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

1992-1995 Table 1.3 Subsidiaries of the 30 Largest Chaebols Table 2.2 Foreign Capital Flows.19 DER and ROE of Publicly Listed Companies by Sector.14 Banking Sector Outstanding Loans. 1992-1999 Table 1.10 Anatomy of the Top 300 Indonesian List of Tables 1. 1990-1998 Table 1. 1996-1998 Table 1.6 GrowthandFinancialPerformanceofState-Owned Companies. 1993-1997 Table 1.16 FinancingPatternsofPubliclyListedNonfinancial Companies. 1992-1997 Table 1.20 ROE of the Banking Sector. 1988-1996 Table 1. Republic of Korea Table 2. 1996-1999 Table 1. 1986-1996 Table 1. 1990-1997 Table 1. 1993-1999 Table 1. 1992-1997 Table 1.15 V alue of Stocks Issued and Stock Market Capitalization.4 Growth Performance of Publicly Listed Companies by Sector.12 CharacteristicsoftheBoardofDirectors Table 1. 1992-1997 Table 1. 1992-1999 Table 1.5 Financial Performance of Publicly Listed Companies by Sector.4 Development of the Stock Market.11 CharacteristicsoftheBoardofCommissioners Table 1.13 Presence of Board Committees in Listed Companies Table 1.8 OwnershipConcentrationofPubliclyListedCompanies. 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 .21 Nonperforming Loans by Type of Bank.1 Growth of the Banking Sector.1 Listed Firms with Positive Economic V alueAdded.2 KeyMacroeconomicIndicators Table 2. Indonesia Table 1.3 GrowthandFinancialPerformanceofPubliclyListed Companies. 1992-1997 Table 1.9 OwnershipConcentrationofPubliclyListedCompanies by Sector.7 Growth Performance of the Top 300 Conglomerates.17 DER of Listed Companies by Degree of Ownership Concentration Table 1. 1996-1998 2. 1992-1998 Table 2. 1997 Table 1.18 GDP Growth by Sector.

8 Table 2.19 Table 2.29 Table 2.21 Table 2. 1997 Ownership Composition of Listed Nonfinancial Firms by Control Type.16 Table 2.12 Table 2.18 Table 2.26 Table 2.6 Table 2. 1992-1997 OwnershipConcentrationofListedNonfinancialFirms.14 Table 2.25 Table 2. 1988-1997 Features of the 30 Largest Chaebols GrowthandFinancialPerformanceofthe30Largest Chaebols. 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 .27 Table 2. 1999 InternalShareholdingsofthe30Largest Chaebols. 1990 and 1997 Ownership Composition of Listed Nonfinancial Firms by Size.11 Table 2. 1994-1997 Cross-Payment Guarantees of the Top 30Chaebols. 1988-1997 OwnershipConcentrationofListedNonfinancialFirms by Industry. 1997 Ownership Composition of Listed Firms in Selected Countries. 1990-1997 InternationalComparisonofRatiosofOrdinaryIncome toSalesinManufacturing GrowthandFinancialPerformanceofSelectedIndustries GrowthandFinancialPerformanceofListedCompanies.28 Table 2.22 Table 2.7 Table 2. 1997 Ownership Concentration ofAll Listed Firms. 1988-1997 Ownership Composition of Listed Nonfinancial Firms by Industry.20 Table 2.30 Private Capital Flows to Korea. 1997 OwnershipConcentrationofListedNonfinancialFirms by Firm Size.23 Table 2.5 Table 2. 1993-1997 The Top 30 Chaebols’ Debt-to-Equity Ratio. 1985-1997 GrowthandFinancialPerformanceofListedCompanies by Size. 1987-1997 FlowofFundsoftheNonfinancialCorporateSector.10 Table 2. 1988-1997 FinancingPatternsoftheNonfinancialCorporateSectorby Industry Financing Patterns of Listed Companies. 1988-1997 FinancingPatternsoftheNonfinancialCorporateSector. 1985-1998 GrowthandFinancialPerformanceoftheNonfinancial Corporate Sector.13 Table 2.9 Table 2.15 Table 2.24 Table 2.vii Table 2. 1995-1997 Ownership Composition of Listed Companies. 1988-1997 Ownership Concentration of the Survey Sample of 81 Listed Firms.17 Table 2. 1994-1998 Financing Patterns of the Top 30 Chaebols.

12 Control Structure of the Top 50 Corporate Entities. 1997 Table 3.7 GrowthandFinancialPerformanceoftheCorporateSector by Industry.22 Foreign Investment Flows. 1992-1999 .33 Net Profit Margins of Chaebols. 1988-1997 Table 3.9 OwnershipConcentrationatCriticalLevelsofControl Over Publicly Listed Companies.1 Public Companies Registered. 1989-1997 Table 3.21 OwnershipConcentration. 1997 Table 3.16 CorporateFinancing PatternsbyOwnershipType.15 Financing Patterns of the Corporate Sector. 1986-1998 Nonperforming Loans of General Banks.2 Public Offerings of Securities.SectorOrientation. Flagship Company. 1978-2000 Table 4. 1995-1998 4. Leverage Table 3. 1988-1997 Table 3. 1992-1996 Table 3.19 Financing Patterns by Firm Size.13 ADB Survey Results on Shareholder Rights Table 3. The Philippines Table 3.4 GrowthandFinancialPerformanceoftheCorporateSector by Ownership Type.Profitability andFinancial . andAffiliated Banks of Selected Business Groups. 1997 Table 3. 1997 Table 3. 1989-1997 Table 3.2 Growth and Financial Performance of the Top 1. Thailand Table 4.viii Table 2.6 GrowthandFinancialPerformanceoftheCorporateSector by Firm Size.20 Financing Patterns by Industry. 1989-1997 Table 3. 1988-1997 Table 3.11 TotalandPerCompanySales.10 Composition of Top Five Shareholders of Philippine Publicly Listed Companies by Sector. 1983-1997 Table 3.31 Table 2. 1985-1997 Number of Firms with Dishonored Checks.5 GrowthandFinancialPerformanceoftheCorporateSector by Control Structure.14 Philippine Stock Market Performance.1989-1997 Table 3. 1997 Table 3. 1988-1997 Table 3.18 Financing Patterns by Control Structure.3 TheCorporateSectorandGrossDomesticProduct. 1990-1999 Table 3.32 Table 2. 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. 1988-1997 Table 3.1 GDP Growth of SoutheastAsian Countries.8 Ownership Composition of Philippine Publicly Listed Companies by Sector. 1988-1997 Table 3. 1989-1997 Table 3.000 Companies.17 Composition ofAssets and Financing of the Publicly Listed Sector.

2 TheSuhartoGroup TypicalInternalOrganizationalStructureofaPublicly Listed Company in Indonesia CorporateControlStructure:TheCaseofAyalaCorporation CorporateControlStructure:theCaseofLopezGroup 24 25 195 197 .13 Table 4. 1990-1996 External Debt.1 Figure 1.1 Figure 3. 1992-1999 Offerings of Debt Securities. Ownership Concentration.11 Table 4.3 Table 4.5 Table 4. Leverage. 1985-1999 237 238 239 241 242 243 251 252 256 258 259 260 261 262 264 List of Figures Figure 1. 1990-1996 Financial Ratios of All Listed Firms.9 Table 4.ix Table 4. and Company Size Top-Five Shareholder Composition of Publicly Listed Companies in Thailand. 1990-1996 Common-Size Statements of Public Companies by Ownership Concentration. 1985-1996 Average Key Financial Ratios by Company Size. 1990-1998 Merger and Acquisition Activities. 1985-1996 Top-Five Ownership Concentration of Publicly Listed Companies in Thailand. 1993-1999 Size and Composition of the Thai Financial Sector.17 StatisticalHighlightsoftheStockExchangeofThailand.12 Table 4.6 Table 4.15 Table 4.4 Table 4.8 Table 4. 1990-1998 StatisticalRelationshipsbetweenCorporateProfitability.16 Table 4.10 Table 4.14 Table 4. 1986-1999 NumberofNewlyRegisteredandBankrupted/Closed Companies.2 Figure 3. 1993-1999 Key Financial Ratios of Publicly Listed Companies. 1990-1996 Financial Ratios of Listed Companies by Ownership Concentration. 1992-1999 Common-Size Statements for Companies Listed in SET.7 Table 4.


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

Arvind Panagariya ChiefEconomist


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


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

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

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

1 Indonesia
Saud Husnan1



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

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

Foreign debt reached more than $100 billion. placed a high premium on these political connections in assessing the chances of being repaid. particularly those with large foreign loans. patterns of financing. the Indonesian economy seemed to be in generally good shape. It analyzes the weaknesses of corporate governance in Indonesia. The study also identifies family-based companies and corporate groups. II rate reached 58. Malaysia. and . the currency composition and term structure of corporate foreign indebtedness were causes for concern. All sectors. 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. To facilitate even easier access to credit. no doubt. and how it contributed to the crisis.2 presents an overview of the Indonesian corporate sector. how it has affected corporate financial performance and financing. On the other hand. these controlling families had political connections that allowed their companies to enjoy special privileges. short-term loans were used to finance long-term investments.3 looks at patterns of corporate ownership and control. patterns of ownership and control. Section 1. this left the Indonesian economy extremely vulnerable. The construction sector was the worst hit. prior to the financial crisis. These banks were allowed to operate even if they violated minimum capital adequacy requirements. In many instances. and responses to the financial crisis. When the crisis hit the country. the controlling families of corporate groups often established banks to provide funds to affiliated nonfinancial companies. or Thailand.6 percent) and trade (-18 percent). contracting by 36. Economic growth reached more than 7 percent per year and the inflation rate was kept at single digit levels. posted negative growth. Section 1.5 percent.2 Corporate Governance and Finance in East Asia. 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. and analyzes their importance to the corporate sector in Indonesia. Foreign creditors. However. This study reviews the Indonesian corporate sector’s historical development. were the ones most affected. regulatory framework.5 percent. In this setup. These were already contributing to high levels of nonperforming loans (NPLs) in the Indonesian banking sector several years before the 1997 crisis erupted. The scale of the financial crisis exposed weaknesses of the country’s corporate sector. Vol. followed by finance (-26. highly leveraged companies. 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. except utilities.

With the relatively liberal laws governing foreign and domestic private investments introduced by the New Order Government in 1967 and 1968. while Chinese and indigenous entrepreneurs ran some large businesses in trading. Subsequently. medium.2 1. and tobacco industries. the windfall from oil and gas revenues was an important factor that allowed the Government to promote industrial development via import substitution. in the course of the fight for nationhood from 1942 to 1950. In the early 1970s. .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.2.5 examines the corporate sector during the financial crisis in terms of its role.Chapter 1: Indonesia 3 profiles the corporate sector’s governance characteristics. substantial volumes of private investment entered the scene. The Government became directly involved in industry as a result of the nationalization of Dutchowned shipping firms and oil companies. a gradual shift in public investment away from manufacturing took place. However. only 40 companies replied—39 are private companies and one state-owned company (Bank BNI). The industries that emerged were highly import-dependent and reliant on tariff protection.6 summarizes the major findings of the study and suggests recommendations to improve governance in the Indonesian corporate sector. Section 1.and large-scale companies were dominated by state-run industrial concerns. 2 Survey questionnaires were sent to 280 companies listed in the Jakarta Stock Exchange. 1. and its response.2 Section 1. This section reports the results of an Asian Development Bank (ADB) survey on corporate management and control practices in Indonesian publicly listed companies.4 analyzes corporate financing patterns. It also examines the statistical relationship between corporate performance and corporate governance characteristics. textiles. Up until the mid-1960s. Not all items in the questionnaires were answered by the respondents. Section 1. how it was affected by the crisis. Despite the oil revenues.

4 Corporate Governance and Finance in East Asia. II the currency needed to be devalued periodically under a managed floating exchange rate system to avoid large current account deficits. Partly as a result of various government policies. In 1992. 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). Regulations in the banking sector led to equities having higher risk but lower returns than bank deposits.2. even when new shareholders do not threaten the control exercised by the original owners. . Generally speaking. Last. the dilution of corporate ownership. mostly nonbank financial institutions and stockbrokers. exports of nonoil products (particularly textiles and footwear. the number of firms quoted in the stock market was only 24.2 The Capital Market The Government reactivated the stock exchange in 1977. the stock exchange was also unattractive to companies trying to raise capital as they could borrow from state banks at very low interest rates. many founding owners of companies were reluctant to go public and dilute their corporate ownership. But these proved counterproductive because they limited the potential for capital gains to prospective investors. Vol. wood. 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. But until the end of 1988. a distinct industrial elite started to emerge. By 1987. Second. which dominated their respective sectoral outputs and markets. During this period. the Government shifted its industrial policy toward the promotion of labor-intensive exports. 1. The equity market remained largely unappealing due to a number of factors. 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. produced consumer goods. Third. potentially subjects companies to greater regulatory scrutiny. While most of the companies were small. the Indonesian industrial sector was quite diverse. 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. A number of underwriters emerged. and related products) had shares in total exports that were rapidly increasing. and employed the bulk of the industrial labor force. First. there were also many rapidly growing large-scale companies and business groups or conglomerates.

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

8 166 248.2 161 214.6 164 144 130 92 387.9 27 113.8 31 10.9 291.1 Growth of the Banking Sector.5 7 9.9 304.5 27 66.8 27 200.3 201.8 10 37.5 7 7 7 5 15.7 351. 1993 100. Bank Danamon (ranked 7th). Of these.4 34 12.0 234 1994 104.8 391.6 Corporate Governance and Finance in East Asia. But the banking system proved incapable of performing its intermediation function.5 528. private domestic banks among the top 10 in 1997 included Bank Central Asia (BCA) (ranked first and linked to the Salim group).5 165 308.3 27 51. In terms of assets.5 27 88.7 27 37.3 30 7.4 789. The other banks among the top 10 were state banks.1 10 47. 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. II Table 1. BCA.8 27 147. Because regulation was weak.9 10 11. Among private domestic banks. Bank Danamon. the 10 largest were all affiliated with major business groups.6 34 14.6 7 7. and Bank International Indonesia (ranked 9th). banks could earn profits even when they did not gather and process information about risk.9 31 9.9 762.1 240 1995 122.4 239 222 208 173 Assets and liabilities were concentrated in the top 10 banks.6 240 1996 1997 1998 1999 141. . while BUN has been closed down by the Government. Both BCA and BUN have shareholders linked to the former President Suharto.8 10 19. 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. and Bank Umum Nasional (BUN) have failed and the first two are now under management of the Indonesian Bank Restructuring Agency (IBRA). Vol.9 248.8 29 6.6 7 12.2 10 14.3 10 17.4 10 35.9 39 18.

2.00 2. the Government allowed foreign investors to own 100 percent of an Indonesian company.59 billion in 1996.09) 1. From the mid-1980s until July 1997.01) (0. and footwear. November 2000. as shown in Table 1. Table 1. Source: IFS CD-ROM. such as metal goods. Increasingly.81 3.01 (2. But FDIs were only one form of foreign capital inflows to Indonesia. initially from Japan and the Republic of Korea.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. Most FDIs came in through joint ventures with business groups having strong political connections. 1.78 2. Although these inflows were not nearly as large as those received by Thailand (10 percent of GDP) and Malaysia (9 percent of GDP).74 5. Until the onset of the crisis. Indonesia received capital inflows averaging about 4 percent of GDP. textiles.09) (0. .33 (13. when the financial crisis hit Indonesia. Net FDI flows increased to $5.63) (1. foreign investment also had a strong presence in the services and infrastructure sectors. foreign creditors were eager to provide financing to Indonesia. Joint BIS-IMF-OECD-World Bank Statistics on External Debt.50 (0.11 3.87 7.59 4. except in certain strategic sectors.09 1.2 Foreign Capital Flows. In 1994.4 Foreign Capital The years of rapid industrial growth attracted a large amount of foreign direct investments (FDIs).40) (0. especially through bank loans.88) — — — — — — 8.88 4. In effect.15) — = not available.48 1.2. Successive policy deregulation facilitated FDIs in various light manufacturing industries. they still amounted to a large sum for the economy to absorb. IMF. FDI flows were strong. there was a phenomenal growth in direct borrowings by Indonesian corporations.10 5. there was an explosion of credit for which the probability of repayment was based on little but blind faith in the sustainability of rapid growth and on the presumption that political connections were as good as government guarantees against bankruptcy of borrowers. In the 1990s. Between 1990 and 1996. 1990-1998 ($ billion) Type of Flows Net FDI Net Portfolio Investment Foreign Bank Loans 1990 1991 1992 1993 1994 1995 1996 1997 1998 1. September 2000.

especially the short-term ones. Capital account liberalization permitted the inflow of foreign capital that fueled the credit boom in the country. 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. state-owned companies (SOCs). 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. participation in the Indonesian stock market was exclusive to domestic investors. allowing foreign investors to buy up to 49 percent of stocks of a publicly listed company. Domestic corporate debt was about $50 billion equivalent. In the 1990s. Due to data constraints. with the onset of the Asian crisis.8 Corporate Governance and Finance in East Asia.2. plus 4 percent for the depreciation of the rupiah.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.4 trillion in 1997. Consequently. This is lower than the average borrowing rate of 18 percent for loans in domestic currency. In September 1997. From 1987 to 1996. The Government relaxed this restriction in 1988. By the end of 1997. the analysis focuses only on publicly listed companies. foreign banks became a significant source of financing for the corporate sector. II Up until the late 1980s. . the average borrowing rate for dollar loans was 9 percent. The excessive dollar borrowings made the corporate sector vulnerable to sudden currency fluctuations. Between 1989 and 1992. an interesting question is whether standard measures of corporate profitability and performance also indicated the same. increasing the total trading value from Rp8 trillion in 1992 to Rp120. and conglomerates. the average foreign ownership of listed companies was 21 percent. This increased to 30 percent by the end of 1993. The following section looks at the growth and financial performance of the corporate sector. of which two thirds were rupiah-denominated. total corporate debt reached nearly $118 billion. Vol. Private borrowers preferred foreign loans since these were relatively cheaper. The external corporate debt owed to foreign commercial banks was $67 billion. In November 1998. 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. but declined to an average of 25 percent during 19951997. foreign investors began to dominate daily trading. 1.

4 1997 7.0 12.7 — 250.0 12.5 240.1 0. ranging from 220 to 250 percent between 1992 and 1996. When the crisis battered Indonesia in 1997. while total assets grew at 43 percent. 226 firms. and 1992. 1994.2 7.0 1.3 Growth and Financial Performance of Publicly Listed Companies. there were 204 firms. the average DER increased to 310 percent from 230 percent the .4 1993 45. Source: JSX Monthly (several publications). In 1997.0 3. Despite such rapid growth.6 24. 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. Asset turnover was above 30 percent until 1996.7 3.4 percent.6 percent in 1997.4 1996 18.1 percent in 1997 when the crisis began to buffet Indonesia.0 11. 1995.5 34. Return on assets (ROA) was also relatively stable during 1992-1996.0 33. but fell to 24. total sales of listed companies grew at an annual average rate of 31 percent.8 6.8 230.3 shows the growth and financial performance of Indonesian publicly listed companies.5 37. 1996. averaging 3. Table 1. 174 firms.1 220.7 percent in 1997.3 6.7 — = not available. a Value added was assumed to be 30 percent of total sales.0 10. Note: The number of firms is not identical for each year. publicly listed companies as a group contributed less than 10 percent to GDP.0 64.4 38.5 3.0 12.Chapter 1: Indonesia 9 Publicly Listed Companies Table 1. Average return on equity (ROE) of listed firms was 11. b Asset turnover is defined as sales over assets. 250 firms.6 48.6 1994 50.3 3.5 34. but declined to 0.4 31.8 percent between 1992 and 1996.6 3.8 220.2 1995 37. 248 firms.2 30.1 4. although the contribution increased over time. Net profits grew at an annual rate of more than 20 percent from 1992 to 1996.9 310.9 37. but dropped to 1.0 6. The debt-to-equity ratio (DER) was high compared to those of listed companies in Malaysia and the Philippines. but turned negative in 1997. During 1992-1997. 246 firms. The growth of listed companies was sustained by continuing investments. 1993.

7 percent during 1992-1996. Four sectors (basic industry and chemicals. Table 1. infrastructure. miscellaneous industry. when the property sector was booming during 1993-1997. followed by agriculture (Table 1.64 percent in 1997.10 Corporate Governance and Finance in East Asia. The finance.2 in 1997. still posting a positive but lower ROE. averaging 21. ROA of all sectors dropped in 1997. the mining sector had the lowest DER.4). ROE fell drastically because the sector had one of the highest DERs. only two sectors (mining and finance) showed a consistently increasing trend from 1992. with ROE falling to -11. the dominant sector was the finance sector.3 percent between 1992 and 1996. and trade. investment. Vol. it appeared that the performance of listed companies was quite satisfactory prior to the crisis. although asset turnover was slow. consumer goods. and services.5 presents the financial performance of listed companies by sector. the mining sector had the highest ROE. The Jakarta Stock Exchange (JSX) classified listed companies into nine sectors: agriculture. and services. and building construction. For instance. Also. the companies in the sector did not operate with a high leverage. the fluctuation in nickel and copper prices contributed to the oscillation of ROE. the banks eagerly provided credit to property development companies. and property. However. miscellaneous industry. investment. mining. The consumer goods sector ranked second in terms of ROE. finance. During those years. Most companies in the sector that had unhedged dollar-denominated loans suffered exchange rate losses when the rupiah weakened. But the sector’s ROE fluctuated a lot. basic industry and chemicals. averaging 17. This sector was less affected by the crisis. in terms of growth of sales and assets. property. Overall. which operated in nickel and copper mining in 1992 and 1993. due mainly to the domination of the International Nickel Company of Canada. indicating its reliance on equity to support growth. The finance sector’s contribution to GDP. The same applied to the trade sector. trade. Before the crisis. II previous year. When interest rates increased. and trade) even posted . and building construction sectors had the highest DERs because companies in these sectors found it easy to obtain credit from banks.73 percent in 1992 to 1. From 1995. increased from 0. The ROE levels suggest that high leverage enabled listed companies to achieve high returns on equity. helped in part by the relatively strong demand for consumer goods. the property sector was severely affected by the crisis. real estate. the mining sector ranked first. meanwhile. Meanwhile. In terms of share of value added to GDP. This indicates that a substantial part of corporate debt was denominated in dollars and unhedged. real estate. In terms of sales and asset levels in 1997. property.

1 1.9 25.8 1.0 0.7 17.4) 8.0 0.6 51.6 0.0 22.5 13.1 42.5 1.6 28. Investment.6 1.5 61..8 29. 1992 — — — — — — — — — — — — — — — — — — — — — — — — — — — 0.5 23.9 53.1 0.3 0.1 35.7 1995 51.4 30. and Bldg. Infrastructure Finance Trade. Industry Consumer Goods Industry Prop.8 1.1 1.6) 19.8 62. Constn..2 5. and Bldg.4 1993 155.0 43.7 133.3 17.0 0.9 1. and Bldg.4 0.7 34.3 (203.2 11.1 0.7 28.5 1.6 (0.6) 119.1 0.7 112..5 (11.5 0.6 133.8 (76.9 .9 123.0 1996 1997 58.9 0. 1992-1997 (percent) Indicator/Sector Sales Growth Agriculture Mining Basic Industry and Chemicals Misc. and Services Asset Growth Agriculture Mining Basic Industry and Chemicals Misc.1 0. Constn.9 (7.4 (149.5 9.3 92.7) 26.4 21.9 64.4 1.7 24.0 0.1 71.8 0. Industry Consumer Goods Industry Prop.7 62. Real Estate. Source: JSX Monthly (several publications).6 0.4) 6.0 (192.8 32.1 1. and Services Net Profit Growth Agriculture Mining Basic Industry and Chemicals Misc.5 0.5) 49. Investment.2 41.4 1.4 1.9 54.1 0.1 23.0 (28.1 1.2 41..6 0. Infrastructure Finance Trade.0 64.1 16.Table 1.0 16.8) 0. Infrastructure Finance Trade.9 0.6 0.9 54.3 31.8 24.5 92. Industry Consumer Goods Industry Prop.3) 39.7 54.8 28.3 0.1 67.0 68.7 — 36.6 26.0 24.8 50.4 64.9 31.6 24.7) 17.9 14.6 83.0 1.4 77.7 43.0) 46.0 0. Real Estate.7 40.3 1.6 1994 (75.2 0.6 22.1 0.6 135.1 0.8 66.2 35.4 30.2 13.1 0.7 — — 11.8 51.7 0.5) 6.4 43.1 — 39.1 1. Real Estate.9 59.3 340.1 32. and Services Share of Value Added in GDP Agriculture Mining Basic Industry and Chemicals Misc.3 0.4 Growth Performance of Publicly Listed Companies by Sector. Investment.3) 53.8) (12.5 68.7) (113.7 21.6 15.9 8.1 (41. Infrastructure Finance Trade.9 36.4 38.7 90. Industry Consumer Goods Industry Prop. Constn.7 (82.0 0.5) 13.3 51.7 0.5 (8.4 170.6 85.7) (27. and Services — = not available.2 14.0 18. Real Estate.4 103.8 27.3 31.4 44.1 (11.5 95.5 1.2) 0.6 (41.2 59. and Bldg.4 31.5 45.3 0.3 0. Investment.0 31.5 28.5 53.1 0.0 (20.2 0.6) 25.1 0.1 28. Constn.

1 13.3 33.1 4.7 10.4 79. Infrastructure Finance Trade.6) 36.2) 15.3 38.5 56.7 71.6 8.0 66.4 13.1 1.4 6.8 479. and Bldg.0 12.3 1.6 (2.4 35.8 168.4 20.0 150.2 30. Industry Consumer Goods Industry Prop.1 (5.7 4.Table 1.0 70.0 680.8) 8.2 7.7 5.3 18.3 0.8 81.1 4.2 13.3 17. Investment.2 3.0 69.1 7.4 13.4 4.2 23.7 12.0 70.2 11.0 46.1 3.9 4.0 130.7 10.0 150. and Services Return on Assets Agriculture Mining Basic Industry and Chemicals Misc.0 8..0 140.7 12.9 17.8 11.6) 18.0 170.0 120.2 15. Industry Consumer Goods Industry Prop. and Services Source: JSX Monthly (several publications).0 3.6 14. Constn.6 19.0 19.1 9.0 11.8 5.0 50.5 1995 80.8 382.4 .3 17. Real Estate.6 (11..0 80.2 6.8 20.0 700.0 100.7 10.9 40.2 7.2 1993 130. Infrastructure Finance Trade.0 110. Investment.4 5.0 (0. Investment.8 44. 1992-1997 (percent) Indicator/Sector Debt-to-Equity Agriculture Mining Basic Industry and Chemicals Misc.0 180.0 15.1 1996 100.0 17.7 (3.1 6.9 87.4 1.0 100.2) 7. and Bldg.5 17.0 220.1 10. Infrastructure Finance Trade.9 38.0 100.0 120.1 11.7 5. Real Estate.8 11.0 190. Infrastructure Finance Trade.7 1.5 4.0 39.7 8.4 71.2 53.6 74.7 1.0 86.2 8.0 110.0 160.5 4. Real Estate.9 41. and Services Return on Equity Agriculture Mining Basic Industry and Chemicals Misc.4 46.0 190. Industry Consumer Goods Industry Prop. 1992 20.1 89.6 18. Constn.6 8.1 65.9 10.0 8.7 4.3 5.8 9.0 80.3 73.0 120.8 16. Investment.7 4. and Bldg.3 7.0 650.0 210.1 4.3 13.5 19..7 13.7 61.0 120. Real Estate.5 7.5 43.0 160.7 46.0 150.2 (4. Industry Consumer Goods Industry Prop.8 67.6 1.0 110.5 5.0 70.1 2.2 39.3) 5.0 90.9 29.1 10.9 14.4 6.1 1994 80.0 180.1 (3.8 3.6 13.0 9.0) 7.0 380.5 Financial Performance of Publicly Listed Companies by Sector.6 23.5 14.5 11.0 560.0 110.0 1997 230.4 46.9 42.3 64.0 100.0 190.8 25.5 13.7 12.0 650. Constn.1 8.1 63.7 26.0 110.2 3.4 35. Constn.0 110.0 60.8 8.0 140.4 17.0 80.0 110.7 9.1 9.9 38..1 10.0 180. and Services Asset Turnover Agriculture Mining Basic Industry and Chemicals Misc.3 7.9 7.0 630.2 111.0 3.0 160.6 13. and Bldg.0 14.7 8.4) (1.

which collectively had the largest assets. Asset turnover rates were lower relative to those of publicly listed companies.3 trillion.1 percent in 1993.1 percent in 1992 to 28. growth of net profits and assets was erratic. increasing from 21. The Department of Mining and Energy ranked first in terms of sales of SOCs under its control. SOCs’ ROE ranged from 6. Trade had the highest ROA of 39. SOCs actively operated in various sectors4 under the supervision of “technical” departments. For instance. However. The sectoral distribution of 165 SOCs is as follows: nonfinancial (143 companies). averaging 24 and 31 percent.4 percent the following year. the ratio decreased from 8. the SOCs’ value added as a percentage of GDP ranged from 6 to 8.7 to 7 percent for publicly listed companies. between 1993 and 1995. the subsidiaries and affiliates number 459 with total assets of Rp343. registering an average annual rate of 10 percent. ROA had been at high levels from 1992 to 1995. These growth rates were low compared to those for listed companies during the same period. insurance (11 companies). This was relatively high compared to the 3. much lower than that of companies listed in the stock exchange. SOCs’ sales growth fluctuated during 1990-1996. Six SOCs were listed in the Jakarta Stock Exchange. Similarly. The finance and miscellaneous industry. there were 165 state-owned companies (SOCs)3 in Indonesia. but dropped dramatically to 4. Only the agriculture sector showed an increase in ROA in the couple of years before 1997. and basic industry and chemicals sectors had relatively stable ROA before the crisis. banks (seven companies). the Department of Finance supervised 30 SOCs. but it continuously declined from 370 percent in 1992 to 250 percent in 1995. and finance company (four companies).7 percent. By 1995. Assuming a fixed ratio of value added to sales.6). State-Owned Companies At the end of 1995.Chapter 1: Indonesia 13 negative ROA. SOCs diversified into many businesses. there were 58 SOCs with subsidiaries and affiliates.7 percent in 1990 to 6 percent in 1996. This was due to large sales by the National Oil Company (Pertamina).3 percent in 1995. . The DER was slightly higher than for listed companies.6 to 8. respectively. While asset turnover rates of publicly listed 3 4 SOCs are those in which the State has at least a 51 percent equity interest. Taken together.8 percent between 1992 and 1995 (Table 1. indicating SOCs’ declining contribution to GDP. Just like private companies.

Assuming a constant ratio of value added to sales.4 16.0 6.4 13.4 percent in 1994.6 Growth and Financial Performance of State-Owned Companies. SOCs’ asset turnover rates showed a downward trend from 32. these conglomerates owned 9.0 17. mostly private companies.1 310.0 8.6 1995 25.6 28. Source: Indonesian Data Business Center.1 30. 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. a Value added was assumed to be 30 percent of total sales. but dropped to 11.3 30.766 business units. II companies consistently declined over time. Vol.0 12.0 8.6) 260.7 (2.4 percent in 1992 to 28. 1990-1997 (percent) Item Sales Growth Share of Value Added in GDPa 1990 1991 1992 1993 1994 1995 1996 1997 — 17.6 28.8 12.0 28.2 — = not available.2 18.1) 5.7 13.0 7.1 19. Source: Indonesian Data Business Center.5 percent in 1995.1 trillion in 1990 to Rp234 trillion in 1997. In 1997.4 13.0 24.2 percent in 1997 (Table 1.7).2 — 370.4 1993 16. b Asset turnover is defined as sales over assets. .4 7.7 Growth Performance of the Top 300 Conglomerates. a Value added was assumed to be 30 percent of total sales.2 23.7 16.8 21.5 Conglomerates This study used available data on the top 300 conglomerates in Indonesia. but climbed to 30. Table 1. 1992 — 7.7 1994 (9.14 Corporate Governance and Finance in East Asia. Their total sales increased from Rp90. the contribution of conglomerates to GDP increased from 12.3 12.1 12.4 13. Table 1.3 250.8 percent in 1990 to 13.1 6.1 32.8 11.5 3.6 percent in 1994.

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

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

Ownership concentration is usually measured by the proportion of shares owned by the top one. for instance. the collateral could take the form of nonphysical assets (e. A new bankruptcy law was passed in August 1998. states that a bank is not allowed to provide credit without collateral. five. However. holding companies. The two most important elements of ownership structure are concentration and composition. capital adequacy. It reveals characteristics of controlling shareholders. or 20 shareholders. For instance.1 Corporate Ownership Structure Quality of corporate governance is closely related to corporate ownership structure (see discussions in the Consolidated Report of this study).Chapter 1: Indonesia 17 Bankruptcy Law Despite loan covenants. 1.3 Corporate Ownership and Control This section looks at the ownership structure of the corporate sector and reports the results of an ADB survey on corporate management and control of publicly listed companies. The 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. the Banking Law (1992). the viability of a project). or financial institutions. amended in October 1998. families.3. net open positions. The court can declare the debtor bankrupt upon the request of at least two creditors and default on one loan. whether they are individuals.g. 1. A Commercial Court was also set up to deal with bankruptcy cases. 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.. Banking regulations also set lending limits. It aimed to protect creditors by providing easier and faster access to legal redress. . etc. Discussions on corporate ownership cover listed companies and conglomerates. creditors of unsecured loans are unprotected when borrowers fail to meet their obligations. Banking Laws Affecting the Corporate Sector Some elements of the banking law also affect the corporate sector.

The pattern of ownership concentration changed little over this period.2 67.6 3. mining.8 1.6. This preserves the pro rata share of existing shareholders.5 1997 48.0 1.8 shows average proportions of shares owned by the five largest shareholders of publicly listed companies during 1993-1997. Data from the Indonesian Capital Market Directory (various publications) show that between 1993 and 1997.0 67. When a company makes a rights issue.5 Average 48. and Berlian Laju Tankers (liquid bulk maritime transportation services) issued 48.5 72.7 3.1 13.9 Source: The Indonesian Capital Market Directory. This is partly due to the prevailing practice of raising equity through rights issues in Indonesia.1 4. Table 1.9 percent of total outstanding shares.9.3 1995 47.2 11.6 68.8 68.5 12. for instance. ownership widely held by the general public is highest in the infrastructure and transportation sector (not shown in the table). On average.0 0. issued 93.6 13. 2.9 14. This is because a few companies in the transportation sector issued high proportions of shares to the public. II Publicly Listed Companies Table 1.9 2.6 3.2 1.6 4. the founder usually continues to own the majority of shares through a .0 2.0 0. Rig Tenders Indonesia (shipping services) issued 51. the controlling shareholders usually act as standby buyers.8 Ownership Concentration of Publicly Listed Companies. Meanwhile. 1993-1997 (percent) Shareholder Rank First Largest Second Largest Third Largest Fourth Largest Fifth Largest Total 1993 50. about two thirds of publicly listed companies’ outstanding shares were owned by corporations that were directly or indirectly controlled by families.1 0. The percentage owned by each of the five largest shareholders was 48.8. the five largest shareholders owned 68.8 68.9 shows that ownership by the largest shareholder in 1997 was more concentrated in the agriculture.6. and 0.1 1. Zebra Nusantara (taxi services). consumer goods.18 Corporate Governance and Finance in East Asia. When a company goes public. 3.4 percent.0 4.4 2. Table 1. and basic industry and chemicals sectors than in others. 13.9 0.5 16. Vol.5 percent.7 1996 48.7 1994 48. respectively.9 2.6 percent.

1 2.6 0. on the other. In terms of capitalization. and only 0.5 58.1 13.4 1.2 This is confirmed in Claessens et al. Investment.3 36.9 Ownership Concentration of Publicly Listed Companies by Sector.. 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.6 percent of total market capitalization while the top 15 families control 61.9 1.1 0.6 percent were widely held.8 14. and Services Average Source: The Indonesian Capital Market Directory. First Second Third Fourth Fifth Biggest Biggest Biggest Biggest Biggest 54. the top family controls 16.1 1.3 0.Chapter 1: Indonesia 19 fully-owned limited liability company (Perseroan Terbatas). the rule of law.1 1. Real Estate. and the efficiency of the judicial system.1 0.1 2.1 11.6 9. Infrastructure. Industry Consumer Goods Industry Prop. Constn.9 0. 1997 (percent) Sector Agriculture Mining Basic Industry and Chemicals Misc.7 6. and Bldg.2 10.2 46. two thirds (67.2 2. Legal and regulatory developments may have been impeded by the concentration of corporate wealth in . Most of the five largest owners of Indonesian publicly listed companies are limited liability companies rather than individuals. Indonesia has the largest number of companies controlled by a single family.4 11.1 1. (1999) also found.3 0. in a cross-country study.7 9.2 0.4 54.1 2..6 1.9 3.1 percent) of Indonesian publicly listed companies were in family hands.7 13. on the one hand. that the correlation between the share of the largest 15 families in total market capitalization.5 1.9 44.9 50.3 2. Table 1. Util. as well as the existence of corruption.7 1. Claessens et al.6 2. (1999).9 44.4 6.7 percent of the market. These figures suggest that ultimate control of the corporate sector rests in the hands of a small number of families.4 4.2 15.0 5.3 48. and corruption.1 1. and Transportation Finance Trade.4 44. Thus the founder keeps the proportion of shares necessary to retain control over management of the listed firm. In fact.5 4.3 14. which shows that in 1996. is strong.6 8.7 4.

the legal system is less likely to evolve in a manner that protects minority shareholders. But these benefits are few and often dubious compared to the high costs of concentration. In September 1997. However. During 1988-1996. and family origin. 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. there is a dichotomy between corporations owned by indigenous and nonindigenous businesspeople. Among the top 300 conglomerates. Batak. foreign ownership increased to 21 percent.42 percent in December. . Vol. Indian. the proportion of foreign ownership declined from 27. Indigenous businesspeople include the Javanese. and Padang.10 shows the anatomy of the top 300 conglomerates in terms of year of establishment. Coordination is easier because informal communication channels exist. accounting for 64 percent of total conglomerate sales in 1988-1996.20 Corporate Governance and Finance in East Asia. the Government allowed foreign investors to buy up to 100 percent of listed shares. numbering 162 in 1988 and 170 in 1996. their number increased to 5 In 1997. When the Government allowed foreign investors to buy up to 49 percent of listed shares in 1988. In 1993. ethnicity. Sundanese. or other ethnic groups. was able to create a favorable environment for business development. most were established during the New Order Government. but later declined and steadied at around 25 percent. From 193 in 1988. the onset of the crisis negated this development. conglomerates established before 1969 dominated in terms of sales. with all its regulations. political affiliation. The corruption and regulatory problems generated by high ownership concentration by families in Indonesia are likely to overwhelm its benefits.5 Conglomerates Table 1. However. The nonindigenous businesspeople are usually Chinese. In Indonesia. II the small number of families and the tight links between companies and the Government.55 percent in August to 25. This may indicate that the New Order Government. nonindigenous groups owned a larger proportion of the top 300 Indonesian conglomerates. it rose to 30 percent. resulting instead in a decline in the proportion of foreign investor ownership. Family control is said to have positive effects in that it allows group members in conglomerates to make strategic decisions quicker.

4 trillion in 1996.0 18.7 95.7 28. its sales reached Rp1.0 58.4 52.1 52.4 32.0 28.4 86.2 23.9 73.2 33.4 81. more than five times its 1988 level.4 18.8 36.3 120. sales of the Bakrie group before it went public in 1990 were only Rp369.3 36.4 59.8 28. due to their “go public” activities.8 38.7 49.0 116.4 31.0 15.3 134.5 21.6 34. Their total sales also increased from Rp38.10 Anatomy of the Top 300 Indonesian Conglomerates.3 80.6 77.9 47.1 42.8 12.0 31.3 43.2 12.4 22.9 14.8 30.9 77.8 68. Conglomeration Indonesia 1997.9 trillion.4 19.5 120.8 49. Meanwhile.2 48.4 48.0 44.6 12.0 58.1 41.1 percent of total . the number of mixed groups declined from 86 in 1988 to 68 in 1996.4 68.1 25.5 22.6 114. In 1996.8 57.5 106. While they supplied 20.8 25.1 46.7 40.6 95.9 137.9 35.4 37.1 179.4 16.4 69. 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 15.8 Source: Indonesian Business Data Centre.3 101.1 33.2 159.6 trillion in 1988 to Rp137. 204 in 1996.7 24. For instance.2 30.4 31.9 13.2 76.1 46.4 59.1 87.1 58.4 57.Chapter 1: Indonesia 21 Table 1.9 billion.7 106.1 103.1 21.7 89.6 54.9 42.7 64.3 20.6 17.2 29.

including Indofood Sukses Makmur (food industry). 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. More recent alliances were between Bambang Trihatmodjo (former President Suharto’s son) and Johannes Kotjo. Only about 13 percent were formed by official or ex-official families. there were 175 groups that originated from a family business. Vol. Conglomerates were also classified into nonofficial. or have resulted from alliances between entrepreneurs and officials.22 Corporate Governance and Finance in East Asia. Banks owned by groups or conglomerates typically act as a “cashier” that provides credit to companies within the group. In November 1997. The Salim group. Out of 174 companies. The contraction in the number and economic contribution of mixed groups may be an indication of increasing social polarization along ethnic lines. Bambang Rijadi Soegomo. collectively controlling . II sales in 1988. compared with the less than Rp700 billion of a nonofficial-related conglomerate. average sales of official-related conglomerates reached Rp1. Prudential credit analysis tends to be ignored.and officialrelated groups. 117 are jointly owned by the family and 57 are owned by individual family members. which is the largest conglomerate in Indonesia. Official-related groups have owners (or founders) who are or are allied with former or current government officials (or their families). owns four groups with many subsidiaries and affiliate companies. their contribution declined to 13. But only a handful of these companies are listed in the market. Some of them later became public companies by listing in the stock market. The high NPLs accumulated by banks within official-related groups could be partly attributed to this practice. and Wisnu Suhardhono of Apac-Bhakti Karya. Most of the top 300 conglomerates were established by ordinary citizens.7 percent in 1996. In 1996. Bank Indonesia. The well-known official-business alliances are those between Sudwikatmono (former President Suharto’s cousin) and Soedono Salim. and Fast Food (restaurants). Indocement Tunggal Prakarsa (cement industry). But listed companies within conglomerates were few. most of the 16 liquidated banks had violated the legal lending limit set by the central bank. banks that had to be closed down included Bank Surya (owned by Sudwikatmono) and Bank Andromeda (owned by Bambang Trihatmodjo). In 1996. for instance. In 1997 and 1998. and Ibrahim Risyad of the Salim group. Djuhar Soetanto. Average sales of official-related conglomerates were substantially greater than nonoffficial-related ones during 1988-1996.2 trillion.

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

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

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


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

Another case was the takeover of Bank Niaga in 1997 by Djojohadikusumo. with the minister’s approval. Bank Niaga was under a recapitalization program. They then replaced the BOD and later sold the bank. Before the financial crisis. The BOD and BOC of PT Sari Husada were allowed to complete their terms before they were replaced. However. at a large profit. Most Indonesian state companies are 100 percent owned by the Government. the acquiring parties were trying to obtain operating synergies because they had companies in the same industry. 6 7 Later in March 1999.6 In this case. the bank was liquidated. a state-owned insurance company may invest its funds in a private firm. appointment of management. restrictions on market entry. the takeover brought significant losses to Djojohadikusumo when share prices plunged7 during the crisis. Since the NPLs reached up to Rp300 trillion. 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. or direct subsidies. which was acquired by Yopie Wijaya in 1995. This used to be a common practice in companies associated with the Suharto regime. the acquiring interest was apparently seeking economic profits. In April 1999. In these two latter cases. who was acquiring his second commercial bank. For instance. the Government took over NPLs and put them under IBRA management. In the massive restructuring of the banking sector that commenced after the crisis. . The Government is thus able to appoint some officials to be members of the private firm’s BOD or BOC. One famous takeover was Bank Papan Sejahtera. to Hashim Djojohadikusumo. the owner of Tirtamas group. The bank was reported to have high NPLs and had broken the legal lending limit. except for publicly listed SOCs.Chapter 1: Indonesia 31 external acquisitions. A study by Connie Tjandra (1993) shows that internal acquisitions were often initiated for tax shelter purposes. Wijaya and his friends bought shares of the bank on several occasions until they gained control. Control by the Government Government control could be in the form of state ownership. it was common for the Government to invest in certain private companies. The Government appoints the BOD and BOC of these firms. IBRA found itself tasked with managing large amounts of assets in the private sector. State ownership for listed SOCs ranges from 25 to 35 percent.

When the Government liberalized the banking industry at the end of 1988 (which allowed for higher interest rates).1 Corporate Financing Financial Market Instruments Prior to 1977. private national banks overtook state banks as the dominant credit source.9 150. stocks.4 24. 1992-1999 (Rp trillion) Type of Bank State-Owned Banks Foreign Banks Regional Govt Banks Private National Banks Total Source: Bank Indonesia.0 6.0 3.4 1. bank loans were the only instruments available to the corporate sector for short term (working capital) or long term (investment) financing.5 7.3 14.9 153.0 168. equities became available to the corporate sector. when the Government reactivated the stock exchange. Since then.5 42.3 60.1 220. new instruments have been introduced to the corporate sector.14. this market was not well developed.3 66. Vol.6 48.32 Corporate Governance and Finance in East Asia. jointly providing almost 90 percent of loans until 1997.4 56.3 9.6 percent in 1997.5 108.7 122.4 225.7 18. bank credit surged from Rp122. Data from Bank Indonesia show that from 1994 to 1997.6 150.4 trillion in 1998. .2 27.2 6.0 487.4.0 93.6 6.2 5. however.14 Banking Sector Outstanding Loans. including bonds. because of the restrictions discussed below. companies considered alternatives to bank loans. However.4 86.3 111. II 1.6 3. Bank loans. and others offered by nonbank financial institutions or finance companies.9 234. From 34.9 378.3 188.4 percent in 1992.6 4.1 Equities In 1977.7 50. 1992 1993 1994 1995 1996 1997 1998 1999 68.6 292.7 112.2 71.9 trillion in 1992 to Rp487. the share of private national banks in outstanding total loans increased to 44. Table 1. Bank Credit As shown in Table 1. remain the major financing instrument for the corporate sector.5 80. Private national banks and state-owned banks were the biggest domestic creditors.8 193.

They were not.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. finance companies were increasingly used as channels for the inflow of foreign loans.15 Value of Stocks Issued and Stock Market Capitalization. Overall.0 15.5 333. .0 70. factoring. It gradually increased again starting in 1991.6 123. legal lending limit.4 207. but dropped to 8 percent in 1991 when the Government tried to stabilize an overheating economy. shooting up to 18. however. and consumer credit. thus increasing the role of the capital market in raising long-term funds. 1992-1999 (Rp trillion) Item Stocks Issued Outstanding (As % of Outstanding Bank Credit) Market Capitalization Source: Bank Indonesia. funds raised in the stock market were less than 5 percent of the credit disbursed by the banking sector.7 percent in 1997.Chapter 1: Indonesia 33 Some companies went public.7 14. and net open position). the stock market has gained a bigger role in corporate sector financing (Table 1.1 10.4 1996 1997 1998 50. i. allowed to accept deposit accounts from the public. Most banks therefore set up subsidiary finance companies to circumvent banking regulations.9 1999 76.g. 1992 1993 11.5 Financing by Finance Companies Finance companies first emerged at the end of 1980. During the 1990s.1 18.6 91.7 9. Table 1.0 206. the Government issued regulations to supervise and promote prudential practices in finance companies. In 1995. Prior to 1995.. capital adequacy ratio.1 1994 26.1 17. offering services such as leasing. 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 1996.7 15.5 1995 35.2 16.6 859. when foreign investors were not yet allowed to purchase listed shares. limiting loans to a maximum of 15 times equity and foreign loans to five times the equity. The ratio reached 8. the activities of finance companies were not covered by regulations on prudential practices in the banking sector (e. In 1988.8 48..9 406.6 310. credit cards.6 301.15).e.

6 100.5 21. Thus in November 1995.4 23.4. 1986-1996 (percent) Financing Source Internal Borrowings Short-Term Long-Term Debentures/Equity Debentures Equity Trade Credit Others Total 1986-1990 36. This is in contrast to the lower share of borrowings during the same period.5 11.6 23.0 3. II Commercial Papers Commercial papers. otherwise it would be classified as a loss in the banks’ books.8 7. Source: Author’s estimates based on the Pacific-Basin Capital Markets (PACAP) Databases.4 13. short-term borrowings were greater than long-term debts.1) 23. In terms of composition.6 100. have been popular in Indonesia since 1990. .16 shows financing sources of Indonesian publicly listed nonfinancial companies estimated by using flow-of-funds analysis.0 39.16 Financing Patterns of Publicly Listed Nonfinancial Companies.3 (0.5 percent and 36. While banks had some exposure to these instruments.3 37.3 16. which are unsecured negotiable promissory notes with a maximum maturity of 270 days.4 8. at 81 percent of total borrowings.3 14. Table 1. respectively. Vol. they were not rated by a rating agency.0 — = not available.34 Corporate Governance and Finance in East Asia.9 16. 1.1) 23. In the second half of the 1980s.8 17.6 8. Bank Indonesia prohibited banks from underwriting issues of commercial papers but allowed them to act as paying agents.5 (0.0 1991-1996 16.0 1986-1996 17. publicly listed nonfinancial companies had high proportions of equity and internal finance (retained earnings). PACAP Research Center. averaging 26. 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).6 12.8 percent.0 100. 1996.2 Patterns of Corporate Financing Table 1.2 26.7 22.5 — 26.

4. This amount doubled in 1997. Corporate debts grew over time. except Semen Gresik (an SOC). reaching Rp229. while Semen Cibinong’s losses reached Rp2.4 trillion in 1993 to Rp112. . Indofood registered losses of almost Rp1. These liabilities grew significantly because corporate expansion was largely financed by debt.9 trillion. For instance.Chapter 1: Indonesia 35 In the 1990s. They also do not want to dilute corporate control and are more likely to finance growth with debt. Indosat and Telekom. Two telecommunications companies. Note that the corporate sector’s high leverage existed side by side with sizable equity capital raised from the capital market. that ownership concentration may be associated with heightened risk-taking by companies. Bank loans also surged when the banking sector was liberalized in 1988. Many companies suffered big losses in 1997 due to their high exposure to dollar loans. was due largely to a rapid rise in long-term debts. which was masked by the rapid growth in investments. The high share of equity financing was due to the surge in capital market activity following the 1988 reforms. 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.2 trillion. Most corporate charters require commissioners to approve debt issues or sign debt agreements.6 trillion and Rp1. Of the various financing sources. in the context of Indonesia and some other countries. corporate debts accounted for 39. also suffered from foreign exchange losses but managed to post profits of Rp0. respectively. All companies in the cement industry suffered from foreign exchange losses. The results indicate that firms with higher ownership concentration tend to have a higher DER. 1.3 Corporate Financing and Ownership Concentration It has been suggested. with longterm debts increasing rapidly.9 trillion in 1996.1 trillion.17 compares the DER of listed firms by degree of ownership concentration. as evidenced by an average DER of 230 percent during 1992-1996 that rose to 310 percent in 1997. The corporate sector invested heavily from 1991 to 1993 and slowed down its investment spending a few years before the 1997 crisis. the corporate sector’s high leverage. Table 1. Large shareholders are inclined to undertake risky projects intended to generate high returns using borrowed funds. which managed to post significant profits due to low exposure to dollar-denominated loans.3 percent during 1991-1996. the pattern changed.2 trillion (mostly foreign exchange losses). rising from Rp54.

the free capital flow system allowed private companies to borrow dollars offshore without any restriction. Table 1. to maintain control of the company. the borrowings swelled.0 Notes: Firms with high ownership concentration have more than 50 percent of shares owned by the top five shareholders. decisions on debt are made with the implicit endorsement of owners. heavy reliance of companies on bank credits to finance investments. the private sector borrowed heavily in unhedged dollars.5 1. The low cost of foreign loans and the relatively stable exchange rate created a false sense of security for corporations.56 significant at the 10 percent level. 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 . since commissioners represent the controlling party. Source: Author’s estimates. In addition.5.36 Corporate Governance and Finance in East Asia. Vol. As a result.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. ultimately.0 386. The test of the difference between the two means found the t-value of 1. II However. 1.0 1. The availability of bank credit brought by the rapid rise in the number of banks and the free capital flow system led to a credit boom.0 351.1 The Corporate Sector in the Financial Crisis Causes of the Financial Crisis Many intertwined factors led to the crisis.358. and high ownership concentration among families with political affiliation. Controlling parties rely on external financing to maintain their equity share and. Inadequate Financial Regulatory Framework Liberalization of financial markets increased the corporate sector’s access to domestic and foreign private capital. Between 1987 and 1996.

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

Projects involving massive capital investments and long-term operating deals (in telecommunications. There were cases where banks and borrowing companies were controlled by the same groups or families with strong political connections. Families retain control by keeping the majority percentage of outstanding shares. or both. The ultimate control of the corporate sector rests in the hands of a small number of families who own groups of companies. there was also almost universal confidence that the economic growth would continue indefinitely. Collusion between big businesses and the political elite was widespread in Indonesia. as they had done so in the years before the crisis. In many cases. Controlling shareholders also prefer to use debts to finance expansion so as not to dilute their ownership. and investing shares among nonfinancial companies within the group and in other groups’ companies. banks did not lend on the basis of the soundness of the project. Since the Government could not afford to undertake these projects. This was often the case in the banking industry. and power generation) require huge capital. They ensure that commissioners represent their interests and maintain close relationships with the chairperson. and in the process maintain control of the company. High Ownership Concentration High concentration of corporate ownership (particularly by families) led to poor financing and investment practices.5 billion was owed directly by corporations. most often to people who were close to the ruling regime. total private sector foreign debt stood at $72. but on the basis of who the borrower was. $35 billion of Indonesia’s foreign debt owed to private foreign banks was about to mature in less than one year. of which $64. Aside from the fact that many of these loans were channeled through banks and corporations of politically connected families. Corporations were certain that they could roll over short-term loans when these fell due. They enhance their control over companies through cross-shareholdings.5 billion. II By mid-1997. This fact was usually not disclosed in financial statements. In early 1998. . by setting up their own banks. toll roads. partly because they used nominee accounts to register ownership rather than set up a holding company.38 Corporate Governance and Finance in East Asia. where private banks are usually in the hands of big businesses. Family-controlled corporations were generally structured as a complicated web of affiliates and associated companies. politicians. contracts were granted to the private sector. Vol.

58 trillion (meaning their losses were greater than the paid-up capital). followed by the finance and trade sectors.1 5.2 Impact of the Financial Crisis on the Corporate and Banking Sectors Impact on the Corporate Sector Table 1. and building construction.19. The consumer goods industry reported the lowest ROE.7) (8.6 12. Most sectors showed significant increases in leverage.8) (11. when all sectors. much higher than the 307 percent registered in December 1997.6) (0.3 Source: Central Bureau of Statistics (Biro Pusat Statistik.8) (13.0) 1999 2.18 GDP Growth by Sector.5. Only 86 companies reported profits.7 1998 (0.6 4.4 7.7) (2. DER and ROE were calculated per sector. Using the financial statements as of 30 June 1998 of 161 publicly listed companies.0 5. and Fisheries Mining and Quarrying Manufacturing Electricity.0 3.1 6.2 (1. Livestock.6) (3. except utilities. This continued in 1998.370 percent.4 5.5) (18.18 shows that growth in most sectors significantly fell in 1997. Table 1. followed by property.6 13.24 trillion for the first six months of 1998.8 0.9 3.8 8.6 (36. posted negative growth rates.8 7.Chapter 1: Indonesia 39 1. The average DER was found to be 1.52 trillion. Forestry. and Business Services Other Services GDP 1996 3. real estate.7) 2. and 128 companies reported a total loss of Rp46.0 2.1) (26.1 (1. Real Estate. BPS). Hotels. as shown in Table 1. Gas.8 1997 1. 1996-1999 (percent) Sector Agriculture. Sectors with lower ROE generally had higher DER.0) (15.4 7.3 12.4) 2. 53 companies reported negative equity of Rp6.3 11.2 8. The construction sector was the worst hit.6 8.4) (0. The JSX Monthly reported that total losses of 214 listed companies amounted to Rp39.1) 1. indicating a rapid rise in .7 6. and Restaurants Transport and Communications Financial. and Water Supply Construction Trade.

1 (5.0 2.1 (124. As the rupiah weakened and interest rates increased.395. First. foreign exchange losses came about with the use of unhedged foreign debt.0 219.0 1. Impact on the Banking Sector Table 1.0 105. and would have kept on increasing if interest rates had not declined.370. This figure further increased to 47.0 158.0 65.8 17.20 reveals that the banking sector’s ROE decreased significantly in 1997.9 12.0 631. small foreign banks enjoyed the highest profits.0 229.6) 15.19 DER and ROE of Publicly Listed Companies by Sector.5 percent in April 1998. private banks posted negative ROEs in the same year. Financial and banking analysts estimate that by September 1998.0 205.0 177.0 108. The huge losses suffered by most companies were caused by three factors.2 23.0 1.0 2. the NPL ratio rose to 25.0 a ROE 1996 1997 1998a 14.0 97.097.0 1998 186.0 163.0 177.1 (3.4 (6. The table also reveals that although private national banks dominated the banking sector in terms of assets and credits.0 307.7 percent in July 1998. a Actual data for 1st semester only. Mostly suffering from a liquidity squeeze.1) 7. but annualized to approximate full year values.1 (92.0 193.625.8 (373.8) 36.0 191.7 1.0 864.0 12.0 1.0 111.0 635. Source: JSX Monthly. Vol.0 72.5 8.271.40 Corporate Governance and Finance in East Asia. .0 1997 234. interest expenses rose as credit rates increased from 20 percent in early 1998 to 40 percent in mid-1999.6) (115.1) Note: DERs were calculated for only 161 companies (out of 214) that had positive equity.0 108. from only 8. Third.0) 10.4 5. losses in operation were due to declines in sales and increases in the cost of imported inputs.1 1. Second. several publications. as shown in Table 1.2) (264. II Table 1. the NPL ratio had reached more than 60 percent.4) 8.0) (78.1 30. rupiah values of dollar-denominated debts due to the weakening of the local currency and the rapid decline in equity because of losses.7) 6.2 (4.21.3 7.4) 18.8 percent in 1996.6 (11.0 92.2 13. 1996-1998 (percent) DER Sector Agriculture Mining Basic Industry Miscellaneous Industry Consumer Goods Industry Property Infrastructure Finance Trade/Services Average 1996 104.0 697.

09 (11.73 30.06 20.6 — 4.2 — 8. 230/1998.1 198.09 11. July No.8 187.4 7.37 19.5 128. coupled with negative spreads (deposit rate was higher than the credit rate).1 13.9 Regional Foreign and Development Joint Venture Banks Banks — 9.9 297. 1992-1997 (percent) Type of Bank State-Owned Banks Foreign Banks Joint Venture Banks Regional Development Banks Private National Banks Total — = not available.34 16.7 106.84 27. Source: The National Banking Association.9 percent.3 445.0 — 4.0 — 32.7 — 1.1 274.3 22.21 Nonperforming Loans by Type of Bank.28 5.2 — 19.7 29.1 30.70 1995 7.6 — 1.5 34.25 22. In July 1998.12 15.69 14.68 1996 1997 8.1 47. 1992 7.5 222.2 8.2 37.Chapter 1: Indonesia 41 Table 1.15 20.9 11. The high and increasing NPLs.45 — 1993 15. 227/1998 and October No.07 1994 14.7 — = not available.2 8.0 129.8 8.3 361.6 — 13.8 3.3 Private National Banks — 179.44 15.2 1.30 5.7 4. put pressure on the banking sector.8 14.24 15.5 57.6 6.5 2. State-owned banks initially had the highest NPL ratio.2 47. private national banks overtook State-owned banks when their NPL ratio jumped to 57.9 — 11.89 27.43 10.8 11. .07 13.24 (4.5 31. Source: Infobank. 1996-1998 (Rp trillion) State-Owned Banks — 140.39 13.38) 11.72 16.86 11.67 8.1 1.0 622.47 20.91 21.2 10.7 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 331.50 9.20 ROE of the Banking Sector.81 13.45 21.2 48. however.20) Table 1.

7 billion of foreign exchange debt. few companies were in a position to resume interest payments. particularly in terms of debt resolution. On 9 September 1998. the committee launched the Jakarta Initiative.6 billion) of Indonesia’s total external debt in March 1998. Corporate debt accounted for 46. the corporate sector had more than Rp600 trillion ($75 billion at Rp8. Semen Cibinong (cement industry) became the first Indonesian company to resume paying part (25 percent) of the interest on its $1. companies were not servicing their debts. The scheme encourages negotiation between creditors and debtors. While the process of restructuring was in progress. and Ciputra (property business).42 Corporate Governance and Finance in East Asia. In June 1998. the scheme failed. The committee was tasked to ascertain the level of private corporate sector debts and arrange negotiations between debtors and creditors. Another option that companies could take under the Jakarta Initiative was debt restructuring via debt-to-equity swaps.5. By end-November. In November. Total amortization payments due on foreign debt in 1998 were placed at $32 billion (before restructuring).4 trillion of domestic debt and $6.000 eligible firms had signed up for the scheme. Aside from being described as overly complicated. 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. the Government and private sector formed a committee to help corporates deal with the crisis. Vol. IBRA was formed to offer Mexican-style resolution for private sector foreign debt. Astra International (automotive). However.2 billion debt. by mid-September 1998. assembling the legal and policy framework to facilitate corporate restructuring. Thus.3 Responses to the Crisis Corporate Restructuring Measures At the end of 1997. a number of prominent companies. none of the 2. The scheme offered a hedging facility against rupiah devaluations for restructuring agreements. Unfortunately. a more comprehensive scheme to tackle domestic and foreign corporate debt. only a .7 percent ($64.000/$1) in debt from domestic commercial banks. about 80 percent of which was private. 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. such as Garuda (a national flag carrier). II 1. the Jakarta Initiative Task Force had conducted negotiations for 52 companies with Rp2. In addition. have been subject to restructuring deals under the initiative. Since September 1998.

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

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

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

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

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

. In particular. Improving the Legal and Regulatory Framework for Bank Supervision After the liberalization of the financial sector. and protecting creditors’ rights. and (iii) strengthening transparency and disclosure requirements. 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. minority shareholders have not been able to oppose controlling shareholders’ decisions to invest in unprofitable projects financed by unhedged foreign currency debts. 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. the regulatory environment was not prepared to supervise the increasing number of banks and nonbank . Protecting Minority Shareholders’ Rights The Corporate Law provides sufficient rights and protection for all shareholders. II measures included internal business restructuring (e. 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. The Government should ensure that all laws and regulations are effectively enforced. (ii) delineating the functions of the board of directors and commissioners.48 Corporate Governance and Finance in East Asia.6.g. but inadequate protection to minority shareholders from the dominance of large shareholders. 1. Most companies claim to have adopted international standards of accounting and auditing procedures. the legal system is less likely to evolve in a manner that will allow it to protect minority shareholders. Vol. Specific recommendations include protecting the rights of minority shareholders. cost cutting and business consolidation) and acquisitions by creditors or foreign investors through debt-to-equity swaps and equity infusions. The Corporate Law should be reviewed and amended in the context of pervasive control by large shareholders.

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

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

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

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

aiming to identify the areas in need of further reform and to provide policy recommendations for improved corporate governance. capital market discipline.54 Corporate Governance and Finance in East Asia. and individual companies. where NOPAT is the net operating profit after taxes and WACC is the weighted average cost of capital multiplied by invested capital. A survey was conducted for the nonfinancial listed companies using a questionnaire developed by the Asian Development Bank (ADB)2 to supplement official data. II Table 2.1 1997 518 104 20. This broad perspective can help clarify the ongoing reform efforts of businesses and the Government. and J Murrin (1995). accountability of controlling shareholders and boards of directors. Government reform goals for the corporate sector include enhancement of corporate transparency. This study also reviews the legal and 2 The survey was conducted mainly through the Korea Stock Exchange. Koller. the corporate sector. Vol. 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.9 1994 531 165 31. Copeland. This study collects and analyzes data on the Korean economy.5 Note: The EVAs are calculated as: EVA = NOPAT – WACC.1 1996 561 163 29. T.1 Listed Firms with Positive Economic Value Added. especially chaebols. and improvement of bankruptcy procedures. 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. 1992-1998 Item Total Number of Firms Firms with Positive EVA Percentage of Firms with Positive EVA 1992 508 180 35. June 1999. Source: Korea Stock Exchange.4 1993 513 174 33. Dividend payments were at less than 2 percent annually as opposed to the double-digit interest rates in the past decades.1 1998 490 164 33. .1 1995 560 163 29. The EVAs are the same as the economic profit as explained in T. Inefficient investment undermined the competitiveness of Korean firms in the global marketplace. Weaknesses in the overall corporate governance system in Korea had many ramifications. which distributed and collected the questionnaire. The total number of respondents was 81 out of about 550 nonfinancial firms listed on the Exchange.

Chapter 2: Korea 55 regulatory framework for the corporate sector and reform measures taken after the crisis.6 discusses responses of the Government and the business sector and explains in detail their reform and restructuring efforts. and Yim (1998). corporate control by the Government. It then presents recommendations for further reform in corporate governance and financing.2.4 contains analyses of corporate financing and its relationship to performance. and employees and their role in shaping corporate governance practices. 3 The review of historical development of the Korean economy draws substantially from the book by Sohn. Yang. and other necessities domestically. the Government relied heavily on aid from the United States (US) and United Nations to alleviate poverty and high inflation. and naturally adopted an import substitution policy. This chapter is composed of six sections.3 identifies characteristics of corporate governance by analyzing the ownership structures and control patterns of listed companies and the largest chaebols. Section 2. The evolution of the modern Korean economy can be divided into four periods. It traces the country’s economic development. Section 2. which account for a substantial portion of the Korean economy. . Import Substitution: 1948-1961 The Korean War (1950-1953) devastated Korea’s industrial capacity.2. Section 2. In the period 19481961.2 2. the board of directors system. From 1948 to 1961. It reviews such elements as shareholders’ rights.1 Overview of the Corporate Sector Historical Development3 The development of the Korean corporate sector is closely related to the progress of the economy.2 presents an overview of the corporate sector. 2. the import liberalization rate was below 7 percent and the average tariff rate was in the range of 25 to 30 percent. The Government tried to produce food. Section 2.5 describes the state of the corporate sector in the financial crisis and draws on the results of the foregoing sections to outline the causes of the crisis. clothing. Major economic indicators for some of these periods are shown in Table 2. Section 2. reviewing government policies responsible for the development of the modern corporate sector. creditors.

949.2 757.265.56 Corporate Governance and Finance in East Asia. the Government called for an unprecedented average annual economic growth rate of 7.1 35.0) (297.8 15.5 38.4 29.2 31.8 12.5 250.2 1. lack of strong drive.9 794.2 30. and inconsistent economic policies. 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 8.4 (1. 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.2 32.6 11.1d 9. Vol.2 6.1 — = not available.7 14.1 15.5) (1.0 27.332. c Refers to 1989.4 1990-1997 7.3 8.8 (8.9b 15.102.2 452.9 — — 21.9) 1.4 10.447. e For maturities of one year or more.0) 492. The Government tried .2 314.7 37.1 percent with moderate rates of inflation and introduced a series of reform packages aimed at developing key industries. the Government redirected the policy focus away from import substitution to an export-led manufacturing-based economy. International Financial Statistics. d Refers to 1997. and implementing new budget and tax measures. IMF.1 29.9) (7. In the Plan.7c 11.753.0 41. Source: Bank of Korea.4 24. This goal required very high savings and investment rates. and large current account deficits.855.5) 8.8 24. high unemployment and inflation. b Refers to 1979.1 9.2 Key Macroeconomic Indicators Annual Average (percent. However. the Government was not successful in solving the problems of slow growth. largely because of political instability. Economic Statistics Yearbook. modernizing the industrial structure.1a 21. II Table 2.8 (724.4 29. Export Drive: 1962-1971 Between 1962 and 1971. In 1961 it devalued the won from W65 to W130/dollar and announced its first Five-Year Economic Development Plan (1962-1966). a Refers to 1971.7 30.2 1980-1989 8.

In 1963-1964. This change raised the import liberalization rate from 9. imports of consumer goods and luxury items were highly restricted. while the average tariff rate was 39 percent. These were considerably liberalized in 1967 when Korea joined the General Agreement on Tariffs and Trade (GATT). the Government tried to provide exporting firms with a free trade environment. and almost doubled the foreign exchange rate from W130/dollar to W256/dollar to enhance the international competitiveness of exports. channeling funds from curb markets into the banking sector. the import liberalization rate was 55 percent. During the first five-year plan period.Chapter 2: Korea 57 to meet its targets by borrowing large amounts of foreign capital on the one hand. but the average growth rate for 1965-1969 shot up to 10 percent. The exchange rate system was a kind of crawling peg until 1974.4 percent. resulting in high real interest rates. up from 30 percent in the late 1950s. boosting internal investment resources. However. In 1965 the interest rate on one-year deposits doubled from 15 to 30 percent. and maximizing mobilization of domestic savings on the other. The Government abolished temporary direct subsidy measures and introduced a new comprehensive export promotion system. due to continuous current account deficits. In 1971. but tariff rates were raised to 40 percent in the 1960s. 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. Bank deposits increased rapidly. .3 percent to 60. the growth of gross domestic product (GDP) raised domestic savings. and cheap labor force was well utilized by the export-led growth strategy. which laid a solid foundation for a steady growth path. In 1964.2 billion in 1972. the Government changed the multiple and fixed exchange rate system to a unitary floating exchange rate system. a modest improvement over the 4. But the liberalization trend turned out to be short lived as current account deficits continued.3 percent average between 1954 and 1959. The positive list system for imports was replaced with a negative list that indicated only those items that could not be imported. Korea normalized political and economic relations with Japan to encourage inflows of Japanese capital that could finance big development projects.5 percent. The average growth rate of the economy from 1960 to 1964 was 5. The well-educated. abundant. Exports increased sharply from $41 million in 1961 to $2. During this period. the Government undertook important economic reforms in two areas: the foreign exchange rate and the interest rate. Also.

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

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

but it chose to liberalize gradually. Industrial and trade policies were modified to be consistent with WTO.2. In 1993. and total workforce. and low oil prices. further increasing its pace of import liberalization. 13. total assets. whose business activities are controlled by an identical person. .” A large-scale business group is called a chaebol. The low value of the dollar led to a low won and high yen. with the 30 largest in the total economy in 1997 standing as follows: value-added. 45.2 percent. By joining the Organisation for Economic Co-operation and Development (OECD) in December 1996. 4.9 percent. 2. the importance of chaebols was increasing. Korea abolished remaining direct subsidy systems for export activities as well as some traditionally managed trade systems. The most important element characterizing chaebols is the concentration of ownership. The birth of chaebols can be traced to the selling of Japanese colonial properties that were reverted to the Korean Government after World 4 The historical review of chaebols draws substantially from the paper of Lee and Lee (1996). 46. the import liberalization ratio reached 98. the Government committed itself to further liberalization of the goods and capital markets. while continuous and large current account surpluses saved Korea from the foreign debt problem. giving up its foreign exchange controls related to the current account. in which the official rate for the day would be based on the interbank transaction volume-weighted average of rates of the previous business day. The official rate fluctuated within a band. II world interest rates. 47. total debts. Korea adopted a market average exchange rate system. Korea began participating in many multilateral trade negotiations during the Uruguay Round. where particular individuals and their family have de facto control of the management of all subsidiary companies of groups. and acceded to the World Trade Organization (WTO) in 1994. and declaring that it would follow Article XI of GATT. which gradually widened.60 Corporate Governance and Finance in East Asia.3 percent. total sales.9 percent. Vol. joined the Asia Pacific Economic Cooperation (APEC) Group in 1993.1 percent and average tariff rates 8.2 Rise of the Large Business Groups (Chaebols)4 The Korean Fair Trade Act defines a business group as “a group of companies. Korea became a signatory country to the International Monetary Fund (IMF) Article VIII. Meanwhile. In 1990. The Government tried to adjust economic policies and regulations to meet global standards.9 percent.1 percent. In 1988.

Chaebols have a history of substantial concentration of ownership. Since the 1960s. large-scale businesses and chaebols were thought to be appropriate actors because they could meet the huge investment requirements of these industries.5 20. reaching 669 in 1996.Chapter 2: Korea 61 War II. of Subsidiaries per Chaebol 20. Important managerial decisions are made primarily by owners. Table 2. Table 2. financial assistance. the Korean Government has set the national goals of economic development and offered all kinds of support and incentives to achieve them.3 Source: The Fair Trade Commission. The Government provided financial and fiscal incentives to chaebols and trading companies with relatively abundant financial resources. and tax breaks to key industries to promote exports and industrial upgrading.8 22. Chaebols are also excessively diversified. chaebols that maintained a close relationship with the political authorities were able to grow fast.when the Government put a great deal of emphasis on development of the HCIs. This galvanized the fast growth of chaebols. after the financial crisis. In the mid-1970s. of Subsidiaries 604 616 623 669 Average No. This policy contributed greatly to the expansion of chaebols. the number of subsidiaries declined drastically due to corporate restructuring. From the standpoint of the Government. the ownership and management of a chaebol’s subsidiaries are not separate. Large-scale companies owned by the Japanese were sold to individuals under preferential terms and later enjoyed a relatively favorable position for accumulating capital. In this sense. The Government provided subsidies. . However.3 shows that the number of subsidiaries of the 30 largest chaebols increased considerably since 1993. One reason for this controlling power is inter-company shareholding among subsidiaries.1 20.3 Subsidiaries of the 30 Largest Chaebols. and they are aided and supported by one another. 1993-1996 Year 1993 1994 1995 1996 No. it was more effective to deal with a small number of companies to secure tangible outcomes. Since the Government controlled most business activities. Subsidiary companies of chaebols are subject to “fleet-type management” in that they are controlled by the overall managerial system of chaebols.

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

4 Development of the Stock Market. Third. especially those paying small or no dividends. This reversal in policy reflected declining stock prices and was generally maintained until the outbreak of the economic crisis in 1997. In this regard.476 79.1 30.0 79. the Government attempted to stabilize the stock market by limiting IPOs and share issues by listed companies. Second.4 654.2 44.9 34.217 141.4 40. of Listed Firms 342 626 669 699 721 760 776 748 Stock Price Index 138.Chapter 2: Korea 63 During the 1980s and 1990s.9 833. the Government announced the gradual opening of the capital market to foreign investors in January 1981.370 70.6 Year 1985 1989 1990 1994 1995 1996 1997 1998 Source: Monthly Review (Securities Supervisory Board) and the Financial Supervisory Service.0 965. the stock market grew rapidly during the 1980s..020 151.0 49. Inc. several important policy measures were implemented to promote the development of the stock market. The Korea Fund. continued until 1989. Beginning 1990.1 16.6 747. Also that year. The aggregate Table 2. 1985-1998 No. in 1986 the Government imposed limits to bond issues on firms that were recommended to go public but refused. mainly by increasing the supply of shares by initial public offerings (IPOs) and seasoned issues.5 406. .1 Market Capitalization (W billion) 6. a country fund. The policy to expand the size of the stock market. First. 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.989 137. however.798 Market Capitalization as a Ratio to GDP (%) 8.151 117. As shown in Table 2. 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).9 918. the Government announced measures to increase the demand for shares by providing tax and financial incentives to individual investors.570 95.7 934.4. Because of government policies and the booming economy. was established to invest in domestic shares beginning in September 1985.

183 12.001 4. However. but increased sharply to 79. trade credits.440 1.852) (2.141 4.64 Corporate Governance and Finance in East Asia.942) 42. 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) (2.5 shows net FDI—inward investments by foreigners less outward investments by Koreans—in the period 1985-1998. but rose again to 34. .287 (340) 73. and other liabilities.008) (3. Table 2.339) (9.868 (518) (418) 63 1.382 Permit basis.86 percent of GDP in 1997.450 24. The reasons for the decline include increases in bankruptcies and mergers involving listed companies since the outbreak of the economic crisis.239 19.149 13.123 3.642 21.583 25 10.264) (3.546 (2. The aggregate market value of listed shares bottomed at 16.126 (1.433) (9.326 1.571 2.296) (6. Other investments include loans.858 4. foreign direct investment (FDI) has been very small relative to GDP and compared to other East Asian countries.500 7.944) 8.658) (3. II market value of all listed firms represented only 8 percent of GDP in 1985.414) 5.5 Private Capital Flows to Korea.800 (7.875 21. currency and deposits.352 471 3.455) 13. The growth in the number of listed firms also slowed in the 1990s. and stayed at the 30-40 percent level up to 1996. Source: Balance of Payments. Table 2.017) 1.785 (1.694) 2.150 5. 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 1986-1989.59 percent in 1998 and to more than 50 percent in the early months of 1999.085 2. and 1993.347 3. Bank of Korea. The relative size of the stock market diminished to 44 percent in 1990. Vol.2 percent by 1989. due to declining stock prices.742 (3.255 2.714 1.924 (1.534) 1.542) (1. The number shrank for the first time in 1998 to 748 firms from 776 the previous year.413) 56.338 4.553 8.737 (333) (297) (607) (2) 218 2.910) 2.870) (1.650 (1.453 (2.817 16.953 10.

excluding FDI. This would lay the foundation for evaluating the effect of corporate governance on performance. 2. Return on equity (ROE) and return on assets (ROA) showed similar patterns. Table 2.6 percent in 1997. Taipei. The same categories will be analyzed in later sections. the growth rates of equity and sales dropped sharply in 1996 and 1997.China and the US. weak incentives for attracting FDI. Japan’s was consistently higher.2. and (iii) chaebols.Chapter 2: Korea 65 Complicated government regulations.China.7 compares the ratio of ordinary income to sales of Korea’s manufacturing sector with those of Japan.5). and high production costs were the main reasons for low FDI in Korea. Profit rates of Korean firms were relatively low compared to those of Taipei. following the sharp depreciation of the won. increased substantially in 1994-1996 due to accelerated liberalization of capital movements (Table 2. In addition to FDI.6). However. Korea had substantial current account surpluses and experienced net private capital outflow. This indicates that a substantial proportion of debt was denominated in dollars. increasing to 76 percent in 1997. The contribution of the corporate sector to GDP was 73. Net private capital inflow. Large amounts of outward investment by Koreans in the mid-1990s arose out of increased liberalization of foreign exchange regulations.7 billion and loans $42. but between 1988 and 1993. The Aggregate Corporate Sector The aggregate corporate sector in this study excludes the financial sector. and US.9 billion. (ii) listed firms.2 percent in 1987. The debt-to-equity ratio (DER) averaged 311 percent for the period 1990-1996 and peaked at 424. The growth rates of total assets. Between 1986 and 1989. but dropped in 1996 and were negative by 1997. Of this. portfolio investments amounted to $73. Corporate sector net proft margins increased from 1993 to 1995. The ratio is generally in the same range for Japan and Korea. equity. and sales of the aggregate sector during this period were very high (Table 2. The dismal performance of the Korean corporate sector compared to the .4 Growth and Financial Performance This section looks at the performance of (i) the aggregate corporate sector. other net private capital inflows amounted to $130 billion during 1985-1998.

0 305.5 2.9 16.6 424.3) 5.3 11.2) (0. Net profit margin = ratio of net income to sales.9 3.8 2.6 318.7 4.9 13.6 (4.9 18.Table 2.7 3.2 1. . ROA = return on assets (ratio of net income to total assets).9 5.3 14. Financial Statement Analysis Yearbook.3 308.3 — 3.3 335.0 13.3 17.5 1.8) 297.0 4.7 2.4 1.3 6.6 1.9 5.4 2.8 3.7 15.9 4.China 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 2.7 325. Table 2.1 — — — = not available.1 2.4 2.4 10.6 4.2 19.4 — 6.6 3.9 2.5 0.5 3.1 2.2 1.5 4.0 13.4 1.1 6.0 7. 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 23.6 9.0 0.7 4.2 13.4 4.7 International Comparison of Ratios of Ordinary Income to Sales in Manufacturing (percent) Year Korea US Japan Taipei.6 13. Financial Statement Analysis Yearbook.6 1.9 2.1 8.1 2.3 21.1 5.0 6.5 4.4 19.5 7.9 3.9 8.6 Growth and Financial Performance of the Nonfinancial Corporate Sector.6 2.3 21. Source: Bank of Korea.7 1.5 1.9) DER = debt-to-equity ratio.7 4.9 2.0 10.4 2.2 13.7 15.8 1. Ordinary income = operating income + nonoperating income (from financial activities) – nonoperating expenses (from financial activities).2 1.3 3.8 1.3 312.4 1.9 18.2 9.3 1. ROE = return on equity (ratio of net income to stockholders’ equity).9 16.2 18.8 22.5 1.8 8.7 3. Note: Ratio of ordinary income to sales = (ordinary income/sales).0 3. Source: Bank of Korea.5 (0.0 8.8 21.9 5.0 (0.

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

1 27.0 15.8 2.3 25.5 338.5 432.5 5.2 15.5 270.8 32.0 16.6 14.2 25.5 6.9 16.5 4.0 1.8 35. Renting.8 0.0 24.1 396.3 8.0 1.2 20.8 7.6 11.9 2.7 21.1 2.5 1.0 15.9 5.8 14.0) 1.0 23.4 10.6 1.5 27.0 1.6) (6.3 15.8 22.1 296.4 4.5 3.3 15.6 17.8 16.5 239.7 10.6 15.0 5.8 526.6 3.8 17.6 12.1 10.7 22.6 1.4 291.9 14.0 22.1 290.8 16.8) 0.8 562.6 318.1) 3.8 23.3 15.4 2.2) 22.9 538.5 (5.5 5.4 3.7 9.6 7.6 0.1 28.3 8.3 10.2 0.7 5.4 10.4 12.0 7.9 (0.4 5.0 (0.3 11.4 5.2 0.3 18.9 16.0 5.5 (0.4 .1) 0.1 7.3 285.7 1.8 461.5 6.0) 4.0 2.7 317.2 0.4 2.1) (3.0 (4.4 9.6 16.4 1.8 2.5 306.0 1.8 616.3 13.4 348.7 (3.2 6.4 5.1 (0.1 2.8 0.4 740.6 655.6 12.3 15.7 228.6 6.7 514.0 9.4 474.4 17.9 2.2) 6.8 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 13.1 0.8 10.4 15.9) 1.3 288.0 24.4) 0.9 1.8 1.0 245.8 302.7 30.0 18.3 14.1 1.7 294.2 20.5 1.8 34.9 340.0 19.4 350.3 1.2 5.4 10.9 13.2 24.4 14.5 286.6 24.4 1.4 2.0) 0.1 0.2 423.1 (0.9 (0.5 13.2) 15.6 3.6 17.4 0.2 315.9 428.3 11.0 22.7 0.5 Construction 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 18.6 5.1 22.5 19.8 1.2 7.1 1.4 (0.9 (0.3 2.5 1.7 520.8 22.0 2.4 0.4 2.5 1.6 0.5 14.2) (0.2 241.8 12.3 14.3) (1.7 16.8 3.0 3.4 10.0 12.6 14.0) 0.0 21.8 16.1 0.0 2.3 8.2 36.0 254.9 31.3 8.8 10.2 6.1 16.5 483.8 24.9 0.5 473.9 10.8 14.3 2.0 1.0 (0.2 16.0 37.5 (1.5 30.0 18.0 1.9 16.7 (0.2 2.3 31.2 (1.9 19.1 21. and Business Activities 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 11.5 1.0 1.8 24.2 18.7 7.9 9.6 375.9 25.9 29.8 13.6) 3.4 2.2 12.1 17.2 16.1 20.2 5.8 345.5 28.8 Real Estate.0 2.5) 0.Table 2.8 3.6 14.7) 2.1 1.7 17.3 10.4 458.7 4.5 569.5 1.8 2.8 12.5 23.2 5.1 1.5 16.9 3.0 16.6 2.3 1.9 10.0 22.

5 11.7 187.3 — — — — — 10.5 16.6 0.6 (2.6 16.2 1.9 17.Table 2.9 9.4 15.4 — — — — — 448.1 12.8 12.8 (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) (12.7 19.0 13.9 10.8 14.5 8.5 26.8 14.4 2.4 30.1) (0.0 2.5 13.1 11.0 2.5 482.8) 1.4 3.9 4.4 633.3 (2.3 524.2 10.5 14.3 543.7) (4.3) 4.6 34.6 3.3 0.3 4.3 0.9 3.1 2.3 740.9 17.0 14.2) 0.2 14.6 (2.1 17.3 18.9 12.1 15.6 8.2) 9.3 18.6 19.1 (11.5 117.6 6.2 3.7 11.8 15.6 12.7 2.9 456.7 7.0 (1.7 7.1 3.4) (1.5 462.6 21.0 (15.5 612.1 14.7 — = not available.3) 15.4 0.8 0.4 13. Financial Statement Analysis Yearbooks.4 1.2 698.4 12.5 15.3 4.9 Electricity.3 8.3 8.4 12.0) (0.1 15.2 10.3 112.3 1.1 (0.4 7.4 6.4 0.3 19.0 98.4 6.9 9.5 15.6 4.7 16.2 18.6 9.5) 22.1) (0.0 5.1) 5.4 3.0 7. Gas.9 1.4 367.7 510.4 2.3 125.0 1.6 — — — — — 17.4 341.062.4 10.4 0.8 4.8 11.4 11.9 7.3 1. Source: Calculated using data from Bank of Korea.0 Transport.9 (11.8 7.0 921.8 0.4 1.5 14.6 12.2 143.9 4.0 1.6 19.1 16.4 9.7 0.5 307.3) (1.7 0.5 30. a New equity does not include capital surplus.3 17.0 21.0) 1.9 18.5 539.3 23.1 8.7 116.7 2.8 3.1 6.0 1.6 512.9 321.5 47.1 4.9 8.9 18.9) (8.5 0.6 9.2 14.9 332.0 106.2) 13.4 (0.6 1.8 3.6 172.7 15.3 12.5 (2.2 7.6 4.4 21.4 14.9 (10.0 5.1 (2. and Communication 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 15.2 15.9 6.3 3.1 323.7 20.7 14.1 11.6 18.8 111.1) 1.3 4.2 11.1 21.6 — — — — — 0.4 1.6 2.6 20.6 14.7 — — — — — 14.5 11.5 344. .6 1.7 11.7 12.6 9.4 7.4 169.5 4.2 90.8 6.7) 0.8 529.4 (2.2 18.2 122. b NPM denotes net profit margin.6 8.8 8.3 9. Storage.0) 1.5 14.8 6.0 14.3 2.1 15.1 1.5 12.2 2.6 6.9 10.2 18.7 11.8 9.6 8.2 — — — — — 2.9 8.4 3.9 12.4 16.5 2.3 34.8 12.3) 11.6 15.6 6.5 14.0 89.2 10. and Steam Supply 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 12.

6 0. the 30 largest chaebols accounted for 13.5 ROA 0.4 2.0 0.9 0.8 5.9 percent). Performance of Chaebols This section uses available data on the top 30 chaebols.2 6.7 Net Profit Margin 0.7) 0.6 (1.1) 4.7 1.9 Source: Constructed using data from Korea Investors Service.3 4.5 0. Vol.9 6.9 21.3 15. II Table 2.7 (5.70 Corporate Governance and Finance in East Asia. of Firms 334 351 386 503 626 669 680 681 687 698 715 754 775 Sales Growth 10. In 1995. It should also be noted that when the financial crisis struck in 1997.9 percent).3 0.3 20.12). and close to half of total assets (46.9 2.9 Growth and Financial Performance of Listed Companies.5 ROE 3.4 22.4 1. it is the chaebols’ large firms that are listed. Hyundai Group.4 0. followed by the top 6-10 (Table 2.9 1.7 percent) of the corporate sector.1 1.4 1.0 3.12). 1998. sales (45. had 46 member companies.9 26.3 2.8 24.9 11.1 percent of the economy’s total value added (excluding the financial sector). the largest chaebol. The criteria for selection of largest chaebols have changed a few times.6 and 2. Generally. Chaebols have been the most important actors and engines of growth in the Korean economy. the top 11-30 chaebols experienced a decline of .6 22.6 23.9 2.4 1.11). but the number of designated groups has been fixed at 30 since 1993. Kis-Fas. unless otherwise indicated) Financial Performance Year 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average No. The number of Hyundai member companies rose to 57 in 1997.2 2.4) 1.2 0. In 1997. the growth of sales of the top 30 chaebols exceeded that of the aggregate corporate sector (compare Tables 2.6 1.5 5. The top five chaebols registered the highest growth rates. of which four were listed.3 (0. The smallest group had 16 members in 1995.3 percent).1 6. Between 1993 and 1997.2 9.5 19.0 18. 1985-1997 (percent. debts (47. and net profits (46. of which 16 were publicly listed (Table 2.7 1.2 9.6 2.1 1.5 19.8 6.6 3.8 0.

7 2.8) 6.6 0.5 17.2 12.4 3.4 11.5 (1.9) (6.5) 1.3) 5. .9 0.4 2.4 6.3 (0.3 (0.7 4.5 5.2 Small 13.0 10.Table 2.0 6.0 1.1) 5.6 (1.0 (4.3 Medium 14.5 25.9 2.2 Note: Large firms have a capital base greater than W15 billion and small firms smaller than W5 billion.3 15.5 1.8 3.2 13.5 0.6 1.7 (0.2) 0.4 16.4 1.7 1.6 8.2 2.8 0.6 3. 1998.9 2.3 3.6 1.1 2.1 11.6 1.8 0.9 2.8 16.9 22.7 (1.3 15. Source: Korea Investors Service.0) 0.8 10.1 0.10 Growth and Financial Performance of Listed Companies by Size.0 1.6 0.3 9.7 (1.2 13.8 0.4 3.8 0.8 6. Others are medium firms.2 1.4 1.0 19.5 Net Profit Margin Year Large Medium Small 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 2.1 8.9 6.5) 1.9 0.0 1.3 1.0 16.9 3.2 10.0 15.6 7.6 6.9 0. Kis-Fas.9 5.5 5.9 6.5 2.2 (0.4 5.2 7.7 2.1 1.8 7.9 1.6 (0.4 Medium Small Large Medium Small ROA Growth Performance Large 17.5 3.8 6.3 6.9 1.9 25.2 0.0 4.2) (1.6 2.6 3.0 1.8 (5.0) 1.2 2.7 18.6 2.6 13.3) 0.4) 1.9 (0.9 14.6 9.0 17.2 3.6 5.2) (1.6 2.6) 0.8) 1.1 2.7 3.3 11.8 1. 1988-1997 (percent) ROE Large 9.8 17.

309 14.287 10.929 12.376 35.967 7.180 2.147 5.766 3.370 6.445 4.090 6.455 22.995 2.398 — 2.158 1.927 16.313 14.364 5.640 4.246 11.743 40.131 3.996 1.303 3. .951 3.599 — 2.651 38.346 3.458 6. 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. 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.798 — No.935 2.774 7.427 9.486 6.677 3.853 1997 53.910 3.423 5.574 3.690 3.756 5.475 2.117 4.433 3.Table 2.129 2.873 2.11 Features of the 30 Largest Chaebols Total Assets (W billion) Name Hyundai Samsung LG Daewoo Sunkyung Ssangyong Hanjin Kia Hanwha Lotte Kumho Doosan Daelim Hanbo Dong-A Halla Hyosung Dongkuk Jinro Kolon Tongyang Hansol Dongbu Kohap Haitai Sammi Hanil Keukdong New Core Byucksan 1995 43.501 13.990 2.761 31.395 31. Source: Fair Trade Commission.457 14.597 351.956 3.177 — 6.158 7.924 2.

8 0.7 15.7 10.3 19.2 (2.3 1.0) ROA 1.7 1.2) (0.2) (2.3 1.7) ROE 5.9 18.0 2.8 18.3 14.1 2.Table 2.8 27.5 2.5 27.3 15.5 (0.2 (16.9 24.1 (1.3 9.5 5.0 1.2 11.0 0.5) (0.3) 0.3 11.7 10.0 19.5) (0.4) (0.4) 1. .1) (0.3 27.9 20.7 13.4 12.0 2.6 Financial Performance Net Profit Margin 1.2 (5.6 25.9 1.0) 12. 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 12.1) (0.4 30.1 (3.12 Growth and Financial Performance of the 30 Largest Chaebols.1) 0.2) 1.3 3.9 3.0 31.7 4.7) Source: Bank of Korea.2 0.0 6.1 (2.6 (0.4 (2.2 3.1 27.7 0.7 15.9 17.2 0.0) 3.1) 0.4 38.0 17.1) (1.5 19.9 3.0 2.0 0.5 32.3 0.3 0.2 1.6 1.9 20.6 18.4 0.8 Assets 12.2 20.2 (2.6 4.5 20.3 16.5) (0.1 10.2 0.4) (14.1 19.6 19.4 26.

except for 1995. 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.” in Korea’s legal and regulatory framework.7 percent growth in total assets. However. more important. Only the top five chaebols registered a positive net profit margin in 1997. includes the largest shareholder.95 percent. and the companies that are under the control of the largest shareholder. 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. coupled with weak corporate governance.3 Corporate Ownership and Control This section looks at the key aspects of corporate governance in Korea. Ownership patterns. 2.765 percent (Table 2. The ROE of the top 30 chaebols was consistently higher than that of the aggregate corporate sector. the average DER of the 30 largest chaebols reached 519 percent.5 Founding families are mostly still the largest shareholders and. his/her relatives. The Commercial Code stipulates the basic governance framework and applies to all corporations. Their worst year was 1997 when ROE hit -15. from 190 to 3.3. and government intervention interacted through a set of laws and regulations to bring about the existing structure.13). Vol. However. chaebols had a higher average DER than the corporate sector as a whole. and access to credit. loopholes and inconsistent policies spawned strategic behavior and agency problems. a pyramidal structure of corporate ownership is prevalent.” This “identical person. it refers to the degree of concentration and shareholdings in the hands of an “identical person.1 Patterns of Corporate Ownership The ownership of most Korean listed firms is highly concentrated. resulted in the chaebols’ excessive leverage. and vulnerable balance sheets. 5 While “ownership concentration” can be defined and measured differently in different contexts. The absence of a well-developed equity market and the provision of subsidized credit. By the end of 1997. II 2 percent in their sales and a very low 4. and led to a high concentration of ownership. weak corporate control. In general. in this instance. There has been a wide range in DER among chaebols. the net profit margin of the aggregate sector exceeded that of the top 30 chaebols. 2. . internal and external control mechanisms.74 Corporate Governance and Finance in East Asia. technology.

8 312. Kia 9.6 . Daewoo 5. 1995-1997 (percent) Chaebols 1995 1.5 3. Sunkyung 6.6 409. Jinro 20. LG 4. Hanwha 10. Doosan 15.8 313.5 2. Dongah 14. Ssangyong 7. Haitai 26.7 621.4 192.2 924. Hanjin 8. Daelim 16.7 267.065.2 328. LG 4. Byucksan 1996 1. Hanwha 10. Halla 13. Lotte 11.441.Table 2.4 622.3 297. Newcore 30. Hyosung 18. Doosan 13. Hanil 28.855. Hansol 17.1 674.3 315.1 190.6 2. Dongkuk Steel 19. Kukdong Construction 29. Kolon 21.0 218.6 516. Kumho 12. Sammi 27.5 337. Kia 9.6 936.4 556. Sunkyung 6.2 2.244. Daelim 14. Halla 17.2 346. Samsung 3.2 423. Kumho 12. Kohap 25. Lotte 11.13 The Top 30 Chaebols’ Debt-to-Equity Ratio.3 328.2 471.764.5 343.7 620. Hyundai 2. Hanjin 8. Hyundai 2.7 688. Dongah Construction 16.3 572.2 292.7 354.5 464. Samsung 3.1 477.1 385.7 416.1 278. Dongbu 24.0 506. Hansol 23.8 336. Hanbo 15.4 205. Daewoo 5.0 436. Jinro Debt-to-Equity Ratio 376.1 3. Tongyang 22. Hyosung 18. Dongkuk Steel 19.4 175. Ssangyong 7.9 751.9 321.0 370.0 486.5 383.

8 307. LG 5.5 261.3 399.8 399.1 472.7 944. Haitai 25.4) 513.498.1 375. Keopyong 29. Shinho 1997 1.5 519. Daelim 14. Shinho 26. Dongkuk Steel 20.214.1 438. Dongbu 21.784. Halla 13.5 576.8 658. Newcore 28.0 907. Kohab 22. SK 6. Haitai 25. Hyundai 2. Dongbu 23.5 386.9 490.5) 404.7 1.9 216.9 465.6 478.9 472.5 (893. Kumho 10. Kolon 19. Financial Statement Analysis Yearbook. Hyosung 17.6 335. Tongyang 24.8 468. Miwon 30.501.0 305.6 416.3 676. Jinro 23. Samsung 3. Saehan Average of All Chaebolsa 1995 1996 1997 Average of All Industries Excluding Financial Sectorb 1995 1996 1997 Debt-to-Equity Ratio 317.8 590. Anam 22.4 1.13 (Cont’d) Chaebols 20. .9 1.6 Sources: aFair Trade Commission.3 347.600. Lotte 12.3 1. Kamgwon Industrial 30. Hanjin 7.8 347. Hansol 16. Hanil 28.7 370. Newcore 26. Doosan 15.8 338.225. Tongyang 24. bBank of Korea.6 590.5 323.0 505.9 578.5 (1.1 359.1 433. Daewoo 4. Kohab 18. Anam 27. Kolon 21. Keopyong 29.5 1.0 419.6 424. Ssangyong 8.8 647.Table 2. Hanwha 9. Dongah 11. Daesang 27.

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

2 5.1 17.3 1.6 16.4 13.9 5.9 2.1 18.6 20.6 8.0 60.5 1.1 60.9 26.3 26.7 18. 1988-1997 (percent) Financial Institutions Securities Firms Total 28. c Data from Korea Stock Exchange.1 21. d Constructed from data files of the Korea Listed Companies Association.6 1991 505 0.6 16.2 7.5 62.8 2.4 18.2 8.0 59.9 15.Table 2.1 3.5 1.1 10.7 9.3 1. etc.5 18.3 17. Listed Nonfinancial Companiesd 1988 406 0.2 1993 511 2.3 5.8 5.0 8. investment trust companies.4 34. mutual savings.7 14.5 7.7 6.9 2.9 37.2 1.5 6. of Firms The Statea Banks.6 36.14 Ownership Composition of Listed Companies.9 1.0 5.1 2.6 16.1 18.8 4.3 5.6 2.9 17.0 7.5 1992 508 2. .8 59.8 17.9 4.0 9.1 68.8 2.4 5.1 1.9 1.4 Insurance Firms Other Corporations Foreigners Individuals 39.0 28.2 5.2 17.1 4.5 16.4 14. and finance companies.7 4.8 59.7 3.5 12.6 9.1 11.2 8.6 13.” includes commercial banks.2 9.2 B.3 18.3 39.1 8. All Listed Companiesc 1992 681 1993 687 1994 698 1995 715 1996 754 1997 775 9.6 22.3 17.7 1990 531 0.0 5.7 8.3 18. a The State covers the Government and state-owned companies.6 Year No.3 1996 570 2.b A.5 6.5 60.5 1989 498 0.4 1997 551 1. b “Banks. etc.4 5.9 19.8 17.3 1994 521 1.2 9.1 8.4 6.7 59.6 9.6 19.0 27.8 69.5 Note: Ownership is based on number of shares.2 18.2 4.9 36.2 3.3 2.8 1995 548 2.7 7.8 5.0 4.5 7.4 13. merchant banks.6 12.5 4.3 8.7 9.2 2.1 21.

did not vary significantly (Table 2. the holdings of institutional investors were expected to increase significantly with the Government’s introduction of US-type investment companies in 1998 and . held 26. indicating their heavier reliance on inter-firm financing investments. other corporations’ holdings shifted toward service industries. However. Over the years. Corporate holdings averaged 16 percent throughout 1988-1997.15). Foreigners gradually increased their equity shares in 1992 when direct purchases by them were first permitted. as distinguished from individual and foreign investors. with the Government continuing to hold a sizable share in the Korea Electric Power Corporation. the Government acquired an even bigger share in several banks as part of its program to bail out these distressed institutions. Compared with its holdings in all listed companies.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. The ownership distribution in listed nonfinancial firms. In general. Institutional investors. Before such liberalization. and US (Table 2. In 1998. financial institutions had more shares in the manufacturing sector than in primary industries. electricity. there appears to be no significant difference in the overall shareholding patterns between the two groups (Table 2. and service of motor vehicles (Table 2. 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. the Government was the sole owner. government ownership in nonfinancial companies was remarkably smaller and more concentrated. foreign holdings were derived from purchases through country funds and direct capital investments. of some banks. categorized into large. However. Individuals held the majority of the shares in all industries except in telecommunications. indicating their increased investments particularly in the service industries with high growth rates. This trend can be explained by government ownership. medium. The Government’s and state-owned institutions’ (including some banks) ownership was generally small except in the power sector. When independent companies are distinguished from firms affiliated with the 30 largest chaebols.16).8 percent of listed shares in 1997.18).17). One minor difference is that the percentage of shareholdings by corporations is slightly higher in large-sized firms. This is low compared with those in Japan. and small companies. UK. The holdings of other corporations are mainly equity investments in affiliate companies. In most instances. whether partial or absolute.

3 6.2 9.Table 2.6 — — 2.2 22.5 4.6 24.4 5. and Printing Pulp.7 2.6 11.3 9.4 — 0.5 19.9 4.9 60.5 3.6 3. Motor Vehicles Electricity.2 1.1 7.5 7.7 63. 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 27.9 1.4 0.7 29.1 88.4 8.4 Banks.8 3.6 5.9 52.9 55. Gas.8 6.9 42.0 9.9 0.8 3.1 65.0 — 39.4 56.1 10.2 17.1 0.4 7.0 Industry 1990 Fishing and Fish Farms Mining Food Products and Beverages Wearing Apparel and Fur Articles Wood.3 1.5 0.7 22.5 12. Rubber.4 2.1 8.5 6.0 8.3 2.9 10.0 9.8 1.8 Individuals 83.2 2.2 0.4 1.0 10.7 2.8 73.2 64.3 10.0 9.4 62.7 6.0 2.2 0.4 56.3 62.3 38.2 1.8 7.2 9.2 7.7 14.4 1.9 19.2 54. and App.7 17..6 8.5 — 1.3 7.9 1.6 18.7 14.1 0.2 0.3 2. Elecl Mach.5 0.3 0.0 7.7 20.15 Ownership Composition of Listed Nonfinancial Firms by Industry.2 9.7 2.5 17.3 0.1 0.8 7.9 8.3 1.5 85. and Printing Chemicals. Paper.0 20.7 64.0 1.8 7.1 19.9 66.9 59.9 15.4 8.8 5.1 8.0 — 0.b Securities Firms Insurance Firms Other Corporations Foreigners — — 0.1 0.9 23.5 — — 0.3 0. and Plastics Basic Metal Fabricated Metal and Machinery Office and Computing Machinery Electronics. 1990 and 1997 (percent) Financial Institutions The Statea — — 0.8 7.3 13.5 — 0.2 0.7 22.2 — 0.3 57.9 16.1 4.7 20.4 14. Etc. Paper.4 8.0 9.3 11.8 8.3 4.6 1.1 1.5 0.0 0.7 59.5 0.8 7.7 1.2 — — 0.

8 4.5 59.6 6.0 6.6 60.1 1.9 20.3 15.5 5.9 2.6 1.1 2.6 20.2 1.8 57.9 2.2 4.9 5.0 3.0 8.5 0.4 1.0 4.4 16.3 8.0 11.4 4.5 — 2.3 0.6 6. Source: Constructed from data files of the Korea Listed Companies Association.8 27.6 75.5 3. and finance companies.5 7.4 76. Motor Vehicles Electricity.4 3.2 0.2 0.3 2.4 6.5 12.4 0.1 3.1 18.1 9. Rubber.5 4.6 2.2 13.5 3.2 4.6 3.2 49.4 58.6 2.78 81.7 2.1 9.3 6.5 63.4 45.6 18.9 7.2 7.6 0.4 1.8 5. and Printing Chemicals.8 2.8 11.8 3.1 54.2 5.5 4.3 6.9 18.8 5.4 68. a The State covers the government and state-owned companies.9 7.” includes commercial banks. b “Banks.4 2.8 54. mutual savings.3 31. and Printing Pulp. merchant banks.9 5.7 1.0 5.0 6.3 60.2 4.0 60.4 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 1.5 6.9 1.7 4.7 2.3 57.2 6.1 3.7 2.1 25.1 4.1 6.7 5.4 58.2 23.2 4. . Note: Ownership is based on number of shares.7 6.8 0.1 — 0.6 59.0 43.6 — = not available.8 2.9 2.9 6.9 20.6 14.4 2.9 6.4 43.8 2.7 23. investment trust companies.2 5.7 19. and App. Paper.3 1.5 3.6 5.7 17. Gas.4 2.2 8.4 20.1 — 1.9 78.1 2.4 — 1.9 69.8 12.3 1.0 1.9 2.9 1.6 2.9 57.0 7. Elecl Mach.9 1.2 1.3 65.4 4.9 0. etc.7 2.6 7.3 7.8 6.5 1.1997 Fishing and Fish Farms Mining Food Products and Beverages Wearing Apparel and Fur Articles Wood. and Plastics Basic Metal Fabricated Metal and Machinery Office and Computing Machinery Electronics.6 0.4 1.5 3.1 1.8 0.2 3. Paper.

4 Firm Sizea No.4 2.5 19.7 1.4 61. Others are medium firms.4 61.c Securities Firms Insurance Firms Other Corporations Individuals 58.8 6. The State covers the government and state-owned companies.8 4.4 21.2 1.8 1.7 Foreigners 4. and finance companies.0 Other Corporations 16.4 4.1 Banks.5 62.4 2.8 3. 1997 (percent) The State 1. etc.9 4.8 4. 1997 (percent) The Stateb Foreigners 4.17 Ownership Composition of Listed Nonfinancial Firms by Control Type.7 4.3 6.1 8.4 17. investment trust companies.3 Banks. c “Banks. b Table 2.4 5.8 60. 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.7 8. mutual savings. Securities Firms Insurance Firms 2. etc.” includes commercial banks.5 16.9 5.4 5.6 16.4 1. .5 8.0 1.7 Control Type No.16 Ownership Composition of Listed Nonfinancial Firms by Size. Source: Constructed from data files of the Korea Listed Companies Association.5 18.1 6.5 2.7 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. etc.0 6.1 2.7 0.5 6.9 2.5 4.8 2.5 Individuals 60. merchant banks.6 60.Table 2.

8 56.7 16. for example. Foreign holdings of Korean shares were 9. the majority shareholder group in all listed companies consists of the corporate.3 47.20). Concentration of Ownership The analysis of ownership concentration in this section focuses on shareholdings of the majority shareholder. At the moment. defined as those holding less than 1 percent of shares. only closed-end investment companies and traditional investment trust companies are allowed. This has had profound implications for corporate governance and the market for corporate control in Korea. the majority shareholder group on average held 23-30 percent of outstanding shares in the period 19881997 (Table 2. investors (Table 2.1 8.4 26. 1997 (percent) Country Japan Korea Taipei. Among nonfinancial listed firms.Chapter 2: Korea 83 Table 2. minority shareholders.1 percent and appear to be similar to the proportion of foreign holdings in the four other countries.5 45.8 10.3 6.18 Ownership Composition of Listed Firms in Selected Countries.1 financial institutions’ establishment of corporate pension fund accounts.6 39.8 9.China United Kingdom United States Source: Stock Exchange of Korea. corporations held 70 percent of the controlling blocks of shares. The majority shareholder group’s shareholdings in listed nonfinancial firms steadily declined from 1990 to 1996. Institutional Investors 42.6 Individuals 23. But these may . his/her family members. and other shareholders who do not belong to either the minority shareholders or the majority shareholder group. 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. while family members accounted for only 30 percent. rather than the individual. Generally. and the companies under the control of the largest shareholder.19).5 20. including those of the largest shareholder.3 54.6 Foreigners 9. In 1997.

6 2.3 2. Minority shareholders are those holding less than 1 percent of shares.2 2.9 6. 1992-1997 (percent) Majority Shareholders Corporation 15.1 15.1 4.4 5.7 6.0 25.6 22.8 8. .1 14. Source: Stock Exchange of Korea.9 3.6 5.0 Year Corporation Individual 1992 1993 1994 1995 1996 1997 41.3 18.4 7. Other shareholders are those who do not belong to either the minority shareholders or the majority shareholder group.8 73.1 28.9 2.7 Note: The majority shareholder includes the largest shareholder.7 18.7 7.7 16.9 Individual 2. his/her family members.Table 2.1 5.19 Ownership Concentration of All Listed Firms.1 37.1 23.2 26.1 32.3 Subtotal 5.0 22.6 26.5 43.3 30. and the companies under the control of the largest shareholder.4 3.0 29.6 73.1 5.9 33.6 46.9 32.0 69.0 4.8 Individual Subtotal Other Shareholders Corporation 3.2 2.7 44.8 72.0 66.2 Minority Shareholders Subtotal 71.1 21.9 7.0 1.0 2.

9 27.2 15. 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.Chapter 2: Korea 85 Table 2.21]). the Government has retained a large number of shares. The practice of hidden shares seems to have been less prevalent in recent years.0 58. 1988-1997 (percent) Year 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Minority Shareholders 53.9 48.3 25.6 57.0 20.5 13.6 58. which held less than 1 percent of a company’s outstanding shares as of 1997. In most industries.5 60.1 50.20 Ownership Concentration of Listed Nonfinancial Firms. It was highest in medium-sized firms before 1993 and.8 Majority Shareholders 27. hiding shares offers no additional tax or other benefits. collectively owned less than 50 percent of an average firm.5 23. and mining categories. Meanwhile.8 25.4 Source: Constructed from data files of the Korea Listed Companies Association.5 12.6 11. Majority ownership is also high in the chemicals. Ownership concentration tended to be lower in large compared to medium and small listed firms. The shareholders that held more than 1 percent but did not belong to the majority group held about 20 percent on average.0 22. thereafter. 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 2.7 18.9 29.9 12.8 57.8 54. In telecommunications. . in the small firms.22). the majority owner held more than 20 percent of an average firm.9 25. minority shareholders.8 12. rubber and plastics. 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 23. Besides. In such cases.8 28.3 62. ownership was relatively diffused due to government regulation. Across industry.9 Other Shareholders 18.4 28.

5 52.6 19.9 44.4 16. Paper.5 21. Gas.2 48.7 17.7 21.8 41.0 54. and Plastics Basic Metal Fabricated Metal and Machinery Electronics.4 11.0 39.7 27. Rubber.5 16.1 43.3 19. Motor Vehicles Electricity.9 10.8 29.1 19.8 24. and Steam Supply Other Manufacturing Construction Wholesale and Retail Trade Transport Telecommunications Other Business Activities Nonmetallic Mineral Products Total Source: Constructed from data files of Korea Listed Companies Association.2 20.4 53.5 47.6 38.2 46.4 Industry Fishing and Fish Farms Mining Food Products and Beverages Wearing Apparel and Fur Articles Wood.0 30.2 26. and App.5 44. .3 39.7 24. Elecl Mach.0 51.2 22. 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 36.9 26.6 53.0 21.8 51.2 37.Table 2.8 55.6 25.7 29.21 Ownership Concentration of Listed Nonfinancial Firms by Industry.7 36. and Printing Chemicals.2 23.5 19. Paper.1 49.3 26.8 44.9 Minority Shareholders Majority Shareholders Other Shareholders 12.1 17.2 19.7 26.5 41.5 20.6 50. and Printing Pulp.8 31.6 34..5 23.8 25.8 21.2 34.

8 50.7 22.5 21.1 58.5 19.0 26.2 12.9 17.5 12.9 21.2 55.3 55.8 17.2 11.0 55.9 23.2 Majority Shareholders 26.2 21.9 28.8 28.4 51.9 12.3 21.3 27.9 56.5 49.8 56.6 27.5 28.2 56.7 57.0 66.4 47.7 57.Table 2.6 62.3 25.7 16. 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 53.5 27.7 28.0 24.6 15.9 60.5 33.9 53.1 48.2 32.7 15.3 19. 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.3 26.8 52.8 11.2 21.5 26.8 52.6 11.8 27.5 10.4 29.9 16.0 59.4 30.22 Ownership Concentration of Listed Nonfinancial Firms by Firm Size.5 Other Shareholders 19.9 22.6 55.9 26.6 65. .7 17.1 27.2 50.2 52.7 14.4 30.2 26.9 55.8 62.4 30.6 24.1 16.2 21.5 12.1 15.4 21.5 51.2 Source: Korea Listed Companies Association.6 31.7 31.1 20.6 59.5 19.2 18.

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

Partial results are shown in Table 2. standalone setups. dominated the majority shareholder group in chaebol-affiliated companies is consistent with the results of the ADB survey conducted for this study. But the controlling power of the owners also stems from inter-company shareholdings of the subsidiaries. If we define the internal shareholdings of a . or an average of 13 firms per company. for example. Among chaebol affiliated firms. there are instances of direct cross-shareholding in Korean firms.5 percent as of 1997. together having a total of 292 domestic subsidiaries.4 corporations. Thus. 59 were parent firms with one or more subsidiaries. financial institutions that are subsidiaries of a chaebol also hold shares in its member firms. Among the subsidiaries or firms receiving investments. Only six firms (or 13 percent) indicated that their subsidiaries also owned shares in themselves. firms linked through partial equity investments could enjoy the advantage of consolidation without an actual formal consolidation or merger of operations taking place. although they are likely to be insignificant. In the case of the 30 largest chaebols. For the same year. The fact that corporations. The extent of pyramiding can be seen in some of the previous tables. This also partly explains why chaebols frequently opted to expand by establishing new firms rather than placing investments internally.Chapter 2: Korea 89 guarantees from other members of the group at no cost. corporations hold about 20 percent of the outstanding shares of all listed nonfinancial firms. the top five shareholders consisted of 2. Among the 81 listed firms in the ADB survey. For the whole sample. the average shareholding of the controlling owners and their families was 8. Until recently. together owning an average of 38. and 319 foreign subsidiaries.5 corporations and two individuals.14. 62 percent (16 out of 26) had a corporation as the largest shareholder. 34 percent were foreign companies. In Table 2. not individuals. In many instances. or about five subsidiaries each. 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.9 percent of shares. The top five shareholders of the chaebol-affiliated firms consisted of one individual and 3. Of the 81 respondents. 53 percent were domestic nonfinancial firms. Thus. neither the investors nor the relevant government authorities were active in monitoring such unfair dealings between firms. the top 30 chaebols’ shareholding by subsidiaries was 34. and about 11 percent were domestic financial institutions.5 percent.5 percent of shares. or about four firms each. together owning an average of 37.23. 59 parent companies collectively had investments in 759 firms. Twenty-two of the 81 respondents were independent.

8 Note: The survey was conducted during the period January through May 1999 and included nonfinancial listed firms only.8 31.5 38.4 11.4 1.5 4.9 5.6 3.5 2.8 37.0 2.5 24.2 25.3 12.7 39.4 42.7 37.5 2.5 1. A few companies reported less than five largest shareholders.3 26.4 2.1 3.8 38.0 1.8 8.7 19.9 34. 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 20.5 4.0 21.5 2.4 25. b The chaebol affiliated firms are those belonging to one of the 30 largest groups.5 18.0 13.0 3. 1999 Five Largest Shareholders No.5 2.0 1.4 21.6 16.4 18.0 17.4 38.5 31.9 21.7 0.6 3.7 5.0 3.2 37. a Number of shareholders.8 18.1 1.6 3.1 22. .6 34.9 29.Table 2.23 Ownership Concentration in the Survey Sample of 81 Listed Firms.

Chapter 2: Korea 91 chaebol as the shareholdings of the controlling family and the member companies of the group. New York: Praeger. pp. 15 October 1998.2 15.5 34.4 1990 45. 1987-1997 Type of Shareholding Internal Shareholdings Family Member Companies Source: Korea Fair Trade Commission. Many attempts have been made by researchers to identify the typical patterns of ownership structures in chaebols.7 9. Chicago. Jae Woo. Internal shareholdings in some chaebols also include shares owned by nonprofit organizations operated by the controlling family.5 percent and member companies.6 33.” Paper presented at the Annual Conference of Financial Management Association.2 1994 42.” In Korean Managerial Dynamics.24 shows the average internal shareholdings in the 30 largest chaebols.4 13. 79-95. 34. . “Japanese Zaibatsu and Korean Chaebols. Table 2. As of 1997.5 percent. “The Ownership Structure and Family Control in Korean Conglomerates: With Cases of the 30 Largest Chaebols.0 8. C.5 Judging from the historical record.4 10.7 1992 46. 6 7 Hattori. Ungki Lim.4 1993 43.24 Internal Shareholdings of the 30 Largest Chaebols. Lee. Hattori (1989) identified three patterns based on data in the early 1980s. Family holdings include shares owned by the family members and by parties considered to be under the influence of the family. the controlling families owned 8. Table 2. the ownership patterns can be described as follows.8 33. The relatively high internal holdings of the 30 largest chaebols were due partly to the fact that many of the chaebols’ firms are still privately held. Chung and H. 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. Lee. 1997. 1998.6 Later studies by Lee (1997) and Lim (1998)7 find similar patterns.2 12. the average internal shareholding ratio of the top 30 chaebols was at least 43 percent. H. 1987 56. Based on these studies. it appears that the chaebol families have had a strong desire to expand their business bases.1 1997 43. 1989.8 40.2 33. edited by K.7 31. “Is the Fair Trade Policy Fair?” Korea Economic Research Institute. Tamio. The family and member companies’ shareholdings have been declining over time.

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

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

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

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

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

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

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. Chairpersons of the board were elected on the basis of professional expertise (33 percent of the firms). However. This rather long tenure must be due to their status as controlling shareholders in most firms. The current chairperson has been in office for 6.98 Corporate Governance and Finance in East Asia. in 23 percent. Remuneration for chairpersons include only fixed fees in 76 percent of the sample firms. including stock options. in some firms. relationship with controlling shareholders (21 percent). In 1997. and shareholding (10 percent). In a very small number of firms. election of directors was based on shareholdings (7 percent) and status as founder (7 percent). . As discussed earlier. The survey results indicate that boards determine remuneration packages for chairpersons in 42 percent of the firms. In one case. one person was sitting on nine boards and this person was the CEO of a chaebol firm. In 13 percent. the management nominated director candidates (64 percent of the directors). the term of appointment of directors and board chairpersons is three years. Vol. founders of the company acted as the chairperson (22 percent). and fixed fees plus performance-related pay. the board had no committees. About five directors per firm have been in office for more than one term.2 years on average. the management determines the remuneration. The board or the management then determines compensation packages for individual directors. Some directors were nominated by significant shareholders (18 percent) or introduced (and elected) at the shareholders meeting. The reason for this high frequency of interlocking directorship is that many listed firms belong to chaebols. among the 81 sample firms. the board had a nomination and an audit committee. In most firms. II shareholder (30 percent). The general practice is that shareholders approve the upper limit on the total amount to be paid to all directors. In some instances. compensation for directors must be approved by the annual shareholders meeting for each fiscal year. a total of 562 directors were sitting on two or more corporate boards. Most frequently. Less frequently. These were established only recently. According to the Commercial Code. In 91 percent of the sample firms. Members of controlling shareholder families or their trusted company personnel often act as directors for multiple chaebol firm boards. 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).

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

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

however. 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. Only 10 percent of the respondents have followed all international accounting standards. they cannot be expected to discharge this responsibility because the representative director selects the internal auditor and can force him or her to resign. In the ADB survey. The primary sources of reference in the revision were International Accounting Standards and US Accounting Standards. Internal and External Auditing The Commercial Code requires a corporation to have at least one internal auditor elected at the general shareholders meeting. 41 percent of the companies believed that they have followed some international 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. they also have the power and duty to monitor the activities of executive directors. Those that never adopted international standards show their willingness to do so once the Government introduces international standards. The new accounting standards for financial institutions adopt the mark-to-market basis to account for securities. the internal auditor is considered to be a subordinate of the . In practice. 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 internal auditors are supposed to play the role of the audit committee found in the board of directors in US corporations without being members of the board. The revised accounting standards apply to the firms subject to external auditing for the fiscal year starting on or after January 1999. 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. Consolidated reporting was introduced before the outbreak of the crisis. 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. Thus. Under the Commercial Code.Chapter 2: Korea 101 (iii) establishment of accounting standards for “combined” financial statements of chaebols. but 49 percent confessed that they have not followed international standards at all.

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

This shows that a relatively larger number of shareholders send in their proxies. Approval of mergers and major divestitures.77 percent of the shares. These voters represented only 5. in general. the Depository is subject to “shadow voting. The above results indicate that. charter amendments. Citizens’ coalitions sometimes solicit proxies in order to file lawsuits against a management. and dismissal of directors and internal auditors require a “special resolution. A total of 326 shareholders per firm.” meaning that it should divide its votes in accordance with the accept/reject ratio of votes cast by other shareholders attending the shareholders meeting. About one fifth of the listed firms issued nonvoting preferred shares. representing 62.3 Shareholder Rights Voting Rights and Practices Under the Commercial Code.93 percent of the shareholders but 26. However.21 percent of total shares issued. About 100 shareholders per firm voted by proxy at the last annual general meetings (of the 40 firms answering the relevant questions). small shareholders do not attend the annual meeting and that.53 percent of the total shareholdings. The Depository represented 20 percent of the shares attending the meetings.” Companies can increase the number . However. respectively. The securities companies and banks are the second and third. attended the last annual general meeting.” The survey shows that the Korea Securities Depository holds 69. 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. corporations cannot issue common shares without voting rights. the Depository is instrumental in getting resolutions passed. No companies have so far introduced voting by mail. One common share should have one vote. or telephone. amendments of the articles of incorporation require a “special resolution. Thus. 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.79 percent of the shareholders. or 10. the only purpose of allowing the Depository to vote was to help listed companies to meet the quorum requirement for the general shareholders meeting.Chapter 2: Korea 103 2. for some firms. A “special resolution” requires two thirds of the votes attending and one third of total votes outstanding. Under the Commercial Code. Preferred shares can be nonvoting and issued up to one quarter of the total number of shares.3. The management is the most important proxy. Internet.

and for access to unpublished accounting books and records. Changes in the authorized capital require an amendment of the articles of incorporation. an activist citizens’ coalition has brought shareholder derivative suits against several large listed firms. laws and regulations were generally very loose in protecting the rights of minority shareholders. Only two out of 62 respondents to this question have had cases in which proposals were rejected. As an example. mergers and acquisition plans. the Tiger Fund. Proposals put forward by management are rarely rejected at the general meetings. dividend proposals.5 percent. The charges included self-dealing by a controlling shareholder and unfair subsidization of affiliated companies by a chaebol firm. from 3 to 1. For recommendations for dismissal of directors and internal auditors. This citizens’ coalition actively contacted the management of selected companies and negotiated measures to protect 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. the requirement was lowered from 1 to 0. Vol. and major investment projects (only five firms answered this question). The company also agreed to the right of the fund . an institutional investor based in the US. the annual general meeting passed a resolution that was not proposed by the management nor the board of directors but rather by shareholders. Those that are most likely to be rejected relate to election of directors. demand changes in business policy. II of votes required for a resolution to amend the articles. 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 0.01 percent. Shareholders have preemptive rights. the board of directors decides on issues of shares within the limit of the authorized capital. It also attended the shareholders meeting of several companies to present the views of outside shareholders.0 percent. Due to the changes in rules for investor protection. Various measures have since been taken to improve investor protection. This coalition also attempted to cooperate with domestic and foreign institutional investors to find their way into general shareholders meetings. However. In February 1998 and again in March.104 Corporate Governance and Finance in East Asia. or block charter amendments considered harmful to minority shareholders. 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. In four out of 62 respondents.

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

this proposal has only a slim chance of being accepted by the Government or legislature. recently banks have been increasingly interested and successful in electing former bank officers as outside directors of firms that underwent workout processes. Emphasis on the monitoring role of banks has been growing since the beginning of the Asian crisis. Some proponents argue that creditors should have the right to send their representatives to boards of directors of borrowers. In turn. The main bank should also monitor and restrict extension of loans to the controlling shareholder and other firms in the group. and purchases of real estate. on average. In 1994 the approval requirement was abolished. However. 10 nonbank . 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. On the other hand. creditors now have a bigger say in court proceedings for receivership and composition. as discussed earlier. the main banks should review the feasibility and financing plans of projects undertaken by the core companies and monitor their financial conditions and prospects. 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. Vol. The objective of the system is to improve the financial condition of the largest business groups and promote the soundness of bank management. Under the system. 11 banks. 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. Purchase of real estate should be financed by equity capital and not by borrowed funds. However. including. 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. there have been concerns that the Government might use the system to intervene in the management of the business groups. II acquisitions. The firms subject to the system are required to get the approval of the main bank prior to purchasing real estate.106 Corporate Governance and Finance in East Asia. In 1996. Besides the setting up of an “External Auditors Committee” by firms.

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

the creditor banks will send a delegation composed of bank officers to the workout firm to oversee its management. In cases where the creditors are unable to reach an agreement on a workout plan. 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. This agreement will provide guiding principles in coordinating diverse interests among creditor institutions and promoting cooperation. and in continued monitoring of debtors. the lead creditor banks formally signed Capital Structure Improvement Plans with chaebols. the Corporate Restructuring Coordination Committee (CRCC) will provide arbitration. In this connection. The new ways through which creditors. banks and other institutional lenders are playing more important roles than ever before. 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 . Under a contract signed between the creditors and the debtor. especially banks. Behind these new strengthened roles of creditors is the newly set-up FSC. and 1 percent by the Government. the Korean Government maintained a policy of protecting the incumbent management of listed companies. This committee was set up in accordance with the provisions of the CRA. major creditors. II by other affiliated companies. a Lead Creditor Council Agreement was signed for restructuring the top five chaebols. have been the driving forces for restructuring activities of the largest 64 chaebols. including commercial and merchant banks. 2 percent by holding companies. Separate from but emulating the CRA.3. The leading creditor banks will continuously monitor the progress in implementing the signed Plans. the delegation has the right to approve wide-ranging financial activities of the firm. Vol. First. 4 percent by subsidiaries. are summarized below. will get involved in the restructuring and workout processes. Second. 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. 2.5 The Market for Corporate Control Government Policy Toward Hostile Takeovers Until 1994.108 Corporate Governance and Finance in East Asia. Third.

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

an electric power company. 172 firms (or 22 percent of listed firms) belong to the 30 largest chaebols. Another reason is that many listed firms belong to chaebols.110 Corporate Governance and Finance in East Asia.6 Control by the Government State-Owned Enterprises Government ownership of listed companies is very limited. The Government-owned listed companies. was newly listed. Charter amendments have also been employed by some firms to limit the maximum number of directors. except for the banks. II The Securities and Exchange Act was revised in 1998 to abolish the 10 percent limit on share repurchases and the Government simultaneously eliminated the limit on foreign ownership of shares of listed firms. For the steel company. As of the end of 1997. the Government became the largest shareholder of several commercial banks through equity participation purporting to recapitalize them out of financial distress. the limit will be eliminated when it is fully privatized in two years. Korea Telecom. .7 percent on average as of the end of 1997 for nonfinancial listed firms). some firms have included a supermajority provision for the dismissal of directors and provided for a staggered board. which are allowed by the Securities and Exchange Act to set the limit on the ownership of shares by one single shareholder. Many of the takeover targets in the past did not have a controlling shareholder (group). Vol. in which the Government still holds the largest ownership. In their charters. In 1998. 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. and a bank had government ownership. are designated as public companies. Hostile takeovers in Korea will be rare in the future. It is harder now to find such firms. 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. In 1999. a steel company. For the others.3. Currently the limit is 3 percent. 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. Some had two or more large shareholders who had joint control of the firm but could not cooperate. As of February 1999. 2. 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.

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

employers are required to meet with representatives of labor unions at least once every three months. they delegate their voting rights to plans’ representatives. which were generally much lower than estimated values. the management usually consults the union on major issues relating to the management. Employee stock ownership plans became popular in 1974 when the Government allowed tax and financial benefits for stock purchases by employees.1 in 1997. Two thirds of the respondents had an organized union. The percentage of shares held by the employee stock ownership plans in listed companies was 1. carried out at the enterprise level. Employees of companies have had the opportunity to buy shares of their employing businesses at favorable prices. Trade unions are organized on an enterprise basis. in principle. operation. The respondents of the ADB survey had 2. In 70 percent of the firms with organized unions. and 2. In these firms. The union had no influence on the management in 17 percent of the firms. Local unions in the same industry have established industrial labor federations. of which 2 percent were senior managers. This practice may be due to the fact that employees are typically submissive to their employers and that their total shareholdings are minimal. there are two federations of labor unions.9 in 1980. .654 employees per firm on average. Under another law enacted in 1972 to induce private companies to go public. and development of the company. employees of listed firms issuing shares through rights offerings are entitled to 10 percent of the rights. In 1987. II shares of their companies through employee stock ownership plans. The relevant regulation was amended recently in order to facilitate voting by individual employees. the council meetings have been superficial. In actuality. union members account for 54 percent of the employees. At the national level. but 27 percent of them felt that it was strong. 2. Vol. Collective bargaining is. The typical collective bargaining agreement has a one-year duration. Under the Labor Management Council Law. This law is not intended for wage negotiations but for employers to seek cooperation and productivity increases from workers. and 66 percent manual workers. 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. these firms have to offer 20 percent of the shares being issued to their employees at the public offer prices. 32 percent technicians and professional staff.112 Corporate Governance and Finance in East Asia. Under the Capital Market Development Act of 1968. About half of these firms considered the influence of the union on the management of the company to be weak.5 in 1990.

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

mutual savings. On the basis of flows of funds. 2. depreciation. Internal funds include retained earnings. the Government simplified various directives and instructions regulating personnel management. revision of the credit control system. Korean firms have been allowed to issue CBs in international financial markets.5 percent in November 1981. and the 30 largest chaebols. as a first step toward liberalization of capital account transactions. Vol.4. the required reserve ratio was substantially lowered from an average of 23 percent in 1979 to 3.1). Moreover. The Government handed over its controlling stakes in four commercial banks to private hands in 1981-1983. Meanwhile. The Government adopted a cautious approach.118 Corporate Governance and Finance in East Asia. . listed companies. etc. The plan was launched partially to accommodate US demands for comprehensive structural deregulation and market opening of the financial sector. the following measures can be constructed: Self-financing ratio (SFR) is the ratio of change in internal funds to change in total assets. It included such important issues as interest rate deregulation. The Government began to considerably deregulate foreign exchange in 1987 due to the shift of the current account into surplus in 1986 (see 2. In addition. Also. In June 1993. which resulted in the establishment of a number of new banks.2 Patterns of Corporate Financing Corporate Financing Practices In this section. was liberalized drastically in 1998 after the financial crisis. With the privatization of nationwide commercial banks. Some policy loans were also abolished. entry barriers to banks and NBFIs were lowered in an attempt to promote competition. finance companies. opting to bring in the plan step-by-step to avoid market dislocation from a sudden shift in the system. Since 1985. short-term finance companies. the Government announced a plan in 1981 that substantially improved foreign investors’ access to the domestic capital market. budget. implementing the first stage in November 1991. the Korean Government announced its Financial Liberalization and Market Opening Plan. and organization of commercial banks. and liberalization of foreign and capital transactions. the business scope of financial institutions was greatly widened from the early 1980s. flow of funds analysis was used to examine patterns of financing of the aggregate corporate sector. The capital market.2. II Interest Rate Deregulation Plan. especially the domestic bond market. development of the money market.

This means that internal funds after dividend payment were insufficient to finance growth in total assets. but it remained less than 10 percent of total financing. and 1997. The share of external financing. the corporate sector’s most important source of external finance was bank borrowings. Meanwhile. In 1988 when the stock market boomed. The SFR averaged 28. and government transfers. on average. It measures the degree of financing growth in total assets by additional debts. Before 1988. the proportion of foreign borrowings in total finance rose steadily. was 71 percent during the period. particularly in the 1990s in response to the liberalization of the capital market. Incremental debt financing ratio (IDFR) is the ratio of change in total borrowings to change in total assets. Additional equity capital used to finance growth reduces the financial cost and the financial risk of investment. financing by corporate bonds and CPs was more significant than by new equity. Incremental equity financing ratio (IEFR) is the ratio of change in stockholders’ equity to change in total assets or 1-IDFR. capital surplus.26 shows the four measures of corporate financing calculated from Table 2. depreciation. including all sources other than retained earnings. Table 2. The corporate sector used . the proportion of borrowings from NBFIs fell to its lowest value at 4 percent. comprising internally generated capital (retained earnings.Chapter 2: Korea 119 and net capital transfers from the Government.25 shows the flow of funds of the nonfinancial corporate sector in Korea during 1988-1997. Financing Patterns of the Aggregate Corporate Sector Table 2. Equity capital represents the shareholders’ commitment to the business. This high proportion deprived Korean businesses of flexibility during recession periods due to high financial costs. It measures the degree of financing growth in total assets by additional equity. In securities finance. The use of additional debt to finance growth increases financial risks as the company may not be able to pay interest during periods of recession or high interest rates. Securities finance became a more important source from 1988 onwards. depreciation. except for the stock market boom of 19871988. and allowances) and new equity capital. New equity financing ratio (NEFR) is the ratio of change in equity (stocks issued + equity other than stocks) to change in total assets. but do not include capital surplus (asset revaluation allowance and the excess of current value over issue value of stock). particularly in the short term.25.4 percent in the precrisis period 1988-1997. except in 1991. 1994.

1 2.0 0.1) 6.1 0.5 2.2 5.1 72.7 1989 1990 1991 1992 1993 1994 1995 1996 22.6 14.2 6.3 27.2 34.3 2.6 0.8 30.7 (0.6 9.4 0.4 1.0 — — — — 8.7 4.4 11.1 10.3) 11.4 27.4 3. a Includes retained earnings.0 1.8 1.0 10.4 15.2 2.7) 11.1 3.4 1.3 — — — — 8.8 4.7 11.6 77.2 6.7 7.2 13.4 2.8 56.1 2.5 0. . Source: Understanding Flow of Fund Accounts.1 (0.7 73.7 15.7 71.4 (0.0 22.6 4.6 2.6 3. 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 10.7 12.3 6.4 (2.4 27.1 1.4 27.0 3.3 1.7 14.0) 12.1 27.3 72.6 (0.3 6.3 1. 1988-1997 (percent) 1988 43.7 2.5 2.0 2.7 14.6 0.6 9.3 16.6 4.5 0.2 1.1 1.5 16.9 0.0 11.9 38.9 10.4 0.6 11.3) 15.1 — 27.3 3.4 2.4 21. 1994.0 5.6 5.8 1.6 11.0 (0.7 10.4 9. and Flow of Funds. b Includes capital surplus.2 10. and net capital transfers from the Government.6 0.3 6.1 8.4 2.8 0.0 70.2 — — — — 9.7 6.7 32.7 13.1 12.4 8.3 3.4 — 28.8 15.7 2.1 17.2 (0.1 3.1 23.7 10.0 9.0 17.0 16.4 71.Table 2.6 8.8 1. depreciation.8 17.5 29.6 4.8 1.2 14.1) 4.9 73.0 3.7 8.7 8.3 1.7 10.8 -2.0 1997 26.2 — 28.4) 13.5 13.1 (1.6 Sources of Funds Internal Financinga External Financing Bank Borrowings Banks Nonbanks Merchant Banks Insurance and Others Securities Natl.1) 4.9 34.6) 5.6 0.0 9.4 10.9 28.3 5.1 36.9 9.8 — 26.5 9.0 3.8 (0.6 3.1 1.6 1.7 — — — — 9.25 Flow of Funds of the Nonfinancial Corporate Sector.5 0.3 — 30.1 0.4 2.7 1.2 0.5 16.6 9.1 — — — — 12.1 3.0 0.9 2. which is the excess of current value over issue value of stock.5 2. Bank of Korea.3 10.2 15.9 72.8 8.7 2. Bank of Korea.8 1.5 2.6 25.7 4.3 25.2 26.8 27.7 1.9 10.3 30.2 13.9 6.

7 9. and IEFRs were declining.26 Financing Patterns of the Nonfinancial Corporate Sector. Bank of Korea. NEFR registered 20. was financed by additional debts. but plunged to 5. the corporate sector relied heavily on external financing for its expansion. declining to 26.1 26.4 IEFR 63. and the total debt ratio was much higher in 1996 and 1997 at 62.4 12. IEFR ranged from 32 percent to 64 percent of asset growth during the boom years.2 IDFR 36.9 28.6 percent.0 27. Incremental financing from equity was 40.6 percent.2 37.7 40.5 and 76. in the manufacturing sector.3 59.6 percent over the 10-year period.4 percent (Table 2.3 60.3 27.7 28.8 percent of its total asset growth through debts. Bank of Korea.3 percent in 1997.9 22.4 percent. and Flow of Funds. The balance.1 53.7 30. In periods of high economic growth such as in 1988.5 31. an average of 59.2 percent of incremental asset growth was financed by equity. Source: Calculations from Understanding Flow of Fund Accounts. higher than the aggregate 40.2 percent of the growth in total assets. On average.7 percent in 1997.7 40. respectively.9 percent by 1997 when net profit margins were negative. SFR peaked at 44 percent. There were significant time trends. higher than the aggregate 28.5 12.Chapter 2: Korea 121 Table 2.6 62.3 11.9 60. respectively.5 percent. While SFRs.6 percent and 1.0 5. 1988-1997 (percent) Year 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average a SFRa 43.4 percent. dropping to 26. It dropped to 28 percent the following year.3 59.1 17.5 68. NEFRs.4 NEFRa 20.4 27.5 percent in 1997.3 73.6 Excludes capital surplus.8 28. 1994.0 57.4 37.8 10.7 40. additional equity to finance 12. Lower income diminished the industry’s equity position toward crisis year 1997. 45.8 62. but also continuously fell. Manufacturing financed 54. IDFR reached 73.3 12.0 11. indicating a high financial risk position.9 46.7 26.27). Across industry. average SFR was 37.6 26. Its IEFR and NEFR dropped to 23.1 12.1 39. .0 42.1 percent in 1988 during the stock market boom.

then increased to 20.3 52.2 21.6 3. and hotels sector and realty/renting/business activities sector were similar. Categorized according to company size.6 53.7 47.9 percent. and fell to about 10 percent in 1997.4 63. and steam) and the transportation.6 4.8 percent in crisis year 1997.0 42.6 37.8 percent in 1990. the utilities (electricity. from 17.1 percent of total asset growth for the period.3 28. this dropped further to 15.4 54.6 45. It had the highest average SFR in 1988 at 31.4 47.9 percent of asset growth. the two sectors also had low equity financing ratios and high debt financing ratios. Since 1992. Total debt financed an average 74.0 57. gas.7 37.5 23.6 62.2 3. large firms showed more cyclical patterns in these financing ratios than small.4 37. On the other hand.0 42.0 30.4 3. their average SFR was higher.8 4.8 IEFR 65.2 62.7 47.4 45.2 percent in 1993.6 53.2 5. and communication sector had relatively high incremental equity ratios. Financing patterns of the wholesale. Table 2.5 76.7 percent in 1996.4 46. explaining partly the collapses of several construction companies in 1995.9 IDFR 34.8 50. In 1997. and low total debt and short-term borrowing ratios. the proportion of short-term borrowings in total financing has been high. Equity financed an average 25.9 6. with the total debt ratio much higher in 1995-1997 at 82 to 84 percent.2 . These sectors had relatively low equity financing ratios and high total debt ratios in financing asset growth between 1988 and 1997. one year ahead of the other industries.0 3. II The construction industry showed the most cyclical pattern in annual asset growth.5 1.27 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. Vol.1 29.7 37. Since large firms were more profitable. storage. retail.6 37.6 54.5 7.5 NEFRa 9.6 36. which decreased to 8.122 Corporate Governance and Finance in East Asia.and medium-sized firms.

5 76.0 34.1 59. and Communication 1988 64.9 9.9 33.2 5.3 (9.1 4.8 54.5 1996 42.7 15.5 62.1 25.7 53.2 1995 16.4) 2.6 9.5 87.3 4.8 74.0 1990 12.6 37.9 16.7 1997 8.6 2.5 70.9 1.3 7.0 68.2 23.9 2.9 30.7 6.9 52.3 1996 16.8 2.7 7.3 21.0 0.0 17.5 12.9 1.0 1.2 20.8 9.4 26.2 70.3 84.9 1.6 71.7 42.7 78.0 74.5 1993 22.5 23.5 1.6 9.6 4. Hotels 1988 33.8 4. Storage.2 10.6 7.5 21.3 57.9 80.2 18.9 1992 56.8 25.2 3. Household Goods.2 74.2 Average 53.3 10.0 1992 24.0 65.9 1993 63.6 37.3 47.4 2.2 4.8 76.6 73.8 81.5 29.9 Average 19.Table 2.2 8.7 78.2 46.7 80.3 19.7 1994 53.5 20.2 25.7 Wholesale/Retail Trade.1 1991 14.2 29.6 8.6 14.4 62.0 60.4 IEFR 46.1 19.4 28.9 1989 63.7 15.4 1995 53.8 1994 15.0 82.3 8.9 20.1 70.9 Construction 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 31.0 4.0 3.1 66.8 1991 51.1 69.8 70.0 10.8 29.1 84.6 1997 29.0 31.1 Trasport.0 1990 50.3 4.0 .27 (Cont’d) Year SFRa NEFRa IDFR 53.9 47.9 15.9 29.0 40.6 8.7 41.7 1989 26.

a Excludes capital surplus.1 71.4 1994 72.4 7.1 1989 34.6 Real Estate.3 85. II Table 2.9 28. Their average IEFR was also higher and IDFR smaller.1 70.4 47.8 17.5 8.4 1996 45.0 0.3 7.0 1.0 33.1 0.1 34.9 45.0 1992 51.2 63.7 37.4 1.4) 3.0 1997 24.9 29.6 1991 18.9 57.0 21.8) 7.3 31.0 53.8 135.6 7.124 Corporate Governance and Finance in East Asia.4 0 0 0 0 1. Source: Calculated using data from Bank of Korea.4 IEFR 69.0 43. Higher growth in total assets and sales and easier access to debts by large firms could be reasons for this.8 36. and Steam Supply 1988 118.7 1994 8.3 62.1 35.6 IDFR = incremental debt financing ratio.3 29. Gas.4 0.6 1990 82.6 1989 118. and Business 1988 51. The trend was reversed in 1996-1997. Renting.3 92.3 207. when large firms had much lower equity financing ratios and higher debt financing ratios than small.3 Electricity.3 3.7 14.5 22. NEFR = new equity financing ratio.0 79.5 77.0 (0.4 1995 62. . however.0 56.6 52.7 70. Vol.6 1.7 1996 18.8 Average 22.9 Average 75.2 1992 18.and short-term borrowings of these firms shot up in that period.7 18.1 42. The large firms had a higher proportion of external financing in 1996-1997.8 1993 11.4 (107.and mediumscale firms.4 5.0 0.0 46.7 69.6 1997 23.9 65.27 (Cont’d) Year SFRa NEFRa 6. SFR = self-financing ratio. Long.0 67. IEFR = incremental equity financing ratio. Financial Statement Analysis Yearbooks.1 54.1 1991 56.1 1993 55.6 1995 17.8 1990 19.9 IDFR 31.3 81.8) (35.9 64.

Cross-payment guarantees have been declining since 1993 and reached 91.8 percent. and using cross-payment guarantees among affiliated companies. at an average 70. the NEFR of the top 30 chaebols plunged while the debt ratio increased substantially. the average SFR was 28. respectively. 91. compared with 89. The chaebols’ drive to expand their empires resulted in heavy borrowings.3 and 89. The proportion of their short-term financing averaged 72. the top 11-30 chaebols had the highest guarantees commitments at 207. In 1997.1 percent of their equity capital. Their shortterm borrowings accounted for 86. In 1997. compared with the entire corporate sector’s 35 percent and 65. Financing Patterns of Chaebols For chaebols.28).9 percent. and higher than that of listed companies (Table 2. Many firms affiliated with the top 30 chaebols saw loan guarantees turn into their own debts because of defaults in debt payments.3 percent of their equity capital in 1997 (Table 2.8 percent of their total finance in 1997.30).5 percent is lower than that of the corporate sector in general. The average IEFR and IDFR were 10.29).7 percent.6 percent of total asset growth. and the top five chaebols. and were large borrowers. the IDFR of listed companies increased to 93. Group-member firms borrowed less. but higher than that of listed companies. The debt financing ratio of listed companies was high since they relied more on external financing. . The largest borrowers were the top 11-30 chaebols. They had easier access to bank loans and the markets for corporate bonds and CPs than nonlisted companies.9 percent. They were able to borrow easily from banks by issuing corporate bonds and CP.6 percent. Another key feature of corporate finance in Korea is the widespread use of loan guarantees among the top 30 chaebols.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 2.2 percent.7 percent for all listed companies. The average IEFR of the top 30 chaebols of 29.7 percent.5 percent and their total external financing. the top 6-10 chaebols. All of the top 30 chaebols relied heavily on short-term borrowings. for listed companies. 153.4 percent. In 1996-1997. External financing reached 94. about the same as that of the corporate sector as a whole. the lowest ratio of 58.

4 1.3 1. Source: Calculated from data obtained from data files of the Korea Listed Companies Association.3 28.6 61.8 76.3 5.2 23.6 0.6 IEFR 42.5 2. .28 Financing Patterns of Listed Companies.5 8.5 2.1 8.9 NEFRa IEFR 14.2 NEFRa 1.3 86.Table 2. 1994-1998 (percent) SFRa IDFR 85.4 12.8 22.4 29.3 Year 1994 1995 1996 1997 Average a Excludes capital surplus.5 8.4 88.7 1.6 11.9 7.5 91. Korea Federation of Industries.1 1.4 38.3 IDFR 57.1 93.5 Year 1994 1995 1996 1997 Average a Excludes capital surplus.7 12.8 89.2 36. Source: Calculated using data of Seung No Choi.9 6.6 1.2 1. 1994-1997 (percent) SFRa 41. Table 2.6 70. Largest Business Groups in Korea.7 13.29 Financing Patterns of the Top 30 Chaebols.2 10.

the Korean economy was plagued with high inflation. the Government provided implicit guarantees on bank lending and large businesses.1 — = not available. bond issues. bond issues. and reserves and retained earnings. Source: Fair Trade Commission and the Federation of Korean Industries.9 — — — 1996 105. There were several reasons for this. Third. According to the ADB survey. Controlling shareholders usually tried to avoid dilution in their shareholdings for fear of losing control. This attitude appears to have changed after the crisis because reserves and retained earnings and rights issues became the preferred financing choices.0 207.9 — — — 1994 258. loans from banks. Second. .1 — — — 1995 161. so that the firms engaged in lobbying to gain access to them.Chapter 2: Korea 127 Table 2. First. Further. Interest payments on debts were considered a loss when calculating taxes.3 64. Factors Influencing Corporate Financing Choices Until recently. Korean firms preferred debt financing (bank and nonbank borrowings). Few firms ranked loans from NBFIs as their first preference. and extended loans based on cross-payment guarantees. And fifth. and loans from NBFIs.3 200. chaebols could easily borrow funds from banks and NBFIs by using cross-payment guarantees. especially in the 1970s when real interest rates of bank loans were negative. more than half of bank loans were priority loans with low interest rates. company preferences in financing investment projects before the crisis were. the Government applied high tax rates on net profits of corporations.30 Cross-Payment Guarantees of the Top 30 Chaebols.7 150.3 58. poor financial and corporate governance resulted in overlending by banks.9 153. rights issues. in order of ranking. inefficient investment and excessive diversification of corporations. Financial institutions did not strictly screen their loan projects and monitor their debtors. and underdevelopment of the stock market. These are followed by loans from banks.0 1997 91. This change implies that firms now give more attention to financial risks. Fourth. 1993-1997 (as percentage of equity capital) Rank Top Top Top Top 30 Chaebols 5 Chaebols 6-10 Chaebols 11-30 Chaebols 1993 469. Firms now prefer internal funds and new equity capital.

5 percent at the end of 1997. they survived for two to three . The percentage of foreign currency denominated loans hedged against exchange rate risks was 21. and reduction in tax burden. Among the responding companies that had foreign currency denominated loans. Among those that never hedged against exchange rate risks. the majority (60 percent) of the firms responding to the ADB survey look first for nonaffiliated financial institutions. 2. in order of importance. more than half (53 percent) hedged against exchange rate fluctuations.4.128 Corporate Governance and Finance in East Asia.36 percent on average for these companies. maintenance of the existing ownership structure. Nonetheless. II In seeking external financing. Korea now provides a better environment for financial risk management. Few companies felt that hedging was too costly or was unnecessary as the exchange rate was considered fixed. Other factors include. For these firms. A futures exchange launched in 1999 trades foreign exchange options. ensuring the liquidity of the company. Diversification. some (36 percent) thought that a hedging facility was not available or not working properly. even with a heavy debt burden. About half of the respondents of the ADB survey borrowed foreign currency denominated loans from foreign banks. This preference has changed little after the crisis. in selecting financing sources. Only a few firms sought foreign loans because domestic loans were not available. 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. the percentage of foreign currency denominated debt in the portfolio was 14. and others (29 percent) expected the local currency to appreciate in value. and futures and other financial derivatives. According to the survey.3 Financial Structure. many firms (or 42 percent) never considered hedging. 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. Vol. firms give their first consideration to minimization of transaction and interest costs. These survey results indicate that many companies were not very attentive to exchange rate risks (and possibly to financial risks in general).

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

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

1 0.4 0.3) (1.7 — (0.3 (3.0 (7.9) (9.1 1. p.2 (0.3 1.9 1.8 0.7 (4.3) 0.1 (4.5 (4.2) 0.1) (1.4 1.4) (1.4 (1.1) 2.7 0.2 0.3 0.6 5.5 (0. 1998.1 1.3 1.5 1.0 1992 1994 1.1 0.7 0.5) (7.1 1.1 (4.2 1.4) (4.3 1.9) (1.4 (1.3 0.4 2.3 1.4 0.7) 0.8) 0.0) 0.6 0.2 1.8) 0. Source: Whan Whang.4 1.9 0.5) (1.5) 0.9) 2.1) (2.4 (0.0 (0.8 3.1 (3.3) 1.5 1.7) (1.6) (20.3 1.8) (11.8 1990 0.9 0.1 0.9) 2.1) (6.2 4.2 (17.8) (4.1) — = not available.6 0.2) (13.2) (0.4 (0.2) 2.1 4.2) (4.6) (0.0 (2.6 0.0) (4.7 3.6 1.2 (0.3) (0.0 0.3 1.7) (0.5) (2.5 1.3 0.3) 0.3 1.6) 0.0) (0.7 0.31 Net Profit Margins of Chaebols.4) (2.1) (1.6 0. Chung Ang University.6 1.8 0.2) (4.2) 1.3 0. Management Research Institute.1 1. 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 1.5 (0.0) (3.5 0.8) 0.0 1987 1.3 (0.0) (0.8 (0.1 (0.4) (0.1 1.7 0.8 1.6 1.6) 0.4 0.3 1.1 (1.1 0.0 0.0) 0.4 1996 0.5 2.2) (4.6 1.1 0.8 0.1 0.6 0.9) 0.2) 1.7 (1.8) 2. .6 (10.6 0.8) (20.9 0. Beyond the Limit.8) 0.5 (6.1) 0.2) (13.8) (0.8) 1.Table 2.4 1.8) (1.7 2.2 (0.5 4.5) (0.8 3.1 0.3) 0.6 1989 1.3 1.4 0.2 1995 3.6 7.11.6 3.1 0.1) 0.7 1.6 (0.9 1.9 (0.2) (3.7 0.7 1.8 1.9 1.2 (1.3) 0. Court Receivership.2) 2.5 (0.0 1.3 0.3) 1.7 1. Background and Task of Structural Adjustment.1) 2.5 1.1 0.3) 0.5 1.3 (0.7 1.3) (0.2 1.5 (0.1) (5.6) (12.6) (12.6) 0.3 1.2) 1.2 1.8 0.1 (9.4) (1.8) (37.3 (0.4 1.0 6.1 1.8 (0.3) 12. 1985-1997 Item Top 5 Hyundai Samsung LG Daewoo SK Top 6-30 Top 31-72 Default.7) 0.0 1.8) 1997 0.9) 2.4) (6.6 0.4 (2.3) 0.8 (0.2) (0.1 2.5) (2.3 3.4 (0.2 1.7 0.1 1.0) 0.8 0.7 (0.9) (8.2 (0.4 (1.3) (12.3 1.6 1.9 1.0 4.1) 1.6 0.1) 1.7) (0.6 (0.8) 0.8) (1.7 (0.3 (0.9 8.3) 0.2 1.6) (0.9 0.4) (1.8) (3.6) 0.

A remote trigger in the Thai crisis was all that took to push the economy over the edge. Moreover. 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. Ownership concentration also had ramifications on corporate transparency. the recently adopted Code of Best Practice in Corporate Governance recommends the strengthening of the board system. and to the development of the market for corporate control. 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. the independence and objectivity of the external auditor were often questioned. and creditors should select (recommend) the external auditor. 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. outside directors. Until 1997. . Along with government policies to protect the status quo. Now. But in 1998.5. a firm’s board of directors had the power to appoint an external auditor. They were then almost automatically elected at the general shareholders meeting. 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. 2. this has led to entrenched management. Thus. Meanwhile. Vol. 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. the boards of all listed companies were composed of insiders only. internal auditors cannot be expected to perform their function independently of management. Thus.1 Weaknesses in Corporate Governance Concentration of Ownership and Entrenched Management Concentration of ownership has been the root cause of many problems related to corporate governance. Until 1997. a committee composed of internal auditors.132 Corporate Governance and Finance in East Asia. after the crisis.

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

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

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

starting 1 July 1998. and shareholders’ equity of all industries. Doubtful loans are those for which interest is not received for six months or longer.200 in 1997.000 per year starting 1992. The bank supervisory 8 NPLs of banks comprise fixed (substandard) and doubtful loans. regardless of whether it is caused by large personal holdings of the controlling shareholder or by pyramiding. and returned to about 1. the NPL ratio reached 7. Moreover. It jumped to 17. the NPL ratio8 of banks and other financial institutions began to increase. Meanwhile. excluding the financial sector. has given rise to various types of self-dealings by the controlling shareholder. and the pursuit of growth through excessive diversification and inefficient investment. These were the definitions until 30 June 1998. According to the “six months” definition. reaching highs of 6 percent in 1997 and 8. Financial Sector Vulnerability Because of financial losses in the corporate sector. the ratios of net profits to sales. The inevitable result of inefficient investment was a fall in corporate profits.136 Corporate Governance and Finance in East Asia. legal and other barriers prevented the exit of financially nonviable firms. they are defined as loans for which interest payments are overdue by three months or more. total assets. .000 from December 1997 to February 1998. The banks and merchant banks lent to large businesses. were low in 1996 and 1997. without strictly evaluating the creditworthiness of businesses and the profitability of projects. a large number of construction companies failed due to the recession in the real estate market and decline in real estate prices. and estimated losses. then 20.1 percent in 1996. However. Vol. Following the “three months” definition. and there is no collateral. In 1997 they became negative.6 percent in June 1998. Further. Before the crisis. 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. Fixed loans are those for which interest is not received for six months or longer. the NPL ratio of commercial banks increased rapidly from 4.7 percent in 1997.000 during January-September of 1998. and there is collateral. especially chaebols.32). They utilized mutual payment guarantees among their affiliates and believed that they would never fail. The monthly number reached more than 3.000 in September 1998 (Table 2. nine out of the 30 top chaebols failed. II Inefficient Corporate Investment and Low Profitability Ownership concentration among Korean firms. The Government could hardly help them because of the number and magnitude of business failures. decelerated from March 1998. The number of insolvent companies increased rapidly in 1991 and doubled to more than 11.

673 Construction 380 354 242 195 294 585 1. those of domestic banks were lower in the 1990s.517 2.544 2. 2.589 171. Source: Bank of Korea.890 4.133 3.4 Shortcomings in Macroeconomic Policy The macroeconomic framework also contributed to the crisis in 1997.244 3. and declined to 4-6 percent in 1994-1996 (Table 2. the ratio reached 7-8 percent.769 9.159 10.859 3.754 3.265 6.5.759 6.210 1. authorities were not too concerned about the high NPL ratios at Korean banks in 1997 simply because the high and rising ratios had precedents. Policymakers thought that economic growth would resolve the NPL problem without the need for corrective action.107 6. As a result they had largely overvalued currencies.33). Meanwhile.502 11.457 2. and continuous and large current account deficits.027 Manufacturing 1.751 1. 1986-1998 Year 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 Total 4.979 8. Compared to ROAs and ROEs of domestic branches of foreign banks.386 5.69 20. This speculation was said to be one of the causes of the financial crisis in Korea. The current account deficits in terms .850 3.32 Number of Firms with Dishonored Checks.992 11.553 3.657 3.Chapter 2: Korea 137 Table 2.053 5.259 2. 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. low efficiency.250 2.472 2.637 6. and large government-directed loans. This was mainly due to the high ratios of NPLs. European countries. ROEs and ROAs of Korean and Japanese banks were low compared with those of the US.238 4.China. In 1990-1993. and Taipei.135 1.114 811 706 696 866 1.647 8.855 6.856 7.573 3.985 Services 3.255 13.417 Others 152 132 108 97 88 161 326 252 274 302 553 861 952 Note: 1998 figures cover only January-September. Exchange rates were virtually pegged to the US dollar in all troubled Asian countries.131 1.

649 375.910 1.221 8. and Indonesia -3. Vol. although per capita income in Korea was much lower.2 4.929 11.1 7.8 5.997 9. which led to large corporate losses.827 289. Korea -4.705 160.1 percent (1995).077 NPL Ratio (%) 8. Related to this.0 8. Businesses served as a social safety net.6 Fixed loans are those requiring collateral and for which interest is not received for six months or longer. even in times of economic slowdown. II Table 2.390 12.537 10. Source: Bank of Korea.China.0 7.832 337. In 1997. The main result of the rigid labor market was a “high-cost and lowefficiency” economy. Thailand -8.556 118.190 9.China.954 9. .584 Fixed (A)a 5. Real interest rates in Korea had been two to three times higher than those of Japan or Taipei.176 7.484 11.8 percent (1996).170 1.6 percent (1995).0 7.430 12.475 143. the ratio of short-term debt to foreign reserves was very high.639 1.520 194.138 Corporate Governance and Finance in East Asia. because of the rigid labor market.874 22. of percentage of GDP were as follows: Malaysia -8. 1990-1998 (W billion) Year 1990 1991 1992 1993 1994 1995 1996 1997 1998 a Total Loans 90.33 Nonperforming Loans of General Banks.652 29.6 percent (1995).192 Doubtful (B)b 952 1.116 1.4 5. The pegged currency also encouraged foreign borrowing as investors believed that the exchange rate would remain stable.600 10. b Doubtful loans are collateral-free loans for which interest is not received for six months or longer.736 8.584 2. Land prices and real estate rents were also high compared to trading partners. Meanwhile large businesses could not legally lay off workers. and 30 percent in 1996. It was estimated that the Korean won was overvalued by 20 to 30 percent from 1989 to 1997.266 10.237 Estimated Loss (C) 958 920 840 816 213 385 490 490 648 NPL (A+B+C) 7. Mass layoffs became legally possible only after the economic crisis.562 18. In addition to the overvaluation of the won.310 6. the terms of trade deteriorated 12 percent in 1996 and 11 percent in 1997.1 6.739 241.160 11. the hourly wage rate in the Korean manufacturing sector was higher than in Singapore or Taipei. judging from the real effective exchange rate indexes using unit labor cost indexes as a deflator and 1985 as a base year.

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. has been actively utilizing its influence to motivate institutions to coordinate debtor firms’ restructuring activities. A guideline informally promulgated by FSC required the 30 largest chaebols to lower their DER of 412. embarked on their own restructuring programs and/or implemented restructuring demands of the creditor banks.6. To achieve this. They have been pressured to stop such practices as providing loan guarantees.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. . 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. Measures have been taken by several chaebols to streamline operations and improve incentives of managers and employees. Nonviable firms and financial institutions. including banks. Downsizing by curtailing employment has been prevalent. which were laden with huge amounts of debt and were on the verge of bankruptcy. the immediate objective centered on restoring the international investment community’s confidence in the Korean economy. Corporations. The FSC—later called the Financial Supervisory Service (FSS)— which is in charge of prudential regulation of financial institutions. the excessive amount of debt of Korean corporations had to be reduced to a sustainable level.6 2.1 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. However. and subsidizing money-losing units.Chapter 2: Korea 139 2. Ailing banks needed to be recapitalized after the huge amount of NPLs was disposed. Other firms experiencing financial distress were subjected to workout procedures through negotiations between debtors and creditor institutions.

It was frequently observed that the negotiating parties could not agree on a price due to large discrepancies in valuation.138 by the end of October. More than 59 percent of potential buyers were foreign firms.045 in October. Involuntary Exits The Government has been involved in the restructuring process mainly through its supervisory capacity over banks. 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. On the other hand. In their first review.140 Corporate Governance and Finance in East Asia. 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. 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. 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. while only 14 percent of the negotiations were completed from the beginning of the crisis up to April 1998. banks and other creditors were reluctant to absorb losses realized by debt compositions. The reasons are manifold. because liquidation of debtor firms would exacerbate the banks’ already weak balance sheets. they were reluctant to allow recontracting for fear of further deterioration in the capital adequacy ratio. II Divestitures to raise cash for debt reduction and to focus on core businesses have not proved to be easy. Locally. the number of potential sellers decreased somewhat from 2. or to agree on debt-equity swaps demanded by potential purchasers as a precondition for the deal. In many cases. Vol. potential foreign buyers waited for the price of acquisition targets to come down further. Noticing this disincentive. Korean firms have been slowly stepping up their restructuring since the latter half of 1998 as the economy began to show signs of recovery. This number was at 779 firms in April and grew to 1. Banks did not have the incentive to force financially nonviable firms to liquidate.281 in April to 2. FSC directed banks to appraise the long-term viability of client firms showing symptoms of failure. Internationally. the creditor .

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

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

Second.6.2 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. these goals were: (i) to enhance managerial transparency. Sixth. the improved procedures stipulated in the Bankruptcy Reorganization Act and the Composition Act reduced what had previously been legalistic exit barriers. The presence of . many of the businesses that Korean firms put on sale did not prove to be attractive to foreign firms. foreign buyers were concerned with the inflexibility of the labor market. (iv) to focus on a small number of core businesses. Seventh. foreign buyers usually employed discounted cash flow methods of valuation while local sellers often put greater emphasis on replacement costs of assets. Fourth. but it also has important implications with respect to corporate workouts. 2. some of the potential acquirers demanded terms that were unreasonable or unacceptable from the sellers’ point of view. Fifth. and (v) to improve the accountability of controlling shareholders and the board. local creditor banks were reluctant to absorb losses arising from debt compositions and debt-equity swaps that were necessary in deals involving insolvent sellers. 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. Overhaul of Bankruptcy Procedures In February 1998. (iii) to reduce financial leverage. the Government and chaebols reached an agreement on the goals of restructuring and reform efforts. Third. In effect. With this in mind. Not only does this represent progress in terms of an improved institutional framework for market competition. 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. 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.Chapter 2: Korea 143 course of the Korean economy remains high. As set forth in the agreement. (ii) to remove cross-guarantees of loans among group members.

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

financial institutions could no longer require cross-debt guarantees. 21 industries were further liberalized or newly opened to FDI (now. only 31 out of 1. (iv) during April and May 1998. Existing cross-debt guarantees should be completely eliminated by the end of March 2000. and (viii) as of 1 April 1998. beginning on 1 April 1999. 514 listed companies had appointed 677 outside directors). 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. either partially or fully. (ii) full liberalization of foreign exchange transactions was legislated and will be put into effect in two stages. which was passed in August 1998. As for promotion. including tax exemptions and reductions. Measures for improving standards in corporate governance are already effecting a generally more open corporate culture and greater transparency in business practices. (vii) by the end of March 1998.148 industries remain closed. crossdebt guarantees totaling about W10 trillion—about 30 percent of the total guarantees among the 30 largest chaebols—were dissolved. (v) by the end of May 1999. 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. Foreign Investment Promotion Act The Foreign Investment Promotion Act was put into effect in November 1998. According to the law. In addition. 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. including financial subsidization. (iii) hostile mergers and acquisitions by foreigners were fully liberalized in May 1998.Chapter 2: Korea 145 (as of the end of May 1998. Foreigners are now able to invest in local bonds and short-term money market instruments without any restrictions. These new standards are and will continue to be strictly enforced. an additional nine industries will be opened or further liberalized. administrative procedures for FDI will be dramatically simplified and made transparent. Capital Market Liberalization Since 1998. (vi) bankruptcy laws were revised in February 1998 to facilitate the exit of insolvent firms. have been instituted for FDI: . the Korea Trade and Investment Agency (KOTRA) will provide a one-stop service with respect to FDI. to FDI). various supporting measures.

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

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

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

Latham. 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. . governance. The Securities and Exchange Act will then require large listed companies to switch to a board audit committee system from an internal auditor system. it will have to include making self-dealings by directors and officers. If and when the law is introduced. The annual shareholders meetings could also elect reputable “monitoring companies” to recommend director candidates (Latham. 1997. One way of motivating institutions to do this is to 10 M. Listing rules may recommend that all or large listed companies adopt an audit committee. 1997). More effective measures to protect investors will enhance corporate transparency and also the accountability of directors to shareholders. using audit. Further. Institutional investors will play an increasingly important role in corporate governance. There has recently been a general shift in individual investor preference from direct personal stock trading to investing in traditional investment trust companies and the newly introduced (closed-end) investment funds. the Korea Stock Exchange could incorporate provisions of the Code of Best Practice in Corporate Governance in its listing rules. and requiring that all directors hold shares of their companies. Since the economic crisis. various measures have been implemented to promote investors’ rights. pp. Class action suits are an efficient means for corporate monitoring. 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.10 Other means to improve independence of the boards include mandating that independent outside directors form the majority. 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. Proposed: A Governance Monitor. Each listed firm should be required to disclose the extent of its compliance with the Code in its annual report. and also negligence of external (independent) auditors actionable. The Corporate Board. and other committees. The Government can prompt institutional investors to contribute more to good corporate governance by paying greater attention to corporate affairs. 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.

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

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

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

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

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

the Philippine Stock Exchange for its help and support in conducting company surveys. the Philippine corporate sector has played a leading role in the government’s efforts to get the country on track toward sustainable economic development. the Philippine nonfinancial corporate sector had managed its borrowing risks relatively well by largely avoiding imprudent use of debts and risky investments. Saldaña1 3.. 1 Principal. Issues such as State ownership of businesses. allowed the Government and the corporate sector to gradually access foreign debt markets after a long absence. David Edwards. in particular Francisco C. staff. Roble. Inc. both of ADB. The lifting of the debt moratorium in 1991. and government subsidies were tackled during that period. after the completion of debt negotiations with the IMF and Paris Club. the Philippine economy and corporate sector were in a relatively sound financial position. Denise B. and Lea Sumulong and Graham Dwyer for their editorial assistance. Pineda. The author wishes to thank Juzhong Zhuang. the PSR Consulting. Companies of other Asian countries were already using these markets to finance investment and growth. aiming at eventually limiting the Government’s role to economic policy setting and allowing the private sector to conduct most economic activity. and Liza V. and David Webb of the London School of Economics for their guidance and supervision in conducting the study. PSR Consulting. Serrana. Inc. for their research assistance. From 1993 to 1996.3 The Philippines Cesar G. the Philippines. The Asian financial crisis revealed that. 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. This has come about following a political and economic upheaval from 1983 to 1987. When the Asian crisis erupted in 1997. about a decade before the recent Asian crisis. 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). state-sanctioned monopolies. overall.1 Introduction In recent years. .

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

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

6) 0. 3.1 8.3 9.8 5. Vol.2 7. however.8 8.2 7.8 5.158 Corporate Governance and Finance in East Asia.2 Korea. 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.6 7.1).7 Malaysia 9.5 8.2 (0.7 (13. net sales of the top 1.5 (7.9 7.0 8.2 Thailand 11.9 5.2 9.4 4. only nonfinancial companies were used.8 4. Key Indicators of Developing Asian and Pacific Countries 2000.8 8.7 5. In this section.5 8.2) 0.3 2.2 Source: ADB.3 7.8 10.9 6. . 1990-1999 (percent) Year 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 Indonesia 9.2 8.1 4. only to be unsettled by the crisis of 1997. which was taken as a representation of the Philippine corporate sector.0 (0.4 Philippines 3. The Philippines substantially lagged behind other countries from 1990 to 1995 (Table 3.0 8.1 5.3 8.2). II market.7) (10. With economic reforms introduced in the 1980s and 1990s. Its growth rate began to catch up with others in 1996.0 7. Table 3. This rate of growth was sustained by a comparable 18.5) 5.5) 3.000 corporations.7) 10.9 (1.3 9. competition from liberalized imports had somewhat reduced oligopolistic tendencies and concentration in many industries.2) 4.5 9.5 percent per year (Table 3.2.2 During 1988-1997.000 Philippine companies grew 17.8 percent growth in fixed 2 The SEC-BusinessWorld Annual Survey of the Top 1.2 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 1.1 GDP Growth of Southeast Asian Countries.000 Corporations covers financial and nonfinancial companies.7 8. of 9.1 5.0 (6. Rep.

8 4.697.3 306.781.6 426.1 66 12.8 902 1.5 119 12.2 4.225.3 382.6 18.9 952.1 468.2 Average 146 12.5 4.4 3.6 75 6.8 618. 1988-1997 1989 519.5 72 7.3 121 12. return on assets (ROA) = net income/total assets.2 900.561.8 5.6 149 12.7 443.8 411.4 Financial Ratios (%) Leverage ROE ROA Turnover Net Profit Margin 222 14.7 1.647.332.1 6.6 1990 1991 1992 1993 1994 1995 1996 1997 1.4 861.7 903 0.6 954.3 107 13.5 64.512.6 102 16.3 46.9 896 2.1 72.6 144.2 Indicators 1988 Growth Indicators (P billion) Net Sales Net Income Fixed Assets Total Assets Total Liabilities Stockholders’ Equity Retained Earnings 464.000 Companies.5 1.1 615.1 5.978.2 338.3 862.9 2. .2 2.3 60 10.3 898 1.6 5.4 260.5 446.2 1.6 896 0.191.0 1.9 629. return on equity (ROE) = net income/ stockholders’ equity.1 73 5.3 68 7.9 96.9 149 6.2 707. Source: SEC-BusinessWorld Annual Survey of Top 1.5 192.8 77 7.4 898 1.8 22.7 20.4 1.Table 3.5 887 0.9 78 6.4 602.1 181 11.177.1 881.1 Other Indicators No.2 27.123.1 95.0 900 1.0 148.5 193.5 570.5 Leverage = total liabilities/stockholders’ equity.341.7 28.209.4 8.8 741.1 197 14. turnover = net sales/total assets.5 1.8 6.2 378.6 900 1.160.1 54 11.1 1.1 33.9 3.7 238.1 714.5 1.6 290.2 Compound Growth (%) 17.0 1.6 1.5 51 4.9 898 1.8 26.1 1.7 73 6.5 14.6 35.7 218.131.4 188.1 4.893.4 776.2 Growth and Financial Performance of the Top 1.6 109 12.394.4 555.2 2.317.1 51.000 Corporations in the Philippines.2 136.9 1.9 617.7 1.4 63. net profit margin = net income/net sales.9 480.3 941.5 508. of Companies Sales per Company (P billion) 899 0.4 411.

Total assets grew at an average annual rate of 22. Further.4 24. various years.172 2. The debt-toequity ratio ranged from 222 percent in 1988 to 102 percent in 1994. These rates of return are high compared with other Asian countries.9 percent for the period.3).8 percent per year.3 percent. 1988-1997 Top 1. Return on equity (ROE) and return on assets (ROA) averaged 12.000 Companies Year 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average Growth (%) a GDP (P billion) 799 925 1. Assuming Table 3.394 1.178 1.2 percent. The data suggest no evidence of excessive borrowing in the run-up to the crisis in 1997.1 19.8 17.697 1. and by equity that grew at a higher average annual rate of 26.248 1.5 Value-added is assumed to be 30 percent of net sales.5 Ratio of Estimated Value Addeda to GDP (%) 17. This is high compared with developed countries but compares favorably with other Asian countries. Asset growth was funded by debt that grew at an average of 20. Vol.5 17.7 percent.000 companies averaged 7.352 1. Key Indicators of Developing Asian and Pacific Countries 1999.906 2.1 Net Sales (P billion) 465 519 630 741 862 954 1. for the 10-year period. and the SEC-BusinessWorld Annual Survey of Top 1.000 Corporations in the Philippines.427 13.693 1.474 1. leverage increased from 109 percent in 1996 to 149 percent in 1997.3 The Corporate Sector and Gross Domestic Product. indicating that the corporate sector’s exposure to foreign currency-denominated loans was not as significant as in other countries. Sources: ADB.4 20.5 16. II assets. The growth rates of corporate sales for the period 1988-1997 exceeded those of the country’s GDP for the same period (Table 3. respectively. but the extent of the increase was not as dramatic as in other Asian countries.077 1.9 21.6 percent and 5. Net income consistently increased from 1988 to 1996 and declined only in the crisis year 1997. Net profit margins for the top 1.160 Corporate Governance and Finance in East Asia. .9 23.979 17.8 19.

6 Total Assets 29. Averaging 42.2 9.4 Stockholders’ Equity 32.4 Fixed Assets 19.5 Retained Earnings 30.0 31.1 ROA 8.1 22 10. The foreign-owned companies were the Table 3.2 103 5.8 No.0 5.Chapter 3: Philippines 161 a constant ratio of value added to sales.1 12.8 606 0.3 146 6. (ii) foreign-owned.5 27.9 17.1 Financial Ratios (%) Leverage 89 ROE 15.4 190 5.3 9.8 3.000 Corporations in the Philippines.8 ForeignOwned 21.4 Growth and Financial Performance of the Corporate Sector by Ownership Type.8 14. these figures suggest a significant and increasing contribution of the corporate sector to GDP. of Companies 73 Sales per Company (P billion) 2. .4).8 percent of the corporate sector’s total sales between 1988 and 1997.3 22.0 Net Income 19.8 2. The premise is that these variables have a direct bearing on corporate performance and growth.0 142 22.3 22. privately owned companies constituted the largest group (Table 3.0 4.9 22. Performance by Ownership Type The Philippine corporate sector can be categorized into four groups based on ownership: (i) publicly listed.5 GovernmentOwned 4.8 Growth Indicators (Compound Annual Growth Net Sales 20. various years. (iii) Government-owned. size. and (iv) privately owned.4 28.9 158 13.8 22.9 196 1. 1988-1997 Indicators Publicly Listed Privately Owned Rate.7 22.4 Total Liabilities 26.3 11. %) 17. A study of company performance by ownership type.3 27. and industry reveals further structural characteristics of the growth and financial performance of the corporate sector.9 26.5 23 4.5 Other Indicators Share of Sales (%) 17. corporate control structure.7 2.5 Source: SEC-BusinessWorld Annual Survey of the Top 1.0 Turnover 53 Net Profit Margin 15.0 5.3 42.0 28.

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

1988-1997 Indicators Group Member Independent 18. and small companies. various years. %) Net Sales 20.000 Corporations in the Philippines.2 23.0 25.5 Growth and Financial Performance of the Corporate Sector by Control Structure. But the conglomerates were larger measured in sales per company.3 No. had a lower leverage ratio.1 Retained Earnings 32.7 Total Assets 32.6 26. Table 3. compared with 32.4 24.2 Net Income 21.3 Financial Ratios (%) Leverage 98 ROE 15.0 166 15.7 Stockholders’ Equity 34.1 Source: SEC-BusinessWorld Annual Survey of Top 1.5). the corporate sector is divided into large. grew faster.3 Total Liabilities 30. of Company 159 Sales per Company (P billion) 2.6 715 0. and achieved higher returns on invested assets than independent companies (Table 3.0 Turnover 67 Net Profit Margin 12.2 Fixed Assets 25.1 124 5. Sales and resources of the .3 Other Indicators Share in Sales (%) 32. The independent companies contributed about 56 percent of corporate sales on average during the period 1988-1997. a company can be a member of a conglomerate or independent. medium.0 55.3 percent for the conglomerates. Performance by Firm Size By firm size. depending on assets and sales.8 Growth Indicators (Compound Annual Growth Rate.0 22.8 6.8 ROA 8.Chapter 3: Philippines 163 Performance by Control Structure By control structure.7 2.

which. although they comprised only 8.2 Stockholders’ Equity 18.3 Turnover 65 Net Profit Margin 8.6 31.164 Corporate Governance and Finance in East Asia.3 Fixed Assets 15.9 89 1. Medium-sized companies.7 44.000 list.9 Retained Earnings 13. of Companies 79 Sales per Company (P billion) 7.6 47. averaged a far less P3 billion in per company sales. . averaging 16 percent.3 Source: SEC-BusinessWorld Annual Survey of Top 1.000 Corporations in the Philippines.2 Other Indicators Share in Sales (%) 56.4 billion in 1997.000 list.2 29. indicating that they deployed resources more efficiently than large and small companies.6).1 ROA 5.5 Total Assets 18.6 36.6 Small 19.1 81 9. II Philippine corporate sector are highly concentrated among the large companies.5 12. defined in this study as the next 200 largest companies in the top 1. %) Net Sales 15.1 percent of the total sales of the corporate sector. averaged only P920 million in per company sales during the same year.4 28. various years.5 Growth Indicators (Compound Annual Growth Rate.5 25.1 No.9 26.7 Net Income 1.5 73 6.8 percent of the total number of companies in the list (Table 3.0 7.0 730 0. 1988-1997 Indicators Large Medium 19. while small companies. are defined as the largest 100 companies in the top 1. Medium-sized companies also performed better in terms of ROE. Sales per company in this group averaged P13. for this study. Table 3. Vol. sales of mediumsized companies grew faster than large companies.9 32.9 Financial Ratios (%) Leverage 158 ROE 13. Large companies accounted for 56.0 156 16.6 Growth and Financial Performance of the Corporate Sector by Firm Size. However.0 32.1 25.4 Total Liabilities 18.5 128 10. referring to the remaining companies in the list.6 49.1 4.2 25.

are shown in Table 3.7 percent in 1997 for medium-sized companies. at 156 percent. Medium-sized companies apparently enjoyed efficiencies associated with economies of scale and made more productive use of their assets. showed the lowest ROE. But small companies’ leverage was significantly lower. assets.8 percent in 1997. with their ROE dropping to 3. The real estate and property sector also suffered significantly in sales. 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. specifically those industries least and most affected by the financial crisis.6 percent. i. although the largest in number. Mediumsized companies’ leverage level was slightly lower. Large.5 percent for medium-sized companies and 8. unlike their counterparts in other Asian countries. manufacturing. and utilities and services sectors.7 percent in 1996 to 8. Performance by Industry This study also looked at corporate performance by industry. at -12. but lower than that of construction. but suffered its largest decline in net profits in 1997. 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.. Net income declined from P54.and medium-sized companies did not substantially increase their leverage in years running up to the crisis in 1997. ROE dropped to 7. ROE dropped from 10. net income. Growth of sales. The Asian financial crisis affected large companies most severely. profits.8 the previous year.1 percent.8 percent. The growth and financial performance of selected industries. utilities. net income. as indicated by the negative annual growth. and the construction sectors than for the manufacturing. at 128 percent for the period.e.2 percent for large ones. of net income. Sales revenue and net income declined from P76.7 billion and P35. at 158 percent on average during 1988-1997. and assets was much higher for the real estate and property. averaging 10. and equity up to 1996.1 billion in 1996 to P4.2 billion in 1997 for this sector. and utilities and services sectors. reflecting to some extent a “bubble” phenomena in the former two sectors. For small companies.8 billion in . and construction. The sector showed consistent growth in sales.7. real estate. from 14. Leverage was the highest for large companies.4 percent in 1997 from 11.7 percent a year earlier. Poor returns appear to have been caused by the low profit margin at 6. compared with 9. especially during the period 1994-1996.Chapter 3: Philippines 165 Small companies.

3 55.7 ROA 5.3 Retained Earnings 17.8) 17. As a result.2 12.4 percent.7 Indicators Manufacturing Construction 27. 1996 to P56. But the impact of the Asian crisis on the real estate and property sector was much smaller than that on the manufacturing sector. of Company 454 17 Sales per Company (P billion) 1. the sector’s ROE dropped from 15.7 billion in 1997.9 billion and P24.7 Net Income (12. it does not appear to have been excessively exposed to foreign currency-denominated loans.2 8.7 28.9 23.1 2. With a modest increase in total liabilities and leverage level of less than 100 percent in 1997.7 52.9 17. various years.4 Total Assets 19. Its knock-on effect on the economy was small as it accounted for less than 3 percent of the top 1. The sector’s buildup in equity during the stock market boom of 1994-1996 may have cushioned the impact of the crisis.3 5.1 24 42.7 83 2.8 48.166 Corporate Governance and Finance in East Asia.2 45.000 Corporations in the Philippines.2 28 0. respectively.0 Turnover 112 24 Net Profit Margin 5.6 No.7 192 9.6 Growth Indicators (Compound Annual Growth Rate.9 2. 1988-1997 Utilities Real Estate and and Services Property 39.4 16. II Table 3.0 25.8 41.7 19.7 percent to 10.0 23.000 companies’ total sales on average during 19881997.6 69 16.5 12.8 Stockholders’ Equity 21.5 Other Indicators Share in Sales (%) 82. Vol.7 Growth and Financial Performance of the Corporate Sector by Industry.4 3.0 21.3 20.0 31 0.1 10.4 19.9 5. and was also much more limited compared with the property sectors in other Asian countries. .6 Financial Ratios (%) Leverage 142 181 ROE 13.3 Fixed Assets 20.4 Source: SEC-BusinessWorld Annual Survey of Top 1.6 Total Liabilities 18.7 10. %) Net Sales 16.2 37.9 2.

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

. shareholders may delegate this power to the board of directors by a two-thirds vote of outstanding capital stock. It implements rules and regulations that protect minority shareholders from possible fraud and misbehavior by controlling shareholders. Vol. (iii) qualifications. among shareholders. In addition. (vi) penalties for violation of the bylaws. supervision (regulatory). To be valid. and (vii) manner of issuing certificates in the case of stock corporations. and employees. 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. 4 Some of the items that a corporation may provide in its bylaws are the following: (i) time. Its mandate is to supervise corporations in order to encourage investments and protect investors. (ii) controversies arising out of intra-corporate relations. uniform. and reasonable. (iii) controversies in the election or appointments of directors and officers of corporations. must be general. and control (adjudicative) of all corporations. PD 902-A expanded SEC’s mandate to include absolute jurisdiction. and between the corporation and the State concerning its franchise or right to exist. and public policy. the corporation’s articles of incorporation. directors. II to adopt a code of bylaws or rules for its internal governance. and compensation of directors. 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. (v) manner of election or appointment and term of office of all officers other than directors. and should not impair vested rights. between the shareholders and the corporation. officers. or officers. (iv) time for holding annual election of directors and manner of giving the election notice. manner of voting. Securities and Exchange Commission: PD 902-A SEC is the government agency responsible for implementation of the Corporation Code. and manner of calling and conducting regular or special meetings of the directors and shareholders. place. However. A majority of the outstanding shares of shareholders must vote to authorize amendments to the bylaws. duties. (ii) required quorum in shareholders’ meetings. and forms of proxies and manner of voting them.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. the bylaws must be consistent with the law. In 1976.168 Corporate Governance and Finance in East Asia.

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

1 percent of publicly listed companies in the Philippines in 1997. In 76 companies.9 shows that in 44 companies. the top five shareholders held more than two-thirds majority control of a company. Table 3.174 Corporate Governance and Finance in East Asia. or 3 percent of the total. Composition of Ownership of Publicly Listed Companies Another important issue concerning corporate ownership is the composition of the controlling shareholders. In 21 companies. a single shareholder held two-thirds majority control. five. a single owner owned more than 80 percent of outstanding shares. In 111 companies. and share prices are sensitive to movements of foreign funds. 66 percent (signifying strategic control). large and family-based shareholders pool the family’s ownership over many . a single shareholder held operating control of a company. and 20 shareholders? In Table 3. In four companies. Who are the top one. or 20 shareholders owned more than 50 percent (signifying operating control). or 80 percent (only nominally publicly listed) of outstanding shares. or 51 percent of the total. Vol. controlling an average of 52. Nonfinancial corporations with controlling shareholdings are likely to be holding companies. With such high levels of ownership concentration. Individuals did not constitute a significant shareholder group among the top five shareholders. the top five controlling shareholders were classified into eight groups. or about 30 percent of the total. Parent companies usually spin off operating units into new companies that they continue to control as affiliates. holding only an average of 2. The limited volume of shares issued to the public is one of the causes of the underdevelopment of the Philippine stock market. nonfinancial corporations held majority control. or almost 75 percent of the total. There are advantages to establishing pure holding companies.10. In 116 companies. II analysis of the number of companies in which the top one. The shares of publicly listed companies are thinly traded and illiquid. five. the top five shareholders owned more than 50 percent of the voting shares. The largest group is nonfinancial corporations. 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. the top 20 shareholders collectively owned a majority of a company’s shares. or 78 percent of the total. or 14 percent of the total.2 percent of outstanding shares of publicly listed companies. including pure holding companies. In four of 11 nonfinancial sectors. which are mostly privately owned and controlled by family-based shareholder blocs. Through these.

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

0 0.6 0.Table 3.8 21.7 3.8 0.0 0.0 0.0 1.6 1.4 2.2 5. and Trading Hotel.6 0.2 3.0 2.1 9.5 53.0 0.1 5.7 0.5 26.0 1.2 3.5 0.0 0.3 0.4 0.5 13.5 4. Beverage.0 5.0 0.2 0.7 67.2 1.2 0. Distribution.3 0.0 7.1 6.0 1. 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.3 0.7 1.6 5.1 0.7 3.3 0.8 0.3 5.2 3.6 2.0 45.2 10.8 11.0 0.3 1. Source: PSE Databank.5 12.9 36.0 0.7 0.4 5.0 0.0 5.0 0.8 0. and Tobacco Holding Companies Manufacturing.9 0.0 1.2 0.0 5.6 0.9 52.8 66.1 1.6 9.2 3.0 0.5 4.0 5.3 26.4 29.9 6.3 0.6 33.5 0.2 0.7 0.6 0.7 0.3 37.6 0.9 0.7 0.1 7.0 0.3 12.6 0.4 19.3 5.3 1.0 0.0 10. and Other Services Property Mining Oil Average Shareholdinga 33.0 0.1 0.6 0.2 59. Recreation.0 1.0 2.5 2.4 8.0 1.1 8.7 0.6 12.0 1.0 1.6 18.2 0.1 a Weighted by market capitalization.0 0.10 Composition of Top Five Shareholders of Philippine Publicly Listed Companies by Sector. .4 1.3 2.6 2.0 4.

Funds of SSS and GSIS consist mainly of compulsory contributions from members of the country’s private sector and government workforce. Investment trust funds were the most important institutional investors.2 percent in 1997. there was no real market for investment information. with an average of only 7. accounting for P258.Chapter 3: Philippines 177 companies and share in the risks and profits of the group. respectively.6 billion or 26. and San Miguel Corporation (SMC) in food and beverages.1 percent). The Philippine capital market did not have an active analyst community comparable to those in more developed capital markets.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.7 percent of market capitalization of the nonfinancial publicly listed companies. As a group. These institutions keep a stock portfolio mostly in shares of a few companies with large capitalization and high liquidity in select industries. Holding companies were themselves 66 percent owned by other nonfinancial corporations. The investment funds’ presence in these sectors ranged from 8.1 percent).3 percent). commercial banks (1. while still allowing the public to own minority shares.5 to 12. financial institutions did not have a significant ownership in nonfinancial corporations. and insurance companies (0. Insurance companies were very minor investors in the stock market because prudential regulations prevent them from investing significant amounts even in equities of large companies.7 percent of shareholdings). The 7. They can also better manage their income taxes because income from affiliated companies passes through a holding company. This complex layering of ownership masks the identity of individuals or families that actually own and control operating companies. Holding companies as a sector had the largest market capitalization in PSE in 1997. . Petron and MERALCO in power and energy. These include Philippine Long Distance Telephone Company (PLDT) in telecommunications. 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.6 percent of market capitalization in 1997. Because of limited ownership by institutional investors. The financial institutions among the top five shareholders of nonfinancial corporations are investment trust funds (with 4. These are mainly the Social Security System (SSS) and the Government Service Insurance System (GSIS). Such advantages have contributed to the popularity of holding companies among publicly listed companies. securities brokers (1.

Commercial banks hold the largest share. To understand the ownership and governance characteristics of family-owned business groups.178 Corporate Governance and Finance in East Asia.000 companies.4 percent of the top 1. The process identified a total of 238 companies belonging to 39 business groups from the SEC-BusinessWorld Annual Survey of the Top 1. remain in force to control excessive lending of banks to insiders. many companies in family-owned groups are not publicly listed. . This could further increase the concentration of ownership and expand the scope of own-group lending by these larger banks. the Central Bank’s reforms are probably changing the conduct but not necessarily the structure of the banking system. so far limiting their involvement to selected products. a nonfinancial company that owns a commercial bank has better access to loans at favorable rates and terms.8 percent of total companies in number. Family-based groups have larger companies since their total sales were about 33. Corporate financing depends on intermediation by banks. A common feature of corporate ownership of a business group is the centrality of a commercial bank. and increased the capital requirements for all types of banks. All major industries were represented. Vol. Foreign banks have a growing presence but have not necessarily increased the supply of credit to the corporate sector. Some 20 financial institutions were affiliated with these groups. However.000 Corporations in the Philippines. liberalized the regulations on entry of foreign bank branches and foreign ownership of local banks. the study put together a list of prominent business 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. including 16 commercial banks.000 corporations’ sales. Prudential regulations. but they comprised only 23.11). 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. More than three fourths of the respondents are either a parent or subsidiary (about 70 percent of these are domestic nonfinancial companies). using data on the Philippines’ top 1.6 The total sales of these groups in 1997 were estimated at P806 billion (Table 3. of the financial resources in the country. suggesting that business groups are common in all major markets. and tracked the financial performance of each company from 1992 to 1997. suggesting that most publicly listed companies are parts of business groups. 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. about three fourths. Large shareholders and their families own these banks directly or through their controlled companies. The Central Bank deregulated interest rates and foreign exchange. Still. 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. For this reason.7 6 7 The study used publicly available shareholder information and published reports.

Family-based business groups are most dominant in sectors such as manufacturing. Foreign-owned companies mainly serve the export markets.2 percent). For the Ayala group. To show this. Cojuangco. the largest family-based business group was the Ayala Corporation Group. Lopez. and Henry Sy—as examples. the largest was the Eduardo Cojuangco group. Also. namely. Gokongwei.1 percent). These corporate entities accounted for 53. as discussed in previous sections.4 percent of the group’s 1997 profits). Lopez. the principal owner of SMC.8 percent). In terms of sales. the three largest entities were family-based groups.12). It is also noteworthy that. In terms of number of companies.000 corporations in 1997. broadcasting (49. with the exception of Banco de Oro. the nonfinancial sector was real estate (60.Chapter 3: Philippines 179 Compared with other Asian countries. In the meantime. for the Gokongwei Group. including business groups and independent companies. the biggest private company in the Philippines. for the Lopez group. nonfinancial companies contributed about 36 to 60 percent of total profits for these groups. Commercial banking contributed about 40 percent of group profits for the Ayala group and Gokongwei group. construction. and more than 20 percent for the Lopez group and Henry Sy group.000 companies. In 1997. with 27 affiliated companies in the top 1. it was manufacturing (36. the two were closely related through their affiliations to business groups. The main constraint may be the availability of family members that could be drawn for top management positions. a substantial proportion of group profits came from its financial subsidiaries. or an average of about 12 per 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. which was majority-owned by the Henry Sy group. and banking. Significantly. retail merchandising (69.6 percent of the total sales of the top 1. Together. real estate. in most . ranged according to their sales (Table 3. and for the Henry Sy group. the study used the four largest business groups—Ayala. The significance of family-based business groups in the Philippine corporate sector is immediately evident in the 50 largest corporate entities. Commercial banks are often affiliated to a particular business group. an average group in the Philippines has fewer member companies. the top 10 family-based business groups had only 119 companies in the top 1. and Ayala. for each of these groups. 25 out of the 50 top corporate entities were familybased groups.000.

Real estate. telecom.2 16. and Affiliated Bank of Selected Business Groups.1 2.5 13.0 13. real estate. 2. Consunji 4 3 Food and dairy products Construction and mining 10.0 5. 17. and tobacco Telecommunications Cement and construction materials Pharmaceutical and distribution 12. power.6 2.3 11. construction. and car manufacturing Car manufacturing and real estate Food and telecommunications Department store and real estate Airlines. of Affiliated Companies Total Sales (P billion) 123. beverages. food.9 3. Eduardo Cojuangco Lopez Family Group Ayala Corp.3 2.0 17.8 84.6 7.5 17.2 1.5 2.5 49. 15. and dairy products Investments. 13. agriculture. and personal care prods Shipping.6 3. 6. 11.3 15. 10. and food Food. coconut oil. 8.9 2.4 48.4 .3 3. Sector Orientation.0 26. 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. and tourism Credit card 18. 9.5 6. Beverages.5 44.5 46. 16. and packaging Power distribution and mass communications Real estate. 7.5 26.6 3.1 4.1 4. 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. food.2 1.0 Average Sales Per Company (P billion) 6.5 47. 5.4 10. 14. and mining Management.Table 3. Flagship Company.11 Total and Per Company Sales.7 98. 4. beverages.4 6.

27.6 2. 21. 38.0 2. 20. Ramos Gaisano Family Group Felipe Yap Felipe F.3 2. Enrile/JAKA Group Jaime Gow Guoco Group Jose Go Jardine Davies Gerardo Lanuza Alfredo C.8 1.1 0. 34.19.1 1. 39.7 0.8 1. 35.1 805.1 2. 28.8 Jollibee Foods Luis Lorenzo Family Group Alcantara Family Group Bienvenido Tantoco Elena Lim Andrew Gotianum Brimo Family Group Andrew Tan J. 26. 22.000 Corporations (1997).7 3. 30.7 1.7 4.2 6. 36. 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 8.4 5.8 6. 37. 23.2 4.9 1.5 8.9 7.7 0. and real estate Retail merchandising Ceramics and real estate Department store and real estate Cement and sugar central Real estate and securities trading Bookstore. and various company annual reports.3 7.9 0. . SEC-BusinessWorld Annual Survey of Top 1. 33. distribution.9 1.7 0.0 1.4 1.4 3. mining. Cruz Jose Luis Santiago Keppel Group Robert John Sobrepeña/ Fil-Estate Group Total Real estate Sources: PSE Databank.9 1.0 0. 32. P. 4 238 1.6 3.8 1.3 2. 29.9 6. 31.5 2.0 5.6 5. 25.2 1.9 0.4 3. 24.6 0.6 Fast food Beverages and agro-industrial products distribution Cement and wood products Retail merchandising Electronic appliances Real estate Mining Real estate Telecommunication.1 1.

and Affiliated Bank of Selected Business Groups. 9. 7. 11. 19. 17. 3. 4. 10. Jollibee Foods Corporation Pepsi Cola Products Alsons Cement . 15. 5. 12.Table 3. 13. Flagship Company. 16. 2. 1. 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. Long Distance Telephone Phinma Zuellig Pharmaceutical Metro Pacific William Gothong and Aboitiz Swift Foods/RFM House of Investment Anscor Equitable Card Network Inc. 20. Uytengsu/General Milling Group David M. 8.11 (continuation) Total and Per Company Sales. Sector Orientation. Alaska Milk Corporation DM Consunji. 6. 18. 21. Inc. 14. 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. 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. Eduardo Cojuangco Lopez Family Group Ayala Corp.

Inc.65 billion. F.000 Corporations (1997). SEC-BusinessWorld Annual Survey of Top 1.65 billion to P4.48 billion. 31. 28. Kepphil Shipyard Inc.East-West Bank International Exchange Bank Ecology Bank (Savings Bank) Dao Heng Bank Orient Bank International Exchange Bank International Exchange Bank Philbanking Corp. 38. Keppel-Monte Bank Bienvenido Tantoco Elena Lim Andrew Gotianum Brimo Family Group Andrew Tan J. Fil-Estate Development Inc. PT&T Corp. 27. 23. 26. small = less than P1.48 billion. . Sources: PSE Databank. 34. 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. 22. 24. P. Cruz & Co. 33. 35. and various company annual reports. Enrile/JAKA Group Jaime Gow Guoco Group Jose Go Jardine Davies Gerardo Lanuza Alfredo C. a b Size class is measured in terms of sales: Large = greater than P4. Ramos Gaisano Family Group Felipe Yap Felipe F. unless otherwise indicated.. 25. medium = P1. 36. Refers to commercial banks. 32. 29. 39. 30. 37.

Inc. food. Fujitsu Computer Products Corp.6 18.8 53.1 60. 1997 Sales (P billion) Control Structure Major Industrial Orientation 123. 3.0 37. and packaging Power distribution. 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.Table 3. Beverages.0 24. food.5 77.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. Philippine National Bank Mercury Drug Corp. of the Phils. mass communications. 17. 22.12 Control Structure of the Top 50 Corporate Entities. Del Rosario/PHINMA Zuellig Group Toshiba Information Equipment (Phils. and car manufacturing Power Refined petroleum products Refined petroleum products Banking. and telecommunications Department store and banking Airlines. and real estate Banking. Texas Instruments (Phils.2 49. and bank Real estate. and dairy products Investments.8 84. 10. 23.0 38. 19. beverages. bank. Petron Corporation Pilipinas Shell Petroleum Corporation George Ty John Gokongwei Henry Sy Lucio Tan Ramon Cojuangco Family Group Caltex (Philippines) Inc. and personal care products Shipping. banking. 5. Inc. 24. 6. 15.5 15. and food Food. 9.8 22. 7.).5 47.).7 98. agriculture.5 46.2 16. 12. 18.5 26.5 17. power. car manufacturing. 20.3 15. Aboitiz Family Group Jose Concepcion/RFM Group Alfonso Yuchengco Philippine Associated Smelting and Refining Corp. and mining Gold and other precious metal refining . First Pacific/Metro Pacific Group 21. beverages. 8. coconut oil. 13.4 19. telecommunication. 14.6 26. food. 4.1 17. 16.4 48. construction. 11.2 Business Group Business Group Business Group Government. Eduardo Cojuangco Lopez Family Group Ayala Corporation Group National Power Corp.5 44. 2.

43.4 8. Philip Morris Philippines.5 8.7 10. 46. Inc. PSE Databank. 41.0 12.9 14. 36. 9. 37.9 7.290 53.0 11. Inc. and various company annual reports. 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. corn (unmilled). 47. 44.4 10.0 5.6 1. 26. including biological products Bank Cement and wood products Retail merchandising Electronic appliances Mining Real estate Sources: SEC-BusinessWorld Annual Survey of Top 1. 42.. 34. Corp. 45.2 7. radio and remote control apparatus Fast food Bank Beverages and distribution of agro-industrial products Drugs and medicines. and other grains wholesaling Other amusement and recreational activities Motor vehicles Food and dairy products Construction and mining Television and radio transmitters.8 9. 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 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. 27.7 10. 29. 39. Amusement and Gaming Corporation Mitsubishi Motors Phils. Inc. 49. 32. 35. 33.7 13.5 10.000 Corporations (1997).1 9.25.8 6.9 7. and apparatus for line telephony and line telegraphy Tobacco products wholesaling Cigarettes Radar equipment. EAC Distributors Inc.0 13. W. Jollibee Foods Citibank N.A.3 8. Uytengsu/General Milling Group David M. National Steel Corporation National Food Authority Phil. 30. 14.9 6.5 8. Consunji Uniden Philippines Laguna. Philips Semiconductors Phils.6 12. 50. 48. real estate.3 13.6 9. 31. 28. .000 Companies Sales (%) Cigarettes Bank Soap and detergents Management. and tourism Banking Radar equipment and radio remote control apparatus Operation of rolling mills Palay.

such as amendments of the articles of incorporation. The Philippine Corporation Code mandates the board of directors to exercise its control over a corporation. issuance of corporate bonds. determination of compensation to board members. Of course. corporate mergers or consolidations. shareholder voting in general meetings and legal protection of their rights. approval of management contracts.3. 3. amendments in the bylaws. although public investors held a majority of shares. 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. sale or disposition of a substantial portion of corporate assets. . issuance of stocks. The Corporation Code holds members of the board of directors liable. Vol. appointment and compensation of senior executives. This section reviews practices of corporate management and shareholder control in Philippine publicly listed companies. II publicly listed commercial banks affiliated to these groups. A total of 44 companies responded to the survey (out of about 221 financial and nonfinancial listed companies).2 Corporate Management and Shareholder Control The main mechanisms by which shareholders control corporate management are the board of directors. However.186 Corporate Governance and Finance in East Asia. 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. jointly and individually. to the corporation and its shareholders for damages caused if they agree to unlawful corporate acts. They are likewise liable if they pursue financial interests that conflict with their duty as directors. accounting and auditing. these were dispersed shareholdings. the board of directors plays a crucial role in corporate governance. Shareholders limit the broad power of the board by ratifying their decisions on critical corporate affairs. business groups had only minority ownership. removal of directors. The review is based on an ADB survey of listed companies in the Philippines conducted in 1999 for this study. investments of corporate funds in other companies or purposes. voluntary dissolution.8 The Board of Directors As the representative of shareholders in a company. and financial disclosure. Actual control of the banks was still held by the groups. and declaration of cash dividends.

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

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

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

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

representing about 24 percent of outstanding shares.900 shareholders per company did not vote during the last annual general meeting. protection.8 56.13 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. About 93 percent of the respondents contracted . The brokers or securities companies were the most important proxy voters.Chapter 3: Philippines 191 in a few controlling shareholders and families.13 summarizes rights that the shareholders of the responding companies enjoyed.6 Independence of Auditing The ADB survey revealed that all the responding companies had an independent auditor. representing 3.2 7.0 48. About 333 shareholders per company voted by proxy. the successful hostile takeover by First Pacific Group of PLDT.2 69. Nevertheless.522 shareholders each.4 70. appointed either by the board or shareholders during the annual general meetings. An average of 327 shareholders per company attended the last annual meeting and they represented about 63 percent of total shares. and their activism in the corporate sector. Table 3.8 30. Nominees held about 45 percent of the outstanding shares. a company that is widely held but has a large shareholder.4 percent of shareholders but 58 percent of outstanding shares. The responding companies had on average 43.0 36. demonstrates the feasibility of developing a market for corporate control if publicly listed companies were widely held.3 56.7 43.2 43.0 63.6 30. An average of about 4. 1999. followed by management and banks.8 92. Table 3.4 No 0.0 51. The ADB survey provides further evidence on shareholder rights. Yes 100.

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

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

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

Inc.96%) Privately-Held Pure Holding Company Public Investors (41. Inc.44%) >50% MajorityControlled Pure Operating Company Makati Development Corporation (100%) <50% MinorityControlled Pure Operating Company Cebu Holdings..6%) <15% Passive MinorityOwned Pure Operating Company Honda Cars Phils.1 Corporate Control Structure: The Case of Ayala Corporation Family Members 100% Mermac. (58.06%) <50% >15% &<50% Active MinorityOwned Pure Operating Company Globe Telecoms (44. (47.2%) >50% MajorityControlled Pure Operating Company BPI Family Savings Bank (100%) <50% MinorityControlled Pure Operating Company Note: Data as of 31 December 1998.04%) <50% Ayala Corporation >50% Publicly Listed Pure Holding Company >50% MajorityControlled Operating and Holding Company Ayala Land (71. Inc.Figure 3. . (15%) MinorityControlled Operating and Holding Company Bank of the Philippine Islands (42.

Vol. and First Philippine Industrial Corporation are indirectly held by a majoritycontrolled holding company. Simeon Djankov. Fan. II Bank of the Philippine Islands owns 100 percent of the BPI-Family Savings Bank. Lang.44%] / [25%] = 1.98% x 42. and 1999c. P. MERALCO. see the World Bank research papers by Stijn Claessens.44%] = [42. The Separation of Ownership and Control in East Asian Corporations. Joseph P. indirect shareholdings do not appear to be a prevalent practice in the Philippine corporate sector.11 The Lopez family’s control rights over MERALCO was 5. defined as control by large shareholders of an operating company through minority ownership by several companies.3% x 5. H. Simeon Djankov.76%)] [39.2). The control of companies through indirect corporate shareholdings. and Larry H. Who Owns and Controls East Asian Corporations? 11 Ibid. P.12 These examples show that even when large shareholder groups are minority shareholders.44%] / [58.7 times 12 . The situation offers large shareholders tremendous incentive to move resources 10 For details. Expropriation of Minority Shareholders: Evidence from East Asia. however.10 The Ayala family’s control rights over BPI was 1. and a minority-controlled holding company. [control right] [control rights via Ayala Corporation] = [cash flow right] [cash flow rights via Ayala Corporation] = [42. 1999b.5%] [39. Lang: 1999a.196 Corporate Governance and Finance in East Asia. Rockwell Land.14%] / [1.64%) + (37. Generally. [control right] [cash flow right] = = = = = [sum of control rights via Benpres and First Holdings] [sum of cash flow rights via Benpres and First Holdings] [1. a privately owned company.64% +37. they exercise far greater control (two to five times more) than they are entitled to by virtue of their ownership rights. Being in the public utilities sector.14%] / [6.7 times its cash flow rights by virtue of its cross-holdings via Benpres and First Holdings. 1998. and Larry H.7 times Ibid.5%] / [(88. Benpres Holdings. is illustrated in the Lopez Group (Figure 3.8%] 5. 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.3% x 1.7 times its cash flow rights by virtue of the double layer pyramid structure of the Ayala group. First Philippine Holdings Corporation.5% x 14. Diversification and Efficiency of Investment by East Asian Corporations. See also Stijn Claessens. companies in the Lopez Group are large and minority-controlled.

5% First Philippine Industrial Corporation 50% 50% Note: Data as of 31 December 1998.3% 11.64% MinorityControlled 14.5% 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. Inc.Figure 3.7% 62.2 Corporate Control Structure: The Case of Lopez Group Public Investors Family Members Lopez. .5% Operating Company MajorityControlled Operating Company Rockwell Land Corporation 24. Privately-Held Pure Holding Company 88.76% Operating Company MinorityControlled 24.

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

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

and fiscal management were among interrelated factors explaining the underdeveloped state of the Philippine financial market. this is because. companies expanded only at a moderate pace. Equity instruments include common stocks.7 billion. Foreign portfolio investments also remained small. the minimum required to qualify as a public corporation. They invested in only a few large companies whose shares were relatively liquid. most listed companies are controlled by their five largest shareholders. From the 1970s up to the early 1990s. Of the 221 companies listed in the Philippine Stock Exchange in 1997. Interest rates. inflation. less exposed to foreign debt. only 84 had sales large enough to be placed in the top 1. 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. about the size of Thailand’s. was one of the smallest in the region at $47. Malaysia. Foreign funds were wary of the Philippine stock market because of its limited liquidity. Equity financing through IPOs was active. however. is far ahead of the flock. Table 3. The period 1993-1997 was one of lower inflation and declining lending rates. and Indonesia ($61. while interest rates were at high levels and volatile.. As a result. The Philippine stock market is not a liquid market. Most companies invested only in projects that met hurdle rates as high as 20 to 30 percent and had short payback periods. The crisis affected the Philippine corporate sector. Even in the real estate sector.g. and less engaged in risky investments. especially short-term debt. The market capitalization of the Philippine stock market in August 1997. the country experienced double-digit inflation.000 companies. but not to the same extent as it did in other Asian economies. Rising stock prices during the Ramos administration reflected to some extent the business optimism. Korea and Thailand).5 billion).14 shows that the average volume of daily trading in 1997 stood at P2. compared with Malaysia ($186 billion). Vol. Korea) ($143 billion).4 billion (or $59 million using the average exchange rate). and convertible securities. Philippine companies were less leveraged. In part. However. The corporate sector raised a substantial amount of . 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. II sector. preferred stocks. The Government financed its chronic fiscal deficits by issuing short-term Treasury bills. the Republic of Korea (henceforth. The stock market was depressed up to the early 1990s. compared with other economies.200 Corporate Governance and Finance in East Asia. Most publicly listed companies issue only up to 20 percent of total shares to the public.

4 9.386.686.251.2 0.2 61.2 57. 1983-1997 Daily Trading Volume (P million) — — — — 129.2 1.9 114. Source: PSE databank.8 1. Note: Combined transactions of Makati and Manila Stock Exchanges are not available for the years 1983 to 1986.474.1 524.373.2 1.7 1.2 ($ million) — — — — 6.2 59.0 161.3 158.1 5.7 207.0 0.351.5 12.445.5 16.0 2.3 4.515.1 0.2 0.6 261.5 Year 369.6 1.Table 3. .6 1.7 391.171.8 0.1 0.7 41.5 72.8 799.3 314.088.4 1.9 608.3 0.9 682.1 0.5 571.2 297.9 1.077.421.2 3.3 Market Capitalization (year end.9 2.3 59.8 1. P billion) 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 19.3 0.121.8 102.9 2.1 0.14 Philippine Stock Market Performance.906.5 1.0 0.0 1.692.4 Ratio of Market Capitalization to GDP 0.1 88.0 0.248.7 2.9 12.8 1.4 728.545. P billion) Gross Domestic Product (current prices.3 2.5 26.7 0.3 — = not available.5 1.2 925.

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

5 0.5 0.7 0. Self-financing ratio of total assets (SFRT): ratio of changes in retained earnings to changes in total assets.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. Incremental equity financing ratio (IEFR): ratio of changes in shareholders’ equity inclusive of retained earnings to changes in total assets.000 Corporations in the Philippines from 1988 to 1997.8 0.5 0.5 Source: SEC-BusinessWorld Annual Survey of Top 1.3 0.0 0.6 0. 1989-1997 Financing Indicators SFRF SFRT NEFR IDFR IEFR 1989 1990 1991 1992 1993 1994 1995 1996 1997 1.3 0.5 0. It measures a company’s capacity to finance asset growth by equity capital. It measures a company’s reliance on borrowings in financing asset growth.5 2. during this period.000 Corporations in the Philippines.4 0.4 1.5 0. It measures a company’s capacity to finance growth in fixed assets by internally generated funds. 1988-1997.3 0.9 0. .15. Retained earnings were sufficient to finance the entire growth of fixed assets in the corporate sector.9 0.1 Average 1.6 0.9 0.4 0. the average SFRF was high at 109 percent.15 Financing Patterns of the Corporate Sector.3 0. As shown in Table 3.5 0.1 0.4 0.5 0.1 0.4 0.9 0.2 0. All Companies Financial flows data were derived from the SEC-BusinessWorld Annual Survey of Top 1. By definition.5 0.1 0.8 0.3 0.1 0.4 0.6 0.2 0.0 0.3 0.2 0. New equity financing ratio (NEFR): ratio of changes in stockholders’ equity (excluding retained earnings) to changes in total assets.2 0. It measures a company’s capacity to finance asset growth by internally generated funds. Incremental debt financing ratio (IDFR): ratio of changes in total liabilities to changes in total assets. it is one minus IDFR.2 0. the SFRT was low at Table 3.4 0.5 0. On the other hand.4 0.3 0.8 0.1 0.

2 (0. In all the years. The corporate sector consistently relied on debt and new equity to finance asset growth throughout the period. In 1997.3 0.0) 0. reflecting the capital flight caused by political instability in the early 1990s. Corporate Financing by Ownership Type As shown in Table 3.204 Corporate Governance and Finance in East Asia.5 Foreign-Owned 1.16 Corporate Financing Patterns by Ownership Type. There were significant year-to-year variations. implying that internal funds were far from sufficient to finance growth in total assets. As a result. for all three types of companies—publicly listed. the level of corporate leverage increased. with debt providing 93 percent of the financing requirements. except for foreignowned companies that had a negative new equity financing ratio. privately. In periods of an economic crunch such as in 1989. 1991.3 0.3 0. internal funds were not a significant source of financing growth in total assets. Total assets grew by 23 percent that year.and foreign-owned. and 1997.9 0. . debts were the most important source of financing.5 Privately-Owned 0. The corporate sector used new equity to finance 32 percent and new debts to finance 49 percent of growth in total assets.7 0. 1988-1997. On Table 3. except in 1991. retained earnings declined and few new equity investments flowed into the corporate sector. II only 19 percent.2 0.1 a Excludes negative balances. This was mainly caused by the declining contribution from retained earnings. 1989-1997 Financing Indicators SFRF SFRTa NEFR IDFRa IEFRa a Publicly Listed 1. Source: SEC-BusinessWorld Annual Survey of Top 1. Companies financed fixed assets from internal sources in hard times.000 Corporations in the Philippines.16. the SFRF was higher.3 0. Retained earnings were the least important. Vol. suggesting that there was a deterioration of financial performance in the Philippine corporate sector in the years running up to the crisis.6 0. when it financed 45 percent of it. 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 1997.5 0.8 0.

4 10.2 3.8 4.0 1995 1996 13.3 12.3 13.8 46.3 10. 1988-1997.6 48.9 38.9 16.3 12.7 100.8 3.7 2.0 9.6 37.and foreign-owned companies.4 41.1 10.0 1994 19. 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. It presents a composition analysis of assets and financing sources for the period 1992-1996.5 41.0 38.8 38.2 100.0 9.8 16.0 6.9 24.2 12. publicly listed companies relied more on new equity financing than privately.4 100.8 3.9 3.0 10.9 4.3 11.5 16.8 0.0 8.4 2.7 13.2 51.7 7.5 12.2 42.1 15.0 1993 14.1 13.9 100.4 12. A breakdown of the financial structure of publicly listed companies measured in balance sheet items is shown in Table 3.9 0. compared with 47 percent for publicly listed companies and 55 percent for privately-held firms.0 10.4 43.0 9.6 26.9 16. Foreign-owned companies relied more heavily on debt financing. .4 2. This financing pattern supports the earlier finding that foreign-owned companies had the highest leverage among the three types of companies.4 3. significantly Table 3.17 Composition of Assets and Financing of the Publicly Listed Sector.000 Corporations in the Philippines.8 17.1 50.1 7.0 Source: SEC-BusinessWorld Annual Survey of Top 1.Chapter 3: Philippines 205 average.6 43.8 100.3 48.2 100. especially bank loans.9 16.7 23.4 100.0 12. The sector built up its short-term debts.7 4.0 53.3 51.8 26.6 0.4 100.8 39.3 10.9 12.3 4.7 13.2 3.0 13.5 9.4 100.17. contributing 90 percent of growth in total assets.8 0.5 0.5 27.1 9.6 48.1 49.3 12.0 9.0 100.7 2.8 51.

18 Financing Patterns by Control Structure. Table 3. compared with an average of 54 percent for independent companies.45 in 1996.9 0. group companies usually financed their investment in member companies by equity rather than debt.3 0. On average. indicating that many publicly listed companies were likely to be in a tight liquidity position. The normal standard liquid position is a current ratio of 2 or higher. for independent companies.5 0. 1989-1997 Financing Indicators SFRFa SFRTa NEFR IDFRa IEFRa a Group Member 1. Group companies were generally more profitable than independent companies.5 0. the average SFRF of business groups was higher compared with that of independent companies. as opposed to 94 and 30 percent. For these two reasons.18. Further.6 Independent Company 0.13 was at 1.206 Corporate Governance and Finance in East Asia. and economies of scale in fund raising. The traditional measure of liquidity.000 Corporations in the Philippines.5 Excludes negative balances Source: SEC-BusinessWorld Annual Survey of Top 1. the easier access to external credit. their inherent ability to pool risks. The SFRF for independent companies would have been even lower if the highly profitable foreign-owned companies were excluded.1 0. II in 1996 and became more vulnerable to the financial crisis in 1997. 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. As shown in Table 3. respectively. 1988-1997.3 0. .3 0. group companies were less reliant on debt financing than 13 Defined as total current assets divided by total current liabilities. the current ratio. Corporate Financing by Control Structure Conglomerates have certain advantages in financing because of the opportunities offered by the internal capital markets. Vol.2 0. Group companies financed an average of 45 percent of growth in total assets by debt.

These results support the earlier finding that the leverage of business groups was lower than that of the independent companies from 1988 to 1997.19 Financing Patterns by Firm Size. These years were 1991 with 110 percent. Corporate Financing by Firm Size SFRF was highest for medium-sized companies. Large companies’ IDFR of 0. The lower SFRF for large companies may be caused by their larger outlays for growth in fixed assets.8 0.5 Medium 3.1 0. 1988-1997. Table 3. With assets growing at a fast pace during this period. Excluding . On average.55 was substantially higher than the small companies’ 0.20). The medium-sized companies’ high debt financing ratio was due mainly to three years of complete reliance on debt to finance growth.3 0.2 0.6 0. The corresponding ratio was 0. with an average of 3. averaging 61 percent of growth in total assets.2 0.6 0.5 Excludes negative balances. There was also increased reliance on debt financing.19). and 1997 with 131 percent.50 (Table 3. equity financed 42 percent of incremental asset growth.5 0. Large firms consistently increased their reliance on debts from 1994 to 1997.88 for large companies (Table 3. Corporate Financing by Industry The manufacturing sector had an average SFRF of 1.3 0.76 for small companies and 0.08 and SFRT of 0. compared with 55 percent for large companies and 47 percent for small ones.Chapter 3: Philippines 207 independent companies.06.9 0. medium-sized companies used more debts. 1993 with 96 percent. 1989-1997 Financing Indicators SFRFa SFRTa NEFR IDFRa IEFRa a Large 0.2 0.3 0.000 Corporations in the Philippines.47.4 Small 0. Source: SEC-BusinessWorld Annual Survey of Top 1.

with an SFRF as low as 0. Equity financed the rapid expansion in the industry’s assets in the period 1994 to 1997. The construction sector was a heavy user of debt financing.3 0. many of the leading real estate companies successfully went public during that time.32. Its SFRF and SFRT were volatile because of chronic losses and reduction in fixed and total assets.20 Financing Patterns by Industry. when debts declined. Table 3. while SFRT averaged only 0.79 and in 1997 at 0. 1989-1997 Financing Indicators Manufacturing SFRFa SFRTa NEFR IDFRa IEFRa 1. debt financed about 78 percent of asset growth in real estate. Total liabilities increased partly as a result of the local currency devaluation and financed all of asset growth for the year. Since the real estate boom coincided with that of the stock market.3 0. II 1991.6 0. the industry generated internal funds. The utilities sector showed weaknesses in internal fund generation in 1989-1994. The effects of the crisis of 1997 were adverse.58 and SFRT of 0. Excluding 1997 when fixed assets declined. SFRF for the sector averaged 0. In the eight years preceding the crisis.2) 0. Source: SEC-BusinessWorld Annual Survey of Top 1. achieving an average SFRF of 3. Up to 1997.5 0. Low incomes diminished the equity financing position of the manufacturing industry toward the crisis year. Vol.4 3.91.1 0.5 0. ranging from 41 to 118 percent. the total debt ratio was much higher in 1996 at 0. The sector had the highest leverage among all industries that year.4 Construction 0. increasing to 0. the incremental equity ratios of the industry were high. Equity financed an average of 62 percent of total asset growth. the manufacturing industry financed 57 percent of its total asset growth by debt. The situation improved beginning 1994. Incremental equity financing amounted to an average of 44 percent of total asset growth.6 a Excludes negative balances.5 Utilities and Real Estate Services and Property 0.3 0.000 Corporations in the Philippines.4 0.4 0. . The real estate industry financed its growth by substantial equity funds.7 0.208 Corporate Governance and Finance in East Asia.6 0.29.5 (0.3 0.4 0. 1988-1997.6 0.27. While this level is considered prudent.04. During the crisis year.47 two years later.

Chapter 3: Philippines 209 3. more profitable. . while if it fails. ROE = return on equity. alternatively. and leverage. Table 3. As shown in Table 3. was regressed against measures of profitability and of financial leverage.14 Large shareholders may borrow excessively to undertake risky projects.4. 14 See for example Michael Jensen (1993).130 ROA 0. and the Failure of Internal Control Systems.004 3. 1992-1996.21 Ownership Concentration. and Financial Leverage Dependent Variable Item Coefficient of Ownership Concentration T-statistics Adjusted R-squared F-statistics ROE 0. ownership concentration = the total shareholdings of the top five shareholders. Exit. Large shareholders may also overuse financial leverage to avoid diluting ownership and control.21. Journal of Finance 48: 831-880. and Performance Previous studies on corporate governance have often associated ownership concentration with heightened risk-taking by companies. and financial leverage are all positively and significantly related to the degree of ownership concentration.00036 2.230 Leverage 0.860 Leverage = the ratio of total assets to total equity.009 5. knowing that if an investment turns out to be successful they could capture most of the gain. The Modern Industrial Revolution. Profitability.00056 1.769 0. ROE. ROA. at the same time. Three regressions were run with the shareholding of the largest five shareholders as an independent variable and ROA.287 0. Financial Leverage.00125 2.008 5.421 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. as the dependent variable. the coefficient of the ownership concentration measure in all the three regressions is positive and statistically significant. ROA = return on assets. ROE. the degree of ownership concentration.3 Ownership Concentration. creditors bear the consequences. Using the PSE database. measured by the percentage of shareholdings of the largest five shareholders.

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

Financial institutions called on their shortterm loans and shortened the maturity of existing loans. resulting in stability in the short-term debt to reserves ratio. The Central Bank conserved international reserves by allowing the local currency to float within a wider trading margin. the ratio of short-term debts to international reserves dipped below 100 percent beginning June 1998. a positive balance of payments from 1992 to 1996. which. unlike their counterparts in the region. In the Philippines.3 percent. the Government sought stability and achieved this in 19921997. Profitable operations since 1992 had allowed it to build equity. in turn.6 billion as of March 1997. the country and the corporate sector had no access to foreign currency debts from the international financial market. After hovering in the range of 100 to 127 percent. Since the regional financial crisis was triggered by the loss of confidence in some East Asian economies by foreign creditors and investors.8 percent. assets grew at a compound annual rate of about 31 percent. adjustments were focused on the quantity and quality of the banking system’s corporate loans. shows that investments of the corporate sector were growing at a faster rate than sales revenues in the years immediately preceding the crisis. Economic performance during 1992-1997 was characterized by an average growth rate of real gross national product (GNP) at 3. During this time.5 percent. however. an average Treasury bill rate of 13. while sales grew by only 20 percent per year. From 1993 to 1997. an average inflation rate of 7. Closer analysis. a government fiscal surplus from 1994 to 1997. fueled also by successful IPOs during the stock market boom of 1993-1996. The lessons from debt restructuring became the basis for the Government’s economic policies.1 percent. the Government restructured its debts into longer tenors with a maximum of 25 years. Five years of stable growth before the crisis enabled the country to build its net international reserves to $10. Prudent fiscal management and controls on foreign borrowings were part of the adjustments required by IMF and foreign creditors. 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. and a relatively healthy banking system. . The corporate sector was in a relatively stable financial condition around the time of the crisis. 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.Chapter 3: Philippines 211 long period of debt moratorium and restructuring that started in 1983 and ended in 1991. From 1988 to 1996. Eventually. average ROE was 13. depended on the quality of the corporate sector’s investments. Total debts were only 52 percent of assets or 108 percent of equity.

22 Foreign Investment Flows. Most of this leverage happened during the boom years in the region. Data for 1998 cover only January-August.101 92.609 1.303 23.212 Corporate Governance and Finance in East Asia.073 (406) 121.22.5. the other immediate impact of the crisis was that on foreign investment flows. Net foreign portfolio investment amounted to $1. These patterns in investment and financing are similar to those of other countries in the region.749 26. The debt level of the Philippine corporate sector in 1997 was low by Asian standards but still high by developed country standards.7 Note: Peso-dollar exchange rates used are: 1995 = 25. growing by about 34 percent per year from 1994 to 1997. but to a lesser degree. II The corporate sector indeed overexpanded after 1993 like its counterparts in the region. or 114 percent of net foreign direct investment (FDI). Net foreign investments more than doubled from 1995 to 1996 but declined by 78 percent in 1997 (Table 3.485 145.718 30.22). It is understandable then that the effect of the Asian financial crisis on the Philippines was correspondingly that of a negative “contagion.4 1997 762 1. 1998 = 41. Sources: Bangko Sentral ng Pilipinas and SEC. In 1997.71. Foreign investments in the Philippines have not been as high as the inflows to other Asian countries—and this. mitigated the effects of the pullout and liquidation of investments in the aftermath. It financed 26 percent of corporate capital growth. 1995-1998 Item Net Foreign Investments ($ 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 1.0 1998 739 555 328 69.” 3. Debts financed a large part of this expansion. Vol. precisely.300 1. net FDI remained stable at more than $1 billion.0 1996 3. 1997 = 29. 1996 = 26. But portfolio investment amounting to $406 million flew out of the Philippines.5 billion in 1995.47.074 2.06.517 1.650 32. Table 3.101 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. It rose to $2. In sum.2 Impact of the Crisis on the Corporate Sector Aside from the foreign exchange adjustment. .

new borrowings financed asset growth. in turn. Manufacturing reduced its loans outstanding by 11 percent from October 1997 levels. Bank spreads over Treasury bill rates increased in 1997 but were within the range experienced in the past. Loan calls. then rose to a high of 22. With the increase in borrowings and reduced liquidity. Companies deferred investments in new fixed assets.2 to 28.7 percent in January 1998. meanwhile. and the wholesale and . in varying degrees for each sector. Loans outstanding of commercial banks declined by the first quarter of 1998. with commercial banks holding P2. suggesting that commercial banks required a higher premium at about the height of the crisis but not beyond. ranged from 11 to 13 percent from 1993 to July 1997. Although corporate borrowers were not highly leveraged. Bank loan pricing was based on the bellwether 91-day Treasury bill rates rather than inflation. they could not initiate a large reduction of their loans because these in part financed long-term growth in assets. The real problem of the corporate sector during the crisis was the rise in interest rates. Net profit margins were at a 10-year low at 4.369 billion. which held about 75 percent of the assets of the financial system in 1997. depended on the liquidity and capital position of commercial banks.3 percent of assets. The interest rates on Treasury bills. albeit at current market interest rates.Chapter 3: Philippines 213 Corporate financial performances and conditions deteriorated during 1997.2 percent in November 1997. sparking a rise in interest rates on corporate loans.2 percent was barely above inflation rate. By October 1998. Because commercial banks were strongly capitalized. lending rates also came down. they were willing to restructure and renegotiate existing loans by corporate borrowers. Because of weak internal fund generation.9 percent. Average bank lending rates climbed to their peak of 25.513 billion. and leverage increased to 149 percent compared with 109 percent in 1996. By March 1988. The banking system was able to absorb the impact of the crisis primarily because of its strong capital position. 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. A number of small banks closed but they represented less than 1 percent of the financial system’s total resources. When the Treasury bill rates eased in March 1998. the corporate sector became vulnerable to loan calls and high interest rates. ROE at 6. The resources of the financial system that year totaled P3. the commercial banking sector’s capital remained strong at 17. The combined effects of shrinking demand and high interest rates reduced the corporate sector’s demand for loans.

The move retained the liquidity position of banks but lowered their cost of reserves. and subsequently went down to 13.9 percent of bank loan portfolios.5-6 percent. But the Philippine banking system had gone through worse crises in the past. set limits on overbought/oversold foreign exchange positions of banks.5 percent by September 1998.5. 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. and its experience of low. The Central Bank adopted other measures to strengthen the financial system. through the Bankers’ Association of the Philippines. thereby reducing overall intermediation costs. and the financial system. The latter measure was especially beneficial to companies with unhedged foreign currency loans from commercial banks. the ratio increased to a high of 11. as with its counterparts in other Asian countries. In March 1997.214 Corporate Governance and Finance in East Asia. by 12 percent. 3. This “voluntary agreement” partly explains why the loan spreads of banks were within the range of recent experience. However. single-digit NPL ratios began only since 1989. This allowed the Central Bank to convince the banks. Vol. loans outstanding of the real estate sector increased by 11 percent from June 1997 to June 1998. including (i) a regulatory limit of 20 percent on banks’ loans to the . These figures show that adjustment problems were industry-specific and that the real estate industry.6 percent in June 1998. II retail trade sector. was a problem sector.3 percent in December 1997. real estate loans averaged 11. The Central Bank introduced regulations on foreign exchange trading to control speculation and nondeliverable forward contracts. to reduce their lending spreads over the 91-day Treasury bill rates from 3-8 percent to 1. the fiscal position. The pattern indicates that real estate loans were of substandard quality but banks had contained the problem by mid-1998. As for nonperforming loans (NPLs).3 Responses to the Crisis Government Responses The Government’s policy and regulatory responses to the crisis focused on monetary and credit issues. and set up a hedging facility for borrowers with foreign currency-denominated loans. 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. Still. These peaked at 14.

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

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

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

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

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

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

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

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

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

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

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

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

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

II Prowse.228 Corporate Governance and Finance in East Asia. Journal of Finance 91: 1121-1139. and Robert W. 2. 1992. Shleifer. Vol. No. Washington. Vishny. 1998. November. Andrei. Credit Markets and the Control of Capital. IFC/WB. Journal of Political Economy 94: 461-88. Jeremy C. Technical paper No. 1997. Some Conceptual Issues in Corporate Governance and Finance. Credit. Stephen. and Robert W. Internal Capital Markets and the Competition for Corporate Resources. 1. Shleifer. Stiglitz. March. East Asia: The Road to Recovery. 1985. Washington. 1997. Large Shareholders and Corporate Control. How Do Large Corporations in Developing Countries Finance their Growth? Corporate Financial Structures in Developing Countries. World Bank. DC. Ajit. Mimeograph. and Banking Lecture 17. No. Webb. . Journal of Finance LII. Journal of Finance L11: 737-783. Singh. Stein. 1991. Vishny. The Structure of Ownership in Japan. 1998. Andrei. DC. 1996. A Survey of Corporate Governance. David. 1. May. Journal of Money. Asian Development Bank. Joseph E.

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

lack of transparency and adequate disclosure.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. This study examines these and other factors that might have weakened corporate sector governance in Thailand. Section 4.5 discusses how the corporate sector contributed to the financial crisis and looks at its impacts.2. The study then considers policy recommendations with emphasis on corporate governance improvement. as well as its legal and regulatory framework. Section 4.230 Corporate Governance and Finance in East Asia. its growth and financial performance. The country initiated national economic development planning in 1961 when the economy was growing rapidly. focusing mainly on the companies listed in the Stock Exchange of Thailand (SET). To protect domestic industries. the Government implemented major infrastructure projects and modified its tax policy to encourage capital investment and savings. the Government increased tariffs on products that could be produced locally. 4. Section 4. while new industries were encouraged to reduce the need for imports. .2 discusses the development of the Thai corporate sector under the National Economic and Social Development Plans.3 looks at corporate ownership patterns that resulted in inadequate protection for minority shareholders and weak corporate governance in Thailand.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. Import tariffs on machinery and heavy equipment were removed. and a family-based corporate ownership structure.2 4. Key factors that led to weak corporate governance include the ineffectiveness of the regulatory framework. The First and Second Plans (1961-1971) Under the first two plans. Vol. II There is now a consensus that weak governance was partly responsible for the corporate sector’s poor financing and investment practices. with government policy providing support but avoiding direct interference. Section 4.

with the devaluation of the baht in 1984 a major step in this direction. textiles. Consequently. including luxury goods. As a result. capital inflows. however. The average budget deficit reached an all-time high of $2. and increases in world food and oil prices. The decline in imports was steady. The Government decided to embark on restructuring measures in the Fifth Plan (1982-1986) to rehabilitate the ailing economy. the government’s debt burden escalated. At the same time. External factors. it proceeded with its development plan for the industrial sector. canned foods. Fourth.3 percent in 1974. the value of the baht remained stable. Budget deficits also increased throughout the Fourth Plan. The results were increased exports. averaging 1. Industrial sector growth was also rapid and many industries (tires.5 percent in 1973 and 24. Inflation levels were low.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. remaining high until 1981. however. Unemployment. including a weakening of the dollar. and reduced current account deficits. the industrial sector grew at a faster rate than the agricultural sector. But the sustained importation of heavy machinery and equipment resulted in large trade deficits. chemicals. The Government had to shift emphasis to restoration of economic stability. the current account registered a surplus in 1986. the Government borrowed $6. leaving the Government no choice but to resort to overseas borrowings. using tax policy to control prices of consumer goods and implementing several price control measures to curb inflation. with the agricultural sector the major contributor. helped offset these deficits. resulted in increases in the current account deficit. To close the fiscal gap. . In the wake of lower world oil prices and the rapid growth in income from the tourism and travel industry. lower than anticipated due to a worldwide economic recession.4 billion from overseas and increased taxes on numerous items. Average growth for the period was 4 percent per year. an improved trade balance.4 percent of GDP.6 percent per year. especially foreign aid from the United States. The Third.15 billion per year or 4. The focus shifted to export promotion. gross national product grew by about 7 percent per year. processed steel. However. and automobile assembly) emerged. Thus. became a major problem as domestic investment declined. Inflation reached 15. Budget deficits remained a major problem during the Fifth Plan.

6 percent target of the Seventh Plan. The country also attracted a large amount of foreign direct investments (FDIs). Europe. property development. By 1995. Growth rates during 1987-1991 ranged from 9. Growth of exports and imports averaged 14.2 and 13.5 to 13. increasing its share in total export value from 42 to 76 percent. United States. compounded by a slump in property sales. while exports expanded considerably. Private sector investment grew at an average annual rate of 7 percent. On top of its predominantly “borrowed” nature.2 percent per year. From 1989. lower than the target of 8. Key to this growth performance was the government’s adoption in 1993 of an aggressive program for attracting foreign capital to finance domestic investments. compared with the 8. With loans increasingly becoming expensive and hard to come by due to a lending squeeze by the central bank and high interest rates.8 percent. an oversupply of housing emerged.232 Corporate Governance and Finance in East Asia. The exchange rate was steady at around B25 to the dollar.4 percent targets.5 percent. compared with the 14. Singapore. the bulk of domestic investments went to speculative ventures such as real estate. Vol. and Hong Kong. better than the 5.2 percent target. reaching an annual inflow of $2 billion in 1991. the Government successfully balanced the budget and even settled its foreign debt of $4 billion before this was due. . Average annual growth in real GDP was 8 percent. China—went to export-oriented manufacturing industries. the property sector began to collapse in 1996. The Seventh Plan (1992-1996) The economy’s performance from 1992 to 1996 generally met the targets of the Seventh Plan. II The Sixth Plan (1987-1991) Industrial sector productivity improved gradually during the Sixth Plan period. with private foreign debt reaching $92 billion by the end of 1996. from only $31 billion in 1992. combined with its liberal financial policies. Thailand’s rapid growth up to the mid-1990s made the country one of the world’s fastest-growing economies. The manufacturing sector became a dominant force in the economy. invited a deluge of capital seeking profitable investments. respectively. Thailand became a debtor’s market. Most of the FDIs—originating mainly from Japan. and the stock market. Inflation was 4. rather than to productive activities. averaging 10.8 percent.7 and 11. The country’s high ratings in the international capital market.6 percent.

the corporate sector’s main source of funding was the banks. In his report. which raised the debt service ratio. A series of increases in customs and excise taxes on luxury imports did little to stem rampant consumer spending. In May 1974. Its most crucial role was to help mobilize funds to support Thailand’s industrialization and economic development. placing all publicly listed companies under regulation. the establishment of the Securities Exchange of Thailand (SET) was legislated and trading began on 30 April 1975.” which later became the master plan for the development of the Thai capital market. with growth shrinking from 23. However. the Bank of Thailand and . many companies considered the Act too restrictive and a hindrance to growth. In 1969. In 1972.” extending its control and regulatory powers to the finance and securities companies operating freely at the time. the capital markets didn’t play a significant role until 1975. on account of an overvalued baht that weakened export competitiveness. Under the 1962 Commercial Banking Act. 58 on the Control of Commercial Undertakings Affecting Public Safety and Welfare. the Government amended the “Announcement of the Executive Council No. the signs of an economy about to falter were there. the Government passed the Public Limited Company Act. which was amended in 1979 and 1985. And because the Government considered the banking system vital to the development of the economy. Robbins. Foreign banks were barred from competing directly with domestic banks. Exports went into a tailspin. The country had a current account deficit of about 8 percent of GDP in 1995 and 1996. a policy that held throughout the first six economic development plans. a former Chief Economist from the US Securities and Exchange Commission.2.Chapter 4: Thailand 233 Toward the end of the Plan period. Before the capital market emerged. prepared a comprehensive report entitled “A Capital Market in Thailand. Included in the Second Plan (1967-1971) was a proposal to establish the country’s first authorized and regulated securities market. its policy had always been to protect domestic banks. The deficits caused the Government to rely on even more external borrowing. 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. 4. Sidney M. SET officially became “the Stock Exchange of Thailand” in 1991.2 Development of Capital Markets Although the corporate sector has long been the government’s main tool for economic development. In 1978.3 percent in 1996.8 percent in 1995 to 1.

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

Insurance.1). the country became recognized as an economic development model for other emerging economies. Forestry.0 Paid-up Capital (B billion) 1.1 30.1 trillion and paid-up capital of B1.0 110. Source: Department of Commercial Registration.3 83. and Fishing Mining and Quarrying Manufacturing Electricity.5 111. Gas. Social and Personal Service Total Note: The data for 2000 is as of October 2000. and Communication Financing.9 261. about 661 companies with total registered capital of B2. 1978-2000 Number Registered of Capital Companies (B billion) 5 6 245 5 13 129 22 194 42 661 1. and Business Service Community. the financial sector is the largest. and Water Construction Wholesale and Retail Trade. and wholesale/ retail trade and restaurant/hotel sectors. Storage. Thailand.6 350.3 trillion have been registered with the authority (Table 4. The stock market boom from 1991 until the financial crash of 1997 reflected international investors’ response to Government policies.4 trillion in registered capital and B791 billion in paid-up capital.0 21.Chapter 4: Thailand 235 fast-growing neighbors.0 19. 4. and Restaurants and Hotel Transport. Hunting. in that order.6 23.9 34.394. The result was a corresponding growth and development in Thailand’s capital markets.3 Growth and Financial Performance Since the 1978 enactment of the Public Limited Company Act. .2 11.1 Public Companies Registered.291. In terms of capital.1 78.5 50.6 16.6 1. The manufacturing sector is a far second with registered capital of B350 billion and paid-up capital of Table 4. finance. Worldwide. with B1. The majority of the companies are in manufacturing. Real Estate.5 791. 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. Ministry of Commerce. however.9 1. Financial deregulation and liberalization were key to realizing that vision.2 Type of Business Agriculture.

4 96. 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. allowed Thai financial institutions and corporations to obtain funds overseas. After the passage of the SEA of 1992.7 9.1 2. this was due to the recapitalization of commercial banks in compliance with the new loan provisioning requirement.6 — = not available. The 1997 crisis battered the primary market for securities.4 277. Market capitalization.3 31.8 151.2 25.1 54.7 7.3 194.0 20.3 22.3 1996 1997 65.5 39.3). Domestic and offshore debt issues reached B54.7 billion and B27. Table 4.9 1998 1999 15. The stock market also became an invaluable source of funds for corporations. The preeminence of the financial sector is a direct result of financial deregulation and liberalization. from only B20.2).2 12. While a rebound was apparent beginning in 1998. Securities and Exchange Commission of Thailand.7 27.5 1. II B261 billion.5 billion and B1 billion the previous year.1 599.8 billion. reached .9 37.2 5.3 6. Source: Key Capital Market Statistics. Debt market activities also increased significantly with the establishment of the Bond Dealers’ Club (BDC) in 1994. These peaked at B89. the value of public offerings rose steadily.0 1994 82.2 40.7 billion in 1996.2 Public Offerings of Securities.4 51.4 34.6 39.8 — 26.9 31.1 286. Vol. The signing of Article VIII with the IMF.7 5.6 8.8 201.1 — — — 6. meanwhile. With the enactment of the SEA of 1992 that brought suppliers of finance services and their clients together. respectively. moreover.0 0.6 7.5 1. the year before the crisis struck. reducing the value of offerings to a little more than a quarter of the previous year’s level. reaching a precrisis peak in 1996 (Table 4.5 — — 56. The number of listed companies and securities steadily increased until 1996 (Table 4. The development of the corporate sector closely followed the development of capital markets. the capital market became instrumental in the rapid growth and development of the corporate sector.7 136.8 1995 64.6 174.236 Corporate Governance and Finance in East Asia.

268 2.114 1.325 3.6 trillion. and gross profit margin. not all public companies are listed on the SET. return on equity (ROE).3 Statistical Highlights of the Stock Exchange of Thailand. pulled down by active public offering activities. however.133 1. The trend reversed in 1995.303 930 855 1. its high point in 1995 at B3. The plunge in profitability and asset turnover—from 117 percent in 1985 to 65 percent in 1996 for the latter—cast doubts on the . The financial leverage of all companies declined until 1994. Foreigners accounted for an increasing proportion of SET’s turnover value.535 1.565 2. 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. as measured by return on assets (ROA). Corporate profitability. corporate profitability had been declining.201 2. The key financial ratios of all companies listed on SET bear this out (Table 4.5 at its peak in 1987. ROA dipped from 10.301 3.193 2. their share rising from 17 percent in 1993 to 43 percent in 1997.8 percent. was the ominous deterioration in the key financial ratios of publicly listed companies.360 1. when long-term debt grew as Thai corporations began to borrow heavily to finance growth. then stalled in 1990.281 832 373 356 482 Due to listing requirements and other reasons. Source: Securities and Exchange Commission of Thailand. gross profit margin rose until 1991 before falling in 1992. the average times interest earned (TIE) was down to 5.683 1. the highly liquid financial system continued offering cheap funds to sustain corporate sector investments. Side by side with this surge of financing for corporate growth. But instead of shifting to a low gear. in the end. From 10. While the decline in gross profit margin was not as sharp. Throughout the 1990s.Chapter 4: Thailand 237 Table 4.560 1. the averages for all three profitability ratios took a downswing all the way until 1996.4 percent in 1996.3 percent in 1989 to 3.4 percent to 5. ROE similarly fell from 21. however. By the early 1990s. had been on the rise throughout the 1980s. Meanwhile.1 by 1996.4). resulting in their inability to fulfill debt obligations. the companies could not generate enough net returns from their assets and equity. The upward trends for ROE and ROA continued through 1989.

3 8. Thailand’s ROE.5 51.4 12. the textiles.7 80. and footwear had the lowest at 11 percent.2 10. Korea and Thailand had the highest debt-to-equity ratios.4 44. Among the crisis-hit countries.4 7.2 27.7 34. 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. A major reason for this was the rapid rise in asset prices.7 54.1 9.0 125.7 59. large companies (where size is reckoned in terms of assets or sales) were more profitable than small companies in terms of ROE (Table 4.0 7.8 151. The downtrend in corporate profitability.8 54.9 14.4 119.4 9.9 144.4 47.7 27. clothing.8 8. practice of heavy borrowing. It has also been argued that family-based controlling shareholders borrowed excessively to avoid diluting their control over their corporations.7 5.6 168.9 27.2 161. Despite the availability of the equity market. II Table 4.8 5. Hotels and travel showed the highest ROE of 15 percent while textiles.5). these companies opted for debt.5 50.8 51.4 34.5 38.7 12.0 63.6 36.8 11.4 7.0 139.4 4.9 8.9 77.9 39.6 125.1 242.5 63.7 20.6 7.6 12.7 15.1 16. Severely affected by global competition throughout the decade.7 5.4 18.8 88.2 64.7 27.6 138. which was particularly significant in the two years preceding the crisis.2 35. Vol.2 49. was felt across industries.2 10. clothing. was also distinct in the region. US.1 52. resulting in higher collateral values for borrowers.8 14.3 4.3 12.4 26. They were generally more efficient in managing their assets and .2 6.5 15.7 4.7 35.1 60.5 30.4 12.0 3.9 66.2 10.4 139.0 145.1 16.4 5.4 51.4 3.0 29.3 10.7 12.8 25.5 52.7 5.6 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.4 24.9 7. Overall. and footwear industries also experienced losses.2 27.7 21.3 91.4 28.6 41.1 114.9 51.238 Corporate Governance and Finance in East Asia.9 140.7 LongTerm Debt to Asset Assets Turnover (%) (%) 14.1 120. which fell from 16 percent in 1991 to just under 6 percent in 1996.4 Key Financial Ratios of Publicly Listed Companies.8 5.1 44.9 7. but was most severe in building and furnishing material industries as a result of the downturn in the real estate market.2 215.6 27.0 117.7 12.7 12.5 9.

For instance.3 52. the law disallowed cumulative voting. However.5 94.6 7.9 13.8 62.8 47.6 10. Although stable in the 1980s.3 88.6 31. capital despite the higher gross margins of small companies. In sum.3 164.6 5.4 116.6 6.5 7.0 48.3 25. There were also concerns that the provisions governing the criminal prosecution and penalties of directors and management were harsh and inappropriate. weaknesses became evident.6 30.1 5. The argument was that having a Board of Directors whose members represented different groups of investors would create conflicts and hamper management effectiveness.9 20.1 25.3 135.2 18.6 12. by the 1990s.2 12.7 10. Cumulative voting.3 49.6 61. it was thought.3 176. although the performance of listed companies in the late 1980s was strong. They also tended to use more financial leverage than small companies as their total DERs show.1 13. some rules and regulations of this particular law were believed to be too restrictive and were discouraging companies from going public.8 142. 4. the Public Limited Company Act of 1978 and its amendments regulated Thai publicly listed companies.4 52. . also deteriorated.5 87.3 15.7 14.3 43. Increasingly heavy borrowings rendered the sector even more vulnerable to lower profitability and sales.4 8.1 29.Chapter 4: Thailand 239 Table 4. total asset turnover declined after 1989. US.5 6.7 Source: Pacific-Basin Capital Markets Database compiled by the University of Rhode Island.0 20. 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 6.2 134.3 23.3 49.2 10. could lead to a high turnover in the board.8 26.5 Average Key Financial Ratios by Company Size.0 83.8 6. measured by total asset turnover.6 30.7 6. the overall activities of listed companies.4 Legal and Regulatory Framework Before 1992. which would be disruptive to company management.8 6.2 121.2.1 6. During the 1990s.8 10.1 Small Medium Large 5.

4. The provision discouraged original family owners from registering their companies.240 Corporate Governance and Finance in East Asia.3 Corporate Ownership and Control Ownership and control of corporations in Thailand are highly concentrated. Cumulative voting was made optional. played an important role in bringing about the financial crisis. as a group. but not all questions were answered.2 The market for corporate control was not active and did not give managers strong incentives to perform efficiently. adopted to promote the development of publicly listed companies. The protection of minority shareholders was inadequate under the Public Company Act of 1992. The Public Company Act of 1992. The legal and regulatory framework for the corporate sector also includes provisions related to insolvency. II Another issue was the proportion of shareholding by top shareholders. the exit of these provisions appears to have contributed to the 1997 financial crisis. for instance. As it turned out. Fortysix companies responded. relaxed the contentious provisions of the 1978 Public Limited Company Act. This will be discussed in Section 4. the new legislation removed a number of incentives that would have kept public companies prudent and diligent in their operations. As the succeeding sections point out. The law prohibited the largest shareholders. the limit on shareholdings by the largest shareholders was increased from 50 to 70 percent of total outstanding shares. An Asian Development Bank (ADB) survey conducted for this study shows. and external monitoring and control of corporations were also weak. from holding more than 50 percent of total outstanding shares and other shareholders from holding more than 10 percent of outstanding shares individually. 2 ADB survey questionnaires were sent to all Thai listed companies in early 1999. Vol. that creditors had generally little influence on the management of corporations. a feature that is believed to have impaired the effectiveness of existing regulatory mechanisms in the corporate sector. However. coupled with weak corporate governance. concentrated ownership. 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 600.5. .

1 percent of control rights. Thai.4 26.2 4.8 5.3 percent and 18.6). these companies obtained funding solely from banks or from their own retained earnings.9 52.3 7.3.4 10. the top five shareholders of each of publicly listed Thai companies held.1 Patterns of Corporate Ownership A World Bank study covering nine Asian countries finds that firms in Japan and Taipei.6 68.Chapter 4: Thailand 241 4.2 4.3 7.4 5.1 5. Source: Comprehensive Listed Company Information Database. with the largest shareholder on average controlling 10.0 56. on average.9 26. .4 6.1 7. Unfortunately.5 Average for 1990-1998 period. But with their increased reliance on new varieties of equity and debt instruments.9 55.4 26.6 28.4 26.1 12.5 28.6 27. Ownership Concentration Between 1990 and 1998. Stock Exchange of Thailand.9 3.1 4.9 3. and minority shareholders to stake their claim in the control and regulation of these companies.7 7.8 11. and 28.5 9. this was not the case.7 12.9 54. 56.3 16.3 28.9 52. 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 28.9 percent of shares of a company. In contrast.0 7.3 percent. one would expect the public.2 4.0 53. creditors.1 3.0 3.6 Top-Five Ownership Concentration of Publicly Listed Companies in Thailand.1 5.6 57.3 11.1 5.2 56.4 percent of outstanding shares. Most large Thai corporations listed on SET started out as family businesses.9 4.7 11.3 5.China have the least concentrated ownership. In the past. there were only slight variations in the pattern.0 3. This implies that the top five shareholders enjoyed full control over the outcomes of shareholder meetings.7 percent.9 6. Indonesian.7 6.0 7. with the top three shareholders accounting for almost 50 percent (Table 4.0 5.9 52.6 4. Table 4.2 11. Across industries. Ownership was most concentrated in the packaging. 33.9 11.4 4.4 6. respectively. China firms have the highest single shareholder ownership concentration at 35. 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.8 32. and Hong Kong.1 11.

II agribusiness.029 3. founding families maintain effective control of entire groups.022*** 0. * Denotes significance at the 10 percent level.8). On the other hand.005** 0. Through these holding companies.037 0. Ownership Concentration.116) Debt-to-Equity (1. Table 4. 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. Company size is significantly related to ROE and leverage.7 Statistical Relationships between Corporate Profitability. and ownership types. It is the practice of Thai corporate founding families to set up holding companies to own shares in affiliated companies or subsidiaries.800 0. owning 26.058* ROE (0. Composition of Controlling Shareholders Affiliated corporations comprise the largest group among the top five shareholders of publicly listed companies.034*** 0. and Company Size Item Intercept Top Five Ownership Concentration Company Size Adjusted R-Squared F-Statistic ROA 0.001*** 0.7). year.080 6.115 9. with a top-five ownership concentration of at least 60 percent.072) (0.647 Note: The regression included dummy variables for industry. including those that are publicly listed .001) 0. ** at the 5 percent level.001 0. Leverage. US. Source: Author’s estimation based on the Pacific-Basin Capital Markets Database compiled by the University of Rhode Island.169*** 0. Based on a regression analysis.031 3.533)*** Debt-to-Assets (0. Vol. results show a significant positive relationship between ownership concentration and financial leverage. and building and furnishing industries. as measured by debt-to-equity and debt-to-asset ratios. Other industries had their top five shareholders controlling at least 55 percent of outstanding shares. *** at the 1 percent level.7 percent of outstanding shares on average (Table 4.090 0. 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.003 0.242 Corporate Governance and Finance in East Asia.

1990-1998 Year 1990 1991 1992 1993 1994 1995 1996 1997 1998 Average Company 28.4 20.4 22.0 3.6 25.5 0.3 20. owned by the Chirathivat family.5 NBFIsa 6. a company listed in the real estate sector of SET. Source: Comprehensive Listed Company Information Database.9 15.9 19.6 percent of outstanding shares.6 1. individual members of the Chirathivat family aggregately hold 25. founding families and their relatives maintain control of many companies by jointly holding on to the most significant chunk of shares.7 1. with 29. the affiliate firms rarely hold shares of their parent companies.1 0.5 1. a joint venture among three families.3 27.0 18. Typically.7 — 1.3 1.4 1.2 1.5 percent.8 0. one of the founding members.4 1.3 1.5 0. a NBFIs denotes nonbank financial institutions. unlike in Japan where crossshareholding is common.7 5.1 1. operates five of the most successful shopping malls in Thailand. .1 4.5 26.2 1.2 5.4 1.5 1. This practice is illustrated by Central Pattana.1 1.0 19.3 1.5 Government Other 0.0 17. The ADB survey indicated that listed companies held shares in an average of 11 companies. Although holding companies set up affiliate firms.6 1.2 18.8 Top-Five Shareholder Composition of Publicly Listed Companies in Thailand.3 27.6 28.8 28.9 0. averaging about 18. the company.2 7. The roster of its major shareholders as of December 1997 illustrates the typical ownership concentration of a publicly listed company in Thailand. These individuals usually hold important management positions in concerned companies. Stock Exchange of Thailand.5 0.7 0. including finance and investment companies.6 1.5 5.8 1. in SET. Individual family members also hold a significant amount of outstanding shares. In addition. The largest shareholder is Central Holdings Company.5 2. the company increased its registered capital and became a public company listed in SET.7 Bank 2.3 27.3 — = not available.8 23.9 18. In 1994.5 Individuals 13. Established in 1980 with a registered capital of B300 million.9 7.Chapter 4: Thailand 243 Table 4.3 0.6 5.9 6.3 percent of outstanding shares. The top 10 shareholders include a holding company owned by the Tejapaibul family.

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

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

Where different. the remuneration packages had to be approved during AGSMs. however. the work of this committee was often considered part of the executive board’s responsibilities. Half of the companies in the SET survey had a separate remuneration committee. Chair. Also. these were attributed to variations in the extent of duties and responsibilities assumed by those directors. 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 1998.246 Corporate Governance and Finance in East Asia. and CEO The majority of company respondents to the SET survey provided similar compensation packages to internal and external directors. Vol. All respondents confirmed the use of external auditors. the majority of the companies (77 percent) did not have outside directors as members of their remuneration committees. with 41 firms admitting the use of services of international auditing firms. Fourteen other companies had profit-related incentive schemes in addition to fixed fees. Companies already with audit committees did not have independent outside directors as audit committee members. Directors with managerial responsibility or those related to major shareholders cannot be members of such audit committees. These committees were mainly responsible for determining compensation for senior and regular staff. the auditor is not . all listed companies have been instructed to establish audit committees to be responsible for examining the quality and reliability of company financial statements. Three companies allowed their management to determine the chair’s compensation package. In one company. 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. not an independent assignment. The ADB survey indicated that 18 of the 46 responding companies compensated their chairpersons using a fixed-fee schedule. II Compensation of Directors. Twenty-five of the 46 respondents to the ADB survey declared adherence to all relevant international standards. The SET survey found that the majority of listed companies (81 percent) still have no separate audit committee. while 19 companies observed only some of them. Audit Committees and Accounting Standards Since January 1999. However. In 25 companies.

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

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

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

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

3 11. While the Thai mutual fund industry compares well to those in other developing countries in the region.1 75. trading by mutual funds in SET represented less than 10 percent of total trading.4 23.9 3.5 6. most of these were forced mergers or related to rescue packages. they have mostly been concerned with short-term gains.1 84.1 19. employees are even less willing to accept common shares as a form of compensation or benefit.1 58.8 8 27 14 6 9 13 23 Tender offer value refers to the minimum offer value. Source: Securities and Exchange Commission of Thailand. Few companies offer employee stock option plans (ESOPs). Provident funds for government workers and workers in public enterprises have been established only recently. not with a view to becoming involved in actual management.2 6.2 6. but the average shareholding is smaller than 1 percent of total outstanding shares.2 8.2 7.7 11.3 6. 1993-1999 Year 1993 1994 1995 1996 1997 1998 1999 a Tender Offer Valuea (B billion) 5.3 60. Twenty-nine firms indicated that employees held shares of their companies. But instead of opting for an active role in the market for corporate control. Employee Participation in Corporate Governance There has been little. Even when companies offer ESOPs. it remains small. if any. Eleven of the 46 responding companies in the ADB survey offer ESOPs.6 17.8 81. The number of domestic institutional investors rose after the mutual fund industry was established in 1991. but employees have never been represented in the board of directors since their shareholdings are minimal.9 Merger and Acquisition Activities.7 Purchase Value Number of % of Tender Offer Value Companies 84. Because of the current crisis.Chapter 4: Thailand 251 Table 4. tion activities increased after 1997.0 B billion 4.0 55. Pension funds are perhaps even weaker in Thailand. employee participation in corporate governance in Thailand. . employees regard the plans as monetary incentives. Since 1994.

775. The share of domestic banks in the banking system’s total assets was 80 percent. II 4.1 5.3 5. .8 3.906.10 Size and Composition of the Thai Financial Sector.9 2.1 6.252 Corporate Governance and Finance in East Asia.300.4 3. The bond market played only a marginal role in corporate financing.979.8 941. Bangkok Bank Ltd. The total values of loans from financial institutions and commercial banks were consistently larger than the market capitalization of SET. Vol.2 262.4 Year 1992 1993 1994 1995 1996 1997 1998 1999 Source: Stock Exchange of Thailand.1 7.5 5.1 3.912. the banking sector was highly concentrated.4 4.663.4 519.161.037.5 trillion.4 4.3 1. total assets of commercial banks amounted to B5. The country’s largest bank.669. Many large commercial banks had affiliates among the 93 finance companies that served the high-risk market.10) shows that Thailand is a highly bank-dependent economy.171.230.0 424.133. there were 29 commercial banks.0 SET Market Capitalization 1.4. the next four largest banks accounted for 63 percent. although its role increased in the wake of the crisis.119. and Bank of Thailand. 1992-1999 (B billion) Outstanding Loans from All Financial Institutions 2.0 8.325.193.6 1. Table 4. 15 of which were domestic banks.477.1 Domestic Debt Securities Outstanding 215.430.. Thai Bond Dealing Centre.4 1.559.5 4.1 3.6 2. In 1996. accounted for 28 percent of the banking sector’s total assets. Competition from foreign banks was limited as they were not allowed to engage in full branch operations.0 339.564.5 6. The Banking System Until recently.360.5 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 4.3 546.825.2 2.390.0 3.485.5 4.6 6.372.268.

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

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

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

0 26.1 141.3 6.2 89.0 33.0 86.9 37.6 19.8 167. The club was considered the first organized secondary bond market in Thailand to serve as the wholesale market for debt securities.256 Corporate Governance and Finance in East Asia.3 29.3 13. The following year.9 329.1 6.0 — 26.4 7. this had climbed to B200.3 8.2 43.3 — — 3.8 31.1 107.6 billion.9 20.1 12.7 132.7 821.2 39. Total offshore debt offerings peaked in the run-up to the financial crisis. By 1995.5 55.1 — — 6.3 140. total offshore debt offerings had plunged by 68 percent to a mere B28.2 28.0 27.5 — — — 3.1 41.5 — 0.0 60.9 37.6 — — 0.5 138.0 333.5 10.7 — — 40.5 5.1 61. 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 59.7 0.3 — 14. .7 — — — — — — — 77. A sharp rise in unsecured offshore debt offerings can be noted all the way through 1996.6 — 0.0 7. The decline in total domestic debt offerings in 1996 can be ascribed to the increase in offshore convertible debts. II Table 4.4 — 26.3 46.4 57.4 — — — 1. then declined substantially in 1996 and 1997.0 — 5.1 55.3 22.7 0. by the end of 1997.4 110.8 55.8 47.0 — 5.5 — 39. BDC was established in November 1994 by 50 securities companies based on the provisions of the SEA of 1992. Vol.3 3. the year the crisis unraveled and the baht was floated.4 billion.7 5.7 7.2 57.5 37.1 10.9 0. The domestic debt market declined after 1994 because corporations could borrow offshore at lower costs. a surge attributed to capital inflows encouraged by high returns on Thai bonds.1 8.1 315.1 289.11 Offerings of Debt Securities.8 191.3 50.1 — — — 29. However.5 billion.1 21.7 5.3 46.7 28.2 — — 50.5 43.7 95.7 — — — — — 4.2 45.9 30.8 Source: Securities and Exchange Commission of Thailand and the Thai Bond Dealing Centre.5 — — 32.2 2.4 49. turnover value had reached B51.5 — — — — 1.1 121.7 90.0 281.9 5.9 40.8 2.7 538.4 — 9.0 17.0 0.0 5.

The proportion of accounts receivable also declined steadily. listed companies experienced liquidity problems with declining reserves of cash and marketable securities during the period 1990 to 1996 (Table 4. 4. Thailand’s publicly listed companies rely mainly on loans from commercial banks and financial institutions to finance their growth. There was also little change in the trend in retained earnings within the seven-year period. The overall trend is consistent with the decline in profitability observed in the analysis of corporate sector performance earlier. Companies in construction and property development seemed unable to generate internal funds.2 Patterns of Corporate Financing An examination of financing patterns among Thai companies listed in SET shows that on the asset side. From 1990 to 1996. In addition.12). steadily easing up between 1990 and 1996.4. cash balances. the use of debentures remains minimal even though the trend was generally upward until the 1997 crisis. a trend most apparent in the leap between 1991 and 1992. In the same year. Construction and property development industries tended to have high proportions of long-term loans and debentures. For the construction industry. Turnover fell further to B72. The closure of 58 finance companies affected the BDC significantly since half of its members were suspended as a result. Equity financing remains an important part of listed companies’ long-term financing. BDC was renamed “the Thai Bond Dealing Centre” following its status upgrade to a bond exchange. judging by their relatively low levels of retained earnings. these accounted for 33 percent of total liabilities. At lower than 5 percent of total liabilities. and marketable securities holdings.1 billion in 1998.Chapter 4: Thailand 257 compared with investment in equities. significant variations can be noted. In any case. The ratio of net working capital to total assets decreased from a peak of 31 percent in 1993 to 28 percent in 1996. turnover value plummeted to B106. these comprised 31 percent. Retained earnings accounted for about 30 percent of total equity financing. overall asset quality and liquidity of listed Thai companies deteriorated throughout the period. short-term loans accounted for more than 40 percent of total liabilities.2 billion as a result of the default of debentures due to the Asian crisis. with equity levels remaining high despite an increase in debt. The average for all industries was only 22 percent. they also had a relatively small proportion of equity and . while for the property development industry. Across industries. In 1997. Longterm loans accounted for about 20 percent of total liabilities.

0 100. The agribusiness industry relied more heavily on short-term loans at 56 percent of the industry’s total liabilities.2 35.3 14.0 1. Analysis of common-size statements by ownership concentration (based on the levels of top-five ownership concentration classified as high.9 0.2 43.5 9.6 2.6 100.8 3.6 14.7 0.2 15.7 14.0 100.5 1.8 6.9 49.8 14.1 2.8 9.9 17.7 7.6 0.9 18.2 3.2 43.0 2.3 6.2 2.9 3.7 36.9 14.7 1.6 36.6 18.8 34.6 11.9 14.0 100.8 19.0 12.0 10.4 49.1 17.5 1.0 100.9 38.9 6.9 17.6 51.1 5.4 14.4 7.8 21.258 Corporate Governance and Finance in East Asia.0 6.3 1.3 48.6 0.7 17.9 40.1 7.6 100.0 100.8 17.5 1.3 34.3 38.3 34.2 1.3 1.6 15.5 37.2 16.8 10.8 25.2 12.6 8.4 43.7 9. US.3 21.9 12.4 21.7 18.1 36.1 49.9 50.5 14.6 50.2 1.0 100. Printing and publishing companies had lower financial leverage than companies in other industries.0 100.3 25.3 49.9 14.4 8.0 10.2 1.9 43.5 11.6 13.6 6.9 14.4 48.8 37. The level of total liabilities for the group characterized by high ownership concentration .2 42.3 18.2 45.9 16.9 15.2 34.2 2. medium.6 0.7 16.2 2.7 15.6 38.8 9. were highly leveraged.4 17.4 6.0 100.0 51.8 35.0 13.9 6.2 22.1 18.2 17.0 48.0 14.8 8.6 12.8 46.0 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.3 2.0 100.0 100. II Table 4.8 37.8 1.7 52.3 17.7 16.5 0.5 9.4 2.6 0.7 50.8 20.6 21.13).4 49.0 100. and low) also underscores that companies with high ownership concentration had high levels of long-term loans (Table 4.2 16.6 10.6 22. compared with the 44 percent general average.9 2.3 14.0 100.2 17.2 2.0 100.5 43.3 12.0 15.8 7. 1990-1996 (percent) Item All Years 1990 1991 1992 1993 1994 1995 1996 2.2 17.1 50.3 18.9 14.0 100.3 50. Vol.0 7.12 Common-Size Statements for Companies Listed in SET.9 10.9 20.1 13.4 17.2 17.

0 14. US.3 1.3 35.5 percent for low ownership concentration companies.0 6.4 3.9 16.0 7.4 13.9 36.9 50.Chapter 4: Thailand 259 Table 4.7 12.3 16.13 Common-Size Statements of Public Companies by Ownership Concentration.8 13.6 0.1 18.6 14.3 1.3 8.0 16.9 21.7 19. For the high ownership concentration group.2 0.4 1.0 41.2 8.7 percent for medium ownership concentration companies and 49.5 18.6 100.6 15.8 37.2 14.0 Source: Pacific-Basin Capital Markets Database compiled by the University of Rhode Island.9 100.4 7.6 9.6 22. was 53 percent of total assets compared with 49.8 13.8 12.0 100. This is consistent with the observation that majority shareholders try to maintain their control by utilizing debt as a major source of funds.1 44.1 36.0 19.0 Low 1.0 100.5 100.4 50.6 47. .1 49.4 18. 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 37. common equity accounted for a smaller proportion of total assets (47 percent) than companies with lower ownership concentration.0 Medium 2.4 35.5 11.5 21.3 100.4 49.7 17.2 22.5 13.0 6.6 2.9 7.2 45. Companies with medium ownership concentration tended to have a higher proportion of short-term loans.1 53.2 11.9 0.9 2.

0 25. As a result.9 7.1 144.1 31. minimization of transaction and interest costs. thus rendering them more vulnerable.1 23. Table 4.4 51. The ratio of total debt to total assets increased from 50.8 51.4 5. bond issues overtook loans from commercial banks as the second preference.3 Source: Estimated from the Pacific-Basin Capital Markets Database compiled by the University of Rhode Island.6 7.4 44. these firms more easily increased their leverage.260 Corporate Governance and Finance in East Asia.0 28.4 12. bond issues.7 percent in 1996.7 12.2 35.7 11.4 139. 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. and rights issues. US. especially from 1994 to 1996.7 34. followed by bank loans.3 31.2 68. 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 8.0 145.7 5.5 52.7 34.1 16.0 50.7 12.2 49.9 63. II Results from the ADB survey reveal that Thai companies preferred to use reserves and retained earnings as their first choice of financing.14).8 5.7 28. 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. the choice of financing is determined by the company’s liquidity considerations.7 66.1 16.8 65.1 52. it would seem that firms with concentrated ownership and associated links to the banking system have easier access to debt financing.8 65.9 51.15.1 64.6 125.6 41.8 151.1 in 1996. Such deterioration of financial positions during the period was a common feature of listed companies. While further detailed investigations are necessary. and maintenance of the existing ownership structure.14 Financial Ratios of All Listed Firms.4 7.8 percent in 1990 to 52. The financing patterns indicate that companies with high ownership concentration were more highly leveraged than companies with medium and low concentration.7 in 1994 to 5. Generally. The TIE ratio declined from its peak of 7.6 138. .3 61. The direct relationship between the degree of leverage and the degree of ownership concentration is apparent in Table 4. however. More important. Vol.1 44.5 38.1 31. however. was the headlong deterioration of firms’ ability to meet their interest payment obligations. After the crisis.9 14.9 140.

debt-creating capital inflows rose to 65 percent in 1990. 4. The corporate sector contributed significantly to the crisis because of its rising levels of leverage.Chapter 4: Thailand 261 Table 4.3 42.1 High 6. The composition and term-structure of this debt. private debt accounted for 84. US. From only 34 percent in 1986.8 percent in 1986 to 52 percent in 1995.4 27.5 percent of external debt in 1996 (Table 4.9 percent in 1997.3 Source: Estimated from the Pacific-Basin Capital Markets Database compiled by the University of Rhode Island. 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 6.7 percent from 1991 to 1996. peaking in 1994 at 84 percent. is even more telling.5 126.8 49.4 52.4 63. unhedged foreign exchange liabilities.8 Medium 7. and a preponderance of short-term debt liabilities.5 percent between 1985 and 1990 to 8. such as direct equity and portfolio investment. however.5 148.1 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.8 29.5.4 percent to 46 percent during the same period.15 Financial Ratios of Listed Companies by Ownership Concentration. Nonbank private debt increased from 27.5 34.2 49.5 4. From 45 percent of total net capital movements in 1985.16).6 11.4 13. continued to slide from 1985 to 1997.8 14. . 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. on the other hand. Additionally. The proportion of external debt as a percentage of GDP consequently increased from 42. the proportion of short-term debt increased from 15.2 124. The proportion of nondebt-creating capital flows. Their average annual growth rate declined from 28.0 64.8 66.8 28. This decline was accompanied.2 percent in 1986 to 251.6 30.

9 43.8 0.9 100.9 1.5 16.8 3.3 3.9 10.6 52.6 Total 18.2 14.9 6.7 23.2 2. .6 7.7 10.3 0.0 21.1 Source: Bank of Thailand.1 0.6 1.5 14.2 0.6 Government Year Long-Term Short-Term 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 12.5 4.4 — — — — — — — 1.1 95.8 12.1 34.9 5.0 4.4 10.9 29.7 0.7 24.6 18.4 18.2 32.7 13.6 — 0.3 — — — — — — — 6.9 10.3 2.1 5.8 10.9 4.0 11.3 0.9 31.1 2.4 15.0 11.2 2.0 3.1 22.16 External Debt.8 3.3 105.1 0.3 0.7 2.1 0.5 1.9 7.8 108.7 20.1 64.8 31.3 20.3 10.9 3.7 109.3 0.7 1.4 3.2 0.9 11.8 13.1 12.9 0.1 0.3 0.9 6.0 8.5 19.1 23.3 0.Table 4. 1986-1999 ($ billion) Private Nonbank Long-Term Short-Term 3.9 35.3 0.3 0.5 12.2 10.2 0.0 Long-Term Short-Term BIBF Commercial Bank Long-Term Short-Term 0.0 6.0 13.3 37.4 5.1 30.5 12.9 13.4 2.2 2.3 12.3 16.2 15.9 3.0 0.3 7.3 3.9 1.5 4.

suggesting that serious investors have not returned to the market.360. nonfinancial companies also experienced severe liquidity problems as a result of the baht’s devaluation. Foreign investors retreated from the market. It hit a 10-year low in the second quarter of 1998. closures. At the end of 1994. After that.17). Similarly. (ii) the rise in the nonperforming loan (NPL) ratio and consequent tightening of credit even for viable firms. and (iii) bankruptcies. outstanding credit also declined throughout the second half of 1998. the number of newly registered companies dropped to a 10-year low in 1998. If lending rates remained high. exposing the companies to disaster when the baht started tumbling on 2 July 1997. large Thai companies had actively borrowed at low interest rates from foreign financial institutions. and drastic decline in the number and capital of newly registered companies.281 in December 1995 and to 831. the index declined to 1. according to the Bank of Thailand. The effects of the crisis were felt across all industry sectors. and poor business confidence on the other. reaching 45 percent of total outstanding credit in December. based on the three-month past due definition. . The severity of the impact of the crisis on the corporate sector was apparent from (i) the decline in the volume of public offerings.Chapter 4: Thailand 263 This shows that although banking and finance companies suffered most because of their short-term exposure. Aside from the problem of NPLs. Even before the crisis.6 in December 1996. Due in part to liquidity problems on the one hand. the numbers of bankruptcies and company closures reached all-time highs in 1998 (Table 4. banks would be recording more of such NPLs. the liquidity problems faced by the corporate sector are likely to continue for some time. foreign currency-denominated debts constituted 55 percent of their total debt portfolio. With easy access to foreign funds. The value of public offerings sank in 1997 to B56. The proportion of NPLs as a percentage of outstanding loans demonstrates the liquidity problem experienced by the corporate sector.6 billion from the 1996 level of B201 billion. On average. from its peak in 1995. Meanwhile. SET’s dismal performance is indicative of the extent of the setback suffered by the Thai capital market. 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. NPLs spiraled from 12 percent in the second quarter of 1997 to almost 40 percent in the third quarter of 1998. the SET Index stood at 1. Most of these foreign debts were not properly hedged. Trading volume has since been thin. leaving domestic investors with large capital losses. trading activity at SET had been on the downturn.

409 6.925 12.410 37.977 Source: Department of Commercial Registration.112 9.410 5. IMF required Thailand to meet a set of performance criteria and implement various restructuring measures.677 Bankrupted/Closed 2.797 4. 4.2 Responses to the Crisis Initially.17 Number of Newly Registered and Bankrupted/Closed Companies.080 9.105 4. the Government was left with no choice.6 in 1997. .264 Corporate Governance and Finance in East Asia.218 3. II Table 4.915 37.407 28.5. Vol.095 14. The increase of the P/E ratio in 1998 was mostly a result of a decrease in earnings for most listed companies. The IMF financial package was a credit facility of $17.792 7.2 billion for balance of payments support and buildup of the country’s reserves.224 4.334 4.201 24.288 35. The price-to-earnings (P/E) ratio deteriorated from 19. Thailand. the Thai Government was lukewarm to the idea of obtaining IMF assistance because of the requirements and conditions attached to the financial package.307 4.066 19.134 31. It also explains the higher dividend yield ratio. 1985-1999 Year 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 Newly Registered 10. The first Letter of Intent was cosigned by the Minister of Finance and the Governor of the Bank of Thailand on 14 August 1997.312 25.096 22. But when assistance from other sources did not materialize.052 36.695 3.933 25.5 at the end of 1994 to 12 in 1996 and further to 6. Ministry of Commerce.902 3. As part of the assistance package.777 11. A steady price decline over the past few years has dragged down the ratio of market price to book value.904 20.

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

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

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

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

with the majority of the debtors coming from the commerce. contributing to the unprecedented rise in the corporate sector’s bad debt. the mere threat of external control alters the incentives faced by managers and controlling shareholders significantly. the court had more than 80 cases for disposition. although since then. where bankruptcy procedures are swift and effective. personal consumption. Within three months. Equally important is the contribution of effective and reliable bankruptcy procedures for improved corporate governance. In particular. accounting for B1. The Bank of Thailand issued guidelines in 1998 encouraging financial institutions to specify their own policies. and procedures for debt restructuring. The reason is that bankruptcy law amendments appear to facilitate settlements outside the court. Another 77. only 7.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. Reforms in bankruptcy procedures should be seen not only in the context of crisis resolution. accounting for B1. as well as those that did not cooperate with CDRAC’s restructuring process.8 trillion had been completed. This point is crucial because compared with . In addition. 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. Another 5 percent of cases (B70 billion) are undergoing restructuring negotiations. will be settled by the courts. Commercial banks initiated 74 percent of these cases. By October 2000. methods.1 trillion of outstanding credit. In response. The first bankruptcy court in Thailand opened on 18 June 1999. 322. CDRAC’s target debtors comprised 10.764 debt restructuring cases involving B1.068 cases involving B475 billion are undergoing restructuring. the Government introduced debt restructuring-related measures to help resolve bad debts.147 cases (B1. Some 82 percent of these cases have been successfully restructured.6 trillion. Considerable progress has been achieved on this front. Corporate Debt Restructuring and Bankruptcy The 1997 crisis led to a severe liquidity problem in the economy.6 trillion) have agreed to cooperate with CDRAC’s restructuring process. and manufacturing sectors. As of November 2000. Cases for which negotiations were unsuccessful.1 trillion in outstanding credit. the number of cases has abated. However.767 cases involving outstanding credit of B2.

Weak bankruptcy procedures were part and parcel of the perverse set of incentives that led firms to build up unsustainable levels of debt. Vol. despite the weakness of their disciplinary powers. Examination of corporate ownership. behavior. Financial information from listed companies will also soon be required to conform to International Accounting Standards.6 4. Reforms through SET and Improved Disclosure The financial crisis prompted SET to introduce a range of improvements to its operation and regulation. 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 . the Government protected certain corporate sectors through tariffs and regulation. In the next three decades. 4. and promoted key industries through incentives. The exchange has already required that listed companies’ quarterly reports be directly comparable with annual statements.270 Corporate Governance and Finance in East Asia. Philippines. 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 1997.6. and Recommendations Summary and Conclusions This study has provided an overview of the corporate sector and governance in Thailand. It required listed companies to establish their own audit committees by the end of 1999. II Malaysia. and even Indonesia. The study covers the period 1985 to 1996. and performance during this period helps understand the causes of the crisis. Conclusions.1 Summary. 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. to push companies to harmonize their accounting with international standards. Such improvements in disclosure standards are part of the efforts of SET and SEC. the Thai Government managed its economy with the corporate sector as the main engine of growth and development. For this reason. Emphasis was on the structure of corporate governance and patterns of corporate ownership and financing of publicly listed companies. The banking industry played a key role in the early stages of economic development because it represented the only avenue for funding Thai corporations.

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

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

. The Government has been moving to amend the Public Company Act of 1992 to increase minority shareholders’ protection in this regard. before the crisis. Certain provisions. For instance. It appears that founding family members use debt extensively to finance investments because they want to preserve control of their firms. The second issue involves the protection of shareholder rights. making them vulnerable to economic shocks. The third issue involves creating external market controls through better regulation and development of the capital markets. the Public Company Act of 1992 allows shareholders to act only when they hold a minimum proportion of shareholdings. However. 4.6. The ownership structure of Thai listed companies also significantly affects company behavior. The first issue involves the development of a comprehensive supervisory framework and the strengthening of the capacity of supervisory agencies. the main challenge is in protecting minority shareholders from the possibility of expropriation by the majority. Consequently. an aim that can be achieved mostly through legal reforms. but is significantly related to financing patterns. For example. because there are shared interests between the controlling shareholders and key management personnel. Ownership concentration appears to have little impact on corporate profit performance. because there is no separation between ownership and management. Rather. moreover. In this third area. the high ownership concentration of many listed Thai companies inhibits the effectiveness of these provisions. In view of this. posed formidable barriers in the minority shareholders’ exercise of their rights. the degree of ownership concentration has a statistically significant positive relationship to the degree of financial leverage. key reforms that will strengthen the regulation of financial institutions. Specifically. 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. laws did not provide minority shareholders sufficient safeguards in cases of transactions involving companies where the controlling shareholders had related interests.Chapter 4: Thailand 273 minority shareholders’ participation in decision making and in initiatives against management conform to international standards. these companies tend to become overleveraged. the main challenge is not how the board can control management to maximize shareholder value.

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

regulators must increase transparency and step up enforcement. the Government can change the shareholding limit for controlling shareholders. transparency. The first recommendation involves the repeal of current legislation to allow minority shareholders to have greater influence over management decision making. SEC is exploring the possibility of amending the law toward this direction. Both SET and SEC are taking an active stance in improving the transparency and efficiency of Thai capital markets. The Ministry of Commerce is conducting a study on proposed amendments to the Public Company Act of 1992. and a prohibition of connected transactions by directors or management. requiring cumulative voting for the election of directors. and . SEC has been trying to lay the foundations of good corporate governance by espousing fairness. there has been much progress in this area. But weaknesses in accounting and auditing practices have been inhibiting the development of capital markets. increasing penalties for directors engaged in misconduct. accountability. The second recommendation is to dilute ownership concentration through the use of regulatory power. Since the Asian financial crisis. Because these holding companies control a number of large public companies in Thailand.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. Some of the legal reforms under consideration concern settling conflictof-interest situations with significant effects on minority shareholders. they should be monitored and regulated. The situation prompts two specific recommendations. The current ownership structure leads to ineffective corporate governance and inadequate protection of minority shareholders. 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. 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. Through an amendment in the Public Company Act. To ensure a level playing field. This move is expected to be unpopular among founding family members and original owners. The slow improvement in the legal framework has likewise obstructed progress in this area. This includes prescribing ways to empower minority shareholders without disrupting the company’s operations. 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.

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

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

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