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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

1992-1998 Table 2.3 GrowthandFinancialPerformanceofPubliclyListed Companies.11 CharacteristicsoftheBoardofCommissioners Table 1. 1992-1999 Table 1.14 Banking Sector Outstanding Loans.12 CharacteristicsoftheBoardofDirectors Table 1.5 Financial Performance of Publicly Listed Companies by Sector.21 Nonperforming Loans by Type of Bank.9 OwnershipConcentrationofPubliclyListedCompanies by Sector. 1996-1998 Table 1. 1997 Table 1.10 Anatomy of the Top 300 Indonesian Conglomerates.19 DER and ROE of Publicly Listed Companies by Sector. 1992-1997 Table 1.15 V alue of Stocks Issued and Stock Market Capitalization.20 ROE of the Banking Sector. Republic of Korea Table 2.16 FinancingPatternsofPubliclyListedNonfinancial Companies.1 Listed Firms with Positive Economic V alueAdded.13 Presence of Board Committees in Listed Companies Table 1. 1992-1999 Table 1. 1992-1997 Table 1.2 Foreign Capital Flows.18 GDP Growth by Sector. 1996-1998 2.4 Development of the Stock Market. 1992-1995 Table 1.1 Growth of the Banking Sector.7 Growth Performance of the Top 300 Conglomerates.6 GrowthandFinancialPerformanceofState-Owned Companies. 1992-1997 Table 1. 1992-1997 Table 1. 1988-1996 Table 1. 1990-1997 Table 1. 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 .2 KeyMacroeconomicIndicators Table List of Tables 1. 1993-1999 Table 1. 1986-1996 Table 1. 1993-1997 Table 1.4 Growth Performance of Publicly Listed Companies by Sector. 1990-1998 Table 1.8 OwnershipConcentrationofPubliclyListedCompanies.3 Subsidiaries of the 30 Largest Chaebols Table 2. Indonesia Table 1.17 DER of Listed Companies by Degree of Ownership Concentration Table 1. 1996-1999 Table 1.

1992-1997 OwnershipConcentrationofListedNonfinancialFirms. 1988-1997 Features of the 30 Largest Chaebols GrowthandFinancialPerformanceofthe30Largest Chaebols.19 Table 2.16 Table 2. 1988-1997 OwnershipConcentrationofListedNonfinancialFirms by Industry.29 Table 2. 1987-1997 FlowofFundsoftheNonfinancialCorporateSector. 1988-1997 FinancingPatternsoftheNonfinancialCorporateSector.27 Table 2. 1994-1997 Cross-Payment Guarantees of the Top 30Chaebols.8 Table 2. 1988-1997 Ownership Concentration of the Survey Sample of 81 Listed Firms.14 Table 2.22 Table 2.15 Table 2.6 Table 2. 1997 Ownership Composition of Listed Nonfinancial Firms by Control Type. 1999 InternalShareholdingsofthe30Largest Chaebols. 1985-1997 GrowthandFinancialPerformanceofListedCompanies by Size.30 Private Capital Flows to Korea.12 Table 2.vii Table 2. 1993-1997 The Top 30 Chaebols’ Debt-to-Equity Ratio. 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 .9 Table 2. 1995-1997 Ownership Composition of Listed Companies. 1985-1998 GrowthandFinancialPerformanceoftheNonfinancial Corporate Sector.24 Table 2. 1988-1997 Ownership Composition of Listed Nonfinancial Firms by Industry.21 Table 2.17 Table 2. 1988-1997 FinancingPatternsoftheNonfinancialCorporateSectorby Industry Financing Patterns of Listed Companies. 1994-1998 Financing Patterns of the Top 30 Chaebols.11 Table 2.20 Table 2.13 Table 2.7 Table 2. 1997 OwnershipConcentrationofListedNonfinancialFirms by Firm Size. 1997 Ownership Composition of Listed Firms in Selected Countries.25 Table 2.10 Table 2.26 Table 2. 1990-1997 InternationalComparisonofRatiosofOrdinaryIncome toSalesinManufacturing GrowthandFinancialPerformanceofSelectedIndustries GrowthandFinancialPerformanceofListedCompanies.23 Table 2.5 Table 2.28 Table 2.18 Table 2. 1990 and 1997 Ownership Composition of Listed Nonfinancial Firms by Size. 1997 Ownership Concentration ofAll Listed Firms.

3 TheCorporateSectorandGrossDomesticProduct. 1986-1998 Nonperforming Loans of General Banks. Thailand Table 4.000 Companies.17 Composition ofAssets and Financing of the Publicly Listed Sector. 1985-1997 Number of Firms with Dishonored Checks.10 Composition of Top Five Shareholders of Philippine Publicly Listed Companies by Sector.13 ADB Survey Results on Shareholder Rights Table 3. 1988-1997 Table 3.Profitability andFinancial . Leverage Table 3. 1988-1997 Table 3.2 Public Offerings of Securities.18 Financing Patterns by Control Structure.1 GDP Growth of SoutheastAsian Countries.8 Ownership Composition of Philippine Publicly Listed Companies by Sector. 1988-1997 Table 3. 1989-1997 Table 3. 1989-1997 Table 3. The Philippines Table 3. 1988-1997 Table 3.2 Growth and Financial Performance of the Top 1.viii Table 2. 1997 Table 3.14 Philippine Stock Market Performance. 1989-1997 Table 3.21 OwnershipConcentration. 1997 Table 3.SectorOrientation. 1992-1996 Table 3. 1983-1997 Table 3. 1992-1999 .1989-1997 Table 3. 1997 Table 3.11 TotalandPerCompanySales. 1988-1997 Table 3.12 Control Structure of the Top 50 Corporate Entities.1 Public Companies Registered.16 CorporateFinancing PatternsbyOwnershipType. 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. 1990-1999 Table 3. 1997 Table 3.20 Financing Patterns by Industry.4 GrowthandFinancialPerformanceoftheCorporateSector by Ownership Type.5 GrowthandFinancialPerformanceoftheCorporateSector by Control Structure.32 Table 2. 1989-1997 Table 3.19 Financing Patterns by Firm Size.7 GrowthandFinancialPerformanceoftheCorporateSector by Industry.6 GrowthandFinancialPerformanceoftheCorporateSector by Firm Size.33 Net Profit Margins of Chaebols. Flagship Company.9 OwnershipConcentrationatCriticalLevelsofControl Over Publicly Listed Companies.31 Table 2. 1988-1997 Table 3. 1978-2000 Table 4. andAffiliated Banks of Selected Business Groups. 1997 Table 3.22 Foreign Investment Flows. 1995-1998 4.15 Financing Patterns of the Corporate Sector.

Ownership Concentration. 1990-1996 Common-Size Statements of Public Companies by Ownership Concentration.5 Table 4. 1993-1999 Size and Composition of the Thai Financial Sector.9 Table 4.8 Table 4.1 Figure 1.14 Table 4. 1992-1999 Common-Size Statements for Companies Listed in SET.13 Table 4. 1986-1999 NumberofNewlyRegisteredandBankrupted/Closed Companies.16 Table 4. 1990-1996 External Debt.ix Table 4.6 Table 4. 1985-1996 Top-Five Ownership Concentration of Publicly Listed Companies in Thailand. 1990-1998 Merger and Acquisition Activities. 1990-1996 Financial Ratios of Listed Companies by Ownership Concentration. 1993-1999 Key Financial Ratios of Publicly Listed Companies.17 StatisticalHighlightsoftheStockExchangeofThailand. 1990-1998 StatisticalRelationshipsbetweenCorporateProfitability.1 Figure 3. 1985-1996 Average Key Financial Ratios by Company Size. 1985-1999 237 238 239 241 242 243 251 252 256 258 259 260 261 262 264 List of Figures Figure 1. Leverage.10 Table 4. 1990-1996 Financial Ratios of All Listed Firms.2 Figure 3.3 Table 4. and Company Size Top-Five Shareholder Composition of Publicly Listed Companies in Thailand.7 Table 4.4 Table 4.15 Table 4.12 Table 4.2 TheSuhartoGroup TypicalInternalOrganizationalStructureofaPublicly Listed Company in Indonesia CorporateControlStructure:TheCaseofAyalaCorporation CorporateControlStructure:theCaseofLopezGroup 24 25 195 197 .11 Table 4. 1992-1999 Offerings of Debt Securities.


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.

3 looks at patterns of corporate ownership and control. Economic growth reached more than 7 percent per year and the inflation rate was kept at single digit levels. these controlling families had political connections that allowed their companies to enjoy special privileges. On the other hand. Section 1. 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. Foreign creditors. This study reviews the Indonesian corporate sector’s historical development. Section 1.6 percent) and trade (-18 percent). particularly those with large foreign loans. and . patterns of ownership and control. and analyzes their importance to the corporate sector in Indonesia. how it has affected corporate financial performance and financing. or Thailand.2 presents an overview of the Indonesian corporate sector. and how it contributed to the crisis. II rate reached 58. In many instances. no doubt. prior to the financial crisis. It analyzes the weaknesses of corporate governance in Indonesia. To facilitate even easier access to credit. this left the Indonesian economy extremely vulnerable. These banks were allowed to operate even if they violated minimum capital adequacy requirements. The scale of the financial crisis exposed weaknesses of the country’s corporate sector. The construction sector was the worst hit. were the ones most affected. All sectors. patterns of financing.5 percent. Vol. placed a high premium on these political connections in assessing the chances of being repaid. highly leveraged companies. When the crisis hit the country.5 percent. In this setup. Malaysia. These were already contributing to high levels of nonperforming loans (NPLs) in the Indonesian banking sector several years before the 1997 crisis erupted. short-term loans were used to finance long-term investments. contracting by 36. the controlling families of corporate groups often established banks to provide funds to affiliated nonfinancial companies. the currency composition and term structure of corporate foreign indebtedness were causes for concern. except utilities. 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. posted negative growth. Foreign debt reached more than $100 billion. regulatory framework. However. and responses to the financial crisis. the Indonesian economy seemed to be in generally good shape.2 Corporate Governance and Finance in East Asia. The study also identifies family-based companies and corporate groups. followed by finance (-26. 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.

5 examines the corporate sector during the financial crisis in terms of its role. only 40 companies replied—39 are private companies and one state-owned company (Bank BNI). Despite the oil revenues. Section 1. medium. However. With the relatively liberal laws governing foreign and domestic private investments introduced by the New Order Government in 1967 and 1968. Section 1.2 Section 1. while Chinese and indigenous entrepreneurs ran some large businesses in trading.2 1. The Government became directly involved in industry as a result of the nationalization of Dutchowned shipping firms and oil companies. Subsequently. In the early 1970s. in the course of the fight for nationhood from 1942 to 1950. how it was affected by the crisis. 2 Survey questionnaires were sent to 280 companies listed in the Jakarta Stock Exchange. Up until the mid-1960s.6 summarizes the major findings of the study and suggests recommendations to improve governance in the Indonesian corporate sector. Not all items in the questionnaires were answered by the respondents. textiles.2.and large-scale companies were dominated by state-run industrial concerns.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. It also examines the statistical relationship between corporate performance and corporate governance characteristics. The industries that emerged were highly import-dependent and reliant on tariff protection. This section reports the results of an Asian Development Bank (ADB) survey on corporate management and control practices in Indonesian publicly listed companies. the windfall from oil and gas revenues was an important factor that allowed the Government to promote industrial development via import substitution. a gradual shift in public investment away from manufacturing took place. 1. and tobacco industries.Chapter 1: Indonesia 3 profiles the corporate sector’s governance characteristics. substantial volumes of private investment entered the scene. . and its response.4 analyzes corporate financing patterns.

the stock exchange was also unattractive to companies trying to raise capital as they could borrow from state banks at very low interest rates. mostly nonbank financial institutions and stockbrokers. there were also many rapidly growing large-scale companies and business groups or conglomerates. Second. and related products) had shares in total exports that were rapidly increasing. wood. By 1987. A number of underwriters emerged. even when new shareholders do not threaten the control exercised by the original owners. During this period. . 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). 1. exports of nonoil products (particularly textiles and footwear. which dominated their respective sectoral outputs and markets. In 1992.2 The Capital Market The Government reactivated the stock exchange in 1977. a distinct industrial elite started to emerge. These were families with strong links to the political elite of the New Order. the value of manufactured exports overtook the value of oil and gas exports for the first time. Vol. II the currency needed to be devalued periodically under a managed floating exchange rate system to avoid large current account deficits. the Indonesian industrial sector was quite diverse. many founding owners of companies were reluctant to go public and dilute their corporate ownership. While most of the companies were small. First. the dilution of corporate ownership. Regulations in the banking sector led to equities having higher risk but lower returns than bank deposits. the number of firms quoted in the stock market was only 24. Third. Generally speaking. The equity market remained largely unappealing due to a number of factors. Last. But these proved counterproductive because they limited the potential for capital gains to prospective investors. and employed the bulk of the industrial labor force. produced consumer goods. Partly as a result of various government policies. 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. potentially subjects companies to greater regulatory scrutiny. Export credits with low interest rates were granted to industries that were intensive in the use of local labor and raw materials. In the 1980s.4 Corporate Governance and Finance in East Asia.2. But until the end of 1988. the Government shifted its industrial policy toward the promotion of labor-intensive exports.

Consequently. . which were previously constrained to 4 percent per day. Since 1977. private domestic banks dominated the sector in terms of number and total assets. the controlling shareholder of these SOCs is still the State.3 The Banking Sector Despite the development of the stock market.1 shows that from 1994 to 1998. from 24 in 1988 to more than 300 in 1997. Table 1.5 trillion. the legal infrastructure that was supposed to guide the evolution of the banking sector was not backed by effective enforcement. which up to then was channeling oil revenues to priority sectors. reduced restrictions on foreign exchange transactions. However. to date. Interest rate regulations on state banks and credit ceilings in general were removed. These included the opening of the banking industry to new entrants. The initial banking sector reform was introduced in 1983. During this period.Chapter 1: Indonesia 5 At the end of 1988. The Government also allowed foreign investors to buy up to 49 percent of listed shares. the banking sector has undergone many reforms. The banking sector. Conglomerates carried out 210 out of 257 IPOs. 1. six SOCs had issued equities in the market. priority credits still enjoyed subsidized interest rates and funding from the Central Bank. In 1988. the number of private domestic banks increased. state-owned banks were still among the biggest. began to face competition. The Government also abolished the practice of setting prices for IPOs and removed restrictions on price movements in the secondary market. The dominance of state banks started to erode. Partly as a result of these reforms. Through the years. But in terms of assets per bank. Further reforms along the same direction and affecting state-controlled banks came in the 1990s. the liberalization of the banking industry allowed banks to determine lending rates for nonpriority loans. and increased access of domestic banks to international financial markets. more significant reforms were introduced. with a total value of more than Rp8 trillion. However. with a total value of Rp16. Thus.2. The development of the Indonesian stock market also provided a vehicle for the privatization of state-owned companies (SOCs). However. the number of listed companies in the stock exchange increased substantially. companies could no longer enjoy low-interest credit from state banks. the capital market played an increasing role in raising long-term funds needed by the corporate sector. the banking sector has been and still is the major source of credit for the corporate sector.

In terms of assets.6 7 12. Of these.5 165 308.8 10 19. and Bank Umum Nasional (BUN) have failed and the first two are now under management of the Indonesian Bank Restructuring Agency (IBRA). private domestic banks among the top 10 in 1997 included Bank Central Asia (BCA) (ranked first and linked to the Salim group). Both BCA and BUN have shareholders linked to the former President Suharto.9 304. and Bank International Indonesia (ranked 9th).8 29 6.3 30 7.7 27 37. the 10 largest were all affiliated with major business groups. Bank Danamon (ranked 7th).0 234 1994 104.5 27 66.1 240 1995 122.4 789.3 10 17.9 762.9 248.5 528. BCA.4 10 35. banks could earn profits even when they did not gather and process information about risk.3 27 51.9 27 113.8 27 147. But the banking system proved incapable of performing its intermediation function.2 161 214.4 239 222 208 173 Assets and liabilities were concentrated in the top 10 banks.3 201.9 10 11. Bank Danamon. 1993 100. while BUN has been closed down by the Government.6 34 14. II Table 1.6 164 144 130 92 387. Vol.1 Growth of the Banking Sector.5 27 88. .1 10 47.8 27 200.6 Corporate Governance and Finance in East Asia.8 166 248. Among private domestic banks. The other banks among the top 10 were state banks.6 7 7.8 391. Because regulation was weak.8 10 37. 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.9 291.8 31 10.9 39 18.2 10 14.7 351.6 240 1996 1997 1998 1999 141.5 7 9.4 34 12.9 31 9.5 7 7 7 5 15. 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.

74 5. there was a phenomenal growth in direct borrowings by Indonesian corporations. In 1994.81 3.4 Foreign Capital The years of rapid industrial growth attracted a large amount of foreign direct investments (FDIs). .88 4.01 (2.2 Foreign Capital Flows. initially from Japan and the Republic of Korea.00 2. Until the onset of the crisis.09) 1.15) — = not available.01) (0.40) (0.59 billion in 1996.09 1. textiles. especially through bank loans. Indonesia received capital inflows averaging about 4 percent of GDP. when the financial crisis hit Indonesia. as shown in Table 1. FDI flows were strong. Successive policy deregulation facilitated FDIs in various light manufacturing industries.2. and footwear.09) (0. September 2000. In effect. Increasingly.78 2. 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.11 3. Table 1.88) — — — — — — 8. November 2000. Net FDI flows increased to $5. From the mid-1980s until July 1997. IMF.50 (0. Between 1990 and 1996.48 1. 1990-1998 ($ billion) Type of Flows Net FDI Net Portfolio Investment Foreign Bank Loans 1990 1991 1992 1993 1994 1995 1996 1997 1998 1.63) (1. foreign investment also had a strong presence in the services and infrastructure sectors. foreign creditors were eager to provide financing to Indonesia. 1. they still amounted to a large sum for the economy to absorb. In the 1990s. except in certain strategic sectors. the Government allowed foreign investors to own 100 percent of an Indonesian company.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.59 4. Source: IFS CD-ROM. But FDIs were only one form of foreign capital inflows to Indonesia. Although these inflows were not nearly as large as those received by Thailand (10 percent of GDP) and Malaysia (9 percent of GDP). Most FDIs came in through joint ventures with business groups having strong political connections. such as metal goods.2. Joint BIS-IMF-OECD-World Bank Statistics on External Debt.33 (13.10 5.87 7.

Vol. From 1987 to 1996. especially the short-term ones. the average borrowing rate for dollar loans was 9 percent. allowing foreign investors to buy up to 49 percent of stocks of a publicly listed company. 1. and conglomerates.2. Due to data constraints. Between 1989 and 1992. The excessive dollar borrowings made the corporate sector vulnerable to sudden currency fluctuations. II Up until the late 1980s. the average foreign ownership of listed companies was 21 percent. increasing the total trading value from Rp8 trillion in 1992 to Rp120. 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. the analysis focuses only on publicly listed companies. plus 4 percent for the depreciation of the rupiah. participation in the Indonesian stock market was exclusive to domestic investors. This is lower than the average borrowing rate of 18 percent for loans in domestic currency. In November 1998. foreign investors began to dominate daily trading. Domestic corporate debt was about $50 billion equivalent. but declined to an average of 25 percent during 19951997. The Government relaxed this restriction in 1988.5 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. of which two thirds were rupiah-denominated. Private borrowers preferred foreign loans since these were relatively cheaper.8 Corporate Governance and Finance in East Asia. an interesting question is whether standard measures of corporate profitability and performance also indicated the same. In September 1997.4 trillion in 1997. 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. In the 1990s. with the onset of the Asian crisis. By the end of 1997. This increased to 30 percent by the end of 1993. . 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. Capital account liberalization permitted the inflow of foreign capital that fueled the credit boom in the country. state-owned companies (SOCs). total corporate debt reached nearly $118 billion. The external corporate debt owed to foreign commercial banks was $67 billion. foreign banks became a significant source of financing for the corporate sector. Consequently. The following section looks at the growth and financial performance of the corporate sector.

but declined to 0.0 3.7 — = not available.0 33.9 310.5 34. there were 204 firms.4 percent.Chapter 1: Indonesia 9 Publicly Listed Companies Table 1.8 220. the average DER increased to 310 percent from 230 percent the . but fell to 24.3 Growth and Financial Performance of Publicly Listed Companies.6 24.5 240. When the crisis battered Indonesia in 1997. a Value added was assumed to be 30 percent of total sales.5 34.4 1996 18.8 230.7 — 250.0 12. and 1992.0 12. In 1997. Net profits grew at an annual rate of more than 20 percent from 1992 to 1996.1 4.0 10.1 0.7 3. 250 firms.4 38. 248 firms. ranging from 220 to 250 percent between 1992 and 1996.6 percent in 1997.4 31. 1993.2 30.5 37. Asset turnover was above 30 percent until 1996.1 percent in 1997 when the crisis began to buffet Indonesia.8 6.2 1995 37.8 percent between 1992 and 1996. Despite such rapid growth.5 3. 174 firms.6 1994 50.4 1997 7. 246 firms. 226 firms. publicly listed companies as a group contributed less than 10 percent to GDP.6 48.4 1993 45.7 percent in 1997.0 12.2 7. while total assets grew at 43 percent.3 6. The growth of listed companies was sustained by continuing investments. but turned negative in 1997. Average return on equity (ROE) of listed firms was 11. b Asset turnover is defined as sales over assets. Return on assets (ROA) was also relatively stable during 1992-1996.3 shows the growth and financial performance of Indonesian publicly listed companies. 1996.3 3.0 64. total sales of listed companies grew at an annual average rate of 31 percent. averaging 3. Source: JSX Monthly (several publications).1 220. but dropped to 1. although the contribution increased over time. 1994. Table 1. Note: The number of firms is not identical for each year.9 37. 1995. 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 1. During 1992-1997.0 6.6 3.0 11.

the companies in the sector did not operate with a high leverage. basic industry and chemicals.3 percent between 1992 and 1996.64 percent in 1997. Meanwhile. Also. averaging 17. meanwhile. property. the property sector was severely affected by the crisis. miscellaneous industry. and building construction. still posting a positive but lower ROE. ROE fell drastically because the sector had one of the highest DERs. indicating its reliance on equity to support growth. But the sector’s ROE fluctuated a lot. with ROE falling to -11. miscellaneous industry. and trade. helped in part by the relatively strong demand for consumer goods. For instance. averaging 21. Four sectors (basic industry and chemicals. consumer goods. only two sectors (mining and finance) showed a consistently increasing trend from 1992. and building construction sectors had the highest DERs because companies in these sectors found it easy to obtain credit from banks. and services. The ROE levels suggest that high leverage enabled listed companies to achieve high returns on equity. The Jakarta Stock Exchange (JSX) classified listed companies into nine sectors: agriculture. investment. The finance. the mining sector ranked first. Vol.2 in 1997.7 percent during 1992-1996. This sector was less affected by the crisis. From 1995. followed by agriculture (Table 1. the mining sector had the highest ROE. real estate. Overall. During those years. However. the dominant sector was the finance sector. the banks eagerly provided credit to property development companies. the mining sector had the lowest DER. In terms of share of value added to GDP. and property. it appeared that the performance of listed companies was quite satisfactory prior to the crisis. trade. ROA of all sectors dropped in 1997.5 presents the financial performance of listed companies by sector. and trade) even posted . In terms of sales and asset levels in 1997.73 percent in 1992 to 1.4). property. Most companies in the sector that had unhedged dollar-denominated loans suffered exchange rate losses when the rupiah weakened. increased from 0.10 Corporate Governance and Finance in East Asia. Before the crisis. investment. infrastructure. The consumer goods sector ranked second in terms of ROE. real estate. when the property sector was booming during 1993-1997. II previous year. This indicates that a substantial part of corporate debt was denominated in dollars and unhedged. mining. in terms of growth of sales and assets. although asset turnover was slow. When interest rates increased. finance. due mainly to the domination of the International Nickel Company of Canada. The finance sector’s contribution to GDP. Table 1. and services. The same applied to the trade sector. the fluctuation in nickel and copper prices contributed to the oscillation of ROE. which operated in nickel and copper mining in 1992 and 1993.

.4 0.9 53.8 (76.6 0. Investment.. Source: JSX Monthly (several publications).9 54.0 0.4 30.1 71. Investment.5 13.Table 1. Infrastructure Finance Trade.0 68.3) 39.9 1.1 0.8 50.0 0.2 14.4 30.3 340. Infrastructure Finance Trade.6 0.7) (27.1 — 39.2 5.6 22. 1992-1997 (percent) Indicator/Sector Sales Growth Agriculture Mining Basic Industry and Chemicals Misc.5 (11.5 45. Constn.5) 13.3 51. Constn.7 24.1 0.6 51.1 0.1 0.7 (82.6 0.4 64.6 133.0 0.9 0.5 68. and Services Net Profit Growth Agriculture Mining Basic Industry and Chemicals Misc.5 1.1 0. and Bldg.7 28. Real Estate. Real Estate..6) 19.3) 53.5 61.6) 25.0 1996 1997 58.8 29.0 (192. Investment.5 9.9 36.7 — — 11.9 64.0 24. Constn.6 0.0 0.5 28.8 62.5 1.7 17.9 59.3 31.7 0.1 1.4 38.6 15.9 25.6 135. Industry Consumer Goods Industry Prop.1 0.3 17.6 (41.5 (8.0 22.1 0.9 14.3 0.7 112.5 53.1 1.1 1.6 (0.6 26.1 0.7 40. Infrastructure Finance Trade.7) 26.9 . Industry Consumer Goods Industry Prop.7) (113.8) (12.7 133.0 16.0) 46.1 42.4 1.1 23.3 (203.7 62.7 54.6 1994 (75.5 23.4 44.1 0.3 1.0 64.0 43.2 0.5) 49.7 0.1 28.3 0.8 1.8 51.7 21.5 0.5 95.8 66.1 0.0 31.4) 8.4 21.2 35. and Services Share of Value Added in GDP Agriculture Mining Basic Industry and Chemicals Misc.2 41.1 1.1 1.0 0.0 0. Real Estate.6) 119.4 77.4 170.9 123.8) 0. Infrastructure Finance Trade.3 0.9 31.6 1. Constn.4 Growth Performance of Publicly Listed Companies by Sector.6 28.0 (20. Industry Consumer Goods Industry Prop.3 92. and Bldg.9 (7.6 85. and Services Asset Growth Agriculture Mining Basic Industry and Chemicals Misc.1 32. Real Estate.7 43.4 103.7 — 36.7 1995 51.0 1.7 90.4 (149.4 1.5 92. Industry Consumer Goods Industry Prop.7) 17.2 59.4 43.8 1.6 24.0 (28.7 34. and Bldg.1 (41.8 24.1 67.5) 6.8 28.3 0. and Bldg..2 13.2 0.6 83.5 0.1 35. 1992 — — — — — — — — — — — — — — — — — — — — — — — — — — — 0.0 18.8 27.9 0.4 1.3 0. and Services — = not available.2 41.3 31. Investment.4) 6.1 (11.8 32.2) 0.9 8.4 31.4 1993 155.8 0.9 54.1 16.2 11.5 1.

0 120.1 1996 100.1 11.2 1993 130.6 13.3 5.0 110.0 650.1 7.7 10.2 23..4 6.5 56.1 (5.5 17.0 39. Infrastructure Finance Trade.2 13.2 3.8 11.0 90.3 18.9 29.3) 5.7 46.8 479. Industry Consumer Goods Industry Prop.0 50.4 35.0 220.1 13.1 9.0 210.9 42.0 650.1 4.9 40.4 1.5 14. Infrastructure Finance Trade.0 3.0 (0.0 11.6 8.0 120.3 0.2 (4.9 4.7 8.4 46..0 70.0 380.7 10.1 10.4 6.5 4.0 100.0 180.8 168.6 13. Constn.0 100.4 20.1 65.2 11.8 5. and Bldg.7 26.7 13.0 160.0 190. and Services Return on Assets Agriculture Mining Basic Industry and Chemicals Misc.0 60.5 1995 80. Industry Consumer Goods Industry Prop.4) (1.0 140.4 17.2 3.3 17.9 14.0 17.2) 15.0 110.3 38. Investment.0 86. and Services Source: JSX Monthly (several publications).4 46.5 Financial Performance of Publicly Listed Companies by Sector.7 1.2) 7.7 4.0 140.9 38.0 70.6) 36.0 1997 230.9 87.0 19.0 100. Industry Consumer Goods Industry Prop. and Bldg. Constn.9 10.1 63.0 160.2 6.. Industry Consumer Goods Industry Prop.0 700.4 13.0) 7.0 160.7 71.5 11.7 10.6 (2.0 150.1 (3.8 81.7 5.0 110.8 25. and Services Asset Turnover Agriculture Mining Basic Industry and Chemicals Misc.0 8.1 8.0 80.6 19.5 4.0 66.3 64.0 80.7 12.8 11.1 89.0 630.0 46.0 110. and Services Return on Equity Agriculture Mining Basic Industry and Chemicals Misc.0 100.4 71.9 38.8) 8.7 4.0 14.6 (11. and Bldg.3 7. Real Estate.2 15.1 9.5 7. Investment.7 12.6) 18.7 (3.Table 1.1 1. Investment.3 13.1 4.6 14.0 69.7 1.2 30.5 43. and Bldg.0 110.7 61.8 8. Constn. 1992-1997 (percent) Indicator/Sector Debt-to-Equity Agriculture Mining Basic Industry and Chemicals Misc.0 680.4 .8 3.2 7.0 120.4 35.7 4.2 53.5 13.2 39.0 15.0 180.9 17.3 17.3 33.3 73.6 23.0 8.0 120.5 19.6 1.8 9.8 20.0 3.4 79.0 80.8 16.0 70.4 13.0 130.0 180.7 8.6 8.1 1994 80. Infrastructure Finance Trade.1 6.3 7.9 41.0 150. Infrastructure Finance Trade.6 18.5 5.0 190.2 7. Real Estate.0 9.1 2.7 9.0 190.1 4.3 1.8 44.0 560.0 12.2 8.8 67.7 5.0 110.0 110.4 5.4 4.1 10.2 111. Investment.6 74.1 3. 1992 20.9 7.0 170. Real Estate.7 12.0 150. Real Estate.8 382. Constn.1 10..

Only the agriculture sector showed an increase in ROA in the couple of years before 1997. the Department of Finance supervised 30 SOCs. Assuming a fixed ratio of value added to sales.6). However. but dropped dramatically to 4. State-Owned Companies At the end of 1995. The sectoral distribution of 165 SOCs is as follows: nonfinancial (143 companies). Asset turnover rates were lower relative to those of publicly listed companies. While asset turnover rates of publicly listed 3 4 SOCs are those in which the State has at least a 51 percent equity interest.7 to 7 percent for publicly listed companies. These growth rates were low compared to those for listed companies during the same period. banks (seven companies). much lower than that of companies listed in the stock exchange. SOCs actively operated in various sectors4 under the supervision of “technical” departments. and basic industry and chemicals sectors had relatively stable ROA before the crisis. indicating SOCs’ declining contribution to GDP. By 1995. Similarly. the subsidiaries and affiliates number 459 with total assets of Rp343.8 percent between 1992 and 1995 (Table 1. This was due to large sales by the National Oil Company (Pertamina). This was relatively high compared to the 3. respectively.3 trillion. averaging 24 and 31 percent. The Department of Mining and Energy ranked first in terms of sales of SOCs under its control. the SOCs’ value added as a percentage of GDP ranged from 6 to 8. SOCs diversified into many businesses. Just like private companies.7 percent in 1990 to 6 percent in 1996. The DER was slightly higher than for listed companies. insurance (11 companies). registering an average annual rate of 10 percent. there were 165 state-owned companies (SOCs)3 in Indonesia.6 to 8.1 percent in 1992 to 28.7 percent.3 percent in 1995. but it continuously declined from 370 percent in 1992 to 250 percent in 1995. . there were 58 SOCs with subsidiaries and affiliates. SOCs’ sales growth fluctuated during 1990-1996.Chapter 1: Indonesia 13 negative ROA. which collectively had the largest assets. increasing from 21. between 1993 and 1995. The finance and miscellaneous industry. SOCs’ ROE ranged from 6. Six SOCs were listed in the Jakarta Stock Exchange. Trade had the highest ROA of 39.1 percent in 1993. Taken together.4 percent the following year. growth of net profits and assets was erratic. the ratio decreased from 8. and finance company (four companies). ROA had been at high levels from 1992 to 1995. For instance.

1 30.4 1993 16.2 18.8 12.8 21.0 17.4 16.1) 5. II companies consistently declined over time.7 Growth Performance of the Top 300 Conglomerates.4 percent in 1994.7 1994 (9. Source: Indonesian Data Business Center.2 — = not available.766 business units.6 Growth and Financial Performance of State-Owned Companies. but dropped to 11.14 Corporate Governance and Finance in East Asia.4 13.4 13.3 30. Their total sales increased from Rp90.1 6. b Asset turnover is defined as sales over assets.1 12.0 24. SOCs’ asset turnover rates showed a downward trend from 32.6 percent in 1994. mostly private companies. Source: Indonesian Data Business Center.3 250.4 percent in 1992 to 28.5 percent in 1995. 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 8. but climbed to 30. a Value added was assumed to be 30 percent of total sales.5 3.2 percent in 1997 (Table 1.6 28.6 1995 25.0 12. 1990-1997 (percent) Item Sales Growth Share of Value Added in GDPa 1990 1991 1992 1993 1994 1995 1996 1997 — 17.4 7.6 28.0 28. the contribution of conglomerates to GDP increased from 12.4 13. Assuming a constant ratio of value added to sales.5 Conglomerates This study used available data on the top 300 conglomerates in Indonesia. a Value added was assumed to be 30 percent of total sales.6) 260. 1992 — 7.7 (2.8 percent in 1990 to 13. these conglomerates owned 9.1 310.1 trillion in 1990 to Rp234 trillion in 1997.1 32.0 6. Table 1.7 16. Table 1. In 1997.1 19.8 11.3 12. Vol. .2 — 370.0 8.2 23.7).7 13.0 7.

The actual responsibilities of BOCs vary by company and are stipulated in the company’s charter. For instance. except in strategic issues stated in the law. and the accountant. the decision to use certain company assets as collateral for bank credit might need BOC approval. . For example. the decision to amend the company charter should be approved by two thirds of shareholders present in the meeting. and the board of directors (BOD). and the attendance should at least be two thirds of total shareholders. The law mandates the BOC and BOD to work for the best interests of the company and not just of the shareholders. mergers. acquisitions. The law replaced an earlier statute that was based on the Dutch system. The 1995 law requires limited liability companies to set up two boards: the board of commissioners (BOC). The company charter details the issues that need shareholder meeting approval. as representative of shareholders. tasked with supervising the firm.2. This guards against shady intercompany dealings within a group of companies. The BOC. shareholders lose control. however.Chapter 1: Indonesia 15 1. In general. For mergers. The BOD undertakes operating decisions while the BOC participates in strategic decisions and operations review. an approval needs the majority (50 percent plus one) vote.6 Legal and Regulatory Framework During the 1990s. For instance. The Corporate Law The Corporate Law of 1995 governs the establishment and operation of limited liability companies in Indonesia. If the BOC does not perform well. The meeting decides on important issues. The law explicitly requires approval during the meeting of decisions on strategic issues such as amendment of the company charter (articles of incorporation). the Government promulgated a number of laws and regulations to protect investors. The law also specifies that the highest “institution” in the limited company is the shareholders’ meeting. A chairman heads the BOC while a chief executive officer (CEO) heads the BOD. and consolidations. the legal and regulatory framework of the corporate sector was far from adequate. tasked to provide direction to the company. The law also holds the directors and commissioners jointly responsible for decisions made by the company. a member company might sign a disadvantageous contract with another company where the same controlling shareholder has a higher stake. By international standards. and declaration of bankruptcy. is the only shareholder mechanism for monitoring and controlling the BOD. commissioners. such as the appointment (or replacement) of directors.

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

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

13. This preserves the pro rata share of existing shareholders.5 Average 48. respectively.8 shows average proportions of shares owned by the five largest shareholders of publicly listed companies during 1993-1997. 1993-1997 (percent) Shareholder Rank First Largest Second Largest Third Largest Fourth Largest Fifth Largest Total 1993 50.9 2.4 2.6 percent. Meanwhile. mining. and Berlian Laju Tankers (liquid bulk maritime transportation services) issued 48.0 2. ownership widely held by the general public is highest in the infrastructure and transportation sector (not shown in the table). Vol.5 12.18 Corporate Governance and Finance in East Asia.8.0 1.0 0.2 1. This is partly due to the prevailing practice of raising equity through rights issues in Indonesia.9 2.6 3.4 percent. When a company goes public.3 1995 47.0 0.9 shows that ownership by the largest shareholder in 1997 was more concentrated in the agriculture. about two thirds of publicly listed companies’ outstanding shares were owned by corporations that were directly or indirectly controlled by families.9 percent of total outstanding shares. The pattern of ownership concentration changed little over this period.9.1 13.2 11.6. the controlling shareholders usually act as standby buyers.9 0. the founder usually continues to own the majority of shares through a .8 68. for instance.7 1994 48.6 13. This is because a few companies in the transportation sector issued high proportions of shares to the public.5 percent. 3.6. Table 1.7 1996 48.9 14. Zebra Nusantara (taxi services). Rig Tenders Indonesia (shipping services) issued 51.0 4.0 67.2 67. 2. The percentage owned by each of the five largest shareholders was 48.5 72. and 0.8 Ownership Concentration of Publicly Listed Companies. issued 93. On average.9 Source: The Indonesian Capital Market Directory. and basic industry and chemicals sectors than in others.6 3.1 1.5 16. When a company makes a rights issue. Table 1. II Publicly Listed Companies Table 1.1 0.6 68.6 4.7 3. the five largest shareholders owned 68. Data from the Indonesian Capital Market Directory (various publications) show that between 1993 and 1997.8 1.1 4.5 1997 48.8 68. consumer goods.

1 1.6 0. Table 1.4 4. 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.2 10.5 4. as well as the existence of corruption.1 percent) of Indonesian publicly listed companies were in family hands. Investment.9 50..4 6. First Second Third Fourth Fifth Biggest Biggest Biggest Biggest Biggest 54.. and corruption.3 0.7 4. and Services Average Source: The Indonesian Capital Market Directory.2 0. is strong.8 14.7 13.5 1.6 1. the top family controls 16.1 1. These figures suggest that ultimate control of the corporate sector rests in the hands of a small number of families.3 14.2 This is confirmed in Claessens et al.7 percent of the market.4 44.7 6. on the one hand.3 36.6 percent of total market capitalization while the top 15 families control 61.4 11. the rule of law.9 1. and Bldg.1 2. and the efficiency of the judicial system.6 8.1 2. which shows that in 1996.4 54.1 2.7 1.2 2. Infrastructure. In terms of capitalization. two thirds (67. and Transportation Finance Trade.2 46.7 9.6 percent were widely held. Most of the five largest owners of Indonesian publicly listed companies are limited liability companies rather than individuals.4 1. Claessens et al. and only 0.1 0.6 9. Industry Consumer Goods Industry Prop.1 13. Legal and regulatory developments may have been impeded by the concentration of corporate wealth in .9 44.9 0. on the other. Util. (1999) also found. Constn.3 2. in a cross-country study. Real Estate.9 Ownership Concentration of Publicly Listed Companies by Sector.2 15.9 3. Thus the founder keeps the proportion of shares necessary to retain control over management of the listed firm.6 2.0 5.1 1.1 0.1 1.5 58.3 48.1 11.3 0. Indonesia has the largest number of companies controlled by a single family. In fact. (1999). that the correlation between the share of the largest 15 families in total market capitalization.Chapter 1: Indonesia 19 fully-owned limited liability company (Perseroan Terbatas). 1997 (percent) Sector Agriculture Mining Basic Industry and Chemicals Misc.9 44.

Among the top 300 conglomerates. Indigenous businesspeople include the Javanese. Sundanese. and family origin. their number increased to 5 In 1997. However. During 1988-1996. Vol. the onset of the crisis negated this development. . political affiliation. In 1993. foreign ownership increased to 21 percent. II the small number of families and the tight links between companies and the Government.5 Conglomerates Table 1. In Indonesia. with all its regulations. However. but later declined and steadied at around 25 percent. it rose to 30 percent. In September 1997. or other ethnic groups. But these benefits are few and often dubious compared to the high costs of concentration. the proportion of foreign ownership declined from 27. most were established during the New Order Government.10 shows the anatomy of the top 300 conglomerates in terms of year of establishment. and Padang. The corruption and regulatory problems generated by high ownership concentration by families in Indonesia are likely to overwhelm its benefits. the Government allowed foreign investors to buy up to 100 percent of listed shares. numbering 162 in 1988 and 170 in 1996. Batak. 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. Indian. Family control is said to have positive effects in that it allows group members in conglomerates to make strategic decisions quicker. This may indicate that the New Order Government. The nonindigenous businesspeople are usually Chinese. From 193 in 1988. accounting for 64 percent of total conglomerate sales in 1988-1996. When the Government allowed foreign investors to buy up to 49 percent of listed shares in 1988.42 percent in December.55 percent in August to 25.20 Corporate Governance and Finance in East Asia. was able to create a favorable environment for business development. the legal system is less likely to evolve in a manner that protects minority shareholders. Coordination is easier because informal communication channels exist. resulting instead in a decline in the proportion of foreign investor ownership. nonindigenous groups owned a larger proportion of the top 300 Indonesian conglomerates. conglomerates established before 1969 dominated in terms of sales. ethnicity. there is a dichotomy between corporations owned by indigenous and nonindigenous businesspeople.

2 29.1 87. Meanwhile.2 33.8 Source: Indonesian Business Data Centre.9 47.8 12.6 trillion in 1988 to Rp137.1 52.2 23.0 28. 204 in 1996.4 31.8 49.4 trillion in 1996.9 billion. Their total sales also increased from Rp38.9 137.7 24.6 95.6 54.2 12. For instance.4 19.3 20.2 159.8 68.6 34.9 13.4 15.1 33.4 48.4 32.4 59.2 30.8 30.4 81.1 41.10 Anatomy of the Top 300 Indonesian Conglomerates.8 38.7 89.1 103.1 25. sales of the Bakrie group before it went public in 1990 were only Rp369.4 69.Chapter 1: Indonesia 21 Table 1.1 46. more than five times its 1988 level.4 22.4 18.3 80.6 77.7 40.1 42.1 21.8 57. due to their “go public” activities.1 percent of total .0 58.9 14.0 116.3 134.3 36.3 120.6 12.8 28.8 25.2 48. 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 52.4 37.5 21.4 57.9 trillion.0 58.6 17. the number of mixed groups declined from 86 in 1988 to 68 in 1996.9 42.4 59.7 28.4 68.9 77.7 64.4 16.1 58. While they supplied 20.1 179.5 22.5 120.4 31.4 86.0 31.9 35.0 44.9 73.0 18.0 15. Conglomeration Indonesia 1997.7 106.5 106.7 49.2 76.3 101.6 114.1 46.3 43.8 36.7 95. its sales reached Rp1. In 1996.

Official-related groups have owners (or founders) who are or are allied with former or current government officials (or their families). The contraction in the number and economic contribution of mixed groups may be an indication of increasing social polarization along ethnic lines. there were 175 groups that originated from a family business. compared with the less than Rp700 billion of a nonofficial-related conglomerate. Average sales of official-related conglomerates were substantially greater than nonoffficial-related ones during 1988-1996. Some of them later became public companies by listing in the stock market. and Fast Food (restaurants). collectively controlling . 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. average sales of official-related conglomerates reached Rp1. More recent alliances were between Bambang Trihatmodjo (former President Suharto’s son) and Johannes Kotjo. for instance. II sales in 1988. In 1996. their contribution declined to 13.7 percent in 1996. Conglomerates were also classified into nonofficial. Out of 174 companies. Djuhar Soetanto. Vol. Prudential credit analysis tends to be ignored. most of the 16 liquidated banks had violated the legal lending limit set by the central bank.22 Corporate Governance and Finance in East Asia. The Salim group. In 1997 and 1998. Political alliances between entrepreneurs and officials have often led to the violation of regulations meant to promote prudent business practices in the banking industry. The Suharto family is the largest stockholder in Indonesia.and officialrelated groups. Only about 13 percent were formed by official or ex-official families. Indocement Tunggal Prakarsa (cement industry). Most of the top 300 conglomerates were established by ordinary citizens. banks that had to be closed down included Bank Surya (owned by Sudwikatmono) and Bank Andromeda (owned by Bambang Trihatmodjo). 117 are jointly owned by the family and 57 are owned by individual family members. In November 1997. But only a handful of these companies are listed in the market. Bank Indonesia. owns four groups with many subsidiaries and affiliate companies. The high NPLs accumulated by banks within official-related groups could be partly attributed to this practice.2 trillion. But listed companies within conglomerates were few. Bambang Rijadi Soegomo. and Ibrahim Risyad of the Salim group. or have resulted from alliances between entrepreneurs and officials. and Wisnu Suhardhono of Apac-Bhakti Karya. which is the largest conglomerate in Indonesia. In 1996. including Indofood Sukses Makmur (food industry).

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

(Feb. P. . 1999). Simeon Djankov. World Bank. Lang. and Larry H.Figure 1. Who Controls East Asian Corporations? Financial Economics Unit.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. Financial Sector Practice Department.

As the owners’ representatives. the BOC supervises the work of directors. The discussions are based on the ADB survey of 40 companies listed in the Jakarta Stock Exchange.Chapter 1: Indonesia 25 problem is inconclusive. both controlling and minority. This is based on the Dutch system. request a shareholders’ meeting. seek an audience with directors. the BOC has the right to obtain any information concerning the firm. role and protection of minority shareholders. Shareholders are at the top of the organization. The typical structure of a publicly listed company in Indonesia is shown in Figure 1.2 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. if necessary. and.2. 1. Figure 1. .3.2 Management and Internal Control A company’s internal organizational structure determines how shareholders control management. management and managerial compensation. The BOD leads the company and makes strategic and operational decisions. including the boards. The managers execute the BOD’s decisions and lead employees in their departments. the directors. one possibility is that legal lending limits had been violated. Therefore. and accounting and auditing procedures.


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

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

14. Since then. private national banks overtook state banks as the dominant credit source.0 168. new instruments have been introduced to the corporate sector.9 378.0 3.4 24. and others offered by nonbank financial institutions or finance companies.2 6. Vol.6 292. jointly providing almost 90 percent of loans until 1997.4 percent in 1992.9 234.2 27. 1992 1993 1994 1995 1996 1997 1998 1999 68.6 3.3 14.3 111.14 Banking Sector Outstanding Loans.9 trillion in 1992 to Rp487.6 48.3 66.5 108.5 42. bank credit surged from Rp122.4 86.4.3 188.3 60.4 1. However.1 220.1 Corporate Financing Financial Market Instruments Prior to 1977.7 50.6 150.32 Corporate Governance and Finance in East Asia. . Bank loans. when the Government reactivated the stock exchange. When the Government liberalized the banking industry at the end of 1988 (which allowed for higher interest rates).7 122.5 7.2 5. 1992-1999 (Rp trillion) Type of Bank State-Owned Banks Foreign Banks Regional Govt Banks Private National Banks Total Source: Bank Indonesia.6 4. stocks. including bonds. equities became available to the corporate sector. Private national banks and state-owned banks were the biggest domestic creditors.6 percent in 1997. From 34.4 trillion in 1998.0 487.9 153.5 80.7 18.2 71. this market was not well developed. the share of private national banks in outstanding total loans increased to 44.6 6. however. Bank Credit As shown in Table 1.8 193.3 9. remain the major financing instrument for the corporate sector.4 225. Data from Bank Indonesia show that from 1994 to 1997.9 150.1 Equities In 1977.0 93. bank loans were the only instruments available to the corporate sector for short term (working capital) or long term (investment) financing. companies considered alternatives to bank loans.4 56.0 6. II 1. because of the restrictions discussed below. Table 1.7 112.

15).7 9.5 Financing by Finance Companies Finance companies first emerged at the end of 1980. Most banks therefore set up subsidiary finance companies to circumvent banking regulations. legal lending limit.. Overall.7 14. In 1988. limiting loans to a maximum of 15 times equity and foreign loans to five times the equity. the Government issued regulations to supervise and promote prudential practices in finance companies. 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 1996.1 18. 1992-1999 (Rp trillion) Item Stocks Issued Outstanding (As % of Outstanding Bank Credit) Market Capitalization Source: Bank Indonesia.9 1999 76.4 207. the stock market has gained a bigger role in corporate sector financing (Table 1.. During the 1990s. offering services such as leasing.2 16.6 310.6 859. In 1995.1 17.7 15. allowed to accept deposit accounts from the public.6 301. capital adequacy ratio.0 206. 1992 1993 11. finance companies were increasingly used as channels for the inflow of foreign loans.5 1995 35.Chapter 1: Indonesia 33 Some companies went public.0 70. shooting up to 18. i. .9 406. funds raised in the stock market were less than 5 percent of the credit disbursed by the banking sector.7 percent in 1997. It gradually increased again starting in 1991.4 1996 1997 1998 50. credit cards. however. Prior to 1995.g.1 10. factoring.0 15.8 48.1 1994 26. when foreign investors were not yet allowed to purchase listed shares. the activities of finance companies were not covered by regulations on prudential practices in the banking sector (e. Table 1.e.15 Value of Stocks Issued and Stock Market Capitalization.5 333.3 percent in 1990 when the stock market was liberalized and foreign investors were allowed to purchase up to 49 percent of listed firms’ shares.6 91. thus increasing the role of the capital market in raising long-term funds. They were not. and consumer credit. The ratio reached 8. but dropped to 8 percent in 1991 when the Government tried to stabilize an overheating economy. and net open position).6 123.

8 percent. short-term borrowings were greater than long-term debts. PACAP Research Center.34 Corporate Governance and Finance in East Asia. Thus in November 1995. 1986-1996 (percent) Financing Source Internal Borrowings Short-Term Long-Term Debentures/Equity Debentures Equity Trade Credit Others Total 1986-1990 36.3 16. II Commercial Papers Commercial papers. In terms of composition.1) 23.2 26.9 16. Bank Indonesia prohibited banks from underwriting issues of commercial papers but allowed them to act as paying agents.8 17. which are unsecured negotiable promissory notes with a maximum maturity of 270 days. Table 1.5 — 26.6 100.7 22.6 8.4 8.8 7.5 21. Source: Author’s estimates based on the Pacific-Basin Capital Markets (PACAP) Databases.4 13.6 23.0 39. otherwise it would be classified as a loss in the banks’ books. 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).3 14.5 11. . at 81 percent of total borrowings.4. have been popular in Indonesia since 1990.0 1986-1996 17.16 shows financing sources of Indonesian publicly listed nonfinancial companies estimated by using flow-of-funds analysis. 1. they were not rated by a rating agency. This is in contrast to the lower share of borrowings during the same period.3 (0. respectively. While banks had some exposure to these instruments.0 1991-1996 16. publicly listed nonfinancial companies had high proportions of equity and internal finance (retained earnings).5 percent and 36.2 Patterns of Corporate Financing Table 1.16 Financing Patterns of Publicly Listed Nonfinancial Companies.0 — = not available. In the second half of the 1980s.0 3.4 23.5 (0.3 37.1) 23. 1996.6 100.0 100. averaging 26. Vol.6 12.

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

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 699.0 Notes: Firms with high ownership concentration have more than 50 percent of shares owned by the top five shareholders. heavy reliance of companies on bank credits to finance investments. the borrowings swelled. Between 1987 and 1996.0 351. Table 1.0 386. Source: Author’s estimates.0 1. the free capital flow system allowed private companies to borrow dollars offshore without any restriction. the private sector borrowed heavily in unhedged dollars. Controlling parties rely on external financing to maintain their equity share and.36 Corporate Governance and Finance in East Asia.56 significant at the 10 percent level.358. and high ownership concentration among families with political affiliation. In addition. The test of the difference between the two means found the t-value of 1.5 1. As a result. 1. Vol. The low cost of foreign loans and the relatively stable exchange rate created a false sense of security for corporations. Inadequate Financial Regulatory Framework Liberalization of financial markets increased the corporate sector’s access to domestic and foreign private capital.1 The Corporate Sector in the Financial Crisis Causes of the Financial Crisis Many intertwined factors led to the crisis. since commissioners represent the controlling party. to maintain control of the company. 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. aided . 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. II However.5. decisions on debt are made with the implicit endorsement of owners. ultimately.

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

5 billion. The ultimate control of the corporate sector rests in the hands of a small number of families who own groups of companies. Collusion between big businesses and the political elite was widespread in Indonesia. banks did not lend on the basis of the soundness of the project. there was also almost universal confidence that the economic growth would continue indefinitely. Corporations were certain that they could roll over short-term loans when these fell due. or both. toll roads. total private sector foreign debt stood at $72. where private banks are usually in the hands of big businesses. partly because they used nominee accounts to register ownership rather than set up a holding company. II By mid-1997.5 billion was owed directly by corporations. politicians. and in the process maintain control of the company. and investing shares among nonfinancial companies within the group and in other groups’ companies.38 Corporate Governance and Finance in East Asia. . but on the basis of who the borrower was. They enhance their control over companies through cross-shareholdings. There were cases where banks and borrowing companies were controlled by the same groups or families with strong political connections. They ensure that commissioners represent their interests and maintain close relationships with the chairperson. High Ownership Concentration High concentration of corporate ownership (particularly by families) led to poor financing and investment practices. contracts were granted to the private sector. In early 1998. of which $64. by setting up their own banks. In many cases. most often to people who were close to the ruling regime. Controlling shareholders also prefer to use debts to finance expansion so as not to dilute their ownership. This was often the case in the banking industry. as they had done so in the years before the crisis. Families retain control by keeping the majority percentage of outstanding shares. Aside from the fact that many of these loans were channeled through banks and corporations of politically connected families. Family-controlled corporations were generally structured as a complicated web of affiliates and associated companies. This fact was usually not disclosed in financial statements. $35 billion of Indonesia’s foreign debt owed to private foreign banks was about to mature in less than one year. Vol. Projects involving massive capital investments and long-term operating deals (in telecommunications. and power generation) require huge capital. Since the Government could not afford to undertake these projects.

Table 1. Only 86 companies reported profits.3 12. indicating a rapid rise in .3 11.5.4) 2.0 3. This continued in 1998.7) (8.7 6. as shown in Table 1.0) (15.370 percent. Gas.1 (1.3 Source: Central Bureau of Statistics (Biro Pusat Statistik.7) (2.2 Impact of the Financial Crisis on the Corporate and Banking Sectors Impact on the Corporate Sector Table 1.18 shows that growth in most sectors significantly fell in 1997. The consumer goods industry reported the lowest ROE.58 trillion (meaning their losses were greater than the paid-up capital). Most sectors showed significant increases in leverage. posted negative growth rates. Forestry.6 4. 1996-1999 (percent) Sector Agriculture.1) 1.4) (0.5) (18. and Water Supply Construction Trade.6 13.7 1998 (0. Sectors with lower ROE generally had higher DER.8 7. The construction sector was the worst hit.8 1997 1. and 128 companies reported a total loss of Rp46.7) 2.2 8. The JSX Monthly reported that total losses of 214 listed companies amounted to Rp39.6 12. Real Estate. Livestock.1 6.8 8. and building construction. BPS). real estate. and Business Services Other Services GDP 1996 3. Hotels.8) (11. Using the financial statements as of 30 June 1998 of 161 publicly listed companies.6 (36.4 7.0 2.4 5. followed by the finance and trade sectors.4 7.1) (26. DER and ROE were calculated per sector. except utilities.24 trillion for the first six months of 1998.2 (1. and Fisheries Mining and Quarrying Manufacturing Electricity.18 GDP Growth by Sector.9 3.0) 1999 2. 53 companies reported negative equity of Rp6. followed by property.1 5.6) (3.6) (0. when all sectors.19.6 8. The average DER was found to be 1. much higher than the 307 percent registered in December 1997. and Restaurants Transport and Communications Financial.8 0.52 trillion.8) (13.0 5.Chapter 1: Indonesia 39 1.

7) 6.6) (115.0 193.0 2.4 5.1) Note: DERs were calculated for only 161 companies (out of 214) that had positive equity. rupiah values of dollar-denominated debts due to the weakening of the local currency and the rapid decline in equity because of losses. This figure further increased to 47.2 (4.0 219.0 631. private banks posted negative ROEs in the same year.1 (124.1) 7.0 1.0 111. Vol. from only 8.1 1.1 (5.0 2.395.4) 8.370.5 percent in April 1998.0 163.0 177.0 1. a Actual data for 1st semester only.6) 15. Second. First.2 13. but annualized to approximate full year values.0 205.0 65.0) 10. foreign exchange losses came about with the use of unhedged foreign debt. The huge losses suffered by most companies were caused by three factors.8 (373.0 177.0 697.20 reveals that the banking sector’s ROE decreased significantly in 1997. 1996-1998 (percent) DER Sector Agriculture Mining Basic Industry Miscellaneous Industry Consumer Goods Industry Property Infrastructure Finance Trade/Services Average 1996 104.271.1 30.0 105.0 229. the NPL ratio had reached more than 60 percent.4 (6. and would have kept on increasing if interest rates had not declined. several publications. II Table 1. .0 864. Financial and banking analysts estimate that by September 1998.2 23.097.9 12.0 1998 186.19 DER and ROE of Publicly Listed Companies by Sector.0 1. The table also reveals that although private national banks dominated the banking sector in terms of assets and credits.0 97. As the rupiah weakened and interest rates increased. the NPL ratio rose to 25.6 (11. losses in operation were due to declines in sales and increases in the cost of imported inputs.40 Corporate Governance and Finance in East Asia.5 8.0) (78.21.1 (92.3 7. small foreign banks enjoyed the highest profits.8 17. Mostly suffering from a liquidity squeeze. interest expenses rose as credit rates increased from 20 percent in early 1998 to 40 percent in mid-1999.0 92.0 108.2) (264.7 percent in July 1998. Source: JSX Monthly.0 191. Third.8) 36.0 1997 234.0 635.7 1. as shown in Table 1.0 158.8 percent in 1996.0 108.0 72.1 (3.0 12. Impact on the Banking Sector Table 1.0 a ROE 1996 1997 1998a 14.625.0 307.4) 18.

3 22.07 1994 14.3 445. In July 1998. State-owned banks initially had the highest NPL ratio.12 15. coupled with negative spreads (deposit rate was higher than the credit rate).2 10.7 29.39 13.3 361.70 1995 7.45 21.84 27.34 16.20) Table 1.37 19.8 8.2 48.6 6.1 1.20 ROE of the Banking Sector.7 106.73 30.67 8. The high and increasing NPLs.44 15.2 8.8 14.9 297.7 — = not available.2 1.0 — 4.25 22.3 Private National Banks — 179.4 7.45 — 1993 15. July No. however. 227/1998 and October No.81 13.5 128.1 30.2 47. private national banks overtook State-owned banks when their NPL ratio jumped to 57.2 — 19.0 129.21 Nonperforming Loans by Type of Bank.69 14. 230/1998.9 Regional Foreign and Development Joint Venture Banks Banks — 9. 1992-1997 (percent) Type of Bank State-Owned Banks Foreign Banks Joint Venture Banks Regional Development Banks Private National Banks Total — = not available.72 16.30 5.47 20.1 274.6 — 13.5 31.50 9.38) 11. Source: The National Banking Association.5 34.8 187.1 13.1 47.15 20.6 — 4.Chapter 1: Indonesia 41 Table 1.0 622.5 222.09 11.86 11.24 15.9 percent.8 3. 1996-1998 (Rp trillion) State-Owned Banks — 140.2 8.5 2.9 11.7 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 331.8 11.06 20.43 10.07 13.9 — 11.0 — 32.24 (4.68 1996 1997 8.1 198.5 57. 1992 7.28 5.6 — 1.7 4. put pressure on the banking sector.2 37.2 — 8.7 — 1.09 (11.89 27. Source: Infobank. .91 21.

Astra International (automotive).000 eligible firms had signed up for the scheme.3 Responses to the Crisis Corporate Restructuring Measures At the end of 1997. By end-November. IBRA was formed to offer Mexican-style resolution for private sector foreign debt. have been subject to restructuring deals under the initiative. 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. In November. the Government and private sector formed a committee to help corporates deal with the crisis. In addition. particularly in terms of debt resolution. The scheme offered a hedging facility against rupiah devaluations for restructuring agreements. Another option that companies could take under the Jakarta Initiative was debt restructuring via debt-to-equity swaps.2 billion debt. On 9 September 1998. such as Garuda (a national flag carrier). and Ciputra (property business). about 80 percent of which was private. a more comprehensive scheme to tackle domestic and foreign corporate debt. The committee was tasked to ascertain the level of private corporate sector debts and arrange negotiations between debtors and creditors. only a .4 trillion of domestic debt and $6. Total amortization payments due on foreign debt in 1998 were placed at $32 billion (before restructuring). Unfortunately. companies were not servicing their debts. Corporate debt accounted for 46. the scheme failed. assembling the legal and policy framework to facilitate corporate restructuring. Vol. Since September 1998.6 billion) of Indonesia’s total external debt in March 1998.7 percent ($64. a number of prominent companies. by mid-September 1998. Semen Cibinong (cement industry) became the first Indonesian company to resume paying part (25 percent) of the interest on its $1.7 billion of foreign exchange debt. the corporate sector had more than Rp600 trillion ($75 billion at Rp8. Aside from being described as overly complicated. the committee launched the Jakarta Initiative.42 Corporate Governance and Finance in East Asia. In June 1998. However. 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. II 1. The scheme encourages negotiation between creditors and debtors. few companies were in a position to resume interest payments. While the process of restructuring was in progress.5. the Jakarta Initiative Task Force had conducted negotiations for 52 companies with Rp2. none of the 2. Thus.000/$1) in debt from domestic commercial banks.

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

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

However. improvement of rules and prudential regulations. and Bapindo) will be merged into one bank named Bank Mandiri. Liquidity support given to troubled banks should be repaid in four years. 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. It has also drafted regulations to remove obstacles for converting debt to equity. In October 1998.1 Summary. To overcome these problems. or sold (after transferring NPLs to the AMU). To obtain a clearer picture of the banking sector. and Recommendations Summary and Conclusions Corporate Ownership and Structure Most of Indonesia’s top conglomerates were established as family businesses. regulations will need to be issued to permit debt-toequity swaps in the context of corporate restructuring plans. A new central banking law. Other Regulatory Reforms To push corporate restructuring further. providing Bank Indonesia with substantially enhanced autonomy. BEII.6 1. Banks deemed ineligible for recapitalization will be closed. and follow-up action on bank restructuring. In particular. was enacted in 1999.Chapter 1: Indonesia 45 In 1997. The Bank Indonesia 21st package includes recapitalization. The importance of this legislation may need to be emphasized. Conclusions. BBD. Some 175 groups that originated from family businesses controlled . The agency set up an Asset Management Unit (AMU) to directly manage problem loans of banks under its supervision. it is doubtful whether pure holding companies are able to enter into swaps. The merger process will be finished within two years. The Company Law at present can be interpreted as severely limiting the scope for debt-equity swaps. merged. the Government established IBRA to supervise problem banks. the Government required banks to be audited by international external auditors. Bank Indonesia has announced a recapitalization program for potentially viable private banks.6. depositors will be fully protected by the Government. 1. The four state banks (BDN.

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

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

. The Corporate Law should be reviewed and amended in the context of pervasive control by large shareholders. Specific recommendations include protecting the rights of minority shareholders. and (iii) strengthening transparency and disclosure requirements.48 Corporate Governance and Finance in East Asia. (ii) delineating the functions of the board of directors and commissioners. the regulatory environment was not prepared to supervise the increasing number of banks and nonbank . 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. but inadequate protection to minority shareholders from the dominance of large shareholders. and protecting creditors’ rights. Most companies claim to have adopted international standards of accounting and auditing procedures.g. Improving the Legal and Regulatory Framework for Bank Supervision After the liberalization of the financial sector. cost cutting and business consolidation) and acquisitions by creditors or foreign investors through debt-to-equity swaps and equity infusions. In particular. minority shareholders have not been able to oppose controlling shareholders’ decisions to invest in unprofitable projects financed by unhedged foreign currency debts. Vol. The Government should ensure that all laws and regulations are effectively enforced. 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. 1.6. 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. improving the legal and regulatory framework for bank supervision.2 Policy Recommendations The Government should introduce measures to address the weaknesses in corporate governance identified in this study. II measures included internal business restructuring (e.

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

despite the smaller level of capital inflows (as a percentage of GDP). Only when creditors have the confidence that their rights are protected will they resume financing companies.50 Corporate Governance and Finance in East Asia. . II explaining the greater depth of the crisis in Indonesia. 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.

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

Inefficient investment coupled with excessive financial leverage was found to be at the root of the economic crisis at the corporate level. Business managers and controlling shareholders were maximizing firm size at the expense of profits. 1 Professors. Poor corporate governance and political and government intervention in the business and financial sectors are widely viewed as contributory factors. .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. As the Korean currency. timely exit of poor performers from the market. or capital market discipline.1). The country’s winners would then emerge based only on economic efficiency.2 Republic of Korea Kwang S. The authors wish to thank Juzhong Zhuang. both of ADB. Chung and Yen Kyun Wang1 2. 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. the Korea Stock Exchange for its help and support in conducting company surveys. This has been the crux of the corporate governance problem in Korea. a practice that was not checked by creditors. markets. Chung-Ang University. Korea) in November of that year. Further. and David Webb of the London School of Economics for their guidance and supervision in conducting the study. It had been the norm in Korea to conduct business based on political and administrative favoritism rather than on competitive merits. the Republic of Korea. Seoul. 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. the Government and business sector had good reason to reflect on the causes of the crisis. and curtailing of morally hazardous behavior that has been prevalent among economic decision makers. and corporates were sent reeling. internal control mechanisms. 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. Department of Economics. and Graham Dwyer for his editorial assistance.

1 1997 518 104 20. A survey was conducted for the nonfinancial listed companies using a questionnaire developed by the Asian Development Bank (ADB)2 to supplement official data. June 1999. capital market discipline. especially chaebols.9 1994 531 165 31.54 Corporate Governance and Finance in East Asia. Restructuring efforts have focused on reduction in the degree of business diversification and in the financial leverage of large-sized firms. Many firms left some questions unanswered. Dividend payments were at less than 2 percent annually as opposed to the double-digit interest rates in the past decades. The EVAs are the same as the economic profit as explained in T. Vol. the corporate sector. Inefficient investment undermined the competitiveness of Korean firms in the global marketplace. accountability of controlling shareholders and boards of directors. and J Murrin (1995). Government reform goals for the corporate sector include enhancement of corporate transparency.4 1993 513 174 33.1 Listed Firms with Positive Economic Value Added. 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. Copeland. II Table 2. and improvement of bankruptcy procedures.1 1998 490 164 33. This broad perspective can help clarify the ongoing reform efforts of businesses and the Government. 1992-1998 Item Total Number of Firms Firms with Positive EVA Percentage of Firms with Positive EVA 1992 508 180 35. and individual companies. Weaknesses in the overall corporate governance system in Korea had many ramifications.1 1995 560 163 29. Source: Korea Stock Exchange. The total number of respondents was 81 out of about 550 nonfinancial firms listed on the Exchange. which distributed and collected the questionnaire. This study also reviews the legal and 2 The survey was conducted mainly through the Korea Stock Exchange.5 Note: The EVAs are calculated as: EVA = NOPAT – WACC. where NOPAT is the net operating profit after taxes and WACC is the weighted average cost of capital multiplied by invested capital. . aiming to identify the areas in need of further reform and to provide policy recommendations for improved corporate governance. Koller. T.1 1996 561 163 29. This study collects and analyzes data on the Korean economy.

the Government relied heavily on aid from the United States (US) and United Nations to alleviate poverty and high inflation. It then presents recommendations for further reform in corporate governance and financing. In the period 19481961. 2. and Yim (1998).2. . the board of directors system.3 identifies characteristics of corporate governance by analyzing the ownership structures and control patterns of listed companies and the largest chaebols. corporate control by the Government. Section 2. It traces the country’s economic development.1 Overview of the Corporate Sector Historical Development3 The development of the Korean corporate sector is closely related to the progress of the economy. Section 2.2 presents an overview of the corporate sector.2 2.2. and other necessities domestically. The evolution of the modern Korean economy can be divided into four periods. It reviews such elements as shareholders’ rights. creditors.Chapter 2: Korea 55 regulatory framework for the corporate sector and reform measures taken after the crisis. reviewing government policies responsible for the development of the modern corporate sector. From 1948 to 1961.4 contains analyses of corporate financing and its relationship to performance. which account for a substantial portion of the Korean economy. the import liberalization rate was below 7 percent and the average tariff rate was in the range of 25 to 30 percent. Major economic indicators for some of these periods are shown in Table 2. Section 2. clothing. Section 2. and naturally adopted an import substitution policy. 3 The review of historical development of the Korean economy draws substantially from the book by Sohn. This chapter is composed of six sections. Yang.6 discusses responses of the Government and the business sector and explains in detail their reform and restructuring efforts.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. Section 2. The Government tried to produce food. and employees and their role in shaping corporate governance practices. Import Substitution: 1948-1961 The Korean War (1950-1953) devastated Korea’s industrial capacity.

4 29.6 11. a Refers to 1971. In the Plan.102. and large current account deficits. Export Drive: 1962-1971 Between 1962 and 1971.8 15.2 452.8 12.7 37.1 9. Economic Statistics Yearbook. the Government was not successful in solving the problems of slow growth.5) 8. and inconsistent economic policies. However.855. e For maturities of one year or more. d Refers to 1997.7 14.1d 9. and implementing new budget and tax measures. largely because of political instability. modernizing the industrial structure. the Government called for an unprecedented average annual economic growth rate of 7.0) 492.5 250. In 1961 it devalued the won from W65 to W130/dollar and announced its first Five-Year Economic Development Plan (1962-1966).949. Source: Bank of Korea. II Table 2.7c 11.2 30. IMF.0 27.9b 15.9) 1.1 29.2 1. high unemployment and inflation.0) (297.3 8. c Refers to 1989.1a 21. 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 8.8 24.1 35.2 6. Vol.2 314.5 38.7 30.447. The Government tried . lack of strong drive. the Government redirected the policy focus away from import substitution to an export-led manufacturing-based economy. 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.1 — = not available.9 794.265.5) (1. International Financial Statistics.4 10.4 29.2 Key Macroeconomic Indicators Annual Average (percent.1 15.1 percent with moderate rates of inflation and introduced a series of reform packages aimed at developing key industries.2 1980-1989 8. This goal required very high savings and investment rates.2 31.9 — — 21.4 24.8 (724.2 757.9) (7.56 Corporate Governance and Finance in East Asia.0 41.753.332. b Refers to 1979.2 32.4 1990-1997 7.8 (8.4 (1.

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

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

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

with the 30 largest in the total economy in 1997 standing as follows: value-added. 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.60 Corporate Governance and Finance in East Asia. The Government tried to adjust economic policies and regulations to meet global standards. and total workforce. By joining the Organisation for Economic Co-operation and Development (OECD) in December 1996. In 1990. further increasing its pace of import liberalization. . The low value of the dollar led to a low won and high yen.9 percent. total assets. 4. 47. Korea became a signatory country to the International Monetary Fund (IMF) Article VIII.” A large-scale business group is called a chaebol. the import liberalization ratio reached 98. The most important element characterizing chaebols is the concentration of ownership.1 percent and average tariff rates 8.9 percent. total debts. Meanwhile. while continuous and large current account surpluses saved Korea from the foreign debt problem. the Government committed itself to further liberalization of the goods and capital markets. In 1993. 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). but it chose to liberalize gradually. the importance of chaebols was increasing. whose business activities are controlled by an identical person.1 percent.2 percent. 46. and declaring that it would follow Article XI of GATT. Korea abolished remaining direct subsidy systems for export activities as well as some traditionally managed trade systems. In 1988.9 percent. 45. Korea began participating in many multilateral trade negotiations during the Uruguay Round. which gradually widened. total sales. where particular individuals and their family have de facto control of the management of all subsidiary companies of groups.2. Vol. 13. Industrial and trade policies were modified to be consistent with WTO. giving up its foreign exchange controls related to the current account.2 Rise of the Large Business Groups (Chaebols)4 The Korean Fair Trade Act defines a business group as “a group of companies. joined the Asia Pacific Economic Cooperation (APEC) Group in 1993. 2.3 percent. and acceded to the World Trade Organization (WTO) in 1994. and low oil prices. The official rate fluctuated within a band. II world interest rates. Korea adopted a market average exchange rate system.

1993-1996 Year 1993 1994 1995 1996 No. Subsidiary companies of chaebols are subject to “fleet-type management” in that they are controlled by the overall managerial system of chaebols. chaebols that maintained a close relationship with the political authorities were able to grow fast. However.1 20. Important managerial decisions are made primarily by owners.3 Source: The Fair Trade Commission. Table 2. Chaebols have a history of substantial concentration of ownership. Large-scale companies owned by the Japanese were sold to individuals under preferential terms and later enjoyed a relatively favorable position for accumulating capital. reaching 669 in 1996. large-scale businesses and chaebols were thought to be appropriate actors because they could meet the huge investment requirements of these industries. Table 2.5 20. From the standpoint of the Government. The Government provided financial and fiscal incentives to chaebols and trading companies with relatively abundant financial resources. after the financial crisis. and they are aided and supported by one another. the number of subsidiaries declined drastically due to corporate restructuring. financial assistance. of Subsidiaries per Chaebol 20. In the mid-1970s. In this sense.8 22. the ownership and management of a chaebol’s subsidiaries are not separate.3 shows that the number of subsidiaries of the 30 largest chaebols increased considerably since 1993. Since the 1960s. Since the Government controlled most business activities. The Government provided subsidies. Chaebols are also excessively diversified. the Korean Government has set the national goals of economic development and offered all kinds of support and incentives to achieve them.when the Government put a great deal of emphasis on development of the HCIs. This policy contributed greatly to the expansion of chaebols. . of Subsidiaries 604 616 623 669 Average No. it was more effective to deal with a small number of companies to secure tangible outcomes. and tax breaks to key industries to promote exports and industrial upgrading.3 Subsidiaries of the 30 Largest Chaebols. One reason for this controlling power is inter-company shareholding among subsidiaries. This galvanized the fast growth of chaebols.Chapter 2: Korea 61 War II.

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

Also that year. continued until 1989. Because of government policies and the booming economy.217 141. Inc.Chapter 2: Korea 63 During the 1980s and 1990s. mainly by increasing the supply of shares by initial public offerings (IPOs) and seasoned issues. As shown in Table 2. however.9 34. Third.1 30. In this regard.6 747. The policy to expand the size of the stock market.9 918. in 1986 the Government imposed limits to bond issues on firms that were recommended to go public but refused. the Government attempted to stabilize the stock market by limiting IPOs and share issues by listed companies. the Government announced measures to increase the demand for shares by providing tax and financial incentives to individual investors. a country fund.9 833.7 934. 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.0 965. This reversal in policy reflected declining stock prices and was generally maintained until the outbreak of the economic crisis in 1997.476 79. especially those paying small or no dividends. .0 49.151 117.. of Listed Firms 342 626 669 699 721 760 776 748 Stock Price Index 138.570 95.5 406. The Korea Fund.370 70. Beginning 1990. was established to invest in domestic shares beginning in September 1985.798 Market Capitalization as a Ratio to GDP (%) 8.020 151.0 79. the Government announced the gradual opening of the capital market to foreign investors in January 1981. Second. 1985-1998 No.2 44.1 16. The aggregate Table 2.989 137.4. the stock market grew rapidly during the 1980s. several important policy measures were implemented to promote the development of the stock market.1 Market Capitalization (W billion) 6.4 Development of the Stock Market.6 Year 1985 1989 1990 1994 1995 1996 1997 1998 Source: Monthly Review (Securities Supervisory Board) and the Financial Supervisory Service.4 40.4 654. First. 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).

453 (2. and other liabilities. The relative size of the stock market diminished to 44 percent in 1990.433) (9. 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 1986-1989.942) 42.500 7. and 1993.450 24.338 4. Table 2.352 471 3.944) 8.008) (3. The growth in the number of listed firms also slowed in the 1990s.183 12.571 2.382 Permit basis.017) 1.141 4.126 (1.264) (3.742 (3.2 percent by 1989.085 2.296) (6.64 Corporate Governance and Finance in East Asia. Vol.546 (2.150 5.326 1.255 2.642 21.852) (2.870) (1. but increased sharply to 79.413) 56.123 3.239 19.86 percent of GDP in 1997.347 3.455) 13. Bank of Korea. trade credits.287 (340) 73. Table 2.868 (518) (418) 63 1. currency and deposits.858 4. The reasons for the decline include increases in bankruptcies and mergers involving listed companies since the outbreak of the economic crisis.553 8.534) 1.414) 5.5 Private Capital Flows to Korea.650 (1.875 21. foreign direct investment (FDI) has been very small relative to GDP and compared to other East Asian countries.817 16.440 1. II market value of all listed firms represented only 8 percent of GDP in 1985.953 10.542) (1.924 (1.583 25 10. but rose again to 34.800 (7. The number shrank for the first time in 1998 to 748 firms from 776 the previous year.339) (9. The aggregate market value of listed shares bottomed at 16. .149 13.001 4. However.658) (3.785 (1. 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) (2.59 percent in 1998 and to more than 50 percent in the early months of 1999. and stayed at the 30-40 percent level up to 1996.5 shows net FDI—inward investments by foreigners less outward investments by Koreans—in the period 1985-1998. due to declining stock prices.910) 2. Source: Balance of Payments.714 1.694) 2. Other investments include loans.737 (333) (297) (607) (2) 218 2.

Between 1986 and 1989.7 billion and loans $42. following the sharp depreciation of the won. Net private capital inflow. This would lay the foundation for evaluating the effect of corporate governance on performance. The Aggregate Corporate Sector The aggregate corporate sector in this study excludes the financial sector. the growth rates of equity and sales dropped sharply in 1996 and 1997. Taipei. other net private capital inflows amounted to $130 billion during 1985-1998. The contribution of the corporate sector to GDP was 73. 2. In addition to FDI.2. and US. excluding FDI.6). equity. but dropped in 1996 and were negative by 1997.China and the US. Large amounts of outward investment by Koreans in the mid-1990s arose out of increased liberalization of foreign exchange regulations. Japan’s was consistently higher. This indicates that a substantial proportion of debt was denominated in dollars. The same categories will be analyzed in later sections.5).4 Growth and Financial Performance This section looks at the performance of (i) the aggregate corporate sector. and sales of the aggregate sector during this period were very high (Table 2. increasing to 76 percent in 1997. Korea had substantial current account surpluses and experienced net private capital outflow. but between 1988 and 1993. Return on equity (ROE) and return on assets (ROA) showed similar patterns. increased substantially in 1994-1996 due to accelerated liberalization of capital movements (Table 2. The ratio is generally in the same range for Japan and Korea. Of this. (ii) listed firms. The dismal performance of the Korean corporate sector compared to the . The debt-to-equity ratio (DER) averaged 311 percent for the period 1990-1996 and peaked at 424.9 billion.6 percent in 1997. Profit rates of Korean firms were relatively low compared to those of Taipei. However. portfolio investments amounted to $73. weak incentives for attracting FDI. and high production costs were the main reasons for low FDI in Korea. Corporate sector net proft margins increased from 1993 to 1995. and (iii) chaebols.Chapter 2: Korea 65 Complicated government regulations.7 compares the ratio of ordinary income to sales of Korea’s manufacturing sector with those of Japan. The growth rates of total assets.2 percent in 1987.China. Table 2.

8 21.9 5.5 4. Net profit margin = ratio of net income to sales.7 15.5 0.2 1.9 2.3 17.8 1.1 2.0 7.3 — 3.8 1.0 8.2) (0.1 5.9 13.3 6.3 1.4 10.9 16.4 19.4 — 6.9 5.6 9.5 (0.8 8.6 3.2 13.6 1.8 2.0 3.2 18.0 0.4 2.2 13.2 19.9) DER = debt-to-equity ratio.3 308.9 3.4 1.5 1. Note: Ratio of ordinary income to sales = (ordinary income/sales).3 3.China 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 2.7 2.9 2.1 6.5 2. Source: Bank of Korea.0 4.4 1.4 2.2 9.6 1.9 18. 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 23.8) 297.0 (0.0 13.1 8.3 21.3 335.5 1. Financial Statement Analysis Yearbook.4 1.6 4.3 21.7 1.6 Growth and Financial Performance of the Nonfinancial Corporate Sector.8 3.9 18.6 2.6 318.0 10.7 4.3 14.8 22.9 3.9 8.2 1.5 3.0 305. Ordinary income = operating income + nonoperating income (from financial activities) – nonoperating expenses (from financial activities).2 1.1 2.3 11.1 2.9 2.0 13.7 3. ROE = return on equity (ratio of net income to stockholders’ equity).4 4.7 4. Financial Statement Analysis Yearbook.9 16.3) 5.5 4. .7 3.5 7.6 13. Source: Bank of Korea.1 — — — = not available.9 5. ROA = return on assets (ratio of net income to total assets).6 (4.7 325.7 4.Table 2.6 424.0 6.3 312.5 1.7 International Comparison of Ratios of Ordinary Income to Sales in Manufacturing (percent) Year Korea US Japan Taipei.4 2.9 4.7 15. Table 2.

the average ROE was lowest for large firms. Listed Companies The number of listed firms increased from 334 in 1985 to 775 in 1997 (Table 2. but higher than that of small firms. The growth performance of large firms for the 1988-1997 period was better than that of medium. with equity in wholesale and retail trade even contracting. This preference of Korean firms has its roots in the structure of corporate governance. A comparison of performance by firm size reveals some interesting results.6). Again. a year ahead of the other industries. The other financial ratios follow the general pattern of the aggregate corporate sector. Performance followed similar patterns across different industries (Table 2. and ROAs of all listed firms declined substantially in 1996 and turned negative in 1997.Chapter 2: Korea 67 other three economies can be attributed to the emphasis on growth in sales and market shares rather than on profits. Net profit margins. Profit rates of most industries are also quite low. followed by mediumsized firms and large ones. Small listed firms were hardest hit by the financial crisis. The manufacturing. 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.and small-scale firms (Table 2.10). The profit margin of listed firms was generally higher than that of the aggregate corporate sector. and steam supply industry.9). In most years. the sales growth of listed firms was higher than that of the aggregate sector (see Table 2. while their average net profit margin was lower than that of medium firms. Growth rates of total assets are generally high.8). both ROA and ROE were lower for the listed firms compared to the latter. with the wholesale and retail trade sector and the construction sector having the highest figures. It is notable that the construction sector’s profit rate began its decline in 1995. However. . gas.4 percent. ROEs. sales of listed firms grew 18. Profit rates of different industries also mirrored the downward trend of the aggregate corporate sector prior to the crisis. this may be an indication of the bias toward large firms in terms of access to credit. and transport sectors recorded negative profit rates in 1997. In 1997. construction. All sectors experienced a sharp decline in equity and sales growth in 1997.5 percent while the aggregate sector recorded only 13. trade. However. This may be related to its having the lowest DER. the exception being the electricity.

4 5.5 306.8 12.9 31.9 16.8 22.5 473.1 (0.0 1.8 12.0) 1.3 8.8) 0.5 (5.0 7.8 616.8 526.5 3.6 1.5 19.0 15.1 1.8 14.8 345.5 23.6 3.6 16.8 7.7 10.7 (3.3 2.8 302.7 317.0 9.4 (0.2 0.9 340.9 1.8 16.2 315.5 6.1 1.9 (0.2 0.5 (0.6 17.2 20.6 12.0 254.9 29.6 0.5 483.5 (1.8 1.1 17.0 1.5 1.9 3.2 20.5 1.6 15.9 16.8 13.8 2.2 241.1 7.2 25.4 458.6 318.8 3.9 9.0 18.0 1.9 14.4 350.9 (0.0) 0.3 8.3 285.4 10.6 24.8 32.9 25.5 4.2) (0.9 2.3 11.1 0.0 22.0 245.2) 22.5 1.1 290.5 338.7 22.7 520.3 1.1 21.3 15.1 1.6 5.3 11.3 15.4 474.0 1.4 .8 22.2 6.4 3.2 (1.7 21.8 24.3 10.8 17.9 428.3 2.9) 1.6) (6.0 19.0 5.7 16.4 15.0 21.6 14.0 2.4 1.4 2.2 36.5 28.5 5.8 461.0 (0.7 4.6) 3.8 10.5 569.3 8.4 10.6 655.0 22.7 30.0 12.7 7.1 0.4 12.1 10.8 16.1 16.7 17.2 2.1) (3.0 24.2 15.1 20.2 18.8 2.3 15.0 16.2 24.0 5.1 (0.3) (1.8 34.9 19.5 13.4 14.9 2.9 16.0) 0.2 12.0 2.0 24.8 16.0 (0.5 30.5 239.6 1.5) 0.7 514.9 10.0 23.4 348.5 14.1 28.4 10.2 5.4 9.0 15.1 22.0 (4.2 7.7 294.4 291.0 22.8 23.1 396.2) 6.0 1.0 1.4 2.8 0.0 2.1) 0. Renting.9 538.2) 15.6 0.5 1.2 6.4 10.5 270.2 5.4 0.0 37.9 13.3 14.9 10.4 2.7 228.8 14.8 35.8 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 13.9 (0.0 1.8 Real Estate.8 3.3 14.0 16.2 16.1) 3.5 286.0 3.1 2.1 0.4 0.2 16.1 2.5 432.7 (0.5 27.6 14.4) 0.3 8.8 1.3 1.3 15.3 10.2 423.6 7.6 11.7 9.0 2.1 1.4 1.4 17. and Business Activities 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 11.3 13.Table 2.2 0.5 1.5 16.6 17.4 4.4 2.4 5.6 12.1 27.6 2.8 2.5 Construction 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 18.9 0.1 296.7) 2.7 5.2 5.4 5.5 5.0) 4.6 6.4 740.6 375.7 0.6 14.0 18.6 3.5 6.8 0.8 562.5 1.3 31.3 18.3 25.8 24.9 5.3 288.7 1.8 10.4 2.

9 12.4 6.8 0.3) 11.7 7.2 3.1 11.9 456.2) 13.9 7.7 15.0 7.2 143.6 172.3 0.2 10.7 16.8 14.2 10.4 0.6 6.1 12.6 34.9) (8.7 7.9 8.8 11.1) (0.1 (0.0 98.4 30.4 2.6 (2.2 90.062.8 111.0 1.4 13.0 921.7 11.6 9.3 543.3 18. Storage.0 5.9 6.3) 15.3 18.7 0.9 1.4 1.6 — — — — — 0.5 117.4 9.7 14.0 2.2 — — — — — 2.4 2.5 14.5 14.0) 1.9 321.5 15.5 16.9 18.6 4.9 4.4 0.2 18.1 21.4 3.0) 1.7 116.6 4.4 7.1 4.5 30.7 0.6 9.6 21.5 26.3 8. Source: Calculated using data from Bank of Korea.4 — — — — — 448.3 4.3 34.9 Electricity.0 106.3 9.4 16.8 0.2 14.7 19.6 3.5 4.6 0.3 3.8 12.6 18.5 47.3 — — — — — 10.3) 4. and Communication 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 15.9 9.5 12.9 10.9 3.7 — — — — — 14.8 14.4 367.7 2.2 18.6 8.1) 1.5 462.2 14.5 0.1) 5.4 6.9 (11.3 524.6 6.1) (0.9 4.8 6.5 307.5 (2.3 0.3 8.4 169.3 17.3 12.6 (2.1 17.8 4. Gas.9 8. b NPM denotes net profit margin.2 10.4 (0.2 698.0 5. and Steam Supply 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 12.3 112. Financial Statement Analysis Yearbooks.3 125.9 18.4 3.4 (2.1 15.6 15.2) 0.7) 0.3 1.3) (1.4 3.4 1.5 344.1 3.7 187.0 13.9 17.8 8.1 16.6 8.6 8.0) (0.2 11.5 11.4) (1.7) (4.5 539.0 14.8 529.7 2.0 (1.3 (2.3 1.6 19.5 8.2 15.6 19.4 10.6 12.8 12.0 89.0 21.5 13.9 332.5 14.7 — = not available.6 1.1 8.5 612.6 9.1 323.4 14.4 12.9 9.0 (15.6 14.7 11.2 2.6 1.3 19.9 17.4 11.6 512.1 6.3 2.6 — — — — — 17.7 11.1 15.4 7.1 (11. .2) 9.5 11.4 341.1 11.3 740.4 21.5 14.2 122.2 7.0 1.7 510.0 Transport.9 (10.2 1.2 18.6 20.6 2.5 2.8) 1.1 (2.8 7.7 12.4 633.1 2.8 (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 — — — — — 31.8 3.6 6.3 4.4 12.0 1.3 4.4 1. a New equity does not include capital surplus.9 10.6 16.0 14.8 15.1 14.5 15.Table 2.1 1.8 3.7 20.3 23.8) (12.0 2.4 15.6 12.8 9.8 6.5 482.4 0.5) 22.1 15.9 12.

and close to half of total assets (46.9 2. of Firms 334 351 386 503 626 669 680 681 687 698 715 754 775 Sales Growth 10.2 6.6 22.1 percent of the economy’s total value added (excluding the financial sector). The number of Hyundai member companies rose to 57 in 1997.9 6.5 19.9 11.6 3. the largest chaebol.1 6.9 26.9 21. Between 1993 and 1997.1 1.0 18.5 0.6 23.3 (0.11).8 5.1 1. debts (47. Chaebols have been the most important actors and engines of growth in the Korean economy.6 1.6 0.3 20. sales (45.9 Source: Constructed using data from Korea Investors Service.7 (5.0 0.5 ROE 3.70 Corporate Governance and Finance in East Asia.4 2.7 percent) of the corporate sector.8 0. It should also be noted that when the financial crisis struck in 1997. the 30 largest chaebols accounted for 13.7) 0.9 percent).4 0.8 6.8 24.5 19. In 1997.2 9. II Table 2. The criteria for selection of largest chaebols have changed a few times.7 Net Profit Margin 0.6 (1.1) 4.3 2. of which four were listed. 1985-1997 (percent. but the number of designated groups has been fixed at 30 since 1993.3 15.6 2.9 2.2 9.4 22.4 1. unless otherwise indicated) Financial Performance Year 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average No.12). Vol.0 3. of which 16 were publicly listed (Table 2. In 1995.5 5.6 and 2. The top five chaebols registered the highest growth rates. The smallest group had 16 members in 1995. had 46 member companies. Hyundai Group.9 0. Performance of Chaebols This section uses available data on the top 30 chaebols. the top 11-30 chaebols experienced a decline of . Kis-Fas. followed by the top 6-10 (Table 2.9 Growth and Financial Performance of Listed Companies.9 percent).3 4.7 1. 1998.9 1. Generally.7 1.4 1.5 ROA 0.2 2.12). and net profits (46. it is the chaebols’ large firms that are listed.2 0. the growth of sales of the top 30 chaebols exceeded that of the aggregate corporate sector (compare Tables 2.3 percent).4) 1.4 1.3 0.

5 0.8 (5.9 2.0 19.4 3.4) 1.0 16.0) 1.0 1.1) 5.4 6.4 Medium Small Large Medium Small ROA Growth Performance Large 17.7 (1.4 5.3 (0. 1988-1997 (percent) ROE Large 9.4 3.10 Growth and Financial Performance of Listed Companies by Size.7 4.3 (0.6 (0.5 3.2 0.0 (4.5 (1.2 10.9 2.7 2.6 9.9 6.9 2.5 17.8 7.5 1.0 15.9 1.7 18.1 2.7 (1.9 22.6 0.6 2.3) 0.6 1.2) (1. Kis-Fas.1 8.6 7. Others are medium firms.8 3.3 6.0 17.2) 0.9 0.5 2.4 2.3 3.2 13.6 3.4 1.2 (0.3 15.3 Medium 14.2 3.6 2.8 10.6 1.4 11.9 25.7 (0.0 4.8 16.Table 2. 1998.3 15.3 1.6 5.5 5.2 12.0 10.6 6.6 2.4 16.9 3.3) 5.2 1.6 0.0) 0.6) 0.8) 6.9 0.3 9.7 2.7 3.8 6. Source: Korea Investors Service.1 11.7 1.1 1.9 1.9 5.5 5.0 6.8 0.6 3.6 1.8 17.5) 1.8 0.6 8.0 1.4 1.2 2.2 2.2 Small 13.8 1.6 13.8 0. .0 1.0 1.6 (1.5) 1.9 6.1 2.5 25.8 6.2 13.1 0.8 0.2) (1.2 7.2 Note: Large firms have a capital base greater than W15 billion and small firms smaller than W5 billion.5 Net Profit Margin Year Large Medium Small 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 2.3 11.9 14.9 0.8) 1.9 (0.9) (6.

158 1.766 3.486 6.475 2.147 5.131 3.398 — 2.574 3.177 — 6.445 4. .927 16.798 — No.346 3.774 7.929 12.287 10.427 9.599 — 2.853 1997 53.303 3.364 5.967 7.433 3.376 35.873 2.180 2.956 3.690 3.756 5.597 351.996 1.313 14.158 7.370 6.129 2.951 3. 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.990 2.651 38.761 31.11 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 43.395 31. 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.935 2.423 5.501 13.455 22.Table 2.743 40.117 4.246 11.458 6.457 14.309 14.924 2.995 2. Source: Fair Trade Commission.677 3.640 4.910 3.090 6.

5 5.6 1.2) (0.2) (2.3 16.7 10.Table 2.12 Growth and Financial Performance of the 30 Largest Chaebols.1 (1.7 13.1 19.3 1.0 1.1) (1.7 15.4) 1.8 27.2 (16.9 17.3 19.2 0.4 30.6 4.9 20.3 14.4) (14.7 1.7) ROE 5.2 0.9 3.2 11.0 2.2 (2.8 Assets 12.5 27.7 4.8 18.0 2. 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) 1.9 24.2 0.1 2.1 10.5 2.5) (0.1) 0.1) (0.0) 12.4 12.9 3.7) Source: Bank of Korea.2 1.5 20.6 (0.4 26.5 32.5 19.8 0.9 1.3 1. .6 25.3 11.1 27.1) 0.5 (0.5) (0.0 2.3 0.2 (5.3) 0.3 9.9 20.3 27.0) ROA 1.1) (0.7 15.6 18.0) 3.0 0.1 (3.9 18.0 17.0 6.5) (0.7 0.0 31.3 0.3 15.2 (2.0 19.0 0.2 20.7 10.4 (2.4 38.4) (0.6 Financial Performance Net Profit Margin 1.1 (2.2 3.4 0.3 3.6 19.

2. Only the top five chaebols registered a positive net profit margin in 1997. . technology.95 percent.3. coupled with weak corporate governance. a pyramidal structure of corporate ownership is prevalent. the average DER of the 30 largest chaebols reached 519 percent. and led to a high concentration of ownership.3 Corporate Ownership and Control This section looks at the key aspects of corporate governance in Korea. There has been a wide range in DER among chaebols. weak corporate control. Vol. 2. 5 While “ownership concentration” can be defined and measured differently in different contexts. The ROE of the top 30 chaebols was consistently higher than that of the aggregate corporate sector. 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. resulted in the chaebols’ excessive leverage. his/her relatives. In general. and the companies that are under the control of the largest shareholder.1 Patterns of Corporate Ownership The ownership of most Korean listed firms is highly concentrated. Ownership patterns. except for 1995.” in Korea’s legal and regulatory framework. However. and vulnerable balance sheets. from 190 to 3. it refers to the degree of concentration and shareholdings in the hands of an “identical person. loopholes and inconsistent policies spawned strategic behavior and agency problems. By the end of 1997.5 Founding families are mostly still the largest shareholders and.13). The Commercial Code stipulates the basic governance framework and applies to all corporations.74 Corporate Governance and Finance in East Asia.” This “identical person. chaebols had a higher average DER than the corporate sector as a whole. includes the largest shareholder. and government intervention interacted through a set of laws and regulations to bring about the existing structure. II 2 percent in their sales and a very low 4. Their worst year was 1997 when ROE hit -15.765 percent (Table 2. The better showing of the top five chaebols was a direct result of their dominance in human resources. The financial performance of the top 11-30 chaebols deteriorated during 1993-1997. and access to credit.7 percent growth in total assets. internal and external control mechanisms. the net profit margin of the aggregate sector exceeded that of the top 30 chaebols. However. more important. in this instance. The absence of a well-developed equity market and the provision of subsidized credit.

5 3. Hyundai 2.6 2.2 471. Kohap 25. Haitai 26. Halla 17.5 337. Jinro 20.4 205.6 936. Kukdong Construction 29. Daelim 14.3 328. Ssangyong 7. Doosan 13. Sunkyung 6.7 354. Hansol 17.8 313. Hanbo 15. Dongbu 24.5 343. Hanjin 8.1 477.3 315. Samsung 3.0 370.1 3. Hyosung 18.1 385.5 464. Halla 13. Daelim 16.8 336.4 622. Byucksan 1996 1. Hanwha 10. Hanwha 10.0 436.2 292. Dongkuk Steel 19. Hyosung 18.8 312.6 516.4 556. Kia 9.9 751.0 506.0 486. Kumho 12.2 924. Samsung 3.7 267. 1995-1997 (percent) Chaebols 1995 1. Tongyang 22. LG 4.5 2. Sammi 27.4 192.2 2. Hyundai 2. LG 4. Dongkuk Steel 19.9 321. Daewoo 5. Newcore 30.6 . Kia 9. Sunkyung 6.0 218.13 The Top 30 Chaebols’ Debt-to-Equity Ratio. Doosan 15.Table 2.855.1 190.2 346.6 409.441.1 674.7 621. Lotte 11. Lotte 11. Hansol 23.7 620.2 423.764. Hanil 28.7 688. Ssangyong 7. Daewoo 5.2 328.3 297. Hanjin 8.3 572.1 278. Dongah Construction 16.065. Kolon 21.5 383. Kumho 12. Dongah 14. Jinro Debt-to-Equity Ratio 376.4 175.244.7 416.

Haitai 25.8 590. Dongah 11.6 590.8 347. Doosan 15.9 1. Kohab 18.225.8 307. Kohab 22.3 1.5 1.501.8 399.5 323.3 347.9 465.0 419. Hanjin 7.6 424. Hyosung 17.4 1.5 519. Hyundai 2.4) 513. Saehan Average of All Chaebolsa 1995 1996 1997 Average of All Industries Excluding Financial Sectorb 1995 1996 1997 Debt-to-Equity Ratio 317. . Keopyong 29.0 505.1 359. Hanwha 9. Halla 13. Anam 27.1 375. Hanil 28.9 578.784. Daelim 14. bBank of Korea.5 576.5 (1.3 676.7 1. Miwon 30. Anam 22. Dongbu 21.8 647.8 338.5 (893.9 472. Daesang 27. Jinro 23.8 468.Table 2.7 370.9 490. Financial Statement Analysis Yearbook. Shinho 26.3 399. Daewoo 4.5 386.6 478.498.214. Kolon 21.0 305.1 472. Haitai 25.6 Sources: aFair Trade Commission. Dongbu 23. Shinho 1997 1. SK 6. Kolon 19. Samsung 3. Keopyong 29.600.5) 404. Lotte 12. LG 5.5 261.1 433.6 335.1 438.7 944. Newcore 26. Hansol 16. Tongyang 24. Newcore 28. Dongkuk Steel 20.6 416. Kumho 10. Tongyang 24.8 658. Ssangyong 8.13 (Cont’d) Chaebols 20.9 216. Kamgwon Industrial 30.0 907.

The controlling shareholders of chaebols hold comparatively smaller percentages of shares. Securities companies reduced their holdings over this period of falling stock prices as the size of investment trust companies’ stock portfolios declined. Among listed nonfinancial companies. 10 to 30 percent). the year the stock market was in a frenzy due to buying sprees. the entrenchment effect outweighs the incentive effect. managerial entrenchment becomes more likely. fluctuated widely during the period. the percentage of holdings by individuals slipped to 60. However. The pattern of distribution changed little through 1992-1997. the entrenchment effect and problems of agency may be more pronounced in chaebols than in independent firms. the extent of ownership by these individuals declined gradually after 1988. the incentive effect once again dominates.” followed by banks. The reduction can be .1 percent. including investment trust companies. and insurance companies increased during the period.7 percent by 1997. and then steadily declined after 1993. From 69. When managerial holdings are reinforced by artificial control mechanisms such as pyramiding. while those owned by banks. The percentage of shares owned by “other corporations.e. the Government.14). but their shares declined to 21. an entrenched manager is insulated from market pressure and can pursue personal goals without the fear of being replaced. Thus. with a given range of managerial shareholdings (for instance.” foreigners. individuals were also the largest shareholder group. However. The holdings of financial institutions. the ownership structure can bring about an incentive effect. large ownership can also bring about the entrenchment effect.Chapter 2: Korea 77 When controlling shareholders hold a very small percentage of the shares.. including banks and other financial firms. Composition of Ownership Among listed companies. resorting to extensive use of pyramiding to maintain control. i. Theoretically. Beyond that range. The next important group was “other corporations. that is. Financial institutions owned as much as 28 percent of the total corporate shareholdings in 1992. the individual owners—the portfolio investors as well as the controlling shareholders and their family members—formed the largest shareholder group (Table 2.6 percent by 1997. an increase in their ownership may bring their ownership incentives to converge with those of the minority shareholders. and state-owned companies and securities companies declined. Most non-chaebol listed firms in Korea are believed to have ownership concentrations within the 10-30 percent range.

0 9.1 18.5 12.Table 2. b “Banks.6 9.4 5.4 13.6 16.5 1.3 39.8 59.9 37.3 5.6 13.7 18.3 17.5 7.3 8.9 5.2 7.5 62.0 5. investment trust companies.2 8.8 5. d Constructed from data files of the Korea Listed Companies Association.4 13.1 1.4 34. mutual savings.5 6.7 14.7 8. merchant banks.8 4.8 69.6 16.5 1.1 8.0 8.2 18.8 1995 548 2.2 5.7 6.6 8.1 68.8 17.1 17.2 2.2 B.3 1.6 20.7 4.5 18.0 4.7 1990 531 0.7 9.6 22.3 1996 570 2.9 2.4 Insurance Firms Other Corporations Foreigners Individuals 39.0 60.1 2.1 4.5 1989 498 0.6 16.4 6.3 5.3 1.6 Year No.7 3.8 59.6 36.” includes commercial banks.2 9.3 26. All Listed Companiesc 1992 681 1993 687 1994 698 1995 715 1996 754 1997 775 9. and finance companies.3 18.0 7. of Firms The Statea Banks.1 21.6 1991 505 0.9 17.2 9.0 59.2 1.9 2.b A.9 4.9 1. .0 28.2 8.9 26.3 18.2 1993 511 2.4 14.6 2.4 18.5 60.2 5.5 1992 508 2.7 59.4 5.0 27.2 3.6 9.1 21. 1988-1997 (percent) Financial Institutions Securities Firms Total 28.8 2.7 9.5 7.5 4.14 Ownership Composition of Listed Companies.9 36.1 18.3 2.1 8.5 16. a The State covers the Government and state-owned companies. etc.9 15.3 1994 521 1.9 1. Listed Nonfinancial Companiesd 1988 406 0.2 4.3 17.4 1997 551 1. etc.6 12.5 Note: Ownership is based on number of shares.9 19.1 10.1 11.8 17.1 3.8 5.7 7. c Data from Korea Stock Exchange.2 17.1 60.8 2.6 19.0 5.5 6.

the Government was the sole owner. of some banks. The Government’s and state-owned institutions’ (including some banks) ownership was generally small except in the power sector. government ownership in nonfinancial companies was remarkably smaller and more concentrated. In 1998. However. Corporate holdings averaged 16 percent throughout 1988-1997. Over the years. indicating their increased investments particularly in the service industries with high growth rates. other corporations’ holdings shifted toward service industries. electricity. Foreigners gradually increased their equity shares in 1992 when direct purchases by them were first permitted. The holdings of other corporations are mainly equity investments in affiliate companies. The ownership distribution in listed nonfinancial firms. This trend can be explained by government ownership. 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. Before such liberalization.15). the holdings of institutional investors were expected to increase significantly with the Government’s introduction of US-type investment companies in 1998 and .17). Institutional investors. did not vary significantly (Table 2. One minor difference is that the percentage of shareholdings by corporations is slightly higher in large-sized firms. and US (Table 2. When independent companies are distinguished from firms affiliated with the 30 largest chaebols. UK. categorized into large.18).8 percent of listed shares in 1997. medium. there appears to be no significant difference in the overall shareholding patterns between the two groups (Table 2.16). Compared with its holdings in all listed companies. the Government acquired an even bigger share in several banks as part of its program to bail out these distressed institutions. financial institutions had more shares in the manufacturing sector than in primary industries. with the Government continuing to hold a sizable share in the Korea Electric Power Corporation. and service of motor vehicles (Table 2. This is low compared with those in Japan.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. as distinguished from individual and foreign investors. foreign holdings were derived from purchases through country funds and direct capital investments. However. indicating their heavier reliance on inter-firm financing investments. and small companies. In most instances. Individuals held the majority of the shares in all industries except in telecommunications. whether partial or absolute. In general. held 26.

7 2.9 16.7 64.0 20.4 62. and Plastics Basic Metal Fabricated Metal and Machinery Office and Computing Machinery Electronics.0 8.2 7.8 7.1 65.7 20. Etc.9 66.4 8.5 — — 0.5 7.6 1.3 13.4 2. Motor Vehicles Electricity.8 73.0 7.6 11.6 3.0 — 39.1 0.3 6.2 9.8 5.4 0.4 56.7 17.4 Banks.8 8.7 2.6 5.8 7.3 7.4 8.b Securities Firms Insurance Firms Other Corporations Foreigners — — 0.5 19.1 0.2 9.2 2.2 22. and Printing Pulp.5 6.2 64.2 — — 0.0 Industry 1990 Fishing and Fish Farms Mining Food Products and Beverages Wearing Apparel and Fur Articles Wood.5 3.5 17.2 0.7 29. 1990 and 1997 (percent) Financial Institutions The Statea — — 0.2 1..9 60.4 1.7 20.9 23.7 6.4 5.3 1.9 10.8 7.3 9.8 6. and Printing Chemicals.8 Individuals 83.5 4.8 1.6 8.0 2.2 9.3 62.5 — 0.0 1.7 22.9 42.4 7.9 8.4 56.9 55.2 17.1 1.Table 2.2 0.5 0.5 0. Paper.4 8.7 14.5 — 1.3 38.3 0.5 0. Gas.2 0.3 4.0 9. 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 .9 15.7 1.9 1.9 0.0 9. and App.9 1.6 24.1 0.4 — 0.7 63.3 0.5 85.7 59.3 1.3 2.6 18.9 19.7 14.3 10.7 2. Elecl Mach.8 3.8 3.4 1.9 59.1 88.1 4.9 4.1 10.1 0.9 52.15 Ownership Composition of Listed Nonfinancial Firms by Industry.1 8.7 22.0 9.8 7.1 8.3 11.3 2. Paper.0 9.2 1.8 7.6 — — 2.2 0.1 19.5 0.4 14.3 0.3 57.1 27. Rubber.2 54.1 7.0 10.0 0.0 — 0.5 12.2 — 0.

9 2.7 5. merchant banks. and Printing Chemicals.2 4.2 0.4 16.9 7.3 6.4 — 1.9 1.8 5.6 14.6 60.2 8.6 59. Gas.4 1.8 0.8 57.3 1. b “Banks.6 2.5 3.0 60.6 1.3 60.1 2.5 7.2 0.6 0.2 6.2 4.6 75.0 6.5 3. Paper.4 2.1 9.0 1.5 59.4 45.” includes commercial banks. investment trust companies.3 8.4 2.3 7.5 3.1 1.2 5.8 54. Paper.8 12. and finance companies.9 5.8 27.2 7.1 18.6 7.7 1. and App. mutual savings.7 17.7 2. and Printing Pulp.6 6.3 1.4 43.6 — = not available.3 57.8 4.1 1.4 1.5 4.1 — 0.3 0.5 3.9 7.2 13. and Plastics Basic Metal Fabricated Metal and Machinery Office and Computing Machinery Electronics.5 4.4 3.0 3.6 20.6 5.1 — 1.4 9.2 1.0 8.3 2.2 3.6 6.1 4. a The State covers the government and state-owned companies.0 6.0 4.1 3. .1 3.0 5.3 31.1 9.8 0.4 1.6 2.5 63.3 15.5 0.8 11.9 2.1 6.8 2.8 5.6 2.9 5.7 2.5 — 2.5 5.7 19.4 58. Elecl Mach.0 7.7 2.2 23.3 6.7 23.78 81.8 2.5 12.4 76.9 2.9 0.0 43.9 57.6 0. Note: Ownership is based on number of shares.7 2.4 2.1 25. Source: Constructed from data files of the Korea Listed Companies Association.4 4.8 3.4 6.2 4.5 1.2 49.9 69.9 6.9 2.4 68.4 20.9 20.7 4. etc.6 18.1 2.9 78.9 18.4 0.2 5.2 4. Rubber.6 3.1 54. Motor Vehicles Electricity.9 6.8 6.8 2.3 65.0 11.7 6.9 1.2 1.4 58.5 6.1997 Fishing and Fish Farms Mining Food Products and Beverages Wearing Apparel and Fur Articles Wood.4 4.9 1.9 20. 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.

3 Banks.3 6.8 4. The State covers the government and state-owned companies.7 8.7 4.Table 2.9 5.5 Individuals 60.4 17.1 6. of Firms Independent Firms Affiliates of 30 Largest Chaebols Total 316 117 433 Source: Constructed from data files of the Korea Listed Companies Association. 1997 (percent) The State 1.5 18.8 2.1 8.5 6. etc.5 19.7 0.4 1.5 8. 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.4 5.4 2. b Table 2.7 Foreigners 4.4 5.7 1. etc.8 60. and finance companies.6 16.7 6.1 2.8 3.6 60.9 2. etc.8 4. c “Banks.4 61.4 61.4 2. .0 Other Corporations 16.5 62.” includes commercial banks. Securities Firms Insurance Firms 2.9 4.4 4.4 Firm Sizea No.17 Ownership Composition of Listed Nonfinancial Firms by Control Type.5 4.c Securities Firms Insurance Firms Other Corporations Individuals 58.4 21.1 Banks. mutual savings. Source: Constructed from data files of the Korea Listed Companies Association.16 Ownership Composition of Listed Nonfinancial Firms by Size.0 1. 1997 (percent) The Stateb Foreigners 4. investment trust companies.5 2.5 16.2 1.8 6.8 1.0 6. merchant banks.7 Control Type No. Others are medium firms.

8 56. minority shareholders. his/her family members.19). This has had profound implications for corporate governance and the market for corporate control in Korea.8 10.18 Ownership Composition of Listed Firms in Selected Countries. while family members accounted for only 30 percent. the majority shareholder group on average held 23-30 percent of outstanding shares in the period 19881997 (Table 2. Among nonfinancial listed firms.8 9. including those of the largest shareholder. defined as those holding less than 1 percent of shares. The majority shareholder group’s shareholdings in listed nonfinancial firms steadily declined from 1990 to 1996.1 percent and appear to be similar to the proportion of foreign holdings in the four other countries. rather than the individual. Concentration of Ownership The analysis of ownership concentration in this section focuses on shareholdings of the majority shareholder. investors (Table 2.5 45. Generally. and the companies under the control of the largest shareholder. At the moment. and other shareholders who do not belong to either the minority shareholders or the majority shareholder group.China United Kingdom United States Source: Stock Exchange of Korea.1 financial institutions’ establishment of corporate pension fund accounts.5 20.1 8. But these may .6 Individuals 23. 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.6 39.3 47.4 26. corporations held 70 percent of the controlling blocks of shares. Foreign holdings of Korean shares were 9. 1997 (percent) Country Japan Korea Taipei.Chapter 2: Korea 83 Table 2. Institutional Investors 42. for example.7 16. the majority shareholder group in all listed companies consists of the corporate. In 1997. only closed-end investment companies and traditional investment trust companies are allowed.20).3 54.3 6.6 Foreigners 9.

1 5.0 2.8 8. Minority shareholders are those holding less than 1 percent of shares.7 44.7 Note: The majority shareholder includes the largest shareholder.19 Ownership Concentration of All Listed Firms.1 28.9 6.9 3.4 3.9 2.1 21.1 4.7 7.6 2.6 46.9 7.6 22.3 18. and the companies under the control of the largest shareholder.1 15. 1992-1997 (percent) Majority Shareholders Corporation 15.7 6.2 26.0 4.2 Minority Shareholders Subtotal 71.1 5.0 Year Corporation Individual 1992 1993 1994 1995 1996 1997 41.0 1.3 Subtotal 5.1 37.9 Individual 2.6 73. Other shareholders are those who do not belong to either the minority shareholders or the majority shareholder group.8 Individual Subtotal Other Shareholders Corporation 3.8 73.Table 2.0 25.5 43. Source: Stock Exchange of Korea.0 22. his/her family members.3 30.4 5.2 2.1 32.3 2.8 72. .4 7.7 16.6 26.0 29.2 2.1 23.0 69.6 5.9 33.0 66.9 32.7 18.1 14.

The shareholders that held more than 1 percent but did not belong to the majority group held about 20 percent on average.2 15.5 12. rubber and plastics.5 13.8 54.6 58. Besides. The practice of hidden shares seems to have been less prevalent in recent years. Majority ownership is also high in the chemicals.6 57. In most industries.8 12.3 25.9 Other Shareholders 18.5 23.8 Majority Shareholders 27.9 12.4 Source: Constructed from data files of the Korea Listed Companies Association. thereafter.22). In telecommunications. and mining categories.0 20. the majority owner held more than 20 percent of an average firm. .7 18.20 Ownership Concentration of Listed Nonfinancial Firms.8 57.6 11. 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.9 25.1 50. Across industry.Chapter 2: Korea 85 Table 2.5 60. minority shareholders.8 28.9 27. hiding shares offers no additional tax or other benefits. 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 2.9 48.3 62.0 22. collectively owned less than 50 percent of an average firm. 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 2.4 28.8 25. ownership was relatively diffused due to government regulation. the Government has retained a large number of shares.9 29. It was highest in medium-sized firms before 1993 and. in the small firms. which held less than 1 percent of a company’s outstanding shares as of 1997. Meanwhile. 1988-1997 (percent) Year 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Minority Shareholders 53.21]). In such cases. Ownership concentration tended to be lower in large compared to medium and small listed firms.0 58.4 23.

6 34.6 50.5 19.9 Minority Shareholders Majority Shareholders Other Shareholders 12.2 48.8 55.5 16.21 Ownership Concentration of Listed Nonfinancial Firms by Industry.1 19. Paper.5 52. and App. Rubber.7 24.5 44. and Plastics Basic Metal Fabricated Metal and Machinery Electronics.8 44.7 21.Table 2.8 25. Gas.5 23.4 16.5 21.0 54.9 44.6 53.3 39.4 53.2 19.0 51.6 19.5 41.1 49.0 30.2 34. 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.4 11.9 10. .7 29.7 26.1 43. Paper. Elecl Mach.2 20.2 26.0 21.8 31.6 38..8 24.2 22.0 39.7 36.8 21.9 26.4 Industry Fishing and Fish Farms Mining Food Products and Beverages Wearing Apparel and Fur Articles Wood. Motor Vehicles Electricity.3 26.8 41. and Printing Chemicals.8 29. and Printing Pulp. 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 36.5 47.1 17.5 20.8 51.3 19.7 17.2 37.7 27.2 46.2 23.6 25.

0 59.5 51.9 60.5 28.8 62.4 21.2 11.9 23.2 21.9 53.3 25. 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.7 17.6 27.0 24.3 19.2 18.5 19.2 21.5 21.6 15.1 27.1 16.4 30.8 50.2 52.5 10.5 12.2 55.9 21.9 16.4 51.8 17.9 55.5 Other Shareholders 19.2 12.5 26.6 62.3 55.5 27.0 55.Table 2.6 11.7 22.3 21.8 52.7 31.7 57.9 56.6 59.5 33.9 12.8 52.8 11.4 47.3 27.3 26.1 15. .7 57.6 55.4 29.0 26.7 14.6 65.9 22.2 32.1 20.2 56.7 28.2 26.6 31.6 24.2 Majority Shareholders 26.1 48.7 16.1 58.22 Ownership Concentration of Listed Nonfinancial Firms by Firm Size.5 19.5 12.9 28.4 30.8 56.8 28.8 27.4 30.2 21.9 26.9 17. 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 53.2 50.0 66.2 Source: Korea Listed Companies Association.5 49.7 15.

For example. and the shareholding of a controlling shareholder (SCS) as the degree of ownership concentration. J. TQ increases as the SCS increases. If TQ is higher than 1.88 Corporate Governance and Finance in East Asia. The relationship between TQ and SCS shows a similar pattern. Inter-Firm Investments and Pyramiding in Chaebols The Commercial Code imposes limits on direct cross-shareholding. if TQ is lower than 1. The Code prohibits a subsidiary company from owning shares of its parent company. and Kim (1995) studied the empirical relationship between the degree of ownership concentration and financial performance in Korea. affiliated companies have been able to conduct inter-firm transactions. Kim (1992) found the relation between TQ and SCS to be nonlinear. Hong. is effective control of a certain group of companies even with a smaller investment. This refers to the situation wherein Company A holds shares of Company B and simultaneously Company B holds shares of Company A. one company can still place equity investments in another. which can then pass the equity capital to a third. Both studies used Tobin’s Q (TQ) for the value of a firm as an index of financial performance. the firm destroys value. often at terms unfair to one of the transacting parties. and Vishny. TQ is above 1. In Korea. and Kim (1995) reached a similar conclusion. called “pyramiding”— commonly (though incorrectly) known as “indirect cross-shareholding”— is prevalent in Korea. Shleifer. If SCS is below 10 percent. which is the company holding more than 40 percent of outstanding shares of its subsidiary. This type of inter-firm investment. They analyzed firms in which controlling shareholders participate as managers. If SCS reaches 10 percent. TQ has a maximum value. TQ was calculated by dividing the market value of a firm by the substitution price of its assets. The study by Kim. from the standpoint of the controlling shareholder. Kim (1992) and Kim. II Ownership Concentration and Financial Performance J. Vol. Then TQ declines until SCS reaches 45 percent and increases until it reaches 50 percent. thus a firm creates value. TQ is below 1. H. H. one company from a chaebol group could obtain debt payment . If SCS is above 20-25 percent. The pattern of the relationship between SCS and TQ is similar between Korean and US firms (Mork. Hong. although turning points in the value of firms are different. If SCS is below the range of 20-25 percent. Where direct cross-shareholding is not allowed. 1988). it means the firm creates value. thus a firm destroys value. One of the merits of pyramiding.

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. the top 30 chaebols’ shareholding by subsidiaries was 34. Thus. The top five shareholders of the chaebol-affiliated firms consisted of one individual and 3. there are instances of direct cross-shareholding in Korean firms. 59 were parent firms with one or more subsidiaries. together owning an average of 38. For the same year. not individuals. together having a total of 292 domestic subsidiaries.5 corporations and two individuals.23. the average shareholding of the controlling owners and their families was 8. For the whole sample.5 percent. neither the investors nor the relevant government authorities were active in monitoring such unfair dealings between firms. 34 percent were foreign companies. The extent of pyramiding can be seen in some of the previous tables. although they are likely to be insignificant. the top five shareholders consisted of 2. In the case of the 30 largest chaebols. 59 parent companies collectively had investments in 759 firms. and about 11 percent were domestic financial institutions. In Table 2. for example. Among chaebol affiliated firms. But the controlling power of the owners also stems from inter-company shareholdings of the subsidiaries. firms linked through partial equity investments could enjoy the advantage of consolidation without an actual formal consolidation or merger of operations taking place. Thus. 53 percent were domestic nonfinancial firms. In many instances.14. or an average of 13 firms per company. and 319 foreign subsidiaries.5 percent as of 1997. 62 percent (16 out of 26) had a corporation as the largest shareholder. Twenty-two of the 81 respondents were independent. Of the 81 respondents. If we define the internal shareholdings of a . or about four firms each. Among the 81 listed firms in the ADB survey.9 percent of shares. Only six firms (or 13 percent) indicated that their subsidiaries also owned shares in themselves. or about five subsidiaries each. Partial results are shown in Table 2.5 percent of shares. together owning an average of 37.Chapter 2: Korea 89 guarantees from other members of the group at no cost. This also partly explains why chaebols frequently opted to expand by establishing new firms rather than placing investments internally. The fact that corporations. corporations hold about 20 percent of the outstanding shares of all listed nonfinancial firms. financial institutions that are subsidiaries of a chaebol also hold shares in its member firms. Among the subsidiaries or firms receiving investments. standalone setups. Until recently.4 corporations. dominated the majority shareholder group in chaebol-affiliated companies is consistent with the results of the ADB survey conducted for this study.

0 1.4 25.0 1.8 Note: The survey was conducted during the period January through May 1999 and included nonfinancial listed firms only.7 39.4 18.7 19. 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. a Number of shareholders.23 Ownership Concentration in the Survey Sample of 81 Listed Firms.5 38.8 31.3 26.9 21.0 3.5 18.4 21.6 3.6 16.6 3.2 37.6 34.8 37.1 1.0 3.5 2.0 13.1 22. 1999 Five Largest Shareholders No.4 38.5 2.9 5.9 34.5 2.0 21.4 42.5 4.5 4.0 2.6 3.0 17.9 29. b The chaebol affiliated firms are those belonging to one of the 30 largest groups.2 25.4 1.5 2.7 37.7 5.7 0.8 18.8 8. A few companies reported less than five largest shareholders.8 38.5 1.Table 2.5 31.3 12. .4 11.4 2.1 3.5 24.

5 percent.7 1992 46. 15 October 1998.4 10. Tamio. Ungki Lim.2 12.5 34. “The Ownership Structure and Family Control in Korean Conglomerates: With Cases of the 30 Largest Chaebols. 1987-1997 Type of Shareholding Internal Shareholdings Family Member Companies Source: Korea Fair Trade Commission.Chapter 2: Korea 91 chaebol as the shareholdings of the controlling family and the member companies of the group.24 shows the average internal shareholdings in the 30 largest chaebols. Family holdings include shares owned by the family members and by parties considered to be under the influence of the family. 6 7 Hattori. Table 2. Lee. “Japanese Zaibatsu and Korean Chaebols. H.7 9.0 8. Chung and H. “Is the Fair Trade Policy Fair?” Korea Economic Research Institute.2 33. Hattori (1989) identified three patterns based on data in the early 1980s. the ownership patterns can be described as follows.” Paper presented at the Annual Conference of Financial Management Association. Table 2.6 Later studies by Lee (1997) and Lim (1998)7 find similar patterns. . the average internal shareholding ratio of the top 30 chaebols was at least 43 percent.1 1997 43. New York: Praeger.8 40. 1989.5 percent and member companies. 1998.6 33. Lee. 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.4 1993 43. Chicago.” In Korean Managerial Dynamics. edited by K. Internal shareholdings in some chaebols also include shares owned by nonprofit organizations operated by the controlling family.4 1990 45. As of 1997.5 Judging from the historical record. Many attempts have been made by researchers to identify the typical patterns of ownership structures in chaebols. 79-95. C. Jae Woo. pp. 34. it appears that the chaebol families have had a strong desire to expand their business bases.2 1994 42. 1987 56.8 33.7 31. 1997.24 Internal Shareholdings of the 30 Largest Chaebols. Based on these studies. the controlling families owned 8.4 13.2 15. 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. The family and member companies’ shareholdings have been declining over time.

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

These amendments prohibited holding companies and direct cross-shareholding. direct control of the management of chaebols was attempted through amendments of the act in 1986 and 1990. Initially. .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. A third disallows multiple layering of holding companies. following the amendment of the law. This was the reason why chaebols chose to employ pyramidal structures. the Fair Trade Act). The Government is also considering whether to allow consolidated taxation for pure holding companies. the Credit Management Regulation rules were amended to prohibit financial institutions from requiring guarantees from affiliated firms when extending new loans. 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. The prohibition of holding companies was also abolished in 1999. Existing guarantees had to be resolved by March 2000. However. only operating holding companies were allowed to be established. Cross-guarantees are believed to constitute a form of wealth transfer from financially strong members to weak ones. 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. The limit on investments was reduced to 25 percent in 1994 and completely eliminated by 1997. there are reports that some top chaebols are studying the feasibility of transforming their organizational structure. bankruptcy reorganization. The Fair Trade Act was amended in 1998 to allow pure holding companies to be established under restrictive conditions. Also. The first serious attempt to deal with this issue was the introduction of the Monopoly Regulation and Fair Trade Act of 1980 (hereinafter. It remains to be seen whether they will adopt the holding company structure in the future. At this early stage. Until the end of 1998. 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. They hindered early exits (liquidation. These conditions are aimed at restricting excessive pyramiding and expansion of chaebols. The Fair Trade Act was also revised in February 1998 to prohibit cross-guarantees of debt among members of a chaebol. thus hurting the shareholders of stronger firms. the act did not have any important provisions except the standard clauses prohibiting monopolization of an industry through business combinations. One condition requires that the DER of the holding company should not exceed 100 percent. This limit was also applicable to banks and insurance companies.

and transferred funds generated by one firm to another. Vol. planned for capital raising and allocation on a groupwide basis. 2.) 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. The office established strategies for the group as a whole. The 30 largest chaebols are now required to publish “combined” financial statements. Their operating costs were borne by the member companies rather than by the controlling shareholder. even though they were legally independent with their own board of directors and the outside shareholder groups were not identical. which put together the accounts of all members of a chaebol. Some chaebols operated “group management boards” attended by top executives (presidents or chairpersons) of larger member firms.3. II etc. Despite chaebols’ decision to dismantle the chairman’s offices. Chaebols maintain that the restructuring headquarters will exist only for a limited period. usually in the rank of a company president. until urgent restructuring is complete. boards of directors. chaebols dismantled their “planning and coordination offices” or “chairman’s offices” under pressure from the Government. Since the economic crisis. It also acted as the secretariat for the unofficial “presidential meeting” of the member firm presidents. there have been no significant changes.2 Internal Management and Control Monitoring of corporate management by shareholders.” The group chairman operated through these offices and treated the individual member firms as if they were the divisions of a single legal entity. These offices were legally informal and functioned as the headquarters of chaebols. The staff of these organizations were employees of member firms. and the capital market was almost nonexistent until the recent reform . who is universally called the “group chairman. In 1998. 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. Some chaebols have disintegrated or shrunk in size. The chairman’s office had its own chief executive officer. but the larger and stronger ones still operate their newly named “restructuring headquarters” under the control of the group chairperson. unlike the regular consolidated statements that only cover those firms that are related through direct equity participation.94 Corporate Governance and Finance in East Asia. the Commission has strengthened its investigative activities to eradicate cross-subsidization and wealth transfer activities among group members.

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

other than the representative director(s). 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 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. were supposed to be outside directors. 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. cumulative voting is not mandatory and a company can exclude itself from its application by amending its charter. all of whom were managers. almost all companies succeeded in adopting cumulative voting. Moreover. 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. A few large companies had more than 50 directors. Recent Reform Efforts on the Board System In 1997. Despite the qualification requirements. and their positions (accept or reject) on matters voted on in board meetings. In order to address this concern. Vol. 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. there is concern that newly elected outside directors still lack independence from the management or the controlling shareholder. members of the board. With the boards consisting only of insiders.96 Corporate Governance and Finance in East Asia. However. 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. . Further. II When the Commercial Code first introduced the corporate board system in the 1960s. 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. Most of the outside directors in those days were the controlling shareholders of chaebols or executives of affiliated companies. In the 1999 annual shareholders meetings. The Commercial Code was also revised in 1998 to introduce cumulative voting for the election of directors. However.

a blue-ribbon committee. which had extended financial support in their recent recapitalization efforts. Among others. inside directors owned 16. the OECD principles of corporate governance were the minimum standard for the Korean Code of Best Practice. Directors were also chosen on the basis of their relationship with the controlling .4 directors. The controlling shareholder of some banks is the Government. an audit committee. Where the chairperson was not the CEO.1 percent and outside directors 1. although some banks recently have established board committees. and a nominating committee. These results are in accordance with the new listing rules introduced in 1998. he or she held 6. Almost all (92 percent) of the respondents had one or more outside directors and 70 percent were elected after the Asian financial crisis. are required to have a majority of outside directors. Directors were most frequently elected because of their professional expertise (74 percent of the respondents marked this answer). ADB Survey Results on Boards The ADB survey results confirm the above assessments and provide early indications on the effects of the reforms. In 78 percent of the responding firms. Where the two were separate. The Securities and Exchange Act will require large listed firms with W2 trillion or more in total assets to adopt the audit committee system.2 percent and the CEO 14.Chapter 2: Korea 97 The committee structure of the board as found in the US has not yet been adopted by listed companies. 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. they had a parent/child relationship in 20 percent of the cases. On average. who would comprise at least 50 percent of the boards. the chairperson of the board was also the CEO and on average held 10. Among the firms with no outside directors.1 percent of outstanding shares of a listed company. was established under the auspices of the Ministry of Finance and Economy and the Korea Stock Exchange. In March 1999. The average board had 8. In September of the same year. 88 percent had plans to hold elections in the near future. The Commercial Code is being amended to allow a choice between the audit committee system and the current internal auditor system. having no controlling shareholders.9 percent on average. Meanwhile. the Corporate Governance Reform Committee.5 percent of the shares. This is because most banks.

The general practice is that shareholders approve the upper limit on the total amount to be paid to all directors. As discussed earlier. and shareholding (10 percent). According to the Commercial Code. Most frequently. Remuneration for chairpersons include only fixed fees in 76 percent of the sample firms. Chairpersons of the board were elected on the basis of professional expertise (33 percent of the firms). In some instances. The reason for this high frequency of interlocking directorship is that many listed firms belong to chaebols. About five directors per firm have been in office for more than one term. In a very small number of firms. founders of the company acted as the chairperson (22 percent). the board had no committees. a total of 562 directors were sitting on two or more corporate boards. the management nominated director candidates (64 percent of the directors). election of directors was based on shareholdings (7 percent) and status as founder (7 percent). the board had a nomination and an audit committee. In one case. The board or the management then determines compensation packages for individual directors.98 Corporate Governance and Finance in East Asia. the management determines the remuneration. in 23 percent. . In 13 percent. In 1997. Members of controlling shareholder families or their trusted company personnel often act as directors for multiple chaebol firm boards. However. The current chairperson has been in office for 6.2 years on average. In 91 percent of the sample firms. in some firms. Vol. 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. and fixed fees plus performance-related pay. among the 81 sample firms. II shareholder (30 percent). Less frequently. In most firms. one person was sitting on nine boards and this person was the CEO of a chaebol firm. compensation for directors must be approved by the annual shareholders meeting for each fiscal year. including stock options. relationship with controlling shareholders (21 percent). These were established only recently. This rather long tenure must be due to their status as controlling shareholders in most firms. The survey results indicate that boards determine remuneration packages for chairpersons in 42 percent of the firms. 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). the term of appointment of directors and board chairpersons is three years. Some directors were nominated by significant shareholders (18 percent) or introduced (and elected) at the shareholders meeting.

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

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. Korean firms have rarely used shares for executive compensation. in particular. II Senior Executives In the past. The commission has played an active role in introducing new rules on corporate governance. 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. 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. disclosure. in practice) allocates the unsubscribed portion of new shares issued in rights offerings to executives. but as of March 1999 only 27 firms actually had given stock options to their executives or employees. Vol. from IMF and the World Bank. but in practice is fixed and understood as part of a fixed salary. executives sometimes have the opportunity to buy company shares at favorable prices because the board of directors (CEO. and . it was common for all senior executives to be elected as directors at the shareholders meeting. and accounting standards. Senior managers were even often called directors although they were not official members of the board. 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. 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. Penalties for fraudulent financial reports were increased. (ii) establishment of accounting standards for financial institutions. About 40 percent of the listed companies had amended their charters to introduce incentive stock options by the 1999 shareholders meetings. This action was in response to calls by international investors and.100 Corporate Governance and Finance in East Asia. One area has been to enhance the reliability of financial statements of corporations in line with internationally accepted standards. However.

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. Most of the companies following all or some of the international standards in the past adopted such standards before the crisis started. 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. 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 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. The new accounting standards for financial institutions adopt the mark-to-market basis to account for securities. Internal and External Auditing The Commercial Code requires a corporation to have at least one internal auditor elected at the general shareholders meeting. Thus. they cannot be expected to discharge this responsibility because the representative director selects the internal auditor and can force him or her to resign. but 49 percent confessed that they have not followed international standards at all. 41 percent of the companies believed that they have followed some international accounting standards. Under the Commercial Code. Consolidated reporting was introduced before the outbreak of the crisis. they also have the power and duty to monitor the activities of executive directors. In the ADB survey.Chapter 2: Korea 101 (iii) establishment of accounting standards for “combined” financial statements of chaebols. however. In practice. Only 10 percent of the respondents have followed all international accounting standards. The revised accounting standards apply to the firms subject to external auditing for the fiscal year starting on or after January 1999. the internal auditor is considered to be a subordinate of the . 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.

6 years. II controlling shareholder/CEO. 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. If the company changes its external auditor for reasons that are not listed in the relevant regulation. the board of directors had the power to appoint an external auditing firm. 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. If the status of internal auditors is elevated to that of independent board members. The problem of misconduct on the part of the external auditor was caused partly by weak penalties on wrongdoing. Listed and registered corporations must publish financial statements audited by external accounting firms. however. . Previously. About 100 listed firms will be subject to this requirement. 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. almost all firms affirmed that the external auditor is independent from the company. does not have the power to hire and fire the managers. Accepting these arguments. In the ADB survey. there were many cases where external auditors failed to detect omissions and false numbers in financial statements of listed firms. outside directors. In the past. then the Securities and Futures Commission can appoint a new one.102 Corporate Governance and Finance in East Asia. but since 1998 a committee consisting of internal auditors. External auditors are selected for a term of three years. 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. Big Korean accounting firms are affiliated with US accounting firms. 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. This is because the auditor. In order to increase independence. and lack of strong professional ethics in the accounting profession. The Commercial Code will be revised to allow corporations to choose from the two options: the internal auditor or the board audit committee system. The general organizational/social culture in Korea abhors conflict and may also have hindered effective functioning of internal auditors. as a monitor of management in the Korean (and also the Japanese) system. Vol. But this problem can be mitigated if auditors function under the umbrella of the board. this problem will largely disappear. The current external auditors have been associated with the surveyed companies for an average of 4. and creditors selects it. underdeveloped market discipline for accounting firms.

79 percent of the shareholders.93 percent of the shareholders but 26. or 10.” meaning that it should divide its votes in accordance with the accept/reject ratio of votes cast by other shareholders attending the shareholders meeting. Under the Commercial Code. and dismissal of directors and internal auditors require a “special resolution. Approval of mergers and major divestitures. the Depository is instrumental in getting resolutions passed. The Depository represented 20 percent of the shares attending the meetings. This shows that a relatively larger number of shareholders send in their proxies. A “special resolution” requires two thirds of the votes attending and one third of total votes outstanding. or telephone. Citizens’ coalitions sometimes solicit proxies in order to file lawsuits against a management. A total of 326 shareholders per firm.” The survey shows that the Korea Securities Depository holds 69. The above results indicate that. The securities companies and banks are the second and third. However.53 percent of the total shareholdings. About 100 shareholders per firm voted by proxy at the last annual general meetings (of the 40 firms answering the relevant questions). The management is the most important proxy. the only purpose of allowing the Depository to vote was to help listed companies to meet the quorum requirement for the general shareholders meeting. attended the last annual general meeting. Preferred shares can be nonvoting and issued up to one quarter of the total number of shares. representing 62.21 percent of total shares issued. Internet. small shareholders do not attend the annual meeting and that.Chapter 2: Korea 103 2. These voters represented only 5. About one fifth of the listed firms issued nonvoting preferred shares. in general. amendments of the articles of incorporation require a “special resolution.77 percent of the shares. 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. charter amendments. 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. One common share should have one vote.” Companies can increase the number . for some firms.3. However.3 Shareholder Rights Voting Rights and Practices Under the Commercial Code. respectively. the Depository is subject to “shadow voting. corporations cannot issue common shares without voting rights. No companies have so far introduced voting by mail. Thus.

Vol. the requirement was lowered from 1 to 0.5 percent. an activist citizens’ coalition has brought shareholder derivative suits against several large listed firms.0 percent. Shareholders have preemptive rights. The company also agreed to the right of the fund . As an example. from 3 to 1. 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. and for access to unpublished accounting books and records. Various measures have since been taken to improve investor protection. This citizens’ coalition actively contacted the management of selected companies and negotiated measures to protect shareholders. Due to the changes in rules for investor protection. and major investment projects (only five firms answered this question). Proposals put forward by management are rarely rejected at the general meetings. mergers and acquisition plans. In four out of 62 respondents. Shareholder Protection Before the economic crisis. the Securities and Exchange Act was revised to lower the representation requirement for shareholder derivative suits from 1 to 0. The charges included self-dealing by a controlling shareholder and unfair subsidization of affiliated companies by a chaebol firm. Only two out of 62 respondents to this question have had cases in which proposals were rejected. or block charter amendments considered harmful to minority shareholders. For recommendations for dismissal of directors and internal auditors. It also attended the shareholders meeting of several companies to present the views of outside shareholders. was able to force a change in the charter of SK Telecom. but these can be waived by an amendment of the articles of incorporation. 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. laws and regulations were generally very loose in protecting the rights of minority shareholders. Changes in the authorized capital require an amendment of the articles of incorporation. II of votes required for a resolution to amend the articles. the Tiger Fund.104 Corporate Governance and Finance in East Asia. Those that are most likely to be rejected relate to election of directors. the board of directors decides on issues of shares within the limit of the authorized capital.01 percent. This coalition also attempted to cooperate with domestic and foreign institutional investors to find their way into general shareholders meetings. demand changes in business policy. However. In February 1998 and again in March. an institutional investor based in the US.

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

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

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

First. and 1 percent by the Government. including commercial and merchant banks. 2. and in continued monitoring of debtors. a Lead Creditor Council Agreement was signed for restructuring the top five chaebols. 4 percent by subsidiaries. the delegation has the right to approve wide-ranging financial activities of the firm. Separate from but emulating the CRA. Vol. will get involved in the restructuring and workout processes. In this connection. the Corporate Restructuring Coordination Committee (CRCC) will provide arbitration. the Korean Government maintained a policy of protecting the incumbent management of listed companies. major creditors.3. II by other affiliated companies. especially banks. Under a contract signed between the creditors and the debtor. 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 1998.108 Corporate Governance and Finance in East Asia. The new ways through which creditors. Third. the lead creditor banks formally signed Capital Structure Improvement Plans with chaebols. The leading creditor banks will continuously monitor the progress in implementing the signed Plans. banks and other institutional lenders are playing more important roles than ever before. This committee was set up in accordance with the provisions of the CRA. 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 . In cases where the creditors are unable to reach an agreement on a workout plan. the creditor banks will send a delegation composed of bank officers to the workout firm to oversee its management. are summarized below. 2 percent by holding companies. This agreement will provide guiding principles in coordinating diverse interests among creditor institutions and promoting cooperation. Behind these new strengthened roles of creditors is the newly set-up FSC. Second.5 The Market for Corporate Control Government Policy Toward Hostile Takeovers Until 1994. 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.

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

For the steel company. an electric power company.6 Control by the Government State-Owned Enterprises Government ownership of listed companies is very limited. the limit will be eliminated when it is fully privatized in two years. In 1999. It is harder now to find such firms. 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. the Government became the largest shareholder of several commercial banks through equity participation purporting to recapitalize them out of financial distress. In their charters. except for the banks. Charter amendments have also been employed by some firms to limit the maximum number of directors. As of February 1999. Vol. which are allowed by the Securities and Exchange Act to set the limit on the ownership of shares by one single shareholder. some firms have included a supermajority provision for the dismissal of directors and provided for a staggered board. 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. are designated as public companies. and a bank had government ownership. 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. 172 firms (or 22 percent of listed firms) belong to the 30 largest chaebols. 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. .3. in which the Government still holds the largest ownership. Korea Telecom. Many of the takeover targets in the past did not have a controlling shareholder (group). 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. was newly listed. a steel company. Some had two or more large shareholders who had joint control of the firm but could not cooperate.7 percent on average as of the end of 1997 for nonfinancial listed firms). Another reason is that many listed firms belong to chaebols. Hostile takeovers in Korea will be rare in the future. Currently the limit is 3 percent. In 1998. For the others. 2. The Government-owned listed companies. As of the end of 1997.110 Corporate Governance and Finance in East Asia.

The objective of the system was to improve the financial condition of the chaebols and to promote the soundness of bank management. Beginning in 1999. 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. only qualified firms could issue new shares. For example.7 Employee Participation in Corporate Governance Employee participation in corporate governance is very limited. There is no active debate or discussion going on about this potentially difficult issue.3. and approved by the Chairperson of the Planning and Budget Commission.1). nominated by the minister in charge of the company in question. 2. In addition. This was aimed at limiting the supply of bonds thereby stabilizing interest rates. which limits the total amount of bonds issued by the five largest chaebols. The nonexecutive directors are now recommended by a committee. Labor is not represented in corporate boards.3.Chapter 2: Korea 111 The Government used to appoint a few public officials to the boards of state-owned corporations. went into effect in 1998 to prevent them from absorbing too much of the funds available in the market. But this rule. There were also limits on the amount raised and the number of issues per year. It was abolished before the economic crisis but another regulation. administering through a self-regulatory committee of the securities industry. which was introduced in 1996. the main bank system. controlled the total amount of corporate bonds issued per month and allocated amounts to individual corporations. the Government. 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. Further. The Government has frequently imposed restrictions on the use of capital markets by large companies. Meanwhile. especially those belonging to chaebols. The Government’s right to send public officials to the boards was eliminated. was amended in 1997 to introduce a board structure consisting of a majority of nonexecutive directors. more state-owned corporations became subject to this new board structure. as applied to four large corporations. Even where employees hold . is being applied to the 51 largest business groups to which the banks extended more than W250 billion in loans and payment guarantees.

of which 2 percent were senior managers. and 66 percent manual workers. The respondents of the ADB survey had 2. these firms have to offer 20 percent of the shares being issued to their employees at the public offer prices.5 in 1990. This practice may be due to the fact that employees are typically submissive to their employers and that their total shareholdings are minimal. In actuality. Trade unions are organized on an enterprise basis. At the national level. In these firms. in principle. About half of these firms considered the influence of the union on the management of the company to be weak. 32 percent technicians and professional staff. but 27 percent of them felt that it was strong. which were generally much lower than estimated values. the management usually consults the union on major issues relating to the management. there are two federations of labor unions. employers are required to meet with representatives of labor unions at least once every three months. Collective bargaining is.112 Corporate Governance and Finance in East Asia. and development of the company.1 in 1997.654 employees per firm on average. This law is not intended for wage negotiations but for employers to seek cooperation and productivity increases from workers. operation. . Two thirds of the respondents had an organized union. Under the Labor Management Council Law. Under another law enacted in 1972 to induce private companies to go public. Employees of companies have had the opportunity to buy shares of their employing businesses at favorable prices. Employee stock ownership plans became popular in 1974 when the Government allowed tax and financial benefits for stock purchases by employees. 2. In 1987. 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. The percentage of shares held by the employee stock ownership plans in listed companies was 1. employees of listed firms issuing shares through rights offerings are entitled to 10 percent of the rights. The union had no influence on the management in 17 percent of the firms. The relevant regulation was amended recently in order to facilitate voting by individual employees. The typical collective bargaining agreement has a one-year duration. Local unions in the same industry have established industrial labor federations. Vol. and 2. they delegate their voting rights to plans’ representatives. Under the Capital Market Development Act of 1968. the council meetings have been superficial. carried out at the enterprise level. II shares of their companies through employee stock ownership plans.9 in 1980. union members account for 54 percent of the employees. In 70 percent of the firms with organized unions.

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

It included such important issues as interest rate deregulation. especially the domestic bond market. which resulted in the establishment of a number of new banks. flow of funds analysis was used to examine patterns of financing of the aggregate corporate sector. Korean firms have been allowed to issue CBs in international financial markets. the required reserve ratio was substantially lowered from an average of 23 percent in 1979 to 3. The Government adopted a cautious approach. and liberalization of foreign and capital transactions. Vol. finance companies. 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 Korean Government announced its Financial Liberalization and Market Opening Plan. In addition. as a first step toward liberalization of capital account transactions.2. etc. the Government announced a plan in 1981 that substantially improved foreign investors’ access to the domestic capital market. On the basis of flows of funds. short-term finance companies. With the privatization of nationwide commercial banks.1).4. Since 1985. entry barriers to banks and NBFIs were lowered in an attempt to promote competition. the business scope of financial institutions was greatly widened from the early 1980s. revision of the credit control system. II Interest Rate Deregulation Plan. The capital market. development of the money market. Also. depreciation. and organization of commercial banks. and the 30 largest chaebols. 2. budget. Some policy loans were also abolished. Moreover.118 Corporate Governance and Finance in East Asia.2 Patterns of Corporate Financing Corporate Financing Practices In this section. Meanwhile. the Government simplified various directives and instructions regulating personnel management. the following measures can be constructed: Self-financing ratio (SFR) is the ratio of change in internal funds to change in total assets. Internal funds include retained earnings. The Government handed over its controlling stakes in four commercial banks to private hands in 1981-1983. . In June 1993.5 percent in November 1981. listed companies. mutual savings. The Government began to considerably deregulate foreign exchange in 1987 due to the shift of the current account into surplus in 1986 (see 2. implementing the first stage in November 1991. was liberalized drastically in 1998 after the financial crisis.

It measures the degree of financing growth in total assets by additional equity. and allowances) and new equity capital.Chapter 2: Korea 119 and net capital transfers from the Government. except for the stock market boom of 19871988. including all sources other than retained earnings. comprising internally generated capital (retained earnings. 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. Table 2. Meanwhile. the corporate sector’s most important source of external finance was bank borrowings. Equity capital represents the shareholders’ commitment to the business. on average. particularly in the short term. Additional equity capital used to finance growth reduces the financial cost and the financial risk of investment. It measures the degree of financing growth in total assets by additional debts. This means that internal funds after dividend payment were insufficient to finance growth in total assets. This high proportion deprived Korean businesses of flexibility during recession periods due to high financial costs. Incremental equity financing ratio (IEFR) is the ratio of change in stockholders’ equity to change in total assets or 1-IDFR. the proportion of borrowings from NBFIs fell to its lowest value at 4 percent.4 percent in the precrisis period 1988-1997. The SFR averaged 28. New equity financing ratio (NEFR) is the ratio of change in equity (stocks issued + equity other than stocks) to change in total assets. The share of external financing. Before 1988.26 shows the four measures of corporate financing calculated from Table 2. particularly in the 1990s in response to the liberalization of the capital market. depreciation. except in 1991.25 shows the flow of funds of the nonfinancial corporate sector in Korea during 1988-1997.25. In securities finance. but do not include capital surplus (asset revaluation allowance and the excess of current value over issue value of stock). In 1988 when the stock market boomed. capital surplus. and 1997. but it remained less than 10 percent of total financing. was 71 percent during the period. Incremental debt financing ratio (IDFR) is the ratio of change in total borrowings to change in total assets. 1994. Financing Patterns of the Aggregate Corporate Sector Table 2. and government transfers. depreciation. financing by corporate bonds and CPs was more significant than by new equity. the proportion of foreign borrowings in total finance rose steadily. Securities finance became a more important source from 1988 onwards. The corporate sector used .

1) 4.3 1.7 2.0 17.3) 11.3 — — — — 8.9 73.0 16.1 1.2 15.1 (0.7 10. 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.6 9.6 77.9 28.4 2.0 0.3 1.8 17.5 0. which is the excess of current value over issue value of stock.3 2.8 30.3 25.6) 5.7 73.1 23.2 5.2 26.7 1989 1990 1991 1992 1993 1994 1995 1996 22.8 1.6 4.6 25.0 9.3 6.4 (0.7 1.1 — 27. depreciation. and Flow of Funds.3 6.0 11.2 14.2 1.0) 12.1) 4.3 6.4 11.9 6.3 — 30.4 15.0 9.7 10.4 9.1 0.6 4.8 — 26.2 — 28.1 2.2 (0.1 1.7 10.1 3. and net capital transfers from the Government.4 27.7 1.0 — — — — 8.8 -2.1 0.8 0.2 0. 1988-1997 (percent) 1988 43.2 34.0 0.8 4.7 11.0 1.4 1.4 — 28.7 8.7 8.0 3.7 2.Table 2.3 1.2 13.2 2.1 8.5 0.6 3.7 12.6 3.6 2.7 71.0 5.1 — — — — 12.8 1.6 9.1 36.7 32.3 3.5 0.6 11.2 10.8 27.2 6.3 5. b Includes capital surplus.4) 13.9 10.9 34.3 16.1 2.1 12.5 13.1 3.7 15.4 10.7 14.6 9. Bank of Korea. 1994.0 3.4 27.7) 11.2 — — — — 9.7 (0.4 21.1 10.3 72.5 9.5 2.3 27.7 — — — — 9.6 0.4 3.3) 15. .6 4.1 27.1 (1.4 0.1 72.6 (0.7 2.5 2.4 2.1) 6.5 29.4 71.0 10.8 1.5 16.5 16.8 (0.6 8.7 13. a Includes retained earnings.4 2.9 10.6 0.9 9.6 5.4 1.6 Sources of Funds Internal Financinga External Financing Bank Borrowings Banks Nonbanks Merchant Banks Insurance and Others Securities Natl.0 70.2 13.6 11.7 14. Source: Understanding Flow of Fund Accounts.3 30.8 56.0 3.1 1.25 Flow of Funds of the Nonfinancial Corporate Sector.8 8.0 1997 26.8 1.4 2.3 10.4 27.8 15.9 2.4 8.8 1.1 3.0 (0.7 7.3 3.5 2.0 22.7 4.0 2.7 6.6 1.5 2.6 10.7 4.9 0.6 0. Bank of Korea.9 72.9 38.1 17.4 (2.2 6.4 0.6 0.6 14.

and Flow of Funds. On average.3 60.1 39. Bank of Korea. higher than the aggregate 40.4 37.4 IEFR 63. .3 73.27).9 28. In periods of high economic growth such as in 1988.0 11.4 percent. SFR peaked at 44 percent. It dropped to 28 percent the following year.6 percent. and the total debt ratio was much higher in 1996 and 1997 at 62.4 NEFRa 20. average SFR was 37.3 percent in 1997.3 27.4 27.5 31. Source: Calculations from Understanding Flow of Fund Accounts.6 26. indicating a high financial risk position. respectively. the corporate sector relied heavily on external financing for its expansion.2 percent of the growth in total assets. Its IEFR and NEFR dropped to 23.7 40.8 10.7 40. Manufacturing financed 54.4 percent. 45.0 42. and IEFRs were declining.5 68. There were significant time trends. dropping to 26.6 percent and 1. but plunged to 5. declining to 26.3 59.Chapter 2: Korea 121 Table 2. NEFR registered 20.7 28.6 percent.1 26. IDFR reached 73.4 12.6 62.3 11.5 percent in 1997.9 percent by 1997 when net profit margins were negative.1 12. Lower income diminished the industry’s equity position toward crisis year 1997. NEFRs. additional equity to finance 12.5 percent.6 percent over the 10-year period.26 Financing Patterns of the Nonfinancial Corporate Sector.0 57.9 22.1 percent in 1988 during the stock market boom.7 9.3 59. While SFRs. respectively.0 5.6 Excludes capital surplus.8 percent of its total asset growth through debts. but also continuously fell.5 and 76. IEFR ranged from 32 percent to 64 percent of asset growth during the boom years.7 40.2 percent of incremental asset growth was financed by equity. Incremental financing from equity was 40.5 12.1 17.8 28.1 53.7 26. Bank of Korea.2 IDFR 36.9 46.0 27.3 12. 1994. was financed by additional debts. in the manufacturing sector.7 30.9 60. 1988-1997 (percent) Year 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average a SFRa 43.8 62.2 37. The balance.4 percent (Table 2. higher than the aggregate 28. an average of 59.7 percent in 1997. Across industry.

and medium-sized firms. Equity financed an average 25.5 23.4 46.2 21. explaining partly the collapses of several construction companies in 1995.7 37.0 30.5 NEFRa 9. with the total debt ratio much higher in 1995-1997 at 82 to 84 percent. Table 2.5 7.27 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. and communication sector had relatively high incremental equity ratios.2 .4 47.6 45.1 percent of total asset growth for the period.8 4.9 percent. gas. and fell to about 10 percent in 1997. Financing patterns of the wholesale.1 29. Total debt financed an average 74.7 47.0 42.7 percent in 1996.0 3.6 62. and hotels sector and realty/renting/business activities sector were similar.7 47.5 1. Categorized according to company size.8 IEFR 65. It had the highest average SFR in 1988 at 31.8 50. and steam) and the transportation. then increased to 20. Since large firms were more profitable.6 54.2 3. In 1997.2 62.0 42.9 percent of asset growth.4 63.4 54.7 37. Since 1992. These sectors had relatively low equity financing ratios and high total debt ratios in financing asset growth between 1988 and 1997. large firms showed more cyclical patterns in these financing ratios than small. II The construction industry showed the most cyclical pattern in annual asset growth. one year ahead of the other industries. which decreased to 8.8 percent in 1990.9 6.6 4.5 76. storage.6 53. the proportion of short-term borrowings in total financing has been high. from 17. the utilities (electricity. the two sectors also had low equity financing ratios and high debt financing ratios.4 37.6 37.9 IDFR 34.6 53. their average SFR was higher. Vol.4 3.3 28.8 percent in crisis year 1997.2 5.2 percent in 1993.0 57. On the other hand. retail.6 37.4 45. and low total debt and short-term borrowing ratios.6 36.3 52.122 Corporate Governance and Finance in East Asia.6 3. this dropped further to 15.

1 66.1 69.9 29.8 54.3 19.8 29.0 10.9 15.0 65.7 15.5 1996 42.3 (9.9 1989 63.7 6.2 70.0 34.7 Wholesale/Retail Trade. Storage.4 26.1 1991 14.0 17.5 21.6 9.5 20.3 8.9 1992 56.6 73.3 47.7 1994 53.0 74.4) 2.6 71.7 78.27 (Cont’d) Year SFRa NEFRa IDFR 53.2 29.4 62.5 23.7 1989 26.0 4.0 3.7 15.3 57.4 2.4 IEFR 46.6 9.2 3.9 1.9 2.9 33.2 18.6 37.0 60.9 Average 19.2 10.6 7.2 1995 16.0 31.9 1993 63.0 68.5 1993 22.7 53.0 82.8 81.3 10.8 1994 15.6 8.9 1. and Communication 1988 64.9 1.5 76.1 59.9 Construction 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 31.5 62.7 42.0 1990 50.8 70.5 87.2 20.3 1996 16.2 4.0 1.9 47.1 25.3 7.3 4.4 28.8 74.Table 2.9 9.3 21.0 0.1 70.9 20.6 8.5 70.6 1997 29.7 7.3 84.6 4.2 25.2 5.7 1997 8.1 4.6 37.6 14. Household Goods.9 16.9 80.2 46.5 12.2 74.3 4.9 30.8 76.8 4.8 25.9 52.6 2.1 19.7 78.8 1991 51. Hotels 1988 33.2 8.2 Average 53.5 1.0 40.0 1990 12.5 29.1 84.8 2.2 23.8 9.0 1992 24.0 .1 Trasport.7 41.7 80.4 1995 53.

IEFR = incremental equity financing ratio. when large firms had much lower equity financing ratios and higher debt financing ratios than small.3 3.2 1992 18.8 36.0 79. Vol.1 42.0 1.1 71. The large firms had a higher proportion of external financing in 1996-1997.1 0.6 Real Estate.0 1992 51.1 34.2 63.6 7. SFR = self-financing ratio.8) 7.4 7.9 IDFR 31.6 1991 18.4 1996 45.9 57. NEFR = new equity financing ratio.3 Electricity.4 (107.1 54.6 52.3 85.0 56.0 46.4 1995 62.0 43.5 22.9 29.7 1996 18.0 (0.4) 3.9 64.3 29.6 1997 23. Their average IEFR was also higher and IDFR smaller.6 1995 17. Gas.9 45.5 8.and mediumscale firms.3 7.4 1994 72.1 70.0 67.3 31.6 IDFR = incremental debt financing ratio.6 1990 82.1 35.4 0 0 0 0 1.8 17.7 69.4 IEFR 69.7 1994 8. Financial Statement Analysis Yearbooks.27 (Cont’d) Year SFRa NEFRa 6.1 1993 55.6 1.0 21.7 37. and Business 1988 51.8 1990 19.0 0. II Table 2.8) (35.0 53.6 1989 118.and short-term borrowings of these firms shot up in that period.4 1.9 Average 75. however.3 92.3 62.124 Corporate Governance and Finance in East Asia. Renting.1 1991 56.7 70.7 14.4 47.4 5. a Excludes capital surplus. Long.8 Average 22.5 77.9 28. The trend was reversed in 1996-1997.1 1989 34.9 65.8 135.0 0. Source: Calculated using data from Bank of Korea.0 1997 24.8 1993 11. .0 33.7 18. and Steam Supply 1988 118. Higher growth in total assets and sales and easier access to debts by large firms could be reasons for this.3 207.3 81.4 0.

The largest borrowers were the top 11-30 chaebols.28).7 percent. the NEFR of the top 30 chaebols plunged while the debt ratio increased substantially. at an average 70. In 1997. Their shortterm borrowings accounted for 86. Financing Patterns of Chaebols For chaebols.3 percent of their equity capital in 1997 (Table 2.9 percent. compared with the entire corporate sector’s 35 percent and 65.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. the lowest ratio of 58.3 and 89. about the same as that of the corporate sector as a whole. the top 11-30 chaebols had the highest guarantees commitments at 207. and the top five chaebols. the IDFR of listed companies increased to 93. compared with 89. Cross-payment guarantees have been declining since 1993 and reached 91.5 percent and their total external financing.7 percent for all listed companies.1 percent of their equity capital. but higher than that of listed companies. The proportion of their short-term financing averaged 72.30). They had easier access to bank loans and the markets for corporate bonds and CPs than nonlisted companies. for listed companies. and using cross-payment guarantees among affiliated companies.29). the top 6-10 chaebols. All of the top 30 chaebols relied heavily on short-term borrowings.2 percent.4 percent.9 percent.5 percent is lower than that of the corporate sector in general. and were large borrowers. Another key feature of corporate finance in Korea is the widespread use of loan guarantees among the top 30 chaebols. 91. The average IEFR of the top 30 chaebols of 29.6 percent. The average IEFR and IDFR were 10. They were able to borrow easily from banks by issuing corporate bonds and CP. and higher than that of listed companies (Table 2. In 1996-1997.8 percent. the average SFR was 28. respectively. The debt financing ratio of listed companies was high since they relied more on external financing. . The chaebols’ drive to expand their empires resulted in heavy borrowings. Many firms affiliated with the top 30 chaebols saw loan guarantees turn into their own debts because of defaults in debt payments.7 percent. Group-member firms borrowed less. 153. External financing reached 94.6 percent of total asset growth. In 1997.8 percent of their total finance in 1997.

4 1.6 61.29 Financing Patterns of the Top 30 Chaebols.6 0.4 12.5 8. 1994-1998 (percent) SFRa IDFR 85. 1994-1997 (percent) SFRa 41. Largest Business Groups in Korea.4 38. Table 2.5 2.9 7.8 22.3 86.6 IEFR 42.6 11.2 10.1 8.8 76.2 36.1 1.2 NEFRa 1.8 89.3 1.5 2. .28 Financing Patterns of Listed Companies.7 1. Source: Calculated from data obtained from data files of the Korea Listed Companies Association.6 1.3 IDFR 57.4 88.5 Year 1994 1995 1996 1997 Average a Excludes capital surplus. Korea Federation of Industries.6 70.9 6.3 Year 1994 1995 1996 1997 Average a Excludes capital surplus.3 28.2 1.7 12.1 93.5 8.5 91. Source: Calculated using data of Seung No Choi.9 NEFRa IEFR 14.2 23.7 13.3 5.4 29.Table 2.

3 64. the Government applied high tax rates on net profits of corporations.9 — — — 1994 258. These are followed by loans from banks. more than half of bank loans were priority loans with low interest rates. Fourth. And fifth. Third. Financial institutions did not strictly screen their loan projects and monitor their debtors. Interest payments on debts were considered a loss when calculating taxes.1 — — — 1995 161. This attitude appears to have changed after the crisis because reserves and retained earnings and rights issues became the preferred financing choices. rights issues.0 207.30 Cross-Payment Guarantees of the Top 30 Chaebols. Factors Influencing Corporate Financing Choices Until recently. . the Korean economy was plagued with high inflation.1 — = not available. loans from banks. especially in the 1970s when real interest rates of bank loans were negative. inefficient investment and excessive diversification of corporations. and underdevelopment of the stock market. According to the ADB survey. There were several reasons for this. chaebols could easily borrow funds from banks and NBFIs by using cross-payment guarantees. This change implies that firms now give more attention to financial risks.3 58. Source: Fair Trade Commission and the Federation of Korean Industries.0 1997 91.7 150. Further. and reserves and retained earnings. Controlling shareholders usually tried to avoid dilution in their shareholdings for fear of losing control. bond issues. 1993-1997 (as percentage of equity capital) Rank Top Top Top Top 30 Chaebols 5 Chaebols 6-10 Chaebols 11-30 Chaebols 1993 469.3 200. Firms now prefer internal funds and new equity capital. the Government provided implicit guarantees on bank lending and large businesses. poor financial and corporate governance resulted in overlending by banks. Korean firms preferred debt financing (bank and nonbank borrowings). Second. and loans from NBFIs. so that the firms engaged in lobbying to gain access to them.9 — — — 1996 105. First. Few firms ranked loans from NBFIs as their first preference.9 153. bond issues. company preferences in financing investment projects before the crisis were. in order of ranking. and extended loans based on cross-payment guarantees.Chapter 2: Korea 127 Table 2.

Nonetheless. II In seeking external financing. and futures and other financial derivatives. Vol. Only a few firms sought foreign loans because domestic loans were not available. more than half (53 percent) hedged against exchange rate fluctuations. the percentage of foreign currency denominated debt in the portfolio was 14.3 Financial Structure. For these firms. firms give their first consideration to minimization of transaction and interest costs. maintenance of the existing ownership structure. ensuring the liquidity of the company. many firms (or 42 percent) never considered hedging.36 percent on average for these companies. This preference has changed little after the crisis. in order of importance. some (36 percent) thought that a hedging facility was not available or not working properly. According to the survey. A futures exchange launched in 1999 trades foreign exchange options. About half of the respondents of the ADB survey borrowed foreign currency denominated loans from foreign banks. even with a heavy debt burden. the majority (60 percent) of the firms responding to the ADB survey look first for nonaffiliated financial institutions.5 percent at the end of 1997. These survey results indicate that many companies were not very attentive to exchange rate risks (and possibly to financial risks in general). Other factors include. they survived for two to three . Diversification. Korea now provides a better environment for financial risk management. and reduction in tax burden. Few companies felt that hedging was too costly or was unnecessary as the exchange rate was considered fixed. 2. The percentage of foreign currency denominated loans hedged against exchange rate risks was 21. 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. Among those that never hedged against exchange rate risks. and others (29 percent) expected the local currency to appreciate in value. in selecting financing sources. 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. Among the responding companies that had foreign currency denominated loans.4.128 Corporate Governance and Finance in East Asia.

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

however. The diversification of chaebols under workout was much lower than that of the top 6-30. 2. The diversification of the top five chaebols remained at about the same level within the period. Factors related to weak corporate governance were closely intertwined with shortcomings in macroeconomic policy and vulnerabilities in the financial sector. larger research and development expenditure. the top 6-30 and 31-72 chaebols gradually increased their diversification beginning 1990.31). This indicates that excessive diversification and inefficient investment of the top 30 chaebols resulted in relatively low net profit margins (Table 2. too. net profit margins of the top 31-72 chaebols were always higher than those of the top 6-30. had easier access to credit than the top 31-72 chaebols. During 1985-1997. Chaebols have been subsidizing new or low-profit industries by transferring resources from high-profit industries through inside dealings. In terms of the net profit margin (the ratio of net profits to sales revenue). But the net profit margins of the top 31-72 chaebols were higher than those of the top five in 1985-1992. debt guarantees for free. rising nonperforming loans (NPLs) and falling . except in the recession years of 1996-1997. the degree of diversification was highest in the top five chaebols. second highest in the top 6-30. Meanwhile. then declined to levels lower than those of the top five in the years of economic downturn 1993-1997. and lowest in the top 3172 chaebols. or outright transfer of resources due to poor corporate governance practices. Vol. and easier access to cheap credit. court receivership. The degree of diversification of chaebols that fell into default. Indicators such as increasing debt-to-equity ratios. Government intervention. had a significant role. The differences in the degrees of diversification among the three groups are substantial.5 The Corporate Sector in the Financial Crisis This section looks at the various causes of the crisis in 1997.130 Corporate Governance and Finance in East Asia. Their subsidiaries. II Corporate Performance and Diversification As a chaebol further diversified into nonrelated areas. its profit rate declined. and composition was lower than that of the top 6-30 but higher than that of the top 31-72 chaebols on average. 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 five chaebols outperformed the top 6-30 chaebols for most of 1985-1997.

3 (3.1) — = not available.4 (0. Chung Ang University.3) 0.7) (0.6 1.7 1.4 1996 0.6 1.2) (13.1 (4.7 0.0 0.7 (0.7 1.31 Net Profit Margins of Chaebols.5 (0.3 1.3 (0.1 2.4 (1.7 0.9) (8.4) (0.5 1.2) 2.6 0.7 3.0 (2. Background and Task of Structural Adjustment.0) (0.1 1.8 0.2 1.5) (0.6 1989 1.0) (4.6 0.0 (7.0 6.3 (0.3) 0.3 1.8 1.9 1.2 4.0) (0.4 (0.8 (0.1 (4.1 (1.9 0.2) 1.9) (9.5 1.3) 1.1) 0.7) 0.5 (0. Management Research Institute.1 1.8 0.7) (1.3) 0.6) (20. .5 (0.6) (12.2 (17.8 1990 0.1 0.6 1.2) (13.4 1.5 1.3 1.0) 0.0 1987 1.8) 0.3) 0.3 0.6) (0.6) 0.3 1. Beyond the Limit.2) (3.2 1.6 5.1) (1.5 (4.0 1992 1994 1.1 1.7 1.1) (6.3) 0.9) 2. 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 1.8) (20.5 4.1 0.2 1.6 0.6) 0.3) (0.2) 1. p.1) 2.0 1.2 1.3) (0.5 1.7) 0.8) 1997 0.4 (0.5) 0.7 0.8 3.7 0.2) 1.2) (0.6 3.2) 0.4 (2.6 1.7 2.8 (0.2) 2.4) (1.4) (2.2 (1. 1998.2 1995 3.5) (2.3) 1.5 0.6 0.8) 1.6 (10.2 (0.1 0.11.8 0.4 0.3 1.5 1.9 1.6 (0.3) (1.8) (37.4 0.0 0.6 0.3 1.6) (12.3) (12.3 (0.9 1.5 2.3 0.1 (3.7 — (0.5) (2.6 0.2 0.2 1.1) (2.2) (0.4) (4.3 1.6 0.3) 12.5) (1.4 (1. Source: Whan Whang.7 1.6 (0.2) (4.3 1.4) (1.9 8.5) (7.8 0.9) 0.3 1.8) (11.3) 0.7 0.0) (3.9 0.1 0.3) 0.8) (3.9) (1.4 2.1 1.9 1.2 (0.8) (1.2) (4.1) 0.7 (0.6 0.2 (0.7 0.3 3.7 (4.9) 2.4 1.6) 0.1 1.1) 2.2 1.4 (1.4 0.6) 0.3 0. Court Receivership.9) 2.4) (6.6) (0. 1985-1997 Item Top 5 Hyundai Samsung LG Daewoo SK Top 6-30 Top 31-72 Default.9 0.1) (1.8) 2.1) 1.3 (0.1 (0.1) 1.0 (0.8) 0.2 (0.8 (0.8) (0.4 0.5 (0.1 1.1 (9.1 0.7 (1.1 4.6 1.9 0.1 0.9 (0.Table 2.8) 0.3 0.3 1.1 1.0) 0.1 0.1 0.3 0.1) (5.0 4.8 1.1 0.4 1.8) (1.8 3.3 1.5 (6.7) (0.8) 0.4) (1.2) (4.0 1.4 1.8 0.8) (4.8) 0.6 7.0) 0.

the boards of all listed companies were composed of insiders only. 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. Vol. Ownership concentration also had ramifications on corporate transparency. But in 1998. a committee composed of internal auditors. internal auditors cannot be expected to perform their function independently of management. the independence and objectivity of the external auditor were often questioned. 2. outside directors. They were then almost automatically elected at the general shareholders meeting. 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. Moreover. Now. . and to the development of the market for corporate control. Until 1997. The hold was tightened by the practice wherein candidates for directors were handpicked from among the managers by the controlling shareholder. 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.5. the recently adopted Code of Best Practice in Corporate Governance recommends the strengthening of the board system. this has led to entrenched management. Along with government policies to protect the status quo.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. Meanwhile. and creditors should select (recommend) the external auditor. a firm’s board of directors had the power to appoint an external auditor. after the crisis. Until 1997.132 Corporate Governance and Finance in East Asia. Thus. The most serious problem among most Korean listed firms has been that a controlling shareholder acting as CEO could never be replaced. 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. 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.

prevalent window dressing practices. participated in the stock market as short-term traders rather than long-term investors. There were no effective monitoring mechanisms for its management. Many changes were introduced to promote M&A in the 1990s. 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. Banks did not function as monitors of corporate management although they were shareholders as well as the most influential creditors. hostile takeovers in Korea will likely be rare in the future. restrictions of voting rights of shares of institutional investors.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. individuals. and some differences in Korea’s generally accepted accounting principles from international standards. These included restrictions of shareholdings of institutional investors. a large issuance of preferred stocks with no voting rights. corporate accounting information was not reliable due to the lack of independence of external auditors. Diversification can reduce chaebols’ risks through the portfolio effect. However. has an unsound capital structure and . Under the direction of the controlling shareholder. the Government maintained a policy of protecting the incumbent management of a listed company. In this situation. 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. 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. Dominance of Chaebols A chaebol is tightly controlled by the largest shareholder. and restrictions on hostile takeovers. Many of the takeover targets in the past did not have a controlling shareholder. Traditionally. as a whole. One reason is that the percentage of inside shareholdings for an average listed firm is very high. when a large diversified chaebol. usually a member of the founding family. as well as institutions. profitable firms within a chaebol tended to subsidize unprofitable firms. regulatory and practical difficulty in implementing proxy voting. however. Meanwhile.

Net profit margins of the top 31-72 chaebols were higher than those of the top five or of the top 6-30. 2. 2. the authorities did not properly check on banks’ lending practices—banks did not screen the lending projects and evaluate the creditworthiness of corporations properly. Such problems may eventually cause ripples through the entire economy. financing choices of listed firms in order of preference were bank loans. Further.5. As mentioned earlier. The Government’s supervision and regulation of financial institutions were poor. This effectively becomes an exit barrier for chaebols and would justify the intervention and support of the Government. prevalence of rent-seeking and morally hazardous behavior by economic decision makers. Profitability of the top 6-70 chaebol firms has been lower than that of the top five chaebol firms. Financing preferences changed drastically after the crisis. and a high degree of inefficiency in the economy. the financial distress of one or a few marginal firms can lead to a chain of bankruptcies across the entire chaebol. and internal funds. although their subsidiaries had better quality workforce and easier access to cheap credit than the top 31-72 chaebol affiliates.134 Corporate Governance and Finance in East Asia. the typical chaebol firm had an extremely high DER. and other individual markets. Vol. bond issues. The new preference ordering is as . This indicates that too much diversification and overinvestment in the top 30 chaebols resulted in relatively low net profit margins. However.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 intervention later resulted in the accumulation of adverse side effects: underdeveloped product. The Government and the Bank of Korea did not have accurate information on the extent of transactions that corporations and financial institutions had abroad. share issues. while (non-chaebol) independent firms had much lower borrowing ratios. II strong financial links among its member firms through investments and cross-guarantees. capital.3 Manifestations of Weak Corporate Governance and Government Intervention Preference of Debt Over Equity Financing in the Precrisis Period Before the crisis.5. as the latter are well established in most business areas.

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. In November 1997. The lending practices of banks. At the end of 1996. The high proportion of foreign debt led to a mismatch problem where borrowers were unhedged against foreign exchange risk. which is far higher than the average ratio of around 400 percent for nonfinancial listed firms. Implicit guarantees by the Government on bank loans to large businesses. Bank loans. were advantageous to chaebols because they were in an “ideal” position to meet the loan requirement through cross-guarantees among their member firms. the Government and the Bank of Korea defended the currency. share issues. 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. overseas borrowing became difficult and higher interest rates were charged on foreign borrowing. However. the exchange rate (won/dollar) increased sharply and the financial crisis erupted in Korea. won/dollar nondeliverable forward rates increased rapidly. 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.5 billion.Chapter 2: Korea 135 follows: internal funds. After the financial crisis erupted in Indonesia and Thailand. As of the end of 1997. The financing choice of listed firms was also influenced by the underdevelopment of the stock market. which were the most important financing source until 1987. consisted of high proportions of policy loans. as evidenced by occasional. Other factors also contributed to this preference. 63 percent of which was short-term. reducing foreign exchange reserves to a dangerous level. which generally required guarantees or collateral. The preference for debt finance also led to a relatively large foreign debt. signaling a bearish speculative move on the won. 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. large-scale bailouts of financially distressed firms. Nonpolicy loans were also considered to be cheap because of interest rate regulations. obviously contributed to overlending and aggravated the situation. and bond issues. The ratio of external debts to GDP reached 48 percent at the end of 1998. the top 30 chaebols showed a DER of 519 percent. . In the international financial market. total foreign debt amounted to $157. bank loans. Although the ratio of stock market capitalization to GDP in Korea was not very different from those in the Philippines and Thailand.

The number of insolvent companies increased rapidly in 1991 and doubled to more than 11. The Government could hardly help them because of the number and magnitude of business failures.6 percent in June 1998.7 percent in 1997. Further. without strictly evaluating the creditworthiness of businesses and the profitability of projects. total assets. especially chaebols. Following the “three months” definition. and there is collateral. the ratios of net profits to sales. Meanwhile. Before the crisis. Fixed loans are those for which interest is not received for six months or longer. legal and other barriers prevented the exit of financially nonviable firms.000 per year starting 1992. These were the definitions until 30 June 1998. regardless of whether it is caused by large personal holdings of the controlling shareholder or by pyramiding. they are defined as loans for which interest payments are overdue by three months or more. . It jumped to 17. a large number of construction companies failed due to the recession in the real estate market and decline in real estate prices.000 from December 1997 to February 1998. the NPL ratio of commercial banks increased rapidly from 4. and shareholders’ equity of all industries. The inevitable result of inefficient investment was a fall in corporate profits. Doubtful loans are those for which interest is not received for six months or longer. Financial Sector Vulnerability Because of financial losses in the corporate sector. They utilized mutual payment guarantees among their affiliates and believed that they would never fail. and there is no collateral. reaching highs of 6 percent in 1997 and 8. The banks and merchant banks lent to large businesses. excluding the financial sector. However. were low in 1996 and 1997. and estimated losses. The monthly number reached more than 3.1 percent in 1996.000 in September 1998 (Table 2. nine out of the 30 top chaebols failed. The bank supervisory 8 NPLs of banks comprise fixed (substandard) and doubtful loans. and the pursuit of growth through excessive diversification and inefficient investment. Moreover. 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. According to the “six months” definition. starting 1 July 1998.136 Corporate Governance and Finance in East Asia. II Inefficient Corporate Investment and Low Profitability Ownership concentration among Korean firms. the NPL ratio8 of banks and other financial institutions began to increase. has given rise to various types of self-dealings by the controlling shareholder. and returned to about 1.200 in 1997. decelerated from March 1998. In 1997 they became negative. the NPL ratio reached 7.32). Vol. then 20.000 during January-September of 1998.

573 3.472 2.890 4.386 5.131 1.673 Construction 380 354 242 195 294 585 1. Compared to ROAs and ROEs of domestic branches of foreign banks.32 Number of Firms with Dishonored Checks.637 6.255 13. Source: Bank of Korea. As a result they had largely overvalued currencies.517 2.657 3. 2. This speculation was said to be one of the causes of the financial crisis in Korea.China. This was mainly due to the high ratios of NPLs.856 7.859 3. and continuous and large current account deficits.979 8.107 6. authorities were not too concerned about the high NPL ratios at Korean banks in 1997 simply because the high and rising ratios had precedents.754 3.135 1.159 10.265 6.417 Others 152 132 108 97 88 161 326 252 274 302 553 861 952 Note: 1998 figures cover only January-September.502 11. In 1990-1993. Meanwhile.238 4.751 1. 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.114 811 706 696 866 1. Policymakers thought that economic growth would resolve the NPL problem without the need for corrective action.259 2.69 20.850 3.769 9.457 2. The current account deficits in terms . Exchange rates were virtually pegged to the US dollar in all troubled Asian countries.027 Manufacturing 1. and declined to 4-6 percent in 1994-1996 (Table 2.33). ROEs and ROAs of Korean and Japanese banks were low compared with those of the US.544 2.5.244 3. those of domestic banks were lower in the 1990s.Chapter 2: Korea 137 Table 2.992 11. European countries.647 8.855 6.553 3.210 1.759 6. and Taipei.589 171.985 Services 3.133 3. the ratio reached 7-8 percent.053 5.4 Shortcomings in Macroeconomic Policy The macroeconomic framework also contributed to the crisis in 1997. 1986-1998 Year 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 Total 4. low efficiency.250 2. and large government-directed loans.

116 1.0 8. Source: Bank of Korea. Korea -4.2 4. of percentage of GDP were as follows: Malaysia -8. In 1997.649 375.310 6. II Table 2. In addition to the overvaluation of the won.652 29. even in times of economic slowdown.190 9.874 22.739 241. Businesses served as a social safety net. Mass layoffs became legally possible only after the economic crisis.China. It was estimated that the Korean won was overvalued by 20 to 30 percent from 1989 to 1997.077 NPL Ratio (%) 8.6 percent (1995).1 percent (1995).520 194. Vol.584 2.705 160. The pegged currency also encouraged foreign borrowing as investors believed that the exchange rate would remain stable.170 1.8 5.997 9. 1990-1998 (W billion) Year 1990 1991 1992 1993 1994 1995 1996 1997 1998 a Total Loans 90.192 Doubtful (B)b 952 1.8 percent (1996).827 289.562 18.929 11.6 Fixed loans are those requiring collateral and for which interest is not received for six months or longer.266 10.639 1. Meanwhile large businesses could not legally lay off workers. Thailand -8. Land prices and real estate rents were also high compared to trading partners. the hourly wage rate in the Korean manufacturing sector was higher than in Singapore or Taipei. Real interest rates in Korea had been two to three times higher than those of Japan or Taipei.484 11.910 1.475 143. because of the rigid labor market.556 118.China.0 7. and Indonesia -3. which led to large corporate losses.237 Estimated Loss (C) 958 920 840 816 213 385 490 490 648 NPL (A+B+C) 7.736 8.160 11.600 10. Related to this.221 8.33 Nonperforming Loans of General Banks.138 Corporate Governance and Finance in East Asia.584 Fixed (A)a 5.1 6.1 7.430 12.954 9.0 7. although per capita income in Korea was much lower. and 30 percent in 1996. b Doubtful loans are collateral-free loans for which interest is not received for six months or longer. judging from the real effective exchange rate indexes using unit labor cost indexes as a deflator and 1985 as a base year. .176 7. the terms of trade deteriorated 12 percent in 1996 and 11 percent in 1997.390 12. the ratio of short-term debt to foreign reserves was very high.6 percent (1995).537 10. The main result of the rigid labor market was a “high-cost and lowefficiency” economy.832 337.4 5.

and subsidizing money-losing units. which were laden with huge amounts of debt and were on the verge of bankruptcy. including banks. Measures have been taken by several chaebols to streamline operations and improve incentives of managers and employees. embarked on their own restructuring programs and/or implemented restructuring demands of the creditor banks. A guideline informally promulgated by FSC required the 30 largest chaebols to lower their DER of 412.Chapter 2: Korea 139 2. 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 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. To achieve this. 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.6 percent as of the end of June 1998 to no more than 200 percent by the end of 1999. ‘Voluntary’ Restructuring Chaebols have been under pressure from the Government to abolish their informal group headquarters to increase the managerial independence of member firms.6 2. Corporations. has been actively utilizing its influence to motivate institutions to coordinate debtor firms’ restructuring activities. They have been pressured to stop such practices as providing loan guarantees. the immediate objective centered on restoring the international investment community’s confidence in the Korean economy. .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. had been forced into bankruptcy proceedings or merged into healthier entities. Downsizing by curtailing employment has been prevalent. However. Nonviable firms and financial institutions.6. the excessive amount of debt of Korean corporations had to be reduced to a sustainable level. Other firms experiencing financial distress were subjected to workout procedures through negotiations between debtors and creditor institutions.

the creditor . Vol. More than 59 percent of potential buyers were foreign firms. II Divestitures to raise cash for debt reduction and to focus on core businesses have not proved to be easy. Internationally. Banks did not have the incentive to force financially nonviable firms to liquidate. they were reluctant to allow recontracting for fear of further deterioration in the capital adequacy ratio. The reasons are manifold. potential foreign buyers waited for the price of acquisition targets to come down further. or to agree on debt-equity swaps demanded by potential purchasers as a precondition for the deal. In their first review. 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. Locally. On the other hand.281 in April to 2. Involuntary Exits The Government has been involved in the restructuring process mainly through its supervisory capacity over banks. banks and other creditors were reluctant to absorb losses realized by debt compositions.140 Corporate Governance and Finance in East Asia.138 by the end of October. Noticing this disincentive. because liquidation of debtor firms would exacerbate the banks’ already weak balance sheets. while only 14 percent of the negotiations were completed from the beginning of the crisis up to April 1998. FSC directed banks to appraise the long-term viability of client firms showing symptoms of failure. 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. More important. It was frequently observed that the negotiating parties could not agree on a price due to large discrepancies in valuation. 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 1998.045 in October. 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. The data also show that about 24 percent of acquisition negotiations ended up in actual deals. In many cases. This number was at 779 firms in April and grew to 1. the number of potential sellers decreased somewhat from 2.

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

inducement of foreign direct investments was considered to be the most effective means of achieving that end. railroad cars. In the early days after the outbreak of the crisis. aircraft. As of April 1999. Big Deals Ever since the outbreak of the economic crisis. However. In one case. chaebols did announce their agreements on big deals in seven industries excluding the automobile industry. oil refineries. Thus. Foreign Acquisitions Confidence in the Korean economy depends critically on the lowering of the level of corporate debt. labor union demands of the seller were not acceptable to the transacting parties. Restrictions on foreign ownership of land were also abolished. vessel engines. Big deals would. the Government has been urging the largest chaebols to strike “big deals” or business swaps among themselves to consolidate overlapping manufacturing facilities. automobiles.142 Corporate Governance and Finance in East Asia. On 3 September 1998. Hyundai Motor Corporation won the international auction of Kia Motors in its third bidding and Daewoo Motors agreed to acquire Samsung Motors. Foreign investment—in the form of acquisition of controlling interests. Big deals have been elevated to the status of the most important means of effective corporate restructuring. the foreign buyer demanded specific protections against adverse developments in the business environment. most of the big deals have entered their final stages of negotiation. purchase of divested assets. This figure contrasts sharply with the total of $700 million for all of 1997. These deals could eliminate excess capacity in such industries as semiconductors. enable chaebols to streamline their overly diversified operations and focus on several core business areas. uncertainty over the future . and petrochemicals. First. and equity participation—reached about $8. Korea adopted and implemented policies to open its capital market completely.5 billion on agreement basis during the 10-month period after December 1997. power plant facilities. it is hoped. In another. Vol. The less than satisfactory state of foreign capital infusion in the early days stems from a number of factors. In the case of automobiles. some of the acquisition agreements have been discarded for various reasons. II creditor banks and the corporations will devise detailed workout programs based on the rehabilitation plans submitted by the corporations.

2. Sixth. Overhaul of Bankruptcy Procedures In February 1998.6. local creditor banks were reluctant to absorb losses arising from debt compositions and debt-equity swaps that were necessary in deals involving insolvent sellers. (iv) to focus on a small number of core businesses. (ii) to remove cross-guarantees of loans among group members. 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. (iii) to reduce financial leverage. foreign buyers were concerned with the inflexibility of the labor market. the improved procedures stipulated in the Bankruptcy Reorganization Act and the Composition Act reduced what had previously been legalistic exit barriers. Fourth. these goals were: (i) to enhance managerial transparency. Seventh. Second.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. but it also has important implications with respect to corporate workouts. 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. some of the potential acquirers demanded terms that were unreasonable or unacceptable from the sellers’ point of view. Fifth. In effect. foreign buyers usually employed discounted cash flow methods of valuation while local sellers often put greater emphasis on replacement costs of assets. and (v) to improve the accountability of controlling shareholders and the board. With this in mind. many of the businesses that Korean firms put on sale did not prove to be attractive to foreign firms. the Government and chaebols reached an agreement on the goals of restructuring and reform efforts. Not only does this represent progress in terms of an improved institutional framework for market competition. 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. As set forth in the agreement. Third. The presence of .Chapter 2: Korea 143 course of the Korean economy remains high.

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

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

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

No qualification requirements are being imposed on investors who are sponsoring new mutual funds. but may be extended as required. but it will also help improve financial institutions’ risk management. and the demand for longerterm bonds increases in the future. It is now easy for private investors. According to the law. To ensure transparency and efficiency of the fund operations. a primary dealers system will be introduced for healthy financial institutions. with only minor standard exceptions. a debt restructuring fund and three balanced funds (funds that invest in both equity and debt) were established in September 1998. the Government will correspondingly expand the issuance of government bonds that have a maturity of five years or more. and is promoting joint ventures between foreign and domestic agencies. 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.Chapter 2: Korea 147 monthly. invested a total of W1. to establish closed-end investment companies. Asset-Backed Securities A new law providing for asset-backed securities (ABS) was passed in September 1998. Prior to the introduction of this system. As a pilot program. including the Korea Development Bank. Related legislation was put into effect in September 1998. These are expected to operate for the next three years. both domestic and foreign. they will be managed by foreign investment management companies. This law will not only provide an effective institutional environment for the disposal of NPLs.6 trillion for the debt restructuring fund. financial institutions . If interest rates stabilize at a low level. In order to promote a greater market demand for government bonds. It also opened the credit rating service market to foreign competition. commercial banks were allowed to carry out dealing operations for government bonds starting in October 1998. Twenty-five domestic financial institutions. In August 1998. and W1 trillion divided equally between the three balanced funds. Moody’s signed a joint venture contract with Korea Investors Service. The Government established specific qualification criteria and selected the primary dealers in 1999.6 trillion in these funds: W0. Mutual funds (or open-end investment companies) will be allowed starting 2001.

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

Listing rules may recommend that all or large listed companies adopt an audit committee. The Securities and Exchange Act will then require large listed companies to switch to a board audit committee system from an internal auditor system. If and when the law is introduced. The annual shareholders meetings could also elect reputable “monitoring companies” to recommend director candidates (Latham. and requiring that all directors hold shares of their companies. pp. Each listed firm should be required to disclose the extent of its compliance with the Code in its annual report. . thereby helping to strengthen board independence and enlisting boards’ more active involvement in monitoring corporate management.Chapter 2: Korea 149 investors or their trade associations. September/ October 1997. the Korea Stock Exchange could incorporate provisions of the Code of Best Practice in Corporate Governance in its listing rules. 1997). More effective measures to protect investors will enhance corporate transparency and also the accountability of directors to shareholders. Proposed: A Governance Monitor. various measures have been implemented to promote investors’ rights. and other committees. The Corporate Board. Class action suits are an efficient means for corporate monitoring. and also negligence of external (independent) auditors actionable. 1997. 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. 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. Since the economic crisis. using audit. governance. 23-26. 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. 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 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. it will have to include making self-dealings by directors and officers. One way of motivating institutions to do this is to 10 M. Latham.10 Other means to improve independence of the boards include mandating that independent outside directors form the majority. Further.

objecting to certain defensive measures proposed by the management. Another measure. is to restrict ownership of investment trust companies and NBFIs by the five largest chaebols and. The institutions’ respective trade associations. .150 Corporate Governance and Finance in East Asia. 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. strengthening incentive compensation schemes for executives. These guidelines would recommend shareholder activism and faithful discharge of fiduciary duties by actively participating in shareholder voting. In the coming years. more drastic in nature. The Government can also lower the limits on investments in affiliated companies. Shareholdings concentrated in investment companies and other institutional investors pose a serious dilemma. Also. Rights of minority shareholders should also be strengthened for these institutions. II provide comprehensive guidelines for their actions in matters related to corporate governance. The Government recently proposed the revision of bankruptcy-related laws. an audit committee. insurance companies. possibly. 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. could prepare such guidelines. Many of the larger investment trust companies. Application of more stringent bankruptcy-related rules to firms in financial distress will effect greater discipline over corporate management. by all nonfinancial companies (or “industrial capital”). the Government will have to come up with appropriate policy measures to solve these problems. 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. strengthen its supervisory activities. and compliance officers. Vol. such as the Korea Investment Trust Association. 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. etc. 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. securities companies. and impose stronger penalties on violations of the rules on portfolio investments. and thus cannot be expected to be actively involved in monitoring portfolio firms. reviewing independence and expertise of candidates for outside directors.

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

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

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

Chicago. C. Ungki. U. II Lee. I.. Lim. and J. Sohn. Whang. Background and Task of Structural Adjustment. J. Vol. Seoul. 1996. Lim. 1998. March 1999. October 1998. S. C. 1998. The Ownership Structure and Family Control in Korean Conglomerates: With Cases of the 30 Largest Chaebols. Korea Institute for Industrial Economics and Trade. 1995. S. Korea Finance Institute. KIEP Working Paper 98-05. and H. I. Ministry of Finance and Economy. Beyond the Limit. Corporate Governance in Korea. Business Groups in Korea: Characteristics and Government Policy. K. Yang. . Korea Institute for International Economics and Trade. Chung Ang University. Whan. 1999. W. 1998. Lee. Management Research Institute. November 1996.. Korea Development Institute and World Bank. January 1995. and J. Real Exchange Rate and Policy Measures. Wang. Joh. KIET Occasional Paper No. S. K. Y. H. Annual Conference of Financial Management Association. 1999. Nam. The Pattern of Ownership Structure and their Characteristics in Korean Conglomerates: With Cases of the 30 Largest Chaebols. 23.154 Corporate Governance and Finance in East Asia. Kang. J. K. September 1998. October 1998. H. 1996.. Y. Yonsei University. Yim. A New Trade and Industrial Policy in the Globalization of Korea. S. Capital Liberalization. Korea’s Trade and Industrial Policies: 1948-1998. 2nd Sangnam Forum. Ungki. 1998. Conference on Corporate Governance in Asia: A Comparative Perspective. J. Y. Kim. Kim. Korea Institute for International Economic Policy. Lee. Korea’s Economic Progress Report.

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

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

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

0 (0.7 8.9 5.3 8.2).5) 5.0 8.6 7.6) 0.7 (13.2 8.2 Korea. however.1 5. In this section. only nonfinancial companies were used.8 8. only to be unsettled by the crisis of 1997.2 Source: ADB.5 8.7) 10.5 8.000 Corporations covers financial and nonfinancial companies.3 2.1 5.4 4.2) 4. 1990-1999 (percent) Year 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 Indonesia 9.3 7.2 7.3 9.9 6.2 9.1).0 8.5 percent per year (Table 3.2 (0.000 Philippine companies grew 17. Key Indicators of Developing Asian and Pacific Countries 2000.7) (10.8 8.0 (6. competition from liberalized imports had somewhat reduced oligopolistic tendencies and concentration in many industries.8 5. The Philippines substantially lagged behind other countries from 1990 to 1995 (Table 3.8 5. II market.4 Philippines 3.5 9.158 Corporate Governance and Finance in East Asia.2) 0.8 4. which was taken as a representation of the Philippine corporate sector. .8 percent growth in fixed 2 The SEC-BusinessWorld Annual Survey of the Top 1.7 5.9 7. This rate of growth was sustained by a comparable 18.2.7 Malaysia 9.000 corporations.3 9.5) 3.8 10.2 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 1.9 (1. Table 3. net sales of the top 1. Vol.0 7.1 GDP Growth of Southeast Asian Countries.1 8. 3.5 (7.2 Thailand 11.2 7. Its growth rate began to catch up with others in 1996.2 During 1988-1997. Rep.1 4. 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. of 9. With economic reforms introduced in the 1980s and 1990s.

3 60 10.4 3.1 51.1 181 11.2 707.1 881.1 Other Indicators No.697.131.2 Growth and Financial Performance of the Top 1.1 95.647.2 Compound Growth (%) 17.1 1.2 1.000 Corporations in the Philippines.6 290.1 66 12.561.2 27.6 144.9 898 1.9 480.3 862.1 33.191.2 2.5 1.177.5 1.9 1.512.6 18.5 1.7 73 6.9 78 6.6 149 12.0 1.4 555.160.000 Companies.3 121 12. of Companies Sales per Company (P billion) 899 0.1 1.5 193.2 Average 146 12.5 4.9 952.394.8 26.2 900.9 2.8 411.7 1.7 20.6 102 16.5 119 12.9 96.4 411.8 6.6 109 12.5 64. Source: SEC-BusinessWorld Annual Survey of Top 1.0 900 1.8 77 7.9 896 2. return on equity (ROE) = net income/ stockholders’ equity.3 68 7. return on assets (ROA) = net income/total assets.7 1.4 8.893. turnover = net sales/total assets.6 896 0.6 35.6 1.3 898 1.9 3. .9 629.7 903 0.5 192.0 148.4 63.6 75 6.3 382.781.8 618.5 51 4.123.4 776.317. net profit margin = net income/net sales.6 5.341.1 6.3 941.8 902 1.2 378.Table 3.8 741.2 2.7 28.1 714.209.7 238.7 218.8 5.8 22.4 602.3 107 13.2 4.4 861.6 426.3 46.5 508.1 197 14.5 Leverage = total liabilities/stockholders’ equity.4 1.9 149 6.2 Indicators 1988 Growth Indicators (P billion) Net Sales Net Income Fixed Assets Total Assets Total Liabilities Stockholders’ Equity Retained Earnings 464.5 72 7.6 900 1.9 617.5 446.978.1 615.332.0 1.7 443.3 306.1 73 5.2 338.1 72. 1988-1997 1989 519.4 Financial Ratios (%) Leverage ROE ROA Turnover Net Profit Margin 222 14.4 260.5 570.1 4.8 4.5 14.2 136.5 887 0.225.1 468.1 54 11.6 954.4 898 1.1 5.6 1990 1991 1992 1993 1994 1995 1996 1997 1.4 188.

160 Corporate Governance and Finance in East Asia.1 Net Sales (P billion) 465 519 630 741 862 954 1.3 percent. 1988-1997 Top 1. These rates of return are high compared with other Asian countries.000 Corporations in the Philippines.394 1. and by equity that grew at a higher average annual rate of 26. The data suggest no evidence of excessive borrowing in the run-up to the crisis in 1997. . but the extent of the increase was not as dramatic as in other Asian countries. Sources: ADB. and the SEC-BusinessWorld Annual Survey of Top 1.4 24.474 1.693 1.2 percent. Key Indicators of Developing Asian and Pacific Countries 1999.4 20.697 1.6 percent and 5.8 percent per year. Total assets grew at an average annual rate of 22. Further.5 Value-added is assumed to be 30 percent of net sales.7 percent.8 17.5 Ratio of Estimated Value Addeda to GDP (%) 17.427 13.000 companies averaged 7.077 1.248 1. Net income consistently increased from 1988 to 1996 and declined only in the crisis year 1997.352 1. Vol.000 Companies Year 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average Growth (%) a GDP (P billion) 799 925 1.9 percent for the period.172 2. various years.1 19. Assuming Table 3.178 1.5 16.9 23.3). leverage increased from 109 percent in 1996 to 149 percent in 1997. This is high compared with developed countries but compares favorably with other Asian countries. for the 10-year period.8 19.906 2. respectively. Asset growth was funded by debt that grew at an average of 20.5 17. The growth rates of corporate sales for the period 1988-1997 exceeded those of the country’s GDP for the same period (Table 3. The debt-toequity ratio ranged from 222 percent in 1988 to 102 percent in 1994.979 17. Return on equity (ROE) and return on assets (ROA) averaged 12.3 The Corporate Sector and Gross Domestic Product. Net profit margins for the top 1. indicating that the corporate sector’s exposure to foreign currency-denominated loans was not as significant as in other countries.9 21. II assets.

Performance by Ownership Type The Philippine corporate sector can be categorized into four groups based on ownership: (i) publicly listed.3 146 6. and (iv) privately owned. size.9 158 13.0 5.3 22.1 12.4 190 5.9 22.9 26.9 17.8 ForeignOwned 21.3 22.8 606 0.8 No.8 percent of the corporate sector’s total sales between 1988 and 1997. . 1988-1997 Indicators Publicly Listed Privately Owned Rate. privately owned companies constituted the largest group (Table 3.5 Other Indicators Share of Sales (%) 17. The premise is that these variables have a direct bearing on corporate performance and growth. of Companies 73 Sales per Company (P billion) 2.7 22.3 42.8 2.5 GovernmentOwned 4. %) 17.2 103 5.9 196 1.8 14.3 11.0 Net Income 19.1 22 10. these figures suggest a significant and increasing contribution of the corporate sector to GDP. and industry reveals further structural characteristics of the growth and financial performance of the corporate sector.4).5 Retained Earnings 30.8 Growth Indicators (Compound Annual Growth Net Sales 20.3 27.6 Total Assets 29.4 Growth and Financial Performance of the Corporate Sector by Ownership Type.0 31.8 22. (iii) Government-owned.7 2.Chapter 3: Philippines 161 a constant ratio of value added to sales.0 4.4 Fixed Assets 19. corporate control structure.2 9. (ii) foreign-owned.5 27. Averaging 42.4 Stockholders’ Equity 32. A study of company performance by ownership type.5 23 4. The foreign-owned companies were the Table 3.3 9.1 Financial Ratios (%) Leverage 89 ROE 15.0 5.5 Source: SEC-BusinessWorld Annual Survey of the Top 1. various years.000 Corporations in the Philippines.4 28.4 Total Liabilities 26.0 Turnover 53 Net Profit Margin 15.1 ROA 8.8 3.0 28.0 142 22.

and low return on investment is the norm. a level high by Western standards but at par with those of other Asian countries. the highest net profit margin of 15. or 38 percent.162 Corporate Governance and Finance in East Asia. although small in number. the asset base is large. compared with P2. but lower than those of foreignowned and publicly listed companies. But by being most efficient in employing assets. Bases Conversion Development Authority. Their ROA and ROE were both more than twice as high as those of government-owned companies. However.2 percent and ROA of 9.5 percent. selling an average of P4. . The compound annual sales growth rate was 21. and the second lowest asset turnover. these companies were comparatively large.8 percent for foreign-owned companies and 20 percent for publicly listed companies during 1988-1997. exceeding the 17. with an average ROE of 22. they generated the highest return on investments. With an average leverage ratio of 142 percent.000 companies in 1997. These were mostly large public utilities.3 percent. 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. The privately-owned companies were only about one third of the average size of per company sales of the publicly listed companies. foreign-owned companies borrowed more than publicly listed ones. followed by publicly listed ones.000 list. registered the largest per company sales at about P9 billion in 1997. Publicly listed companies had a minor though steadily increasing share in total sales. were among the top 1.5 percent average growth rate of the entire corporate sector. 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. while there were few of them. reflecting the significant presence of holding companies as the gross revenues of holding companies flow through to operating income. The privately-owned companies had a high average leverage ratio of 158 percent.1 billion per company in 1997. Publicly listed companies had the lowest leverage at 89 percent. Governmentowned companies in the top 1. Vol. 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. the second best ROE and ROA.75 billion per company for foreign-owned companies. II second largest at about 27. Privately-owned and Government-owned companies grew at slower rates.9 percent. and government-subsidized agencies such as the National Food Authority and Local Water Utilities Administration.

6 26. and small companies. medium. depending on assets and sales. of Company 159 Sales per Company (P billion) 2.1 124 5. But the conglomerates were larger measured in sales per company.Chapter 3: Philippines 163 Performance by Control Structure By control structure.3 Other Indicators Share in Sales (%) 32.000 Corporations in the Philippines.7 2.5 Growth and Financial Performance of the Corporate Sector by Control Structure. compared with 32. a company can be a member of a conglomerate or independent. had a lower leverage ratio.1 Retained Earnings 32. the corporate sector is divided into large.0 55. grew faster. and achieved higher returns on invested assets than independent companies (Table 3.5). Performance by Firm Size By firm size. The independent companies contributed about 56 percent of corporate sales on average during the period 1988-1997.8 Growth Indicators (Compound Annual Growth Rate. Sales and resources of the .4 24.3 Financial Ratios (%) Leverage 98 ROE 15.3 percent for the conglomerates.3 No.8 ROA 8.8 6.6 715 0.1 Source: SEC-BusinessWorld Annual Survey of Top 1.2 Fixed Assets 25. %) Net Sales 20.0 25.2 23. 1988-1997 Indicators Group Member Independent 18.0 166 15.0 22.3 Total Liabilities 30. various years. Table 3.0 Turnover 67 Net Profit Margin 12.7 Total Assets 32.2 Net Income 21.7 Stockholders’ Equity 34.

3 Source: SEC-BusinessWorld Annual Survey of Top 1. averaged a far less P3 billion in per company sales.000 Corporations in the Philippines.5 Growth Indicators (Compound Annual Growth Rate.0 156 16.4 Total Liabilities 18.3 Turnover 65 Net Profit Margin 8.7 Net Income 1. 1988-1997 Indicators Large Medium 19.6 Small 19.9 32.2 Other Indicators Share in Sales (%) 56. However. Table 3. for this study.0 32.6 Growth and Financial Performance of the Corporate Sector by Firm Size.000 list.1 81 9.6 36.8 percent of the total number of companies in the list (Table 3.9 Retained Earnings 13. Vol.1 4.5 73 6.7 44.6 49.5 128 10.4 billion in 1997. %) Net Sales 15.000 list. II Philippine corporate sector are highly concentrated among the large companies. while small companies.9 Financial Ratios (%) Leverage 158 ROE 13.5 Total Assets 18.0 730 0.6 31.6 47.1 ROA 5.2 29. although they comprised only 8. averaging 16 percent. Medium-sized companies. Sales per company in this group averaged P13. sales of mediumsized companies grew faster than large companies. various years.164 Corporate Governance and Finance in East Asia.6).1 No.5 12.9 26. averaged only P920 million in per company sales during the same year.0 7. referring to the remaining companies in the list.5 25. indicating that they deployed resources more efficiently than large and small companies.1 percent of the total sales of the corporate sector.2 Stockholders’ Equity 18.3 Fixed Assets 15. Medium-sized companies also performed better in terms of ROE.1 25. are defined as the largest 100 companies in the top 1. defined in this study as the next 200 largest companies in the top 1. . which.9 89 1.4 28. Large companies accounted for 56.2 25. of Companies 79 Sales per Company (P billion) 7.

1 percent.e.7 percent a year earlier. i. The sector showed consistent growth in sales.Chapter 3: Philippines 165 Small companies. Growth of sales. Net income declined from P54. assets.5 percent for medium-sized companies and 8. at 128 percent for the period. of net income. and utilities and services sectors. but suffered its largest decline in net profits in 1997. utilities.6 percent.1 billion in 1996 to P4. The growth and financial performance of selected industries. Poor returns appear to have been caused by the low profit margin at 6. ROE dropped from 10.2 billion in 1997 for this sector. Sales revenue and net income declined from P76. reflecting to some extent a “bubble” phenomena in the former two sectors. For small companies. with their ROE dropping to 3. are shown in Table 3.7 percent in 1997 for medium-sized companies. although the largest in number.2 percent for large ones. compared with 9. The leverage ratio of the manufacturing sector was higher than that of the real estate and property sector. and profitability in 1997 when the crisis started.7 percent in 1996 to 8.7. Mediumsized companies’ leverage level was slightly lower.4 percent in 1997 from 11. The real estate and property sector also suffered significantly in sales.7 billion and P35. Performance by Industry This study also looked at corporate performance by industry. net income. Leverage was the highest for large companies. and utilities and services sectors.and medium-sized companies did not substantially increase their leverage in years running up to the crisis in 1997. profits. 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. unlike their counterparts in other Asian countries. Medium-sized companies apparently enjoyed efficiencies associated with economies of scale and made more productive use of their assets. and assets was much higher for the real estate and property. Large.8 the previous year. and construction. manufacturing. at 158 percent on average during 1988-1997.8 percent in 1997. from 14. ROE dropped to 7. real estate.. But small companies’ leverage was significantly lower.8 billion in . especially during the period 1994-1996. but lower than that of construction. as indicated by the negative annual growth. showed the lowest ROE. The Asian financial crisis affected large companies most severely. at 156 percent. averaging 10. net income.8 percent. specifically those industries least and most affected by the financial crisis. and the construction sectors than for the manufacturing. and equity up to 1996. at -12.

1996 to P56.6 69 16.7 Indicators Manufacturing Construction 27.2 45. Vol. %) Net Sales 16. 1988-1997 Utilities Real Estate and and Services Property 39.4 3.2 8.000 Corporations in the Philippines.9 2.6 Growth Indicators (Compound Annual Growth Rate.2 37. Its knock-on effect on the economy was small as it accounted for less than 3 percent of the top 1.7 83 2.8) 17.7 percent to 10.166 Corporate Governance and Finance in East Asia.3 5.2 12. With a modest increase in total liabilities and leverage level of less than 100 percent in 1997.4 16.7 192 9. The sector’s buildup in equity during the stock market boom of 1994-1996 may have cushioned the impact of the crisis.000 companies’ total sales on average during 19881997.0 23.2 28 0.6 No.7 52.0 Turnover 112 24 Net Profit Margin 5.1 24 42. II Table 3.8 48. .4 Source: SEC-BusinessWorld Annual Survey of Top 1.7 ROA 5. respectively. of Company 454 17 Sales per Company (P billion) 1.7 28.3 20.7 billion in 1997.5 Other Indicators Share in Sales (%) 82.6 Total Liabilities 18.4 19.7 Net Income (12.4 Total Assets 19.3 55.0 21.9 billion and P24. it does not appear to have been excessively exposed to foreign currency-denominated loans.8 Stockholders’ Equity 21.9 2.7 Growth and Financial Performance of the Corporate Sector by Industry.3 Fixed Assets 20.9 17.3 Retained Earnings 17. But the impact of the Asian crisis on the real estate and property sector was much smaller than that on the manufacturing sector. the sector’s ROE dropped from 15.5 12.1 10.7 19.1 2.8 41.7 10. As a result.0 31 0.4 percent.9 5.9 23. and was also much more limited compared with the property sectors in other Asian countries.0 25.6 Financial Ratios (%) Leverage 142 181 ROE 13. various years.

Overall. (vi) names. operation. For publicly listed companies. 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. Two other pertinent laws are Presidential Decree (PD) 902-A. par value. and residences of original subscribers. The General Banking Law. Corporation Code of 1980 Supplanting the old Corporation Law of 1906. . (v) number of directors (not less than five nor more than 15). and the Insolvency Law. (iv) term of existence. 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. nationalities. (vii) number. reaching up to 313 percent in 1997. the leverage of all four industries was low. and restrictions. and residences of incorporators and directors. administrative regulations. and dissolution of corporations. the Corporation Code of 1980 is a compilation of important juridical rulings. and (viii) names. unlike in neighboring countries hit by the Asian crisis. which regulates banks and nonbank financial institutions except insurance companies.Chapter 3: Philippines 167 The utilities sector had the second highest leverage during 19881997 at 181 percent on average. the Revised Securities Act (RSA) and PSE’s public listing requirements also apply. nationalities. and amount of authorized capital stock.2. and amount subscribed and paid by each. the ownership of Filipino citizens in the corporation is not less than the legally required percentage of capital stock. and recognized rules on corporate practices. (ii) purpose of the corporation. 3. contains some provisions affecting corporations’ dealings with banks. One month after registration. The currency devaluation bloated the foreign currency-denominated loans of these companies.3 which serve as the company’s declaration that the minimum percentage of authorized capital required by law has been subscribed and paid-up. It specifies the minimum information to be indicated in the articles of incorporation. the Code requires a corporation 3 A company’s articles of incorporation should include: (i) corporate name. It provides the basic constitutional structure for the organization. privileges.3 Legal and Regulatory Framework The Corporation Code of 1980 is the main law governing the corporate sector. which was based on American corporate law. which is also the organic law governing the operations of SEC. (iii) principal office. Under the Code.

However. uniform.168 Corporate Governance and Finance in East Asia. directors. duties. In addition. (iii) controversies in the election or appointments of directors and officers of corporations. between the shareholders and the corporation. Vol.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. It implements rules and regulations that protect minority shareholders from possible fraud and misbehavior by controlling shareholders. 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. manner of voting. or officers. and public policy. and control (adjudicative) of all corporations. officers. and between the corporation and the State concerning its franchise or right to exist. (iii) qualifications. In 1976. among shareholders. To be valid. and reasonable. 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. II to adopt a code of bylaws or rules for its internal governance. (ii) required quorum in shareholders’ meetings. . (ii) controversies arising out of intra-corporate relations. 4 Some of the items that a corporation may provide in its bylaws are the following: (i) time. and (vii) manner of issuing certificates in the case of stock corporations. supervision (regulatory). the corporation’s articles of incorporation. A majority of the outstanding shares of shareholders must vote to authorize amendments to the bylaws. (iv) time for holding annual election of directors and manner of giving the election notice. and forms of proxies and manner of voting them. Its mandate is to supervise corporations in order to encourage investments and protect investors. Securities and Exchange Commission: PD 902-A SEC is the government agency responsible for implementation of the Corporation Code. and employees. and compensation of directors. the bylaws must be consistent with the law. shareholders may delegate this power to the board of directors by a two-thirds vote of outstanding capital stock. and should not impair vested rights. (vi) penalties for violation of the bylaws. must be general. (v) manner of election or appointment and term of office of all officers other than directors. place. and manner of calling and conducting regular or special meetings of the directors and shareholders. PD 902-A expanded SEC’s mandate to include absolute jurisdiction.

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

II analysis of the number of companies in which the top one. or 78 percent of the total. a single owner owned more than 80 percent of outstanding shares.10. five. Nonfinancial corporations with controlling shareholdings are likely to be holding companies. The shares of publicly listed companies are thinly traded and illiquid. or 80 percent (only nominally publicly listed) of outstanding shares. In four companies. five. 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. Composition of Ownership of Publicly Listed Companies Another important issue concerning corporate ownership is the composition of the controlling shareholders. There are advantages to establishing pure holding companies. In 116 companies. large and family-based shareholders pool the family’s ownership over many .2 percent of outstanding shares of publicly listed companies. Parent companies usually spin off operating units into new companies that they continue to control as affiliates. the top 20 shareholders collectively owned a majority of a company’s shares. holding only an average of 2. In 111 companies. The limited volume of shares issued to the public is one of the causes of the underdevelopment of the Philippine stock market. In 21 companies.9 shows that in 44 companies. the top five controlling shareholders were classified into eight groups. nonfinancial corporations held majority control. In four of 11 nonfinancial sectors.1 percent of publicly listed companies in the Philippines in 1997. 66 percent (signifying strategic control). or almost 75 percent of the total. Through these. the top five shareholders held more than two-thirds majority control of a company. Table 3. Vol. controlling an average of 52. which are mostly privately owned and controlled by family-based shareholder blocs. or 51 percent of the total. or 14 percent of the total. or about 30 percent of the total. The largest group is nonfinancial corporations. or 20 shareholders owned more than 50 percent (signifying operating control). a single shareholder held two-thirds majority control. a single shareholder held operating control of a company. the top five shareholders owned more than 50 percent of the voting shares. With such high levels of ownership concentration. Individuals did not constitute a significant shareholder group among the top five shareholders. and 20 shareholders? In Table 3. In 76 companies. and share prices are sensitive to movements of foreign funds.174 Corporate Governance and Finance in East Asia. or 3 percent of the total. Who are the top one. including pure holding companies.

. 10 manufacturing companies. and two companies in the property sector. Distribution. 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. Source: PSE databank. Beverage.9 Ownership Concentration at Critical Levels of Control Over Publicly Listed Companies. and Trading Holding Power Transportation Property Total — = not available. a Data for top 20 shareholders were not available for five holding companies. and Tobacco Manufacturing.Table 3.

3 12.7 0.0 7.3 0.5 4.1 1.0 0.2 1.5 26.4 8. Recreation.4 2.4 0.7 3.1 0.0 5.0 2.0 0.0 10.6 0.6 0.8 0.6 2.2 3.8 0.2 5.4 1.2 10.6 2.5 0.Table 3.0 0.7 3.8 11.5 53.0 0.0 1.0 0.9 0.0 1.2 0.5 0.3 5.0 1.8 66.2 3.6 0.3 0.3 2.6 0.1 8.9 36.4 19. and Other Services Property Mining Oil Average Shareholdinga 33.0 5.1 7.0 0.0 0.4 5.3 0.6 0.3 1.1 6.3 37.7 67.0 4.0 0. and Tobacco Holding Companies Manufacturing.6 0.9 6.0 1.9 52.0 2.6 18.10 Composition of Top Five Shareholders of Philippine Publicly Listed Companies by Sector.7 1.5 2.0 0.3 5.7 0. Source: PSE Databank.0 5.6 5.5 13.0 5.3 26.0 1.6 0.3 0.6 9.2 0.0 1.0 0.9 0.6 33.2 0.2 3.7 0.0 1.2 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. Distribution.2 3.0 0.3 1.2 0.0 0.1 9.0 45.0 0.1 5.5 12.5 4.0 1.2 59.3 0.7 0.4 29.8 21.7 0. .1 0.6 1.8 0. and Trading Hotel.0 0.1 a Weighted by market capitalization.0 0.7 0. Beverage.6 12.

The financial institutions among the top five shareholders of nonfinancial corporations are investment trust funds (with 4.Chapter 3: Philippines 177 companies and share in the risks and profits of the group. commercial banks (1. and San Miguel Corporation (SMC) in food and beverages.7 percent of shareholdings).3 percent). 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. These institutions keep a stock portfolio mostly in shares of a few companies with large capitalization and high liquidity in select industries. The 7. The Philippine capital market did not have an active analyst community comparable to those in more developed capital markets.5 to 12. Petron and MERALCO in power and energy. while still allowing the public to own minority shares. and insurance companies (0.6 percent of market capitalization in 1997. financial institutions did not have a significant ownership in nonfinancial corporations. Investment trust funds were the most important institutional investors. These are mainly the Social Security System (SSS) and the Government Service Insurance System (GSIS). These include Philippine Long Distance Telephone Company (PLDT) in telecommunications.1 percent). The investment funds’ presence in these sectors ranged from 8. This complex layering of ownership masks the identity of individuals or families that actually own and control operating companies. respectively. accounting for P258. Funds of SSS and GSIS consist mainly of compulsory contributions from members of the country’s private sector and government workforce. As a group. Such advantages have contributed to the popularity of holding companies among publicly listed companies. Holding companies were themselves 66 percent owned by other nonfinancial corporations.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. They can also better manage their income taxes because income from affiliated companies passes through a holding company. Holding companies as a sector had the largest market capitalization in PSE in 1997. there was no real market for investment information. with an average of only 7.6 billion or 26. Because of limited ownership by institutional investors.1 percent).2 percent in 1997. securities brokers (1. .7 percent of market capitalization of the nonfinancial publicly listed companies.

For this reason. including 16 commercial banks.000 companies. and increased the capital requirements for all types of banks. Family-based groups have larger companies since their total sales were about 33.000 Corporations in the Philippines. Vol. Some 20 financial institutions were affiliated with these groups. Banks that are members of business groups have an advantage in raising funds from the internal capital market of the group. including SBL and DOSRI rules. identified the companies belonging to each of these groups. This is significant considering that there were only 31 local commercial banks in the country in 1997.8 percent of total companies in number. All major industries were represented. many companies in family-owned groups are not publicly listed. and tracked the financial performance of each company from 1992 to 1997. Corporate financing depends on intermediation by banks. A common feature of corporate ownership of a business group is the centrality of a commercial bank. The Central Bank deregulated interest rates and foreign exchange. 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. To understand the ownership and governance characteristics of family-owned business groups. . the study put together a list of prominent business groups. Large shareholders and their families own these banks directly or through their controlled companies. Still. suggesting that most publicly listed companies are parts of business groups. remain in force to control excessive lending of banks to insiders. Commercial banks hold the largest share.11). Foreign banks have a growing presence but have not necessarily increased the supply of credit to the corporate sector. of the financial resources in the country. about three fourths. so far limiting their involvement to selected products. 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.178 Corporate Governance and Finance in East Asia. Prudential regulations. liberalized the regulations on entry of foreign bank branches and foreign ownership of local banks. a nonfinancial company that owns a commercial bank has better access to loans at favorable rates and terms. 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 1.7 6 7 The study used publicly available shareholder information and published reports.000 corporations’ sales. using data on the Philippines’ top 1. but they comprised only 23. the Central Bank’s reforms are probably changing the conduct but not necessarily the structure of the banking system. However.4 percent of the top 1. suggesting that business groups are common in all major markets.6 The total sales of these groups in 1997 were estimated at P806 billion (Table 3. This could further increase the concentration of ownership and expand the scope of own-group lending by these larger banks.

For the Ayala group. with the exception of Banco de Oro. the study used the four largest business groups—Ayala. Family-based business groups are most dominant in sectors such as manufacturing. and for the Henry Sy group.2 percent). Significantly. Foreign-owned companies mainly serve the export markets.000 companies. real estate. the nonfinancial sector was real estate (60. in most . 25 out of the 50 top corporate entities were familybased groups. Also.4 percent of the group’s 1997 profits). The significance of family-based business groups in the Philippine corporate sector is immediately evident in the 50 largest corporate entities. To show this. it was manufacturing (36. nonfinancial companies contributed about 36 to 60 percent of total profits for these groups. Lopez.000. In the meantime. the two were closely related through their affiliations to business groups. In 1997. and more than 20 percent for the Lopez group and Henry Sy group. 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. Commercial banks are often affiliated to a particular business group. the biggest private company in the Philippines. Commercial banking contributed about 40 percent of group profits for the Ayala group and Gokongwei group. with 27 affiliated companies in the top 1. namely. and Henry Sy—as examples. construction. In terms of number of companies. It is also noteworthy that. a substantial proportion of group profits came from its financial subsidiaries. the largest was the Eduardo Cojuangco group. including business groups and independent companies.12). and banking. which was majority-owned by the Henry Sy group. for the Lopez group. ranged according to their sales (Table 3. the top 10 family-based business groups had only 119 companies in the top 1.000 corporations in 1997.1 percent). These corporate entities accounted for 53.Chapter 3: Philippines 179 Compared with other Asian countries. broadcasting (49. for each of these groups. Together.6 percent of the total sales of the top 1. the three largest entities were family-based groups.8 percent). as discussed in previous sections. Gokongwei. an average group in the Philippines has fewer member companies. for the Gokongwei Group. and Ayala. retail merchandising (69. Cojuangco. In terms of sales. Lopez. the largest family-based business group was the Ayala Corporation Group. or an average of about 12 per group. the principal owner of SMC. The main constraint may be the availability of family members that could be drawn for top management positions.

9 3. and packaging Power distribution and mass communications Real estate. 15.5 26. beverages. beverages. Consunji 4 3 Food and dairy products Construction and mining 10. food. 6.4 10. 4.6 2. 5.0 13. coconut oil. Beverages.6 3. 14.0 17. Sector Orientation.3 3. 2. and mining Management. and Affiliated Bank of Selected Business Groups. telecom. Real estate. 10. Eduardo Cojuangco Lopez Family Group Ayala Corp. 11.5 17. 8.5 13. and tourism Credit card 18.9 2.5 6. 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. and personal care prods Shipping. 3. 9. 17.3 2.5 44. agriculture.1 2. 16.1 4. real estate. 1997 Business Group 19 15 27 12 12 9 4 6 11 4 8 9 5 4 5 6 Major Sector Orientation Estimated No.3 11. of Affiliated Companies Total Sales (P billion) 123.5 49. power.4 6. and food Food.0 5.6 3. and car manufacturing Car manufacturing and real estate Food and telecommunications Department store and real estate Airlines.0 Average Sales Per Company (P billion) 6. Flagship Company.5 46.8 84. 13.6 7.5 47.4 48. and tobacco Telecommunications Cement and construction materials Pharmaceutical and distribution 12.Table 3.2 16. and dairy products Investments.2 1.5 2. food.0 26.7 98.11 Total and Per Company Sales. 7. construction.4 .2 1.1 4.3 15.

4 5. mining. 21.9 1. 33.7 1.7 3. 23.3 7. 26.8 1. and various company annual reports. P.19.0 1.2 1. 38.6 3.5 8. 34.9 6.1 1.6 0.2 4. 4 238 1. distribution. 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. 24.0 2.1 805. 22.6 Fast food Beverages and agro-industrial products distribution Cement and wood products Retail merchandising Electronic appliances Real estate Mining Real estate Telecommunication.0 0.9 0.000 Corporations (1997).8 1. 32.4 3.1 2. 27.2 6.7 0. Ramos Gaisano Family Group Felipe Yap Felipe F.9 1.4 1.7 0. 29.5 2. 31. SEC-BusinessWorld Annual Survey of Top 1. Cruz Jose Luis Santiago Keppel Group Robert John Sobrepeña/ Fil-Estate Group Total Real estate Sources: PSE Databank.6 2. . 20. 30.6 5. 25.4 3.7 0.8 Jollibee Foods Luis Lorenzo Family Group Alcantara Family Group Bienvenido Tantoco Elena Lim Andrew Gotianum Brimo Family Group Andrew Tan J.8 1.3 2. 28. 37.1 1.8 6.9 7.9 1.1 0.7 4.3 2. Enrile/JAKA Group Jaime Gow Guoco Group Jose Go Jardine Davies Gerardo Lanuza Alfredo C. 35. and real estate Retail merchandising Ceramics and real estate Department store and real estate Cement and sugar central Real estate and securities trading Bookstore. 39.0 5.9 0. 36.

Flagship Company. 5. 6. Uytengsu/General Milling Group David M. 2. 10. 15. Sector Orientation. 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. 13. Eduardo Cojuangco Lopez Family Group Ayala Corp. and Affiliated Bank of Selected Business Groups. 20. 7. 8. 4.Table 3. 11. 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. 21. 17. Inc. Long Distance Telephone Phinma Zuellig Pharmaceutical Metro Pacific William Gothong and Aboitiz Swift Foods/RFM House of Investment Anscor Equitable Card Network Inc. 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. 18. 3. 9. Jollibee Foods Corporation Pepsi Cola Products Alsons Cement . 19. 16. 14. Alaska Milk Corporation DM Consunji. 12.11 (continuation) Total and Per Company Sales. 1.

31. 36. 35. Keppel-Monte Bank Bienvenido Tantoco Elena Lim Andrew Gotianum Brimo Family Group Andrew Tan J.. a b Size class is measured in terms of sales: Large = greater than P4. 26. 28. Fil-Estate Development Inc. SEC-BusinessWorld Annual Survey of Top 1. small = less than P1. 34. Refers to commercial banks. Sources: PSE Databank. 30.48 billion. 39. PT&T Corp. . medium = P1.65 billion to P4. and various company annual reports. 38.000 Corporations (1997). 27. 22. Enrile/JAKA Group Jaime Gow Guoco Group Jose Go Jardine Davies Gerardo Lanuza Alfredo C. Ramos Gaisano Family Group Felipe Yap Felipe F. Kepphil Shipyard Inc. 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. unless otherwise indicated. Cruz & Co. 32. 23. F.East-West Bank International Exchange Bank Ecology Bank (Savings Bank) Dao Heng Bank Orient Bank International Exchange Bank International Exchange Bank Philbanking Corp. Inc. 29.65 billion. 37. 25. P. 24. 33.48 billion.

0 38.4 19. telecommunication. 10. 8. beverages. 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. agriculture.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. 4. 11. and bank Real estate.). and car manufacturing Power Refined petroleum products Refined petroleum products Banking.Table 3. construction.6 26.12 Control Structure of the Top 50 Corporate Entities.5 17. 24. and mining Gold and other precious metal refining . 12. banking. Inc.2 16. car manufacturing.6 18.8 53. mass communications.). Beverages. beverages.8 84.5 46. 17. Philippine National Bank Mercury Drug Corp. 18.5 26. Inc. food. food. First Pacific/Metro Pacific Group 21. and telecommunications Department store and banking Airlines. Texas Instruments (Phils. Del Rosario/PHINMA Zuellig Group Toshiba Information Equipment (Phils.1 60. bank. and packaging Power distribution.2 49. 22.2 Business Group Business Group Business Group Government. and personal care products Shipping.5 15. of the Phils.1 17. Fujitsu Computer Products Corp.5 47.3 15. and dairy products Investments.8 22. 6. 9. 14. and food Food.0 37. 19. 15. Aboitiz Family Group Jose Concepcion/RFM Group Alfonso Yuchengco Philippine Associated Smelting and Refining Corp.4 48. 23. 3.5 77.5 44. 13. and real estate Banking. 20.0 24. Eduardo Cojuangco Lopez Family Group Ayala Corporation Group National Power Corp. 5. food. coconut oil. Petron Corporation Pilipinas Shell Petroleum Corporation George Ty John Gokongwei Henry Sy Lucio Tan Ramon Cojuangco Family Group Caltex (Philippines) Inc. 2. power.7 98. 16. 1997 Sales (P billion) Control Structure Major Industrial Orientation 123. 7.

5 8.25. 36. 39. 14.1 9. Philips Semiconductors Phils. PSE Databank.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. 32.5 10.9 7. Corp. 33. W. 48. real estate. Philip Morris Philippines. 27.8 6. Jollibee Foods Citibank N.2 7. radio and remote control apparatus Fast food Bank Beverages and distribution of agro-industrial products Drugs and medicines.4 8. 50. 9. 29. Consunji Uniden Philippines Laguna.7 10. 44.6 9.5 8. 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 1.8 9. 46.290 53. 43.0 13. Inc.000 Corporations (1997). and apparatus for line telephony and line telegraphy Tobacco products wholesaling Cigarettes Radar equipment. Amusement and Gaming Corporation Mitsubishi Motors Phils. Uytengsu/General Milling Group David M.3 8.0 11. and tourism Banking Radar equipment and radio remote control apparatus Operation of rolling mills Palay.9 14. National Steel Corporation National Food Authority Phil. EAC Distributors Inc.0 5. 31. 41. 28.4 10.3 13. corn (unmilled). Inc. 42. 26. and other grains wholesaling Other amusement and recreational activities Motor vehicles Food and dairy products Construction and mining Television and radio transmitters. 34.9 6. 30. Inc.7 10. 37. 49. 47. .6 1.0 12. 35. 40.6 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.A. 45.7 13.. and various company annual reports.000 Companies Sales (%) Cigarettes Bank Soap and detergents Management. including biological products Bank Cement and wood products Retail merchandising Electronic appliances Mining Real estate Sources: SEC-BusinessWorld Annual Survey of Top 1.6 12.9 7.

although public investors held a majority of shares. Actual control of the banks was still held by the groups. . and declaration of cash dividends. The Philippine Corporation Code mandates the board of directors to exercise its control over a corporation. Vol. 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. business groups had only minority ownership.8 The Board of Directors As the representative of shareholders in a company. such as amendments of the articles of incorporation. 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. determination of compensation to board members. accounting and auditing. amendments in the bylaws.186 Corporate Governance and Finance in East Asia. corporate mergers or consolidations. Of course. these were dispersed shareholdings. A total of 44 companies responded to the survey (out of about 221 financial and nonfinancial listed companies). II publicly listed commercial banks affiliated to these groups. investments of corporate funds in other companies or purposes.3. The review is based on an ADB survey of listed companies in the Philippines conducted in 1999 for this study. 3.2 Corporate Management and Shareholder Control The main mechanisms by which shareholders control corporate management are the board of directors. shareholder voting in general meetings and legal protection of their rights. voluntary dissolution. appointment and compensation of senior executives. jointly and individually. removal of directors. However. sale or disposition of a substantial portion of corporate assets. issuance of corporate bonds. Shareholders limit the broad power of the board by ratifying their decisions on critical corporate affairs. They are likewise liable if they pursue financial interests that conflict with their duty as directors. This section reviews practices of corporate management and shareholder control in Philippine publicly listed companies. issuance of stocks. the board of directors plays a crucial role in corporate governance. and financial disclosure. to the corporation and its shareholders for damages caused if they agree to unlawful corporate acts. The Corporation Code holds members of the board of directors liable. approval of management contracts.

board directors were the founder of a company. But half of respondents indicated that they also had board directors directly nominated by controlling shareholders or management. In practice. The ADB survey shows that the number of board directors ranged from six to nine among the responding companies. The majority of respondents indicated that board directors and chairpersons were elected mainly on the basis of either relationship with major shareholders (31. or a per diem for meetings (18 percent). with a maximum of 36 percent. 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. the average number of years of holding office was 6.7 percent). or representatives of creditors. a fixed fee plus performance-related bonuses (30 percent). 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. The longest was 27 years for board chairpersons and 14 years for board directors. The average stipulated term of office of the chairperson and members of the board for most responding companies was one year. According to the ADB survey. or percentages of shareholdings (28. More than half of respondents indicated that board directors were elected during the shareholder general meetings.Chapter 3: Philippines 187 actual practices of board functions and the role of shareholders may diverge somewhat from the legal framework.5 for board members. Respondents of the ADB survey ranked the following as the most important responsibilities of the board: making strategic decisions. or the Government without approval by shareholder general meetings. appointed by the Government. But professional expertise is also an important criterion (28. ensuring that a company follows legal and regulatory requirements. and determining remuneration for board directors and senior management. The ADB survey results show that a chairperson is compensated either by a fixed fee (52 percent of respondents).6 for board chairpersons and 7.9 percent). in a descending order. protecting shareholder interests.7 percent). Such a short tenure may to some extent suggest that large shareholders want to keep their board members under close control. . In a few cases. Board chairpersons in a substantial number of responding companies did not own significant amounts of shares in their personal capacities. appointing senior management. a typical chairperson owned 3 to 5 percent of outstanding shares of a company on average.

II Compensation for the chairperson was determined either by the board (54 percent of respondents). The audit committee selects external auditors. 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. 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. the parent company or company bylaws (21 percent). negotiates the audit fees and scope of audits. When the CEO was not the chairperson. This suggests that large shareholders control CEOs by means other than shareholdings. the chairperson of the board was also the chief executive officer (CEO). or amount of shareholding (15 percent). Ninetythree percent of the respondents had one or more outside directors. Companies may set up special board committees to strengthen due diligence procedures. . namely. large shareholder-dominated companies often view such committees as unnecessary formalities. These committees were established only recently. CEOs apparently cannot increase their shareholdings because family-based owners restrict the number of shares available to management. About half of the active committees were audit committees and the other half nomination committees. Senior Executives The Corporation Code does not specify the role and responsibilities of senior executives. The compensation committee reviews and recommends remuneration plans of key officers and employee stock option plans. and nomination committees. Unlike in Western corporate models. The nomination committee searches and reviews candidates for key management positions. or management (15 percent). A CEO that was not the chairperson of the board was selected on the basis of professional expertise (42 percent of respondents). But the independence of these outside directors is often doubtful. The ADB survey shows that in 41 percent of the responding companies.9 In practice. and reviews the findings of external audits. In the ADB survey. by tenure and compensation. The Corporation Code prohibits the removal of any director without cause if that act would deprive minority shareholders of representation in the board. audit.188 Corporate Governance and Finance in East Asia. In some companies. only 35 percent of responding companies have set up board committees. relationship with controlling shareholders (35 percent). however. Vol. It is also not clear whether the outside directors were elected before or after the financial crisis.

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

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

followed by management and banks.0 48. the successful hostile takeover by First Pacific Group of PLDT. Table 3.0 63.0 51. An average of about 4. An average of 327 shareholders per company attended the last annual meeting and they represented about 63 percent of total shares. Nominees held about 45 percent of the outstanding shares. Yes 100. About 93 percent of the respondents contracted .8 92.13 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.13 summarizes rights that the shareholders of the responding companies enjoyed. The brokers or securities companies were the most important proxy voters. and their activism in the corporate sector.2 43. appointed either by the board or shareholders during the annual general meetings.0 36. 1999.6 Independence of Auditing The ADB survey revealed that all the responding companies had an independent auditor.3 56. protection.8 56.522 shareholders each.900 shareholders per company did not vote during the last annual general meeting.Chapter 3: Philippines 191 in a few controlling shareholders and families.4 percent of shareholders but 58 percent of outstanding shares. representing 3. representing about 24 percent of outstanding shares. a company that is widely held but has a large shareholder.4 No 0.2 69.4 70. The ADB survey provides further evidence on shareholder rights. Nevertheless. demonstrates the feasibility of developing a market for corporate control if publicly listed companies were widely held.2 7.6 30.8 30. The responding companies had on average 43. About 333 shareholders per company voted by proxy.7 43. Table 3.

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

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

Depending on the performance of the company. of Cebu Holdings (a publicly listed government-owned company). an active minority share at 44. at 47. They may have a representative in the board. This is most evident when a minority-owned company transacts with other members of the group where the controlling shareholders hold majority control. II equity investment for public listing. These investments can be classified according to the role of the controlling shareholders in the management of the invested company. Minority-owned companies may also need access to resources of the group. Ayala Corporation. Ayala Corporation’s majority. The stylized features of control structure of business groups in the Philippines can be illustrated by using a leading Philippine family-based conglomerate. Inc.1 percent of Ayala Land. . In a passive minority-owned operating company. controlling shareholders of the parent company may eventually increase their shares to a majority position. Public investors collectively hold a minority of 41 percent. with 59 percent of shares. Some holding companies are not pure holding companies.194 Corporate Governance and Finance in East Asia. financing. minority control at 42. Honda Cars (Philippines). 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 is majority-owned by Mermac. It has a majority control at 71. controlling shareholders of a parent company hold these shares as “strategic investments” that they could increase or reduce depending on business opportunities.2 percent. the parent company plays an active role in management. especially its management. Controlling shareholders gain additional leverage in management control over minority-owed companies. and customers. Selective public listing combined with use of pure holding companies to own and control member companies lead to various organizational structures of business groups. as an example (Figure 3. Ayala Land fully owns Makati Development Corporation and holds a minority stake. namely.. a family-owned pure holding company. and a passive minority investment at 15 percent in Honda Cars (Philippines). They are operating companies but at the same time have majority or minority share ownership in other operating companies. In an active minority-owned operating company. Vol. Ayala Corporation is a publicly listed pure holding company. controlling shareholders of the parent company do not participate in management. active minority or passive minority holdings. The first three companies are publicly listed while the fourth.1).and minority-controlled operating companies are also holding companies.6 percent of Globe Telecom.4 percent of Bank of the Philippine Islands. is privately owned. In cases of minority ownership.

Figure 3.1 Corporate Control Structure: The Case of Ayala Corporation Family Members 100% Mermac.6%) <15% Passive MinorityOwned Pure Operating Company Honda Cars Phils. Inc.44%) >50% MajorityControlled Pure Operating Company Makati Development Corporation (100%) <50% MinorityControlled Pure Operating Company Cebu Holdings. .06%) <50% >15% &<50% Active MinorityOwned Pure Operating Company Globe Telecoms (44.. (47. (15%) MinorityControlled Operating and Holding Company Bank of the Philippine Islands (42.04%) <50% Ayala Corporation >50% Publicly Listed Pure Holding Company >50% MajorityControlled Operating and Holding Company Ayala Land (71. Inc.96%) Privately-Held Pure Holding Company Public Investors (41. Inc.2%) >50% MajorityControlled Pure Operating Company BPI Family Savings Bank (100%) <50% MinorityControlled Pure Operating Company Note: Data as of 31 December 1998. (58.

12 These examples show that even when large shareholder groups are minority shareholders.76%)] [39. and 1999c. Simeon Djankov.7 times 12 . Being in the public utilities sector.14%] / [1.7 times its cash flow rights by virtue of the double layer pyramid structure of the Ayala group. See also Stijn Claessens. Benpres Holdings. Fan. see the World Bank research papers by Stijn Claessens. and a minority-controlled holding company. II Bank of the Philippine Islands owns 100 percent of the BPI-Family Savings Bank. H.5%] [39. however.5% x 14. Simeon Djankov. [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. 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. Rockwell Land.7 times its cash flow rights by virtue of its cross-holdings via Benpres and First Holdings. companies in the Lopez Group are large and minority-controlled.2). Expropriation of Minority Shareholders: Evidence from East Asia.44%] / [25%] = 1. P. 1999b.14%] / [6. defined as control by large shareholders of an operating company through minority ownership by several companies. Joseph P. they exercise far greater control (two to five times more) than they are entitled to by virtue of their ownership rights. Lang: 1999a.44%] / [58.5%] / [(88.8%] 5. [control right] [control rights via Ayala Corporation] = [cash flow right] [cash flow rights via Ayala Corporation] = [42.7 times Ibid. Generally. Who Owns and Controls East Asian Corporations? 11 Ibid. Diversification and Efficiency of Investment by East Asian Corporations. indirect shareholdings do not appear to be a prevalent practice in the Philippine corporate sector.64% +37. Lang. is illustrated in the Lopez Group (Figure 3. and Larry H. a privately owned company. MERALCO. The situation offers large shareholders tremendous incentive to move resources 10 For details.3% x 1. The Separation of Ownership and Control in East Asian Corporations.64%) + (37. Vol. and Larry H. First Philippine Holdings Corporation.10 The Ayala family’s control rights over BPI was 1.196 Corporate Governance and Finance in East Asia.98% x 42. 1998. and First Philippine Industrial Corporation are indirectly held by a majoritycontrolled holding company. P.3% x 5. The control of companies through indirect corporate shareholdings.44%] = [42.11 The Lopez family’s control rights over MERALCO was 5.

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 1.5% First Philippine Industrial Corporation 50% 50% Note: Data as of 31 December 1998.2 Corporate Control Structure: The Case of Lopez Group Public Investors Family Members Lopez.Figure 3.64% MinorityControlled 14.3% 11. Privately-Held Pure Holding Company 88.76% Operating Company MinorityControlled 24.5% Operating Company MajorityControlled Operating Company Rockwell Land Corporation 24.7% 62. . Inc.

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

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. which determines the viability of the rehabilitation plan and appoints a Mancom or a rehabilitation receiver to implement the proposal if approved. Under this mode. 3. In practice. Markets for equity and debt instruments are small and there are serious structural problems that discourage large. Consequently. There are two modes of suspension of payments under PD 902A. including the rehabilitation of the corporation. The borrower will propose a rehabilitation plan to SEC. under which. Commercial banks hold about three fourths of the resources of the financial system.1 Corporate Financing The Financial Market and Instruments The Philippine financial market has remained underdeveloped compared with other countries in the region. This explains why creditors invariably oppose any move by borrowers to file for suspension of payments at SEC.4. a company’s assets are of sufficient value to cover all of its debts. could take an indefinite period.. The corporation continued to be under rehabilitation receivership as of June 1999. it is not clear whether the corporate borrower’s assets are of sufficient value to cover its liabilities. SEC could intervene to avoid asset dissipation. 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. the litigation process. For example. The second mode is for suspension of payments with the appointment of a management committee (Mancom) or rehabilitation receiver. Inc. wait for 14 years from the time the company petitioned for suspension of payments in 1984. PD 902-A granted SEC blanket powers to intervene and adjudicate claims. SEC and the court required that the creditors of BF Homes.4 3. bank credit is the main source of corporate financing. There are no legal or practical limits to the time period of suspension of payments. the borrower requests to defer payments for a certain period to enable it to generate the necessary liquidity. The first mode is for simple suspension of payments. Publicly listed companies do not represent a cross section of the Philippine corporate . Under such circumstances.Chapter 3: Philippines 199 agreement. profitable companies from going public.

Interest rates. especially short-term debt. However. 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. Most companies invested only in projects that met hurdle rates as high as 20 to 30 percent and had short payback periods.14 shows that the average volume of daily trading in 1997 stood at P2. As a result. Foreign portfolio investments also remained small. less exposed to foreign debt. From the 1970s up to the early 1990s. and convertible securities. In part. The crisis affected the Philippine corporate sector. this is because. Korea and Thailand). Equity financing through IPOs was active. and fiscal management were among interrelated factors explaining the underdeveloped state of the Philippine financial market. Korea) ($143 billion). The corporate sector raised a substantial amount of . the Republic of Korea (henceforth.g. II sector. Vol. the country experienced double-digit inflation.000 companies. companies expanded only at a moderate pace. Most publicly listed companies issue only up to 20 percent of total shares to the public. while interest rates were at high levels and volatile. however.4 billion (or $59 million using the average exchange rate). was one of the smallest in the region at $47. about the size of Thailand’s. Of the 221 companies listed in the Philippine Stock Exchange in 1997. inflation. 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 Philippine stock market is not a liquid market. 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.7 billion.5 billion). only 84 had sales large enough to be placed in the top 1. Even in the real estate sector. The market capitalization of the Philippine stock market in August 1997. and Indonesia ($61. The stock market was depressed up to the early 1990s. Equity instruments include common stocks. most listed companies are controlled by their five largest shareholders. and less engaged in risky investments. is far ahead of the flock. compared with Malaysia ($186 billion). Table 3. Malaysia. Foreign funds were wary of the Philippine stock market because of its limited liquidity. but not to the same extent as it did in other Asian economies. the minimum required to qualify as a public corporation. The Government financed its chronic fiscal deficits by issuing short-term Treasury bills.200 Corporate Governance and Finance in East Asia. compared with other economies. They invested in only a few large companies whose shares were relatively liquid. preferred stocks. Philippine companies were less leveraged.

8 102.121.9 1.8 1.2 1.4 9.351.474.5 72.373.7 207.Table 3.7 0.9 608.4 1.3 4.2 0.088.0 0.9 682.2 61.077.2 57.3 0.3 0.8 1.3 314.5 Year 369.1 0.7 2.2 0.8 0.686.0 2.2 3.171.3 2.692.0 0.4 728.421.7 391.4 Ratio of Market Capitalization to GDP 0.1 0.0 1.8 1.0 161.2 ($ million) — — — — 6.9 114.9 2.2 925.0 0.1 88.386.5 1.5 571.9 2.3 59.14 Philippine Stock Market Performance. Source: PSE databank. 1983-1997 Daily Trading Volume (P million) — — — — 129.7 41.3 — = not available.5 26.515.545.5 16.5 12. P billion) Gross Domestic Product (current prices.9 12. Note: Combined transactions of Makati and Manila Stock Exchanges are not available for the years 1983 to 1986. P billion) 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 19. .251.2 1.6 1.3 Market Capitalization (year end.6 261.1 0.5 1.1 5.1 524.2 297.6 1.8 799.1 0.3 158.7 1.2 59.445.248.906.

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

3 0.3 0. . Incremental debt financing ratio (IDFR): ratio of changes in total liabilities to changes in total assets.6 0.5 0. It measures a company’s capacity to finance growth in fixed assets by internally generated funds. By definition.2 0.9 0.2 0.1 0.3 0. All Companies Financial flows data were derived from the SEC-BusinessWorld Annual Survey of Top 1.2 0. It measures a company’s capacity to finance asset growth by equity capital. 1989-1997 Financing Indicators SFRF SFRT NEFR IDFR IEFR 1989 1990 1991 1992 1993 1994 1995 1996 1997 1.5 0.3 0.4 1.4 0.0 0.000 Corporations in the Philippines from 1988 to 1997.0 0.8 0.1 0.6 0. during this period.1 0.4 0.000 Corporations in the Philippines.9 0. It measures a company’s capacity to finance asset growth by internally generated funds. On the other hand.8 0.9 0.5 0.4 0.5 0.1 0. Incremental equity financing ratio (IEFR): ratio of changes in shareholders’ equity inclusive of retained earnings to changes in total assets.2 0. Self-financing ratio of total assets (SFRT): ratio of changes in retained earnings to changes in total assets.15. New equity financing ratio (NEFR): ratio of changes in stockholders’ equity (excluding retained earnings) to changes in total assets.7 0.5 0.3 0.6 0.15 Financing Patterns of the Corporate Sector.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. the SFRT was low at Table 3. It measures a company’s reliance on borrowings in financing asset growth. As shown in Table 3.5 2.4 0.3 0.1 0. Retained earnings were sufficient to finance the entire growth of fixed assets in the corporate sector.5 0.4 0. the average SFRF was high at 109 percent.5 0.4 0.3 0. 1988-1997.8 0. it is one minus IDFR.5 Source: SEC-BusinessWorld Annual Survey of Top 1.5 0.5 0.1 Average 1.2 0.4 0.9 0.

This was mainly caused by the declining contribution from retained earnings.7 0. suggesting that there was a deterioration of financial performance in the Philippine corporate sector in the years running up to the crisis. Corporate Financing by Ownership Type As shown in Table 3.3 0.1 a Excludes negative balances.5 Privately-Owned 0. except for foreignowned companies that had a negative new equity financing ratio. II only 19 percent.3 0. The corporate sector used new equity to finance 32 percent and new debts to finance 49 percent of growth in total assets. .3 0.6 0. Companies financed fixed assets from internal sources in hard times.2 (0. internal funds were not a significant source of financing growth in total assets. with debt providing 93 percent of the financing requirements. Vol.8 0.2 0. when it financed 45 percent of it. the SFRF was higher. debts were the most important source of financing. privately. Source: SEC-BusinessWorld Annual Survey of Top 1. The corporate sector consistently relied on debt and new equity to finance asset growth throughout the period.5 Foreign-Owned 1. implying that internal funds were far from sufficient to finance growth in total assets. In periods of an economic crunch such as in 1989. and 1997. There were significant year-to-year variations.5 0. 1989-1997 Financing Indicators SFRF SFRTa NEFR IDFRa IEFRa a Publicly Listed 1. In all the years. On Table 3. Total assets grew by 23 percent that year. the level of corporate leverage increased.and foreign-owned.000 Corporations in the Philippines.204 Corporate Governance and Finance in East Asia.0) 0.16. 1988-1997. for all three types of companies—publicly listed. Retained earnings were the least important.9 0. 1991.16 Corporate Financing Patterns by Ownership Type. As a result. retained earnings declined and few new equity investments flowed into the corporate sector. 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. except in 1991. reflecting the capital flight caused by political instability in the early 1990s.3 0. In 1997.

0 53.0 1995 1996 13.3 12.9 4. Foreign-owned companies relied more heavily on debt financing.4 100.6 48.3 12.9 16.5 16.8 17.1 9.7 13.7 2.and foreign-owned companies.4 100. contributing 90 percent of growth in total assets.17 Composition of Assets and Financing of the Publicly Listed Sector. compared with 47 percent for publicly listed companies and 55 percent for privately-held firms.9 24.4 41.2 3.0 6.0 12.3 48.3 10.0 10.0 10.6 26.0 13.8 51.Chapter 3: Philippines 205 average.9 12.5 12.4 2.8 39.4 3.000 Corporations in the Philippines.2 51. The sector built up its short-term debts.0 9.0 Source: SEC-BusinessWorld Annual Survey of Top 1.8 0.4 43.8 38. especially bank loans.2 3.1 7.7 13.7 2.4 2.6 48. This financing pattern supports the earlier finding that foreign-owned companies had the highest leverage among the three types of companies.9 0. .0 100.3 10. A breakdown of the financial structure of publicly listed companies measured in balance sheet items is shown in Table 3.1 13.17.2 100.7 4.0 9.1 10.8 100.6 43.0 1993 14.8 4.5 41.9 16.8 3.8 26.0 1994 19.7 100.9 3.1 50.3 11. It presents a composition analysis of assets and financing sources for the period 1992-1996.3 51.7 23.3 13.4 12. 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 14.5 0.8 3. 1988-1997.6 37.9 38. publicly listed companies relied more on new equity financing than privately.1 15.0 8.9 100.2 100.9 16.8 16.1 49.5 9.2 42.0 38.3 12.5 27.0 9.2 12.8 46.4 100. significantly Table 3.8 0.4 10.3 4.4 100.7 7.6 0.0 9.

The normal standard liquid position is a current ratio of 2 or higher.3 0. compared with an average of 54 percent for independent companies. and economies of scale in fund raising. Corporate Financing by Control Structure Conglomerates have certain advantages in financing because of the opportunities offered by the internal capital markets.6 Independent Company 0.18 Financing Patterns by Control Structure. The traditional measure of liquidity. 1988-1997. Further.206 Corporate Governance and Finance in East Asia. their inherent ability to pool risks. .45 in 1996. II in 1996 and became more vulnerable to the financial crisis in 1997. Group companies were generally more profitable than independent companies. indicating that many publicly listed companies were likely to be in a tight liquidity position.2 0. Vol.9 0. Table 3. the easier access to external credit. group companies usually financed their investment in member companies by equity rather than debt.1 0. Group companies financed an average of 45 percent of growth in total assets by debt. respectively. As shown in Table 3.13 was at 1.18. For these two reasons. group companies were less reliant on debt financing than 13 Defined as total current assets divided by total current liabilities. as opposed to 94 and 30 percent.5 Excludes negative balances Source: SEC-BusinessWorld Annual Survey of Top 1.5 0. the average SFRF of business groups was higher compared with that of independent companies.3 0.000 Corporations in the Philippines. 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.5 0. The SFRF for independent companies would have been even lower if the highly profitable foreign-owned companies were excluded. On average. 1989-1997 Financing Indicators SFRFa SFRTa NEFR IDFRa IEFRa a Group Member 1. the current ratio. for independent companies.3 0.

20).5 Excludes negative balances. Source: SEC-BusinessWorld Annual Survey of Top 1.08 and SFRT of 0. These years were 1991 with 110 percent.06.9 0. and 1997 with 131 percent.000 Corporations in the Philippines.Chapter 3: Philippines 207 independent companies.2 0.3 0. 1989-1997 Financing Indicators SFRFa SFRTa NEFR IDFRa IEFRa a Large 0.3 0.5 0. Corporate Financing by Firm Size SFRF was highest for medium-sized companies. medium-sized companies used more debts.88 for large companies (Table 3.3 0.47.50 (Table 3. Excluding . compared with 55 percent for large companies and 47 percent for small ones.19 Financing Patterns by Firm Size. On average. There was also increased reliance on debt financing. with an average of 3. Large companies’ IDFR of 0. equity financed 42 percent of incremental asset growth. averaging 61 percent of growth in total assets.1 0.19).2 0. The corresponding ratio was 0. Table 3. The medium-sized companies’ high debt financing ratio was due mainly to three years of complete reliance on debt to finance growth. These results support the earlier finding that the leverage of business groups was lower than that of the independent companies from 1988 to 1997.4 Small 0.6 0. Corporate Financing by Industry The manufacturing sector had an average SFRF of 1.5 Medium 3. 1988-1997.6 0. 1993 with 96 percent.76 for small companies and 0.8 0.2 0. The lower SFRF for large companies may be caused by their larger outlays for growth in fixed assets. With assets growing at a fast pace during this period. Large firms consistently increased their reliance on debts from 1994 to 1997.55 was substantially higher than the small companies’ 0.

1 0. The situation improved beginning 1994. . The real estate industry financed its growth by substantial equity funds.6 a Excludes negative balances. the manufacturing industry financed 57 percent of its total asset growth by debt.000 Corporations in the Philippines. The construction sector was a heavy user of debt financing.5 0.3 0. Vol. While this level is considered prudent. Incremental equity financing amounted to an average of 44 percent of total asset growth.3 0. increasing to 0. The utilities sector showed weaknesses in internal fund generation in 1989-1994. II 1991.4 3.4 0. the industry generated internal funds. Up to 1997. the total debt ratio was much higher in 1996 at 0. the incremental equity ratios of the industry were high. Since the real estate boom coincided with that of the stock market. Excluding 1997 when fixed assets declined. Table 3.4 0.32. many of the leading real estate companies successfully went public during that time. The sector had the highest leverage among all industries that year. In the eight years preceding the crisis. Low incomes diminished the equity financing position of the manufacturing industry toward the crisis year.3 0. debt financed about 78 percent of asset growth in real estate.5 (0.6 0.6 0. Equity financed an average of 62 percent of total asset growth.47 two years later.208 Corporate Governance and Finance in East Asia. SFRF for the sector averaged 0.04. Source: SEC-BusinessWorld Annual Survey of Top 1.3 0. achieving an average SFRF of 3.5 0.7 0. Its SFRF and SFRT were volatile because of chronic losses and reduction in fixed and total assets. Total liabilities increased partly as a result of the local currency devaluation and financed all of asset growth for the year. 1989-1997 Financing Indicators Manufacturing SFRFa SFRTa NEFR IDFRa IEFRa 1.29.4 0. when debts declined. ranging from 41 to 118 percent. with an SFRF as low as 0. while SFRT averaged only 0.27.58 and SFRT of 0.5 Utilities and Real Estate Services and Property 0.20 Financing Patterns by Industry. During the crisis year.6 0.79 and in 1997 at 0. The effects of the crisis of 1997 were adverse. Equity financed the rapid expansion in the industry’s assets in the period 1994 to 1997.2) 0. 1988-1997.91.4 Construction 0.

230 Leverage 0. These results suggest that companies with higher ownership concentration tend to be more highly leveraged and. Source: Author’s estimates based on the PSE databank. Large shareholders may also overuse financial leverage to avoid diluting ownership and control.3 Ownership Concentration.287 0.14 Large shareholders may borrow excessively to undertake risky projects.008 5. ownership concentration = the total shareholdings of the top five shareholders. As shown in Table 3.Chapter 3: Philippines 209 3. ROA. alternatively. Exit.769 0.4.004 3.009 5.00125 2. and Financial Leverage Dependent Variable Item Coefficient of Ownership Concentration T-statistics Adjusted R-squared F-statistics ROE 0.21. the degree of ownership concentration. as the dependent variable.130 ROA 0. ROE = return on equity. and Performance Previous studies on corporate governance have often associated ownership concentration with heightened risk-taking by companies. ROE. at the same time.21 Ownership Concentration. while if it fails. Using the PSE database.860 Leverage = the ratio of total assets to total equity. Profitability. Three regressions were run with the shareholding of the largest five shareholders as an independent variable and ROA. and leverage. creditors bear the consequences.00056 1. and financial leverage are all positively and significantly related to the degree of ownership concentration. and the Failure of Internal Control Systems. more profitable. Table 3. Financial Leverage. was regressed against measures of profitability and of financial leverage.421 0. ROE. 14 See for example Michael Jensen (1993). The Modern Industrial Revolution. measured by the percentage of shareholdings of the largest five shareholders.00036 2. Journal of Finance 48: 831-880. ROA = return on assets. 1992-1996. the coefficient of the ownership concentration measure in all the three regressions is positive and statistically significant. . knowing that if an investment turns out to be successful they could capture most of the gain.

8 percent of GDP from 1995 to 1997. and agriculture at 21 percent. In sum. their growth gathering momentum only beginning in 1992. the growth in foreign investments fueled that of the manufacturing and services sectors in the years preceding the crisis. Garments was the second largest export sector at about 9 percent. Net trades in goods and services averaged a deficit of 4. Although much lower than those of other Asian countries. industry at 34 percent. notably remittances of overseas workers. The Government explained that the country had “sound economic fundamentals” but that the problems were caused by “contagion. The largest contributors to GDP were services at 43 percent. an overexpansion of capacities. 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. II 3. the economy still showed vestiges of its import-dependent and substituting character. Historically. Because of limited local capital. the country’s GDP growth pace indicated that it did not have a “bubble economy. which averaged 4. Net investment inflows were $3. Compared to other East Asian crisis-affected countries. The export sector had a very narrow breadth. raw materials. The structure of the economy may be understood by looking at its sectoral composition and export competitiveness. Manufactures accounted for about 85 percent of exports.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 1997.210 Corporate Governance and Finance in East Asia.5. About 80 percent of imports were capital goods (particularly power generating and telecommunications equipment).5 billion in 1996 and grew at an average of 48 percent per annum from 1992 to 1996. with commodities accounting for the balance.5 percent per year from 1992 to 1997. The country experienced balance of payments surpluses but these were due to transfers. Commercial and industrial activities in the country were largely oriented to domestic markets.” The Government’s judgment that economic fundamentals were strong was based on stable growth rates. more than half (52 percent) of exports were semiconductors.5 3. Exports were growing at about 20 percent per year in the three years preceding the crisis. with a narrow exporting industry base. the country was less dependent on foreign private capital. and intermediate goods. After a . In 1997. Vol. foreign investments in the country have been low.” that is. but its share had been declining by 4 percent per year since 1995.

Total debts were only 52 percent of assets or 108 percent of equity.3 percent. which. The corporate sector was in a relatively stable financial condition around the time of the crisis. the country and the corporate sector had no access to foreign currency debts from the international financial market. Five years of stable growth before the crisis enabled the country to build its net international reserves to $10. 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 Government restructured its debts into longer tenors with a maximum of 25 years. an average Treasury bill rate of 13. The Central Bank conserved international reserves by allowing the local currency to float within a wider trading margin.Chapter 3: Philippines 211 long period of debt moratorium and restructuring that started in 1983 and ended in 1991. Prudent fiscal management and controls on foreign borrowings were part of the adjustments required by IMF and foreign creditors. in turn. resulting in stability in the short-term debt to reserves ratio. while sales grew by only 20 percent per year.6 billion as of March 1997. however. During this time. . Closer analysis. From 1988 to 1996. depended on the quality of the corporate sector’s investments.1 percent. a government fiscal surplus from 1994 to 1997. average ROE was 13. unlike their counterparts in the region. In the Philippines. Economic performance during 1992-1997 was characterized by an average growth rate of real gross national product (GNP) at 3. After hovering in the range of 100 to 127 percent. From 1993 to 1997. assets grew at a compound annual rate of about 31 percent. Profitable operations since 1992 had allowed it to build equity. the ratio of short-term debts to international reserves dipped below 100 percent beginning June 1998.5 percent. adjustments were focused on the quantity and quality of the banking system’s corporate loans.8 percent. The lessons from debt restructuring became the basis for the Government’s economic policies. Financial institutions called on their shortterm loans and shortened the maturity of existing loans. 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. the Government sought stability and achieved this in 19921997. shows that investments of the corporate sector were growing at a faster rate than sales revenues in the years immediately preceding the crisis. and a relatively healthy banking system. a positive balance of payments from 1992 to 1996. Eventually. fueled also by successful IPOs during the stock market boom of 1993-1996. an average inflation rate of 7. Since the regional financial crisis was triggered by the loss of confidence in some East Asian economies by foreign creditors and investors.

or 114 percent of net foreign direct investment (FDI). It rose to $2. The debt level of the Philippine corporate sector in 1997 was low by Asian standards but still high by developed country standards.749 26.4 1997 762 1. net FDI remained stable at more than $1 billion. Data for 1998 cover only January-August. It financed 26 percent of corporate capital growth. the other immediate impact of the crisis was that on foreign investment flows.101 92. Sources: Bangko Sentral ng Pilipinas and SEC. . 1995-1998 Item Net Foreign Investments ($ 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.” 3. 1996 = 26. 1998 = 41. These patterns in investment and financing are similar to those of other countries in the region. In sum.5 billion in 1995. Most of this leverage happened during the boom years in the region.517 1. Vol.303 23. growing by about 34 percent per year from 1994 to 1997.5.212 Corporate Governance and Finance in East Asia.06.22 Foreign Investment Flows.485 145. Foreign investments in the Philippines have not been as high as the inflows to other Asian countries—and this.22.101 billion or 196 percent of net FDI in 1996. 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. precisely.22).0 1998 739 555 328 69.718 30.2 Impact of the Crisis on the Corporate Sector Aside from the foreign exchange adjustment.47.073 (406) 121. It is understandable then that the effect of the Asian financial crisis on the Philippines was correspondingly that of a negative “contagion.7 Note: Peso-dollar exchange rates used are: 1995 = 25. Debts financed a large part of this expansion. but to a lesser degree. 1997 = 29.650 32.0 1996 3. Net foreign portfolio investment amounted to $1. II The corporate sector indeed overexpanded after 1993 like its counterparts in the region.300 1. In 1997.609 1. mitigated the effects of the pullout and liquidation of investments in the aftermath. But portfolio investment amounting to $406 million flew out of the Philippines.074 2.71. Net foreign investments more than doubled from 1995 to 1996 but declined by 78 percent in 1997 (Table 3. Table 3.

2 to 28. The banking system was able to absorb the impact of the crisis primarily because of its strong capital position.2 percent in November 1997. Bank loan pricing was based on the bellwether 91-day Treasury bill rates rather than inflation. then rose to a high of 22. with commercial banks holding P2. Manufacturing reduced its loans outstanding by 11 percent from October 1997 levels. meanwhile. Bank spreads over Treasury bill rates increased in 1997 but were within the range experienced in the past. the corporate sector became vulnerable to loan calls and high interest rates. Because commercial banks were strongly capitalized.7 percent in January 1998. in turn. sparking a rise in interest rates on corporate loans. the commercial banking sector’s capital remained strong at 17. in varying degrees for each sector. they were willing to restructure and renegotiate existing loans by corporate borrowers.369 billion.3 percent of assets. By October 1998. A number of small banks closed but they represented less than 1 percent of the financial system’s total resources. Because of weak internal fund generation. By March 1988. The resources of the financial system that year totaled P3. Net profit margins were at a 10-year low at 4. When the Treasury bill rates eased in March 1998.2 percent was barely above inflation rate. they could not initiate a large reduction of their loans because these in part financed long-term growth in assets. the sectors with the highest outstanding loans had reduced their credit exposures. Lending rates were well above the 20 percent level from July 1997 to March 1998. ROE at 6. The combined effects of shrinking demand and high interest rates reduced the corporate sector’s demand for loans. lending rates also came down. Loan calls. albeit at current market interest rates. new borrowings financed asset growth. The real problem of the corporate sector during the crisis was the rise in interest rates. Average bank lending rates climbed to their peak of 25. depended on the liquidity and capital position of commercial banks.513 billion. which held about 75 percent of the assets of the financial system in 1997. Although corporate borrowers were not highly leveraged.Chapter 3: Philippines 213 Corporate financial performances and conditions deteriorated during 1997. suggesting that commercial banks required a higher premium at about the height of the crisis but not beyond. Loans outstanding of commercial banks declined by the first quarter of 1998. The interest rates on Treasury bills. With the increase in borrowings and reduced liquidity. Companies deferred investments in new fixed assets. and leverage increased to 149 percent compared with 109 percent in 1996. and the wholesale and . ranged from 11 to 13 percent from 1993 to July 1997.9 percent.

The Central Bank adopted other measures to strengthen the financial system. As for nonperforming loans (NPLs). Still. The latter measure was especially beneficial to companies with unhedged foreign currency loans from commercial banks. But the Philippine banking system had gone through worse crises in the past. single-digit NPL ratios began only since 1989. This allowed the Central Bank to convince the banks. The pattern indicates that real estate loans were of substandard quality but banks had contained the problem by mid-1998. However. II retail trade sector. These figures show that adjustment problems were industry-specific and that the real estate industry. by 12 percent. The Central Bank introduced regulations on foreign exchange trading to control speculation and nondeliverable forward contracts.6 percent in June 1998. real estate loans averaged 11. set limits on overbought/oversold foreign exchange positions of banks. The move retained the liquidity position of banks but lowered their cost of reserves. and subsequently went down to 13. and set up a hedging facility for borrowers with foreign currency-denominated loans.9 percent of bank loan portfolios.3 Responses to the Crisis Government Responses The Government’s policy and regulatory responses to the crisis focused on monetary and credit issues. including (i) a regulatory limit of 20 percent on banks’ loans to the . as with its counterparts in other Asian countries. Vol. and the financial system.5-6 percent.214 Corporate Governance and Finance in East Asia. 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. These peaked at 14. was a problem sector. thereby reducing overall intermediation costs. 3. In March 1997.5 percent by September 1998. the fiscal position. 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.3 percent in December 1997. This “voluntary agreement” partly explains why the loan spreads of banks were within the range of recent experience. and its experience of low.5. 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. to reduce their lending spreads over the 91-day Treasury bill rates from 3-8 percent to 1. through the Bankers’ Association of the Philippines.

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

Although considered the prime industrial company in the Philippines. is whether there are sufficient safeguards to prevent controlling shareholders from . II of investing to control companies that are dominant players in their industries.1 Summary.6. In a legal process that ended in his takeover of management. the Cojuangcos. using some or all of these means.6 3. Corporate governance is conditioned by the high ownership concentration of these large companies. Conclusions. concentrated ownership of companies is not equivalent to weakness in corporate governance. Eduardo Cojuangco was able to assert his ownership of shares taken over by the Government during the transition of power in 1986. 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. Ownership is highly concentrated and a few dominant players control major industries. however. A third method was to make a formal tender offer to PLDT’s controlling minority shareholders. SMC is another widely-held company managed by a minority shareholder. First Pacific. SMC had lagged behind other groups of companies such as Ayala Corporation in financial performance for some years. the Soriano family. 3. the stock price of PLDT was buoyant during the takeover period. A second method was to purchase the shares of other large minority shareholders. The question. 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. Consequently. By itself.216 Corporate Governance and Finance in East Asia. When companies are highly profitable. 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. controlling shareholders can capture these profits by excluding public investors from ownership. at a premium over the market price to reflect the value of management control. First Pacific could have acquired sufficient shares to take control of PLDT in three ways. eventually took over PLDT and announced a restructuring plan for the entire group of companies. When Cojuangco took over. One mode was the outright purchase of shares in the open market. Vol.

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

statistical analysis of company-level data revealed significant relationships between corporate performance and corporate governance. and sustained growth. 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. and leverage were all positively related to the degree of ownership concentration. A business group is an effective business organizational model for achieving leadership in industries. Such structures result in control by large shareholders through disproportionately smaller investments in equity ownership. Large. as typified by the Ayala Group. 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.218 Corporate Governance and Finance in East Asia. ROA. . Companies whose large shareholders have higher degree of control tend to borrow more but generate better returns. After controlling for industry effects. the bank usually accounted for a large share of each group’s net profits. and the extent of supervision of outside institutions such as independent auditors and SEC. superior profitability. Vol. II type gave similar results. the amount of pressure from stock market investors and PSE (for publicly listed companies in the group). The extent of governance problems depends on internal control policies of the controlling shareholders. family-based shareholders gain control by such means as the setting up of holding companies. Business groups with pyramiding structures heighten the issue of corporate governance. Publicly listed companies were responsive to investors’ requirements for prudent use of debts. The difference between management control and ownership rights is usually substantial. Large companies owned or controlled by business groups tend to dominate their industries. A commercial bank is an important part of most business groups. Internal financial markets operated by business groups allowed them to optimize their financial resources at lower external debt levels. Even in cases where the group owned only a minority share of a commercial bank. Ownership concentration was positively related to both returns and leverage. and centralized management and financing. The pyramid model is useful for centrally managing smaller companies. Family-based business groups have focused their investments in industries where their superior financing capacities and political/social influence give them unique advantages. with the foreign-owned companies found to rely more on borrowed funds. selective public listing of companies in the group. ROE.

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

Another measure would be to impose a statutory limit on the number of directorships that one can accept. To help ensure this. 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. depending on the size of the company. Vol. and self-dealing. This may limit current practices of appointing prominent individuals and family members as directors. Clear legal accountability is a precondition for successful shareholder activism. SEC should strengthen disclosure requirements by issuing specific guidelines on minimum disclosures required for related party transactions. It has suffi- . the PSE Listing Rules require the appointment of a minimum number of independent directors in the board of publicly listed companies. inadequate disclosures. insider information. to 25 percent. 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. and (iii) increase the minimum required percentage of outstanding shares for public listing in the stock exchange from the present 10-20 percent. To strengthen the board. Increasing the Statutory Accountability of Directors and Strengthening the Board System The Government should clarify statutory fiduciary responsibilities of the board of directors.220 Corporate Governance and Finance in East Asia. II ers often cause wide volatility in stock prices and invite reaction from creditors. they serve to curb the powers of controlling shareholders. (ii) require disclosure of material changes in ownership. Because independent directors tend to adopt the perspective of minority shareholders in board decisions. 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. This will enable SEC to enforce prudential requirements on management of companies and enable minority shareholders to pursue grievances against their boards. The adjustment should be made over a fixed period of time.

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

The other is the addition of provisions in the Corporation Code to facilitate class action suits against corporate directors.222 Corporate Governance and Finance in East Asia. Other investors benefit from the information that analysts produce for these institutional investors as information technology makes their output a public good. By supporting the establishment and operation of institutional investors. Managements find that their investment and financing decisions affect stock prices and become aware of their responsibility to create shareholder value. an active financial analyst community can begin to form. II proper rule. 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. management. institutional investors lead public investors in providing market signals to companies. Investment and venture capital funds meet this description. foreign ownership of banks. SEC appears to be taking a primarily regulatory posture in the operation of investment funds. 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. SEC and PSE can help ensure that these external control agents provide market discipline even in companies controlled by large investors. This way. institutional investors can be a driving force in providing market discipline to management. In developed capital markets. The current law should expand class action suits to include management and . Presently. 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. Institutional investors impose market discipline by voting on strategic corporate decisions. and external auditors. and lending to DOSRI. transparency. Vol. One is improved transparency and disclosure on specific items that potentially involve expropriation of wealth of minority shareholders. Its priority is to protect prospective fund investors from unscrupulous fund managers. If institutional investors are present. Two measures should be adopted to promote shareholder activism. The absence of institutional investors indicates that the legal and regulatory basis is inadequate.

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

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

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

Agency Problems. XXIX. Dennis Gromb. Dennis. Working Paper. P. George. 1998a. and Atulya Sarin. . Fan. 1997. Stijn. Diane K. H. Asian Development Bank. Who Owns and Controls East Asian Corporations? Discussion Paper 2054. Key Indicators of Developing Asian and Pacific Countries 1998. Lang. Thailand: From Financial Crisis to Economic Renewal. Working Paper 2088. 1989. Burkart. Joseph P. Barclay. Quarterly Journal of Economics. Bangko Sentral ng Pilipinas. Thailand’s Corporate Financing and Governance Structures: Impact on Firms’ Competitiveness. Stijn. Claessens. July. Monitoring and the Value of the Firm. Journal of Political Economy 93 (6). Journal of Financial Economics 25: 371-395. Lang. H. 1999.. Discussion Paper. 1985. David J. The Structure of Corporate Ownership: Causes and Consequences. Lang. 693-728. P. Asian Industrializing Region in 2005. and Larry H. Emilio. Harold. Tokyo: Institute of Developing Economies. Claessens. Simeon Djankov. and Simeon Djankov. 1999. Lang. and Larry H. World Bank. 1998. Joseph Fan. and Larry H. and Clifford Holderness. Fan. P. Private Benefits from Control of Public Corporations. Stijn. Journal of Finance 2 (1). Claessens. Expropriation of Minority Shareholders in East Asia. Joseph P. Vol. Lang. Simeon Djankov. The Separation of Ownership and Control in East Asian Corporations. and Corporate Diversification. Stijn Claessens. May. World Bank. Simeon Djankov. Denis. 1994. Conference on Thailand’s Dynamic Economic Recovery and Competitiveness. 1998. Institute of Southeast Asian Studies. The Philippines: Onward to Recovery. Simeon Djankov. M. World Bank. Michael. P. 1997. Manila: Asian Development Bank.226 Corporate Governance and Finance in East Asia. Philippine Macroeconomic Prospects: The Next Ten Years. Ownership Structure and Corporate Performance in East Asia. 1998c. Stijn. and Larry H. and Kenneth Lehn. Simeon Djankov. Claessens. Large Shareholders. Pedro. H. Jr. Antonio. Joseph P. Stijn.. 1999. Fan. Working Paper. World Bank. and Fausto Panunzi. Claessens. October. 1998b. Demsetz. and Larry H. Vol. March. edited by Toida Mitusuru and Daisuke Hiratsuka. World Bank. II References Abonyi. P. Diversification and Efficiency of Investment by East Asian Corporations. Alba. Equity Ownership. 1988.

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

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

The study then considers policy recommendations with emphasis on corporate governance improvement. focusing mainly on the companies listed in the Stock Exchange of Thailand (SET).2. 4. while new industries were encouraged to reduce the need for imports. as well as its legal and regulatory framework. Import tariffs on machinery and heavy equipment were removed. Section 4. Vol.1 Overview of the Corporate Sector Historical Development The corporate sector has long been considered the engine of Thailand’s economic growth. The National Economic and Social Development Board was created to plan the country’s economic and social development. Section 4. the Government implemented major infrastructure projects and modified its tax policy to encourage capital investment and savings. Section 4.2 4. . II There is now a consensus that weak governance was partly responsible for the corporate sector’s poor financing and investment practices. Section 4.230 Corporate Governance and Finance in East Asia. Key factors that led to weak corporate governance include the ineffectiveness of the regulatory framework. To protect domestic industries. lack of transparency and adequate disclosure. This study examines these and other factors that might have weakened corporate sector governance in Thailand.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. with government policy providing support but avoiding direct interference.5 discusses how the corporate sector contributed to the financial crisis and looks at its impacts. and a family-based corporate ownership structure. The country initiated national economic development planning in 1961 when the economy was growing rapidly.2 discusses the development of the Thai corporate sector under the National Economic and Social Development Plans. the Government increased tariffs on products that could be produced locally. its growth and financial performance. The First and Second Plans (1961-1971) Under the first two plans.3 looks at corporate ownership patterns that resulted in inadequate protection for minority shareholders and weak corporate governance in Thailand.

But the sustained importation of heavy machinery and equipment resulted in large trade deficits. the current account registered a surplus in 1986. The Government had to shift emphasis to restoration of economic stability. and reduced current account deficits. Industrial sector growth was also rapid and many industries (tires. Budget deficits remained a major problem during the Fifth Plan. the Government borrowed $6. Budget deficits also increased throughout the Fourth Plan. Unemployment.3 percent in 1974. including a weakening of the dollar. the government’s debt burden escalated. it proceeded with its development plan for the industrial sector.Chapter 4: Thailand 231 During this period. and Fifth Plans (1972-1986) An economic downturn at the end of the Second Plan led to an adjustment in policies. leaving the Government no choice but to resort to overseas borrowings. especially foreign aid from the United States. Fourth. The decline in imports was steady. At the same time.4 percent of GDP. chemicals. processed steel. gross national product grew by about 7 percent per year. and increases in world food and oil prices. To close the fiscal gap. averaging 1. canned foods. however. textiles. became a major problem as domestic investment declined. As a result. using tax policy to control prices of consumer goods and implementing several price control measures to curb inflation. Average growth for the period was 4 percent per year. However.15 billion per year or 4. External factors. with the agricultural sector the major contributor. Consequently. The results were increased exports. The Third. however.6 percent per year. remaining high until 1981.4 billion from overseas and increased taxes on numerous items. and automobile assembly) emerged. an improved trade balance. .5 percent in 1973 and 24. helped offset these deficits. capital inflows. The Government decided to embark on restructuring measures in the Fifth Plan (1982-1986) to rehabilitate the ailing economy. The average budget deficit reached an all-time high of $2. with the devaluation of the baht in 1984 a major step in this direction. Thus. the industrial sector grew at a faster rate than the agricultural sector. resulted in increases in the current account deficit. The focus shifted to export promotion. Inflation levels were low. lower than anticipated due to a worldwide economic recession. the value of the baht remained stable. including luxury goods. Inflation reached 15. In the wake of lower world oil prices and the rapid growth in income from the tourism and travel industry.

8 percent. Average annual growth in real GDP was 8 percent. respectively.2 and 13. Growth rates during 1987-1991 ranged from 9. United States.4 percent targets. China—went to export-oriented manufacturing industries. On top of its predominantly “borrowed” nature. Vol. Growth of exports and imports averaged 14. From 1989. The country’s high ratings in the international capital market.8 percent. By 1995. and the stock market. reaching an annual inflow of $2 billion in 1991. With loans increasingly becoming expensive and hard to come by due to a lending squeeze by the central bank and high interest rates. and Hong Kong. increasing its share in total export value from 42 to 76 percent. the property sector began to collapse in 1996. rather than to productive activities. the bulk of domestic investments went to speculative ventures such as real estate. property development. the Government successfully balanced the budget and even settled its foreign debt of $4 billion before this was due. Inflation was 4.6 percent target of the Seventh Plan. from only $31 billion in 1992.2 percent target.6 percent.5 percent.7 and 11. Thailand became a debtor’s market. Key to this growth performance was the government’s adoption in 1993 of an aggressive program for attracting foreign capital to finance domestic investments. II The Sixth Plan (1987-1991) Industrial sector productivity improved gradually during the Sixth Plan period. The exchange rate was steady at around B25 to the dollar.2 percent per year. Singapore. invited a deluge of capital seeking profitable investments. The Seventh Plan (1992-1996) The economy’s performance from 1992 to 1996 generally met the targets of the Seventh Plan. better than the 5. compared with the 14. with private foreign debt reaching $92 billion by the end of 1996.5 to 13. Europe.232 Corporate Governance and Finance in East Asia. compared with the 8. Private sector investment grew at an average annual rate of 7 percent. combined with its liberal financial policies. Most of the FDIs—originating mainly from Japan. while exports expanded considerably. . The manufacturing sector became a dominant force in the economy. an oversupply of housing emerged. averaging 10. lower than the target of 8. The country also attracted a large amount of foreign direct investments (FDIs). compounded by a slump in property sales. Thailand’s rapid growth up to the mid-1990s made the country one of the world’s fastest-growing economies.

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

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

Thailand. Real Estate. and Communication Financing.0 19.291. The stock market boom from 1991 until the financial crash of 1997 reflected international investors’ response to Government policies.0 Paid-up Capital (B billion) 1.3 83. Hunting. The result was a corresponding growth and development in Thailand’s capital markets. and Business Service Community. The majority of the companies are in manufacturing.6 23.5 791. . Financial deregulation and liberalization were key to realizing that vision. and Fishing Mining and Quarrying Manufacturing Electricity. The manufacturing sector is a far second with registered capital of B350 billion and paid-up capital of Table 4. and Restaurants and Hotel Transport. Worldwide.Chapter 4: Thailand 235 fast-growing neighbors.1 78. and wholesale/ retail trade and restaurant/hotel sectors.3 Growth and Financial Performance Since the 1978 enactment of the Public Limited Company Act.4 trillion in registered capital and B791 billion in paid-up capital.9 1.1). the financial sector is the largest.5 111.394. Ministry of Commerce. 1978-2000 Number Registered of Capital Companies (B billion) 5 6 245 5 13 129 22 194 42 661 1.9 261. about 661 companies with total registered capital of B2.9 16.6 1. Forestry.0 21.2. Source: Department of Commercial Registration. Storage.6 350. however.101.2 11.9 34. 4. and Water Construction Wholesale and Retail Trade.5 50. In terms of capital. finance.3 trillion have been registered with the authority (Table 4.1 trillion and paid-up capital of B1.1 Public Companies Registered.6 2. Social and Personal Service Total Note: The data for 2000 is as of October 2000.1 30. the country became recognized as an economic development model for other emerging economies. 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. Gas. in that order. with B1. Insurance.2 Type of Business Agriculture.0 110.

Table 4. Source: Key Capital Market Statistics.0 1994 82.7 27. respectively.6 39.2). this was due to the recapitalization of commercial banks in compliance with the new loan provisioning requirement.1 — — — 6. Securities and Exchange Commission of Thailand. reducing the value of offerings to a little more than a quarter of the previous year’s level.8 billion.2 Public Offerings of Securities.7 5.3 22.7 7.4 34.4 96. the year before the crisis struck. The preeminence of the financial sector is a direct result of financial deregulation and liberalization.1 286.0 20.4 51.1 2.5 1.8 — 26. Vol. The development of the corporate sector closely followed the development of capital markets. The signing of Article VIII with the IMF.1 599. moreover.6 7.5 billion and B1 billion the previous year. from only B20.2 5. Domestic and offshore debt issues reached B54.5 — — 56.3 31. allowed Thai financial institutions and corporations to obtain funds overseas. With the enactment of the SEA of 1992 that brought suppliers of finance services and their clients together.2 12. reaching a precrisis peak in 1996 (Table 4. The stock market also became an invaluable source of funds for corporations.5 39.6 8.0 0.7 billion and B27. II B261 billion. 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 1.6 174.7 136.9 31. The 1997 crisis battered the primary market for securities. meanwhile.6 — = not available.7 billion in 1996. the capital market became instrumental in the rapid growth and development of the corporate sector. While a rebound was apparent beginning in 1998.9 1998 1999 15. reached . the value of public offerings rose steadily.8 151. The number of listed companies and securities steadily increased until 1996 (Table 4.236 Corporate Governance and Finance in East Asia.8 1995 64.7 9.2 25.3).9 37.3 194. These peaked at B89.8 201. After the passage of the SEA of 1992.1 54.5 1.3 1996 1997 65. Market capitalization.4 277.2 40.3 6. Debt market activities also increased significantly with the establishment of the Bond Dealers’ Club (BDC) in 1994.

Chapter 4: Thailand 237 Table 4. From 10. gross profit margin rose until 1991 before falling in 1992. had been on the rise throughout the 1980s.4 percent to 5. Source: Securities and Exchange Commission of Thailand. when long-term debt grew as Thai corporations began to borrow heavily to finance growth. in the end. ROA dipped from 10. Throughout the 1990s. their share rising from 17 percent in 1993 to 43 percent in 1997.3 percent in 1989 to 3. The key financial ratios of all companies listed on SET bear this out (Table 4.4). not all public companies are listed on the SET. its high point in 1995 at B3. resulting in their inability to fulfill debt obligations. and gross profit margin.360 1. But instead of shifting to a low gear. the average times interest earned (TIE) was down to 5. the highly liquid financial system continued offering cheap funds to sustain corporate sector investments. however. was the ominous deterioration in the key financial ratios of publicly listed companies. The upward trends for ROE and ROA continued through 1989.201 2. as measured by return on assets (ROA).5 at its peak in 1987. Meanwhile. Corporate profitability.133 1.268 2.4 percent in 1996. return on equity (ROE).114 1. ROE similarly fell from 21. The plunge in profitability and asset turnover—from 117 percent in 1985 to 65 percent in 1996 for the latter—cast doubts on the . corporate profitability had been declining.560 1.6 trillion.565 2.1 by 1996. the companies could not generate enough net returns from their assets and equity.303 930 855 1.8 percent. While the decline in gross profit margin was not as sharp. Side by side with this surge of financing for corporate growth.301 3. By the early 1990s. then stalled in 1990. pulled down by active public offering activities.535 1.325 3.193 2. The financial leverage of all companies declined until 1994. the averages for all three profitability ratios took a downswing all the way until 1996. 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 3.610 1. The trend reversed in 1995. Foreigners accounted for an increasing proportion of SET’s turnover value.281 832 373 356 482 Due to listing requirements and other reasons.683 1.3 Statistical Highlights of the Stock Exchange of Thailand. however.

0 139.6 27.1 16.9 14.7 5.6 125. was felt across industries.7 4.7 5. but was most severe in building and furnishing material industries as a result of the downturn in the real estate market.3 12.6 41.7 LongTerm Debt to Asset Assets Turnover (%) (%) 14.7 12.6 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. Severely affected by global competition throughout the decade.4 34.5 51.6 138.5 63.4 44.5 9. They were generally more efficient in managing their assets and .6 36.2 10. Hotels and travel showed the highest ROE of 15 percent while textiles.7 20.4 12.0 125.9 7. Korea and Thailand had the highest debt-to-equity ratios.5 52.4 24.8 5.1 114.4 51.4 7.238 Corporate Governance and Finance in East Asia.8 151.3 8.9 27.9 77.9 8.7 35.4 18.5).4 28.7 12.4 26.1 60.7 12.2 10.2 27.1 242. Vol.6 12.0 63.1 44.2 64. the textiles.4 12.1 9.4 4.2 215.8 54.4 3.8 5.6 168.7 27. II Table 4.4 139.0 7. It has also been argued that family-based controlling shareholders borrowed excessively to avoid diluting their control over their corporations. 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 (%) (%) (%) 3.3 91. was also distinct in the region.8 88.8 14.9 140.2 35.2 161.5 50.9 7.8 8.8 25. resulting in higher collateral values for borrowers.7 12. Among the crisis-hit countries.7 34.5 15.2 10.7 5. Thailand’s ROE.0 29.8 51.3 4.7 80.4 47.4 9.4 Key Financial Ratios of Publicly Listed Companies.3 10. clothing.4 5. which was particularly significant in the two years preceding the crisis.0 3.0 117.7 15.2 27.2 6.7 54.0 145. these companies opted for debt. A major reason for this was the rapid rise in asset prices.8 11.6 7.4 119.7 27.2 49. Despite the availability of the equity market.9 66. Overall. which fell from 16 percent in 1991 to just under 6 percent in 1996. practice of heavy borrowing.7 21.9 144. The downtrend in corporate profitability.9 51.1 120. and footwear industries also experienced losses.5 38. US.7 59.9 39.1 52. and footwear had the lowest at 11 percent. large companies (where size is reckoned in terms of assets or sales) were more profitable than small companies in terms of ROE (Table 4. clothing.1 16.5 30.4 7.

5 Average Key Financial Ratios by Company Size. by the 1990s. . Cumulative voting.0 83.2 121.4 Legal and Regulatory Framework Before 1992.8 6.6 31.3 23. also deteriorated. They also tended to use more financial leverage than small companies as their total DERs show.6 7. the Public Limited Company Act of 1978 and its amendments regulated Thai publicly listed companies.3 88.5 94. However.6 12.5 87. Although stable in the 1980s. it was thought.6 5.7 10. which would be disruptive to company management.1 Small Medium Large 5.3 15.8 26.3 135.8 6.9 20.2 10.7 Source: Pacific-Basin Capital Markets Database compiled by the University of Rhode Island.4 52.9 13. In sum. Increasingly heavy borrowings rendered the sector even more vulnerable to lower profitability and sales.1 5. some rules and regulations of this particular law were believed to be too restrictive and were discouraging companies from going public.6 30.8 10.0 20.2 18. weaknesses became evident.0 48. The argument was that having a Board of Directors whose members represented different groups of investors would create conflicts and hamper management effectiveness.1 13.4 116.1 25. US.3 49. the law disallowed cumulative voting.Chapter 4: Thailand 239 Table 4. capital despite the higher gross margins of small companies.8 62.6 61.2 12. 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. total asset turnover declined after 1989.1 6.3 43.8 142.8 47.7 14.2.1 29. measured by total asset turnover. There were also concerns that the provisions governing the criminal prosecution and penalties of directors and management were harsh and inappropriate.3 49.4 8.6 30.6 10.6 6.3 164. 4.3 52. the overall activities of listed companies. During the 1990s.3 25.2 134.5 6.3 176.5 7. For instance. although the performance of listed companies in the late 1980s was strong.7 6. could lead to a high turnover in the board.

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

6 4. with the top three shareholders accounting for almost 50 percent (Table 4.6 57. 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.1 3.1 4. But with their increased reliance on new varieties of equity and debt instruments.4 5. the top five shareholders of each of publicly listed Thai companies held.1 5. This implies that the top five shareholders enjoyed full control over the outcomes of shareholder meetings. with the largest shareholder on average controlling 10. .6).9 55.9 3.Chapter 4: Thailand 241 4.3 percent and 18.6 Top-Five Ownership Concentration of Publicly Listed Companies in Thailand. respectively.4 26.4 percent of outstanding shares.5 28.0 3.0 56.7 7.9 6. Across industries.8 11. Thai.9 26.3 16. this was not the case.1 Patterns of Corporate Ownership A World Bank study covering nine Asian countries finds that firms in Japan and Taipei. one would expect the public.0 5.0 7.4 4.9 52.9 52.4 6.7 6.9 11. Source: Comprehensive Listed Company Information Database.4 26.0 53. Table 4. 33. 56. Stock Exchange of Thailand.7 12.1 5.China have the least concentrated ownership.0 3. China firms have the highest single shareholder ownership concentration at 35.1 12. and minority shareholders to stake their claim in the control and regulation of these companies.9 percent of shares of a company.2 56.3 28.4 26. and Hong Kong.8 32.1 5.3 percent.2 4.2 4.4 6.6 68.5 Average for 1990-1998 period. on average.0 7.3 7. In contrast.2 11.9 4. there were only slight variations in the pattern. Ownership Concentration Between 1990 and 1998. Indonesian.2 4. Ownership was most concentrated in the packaging.5 9.6 28.9 3. 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 28.3 7.1 percent of control rights.4 10.8 5. In the past. Most large Thai corporations listed on SET started out as family businesses.3 5.3 11.1 7.9 54.1 11.7 percent. these companies obtained funding solely from banks or from their own retained earnings.6 27.3. and 28. creditors. Unfortunately.7 11.9 52.

and building and furnishing industries.169*** 0. *** at the 1 percent level.001) 0.001*** 0. Source: Author’s estimation based on the Pacific-Basin Capital Markets Database compiled by the University of Rhode Island. Ownership Concentration. Vol. as measured by debt-to-equity and debt-to-asset ratios. with a top-five ownership concentration of at least 60 percent. ** at the 5 percent level.001 0. owning 26.7 percent of outstanding shares on average (Table 4.090 0. including those that are publicly listed .037 0. On the other hand. Through these holding companies.533)*** Debt-to-Assets (0.003 0.072) (0.031 3.7).7 Statistical Relationships between Corporate Profitability.022*** 0.242 Corporate Governance and Finance in East Asia. founding families maintain effective control of entire groups.800 0. Company size is significantly related to ROE and leverage. Leverage. Composition of Controlling Shareholders Affiliated corporations comprise the largest group among the top five shareholders of publicly listed companies. 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. 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. US.029 3. and ownership types.034*** 0.8). results show a significant positive relationship between ownership concentration and financial leverage. Table 4. year.080 6.115 9.647 Note: The regression included dummy variables for industry. It is the practice of Thai corporate founding families to set up holding companies to own shares in affiliated companies or subsidiaries. * Denotes significance at the 10 percent level. Based on a regression analysis.116) Debt-to-Equity (1. and Company Size Item Intercept Top Five Ownership Concentration Company Size Adjusted R-Squared F-Statistic ROA 0. Other industries had their top five shareholders controlling at least 55 percent of outstanding shares.058* ROE (0.005** 0. II agribusiness.

3 20. in SET. individual members of the Chirathivat family aggregately hold 25.9 6.5 0. Although holding companies set up affiliate firms. one of the founding members.3 — = not available.9 15.8 Top-Five Shareholder Composition of Publicly Listed Companies in Thailand.2 18.0 19. a NBFIs denotes nonbank financial institutions.2 5.0 17. owned by the Chirathivat family. Stock Exchange of Thailand. 1990-1998 Year 1990 1991 1992 1993 1994 1995 1996 1997 1998 Average Company 28.3 1. the company.9 0.2 1.4 22. founding families and their relatives maintain control of many companies by jointly holding on to the most significant chunk of shares. The roster of its major shareholders as of December 1997 illustrates the typical ownership concentration of a publicly listed company in Thailand.3 27.1 0. The largest shareholder is Central Holdings Company. The ADB survey indicated that listed companies held shares in an average of 11 companies.5 percent. including finance and investment companies.5 Individuals 13.4 20. with 29. Source: Comprehensive Listed Company Information Database.1 1.8 0. This practice is illustrated by Central Pattana.3 percent of outstanding shares.2 1. unlike in Japan where crossshareholding is common.3 1.1 1.9 7.6 28. In 1994. Established in 1980 with a registered capital of B300 million.5 1. averaging about 18. The top 10 shareholders include a holding company owned by the Tejapaibul family.7 — 1.6 5.6 1.4 1.7 5. .5 26.5 1.8 1.1 4.3 0.5 Government Other 0.5 0.5 0.0 3.9 19.8 23.2 7. Typically.6 1.5 NBFIsa 6.0 18.6 25.7 Bank 2.Chapter 4: Thailand 243 Table 4.4 1. the affiliate firms rarely hold shares of their parent companies.7 0. In addition.9 18.5 2. a company listed in the real estate sector of SET. operates five of the most successful shopping malls in Thailand.3 27.6 percent of outstanding shares.8 28.5 5. a joint venture among three families.3 27.6 1.4 1. Individual family members also hold a significant amount of outstanding shares.3 1. These individuals usually hold important management positions in concerned companies. the company increased its registered capital and became a public company listed in SET.7 1.

the Petroleum Authority of Thailand. and responsibilities of directors of public companies. the Government’s role in public companies is expected to decline. Only a handful of companies have the Government among their large shareholders. they exercise limited influence in operations because of the restricted size of their shareholdings. In such cases. Another example is Bangchak Petroleum Plc. with the envisioned privatization master plan. the predominance of individual family members and holding companies in the top shareholder list remains valid. they account for 80 percent of total outstanding shares. On average. holdings by individual family members and holding companies account for at least 50 percent of outstanding shares of an average listed company. both conducted in 1999. Although the list of top shareholders of publicly listed companies includes financial institutions. qualification.1 percent of total outstanding shares of listed companies. on average. 1. 4.2 Corporate Management and Control3 Board of Directors The Public Company Act of 1992 stipulates the appointment process. the Government owns the majority of the shares.5 percent of total outstanding shares of listed companies. Except in the hotel and travel service sector. where the top three shareholders are the Ministry of Finance. roles.5 percent of total outstanding shares. has the Ministry of Finance as its only large shareholder with 92.244 Corporate Governance and Finance in East Asia. Vol. Nonbank financial institutions hold an aggregate 5. Together. the top 10 shareholders consist predominantly of members of founding families and their holding companies. Across industries.9 percent of outstanding shares. For example. The Government holds. II another of the company’s founding members. About half of listed companies have nonbank financial institutions such as finance and investment companies in their top-five shareholder list. . and a state bank. these shareholders are able to control the company.. 3 Discussions in this section are based on results of company surveys by SET and ADB. However.3. only one tenth of listed companies have commercial banks on their top-five shareholder list. There was a trend of rising government shareholdings throughout the period 1990 to 1998. duties. By owning 62 percent of voting shares. Moreover. In effect. Thai Airways International Plc. commercial banks account for only 1.

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

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

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

minority shareholders may also appoint an outside inspector to examine the company’s operations and financial condition. did not vote in previous AGSMs. 4. such protection has been insufficient. Banks would be obvious candidates to implement these mechanisms.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. On paper. In effect.248 Corporate Governance and Finance in East Asia. In practice. The difficulty minority shareholders have in exercising their rights can be seen from the ADB survey results. But with the ownership concentration of Thai companies. representing only about 28 percent of shareholdings. 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. II mechanisms in place: mandatory shareholder approval of major transactions and interested or related party transactions. it would be difficult for minority shareholders to gather the shares needed to take action. . Vol. however. given their importance in providing finance and their stake in companies. and insider trading. 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. takeover of the company. the only group of shareholders that can exercise rights is the top five shareholders. and call an extraordinary session. 66 percent of total outstanding shares. Almost 82 percent of shareholders. In theory. minority shareholders are assured adequate legal protection. The SEA of 1992 and the listing rules also contain provisions for the protection of shareholders against transfer pricing. the new Public Company Act of 1992 inadvertently weakened the governance of public companies by diminishing minority shareholder rights. on average. Only a small number of shareholders attended the latest AGSMs. But the exercise of these rights requires even higher shareholding levels. they comprised only 8 percent of total shareholders. The ADB survey results reveal that the proposals presented by management were rarely rejected during the general meetings. and mandatory disclosure of related interests and significant shareholders’ transactions. While stimulating the growth of the sector.3. Although the attendees held.

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

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

But instead of opting for an active role in the market for corporate control.1 58.7 Purchase Value Number of % of Tender Offer Value Companies 84. Pension funds are perhaps even weaker in Thailand.2 7. 1993-1999 Year 1993 1994 1995 1996 1997 1998 1999 a Tender Offer Valuea (B billion) 5.3 60. employees regard the plans as monetary incentives. Twenty-nine firms indicated that employees held shares of their companies. it remains small. tion activities increased after 1997.9 Merger and Acquisition Activities. Employee Participation in Corporate Governance There has been little. employee participation in corporate governance in Thailand. .3 11.9 3. trading by mutual funds in SET represented less than 10 percent of total trading.Chapter 4: Thailand 251 Table 4.5 6.1 19.0 B billion 4. Even when companies offer ESOPs.2 6.4 23.2 6. if any. but employees have never been represented in the board of directors since their shareholdings are minimal. Provident funds for government workers and workers in public enterprises have been established only recently. Because of the current crisis. they have mostly been concerned with short-term gains.1 75. most of these were forced mergers or related to rescue packages. employees are even less willing to accept common shares as a form of compensation or benefit. Since 1994. but the average shareholding is smaller than 1 percent of total outstanding shares. Few companies offer employee stock option plans (ESOPs).8 81.7 11.0 55.1 84. While the Thai mutual fund industry compares well to those in other developing countries in the region. The number of domestic institutional investors rose after the mutual fund industry was established in 1991.8 8 27 14 6 9 13 23 Tender offer value refers to the minimum offer value.2 8. Eleven of the 46 responding companies in the ADB survey offer ESOPs. not with a view to becoming involved in actual management.3 6. Source: Securities and Exchange Commission of Thailand.6 17.

Many large commercial banks had affiliates among the 93 finance companies that served the high-risk market.252 Corporate Governance and Finance in East Asia.0 8.485.0 SET Market Capitalization 1. The total values of loans from financial institutions and commercial banks were consistently larger than the market capitalization of SET.1 Domestic Debt Securities Outstanding 215.5 5. 15 of which were domestic banks. although its role increased in the wake of the crisis.979. Bangkok Bank Ltd.390. the next four largest banks accounted for 63 percent..4 519.1 7.1 6.5 6.268.1 5. The bond market played only a marginal role in corporate financing. The Banking System Until recently.912. II 4.8 3. total assets of commercial banks amounted to B5.6 1.6 2.10) shows that Thailand is a highly bank-dependent economy.430.0 424.193. The country’s largest bank.5 4. and Bank of Thailand.559.0 3.8 941.5 trillion. 1992-1999 (B billion) Outstanding Loans from All Financial Institutions 2.906.3 1.4 1.230. Competition from foreign banks was limited as they were not allowed to engage in full branch operations.4. accounted for 28 percent of the banking sector’s total assets. 2.775.669.360.477.5 4.1 3.161.663.4 4. Thai Bond Dealing Centre.10 Size and Composition of the Thai Financial Sector. Vol.3 5.171.3 546.5 Outstanding Loans from Commercial Banks 2.1 Corporate Financing Overview of the Financial Sector A breakdown of the Thai financial sector for the period 1992-1999 (Table 4.825.1 3.564.4 3.2 262.0 339. the banking sector was highly concentrated.6 6. .372.325.4 4. Table 4.4 Year 1992 1993 1994 1995 1996 1997 1998 1999 Source: Stock Exchange of Thailand.2 2. The share of domestic banks in the banking system’s total assets was 80 percent. there were 29 commercial banks. In 1996.

the market rose steadily and reached a record high in the fourth quarter of 1993. The Government removed controls on capital and dividend repatriation in 1991. Many company founders did not want to release even a small portion of corporate ownership and refused to go public.3 trillion. due to their close ties. Turnover value reached B2. SET is organized into 32 major industries. Benefiting from rapid economic and industrial growth. The number of listed companies also quadrupled between 1981 and 1993.8 in 1998. SET was not very active. Easy access to commercial bank loans by family business groups. and almost all capital account transactions were deregulated. also made it unattractive to raise capital from the equity market. In 1993. After that. BSDC is a nonprofit.Chapter 4: Thailand 253 The Government was also a major figure in the banking system. owning 70 percent of the country’s second largest bank. was set up by 74 members with an initial capital of B500 million. BIBF banks also enjoyed tax incentives on their operations and profits. the Bangkok Stock Dealing Center (BSDC). Because borrowers carried the exchange rate risk. In the following years. The lack of supply of quality shares was a big problem for SET at that time. the liberalization of interest rates and capital account transactions stimulated a credit expansion through short-term borrowings in foreign currency. reaching 355. the SET index declined. Through the years. Licenses were granted to 15 Thai banks. Despite the worldwide market crash in 1987. The Equity Market During the first few years of its operations. and 20 new foreign banks. hardly any progress was made in lowering the cost of domestic financial intermediation or in developing new financial instruments for corporations. Stock prices tripled in the next three years until the market experienced its first crash as a result of the Gulf Crisis in 1990. finance. Banking activity peaked in the mid-1990s. In 1995. 12 existing foreign banks. the stock market entered its first boom period in 1986. an over-the-counter market. Banks under the BIBF scheme were allowed to mobilize funds from abroad and lend to Thai companies in foreign currency. self-regulatory organization under the . banking. and property have accounted for the bulk of trading volumes. In contrast. the Government established the BIBF to expand the banking sector and reduce the borrowing costs of Thai companies. Some 347 companies were listed in the same year with a total market capitalization of B3. SET immediately recovered due to the strength of the Thai economy.2 trillion.

Turnover value was B1. securities can be traded in the secondary markets. Listed companies were those that had (i) paid-up capital of at least B20 million. Consequently. If the issue is oversubscribed. The company should then appoint a financial adviser.5 percent and collectively owning at least 30 percent of paidup capital. also acts as a clearinghouse. The listing application should be submitted concurrently to SEC and SET. however. 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. securities deposit center. among other functions approved by SEC. to assist in the public offering process. Authorized companies were those with a minimum of 200 shareholders owning collectively at least 25 percent of paid-up capital. Vol. there were two kinds of companies in SET—“listed” and “authorized” companies. Its main role is to serve as a secondary market for unlisted companies trying to raise capital. If approved by SEC and the SET Board of Governors. stock trading can commence within five days. with each facing different listing requirements. SET established new requirements for initial public offerings. and securities registrar. 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. In July 1990. the two classifications were merged. The primary market is supervised by SEC. . The allocation procedure is nondiscretionary. but dropped the following year to B122 million. After initial public offerings. and (ii) a minimum of 300 shareholders. which consist of SET and BSDC. Only one security was listed in BSDC in 1995 and two more in 1996. and pro forma balance sheet and income statements. II jurisdiction of SEC.8 billion in 1996. turnover value was negligible and the BSDC Index remained flat throughout 19961998. It separated the primary and secondary markets to promote more flexible and effective supervision of both. approved by SET. lottery drawing must be used to ensure fairness. In 1998. The SEA of 1992 installed the legal and regulatory framework for Thai capital markets. According to the SEA of 1992. In 1996.254 Corporate Governance and Finance in East Asia. Before 1993. SET. which has a legal mandate to examine a company’s financial status and operations before allowing it to issue securities to the public. each holding no more than 0. Company applicants must have an established history of operating under substantially the same management. so now only listed companies are traded in SET. financial projections. Proposed changes in capital must be submitted for approval to SET accompanied by a detailed memorandum outlining the use of proceeds.

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

BDC was established in November 1994 by 50 securities companies based on the provisions of the SEA of 1992.0 60.1 141.0 0. then declined substantially in 1996 and 1997.1 8.1 289.7 821.0 333.7 7.0 27. by the end of 1997.4 — 9. II Table 4.3 29.8 2.3 50.9 37.0 — 5.9 30.7 90.9 40.2 2.1 12.3 46. A sharp rise in unsecured offshore debt offerings can be noted all the way through 1996. the year the crisis unraveled and the baht was floated.256 Corporate Governance and Finance in East Asia.5 — 39. this had climbed to B200.2 — — 50.1 59.0 86. Total offshore debt offerings peaked in the run-up to the financial crisis.1 — — — 29.6 billion.6 — — 0.7 95.3 140.5 billion.2 45.2 57. turnover value had reached B51.4 110. However.5 43.5 55.5 — 0.8 Source: Securities and Exchange Commission of Thailand and the Thai Bond Dealing Centre.1 — — 6.3 6. 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 61.0 281.1 107.5 — — — 3.7 0.4 billion. The decline in total domestic debt offerings in 1996 can be ascribed to the increase in offshore convertible debts.0 5.4 49.4 — — — 1.1 315.3 — 14.2 39.3 13.5 5.7 5.8 55.2 89.4 — 26.5 138.2 28.9 5.0 33.7 132.0 17.7 28.5 — — 32.7 0.1 55.1 10. a surge attributed to capital inflows encouraged by high returns on Thai bonds.3 22.1 41.3 3.3 46.4 57.8 47.9 0.0 7.9 329.1 121.3 8. The domestic debt market declined after 1994 because corporations could borrow offshore at lower costs.1 21. Vol. The club was considered the first organized secondary bond market in Thailand to serve as the wholesale market for debt securities.7 — — 40.7 5.4 7.2 43.0 26.0 — 5.5 37.7 — — — — — 4. The following year.8 191.6 — 0.5 10.11 Offerings of Debt Securities.5 — — — — 1.3 — — 3.8 31.9 20.9 37.6 19.7 — — — — — — — 77.7 538. By 1995. .0 — 26.8 167.1 6. total offshore debt offerings had plunged by 68 percent to a mere B28.

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

3 34. compared with the 44 percent general average.4 17. were highly leveraged.8 20.3 21.2 17.5 1.6 0.2 15.2 3.0 2.9 17.7 16.2 34.8 37.2 17.0 100.9 6.6 21.2 35. Analysis of common-size statements by ownership concentration (based on the levels of top-five ownership concentration classified as high.9 17.0 48.1 50.2 12.8 25.1 2.8 1.7 52.12 Common-Size Statements for Companies Listed in SET.6 13.0 100.8 21.9 14.3 25. Vol.9 20.9 14.7 9.0 51.4 43.4 7.6 100.7 18.4 48.7 15.2 1.8 19.0 14.4 17.2 2.2 17.0 100.6 11.1 13.3 18.3 1.3 49.7 7.3 14.0 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.8 17.2 22.9 14.4 49.8 9. The agribusiness industry relied more heavily on short-term loans at 56 percent of the industry’s total liabilities.6 2.3 48.9 12.6 50.8 6.3 2.6 51.5 0.0 100.1 36.4 14.8 10.5 9.4 21.0 1.9 16.5 11.7 14.0 100.6 10.2 43.5 14.3 34.2 2.9 3.9 49.9 50.6 6.6 0.8 7.9 38.7 0.8 8.0 100.3 6.0 6.6 36.9 2.3 1.9 6.3 18.4 49.6 14.6 12.0 100.6 100.1 7.9 0. and low) also underscores that companies with high ownership concentration had high levels of long-term loans (Table 4.0 100.5 1. II Table 4.0 100.0 100.3 17.5 1.9 40.7 17.0 10.3 12.5 37.9 15.6 8.5 43.6 18.0 100.8 35.2 2.3 14.8 46.0 100. The level of total liabilities for the group characterized by high ownership concentration .1 5.0 100.13).6 15.6 0.2 1.1 49.0 7.1 17.2 1.8 9.2 42. medium.3 50.7 1.9 18.8 34.9 43.7 36.2 45.8 3.4 6.0 12.7 50.8 37.6 22.6 38.6 0. US.9 14. 1990-1996 (percent) Item All Years 1990 1991 1992 1993 1994 1995 1996 2. Printing and publishing companies had lower financial leverage than companies in other industries.0 15.1 18.0 10.9 10.8 14.2 16.3 38.7 16.9 14.0 13.2 2.2 17.4 8.258 Corporate Governance and Finance in East Asia.5 9.4 2.2 43.2 16.0 100.

9 7.2 0.0 41.5 11.0 Source: Pacific-Basin Capital Markets Database compiled by the University of Rhode Island.3 100.3 1.7 17.0 100.0 14.9 0.0 Low 1.0 100.4 35.1 53.0 19.3 16.0 6. was 53 percent of total assets compared with 49.2 14.9 2.4 37.7 19.8 13.13 Common-Size Statements of Public Companies by Ownership Concentration.9 50.9 100.0 6.4 3.4 13.1 44.5 100.4 49.6 47.3 8.2 8.2 22.1 36.4 18.9 21.8 13.6 0.6 100. Companies with medium ownership concentration tended to have a higher proportion of short-term loans.Chapter 4: Thailand 259 Table 4. For the high ownership concentration group.3 35.6 14.4 1. 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 2.4 50.1 49. This is consistent with the observation that majority shareholders try to maintain their control by utilizing debt as a major source of funds.6 2.9 36.0 7.5 21.5 percent for low ownership concentration companies.8 12.4 7.7 12.1 18.0 Medium 2.6 22. common equity accounted for a smaller proportion of total assets (47 percent) than companies with lower ownership concentration. US.5 18. .0 16.5 13.7 percent for medium ownership concentration companies and 49.6 15.8 37.9 16.3 1.6 9.2 11.2 45.

Short-term debt accounted for most of the increase. Public companies relied more on short-term debt financing in the period before the financial crisis.1 16. and maintenance of the existing ownership structure. and rights issues.0 50.5 52.7 percent in 1996.1 16. The financing patterns indicate that companies with high ownership concentration were more highly leveraged than companies with medium and low concentration.2 35. More important.15.9 63.7 34. While further detailed investigations are necessary.7 28.1 31.2 49.8 65.1 44. .4 44.0 145. the choice of financing is determined by the company’s liquidity considerations. Table 4. however.1 31.8 5. bond issues.3 Source: Estimated from the Pacific-Basin Capital Markets Database compiled by the University of Rhode Island.260 Corporate Governance and Finance in East Asia.3 61.4 12. Vol.7 34.5 38. especially from 1994 to 1996. The TIE ratio declined from its peak of 7.3 31.1 23. Generally.0 28.8 65. The direct relationship between the degree of leverage and the degree of ownership concentration is apparent in Table 4.4 139. II Results from the ADB survey reveal that Thai companies preferred to use reserves and retained earnings as their first choice of financing.9 51.2 68.9 140.1 52. it would seem that firms with concentrated ownership and associated links to the banking system have easier access to debt financing. The ratio of total debt to total assets increased from 50. these firms more easily increased their leverage.7 11. followed by bank loans.14 Financial Ratios of All Listed Firms. however.6 138.8 51. US.4 51. was the headlong deterioration of firms’ ability to meet their interest payment obligations. After the crisis.1 64.9 7. Such deterioration of financial positions during the period was a common feature of listed companies.7 12.7 12. minimization of transaction and interest costs.7 in 1994 to 5.8 percent in 1990 to 52.14).0 25.4 7.6 41.7 5.6 125.9 14.4 5. 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 4.1 144. bond issues overtook loans from commercial banks as the second preference. 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. As a result.1 in 1996.7 66.6 7. thus rendering them more vulnerable.

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. debt-creating capital inflows rose to 65 percent in 1990.2 124.8 28.0 64. and a preponderance of short-term debt liabilities.1 High 6.4 13. 4. private debt accounted for 84. From 45 percent of total net capital movements in 1985. unhedged foreign exchange liabilities. The corporate sector contributed significantly to the crisis because of its rising levels of leverage.5 4.4 27. US.5 148.5 percent of external debt in 1996 (Table 4.3 42.8 29.4 63.15 Financial Ratios of Listed Companies by Ownership Concentration.4 percent to 46 percent during the same period.2 49. is even more telling. 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. the proportion of short-term debt increased from 15. on the other hand.2 percent in 1986 to 251. . Their average annual growth rate declined from 28.16).5 126. 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.8 49. The proportion of nondebt-creating capital flows.Chapter 4: Thailand 261 Table 4. continued to slide from 1985 to 1997.8 Medium 7.8 14.6 30. From only 34 percent in 1986.8 percent in 1986 to 52 percent in 1995. however.6 11.9 percent in 1997.3 Source: Estimated from the Pacific-Basin Capital Markets Database compiled by the University of Rhode Island.5 34. The proportion of external debt as a percentage of GDP consequently increased from 42.8 66.7 percent from 1991 to 1996.5 percent between 1985 and 1990 to 8.5. Nonbank private debt increased from 27. Additionally. peaking in 1994 at 84 percent. This decline was accompanied. The composition and term-structure of this debt.4 52. such as direct equity and portfolio investment.

0 0.7 20.7 23.2 0.4 2.4 15.3 3.5 14.9 29.0 4.1 95.5 12.9 43.0 6.9 10.1 5.2 2.5 4.9 31.3 37.0 Long-Term Short-Term BIBF Commercial Bank Long-Term Short-Term 0.3 10.9 1.9 10.9 100.5 19.0 21.5 4.3 12.9 11.9 6.3 0.4 18.7 10.9 35.1 64.3 0.1 12.3 0.4 3.5 16.9 7.2 2.4 5.7 0.2 14.9 3.3 0. .2 0.4 10.6 52.8 3.6 — 0.3 0.9 5.3 0.3 7.9 6.7 1.0 13.9 3.8 108.7 2.8 3.5 1.1 34.8 13.3 0.1 0.1 22.1 Source: Bank of Thailand.9 13.2 15.6 Government Year Long-Term Short-Term 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 12.6 Total 18.9 1.3 — — — — — — — 6.6 1.8 31.2 32.1 2.7 109.7 13.3 0.6 18.2 10.0 11.2 0.8 10.3 16.3 3.9 4.5 12.4 — — — — — — — 1.1 0.8 12.3 105. 1986-1999 ($ billion) Private Nonbank Long-Term Short-Term 3.9 0.16 External Debt.2 2.1 23.0 3.1 0.3 2.8 0.1 30.1 0.0 11.7 24.3 20.6 7.0 8.Table 4.

The value of public offerings sank in 1997 to B56. (ii) the rise in the nonperforming loan (NPL) ratio and consequent tightening of credit even for viable firms. trading activity at SET had been on the downturn. Foreign investors retreated from the market. exposing the companies to disaster when the baht started tumbling on 2 July 1997. and drastic decline in the number and capital of newly registered companies. foreign currency-denominated debts constituted 55 percent of their total debt portfolio. Meanwhile. from its peak in 1995. the SET Index stood at 1. closures.6 in December 1996.6 billion from the 1996 level of B201 billion. suggesting that serious investors have not returned to the market. and poor business confidence on the other. nonfinancial companies also experienced severe liquidity problems as a result of the baht’s devaluation. Similarly. the numbers of bankruptcies and company closures reached all-time highs in 1998 (Table 4.281 in December 1995 and to 831.17). . The proportion of NPLs as a percentage of outstanding loans demonstrates the liquidity problem experienced by the corporate sector. large Thai companies had actively borrowed at low interest rates from foreign financial institutions. the number of newly registered companies dropped to a 10-year low in 1998. Trading volume has since been thin. Due in part to liquidity problems on the one hand. The effects of the crisis were felt across all industry sectors. Most of these foreign debts were not properly hedged. The severity of the impact of the crisis on the corporate sector was apparent from (i) the decline in the volume of public offerings. Even before the crisis.360. according to the Bank of Thailand. outstanding credit also declined throughout the second half of 1998. On average. With easy access to foreign funds. leaving domestic investors with large capital losses. At the end of 1994. the liquidity problems faced by the corporate sector are likely to continue for some time. banks would be recording more of such NPLs.Chapter 4: Thailand 263 This shows that although banking and finance companies suffered most because of their short-term exposure. If lending rates remained high. Aside from the problem of NPLs. NPLs spiraled from 12 percent in the second quarter of 1997 to almost 40 percent in the third quarter of 1998. reaching 45 percent of total outstanding credit in December. 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. SET’s dismal performance is indicative of the extent of the setback suffered by the Thai capital market. After that. and (iii) bankruptcies. It hit a 10-year low in the second quarter of 1998. based on the three-month past due definition. the index declined to 1.

A steady price decline over the past few years has dragged down the ratio of market price to book value.134 31. Vol. IMF required Thailand to meet a set of performance criteria and implement various restructuring measures.5 at the end of 1994 to 12 in 1996 and further to 6. II Table 4. 1985-1999 Year 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 Newly Registered 10.334 4.218 3.096 22. The IMF financial package was a credit facility of $17. 4.777 11.17 Number of Newly Registered and Bankrupted/Closed Companies. As part of the assistance package.105 4.6 in 1997.080 9.112 9.407 28.792 7.201 24. the Thai Government was lukewarm to the idea of obtaining IMF assistance because of the requirements and conditions attached to the financial package.977 Source: Department of Commercial Registration.2 billion for balance of payments support and buildup of the country’s reserves.052 36. The first Letter of Intent was cosigned by the Minister of Finance and the Governor of the Bank of Thailand on 14 August 1997.410 5. It also explains the higher dividend yield ratio.288 35.312 25.410 37.5.409 6. The price-to-earnings (P/E) ratio deteriorated from 19. The increase of the P/E ratio in 1998 was mostly a result of a decrease in earnings for most listed companies. Ministry of Commerce.224 4.925 12.797 4. But when assistance from other sources did not materialize.695 3.2 Responses to the Crisis Initially.902 3.307 4.915 37.066 19.677 Bankrupted/Closed 2.904 20. the Government was left with no choice.933 25. . Thailand.264 Corporate Governance and Finance in East Asia.095 14.

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

time consuming. the National Assembly passed an amended Bankruptcy Act and approved the establishment of special bankruptcy courts. Companies need . any new loan to a company extended after the creditor discovered the insolvency would not be eligible for repayment. 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. The model for Thailand’s amended bankruptcy law was the US Chapter 11.266 Corporate Governance and Finance in East Asia. There are other potential problems. In Thailand. (ii) management of the company reverts to the borrower. Foreign secured creditors had to go through the motions of establishing that their country of domicile granted Thai creditors similar rights. it covers only the court-supervised reorganization of distressed companies. If the process fails to revive the business. The reorganization process is successful if (i) the debts shall have been discharged. II for the recovery of debt through the realization of any collateral. and (iv) the debts shall have been settled within a five-year period. creditors always had to contend with the threat of disruptions in a delinquent borrower’s business. but it is a complicated. Enforcement of the new law is bound to be ponderous and lengthy. which means that a debtor could continue in business while the reorganization program was being implemented. In 1999. the judges and court officers have yet to learn and master the new bankruptcy procedure. the amended law limits the rights of secured creditors. 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. and expensive process. (iii) shareholders regain their legal rights. The original Bankruptcy Act dealt only with liquidation and composition. But more important. Chapter 11 cases account for only 5 percent of bankruptcy suits in the US but consume 90 percent of the courts’ time. In effect. The amended legislation also includes voluntary bankruptcy as a new feature. The amendment added reorganization provisions to the Bankruptcy Act of 1940. thereby allowing court-supervised corporate restructuring. 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. To make matters worse for creditors. the company shall be declared bankrupt and liquidation of assets shall follow. The amended law also introduced the concept of automatic stay. For one. Vol. Under the old Bankruptcy Act. Chapter 11 is the main tool in restructuring bankrupted companies in the US.

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

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

the Government introduced debt restructuring-related measures to help resolve bad debts. The Bank of Thailand issued guidelines in 1998 encouraging financial institutions to specify their own policies. As of November 2000.1 trillion in outstanding credit. By October 2000.1 trillion of outstanding credit. Some 82 percent of these cases have been successfully restructured. In addition. However. The first bankruptcy court in Thailand opened on 18 June 1999. In particular. the mere threat of external control alters the incentives faced by managers and controlling shareholders significantly. In response. Reforms in bankruptcy procedures should be seen not only in the context of crisis resolution. although since then. as well as those that did not cooperate with CDRAC’s restructuring process. accounting for B1. 322. and procedures for debt restructuring.764 debt restructuring cases involving B1. The reason is that bankruptcy law amendments appear to facilitate settlements outside the court. Another 5 percent of cases (B70 billion) are undergoing restructuring negotiations. 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. the number of cases has abated. Within three months. contributing to the unprecedented rise in the corporate sector’s bad debt.767 cases involving outstanding credit of B2. only 7. methods. Considerable progress has been achieved on this front. personal consumption.8 trillion had been completed.147 cases (B1. CDRAC’s target debtors comprised 10.6 trillion. Commercial banks initiated 74 percent of these cases. with the majority of the debtors coming from the commerce.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. Corporate Debt Restructuring and Bankruptcy The 1997 crisis led to a severe liquidity problem in the economy. and manufacturing sectors.6 trillion) have agreed to cooperate with CDRAC’s restructuring process. the court had more than 80 cases for disposition. accounting for B1. Another 77. will be settled by the courts.068 cases involving B475 billion are undergoing restructuring. Equally important is the contribution of effective and reliable bankruptcy procedures for improved corporate governance. where bankruptcy procedures are swift and effective. This point is crucial because compared with . Cases for which negotiations were unsuccessful.

270 Corporate Governance and Finance in East Asia. and performance during this period helps understand the causes of the crisis. Examination of corporate ownership. 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. It required listed companies to establish their own audit committees by the end of 1999. 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. The . and Recommendations Summary and Conclusions This study has provided an overview of the corporate sector and governance in Thailand. 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. and promoted key industries through incentives. Emphasis was on the structure of corporate governance and patterns of corporate ownership and financing of publicly listed companies.1 Summary. The study covers the period 1985 to 1996. to push companies to harmonize their accounting with international standards. Reforms through SET and Improved Disclosure The financial crisis prompted SET to introduce a range of improvements to its operation and regulation. the Government protected certain corporate sectors through tariffs and regulation. the Thai Government managed its economy with the corporate sector as the main engine of growth and development. 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. Such improvements in disclosure standards are part of the efforts of SET and SEC. Financial information from listed companies will also soon be required to conform to International Accounting Standards. 4.6 4. Vol.6. In the next three decades. For this reason. The exchange has already required that listed companies’ quarterly reports be directly comparable with annual statements. Philippines. despite the weakness of their disciplinary powers. and even Indonesia. Weak bankruptcy procedures were part and parcel of the perverse set of incentives that led firms to build up unsustainable levels of debt. II Malaysia.

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

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

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

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

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. Some of the legal reforms under consideration concern settling conflictof-interest situations with significant effects on minority shareholders. SEC has been trying to lay the foundations of good corporate governance by espousing fairness. Both SET and SEC are taking an active stance in improving the transparency and efficiency of Thai capital markets. The second recommendation is to dilute ownership concentration through the use of regulatory power. accountability. and . 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. The situation prompts two specific recommendations. 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. The current ownership structure leads to ineffective corporate governance and inadequate protection of minority shareholders. transparency. increasing penalties for directors engaged in misconduct. there has been much progress in this area. the Government can change the shareholding limit for controlling shareholders. This move is expected to be unpopular among founding family members and original owners. Through an amendment in the Public Company Act. The slow improvement in the legal framework has likewise obstructed progress in this area. 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. But weaknesses in accounting and auditing practices have been inhibiting the development of capital markets. The first recommendation involves the repeal of current legislation to allow minority shareholders to have greater influence over management decision making. To ensure a level playing field. requiring cumulative voting for the election of directors. they should be monitored and regulated. SEC is exploring the possibility of amending the law toward this direction. Because these holding companies control a number of large public companies in Thailand. and a prohibition of connected transactions by directors or management.

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

PACAP-Thailand Database. Key Capital Market Statistics. Fact Book. 1995-1999. 1995-1999. US. Thailand. Thai Accounting Standards. Bank of Thailand Monthly Bulletin. 1995. Bank of Thailand Quarterly Bulletin. 1997. The Stock Exchange of Thailand. The Stock Market in Thailand. Bank of Thailand. The University of Rhode Island.Chapter 4: Thailand 277 References Annual Report. The Stock Exchange of Thailand. 1997. The Thai Bond Dealing Centre. 1997-1999. Bond Market Development in Thailand. Pacific-Basin Capital Markets Research Center. Bank of Thailand. . 1998. The Stock Exchange of Thailand. Kingston. The Securities and Exchange Commission of Thailand. Department of Commercial Registration Database. 1995-1999. The Securities and Exchange Commission of Thailand. Ministry of Commerce.

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