 ($ million) — — — — 6.0 0.5 12.5 16.2 297.7 2.4 Ratio of Market Capitalization to GDP 0.2 1.686.545.4 9.6 261.2 0.4 728.3 — = not available. 1983-1997 Daily Trading Volume (P million) — — — — 129.251.3 59.171.3 0.2 925.8 1.1 5.0 161.2 0.248.1 88.4 1.7 1.8 102.1 524.5 26.2 61.8 0.474.Table 3.2 59.9 2.692. P billion) Gross Domestic Product (current prices.8 1.7 207.9 2.421.088.8 1.2 1.351.3 2.1 0.5 72.0 0.515.0 1.5 571.2 57.9 608.8 799.121.0 2.3 0.5 1.1 0.386.9 1. Note: Combined transactions of Makati and Manila Stock Exchanges are not available for the years 1983 to 1986.445.1 0.077. Source: PSE databank.14 Philippine Stock Market Performance. .373.1 0.9 12.3 4.3 158.7 391.0 0.

The picture of the financial system that emerges is thus one of limited capital markets. This is because only companies with strong capitalization and predictable cash flows such as public utility companies can issue bonds.2 Patterns of Corporate Financing The study looked at retained earnings. which were the principal source of corporate financing in the Philippines. lack of competition among financial institutions. The measures used in the analysis are: . Corporate bonds are another type of debt securities. Only the commercial banks. leases. Vol. Because existing shareholders wanted to retain their proportionate control over their companies. Few companies offer preferred stocks because the Philippine tax system does not allow tax deductibility of dividends on preferred stocks. which buy commercial papers either for their own account or for their clients. and high transaction costs. However. and inventory financing. Under SEC regulations. Debt instruments include negotiated credits and debt securities. From 1988 to 1997. asset-backed credits.. because business groups often own large commercial banks. corporate bond issuing was even more limited. by virtue of their large stakes in the financial system. discounting of receivables. and the dominance of large commercial banks. which in most cases is an affiliate of the issuing company. moreover. and debt as sources of corporate financing by using flow of funds analysis. which ultimately influences the pricing of commercial paper issues. Negotiated credits. of which 85 percent was raised from 1993 to the first half of 1997. The underwriter. by volatile interest rates and the absence of a secondary market. II equity capital through IPOs during the stock market boom from 1993 to the first half of 1997. include bank credits. sells these commercial papers through brokers. are in a position to provide such discipline. issuing companies had to undergo a process of review and credit rating by the Credit Information Bureau Inc.4. Only a few large companies floated commercial papers because of the limited market. a strong regulatory system for bank supervision is imperative. 3. Capital markets cannot provide the market discipline that corporate investors need. Debt securities include commercial papers and corporate bonds.202 Corporate Governance and Finance in East Asia. However. tight regulations. the rights issue was a popular way of raising equity capital.6 billion. about 127 companies went public with a total value of offerings of about P134. The largest buyers have been commercial banks. new equity. The corporate bond market was stunted.

5 0. As shown in Table 3.5 0.1 0.6 0.7 0.2 0. Self-financing ratio of total assets (SFRT): ratio of changes in retained earnings to changes in total assets.000 Corporations in the Philippines from 1988 to 1997. the average SFRF was high at 109 percent.2 0.3 0. during this period.4 1. it is one minus IDFR.3 0.3 0.Chapter 3: Philippines 203 (i) (ii) (iii) (iv) (v) Self-financing ratio of fixed assets (SFRF): ratio of changes in retained earnings to changes in fixed assets.5 0. All Companies Financial flows data were derived from the SEC-BusinessWorld Annual Survey of Top 1. 1988-1997. New equity financing ratio (NEFR): ratio of changes in stockholders’ equity (excluding retained earnings) to changes in total assets.3 0.15.1 Average 1.4 0.9 0.1 0.1 0. the SFRT was low at Table 3.0 0. 1989-1997 Financing Indicators SFRF SFRT NEFR IDFR IEFR 1989 1990 1991 1992 1993 1994 1995 1996 1997 1.2 0.9 0.3 0. It measures a company’s reliance on borrowings in financing asset growth. .6 0.1 0.5 0.4 0.15 Financing Patterns of the Corporate Sector.4 0.5 0. Incremental equity financing ratio (IEFR): ratio of changes in shareholders’ equity inclusive of retained earnings to changes in total assets.5 0.8 0.5 0.9 0.5 0.5 0.4 0.4 0.0 0.8 0. It measures a company’s capacity to finance growth in fixed assets by internally generated funds.2 0.4 0.8 0. Retained earnings were sufficient to finance the entire growth of fixed assets in the corporate sector.000 Corporations in the Philippines. On the other hand.3 0. Incremental debt financing ratio (IDFR): ratio of changes in total liabilities to changes in total assets.2 0.4 0.6 0.3 0.5 Source: SEC-BusinessWorld Annual Survey of Top 1. It measures a company’s capacity to finance asset growth by equity capital. It measures a company’s capacity to finance asset growth by internally generated funds.5 2.9 0.1 0. By definition.

Vol. 1988-1997.and foreign-owned.8 0. It can also be observed that the relative importance of stockholders’ equity (including retained earnings and new equity investment) was declining and that of debts increasing in financing the growth of the corporate sector from 1991 to 1997. In all the years.3 0. In periods of an economic crunch such as in 1989.3 0. The corporate sector used new equity to finance 32 percent and new debts to finance 49 percent of growth in total assets.0) 0. except for foreignowned companies that had a negative new equity financing ratio. There were significant year-to-year variations. with debt providing 93 percent of the financing requirements. 1991. Retained earnings were the least important. Corporate Financing by Ownership Type As shown in Table 3. II only 19 percent. 1989-1997 Financing Indicators SFRF SFRTa NEFR IDFRa IEFRa a Publicly Listed 1. internal funds were not a significant source of financing growth in total assets.204 Corporate Governance and Finance in East Asia.2 0. The corporate sector consistently relied on debt and new equity to finance asset growth throughout the period.5 Foreign-Owned 1. the level of corporate leverage increased.5 0. On Table 3.16 Corporate Financing Patterns by Ownership Type.6 0. Companies financed fixed assets from internal sources in hard times. .2 (0. for all three types of companies—publicly listed. and 1997. This was mainly caused by the declining contribution from retained earnings. except in 1991. As a result. reflecting the capital flight caused by political instability in the early 1990s.3 0. retained earnings declined and few new equity investments flowed into the corporate sector.1 a Excludes negative balances.9 0. suggesting that there was a deterioration of financial performance in the Philippine corporate sector in the years running up to the crisis. debts were the most important source of financing.16.3 0.000 Corporations in the Philippines. when it financed 45 percent of it. Source: SEC-BusinessWorld Annual Survey of Top 1. implying that internal funds were far from sufficient to finance growth in total assets.7 0.5 Privately-Owned 0. privately. In 1997. Total assets grew by 23 percent that year. the SFRF was higher.

9 16.1 9. especially bank loans.4 2.4 100.8 26.8 0.5 41.9 0.1 49. significantly Table 3. publicly listed companies relied more on new equity financing than privately.4 100.0 38.6 48.9 16.0 8.7 13.0 53.8 0.0 100. A breakdown of the financial structure of publicly listed companies measured in balance sheet items is shown in Table 3.8 4.4 100.17.4 41.3 10.3 11.0 Source: SEC-BusinessWorld Annual Survey of Top 1.6 43.4 3.0 9.7 2.3 10.3 48.3 12.6 26.1 15. 1988-1997.1 50.0 12.8 39.0 9.8 38.4 100.8 16.Chapter 3: Philippines 205 average.2 3.0 9.7 2. .5 16.3 4. compared with 47 percent for publicly listed companies and 55 percent for privately-held firms. The sector built up its short-term debts. 1992-1996 (percent) 1992 Assets Cash and Temporary Investment Accounts Receivable Inventory Other Current Assets Total Current Assets Investment Fixed Assets Other Assets Total Assets Liabilities and Equity Accounts Payable Short-Term Loans Other Current Liabilities Total Current Liabilities Long-Term Debt Other Long-Term Debt Other Long-Term Liabilities Total Liabilities Stockholders’ Equity Total Liabilities and Stockholders’ Equity 14.0 1994 19.8 46.5 9.000 Corporations in the Philippines.3 51.8 17.2 12.3 12.6 48.1 13.9 16.2 42.4 43.5 12.0 10. contributing 90 percent of growth in total assets.2 100.9 12.7 4.5 0.4 10.7 23.8 3.9 24.and foreign-owned companies.1 10.0 1995 1996 13.7 7.8 3.7 13.5 27.6 37.0 6. Foreign-owned companies relied more heavily on debt financing.4 12.2 3.9 100.3 12.2 51.9 38.1 7.4 2.9 4. It presents a composition analysis of assets and financing sources for the period 1992-1996.0 9.3 13.8 51.2 100.0 13.0 10.6 0.0 1993 14.17 Composition of Assets and Financing of the Publicly Listed Sector. This financing pattern supports the earlier finding that foreign-owned companies had the highest leverage among the three types of companies.8 100.7 100.9 3.

Table 3. Vol. the current ratio.3 0. Corporate Financing by Control Structure Conglomerates have certain advantages in financing because of the opportunities offered by the internal capital markets. As shown in Table 3.5 0.5 0. retained earnings financed 113 percent of growth in fixed assets and 23 percent of growth in total assets from 1989 to 1997 for business groups. group companies usually financed their investment in member companies by equity rather than debt.13 was at 1. the average SFRF of business groups was higher compared with that of independent companies. their inherent ability to pool risks. The traditional measure of liquidity. and economies of scale in fund raising. 1989-1997 Financing Indicators SFRFa SFRTa NEFR IDFRa IEFRa a Group Member 1.18. Group companies financed an average of 45 percent of growth in total assets by debt. the easier access to external credit. group companies were less reliant on debt financing than 13 Defined as total current assets divided by total current liabilities.3 0. for independent companies.2 0. For these two reasons. II in 1996 and became more vulnerable to the financial crisis in 1997. indicating that many publicly listed companies were likely to be in a tight liquidity position. respectively.6 Independent Company 0. The SFRF for independent companies would have been even lower if the highly profitable foreign-owned companies were excluded. Further. The normal standard liquid position is a current ratio of 2 or higher. compared with an average of 54 percent for independent companies.206 Corporate Governance and Finance in East Asia. On average.1 0. .18 Financing Patterns by Control Structure.5 Excludes negative balances Source: SEC-BusinessWorld Annual Survey of Top 1.9 0.45 in 1996.3 0. as opposed to 94 and 30 percent.000 Corporations in the Philippines. 1988-1997. Group companies were generally more profitable than independent companies.

19 Financing Patterns by Firm Size.9 0.5 0. 1988-1997.06.4 Small 0. averaging 61 percent of growth in total assets.76 for small companies and 0.2 0. and 1997 with 131 percent. 1993 with 96 percent.5 Medium 3. Source: SEC-BusinessWorld Annual Survey of Top 1.47. medium-sized companies used more debts. Excluding . These years were 1991 with 110 percent.2 0.2 0. Corporate Financing by Industry The manufacturing sector had an average SFRF of 1.3 0.000 Corporations in the Philippines. equity financed 42 percent of incremental asset growth.1 0. with an average of 3.6 0. The medium-sized companies’ high debt financing ratio was due mainly to three years of complete reliance on debt to finance growth.6 0. 1989-1997 Financing Indicators SFRFa SFRTa NEFR IDFRa IEFRa a Large 0.3 0.50 (Table 3.20).3 0.Chapter 3: Philippines 207 independent companies.55 was substantially higher than the small companies’ 0. compared with 55 percent for large companies and 47 percent for small ones. These results support the earlier finding that the leverage of business groups was lower than that of the independent companies from 1988 to 1997.5 Excludes negative balances. The corresponding ratio was 0. Large companies’ IDFR of 0. The lower SFRF for large companies may be caused by their larger outlays for growth in fixed assets. Table 3. Corporate Financing by Firm Size SFRF was highest for medium-sized companies. On average. Large firms consistently increased their reliance on debts from 1994 to 1997. With assets growing at a fast pace during this period.08 and SFRT of 0.19).88 for large companies (Table 3.8 0. There was also increased reliance on debt financing.

In the eight years preceding the crisis. Equity financed an average of 62 percent of total asset growth.58 and SFRT of 0. while SFRT averaged only 0.3 0.5 0.20 Financing Patterns by Industry. During the crisis year.4 Construction 0. with an SFRF as low as 0. achieving an average SFRF of 3.5 (0. when debts declined.6 0. Table 3.6 0.32. the incremental equity ratios of the industry were high. many of the leading real estate companies successfully went public during that time. The construction sector was a heavy user of debt financing. Up to 1997. the manufacturing industry financed 57 percent of its total asset growth by debt.91. The utilities sector showed weaknesses in internal fund generation in 1989-1994.4 0.29. 1988-1997.3 0. The situation improved beginning 1994. .6 a Excludes negative balances.208 Corporate Governance and Finance in East Asia.000 Corporations in the Philippines. Excluding 1997 when fixed assets declined.79 and in 1997 at 0. While this level is considered prudent. The sector had the highest leverage among all industries that year. Source: SEC-BusinessWorld Annual Survey of Top 1.6 0. increasing to 0.27. Incremental equity financing amounted to an average of 44 percent of total asset growth. Vol. II 1991.3 0.04. the industry generated internal funds.47 two years later.4 0. 1989-1997 Financing Indicators Manufacturing SFRFa SFRTa NEFR IDFRa IEFRa 1. Low incomes diminished the equity financing position of the manufacturing industry toward the crisis year. the total debt ratio was much higher in 1996 at 0. debt financed about 78 percent of asset growth in real estate.7 0.2) 0.5 Utilities and Real Estate Services and Property 0. The effects of the crisis of 1997 were adverse.4 3. Equity financed the rapid expansion in the industry’s assets in the period 1994 to 1997. Its SFRF and SFRT were volatile because of chronic losses and reduction in fixed and total assets. Since the real estate boom coincided with that of the stock market. SFRF for the sector averaged 0.5 0.4 0.1 0.3 0. Total liabilities increased partly as a result of the local currency devaluation and financed all of asset growth for the year. The real estate industry financed its growth by substantial equity funds. ranging from 41 to 118 percent.

more profitable.21 Ownership Concentration. the degree of ownership concentration.421 0. ROE. measured by the percentage of shareholdings of the largest five shareholders. Source: Author’s estimates based on the PSE databank. ROE. knowing that if an investment turns out to be successful they could capture most of the gain. and Performance Previous studies on corporate governance have often associated ownership concentration with heightened risk-taking by companies. was regressed against measures of profitability and of financial leverage. Exit. As shown in Table 3.14 Large shareholders may borrow excessively to undertake risky projects. Using the PSE database.004 3.769 0. These results suggest that companies with higher ownership concentration tend to be more highly leveraged and. and the Failure of Internal Control Systems. and leverage.860 Leverage = the ratio of total assets to total equity. Large shareholders may also overuse financial leverage to avoid diluting ownership and control. 1992-1996.21.Chapter 3: Philippines 209 3.3 Ownership Concentration. Journal of Finance 48: 831-880. Financial Leverage. ownership concentration = the total shareholdings of the top five shareholders. as the dependent variable. at the same time. Table 3.287 0. creditors bear the consequences. 14 See for example Michael Jensen (1993). ROA = return on assets. The Modern Industrial Revolution. .230 Leverage 0. ROE = return on equity. ROA. Profitability. and Financial Leverage Dependent Variable Item Coefficient of Ownership Concentration T-statistics Adjusted R-squared F-statistics ROE 0.4. alternatively.00056 1.00036 2. Three regressions were run with the shareholding of the largest five shareholders as an independent variable and ROA.009 5.130 ROA 0. the coefficient of the ownership concentration measure in all the three regressions is positive and statistically significant. while if it fails.00125 2. and financial leverage are all positively and significantly related to the degree of ownership concentration.008 5.

the growth in foreign investments fueled that of the manufacturing and services sectors in the years preceding the crisis.5. In sum. the economy still showed vestiges of its import-dependent and substituting character. but its share had been declining by 4 percent per year since 1995. the country’s GDP growth pace indicated that it did not have a “bubble economy. Garments was the second largest export sector at about 9 percent. Manufactures accounted for about 85 percent of exports. Because of limited local capital.1 The Corporate Sector in the Financial Crisis The Financial Crisis: Causes and Manifestations A devaluation of the local currency signaled the arrival of the financial crisis in 1997. which averaged 4.5 billion in 1996 and grew at an average of 48 percent per annum from 1992 to 1996. and agriculture at 21 percent. In 1997. industry at 34 percent.” that is. Compared to other East Asian crisis-affected countries.210 Corporate Governance and Finance in East Asia. an overexpansion of capacities. Net trades in goods and services averaged a deficit of 4. The largest contributors to GDP were services at 43 percent.5 percent per year from 1992 to 1997. more than half (52 percent) of exports were semiconductors. Historically. Net investment inflows were $3. Vol. and intermediate goods. Commercial and industrial activities in the country were largely oriented to domestic markets. Exports were growing at about 20 percent per year in the three years preceding the crisis.5 3. The Government explained that the country had “sound economic fundamentals” but that the problems were caused by “contagion. II 3. Although much lower than those of other Asian countries. The structure of the economy may be understood by looking at its sectoral composition and export competitiveness. the country was less dependent on foreign private capital.8 percent of GDP from 1995 to 1997. The costs of an economic correction brought about by the regional financial crisis were thought probably to be low due to the sound structure of the real economy and the strong position of the financial sector. notably remittances of overseas workers. The export sector had a very narrow breadth. with commodities accounting for the balance. About 80 percent of imports were capital goods (particularly power generating and telecommunications equipment). After a . raw materials. their growth gathering momentum only beginning in 1992. with a narrow exporting industry base. foreign investments in the country have been low.” The Government’s judgment that economic fundamentals were strong was based on stable growth rates. The country experienced balance of payments surpluses but these were due to transfers.

6 billion as of March 1997. The Central Bank conserved international reserves by allowing the local currency to float within a wider trading margin. Economic performance during 1992-1997 was characterized by an average growth rate of real gross national product (GNP) at 3.8 percent. Five years of stable growth before the crisis enabled the country to build its net international reserves to $10. unlike their counterparts in the region. depended on the quality of the corporate sector’s investments. an average inflation rate of 7. average ROE was 13. a positive balance of payments from 1992 to 1996. Eventually. shows that investments of the corporate sector were growing at a faster rate than sales revenues in the years immediately preceding the crisis. the Government sought stability and achieved this in 19921997. From 1988 to 1996. Financial institutions called on their shortterm loans and shortened the maturity of existing loans. Closer analysis. Total debts were only 52 percent of assets or 108 percent of equity. After hovering in the range of 100 to 127 percent. the country and the corporate sector had no access to foreign currency debts from the international financial market. which.Chapter 3: Philippines 211 long period of debt moratorium and restructuring that started in 1983 and ended in 1991. fueled also by successful IPOs during the stock market boom of 1993-1996. Since the regional financial crisis was triggered by the loss of confidence in some East Asian economies by foreign creditors and investors. The lessons from debt restructuring became the basis for the Government’s economic policies. the ratio of short-term debts to international reserves dipped below 100 percent beginning June 1998. and a relatively healthy banking system. Profitable operations since 1992 had allowed it to build equity. an average Treasury bill rate of 13. the discipline of the loan moratorium and the restructuring of the country’s loans to long-term maturity kept this ratio below 100 percent up to September 1997. The adverse impact of the crisis in most Asian countries was proportional to the amount of short-term foreign debts relative to net international reserves. resulting in stability in the short-term debt to reserves ratio. During this time. the Government restructured its debts into longer tenors with a maximum of 25 years. assets grew at a compound annual rate of about 31 percent.5 percent.3 percent. The corporate sector was in a relatively stable financial condition around the time of the crisis. In the Philippines. . a government fiscal surplus from 1994 to 1997.1 percent. adjustments were focused on the quantity and quality of the banking system’s corporate loans. while sales grew by only 20 percent per year. Prudent fiscal management and controls on foreign borrowings were part of the adjustments required by IMF and foreign creditors. From 1993 to 1997. however. in turn.

II The corporate sector indeed overexpanded after 1993 like its counterparts in the region. Net foreign portfolio investment amounted to $1. Sources: Bangko Sentral ng Pilipinas and SEC. precisely. mitigated the effects of the pullout and liquidation of investments in the aftermath. Vol. Data for 1998 cover only January-August. The debt level of the Philippine corporate sector in 1997 was low by Asian standards but still high by developed country standards. Table 3.073 (406) 121. net FDI remained stable at more than $1 billion.101 92. In 1997.749 26.303 23.06. These patterns in investment and financing are similar to those of other countries in the region.609 1. the country’s economic and corporate sector growth in 1994 to 1997 appeared to have been part of a positive “contagion” effect of optimism by investors and creditors about the region. the other immediate impact of the crisis was that on foreign investment flows.5. But portfolio investment amounting to $406 million flew out of the Philippines.5 billion in 1995. It financed 26 percent of corporate capital growth.22 Foreign Investment Flows. Net foreign investments more than doubled from 1995 to 1996 but declined by 78 percent in 1997 (Table 3. 1997 = 29.4 1997 762 1.212 Corporate Governance and Finance in East Asia.101 billion or 196 percent of net FDI in 1996.” 3.074 2.0 1998 739 555 328 69. .47. Most of this leverage happened during the boom years in the region.71. In sum.22.517 1. or 114 percent of net foreign direct investment (FDI).650 32.7 Note: Peso-dollar exchange rates used are: 1995 = 25. Foreign investments in the Philippines have not been as high as the inflows to other Asian countries—and this. It is understandable then that the effect of the Asian financial crisis on the Philippines was correspondingly that of a negative “contagion.485 145. It rose to $2.718 30. but to a lesser degree. 1995-1998 Item Net Foreign Investments ($ million) Foreign Direct Investment (FDI) Foreign Portfolio Investment Net Capital Increase by Corporations (P million) Net FDI as a Percentage of Corporate Net Capital Increase (%) 1995 1. Debts financed a large part of this expansion. 1998 = 41.22).2 Impact of the Crisis on the Corporate Sector Aside from the foreign exchange adjustment. 1996 = 26.0 1996 3. growing by about 34 percent per year from 1994 to 1997.300 1.

and the wholesale and .513 billion. Average bank lending rates climbed to their peak of 25. Because of weak internal fund generation. The banking system was able to absorb the impact of the crisis primarily because of its strong capital position. depended on the liquidity and capital position of commercial banks. in turn. Manufacturing reduced its loans outstanding by 11 percent from October 1997 levels. Bank loan pricing was based on the bellwether 91-day Treasury bill rates rather than inflation. they could not initiate a large reduction of their loans because these in part financed long-term growth in assets. in varying degrees for each sector.2 percent in November 1997.2 to 28.369 billion. and leverage increased to 149 percent compared with 109 percent in 1996. new borrowings financed asset growth. Loan calls. then rose to a high of 22. meanwhile.3 percent of assets. With the increase in borrowings and reduced liquidity. which held about 75 percent of the assets of the financial system in 1997.7 percent in January 1998. suggesting that commercial banks required a higher premium at about the height of the crisis but not beyond. Because commercial banks were strongly capitalized. Lending rates were well above the 20 percent level from July 1997 to March 1998. lending rates also came down. When the Treasury bill rates eased in March 1998. with commercial banks holding P2. Net profit margins were at a 10-year low at 4. The interest rates on Treasury bills. The real problem of the corporate sector during the crisis was the rise in interest rates. The combined effects of shrinking demand and high interest rates reduced the corporate sector’s demand for loans. ranged from 11 to 13 percent from 1993 to July 1997. Although corporate borrowers were not highly leveraged. By October 1998. ROE at 6. sparking a rise in interest rates on corporate loans. the commercial banking sector’s capital remained strong at 17. A number of small banks closed but they represented less than 1 percent of the financial system’s total resources.Chapter 3: Philippines 213 Corporate financial performances and conditions deteriorated during 1997. albeit at current market interest rates.2 percent was barely above inflation rate. Loans outstanding of commercial banks declined by the first quarter of 1998. they were willing to restructure and renegotiate existing loans by corporate borrowers.9 percent. Bank spreads over Treasury bill rates increased in 1997 but were within the range experienced in the past. Companies deferred investments in new fixed assets. the corporate sector became vulnerable to loan calls and high interest rates. the sectors with the highest outstanding loans had reduced their credit exposures. The resources of the financial system that year totaled P3. By March 1988.

and set up a hedging facility for borrowers with foreign currency-denominated loans. However.214 Corporate Governance and Finance in East Asia.3 percent in December 1997. real estate loans averaged 11. The pattern indicates that real estate loans were of substandard quality but banks had contained the problem by mid-1998. by 12 percent. II retail trade sector. as with its counterparts in other Asian countries. But the Philippine banking system had gone through worse crises in the past. thereby reducing overall intermediation costs. was a problem sector. and its experience of low. This allowed the Central Bank to convince the banks. the aggregate effect of the crisis on NPLs was of a magnitude comparable only to the country’s last major banking crisis in 1984-1986. to reduce their lending spreads over the 91-day Treasury bill rates from 3-8 percent to 1. The move retained the liquidity position of banks but lowered their cost of reserves. through the Bankers’ Association of the Philippines.3 Responses to the Crisis Government Responses The Government’s policy and regulatory responses to the crisis focused on monetary and credit issues. the ratio increased to a high of 11. loans outstanding of the real estate sector increased by 11 percent from June 1997 to June 1998. These peaked at 14. single-digit NPL ratios began only since 1989.9 percent of bank loan portfolios.6 percent in June 1998.5 percent by September 1998. Vol. and the financial system. The latter measure was especially beneficial to companies with unhedged foreign currency loans from commercial banks. 3. including (i) a regulatory limit of 20 percent on banks’ loans to the . and subsequently went down to 13. This “voluntary agreement” partly explains why the loan spreads of banks were within the range of recent experience.5. Still. In March 1997. The Central Bank introduced regulations on foreign exchange trading to control speculation and nondeliverable forward contracts.5-6 percent. The Central Bank also moved to control inflation and bring down domestic interest rates by reducing the statutory reserve requirement by 3 percentage points and raising the liquidity reserve ratio by the same amount. These figures show that adjustment problems were industry-specific and that the real estate industry. the fiscal position. The Central Bank adopted other measures to strengthen the financial system. set limits on overbought/oversold foreign exchange positions of banks. As for nonperforming loans (NPLs).

(iii) fixing loan loss provisions of 2 percent of the gross amount of loan portfolio on top of individually rated bad loan accounts. (iv) increasing banks’ capital requirement by 20 percent for universal banks (banks with expanded licenses) and 40 percent for ordinary commercial banks. Responses of the Corporate Sector The corporate sector’s financial position. The real estate portfolio of commercial banks also declined and was well below the Central Bank’s regulatory ceiling by March 1998. With its weakened financial position. A 40 percent devaluation of the Philippine peso lowered the purchase price of PLDT to foreign investors. bank loan rates have also come down. (ii) shortening the period for classifying unpaid loans as past due from three months to one month.6 percent growth in 1999. In the case of PLDT. its accessibility to foreign capital. subcontracting and outsourcing. The policy directions and actions taken by the Government appear to have ushered in recovery. Large companies with heavy loan exposures such as Philippine Airlines Inc. In response to calls for lower bank intermediation costs. the corporate sector dealt with the crisis as any company facing a recession and drying up of credit would—companies cut costs by reducing staff. and the legal framework for reorganization and liquidation conditioned its response to the crisis. First Pacific Corporation. consolidating business units. Average Treasury bill rates have cooled since mid-1998. changing technologies. PAL. Takeovers in the past involved cooperative negotiations between purchasers of a target company and family-based large shareholders. which was privatized with the Lucio Tan group gaining control and the Government retaining minority ownership. took more action. Publicly listed Philippine companies could also be restructured through takeovers by local and foreign investors. and giving up noncore businesses. the Government kept inflation below 10 percent. Financially strong companies were able to survive the crisis by effecting such internal restructuring. With prudent monetary management. was known to have a policy . The economy avoided a recession in 1998 and achieved 3. (PAL).Chapter 3: Philippines 215 real estate sector. The acquiring company. the Asian crisis opened a unique opportunity for foreign investors. the country’s flag carrier. (v) improving disclosure requirements on the financial position of banks. and (vi) issuing guidelines on duties and responsibilities of banks’ boards of directors for improved quality of bank management. the largest telecommunications setup in the Philippines. came up with a rehabilitation plan by May 1999 that was found acceptable to all parties.

controlling shareholders can capture these profits by excluding public investors from ownership. 3.6 3. the Soriano family. Its stock price and returns to shareholders had stagnated. PLDT’s large minority shareholders such as the SSS and First Philippine Fund publicly announced their willingness to offer their entire holdings in a block sale at a premium. the stock price of PLDT was buoyant during the takeover period. concentrated ownership of companies is not equivalent to weakness in corporate governance. is whether there are sufficient safeguards to prevent controlling shareholders from . A second method was to purchase the shares of other large minority shareholders. It may even solve agency problems that a separation of control and ownership could precipitate because large shareholders have an incentive to closely oversee management. By itself.216 Corporate Governance and Finance in East Asia. II of investing to control companies that are dominant players in their industries. he restructured the company toward its core brewery business and sold off local and foreign subsidiaries. and Recommendations Summary and Conclusions The Philippine corporate sector has been shaped by the country’s economic and industrial development policies. Although considered the prime industrial company in the Philippines. SMC is another widely-held company managed by a minority shareholder. Corporate governance is conditioned by the high ownership concentration of these large companies. Conclusions. First Pacific could have acquired sufficient shares to take control of PLDT in three ways. When companies are highly profitable. The question. When Cojuangco took over. using some or all of these means. at a premium over the market price to reflect the value of management control. however.6. SMC had lagged behind other groups of companies such as Ayala Corporation in financial performance for some years. Ownership is highly concentrated and a few dominant players control major industries. Consequently. A third method was to make a formal tender offer to PLDT’s controlling minority shareholders. One mode was the outright purchase of shares in the open market. Eduardo Cojuangco was able to assert his ownership of shares taken over by the Government during the transition of power in 1986. the Cojuangcos. Vol. eventually took over PLDT and announced a restructuring plan for the entire group of companies.1 Summary. In a legal process that ended in his takeover of management. First Pacific.

The five largest shareholders have majority control of an average publicly listed company. ownership of banks by business groups. By control structure. the most numerous in the corporate sector. and the lack of market for corporate control. while the largest 20 shareholders control more than 75 percent of shares. The result is that corporate governance depends only on internal controls. By size. Privately-owned companies. influenced by industry characteristics. The corporate sector consistently relied on internally generated funds and equity before resorting to borrowings. were the least profitable. companies that are members of family-based conglomerates had higher returns and lower leverage than independent companies. The financing pattern of the corporate sector was influenced by the tight financial conditions prevailing in the country up to 1992. This study analyzed trends in corporate performance and financing in relation to corporate governance from 1988 to 1997. foreign companies were the most profitable but highly leveraged. to some extent. Financial institutions are not significant shareholders. an underdeveloped capital market. Analysis of corporate financing by ownership . passive independent auditing. oligopolistic market structures. Leverage was within Asian norms but above developed country standards. The Philippine corporate sector was relatively efficient in investing and financing compared with other countries affected by the Asian crisis. with the real estate and public utilities industries standing out for their pronounced cyclical patterns. By ownership structure. Publicly listed companies had the highest profit margins and lowest leverage among the local companies. With large shareholders in control. Returns to capital exceeded inflation rates. Business groups occupied seven of the top 10 and 25 of the top 50 largest corporate entities in the Philippines in 1997. Corporate governance should be viewed in the context of an increasing presence and growth of large shareholders-centered conglomerate business organizations. Performance was.Chapter 3: Philippines 217 expropriating the wealth of minority shareholders through aggressive and risky investment. minority shareholders need to be protected by external control mechanisms. Forming business groups appears to be a viable means of competing because this allows for more efficient organization and utilization of resources of large controlling shareholders. This study points out weaknesses in external control mechanisms such as weak legal protection for minority shareholders. medium companies showed higher profitability than large and small ones. an ineffective insolvency system. Ownership of publicly listed companies is highly concentrated.

A commercial bank is an important part of most business groups. and leverage were all positively related to the degree of ownership concentration. superior profitability. and the extent of supervision of outside institutions such as independent auditors and SEC. the amount of pressure from stock market investors and PSE (for publicly listed companies in the group). Even in cases where the group owned only a minority share of a commercial bank. Large companies owned or controlled by business groups tend to dominate their industries. ROE. After controlling for industry effects. Internal financial markets operated by business groups allowed them to optimize their financial resources at lower external debt levels. The difference between management control and ownership rights is usually substantial. The extent of governance problems depends on internal control policies of the controlling shareholders. as typified by the Ayala Group. Publicly listed companies were responsive to investors’ requirements for prudent use of debts. Such structures result in control by large shareholders through disproportionately smaller investments in equity ownership. Companies whose large shareholders have higher degree of control tend to borrow more but generate better returns. Larger disparities in control over cash flow rights imply higher incentives for large shareholders to (i) expropriate wealth of shareholders not belonging to the controlling group and (ii) invest in empirebuilding and high-risk projects. Business groups with pyramiding structures heighten the issue of corporate governance. The positive relationship between financial leverage and ownership concentration is consistent with the hypothesis that controlling shareholders prefer to use debt financing in order to avoid ownership dilution. The pyramid model is useful for centrally managing smaller companies.218 Corporate Governance and Finance in East Asia. selective public listing of companies in the group. with the foreign-owned companies found to rely more on borrowed funds. II type gave similar results. the bank usually accounted for a large share of each group’s net profits. and centralized management and financing. Vol. Large. A business group is an effective business organizational model for achieving leadership in industries. Family-based business groups have focused their investments in industries where their superior financing capacities and political/social influence give them unique advantages. Ownership concentration was positively related to both returns and leverage. family-based shareholders gain control by such means as the setting up of holding companies. ROA. statistical analysis of company-level data revealed significant relationships between corporate performance and corporate governance. and sustained growth. .

resulting in the banks’ accelerated restructuring of troubled debts in this sector. SEC’s quasijudicial functions. As the crisis wore on in 1998. there was a sharp rise in borrowings and decreasing productivity of investments a few years before the crisis in a pattern similar to that of Asian crisis countries. 3. low inflation. and a market-oriented policy environment. The Central Bank responded by improving the liquidity of the system and by establishing conditions for bringing down interest rates on bank loans. decide on the financial future of a troubled debtor. The Central Bank imposed strict limits on real estate lending. the government budget in surplus. Still. decisions by large sharehold- . That is.6. There are systemic risks involved in highly concentrated ownership. For example. are to be removed and transferred to courts. The corporate sector accessed the foreign debt market only in the mid-1990s because of the country’s long-drawn debt moratorium. Under the new Securities Regulation Code enacted in 2000. The corporate sector was also in good financial condition with rich internal cash flows accumulated from a number of profitable years. rather than the banks that lent millions of pesos. mostly by highly leveraged companies and speculative investors in real estate. with recently restructured public debt. including suspension of payments. there were sharp rises in the number of bankruptcies and petitions for debt relief. SEC officials.Chapter 3: Philippines 219 The financial crisis came when the Philippine economy was in a relatively strong financial position. Specific actions recommended are described below. Promoting a Broader Ownership of the Corporate Sector The highly concentrated ownership of the publicly listed corporate sector should be a concern of SEC and PSE. a strong international reserves position. and sound overall creditworthiness. The crisis caused a tightening of credit to the corporate sector and a spike in interest rates. adversely affecting companies’ operations and financial position. A number of large debtors petitioned SEC for rehabilitation under procedures set by PD 902-A.2 Policy Recommendations The Government should address weaknesses in corporate governance identified in this study by introducing reforms in the policy and regulatory framework and promoting the development of markets. strong capital position built on IPOs in a buoyant stock market. This law is flawed in concept because it supplants a market-based credit agreement with a political process.

inadequate disclosures. depending on the size of the company. Clear legal accountability is a precondition for successful shareholder activism. and self-dealing. To strengthen the board. the PSE Listing Rules require the appointment of a minimum number of independent directors in the board of publicly listed companies. insider information. To help ensure this. This will enable SEC to enforce prudential requirements on management of companies and enable minority shareholders to pursue grievances against their boards. SEC should strengthen disclosure requirements by issuing specific guidelines on minimum disclosures required for related party transactions. they serve to curb the powers of controlling shareholders. Strengthening Minority Shareholder Rights An issue that concerns minority shareholders is whether they have instruments—legal or ethical—that can prevent controlling shareholders from expropriating their wealth through risky investment and financing. The adjustment should be made over a fixed period of time. (ii) require disclosure of material changes in ownership. Another measure would be to impose a statutory limit on the number of directorships that one can accept. Vol.220 Corporate Governance and Finance in East Asia. Increasing the Statutory Accountability of Directors and Strengthening the Board System The Government should clarify statutory fiduciary responsibilities of the board of directors. II ers often cause wide volatility in stock prices and invite reaction from creditors. PSE Listing Rules should specify criteria and a selection process that will help ensure that the nominees for the position are truly independent and qualified. Because independent directors tend to adopt the perspective of minority shareholders in board decisions. It has suffi- . and (iii) increase the minimum required percentage of outstanding shares for public listing in the stock exchange from the present 10-20 percent. The following recommendations involve amendments to the Corporation Code that will improve transparency of ownership and address the current high level of ownership concentration in Philippine business: (i) require disclosures of underlying ownership of shares held by nominees and holding companies. This may limit current practices of appointing prominent individuals and family members as directors. to 25 percent.

For example. prudential measures and regulations. limit. current rules allow boards of directors to approve own-dealings or related party transactions by simple majority. Finally. (ii) set strict limits on lending by banks to affiliated companies. The Government should improve its prudential supervision system to ensure that banks perform their role as external control agents of their corporate debtors. the board can easily muster the needed majority to approve the deal. Improving Financial Regulation and Strengthening Implementation The Asian crisis demonstrated the need to strengthen banking regulation.. The following recommendations aim to further improve banking regulations and supervision in the Philippines: (i) limit shareholdings of nonfinancial companies in banks.g. and disclosure standards. They need legal empowerment such as higher majority voting requirements. e. By requiring sufficient disclosure and a 75 percent majority vote on such decisions. (iv) require banks to follow international financial accounting. in particular. Because ownership is generally concentrated in five shareholders. Minority shareholders have failed to use traditional venues such as the annual general shareholders’ meetings to discipline controlling shareholders that expropriate their wealth. fit and .Chapter 3: Philippines 221 cient case history that can be used as a basis for tightening its disclosure requirements. raising the current two-thirds majority to a three-fourths majority. the board will be compelled to initiate a thorough discussion of the merits of the proposed related-party deals that will require the participation of minority shareholders. (iii) adopt international standards of capital adequacy and ensure that banks comply with these standards. reporting. It is encouraging that the newly enacted 2000 Banking Laws have introduced changes along these lines. the Corporation Code should be amended to impose sufficiently stiff penalties for self-dealings that patently expropriate the wealth of other shareholders. and (v) closely monitor. or prohibit cross-guarantees by companies belonging to affiliated groups. Impose severe penalties for any attempt by banks to circumvent this regulation. officers. directors. and of banks in nonfinancial companies in order to avoid connected lending. in areas of supervisory functions of the central bank. and related interests.

Two measures should be adopted to promote shareholder activism. II proper rule. Vol. Reforming the Legal and Regulatory Framework for Investment Funds and Venture Capital Owners of Philippine publicly listed companies consist of controlling shareholders and investors that hold trading portfolios. and external auditors. and lending to DOSRI. The current law should expand class action suits to include management and . In developed capital markets. Other investors benefit from the information that analysts produce for these institutional investors as information technology makes their output a public good. foreign ownership of banks. transparency. The absence of institutional investors indicates that the legal and regulatory basis is inadequate. Institutional investors impose market discipline by voting on strategic corporate decisions. This way. Promoting Shareholder Activism Promoting shareholder activism to encourage small shareholders to actively monitor management is an approach that has not been tried out in the Philippines. If institutional investors are present. One is improved transparency and disclosure on specific items that potentially involve expropriation of wealth of minority shareholders. The other is the addition of provisions in the Corporation Code to facilitate class action suits against corporate directors. management. This investor profile has a “missing middle”—long-term investors who intend to participate in longterm growth of a company and who also trade shares depending on company performance. Investment and venture capital funds meet this description. SEC and PSE can help ensure that these external control agents provide market discipline even in companies controlled by large investors. By supporting the establishment and operation of institutional investors. institutional investors can be a driving force in providing market discipline to management. an active financial analyst community can begin to form. SEC appears to be taking a primarily regulatory posture in the operation of investment funds. institutional investors lead public investors in providing market signals to companies. Managements find that their investment and financing decisions affect stock prices and become aware of their responsibility to create shareholder value. Its priority is to protect prospective fund investors from unscrupulous fund managers.222 Corporate Governance and Finance in East Asia. Presently.

leadership. the Government could develop the market for future issues of corporate bonds. Promoting Competition in Product Markets The Government should pursue industrial development policies that promote competition through the elimination of subsidies. It should develop a medium-term yield curve for the corporate debt market by strengthening the Government bond market. and the external auditors. where the threat of class action suits alone is sufficient to encourage quality decisions and behavior from management. These groups have an incentive to gather technical expertise. Companies are likely to remain dependent on bank financing if the authorities do not strictly enforce prudential lending regulations. There are existing institutions such as Dun and Bradsreet. entry . Promoting the corporate bond market requires that the Government develop trading systems and services of credit risk rating of corporate issuers. Placing the means for prosecuting in the hands of minority shareholders may instill more discipline in controlling shareholders. Legal provisions for class action suits should cover self-dealing by directors. The present provision on class action suits is inadequate because shareholders view the process as ineffective and expensive. Securities market development efforts should coincide with strict regulation of the commercial banking sector. SEC should take steps to simplify the process of class action suits and provide an avenue for out-of-court settlements similar to practices in the US. compensation contracts. and dividend decisions. information disclosures. The Government should enhance the securities markets as an alternative source of corporate financing and pursue aggressive development of the local debt securities markets. and Credit Information Bureau that can be the starting point of this effort. guarantees. Expanding Debt Securities Financing The Philippine corporate sector relies on bank loans because controlling shareholders do not want to dilute their control by issuing equities. Philippine Government Treasury bonds should provide bellwether rates for corporate bonds in the way that they have for short-term bank debts. SEC should allow minority shareholders to be represented by activist groups.Chapter 3: Philippines 223 auditors. their directors and management. and broad-based political and popular support to pursue possible cases involving expropriation of minority shareholders’ wealth. And by issuing Government Treasury securities in longer tenors.

Many of the problems associated with auditing and disclosure stem from the tendency of SEC and PICPA to be satisfied with replicating what their counterparts in the US require by way of audit standards and disclosures. and various other forms of protection. there is a need to increase the supply of quality securities from top-tier local companies in the Philippine stock market. The increase in percentage of public holdings may be gradually implemented to enable the companies to adjust. Improving External Audit Standards and Information Disclosure Effective external control in corporate governance requires accurate and timely information about companies. Lack of liquidity deters institutional investors. SEC should require that a larger percentage of publicly listed companies’ shares be sold to the public. and publicly listed companies trade barely the minimum number of shares required for public listing. The resulting absence of a strong investor base makes share prices vulnerable to manipulation or insider trading by large shareholders. Penalties for poor conduct of auditing by independent . Another problem is the orientation of external auditors to the interest of large shareholders rather than public investors. The Government should also continue to improve infrastructure.224 Corporate Governance and Finance in East Asia. Efforts to reduce graft and corruption. Increasing the Supply of Quality Equities in the Stock Market To promote the capital market as an external control agent in corporate governance. PSE and SEC need to build a liquid and efficient market. improve enforcement of the rule of law. Current disclosure requirements of SEC are not rigorous enough for public investors. PSE should campaign for top-tier companies to go public and work with SEC in encouraging publicly listed companies to expand their share offerings to the public. so that small. and provide quality basic services should also be heightened. II and exit barriers. Vol.and medium-scale companies can become more competitive relative to large companies. Little attention is given to the conditions that make those regulations effective in the US corporate sector but not present in the Philippines. The Government’s competition policies should aim to facilitate the free entry and exit of domestic and foreign companies and regulation of anticompetitive practices. Many large companies remain privately owned. Audited financial statements contain basic information about a company’s financial position and performance.

Instead. violators were made to pay only nominal penalties. In spite of the many well-known cases of poorly audited financial statements that resulted in losses for investors. and liquidation of troubled companies should be made a priority of the Government. The law is obviously not in line with the Government’s policy of allowing market mechanisms to work and not intervening in private sector business. For that matter. it creates a moral hazard problem. the new law needs to be effectively implemented and enforced. and Liquidation. PD 902-A has not accomplished any successful rehabilitation of a petitioning company since its implementation. including the resolution of intracorporate disputes. . SEC and PICPA have not publicly penalized any auditor company that violated disclosure requirements or failed to submit audited financial statements. and transferred these to courts.Chapter 3: Philippines 225 auditors and the mechanism for imposing them are weak. reorganization. and implement those standards and penalties rigorously. suspension of payments and private damage actions. review the system of penalties on professionals involved in a company’s violation of disclosure rules. The law on suspension of payments replaces a market-oriented solution with a political process. Reforming the legal framework for suspension of payments. Reorganization. SEC and PICPA need to formulate more specific disclosure standards. Although the new Securities Regulation Code enacted in 2000 has removed some of SEC’s quasijudicial functions. Improving the Legal Framework for Suspension of Payments.

P. Discussion Paper. Joseph P. Jr. May. P. Lang. Lang. P. Institute of Southeast Asian Studies. Diversification and Efficiency of Investment by East Asian Corporations. Journal of Finance 2 (1). Simeon Djankov. Emilio. Manila: Asian Development Bank. and Simeon Djankov. edited by Toida Mitusuru and Daisuke Hiratsuka. Antonio. 1999. 1999. and Atulya Sarin. 1997. Barclay. Lang. and Larry H. Denis. Journal of Political Economy 93 (6).. World Bank. and Larry H. Journal of Financial Economics 25: 371-395.226 Corporate Governance and Finance in East Asia. Working Paper. Stijn. Claessens. Key Indicators of Developing Asian and Pacific Countries 1998. Thailand’s Corporate Financing and Governance Structures: Impact on Firms’ Competitiveness. 1985. 1998a. Demsetz. Joseph P. 1999. David J. Stijn. 1994. Joseph P. 1998c. Private Benefits from Control of Public Corporations. Claessens. Burkart. 1998. and Kenneth Lehn. 1988. The Separation of Ownership and Control in East Asian Corporations. Agency Problems. H. H. Pedro. Conference on Thailand’s Dynamic Economic Recovery and Competitiveness. Philippine Macroeconomic Prospects: The Next Ten Years. Quarterly Journal of Economics. Stijn.. Diane K. Lang. Claessens. Asian Industrializing Region in 2005. and Larry H. 1998. and Clifford Holderness. 1998b. October. P. Simeon Djankov. Working Paper. Stijn. and Fausto Panunzi. Thailand: From Financial Crisis to Economic Renewal. Expropriation of Minority Shareholders in East Asia. Lang. 1997. . Harold. Claessens. Monitoring and the Value of the Firm. Who Owns and Controls East Asian Corporations? Discussion Paper 2054. and Corporate Diversification. Simeon Djankov. Fan. Equity Ownership. The Structure of Corporate Ownership: Causes and Consequences. Stijn. World Bank. Large Shareholders. Working Paper 2088. The Philippines: Onward to Recovery. George. Stijn Claessens. Dennis. Michael. 1989. Alba. World Bank. Simeon Djankov. July. Vol. Ownership Structure and Corporate Performance in East Asia. P. Simeon Djankov. Fan. Bangko Sentral ng Pilipinas. Dennis Gromb. H. Fan. 693-728. and Larry H. World Bank. March. Vol. II References Abonyi. and Larry H. Tokyo: Institute of Developing Economies. M. Claessens. Asian Development Bank. XXIX. Joseph Fan. World Bank.

Gestner. Jensen. 1983. Euromoney Books. Michael. Quarterly Journal of Economics 106: 33-60. 1984. 1993. Exit. Myers. 1998. 1990. Douglas. Michael. . Stuart. and William Meckling. The Market for Corporate Control: A Scientific Evidence. Jensen. Jensen. and Artur Raviv. 1994 and Investment Guide 1997. Stein. and Jeremy C. Internal versus External Capital Markets. Michael. Financial Intermediation and Delegated Monitoring.Chapter 3: Philippines 227 Diamond. Journal of Finance 45: 321-350. 1994. Harris. Institutional Investment Patterns and Corporate Financial Behavior in the United States and Japan. Hart. The Modern Industrial Revolution. Liquidity and Investment: Evidence from Japanese Industrial Groups. Joseph C.. Lufkin. American Economic Review 48 (3): 261297. Journal of Financial Economics 11: 5-50. Jensen. Anil Kashyap. 1958. Corporation Finance. 1995. and the Theory of Investment. 1991. Milton. Corporate Governance: Emerging Issues and Lessons from East Asia. American Economic Review 76: 323-29. Modigliani. Corporate Structure. The Cost of Capital. Prowse. Takeo. Agency Costs of Free Cash Flow. Stephen. Journal of Financial Economics 27: 4366. Determinants of Corporate Borrowing. World Bank. Prowse. Agency Costs and Ownership Structure. 1990. Franco. Journal of Financial Economics 5: 147-175.). 1995. Michael. November. Stephen. and Richard Ruback. Journal of Financial Economics 3: 305-360. Hoshi. 1986. F. International Corporate Governance. Oliver. and Merton Miller. 1990. Debt and Seniority: An Analysis of the Role of Hard Claims in Constraining Management. 1977. Review of Economic Studies 51: 393-414.. Robert H. Theory of the Firm: Managerial Behavior. and David Gallagher (eds. David S. Journal of Finance 48: 831-80. American Economic Review 85: 567-85. and John Moore. Scharfstein. 1976. and the Failure of Internal Control Systems. Capital Structure and the Information Role of Debt. Philippine Stock Exchange Fact Book 1997. and David Scharfstein. Corporate Finance and Takeovers. The Quarterly Journal of Economics.

Internal Capital Markets and the Competition for Corporate Resources. 1985. Credit. Washington. Asian Development Bank. Joseph E. 1998. and Banking Lecture 17. Andrei. Journal of Political Economy 94: 461-88. May. 1996. 1. Stiglitz. Mimeograph. and Robert W. 2. World Bank. East Asia: The Road to Recovery. Vishny. Ajit. Shleifer. Journal of Money. DC. Andrei. Washington. DC. Journal of Finance L11: 737-783. II Prowse. 1991. 1992. November. A Survey of Corporate Governance. Singh. Journal of Finance LII. . Shleifer. Credit Markets and the Control of Capital. How Do Large Corporations in Developing Countries Finance their Growth? Corporate Financial Structures in Developing Countries. No. No. 1998. Technical paper No. IFC/WB. 1997.228 Corporate Governance and Finance in East Asia. and Robert W. Stein. Large Shareholders and Corporate Control. Vishny. Vol. Some Conceptual Issues in Corporate Governance and Finance. David. Stephen. 1. Journal of Finance 91: 1121-1139. 1997. March. The Structure of Ownership in Japan. Jeremy C. Webb.

with Thai corporations overutilizing short-term foreign currency-denominated loans. the Stock Exchange of Thailand for its help and support in conducting company surveys. and Philippines all depreciating significantly. Thailand. The author wishes to thank Juzhong Zhuang.4 Thailand Piman Limpaphayom1 4. Republic of Korea (henceforth. magnified the impact of these problems on the economy when the crisis hit.” After mounting an aggressive defense of the currency. 1 Associate Professor. Malaysia. Chonburi. heralding not only a financial crisis in the country. both of ADB. Faculty of Business. Instead of serving as a buffer between the large inflow of foreign capital and the corporate sector. Thai corporations were collectively overexposed to exchange rate risks. For the period 1994-1996. and David Webb of the London School of Economics for their guidance and supervision in conducting the study. but also the stalling of East Asia’s “economic miracle. David Edwards. the Thai baht came under pressure from speculative attacks. The corporate sector also contributed significantly to the crisis. Korea). The crisis in Thailand stemmed directly from unsound macroeconomic policies and imbalances. annual short-term capital inflows to Thailand were equivalent to 7-10 percent of gross domestic product (GDP). The fixed exchange rate policy. Thailand’s crisis exposed similar vulnerabilities in other East Asian economies.1 Introduction In May to July 1997. the banking system merely validated the financial risks. It was inefficient in financial intermediation. In the prelude to the 1997 crisis. The banking system. short-term private debt obligations grew to about 60 percent of total private sector debts. with the currencies of Indonesia. But it also laid bare weaknesses in both the financial and corporate sectors. the Thai Government conceded and adopted a floating exchange rate regime. and Lea Sumulong and Graham Dwyer for their editorial assistance. The majority of these debts were not properly hedged. Asian University of Science and Technology. . As a result. coupled with financial liberalization and deregulation in the absence of an effective regulatory and supervisory system. had been plagued with prudential problems for a long time. poorly regulated and sheltered from competition.

. The study then considers policy recommendations with emphasis on corporate governance improvement. lack of transparency and adequate disclosure. The First and Second Plans (1961-1971) Under the first two plans. with government policy providing support but avoiding direct interference. The country initiated national economic development planning in 1961 when the economy was growing rapidly. Section 4. focusing mainly on the companies listed in the Stock Exchange of Thailand (SET).1 Overview of the Corporate Sector Historical Development The corporate sector has long been considered the engine of Thailand’s economic growth. Import tariffs on machinery and heavy equipment were removed. as well as its legal and regulatory framework.2 discusses the development of the Thai corporate sector under the National Economic and Social Development Plans. To protect domestic industries.2 4.4 provides an overview of Thailand’s financial markets and examines patterns of corporate financing and investment in the years prior to the 1997 crisis. Key factors that led to weak corporate governance include the ineffectiveness of the regulatory framework.2. This study examines these and other factors that might have weakened corporate sector governance in Thailand. Vol. while new industries were encouraged to reduce the need for imports. its growth and financial performance. the Government increased tariffs on products that could be produced locally.5 discusses how the corporate sector contributed to the financial crisis and looks at its impacts.230 Corporate Governance and Finance in East Asia. The National Economic and Social Development Board was created to plan the country’s economic and social development. and a family-based corporate ownership structure. Section 4. Section 4. 4.3 looks at corporate ownership patterns that resulted in inadequate protection for minority shareholders and weak corporate governance in Thailand. the Government implemented major infrastructure projects and modified its tax policy to encourage capital investment and savings. II There is now a consensus that weak governance was partly responsible for the corporate sector’s poor financing and investment practices. Section 4.

The focus shifted to export promotion. leaving the Government no choice but to resort to overseas borrowings.15 billion per year or 4. and increases in world food and oil prices. As a result. however. Inflation reached 15.3 percent in 1974. In the wake of lower world oil prices and the rapid growth in income from the tourism and travel industry. The average budget deficit reached an all-time high of $2. including luxury goods.6 percent per year.5 percent in 1973 and 24. Budget deficits remained a major problem during the Fifth Plan. . However. lower than anticipated due to a worldwide economic recession. became a major problem as domestic investment declined.Chapter 4: Thailand 231 During this period. especially foreign aid from the United States. averaging 1. the current account registered a surplus in 1986. The results were increased exports. At the same time. the value of the baht remained stable. helped offset these deficits. Average growth for the period was 4 percent per year. Budget deficits also increased throughout the Fourth Plan. To close the fiscal gap. External factors. The decline in imports was steady. Inflation levels were low. it proceeded with its development plan for the industrial sector. The Government decided to embark on restructuring measures in the Fifth Plan (1982-1986) to rehabilitate the ailing economy. and automobile assembly) emerged. an improved trade balance. including a weakening of the dollar. the Government borrowed $6. remaining high until 1981. with the devaluation of the baht in 1984 a major step in this direction. But the sustained importation of heavy machinery and equipment resulted in large trade deficits. The Third. Unemployment. Fourth. textiles. canned foods. processed steel.4 percent of GDP. The Government had to shift emphasis to restoration of economic stability. with the agricultural sector the major contributor. using tax policy to control prices of consumer goods and implementing several price control measures to curb inflation. Consequently. gross national product grew by about 7 percent per year. capital inflows. chemicals. however. the industrial sector grew at a faster rate than the agricultural sector. the government’s debt burden escalated. resulted in increases in the current account deficit.4 billion from overseas and increased taxes on numerous items. Thus. and Fifth Plans (1972-1986) An economic downturn at the end of the Second Plan led to an adjustment in policies. and reduced current account deficits. Industrial sector growth was also rapid and many industries (tires.

Thailand became a debtor’s market. II The Sixth Plan (1987-1991) Industrial sector productivity improved gradually during the Sixth Plan period.8 percent. The manufacturing sector became a dominant force in the economy. the property sector began to collapse in 1996.5 to 13.8 percent. United States. and Hong Kong. from only $31 billion in 1992. With loans increasingly becoming expensive and hard to come by due to a lending squeeze by the central bank and high interest rates. increasing its share in total export value from 42 to 76 percent.2 percent target. The Seventh Plan (1992-1996) The economy’s performance from 1992 to 1996 generally met the targets of the Seventh Plan. The exchange rate was steady at around B25 to the dollar.5 percent. Inflation was 4. compounded by a slump in property sales. rather than to productive activities.2 and 13.6 percent. Most of the FDIs—originating mainly from Japan. invited a deluge of capital seeking profitable investments. compared with the 8. an oversupply of housing emerged. Key to this growth performance was the government’s adoption in 1993 of an aggressive program for attracting foreign capital to finance domestic investments. Growth rates during 1987-1991 ranged from 9. From 1989. Vol.7 and 11. Singapore. Private sector investment grew at an average annual rate of 7 percent. Average annual growth in real GDP was 8 percent.2 percent per year. the bulk of domestic investments went to speculative ventures such as real estate. property development. and the stock market. The country also attracted a large amount of foreign direct investments (FDIs). while exports expanded considerably. . Europe. On top of its predominantly “borrowed” nature.232 Corporate Governance and Finance in East Asia. Thailand’s rapid growth up to the mid-1990s made the country one of the world’s fastest-growing economies.6 percent target of the Seventh Plan. respectively. with private foreign debt reaching $92 billion by the end of 1996. By 1995. combined with its liberal financial policies. the Government successfully balanced the budget and even settled its foreign debt of $4 billion before this was due. lower than the target of 8.4 percent targets. Growth of exports and imports averaged 14. averaging 10. The country’s high ratings in the international capital market. reaching an annual inflow of $2 billion in 1991. China—went to export-oriented manufacturing industries. better than the 5. compared with the 14.

Robbins. placing all publicly listed companies under regulation. In 1972. the Government amended the “Announcement of the Executive Council No. The country had a current account deficit of about 8 percent of GDP in 1995 and 1996.8 percent in 1995 to 1. In 1969. the capital markets didn’t play a significant role until 1975.2 Development of Capital Markets Although the corporate sector has long been the government’s main tool for economic development. Robbins recommended an overhaul of the existing informal stock market established earlier by a group of local brokers in favor of a centrally regulated institution.” which later became the master plan for the development of the Thai capital market. In 1978. prepared a comprehensive report entitled “A Capital Market in Thailand.3 percent in 1996. And because the Government considered the banking system vital to the development of the economy. Foreign banks were barred from competing directly with domestic banks. its policy had always been to protect domestic banks. Its most crucial role was to help mobilize funds to support Thailand’s industrialization and economic development. the corporate sector’s main source of funding was the banks. However. In May 1974. Under the 1962 Commercial Banking Act.2. with growth shrinking from 23. The deficits caused the Government to rely on even more external borrowing.Chapter 4: Thailand 233 Toward the end of the Plan period.” extending its control and regulatory powers to the finance and securities companies operating freely at the time. Included in the Second Plan (1967-1971) was a proposal to establish the country’s first authorized and regulated securities market. many companies considered the Act too restrictive and a hindrance to growth. Sidney M. the Bank of Thailand and . Before the capital market emerged. the signs of an economy about to falter were there. which raised the debt service ratio. In his report. SET officially became “the Stock Exchange of Thailand” in 1991. the Government passed the Public Limited Company Act. A series of increases in customs and excise taxes on luxury imports did little to stem rampant consumer spending. Exports went into a tailspin. 58 on the Control of Commercial Undertakings Affecting Public Safety and Welfare. a policy that held throughout the first six economic development plans. on account of an overvalued baht that weakened export competitiveness. the establishment of the Securities Exchange of Thailand (SET) was legislated and trading began on 30 April 1975. a former Chief Economist from the US Securities and Exchange Commission. which was amended in 1979 and 1985. 4.

Vol. The pressure dovetailed with the Government’s intention to make Bangkok one of the financial centers of the region. II the Ministry of Finance had full authority to supervise all commercial banks. there were 29 commercial banks (15 domestic and 14 foreign banks) in Thailand. while the Securities and Exchange Act (SEA) the same year sought to improve capital market supervision. Laws were enacted to stimulate growth of the corporate sector. Externally. At the end of the Sixth Plan. The Public Company Act of 1992 relaxed some of the rules and restrictions contained in the original laws. Financial deregulation and liberalization allowed the country to attract foreign savings and investments that helped finance the growth of the economy. Earlier. creating a moral hazard problem—the perverse expectation that imprudent bank behavior would be rewarded with forbearance and bailout. While the Bank of Thailand had the regulatory power to influence business practices. Thai banks gained access to a variety of funding sources from around the world. and new financial instruments. increased financial market activities. The introduction of these two laws came just after the Government’s signing of Article VIII of an Agreement with the International Monetary Fund (IMF) in May 1990 to deregulate and liberalize financial markets. Thailand discarded controls on foreign exchange transactions and capital flows—a turning point for the Thai corporate sector. the financial and banking laws were generally ineffective. Thailand’s capital market entered a new era with improved legislation and regulation. The regulatory measures were inadequately designed and poorly enforced. The resulting availability of funds propelled the corporate sector’s growth through the early part of the 1990s. The banks and finance companies operated at insufficient levels of reserve capital and were overexposed in high-risk businesses such as real estate.” The Government also granted financial institutions overly generous bailouts. and the General Agreement on Tariffs and Trade (GATT) meeting in Uruguay had the liberalization of financial services on its agenda. A number of internal and external factors contributed to the Thai Government’s acceptance of the IMF’s Article VIII agreement. In the 1990s. With the liberalization of financial markets. the World Bank had recommended such a move. Economic growth had been rapid and domestic savings could not keep up with the pace to support investments. the Government was under international pressure to deregulate the financial sector. it usually relied on “moral suasion. to cater specifically to its . However.234 Corporate Governance and Finance in East Asia.

Storage. with B1.2 11. 4. The manufacturing sector is a far second with registered capital of B350 billion and paid-up capital of Table 4. and Communication Financing. Ministry of Commerce. The stock market boom from 1991 until the financial crash of 1997 reflected international investors’ response to Government policies. Real Estate.9 1. Hunting.1 trillion and paid-up capital of B1. In terms of capital.5 111. Gas.1).3 83. and Water Construction Wholesale and Retail Trade.4 trillion in registered capital and B791 billion in paid-up capital. 1978-2000 Number Registered of Capital Companies (B billion) 5 6 245 5 13 129 22 194 42 661 1. Worldwide.0 19. and Restaurants and Hotel Transport.1 30.2 Type of Business Agriculture.Chapter 4: Thailand 235 fast-growing neighbors. finance.6 350.9 261.3 trillion have been registered with the authority (Table 4.5 791.0 21. the country became recognized as an economic development model for other emerging economies. in that order. and wholesale/ retail trade and restaurant/hotel sectors.6 2. Source: Department of Commercial Registration. The Bangkok International Banking Facility (BIBF) was thus established to facilitate international borrowings and encourage capital flows as a means of financing the current account deficit.1 78. the financial sector is the largest. about 661 companies with total registered capital of B2.101. .9 34.5 50.2. The result was a corresponding growth and development in Thailand’s capital markets.6 1. Forestry. however. Financial deregulation and liberalization were key to realizing that vision. The majority of the companies are in manufacturing.394.9 16.0 Paid-up Capital (B billion) 1.1 Public Companies Registered. Social and Personal Service Total Note: The data for 2000 is as of October 2000. and Business Service Community.6 23. and Fishing Mining and Quarrying Manufacturing Electricity.0 110. Insurance.291.3 Growth and Financial Performance Since the 1978 enactment of the Public Limited Company Act. Thailand.

8 151.0 1994 82.6 174.7 7.2 12. the capital market became instrumental in the rapid growth and development of the corporate sector. While a rebound was apparent beginning in 1998. The number of listed companies and securities steadily increased until 1996 (Table 4.1 286.3).3 1996 1997 65.3 6.5 — — 56. The signing of Article VIII with the IMF.5 39.4 96. Debt market activities also increased significantly with the establishment of the Bond Dealers’ Club (BDC) in 1994.8 billion.2). The development of the corporate sector closely followed the development of capital markets. 1992-1999 (B billion) Type of Securities Equity Debt Instrument Domestic Offering Offshore Offering Hybrid Instrument Domestic Offering Offshore Offering Total Funds Raised 1992 1993 1.2 Public Offerings of Securities. from only B20. Source: Key Capital Market Statistics. respectively.3 194.7 136.7 27. Securities and Exchange Commission of Thailand.1 54.4 34. The 1997 crisis battered the primary market for securities.9 31.6 39.4 277. Domestic and offshore debt issues reached B54.9 37.6 7.1 — — — 6.1 599.6 — = not available. this was due to the recapitalization of commercial banks in compliance with the new loan provisioning requirement.2 40.8 — 26.0 0.7 9. reached .2 25.236 Corporate Governance and Finance in East Asia. the value of public offerings rose steadily.8 1995 64.4 51.5 1. Vol.2 5.9 1998 1999 15.7 5.8 201.3 22. With the enactment of the SEA of 1992 that brought suppliers of finance services and their clients together. Market capitalization. moreover.5 billion and B1 billion the previous year. After the passage of the SEA of 1992.0 20.6 8. the year before the crisis struck. reducing the value of offerings to a little more than a quarter of the previous year’s level.7 billion in 1996. allowed Thai financial institutions and corporations to obtain funds overseas.5 1. reaching a precrisis peak in 1996 (Table 4. meanwhile. II B261 billion. These peaked at B89.3 31.7 billion and B27. The stock market also became an invaluable source of funds for corporations. The preeminence of the financial sector is a direct result of financial deregulation and liberalization.1 2. Table 4.

as measured by return on assets (ROA). in the end. Corporate profitability. when long-term debt grew as Thai corporations began to borrow heavily to finance growth.193 2. however. The financial leverage of all companies declined until 1994.281 832 373 356 482 Due to listing requirements and other reasons. then stalled in 1990.301 3. But instead of shifting to a low gear. corporate profitability had been declining.565 2. The key financial ratios of all companies listed on SET bear this out (Table 4.4 percent in 1996. and gross profit margin.325 3.3 Statistical Highlights of the Stock Exchange of Thailand. Source: Securities and Exchange Commission of Thailand. the averages for all three profitability ratios took a downswing all the way until 1996.610 1. Foreigners accounted for an increasing proportion of SET’s turnover value.303 930 855 1. not all public companies are listed on the SET. had been on the rise throughout the 1980s.4).133 1. gross profit margin rose until 1991 before falling in 1992. From 10.201 2.1 by 1996. Meanwhile. the companies could not generate enough net returns from their assets and equity. The trend reversed in 1995. ROA dipped from 10. Side by side with this surge of financing for corporate growth.268 2. however.3 percent in 1989 to 3. was the ominous deterioration in the key financial ratios of publicly listed companies. its high point in 1995 at B3. The plunge in profitability and asset turnover—from 117 percent in 1985 to 65 percent in 1996 for the latter—cast doubts on the . While the decline in gross profit margin was not as sharp.535 1. Throughout the 1990s. By the early 1990s. the average times interest earned (TIE) was down to 5.560 1.6 trillion.5 at its peak in 1987.360 1. return on equity (ROE).114 1. their share rising from 17 percent in 1993 to 43 percent in 1997.8 percent. the highly liquid financial system continued offering cheap funds to sustain corporate sector investments.4 percent to 5.Chapter 4: Thailand 237 Table 4. pulled down by active public offering activities. resulting in their inability to fulfill debt obligations. ROE similarly fell from 21.683 1. 1993-1999 Item Number of Listed Companies Number of Listed Securities Market Capitalization (B billion) Turnover Value (B billion) SET Index a 1993 1994 1995 1996 1997 1998 1999 a 347 408 389 494 416 538 454 579 431 529 418 494 392 450 3. The upward trends for ROE and ROA continued through 1989.

2 64.2 6.3 10.8 5.1 114.9 7. They were generally more efficient in managing their assets and .8 25.5 38.9 7. The downtrend in corporate profitability.4 9.7 5.7 4. was felt across industries.7 LongTerm Debt to Asset Assets Turnover (%) (%) 14.6 7.2 49.9 77. resulting in higher collateral values for borrowers.5 63.7 12.6 27.7 34.8 14.2 35. but was most severe in building and furnishing material industries as a result of the downturn in the real estate market.7 59. was also distinct in the region. which fell from 16 percent in 1991 to just under 6 percent in 1996.1 16.0 7. Hotels and travel showed the highest ROE of 15 percent while textiles.4 Key Financial Ratios of Publicly Listed Companies.6 Year 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 Source: Pacific-Basin Capital Markets Database compiled by the University of Rhode Island.7 80.1 242.4 7.3 91.4 34.0 139.8 11.0 63.2 215.4 26.2 10.8 5.4 12.2 10.7 12.5 51.9 27.238 Corporate Governance and Finance in East Asia.8 51.4 24.7 54.6 125.1 9.9 140.6 12.4 44.7 5.4 139.4 7. clothing. Despite the availability of the equity market. these companies opted for debt.5 30.2 27.6 138.5 50.3 4.7 15.7 12.4 3.5 52.4 28. which was particularly significant in the two years preceding the crisis. It has also been argued that family-based controlling shareholders borrowed excessively to avoid diluting their control over their corporations.1 44. Among the crisis-hit countries. Thailand’s ROE. US.0 3. and footwear industries also experienced losses. Severely affected by global competition throughout the decade.8 8.6 36.7 35.1 16.9 39.6 41.5).9 14.0 145.1 120.2 10.9 8.4 119.2 27.1 52.7 20. large companies (where size is reckoned in terms of assets or sales) were more profitable than small companies in terms of ROE (Table 4.5 15.7 5. Vol.1 60.8 151.7 12.0 125.4 4.4 51.4 18. 1985-1996 LongTotal Term Total Return Return Gross Debt Debt Debt on on Profit Times to to to Assets Equity Margin Interest Equity Equity Assets (%) (%) (%) Earned (%) (%) (%) 3.2 161. A major reason for this was the rapid rise in asset prices.6 168. practice of heavy borrowing.9 144.5 9.9 51.3 12. and footwear had the lowest at 11 percent.8 54.7 21. Overall.7 27.4 5.8 88.4 47.0 117. II Table 4.4 12. clothing. the textiles.0 29.9 66. Korea and Thailand had the highest debt-to-equity ratios.7 27.3 8.

9 20.Chapter 4: Thailand 239 Table 4. 1985-1996 Company Size by Assets Company Size by Sales Item Return on Assets (%) Return on Equity (%) Gross Profit Margin (%) Times Interest Earned Total Debt-to-Equity (%) Long-Term Debt-to-Equity (%) Total Debt-to-Assets (%) Long-Term Debt-to-Assets (%) Asset Turnover (%) Small Medium Large 6.6 30.7 14.1 13.6 7.4 8. some rules and regulations of this particular law were believed to be too restrictive and were discouraging companies from going public.5 7. Although stable in the 1980s. 4. The argument was that having a Board of Directors whose members represented different groups of investors would create conflicts and hamper management effectiveness. However.3 88.6 5.6 12.8 26.5 Average Key Financial Ratios by Company Size.3 135.6 61. also deteriorated.2 12.5 6. There were also concerns that the provisions governing the criminal prosecution and penalties of directors and management were harsh and inappropriate.3 49.8 10. During the 1990s.6 31.8 6.2 10.7 10.2 18.0 83.8 6.3 176. the law disallowed cumulative voting. .2.5 87.2 121.0 48. the Public Limited Company Act of 1978 and its amendments regulated Thai publicly listed companies. by the 1990s. For instance.5 94. They also tended to use more financial leverage than small companies as their total DERs show.3 52.7 6.1 Small Medium Large 5. Cumulative voting. capital despite the higher gross margins of small companies.8 47. it was thought.6 30.1 25. which would be disruptive to company management.8 62.3 43. In sum.3 164.2 134.6 10. Increasingly heavy borrowings rendered the sector even more vulnerable to lower profitability and sales.3 25.1 6. although the performance of listed companies in the late 1980s was strong.0 20.1 29.3 23.7 Source: Pacific-Basin Capital Markets Database compiled by the University of Rhode Island.9 13.3 49.4 116.4 52. US. weaknesses became evident. could lead to a high turnover in the board.1 5.8 142. total asset turnover declined after 1989. the overall activities of listed companies.3 15.6 6. measured by total asset turnover.4 Legal and Regulatory Framework Before 1992.

a feature that is believed to have impaired the effectiveness of existing regulatory mechanisms in the corporate sector. from holding more than 50 percent of total outstanding shares and other shareholders from holding more than 10 percent of outstanding shares individually.2 The market for corporate control was not active and did not give managers strong incentives to perform efficiently. An Asian Development Bank (ADB) survey conducted for this study shows. The protection of minority shareholders was inadequate under the Public Company Act of 1992. The legal and regulatory framework for the corporate sector also includes provisions related to insolvency. Cumulative voting was made optional.240 Corporate Governance and Finance in East Asia. The original company owners welcomed the changes and the number of publicly listed companies subsequently rose to more than 600. for instance. the new legislation removed a number of incentives that would have kept public companies prudent and diligent in their operations. II Another issue was the proportion of shareholding by top shareholders. and the punishment for management misconduct was also lightened considerably.5. coupled with weak corporate governance. as a group.3 Corporate Ownership and Control Ownership and control of corporations in Thailand are highly concentrated. As it turned out. adopted to promote the development of publicly listed companies. concentrated ownership. the exit of these provisions appears to have contributed to the 1997 financial crisis. The provision discouraged original family owners from registering their companies. 4. As the succeeding sections point out. the limit on shareholdings by the largest shareholders was increased from 50 to 70 percent of total outstanding shares. The Public Company Act of 1992. relaxed the contentious provisions of the 1978 Public Limited Company Act. and external monitoring and control of corporations were also weak. but not all questions were answered. 2 ADB survey questionnaires were sent to all Thai listed companies in early 1999. The law prohibited the largest shareholders. . However. that creditors had generally little influence on the management of corporations. Fortysix companies responded. This will be discussed in Section 4. played an important role in bringing about the financial crisis. Vol.

1 4. 1990-1998 Averagea 1990 1991 1992 1993 1994 1995 1996 1997 1998 1st Largest 2nd Largest 3rd Largest 4th Largest 5th Largest Top Five a 28.2 11. these companies obtained funding solely from banks or from their own retained earnings. Ownership Concentration Between 1990 and 1998.9 55.0 3. This implies that the top five shareholders enjoyed full control over the outcomes of shareholder meetings.7 6.6 68.9 26.0 56.9 4.2 4.9 52. and minority shareholders to stake their claim in the control and regulation of these companies.3 5.0 7.5 Average for 1990-1998 period.0 3.9 52.0 5. China firms have the highest single shareholder ownership concentration at 35.4 26.9 3.China have the least concentrated ownership.2 4. and 28.7 7. In contrast.9 54.3 7.3 16.6).6 27.3 percent.9 52. creditors.5 9.9 3.4 5. Table 4. on average.7 12. Most large Thai corporations listed on SET started out as family businesses.1 5.9 6. The Public Company Act of 1992 allowed ownership and control of these companies to remain with the founding families even as they became increasingly dependent on nonfamily resources. But with their increased reliance on new varieties of equity and debt instruments.1 11. Ownership was most concentrated in the packaging. Across industries.4 26.1 5.4 percent of outstanding shares. and Hong Kong.3 11. Thai.6 4. with the top three shareholders accounting for almost 50 percent (Table 4. Source: Comprehensive Listed Company Information Database. . Unfortunately. this was not the case.3 percent and 18.2 4. Indonesian.2 56. 56.1 3.4 6.3.1 5.6 57.3 7.4 6.1 Patterns of Corporate Ownership A World Bank study covering nine Asian countries finds that firms in Japan and Taipei.1 percent of control rights.Chapter 4: Thailand 241 4.6 Top-Five Ownership Concentration of Publicly Listed Companies in Thailand.1 12. Stock Exchange of Thailand.1 7.8 5.0 7.4 10.5 28. there were only slight variations in the pattern.9 percent of shares of a company.4 4.4 26.0 53. one would expect the public. the top five shareholders of each of publicly listed Thai companies held. respectively. In the past.6 28.8 32.7 percent.9 11.7 11. 33. with the largest shareholder on average controlling 10.3 28.8 11.

800 0. II agribusiness. owning 26. * Denotes significance at the 10 percent level. It is the practice of Thai corporate founding families to set up holding companies to own shares in affiliated companies or subsidiaries. On the other hand. Other industries had their top five shareholders controlling at least 55 percent of outstanding shares.169*** 0.533)*** Debt-to-Assets (0. with a top-five ownership concentration of at least 60 percent.116) Debt-to-Equity (1.080 6. Table 4. *** at the 1 percent level.001*** 0. and building and furnishing industries. as measured by debt-to-equity and debt-to-asset ratios. Based on a regression analysis. These are consistent with the hypothesis that companies with more concentrated ownership tend to engage in higher debt financing because their controlling owners do not want to dilute their control by bringing in new equity holders. and ownership types. Through these holding companies.7 percent of outstanding shares on average (Table 4. Leverage. including those that are publicly listed .005** 0. Vol.7 Statistical Relationships between Corporate Profitability.8). Source: Author’s estimation based on the Pacific-Basin Capital Markets Database compiled by the University of Rhode Island.647 Note: The regression included dummy variables for industry. ** at the 5 percent level. Company size is significantly related to ROE and leverage.034*** 0. year. US. there is no statistically significant relationship between ownership concentration (measured by percentage of shares owned by the top five shareholders) and profitability of Thai publicly listed companies (Table 4.242 Corporate Governance and Finance in East Asia.022*** 0. results show a significant positive relationship between ownership concentration and financial leverage. founding families maintain effective control of entire groups. Composition of Controlling Shareholders Affiliated corporations comprise the largest group among the top five shareholders of publicly listed companies.001) 0.003 0. Ownership Concentration.115 9. and Company Size Item Intercept Top Five Ownership Concentration Company Size Adjusted R-Squared F-Statistic ROA 0.029 3.031 3.001 0.037 0.090 0.058* ROE (0.072) (0.7).

5 NBFIsa 6.4 22.3 27.1 4. owned by the Chirathivat family.9 6. a company listed in the real estate sector of SET.3 0.9 7.7 1.3 27.5 0.5 0. the affiliate firms rarely hold shares of their parent companies.1 1.3 1.6 percent of outstanding shares.9 0.4 1.9 19.9 15.2 5.2 18.1 1. a joint venture among three families. These individuals usually hold important management positions in concerned companies. Stock Exchange of Thailand. 1990-1998 Year 1990 1991 1992 1993 1994 1995 1996 1997 1998 Average Company 28. The largest shareholder is Central Holdings Company.7 5. operates five of the most successful shopping malls in Thailand. the company.4 20. The top 10 shareholders include a holding company owned by the Tejapaibul family. a NBFIs denotes nonbank financial institutions.6 1.5 0.2 1.2 1.3 — = not available.0 18.9 18. Source: Comprehensive Listed Company Information Database. founding families and their relatives maintain control of many companies by jointly holding on to the most significant chunk of shares.5 2. one of the founding members.7 0.5 percent.8 0.5 Individuals 13. Typically.5 26.2 7.5 1. Established in 1980 with a registered capital of B300 million.7 Bank 2.6 5.8 1.0 19. averaging about 18. This practice is illustrated by Central Pattana.3 1.0 3.6 28.4 1.8 23.3 27. with 29. Individual family members also hold a significant amount of outstanding shares.7 — 1. including finance and investment companies. In 1994. the company increased its registered capital and became a public company listed in SET.3 1. individual members of the Chirathivat family aggregately hold 25.5 1.4 1.3 20. Although holding companies set up affiliate firms. In addition.0 17.8 28.Chapter 4: Thailand 243 Table 4.8 Top-Five Shareholder Composition of Publicly Listed Companies in Thailand. . unlike in Japan where crossshareholding is common.5 5.1 0. The ADB survey indicated that listed companies held shares in an average of 11 companies.6 1. The roster of its major shareholders as of December 1997 illustrates the typical ownership concentration of a publicly listed company in Thailand.6 1.3 percent of outstanding shares.5 Government Other 0. in SET.6 25.

5 percent of total outstanding shares of listed companies. the top 10 shareholders consist predominantly of members of founding families and their holding companies. In such cases.244 Corporate Governance and Finance in East Asia. II another of the company’s founding members. holdings by individual family members and holding companies account for at least 50 percent of outstanding shares of an average listed company. Nonbank financial institutions hold an aggregate 5. and responsibilities of directors of public companies. Another example is Bangchak Petroleum Plc. 4.. the Government’s role in public companies is expected to decline. they exercise limited influence in operations because of the restricted size of their shareholdings. and a state bank. However. Together. duties. In effect. Vol. The Government holds.1 percent of total outstanding shares of listed companies. Moreover. roles. By owning 62 percent of voting shares.9 percent of outstanding shares. There was a trend of rising government shareholdings throughout the period 1990 to 1998. .5 percent of total outstanding shares. 3 Discussions in this section are based on results of company surveys by SET and ADB. About half of listed companies have nonbank financial institutions such as finance and investment companies in their top-five shareholder list. has the Ministry of Finance as its only large shareholder with 92. only one tenth of listed companies have commercial banks on their top-five shareholder list.2 Corporate Management and Control3 Board of Directors The Public Company Act of 1992 stipulates the appointment process. Only a handful of companies have the Government among their large shareholders. they account for 80 percent of total outstanding shares. qualification. on average. Thai Airways International Plc. the Government owns the majority of the shares. On average. Across industries. For example. with the envisioned privatization master plan. these shareholders are able to control the company. Although the list of top shareholders of publicly listed companies includes financial institutions. the Petroleum Authority of Thailand. 1. where the top three shareholders are the Ministry of Finance. both conducted in 1999. Except in the hotel and travel service sector. the predominance of individual family members and holding companies in the top shareholder list remains valid. commercial banks account for only 1.3.

In addition. Unless stipulated in public companies’ articles of association.Chapter 4: Thailand 245 Directors are required to meet minimum qualifications specified under the SEA of 1992 and the Listing Rules issued by SET. the majority (71 percent) had board chairs who were also members of top management teams. meanwhile. A survey by SET found that the majority (58 percent) of the 202 responding companies held their board meetings every quarter. and to comply with the laws and articles of association. Some companies (36 percent) had five to six main board members holding seats in their executive boards. directors may be imprisoned or fined. an executive board consists of senior management and some main board members. directors could be compelled to compensate the company for damages arising from their misconduct. The ADB survey indicated. Generally. Nineteen companies stated that selection was based on professional qualifications. directors are required to act with care and honesty for the company’s best interest. the ADB survey found that 31 companies (out of 46 responding) required outside directors to be present at all board meetings. In their business conduct. Many companies have a formal policy on corporate governance and business ethics. Although 28 percent of the chairpersons came from the ranks of independent outside directors. that only in two of the 46 responding companies were the chair of the boards elected based on the extent of their shareholdings. In five other companies. but not in 22 others. If found in violation of these provisions. while 15 percent of respondents went beyond the requirement. directors shall be elected at the annual general shareholders’ meetings (AGSMs). . while 30 percent of respondent companies held board meetings monthly. The appointment of the chief executive officer (CEO) needed approval during the AGSM in 11 of the responding companies. Meanwhile. Three companies indicated that the CEO and the chair were close relatives. Almost all companies (98 percent) exceeded the minimum required five members in their Board of Directors. Chair of the Board and Chief Executive Officer The SET survey showed that about 73 percent of listed companies had a separate executive (management) board. selection was based on relationships with controlling shareholders. Most companies (83 percent) satisfied SET’s requirement of having two independent board members.

The ADB survey indicated that 18 of the 46 responding companies compensated their chairpersons using a fixed-fee schedule. the work of this committee was often considered part of the executive board’s responsibilities. with 41 firms admitting the use of services of international auditing firms. Twenty-five of the 46 respondents to the ADB survey declared adherence to all relevant international standards. Also. Companies already with audit committees did not have independent outside directors as audit committee members. while 19 companies observed only some of them. Where different. II Compensation of Directors. Half of the companies in the SET survey had a separate remuneration committee. Fourteen other companies had profit-related incentive schemes in addition to fixed fees. the remuneration packages had to be approved during AGSMs. These committees were mainly responsible for determining compensation for senior and regular staff. The SET survey found that the majority of listed companies (81 percent) still have no separate audit committee. Vol. these were attributed to variations in the extent of duties and responsibilities assumed by those directors.246 Corporate Governance and Finance in East Asia. Audit Committees and Accounting Standards Since January 1999. In one company. all listed companies have been instructed to establish audit committees to be responsible for examining the quality and reliability of company financial statements. The directors’ compensation was determined largely by the Board of Directors except in 19 percent of the companies surveyed where a remuneration committee was in charge. SET’s attempts to bring accounting practices to international standards have included requiring listed companies to consolidate all liabilities— including those on off-balance sheets—in their financial statements beginning June 1998. However. and CEO The majority of company respondents to the SET survey provided similar compensation packages to internal and external directors. the auditor is not . All respondents confirmed the use of external auditors. Chair. In 25 companies. Three companies allowed their management to determine the chair’s compensation package. however. Directors with managerial responsibility or those related to major shareholders cannot be members of such audit committees. the majority of the companies (77 percent) did not have outside directors as members of their remuneration committees. not an independent assignment.

there is the danger that top management may be capable of unduly influencing the board’s decisions. The Act. However. According to the ADB survey. or other financial instruments. Shareholders are also entitled to call emergency meetings and present proposals at AGSMs. (i) No standards are enforced in the content and timing of notices for shareholder meetings.Chapter 4: Thailand 247 independent from the company. although recently. While safeguards are in place. SEC. shareholders can claim compensation in cases of negligence or dishonesty by management. the corporate sector lacks a strong self-regulatory body to compel compliance with these standards. and the Bank of Thailand— are not clearly defined. Proxy solicitation tends to be abused to the extent that shareholders are inadequately informed about matters to be taken up in shareholder assemblies. likewise. (ii) The prudential role of outside directors is limited by the noncompulsory character of their participation in key decision-making bodies such as the audit. SET’s rules and regulations closely follow this Act. debentures. SET. with 13 companies allowing proxy voting through mail. At least 28 responding companies had the following . Minority Shareholders and their Rights Many different rights and entitlements of shareholders are laid out in the Public Company Act of 1992. as well as the registration and holding of shares. The majority of the companies (85 percent) require the appointment of external auditors during annual general meetings. averaging about 14 years. and executive committees. For instance. including false statements to conceal information about the financial condition and operations of the company during the sale of shares. most responding companies have rules and regulations intended to protect shareholders. the Securities and Exchange Commission (SEC) and SET were actively prosecuting violating firms. remuneration. Forty-four companies indicated that they had proxy voting in place. (iii) Because the chair is frequently also part of the top management team. As a result. there are also significant gaps in the system of shareholder protection. Relationships between firms and external auditors are generally long-term. stipulates the proper conduct of shareholder meetings. the institutional machinery is not fully responsive to complaints about violation of shareholder rights. shareholders have access to reliable information at no cost. (iv) The roles and responsibilities of the major government agencies regulating shareholder rights—the Ministry of Commerce. In the majority of these companies (38 out of 46 respondents). The Act also holds directors liable for any damage to shareholders.

it would be difficult for minority shareholders to gather the shares needed to take action. II mechanisms in place: mandatory shareholder approval of major transactions and interested or related party transactions.3. however. In theory. In effect. and insider trading. did not vote in previous AGSMs. the new Public Company Act of 1992 inadvertently weakened the governance of public companies by diminishing minority shareholder rights. While stimulating the growth of the sector. takeover of the company. . But the exercise of these rights requires even higher shareholding levels. and mandatory disclosure of related interests and significant shareholders’ transactions. These problems appear to be partly a result of the relaxation of the rules and regulations in the original Public Limited Company Act of 1978. But with the ownership concentration of Thai companies.3 External Control Control by Creditors The fact that insider control in Thai companies is very strong should compel a search for alternative external control and monitoring mechanisms. Almost 82 percent of shareholders. Only a small number of shareholders attended the latest AGSMs. Written law and its enforcement diverge partly because of a provision that shareholders who take action against erring directors must have at least 5 percent of the total number of shares. The difficulty minority shareholders have in exercising their rights can be seen from the ADB survey results. 66 percent of total outstanding shares. 4.248 Corporate Governance and Finance in East Asia. given their importance in providing finance and their stake in companies. and call an extraordinary session. Banks would be obvious candidates to implement these mechanisms. such protection has been insufficient. minority shareholders are assured adequate legal protection. representing only about 28 percent of shareholdings. Vol. The SEA of 1992 and the listing rules also contain provisions for the protection of shareholders against transfer pricing. minority shareholders may also appoint an outside inspector to examine the company’s operations and financial condition. The ADB survey results reveal that the proposals presented by management were rarely rejected during the general meetings. the only group of shareholders that can exercise rights is the top five shareholders. In practice. on average. Although the attendees held. they comprised only 8 percent of total shareholders. On paper.

Seven of the companies responding to the ADB survey indicated that all their creditors required collateral. However. Only three companies thought otherwise. as the ADB survey confirmed. Only 28 of the responding companies in the ADB survey indicated that their creditors required such feasibility studies. when insiders want to expand their company’s operations without losing control. to solve debt repayment problems. such as that seen in Thailand before the crisis. Leverage allows the assets and operations of the company to grow without diluting corporate control. creditors do not always require project feasibility studies or business plans in granting loans. however. Most companies reported that banks were more likely to require collateral. they resort to borrowing. including procedural disputes. Apparently. the majority believed that creditors had little influence on company management and decision making. The presence of collateral usually diminishes banks’ incentives for screening project feasibility and monitoring project implementation. Debtors had many handles to stall the bankruptcy process. One tempering mechanism that could inhibit the excessive use of borrowing is the threat of losing control in the event of bankruptcy. a company’s reputation and its long-term relationship with creditors sufficed in many instances. Thailand has relied on commercial banks and finance companies to channel funds to private enterprises. Under a weak bankruptcy system. which could cause a delay by at least a year. 11 experienced rejection after the crisis started.Chapter 4: Thailand 249 Historically. Among 16 companies in the ADB survey whose loan applications in the last three years were rejected. borrowers seldom lose control to creditors even when they default and become insolvent. There were many options. creditors’ collateral requirements were tightened after the crisis. Fifteen of the 20 companies that had to renegotiate loan repayment with creditors in the last five years did so after the crisis. The old bankruptcy law in Thailand also made it difficult for creditors to obtain payment against bankrupt borrowers. while loans for fixed investment were also more likely to be supported by collateral. The impact of the financial crisis on credit eligibility and supervision requirements has been significant. For 20 of the 46 responding companies. 17 indicated that only some of their creditors had such a requirement. other than losing control. Eleven companies stated that creditors usually exercised whatever influence they had on management through covenants regarding the use of loans. Actual bankruptcy proceedings took more than five years on average. . Normally. while 18 said none of their creditors required collateral. In the end.

9). and (iii) tender offers will be effective 30 days after the report has been filed with the SEC.3 billion. SEC has no authority to either approve or reject tender offers. with a significantly lower total tender offer value of B8. which is a general offer made to shareholders of a company to acquire at least 25 percent of outstanding shares. there were only six tender offers. whether directly or indirectly. and failed to provide managers with strong incentives to perform efficiently. however. There are detailed requirements regarding such notification. before the extent to which the bankruptcy framework has been strengthened becomes clear. a person who acquires more than 5 percent of issued shares must file a report with SEC one day after the date of acquisition.250 Corporate Governance and Finance in East Asia. According to the SEA of 1992. Although merger and acquisi- . the minimum tender offer was reduced to 10 percent and some procedural modifications have also been introduced. The company has 21 days to evaluate the tender offer and submit a report to SEC and all shareholders. The market for corporate control has not been active in Thailand. The dearth of tender offers before the crisis suggests that the Thai capital market did not offer a venue for imposing market discipline on corporate management. with a total tender offer value of B42. In 1994 and 1995. It will take years. The first category is the acquisition of shares in the open market. The second category is the tender offer.3 billion (Table 4. SEC was later made responsible for regulating corporate takeovers. only a limited number of successful mergers of public companies have taken place. there are two categories of merger and acquisition activities with associated regulatory measures. Recently. Such efforts would serve to strengthen external discipline on controlling owners. there were 41 cases of tender offers. its main role is to ensure transparency and fairness. of shareholders: (i) all shareholders must receive tender offers. The Market for Corporate Control The SEA of 1992 was the first legislation that stipulated rules and regulations regarding the market for corporate control. Since the introduction of the Public Limited Company Act of 1978. II The financial crisis has presented a unique opportunity for reinventing the framework for corporate bankruptcy and for creating regulatory and judicial precedents. In 1996. Vol. The situation remained sluggish in 1997 at nine tender offers and a further decline in total offered value. if the purchase of shares implies a change in the directors or business activities. (ii) an advertisement regarding the tender offer must be placed in major newspapers for at least three consecutive days. In this case.

employees are even less willing to accept common shares as a form of compensation or benefit. employee participation in corporate governance in Thailand.7 Purchase Value Number of % of Tender Offer Value Companies 84. Since 1994. but employees have never been represented in the board of directors since their shareholdings are minimal. trading by mutual funds in SET represented less than 10 percent of total trading. it remains small.2 7.2 8. Employee Participation in Corporate Governance There has been little. tion activities increased after 1997. if any.7 11. but the average shareholding is smaller than 1 percent of total outstanding shares.2 6. Eleven of the 46 responding companies in the ADB survey offer ESOPs. 1993-1999 Year 1993 1994 1995 1996 1997 1998 1999 a Tender Offer Valuea (B billion) 5.1 19. not with a view to becoming involved in actual management.2 6. While the Thai mutual fund industry compares well to those in other developing countries in the region.3 60. they have mostly been concerned with short-term gains. Few companies offer employee stock option plans (ESOPs).9 3.9 Merger and Acquisition Activities.1 84. employees regard the plans as monetary incentives.0 55.6 17. most of these were forced mergers or related to rescue packages. Provident funds for government workers and workers in public enterprises have been established only recently. Twenty-nine firms indicated that employees held shares of their companies.5 6. The number of domestic institutional investors rose after the mutual fund industry was established in 1991. Even when companies offer ESOPs. But instead of opting for an active role in the market for corporate control.4 23. Source: Securities and Exchange Commission of Thailand.8 81. Pension funds are perhaps even weaker in Thailand.0 B billion 4.Chapter 4: Thailand 251 Table 4.1 58.8 8 27 14 6 9 13 23 Tender offer value refers to the minimum offer value. Because of the current crisis. .3 11.1 75.3 6.

Vol.8 941. .912.161.1 6. Competition from foreign banks was limited as they were not allowed to engage in full branch operations. 15 of which were domestic banks.3 5.8 3.119.775.3 546.564.372.4 3.5 Outstanding Loans from Commercial Banks 2.5 5. 1992-1999 (B billion) Outstanding Loans from All Financial Institutions 2. In 1996.4 519. The country’s largest bank.663.2 262. Many large commercial banks had affiliates among the 93 finance companies that served the high-risk market.0 424. The share of domestic banks in the banking system’s total assets was 80 percent..10 Size and Composition of the Thai Financial Sector.430.559. Thai Bond Dealing Centre.1 5.5 4.477.0 8.906. although its role increased in the wake of the crisis.133.3 1.0 3.4 Year 1992 1993 1994 1995 1996 1997 1998 1999 Source: Stock Exchange of Thailand.252 Corporate Governance and Finance in East Asia.268.825.037.390.4.1 7. there were 29 commercial banks.1 3.9 2. The total values of loans from financial institutions and commercial banks were consistently larger than the market capitalization of SET.10) shows that Thailand is a highly bank-dependent economy.669.0 SET Market Capitalization 1.6 2.4 1.6 1.1 3.979.2 2. the next four largest banks accounted for 63 percent.0 339.325.300. and Bank of Thailand. the banking sector was highly concentrated.5 6. The Banking System Until recently.360. total assets of commercial banks amounted to B5. accounted for 28 percent of the banking sector’s total assets.193.230. Bangkok Bank Ltd.485.6 6.1 Domestic Debt Securities Outstanding 215. Table 4. II 4. The bond market played only a marginal role in corporate financing.4 4.5 4.1 Corporate Financing Overview of the Financial Sector A breakdown of the Thai financial sector for the period 1992-1999 (Table 4.4 4.5 trillion.171.

also made it unattractive to raise capital from the equity market. and 20 new foreign banks. was set up by 74 members with an initial capital of B500 million. Despite the worldwide market crash in 1987. the liberalization of interest rates and capital account transactions stimulated a credit expansion through short-term borrowings in foreign currency.8 in 1998. In 1993. the Government established the BIBF to expand the banking sector and reduce the borrowing costs of Thai companies. BIBF banks also enjoyed tax incentives on their operations and profits. SET immediately recovered due to the strength of the Thai economy. The number of listed companies also quadrupled between 1981 and 1993. SET is organized into 32 major industries. the stock market entered its first boom period in 1986. finance. Some 347 companies were listed in the same year with a total market capitalization of B3.Chapter 4: Thailand 253 The Government was also a major figure in the banking system. the market rose steadily and reached a record high in the fourth quarter of 1993. Easy access to commercial bank loans by family business groups. the SET index declined. and property have accounted for the bulk of trading volumes. due to their close ties. The Government removed controls on capital and dividend repatriation in 1991. owning 70 percent of the country’s second largest bank. Banking activity peaked in the mid-1990s. In the following years. The lack of supply of quality shares was a big problem for SET at that time. Licenses were granted to 15 Thai banks. BSDC is a nonprofit. Stock prices tripled in the next three years until the market experienced its first crash as a result of the Gulf Crisis in 1990. and almost all capital account transactions were deregulated. Through the years. reaching 355. Benefiting from rapid economic and industrial growth. Banks under the BIBF scheme were allowed to mobilize funds from abroad and lend to Thai companies in foreign currency. an over-the-counter market.2 trillion. In contrast. hardly any progress was made in lowering the cost of domestic financial intermediation or in developing new financial instruments for corporations. SET was not very active. In 1995. The Equity Market During the first few years of its operations.3 trillion. Because borrowers carried the exchange rate risk. Turnover value reached B2. After that. self-regulatory organization under the . Many company founders did not want to release even a small portion of corporate ownership and refused to go public. 12 existing foreign banks. banking. the Bangkok Stock Dealing Center (BSDC).

Listed companies were those that had (i) paid-up capital of at least B20 million. with each facing different listing requirements. Before 1993. which has a legal mandate to examine a company’s financial status and operations before allowing it to issue securities to the public. Vol. Turnover value was B1. The primary market is supervised by SEC. the BSDC was dissolved in 1999. A company wishing to qualify for listing in SET must file an information booklet (prospectus) with SEC and SET. In July 1990. SET established new requirements for initial public offerings. The allocation procedure is nondiscretionary. and securities registrar. The company should then appoint a financial adviser. SET. In 1996. which consist of SET and BSDC.8 billion in 1996. to assist in the public offering process. After initial public offerings. so now only listed companies are traded in SET. lottery drawing must be used to ensure fairness. Its main role is to serve as a secondary market for unlisted companies trying to raise capital. however. If the issue is oversubscribed. In 1998. each holding no more than 0. Company applicants must have an established history of operating under substantially the same management. and (ii) a minimum of 300 shareholders. Only one security was listed in BSDC in 1995 and two more in 1996. securities can be traded in the secondary markets. financial projections. approved by SET. securities deposit center. and pro forma balance sheet and income statements.5 percent and collectively owning at least 30 percent of paidup capital. turnover value was negligible and the BSDC Index remained flat throughout 19961998. among other functions approved by SEC. there were two kinds of companies in SET—“listed” and “authorized” companies. also acts as a clearinghouse. According to the SEA of 1992. If approved by SEC and the SET Board of Governors. . the two classifications were merged. It separated the primary and secondary markets to promote more flexible and effective supervision of both. SET’s primary functions are to serve as a center for the trading of listed securities and to provide the essential systems needed to facilitate securities trading. but dropped the following year to B122 million. Authorized companies were those with a minimum of 200 shareholders owning collectively at least 25 percent of paid-up capital. stock trading can commence within five days.254 Corporate Governance and Finance in East Asia. Proposed changes in capital must be submitted for approval to SET accompanied by a detailed memorandum outlining the use of proceeds. Consequently. The listing application should be submitted concurrently to SEC and SET. The SEA of 1992 installed the legal and regulatory framework for Thai capital markets. II jurisdiction of SEC.

the market for these bonds has been slow owing to the change in the Government’s original policy of requiring the use of state-guaranteed bonds as legal reserves. while secured debt instruments accounted for just above 10 percent.9 billion. The bond market in Thailand started in 1933. Beginning 1961. The Thai Rating Information Services. which encouraged limited companies and public companies to issue debt instruments. the Bank of Thailand assumed responsibility for regulating the bond market. the first bond rating agency in Thailand. . the size of the corporate debt market rose to B132. To gain some perspective of the size of the bond market in Thailand. State-owned enterprises became active issuers of bonds since 1993 because the Government constrained their borrowings (Table 4. In 1996. it accounted for a small share of the entire financial sector. A turning point of the corporate debt market was the enactment of the SEA of 1992. at about 11 percent of the total value of outstanding loans extended by commercial banks and 20 percent of total equity market capitalization. The Thai bond market was also smaller than that of Malaysia (56 percent of GDP) and the Philippines (39 percent of GDP) in that year. was also instrumental to the growth of the corporate debt market. led to the renewed issuance of Government bonds to finance the resurgent budget deficit and support cash-strapped financial institutions. Investors had limited knowledge of debt instruments. the Government issued more bonds to finance industrial development projects and perennial deficits. and the Government did not issue new bonds during 1990-1997. Four years after the passage of the SEA. The proportion of domestic convertible debt instruments increased until 1995. The recent financial crisis. However. The budget surpluses of the 1990s eliminated the need for new bond issuance. however. in 1994. The corporate sector played a limited role in the bond market in the early years because of the complicated rules and regulations in effect at that time. the year the Ministry of Finance first issued government bonds to finance infrastructure projects and economic development. Upon its founding in 1942. it represented only 9 percent of GDP. A breakdown of domestic offerings of corporate debt securities from 1992 to 1996 shows that unsecured debts accounted for about 60 percent.Chapter 4: Thailand 255 The Bond Market The Thai bond market has played a marginal role in corporate financing until recently. compared to 110 percent in the US and 74 percent in Japan in the same year. Companies generally issued short-term debt instruments like promissory notes or bills of exchange.11).

1 6.3 140. the year the crisis unraveled and the baht was floated.3 6. The club was considered the first organized secondary bond market in Thailand to serve as the wholesale market for debt securities.9 329.7 5.1 21.5 — 39.0 5.9 40.0 60.3 — 14.8 2.0 7.9 37.1 10. .7 0. The following year. II Table 4. by the end of 1997.0 — 5.4 49.5 55.3 3.7 — — 40.1 55.5 — — — — 1.7 90.0 27. 1992-1999 (B billion) Item Government Bonds Treasury Bills State Enterprise Bonds Guaranteed Nonguaranteed Other Government Bonds Corporate Bonds Domestic Secured Unsecured With Warrant Convertible Short-Term Offshore Secured Unsecured With Warrant Convertible Total 1992 1993 1994 1995 1996 1997 1998 1999 — — — — — — 400.1 107.9 20.8 191.0 — 26.5 — — 32. The decline in total domestic debt offerings in 1996 can be ascribed to the increase in offshore convertible debts.2 — — 50.6 — 0.4 7. a surge attributed to capital inflows encouraged by high returns on Thai bonds. this had climbed to B200.7 538.4 — — — 1.7 28.8 Source: Securities and Exchange Commission of Thailand and the Thai Bond Dealing Centre.1 41.256 Corporate Governance and Finance in East Asia.2 45.1 121. Total offshore debt offerings peaked in the run-up to the financial crisis.5 10.7 0.11 Offerings of Debt Securities.7 132.7 95. A sharp rise in unsecured offshore debt offerings can be noted all the way through 1996.8 167. total offshore debt offerings had plunged by 68 percent to a mere B28.8 55.3 50.3 22. Vol. turnover value had reached B51.6 billion.7 5.3 29. BDC was established in November 1994 by 50 securities companies based on the provisions of the SEA of 1992.5 5.1 141.5 — — — 3.8 31.6 19.8 47.2 28.4 57.9 0.3 8.3 46.2 39.5 37.0 — 5.0 333.7 — — — — — 4.6 — — 0.1 315. The domestic debt market declined after 1994 because corporations could borrow offshore at lower costs.0 281.0 0.1 — — 6.7 821.4 billion.0 17.5 138.3 13.4 — 26.1 12.0 86.9 37.7 7.9 5.5 — 0. then declined substantially in 1996 and 1997.7 — — — — — — — 77.1 61.9 30.2 2.4 110.1 59.2 89.3 — — 3.1 — — — 29.1 8. However.0 33.0 26.5 billion.2 57. By 1995.4 — 9.2 43.5 43.1 289.3 46.

Longterm loans accounted for about 20 percent of total liabilities. In 1997. The proportion of accounts receivable also declined steadily. steadily easing up between 1990 and 1996. The average for all industries was only 22 percent. Turnover fell further to B72.12). There was also little change in the trend in retained earnings within the seven-year period. In addition. In any case. and marketable securities holdings. significant variations can be noted. Equity financing remains an important part of listed companies’ long-term financing. they also had a relatively small proportion of equity and . At lower than 5 percent of total liabilities.2 billion as a result of the default of debentures due to the Asian crisis.1 billion in 1998. while for the property development industry. Thailand’s publicly listed companies rely mainly on loans from commercial banks and financial institutions to finance their growth.4. a trend most apparent in the leap between 1991 and 1992. these comprised 31 percent. turnover value plummeted to B106. the use of debentures remains minimal even though the trend was generally upward until the 1997 crisis. cash balances. In the same year. Companies in construction and property development seemed unable to generate internal funds. Across industries. overall asset quality and liquidity of listed Thai companies deteriorated throughout the period. Retained earnings accounted for about 30 percent of total equity financing. The closure of 58 finance companies affected the BDC significantly since half of its members were suspended as a result. The overall trend is consistent with the decline in profitability observed in the analysis of corporate sector performance earlier.Chapter 4: Thailand 257 compared with investment in equities. short-term loans accounted for more than 40 percent of total liabilities. BDC was renamed “the Thai Bond Dealing Centre” following its status upgrade to a bond exchange. these accounted for 33 percent of total liabilities. listed companies experienced liquidity problems with declining reserves of cash and marketable securities during the period 1990 to 1996 (Table 4. with equity levels remaining high despite an increase in debt.2 Patterns of Corporate Financing An examination of financing patterns among Thai companies listed in SET shows that on the asset side. The ratio of net working capital to total assets decreased from a peak of 31 percent in 1993 to 28 percent in 1996. 4. For the construction industry. From 1990 to 1996. Construction and property development industries tended to have high proportions of long-term loans and debentures. judging by their relatively low levels of retained earnings.

8 37.2 2.0 100.9 0.2 3.5 37.1 49.9 40.0 100.2 16.0 100.6 21.6 15.3 14.8 25.4 17.2 43.2 42.6 100. The agribusiness industry relied more heavily on short-term loans at 56 percent of the industry’s total liabilities.9 50.0 100.3 12. US.0 Assets Cash Marketable Securities Accounts Receivable Inventories Other Current Assets Total Current Assets Net Fixed Assets Other Assets Total Assets Liabilities and Equity Accounts Payable Short-Term Loans Other Current Liabilities Total Current Liabilities Long-Term Loans Debentures Other Liabilities Total Liabilities Capital Stock Paid-In Capital Retained Earnings Total Equity Total Liabilities and Equity Source: Pacific-Basin Capital Markets Database compiled by the University of Rhode Island.9 16.0 13.7 14.7 52.1 36.3 48.9 20.8 3.5 1.6 6.2 45.6 12.2 1.6 14. 1990-1996 (percent) Item All Years 1990 1991 1992 1993 1994 1995 1996 2.5 9.3 6.4 7.0 100.3 18.2 22.4 43.9 18.8 17.4 48.6 10.1 13.6 13. compared with the 44 percent general average.9 3.1 18.7 36.2 15.9 10.2 35.6 100.5 1.7 9.2 17.0 7.8 6.3 49.0 12.7 50.9 6.8 21.258 Corporate Governance and Finance in East Asia.0 2.9 14.8 8.8 37.4 17.5 9.8 10.0 100.2 2.2 16.4 8.8 7.3 50.8 9.4 14.6 8.3 34.2 2.7 0.3 18.5 43.6 11.0 100.9 12.0 51.3 1.12 Common-Size Statements for Companies Listed in SET.6 36.9 2.0 15.0 14.2 17.7 17.7 15. Printing and publishing companies had lower financial leverage than companies in other industries.1 17.0 6.6 50.6 0.2 17.4 49.9 49.2 43. and low) also underscores that companies with high ownership concentration had high levels of long-term loans (Table 4.3 25.8 14.8 9.7 16.3 1.0 100.5 11.9 17.6 0.6 2.8 35.6 0.6 51.2 1.3 14.5 0.4 6.3 17.0 10.6 18.8 19.8 20.5 14.0 100.0 100.0 10.3 34. The level of total liabilities for the group characterized by high ownership concentration .6 22.3 38.7 1.13).4 49. II Table 4.1 7.9 6.7 7.3 21.4 2.1 50.2 2. Analysis of common-size statements by ownership concentration (based on the levels of top-five ownership concentration classified as high.1 5.9 38.0 48.9 14.0 100.8 34.0 100.3 2.8 1.6 38.2 1.9 14.7 16.8 46. Vol.2 34.0 1.1 2.6 0.9 17.0 100.0 100.9 43.9 14.5 1.2 17. medium. were highly leveraged.9 15.2 12.9 14.4 21.7 18.

9 0. .8 12.0 19.3 1.0 16.9 2.0 6.9 7.5 percent for low ownership concentration companies.6 47.0 Medium 2.5 13.1 49.4 35.9 21.8 13.8 13.0 7.3 8.9 100.4 18.0 100.2 14.2 11.2 22.7 percent for medium ownership concentration companies and 49.3 16. This is consistent with the observation that majority shareholders try to maintain their control by utilizing debt as a major source of funds.2 0.4 49.9 16.6 15.0 100.2 45.3 100.1 44.4 37. common equity accounted for a smaller proportion of total assets (47 percent) than companies with lower ownership concentration.0 Low 1.6 14.7 12.4 3.5 21.0 Source: Pacific-Basin Capital Markets Database compiled by the University of Rhode Island.4 13.3 35.13 Common-Size Statements of Public Companies by Ownership Concentration.6 0.9 36. was 53 percent of total assets compared with 49. Companies with medium ownership concentration tended to have a higher proportion of short-term loans.2 8.1 36. US.0 14.5 100.Chapter 4: Thailand 259 Table 4.0 6.6 9. 1990-1996 Degree of Ownership Concentration Item Assets Cash Marketable Securities Accounts Receivable Inventories Other Current Assets Total Current Assets Net Fixed Assets Other Assets Total Assets Liabilities and Equity Accounts Payable Short-Term Loans Other Current Liabilities Total Current Liabilities Long-Term Loans Debentures Other Liabilities Total Liabilities Capital Stock Paid-In Capital Retained Earnings Total Equity Total Liabilities and Equity High 2.6 22.6 2.1 53.5 11.1 18.6 100.0 41.4 7. For the high ownership concentration group.7 17.4 50.4 1.9 50.7 19.8 37.3 1.5 18.

however. An overall picture of SET-listed companies’ financing and investment patterns in the 1990s shows a steady rise in the use of financial leverage (Table 4. Vol. bond issues overtook loans from commercial banks as the second preference. Short-term debt accounted for most of the increase.9 51. II Results from the ADB survey reveal that Thai companies preferred to use reserves and retained earnings as their first choice of financing.7 in 1994 to 5. More important.1 31. The ratio of total debt to total assets increased from 50.14 Financial Ratios of All Listed Firms.9 63.7 12.6 138.1 64. Generally.8 percent in 1990 to 52.9 14. 1990-1996 Ratio Times Interest Earned Total Debt to Equity (%) Long-Term Debt to Equity (%) Total Debt-to-Assets (%) Long-Term Debt-to-Assets (%) Net Working Capital-to-Assets (%) Operating Capital-to-Assets (%) 1990 1991 1992 1993 1994 1995 1996 8.8 151. followed by bank loans.1 144. was the headlong deterioration of firms’ ability to meet their interest payment obligations. and rights issues. the choice of financing is determined by the company’s liquidity considerations. especially from 1994 to 1996. it would seem that firms with concentrated ownership and associated links to the banking system have easier access to debt financing. After the crisis.8 5. Such deterioration of financial positions during the period was a common feature of listed companies. however. The financing patterns indicate that companies with high ownership concentration were more highly leveraged than companies with medium and low concentration. and maintenance of the existing ownership structure.1 44.1 in 1996.4 12.5 52.0 50.9 7.7 percent in 1996. As a result. While further detailed investigations are necessary.7 66.7 12.14). US.6 7.1 52.7 11.0 28. these firms more easily increased their leverage. bond issues. Public companies relied more on short-term debt financing in the period before the financial crisis.15.4 7.0 25.1 31. thus rendering them more vulnerable. . The direct relationship between the degree of leverage and the degree of ownership concentration is apparent in Table 4.8 51.4 139.7 28.8 65.7 34.7 5.4 44. minimization of transaction and interest costs.3 31.4 51.2 49.8 65.6 41.2 35.4 5.9 140. Table 4.260 Corporate Governance and Finance in East Asia.0 145.6 125. The TIE ratio declined from its peak of 7.3 Source: Estimated from the Pacific-Basin Capital Markets Database compiled by the University of Rhode Island.7 34.5 38.1 16.1 23.1 16.3 61.2 68.

4 percent to 46 percent during the same period.2 124. continued to slide from 1985 to 1997.5 percent of external debt in 1996 (Table 4.9 percent in 1997. unhedged foreign exchange liabilities.5 4.8 percent in 1986 to 52 percent in 1995.2 49.8 66. 1990-1996 Degree of Ownership Concentration Ratio Times Interest Earned Total Debt to Equity (%) Long-Term Debt to Equity (%) Total Debt-to-Assets (%) Long-Term Debt-to-Assets (%) Net Working Capital-to-Assets (%) Operating Capital-to-Assets (%) Low 6. . Their average annual growth rate declined from 28.2 percent in 1986 to 251. The composition and term-structure of this debt. The proportion of external debt as a percentage of GDP consequently increased from 42. the proportion of short-term debt increased from 15. debt-creating capital inflows rose to 65 percent in 1990.7 percent from 1991 to 1996.5.16).6 11. on the other hand.8 28.6 30.4 13. This decline was accompanied.8 Medium 7.1 The Corporate Sector during the Financial Crisis Impact of the Financial Crisis on the Corporate Sector The financial crisis came after a period of rapid growth in the Thai economy. 4. by a remarkable growth in the proportion of debt-creating capital inflows in the wake of the development of the debt market and the establishment of the BIBF. such as direct equity and portfolio investment.15 Financial Ratios of Listed Companies by Ownership Concentration. Additionally. however. private debt accounted for 84.5 148. is even more telling. The corporate sector contributed significantly to the crisis because of its rising levels of leverage.4 52.5 126.1 High 6.3 42. From 45 percent of total net capital movements in 1985. US. The proportion of nondebt-creating capital flows. peaking in 1994 at 84 percent.5 percent between 1985 and 1990 to 8.4 27. From only 34 percent in 1986.Chapter 4: Thailand 261 Table 4.3 Source: Estimated from the Pacific-Basin Capital Markets Database compiled by the University of Rhode Island.8 14.8 49.8 29. and a preponderance of short-term debt liabilities.0 64. Nonbank private debt increased from 27.4 63.5 34.

0 6.9 3.7 1.9 35.6 1.9 1.1 64.7 10.4 — — — — — — — 1.0 3.2 2.6 18.Table 4.8 108.7 13.1 Source: Bank of Thailand.9 4.1 95.3 0.1 0.1 2.1 34.3 20.9 100.1 12.5 12.8 31.6 — 0.4 3.8 0.3 37.3 0.5 14.7 24.3 0.1 30.9 10.0 Long-Term Short-Term BIBF Commercial Bank Long-Term Short-Term 0.9 1.9 43.9 29.2 2.3 0.1 23.5 4.1 22.2 15.0 4.3 105.4 5.5 19.16 External Debt.9 7.6 Government Year Long-Term Short-Term 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 12.4 15.3 2.9 31.7 23.7 0.5 12.8 3.4 2.3 12.5 16.8 12.3 16.3 0.2 0.3 0.8 10.2 2.1 0.3 3.4 10.2 0.0 8.9 13.1 0.6 Total 18.5 1.2 14.2 10.0 21.9 10.4 18.9 6.8 13.2 32.9 0.3 — — — — — — — 6.3 0.1 0.0 0. .3 7.9 3.1 5.7 2. 1986-1999 ($ billion) Private Nonbank Long-Term Short-Term 3.7 109.5 4.3 0.2 0.6 52.0 13.6 7.0 11.9 11.3 3.9 5.9 6.0 11.3 10.8 3.7 20.

The value of public offerings sank in 1997 to B56. the index declined to 1. nonfinancial companies also experienced severe liquidity problems as a result of the baht’s devaluation. closures. Meanwhile. Even before the crisis. NPLs spiraled from 12 percent in the second quarter of 1997 to almost 40 percent in the third quarter of 1998.17). After that. foreign currency-denominated debts constituted 55 percent of their total debt portfolio. the numbers of bankruptcies and company closures reached all-time highs in 1998 (Table 4. It hit a 10-year low in the second quarter of 1998. according to the Bank of Thailand. and (iii) bankruptcies. reaching 45 percent of total outstanding credit in December. large Thai companies had actively borrowed at low interest rates from foreign financial institutions. and poor business confidence on the other. from its peak in 1995. At the end of 1994. Trading volume has since been thin.Chapter 4: Thailand 263 This shows that although banking and finance companies suffered most because of their short-term exposure.360. Most of these foreign debts were not properly hedged. banks would be recording more of such NPLs. the SET Index stood at 1. suggesting that serious investors have not returned to the market. the number of newly registered companies dropped to a 10-year low in 1998. and drastic decline in the number and capital of newly registered companies. the liquidity problems faced by the corporate sector are likely to continue for some time. Due in part to liquidity problems on the one hand. (ii) the rise in the nonperforming loan (NPL) ratio and consequent tightening of credit even for viable firms.6 billion from the 1996 level of B201 billion. outstanding credit also declined throughout the second half of 1998. The severity of the impact of the crisis on the corporate sector was apparent from (i) the decline in the volume of public offerings. SET’s dismal performance is indicative of the extent of the setback suffered by the Thai capital market. . based on the three-month past due definition. The ADB survey conducted for this study confirms this: 35 of the 46 respondents indicated that they took out foreign-denominated loans mostly from foreign banks.281 in December 1995 and to 831. exposing the companies to disaster when the baht started tumbling on 2 July 1997. Foreign investors retreated from the market. Aside from the problem of NPLs. The effects of the crisis were felt across all industry sectors.6 in December 1996. trading activity at SET had been on the downturn. The proportion of NPLs as a percentage of outstanding loans demonstrates the liquidity problem experienced by the corporate sector. Similarly. If lending rates remained high. With easy access to foreign funds. On average. leaving domestic investors with large capital losses.

902 3.112 9. The increase of the P/E ratio in 1998 was mostly a result of a decrease in earnings for most listed companies.925 12. The IMF financial package was a credit facility of $17.933 25. 4. But when assistance from other sources did not materialize.105 4.677 Bankrupted/Closed 2. IMF required Thailand to meet a set of performance criteria and implement various restructuring measures. 1985-1999 Year 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 Newly Registered 10.134 31. the Government was left with no choice.2 Responses to the Crisis Initially.2 billion for balance of payments support and buildup of the country’s reserves.095 14.218 3. It also explains the higher dividend yield ratio. As part of the assistance package.307 4.334 4.904 20.5 at the end of 1994 to 12 in 1996 and further to 6. The first Letter of Intent was cosigned by the Minister of Finance and the Governor of the Bank of Thailand on 14 August 1997.6 in 1997.5.052 36. the Thai Government was lukewarm to the idea of obtaining IMF assistance because of the requirements and conditions attached to the financial package. Thailand.312 25.915 37.409 6. Ministry of Commerce.977 Source: Department of Commercial Registration. .066 19.096 22.695 3.264 Corporate Governance and Finance in East Asia.17 Number of Newly Registered and Bankrupted/Closed Companies.797 4.407 28. The price-to-earnings (P/E) ratio deteriorated from 19. II Table 4.201 24.224 4.777 11. Vol.410 5.792 7.288 35.410 37.080 9. A steady price decline over the past few years has dragged down the ratio of market price to book value.

and if necessary. There were many options for solving debt repayment problems. and Credit Foncier Businesses. For example. drawn up with World Bank and ADB assistance. As it turned out. Creditors could negotiate to reschedule debt repayments. They could seek civil action through the courts and could also use criminal sanctions to enforce debt repayments. Securities. follow through with a civil or bankruptcy suit. The Government required all remaining financial institutions to recapitalize and instituted closer monitoring measures to ensure full compliance with this requirement. only two companies emerged intact from the suspension. and worked on revisions to the Secured Transaction Law. Regulatory Response by the Government The IMF program. The Financial Sector Restructuring Authority was established in October 1997 to address the problems of 58 finance companies that were suspended in 1997. By invoking procedural loopholes. increase profitability. and did not recognize debtor-initiated bankruptcy declarations. debtors could drag out the process for many years. IMF relaxed these key conditions. In early 1998. While no definition for “insolvency” could be found in the bankruptcy law. however. Many believed that the process was inefficient. also aimed at institutionalizing legal and regulatory reforms. Several changes in the banking and financial policy environment have been effected in line with the restructuring program. Strict loan classifications. and restore solvency. and the Act Regulating the Finance. Under the old bankruptcy laws. The old law allowed only creditors to file bankruptcy suits. secured creditors had to obtain the court’s approval before starting proceedings . The Bank of Thailand also improved banking standards. The Government also passed the Bankruptcy Act and Foreclosure Act Amendments. The assets of the other companies were liquidated by auctions. it was widely interpreted as “having debts more than assets. creditors seldom succeeded in obtaining payment against bankrupt borrowers. and income recognition were implemented. These include repeal of the Commercial Bank Act.” Creditors thus bore the burden of proving a debtor’s insolvency before the courts. the Civil and Commercial Code. loan provisioning. The core of the IMF conditionalities was the restructuring of the banking and financial sector to regain investor confidence.Chapter 4: Thailand 265 The terms of the agreement required the Government to maintain tight monetary and fiscal policies.

If the process fails to revive the business. II for the recovery of debt through the realization of any collateral. Enforcement of the new law is bound to be ponderous and lengthy. a remedy beneficial to borrowers and creditors is made possible through a business reorganization that should improve the borrower’s debt position and ensure its continued operations. and (iv) the debts shall have been settled within a five-year period. Under the old Bankruptcy Act. any new loan to a company extended after the creditor discovered the insolvency would not be eligible for repayment. and expensive process. The amendment added reorganization provisions to the Bankruptcy Act of 1940. The original Bankruptcy Act dealt only with liquidation and composition. The amended law also introduced the concept of automatic stay. The reorganization process is successful if (i) the debts shall have been discharged. The amended legislation also includes voluntary bankruptcy as a new feature. which means that a debtor could continue in business while the reorganization program was being implemented. (iii) shareholders regain their legal rights. Chapter 11 is the main tool in restructuring bankrupted companies in the US.266 Corporate Governance and Finance in East Asia. creditors always had to contend with the threat of disruptions in a delinquent borrower’s business. Companies need . thereby allowing court-supervised corporate restructuring. But more important. Foreign secured creditors had to go through the motions of establishing that their country of domicile granted Thai creditors similar rights. but it is a complicated. the National Assembly passed an amended Bankruptcy Act and approved the establishment of special bankruptcy courts. The model for Thailand’s amended bankruptcy law was the US Chapter 11. time consuming. The new law is designed to prevent bankruptcy due to temporary liquidity problems by allowing an insolvent debtor to file a reorganization plan with the court. Vol. (ii) management of the company reverts to the borrower. it covers only the court-supervised reorganization of distressed companies. the judges and court officers have yet to learn and master the new bankruptcy procedure. the main purpose of which is to assist in the rehabilitation process so that a company can repay its debt and still retain its assets while remaining in business. In Thailand. There are other potential problems. For one. the company shall be declared bankrupt and liquidation of assets shall follow. To make matters worse for creditors. In effect. the amended law limits the rights of secured creditors. Chapter 11 cases account for only 5 percent of bankruptcy suits in the US but consume 90 percent of the courts’ time. In 1999.

Minority shareholders also have to absorb the costs related to their actions because the 1992 Act does not allow them to be reimbursed by the company. Without the necessary corporate restructuring. The proposed new law seeks to expand the type of assets that a borrower can use as collateral. the court.” as opposed to the more appropriate criterion of “ability to pay when the debt falls due.. The amendment seeks to revise old rules and procedures that tended to delay foreclosure proceedings. the test for insolvency still uses the balance sheet criterion. corporate governance) that caused the bankruptcy in the first place. only tangible assets were the norm. Procedural delays give borrowers an advantage because they can refuse to pay back their loans even though they can meet their obligations. The new foreclosure law cuts short the procedures required under the Civil and Commercial Code for petty or simple cases dealing with mortgage defaults: (i) submission by the drafting committee of a default judgment bill within a week. namely “liabilities exceed assets. SEC also examined the possibility of an amendment to the Public Company Act of 1992. has not been satisfactory. The result. the Bankruptcy Amendment will just prolong the problems of nonviable borrowers. . Under the new law. shall have the power to call the extraordinary general meeting. Still pending Parliament approval is the amendment to the Secured Transaction Law. and (ii) processing of default cases within four to six months of filing of a court claim. Consequently.g. minority shareholders’ rights are not adequately protected. questions have been raised regarding the appropriateness of the 1992 Act. There have been proposals to lower the minimum shareholdings required for a minority group to request the board of directors to call an extraordinary general meeting at any time. In case the board of directors does not comply.” The Foreclosure Act Amendment was likewise passed in 2000. however. In the past. The proposed amendment also includes a provision for the company to reimburse minority shareholders for expenses related to calling such a meeting. Most important. The minimum shareholding requirement is too high for any individuals or groups of minority shareholders to take action against controlling shareholders. the 1992 Act relaxed some of the original restrictive rules and regulations to encourage public company registration. The amendment also remedies the slow process of executing or disposing of assets in a public auction. after determining the legitimacy of the request.Chapter 4: Thailand 267 to solve the problems (e. which aims to increase liquidity in the domestic economy by allowing businesses to use both tangible and intangible assets in securing credit. Replacing the Public Limited Company Act of 1978.

there are few provisions in the Act that deal with related or connected transactions that potentially reduce shareholders’ value. The regulators are drafting a proposal to amend the provisions on related transactions. with the approval of the board. the dominance of controlling shareholders. minority shareholders have no chance of being represented in the board. this is not so in publicly traded companies in Thailand. minority shareholders are likely to be wary of increasing their equity without corresponding control mechanisms at their disposal. to borrow from the company without consideration to the fairness of the transaction or transparency of the approval process. vis-a-vis the minority shareholders. and determine voting results on virtually any matter. disrupts the company’s management and decision making. Most companies decide against cumulative voting. Where equity will come forward. The proposal clearly delineates duties of care and loyalty for directors of public companies. the main problem is overlooked. The only reason Thai investors placed their money in stock issues despite these legal cracks was the rapid increase in stock prices in the 1990s. it permits directors. The textbook separation between owners who sit in the company’s board and professional managers who run the company does not apply in Thailand. This may be true in countries where publicly traded companies are widely held.. Otherwise. The radically changed circumstances after 1997 offer the possibility that firms and their controlling shareholders will be under greater pressure to concede to the exercise of minority rights. which. Consequently. II Another issue is the assumption in the 1992 Act that there is a separation of ownership and control functions. Because of high ownership concentration. The proposal for the amendment of the Public . Vol. However. But as demonstrated. the controlling shareholders have the exclusive domain to appoint or exercise management. i. The 1992 Act only prescribes—not requires—the use of the cumulative voting procedure. who are also the managers.e. But because this is the assumption embedded in the regulation. In addition. it will probably be expensive because of the higher risk that comes with weak accountability mechanisms. The 1992 Act also allows directors to engage in business activities that may directly or indirectly affect the company. without cumulative voting.268 Corporate Governance and Finance in East Asia. In the absence of such a stock market boom now. claiming that it creates fragmentation in the board of directors. subject only to approval by the board of directors. in turn. Directors enjoy unusual protection under the 1992 Act in that they can be pardoned by shareholders in the annual general shareholders’ meeting for any violation of fiduciary duties. they face the prospect of being unable to compete for the scarce funds available in the equities market.

Equally important is the contribution of effective and reliable bankruptcy procedures for improved corporate governance. CDRAC’s target debtors comprised 10. only 7.6 trillion) have agreed to cooperate with CDRAC’s restructuring process. personal consumption. although since then. Considerable progress has been achieved on this front. By October 2000.8 trillion had been completed. as well as those that did not cooperate with CDRAC’s restructuring process. the number of cases has abated. and procedures for debt restructuring.767 cases involving outstanding credit of B2. In addition. accounting for B1. Another 77.068 cases involving B475 billion are undergoing restructuring.1 trillion of outstanding credit.Chapter 4: Thailand 269 Company Act of 1992 includes a recommendation to require all public companies to use cumulative voting to ensure that the board of directors consists of representatives from all groups of shareholders. The reason is that bankruptcy law amendments appear to facilitate settlements outside the court. the court had more than 80 cases for disposition. methods. In response. The first bankruptcy court in Thailand opened on 18 June 1999. a Corporate Debt Restructuring Advisory Committee (CDRAC) was established in 1998 to map out debt restructuring measures in support of efficient negotiations between the private sector and financial institutions. will be settled by the courts. with the majority of the debtors coming from the commerce. contributing to the unprecedented rise in the corporate sector’s bad debt. and manufacturing sectors. Cases for which negotiations were unsuccessful. The Bank of Thailand issued guidelines in 1998 encouraging financial institutions to specify their own policies.764 debt restructuring cases involving B1. 322. where bankruptcy procedures are swift and effective. Commercial banks initiated 74 percent of these cases. As of November 2000. Some 82 percent of these cases have been successfully restructured. However. the mere threat of external control alters the incentives faced by managers and controlling shareholders significantly. This point is crucial because compared with . Reforms in bankruptcy procedures should be seen not only in the context of crisis resolution. the Government introduced debt restructuring-related measures to help resolve bad debts. accounting for B1. Another 5 percent of cases (B70 billion) are undergoing restructuring negotiations.147 cases (B1. Corporate Debt Restructuring and Bankruptcy The 1997 crisis led to a severe liquidity problem in the economy.6 trillion. In particular.1 trillion in outstanding credit. Within three months.

The exchange has already required that listed companies’ quarterly reports be directly comparable with annual statements. Weak bankruptcy procedures were part and parcel of the perverse set of incentives that led firms to build up unsustainable levels of debt. The study covers the period 1985 to 1996. II Malaysia. despite the weakness of their disciplinary powers. The banking industry played a key role in the early stages of economic development because it represented the only avenue for funding Thai corporations. behavior. The .6. Vol. and promoted key industries through incentives. The economic development of Thailand took off with the implementation of a series of National Economic and Social Development Plans beginning with the first medium-term plan for 1961 to 1966. Such improvements in disclosure standards are part of the efforts of SET and SEC. Thailand is coming from a situation where excessively high leverage became the norm because firms could obtain finance without having to concede a measure of control to outsiders. Conclusions. Financial information from listed companies will also soon be required to conform to International Accounting Standards. and even Indonesia.270 Corporate Governance and Finance in East Asia. to push companies to harmonize their accounting with international standards. 4. It required listed companies to establish their own audit committees by the end of 1999. Philippines. and Recommendations Summary and Conclusions This study has provided an overview of the corporate sector and governance in Thailand. For this reason.6 4. Examination of corporate ownership. In the next three decades. and performance during this period helps understand the causes of the crisis. the Government protected certain corporate sectors through tariffs and regulation. Emphasis was on the structure of corporate governance and patterns of corporate ownership and financing of publicly listed companies. the Thai Government managed its economy with the corporate sector as the main engine of growth and development.1 Summary. a time span that includes the onset of financial liberalization—the turning point of Thai economic development in the last decade—and represents the decade preceding the Asian financial crisis of 1997. Reforms through SET and Improved Disclosure The financial crisis prompted SET to introduce a range of improvements to its operation and regulation.

The financial performance of the corporate sector remained satisfactory up to the years before the outbreak of the financial crisis.000 from the previous year’s level.Chapter 4: Thailand 271 importance of bank financing continued throughout the 1990s. the Public Company Act of 1992 and the SEA of 1992. After 1992. the number of listed companies in SET fell from 454 in 1996 to 392 in 1999. Although there are some variations across industries. Nonbank private corporations accounted for most of the increase. During 1992-1997. Profitability increased throughout the 1980s but began to decline in the first half of the 1990s. One of the major findings is the high ownership concentration among Thai companies listed on SET. One of the principal causes of the crisis was the excessive use of foreign debt by the corporate sector. the top five largest shareholders hold about 56 percent of total outstanding shares. Because most of these debts were not hedged. the devaluation of the baht that began on 2 July 1997 affected the financial condition of Thai corporations. at a time when most of them were already experiencing declining profits and high leverage. The study examined the impact of ownership structure on corporate governance and financing patterns. The impact of the crisis was felt across all industries. Although there was a decline in short-term foreign debt. On average. The number of newly registered companies in 1997 dropped by almost 10. the number and value of public offerings of securities accelerated. Meanwhile. Financial liberalization apparently encouraged companies to borrow overseas to finance investments that were not productively employed. In 1992. Subsequently. the corporate sector entered a new era with the enactment of two major pieces of legislation. the profitability of publicly listed companies abruptly declined and their financial leverage increased. In 1995 and 1996. Minority shareholders. the overall corporate sector was seriously affected. At the onset of the 1997 financial crisis. the overall pattern of ownership concentration seems to have been stable for the past 10 years. This implies that the control of an average Thai company is typically in the hands of a few persons (founders or their associates) who own a majority of total outstanding shares. even after the development of capital markets. there was a marked increase in the number of public corporations. the increase in long-term debt more than compensated for the drop. . At the same time. the numbers of bankruptcy cases and company closures reached alltime highs. Thai companies were vulnerable to exchange rate risks. foreign debt in the Thai corporate sector increased continuously. The SEA of 1992 also marked the beginning of an active bond market in Thailand. reaching its peak in 1996. Consequently.

there is a clear lack of outside monitors for these publicly listed but family-controlled companies.272 Corporate Governance and Finance in East Asia. Individuals and insiders hold the second largest proportion at about 19 percent. they have little influence over management decision making and control. II although larger in number. Financial institutions hold a very small proportion. Most foreign institutional investors invest only on a short-term basis and aim for short-term trading profits. All these. These laws stipulate rules and regulations concerning the activities of all public companies. Among the five largest shareholders of Thai companies listed on SET. along with a highly concentrated ownership structure. The Government holds about 1 percent of total outstanding shares but these holdings represent majority shares of a few companies. The key laws. The investing public holds the rest of the outstanding shares. The implications of ownership structures that are concentrated to such a high degree are serious. through the use of holding and affiliated companies. Vol. commercial banks hold only about 2 percent of total outstanding shares while nonbank financial institutions hold about 6 percent. The absence of external market controls on the management of publicly listed corporations is dangerous. protect the interests of all shareholders of public companies. The rules in both Acts governing . Nominally. the government pension fund was the only major institutional investor. averaging 46 percent. It remains to be seen how reforms in bankruptcy procedures—including the increased threat of creditor control—could shift the incentives of controlling shareholders toward greater acceptance of equity finance and its consequent accession of control to new shareholders. Institutional investors in Thailand. Recently. contribute to the lack of external controls on the corporate sector through the capital markets. An analysis of the corporate ownership structure in Thailand suggests that founders and management continue to own and control publicly listed Thai companies. publicly listed and unlisted companies in Thailand are equally subject to the consequences of the risk-taking behavior of controlling owners. the mutual fund industry has entered the picture but with limited roles and activities. With financial institutions playing limited roles in the capital market. Consequently. hold only a small portion of total outstanding shares. Thus. the Public Company Act of 1992 and the SEA of 1992. In the past. The highly concentrated ownership structure weakens the protection of minority shareholder rights. holding companies and affiliated corporations hold the largest proportion at 27 percent of total outstanding shares. foreign and domestic. are not active. the existing legal and regulatory framework suggests otherwise.

Specifically. because there is no separation between ownership and management. Ownership concentration appears to have little impact on corporate profit performance.Chapter 4: Thailand 273 minority shareholders’ participation in decision making and in initiatives against management conform to international standards.2 Policy Recommendations There are three major policy issues and recommendations that could improve corporate governance in Thailand. For example. a requirement impossible to meet due to the concentrated shareholdings of founding family members and management. The Government has been moving to amend the Public Company Act of 1992 to increase minority shareholders’ protection in this regard. In view of this. In this third area. Consequently. an aim that can be achieved mostly through legal reforms.6. the high ownership concentration of many listed Thai companies inhibits the effectiveness of these provisions. It appears that founding family members use debt extensively to finance investments because they want to preserve control of their firms. laws did not provide minority shareholders sufficient safeguards in cases of transactions involving companies where the controlling shareholders had related interests. the main challenge is in protecting minority shareholders from the possibility of expropriation by the majority. Rather. making them vulnerable to economic shocks. 4. key reforms that will strengthen the regulation of financial institutions. the degree of ownership concentration has a statistically significant positive relationship to the degree of financial leverage. but is significantly related to financing patterns. these companies tend to become overleveraged. the Public Company Act of 1992 allows shareholders to act only when they hold a minimum proportion of shareholdings. The first issue involves the development of a comprehensive supervisory framework and the strengthening of the capacity of supervisory agencies. The second issue involves the protection of shareholder rights. The ownership structure of Thai listed companies also significantly affects company behavior. For instance. However. The third issue involves creating external market controls through better regulation and development of the capital markets. before the crisis. the main challenge is not how the board can control management to maximize shareholder value. because there are shared interests between the controlling shareholders and key management personnel. moreover. posed formidable barriers in the minority shareholders’ exercise of their rights. Certain provisions. .

and SEC) are involved in corporate supervision. the supervisory system is fragmented and not as effective as it should be. There is also supposed to be separation of ownership and control. SET was mandated to supervise listed companies. this is a problem in Thailand. with control delegated to professional managers. Development of a Comprehensive Supervisory Framework There is a need for the Government to establish a comprehensive supervisory framework for the corporate sector. Only then will these agencies be able to act promptly and effectively. . in 1975. activate the market for corporate control. Protection of Shareholder Rights The common assumption is that publicly traded corporations are widely dispersed in terms of ownership. The owners of a firm rely on a board of directors to supervise the managers. Vol. If this were the situation. in most of Thailand’s publicly traded firms. three major government organizations (the Ministry of Commerce. II encourage market competition. the key issue in corporate governance is how to prevent insiders from expropriating assets of minority shareholders. voting only on major decisions. SEC was established as another supervisory agency. Once the roles and responsibilities are clearly defined. and increase the participation of institutional investors are imperative.274 Corporate Governance and Finance in East Asia. and after the enactment of the SEA in 1992. The board therefore plays a pivotal role. The best approach may entail establishing a single. If the principal shareholder is in fact chair of the board. Under the current system. he/she often has the decisive vote. the supervisory agencies also need to be empowered to enforce the laws. As in other crisis economies in the region. In this setting. Consequently. It is important that the roles and responsibilities of each agency are clearly defined to the public. the principal shareholder typically plays a key role in management and often serves as the chief executive officer. the key issue in corporate governance would then be to ensure that managers act in the best interests of the shareholders. In reality. unified supervisory agency or a permanent regulatory division consisting of supervisory units from the three agencies. SET. the Ministry of Commerce had the sole supervisory responsibility. The Government must develop an overall framework for corporate sector supervision and redefine the regulatory jurisdiction of each agency along functional lines. This is due to the historical development of the Thai corporate sector: before 1975.

transparency. To ensure a level playing field. and a prohibition of connected transactions by directors or management. The Government does not have an effective way of monitoring the financial activities of these companies even as it is widely believed that a large amount of funds is being channeled through them. regulators must increase transparency and step up enforcement.Chapter 4: Thailand 275 There is a need to recognize the unique ownership structure in Thailand and its effects on corporate investment and financing behavior. SEC is exploring the possibility of amending the law toward this direction. Since the Asian financial crisis. The Ministry of Commerce is conducting a study on proposed amendments to the Public Company Act of 1992. This includes prescribing ways to empower minority shareholders without disrupting the company’s operations. This move is expected to be unpopular among founding family members and original owners. The current ownership structure leads to ineffective corporate governance and inadequate protection of minority shareholders. accountability. There is also a need for legislation dealing with nominee or holding companies because they are the institutional means that founding family members use to maintain control. increasing penalties for directors engaged in misconduct. The slow improvement in the legal framework has likewise obstructed progress in this area. The second recommendation is to dilute ownership concentration through the use of regulatory power. requiring cumulative voting for the election of directors. Because these holding companies control a number of large public companies in Thailand. SEC has been trying to lay the foundations of good corporate governance by espousing fairness. Through an amendment in the Public Company Act. The situation prompts two specific recommendations. they should be monitored and regulated. there has been much progress in this area. Both SET and SEC are taking an active stance in improving the transparency and efficiency of Thai capital markets. The first recommendation involves the repeal of current legislation to allow minority shareholders to have greater influence over management decision making. and . the Government can change the shareholding limit for controlling shareholders. Current laws allow a high degree of ownership concentration and provide inadequate safeguards against possible conflict-of-interest transactions and their impact on minority shareholders. But weaknesses in accounting and auditing practices have been inhibiting the development of capital markets. Some of the legal reforms under consideration concern settling conflictof-interest situations with significant effects on minority shareholders.

276 Corporate Governance and Finance in East Asia. In the stock market. in turn. there is a need to increase market disciplinary power through market competition. Thailand should develop a strong public debt market to supplement the banking system in financing corporate investments. . Because the financing of Thailand’s corporate sector is predominantly bank-based and will remain so for a long while yet. Accounting standards have also been under review. Capital Market Development and Regulation Another important issue concerns the development of capital markets. The same goes for improvements in the bankruptcy system. aimed at ensuring that banks finance only creditworthy projects. the SEC’s disposition toward a largely voluntary approach for adoption of these characteristics has resulted in uneven compliance among public companies. The promotion of active roles for domestic institutional investors should also improve corporate governance in Thailand. will incidentally close off easy sources of finance for companies that have been practicing regulatory arbitrage. A well-developed domestic debt market will provide corporations with an alternative to bank financing. which. Vol. There will be no incentive for companies to raise capital in the equities market if they can obtain funds at a lower cost elsewhere. The variety of debt instruments available to the corporate sector and investors should be increased and longer-term sources of bond finance actively promoted. a well-developed secondary market will pave the way for market disciplinary forces to act against poorly managed companies. will lead to the emergence of a reference yield curve. it will be difficult to improve corporate governance in Thailand. The Bank of Thailand’s enforcement of prudent lending practices among Thai financial institutions. it is important to explore reforms that can lead to the enhanced role of banks in monitoring enterprises. In an environment of highly concentrated ownership. Further. while a strong domestic debt market will also offer protection from foreign exchange risk. Without a strong and efficient capital market. However. the power of the capital market to discipline inefficient management is almost nonexistent. One way the Government can improve the current situation is to require publicly listed companies to trade a higher proportion of outstanding shares in the secondary market. The first step is to establish an active secondary Government bond market. especially in the area of connected lending. This may not be possible without reforms in the banking sector itself. for instance. II responsibility among companies.

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